April 24, 2017
Low Fees and Diversification Do Not Protect from Major Loss
We believe traditional wealth management services are often expensive for the service provided. Historically, wealth managers have invested client money in a diversified portfolio of stocks and bonds using a buy-and-hold approach. Apart from periodic rebalancing and an occasional position change, client portfolios are held through bull and bear market cycles.
The popularity of low-fee index funds and the rise of the robo-advisor (computer based advisor) evolved from the traditional wealth management model. A buy-and-hold approach to investing is relatively simple and tax efficient. The strategy is easy to implement and manage. Many investors feel comfortable managing their own money with a buy-and-hold approach using low fee funds such as Vanguard or using the allocation advice of a simple robo-advisor Internet interface.
With the buy-and-hold approach, one of the few variables the investor can control is the fee level. Hence the increasing popularity of low-cost alternatives such as indexed funds and robo-advisor created exchange traded fund (ETF) portfolios.
What investors struggle to control are their emotions, especially during periods of euphoria and duress.
Two Major Problems with Buy-and-Hold
There are two significant problems with buy-and-hold. The first is it presumes an investor has a long-term investment horizon (20+ years). A buy-and-hold asset allocation plan takes no action to avoid an upcoming bear market. Let’s not forget that low-cost S&P 500 index funds lost 55% of their value in the last bear market and a 60/40 diversified stock/bond portfolio lost 41% of its value. The corrective action of buy-and-hold is to wait it out. Unfortunately, this can take years. Waiting to recover may not overlay well with life events including college tuition, home purchase, retirement, etc.
The second problem is investors have emotions. When we see our life savings cut in half, we can become scared that we are going to lose it all. When investors are unable to tolerate the discomfort of extreme paper loss, they often sell at the low. Conversely, when the market is in a strong bull trend, we tend to work up the courage to buy closer to the top than the bottom. For many, our emotions prevent us from being true to a long-term buy-and-hold approach.
The chart below shows the annualized returns of the average investor compared to stocks, bonds, REITs, a 60/40 equity/bond portfolio, a 40/60 equity bond portfolio, gold and inflation. Over the twenty-year period from 1996 – 2015, the average investor underperformed all of these asset classes and inflation. It is likely emotions played a significant part in the underperformance of the average investor.
The chart shows the average investor is not following a buy-and-hold plan either because of time or emotions or both. If they were on plan, their returns would fall in the range of bonds to stocks (i.e., 5.3% to 8.2% annually versus 2.1% realized).
What Do You Believe?
Do you believe the markets are perfectly efficient? Do you believe it is impossible to time the market? Do you believe stocks are equally attractive when the Price/Earnings (P/E) multiple of the market is 30 versus 10? Do you believe stocks are equally attractive when the economy is entering a recession versus emerging from a recession?
If your intuition says that owning stocks no matter what is probably not the optimal way to invest, we agree with you. So do the people who award the Nobel Prize. Robert Shiller won the prize in 2013 for showing that the price of stocks does matter and can be used to predict future stock action. History also agrees with you as we have never experienced a greater than -40% stock market drawdown in the past century without a simultaneous economic recession.
A Better Way
Even at a low fee and using diversified index securities, buy-and-hold is not working for the average investor. Potentially in the late innings of a multi-year bull run, adopting a buy-and-hold approach for the next eight years may prove to be a significant source of emotional and financial stress.
It makes sense to have at least some of your money managed by experienced market professionals who specialize in non-emotions based risk mitigation to reduce your exposures to avoid major loss during bearish periods. The preservation of capital and the avoidance of loss is often well worth the fee. A good investment advisor may lower your expense of investing with reduced commission rates and institutional share class funds which offer the industry’s lowest possible costs. As Vanguard states in their Advisor’s Alpha report, advisor’s most significant opportunity to add value may present themselves intermittently over the years, and often during periods of either market duress or euphoria.
In a complex, constantly evolving world, avoiding major bear market periods is a complex task. At some level, all information inputs must be considered and run through a filter of decades of experience. Financial and economic mathematical relationships need to be understood in an applied manner. The nuts and bolts of how markets work needs to be understood. Often, taking no action can be just as valuable as taking action. Emotions must be kept in check. It is a full-time endeavor.
This newsletter and our wealth management services are devoted to the task of building and protecting client wealth using rules-based, non-emotional tools and our experience. As the bull market extends and stock valuations rise, the importance of being prepared for the eventual negative trend change also rises. Please give us a call if you would like to have a free consultation with a principal of our firm.
We invite you to call or email anytime if you have questions about how we can help you with your wealth management. Please give us a call at (415) 249-6337 or email us at firstname.lastname@example.org to learn more.
Stock Market Dashboard
This commentary and a sampling of previous editions are available as PDFs:
4/21/2017: Low Fees and Diversification Do Not Protect from Major Loss
4/14/2017: “Housing IS the Business Cycle”
4/7/2017: Bond Risk Rising with Rates
3/31/2017: Exclusive Stock Market, Higher Stock Price
3/24/2017: Indications of a Positive Stock Market Future
3/17/2017: Hallelujah, Reflation!
3/10/2017: Small Cap Stock Divergence
3/3/2017: Velocity Pivot Good for Stocks
2/24/2017: How Safe Are The Banks
2/17/2017: Climbing A Wall of Worry
2/10/2017: Value Shopper – Europe on Sale
2/3/2017: What, Me Worry
1/27/2017: Extraordinary Earnings Louder Than Trump
1/20/2017: It’s Not All About Trump
12/30/2016: Predicting the Future -2017
12/2/2016: Trade What Is, Not What You Think It Should Be – 2017 Outlook