Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer (2016)

Part III. PLANNING FOR THE INEVITABLE

Planning for the future is made simpler by bringing it into the present.

Chapter 9. INVESTING: A Simple Portfolio That’s Beaten the Pros

WHY do I need to read this chapter?

More information is available today than at any time in history. Especially regarding investing, most of the information available is conflicting. This makes sense because each of the world’s financial superpowers, gurus, newsletters, authors, and bloggers rely on differentiation to sell their philosophies.

Whose philosophy can and can’t be relied upon? The good news is that you can ignore most of what is already out there. Instead of relying on the opinion of a “guru” or the predictions of a prophet, you can choose to rely on the evidence—the peer-reviewed, back-tested, academically vetted, reputably published findings.

While you can’t guarantee the future, you can build a surprisingly simple portfolio that has consistently outperformed the majority of professional investors in the past.

The Simple Money Portfolio—engineered for Enough (chap. 1) and designed with both the Elephant and Rider (chap. 3) in mind—is on the other side of a mountain of complexity. I won’t torture you with all of the evidence that goes into this strategy, but it’s important you know enough to maintain a conviction to stick with whatever strategy you choose to employ. So please allow me to establish some context as we work our way toward your portfolio prescription.

A Compressed History of “the Market”

Since 1926, the annualized rate of return of the US stock market has been approximately 10 percent per year. If you invested $10,000 in the US stock market in 1926 and “let it ride,” you’d have roughly $40 million to show for it today, 87 years later. Not bad.

Annualized rate of return: When an investment period is more or less than one year, an annualized return shows what you would have earned per year.

But oh, how it would’ve been a bumpy ride. You’d have lost 90 percent—yes, nine-zero—of your investment following the 1929 crash, and it wouldn’t have been until 1943 that you’d get back to where you started prior to the Great Depression. From 1949 through 1966, the market experienced consistent growth, but from the mid-sixties through 1981, the market traversed 15 years of relative mediocrity. In 1982, however, a bull market began that, despite numerous short-term scares, wouldn’t be reversed until the turn of the century. Fourteen years later, we’re looking back on another decade-plus stretch of relatively paltry market returns. Do the phrases “tech bubble” or “financial crisis” ring any bells?

Bull markets, by the way, are good. Bear markets are bad. If you’re looking for a way to remember that, bulls thrust their horns upward, the direction we’d prefer to see the stock market go. Bears use their powerful paws to thrash downward on their victims.

Do You Have What It Takes?

Let’s leave the realm of hypothetical percentages for a moment and put you in the position of many who experienced the real-life pain of market ups and downs. We’ll determine if you have what it takes to endure the white-knuckle roller coaster ride of the market.

You decided to retire at the end of 2007. You sold your house and downsized, netting an additional $250,000 to add to your $750,000 retirement nest egg, bringing your total retirement savings to $1 million. The income from your nest egg will supplement your Social Security retirement benefit and a small pension. (More on both of those in chap. 11.)

The market had always treated you pretty well, and you’d recovered nicely from the bursting of the tech bubble in the early 2000s. You were confident enough in the market that you left all of your money in a handful of brand-name mutual funds that owned mostly large company stocks. You were certain that you’d be able to ride out any downside. Then came 2008.

In a single year, you saw the head and shoulders of your million-dollar nest egg lopped off—losing $370,000. But the slide didn’t stop there. With optimism brewing over the holidays, you waited to see what happened in the beginning of 2009. What happened was that you lost even more. But you were also taking the old standard of 5 percent per year income stream out of your original portfolio to live on in retirement, so by the end of March 2009, you had only about half of your $1 million nest egg left.

What did you do next?

The Behavior Gap

You sold, of course, right as the market began its recovery and “refunded” your losses. The emotional Elephant took over and tossed the rational Rider (chap. 3).

There’s no shame in this. It felt like the rational thing to do, especially because, at that time, even the world’s top economic and investment minds acknowledged that the crisis could have deepened to Depression-like levels.

But you acted on the basis of the limited information at hand and the emotional turmoil within. Carl Richards, author and New York Times contributor, coined a term for this persistent investment error: the “behavior gap.”

It’s the gap between the return that investments produce and the return that investors in those investments actually earn. They are the same only if an investor holds the investment the entire period in question. As you might suspect, many investors earn less than the very mutual funds in which they invest because they don’t remain invested, getting in and out at the behest of their emotions.

We have a tendency to wait until everyone, including our barista, is blabbing about how much money they’ve made in the market before we finally decide to get in. That inevitably seems to occur near the market’s top. Then, like our friend who retired at the perfectly wrong time, investors historically wait until the market has sufficiently bruised and bloodied them before giving up and getting out.

In short, the research has proven that the average investor has an uncanny propensity to buy high and sell low, the opposite of the profitable investing maxim. As Benjamin Graham, the father of value investing and Warren Buffett’s mentor, said, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”

There’s got to be a better way forward. One better than simply relying on the past to repeat itself and then the second time around knowing enough to talk yourself out of hitting the eject button, right? Can we create an investment plan that accommodates both the Elephant and the Rider?

Thankfully, yes.

The Real Point of Investing

The real point of investing is not actually to make money but to have a better life and facilitate Enough (chap. 1).

The primary objective of investing in stocks, however, is to make money. The primary objective of investing in bonds and cash, then, is to help you stay invested in stocks when it inevitably becomes difficult to do so. The net effect should be that investing adds value to your life, in accordance with your priorities (chap. 2) and in pursuit of your goals (chap. 3).

Evidence-based investing forces us to submit all our opinions and educated guesses to actual peer-reviewed scrutiny. The evidence shows, after all, that it is extremely difficult to “beat the market.” There is a significant body of research, however, that indicates certain asset classes—slices of the full market spectrum—have performed better than others. For example, you already likely know that stocks have historically performed better than bonds. What you may not know is that small-company stocks have outperformed large-company stocks, and value stocks historically have outperformed growth stocks.

· Stocks—Shares of partial ownership in a company.

· Bonds—Loans to a company that pay interest.

· “The market”—Typically refers to a selection of the largest United States companies, best represented by the S&P 500 Index.

· Index—A tracking mechanism for various asset classes.

· Asset Class—A collection of investments with similar characteristics; could be as broad as “stocks” and “bonds” or as specific as “Japanese small cap value.”

Unfortunately, the asset classes that have historically produced outsized returns have also required more intestinal fortitude, at times, in order to reap a reward. Their highs may be higher, but their lows can also be lower. What’s more, they tend to perform poorly in the scariest of times.

The Evolution of Evidence-Based Investing in Four Steps

Fortunately, “the market” so commonly referred to in the financial media isn’t the only market. So let’s examine the impact of blending other asset classes—like bonds, the stocks of smaller companies, and the stocks of international companies—with our large company United States stock market exposure. This is a story first told to me by Larry Swedroe, a chief proponent of evidence-based investing and the author of numerous books on the subject, including his most recent, The Incredible Shrinking Alpha, coauthored with Andrew Berkin.

To ensure we’re comparing apples to apples, we’ll conduct our portfolio examination over the past thirty-nine years, for which there is accurate data across a broad range of asset classes. Since 1975, we have experienced some of the market’s most pronounced ups and downs, but the market has survived them quite respectably. The S&P 500—likely the best United States market-tracking device, which mimics the aggregate price movement of 500 influential stocks—has had an annualized return of 12.15 percent.

Throughout that time, however, there was a great deal of market volatility—that is, the dispersion of market returns was wide. The market suffered three straight down years for the first time since the Great Depression beginning in 2000, and in 2008, I don’t need to remind you that the market got hammered. That year, the S&P 500 lost 37 percent. Its best year during that stretch came in 1995, when the market was up 37 percent.

We measure the volatility of a particular investment by examining its standard deviation. It’s a proportionate gauge of how far the actual returns of an investment deviate from its average return. Between 1975 and 2013, the standard deviation of the S&P 500 was 16.9 percent, which won’t mean a whole lot until we compare it to the standard deviation of a portfolio that includes other asset classes.

To do so, we’ll look through the lens of the Fama/French “Three-Factor Model,” proposed by Nobel Prize winners Kenneth French and Eugene Fama. At its simplest, the Three-Factor Model recognizes a triad of persistent investing factors that tend to offer investors a “premium” in the form of higher returns. The first factor recognizes the higher returns expected for investing in stocks over bonds, but it also forces us to acknowledge that if we want a chance at a higher return, we’ll need to accept greater risk and increased volatility. If we, however, blend a helping of stock exposure along with conservative bonds (note the addition of 5-Year Treasuries), the overall portfolio volatility goes down dramatically, as evidenced in the portfolio below:

The expected return drops by a relative 11 percent (an absolute 1.35 percentage points), a sacrifice most would be willing to make, especially when the volatility is 38 percent lower!

The benefits of stability in a portfolio cannot be underestimated because the evidence, now termed the endowment effect, suggests that portfolio declines are twice as painful to investors as portfolio gains are blissful. This helps explain the behavior gap and screams that the average investor should help keep himself in the game by reducing the downside risk through a meaningful allocation to conservative fixed income.

You need to construct a portfolio that you can live with long term, and I recommend that you err on the side of conservatism, because you don’t know exactly how you’ll respond to sharp market downside until you get there.

Since the foremost portfolio stabilizing agent is fixed income, and since the primary reason we hold fixed income is to steady our portfolio in bad times to avoid exceeding our risk tolerance, it only makes sense to hold the most stable of the stable investments. Those include FDIC-insured CDs, US Treasuries, agencies, and only if you’re in a high tax bracket, AAA- and AA-rated diversified municipal bonds. These can be either general obligation bonds or essential service revenue bonds.

Yes, I omitted corporate bonds from that list as well as high-yield “junk” bonds, because these varietals tend to exhibit more stock-like risk characteristics in down markets. If you’re going to take more risk, you may as well do it in the asset class that offers a higher potential reward—stocks. (While the annual premium for taking stock risk has been about 8 percent, the annual risk premium for taking corporate credit risk has been only about 0.3 percent.)

The second of Fama and French’s three factors is size. Popular culture’s mantra of “bigger is better” does not apply here. In this case small companies outperformed their larger cohorts by a noticeable margin. Thus, splitting one’s stock exposure between large company stocks and small company stocks results in a meaningful increase in the portfolio’s return, but also (to a lesser degree) in its standard deviation:

Factor number three is value. Fama and French demonstrated that, over a long time horizon, value stocks (companies whose share price is low relative to their intrinsic value) have a higher expected return than growth stocks (like social media stocks that haven’t made a profit yet). Adding them increases the portfolio’s expected rate of return, while also increasing its volatility. Take a look:

But here’s where it gets really interesting. Another Nobel Prize-winning brainiac, Harry Markowitz, shocked the world—the investing world, anyway—when he showed that you can stir a more volatile asset class into the mix and actually see the overall portfolio volatility go down. Case in point:

In this particular case, we reduced the portfolio’s United States stock exposure and introduced exposure to international stocks. While they are a more volatile asset class, the total portfolio’s volatility is actually reduced. The reason is because the asset classes are not highly correlated. That means, at times, there is a divergence between how the two asset classes respond to the same market and economic stimuli.

But here’s something you may not have noticed along our four-step portfolio construction journey: By the time we get to Step 4, we have constructed a portfolio with a higher expected rate of return than “the market” with substantially less volatility. Who wouldn’t want that?

The success of the portfolio isn’t based on constantly jumping in and out of the market or betting on hot stock tips and rock-star mutual fund managers. Its success comes from evidence-based diversification and discipline.

The Simple Money Portfolio

Our four-step process brings us to the Simple Money Portfolio. It’s a moderate portfolio grounded in decades of academically scrutinized, peer-reviewed research into the “science” of investing. Between 1975 and 2013, it managed a higher annualized return than “the market,” and did so taking meaningfully less risk:

How, you might ask, can a simple, index-based portfolio outperform the market and most professional investors while taking less risk?

· It diversifies the stock-based investments across a broad range of asset classes that historically have rewarded investors with higher returns than the broader market (small cap stocks and value stocks).

· It diversifies half of the stock exposure beyond the United States and Canada into the international landscape. This exposes the portfolio to many opportunities beyond our borders. But because foreign stocks often don’t move in concert with domestic stocks, investing in these riskier stocks actually reduces the overall risk of the portfolio.

· It lowers the overall risk by investing 40 percent of the portfolio in fixed-income instruments, like bonds. While some will decry the Simple Money Portfolio for being too conservative, the research clearly demonstrates that most investors aren’t capable of enduring the volatility inherent in riskier portfolios. The best portfolio strategy is the one you can live with.

· It limits the negative impact of riskier fixed-income securities by investing in only the most conservative bonds (or bond equivalents) available.

Although it’s surprisingly simple, there is a ton of intellectual horsepower under the hood. It is engineered to forestall the emotions of fear and greed that get the Elephant in trouble, and the Rider appreciates its systematic approach to investing.

Although it may not be the perfect portfolio for you, it could be. Your ideal portfolio will account, most importantly, for your ability, willingness, and need to take risk, reshaping your portfolio by adjusting for those factors. (Go through an exercise designed for this purpose at www.simplemoneyportfolio.com/customize.) And it’s vastly better than inaction, investing without a strategy, or chasing a poorly conceived strategy.

Why haven’t you heard of it before? Well, it has earned the disdain of the broader financial industry because it’s beaten most of their high-paid stock-and-bond-picking pros. They’re too busy trying to beat the market, or at least convincing us that it’s possible.

But Why Not Try to “Beat the Market”?

But why settle? Why not actively work to beat the benchmarks instead of maintaining a more passive, disciplined approach? In short, it’s because the probability of beating the market is so low that it’s prohibitive to try.

First, we must define what it means to actually “beat the market.” We’re not talking about simply outperforming one of the major stock or bond market indexes, like the S&P 500 or the Barclays US Aggregate Bond indexes.

Investors who take more risk than these benchmarks contain in years where taking risk is rewarded could—even should—have a higher expected rate of return. But doing so does not equate to a feat of investing brilliance. No, in order to claim dominance over the market, an investor must achieve a higher risk-adjusted rate of return—the prized, yet elusive, Alpha.

Beta, in investing parlance, is a risk measurement of the overall market. The market has a default Beta of 1. An investment with a Beta of 1.5, therefore, is taking on more risk than the market and should enjoy a proportionately higher reward at a time when the market has an upward trajectory. Of course, you should also expect to lose more on the downside. An investment with a Beta of less than 1 should respond to market stimuli with less gusto, or volatility, than the market.

Beta is all around us, but Alpha is more like a shrouded ghost that investors occasionally glimpse but rarely capture.

Depending on the year, you’ll find statistics confirming that the majority of actively managed funds—mutual funds and hedge funds, whose very existence is justified only by the unlikely hope of attaining Alpha—underperform their appropriate benchmarks. In any typical year, about 60 percent of actively managed funds underperform, and the figure increases as the horizon lengthens.

An even more colossal failing is active managers’ inability to beat the market over an extended period of time, or even a few years consecutively. A Vanguard study confirming previous research found that only 18 percent of active managers were able to outperform their benchmark over the fifteen-year period from 1998 through 2012.1 And that’s before taxes, which are often the largest expense of actively managed funds.

Fully 97 percent of active funds underperformed in at least five of those years, and “two-thirds of them experienced at least three consecutive years of underperformance”during that span. 2

Moneyball

Perhaps you’ve seen the movie Moneyball or read the book by Michael Lewis upon which the film was based. It’s an underdog story about how a financially underresourced baseball team, the Oakland Athletics, managed to compete with and often beat the richest teams in the league. They did so by applying a systematic, evidence-based approach to the recruitment of team talent. Stripping themselves of the predominant prejudices of the sport—for example, that ranked players whose visible physiques mirrored the athletic ideal higher—they focused entirely on the evidence before them, favoring calculations like on-base percentage.

The subtitle of Moneyball is “The Art of Winning an Unfair Game.” According to many, investing is an unfair game, dominated by Wall Street’s power brokers who operate primarily in pursuit of personal gain. (Incidentally, Michael Lewis, a former Salomon Brothers bond trader, is one who holds this opinion.)

But much in the same way that the evidence helped the A’s compete with baseball’s most powerful franchises, evidenced-based investing can help you compete with—and often beat—Wall Street at its own game.

1. Instead of relying on the opinion of a guru or the predictions of a prophet, you can choose to rely on the evidence—the peer-reviewed, back-tested, academically vetted, reputably published evidence.

2. If you invested $10,000 in the United States stock market in 1926 and “let it ride,” you’d have roughly $40 million to show for it today, but it was an almost unendurable ride—including a 90 percent loss following the 1929 crash. There’s got to be a better way than simply buying and holding “the market.” (And there is.)

3. The emotional damage done by market downside leads to the “behavior gap,” causing investors to jump in and out of investments, inevitably earning less than the investments they hold.

4. The real point of investing is not to actually make money but to have a better life. The primary objective of investing in stocks, however, is to make money. The primary objective of investing in bonds and cash, then, is to help you stay invested in stocks when it becomes difficult to do so.

5. The evidence suggests the following:

· It’s extremely difficult to “beat the market” by picking stocks.

· Stocks have historically performed better than bonds.

· Small-company stocks have outperformed large-company stocks.

· Value stocks have outperformed growth stocks.

6. The Simple Money Portfolio—broadly diversified with 40 percent in bonds and tilted in the direction of outperforming asset classes—has had returns as good or better than “the market” since 1975, and has done so with meaningfully less risk.

7. Much in the same way that Billy Beane helped the Oakland Athletics beat “superior” teams with evidence-based baseball, evidence-based investing can help you compete with—and often beat—Wall Street at its own game.