Diversification, Beating the Market, and Telling the Future – The White Coat Investor – Investing & Personal Finance for Doctors

[Editor’s Note: Today guest post was submitted by Donovan Sanchez, ChFC®, CSLP®, CLU® of Skyview Financial Planning. We have no financial relationship.]

Diversification is vital to long-term investing success, but it doesn’t guarantee stable returns year in and year out. Diversification can only go so far.

The perfect scenario, of course, would be knowing beforehand the future returns on available investments. In that event, the logical thing to do would be not to diversify at all but put everything in the investment with the highest future return.

But because we live in the real world and predicting the future isn’t actually a thing, diversification continues to be relevant.

Diversification Doesn’t Eliminate Market Risk

In light of current market fluctuations, some investors may be disappointed that diversification doesn’t “work” for them as all equities fall in tandem.

For this reason, it’s important to remember that diversification doesn’t eliminate market (systematic) risk.

What does this actually mean?

Most equities are positively correlated—meaning that they tend to move similarly in response to new information. That notwithstanding, a non-perfect correlation can still provide risk-reduction benefits.

According to Burton Malkiel, “. . . note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio.” (A Random Walk Down Wall Street, 202)

Paradoxically, periods of decline are precisely when owners of equities “earn” their return. As the adage states, “no pain, no gain.” Stock owners must be willing to bear the pain of potential and inevitable decline in order to earn the possible superior returns bought at the price of increased risk.

Some investors incorrectly believe it’s possible to obtain high levels of return with low levels of risk. Yet investment performance that only steadily rises can be a mark of mischief, as it was for Mr. Bernard Madoff.  The December 12th, 2008 article, “Top Broker Accused of $50 Billion Fraud“, highlighted that Madoff’s clients “consistently enjoyed small monthly gains, usually between zero and 2%.” This raised red flags, including for one Harry Markopolos who, over the course of nine years, accused Madoff of foul play and “urg[ed] regulators to investigate.”

Diversification is More than Holding Stocks

Reflecting on the 2007-2009 financial crisis, Laurence Siegel smartly points out that diversification is more than holding stocks.

He writes:

“Some critics of optimization have a simpler tale to tell. They say that ‘[Modern Portfolio Theory] told you to diversify and diversification didn’t work.’ Baloney. Diversifying among 50 kinds of equities isn’t diversifying—and in bad times, corporate credit and even mortgage credit are forms of equity! Diversifying into government bonds and cash did work, and investors who held substantial positions in those asset classes did well in the crash.” (“Black Swan or Black Turkey? The State of Economic Knowledge and the Crash of 2007-2009,” Financial Analysts Journal, July/August 2010)

It seems prudent for many investors to have government bonds as a component of their portfolio to hedge against market downturns when most equities fall together.

Sophisticated Investment Strategies

Many firms and investment advisors want you to believe that they have a “sophisticated” investment strategy that will produce superior returns to those you’ll receive by simply buying and holding low-cost mutual funds or ETFs that track a broad index. I encourage you to be wary of investment advisors who claim they can beat the market, or avoid the consequences of a downturn.

The hedge fund Long-Term Capital Management (LTCM) is an interesting historical example of additional risks brought about by “sophisticated” investment strategies. In its first three years of operation, the firm boasted after-fee returns of 21%, 43%, and 41%. Backing its investment strategy, LTCM’s board included Myron Scholes and Robert Merton, some of the greatest financial minds of the day, and recipients of the Nobel Memorial Prize in Economics.

But following the 1997 Asian financial crisis and the 1998 Russian financial crisis, LTCM lost $4.6 billion in less than four months.

Roger Lowenstein’s, When Genius Failed: The Rise and Fall of Long-Term Capital Management, led me to conclude that LTCM’s managers made the mistake of believing they had created infallible models that would virtually ensure investment success. With this mindset, Long-Term Capital Management used leverage in order to maximize returns. Clearly this worked for a few years, but unforeseen (and unforeseeable) events took them down quickly.

I’ve since had a growing distrust of investment professionals and their “expert” opinions, and it appears that I’m not the only one. Just a few months ago, James Mackintosh wrote a piece in The Wall Street Journal regarding the World Economic Forum titled, “Ebullient Mood in Davos Should Put Investors on Edge.” (Jan. 23, 2020) He pointed out that “[t]wo years ago the elite assembled for the World Economic Forum in the Alps strongly believed in global growth, and were completely wrong. A year ago they were concerned, and again entirely wrong as markets subsequently soared.”

Mackintosh concluded that one of the reasons he was worried was because it seemed like there was nothing to worry about—his analysis, and that of the experts, pointed to a good 2020.

Obviously things haven’t turned out that way thus far.

Predicting Future Returns

A few months ago, no one could have predicted the damaging effect of COVID-19 on our financial markets. Even now, I’m not suggesting anything about how “good” or “bad” 2020 will be. The fact of the matter is that no one knows. We might have opinions, and the experts certainly do, but it doesn’t mean any of our opinions matter.

In “The Legacy of Modern Portfolio Theory” by Fabozzi, Gupta, and Markowitz (Institutional Investor, Inc., Fall 2002), the authors admit that finding the optimal portfolio is predicated on appropriate assumptions. They list the political environment, monetary and fiscal policy, consumer confidence, and an understanding of sector and regional business cycles as “some of the key factors that can assist in forming future expectations of the performance of asset classes.” (11)

This is a daunting task and one that I don’t believe anyone can do accurately, at least not on a consistent basis. If one’s predictions about the future turn out to be true, I suspect that it will be impossible to know whether those predictions represent superior smarts or just dumb luck.

Modern Portfolio Theory is valuable because it provides us with a framework for building an optimal portfolio—one seeking the highest level of return for the associated amount of risk. But it is impossible to know beforehand what exact mixture of assets will produce the highest returns.

Taking Cost into Consideration

One of the greatest challenges an active trader (or active fund manager) faces is producing superior returns after costs and transaction fees. It costs money to hire a manager to make trades, and those costs eat away at returns. The great John C. Bogle amusingly pointed out that in investing, you get what you don’t pay for. He also didn’t waste words when he said, “Costs matter. A lot.”

For the active trader or fund manager, history has shown that it’s very difficult to produce superior returns after expenses are taken into consideration.

(For perspective, check out the current statistics and reports at S&P Indices versus Active. As of June 30, 2019, only 21.48% of funds in the United States outperformed the S&P 500 over a five-year period.)

The 1% fee you’re paying your advisor for financial planning and investment management is also a cost to take into consideration. If you’re paying $10,000 or more for financial planning and investment management, be aware that an increasing number of advisors are willing to offer those services for a fraction of that amount.

When Financial Advisors Try to Predict the Future

It’s unfortunate that so many of us (financial advisors) feel the need to act as if we know where the market is headed.

Prior to launching my firm, I worked with a Registered Investment Advisor (RIA) based outside Chicago. The firm focused on low-cost index fund investments and in most ways was doing planning/investing right. It was 2018 and for some reason our firm kept producing market analysis literature providing our estimates of how the market would react to various events. My colleague at the time was in the habit of telling our clients how he thought 2018 was going to turn out. By December 31, 2018, the S&P 500 returned -6.24%.

With all due respect to my former colleague, I didn’t see any reason to act as if our opinions on where the market was going to go mattered. In fact, any thoughts that were expressed that 2018 might be a good year set inappropriate expectations.

Dr. Dave Yeske‘s admonition that “the market doesn’t give a damn what you think” is so good because it’s so true.

Building an Investment Strategy

Jason Zweig began a recent article by stating, “[f]orget about what the stock market is going to do. Instead focus on what you, as an investor, ought to do.”  Zweig further points out that Benjamin Graham thought that paying “too much attention to what the stock market is doing currently” is the “primary reason many individuals fail as long-term investors.”

For Graham, the “intelligent investor” doesn’t need “superior intellect, training or expertise.” Instead, he cited traits such as self-control and patience as marks of the intelligent investor.

Indeed, a successful investment strategy involves principles of patience, resilience, and discipline. More specifically, this includes:

• investing for the long-term
• not using debt to enhance returns
• incorporating a buy-and-hold strategy
• diversifying globally
• carefully basing your asset allocation (ratio of stocks to bonds) on your unique risk tolerance
• and keeping costs low.

This is a slow-and-steady way to build wealth that likely won’t produce spectacular returns year over year. In fact, some years will yield unfavorable results.

But the whole point of investing is to take reasonable risk for the possibility of having more in the future than you do today. Risk and return are inseparably related and investors should understand that although downturns (like the one we are currently experiencing) are uncomfortable, they aren’t surprising.

If you find yourself energetically and frantically making trades in order to try to time the market, outwit your fellow investors, or simply avoid the pain of a market downturn, don’t be surprised if you get burned in the process.

Investors should take counsel from Warren Buffet’s 1990 Berkshire Hathaway Inc. Chairman’s Letter in which he wrote, “[l]ethargy bordering on sloth remains the cornerstone of our investment style.” Jack Bogle’s refrain “stay the course” rings true today, and wise investors will heed the advice: “Don’t just do something—sit there!

Do you agree? What principles of good investing are helping you weather this economic downturn? Comment below!

Author Disclaimer: The content provided is for informational purposes only and represents my personal opinions based on my experience, study, and practice. Yes, I’m a financial advisor, but this article isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply. Please make sure you do your due diligence before implementing anything. Due diligence includes hiring a qualified professional who understands your situation completely and can offer you personalized advice.