In an ideal investment world, we would achieve a sky-high rate of return and incur absolutely zero risk. Unfortunately, in the real world, just as there are no “free lunches,” there is no such thing as a no-risk investment. Low risk assets such as bonds, certificates of deposit, and money markets produce relatively low returns. Assets that can potentially provide a higher return are usually riskier.
With Higher Potential Return Comes Higher Risk
Assets such as common stocks have the potential for higher returns, but come with a risk of loss. A stock (a fractional ownership in a business) can go down in value, or even become utterly worthless if the company goes out of business.
The only reason an investor would want to take on the risk of investing in stocks would be for a higher potential return. A logical and appropriate investment goal is to achieve the maximum possible return for an appropriate level of risk. Said another way, we want to get the best rate of return for a tolerable amount of risk, or maximize our risk-adjusted return.
Types Of Investment Risk
There are two general types of investment risk:
- Systematic risk is the risk that the general market will swing up or down. Examples of this would be the boom in the late-90’s (when everything seemed to be going up) or the crash of 1987 (when everything seemed to crash down).
- Non-systematic risk is the risk that ABC, Inc. will go out of business or XYZ, Inc. will be a “home run”. Examples would be Google’s recent success (initially offered at $100/share and skyrocketed to over $500/share within three years) and Citigroup’s recent woes (its stock has decreased in value by over 50% in the last year).
Dealing with Risk
The best way to deal with systematic risk is with a long investment horizon. In other words, if you only plan to invest for a few years, the stock market is very risky. The longer you’re in, the higher the likelihood of gain, and the lower the likelihood of loss—at least based on past history. My personal rule of thumb is a minimum of ten years. That doesn’t guarantee you a profit, but it puts the odds in your favor.
This isn’t a rule of thumb that I just pulled out of thin air. In the last fifty years, there have been ZERO 10-year periods which resulted in a loss in the S&P 500 Index (an index of 500 large, mostly US companies, representing approximately 75% of the US equities market). In fact, the worst 10-year period was a 12.3% gain for 1965 – 1974. (Source: Mutual of America) Other stock market indexes have behaved in a similar manner.
Non-systematic risk is also called “diversifiable risk”. The good news is that non-systematic risk can be virtually eliminated by diversification and “Asset Allocation”. The greater the number of stocks you own (and the more diverse your holdings) the greater the chance that you will have some winners and some losers, thus increasing the potential for the winners and losers to average out. Since we know that historically, in the long-run, the stock market moves generally in an upward direction, offsetting the winners and the losers should produce a positive result.
Asset Allocation At A Glance
The key to diversification (and thus reducing your risk) is allocating your portfolio among the possible asset classes. This process is referred to as “Asset Allocation”, and involves three crucial steps.
Step One: Determine The Appropriate Level Of Risk For You:
What is an appropriate level of risk? That depends upon many factors, including your age, income, net worth, and tax bracket, how soon you will need to access any income or principal, and your relative willingness to accept risk in exchange for potential profit. There are various methods of quantifying this risk level for each investor.
Step Two: Allocate Your Portfolio Among The Available Asset Classes:
Once the appropriate level of risk is determined, the next step is to create an asset allocation model commensurate with that risk level. Depending upon your investment advisor, there will be approximately ten different models ranging from capital preservation (the most conservative model) all the way to ultra-aggressive growth (the highest risk model). Your portfolio will be divided among bonds (or other assets that are considered equally safe) and stocks, based upon the specific model that applies to you.
[Note: Bonds are chosen largely by credit rating, stated interest rate, whether the interest is taxable or tax-free, and the number of years to maturity.]
There are various ways to classify stocks:
- Domestic companies, foreign companies in established economies, or foreign companies in emerging markets
- Large, mid-size, or small companies
- Growth or value companies
If you look at all these classifications, you’ll see that there are 18 possible combinations (e.g. domestic/large/growth stocks or foreign/small/value stocks) before we even look at specific industries or sectors. Most asset allocations include some stocks from each of these combinations. The specifics are determined partly by your acceptable level of risk (which was determined in step one).
A second, equally important aim of the “asset allocation” is to mix asset classes whose market performances do not correlate well with each other. The idea is that when some of the portfolio is going down, another part may be going up, so the wild swings in value are smoothed out. Since risk is often measured by how wildly a portfolio swings in value (technically called its “standard deviation”), the smaller the swings in value, the smaller is your risk.
Step Three: Implementation—Purchasing The Assets For Each Category In The Asset Allocation:
There are four ways to purchase securities to implement your asset allocation model.
1. Pick and choose a combination of individual securities. You can do this yourself or with the advice of a stock broker.
2. Hire a professional money manager (in each asset class) to select the individual securities for that class. This is often implemented in a “manager of managers” program in which a professional institution selects, monitors, and replaces (if necessary) the managers.
3. Purchase actively managed mutual funds for each asset class in the allocation. This can be done directly or in a “manager of managers” format, often called a “wrap account”.
4. Purchase passive mutual funds designed to reflect the performance of each asset class within the asset allocation. Again, this can be implemented directly or through a “manager of managers” type arrangement.
Purchasing Individual Securities
Many people who “play the stock market” claim they do really well. In reality, there is no way for an individual investor to measure this in a systematic or scientific way. Further, these “self reporting” individuals rarely consider, calculate, or tell people of the risk they have taken to achieve their return. Also, there is a tendency to talk about the winners and forget about the losers. Information about working with stock brokers purchasing individual securities is also not available on a scientific or verifiable basis.
My thinking on this matter is that picking individual stocks should be confined to your “play money”. Play money is an amount of money which if lost, would not impact your financial security. As a hobby, it might be fun. As a wealth building strategy, it’s at the very bottom of my list.
Professional Money Managers And Institutional Stock Pickers
Money managers come in two flavors—mutual fund managers and individual managers. They essentially have the same goal—picking the winners among a particular asset class, while avoiding the losers. This includes determining when to purchase a particular stock and when to sell it.
Note: Individual managers and “manager of manager” programs usually have higher minimum investment requirements than do mutual funds. For this reason, depending on the amount invested, it may be easier to properly diversify with mutual funds.
One huge disadvantage of purchasing mutual fund shares is that you may be indirectly purchasing shares with an existing taxable gain (or loss). When the mutual fund sells a stock with a gain, that gain is taxed to you, even though you made no profit, or maybe even incurred a loss. This means that at the end of the year, you might receive an IRS form 1099, requiring you to pay taxes on gains that you may never have actually made!
Contrarily, one of the advantages of individual managers is that they purchase the individual securities for your account, so your tax basis in those securities is what you actually paid for them.
Now, one would think that teams of financial experts, organized for the sole purpose of managing stock portfolios (with many research and information resources available to them), would consistently “beat the market” or substantially outperform the benchmark (index) for that asset class.
Shockingly, conventional thinking is wrong on this one—and the objective evidence proves it. In fact, there has been much written about this issue. One recent article, “The Difficulty of Selecting Superior Mutual Fund Performance” by Thomas Pl. McGulgan, CFP®, appeared in the February 2006 issue of FPA Journal. In this article, the author studied a universe of Large Cap and Mid Cap mutual funds over a twenty year period, with ten rolling 10-year periods (1965-1974, 1966-1975, 1967-1976, etc.).
His conclusion was that only 20% of money managers (approximately) equaled or exceeded their benchmarks in any period. This means that the money managers underperformed their index approximately 80% of the time! Further, a manager’s success in one period was not at all predictive of that manager’s success or failure in any other period.
In other words, money managers, with all the research and analytical tools available to them, consistently under-performed a “passive” index strategy.
That’s bad enough, but it keeps getting worse. There are also the matters of taxes, fees, and expenses—all possibly eating away at your potential gain.
Avoidable Taxes: Realized Short-Term Capital Gain
Money managers buy and sell securities. That’s what they’re supposed to do. The problem is that these managers might turn over 50%, 100%, or even more of the securities in the portfolio each year (their “turnover ratio”). When a security is sold, the gain is taxed in the year of the sale.
If a security has been held for more than a year and then sold, your profit is taxed at the rate for long-term capital gains, currently a maximum of 15%. Otherwise, that profit is taxed as a short-term capital gain at ordinary income tax rates, currently as high as 35%.
The difference between turning the portfolio over every year, and holding for the long haul can be the difference between a 35% tax on your profit every year versus a maximum of 15% far in the future. This is a tremendous argument in favor of a passive, long-term investment strategy.
Fees & Expenses of The Managers
There are two types of expenses in mutual funds. The first consists of the fees and expenses of the manager for managing the money, doing the research, and executing the trades. This is called the “expense ratio”. If you do not use a financial professional and invest only in no-load funds, you still pay this, but it is all you pay (except possibly a “12-b-1” or distribution fee). These fees and expenses can vary greatly by manager or type of fund. However, using 1.5% as an average for actively managed equity funds is a good rule of thumb.
Fees & Expenses For Professional Advice
If you are working through a broker or a financial planner, you will pay a fee and/or a commission for advice and ongoing counsel regarding your investment portfolio and other financial matters. This cost can consist of an up-front sales charge, an ongoing fee (either built into the fund, or separately stated), a back-end fee, or some combination. The value of this advice to you varies wildly from professional to professional, and is somewhat subjective. In my opinion, this type of relationship should entitle you to the following:
- Getting to know you, your circumstances, wants, needs, goals, and risk propensities.
- Educating you on the choices you have and their relative advantages and disadvantages to you.
- Assisting you in choosing the strategy and asset allocation that best fits your circumstances.
- Providing you with ongoing counsel, including helping you avoid panic selling in a market downturn and inappropriate purchases when the market is rising.
This last point is vital. The average investor in any market-driven investment may enjoy a lower return over a period of time than the actual market performance. The reason for this is that people tend to want to buy when the market has already started to move up, and sell after the market has already started to move down—thus buying high and selling low. In other words, they try to “time the market” (more on this below). In my opinion, a good professional advisor might “earn back” all of the fee, or even more, just by helping you avoid this situation, along with providing you other advice and planning services.
Whether you are using actively managed funds or indexing using index funds or ETF’s (which are discussed below), the decision to do it yourself or use a professional is a separate matter. I believe that the value added by a quality professional is worth the fee, but I’m biased. That’s part of what I do for a living. Of course, financial professionals vary as greatly as do other professionals like doctors, lawyers, and engineers. If you are using one, make sure that his or her education, training, experience, reputation, philosophy, and service orientation are consistent with your needs and goals.
Timing The Market Just Doesn’t Work
Most investors seek to get into the market at the “right time” and get out at the “right time”. The problem is that there is absolutely no way to determine the “right time” in advance! Just a few days can make a huge difference. Here’s why market timing is ineffective:
Examine a hypothetical investment of $10,000 in the S&P 500 from 1997 through 2006. This initial investment would have grown to $19,147 (ignoring all taxes and investment costs). That even includes the 2-year bear market from August of 2000 to September of 2002, when the S&P 500 lost 40% of its value. (Source: American Funds)
Now let’s say that by trying to time the market, you missed just a few of the best days out of the 3,650 days during this period. Your results would be as follows: (Source: American Funds)
In fact, studies show that over 90% of a portfolio’s success is determined by asset allocation and less than 2% by market timing. In fact, investment selection is just under 5% of the result, thus reinforcing the argument in favor of passive management. (Source: Financial Analysis Journal, May/June 1991)
Indexing with Exchange Traded Funds (ETF’s)…
The opposite of active money management is passive money management or “indexing”. This consists of buying one or more securities that replicate a particular index, such as the S&P 500. This can be easily accomplished by purchasing index mutual funds, or a special kind of closed end index mutual fund called an Exchange Traded Fund, or ETF. On average, the expense ratios of index funds are about 1% less than those of actively managed funds, and those of Index ETF’s are even less. The expense ratios of Index ETFs range from .09% to .5%, however most are towards the lower end of that range.
In addition to having lower expense ratios, ETF’s facilitate tax minimization. There is very little “activity” inside an ETF, so there is very little tax consequence until an ETF is sold. Thus, most of the gain is deferred from year to year. If the ETF share is held for over one year, any gain is long-term capital gain. In addition, just like other shares of stock, you can sell your highest basis shares first, further minimizing current taxation.
So, Is Indexing Better Than Active Management?
If money managers under-perform the appropriate index approximately 80% of the time, and charge higher fees, and generate higher tax liability, doesn’t it make more sense to “buy the index” by buying the corresponding ETF? Opinions vary, but in my opinion it’s a “No-Brainer”. Whenever anybody tells me otherwise, I always ask for their long term data, showing that their money management system consistently creates better after-tax, risk-adjusted, net returns than the appropriate index. So far, no one ever has met this challenge.
A Pure Mathematical Hypothetical
As mentioned above, an index fund will have at least a 1% lower expense ratio and will also facilitate tax minimization. How big an affect can the expense and tax drag have on a portfolio, over time?
Example: Let’s look at two portfolios, A and B. We’ll use a hypothetical level 12% gross annual rate of return (the actual number used is irrelevant) before any fees or taxes. We will assume that all taxes are paid annually with no deferral.
Portfolio A represents an investment in a passive (index) strategy. All expenses and fees combined are assumed to be 1.0%. Taxes are assumed to be 1.5% for a total of 2.8%. Portfolio B represents an investment with an active investment strategy. The expenses are assumed to be an additional 1%, and the taxes are assumed to be an additional 1%. We’ll start with an initial investment of $100,000.
Twenty years from now portfolio A will be worth $128,345 (45%) more, without even considering possible deferral of long-term capital gains tax!
Of course no real portfolio will perform exactly this way. This is a hypothetical, mathematical exercise designed to demonstrate the profound effect of an extra 1% of expense and an extra 1% of tax. This exercise dramatically shows the potential advantage of a passive, low cost, tax-effective strategy compared to active management.
Monitoring and Rebalancing Your Asset Allocation
Each asset class performs somewhat independently of the others. That’s one of the reasons we have more than one. It is important that the proportions of each asset class remain relatively close to the allocation. Therefore, your portfolio should be re-adjusted periodically to maintain its original allocation among those classes.
The high-performing asset classes from the prior period should be trimmed and the proceeds added to the under-performing classes. By acting in this manner, you are buying low, and selling high—our precise goal. The best tax result is obtained if this is performed every year plus one day, insuring that any realized gain is taxed as long-term capital gain, at the lower rate.
If your needs, goals, or circumstances change, the entire allocation should be reviewed, and adjusted if necessary to suit your new situation. Again, this should be done on an annual basis in order to minimize the tax effect of repositioning your portfolio.
Final Conclusion:
On average, stock market returns are higher than the returns you’ll get on safe assets, but equity investments are subject to higher risk. Non-systematic risk is virtually eliminated with diversification, and systematic risk is dealt with (not eliminated) with a long investment horizon. Since only 20% of money managers equal or exceed their benchmarks in any period, and there is no consistency in which 20% that is from period to period, passive investment makes more sense than does active management. Further, active management costs more than passive strategies AND generates higher income tax liability. That hits me as paying higher fees and higher taxes for a worse result.
For all these reasons, I believe equity investments are best made in a diversified passive strategy (such as with Index ETF’s) and managed for the long haul.