Advisor Blog

We frequently explain to clients that all investment portfolio designs are based on a set of tradeoffs.  Brad Steiman, Vice President at DFA, in his Northern Exposure article series does very good job of explaining one of the considerations in portfolio design in the following article.

Many aspects of life require careful consideration and balancing of the tradeoffs that arise from competing demands. For example, a common lifestyle tradeoff is working longer hours versus spending more time with your family. The competing demands within this decision are the income necessary to provide a suitable quality of life for your family versus the immeasurable benefits of quality time with your family. There is no right answer, but most people understand the tradeoff and attempt to find the balance that is right for them.

Successful investing and financial planning also require balancing tradeoffs. For example, a common investment tradeoff is that of risk and return. One of the competing demands is preservation of capital versus preservation of purchasing power. The former may allow for a better night's sleep during periods of heightened uncertainty and corresponding volatility, but the latter helps ensure you'll have a comfortable bed in the future when accounting for rising prices from inflation. Once again, there is no right answer, no "optimal" solution. Understanding the tradeoffs between preserving capital and preserving purchasing power will help investors find the balance that is right for them. This balance will depend on their definition of risk and attitude towards it.

1968 was a turbulent year in the US and around the world.  In January, the war in Vietnam exploded with the start of the Tet Offensive.  Martin Luther King, Jr. was killed in Memphis and violence broke out in cities across the country.  Just two months later, Robert Kennedy was assassinated after announcing his victory in the California primary.  The democratic national convention was marred by violent clashes between police and war protesters.  Around the world, people - particularly youth and students, were demonstrating for change. 

Much like the shepherds and wise men during the first Christmas, people around the world turned their attention toward the heavens as Christmas approached that year.  Commander Frank Borman, Command Module Pilot Jim Lovell and Lunar Module Pilot William Anders launched aboard Apollo 8 on a mission to become the first humans to orbit the Moon in preparation for the big event of Apollo 11. They entered lunar orbit on Christmas Eve.

The Apollo crew sent Christmas greetings and live images back to Earth and read from the book of Genesis.  It is estimated that more than one billion people watched the historic broadcast or listened on the radio. The Apollo 8 crewmembers ended their history-making journey when they splashed down in the Pacific Ocean on December 27.

Here is the original broadcast:

It is said that those who ignore history are doomed to repeat it.  We should also learn from history in a contextual sense, as Jim Parker mentioned in our previous article.  It can be difficult to appreciate what we have without knowing where we've come from.  The lessons of 1968 are relevant today.  We live in a world with far less poverty and far more freedom, at least partially as a result of the struggles of the past and the technologies that were developed as we strived to meet the challenge of putting a man on the moon.  If we are dissatisfied with the status quo, as many of us are, then we have the freedom and the opportunity to effect change. 

From all of us to our valued clients and friends, best wishes for a safe and happy holiday season however you may choose to celebrate it.  Merry Christmas.  Happy Hanakkuh.  Happy Festivus!  And, best wishes for a New Year filled with peace, hope and prosperity.

The book entitled “The Quest For Alpha” by Larry E. Swedroe presents comprehensive evidence documenting the futility of active portfolio management by examining the quest for money managers that are capable of delivering alpha¹.  Swedroe references academic studies on mutual funds, pension plans, hedge funds, private equity/venture capital, individual investors, and behavioral finance.  He demonstrates that markets are indeed highly efficient and makes the ultimate conclusion that the only winning move is not to play the game.  Girolamo Cardana who was a sixteenth-century physician, mathematician, and quintessential Renaissance man made the same conclusion for gambling (which is quite similar to active management) when he said “The greatest advantage from gambling comes from not playing at all.”

Referenced in the book, Philip E. Tetlock, a professor of psychology, business and political science at the University of California (Berkeley) found that the so-called experts who make prediction their business – appearing as experts on television and talk radio, being quoted in the press, etc. – are no better than the proverbial chimps throwing darts.  His research indicates that it makes no difference whether forecasters are PhDs, economists, political scientists, journalists, or historians; whether they had policy experience or access to classified information; or whether they had logged many or few years of experience in their chosen line of work.  The only predictor of accuracy was fame, which was negatively correlated with accuracy.  The most famous made the worst forecasts.  All of these so-called experts seem to fall victim to hindsight and/or confirmation bias.

I strongly encourage you to read the book for the deeper discussions and supporting research that examines the dismal results of active management in its multiple forms.

1. If an asset's return is even higher than the risk adjusted return, that asset is said to have "positive alpha" or "abnormal returns". Investors are constantly seeking investments that have higher alpha.

I picked up Larry Swedroe's excellent new book, The Quest for Alpha - The Holy Grail of Investing, at the local bookstore last week.  Swedroe is the Director of Research at The Buckingham Family of Financial Services and has previously written several very good books on investing.  Outside of academic journals, this book offers the most compelling and complete evidence-based case for passive investment that I have found. 

Most arguments against active management use data from mutual funds to make the point that the vast majority of actively managed funds underperform their benchmarks.  That's important, but what about the evidence from pension plans, hedge funds, private equity, individual investors, and behavioral finance?  Swedroe covers each topic and cites numerous academic studies in each area.

"The search for alpha is dominated by the "wizards of advertising" - and, for relatively sophisticated investors, by the "wizards of overconfidence." -- John A. Haslem, Professor Emeritus of Finance, University of Maryland

"...a clear and concise message that is supported by decades of research" -- Dr. William Reichenstein, CFA, Professor of Finance, Baylor University

If you've read The Investment Answer, this book is an excellent next step in your education process - it's listed in the library section of our website where you can click on the picture of the book's cover to purchase it through Amazon. We've discussed the evidence based on mutual funds previously, but in subsequent articles, we'll examine the evidence from other sources presented here.

Dalbar is an independent research firm that evaluates mutual fund investor returns on an annual basis.  The research uses data from the Investment Company Institute (ICI), Standard and Poor's and Barclays Capital Index Products to compare mutual fund investor returns to an appropriate set of benchmarks.  The annual Quantitative Analysis of Investor Behavior (QAIB) covers the time period ending December 31, 2010.

For the 17th year in a row, the study shows that both equity and fixed income investors underperformed the broad indices.  For 2010, equity investors trailed the S&P 500 by almost 1.5% and fixed income investors underperformed the Barclays Aggregate bond index by more than 3.5%.

Why do average investors underperform broad indices by such significant amounts?  The primary reason is investor behavior - reacting to market movements and news results in never staying invested long enough to derive the benefits of a long-term strategy.  Retail investors, in particular, tend to abandon investing at the most inopportune times, often in response to bad news or market corrections.

Behavioral finance experts have identified psychological factors that help explain why investors often make buy and sell decisions that contradict best practices.  These include:

• Loss aversion – expecting high returns with low risk.  Searching for investments that don’t exist, resulting in taking no action or selling at an imprudent time.

In order to achieve desirable results, investors must manage the behaviors that destroy long-term success.  Working with an advisor can often be helpful in this regard.  It is also important to understand your risk tolerance and construct a portfolio that does not exceed the level of volatility that you are comfortable with.  Taking excessive risk often leads to decisions to exit the market at exactly the wrong time.