Advisor Blog

A recent New York Times article by Tara Siegel Barnard titled "Why Panic? A couple's Nest Egg Better Left Alone" discusses the experience of a typical retired couple during the market plunge of 2008-2009.  It makes a number of good points and it is particularly interesting to us because the retired couple in the article are the parents of a long-time friend and colleague at DFA, Mark Gochnour.  Mark was the guy who happened to answer the phone when I first called DFA a dozen or so years ago. 

Among other things, the article discusses the importance of disciplined savings, choosing a portfolio with characteristics that fit within your risk tolerance, and being able to draw income from stable high-quality bond funds during periods of stock market stress.  At a conference a couple of weeks ago, I got to see how some planners have referred to this as the portfolio's "liquidity ratio", to borrow a term from balance sheet analysis.  Essentially, this is how many years of expenses can be covered without selling equity positions in the portfolio.  For retirees that choose to work with us for financial planning/wealth management, this is typically many years - more than enough time for the stock market to recover from even a serious decline. 

“It is really the simple things that I call the blocking and tackling of investing,” Mr. Gochnour said. “And you have to stay disciplined and stick with your plan, not only in good times but in more challenging times as well."  As the author points out, it also helps to turn off the television.

I read a great article last week that was written by an active manager about different portfolio management strategies and his opinions about them.  It was particularly interesting to me to read what he thought about what is, essentially, our strategy:

A passive investment strategy has been promoted as an intelligent strategy for two reasons. The first is that the strategy acknowledges that markets are relatively efficient and that it's very difficult to consistently price assets more effectively than the market mechanism. The second reason flows from the first: The significant costs associated with asset value analysis and the active management of an investment portfolio (management fees, transaction costs, etc.) make it even harder to outperform the returns obtained by passively accepting market prices.

He's exactly right, so far - and, he goes on to say:

Contrary to popular belief, the fatal flaw with this paradigm is not that it assumes that markets are relatively efficient. If anything, this assumption constitutes a great advantage of this investment strategy. For it would be quite absurd indeed to assume that the average individual (or portfolio manager) will consistently be able to price assets more effectively than the market mechanism. And it is a mathematical impossibility for the majority of people to outperform the overall market.

So, now he has admitted that the underlying methodology is correct, but let's examine his conclusion:

The problem with the passive investment strategy derives from an entirely different aspect of human nature that is distinct from analytical capacity: emotions. Constant exposure to markets means that passive investors will be subjected to intermittent episodes of hair-raising volatility. And the fact of the matter is that very few have the sort of emotional makeup that would allow them to sustain such a strategy over time.

The herding instinct is powerful. Very few individuals are emotionally equipped to stay the course and hold their positions -- much less buy -- when everyone around them is selling in a panic. The strategy of passive investing may be theoretically sound on its own terms. However, in practice, it tends to fail because most people are emotionally unable to sustain it.

Fortunately, our experience has been quite different. Why?  I think that there are several reasons, but the most important is that we use a process of measuring a client's risk tolerance and constructing a portfolio that adds high quality short duration global fixed income to the equity allocation.  This very effectively dampens the portfolio volatility to a level that the client should be able to tolerate.  In addition, we do our best to educate clients about what they should expect from capital market behavior.  And, looking back over the past 10 years, our portfolios have achieved outstanding risk adjusted rates of return for clients that stayed the course - even through two major rough spots in the market (2000-2002 and 2007-2009).