November 22, 2013

7 Deadly Risks

Underperformance Risk | Structure Risk | Media Risk | Advisor Risk | Cost Risk | Planning Risk | Complacency Risk

Avoiding the 7 Deadly Risks is critical to long-term investment success.

Underperformance Risk

active-passive-roadsign-smallUnderperformance Risk is the risk of permanently underperforming the markets due to the use of “active” investment management strategies.

Active investors believe that it’s possible to consistently outperform the market averages (e.g., an S&P 500 index fund) by analyzing company fundamentals or charting stock price movements or taking advantage of economic forecasts or any one of dozens of other active trading techniques.  They believe that highly-skilled portfolio managers provide value by navigating the complexities of the stock market.  Unfortunately, the objective evidence is clear:  active managers rarely, if ever out-perform the market indexes over long periods of time, and the only “value” they add is to their own pocketbook via the additional fees they charge unsuspecting investors.

Passive investors, on the other hand, understand that markets, not managers, create wealth. They understand that it’s virtually impossible for anyone to consistently outperform the market averages by stock-picking or market-timing (or any other active trading technique) so they employ low-cost passive strategies (like index funds) designed to simply match the returns of the market. They understand that active management is largely a marketing ploy, a “Loser’s Game” as Charles Ellis so eloquently described it, and they point to decades of data and statistical research which demonstrates – quite conclusively – that, over any reasonable investment time horizon, active strategies will underperform passive strategies by the amount of the additional costs that active investors incur.

Warren Buffett is, perhaps, the manager who is most often cited as proof that active management works.  Yet even Warren’s stellar performance can be largely duplicated with a well-structured index fund portfolio.  From 2000 through 2013, for example, Buffett’s Berkshire Hathaway returned 8.8% annually, thoroughly trouncing the S&P 500 index which returned just 3.6% annually. But the S&P 500, which is a growth-oriented index, is an inappropriate benchmark for Buffett/Berkshire’s value-oriented investment style. A more appropriate benchmark would be a domestic value index. A passive portfolio, for example, comprised of DFA’s Large Value Index (80%) and their Small Value Index (20%) – which loosely mimics the overall structure of Berkshire – would have returned about 9.1% annually from 2000 through 2013, handily beating Mr. Buffett.

Additional research comparing active and passive strategies can be found here and here.

Structure Risk

money-puzzle-300x282Structure Risk is the risk of ignoring the benefits of diversification, asset-allocation, and “factor loading”.

Many investors would significantly improve their portfolios’ long-term risk-adjusted returns by owning just three low-cost index funds:  a Total U.S. Stock Market fund, a Total International Stock Market fund, and a Total U.S. Bond Market fund.  These three “asset classes” should form the foundation of almost every investor’s portfolio.  Any decision to deviate, or “tilt”, from this widely diversified “own everything” strategy should be based on rigorous objective research that has demonstrated that such deviations are likely to provide statistically significant excess returns in the future.  Very few strategies will meet this test: there are only a handful of known tilting strategies, or “risk factors”, that have proven to be persistent.

Proven equity risk factors include “Price”, “Size” and “Profitability”. The “Price” factor refers to the tendency for value stocks to provide higher returns than growth stocks. The “Size” factor refers to the tendency for the stocks of small companies to provide higher returns than the stocks of large companies. And the “Profitability” factor refers to the tendency for companies with higher relative profits to have higher returns than companies with lower relative profits. Tilting passive portfolios toward value and small-cap stocks while screening for profitability historically has provided, and is likely to continue to provide, higher-risk adjusted returns.

For example, from 1979 through 2013 the Russell 3000 index – an index often used as a proxy for the entire U.S. stock market – returned just shy of 12% per year, on average, with a standard deviation (risk) of 17.1% (Portfolio 1, below). Over that same time period, however, a portfolio comprised of the Russell 3000 index plus modest tilts toward value and small-cap stocks (70% R3000, 15% large value, 15% small value), would have returned 13.3% with exactly the same level of risk (Portfolio 2, below).

Tilts

More information on tilting, which is also known as factor-based investing, can be found here.

 Behavior Risk

MediaCoverageSmallBehavior Risk includes the risk of acting upon the insidious stream of investment pornography that permeates modern financial news sources.

For all intents and purposes, the financial media has a single, overriding “raison d’etre”:  To maximize the amount of advertising dollars it gets from Wall Street and its agents.  And, since Wall Street is the biggest purveyor of active investing strategies, most news outlets are going to run a constant stream of ever-changing headlines to promote frequent trading.  The media, like Wall Street, has minimal incentive to tout the effectiveness of low-cost passive strategies because indexing is a boring strategy that doesn’t require frequent trading (or any assistance from Wall Street) to be effective. Since boring doesn’t sell, you can count on the financial media to continue to generate a steady stream of investment pornography designed to lure unsuspecting investors to trade as frequently as possible.

As an anonymous Fortune reporter noted in Confessions of a Former Mutual Fund Reporter:1

“ . . . I worried I’d misdirect readers, but I was assured that in personal-finance journalism it doesn’t matter if the advice turns out to be right, as long as it’s logical. You’re supposed to produce the most stories that ‘end in investment decisions,’ so publications substitute formulas for wisdom. The formula for recommending funds: Filter according to returns, then add something trendy–high tech, no tech, whatever.”

“The problem is that recent returns, whether from one week or the old standby three years, don’t predict future results. Nothing predicts future results. The best you can do is to hold on to low-cost, diversified funds and be oblivious to short-term static.”

“Unfortunately, rational, pro-index-fund stories don’t sell magazines, cause hits on websites, or boost Nielsen ratings. So rest assured: You’ll keep on seeing those enticing but worthless SIX FUNDS TO BUY NOW! headlines as long as there is personal-finance media.”

1 http://www.bylo.org/confess.html

Also see, for example, this article: Seven Ways to Fool Yourself.

Advisor Risk

Fiduciary-v-Suitability-standard-smallAdvisor Risk is the risk of trusting your money to the wrong type of advisor.

The fiduciary standard requires that an advisor put his clients’ interests before his own.  Most “advisors” are not held to the fiduciary standard.  And even many of the relatively few advisors who do hold themselves out as fiduciaries find subtle ways around ‘inconvenient’ parts of the standard (often through fine-print disclosures that few investors take the time to read).

A key aspect of being a fiduciary is objectivity:  the ability to offer conflict-free advice.  It is very difficult to be truly objective if your primary incentive is to sell product.  For example, very few advisors will admit that the simple three-fund portfolio outlined above could serve their clients exceptionally well.  Why?  Because it’s simple enough for many of their clients to do on their own which, of course, would mean that the advisor wouldn’t receive an ongoing stream of revenue from asset management fees, commissions and/or 12b-1 fees.

And that is the primary problem with the “advice” industry:  Most “advisors” are simply asset gatherers.  They are little more than well-dressed salesmen, with very little training in statistics or factor-based investing, who get paid not for providing sound advice but, rather, for gathering assets to be “managed” by active fund managers and insurance companies who offer them the greatest “kickback”.  Their “advice” is incidental to the sale of their company’s product.

Cost Risk

EPP-monopoly-smallCost Risk is the risk of paying too much in advisor fees, mutual fund fees, trading costs, and taxes.

High costs relative to passively-managed strategies is one of the primary reasons for the failure of active management.  And, while many advisors have wisely recognized the importance of low-cost investment strategies to their clients’ success, very few have looked in the mirror and questioned the value of their own exhorbitant fee structures.

Once you understand that markets, not managers, create wealth, you’ll understand just how outrageous a 1.0% AUM fee really is. Yes, a good advisor can help educate you and, yes, his advice could be worth an awful lot of money over time.  But just as a doctor wouldn’t charge you hundreds-of-thousands of dollars for a life-saving prescription or to vaccinate your child against a life-threatening disease, an advisor shouldn’t expect to take 20% – 25% of your lifetime investment profits (the true cost of a 1% AUM fee) for showing you how to obtain your fair share of market returns.  

Among independent RIAs, AUM fees can vary from about 25 basis points (0.25%) to 1.5% or more, and they probably average 1%  to 1.25% overall. 1% may not seem like a large fee, but it is. For example:

1% is really 25% (or more). The long-term historical average annual return for the stock market is just shy of 10%, and most financial economists expect future returns to be significantly lower. In addition, the intermediate-term bond market is currently yielding around 3%. That means that (optimistically) the long-term expected annual return on a balanced portfolio comprised of 50% stocks and 50% bonds is about 6.5% before inflation. With inflation currently running about 2.5% per year, that means the real return on a balanced portfolio, before taxes, mutual fund fees, and trading costs, is about 4% per year. So, before all those other costs, a 1% AUM fee really translates into a 25% fee on your profits (1% / 4% = 25%). If you net all those other costs against your profits, a 1% AUM fee could be costing you 30% or more of your returns. No advisor on the planet is worth 25% – 30% of your money.

AUM fees penalize affluent investors. Most advisors have a minimum account size. This, in effect, sets a floor for their fees. And that floor tells us a whole lot about the advisor. For example, the fee floor for an advisor charging a 1% AUM fee with a $200,000 minimum portfolio is $2,000 (1% X $200,000). This means that the advisor can profitably manage a $200,000 portfolio for $2,000. What most investors don’t realize is that it takes very little, if any, additional effort to manage a $1,000,000 portfolio than it does to manage a $200,000 portfolio. But, under a 1% AUM arrangement, the $1,000,000 client is going to pay five times as much as the $200,000 client for a portfolio that is probably very similar in terms of its individual components.

AUM fees are, essentially, commissions that promote numerous conflicts of interest and disguise the disgustingly high costs being charged to investors. Even low AUM fees are punitive. Professionals like doctors, CPAs and attorneys, don’t charge commissions. Your next financial advisor shouldn’t either.

Planning Risk

2+25-Mistake-smallPlanning Risk is the risk of misallocating your resources relative to your most important financial goals. Planning Risk includes the risks of 1) taking too much (or too little) portfolio risk to meet your financial objectives, and 2) having unreasonable expectations about future market returns.

Portfolio returns are largely dependent upon just two variables:  structure (asset allocation) and cost.  All else being equal, those two variables will determine pretty much 100% of your portfolio’s returns.

Most advisors determine a client’s overall asset allocation using something called a Risk Tolerance Questionnaire (RTQ).  While RTQs can provide some useful information, they are lousy as a stand-alone tool for determining asset allocation.  Individual risk tolerances can and do change over time, and are largely subject to an investor’s emotional state at the time he completes the questionnaire.  Ask an investor to fill out an RTQ at the depths of a bear market, and you are likely to get a completely different answer than if you ask him to fill one out at the height of a bull market.

More importantly, however, RTQs fail to take into account an investor’s need to take risk.  RTQs are designed to try to determine the maximum amount of risk that an investor can bear, regardless of whether or not the investor needs to take that level of risk.  It’s kind of like going to the dentist for a root canal and, rather than asking to be completely numbed, asking for just enough medication so that you don’t go beyond your maximum tolerance for pain.

Taking unnecessary risk is the equivalent of gambling. This is a particularly important point for affluent investors to remember.  Once you’ve won the investment game, once you have enough money “in the bank” to meet your most important financial goals, you should decrease your level of investment risk as far as possible to protect what you have.  In other words, once you’ve arrived at your financial destination, your focus should shift from maximizing the chances of becoming richer to minimizing the chances of becoming poorer. Unfortunately, it’s a sad truism that those who are most often advised to take the most risk (i.e. the affluent), are also the ones who most often can (and should) take the least risk.  One need look no further than the Nikkei to understand just how risky the stock markets can be:  after almost 24 years, the Nikkei is still down 60% versus it’s peak in early 1990.

As a quick aside . . .  Advisors often justify their high fees by promising to help their clients maintain their allocations during severe bear markets.  I would argue that such bear-market counseling would occur far less frequently if advisors hadn’t used RTQs to set their clients allocations to “maximum risk” in the first place.  But I digress . . .

The only way to approximate a truly useful overall asset allocation is through careful planning – quantifying goals and time frames, balancing the levers that can be controlled (i.e., cash flow and risk), and stress testing different allocations against a variety of possible market conditions.  Many investors will find that they can meet their most important financial goals with far less portfolio risk than their RTQ suggests they can tolerate.

Complacency Risk

Just-Do-It-Now-smallComplacency Risk is the risk of not acting to remove any/all of the above-mentioned risks from your investment strategy.

Complacency Risk is, perhaps, the most difficult to overcome.  Change is hard. Especially if that change involves second-guessing yourself (or an advisor that you’ve trusted for years). Belief Perseverance (the tendency to hold onto one’s beliefs despite overwhelming evidence to the contrary) and Confirmation Bias (the tendency to look for or interpret information in a way that confirms currently held beliefs) are especially difficult to overcome.

Yet the consequences of not changing are far too significant for any investor to ignore.  Addressing, for example, Cost Risk alone can result in a massive lifetime increase in wealth.  For example, over a 10 year investing time horizon (about 1/5 of the typical investor’s time horizon), a 1% fee savings on a $100,000 portfolio could result in tens-of-thousands-of-dollars of additional wealth.  On a million dollar portfolio, a 1% cost savings could result in hundreds-of-thousands-of-dollars of additional wealth.

So, yes, change is hard . . .  but when it comes to managing your investments, change can be highly profitable.