History and Presidential Elections

What History Tells Us About US Presidential Elections and the Market

It’s natural for investors to look for a connection between who wins the White House and which way stocks will go. But as nearly a century of returns shows, stocks have trended upward across administrations from both parties.

Stocks have rewarded disciplined investors for decades, through Democratic and Republican presidencies. It’s an important lesson on the benefits of a long-term investment approach.

Shareholders are investing in companies, not a political party. And companies focus on serving their customers and growing their businesses, regardless of who is in the White House.

US presidents may have an impact on market returns, but so do hundreds, if not thousands, of other factors—the actions of foreign leaders, a global pandemic, interest rate changes, rising and falling oil prices, and technological advances, just to name a few.

The anticipation building up to elections often brings with it questions about how financial markets will respond. But the outcome of an election is only one of many inputs to the market. Below is a link to an interactive exhibit that examines market and economic data for nearly 100 years of US presidential terms and shows a consistent upward march for US equities regardless of the administration in place. This is an important lesson on the benefits of a long-term investment approach.

Follow this link to learn more about each presidency:   Interactive Exhibit - Markets Under Each Presidency

As always, we are here to help.

Best,

CAM Investor Solutions

Source: In US dollars. Stock returns represented by Fama/French Total US Market Research Index, provided by Ken French and available at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html; US Government Presidential and Congressional data obtained from the History, Art & Archives of the United States House of Representatives. US Senate data is from the Art & History records of the United States Senate; Federal surplus or deficit as a percentage of gross domestic product, inflation, and unemployment data from Federal Reserve Bank of St. Louis (FRED). GDP Growth is annual real GDP Growth, using constant 2012 dollars, as provided by the US Bureau of Economic Analysis. Unemployment data not reported prior to April 1929; Dimensional Fund Advisors; M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. As a fee-only firm, we do not receive commissions nor sell any insurance products. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. This blog has been provided solely for informational purposes and does not represent investment advice or provide an opinion regarding fairness of any transaction. It does not constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Any stated performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss. Charts and graphs provided herein are for illustrative purposes only. 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.

Will I Have Enough

Many investors in retirement have certain goals in common: more money rather than less, minimal wealth volatility, and enough financial cushion to cover the extra costs of, hopefully, living a very long life.

Retirees have generally tried to meet those goals with a simple rule of thumb: hold a balanced stock/bond portfolio and withdraw at a sustainable rate. Historically this worked in large part because risk-free rates averaged 5.9% the last 65 years. Risk-free rates form the foundation of expected total return to every risky asset, i.e.:

Expected total return = risk-fee rate + expected risk premium

So, total returns to stocks and bonds were sufficiently high to meet investor needs. After all, if you followed the rule of thumb, withdrawing 4% of your portfolio in retirement when risk-free rates were 5%+, you didn't need to worry much about running out of money, and you probably ended up having plenty to pass on to your heirs. It was all pretty easy.

Unfortunately, the days of adequate and reliable expected total returns on a traditional stock/bond balanced portfolio could look different. Risk-free rates are near zero or negative in all developed markets, and global yield curves appear to forecast persistently low or negative rates for some time to come. Low or negative risk-free rates can pull down the expected total returns on all investments, stocks and bonds alike.

What about volatility? Volatility is driven by the non-risk-free portion of returns, so it doesn't decline just because expected total returns are lower. Given the potential new combination of lower expected total return and not lower volatility, simple math tells us that the probability of a low or negative cumulative return over any future period may now be (much) higher in some asset classes. Recent research calls this "The New Arithmetic of Financial Planning" and it represents a direct challenge to traditional retirement analysis.

So risk-free rates have collapsed vs. historical averages, but what about risk premiums? Risk premiums are unknowable in advance, of course, but what's not unknowable is just how tenuous realized risk premiums on traditional asset classes can be. For example, in Japan the equity risk premium has been negative for the last three decades, and counting. In the U.S., stocks have experienced a worst-case drawdown of 865. And while investors don't need to be reminded of the 55% drop in their equity portfolios ten years ago, what some may find surprising is that in just the last 12 months, the average small stock in the U.S. is down 9%, and the average international stock is down 1%. Investors are not entitled to the equity risk premium - certainly over shorter periods (10-20 years) and even over periods that many investors typically consider very long term (30 years+).

As we look ahead to the future, it is also interesting to note several of the following which may impact one's financial planning assumptions going forward:

Historically, the equity risk premium has been reliant on the outsized performance of a small number of companies.

Over the last 93 years, 4% of stocks have driven 100% of U.S. stock market wealth creation. The other 96% are a push.

About 25 stocks (out of about 26,000 ever to exist) have driven 30% of all stock market wealth creation. 

Some may ask, where is the next Microsoft and Amazon? Here are a few more thoughts to keep in mind for planning purposes:

Something perhaps not well known to most investors is that companies are staying private longer.

Sarbines-Oxley may be forcing some of this reaction by company executives.

The significant growth in available private market capital is also a reason since an IPO may not be needed.

How can investors capture the hyper-performance in their early few post-IPO years?

Microsoft and Amazon went public with much lower valuations than companies today such as Uber, Peloton and Lyft just to name a few.

While there is a significant amount of data and evidence on this topic, most agree that future expected returns could be lower going forward in some areas of the market. To be clear, lower does not mean negative nor does it imply a forecast for a recession or a stock market crash. However, it may mean that one's current financial planning or longevity planning assumptions are affected. What this evidence does make pretty clear is the case for smart diversification, risk management, and holistic financial planning.

As always we are here to help.

Best,
Marc

Source: U.S. Treasury 10-year constant maturity rates; Morningstar; Bloomberg; Thomson Reuters; Stone Ridge Asset Management; Oliver Wyman: Longevity Risk Premium October 2019; Bessembinder, Hendrik, et al., "Do Stocks Outperform Treasury Bills?" Journal of Financial Economics, forthcoming; M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. As a fee-only firm, we do not receive commissions nor sell any insurance products. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. This blog has been provided solely for informational purposes and does not represent investment advice or provide an opinion regarding fairness of any transaction. It does not constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Any stated performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss. Charts and graphs provided herein are for illustrative purposes only. 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.

Has a Global Recession Arrived

Some claim that a global recession has begun following a lot of the recent economic data. Others might argue that major problems only exist overseas, and signs of any recession is not present in the United States.

Regardless of who is right, we expect a recession won't be confirmed until twelve months or longer after the fact. This is similar to what we've seen in the past and is usually confirmed by the National Bureau of Economic Research (NBER) as well as other sources. The challenge is that predicting a recession is harder than you think.

INTEREST RATES

A lot of this debate and investor concern has been fueled by the recent steep decline in interest rates and does deserve further attention. Many of you may be wondering what happens if we experience zero or negative interest rates in the future? To be blunt, nobody knows with certainty what will happen because we've never experienced such an environment in the United States. It's also expected many "experts" will pretend they know what will happen and we recommend investors use caution around those who provide this kind of advice. Just remember, interest rates can increase too which many seem to forget.

As many of you know, our firm uses facts, logic, and an evidence-based approach to financial planning and investing. Instead of trying to forecast or "guess" future events, we look to focus on what we know to be true as well as seek to provide our clients with a higher probability of success. In our recent blog A Stock Market Cycle and Investor Discipline, we highlighted interest rate yields and inflation expectations are at generational lows. Given this current environment, we address several investor questions below that relate to the possibility of zero (or negative) interest rates including considerations for the next recession:

If we anticipate a recession is coming, should we get out of the stock market and go to cash and bonds? No. If you have a good financial plan in place that is properly managing investment risk and liquidity, then you should have been planning for market volatility (or you would have been 100% in the stock market). Also, some bond strategies may carry more risk than you think even though they are deemed to be safe.

Aren't my treasury bills (T-bills) safe in a recession or low-rate environment? Yes, the principal value for individual issues is guaranteed, however, T-bills are not immune to inflation. There are other solutions to accomplish this.

Should we continue to expect low inflation? By traditional measurements, inflation is at generational lows in the United States. However, if you look closer it is present in the economic data and in the goods and services we buy every day. Should tariffs continue, this is expected to also push up inflation pressures.

Should I sell all my fixed income if rates go to zero? Probably not all, but yes, it's possible some of the longer duration or higher risk bond funds may no longer offer appropriate compensation for risk. Fixed income has had a historic bull market given declining rates. At these levels it seems reasonable to expect most fixed income will produce lower returns going forward and some of these strategies may also bear greater risk if rates reverse course and increase. Hence, some holdings may warrant selling and rebalancing into higher quality, short-term duration funds which should still provide ample liquidity, but be less sensitive to interest rate fluctuations. In terms of individual bonds, their yield to maturity or yield to worst should not be impacted.

Given the risk of recession and interest rate fluctuations, will this hurt my real estate investments? Not necessarily as it depends on what sector of real estate (public vs. private; residential vs. commercial, etc.). Also, if short-term interest rates began to rise, it doesn't mean this will be bad for the sector.

Are there any fixed income strategies to consider that are not tied to interest rate fluctuations? Yes, some exist such as alternative lending, private debt, and inflation protection strategies. However, it is important to evaluate if these are appropriate in the context of one's risk tolerance and asset allocation.

Should I still hold as much cash if rates keep dropping? Any good financial plan will always retain a healthy amount of cash for emergency reserves, essential living expenses, and other needs. This level of liquidity avoids having to sell or realize losses in a down market or tough recessionary environment.

Given recession risks, should I reallocate into alternative investments? While some alternatives may offer diversification benefits for certain investors, many of these solutions will still feel the pain and impact of weak economic activity and recessionary periods. In particular, many private alternatives don't price each day or will experience a lag in reporting. Lack of liquidity is often an issue too for many private alternatives during a period of distress.

Should I own individual bonds or bond mutual funds? Potentially both, especially if rates continue to fall further.

How long should we expect low interest rates? There is a lot of research that suggests the best predictor of future rates are today's interest rates. So, it's possible low rates may continue for some time.

What is the impact of a long-term, low rate environment? Its positive for those looking to borrow, refinance, structure businesses, debt, and many other common financial needs. For income investors, it may present a challenge to generate enough income due to lower yields. It also seems reasonable to expect that traditional fixed income returns will be lower in the future compared to the past twenty or thirty years. This will impact financial planning and retirement income expectations for some. A low-rate world may also decrease future stock market returns which was a critical discussion that we covered earlier this year in The 60/40 Investment Debate.

For investors who have a sound financial plan in place and are properly managing risk, most of this discussion should have no impact on you. However, a second opinion never hurts.

As always, we appreciate our relationship with you, and we are here to help.

Best,
Marc

Source:  J.P. Morgan; Federal Reserve Bank of St. Louis; Dimensional Fund Advisors; Bloomberg; Stone Ridge Asset Management. M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. As a fee-only firm, we do not receive commissions nor sell any insurance products. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. This blog has been provided solely for informational purposes and does not represent investment advice or provide an opinion regarding fairness of any transaction. It does not constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Any stated performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss. Charts and graphs provided herein are for illustrative purposes only. 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.

A Stock Market Cycle and Investor Discipline

Every point in a stock market cycle brings its own emotional challenges for long-term investors. When volatility spikes, as it did in 2018, investors need to muster their intestinal fortitude and avoid the temptation to flee to cash. In times of extended market doldrums, as we saw in 2015-16 when stocks mostly moved sideways, investors must avoid the temptation to go looking for higher returns in risky investments that can lead to big losses.

Then there is the environment we currently find ourselves in – with most major market indices at or near all-time highs. When stocks push into record territory, no one other than short sellers are unhappy. Real Estate continues to look unstoppable as well. It is also worthy to note that interest rate yields and inflation expectations are at generational lows.

Source: Federal Reserve Bank of St. Louis, FRED Economic Data Period: January 1, 1964 to March 31, 2018; Source: Illuminating the Path Forward, Ross Stevens, Joshua Zwick, Randolph Cohen, February 2017, p 5.

But the enthusiasm is often tempered with anxiety about stocks being overvalued and poised for a fall. These fears are only enhanced by the endless stream of stories in the financial media highlighting analysts’ predictions of a looming downturn. These stories are often accompanied by suggestions that investors should “take some winnings off the table” and pare back their stock exposure. We even discussed some related concerns in a recent blog The 60/40 Investment Debate.

To better understand how long-term investors should view the future direction of the stock market, it’s helpful to revisit the past. A look back at some of the major milestones the Dow Jones Industrial Average has achieved through the years is insightful.

The Dow first closed above the 1,000 threshold in 1972. It cleared 2,000 in 1987, closed above 5,000 in 1995 and hit 10,000 for the first time in 1999. Several times along this journey, the Dow failed to hold its ground when it reached a milestone and pulled back. Stocks entered a long bear market in 1973 and struggled to emerge from it for the rest of the decade. The Dow also spent much of the 2000s trying to hold the 10,000 level, only to fall back during the bear markets of 2001-02 and 2008-09. But the Dow also frequently blew through other milestones without looking back, notably during the mid and late 1990s, as well as in recent years. The below chart for the period from 1995 to 2017 highlights the journey to new milestones for the Dow:

Source: CBS Marketwatch research

The bottom line is that stocks hitting record highs and major milestones is not a clear indicator that a downturn is looming. Stocks can, and often do, keep soaring well after the conventional wisdom has decided equities are overvalued. And even if a downturn occurs, they are often temporary and shouldn’t dissuade long-term investors from putting money to work in the stock market. Of course, trying to predict market events in advance with long-term success is impossible. However, we do understand the importance of proper risk management and believe everyone should have a custom financial plan in place that is aligned with their investment strategy. This not only helps achieve one's goals, but can provide a better way to protect their financial health for both their current and future needs. 

As usual, the Oracle of Omaha, Warren Buffet, had some keen insight on this topic. At a Forbes magazine conference in 2017, Buffet scoffed at those who are bearish about the future performance of the U.S. stock market. “Being short America has been a loser’s game, and I predict to you it will continue to be a loser’s game,” he said. He then made a prediction that the Dow would reach the 1,000,000 level within a century.

At first glance that seems incredibly bullish on Mr. Buffet’s part, but it’s worth noting that it would only require a 4% average annual gain in the Dow to reach the 1,000,000 milestone in a hundred years. And that’s really the whole point we are making: stocks are always plowing ahead, though rarely on a straight line. But the climb through record highs and major milestones is an inevitable part of the stock market’s nature, and those investors who let fears of stocks being “too high” are the ones who won’t be along to enjoy the ride.

A bit of esoteric-but-still-interesting research crossed our desk this quarter. The research firm TS Lombard conducted a study in which they separated out the returns generated in the S&P 500 from domestic (U.S. based) investors vs. the returns generated by overseas investors. The study covered the period from January 1, 2017 to April 24, 2019, and the results were striking.

The study found that nearly all of the 30% gain in the S&P 500 during that time period came outside of U.S. hours. When the U.S. exchanges were open, the S&P gained a mere 2%, with the rest of the gain coming after U.S. exchanges had closed. The spread was especially striking since the beginning of 2018, with the S&P 500 actually experiencing a 5.4% decline during U.S. trading hours, yet still posting a 9% gain for the period thanks to the bullishness of overseas investors.

So what can we glean from this research study? To us, it seems clear that overseas investors in U.S. stocks are focused much more on long-term fundamentals than they are on the short-term news cycle. Stocks in the U.S. tend to be more volatile while the U.S. exchanges are open because American investors are immersed in all the short-term noise surrounding the markets. How often have we seen the Dow plunge 100 points or more over a news report that momentarily panics the market, only to fully recover the next moment when the report proves false or less dire than initially believed?

While news about the U.S. certainly doesn’t end at our borders, it’s logical to assume that overseas investors aren’t as obsessed with every iota of new information that comes out during the U.S. trading day and are instead focused on finding the best investments for their money. And U.S. stocks have proven, time and again, to be an outstanding long-term investment.

Something to keep in mind the next time irrational anxiety grips the market and sends investors scurrying to hit the panic button.

As always, we appreciate our relationship with you and we are here to help.

Best,
Marc

Source:  Forbes; J.P. Morgan; Federal Reserve Bank of St. Louis; Bloomberg; Stone Ridge Asset Management. M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. As a fee-only firm, we do not receive commissions nor sell any insurance products. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. This blog has been provided solely for informational purposes and does not represent investment advice or provide an opinion regarding fairness of any transaction. It does not constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Any stated performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss. Charts and graphs provided herein are for illustrative purposes only. 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.

Longevity Planning vs. The 4% Retirement Rule

Last month, in our blog The 60/40 Investment Debate, we discussed a few key considerations when it comes to longevity risk. As our focus continues in a pursuit to solve this very important issue, we realize longevity planning is often confused with traditional planning for one’s future retirement.

For most, today’s retirement planning only focuses on planning “to” retirement rather than “through” retirement. Financial planners generally do a good job of putting focus on the accumulation years before retirement; sometimes using rules of thumb for the subsequent post retirement years. One popular example is the well-known 4% Retirement Rule, which was first stated by William Bengen’s 1994 paper. This framework used historical data to determine “safe” rates of withdrawal from a portfolio. How many times have we heard, "Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4%, followed by inflation-adjusted withdrawals in subsequent years, should be safe."

What’s the biggest assumption underlying the 4% rule?

It is neither investment returns, nor the longevity of the retiree. It is the presumption that the retiree won’t withdraw more than 4% of the initial asset balance each year. To be sure, investors could always withdrawal less than 4% and cut back on essentials in the case of poor investment performance. But without knowing how much they’ll need later in life; the decision is filled with uncertainty. Regardless, it seems retirees may not even adhere to the 4% rule when you consider actual behavior. While the 4% rule may not be realistic, many scholars and marketers quickly adapted Bengen’s research. In years that followed, its simple approach made it popular. Since nobody knows how long they will live, planning decumulation around actuarial averages results in a retirement income strategy that may lack precision.

But investors ideally need a roadmap that considers all phases of life. Predicting the length of the journey may be difficult, but one can still plan for all possibilities, matching the inflow and outflow of assets over the totality of retirement. Conventional financial wisdom reveals the path to retirement, but the road through it still needs to be made. Since nobody knows their exact retirement income needs, investors need to build a conservative margin in their household balance sheet to fund any unexpected expenses from longevity. This may come from their investment portfolio or through a custom insurance solution to share in the risk.

Source: One-Year Treasury Constant Maturity (DGSI) from FRED website 11/1/2018. Past results are no guarantee of future results.

How Much Risk Are You Willing to Accept?

Since the size of the cushion has profound implications for the retiree’s financial well-being, it should depend on how averse the investor is to longevity risk. Those who save too little, risk hardship or forced dependence, whereas those who save too much may experience unnecessary deprivation. If you factor in sequence of returns risk as well as a low interest rate world (as highlighted in the chart above) , this will require additional consideration for most investors as they look to create wealth, generate income, and manage portfolio risk at retirement.

Can any asset allocation address longevity risk? By building a cushion, the investor may be able to reduce the investment risk portion of the income risk, but no traditional asset has the capability of insuring against longevity risk. Hence, the investor can tweak asset allocations forever to arrive at an “efficient” portfolio from an investment risk perspective, but the exclusive use of traditional assets leaves an entire source of risk unaddressed. The investor unnecessarily hinders his or her portfolio efficiency. Put bluntly it is impossible to have an optimal income efficient portfolio if the underlying assets’ investment strategy cannot address all the risk.

As always, we appreciate our relationship with you and we are here to help.

Best,
Marc

How much Retirement Income is right for you

Source:  J.P. Morgan; Dimensional Fund Advisors; Vert Asset Management; Morningstar, Inc.; Federal Reserve Bank of St. Louis; Bloomberg; FRED; McKinsey; SIFMA; Morgan Stanley; BIS; Deloitte; Stone Ridge Asset Management. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.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.

The 60/40 Investment Debate

For decades, many individual and institutional investors have used a 60/40 asset allocation as common strategy for investing in stocks and bonds. This rule of thumb came from the work of two Nobel Prize winning economists, Harry Markowitz (1952) and Bill Sharpe (1964), and their contributions to modern portfolio theory continue to drive today’s innovation in finance.

Since the dot.com bubble in the early 2000’s, and certainly since the Global Financial Crisis just over ten years ago, some have challenged the viability of the 60/40 approach and whether it properly manages investment risk. Some have also revisited whether or not the 60/40 philosophy can continue to deliver long-term investor returns which are necessary to meet future financial planning and retirement income objectives.

LIKELIHOOD OF SUCCESS AFTER 30 YEARS

Various initial withdrawal rates and asset allocations

Source: JP Morgan Asset Management; note that this chart is for illustrative purposes only and must not be used, or relied upon to make investment decisions. Portfolios are described using equity/bond denotation. Hypothetical portfolios are composed of All Country World Equity and U.S. Aggregate Bonds, with compound returns projected to be 6.0% and 4.0% respectively.

 

SHOULD OUR MARKET EXPECTATIONS CHANGE?

As investors balance risk in order to achieve necessary investment returns, it’s important to consider the impact sequence of returns risk can have on future income needs. However, as we’ve highlighted, the failure to achieve necessary investor returns can also have a dramatic effect on outcomes. For example, the above chart uses a 6% assumption for stock returns and a 4% return for fixed income returns over a period of time. Nobody knows for certain, but some may argue that a 4% return for fixed income is too high of an assumption given today’s interest rates. As a result of market structure (and normal stock market risk), this could change sustainable withdrawal rates as well as pose greater risk to investors.

In addition, as sources of guaranteed income disappear, retirees must rely on non-guaranteed income to fund their expenses.  Under the old school of thought, investors saved during their working lives and cashed in those assets over their golden years, hoping they wouldn't outlive their reserves. As investors balanced risk, they accumulated a portfolio combining "safe" assets, such as bonds, and "risky" assets, such as stocks. However, we also know investors benefited from:

A falling or stable interest rate environment, which supported a 30-year bond bull market

A steady and relatively low-volatility recovery in equities following the global financial crisis

It is possible that the structural forces helping past retirees are unlikely to persist. Interest rates are at or near historical lows and any increase can have a negative impact on the value of some bond allocations, which can also pressure all traditional asset classes. Of course, we know the future is hard to predict.

Unfortunately, as usual, there are many in the investment community who use this information for their own motives and its often not beneficial to consumers. Its during times like this of investor uncertainty and/or economic crisis that “guaranteed” products, exotic investments and high cost solutions with no merit or academic framework to back them up find their way into someone’s portfolio. While many of these are positioned as ways to better manage risk or achieve return, they often fail to deliver in more ways than one. As our clients know, one should use caution when confronted with many of these products.

At CAM, any and all reasoning takes an evidence-based approach. Diversification and proper asset allocation are some of the last free lunches available to investors and therefore we prefer an academic framework that utilizes research allowing us to think about the 60/40 problem differently. That research shows us that since 1964, the investable market has changed:

THE INVESTABLE MARKET HAS CHANGED SINCE 1964

Sources: Bloomberg; McKinsey; SIFMA; Morgan Stanley; BIS; Delotte; Stone Ridge; "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.

 

THE WORLD IS A BIG PLACE NOW

As you can see by the chart above, large public U.S stocks (i.e. S&P 500) no longer make up as much of the investable market as they once did. Not only have foreign stock markets, global real estate, and fixed income grown in size, so have other asset classes.

There are now additional investable options in today’s markets that didn't exist before. Given changes in the market structure, this might suggest that additional diversification and wealth creation opportunities are available. However, it’s also important to remember that other key difference in today’s environment that will impact some investors’ ability to achieve investment goals, especially in retirement:

IS THE MARKET DIFFERENT NOW?

Source: Federal Reserve Bank of St. Louis, FRED Economic Data Period: January 1, 1964 to March 31, 2018; Source: Illuminating the Path Forward, Ross Stevens, Joshua Zwick, Randolph Cohen, February 2017, p 5.

 

Since 1964, interest rates, as measured by 10 Year Treasury Rates, have experienced significant fluctuations. Based on today's rates, expected return in fixed income has declined much like our return on cash has. Many of us can still remember not too long ago when we could earn 6% or more on our cash and money markets. Unfortunately, this is not possible in today’s market. As a result, the investment return a 60/40 allocation achieved in the past may not be the same going forward. This could result in investors having to take on more risk, pursue other investment strategies, or save more for the future.

To add to the 60/40 debate, our research and academic findings suggest what some call “The Triple Threat”, deserves further attention:

WEALTH CREATION

Whether good or bad its no secret that our workforce is changing due to advancements in technology. For some, this creates the risk of reduced wealth creation during a period of time for restructuring while many workers need to be retrained and adapt to changing (dynamic) jobs. As the first tier in the triple threat is important, we recognize that the shifting of workforces will impact our investments.

FUTURE INVESTMENT RETURNS

A lower interest rate environment may not just impact lower returns in fixed income, but also other traditional asset classes. Many argue whether or not lower interest rates may result in less of a compounding effect or less overall wealth creation.

Also worthy to mention, it seems more and more evidence is suggesting that companies are staying private much longer given its often more attractive in the early years for small companies and shareholders. Many of these company leaders will tell you that they will only do an IPO when they have to, if ever. As a result, due to this delay in going public until a company is more stable and mature (i.e. a little less risky), the expected return (or equity risk premium) for these companies could be less. A few good names to consider are Microsoft and Amazon in terms of how small they were in market value when they went public ($778 million and $438 million respectively).Their incredible returns since their IPO has had a significant contribution to the equity risk premium. Now if we think about companies like Uber, Pelaton, and Lyft that are set to go public with market valuations between $4 billion and $100 billion+, one might ask if public market investors will benefit from as much upside or will the private equity/venture capital audience capture more of this. As we know from substantial research, only a small number of public companies drive most of the public market returns.

LONGEVITY

Until recently, the number one fear to the average person was speaking in front of a crowd. Times have changed. While many still fear public speaking, running out of money has become a leading cause of anxiety. Rapid improvement in health technology is driving some of this concern as cures are happening every day due to medical advancements. It is possible at this pace, we all live much longer than expected. How do we pay for this? In reality, few people exhaust all of their assets, but its true many are forced to cut their spending and/or seek help from friends and loved ones. For those who saved for a comfortable, independent, and dignified retirement, such outcomes are unacceptable.

The 60/40 investment debate is far from over. Even if future long-term equity returns equal those of the past, increased stock market volatility, advancements in technology, or greater longevity may undermine a retirees financial security. We know the future is impossible to predict. However, we'd rather use research, logic, and what we know today in order to best stack the odds in our clients' favor. Hence, we think everyone should review their own situation and possibly revisit some assumptions for the future.

As always, we appreciate our relationship with you and we are here to help.

Best,
Marc

How much Retirement Income is right for you

 

Source:  J.P. Morgan; Morningstar, Inc.; Federal Reserve Bank of St. Louis; Bloomberg; FRED; McKinsey; SIFMA; Morgan Stanley; BIS; Deloitte; Stone Ridge Asset Management. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.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.

We All Love Investment Fads

Investment fads are nothing new. When selecting strategies for their portfolios, investors are often tempted to seek out the latest and greatest investment opportunities. Over the years, these approaches have sought to capitalize on developments such as the perceived relative strength of particular geographic regions, technological changes in the economy, or the popularity of different natural resources. But long-term investors should be aware that letting short-term trends influence their investment approach may be counterproductive. As Nobel laureate Eugene Fama said, “There’s one robust new idea in finance that has investment implications maybe every 10 or 15 years, but there’s a marketing idea every week.”

WHAT’S HOT BECOMES WHAT’S NOT

Looking back at some investment fads over recent decades can illustrate how often trendy investment themes come and go. In the early 1990s, attention turned to the rising “Asian Tigers” of Hong Kong, Singapore, South Korea, and Taiwan. A decade later, much was written about the emergence of the “BRIC” countries of Brazil, Russia, India, and China and their new place in global markets. Similarly, funds targeting hot industries or trends have come into and fallen out of vogue. In the 1950s, the “Nifty Fifty” were all the rage. In the 1960s, “go-go” stocks and funds piqued investor interest.

Later in the 20th century, growing belief in the emergence of a “new economy” led to the creation of funds poised to make the most of the rising importance of information technology and telecommunication services. During the 2000s, 130/30 funds, which used leverage to sell short certain stocks while going long others, became increasingly popular. In the wake of the 2008 financial crisis, “Black Swan” funds, “tail-risk-hedging” strategies, and “liquid alternatives” abounded. As investors reached for yield in a low interest-rate environment in the following years, other funds sprang up that claimed to offer increased income generation, and new strategies like unconstrained bond funds proliferated. More recently, strategies focused on peer-to-peer lending, cryptocurrencies, and even cannabis cultivation and private space exploration have become more fashionable. In this environment, so-called “FAANG” stocks and concentrated exchange-traded funds with catchy ticker symbols have also garnered attention among investors.

THE FUND GRAVEYARD

Unsurprisingly, however, numerous funds across the investment landscape were launched over the years only to subsequently close and fade from investor memory. While economic, demographic, technological, and environmental trends shape the world we live in, public markets aggregate a vast amount of dispersed information and drive it into security prices. Any individual trying to outguess the market by constantly trading in and out of what’s hot is competing against the extraordinary collective wisdom of millions of buyers and sellers around the world.

The sample includes funds at the beginning of the 5-, 10-, and 15-year periods ending December 31, 2017. Survivors are funds that had returns for every month in the sample period. Winners are funds that survived and outperformed their respective Morningstar category index over the period. US-domiciled open-end mutual fund data is from Morningstar and Center for Research in Security Prices (CRSP) from the University of Chicago. Past performance is no guarantee of future results. See Data Appendix for more information.

 

With the benefit of hindsight, it is easy to point out the fortune one could have amassed by making the right call on a specific industry, region, or individual security over a specific period. While these anecdotes can be entertaining, there is a wealth of compelling evidence that highlights the futility of attempting to identify mispricing in advance and profit from it.

It is important to remember that many investing fads, and indeed, most mutual funds, do not stand the test of time. A large proportion of funds fail to survive over the longer term. Of the 1,622 fixed income mutual funds in existence at the beginning of 2004, only 55% still existed at the end of 2018. Similarly, among equity mutual funds, only 51% of the 2,786 funds available to US-based investors at the beginning of 2004 endured.

WHAT AM I REALLY GETTING?

When confronted with choices about whether to add additional types of assets or strategies to a portfolio, it may be helpful to ask the following questions:

What is this strategy claiming to provide that is not already in my portfolio?

If it is not in my portfolio, can I reasonably expect that including it or focusing on it will increase expected returns, reduce expected volatility, or help me achieve my investment goal?

Am I comfortable with the range of potential outcomes?

If investors are left with doubts after asking any of these questions, it may be wise to use caution before proceeding. Within equities, for example, a market portfolio offers the benefit of exposure to thousands of companies doing business around the world and broad diversification across industries, sectors, and countries. While there can be good reasons to deviate from a market portfolio, investors should understand the potential benefits and risks of doing so.

In addition, there is no shortage of things investors can do to help contribute to a better investment experience. Maintaining discipline and seeking independent advice can help individual investors create a plan that fits their needs and risk tolerance. Pursuing a globally diversified approach; managing expenses, turnover, and taxes; and staying disciplined through market volatility can help improve investors’ chances of achieving their long-term financial goals.

THE IMPORTANT STUFF

Fashionable investment approaches will come and go, but investors should remember that a long-term, disciplined investment approach based on robust research and implementation may be the most reliable path to success in the global capital markets. With all of the latest "investment fad" hype, I can't help but recall a recent quote from one of our academic research partners, "We just don't get 45 degree lines in finance. In trigonometry maybe, but not in finance."

As always, we appreciate our relationship with you and we are here to help.

Best,
Marc

How much Retirement Income is right for you

 

Source:  Morningstar, Inc.; Center for Research in Security Prices (CRSP) from the University of Chicago; Dimensional Fund Advisors LP. Stone Ridge Asset Management 2018 Shareholder Letter. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.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.

Did You Give Up on Diversification

Once again, the media and talking heads are back at it mourning over the recent "crash" in the stock market and how diversification doesn't work. Many social outlets such as Twitter, LinkedIn, and Facebook are filled with many of our coworkers, friends and family predicting the next market downturn is just around the corner. They may be very right or very wrong. But we know from the past that the market has a way of surprising us all. So time will only tell.

As 2019 approaches, and with US stocks outperforming non-US stocks in recent years, some investors have turned their attention and questioned the role that global diversification plays in their portfolios.

For the five-year period ending October 31, 2018, the S&P 500 Index had an annualized return of 11.34% while the MSCI World ex USA Index returned 1.86%, and the MSCI Emerging Markets Index returned 0.78%. As US stocks have outperformed international and emerging markets stocks over the last several years, some investors might be reconsidering the benefits of investing outside the US. However, you might be surprised to find out that other parts of the market (including non-US stocks) have performed much better than the US market over the 4th quarter of 2018.

While there are many reasons why a US-based investor may prefer a degree of home bias in their equity allocation, using return differences over a relatively short period as the sole input into this decision may result in missing opportunities that the global markets offer. While international and emerging markets stocks have delivered disappointing returns relative to the US over the last few years, it is important to remember that:

Non-US stocks help provide valuable diversification benefits.

Recent performance is not a reliable indicator of future returns.

 

THERE’S A WORLD OF OPPORTUNITY IN EQUITIES

The global equity market is large and represents a world of investment opportunities. As shown in Exhibit 1, nearly half of the investment opportunities in global equity markets lie outside the US. Non-US stocks, including developed and emerging markets, account for 48% of world market capitalization and represent thousands of companies in countries all over the world. A portfolio investing solely within the US would not be exposed to the performance of those markets.

Exhibit 1.      World Equity Market Capitalization

As of December 31, 2017. Data provided by Bloomberg. Market cap data is free-float adjusted and meets minimum liquidity and listing requirements. China market capitalization excludes A-shares, which are generally only available to mainland China investors. For educational purposes; should not be used as investment advice.

 

THE LOST DECADE

We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the period in global markets from 2000–2009. During this period, often called the “lost decade” by US investors, the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of –9.1%. However, looking beyond US large cap equities, conditions were more favorable for global equity investors as most equity asset classes outside the US generated positive returns over the course of the decade. (See Exhibit 2.) Expanding beyond this period and looking at performance for each of the 11 decades starting in 1900 and ending in 2010, the US market outperformed the world market in five decades and underperformed in the other six. This further reinforces why an investor pursuing the equity premium should consider a global allocation. By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur.

Exhibit 2.      Global Index Returns, January 2000–December 2009

S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2018, all rights reserved. Indices are not available for direct investment. Index performance does not reflect expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

 

PICK A COUNTRY?

Are there systematic ways to identify which countries will outperform others in advance? Exhibit 3 illustrates the randomness in country equity market rankings (from highest to lowest) for 22 different developed market countries over the past 20 years. This graphic conveys how difficult it would be to execute a strategy that relies on picking the best country and the resulting importance of diversification.

Exhibit 3.      Equity Returns of Developed Markets

Source: MSCI country indices (net dividends) for each country listed. Does not include Israel, which MSCI classified as an emerging market prior to May 2010. MSCI data © MSCI 2018, all rights reserved. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

 

In addition, concentrating a portfolio in any one country can expose investors to large variations in returns. The difference between the best- and worst‑performing countries can be significant. For example, since 1998, the average return of the best‑performing developed market country was approximately 44%, while the average return of the worst-performing country was approximately –16%. Diversification means an investor’s portfolio is unlikely to be the best or worst performing relative to any individual country, but diversification also provides a means to achieve a more consistent outcome and more importantly helps reduce and manage catastrophic losses that can be associated with investing in just a small number of stocks or a single country.

A DIVERSIFIED APPROACH

Over long periods of time, investors may benefit from consistent exposure in their portfolios to both US and non‑US equities. While both asset classes offer the potential to earn positive expected returns in the long run, they may perform quite differently over short periods. While the performance of different countries and asset classes will vary over time, there is no reliable evidence that this performance can be predicted in advance. An approach to equity investing that uses the global opportunity set available to investors can provide diversification benefits as well as potentially higher expected returns. In addition to global equity investing, here is an overview of additional asset class opportunities that we feel investors may find beneficial in their pursuit of proper diversification:

Global Real Estate 

Sustainable Real Estate

Reinsurance

Corporate Bonds

Municipal Bonds

Volatility

Inflation Protected Securities

 

As always, we appreciate our relationship with you and we are here to help.

Best,
Marc

Schedule a Personal Financial Planning Review Today

 

Source:  Bloomberg; Standard & Poors; Morningstar, Inc. Dimensional Fund Advisors LP. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.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.

 

We Knew Volatility Was Coming

Many people have made predictions on when volatility would return. We agree that it has been unusually low for a few years and fully expected it to increase at some point. The truth is that we just didn't know when nor would we ever try to time the market in anticipation of such events. However, there are many data points that we can point to which serve as a great reminder to those who try to time or predict the future.

After regaining their all-time highs over the summer months, stocks saw a resurgence of volatility in the beginning of October. The downturn was widely attributed to rising interest rates, as the yield on the benchmark 10-year Treasury note surged to 3.25% for the first time since 2011. It didn’t take long for the financial press to ring the alarm bells, reminding us that rising interest rates and falling stocks always go hand in hand.

BUT DO THEY?

A closer look at the data says otherwise, or at least isn’t conclusive. Stock returns have ranged from a 15.56% loss to a 14.27% gain in months when the Federal Funds rate rose. And returns have ranged from a 22.41% decline to a 16.52% gain in months when the Fed Funds rate fell.

Bond prices fall when bond yields rise, and it’s enlightening to see the performance of the stock market during such periods of time. While stocks have certainly experienced prolonged downturns for portions of some rising interest rate cycles, the big picture is that rising bond yields have not been the damper on stock performance that conventional wisdom suggests when looking at the full rate cycles:

It’s been nearly a decade since the S&P 500 last experienced a true bear market (defined as a drop of 20% or more). From that perspective, it’s not hard to argue that stocks are overdue for a prolonged downturn, and market pundits are quick to seize on any perceived negative event (such as rising rates) as the reason that stocks are bound to plunge. But there’s also a lesson here, because those same pundits have been calling for a bear market for five-plus years now, and stocks have continued to climb all along the way. Investors who heeded the call to “protect” their assets in anticipation of the many predicted downturns that never materialized have instead cost themselves the significant gains that stocks enjoyed.

DOMESTIC vs. INTERNATIONAL

U.S. stocks have outperformed international stocks in 2018, a trend that has continued for most of the past decade. When we go through an extended period of time when the stocks that U.S. investors are most familiar with lead the market, it’s easy for investors to wonder if there is any point in diversifying internationally.

When that thought pops to mind, it’s important to remember what the primary goal of strategic asset allocation is – and what it isn’t. Strategic asset allocation is a method of spreading assets across a wide variety of asset classes and investment styles – large and small, domestic and foreign, growth and value, momentum and quality – in an effort to participate in the long-term higher returns that stocks have historically provided, while reducing or eliminating unnecessary risk.

As such, the goal of strategic asset allocation is not to make bets about which asset classes or investment styles will be outperformers going forward. Making such bets only increases the investor’s chances of guessing wrong and being concentrated in an under-performing asset class for an extended period of time.

For example, the difference in performance between large and small stocks, and between growth and value stocks, often fluctuates significantly from year to year. But the fluctuations between U.S. and international stocks tend to be much longer in duration, with one outperforming the other for years and sometimes (as in recent years) a decade or more.

Given these long periods of time when U.S. stocks outperform foreign stocks and vice versa, it’s imperative not to be concentrated in either of them to the exclusion of the other. Large-cap international stocks provided a huge diversification benefit to investor portfolios in the turbulent years of the late 1980s and throughout the 2000s (Remember the Lost Decade?). We are confident that they will provide a similar benefit in the future – though exactly when no one can know.

Further, diversifying into international small stocks and emerging markets stocks over the past 15 years has significantly muted the relatively poor performance of international large stocks. As you can see in the chart below, international small stocks and emerging markets stocks have kept pace with their U.S. counterparts the past 15 years, even as large international stocks have trailed U.S. large stocks by about 3% annually.

MYTH vs. REALITY

I don't want to stop there and instead add one final thought on this subject, more on the behavioral level than the analytical level. Much of the angst that investors experience about asset classes over-performing or under-performing comes from the expectations they have beforehand. In other words, if we expect that international stocks “should” provide a tangible diversification benefit in every market cycle, we’re going to be dismayed when that benefit fails to appear. The same can be said of investor opinions about the merits of growth or value stocks, large or small stocks, and momentum or quality stocks.

The reality of stock investing, however, is that such periods of under-performance are going to happen at some point for every asset class and investment style, and they are inherently unpredictable. If they were predictable we’d have a lot more successful market timers touting their past success instead of their future predictions. For some reason, they are hard to find.

IS THIS TIME DIFFERENT?

Yes, there is always a chance that the world has changed and that this time is truly different. This would mean that what was once true is no longer so. However, we all must first understand the overwhelmingly documented and powerful amount of academic evidence that exists over the long-term.

When it comes to investing, then, the key to contentment is the acceptance of the randomness of returns as a reality of the stock market. Diversification can, and does, smooth those effects, but it can never eliminate them. The only way to do that is to stay out of stocks entirely, and we don't believe this would be a good investment strategy for most.

As always, we appreciate our relationship with you and we are here to help.

Best,
Marc

Schedule a Retirement Review Today

Source:  Factorinvestor.com; Bloomberg; Morningstar. 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.

Mind Over Model in Factor Investing

Checking the weather? Guess what—you’re using a model. While models can be useful for gaining insights that can help us make good decisions, they are inherently incomplete simplifications of reality. In this short entry, we discuss these considerations when it comes to factor investing.

In investing, factor models have been a frequent topic of discussion. Often marketed as smart beta strategies, these products are based on underlying models with limitations that many investors may not be aware of.

To help shed light on this concept, let’s start by examining an everyday example of a model: a weather forecast. Using data on current and past weather conditions, a meteorologist makes a number of assumptions and attempts to approximate what the weather will be in the future. This model may help you decide if you should bring an umbrella when you leave the house in the morning. However, as anyone who has been caught without an umbrella in an unexpected rain shower knows, reality often behaves differently than a model predicts it will.

In investment management, models are used to gain insights that can help inform investment decisions. Financial researchers frequently look for new models to help answer questions like, “What drives returns?” These models are often touted as being complex and sophisticated and incite debates about who has a better model. Investors who are evaluating investment strategies can benefit from understanding that the reality of markets, just like the weather, cannot be fully explained by any model. Hence, investors should be wary of any approach that requires a high degree of trust in a model alone.

Mind The Judgment Gap

Just like with the weather forecasts, investment models rely on different inputs. Instead of things like barometric pressure or wind conditions, investment models may look at variables like the expected return or volatility of different securities. For example, using these sorts of inputs, one type of investment model may recommend an “optimal” mix of securities based on how these characteristics are expected to interact with one another over time. Users should be cautious though. The saying “garbage in, garbage out” applies to models and their inputs. In other words, a model’s output can only be as good as its input. Poor assumptions can lead to poor recommendations. However, even with sound underlying assumptions, a user who places too much faith in inherently imprecise inputs can still be exposed to extreme outcomes.

Given these constraints, we believe bringing financial research to life requires presence of mind on behalf of the user and an acute awareness of the limitations involved in order to identify when and how it is appropriate to apply that model. No model is a perfect representation of reality. Instead of asking, “Is this model true or false?” (to which the answer is always false), it is better to ask, “How does this model help me better understand the world?” and, “In what ways can the model be wrong?”

So what is an investor to do with this knowledge? When evaluating different investment approaches, understanding a manager’s ability to effectively test and implement ideas garnered from models into real-world applications is an important first step.

This step requires judgment on behalf of the manager, and an investor who hires a manager to bridge this judgment gap is placing a great deal of trust in that manager. The transparency offered by some approaches, such as traditional index funds, requires a low level of trust on behalf of investors because the model is often quite simple, and it is easy to evaluate whether they have matched the return of an index. The tradeoff with this level of mechanical transparency is that it may sacrifice the potential for higher returns, as it prioritizes matching the index over anything else. For more opaque and complex approaches, like many active or complex quantitative strategies, the requisite level of trust needed is much higher. Investors should look to understand how these managers use models and question how to evaluate the effectiveness of their implementation. When doing so, rigorous attention must be paid to how any such strategy is implemented. To quote Nobel laureate Robert Merton, successful use of a model is “10% inspiration and 90% perspiration.” In other words, having a good idea is just the beginning. Most of the effort required to make an idea successful is in effectively implementing that idea and making it work.

In the end, there is a difference between blindly following a model and using it judiciously to guide your decisions. As investors, cutting through the noise around the “latest and greatest” investment products and identifying an approach that employs sound judgment and thoughtful implementation may increase the probability of having a positive investment experience.

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

Best,
Marc

Schedule a Second Opinion Meeting

Source:  Dimensional Fund Advisors LP. 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.