“Sustainable Alpha” or Why an Investment Advisor’s Job Isn’t What You Think It Is

“You keep using that word. I do not think it means what you think it means.” Inigo Montoya from the 1987 film The Princess Bride.

“Alpha” is the holy grail of investing. Alpha simply means outperforming the appropriate risk-adjusted benchmark. Basically, alpha shows whether an investment manager is adding value.

The object of every active investment manager is to achieve as much alpha as possible. The object of every investor is to find those managers that achieve alpha.

Here’s the problem: Alpha is exceeding rare in the investing world, and, what’s more, it doesn’t seem to last long when you find it.

Indeed, Larry Swedroe wrote a nice book called “The Incredible Shrinking Alpha!” that shows how investment managers’ ability to capture alpha via clever and unnoticed strategies has shrunk dramatically over time as academics have uncovered their methods, which, in turn, has allowed other investment managers or even index funds to replicate those strategies.

So, is alpha dead?

Well, yes and no. Alpha generated by being smarter than everyone else in the room for long periods of time – what I’ll call IQ Alpha – appears to be going the way of dial up internet. It’s simply too difficult in a world of super computers, huge data bases and armies of genius-level finance experts (whom I’ve heard look a bit like this) to outsmart Wall Street for long.

However, all hope is not lost. A different form of alpha is achievable, and not just achievable, but achievable by us mere mortals. But beware, while this form of alpha doesn’t require a perfect SAT score, it does require something rarer: Discipline. Wes Gray, a former finance professor at Drexel University and founder of the investment firm Alpha Architect, calls this other form of superior performance “Sustainable Alpha.”

Wes uses a great poker analogy to explain sustainable alpha. For poker players, picking the right table is crucial. You need to know who the fish (the suckers) at the table are and who the sharks are. What’s more, you need to figure out a way to beat the other sharks.

The Fish

We know from actual results that your average investor is a fish. Tricked by brains that evolved to stay alive in the wilderness not Wall Street, investors make a host of behavioral mistakes that lead to mispricing any number of assets. We’re simply not mentally built to make good investment decisions.

The Sharks

Hedge fund managers, mutual fund managers and institutional money managers are the sharks. They literally have rooms full of the smartest minds in the world analyzing huge amount of data looking for any little advantage.

Looking at these competitors, we quickly realize that we’re not going to beat them via superior brain power. (Heck, they can’t even beat each other because their big, throbbing brains are canceling each other out.) Luckily, they have an Achilles’ heel that we can exploit.

Those asset mispricings that investors create through their bad behavior, well, they come with a poison pill for our fellow sharks.  You see, those mispricings that sometimes unfairly drive asset prices too far down or too far up can take a very long time to get corrected. A shark that tries to take advantage of those investor mistakes may have to wait years – sometimes more than a decade – to get rewarded.

This presents a serious problem for hedge fund managers, active mutual fund managers and institutional money managers. While they may be willing to wait, their investors are not. Research and surveys show that most investors won’t tolerate “underperformance” for more than a couple of years – if that. Money managers know that they can profit from investor mistakes over the long run, but they also know that their clients operate in the short run.

Employing a strategy that captures the alpha created by investors’ behavioral mistakes will get them fired, and they know it. For them, the alpha dangles just out of reach on a cliff’s edge.

That’s what makes Wes Gray’s alpha sustainable. Big-time money managers face too much career risk to go after it. The other sharks at the table can’t take that pot of cash.

But what if an investment advisor was careful about picking clients and helping them understand what investing really means? What if an investment advisor figured out that his or her real job was less about being the smartest guy in the room and more about educating clients on investing fundamentals and, more importantly, investing history so they were mentally prepared to wait out the eventual periods of underperformance?

As Wes likes to say, “To capture sustainable alpha, you need sustainable clients.”

People often think that an investment advisor’s job is to make a lot of moves, reacting to or anticipating trends in the market. It’s not. A good investment advisor is, above all, an educator. An educated client stops being a fish. An educated client with enough of an understanding of our investment strategy to maintain the discipline needed to capture sustainable alpha becomes a shark.

Stop being a fish and start being a shark!

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Squaring the Low Expected Returns’ Circle: Part II

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” – John Maynard Keynes

In my previous blog, I showed the dismal expected returns for U.S. Treasury bonds and large-cap American stocks over the next seven to ten years. Your typical American investor with a 60% stock/40% bond portfolio is staring down the barrel of potentially devastating returns – ~2.5% a year above inflation compared to ~5.0% a year real returns they’ve earned historically.

Naturally, this leads to the obvious question: What can we do about it?

Well, you could spend less, save more and delay retirement for a couple of years. This would solve the problem for most people. However, from an investment perspective, you can also take some steps that could help improve your returns.

Look Abroad

While U.S. stocks look pretty expensive relative to history, international developed stocks and emerging markets stocks appear reasonably priced. Here’s the breakdown of expected annual real returns for stocks over the next seven to ten years:

U.S. stocks                                 4.0%

International Developed            5.5%

Emerging Markets                     7.0%

As you can see, valuations point to much better returns for international stocks. Sadly, valuations aren’t saying that international stocks are poised for great returns. In fact, they look quite average from a historical perspective; it’s just that they look good compared to the paltry expected returns on U.S. stocks.

Factor Diversification

For those not familiar with “Factor Diversification,” please take a look at my articles here, here and here. Simply put, factors are characteristics that tend to add a premium (additional return) to the underlying stock. Two of the most studied are the Small and Value premiums. Stocks with these attributes have historically outperformed the S&P 500. How much?

January 1928 to June 2016 annual nominal returns*

S&P 500                                        9.7%

U.S. Large Value Stocks              11.1%

U.S. Small Stocks                        12.0%

As you can see, owning value stock would have increased your returns by 1.4% a year, while owning small stocks would have increased returns by 2.3% a year. Unfortunately, factor investing has become more popular with institutional investors, so let’s estimate that going forward the value and small premiums will be worth ~1.0% a year each.

Putting It All Together

Armed with this knowledge, let’s look at a portfolio that’s globally and factor diversified:

Allocation                                                                               Expected Return

15% S&P 500                                                                                   4.0%

15% U.S. Small Value                                                                      6.0%

10% Large International Developed Stocks                                     5.5%

10% International Developed Small Value Stocks                          7.5%

10% Emerging Markets Value Stocks                                              8.0%

40% U.S. Treasury Bonds                                                                0.0%

If you do the math, you’d find that this portfolio is estimated to earn 3.6% annual real return, possibly a touch more due to rebalancing. (Incorporating another factor known as Momentum also likely would improve returns.) Now, that’s still below the historic 5.0% annual real return, but it’s far better than the 2.4% annual real return that we started with.

Why Doesn’t Everybody Do It

Ok, it’s seems like a no-brainer. Add international developed stocks, emerging market stocks, value stocks and small stocks to the stock portion of your portfolio and you likely will help boost your returns while adding diversification, which is always a good thing.

This begs the next question: If this is so obvious, why doesn’t everybody do it?

In a word: Psychology.

To quote Warren Buffet, “Investing is simple but not easy.” Everybody loves the “idea” of being diversified but finds the reality of owning stocks that go up and, particularly, down at different times than the S&P 500 extraordinarily painful.

For example, the S&P 500 has demolished international developed and emerging market stocks for the past FIVE years. If that’s not bad enough, the value premium and small premiums have both been NEGATIVE over that same period. Let’s look at what a $1,000 invested in each asset would have grown to over the past five years**:

S&P 500                                                   $1,770

U.S. Large Value Stocks                          $1,691

U.S. Small Stocks                                    $1,605

International Developed Stocks               $1,009

Emerging Market Stocks                          $985

Look at those international numbers again. You would have endured political turmoil and wild gyrations in stock values for five years just to be more or less flat, while American stocks soared. Most people can’t handle it. The pain becomes too much, and they bail out on their international stocks. The same thing happens with owning small and value stocks when they have long periods of dramatic under performance compared to the S&P 500.

Having a well-diversified portfolio works in the long run (think 10 to 15 years), but our minds don’t operate that way. If you install a washing machine, and it doesn’t work, you don’t wait 15 years to see if it will come around. You get rid of it. The same goes for employees. If you have an employee who has been terrible at their job for the past five years, you fire the person. And rightfully so! They are never going to get better.

But that’s not how investing works. Successful investing is a form of psychological torture, and your only defense is understanding why diversification works and knowing the history of asset returns, which prepares you for the long stretches (sometimes lasting longer than a decade) of under performance that eventually hit all assets.

So, yes, all the evidence (both academic research and live mutual fund returns) shows that a globally, factor diversified portfolio is the best option. In addition, valuations strongly suggest that this type of portfolio could be particularly useful over the next decade.

However, history also shows that unless you have a very good understanding of why a globally, factor diversified portfolio works, the odds are extremely high that you will not stick to the plan, in which case, you would have been better off staying with American stocks and accepting the expected lower returns.

My best advice is to prepare for lower returns and to get the education needed to adopt a globally, factor diversified portfolio.

*Based on Prof. Ken French’s Princeton database, using Large Value Index and Small Cap Index.

**Funds and indexes used are S&P 500 index, DFA Large Value fund, DFA Micro Cap fund, MSCI EAFE Index and DFA Emerging Markets Portfolio

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Squaring the Low Expected Returns’ Circle: Part I

“Face reality as it is, not as it was or as your wish it to be,” Jack Welch.

Alright, Jack, let’s face some reality. Investment returns for your average American investor over the next 10 years or so are not looking good. In fact, they’re looking bad. Actually, they’re looking terrible.

How bad? The best guess for a 60% stock/40% bond portfolio is ~4.0% nominal and ~2.5% real (above inflation) a year. Historically, you’d be looking at ~8.0% nominal and 5.0% real.

Yep, returns over the next seven to ten years could be around half of their historic average. Investors need to understand why this is the case and what they can do about it.

Why Are Expected Returns So Low

Predicting short-term (less than two years) and intermediate-term (two to seven years) investment returns is nearly impossible. However, when you go out a bit further, you can get a pretty decent idea of the range of returns that you can expect. Valuations on various asset classes aren’t a GPS, but they can point you in the right direction.

So, what are valuations on U.S. stocks and bonds showing? Pain, a lot of pain.

Let’s start with bond rates. Why start with bonds? Well, because bonds are easy. They tell you what they’re going to pay you over time. Throw in your best guess of inflation and you know what your real return (what you’ll earn on an investment above inflation – the only number that really matters) will be.

Ok, so what are bonds paying (yielding) these days? Not much. A 10-Year Treasury bond is paying about 1.5% a year. When you consider that 10-Year Treasury bonds have historically paid between 5% and 6% a year, you can see that bonds are paying far below their long-term average.

Alright, so what’s the expected inflation rate for the next 10 years? Unfortunately, inflation is also expected to be around 1.5%, which means that 10-Year U.S. government bonds over the next decade will be paying you right around zero percent a year above inflation. (Historically, 10-year Treasuries paid ~2.0% a year above inflation.)

Well, that’s not so great is it? But, hey, what about stocks? Stocks are the engine of growth, right?

Unfortunately, American stocks look a bit expensive relative to history. There are dozens of ways to value stocks, but they’re all pointing to the same place: U.S. stocks are poised to pay around 4.0% a year real return for the next seven to ten years. (Here’s a nice article showing how various valuation methods get to similar expected returns for big American stocks.)

Alright, let’s look at our 60% stock/40% bond portfolio.

60% (stock allocation) X 4.0% = 2.4%

40% (bond allocation) X 0.0% = 0.0%

Add those together and you get 2.4% a year real return. Throw in 1.5% a year for inflation, and you get ~4.0% a year nominal return.

If you’re thinking that this looks pretty bad, you’re right. Looking over the past century or so, we’ve seen times when bond valuations didn’t look good (as they do today), and we’ve seen times when stock valuations didn’t look good (as they do today); however, we’ve never a situation where BOTH stock and bond valuations look terrible at the same time. We’re truly in uncharted waters.

So, what do we do?

First, don’t panic. These expected returns are just best guesses. We could get better than expected returns or worse than expected returns. However, they are useful for planning purposes. When you have high valuations – like we do now – it’s extremely prudent to plan on lower returns because the chances are much higher that this will be the case.

Second, there are actions that you can take to improve your chances of achieving higher returns by properly diversifying your portfolio, something that we’ll look at in the next article.

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Invert, Always Invert!*

The more that I learn about investing, the more I learn that investing is simply rediscovering commonsense lessons about everything in life through statistics. Here’s one a great lesson in how to think about a problem (any problem) by turning it on its head. (Optional investing lesson at the end.)

During World War II, the Allied Air Command was understandably concerned about bomber losses during raids over Germany. Enemy anti-aircraft batteries were shooting down the lumbering bombers – mostly B-17s – at an alarming rate.

The British and Americans considered adding armor to the aircraft, but the added weight would slow the planes down even more, so the Allies wanted to be sure that the metal would be used most effectively.

After examining the returning planes, the British initially proposed to add armor to the areas that had taken the most hits. However, to be sure of their decision, the Allies brought in the mathematician Abraham Wald, who had fled Austria for the United States in 1938 to escape the Nazis.

Wald began by examining the planes overall design and where the returning planes had taken flack. Like the British, he noticed that while the returning planes had shots in numerous locations, there was a pattern to the location of those hits, i.e. there were areas that were commonly hit and areas relatively unscathed. However, Wald then turned the problem on its head, by thinking about the planes that DIDN’T return. Where had they likely been hit and what would it take to bring a plane down?

Wald realized that the planes that returned were taking hits in exactly the areas that could handle the incoming flack, while the planes that went down likely were taking hits in the most vulnerable parts of the planes – exactly the spots undamaged in the returning planes. The last thing that the Allies needed to do was reinforce the areas damaged in the returning planes. They needed to reinforce the areas that weren’t hit (around the main cockpit and the fuel tanks). Those were spots that brought down planes.

Like Sherlock Holmes in The Dog That Didn’t Bark, Wald understood that the most important evidence was the missing data, not the available data.

Optional Investing Lesson

So, how does this lesson help us in investing? Well, first, it tells us that instead of spending all of our time examining successful investors, we might learn valuable lessons by examining investors that failed. Can we discover the mistakes that caused them to fail and avoid those missteps?

Turns out, yes, we can. If you look at unsuccessful investors, they tend to have one or more of these attributes:

  1. Performance chasing
  2. High Costs
  3. Lack of diversification
  4. Short time horizons
  5. Inappropriate risk levels
  6. Home country bias in stocks
  7. Tax inefficiency

Becoming another Buffet may not be possible (he’s a genius with a unique skill set), but avoiding becoming a failed investor looks pretty simple and very much achievable.

Another lesson that we learn by turning problems on their head involves Value investing – buying only cheap stocks. It turns out that a good part of the premium that you get from buying cheap stocks doesn’t come from owning the cheap stocks themselves but from avoiding expensive stocks. Expensive stocks tend to dramatically under perform the market, so having a strategy that eschews those stocks improves your returns – even if you didn’t then buy cheap stocks. In truth, a Value strategy really should be called the Buy Cheap, Avoid Expensive strategy.

So, the next time that you’re looking at a problem remember to invert, always invert.

*The phrase Invert, always invert (“man muss immer umkehren”) was coined by the German 19th century mathematician Carl Jacobi who believed that the solution for many difficult problems could be found if the problems were expressed in the inverse – by working backward.

 

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How to Fail as an Investor In Three Simple Steps, or Why Institutional Investors Can’t Do Third-Grade Math

It’s one thing for your average Joe or Jane out there to be a poor investor. They likely don’t know much about investing, and they’re so busy with jobs and family that they don’t have a lot of time (or desire) to learn about the subject.

But sophisticated institutional investors would know how to be successful investors, right?

Wrong. And I don’t mean kind of wrong, I mean off the charts, hilariously and frighteningly wrong.

A recent survey of institutional investors (people in charge of hiring manager for pension, insurance, sovereign wealth and endowment funds) from around the world showed the exact steps needed to fail as an investor.

Step 1:   Set Unrealistic Expectations

On average, institutional investors expect their portfolios to earn 10.9% a year for the next five years. As I’ll show in a bit, that’s ridiculous. However, it gets better when you look at the expected annual returns from the assets in their portfolios:

  • Stocks:                 10.0%
  • Bonds:                    5.5%
  • Real Estate:        10.9%
  • Commodities:      8.1%

Do you notice something a tad askew?

Three of the four assets are expected to earn LESS than the overall expected return of the portfolio, and only one – Real Estate – is expected to earn the SAME as the portfolio. So how exactly is the portfolio supposed to earn 10.9% a year if the underlying assets earn the same or significantly less? I mean, diversification does add a little to returns but not that much.

Also, given that 10-Year U.S. Treasury bonds are paying around 1.5% a year interest, how is the fund going to get 5.5% a year from its bonds? Even dangerous junk bonds aren’t paying that much in interest at the moment, so where’s that extra four percentage points going to come from?

What about stocks? Most estimates for the large American stocks (the kind of stocks that dominate institutional funds) is around 6% a year for the next 10 years. Where are the other four percentage points a year going to come from?

Everything about these expectations is insane.

Step 2: Don’t Honestly Track Your Performance

Investors – like gamblers – are notorious for remembering their wins and forgetting their losses. Looks like institutional investors aren’t much different. When asked if their expectations were being met, nearly 75% of them said yes.

Really, because the data shows that institutional funds have averaged between 6.0% and 7.0% a year for the past decade depending on the size of the fund. After employing IBM’s Big Blue to run a deep math analysis, I have determined that 6.0% and 7.0% are less than 10.9%. Hmm.

Step 3: Demand Unrealistic Time Frames

I’ve always said that the central reason that investors do so poorly is that for human beings, three years is a very long time and five years is an eternity, but when it comes to investing five years tells you nothing about a strategy. Basically, investing demands a level of patience that’s literally inhuman.

Every proven, successful investing strategy goes through periods of under performance that lasts well over ten years. Heck, stocks under performed bonds for a 40-year period. Forty years! Puts three years into perspective, doesn’t it.

Now, you’d assume that sophisticated institutional investors would understand this, right? You guessed it. They didn’t; indeed, they are some of the most impatient investors on the planet.

Regardless of the strategy employed by their managers, not one institutional investor was willing to wait more than three years before firing a manager. Unbelievably, 80% of institutional investors whose managers used a “Smart Beta” strategy (my strategy, by the way) would fire their manager if he or she under performed for one year. (Makes me realize yet again that I am blessed to have my clients.)

That’s truly the craziest thing that I’ve ever heard. A well-diversified portfolio – while a proven winner over history – is guaranteed to under perform any benchmark a good portion of years and has under performed for more than ten years several times in the past. (Yes, ten years. Investing is a game won through patience, which is why almost no one succeeds.) These time frames show that institutional investors have absolutely no understanding of the strategies of their managers, nor are they willing to show the patience needed to outperform.

So there it is: How to fail as an investor in three easy steps. Of course, if you want to be a successful investor, you could simply do the reverse. But who wants that? It’s more fun to jump from manager to manager every time your portfolio hits a rough period. Sure, you end up making a lot less money, but you had the satisfaction of feeling like you were “doing something.”

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How Alternative are Alternative Investments?

People love the idea of alternative investments. I mean, they’re alternative, right? Why stick with plain old stocks and bonds when you can invest in cool-sounding investments like hedge funds and private equity.

But just how alternative are these other investment vehicles? After all, the whole point of adding alternative investments to a portfolio is to increase our level of diversification and, perhaps, enhance returns.

Well, it turns out that the most popular alternative investments just aren’t that different than the stock market. In fact, it turns out that “Factor Diversification,” a strategy of investing in different risk premiums, such as small, value and momentum, that help explain the returns of different types of stocks is a far superior way to diversify your portfolio and enhance its returns. (See here, here and here for a discussion of Factor Diversification.)

In their paper, The Tortoise and the Hare: Risk Premium versus Alternative Asset Portfolios, Ron Bird, Harry Liem and Susan Thorp found that hedge funds and private equity funds moved nearly in lock-step with the stock market. (For statistic geeks, the correlation of hedge funds and private equity to stocks from 1990-2009 was 0.79 and 0.71, respectively.) The authors concluded that most of the returns of hedge funds and private equity could be explained by moves in the stock market.

In other words, hedge funds and private equity are simply really expensive vehicles for investing in the same stock market that you could buy for 0.1% a year in a low-cost ETF or mutual fund.

Other popular alternative investments also showed only moderate diversification benefits. REITs and Infrastructure had a correlation of 0.59 and 0.58, respectively, to stocks. High-yield bonds had a correlation of 0.68 to stocks, showing yet again why high-yield bonds should be avoided. Bonds are for safety, so why invest in a class of bonds that gets hammered just when stocks are falling.

So it turns out that alternative investments aren’t all that alternative. Now, let’s see what Factor Diversification does for us.

The various risk premiums had very low to negative correlations to the stock market, which means that they’re often doing well when stocks are doing poorly – the very definition of diversification. The value and momentum premium had correlations to the stock market of -0.32 and -0.04, respectively, while the small premium was 0.27 correlated to the stock market.

The study’s authors found only two alternative investments that provided a diversification benefit on par with the risk premiums: Timberland and commodities both show basically zero correlation with stocks. However, each of those investments has a problem. Timberland, like farmland, must be purchased directly, meaning only large institutional investors can purchase it. Commodities can be bought by retail investors, but research has shown that the expected return of commodities beyond inflation is zero, so while commodities diversify your portfolio, you don’t earn any money for owning them.

The bottom line is that while alternative investments sound exciting and cutting-edge, they add very little a portfolio’s diversification and possibly a lot to its costs. Instead, you can add diversification and returns to a portfolio by including risk premiums such as small, value and momentum (as well as the more recently discovered Quality/Profitability premium).

 

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Why Invest Internationally

“Reports of my death have been exaggerated,” Mark Twain

The last five years have been about as good as it gets for big American stocks. Indeed, the S&P 500 has doubled in value since January 2010. For international stocks, not so much. International developed country stocks have only grown by 35% in value over that time, while emerging market stocks have only increased by 17.5%.

So let me get this straight, you might ask. If I had invested $100,000 in the S&P 500 nearly five years ago, it’d be worth $200,000 today. However, if I had invested that same $100,000 in the international developed stocks, it’d be worth $135,000. Even worse, if I’d put that money into emerging market stocks, it’d be worth $117,500.

Why on earth would anyone invest in international stocks? Looks like the good ol’ U.S. of A. does just fine, thank you very much. Take that France! (Actually, I kind of like France, but don’t tell anyone.)

Well, it turns out that if you give it enough time, investing internationally can be very helpful in smoothing out the roller coaster ride that comes with owning stocks. That’s because investing internationally increases your sources of returns. (Factor diversification does the same thing, see here and here.) Think about it, what’s safer for a business, relying on one customer or having several.

Suppose for an instance that there are two siblings – John and Jane – each of whom inherit corn farms in Iowa. John is happy to stick with owning the corn farm; however, Jane is nervous about having so much of her money tied up in one farm, in one area, growing one crop, so she sells half of her corn farm. With half of the proceeds, she buys part of a soybean farm in Germany. With the other half, she buys part of a Kobe beef ranch in Japan.

Now, Jane doesn’t have anything against corn or Iowa, nor does she expect that over the long run, she’ll necessarily earn any additional money from her other farms. (In a normal year, all of the farms tend to earn about the same amount of money.) She just wants to spread her risk and cut back on those big ups and downs than tend to go with farming.

Now, let’s further assume that for a couple of years, the weather in Iowa is perfect for growing corn. On top of that, corn prices are very high. This results in huge profits for the Iowa corn farms. At the same time, heavy rains in Germany (trust me, I’ve lived there, it happens) and falling beef prices hurt those farms’ profits for a couple of years. As a result, John does extremely well for those years, while Jane does considerably worse, though she’s still making a good return on her money.

Given those circumstances, was Jane “wrong” to have sold some of her Iowa farm and purchased parts of farms in Germany and Japan?

Some people would argue that she was mistaken. After all, she didn’t earn as much money as John over those three years, so it must have been the wrong decision.

I think that those people are confusing strategy and outcome. Jane’s strategy was sound, and, over the long run, it has been a superior strategy to John’s. But we can never know beforehand which investments will do best, and there will always be parts of the market (in this case the Iowa corn farm) that dramatically outperform. That doesn’t make the strategy of diversification wrong. Indeed, in our little parable, just ask the German soybean farmer or Japanese rancher if they would have liked some more diversification.

The S&P 500 has done extremely well over the past five years, just like John’s corn farm. However, just like farms have times of boom and bust so does the S&P 500. Let’s take a look at how the S&P 500 fared during the 1970s compared to international developed country stocks (using the MSCI EAFE index):

Annual Rate of Return (1970-1979)       Growth of $100,000

S&P 500                                         5.9%                                                 $176,760
MSCI EAFE                                  10.1%                                                $261,500

The history of U.S. and foreign stocks is one long game of leap frog. International stocks go on a run for several years (usually around five), followed by similar returns, followed by U.S. stocks taking off for several years and jumping ahead. Of course, occasional dramatic drops in both U.S. and international stocks punctuate that leap frog game.

So what if like Jane, we spread our risk around? Does it help smooth out the ride? You bet it does. Let’s take a look at our two previous examples of outperformance by either the S&P or international developed stocks and see what happens when we spit our money even between them.

1970s                       2010-today

S&P 500                               5.9%                         15.5%
MSCI EAFE                       10.1%                           6.5%

S&P/EAFE                          8.3%                         11.0%

Now, of course, if we knew beforehand which part of the market would outperform, we would have been all-in on international stocks in the 1970s and U.S. stocks the past five year years. But, alas, my crystal ball is as cloudy as ever, so I spread my money around, knowing that while I won’t hit a home run, I won’t strike out either.

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The Value of a Good Plan

What is the value of a good financial plan? It’s a hard question to answer sometimes. What price do you put on sleeping well? How do you put a dollar value on mistakes avoided? Can you quantify the feeling of knowing that you’re not getting ripped off?

As you can see, many of the benefits of good financial planning derive from the comfort of knowing that you’re on the right path. However, sometimes, we can see very clearly the costs in dollars and cents of not having a plan.

According to a recent report by the Federal Reserve, Americans saw their net worth drop by 2% from 2010 to 2013, falling to $81,200. In case you’re thinking that only regular Americans lost money, the wealthiest top 10% of Americans saw their median net worth drop from $2.0 million to $1.9 million. (The amounts are adjusted for inflation.)

During a three-year period where the stock market grew 80% and housing prices recovered, Americans – even rich, high-income Americans – managed to lose money.

How is that possible?

They didn’t have a plan.

Instead of rebalancing into stocks, individual investors poured out of the stock market in late 2008 and early 2009 and never returned. Indeed, those with money still in the stock market continued to take money out – albeit at a slower pace – until just recently.

The vast majority of Americans – even high-income and wealthy Americans – missed out on much of stock market recovery from 2010 to 2013. Instead, an investor with a plan would have seen his or her portfolio grow 30% adjusted for inflation over that same period if they owned a low-cost, globally-diversified portfolio with 60% in stocks and 40% in Treasury bonds.

If you couple that portfolio growth with saving for retirement and paying down your mortgage, your average American should have seen dramatic improvement in their net worth since 2010. Instead, they saw their net worth stagnate in the midst of a booming stock market.

That’s what having a plan does for you. On a day to day basis, it’s hard to notice how much you’re moving forward, but, over time, you find yourself miles ahead of where you would have been without the plan.

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Stock Market Returns: High Hopes, Low Expectations

Nobody can predict what will happen in the stock market over the short term, and, yes, the short term in my book is anything less than five years, which for most investors – and, sadly, most investment advisors – is an eternity. (But that’s the subject of another posting.) However, once you get out a bit farther – seven to ten years – research has shown that we can get a hazy idea of what stock market returns might look like.

And they’re not looking good – at least not for American stocks but more on that below.

“Valuations Matter,” Larry Swedroe

Financial research has shown that stock valuations matter over the long run. When stocks are historically cheap, they generally produce average to spectacular returns over the next decade. When stocks are expensive, they generally produce average to disastrous returns over the next decade.

Now, you’ll notice that both cheap and expensive stock markets can produce average returns over the next decade. That’s true. And that’s why trying to time the market based on stock valuations is a fool’s game. However, you’ll also notice that the other adjectives couldn’t be more different. And that’s why valuations matter.

There are a number of popular methods for valuing the stock market. Luckily for us, almost all of them point in the same direction, so I’ll just use one of my favorites and one of the more well-known metrics – Robert Shiller’s P/E 10, also known as the CAPE ratio – to show why I’m concerned.

The Shiller CAPE ratio is based on average inflation-adjusted earnings from the previous 10 years. The aim is to smooth out some of the volatility of one-year price-to-earnings ratios, as P/E ratios can create a distorted view of valuations at extremes. (Everybody get that. If not, check this out.)

Cliff Asness, a hedge fund manager and University of Chicago Ph.D. in finance, found that when the CAPE went above 25.1, the average annual real return, i.e. your rate of return over inflation, the next decade was 0.5%. The worst 10-year real return was -6.1% a year, while the best 10-year real return was 6.3% a year – about the average real return of the U.S. stock market since 1929. In other words, the best case scenario is average.

As you can see, just because the stock market is historically expensive, it doesn’t mean that you’re doomed to low returns. It just means that the odds of getting average or even above average returns aren’t good. The reverse is true if the market is historically cheap.

When the CAPE was 5.2, the average real return for the next decade was 10.3% a year. The worst real 10-year real return was 4.8% a year, while the best was 17.5% a year.

Currently, the CAPE is at 24.9, disturbingly close to the 25.1 figure used by Asness.

Of course, the CAPE is hardly infallible. Indeed, many very good researchers have issues with it. My concern is that many other valuation methods echo the CAPE. No matter which direction you look at the stock market, it appears to be at best a tad expensive and, at worst, dramatically overpriced.

What To Do

So what to do now? First, I’m not saying that investors should change their asset allocation and suddenly get out of U.S. stocks. As I discussed above, even if the stock market is overvalued, that doesn’t guarantee poor returns in the near future. Indeed, the S&P 500 rose dramatically in the late 1990s at even higher valuations. (Of course, the S&P 500 has returned almost nothing over inflation since that time.)

Instead, now might be a particularly good time for investors to do what they should have done years ago, which is to diversify their stock holdings into other areas, such as international developed stocks, emerging market stocks and the various factors. (You can read my posts on “factor diversification” here and here.) Valuations on international developed and emerging market stocks, while not cheap, don’t appear to be nearly as high as U.S. stocks. The addition of factors such as small, value, momentum and profitability also would help to diversify the sources of returns for investors.

Again, I am not recommending that investors move into international and emerging market stocks, and into factors to “time” the market. I’m suggesting that putting between 25% and 50% of your stock allocation (not your total portfolio but the stock portion of your portfolio) into the foreign stocks has always been a good idea and now may be a very good time to do what you should do anyway. Historically, it has also been a good idea to put a part of your stock money in small, value and momentum stocks.

Whether this additional diversification will pay off in the next one, two or five years is anyone’s guess. But over the next decade or two – which, as hard as it is to believe, should be your time horizon – being diversified has always been the best bet.

The other thing that investors can do is have realistic expectations. If you were planning on stocks earning their historic 9% to 10% a year and bonds earning 4% to 5% annually, you may want to consider a back-up plan. What if stocks return 6.0% a year while bonds earn you 2.5% annually over the next decade? For a 50-50 portfolio, that’s a 4.25% annual return, compared to around 7.5% historically.

How would you achieve your financial goals if your portfolio returns are significantly lower than you expect? All of us need to answer that question.

In a sense, it’s always a good idea to prepare for bad weather, but that preparation becomes imperative when we can see storm clouds on the horizon. Of course, they may pass by and cause no harm, but I wouldn’t bet my future on that happening.

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Things That I’m Thankful For

I’ve always had a soft spot in my heart for Thanksgiving. While seemingly every other holiday has been commercialized and distorted, Thanksgiving remains the simple gathering of friends, family and neighbors to enjoy good food and each other’s company. (I will admit to enjoying some people’s company over others, but even those occasional uncomfortable outbursts are part of the memories.)

So, in honor of the holiday, here are some of the things in that my life for which I’m thankful.

My Family

I suppose this isn’t exactly shocking, but it deserves to be said. Granted, I’m your classic – quite boring – family man. I coach my kid’s soccer team – despite having never played soccer – play board games with the family and have neighborhood barbeques. It’s a simple life in many ways, but one I feel fortunate to have.

Besides, whose heart wouldn’t go out to these two girls?

IMAG0014-1

My Health

I’ve been very fortunate in my life. Outside of some pulled muscles playing golf, I’ve never had any health issues. Come to think about it, my brother and sister have never had any issues beyond the occasional sprained ankle either. Therefore, I suppose that I should give thanks to my parents for giving us pretty good genes. (Actually, my 69-year-old mother still unloads hay bales, rides horses daily and plays volleyball, so here are some additional thanks to her in advance.)

My Clients

Ok, ok, I realize that this sounds a bit like I’m sucking up. But I do mean it, and here’s why: I talk with other advisors fairly often. Other advisors biggest complaint is dealing with their clients; indeed, I’d say that for more than a few, they’d love to avoid meeting with their clients at all. When I think of my biggest complaint, it’s the forty hours of continuing education credits I need to get each year, especially since reading books doesn’t count.

My clients have taken the time to understand what we’re doing and why. (Now, I can hope that I’ve had some part in that through my efforts to educate my clients, but as they say, you can lead a horse to water, but you can’t make him drink.) I can’t overemphasize the importance of that understanding for achieving a success relationship and for making my job dramatically more enjoyable. My clients truly are my partners.

The Stock Market

Wait a minute. Isn’t the stock market evil? Doesn’t it cause people to lose half their money on a regular basis? Doesn’t it cause massive stress?

Well, yes. The stock market can be evil (really, it seems to have a mind of its own at times). The stock market routinely drops by 50% or more. And, yes, the stock market definitely causes people to lose sleep and pop Rolaids like potato chips at times.

However, the stock market also offers regular, middle-class people their best hope at amassing wealth and reaching their financial goals, such as retiring and paying for college. Since 1970, a reasonably diversified stock portfolio has earned 13.3% a year. An initial investment of $10,000 would have grown to $2.36 million. Did that growth come without pain? Absolutely not. From oil embargos to rampant inflation to one day drops of 22% to terrorist attacks to a near Depression, investors endured a seemingly endless barrage of difficulties over that period.

Let’s face it. Investing in stocks – even when done right – is scary. Through proper diversification, we can eliminate some risks and mitigate others, but, at the end the day, risk – big risk – will always be a part of investing in stocks. And thank heavens for that. For it is that risk that we get paid to bear. Without that risk, we would be relegated to investing completely in safe bonds, which barely earn more than inflation. That same $10,000 investment in Treasury bonds would have grown to only $256,000 since 1970. Not bad, but certainly not enough to fund a retirement.

By being able to cheaply invest in the stock market, we are afforded an opportunity that until very recently was the domain of only a sliver of society – the 1% percent, if you will. We can become business owners – albeit in a small way – more easily and more safely that our grandparents could have ever dreamed. And like all business owners, we face many ups and downs, but like all business owners, we have the chance to improve our lives and the lives of our families.

And for that, I’m thankful – at least until the next big drop in the stock market.

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