Trifecta

Picking a trifecta is difficult, at best. Identifying the first three winners of a horse race, in order, is called a trifecta. The 2019 Kentucky Derby had 19 finishers, so you had to choose from 5,814 potential combinations! If you were correct, the $2 trifecta paid $22,950.

During my career in financial planning, I’ve found three things to be true: individuals aren’t aware of the type of investments they own, how much risk they’re taking, or what level of fees they’re paying.

After meeting with someone, I’ll review their investments to give them an idea of their financial situation. Often, they’re surprised how they’re allocated, their risk level, and the fees they’ve paid. I’ll then compare the results to their financial plan to make sure all three (allocation, risk, and fees) are in sync. The goal is to achieve a financial balance.

Let’s look at the three components.

Asset allocation. Your asset allocation determines most of your returns and your risk level. You might be able to improve your results by investing when the market is low; However, the odds of picking a bottom are extremely rare.

For the past 45 years, a portfolio of 100% stocks generated an average annual return of 12.9%. A portfolio consisting of 100% bonds produced an average annual return of 6%. A balanced portfolio of 60% stocks, 40% bonds made an average annual return of 10.4%.[1]

The returns varied depending on the market conditions. The 100% bond strategy never lost money from 1973 to 2018. The returns have dropped dramatically since 1999; the average annual return has been less than 3% for the past 20 years.

The 100% equity portfolio has produced the best returns, but with the highest risk. From 1973 to 1974, it dropped 41.5%. In 2008 it fell 41.8%. Last year it was down 11.8%. To achieve double-digit returns, you need to take some risk.

The balanced portfolio had considerably less downside than the all-equity portfolio. From 1973 to 1974, it dropped 20.8%. In 2008 it fell 24.8%. Last year it was down by 6.2%. The losses have been about half those of the all-equity portfolio.

Risk level. Risk has several definitions. Losing money is a risk. Volatility is a risk. Longevity is a risk. Inflation is a risk. Liquidity is a risk. Investing all your money in a fixed income portfolio will expose you to inflation and longevity risk. Investing everything in the stock market exposes you to volatility and principal risk. It’s hard to identify your risk level, especially after a 10-year bull market. One test is to review your trading during the 2008 Great Recession. When stocks fell 50%, what did you do? Did you sell your shares? Did you buy stocks? Did you buy bonds? Did you do anything?

Using a service like RiskAlyze or Finametrica can help you determine your risk tolerance. If you’re curious, you can take a quiz on my website by clicking on the “free-portfolio risk analysis” tab located on the upper right-hand corner of my website. Here’s the address: www.parrottwealth.com.

Fees. The fees you pay for your investments matter. Of course, the lower your costs, the higher your return (all things being equal). If you and your brother-in-law own the same fund, but your advisor charges you 2% per year, and his advisor charges .5%, he’ll have better returns. Fees vary, so be aware. Your advisor may bill you by the hour, charge a flat fee, assess a percentage of your assets, or take a commission. Regardless, a fee is a fee. Also, your investments may include other charges if you own mutual funds, exchange-traded funds, or insurance products. If your investment is sold with a prospectus, you’re paying a fee.

If you’re not sure about your investments, then hire a Certified Financial Planner® to help you figure it out. But, before you do, ask your planner how they get compensated and what type of investments they recommend.

Last, completing a financial plan will help you organize and quantify your goals, so they’re in sync with your asset allocation, risk level, and fee structure – a trifecta!

A horse gallops with his lungs perseveres with his heart and wins with his character. ~ Federico Tesio

August 13, 2019

Bill Parrott, CFP®, CKA® is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.

[1] 2019-Dimensional Matrix Book returns from 1973 – 2018.

What is Asset Class Investing?

Investors can invest for growth, income or preservation. The three asset classes that fit this bill are stocks, bonds and cash – stocks for growth, bonds for income, and cash for preservation. Since 1926, stocks have returned 10.2%, bonds 5.5%, and cash 3.4%. Inflation during this same time frame has averaged 2.9%.

Stocks can be further subdivided into large, small, or international companies. Bonds can be issued by governments, municipalities, or corporations. Each of these asset classes have their own unique qualities and characteristics.

Active money managers will try outperforming a benchmark by selecting investments they deem superior to the general population. In addition, they’ll try to time their trading based on market and economic conditions.  Some market watchers categorize active money management as aggressive or speculative.  This style of money management is expensive as they tend to trade more often and employ analyst, traders, and other support staff. It’s also well documented that most active fund managers fail to outperform their corresponding benchmark or index.

Passive money managers purchase the underlying index regardless of valuation or external forces.  An index manager won’t try to time the market and will hold their securities through all types of market conditions and cycles. The most popular index is the Standard & Poor’s 500 and since 1926 it has generated an average annual return of 10.2%. Managers who follow this index will own all 500 stocks and when Standard & Poor’s makes an adjustment to their index, fund managers will alter their portfolio accordingly. This investment strategy is rigid and doesn’t allow for much flexibility because the fund managers can’t afford to deviate from the index, also known as tracking error.  Since there is little trading and no need for a large internal research team, the fees are low.

Asset class investing is based on academic research and it allows for more flexibility than the other strategies. Like passive investing, the fees are low, and diversification is high. Since trading is flexible, it’s more tax efficient than the active management style.

Dimensional Fund Advisors applies factors to their asset class investing.[1] This strategy is based on the findings and research of Eugene F. Fama and Kenneth R. French.[2] The outperformance of the Fama-French factors is over time and they are as follows:

  1. Equity premium: Stocks outperform bonds.
  2. Small cap premium: Small companies outperform large companies.
  3. Value premium: Value stocks outperform growth stocks.
  4. Profitability premium: High profitability companies outperform low profitability ones.
  5. Term premium: Longer term bonds outperform shorter term bonds.
  6. Credit premium: Lower credit bonds outperform higher credit bonds.

Allocating your dollars across several asset classes is what makes this strategy popular. The chart below is often referred to as a financial periodical chart, skittles chart, or quilt and this one is provided by Ben Carlson at a Wealth of Common Sense.[3] As you can see, asset classes aren’t static, and they fluctuate often. For example, if you follow the emerging market sector in the yellow box, you’ll notice it’s either near the top or the bottom. In 2017 it was the top performing sector gaining 37.3% while this year it’s near the bottom with a loss of 1.57%.

Investors who don’t adhere to an asset class investing style get frustrated with underperforming sectors and sell them at, or near, the bottom before they rebound. Small cap stocks underperformed in 2014 and 2015 before claiming the top spot in 2016. Likewise, investors will chase returns by pouring money into the hot sector usually before it rolls over like they did with commodities in 2009 and 2010.

A friend of mine who works for one of the largest mutual fund companies in the world told me the unwritten rule for his firm is for employees to invest their bonuses in the worst performing equity fund they manage from the prior year because they know it will eventually rebound.

I, too, like allocating dollars to underperforming sectors because they’ll eventually return to favor. Another advantage of buying a down and out sector is that you’ll buy in at bargain prices, a classic buy low and sell high scenario. An unloved sector also offers tremendous value to the buy and hold investor.

 

 

In a model driven portfolio that diversifies dollars across several asset classes, you can take advantage of down and out sectors by rebalancing your account annually. When it rebalances, the model will sell overpriced assets and buy underpriced ones. This strategy will keep your original asset allocation and risk tolerance intact.

A model driven, asset class portfolio offers many benefits. You get access to thousands of securities across the globe buy owning low-cost, efficient mutual funds. Furthermore, you no longer must stress about finding the right stock at the right time, nor do you have to fret about market timing.  What could be better than a stress free, low-cost, model driven portfolio?

June 11, 2018

Barbecue may not be the road to world peace, but it’s a start. Anthony Bourdain

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

[1] Dimensional Fund Advisors – Dimensions of Returns.

[2] https://www8.gsb.columbia.edu/programs/sites/programs/files/finance/Finance%20Seminar/spring%202014/ken%20french.pdf, Eugene Fama and Kenneth French, March 2014.

[3] http://awealthofcommonsense.com/2018/01/updating-my-favorite-performance-chart-for-2017/, Ben Carlson, 1/14/2018.

No. How Can I Help You?

Are customers always right?   Employees who work in the retail sector are trained to say “yes” to client requests and that they’re always right.  They sell the client what they want, not what they need. It’s hard to find a salesperson who says “no” to client requests.

If I order a triple bacon cheeseburger with guacamole, chili-cheese fries, and a chocolate shake the clerk is going to take my order, deliver my food, and move on to the next customer.  He doesn’t question my order or the ramifications it will have on my health.

My role as an advisor, however, is to recommend what clients need, not what they want. This means I regularly say “no” to client requests especially when it’s not in their best interest.  My goal is to make sure they follow their financial plan.  I want to say “yes”; I want to be the good guy but not at the expense of their financial wellbeing.

In December of 1999 I met with a client who wanted to know why he didn’t have a larger exposure to high-flying technology and internet stocks.  He was questioning his allocation to international, real-estate and bond investments.  He wanted to sell these holdings to buy NASDAQ traded stocks.  I told him “no” because of their rich valuations and that they didn’t fit into his long-range plans.  He didn’t like my answer, so he asked the branch manager to transfer his account to another broker.  A few months later the NASDAQ peaked and proceeded to fall 70%.

Today, investors are once again questioning the wisdom of diversification as bonds, real-estate investment trusts and value stocks underperform growth stocks like Facebook, Amazon, Netflix and Google (Alphabet).  Investors are ready to abandon their asset allocation models to chase returns. Of course, the path of least resistance would be for me to cave into these requests and give them what they want, but is this prudent? Let’s look at a few examples.

  1. From October of 1989 to December of 2016 stocks averaged 9.38% per year. If an investor missed the 25 best days during this stretch his returned dropped to 3.98%.[1]
  2. In 2008 the S&P 500 fell 37% and long-term government bonds rose 25.9%.[2]
  3. From 1994 to 2016 stocks generated an average annual return of 7.3%. If an investor didn’t own the top 25% of performers each year, he lost an average of 5.2% per year.[3]
  4. In 2015, Denmark was the best performing stock market in the world and Canada was the worst. A year later they switched places.  Canada was first; Denmark was last.[4]
  5. International stocks returned a paltry 1.6% in 2016 but gained 25% in 2017.[5]
  6. In Barron’s 2017 Roundtable one prediction called for interest rates to rise and stocks to fall.[6] What happened?  Rates, stocks soared.

It would be nice to own investments that only went up, but this isn’t possible.  Markets rise and fall. Sectors move in and out of favor.  After all, if all your investments went up at the same time you wouldn’t be diversified!

A wise strategy is to follow your financial plan, diversify your investments and rebalance them annually.

“Never ask a barber if you need a haircut.” ~ Warren Buffett

But about that day or hour no one knows, not even the angels in heaven, nor the Son, but only the Father. ~ Matthew 24:36

Bill Parrott is the President and CEO of Parrott Wealth Management an independent, fee-only, fiduciary financial planning and investment management firm in Austin, TX.  For more information please visit www.parrottwealth.com.

3/1/2018

Note:  Past performance is not a guarantee of future returns.  Your returns may differ than those posted in this blog and investments aren’t guaranteed.  Photo credit = lisafx

 

 

[1] DFA –  Investor Discipline – Reacting Can Hurt Performance

[2] 2016 – Dimensional Fund Advisors Matrix Book

[3] DFA –  Diversification May Prevent You from Missing Opportunity

[4] 2016-Dimensional Fund Advisors Matrix Book

[5] http://awealthofcommonsense.com/2018/01/updating-my-favorite-performance-chart-for-2017/, Ben Carlson, 1/14/2018

[6] https://www.barrons.com/articles/stocks-could-post-limited-gains-in-2017-as-yields-rise-1484376687, Laurin R. Rublin, 1/14/17.