Our Investment Philosophy – Summer 2011
Let’s be blunt: Over the past thirty years we have studied the conventional wisdom, we have put it to the test, and we have rejected it. Our time-tested investment philosophy is based upon reason and academic science, and has proven superior to conventional wisdom. There are four basic tenets to our philosophy:
1) Returns Future investment returns are unknown and past returns are useless
as a criteria in investment selection. Conventional wisdom tells us that a skilled financial expert who is in tune with the economy and markets can develop a useful market outlook and can have some success in predicting future returns of stocks. Clients expect their advisors to make forecasts, and most advisors oblige. Many advisors trade portfolios in anticipation of an expected bull or bear market, and make stock selections based upon company analysis. Unfortunately, the data shows that stock pickers are not successful any more than random chance would explain. Therefore in our opinion forecasting and timing of markets is a folly. In summary, we have no market outlook, and we pride ourselves on that fact. In other words, we do not know the future price direction or magnitude of any security or market. We console ourselves with the fact that neither does anyone else! Through close attention to risks, costs, and taxes we attempt to capture full market returns.
2) Risks Certain investment risks add to expected long run returns, others do not.
Conventional wisdom says that the more risk an investor takes, the higher the expected return. We disagree. Although it is true that some risks tend to increase returns on average, there are others that do not, and at times the higher risks cause permanent loss. For example, the risks associated with investing in single issue stocks (versus baskets of securities such as mutual funds and ETFs) do not add to expected returns, and can cause permanent and complete loss. The risks associated with market timing and leverage do not add to expected returns. However, we have identified three risks that do indeed add to expected returns. For more information, ask your advisor about the three factor model.
3) Costs Certain investment costs are worthwhile, others are a waste of money. Those costs correlate with lower returns.
Most advisors and their clients utilize active managers. Active managers trade based upon stock analysis, which is quite expensive and erodes returns due to high transactions costs and increased expense ratios. Active managers who time the market tend to maintain high cash positions from time to time. A high cash position erodes returns over long time periods as a result of an opportunity cost called cash drag. Other advisors charge commissions for the purchase and sale of securities. Commissions create harmful conflicts of interest between advisors and their clients, and in some cases (especially in regard to some annuities, life insurance, and limited partnerships) commissions can be extremely damaging. We believe that it makes sense to pay a fair fee for ongoing financial planning advice if the fee is transparent and the advice is objective. We believe that high costs are a detriment to investors, and every effort should be made to eliminate costs which do not pay for a commensurate benefit.
4) Taxes Certain income tax strategies are worthwhile, others are not.
Higher turnover correlates with higher taxes and reduced after-tax returns. Many advisors and their clients do not take advantage of the tax laws to the fullest extent possible. For example, many do not take full advantage of Roth IRA conversion and recharacterization rules and are unaware of the very attractive tax rules surrounding Health Savings Accounts. Some accountants tend to focus completely upon the current tax return, ignoring the strategies that are designed to reduce taxes in the future. Many clients have not achieved tax balance in their portfolios, thus exposing themselves to high tax bracket risk. Finally, many are paying high taxes because of high turnover in their actively managed mutual funds. The turnover in our portfolios is much lower than that of active portfolios, and lower even than in most index funds. We believe that investment decisions should be made only after the tax impacts have been considered, and that a careful evaluation of the various tax strategies is beneficial.