David Hultstrom | March 12, 2019
WHEN WALL STREET builds a better mousetrap, investors are generally the mouse. Want to avoid getting caught by the Street’s costly, fad-driven selling machine? Here are a dozen principles that have served me well as I’ve helped folks manage their money:
- Accept that markets are generally efficient. This means that, at any given moment, individual securities are priced correctly and incurring additional costs in hopes of finding a mispricing is wasteful—though apparent mispricings will often seem obvious in retrospect. In short, active management does not consistently add value through either security selection or market timing, which is why my firm invests almost exclusively in index funds and other passively managed vehicles.
- Despite the market’s overall efficiency, there are a few anomalies that appear to be both pervasive (they exist in most markets) and persistent (they exist most of the time). The most significant of these anomalies are value and momentum, though there’s evidence of others as well. We tilt portfolios toward factors such as value and momentum that appear to reward investors over time.
- It also appears that, while stocks of smaller companies don’t outperform larger companies, once you adjust for the greater risk involved, it does appear that factor tilts such as value and momentum may be larger among smaller companies—which is why we tilt portfolios toward smaller companies.
- The aforementioned tilts to various factors lead to tracking error. What this means is that the portfolios we build won’t exactly track well-known indexes, such as the S&P 500. Over time, we expect our portfolios to outpace widely followed benchmarks, though this isn’t guaranteed, and it can sometimes take a while for this to happen.
- Both diversification and cost control are crucial. We use mutual funds and exchange-traded funds to gain exposure to various asset classes, because they can offer broad exposure, low costs and low turnover.
- Diversification across risky asset classes, such as owning both U.S. and foreign stocks, is beneficial in prosperous times, because it ensures exposure to whatever area is currently doing well. But during market turmoil, the benefit of this diversification largely vanishes, because these risky asset classes all decline together. Diversification still works, however—but it’s the diversification that comes from holding safe assets, such as investment grade bonds. If everything in your portfolio is going up, you aren’t diversified.
- From peak to trough, U.S. stocks declined between 45% and 55% in 1973-74, 2000-02 and 2007-09. During poor markets, investors should expect the risky portion of their portfolios to decline by roughly half. For example, an investor with a $1 million portfolio that’s 60% stocks-40% bonds should periodically experience a decline to $700,000. This is the necessary pain to achieve the higher returns that are expected from risky assets. If stocks did not occasionally experience losses, they would cease to be priced attractively enough to generate superior returns. As financial advisors, it’s our job to make sure client portfolios are positioned at an appropriate level of risk, and that our clients neither increase their risk-taking when things look rosy (e.g. 2006) nor decrease it when the outlook is frightening (e.g. 2008).
- For international exposure, we invest in smaller companies and emerging markets companies, rather than large companies in developed countries. The reason: Small-cap international and emerging markets offer much greater diversification benefit to an investor who already owns large U.S. companies.
- For additional diversification, we generally invest a portion of client portfolios in alternative investments, such as real estate investment trusts, high-yield (junk) bonds, master limited partnerships and hedge-fund-like investments. While it would be imprudent to place a large percentage of a portfolio in these investments, they can—in smaller amounts—improve a portfolio’s risk-return profile.
- Depending on clients’ inflation exposure outside of their portfolio—such as whether any pension they have is inflation-adjusted or not, and how much of their debt is long-term and fixed-rate—a significant portion of their bond portfolio may be allocated to inflation-indexed Treasury bonds.
- While we review portfolios and the market environment frequently, we make changes very infrequently. Yes, it makes everyone feel better to “do something,” rather than simply stay the course. But turnover has costs and generally doesn’t add value. As Warren Buffett has said, “Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.” He also stated, “Lethargy, bordering on sloth, should remain the cornerstone of an investment style.” Once a client’s portfolio is invested appropriately, we will not do much trading, aside from opportunistic tax-loss harvesting. This is a sign of prudence and patience, not inattention. We do not trade simply to appear busy.
- If we manage multiple household accounts for a family, we will manage them as one portfolio to increase trading efficiency, tax efficiency and so on. Thus, when viewed in isolation, individual accounts may have what appears to be an “odd” investment allocation—but it is indeed appropriate when viewed in the context of the family’s overall portfolio and life circumstances.
David Hultstrom is the president of Financial Architects LLC in Woodstock, Georgia. To read more of David’s writing, check out his blog.