Can You Handle the Truth - Part 2?

| March 02, 2015
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Investing

Peaceful Wealth requires investors to embrace four fundamental truths; 1) Markets work, 2) Risk and reward are related, 3) Broadly diversified, low-cost portfolios maximize investor performance and 4) Time horizons must be understood.

Last essay we unpacked two of the four sails that will power our journey to Peaceful Wealth. Embracing the fact markets work offers freedom from the expensive ruse of active management.  Understanding the rewards of the efficient frontier enables investors to define their own personal comfort level and implement a strategy that properly balances the inextricable relationship between risk and reward.   Our remaining two sails give power and consistency to our voyage.

Build broadly diversified, low cost portfolios using structured asset classes.

Diversification is a divisive concept.  It is a foundational doctrine in modern economic theory, yet many investors continue to reject the benefits it offers.  If markets are broken and active managers can successfully forecast the price of stocks, then diversification only serves to water down the potential to maximize profits.  Owning the 20th “best” stock (let alone the 200th or 2,000th “best” stock) makes little sense to those with special insight and superior stock picking skills. Super-investor Warren Buffett articulates this belief when he states, “Wide diversification is only required when investors do not understand what they are doing”.

And who would argue with Warren Buffett?  Nobel laureate economist Harry Markowitz, for one.  His 1952 thesis Portfolio Selection points out proper diversification is much more than simply owning lots of stocks or only the “best” stocks.  “The adequacy of diversification is not thought by investors to depend solely on the number of different securities held” said Markowitz.  He continues, “A portfolio with sixty different railway securities, for example, would not be as well diversified as the same size portfolio with some railroad, some public utility, mining, various sort of manufacturing, etc.  The reason is that it is generally more likely for firms within the same industry to do poorly at the same time than for firms in dissimilar industries.”  Simply put, proper diversification reduces the risk of a portfolio.  And how do we achieve “proper” diversification?  William Sharpe shared the Nobel prize in economics in 1990 with Harry Markowitz for his Capital Asset Pricing model that teaches proper diversification means owning broad categories of stock to the point you minimize the negative impact of any single company or industry development within your portfolio.

If diversification minimizes portfolio risk, how do we maximize return?    The academic work of Professors Eugene Fama and Kenneth French expanded on Sharpe’s model in an attempt to define the key factors responsible for the returns of a diversified portfolio.  It turns out active management is an unwelcome guest at the table of modern economic theory.  Fama and French found 96% of any portfolio’s returns can be attributed to its exposure to three factors; stock vs. fixed income, company size characteristics as measured by market capitalization and stock price characteristics relative to book value or other accounting measurements of a company’s worth. Their Multifactor Asset Pricing Model reported portfolios favoring stocks over bonds, small companies over large companies and value stocks over growth stocks deliver above-market performance over time.  Fama and French also found these three factors were consistent across markets, enabling investors to further diversify their portfolios and boost potential performance by investing internationally as well as domestically.

The final step in building a portfolio is the efficient acquisition of our desired stocks.  While Index funds and ETFs are adequate for many do-it-yourself investors, our firm uses the building-block funds offered by Dimensional Fund Advisors, a pioneering $381 Billion fund company.  DFA’s structured asset class funds offer superior market coverage, fundamentally low expense ratios and innovative oversight ideally suited to maximize client returns while minimizing costs and managing risks.

Beauty is in the eye of the long-term investor

Successful investing requires an appreciation for the value of patience and a long-term perspective.  Exposure to risk, as defined by the short-term volatility of an asset class, is a key component of total portfolio return. This means investors are systematically rewarded when they embrace nondiversifiable risk. It also means every increment of additional return sought by an investor equates to the potential for larger short-term declines in portfolio value.  Simply put, the world of investing offers very few free lunches.  Risk and return are related.  Even the most beautifully diversified, low cost, properly structured portfolio will encounter market declines. Heading this truth results in a wonderful payoff.  The stock market has proven itself to be an engine of remarkable wealth creation.  The exponential power of compounding rewards investors for their commitment to the long-term.  Ignoring the short-term volatility of a properly constructed portfolio in favor of long-term rewards is the very definition of Peaceful Wealth.

Unfortunately, many investors are jaded because Wall Streets sales agents routinely usurp market truths to justify their own failings or tout their supposed expertise. Holding a bad investment for the long-run is always a bad decision.  Inappropriate risk is harmful.  High fees and expertise are unrelated. Random chance predicts some active managers and a few poorly diversified portfolios will outperform the market over short periods of time.

The challenge we all must face is how to navigate a true course amidst the stormy seas of active management and the pervasive headwinds of dubious advice.  The wisdom of the market and the tenets of Peaceful Wealth systematically trump the broken business model of investing.  Ultimately, every investor must choose how they will handle these truths.

 

This material is intended for educational purposes only and is not intended to serve as the basis for any investment or purchasing decisions.

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