Financial Planning, Index Investing and Bad Behavior

June 21, 2018 10:00 am

When it comes to financial planning and investing, we can all agree that each investor situation can be very unique and require different solutions in order to meet one’s goals or objectives. However, there are two phrases that I believe apply to almost every individual client I have ever served over my twenty year career.

“The market doesn’t owe you a retirement”

“Don’t let the asset allocation decision hijack your financial plan”

I will never forget the first time I heard both of these phrases in 2006 while serving as a Regional Director for Dimensional Fund Advisors (DFA). During educational conferences to independent advisors around the country, two of my friends and former colleagues would often share each perspective during their presentations.

While some areas of the capital markets have changed, these statements hold true and follow our underlying firm philosophy when it comes to financial planning, investing, and retirement income solutions.

Most understand that we should all be disciplined savers, because the market doesn’t owe us anything. It isn’t required to bail us out with extraordinary returns for our bad behavior due to the lack of saving. However, the second phrase is not so clear to some. The initial meaning was to assess the negative impact of active management on one’s financial plan. It has also been significant since we often see so many investors whose asset allocation is not properly diversified.

Regardless if one believes in active or passive investing, a poor asset allocation strategy can add undesired portfolio risk and volatility, as well as cause investors to fail in reaching their long-term performance objectives. As a result, its very likely financial planning and retirement goals are also compromised.

Source: In US dollars. Dimensional Fund Advisors. Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio. Past performance is not a guarantee of future results. Actual returns may be lower.

 

For decades, many investors have often used a rule of thumb as they approach retirement and view a 60% stock / 40% bond portfolio as adequate. A big reason is that there has been academic research going back to the 1950’s (Harry Markowitz, 1952 – Modern Portfolio Theory; Bill Sharpe, 1964 – Capital Asset Pricing Model; both won a Nobel Prize for their work) on why and how someone should diversify in all market conditions.

However, the investable market has grown since 1964. For example, many investors view the S&P 500 Index to be a good representation of “the market”. Although, we know this is not the case and there have been long periods of time when the S&P has severely underperformed other areas of the market. In addition, most would be surprised to learn that the S&P 500 Index is only approximately 4% of the investable market.

As of February 1st, 2016. “Volatility” represents the global market for options; “Royalties” represents the global market for payments made to the owner of an asset for the use of that asset. 

 

As you can see in the chart above, traditional stocks, bonds and real estate make up a large part of the market. Its also worthy to notice other investable markets that did not exist or were not easy to access in decades past.

For some investors, a traditional 60/40 asset allocation may still be desirable. However, its important for investors to understand the risk factors that can drive multiple sources of portfolio return in today’s market. A very good data point to consider would be the level of 10 year treasury rates as illustrated below.

Source: Federal Reserve Bank of St. Louis, FRED Economic Data. Period: January 1, 1964 to March 31, 2018

 

While the market in some ways has changed, its important to emphasize that our investment philosophy has not. At CAM, we are big proponents for an indexing philosophy that is low-cost, well-diversified and tax-efficient.

That being said, we do understand the importance of helping our clients to achieve their long-term performance objectives. As a result, our rigorous academic approach continues to evolve with the latest research for the benefit of our clients. As investable markets grow, we continue to evaluate and invest in more difficult to access markets that are not solely dependent on corporate earnings or interest rate movements. Given our structured and well-diversified approach, we seek to provide continuous and reliable exposure to sources of higher expected return for our clients.  Beyond just pursuing higher performance, this philosophy can provide our clients a higher probability of meeting their financial planning goals and objectives.

We appreciate our relationship with you and we are here to help.

Best,
Marc

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Source:  Dimensional Fund Advisors; Bloomberg; Stone Ridge Asset Management; McKinsey; SIFMA; Morgan Stanley; BIS; Deloitte; 2018 S&P Dow Jones Indices LLC; Federal Reserve Bank of St. Louis; Illuminating the Path Forward, February 2017;  M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. There are many different interpretations of investment statistics and many different ideas about how to best use them. Nothing in this presentation should be interpreted to state or imply that past results are an indication of future performance. Tax planning and investment illustrations are provided for educational purposes and should not be considered tax advice or recommendations. Investors should seek additional advice from their financial advisor or tax professional.

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This post was written by Marc Jimenez, CFA, CFP®

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