It’s so predictable to see the same financial headlines every time the market bounces back up to the old highs. Why pay an asset manager who is destined to underperform most stock indices right? Why not just buy the free to own Vanguard Index funds and forget it? I’ll give you two reasons. This update will build on last week’s commentary (False Expectations) offering you more surprising realities. This update is especially important and timely as we are just now beginning to see a very significant, perhaps generational type, rotation in asset class performance.
180 Years of Market Drawdowns
Ben Carlson, from “A Wealth of Common Sense”, recently highlighted a piece of research called 180 Years of Market Drawdowns – originally created by hedge fund manager Robert Frey. Here’s the link to Ben’s commentary, which is worth a read if you have the time.
http://awealthofcommonsense.com/2016/04/180-years-of-market-drawdowns/
The gist of the research pointed to a simple fact that the financial service industry loves to ignore. It is simply this; Drawdowns, or periodic losses in the market are a lot more common than most investors might be aware. Of course, our industry would like you to think that stocks just go up and up and up all the time, making new highs regularly. The truth, going all the way back to the 1800’s is that the stock market spends more than a quarter of “the time” in a period of loss of recovery (aka not making new highs). Now magnitude is everything, right, because we might say, that’s not so bad! If stocks go up 75% of the time and are in some form of drawdown only 25% of the time, those are good odds. I just buy and hold an index fund! But when we look at the magnitude of drawdowns and measure them, we also recognize that these losses can be enormous, normally wiping out 50-60% of all previous bull market gains on average in a very short period of time. We saw it happen not once, but twice in the first decade of the 2000’s. Now if investors had ice in their veins and did not sell anything at the lows, then one could argue that for long term investors, prices do in fact generally go up. But we know with hard evidence from years of research in behavioral finance, that investors do sell at the lows making recovery nearly impossible. Here’s a clip of the historical market drawdowns including their frequency and magnitude.
Statistically, here’s how it breaks out according to Ben.
Drawdowns (losses) % of the Time
5-10% 12.8%
10-20% 13.1%
20% or more 23.1%
It is the “or more” event that really crushes investors.
So the first and best reason anyone should pay an asset manager is that they have the capacity to reduce their exposure to market drawdowns and keep their portfolio capital and wealth intact. Said another way, you should NOT pay an asset manager who does not have that capacity. You should in fact just buy an index fund and save yourself some money. Our clients know that we are strictly in the business of offering risk managed investment strategies to High Net Worth households (or those on their way). Our mantra is “Create Wealth, Defend It” and we will shamelessly say that is always worth paying for.
The 60/40 Myth
The second reason why anyone should pay an asset manager has to do with the myth of the 60/40 model promoted by the passive index fund world. The 60/40 model suggests that an investor need only buy 60% stocks and 40% bonds, indexes of course, and that’s the best anyone can ever do over time. Bear with me as we walk down the road of risk and return statistics via something called the Efficient Frontier, a favorite of aging academics. The efficient frontier is a curve showing an assumed relationship between risk and return for various blends of stocks and bonds. The idea is that a portfolio with heavier weight in stocks versus bonds will naturally show higher risk AND return properties. The standard curve using data from the last 50 years, looks like this.
Now, if we dig deeper into the data, we find that the shape of this curve changes radically on shorter periods of time. Below, you’ll see the shape of this same curve plotted by each decade. As we discussed last week, the relationship between risk and return for stocks and bonds radically changes over time periods as short as a decade and we might be very close to just such a change now. Think about bonds and where they sit today at near zero interest rates. Where can they go from here? Some countries are playing with weapons of mass destruction by allowing negative interest rates on their bonds. That won’t (can’t) last. The more likely outcome is an environment where bonds, assumed to be in the low risk, low return side of the curve, will in fact create negative returns for your 60/40 portfolio as rates begin to rise again over time. This changes the curve and thereby changes the outcome of your portfolio unless significant adjustments are made in your portfolio asset allocation on a timely basis. This is what we do for our clients.
- Source Greg Morris – “Questionable Practices 2015”
Understanding that this concept may be beyond your patience for financial theory, let me break it down to simple terms. Nearly every decade in the last 50 years we have seen rather dramatic shifts in the risk to return characteristics of stocks and bonds. A manager who is capable of recognizing these shifts early in the rotation can save your portfolio from experiencing an undesirable outcome. As anyone who owned a standard “balanced” fund through 2008 knows, losses can still be dramatic, devastating and recoverable only after many many years of positive gains. Again, paying for a manager’s ability to dynamically shift your money to overweight or underweight an asset class at an appropriate time is…. Priceless.
A timely reminder while we wait to hear from the Federal Reserve regarding their plans to raise interest rates in June!
Have a great week!
Sam Jones
After years of dragging our feet, we have created and launched an All Season Financial Advisors’ LinkedIn page. We invite you to check it out and “follow us” by clicking on the link above.
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