Make It Last – Ep 68 – How Should You Plan for an Unpredictable Market?

August 18, 2018 Victor Medina Uncategorized 0 Comments

On this episode you will find a continuation of the second half of episode 67, where Victor discussed the unpredictability of the stock market. Here, Victor will discuss the answer to the question- if the market is so unpredictable, why should you have a plan at all? As well as, what type of plan is best to follow.

 

Make It Last with Victor Medina is hosted by Victor J. Medina, an estate planning and Certified Elder Law Attorney (CELA®) and Certified Financial Planner™ professional (CFP). Through his law firm and independent registered investment advisory company, Victor provides 360º Wealth Protection Strategies for individuals in or nearing retirement.

For more information, visit Medina Law Group or Palante Wealth Advisors.

Click below to read the full transcript

Victor Medina:  Everybody, welcome back to Make It Last. I’m your host, Victor Medina. I’m so glad that you can join us this Saturday morning. We’ve got an exciting show for you here today.

I’ll tell you something, if you missed last week’s show we’re actually going to be continuing on a little bit of a theme that we touched on last week. Let me recap that for you real quick. Last week, toward the end of the show, in the last segment, I talked a little bit about active fund managers, people who are trying to time the market.

I want to distinguish here between people who are actively trying to underprice securities, those people that think that they’ve got a good deal, that they can predict what a particular security is going to be going in which direction, and actively trying to time the market.

I focused last week on timing the market, knowing that you are at the height and therefore it was appropriate to move to cash before things started to tumble down, and then knowing, for instance, that you were at the bottom, and then to use that cash to invest.

The report that we covered last week disproved anyone’s real ability to do that with any degree of confidence. The numbers that we shared is that in order for that type of strategy to be effective, somebody had to be right north of 70 or 74 percent of the time, and nobody out of the top 28 people that were identified were capable of doing it even slightly more than 50 percent of the time.

Although that sounds numerically like it means that there is an advantage ‑‑ you’re going to be right more than half of the time ‑‑ unfortunately, there are all these transactional costs that go into that that basically dilute any real effectiveness at the end of the day.

So here was the point. The point was that you can’t time the market. I left last week’s show with a bit of a tease, saying, “Well, if there’s no point in timing the market, if they are unpredictable, then why have a plan at all?”

I mentioned that I was going to talk about that today. I do want to talk about the strategy of an investment plan and why one might have some plan going into some investment strategies.

A couple of quotes that come to mind…I think Patton was famous for saying that everyone needs a plan and all plans are useless. Mike Tyson was famous for saying, “Everyone’s got a plan until they get punched in the face.” [laughs]

We’re going to still need a plan at the end of the day here, but we need to understand that the plan is not about the ability to predict with certainty what’s going to happen at any point in time.

This arrives at my own personal philosophy on investing and why we have decided to use a particular fund family within our strategies ‑‑ because their philosophy, their approach to it very much matches what my academic research has suggested is the case.

When you look at it, there are these factors in investing that will allow you to outperform the market on a consistent basis. In order for those kinds of strategies, factors, something like that, in order for them to be valid, they need to be a few things.

Actually, before going to that, let me set the stage a little bit better. When we think about the stock market, you have to understand that we’re thinking about securities, like the price of stocks or the price of bonds. These are securities. We’re thinking about investment opportunities, and they all have a price.

There is some price that is set for that, that’s the value of that. That price is essentially what someone is willing to pay or someone is willing to sell at in order to make a transaction.

The market is a very effective information‑processing machine. Every day, the world processes billions of dollars in trades between buyers and sellers and the real‑time information that they bring that helps set the prices.

If you think about the entire world of available information and about $407 billion in equity trading on a daily average for 2017, that’s going to arrive at a price. What we have to do is not fight that price.

The market’s very good at calculating that and arriving at it by way of consensus just because of the volume of information that’s out there. What we need to do is not to try to outguess the market. The market’s pricing power works against managers who try to outperform through market timing.

Extending on some of the research that I shared last week, in the equity world there are maybe 2,800 beginning fund managers in a 10‑ or 14‑year period. Let’s say 2,800 start. Only about 51 of them are even in existence at the end of that. 51 percent of them.

Only half of them even exist over that period. Everyone else has gone away. Out of those, only 14 percent actually outperformed their benchmarks over the course of the last 15 years. The problem is that, of course, it was impossible to predict which of those 14 percent it was going to be.

If you look at fixed income traders, those are the people that trade bonds and similar fixed income instruments, we start with fewer of those, only about 1,600. The numbers are very, very similar. Only about 55 percent of them exist after 15 years, and only 13 percent of those are winners against their benchmark.

We can’t try to outguess. The other thing that we have to do is resist chasing past performance. What that means is that a lot of investors out there believe that the right thing to do is to select mutual funds or managers of money based on their past returns. Empirically, based on evidence, past performance offers very, very little insight into a future fund’s returns.

Most of the funds in the top quartile, that’s top 25 percent, of the previous three years did not maintain that ranking in the following three years. If you look back over the course of 2005, let’s say, to 2017, somewhere in that range, most of them, over 70 percent of those people that start in the top quarter did not end up in the top quarter.

Now, with all of that said, the evidence also suggests that the financial markets have rewarded long‑term investments as long as people follow a good investment strategy.

There are particular drivers of returns that help distinguish someone’s performance against the general market. Academic research has identified six things that investors can pursue in terms of getting higher returns by structuring their portfolio around these.

What I’m going to do is I’m going to take a break here. I want you to go grab pen and paper, even though there’s a commercial coming up and it’s probably a commercial for [laughs] my law firm, or a book that you can get, or something like that.

Turn the radio up nice and loud. [laughs] Go and get a notepad. When you come back, we’re going to go over each one of those dimensions of returns and why they are essentially drivers of higher portfolio returns than the alternatives in there.

[background music]

Victor:  I’m going to set that up, teaching you a little bit about how they need to be structured. Who knows? We’re going to go into all of that, and, hopefully, it will land. Stick with us, we’ll be right back here on Make It Last.

[commercial break]

[background music]

Victor:  Hey, everybody. Welcome back to Make It Last. We’re talking about investment strategies and, if we can’t outperform the market by timing it, by chasing past performance, for finding relative price differentials on things, then what strategy should we follow?

I’m sharing with you my investment philosophy, the thing that is not what I believe because it’s a guess, but really what I’ve arrived at through examination of academic rigor, putting the lawyer’s hat on that makes me skeptical of anyone that feeds me a line of BS and really diving into the research. Pulling it apart, pushing on it, and then arriving at the smartest investment strategy.

Now, here’s the problem with the smartest investment strategy. The smartest investment strategy is not always the sexiest one. It’s not necessarily exciting. It might be exciting if you’re into numbers and gearhead‑ey stuff like economics and economic philosophy, but if you’re looking for excitement in investing, this strategy is not going to satisfy you.

It will work. The other one might lead you to as likely be broke as wealthy, but mine will work. It will just be boring. [laughs] I don’t know how else to put it on there.

We were talking right before the break about different factors, dimensions of return that will essentially drive investment performance higher, a portfolio that is centered around those than ones that are not.

In order for us to agree to chase one of these six factors, from an academic standpoint this factor needs to be a few things. Needs to be sensible ‑‑ needs to absolutely just make sense that one would work over another. We’ll test that on a few of those that we’re going to walk through.

It needs to be persistent. That means that it can’t be a flash in a pan. It needs to be regular. It needs to be pervasive, pervasive essentially meaning that it needs to be spread across multiple factors of a sector, industry, things like that.

It needs to be wide as well as being consistent. Not only should it be wide, but it should also be robust, which means that it should be deep. We should see something that is measurable off of that.

At the end of the day, it has to be cost effective. We can’t pursue something here that is sensible, persistent, pervasive, robust, but if it costs us too much to go and do that, if it basically erases the return because of the way we have to chase it, then it’s not a right thing to go ahead and tilt portfolios towards.

At the end of the day, there are essentially six different distinctions that you can make in your investment portfolio that will lead to systematic differences in expected returns. The first one is where you are in the market. There is a premium with return on investing in stocks versus bonds.

Now, let’s pull that apart against our test. Does it make sense that stocks are going to outperform bonds? Sure. Bonds are a set of fixed income debt, interest rate driven things, and stocks are about the growth of a company. It’s sensible that stocks are going to outperform.

Is it persistent? Yes. Over the course of time, stocks have outperformed bonds. If you look at bonds over the course of a dollar compounded for the last 80 or 90 years, $1 turned into about $143 for bonds. It turned into $7,000 over the course of that same time on just large‑cap companies.

It is persistent. It is pervasive ‑‑ it’s across all stocks versus all bonds essentially ‑‑ and is robust. The difference between $7,300 of compounded growth versus $143 ‑‑ pretty robust, right? It’s cost effective ‑‑ you can just buy it and hold it and be able to enjoy that.

You see how that works, right? All right, great.

The first one is basically a premium that exists on equity versus fixed income. That’s number one. Number two has to deal with the company size. What we mean by that is that small companies actually return a higher return on investment versus large companies. That meets all of the tests.

At the end of the day, let’s focus just on the number. You remember I was talking to you about the compounded growth of a dollar and I said, $1 turned into $7,300 for US large cap over a period of time compounded. That same dollar turned into $23,000 small‑cap versus large‑cap ‑‑ $15,000 more or nearly three times the return being a small company versus a large company.

The company size is the second one. We talked about the kind of market, equities over fixed income, company size, small companies over large companies. The next one has to do with relative price.

You probably don’t know what that means, but you’ve heard about value versus growth companies. Essentially, value stocks are those with lower price to book ratios because relative price is basically measured as a price to book ratio. Those companies that are value companies will outperform those that are growth companies.

The last one within the world of stocks generally is profitability. What that means is, if you review their income statements, those companies that are highly profitable will outperform those ones that are not as profitable, lower profit.

Those are the ones in the equity. Those are four of them ‑‑ market, equity over fixed income, company size, small over large, relative price, value over stock, and profitability, high profit versus low profit. There are two additional dimensions of return in the fixed income space.

One of them has to do with the term of the fixed income ‑‑ those fixed income instruments that are longer in maturity outperform those that are shorter in maturity ‑‑ and essentially a credit premium ‑‑ depending on the credit quality of the bonds, you will have outperformance in those areas.

If we go through the six, it’s market, company, relative price, profitability, term and credit. Thankfully, you don’t have to think through all of this stuff on your own. What you can do is work with an advisor who follows this same philosophy, and that essentially will get you the benefit of these returns.

There are numbers that we can share about exactly what those dimensions of return outperform versus their other choices. You will see in each of the company size, relative price, profitability, so on and so forth, that there is, in fact, a differential that is pervasive in focusing on those premiums.

That’s really why we need to have a plan ‑‑ because the nature of the unpredictability of the market means we have to find the things that, while they are pervasive and they stand up to academic rigor, will, in fact, allow us to enjoy bigger returns. As I said to you, this becomes boring because, once you’ve figured it out, you don’t change investment strategy.

I’m going a little long on a break here, but I want to be clear about this. When people have investments with us, one of the things that they are surprised to learn is that we are not calling them on a regular or semi‑regular basis with a new idea, with a hot take about what they should be doing with their money. We don’t do that.

We already understand what they should be doing with their money. The discipline comes staying the course. The benefits of following that is in not changing the idea, because it doesn’t matter if you think something’s going to work better, you have to let it stand up to academic rigor, and nothing else does.

At the end of the day, these are the dimensions of return, the premiums that will return back more money if you focus on them.

[background music]

Victor:  Then, as I said, it gets really boring because you just stick with it. [laughs] My clients are happy, they’re happy not to hear from me. It’s working, but that’s the way that you have to set those things up.

I hope that’s helpful for you. We’re going to take a quick break. Depending on how I feel when we come back from that, we might continue on this and wrap it up, but I do have a couple other things that I want to get to today. Do stick with us. We’ll be right back here on Make It Last.

[commercial break]

Victor:  Hey, everybody. Welcome back to Make It Last.

We’ve been talking about investment strategies and really what should you be focusing on in retirement, generally in investing. This strategy actually works very well in accumulation strategies as well decumulation strategies.

If you’re going to participate in the market, let’s be smart about what you’re investing in, so that, at the end of the day, you will actually see dimensions of return and do better than what is conventionally done when you think about how to invest ‑‑ market timing, chasing after past performance.

When we left on that break, I gave you six dimensions of return that, tested against academic rigor, have shown, in fact, that they will outperform. This isn’t to say somebody can’t outperform this strategy. Certainly, with enough correct guessing, you could. We just don’t know that you will.

A typical response to this is, “Doesn’t that mean that what you’re advocating is essentially just indexing?” That is a very valid point, and really kudos to the people that are there thinking about it in this way.

From the perspective of, “Are you following one strategy and allowing that strategy to dictate your passive investments and what you’re going to be doing?” certainly, indexing sounds a lot like it. If you gave me two choices between indexing and active management or chasing past performance, I would certainly try to do indexing.

There were a couple of wrinkles to that that have developed over time that has muddied the waters about this concept of indexing.

Essentially, indexing, what it’s trying to do is create a basket of securities represented in the index. For instance, the S&P 500 is an index. The Russell 2000, the Russell 3000, those are indices. We really need to understand what they represent.

The S&P 500 represents the 500 largest domestic US companies. Over time, companies fall in and out of the definition of that index, but just following that index is not following the strategy that I told you was the result of this economic engineering around investments.

In fact, the S&P 500, while it meets the equity component of the dimensions of return, it fails small cap versus large cap. It fails value versus growth. I don’t know exactly how it shakes out in profitability, but the point is that it doesn’t meet all of them.

What got muddied in the waters of indexing is the definition of the index. People are now investing in ETFs, which are essentially a basket of securities, very low trading costs, and the idea is that they will represent a sector or something like that. You can get now really thin‑sliced…Healthcare as a sector, technology as a sector. You can get all these kinds of ETFs.

What has happened is, rather than buying ETFs that represent the entire market, what they do is reconstruct their sort of magic portfolio. “I got to have some of this, I got to have some of this and I got to have some of that. I’m going to listen to CNBC, I want to follow the rules, and whoever is talking to me the loudest at 4:00 PM when I switch it on, that’s what I’m going to follow.”

They’ve recreated that same problem. It’s just in a low‑cost solution instead of a higher cost solution, but it doesn’t necessarily mean that their portfolio is going to do any better. Man, I just completely blew through anything else I wanted to talk about today. [laughs]

Finishing up on the concept of indexing, again, indexing over active management is probably a good idea, but indexing versus the strategy that I laid out here today will ultimately fail. I don’t mean fail ‑‑ my strategy will outperform it because the index in and of itself does not mean that you are following the other things that will lead to better returns going forward. It doesn’t do that.

In fact, because the index managers, people creating the index, because they follow these prospectuses ‑‑ they can get sued if they don’t do what they say that they’re going to do in the prospectus ‑‑ because they all have to follow this, when the index resets, there are enormous trading costs that go along with getting all of the securities that had fallen out of the index to come back in again.

A few of them reset in June. I think June 25th on the Russell’s. When that happens, there is a massive rush to buy all the new securities that are now defined as being in that index. Of course, we don’t get them at a bargain when we do that.

This is a better strategy, the one that I laid out. This is a better strategy than straight indexing.

I hesitate to go in that direction because I want to give you all of the right information. The people that are chasing indices or using indexes, look, you’re doing something better than chasing past performance and market timing and stuff like that. I want to pat you on the back about that, but, at the same time, I want to let you know…

Like you and me at a bar having a drink or we’re out in coffee and you say to me, “Come on, cards on the table. Is this the absolute best thing to be doing?” I’ve got to come back and say, “No.” I’ve got to say no. I’ve got to say, “No, at the end of the day, this other strategy is better.”

There are a class of investment managers that believe in this strategy. Although, this company, Dimensional Fund Advisors, DFA, is not the only one that does this kind of strategy, they were the first and they have a directory that you can go to to search to find advisors that offer dimensional funds. They will offer you dimensional funds.

What’s good is that you can go to the Dimensional site and tell them that you’re an individual and go search and find an advisor near you that will offer this. Clearly, that’s something that I do. I’ve already been talking about it, so you know that about us. If you’re not near us, if you’re listening far and wide, and you want to find an investment advisor that does that this way, you can go and do that.

Here’s the trick about this, which is that the dimensional funds are not available to the public generally. You have to work with an advisor to do that.

The reason why is that Dimensional understands that individual investors, they’re a little crazy. They’re going to move in and out of money. They’re not going to follow the strategy. They get nervous, and the advisor helps them keep on the path.

It’s important that you work with an advisor because only advisors are cleared to offer these. Then, similarly, only certain advisors have been approved to offer these because they’re going to follow the strategy that is built into that.

I’m not telling you that’s the only one. I’m just telling you that’s the one that we believe in. I think that it’s the best one going forward.

Of course, that’s where we’ve drunk the Kool‑Aid, but not just because it sounds great, but because I took the lawyer’s hat on and I said, “I’m going to test, I’m going to pull on this. I’m not going to believe the thing anybody ever tells me about it. I’m going to go ahead and test it all out.” At the end of the day, this is what won.

I hope that you’ve found this interesting for today. That means I’ve got to take everything I was going to talk about today and push it off to another show. I promise you that other show is going to be as interesting and entertaining as this show.

Every time that you want to listen to this, you should get a notepad and pen. You can go back if you want to go back to this show and you were listening live on the radio.

Remember, we do offer a podcast version of this that will rebroadcast this show. All you have to go is to iTunes or anywhere that you can find a podcast. You can even go to MakeItLastRadio.com, and you can push the Play button that’s in there and play any past episode.

You can go to Spotify, which is absolutely free, search for Make It Last on Spotify. In fact, you can go and play all the past episodes. This is a great one to, I think, go back and listen to again because there’s a lot of stuff really deep into this here.

Then finally, of course, if you have a friend, share it with a friend.

[background music]

Victor:  That’s it for today. Thank you so much for joining us. We will catch you next Saturday on Make It Last, where we help you keep your legal ducks in a row and your financial nest eggs secure. Catch you next time. Bye‑bye.

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