Navigating the Tempest of Markets
In a world of information overload, the key question is, “Where can I get good, ‘non conflicted’ advice?” Our firm, Prosperity Planners, was established to attempt to address this most fundamental premise. For without clear confidence in appropriate expertise the investor is rudder less in the tempest of the markets. There is a capital market rate of return to be achieved but the noise generated by market participants and the sales culture that surrounds this multi-billion dollar industry obscures and confuses the evidence of how this return can be obtained.
There is a wealth of data available. Evidence of the source of investment return has been researched by academics over the decades. This evidence shows how portfolio construction can capture the return of markets most efficiently. Unfortunately, there is a business imperative of the professional investment community in selling something that has a far lower chance of success.
The vast bulk of money to be made by the investment community relies on convincing the consumer of the superior forecasting and analysis capabilities of their particular firm. Empirical research has shown that stock selection and market timing techniques contribute a negligible amount to the total return of a broadly based investment portfolio over time and in many cases detracts from overall portfolio performance. Research conducted by Brinson, Hood and Singer in a well documented study showed that over 94% of the long-term return of broadly based investment portfolios are attributable to the asset allocation decision.[1] The remaining 6% was attributable to stock picking and market timing. This means that if the long term portfolio return was 10% p.a., a full 9.4% would be attributable to the asset class decision and only 0.6 % on average, would be added by selecting individual shares and buying in and selling out of a market periodically as a way of adding value. The costs paid to a fund manager involved in this exercise would be greater than any value added. However, stock picking and market timing the very areas that generate the bulk of the revenue for the investment industry so the truth is not allowed to get in the way of the sale. The myth is reinforced that in selecting the right firm all your investment worries will be over. The search for El Dorado lives on.
Most advice being given to individuals today has little to do with the principles of investment theory and makes very little economic sense. There is much more focus on marketing hype rather than prudent investment advice as the ‘cheerleaders’ sprout whatever is needed to ‘close the sale.’ This has resulted in public skepticism of the investment community and disappointment with advisers or brokers who had a convincing story that ultimately was unable to be realized. Investors in the current environment are looking for a better way. When prospective clients come to our firm, we explain the principles of asset class investing. They find the logic of the ideas incredibly compelling in contrast to so much of the hype that they have been confronted with in the past. In many cases we are talking about peoples life savings, so they should be willing to spend the time learning to understand the concepts of how markets really work. Amazingly, some people spend more time planning their annual holiday than their life’s finances!
The fact is that the vast majority of brokers and fund managers don’t beat a simple buy-and-hold approach to investing. Those that do are part of a randomly changing group that only marginally outperforms over time. These outliers are no more in number than would naturally occur by chance and often the level of risk taken to achieve these results is unacceptably high. “This may sound hard to believe, but it is totally consistent with the ideas of modern finance. An efficiently functioning capital market immediately incorporates all available information into securities prices. The market price of any publicly traded asset reflects the collective estimate of its value by all market participants. We are not suggesting that all market prices are “correct,” only that they reflect all known information. An investment manager can only beat the market if he or she can consistently identify mispriced securities and take advantage of the mispricing after the costs of trading. Given the speed and size of information flow today, this seems unlikely. Historical evidence confirms how difficult it is, for professionals and amateurs alike, to beat the market.”[2]
In contrast to the hype generated by attempts to out-predict the market, asset class investing is a method of managing money that is evidence based, proven and well documented. It does not rely on forecasting the future or consistently out-predicting every other analyst involved in assessing the market. It provides a systematic approach that allows a high degree of confidence in the outcome of the process. Warren Buffett in his 1972 forward to the Benjamin Graham classic, “The Intelligent Investor” stated; “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”[3]
These few words encapsulate the essence of what financial planning should be about. The discipline to ‘stay the course’ can only be achieved with the evidence provided by solid academic research.
Asset class investing is best described as a system where a portfolio is constructed that can reliably deliver the returns of a group of specific asset classes. Each asset class is a number of securities that have common risk and return characteristics. The portfolio is constructed by purchasing a large sample of the securities in the asset class in order to replicate the performance of that class. No attempt is made to forecast or identify undervalued or overvalued securities. They are simply included if they meet the asset class parameters and excluded if they do not. It is the combination of the various asset classes that will determine the risk and return of the overall portfolio. With a proper frame of reference, a well-informed investor can confidently develop an appropriate asset allocation strategy with the guidance of his or her investment adviser. Over time, the asset allocation decisions will be the primary determinant of a portfolio’s volatility/return characteristics.[4]
Prosperity Planners has the objective of providing the framework so that you will be able to discern the difference between good strategy and so much of the speculation that passes for investment advice today. Measurement against predetermined benchmarks is important. Knowledge of the random noise that impacts upon portfolios in the short term is also crucial to the successful execution of a well-constructed strategy. Academic researchers have been uncovering an enormous amount of evidence going back to before the 1960’s that fund managers have not added enough value over time to overcome the drag of their fees. The average investor has fared far worse than even the fund managers’ mediocre results over time due to the impact of buying into particular investments when they are high and selling them when they are low. This is often as a consequence of not having confidence in the long-term strategy or not having a strategy at all. In the absence of an alternative, the overriding determinant of where to invest is often the immediate past performance of any particular investment.
It is no coincidence that the easiest investment for the broker or securities salesperson to sell is the one that has been performing best in the preceding period. Inevitably, we become victims of our immediate past experience as we buy high, get disillusioned as the investment regresses to the mean and sell to transfer to another investment, which has been recently doing well while our choice has languished. Usually, this is just in time for our new choice to have its’ turn on the sidelines.
Those institutions that do outperform for a period of time inevitably come back to the pack unless that out-performance can be attributed to priced risk factors which could have been accessed at far lower cost using an asset class strategy. For most fund managers, there is no consistency in their results. There is a random pattern to the charts of past performance with the vast bulk of inflows going to an institution or market sector after it has had a period of relative out performance. We have seen examples of this in Australia in recent years with fund managers that have each had periods of seemingly unassailable out-performance for a period. This is usually followed by a corresponding period of substandard results as conditions change leaving the investor disillusioned and looking for an alternative.
The experience of many individual shareholders who have failed to match the market return, despite their far greater exposure to stock specific risk than a broadly diversified portfolio, is to blame their broker for poor stock selection without realizing the futility of the exercise in the first place. They believe the solution lies in finding a better broker. Many are blissfully unaware of the risks they are taking. They rarely compare the total performance of their portfolio relative to the market as a whole and are often unaware of their poor relative performance. Some are like the gambler who only remembers the wins at the track but conveniently forgets the loses. During a rising or ‘bull’ market when the ‘rising tide lifts all ships’, share clubs spring up and there is a sense that investment is easy and fun. Interest begins to flag when losses start to accumulate during a prolonged downturn. Nothing substantial is learnt about the nature of investment markets and a belief is usually formed that share investment is speculative and dangerous. With no known alternative, the retail investor often retreats to cash just at the time when market prices are at their lowest and value is most apparent.
Benjamin Graham uses a precise formulation to differentiate between investment and speculation. His description has stood the test of time. “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”[5] Often the unsuspecting public are led into purchases that they think are investments when they are in effect, speculations.
A large proportion of the profit that is generated for providing investment services is sourced from speculative pursuits and enticements using relatively short-term recent performance to encourage participation. It requires an enormous amount of intellectual honesty for an investment professional to acknowledge the futility of so much of the investment industry’s activities. The evidence is available but ignored by the majority of participants for commercial reasons. It is frightening to acknowledge that a career can be built on such a false premise. However, the discovery of the truth and overwhelming evidence to support that truth carries a moral imperative that compels investment professionals to address these issues once they become aware of them.
[1] Brinson, Gary P., Brian D. Singer, and Gilbert L. Hood. 1991 “Determinants of Portfolio Performance 2: An Update,” Financial Analysts Journal, May-June 1991, pp40-48
[2] Bowen, John J. and Daniel C. Goldie 1998. “The Prudent Investor’s Guide to Beating Wall Street at Its Own Game” Mc Graw Hill p3
[3] Graham,Benjamin. 1973. “The Intelligent Investor” Fourth Revised Edition, Harper Business 1973 p vii
[4] Gibson, Roger C. 2000. “Asset Allocation, Balancing Financial Risk,” Third Edition, Mc Graw Hill p3
[5] Graham, Benjamin, 1973. “The Intelligent Investor” Fourth Revised Edition, Harper Business 1973 p 1