Is Passive Investing Right for You?

Posted on August 7, 2013 by Dr. David Edward Marcinko MBA MEd CMP™

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On the “Buy low and Sell high” Strategy 

By Rick Kahler CFP® http://www.KahlerFinancial.com

Rick Kahler CFP“Buy low and sell high.” That was my simple approach when I was a smart young investment advisor. I poured over a company’s balance sheet, earnings statements, and forecasted returns. Then I bought those companies that were bargains and waited for my gains to roll in. More times than not, they did—eventually.

The problem came with the “not” and “eventually.” A majority of my picks did go up in value, but the minority that were “nots” still lost enough to have a negative impact on my bottom line. Even more frustrating, some of my “nots” turned into gains “eventually” after I sold them.

My investment returns were similar to findings from Dalbar, Inc., a financial services research firm. Dalbar’s studies have shown that average active investors barely beat inflation over the long term. They significantly underperform investors who put their money in an index fund of stocks and leave it alone.

So much for my early investment brilliance! Over the past 40 years, I’ve learned that with every passing year I know less than I thought I did the year before. I’ve proven to myself I have no idea where any market is going tomorrow, next month, next year, or in the next 10 years.

This awareness has led me to become increasingly passive in my investments. In passive investing, rather than trying to time the buying and selling of winners and losers, you instead buy a representative sample of the entire market. This is possible in any market: bonds, stocks, real estate investment trusts, or commodities. You simply buy mutual funds and exchange-traded funds (ETF’s) called index funds.

Benefits

The two biggest benefits of passive investing are cost and diversification.

Costs

Index funds have incredibly low costs, with annual fees as low as 0.1%. Contrast that with the average equity fund that costs 1.5%, fifteen times more. According to research, 97% of active mutual fund managers don’t beat the index over 20 years. Even the 3% who do must beat the index by more than the 1.5% fee they charge, in order for their investors to come out ahead.

Diversification

The smaller number of stocks owned – the more my fortunes are tied to those few companies. It’s the old adage, “don’t put all your eggs in one basket.” By owning index funds, I own hundreds or thousands of securities. While I will never hit a home run, I also will never strike out. My returns will be “average.” Investing may be one of the few professions where being average puts you in the 97th percentile of all investment managers.

The NaySayers

Not all of my peers agree with this philosophy. Many very smart investment advisors jumped off the passive investing bandwagon after 2008 and returned to tactical asset allocation, which is another name for timing the markets.

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Harold’ Strategy

A noted investment advisor, Harold Evensky MBA CFP® of Evensky & Katz, addressed this issue at a conference last year. After the 2008 crisis, his firm hired researchers to evaluate whether they could find any tactical strategies that would have avoided the crisis. They found some that, in hindsight, would have worked. Yet he didn’t feel those strategies could be comfortably applied looking forward. Instead, the firm decided to add a 20% allocation to non-correlated alternative investments, something I’ve done since the late 90’s. In other words, they increased their clients’ diversification.

Assessment

The bottom line is that passive investing actually gives you more control. It allows you to focus on reducing costs and taxes, the aspects of investing you can control. It frees you from trying to beat the market and worrying over what you can’t control.

Conclusion

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Asset Allocation Portfolio Decisions

Posted on August 21, 2008 by Dr. David Edward Marcinko MBA MEd CMP™

A Historical Perspective for Physicians

[By Jeffery S. Coons; PhD, CFP®]

Managing Principal-Manning & Napier Advisors, Inc

Dr. Jeff Coons

To a large extent, your investment objectives are driven by your investment time horizon and the needs for cash that may arise from now until then. Once these objectives have been set, you must decide how to allocate assets in pursuit of your goals.

Establishing the appropriate asset allocation for a physician’s [any investor] portfolio is widely considered the most important factor in determining whether or not you meet your investment objectives. In fact, academic studies have determined that more than 90% of a portfolio’s return can be attributed to the asset allocation decision.

The following will provide a historical perspective on the risks which need to be balanced when making the asset allocation decision, and the resulting implications regarding the way this important decision is made by investors today.

Growth versus Capital Preservation Balance

The asset allocation decision (i.e., identifying an appropriate mix between different types of investments, such as stocks, bonds and cash) is the primary tool available to manage risk for your portfolio.  The goal of any asset allocation should be to provide a level of diversification for the portfolio, while also balancing the goals of growth and preservation of capital required to meet your objectives.

Allocation Decisions

How do investment professionals make asset allocation decisions? 

One way is a passive approach, in which a set mix of stocks, bonds and cash is maintained based on a historical risk/return tradeoff.  The alternative is an active approach, in which the expected tradeoff between risk and return for the asset classes is based upon the current market and economic environment.

Can any single mix of stocks, bonds and cash achieve your needs in every market environment that may arise over your investment time frame? If such a mix exists, then it is reasonable for you to maintain that particular passive asset allocation. 

On the other hand, if no single mix exists that will certainly meet your objectives over your time frame then some judgment must be made regarding the best mix for you on a forward-looking basis. This case implies that some form of active decision making is required when determining your portfolio’s asset allocation.  To answer this question, let’s consider the historical tradeoff between the pursuit of growth and the need to preserve capital over various investment time frames.

The Need for Growth

Our first conclusion is that you have to be willing to commit a majority of your assets to stocks to pursue capital growth, but even an equity-oriented portfolio is not guaranteed to meet your growth goals over a long-term time period. 

To provide some historical perspective using Ibbotson data, a mix of 50% stocks and 50% bonds provided an 8.9% annualized return from 1926-1998, but failed to surpass what many consider to be a modest return of 8.0% in approximately 49% of the rolling ten and twenty year periods over this time.  In fact, a portfolio of 100% stocks provided an 11.2% annualized return, but failed to surpass 8.0% in almost 1 of every 3 ten-year periods and more than 1 of every 4 twenty-year periods.

This data also reflects the difficulty through history of consistently achieving an 8.0% rate even with an aggressive mix of stocks and bonds.  In this time of high flying stock markets, it is important to keep in mind that taking more risk is no guarantee of higher returns.  However, what is clear from this data is the importance of allowing a manager the flexibility to achieve meaningful exposure to stocks in attractive market environments to pursue the goal of long-term capital growth.

The Need for Capital Preservation

Of course, there is a clear risk of long-term declines in an equity-oriented investment approach, especially for a portfolio dealing with interim cash needs (e.g., a defined benefit plan with ongoing benefit payments, a defined contribution plan with participants having different dates until retirement, or an endowment with ongoing withdrawal needs).

An illustration of the sustained losses that may result from heavy allocations to stocks is the fact that 1 of every 4 one year periods and 1 of every 10 five-year periods resulted in a loss for a portfolio of 100% stocks.  Even the 50% stock and 50% bond portfolio has seen losses in almost 1 of every 5 one-year periods and more than 1 of every 25 five-year periods over the past 73 years of available data.  Thus, it is clear that no single mix of investments is likely to meet all of the needs for a portfolio in every market environment.

The Need for Active Management of Risk

The analysis to this point has discussed the need to balance long-term growth and preservation of capital, and it has summarized the tradeoff between these conflicting goals. There remains, however, an important issue regarding the appropriate stock exposure for you in the current  environment.  Even though returns over the long-term may have been strong for an all-stock portfolio, your returns will be very much dependent on the market conditions at the start of the investment period.

To set up this discussion, consider the risk of failing to achieve a target return of 5%, 8% or 10% in the S&P 500 over the last 44 years.

 

           FAILURE RATES OF TARGET RETURNS

               IN STOCKS [1955-1998]

 

 

 

 

1 Year

 

3 Years

 

5 Years

 

10 Years

 

% Periods with Less Than a 5% Return:

 

 

32%

 

 

15%

 

 

17%

 

 

13%

 

% Periods with Less Than an 8% Return

 

 

38%

 

 

29%

 

 

27%

 

 

32%

 

% Periods with Less Than a 10% Return

 

 

41%

 

 

41%

 

 

41%

 

 

44%

 

Taking the risk of failing to achieve your return goals one step further, does this risk increase with an expensive stock market?  Looking at several different stock valuation measures, the U.S. stock market is currently at historically extreme levels.  As an example, the S&P Industrials price-to-sales ratio was 2.0 at the end of 1998.  High valuation measures are often associated with periods of high volatility in stocks, and a price-to-sales ratio greater than 1.0 (i.e., ½ of current level) has historically been considered high.

 

FAILURE OF STOCKS TO MEET GOALS WHEN S&P INDUSTRIALS PRICE-TO-SALES RATIO IS GREATER THAN 1.0 [1955-1998]

 

 

 

 

1 Year

 

3 Years

 

5 Years

 

10 Years

 

% Periods with Less Than a 5% Return:

 

 

42%

 

 

26%

 

 

24%

 

 

45%

 

% Periods with Less Than an 8% Return

 

 

47%

 

 

55%

 

 

55%

 

 

79%

 

% Periods with Less Than a 10% Return

 

 

49%

 

 

71%

 

 

71%

 

 

97%

 

The data in the table above indicates that high market valuations significantly increase the risk of failing to achieve even moderate return goals.  In all, there were 50 quarters from 1955 to 1998 in which the S&P Industrials price-to-sales ratio was over the 1.0.  During these periods, strong returns were possible, but less likely to be sustained than when there are less optimistic valuations in the market. 

While this does not mean that a major correction or bear market will necessarily occur, the risk of failing to meet your goals is clearly higher than average based upon this data.  Because the market is a discounting mechanism, the positive economic environment we see today may become over discounted, resulting in moderate returns until fundamentals catch up with the optimism.

Assessment

Clearly, history tells us that no single mix of assets may provide both long-term capital growth and stability of market values in all market and economic conditions.

Far too often, physician investors and investment professionals take a passive approach to asset allocation, relying on past average returns and correlations to determine asset allocation without a full understanding of the long periods of time in history over which there are significant deviations from long-term averages.

Conclusion

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