S&P 500 Index Annual Returns (2008 to 2018)

As you can see in the chart above, prior to 2018 the last time we ended the year worse than we started it was 2008, when the market dropped -37.0% in the midst of the financial crisis.

In fact, the run from 2009 through 2017 matches the nine year economic boom of the 1990s and the two stretches are the longest of their kind dating back to 1926.

During a period of record growth, it’s easy to forget that stocks can, and do, go down. Often, the market moves with astonishing velocity, catching the vast majority of investors by surprise (like it did in the fourth quarter of last year when the S&P 500 index dipped -13.5%).

It’s for this very reason that the single most important decision we make as investors is our asset allocation (i.e. the ratio of stocks vs bonds). More than anything else, this decision is the best way to align our risk profile with the potential for decline in our portfolio.

However, even for the few of investors who get this right, a bear market can still be an extremely challenging time.

And since we don’t know in advance when volatility may come knocking, it’s a good idea to be prepared well before the next market decline takes hold.

To help bring this point home, let’s look at the three general phases that individual investors go through on their path to, and through, retirement and how best to respond:

Accumulators (Young and Mid-Career Investors)

How to Respond

• Ignore the headlines proclaiming the world is ending
• Avoid the temptation to sell. Remain invested. Rebalance and tax loss harvest according to your plan.
• Keep saving. Increase your contributions if you can.

Here’s a simple fact: A bad bear market when you’re a young investor is essentially meaningless in the grand scheme of things.

It probably won’t feel like this when it happens, but a 30%, 40%, or even 50% decline when you’ve got $25,000 invested will be nothing more than a blip on the radar by the time you retire.

In reality, lower stock prices are actually a very good thing if you’re actively contributing to your investment accounts.

Lower prices mean that you get to buy more shares for the same dollar investment than you could before. In turn, owning more shares means that your portfolio will compound even faster in dollar terms as the market recovers.

Ultimately, if you’re a freshly minted college graduate or you’ve only been in the workforce for a few years, the amount you contribute matters far more than short-term performance.

For folks in their 30s and 40s, the middle of your career means higher earnings and an even greater ability to save. By this time the hope is that you can consistently put away a large percentage of your income every year, while also satisfying your short-term goals.

Accordingly, your bear market mindset should also be centered around the opportunity to acquire even more ownership in the world’s companies and to do so at a bargain, sometimes even fire sale, prices.

The reality that a bad stock market is actually good for accumulation-phase investors is one of the greatest ironies in all of personal finance. When you find yourself in the middle of this kind of opportunity, don’t let it pass you by.

Near- and Semi-Retirees (Protectors)

How to Respond

• Regularly review and update your financial plan
• Ensure your asset allocation is aligned with your plan and risk profile
• If necessary, implement a pre-determined alternative to get back on track

If you’ve got five years or less to retirement, you’ve probably already done the bulk of your savings. Certainly the hope would be to continue contributing according to your plan, but now the focus really changes.

Whereas early in your career the amount you put away typically far outpaced how much your portfolio grew in any given year, now the reverse is often true.

For example, even a modest 4% return produces an $80,000 gain for an investor with $2 million saved. That’s more than four times the maximum 401(k) contribution for 2019 of $19,000.

There’s simply more dollars at work.

This fact pattern means that it’s critically important to review your financial plan, ideally well in advance of a market decline.

The primary goal should be to refine your retirement projections and revise your asset allocation so that you’re only taking as much risk as is absolutely necessary for your plan to succeed.

Simply put, while a stock-heavy portfolio might be appropriate for some investors during this stage, most of us are not in a position to handle a 50% decline with retirement just a few years away.

It’s also important to discuss the “what-ifs” and to stress test your plan using scenario-analysis and Monte Carlo simulation.

Having a good plan in place before market disruption means you’ll be well-positioned to handle all but the most extreme sequence of events without forgoing your opportunity to retire.

Accordingly, the primary response to a bear market in this phase is to review and update your plan to determine whether any changes are required. If you need to work a little longer or consider trimming your vacation budget a bit, now is the time to figure that out.

Don’t put yourself in the position of quitting your job without a proper plan even if you have a seven figure portfolio. $1 million doesn’t go nearly as far as some investors would like to think.

Retirees (Distributors)

How to Respond

• Review your withdrawal rate and your retirement plan at least annually
• If your plan requires it, temporarily reduce your withdrawals until the market recovers
• Defer large expenditures that would require an outsized distribution from your portfolio

By the time you’ve reached retirement, the game plan is usually pretty clear: don’t run out of money.

Hopefully you’ve saved enough that your asset allocation only requires a modest weighting in stocks in order to satisfy your goals.

You’ve also lived through numerous business and market cycles so you’ve seen stocks go up and down countless times.

Thus, you might assume that even a bad couple of years isn’t the end of the world and you can just to “sit tight” like you have before.

While avoiding the temptation to get out of the market is generally good advice, retirees face an acute risk that other investors do not as a result of the following realities:

• Since you’re not working, you may be heavily (or entirely) dependent on your portfolio for income.
• Taking large withdrawals during a bear market can mean that you’re forced to sell investments at depressed prices.
• While eliminating stock market risk might sound appealing, doing so can actually have a devastating effect on your portfolio’s ability to survive your lifetime.

The above fact pattern means that retirees need to be particularly careful in the years immediately before, during, and after their retirement date.

The combination of discontinued employment, a severe market decline, and withdrawals that exacerbate the decline of your portfolio is what is known as “the perfect storm of retirement”

When all of these factors hit at once, the storm can sometimes be bad enough to capsize your “retirement boat” unless you take immediate corrective action.

Often this means temporarily reducing your portfolio withdrawals or deferring things like home improvements or vacations. For some retirees it means that part-time work may need to become a part of the conversation.

Whatever the case is, it’s far better to attack a situation like this head on, rather than burying your head in the sand. The facts are the facts regardless of when you decide to assess the damage.

Hopefully, with a sound plan and the right stock/bond mix, you’ll be in better shape than you thought. However, even the best plans are rarely “set it and forget it.” To be successful, you still might need to make some adjustments to confidently stay on track.

Closing Thoughts

As a financial planner, one of the things I focus on with clients is making sure they have the proper expectations for risk and return in their portfolio.

Part of that responsibility means constantly reminding folks about the other side of the investment coin. In other words, when markets are down, we stress the importance of sticking to our plan and prioritizing what we can control.

Conversely, when markets are good, like they are now, I probably sound like a Debbie Downer. Markets are hitting new record highs nearly every day and I’m talking about how to handle the next 2008.

Sadly, most investors won’t plan ahead and will find themselves in the middle of a bear market without any clue as to how to respond. If you’re reading this in 2019, hopefully you’ll take action so you can be the exception to that rule.

The post How to Respond During the Next Market Decline appeared first on Wealth Engineers.

Undoubtedly most of America was surprised by the outcome of Tuesday’s presidential election. For some “surprised” is an understatement of course. Their feelings are probably better described with words like shocked, stunned, or outraged.

For others, the surprise was welcomed. Given the polling leading up to election night, millions likely cast their vote fully expecting their candidate to lose only to wake up to a stunning victory.

Regardless of your political views, the sun did rise on Wednesday morning. Incredibly, it also followed suit by rising on Thursday and on Friday as well.

However, it’s undoubtedly true that the election of a political unknown results in a lot of uncertainty. At the same time, many others would argue that putting a career politician in the White House wouldn’t be good either.

Ultimately, most Americans agree that the government status quo hasn’t worked and many were desperate for a new direction. For some that meant Bernie Sanders. For others, the choice was Donald Trump.

Don’t Let Your Politics Decide Your Portfolio Strategy

The purpose of my discussion here is not to offer thoughts on the direction of the country or my views about the election itself.

In fact, I regularly remind my clients that I do not allow my politics to drive my investment decisions or my recommendations. As we’ll discuss in a moment, doing so is dangerous to our wealth.

Likewise, I encourage my clients to do their best to keep their emotions about any news subject, political or otherwise, in check. Instead we should place as much of our focus as possible on what we can actually control.

When it comes to this election (or any other), it’s perfectly acceptable to have strong positive or negative feelings. However, making drastic decisions about our investments based on those feelings is a slippery slope. Evidence demonstrates that such actions can be far more dangerous to our portfolio than whoever takes control of the Oval Office.

With that in mind, let’s get to the purpose of this post, which is to put this election in perspective by reviewing history.

While Government Policy Can Impact Returns, We Shouldn’t Give the White House too Much Credit (or Blame)

As the chart at the top clearly illustrates, markets have rewarded investors across many political administrations, both Republican and Democrat.

There is no clear pattern that suggests that stocks do better under one party versus the other. Nor do we see any reliable opportunity to time the market based on who is in the White House.

Instead, the takeaway from the chart above is actually quite simple: Over the long-term, investors have greatly benefited from stock market returns regardless of the ebbs and flows of political control.

For those that have embraced this perspective, the rewards have been substantial: The S&P 500 Index has increased by approximately 10.0% per year from 1926 through 2016.

Conversely, we know from extensive research that those who believe they are smarter than the market (on the one hand) or who fear it (on the other), rarely succeed when they take action based on emotion.

Instead, they add risk, increase expenses, raise their tax bill, and typically underperform the very investments they buy and sell.

While it’s tempting to allow our often strong political feelings to influence our investment decisions, it’s better to remain politically agnostic as it relates to our portfolio. Instead, we should focus on designing the right portfolio for our specific needs and remember that returns are not dependent on any particular party or candidate.

Whether you’re feeling victorious or defeated this week just know that this country is resilient and so is the stock market. Inevitably, both will likely surprise us again in the not too distant future.

The post The President and Your Portfolio: Does it Matter Who is in the White House? appeared first on Wealth Engineers.

Count me out.

However, I make exceptions if a sizable percentage of the content is academic research, for example, or if there is a greater emphasis on topics such as index investing or tax-efficient portfolio management.

Last week I decided to spend part of my Tuesday afternoon at the Private Wealth Mountain States Forum that was held here in Denver. I was invited as a guest speaker on a panel discussion entitled Fixed Income: Identifying Liquidity Risk and Finding Yield to provide some commentary and perspective on the bond markets.

With interest rates remaining persistently low, it wasn’t surprising at all that this topic found its way on to the forum’s agenda. Investors are clamoring for yield and turning to asset classes such as preferred stocks, REITs, and junk bonds to find it.

Likewise, I also wasn’t surprised to find myself playing the role of the “lone wolf” on the panel. While my panel colleagues were preaching the typical active management talking points of “picking your spots” and “avoiding overbought” assets, I did my best to serve as the voice of reason for those that were interested in listening.

My goal in attending was to hopefully save a few souls from being tempted by the allure of “outsmarting” the market (with the help of a high-fee manager of course). Reviewing my notes following the forum, I thought it would be helpful to share what I covered during my speaking time on the panel.

Remember the Purpose of Fixed Income in Your Portfolio

Yes, it’s true. Interest rates are historically low. That isn’t really breaking news. In reality, we’ve been in a declining rate environment since the early- to mid-1980s. The yield on the 10-year treasury is currently hovering around 1.60%. In 1981 it peaked at more than 15.0%!

Undoubtedly, declining rates have hurt savers and made it more difficult to earn a respectable income from “safe” investments. However, this fact pattern doesn’t change the primary role that fixed income should be playing in our portfolios. The first obligation of our bonds is to dampen the volatility of the stocks that we own and to reduce the downside risk of our overall portfolio. Don’t ever forget that!

Simply put, even for the most conservative of individual investors, it’s typically a poor idea to invest all of your eggs in the fixed income basket. Instead, it’s generally wise to include at least a small allocation to equities in our portfolio both for purchasing power protection (i.e. managing inflation risk) and for tax efficiency (stocks can take advantage of long-term capital gains rates).

Accordingly, while the majority of retirees would prefer higher interest rates for their bond investments, they are likely still reliant on the stock portion of their portfolio for countering longevity risk and keeping their tax bill in check. This leads me to my next point…

Yield is Not a Replacement for Principal Protection

Some investors assume that because a particular security or asset class has a “high yield” that by itself means that it can serve as a replacement for the existing bonds in their portfolio. This line of thinking varies of course, but a lot of investors have convinced themselves that a higher yield equates to greater safety for the investment.

Repeat after me: High yield is not a replacement for principal protection!

To illustrate this, take a look at the chart from Morningstar below (click to expand):

The chart shows the performance from April 2007 to February 2009 for five ETFs representing the following asset classes:

• High-yield bonds (HYG – iShares iBoxx $ High Yield Corporate Bond ETF)
• US REITs (VNQ – Vanguard REIT ETF)
• Energy Stocks (VDE – Vanguard Energy ETF)
• Preferred Stocks (PFF – iShares U.S. Preferred Stock ETF)
• US Bonds (BND – Vanguard Total Bond Market ETF)

As you can see, the “bond alternative” asset classes experienced declines ranging from 34.21% for energy stocks to 69.80% for US REITS. By comparison, the broad US bond market was not only quite stable, but it actually increased by a modest 2.15% during this same period.

I don’t know about you, but I’d much rather stick with even (very) low yielding bonds, than trying to add yield with an asset class that can decline as much or more than my stocks. Simply put, the very asset classes that many investors are chasing as they hunt for yield are the exact opposite of “safe bond equivalents.”

Don’t kid yourself otherwise.

A Total Return Approach is a Much More Efficient Way to Create Income

Lastly we need to remember that we do in fact have some control over when and how we take distributions from our accounts. There is no rule that says we must rely only on the interest-earning assets in our portfolio for income. Rather, we can use a combination of interest, dividends, and capital gains in order to generate the cash we need for withdrawals from our portfolio. This approach is what is commonly known as “total return” investing.

Let’s say, for sake of argument, that the combined interest and dividend yield for a $100,000 portfolio is 2% (or $2,000). However, our target withdrawal rate for the year is 3.50% (or $3,500).

Where does the additional money come from?

Let’s assume that in addition to the 2% yield (the income return), our portfolio also increases in value by a modest 3% (the capital return). To generate the additional “yield” we can simply sell $1,500 of our portfolio (hopefully at long-term capital gains rates) and then withdraw it, along with the $2,000 of interest and dividend income, in order to reach our $3,500 target.

Of course in some years our portfolio may actually decline in value. However, in other years our portfolio is likely to increase in value by much more than 3%. As a result, the strategy becomes to use the “excess returns” we get in the really good years to provide for withdrawals in the not so good years.

Ultimately, total return investing can be a much more flexible and tax-efficient path to generating portfolio income. Likewise, in a low rate environment, it may be the only path to provide the returns we need.

The post No, Preferred Stocks Are Not a Replacement for Bonds appeared first on Wealth Engineers.

Following Britain’s decision to leave the European Union after a more than 30-year marriage, the S&P 500 index fell 3.59%, while European markets collectively suffered declines in excess of 11%.

The fallout from Brexit simultaneously illustrates two realities of investing:

1. The interconnected nature of modern global stock markets
2. The importance of genuine and broad diversification

While the majority of investors experienced losses on Friday, very few who were properly diversified suffered anything close to a double digit decline. Only those making narrow, concentrated bets felt that kind of pain.

More importantly, for an investor whose risk profile dictates owning a portfolio with less than 100% stocks (which is the case for the majority of investors), several asset classes they likely own went up on Friday. This list included US treasury bonds, TIPS, and international bonds.

Bad Benchmarking

For investors with an appropriate asset allocation and a broadly diversified portfolio, Friday was a perfect example of why it’s a bad idea to judge your investments against the commonly reported stock benchmarks (such as the Dow Jones Industrial Average, the S&P 500, or the FTSE).

If you do this, when markets go down you’re going to think your portfolio lost far more than it actually did. On the other hand, when markets go up you’re going to expect returns for risks you didn’t take.

Neither is good for your psyche.

Don’t Miss the Forest for the Trees

With all of that said, on days like Friday the single most important word for us to lean on as investors is perspective.

It’s rarely ever as bad (or as good) as it seems in the heat of the moment.

Getting to the heart of this post, we also need to avoid the risk of missing the forest for the trees. While the financial news media would have us think that the world is coming to an end following Brexit, Friday was simply one day in an incredibly long investment history.

In other words, it was simply one tree within a gigantic forest.

Zooming Out for Perspective

To help illustrate this, let’s take a look at the history of the S&P 500. The first chart below shows the performance of the index for the five trading days last week:

Not surprisingly the decline on Friday is both obvious and, apparently, quite significant.

The same is true for the last month:

However, when we look at the year-to-date chart, we start to see that while Friday’s losses weren’t fun, the declines essentially just rolled back the clock to the middle of May:

Zooming out to a one year chart, it’s now pretty clear that just in the last 12 months we’ve experienced several ups and downs of equal or greater magnitude than what we witnessed on Friday:

However, even one year of returns represents just a handful of trees within what is a really large forest. Let’s zoom out further by taking a look at the five year and 10 year charts below:

While we can see Friday’s decline in the chart, you’d be hard-pressed to describe it as anything different than many other short periods of time since 2006.

Finally, if we really want to see just how tiny of a blip Friday was on the radar, let’s look at the logarithmic charts dating back to 1990 and then even further back to 1950:

As the charts help us to see, the reliable wealth building power that comes from diversified investing means that short-term declines are outweighed handily by long-term returns.

On the Temptation to Respond

Over the coming days, weeks, and months, we’re going to hear an almost endless barrage of “what to do now” and “how to protect yourself after Brexit” on TV and in print media.

It can be tempting to want to “do something” in response.

However, shooting from the hip in following market events is never a good idea. Instead, we need to ask ourselves a few simple questions:

1. Have I properly evaluated my willingness, ability, and need to take risk as an investor?
2. Does my portfolio align with my risk profile? Is my asset allocation appropriate for my risk tolerance?
3. Do I have a written investment policy statement that outlines these things and illustrates why my portfolio is appropriate for me?

If the above is true, then the best approach is the same as it has always been: Remain disciplined with your asset allocation, monitor regularly and rebalance when appropriate, and make changes to your portfolio only in response to your own path towards your goals.

On the other hand, if the above is not true, there’s no better time than now to review your risk profile and properly align your portfolio accordingly.

Whether markets go up or down from here is anyone’s guess. However, with the wrong asset allocation it’s a virtual certainty that you’ll be unhappy with the outcome.

Either because your portfolio is more risky than you’re comfortable with or because you’re invested too conservatively and won’t benefit enough from the growth of stocks to reach your goals.

The post Perspectives on Brexit: Remember the Forest appeared first on Wealth Engineers.

If you’re not familiar with the word fiduciary and how it fits into the world of financial advice, the shorthand definition is that a fiduciary is someone who is required to act in someone else’s best interest.

Although on the surface, it would seem obvious that more consumers receiving more advice that is actually in their best interest would be a good thing, I have some significant concerns with the new ruling.

More Laws, More Confusion

At the top of my list is that I believe the law is likely to create more confusion, not less, among investors who are seeking professional advice. Likewise, I think that many investors will presume that this new fiduciary ruling will put an end to poor or conflicted advice, when in fact that is far from the truth.

Potentially worst of all is that the ruling comes at a time when I see real progress already being made towards educating consumers about the power of things like index funds, low cost investing, and action-oriented financial planning.

Although the DOL may believe that the expanded fiduciary requirements will accelerate this trend, there is little to nothing in the new law that suggests it actually will.

A Commitment to Doing What is Right

To be clear, as a Registered Investment Advisor (RIA), my firm has consistently adhered to a fiduciary standard since the company’s inception. This commitment is defined in the Wealth Engineers Code of Ethics, in each client’s written services agreement, and in the disclosure brochure that is filed with the regulatory authorities and provided to every client.

More importantly, however, putting clients first is simply the right thing to do. I don’t need a fancy word like “fiduciary” to tell me that. I know that my clients have placed great trust in me to provide them with honest advice and to serve as a steward for their finances. That responsibility is something I take very seriously. No law or compliance requirement will change that.

Unfortunately, the new law takes a word that should have a simple and universal meaning and further muddies the water with a series of “ifs, ands, or buts.”

Part-Time Fiduciaries

For example, under the DOL’s new requirements, an advisor who is a registered representative of a broker dealer will now be required to act as a fiduciary when providing advice or recommendations for an investor’s individual retirement account (IRA). So far, so good (at least it would seem).

However, that very same advisor has no fiduciary obligation to that very same client for any of their non-retirement accounts.

This effectively turns thousands of broker-dealer reps into “part-time fiduciaries” who will now split their time between commissioned sales person and fiduciary advisor, often to the same client.

Even worse, the definition of fiduciary in the ruling still allows broker-dealer rep to sell proprietary products and expensive annuities to the client in their IRA. In what world that meets the definition of fiduciary I’m not sure.

My Advisor is a Fiduciary (Except When He’s Not)

Unfortunately, this is just the most recent instance of broker-dealer reps being granted the authority to confuse clients by wearing multiple hats.

The other recent example is broker-dealer reps who are also CFP® Professionals.

While the CFP Board of Standards states affirmatively that “CFP® professionals are held to strict ethical standards to ensure financial planning recommendations are in your best interest,” that doesn’t tell the whole story.

That’s because the CFP Board only requires broker-dealer reps to act in the client’s best interest specifically when delivering financial planning advice. At all other times, a representative has no such obligation.

Confused yet?

Potentially the most frustrating part for a consumer is not knowing when a broker representative is acting in their best interest and when they are not.

Does the advisor sound an alarm and flash some lights to let the client know?

Does the advisor swap their green tie for a red one?

How to Find a Full-Time Fiduciary

Thankfully, what hasn’t changed as a result of the new “fiduciary standard” is that there is still a clear way for consumers to obtain professional advice that puts their interests first all of the time: When selecting a financial professional, choose a fee-only Registered Investment Advisor (RIA).

Even better, ask them to show you in writing that they specifically adhere to a fiduciary standard when delivering investment and financial planning advice.

While nothing can guarantee a successful relationship, working with a fee-only RIA puts you on much firmer ground.

The post New Fiduciary Ruling Creates More Confusion for Investors appeared first on Wealth Engineers.

That’s one of the first things you hear when the subject of weather comes up in Denver. While that’s a slight exaggeration, it’s not terribly far off.

Case in point: Last Tuesday afternoon. The high temperature was a beautiful 72 degrees. My wife and I went out on a walk with our son early that evening and the weather was bordering on perfect.

Standing outside, you’d have no idea that the scenery was going to change so drastically in less than 12 hours. With the sun beaming down on your head, the prediction for a few of inches of snow the following day might have seemed like an April Fool’s joke come early to an out of town visitor.

However, if you’ve ever spent any time in Colorado, you know that the weather can turn on a dime. In this case, a few inches of snow quickly became nearly a foot and a half, as we saw blizzard-like conditions nearly all day on Wednesday. Denver International Airport shut down for the first time in almost a decade and the freeways turned into parking lots.

The Futility of Forecasts

From what I can gather, none of the meteorologist’s weather models even came close to predicting the magnitude of the storm. Instead, the news channels were scrambling that morning to provide reports on road closures and how many flights had been canceled.

While clearing my driveway for the second time on Wednesday, I couldn’t help but find parallels between the crazy weather we sometimes have here in Colorado and the challenging markets that we often face as investors.

Although weather forecasters in Denver have notoriously poor track records, my experience has been that at least they are directionally correct most of the time. In other words, while they were way off with the volume of snow we got last Tuesday, at least they predicted snow.

Unfortunately, the same cannot be said for our investment forecasting friends. Their predictions are often so bad that the weather equivalent would be like calling for buckets of rain on a day that turns out to be 80 degrees without a cloud in the sky. Needless to say, such forecasts aren’t even worth the paper they are written on.

Putting that aside, instead of diving into the quantitative aspects investing today I thought I would share a few quick tips for managing through weather in Denver that apply equally as well to successful investing. If you keep these tips in mind, you’ll be in good position to stand firm through both volatile weather and volatile markets.

Tip #1: Be Prepared in Advance

Most people that live in climates that can experience sudden changes in weather know that it’s a good idea to take some basic steps of precaution. During the winter months, that means stashing some extra non-perishable food in the house, storing a warm blanket in your car, and keeping your gas tank at least a quarter full at all times. Of course, these things should be done before you actually need them because you’ll be hard pressed to track them down in the middle of a snow storm. Undoubtedly, however, every time you watch the news after severe weather you realize just how many people fail to prepare in advance.

The same type of basic preparation applies to your investments. Since we don’t know where markets are going in the near-term or when they will shift directions, we simply can’t follow a “just-in-time” approach to investing. Instead, we need to determine the proper level of risk for our portfolio at the outset so that when the unexpected inevitably happens, we’re well positioned to successfully manage through it.

This type of preparation is critically important when we’re talking about growth as well. For example, while international and emerging market stocks had a rough third quarter last year, they responded with very strong returns in October. Without continued allocations to a wide range of asset classes, we run the risk of missing out on positive returns.

Tip #2: Dress in Layers

A timeless principle of living in Denver is to always be prepared for a wide range of temperatures by dressing in layers. After seeing a few days with 30 or 40 degree swings, you understand just how good this advice is. So when you reach into your closet before heading out the door, you learn pretty quickly that it’s a bad idea simply to “grab a heavy jacket” because it’s January. While that would probably be good to have at 7am, you might find yourself sweating through it by the afternoon.

The same principle of dressing in layers applies to your portfolio as well. We call it diversification. While a diversified portfolio doesn’t guarantee any specific return or eliminate risk, it does ensure that you aren’t going to experience the extreme swings that are so common with a single stock or even a single asset class. Most importantly, when you invest in a wide range of global asset classes, you not only have the ability to reduce risk, but you can also increase your expected returns. That’s a win-win.

Tip #3. If You Don’t Like the Weather, Wait Five Minutes

Having discussed weather quite a bit already, this tip doesn’t need much of an introduction. However, in my view, it’s probably the most important one for us as investors. The reason is because in the heat of the moment, it can seem like the world is falling apart when stocks are in decline. Every news headline is negative and the tone of every pundit is dire. It truly seems like an economic catastrophe in the same way that the Denver storm was a weather catastrophe last week.

However, in the same way that things improved in short order weather-wise (most of the snow was melted in a few days and it was 66 degrees yesterday), the same can also be said for a bear market. While it may not happen in five minutes, in the grand scheme of things, stock market declines are a handful of fallen trees in an otherwise beautiful forest. For that reason, the next time it seems like the financial world is coming to an end, just pause and remember that brighter days are right around the corner.

The post If You Don’t Like the Weather, Wait Five Minutes appeared first on Wealth Engineers.

The reality that beating the market is really hard is one that I think is starting to set in for a lot of investors. Simply put, the odds of beating the market are so low that it was almost a foregone conclusion that investors would start shifting away from actively managed strategies.

One sign of this is the data that tracks mutual fund inflows and outflows. While traditional active management shops like American Funds are shedding assets like they’re going out of style, index and passively managed fund families are growing at record pace.

I also see this phenomenon on a more anecdotal and personal level in conversations that I have with investors of all ages. It’s much less common these days for someone that I talk to not to have at least heard of index funds, for example, and at a minimum be curious about them.

The Insatiable Desire to Beat the Market

However, even in light of all of the evidence that attempting to beat the market is not a very sound strategy, I think most investors still believe it’s possible if you know what you’re doing.

More importantly, in their minds, they see beating the market as the ticket to success. In other words, their view might be best summed up as, “yeah, the odds of beating the market are low, but the rewards of doing so are too spectacular not to try.”

They might go on to reference Warren Buffett and Berkshire Hathaway before ultimately convincing themselves that beating the market can be done simply because their are living examples of such success.

Given this mindset as a starting point, I thought it would be interesting to consider the highly unlikely sequence of events that are required in order to actually beat the market. Using history as a guide and the track records of highly qualified and educated mutual fund managers, this is what would need to happen in order to achieve market-beating success:

1. 1. Select an actively-managed fund that performs well enough to avoid being liquidated or merged with another fund during your investment horizon.

1. 1. Remain invested in the fund through the inevitable storms when the manager underperforms for long periods of time (almost certainly causing you to second-guess your strategy).

1. Benefit from gross alpha (excess returns before fund expenses) that is high enough to fully offset the fees of the fund and still pass along outperformance to you, the investor.

Let’s take a walk through each of these in a bit more detail to see just how unlikely it is for an investor to enter the active management gauntlet and come out successful on the other side.

How Long do Mutual Funds Live?

The short answer: Not very long.

If you started investing in 1970, you had 358 U.S. stock mutual funds to choose from². Certainly a large pool, but nothing compared to the thousands of mutual funds and ETFs in the marketplace today.

Of those 358, only a shade over 100 existed as of June 2014. The rest were either closed/liquidated or merged with another fund. Simply put, that means you had a 3 in 10 chance of choosing a fund that merely managed to stay alive for 44 years. Pretty poor odds for what in reality isn’t that high of a bar for success.

It might seem surprising that so few funds were able to survive, but it really isn’t. The vast majority of actively managed mutual funds die premature deaths.

While we can’t say that the cause of death for every fund is bad performance, in most cases that is certainly the reason. Mutual fund companies don’t close winning funds very often because touting the performance of those funds is what keeps the active management asset gathering game alive.

Even the Winners Look Like Losers for Much of Their Life

Assuming we get past the first challenge by successfully choosing one of the roughly 100 funds that managed to avoid the axe, the second challenge might be even harder: Staying invested when things look really bleak.

A big misconception about winning managers is that they always outperform. In other words, investors mistakenly assume that the smartest managers not only beat the market, but they are consistent in doing so.

The folks at Research Affiliates looked into this and found that not only is outperformance rare, it is far from a steady ride along the way if you are lucky enough to experience it.

They measured this by tabulating the number of quarters during a fund’s lifetime in which it had underperformed its benchmark over the prior three-year period. Each quarter for which this was true, the fund was determined to be on the “watch list.” Presumably, an investor would be highly concerned by seeing three consecutive years of poor performance.

If you look at the same group of 358 funds that we started with, you would assume that the ourperforming funds would rarely if ever experience three straight years (12 consecutive quarters) if underperformance. That assumption would be very wrong.

In fact, the winning funds spent between 36% to 48% of their lives on the watch list!⁴ Think about that for a second. Even the very best funds looked absolutely pitiful for roughly 4 out of every 10 quarters. That’s 15 to 20 years out of the 44 year period where bailing out probably seemed like the right answer.

You’d need an unbelievable amount of faith in the manager and the strategy to stay invested with performance like that!

Overcoming Incredibly Long Odds for Insultingly Meager Rewards

So let’s assume that we were able to clear both the first and second hurdles. The next question is: What did we get for overcoming the long odds of beating the market?

Well, of the roughly 100 funds that stayed alive throughout the period, less than half (45) also managed to outperform their benchmark. That slices are odds of success down to a pretty grim 12.6%. Not good.

Unfortunately, that’s not the end of the bad news. Logically speaking, if we are going to bear the burden of a high risk that we will underperform, the rewards better be sweet enough to make it worth our while, right?

Unfortunately, that’s not the case when you endeavor to beat the market. Of that small group of 45 funds, just 3 managed to deliver returns of 2% or more in excess of their benchmark. Three funds!

To bring it full circle that means that of the 358 funds we started with, less than 1% (0.84% to be exact) delivered the kind of market-beating results that actually move the needle. The other 355 funds either performed so poorly that they were quietly taken to the woodshed or they roughly approximated their benchmark with almost certainly more risk.

If those odds don’t convince you to embrace passive investing, I’m not sure what will!

<sup>Sources:
1. Hiring Good Managers is Hard? Ha! Try Keeping Them!, Fundamentals by Research Affiliates, November 2014
2. Ibid.
3. Ibid.
4. Flying High: RAFI at 10 Years, Fundamentals by Research Affiliates, March 2015</sup>

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