Investment Philosophy

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 investment philosophy is based upon reason and academic science. 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, but at Financial Plan we do not. 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 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! Read more about the efficient markets hypothesis.

*In S&P’s latest scorecard, active managers trailed nearly across the board, regardless of the types of stocks they invest in. In 16 of 17 fund categories, average five-year returns trailed those of comparable S&P market indexes.

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 may lead to increased returns, 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 also do not add to risk adjusted expected returns. However, we utilize various dimensions that do indeed add to returns.   To learn about these dimensions of return, read more about the three factor model.

3) Costs:

Certain investment costs are worthwhile, others are a waste of money.  Higher costs correlate with lower returns.

Active managers trade based upon stock analysis, which can be quite expensive and may erode 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 may erode returns over long time periods, and creates an opportunity cost called cash drag. Read more about active versus passive management. Other financial strategies involve charging commissions for the purchase and sale of securities. Commissions can sometimes create harmful conflicts of interest between advisors and their clients, and in some cases (especially in regard to annuities, life insurance, and limited partnerships) commissions can be extremely damaging. Read more about commisioned security sales versus fee based advice. 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.

Investors today 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  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. Some investors have not achieved tax balance in their portfolios, thus exposing themselves to high tax bracket risk. Finally, some are paying high taxes because of high turnover in their traditionally managed mutual funds. The turnover in our selected domestic equity funds is much lower than that of tradtional funds.*

To learn more, read about why we partner with DFA.  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.

*IRRC Institute conducted a study evaluating the turnover of traditional long only equity managers between June of 2006 and June of 2009.  Within the entire sample of 991 equity strategies, the average annual turnover was 72%.  John Bogle,  the founder of Vanguard funds, published the turnover of  the Vanguard 500 Index fund over that same time period. The turnover rate was under 7%; less than one – tenth the turnover of the traditional funds.  DFA publishes the turnover rate of our core domestic equity holding  DFA Core Equity 2  (DFQTX).  As of October 31, 2010 the turnover rate was 7%, and it has been in single digits in every year since it’s inception.