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One Size Fits All… If It’s Customized

Portfolio design comes in many flavors, but so do investors. Finding a sensible balance is job one in the pursuit of prudent financial advice. Yet for some folks the idea of keeping an open mind for customizing strategy to match an investor’s goals, risk tolerance and other factors reeks of treachery. There can only be one solution for everyone – all else is deceit. Or so some would have you believe. This biased worldview comes up a lot with the discussion of buy and hold, but the one-size-fits-all argument knows no bounds. The danger is that pre-emptively deciding how to manage assets for all investors is the equivalent of diagnosing illness and recommending treatment before meeting with the patient. Sound financial advice requires more nuance, of course, for two primary reasons: the future’s uncertain and the human species is afflicted with behavioral biases. In other words, a given investment strategy can be appropriate – or not – for different individuals. Consider the concept of buy and hold. By some accounts, it’s all you need to know. Stick your money in, say, the stock market and let the magic of time do the heavy lifting. Sensible? Perhaps. But it may be hazardous. The determining factor is the particulars of the investor for whom the advice is dispensed. Buy and hold – perhaps by focusing heavily if not exclusively on stocks via a handful of equity funds – may be eminently appropriate for a 25-year-old with a budding career, a saver’s mentality, and the behavioral discipline to focus on the long-run future. The same solution can be toxic, however for anyone with a time horizon of 10 years or less. Even for someone who’ll be investing for much longer, may run into trouble with buy and hold if he has a tendency to over-react to short-term events. In that case, buy and hold can be wildly inappropriate for an investor without the discipline to look through market crashes and bear markets. Ah, but that’s where a good financial advisor can help by keeping the client on the straight and narrow: Ignore the short-term volatility and stay focused on the long term. Fair enough, but it doesn’t always work. Some investors will bail at exactly the wrong time no matter how much hand-holding they receive. Deciding who’s vulnerable on that score can be tricky, but not impossible. Perhaps, then, a portfolio strategy with less risk – asset allocation – or the capacity to de-risk at times – some form of tactical – is more appropriate for certain individuals. The flip side of this equation is no less relevant. Forcing every client into a tactical asset allocation strategy simply because that’s your specialty (and/or it pays better for the advisor) is also misguided. Higher trading costs, taxable consequences and the inevitability of timing mistakes can and probably will take a bit out of total return over the long haul relative to buy and hold. The “price” of tactical can still be worthwhile for some folks, if the portfolio has a tamer risk profile. The point is that there’s no way to decide what’s appropriate without first understanding the client. Granted, a 25-year-old investor is more likely to benefit from buy and hold vs. a newly retired 65-year-old client. But there are exceptions and it’s essential to identify where those exceptions arise. The good news is that there’s an appropriate strategy for every client. The great strides in financial research and portfolio design capabilities via computers over the last several decades provide the raw material for building and maintaining portfolios that are suitable for any given client. Buy and hold may still be appropriate, but maybe not. The greatest strategy in the world is worthless if a client jump ships mid-way through the process. As such, the goal for managing money on behalf of individuals isn’t about identifying the strategy with the highest expected return or even the strongest risk-adjusted performance. Rather, the objective is to build a portfolio that’s likely to work for the client. That may or may not lead to a buy-and-hold strategy – or some variation thereof. Such talk is heresy in some corners. But matching portfolio design and management particulars to each client’s time horizon, goals, etc. – and behavioral traits – is the worst way to manage money… except when compared with the alternatives.

The Appropriate Portfolio Vs. The Optimal Portfolio

Perfect is the enemy of the good” – Adapted Italian Proverb We all want the perfect portfolio, the portfolio that achieves the highest amount of return for the lowest degree of risk. But one of the inconveniences of a system as dynamic as a financial market is that it’s impossible to consistently maintain the perfect portfolio. This pursuit, unfortunately, causes more damage than good since it leads to increased activity, higher fees, higher taxes and usually lower returns. I have argued in my new paper, Understanding Modern Portfolio Construction , that this pursuit of alpha is misguided and that we should seek the appropriate portfolio as opposed to the optimal portfolio. Here’s my basic thinking: There is an abundance of data supporting the fact that more active investors do not consistently generate alpha or excess return.¹ Alpha is elusive because it doesn’t exist in the aggregate and because we all generate the after tax and fee return of the aggregate financial markets. So, the diversified low fee indexer must ask themselves – if I want to be properly diversified and alpha is impossible to achieve in the aggregate, then is this a pursuit I should bother engaging in? For most people, the answer should be no. For most people, the generation of “alpha” is not a necessary financial goal. Asset allocators should be concerned with generating the appropriate return as opposed to the optimal return. This means building a portfolio that is consistent with your risk profile and managing it across time so that you maintain that profile while maintaining an appropriately low fee, tax efficient and diversified approach. The pursuit of alpha generation not only reduces returns by increasing taxes and fees, but also misaligns the way the portfolio manager perceives risk with the way the client sees risk. Since the portfolio manager is benchmarked to a passive portfolio they likely cannot outperform they will often exacerbate many of the frictions that degrade portfolio returns all the while increasing the risk that the client will not achieve their financial goals. Of course, the “optimal” portfolio might not seem so different from the “appropriate” portfolio, but I would argue that there’s a substantive difference. For instance, let’s look at an example of a 40-year-old man with $500,000 to allocate. Let’s assume he uses the simple “age in bonds” approach and comes to a 60/40 stock/bond portfolio. Every year this asset allocator should rebalance his portfolio so that he owns approximately 1% more in bonds. In all likelihood, the stock piece of the portfolio will outperform the bonds over long periods of time so he will consistently be tilting further away from stocks and into bonds. But why does he rebalance? He rebalances to maintain an appropriate risk profile, not to optimize returns and generate alpha. He is accepting the high probability of a good return and foregoing the risks associated with pursuing the perfect return. This should be the approach taken by most asset allocators seeking to build a proper savings portfolio. Countercyclical Indexing takes this process of risk profile based rebalancing a step further.¹ Since a 60/40 portfolio derives 85%+ of its risk from the equity market piece (and even more late in a market cycle) it is prudent to try to achieve some degree of risk parity across the market cycle. But we should be clear about the process of this rebalancing – we are not rebalancing to achieve alpha. We are rebalancing to better balance our exposure to asset risk across time. Said differently, we don’t implement this rebalancing to capture the best portfolio, but to capture an appropriate portfolio. In doing so, we are accepting that our portfolio might merely be “good,” but by pursuing the appropriate portfolio we are avoiding many of the pitfalls involved in pursuing the perfect portfolio. If more asset allocators abandoned the false pursuit of the optimal portfolio, I suspect they would perform better. Instead, they’ve let perfect become the enemy of the good. ¹ – See the annual SPIVA reports. ² See, What is Countercyclical Indexing ?

Buy-And-Holders Predict Future Returns Every Day, While Claiming That Predictions Don’t Work

By Rob Bennett Buy-and-holders don’t believe in return predictions . They say it is not possible to predict returns effectively. Their cardinal rule is that investors should never engage in market timing, and so they object strongly when valuation-informed indexers use return predictions to change their stock allocations. That’s market timing. It doesn’t work. It’s crazy. It’s a mistake. They believe this stuff. They are sincere in their repulsion for market timing and for return predictions. But the buy-and-holders make return predictions themselves! They don’t know it. They fool themselves into thinking they are not making return predictions. But it’s not possible to buy stocks without first forming some idea in your mind as to what return you expect to obtain. The buy-and-hold idea that it is not a good idea to make return predictions is not only strategically flawed, it is a logical impossibility. Say you were thinking of buying a car, and for some odd reason you vowed not to consider price when doing so. Could you do it? You could physically do it. But you couldn’t do it with a clear mind. Human reason demands of us that we consider price when trading money for something that we want to obtain. It works that way with stocks too. It’s not possible to buy stocks without the thought entering your head that you would like to obtain a return on your money that is greater than the return you could obtain from buying less risky asset classes. And it’s not possible to go ahead with the purchase without some notion of what return you expect to obtain entering your thought process. The buy-and-holders kid themselves about this. They need to believe that return predictions are not possible or they could not remain buy-and-holders (buy-and-holders who elect to become clear thinkers are transformed into valuation-informed indexers!). But they are not able to keep themselves entirely in the dark. Common sense intrudes. That’s why buy-and-holders become uncomfortable when people like me write on the internet about the implications of the last 35 years of peer-reviewed research in this field. Buy-and-holders believe they are going to obtain a return of 6.5 percent real on their stock investments. That’s the average return. So that’s their default. They compare the 6.5 percent return they expect to obtain from investing in stocks with whatever return they can obtain from less risky asset classes and elect stocks when the expected return from stocks is better. It always is. That’s why buy-and-holders invest most of the money that they do not expect to need within a few years in stocks. Buy-and-holders, of course, understand that they are not going to see that 6.5 percent return every year. There are some years in which stocks provide a return of 30 percent, and there are some years in which stocks provide a return of a negative 30 percent. But a positive 6.5 percent is the norm. That’s what buy-and-holders expect. That’s what buy-and-holders predict. Ask a buy-and-holder what he expects his stock return will be after the passage of 10 years. He will say that he expects something in the neighborhood of 6.5 percent. He doesn’t expect precisely that. Of course, valuation-informed indexers don’t expect their predictions to apply precisely either. He view the predictions we make by looking at the valuation level that applies on the day we make our stock purchases as in-the-neighborhood numbers. That’s how buy-and-holders view their prediction that the usual 6.5 percent return will establish itself once again. The reality, of course, is that there is a strong chance the 6.5 percent return will not re-establish itself. It’s reasonable to expect such a return for stocks purchased at fair value prices. But stocks are frequently sold either at inflated prices or at deflated prices. When stocks are sold at wildly inflated prices or at wildly deflated prices, it is not likely that the 6.5 percent return will apply in 10 years. The likelihood is that a return a good bit lower than 6.5 percent will apply (for stocks purchased at wildly inflated prices), or that a return a good bit higher than 6.5 percent will apply (for stocks purchased at wildly deflated prices). A poster at the Bogleheads Forum once stated this idea in compelling fashion: “I don’t go into a bank and say ‘I’d like to buy three certificates of deposit’ without first asking what rate of return applies – Why should it be different when I buy stocks?” It shouldn’t be any different. We cannot know the return we will obtain from stocks with precision. But then, we cannot know the return that we will obtain from certificates of deposit with precision either. The inflation rate is unknown at the time of purchase of certificates of deposit, and the inflation rate affects the real return obtained. With certificates of deposit, we all do the best we can. We look up the nominal return and form some reasonable expectation of what inflation rate might apply. We educate ourselves to the best of our ability. This is the step that buy-and-holders fail to take when they buy stocks. Why? Buy-and-holders want to know the return they will obtain from the certificates of deposit they purchase. Why don’t they want to know the return they will obtain from the stocks they purchase? They want to believe in bull markets. They want to believe that the 6.5 percent average return is a floor that applies even when prices are insanely high, but that returns that exceed the 6.5 average return are real and do not pull future returns down. They want to believe in a fantasy that makes it impossible for them to purchase stocks in as informed a manner as they purchase certificates of deposit. Disclosure: None.