A Different Way to Invest
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Many investors have unfulfilled expectations. They are looking for a better solution, one that can lead to a better investment experience. What would that approach look like? How can they improve their odds of success? This presentation looks at a different way to invest.
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A Different Way to Invest
- 1. A Different Way to Invest 80 South Eighth Street Suite 4900 Minneapolis, MN 55402 www.totalwealthadvisors.com
- 2. Why Invest?
- 3. In US dollars. Source for 1913 and 1963: Historical Statistics of the United States: Colonial Times to 1970/U.S. Dept. of Commerce. Source for 2013: United States Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index–Average Price Data. Your Money Today Will Likely Buy Less Tomorrow 1913 1963 2013 $0.09 = Quart $0.09 = 1 Small Glass $0.09 = 6 Tablespoons 2
- 4. Investing means taking risks.
- 5. Not investing means taking risks, too.
- 6. Past performance is no guarantee of future results. In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. See "Growth of Wealth Indices" page in the Appendix for more information. US Small Cap Index is the CRSP 6−10 Index; US Large Cap Index is the S&P 500 Index; Long-Term Government Bonds Index is 20-year US government bonds; Treasury Bills are One-Month US Treasury bills; Inflation is the Consumer Price Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Bonds, T-bills, and inflation data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield). Capital Markets Have Rewarded Long-Term Investors Monthly growth of wealth ($1), 1926−2014 $0 $1 $10 $100 $1,000 $10,000 $100,000 1926 1934 1942 1950 1958 1966 1974 1982 1990 1998 2006 2014 $18,176 US Small Cap Index $5,313 US Large Cap Index $135 Long-Term Govt. Bonds Index $21 Treasury Bills $13 Inflation (CPI) 5
- 7. Market cap data is free-float adjusted from Bloomberg securities data. Many nations not displayed. Total may not equal 100% due to rounding. For educational purposes; should not be used as investment advice. China market capitalization excludes A-shares, which are generally only available to mainland China investors. There’s a World of Opportunity in Equities Percent of world market capitalization as of December 31, 2014 6
- 8. Data is from Barclays Global Aggregate Ex-Securitized Bond Index. Many nations not displayed. Total may not equal 100% due to rounding. For educational purposes; should not be used as investment advice. Barclays data provided by Barclays Bank PLC. There’s a World of Opportunity in Fixed Income Percent of global investment grade bond market as of December 31, 2014 7
- 9. How Do Many People Invest?
- 10. They Try to Predict the Future “I have a proven system for picking winning stocks.” “The market is primed for a retreat.” “That sector will continue advancing through next year.” 9
- 11. They Act on Impulse “I can’t take this bear market— I’m getting out!” “Everyone’s making money— I want a piece of the action.” 10
- 12. They Bet their Savings on Tips and Hunches “I heard it on the news. I’d better sell!” “I got a hot tip from my neighbor. It’s a slam dunk.” “My friend works in the industry— he’s got the inside scoop.” 11
- 13. They Are Swayed by the Media “How to Reach $1 Million” Money, 08/2012 “The Death of Equities” Business Week, 08/13/1979 “The Crash of ’98 Can the US Economy Hold Up?” FORTUNE, 09/28/1998 “Retire Rich – A Simple Plan to Have it All” FORTUNE, 08/16/1999 12
- 14. What Have We Learned?
- 15. Eugene Fama and Kenneth French are members of the board of directors for and provide consulting services to Dimensional Fund Advisors LP. Robert Novy-Marx provides consulting services to Dimensional Fund Advisors LP. Many of the Greatest Advancements in Finance Have Come from Academia 14 1966 Efficient Markets Hypothesis EUGENE FAMA Nobel Prize in Economics, 2013 1964 Single-Factor Asset Pricing Risk/Return Model WILLIAM SHARPE Nobel Prize in Economics, 1990 1952 Diversification and Portfolio Risk HARRY MARKOWITZ Nobel Prize in Economics, 1990 1981 The Size Effect ROLF BANZ 1992–1993 Value Effect and Multifactor Asset Pricing Model EUGENE FAMA KENNETH FRENCH 2012 Profitability ROBERT NOVY-MARX EUGENE FAMA KENNETH FRENCH 1984 Term Structure of Interest Rates EUGENE FAMA
- 16. Illustration based on voluntary participation at client event hosted by a financial advisor, August 2013. Results audited by advisor. Together, We Know More Than We Do Alone Participants were asked to estimate the number of jelly beans in a jar. Range: 409-5,365 Average: 1,653 Actual: 1,670 15
- 17. Source: World Federation of Exchanges. Global electronic order book figures gathered from the 59 WFE member exchanges. Markets Integrate the Combined Knowledge of All Participants 16 World Equity Trading in 2014 Number of Trades Dollar Volume Daily Average 60 million $302 billion The market effectively enables competition among many market participants who voluntarily agree to transact. This trading aggregates a vast amount of dispersed information and drives it into security prices.
- 18. What is the Best Way to Invest?
- 19. There Are Differing Approaches 18 Attempts to identify mispricing in securities Relies on forecasting to select “undervalued” securities or time markets Generates higher expenses, trading costs, and risks CONVENTIONAL MANAGEMENT
- 20. Investing involves risks such as fluctuating value and potential loss of principal value. There is no guarantee strategies will be successful. The Conventional Approach Attempts to Outguess the Market Buys a selection of individual securities manager thinks will outperform. Sells securities when deemed overvalued. Can lead to high turnover and excess costs. 19 Market
- 21. Past performance is no guarantee of future results. Survivors are funds that were still in existence as of December 2013. Outperformers are survivors that beat their respective benchmarks over the period. See “Data Appendix” page in the Appendix for additional information. Source: Mutual Fund Landscape, Dimensional Fund Advisors 2014. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. Conventional Investment Methods Have Low Odds of Success Fraction of mutual funds that survived and beat their index for 10 years, ending December 31, 2013 19% 15% Stocks Bonds 20
- 22. There Are Differing Approaches 21 Allows commercial index to determine strategy Attempts to match index performance, restricting which securities to hold and when to trade Prioritizes low tracking error over higher expected returns INDEXING
- 23. Investing involves risks such as fluctuating value and potential loss of principal value. There is no guarantee strategies will be successful. The Indexing Approach Attempts to Match the Returns of a Commercial Benchmark Holds a basket of securities represented in the index. Buys and sells the same securities at the same time as all other funds tracking the index. 22 INDEX LIST Market
- 24. Investing involves risks such as fluctuating value and potential loss of principal value. There is no guarantee strategies will be successful. The Indexing Approach Attempts to Match the Returns of a Commercial Benchmark Six months later: Securities have moved in and out of the index’s targeted range As a result, your investment may have drifted from what you intended. 23 INDEX LIST Market
- 25. There Are Differing Approaches 24 Gains insights about markets and returns from academic research Structures portfolios along the dimensions of expected returns Adds value by integrating research, portfolio management, and trading AN ALTERNATE APPROACH
- 26. Investing involves risks such as fluctuating value and potential loss of principal value. There is no guarantee strategies will be successful. Viewing the Market in a Different Dimension Market 25
- 27. Investing involves risks such as fluctuating value and potential loss of principal value. There is no guarantee strategies will be successful. Viewing the Market in a Different Dimension Decades of academic research have identified relevant dimensions that point to differences in expected returns. Higher Expected Return Market 26
- 28. Diversification does not eliminate the risk of market loss. Investing involves risks such as fluctuating value and potential loss of principal value. There is no guarantee strategies will be successful. Portfolios Can Be Structured along Dimensions of Expected Returns A well-diversified portfolio can emphasize market areas offering higher expected return potential. 27 Overweight Underweight Higher Expected Return Market
- 30. From Insights to Implementation An integrated investment process adds value at each step. Research can be applied throughout the process for an advanced understanding of all aspects of investing. 29
- 31. For illustrative purposes only. Balancing Investment Tradeoffs 30 Two investment opportunities can have the same expected return but invite very different conditions. These conditions result in different costs, which impact net returns. A NET RETURNCOST NET RETURNCOST Broad diversification and patient, flexible trading lead to lower turnover and costs. Concentrated holdings and urgent, inflexible trading result in higher turnover and costs. CONDITIONS B EXPECTED RETURN INVESTMENT OPPORTUNITY
- 32. Adding Value through Flexible, Patient Trading “I want this one—today!” “I’m flexible.” 31
- 33. Diversification neither ensures a profit nor guarantees against loss in a declining market. Focus On What You Can Control A financial advisor can help you create a plan and focus on actions that add value. 32
- 34. Appendix
- 35. Fama/French and CRSP data provided by the Center for Research in Security Prices, University of Chicago. The S&P data are provided by Standard & Poor's Index Services Group. Bonds and T-bills data provided by Morningstar. Inflation data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield). Growth of Wealth Indices Small Cap Value Index is the Fama/French US Small Value Index (ex utilities). Small Cap Index is the CRSP 6−10 Index. Large Cap Index is the S&P 500 Index®. Long-Term Government Bonds Index is 20-year US government bonds. Treasury Bills are One-Month US Treasury bills. Inflation is the Consumer Price Index. 34
- 36. Data Appendix Research conducted by Dimensional Fund Advisors LP. US-domiciled mutual fund data is from the CRSP Survivor- Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. Certain types of equity and fixed income funds were excluded from the performance study. For equities, sector funds and funds with a narrow investment focus, such as real estate and gold, were excluded. Money market funds, municipal bond funds, and asset-backed security funds were excluded from fixed income. Funds are identified using Lipper fund classification codes and are matched to their respective benchmarks at the beginning of the 10-year sample period. Winner funds are those whose cumulative return over the period exceeded that of their respective benchmark. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark. Non-survivors include funds that were either liquidated or merged. Benchmark data provided by Barclays, MSCI, and Russell. Barclays data provided by Barclays Bank PLC. MSCI data copyright MSCI 2014, all rights reserved. Russell data © Russell Investment Group 1995−2014, all rights reserved. Benchmark indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Mutual fund investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost. Diversification neither assures a profit nor guarantees against a loss in a declining market. Past performance is no guarantee of future results. 35
Editor's Notes
- Many investors have unfulfilled expectations. They are looking for a better solution, one that can lead to a better investment experience. What would that approach look like? How can they improve their odds of success? Let’s begin by considering what you want to accomplish as an investor. Why do people invest at all? People have different financial needs and goals, and therefore, they may invest for different reasons. One major reason is to grow their wealth—for example, in preparation for retirement. Whatever their reason for accumulating money, there’s another concern that creates the need to invest: the threat of inflation.
- Inflation erodes the real purchasing power of your wealth. Consider an illustration of the effects of inflation over time. In 1913, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And 100 years later, nine cents would only buy about six tablespoons of milk. So, as the value of a dollar declines over time, you invest to grow wealth and preserve purchasing power.
- We often hear people say, “yes, but investing is risky.”
- But considering the long-term threat of inflation, not investing means taking risks, too. If you don’t grow your money, you may not be able to afford things in the future. So, how do people invest to grow their wealth?
- Most look to the financial markets as their main investment avenue—and the good news is that the capital markets have rewarded long-term investors. The markets represent capitalism at work in the economy—and historically, free markets have provided a long-term return that has offset inflation. This is documented in the growth of wealth graph, which shows monthly performance of various indices and inflation since 1926. These indices represent different areas of the financial markets, such as stocks and bonds. The data illustrates the beneficial role of stocks in creating real wealth over time. T-bills have barely covered inflation, while longer-term bonds have provided higher returns over inflation. Stock returns have far exceeded inflation and have significantly outperformed bonds. One thing to note is that not all stocks, or bonds, are the same. The differences are evident in the performance of US small cap stocks over this time period. A dollar invested in small cap stocks in 1926 would be worth more than $18,000 in 2014. Keep in mind that there’s risk and uncertainty in the markets and that historical results may not be repeated in the future. Nevertheless, the market is constantly pricing securities to reflect a positive expected return going forward. Otherwise, people would not invest their capital.
- These wealth creation opportunities are available not just in the US stock and bond markets, but in markets around the world. This cartogram depicts the world, not according to land mass but by the size of each country’s stock market relative to the world’s total market value.1 Of course, the world is in motion—there is no fixed relationship between markets, and their proportion can change over time. Viewing the world by relative equity market capitalization illustrates the opportunity to invest through a globally diversified portfolio. 1A country’s equity market capitalization, or market cap, reflects the total value of shares issued by all publicly traded companies and is calculated as share price times the number of shares outstanding.
- The same applies in opportunities in the global fixed income markets. Investors can go beyond the US to participate in the expected reward potential in other countries and their economies. This cartogram shows the balance of the investment grade fixed income opportunities around the world, with the size of each country adjusted to reflect the relative size of its fixed-income market. The investment grade universe is represented by the Barclays Global Aggregate Ex-Securitized Bond Index. The index is a subset of a much larger global bond market that includes other market segments, such as securitized bonds, high-yield bonds, and inflation-linked securities. This is how people should think about their investment opportunity set. Investing is about forming an approach for holding stocks and bonds around the globe—and participating in the expected reward potential over time.
- Let’s think about how a lot of people attempt to grow wealth in the capital markets.
- The most common approach is based on prediction and forecasting. Methods include: Picking stocks expected to perform well in the future, Moving in and out of industry sectors, or Attempting to time the market These methods are based on trying to predict the future direction of the economy, the stock market, or an individual stock. This conventional approach assumes that someone has a crystal ball. Many people think this is the key to successful investing. In fact, when people meet financial advisors or others in the investment business, their first question is typically, “where do you think the market is going?” They are basically asking that person to make a prediction. Yet, no one can know the future—and if an investment person could predict the market’s future direction, why would he share that knowledge for free? A prediction about an uncertain future is just an opinion, and it should not determine anyone’s investment decision. Many people learn this the hard way.
- Some people approach investing from an emotional perspective. They act impulsively—and their reaction is typically sparked by fear or greed. Some may get anxious about the stock market and decide to get out. This may ease their fear, but it may be replaced by the anxiety of missing out on a market recovery. Investors who flee the market ultimately have to decide when to get back in. The 2008–09 global market downturn offers an example of how the cycle of fear and greed can drive an investor’s decisions. Some investors fled the market in early 2009, just before the rebound began. They locked in their losses and then experienced the stress of watching the markets climb. The other side of the emotional coin is greed. Investors can get anxious about missing out on what they perceive as a great investment. They may follow the crowd. The idea behind investing is to buy low and sell high. Yet, following an emotional investment cycle sparked by impulsive decisions may bring an opposite effect: buying at high prices and selling at lower prices.
- Other people approach investing from a “get rich quick” perspective and act on tips or hunches. They may seek out investment insight from cable news programs that feature Wall Street experts who appear to know something valuable, or from other sources. There’s also a social element to predictive investing. People like to talk about their winning investments, but they probably don’t mention the losers. People often follow the advice of friends, neighbors, or family—especially if the “insight” offers potential to make a fast, easy return. Most of this advice is just noise. We all know deep down that there’s no shortcut to growing wealth. So why do people keep investing this way? In some cases, it is all they know.
- The financial and popular media define what investing is for many people. Whether the message is crafted by a financial publication, a website, or a cable program, it often targets human emotion. Consider the messages in these sample headlines from major publications. Some prey on an investor’s fear and anxiety about the future, while others suggest you can tap into special knowledge to gain quick, easy wealth. Investors who are tempted to act on these media messages should remember the media is selling entertainment, not real financial advice.
- There is another way to invest—a way that can put the odds of success in your favor. It starts by considering what academic research has revealed about markets and investing over the past 60 years. We call this financial science. It is based on time-tested research into financial markets, asset pricing, expected returns, and other aspects of investing. But what does it mean to follow science? Here’s an example of science applied in everyday life. When you visit a medical doctor, you expect that specialist to be connected to the latest medical knowledge. If your doctor recommends a treatment or writes a prescription, you assume that the advice is based upon a large body of scientific evidence that resulted from a rigorous process of research, testing, and practical application. In the same way, financial science can be applied to practical investing. One can build an approach based on decades of research into the financial markets, including pricing dynamics and the behavior of different areas of the market.
- The academic community offers a wealth of insight into how markets work and the sources of expected returns. This timeline offers some of the high points in the evolution of modern finance. One driving principle is that “markets work”—that is, market prices reflect all available information and expectations of the future. This is known as market efficiency. The forces of supply and demand are constantly at work in the financial markets, and the intense competition pushes stock and bond prices toward their actual value. People trust markets every day. For example, when shopping, you probably don’t question whether the price for an item is “right” or “wrong.” You simply assume the price reflects local market conditions. You might decide the price is too high and choose not to buy—and if enough people don’t buy the item, the price drops. This is how a market works. Yet, many people’s perception of market pricing breaks down when they invest because they assume that the price of a stock or bond may not be right. They are conditioned to view some stocks as being “overvalued” or “undervalued.” In reality, the financial markets work much like any other market, with information and opinions affecting the price of a stock or bond. That price reflects the aggregate view of what the investment is worth at that moment in time. The forces of supply and demand push prices toward market equilibrium—and these forces are at work in the financial markets.
- Here’s a simple example of a market at work. It shows how collective knowledge can come together and be more powerful than the knowledge of any one person. At a client event hosted by a financial advisor, a jar of jelly beans was placed in the lobby and attendees were asked to estimate the number of jelly beans it contained. The participants wrote down their estimates, and whoever offered the closest estimate to the actual count received a prize. There was a wide range of estimates—409 to 5,365 jelly beans. The average of all estimates was 1,653. The actual count was 1,670. This experiment has been repeated at other client events, and the average of all guesses is usually very close to the actual count. The principle is that the combined intelligence of a group is better than the knowledge of one person. Together, we know more than we do alone.
- So, consider how this aggregation of knowledge and opinions works in the financial markets. Millions of participants buy and sell securities around the world. In the US markets alone, investors trade billions of dollars in stocks and bonds each day. The new information buyers and sellers bring to the markets help set prices—and with each bit of new information, prices adjust accordingly. No one knows what the next bit of new information will be, as the future is uncertain. But we can accept current prices as fair. This doesn’t mean that a price is always right because there’s no way to prove that. But investors can accept the market price as the best estimate. If you don’t believe that market prices are good estimates—if you believe that the market has it wrong, you are pitting your knowledge or hunches against the combined knowledge of thousands or millions of other market participants.
- So, guided by these principles and a wealth of research about the financial markets, how should we think about investing? Your particular view of market pricing will shape how you invest, and there are basically three approaches: conventional management, indexing, and our way of investing, which is based on market pricing and dimensions of expected returns.
- The dominant or “conventional” investment approach assumes that prices are not accurate. This leads to an attempt to predict the future, which incurs higher costs and risk. We have already looked at the main problems that people encounter when they follow a predictive investment approach. Let’s see if professional investment managers can do a better job at conventional investing.
- Consider this illustration of how conventional managers invest. This box represents the entire stock market universe, and the dots are individual stocks. A manager buys a handful of securities expected to do well in the future and sells securities expected to not perform well. Note that this type of manager starts with nothing and finds a reason to pick one stock over another. The manager’s selection criteria are based on whether the stock is considered overpriced or underpriced. But choosing only a few stocks in the market often results in poor diversification and higher risk. Equally important, the manager’s frequent buying and selling results in high costs as the portfolio is turned over many times.
- Mutual fund research shows that conventional investing has low odds of success. Over the 10-year period ending in 2013, only 19% of stock managers and 15% of bond managers survived and outperformed their benchmarks. Said another way, 81% of stock managers and 85% of the bond managers who started the 10-year period underperformed their market index. About half of the stock and bond managers did not even survive the 10-year period. Some investors try to improve these odds by picking managers who have outperformed in the past. There’s a significant amount of research into the persistence of manager performance. It shows that among managers that outperformed in the past, only a small fraction continued to beat their market benchmark in the future. Should we be surprised by this poor record of performance? Not really. This makes sense if market prices are the best estimates of actual value. Manager underperformance is not necessarily due to a lack of knowledge or expertise. In fact, many professional investment managers are very bright, educated, and hard working. The problem is that this high level of expertise and motivation results in intense market competition, which drives prices to fair value. With the advent of computing power and data availability, academic research has documented the poor outcome of most conventional managers. This is one reason for the rise in the popularity of another investment approach—indexing.
- Indexing offers a number of investment benefits over a conventional approach. Broad-based indexes offer better diversification, have lower fees, and follow a more transparent investment process, which means investors have a clearer idea of what they are getting. The problem with indexing is that the commercial index provider determines the stocks or bonds held in the portfolio. The firm publishes a list—usually annually or semi-annually—containing all the stocks composing that index, or benchmark. The manager attempts to closely track the benchmark. But rigid construction works against the strategy. Most index fund managers are judged by their ability to closely track their respective index. The main problems with this approach are loss of control, trading disadvantage, and style drift. Let’s consider each of these.
- Loss of control An index manager does not start with the whole market, but with a list of stocks published by the index provider. The manager holds a basket of stocks in an attempt to match or closely replicate that list. The investment strategy is defined by a commercial index provider, and the manager has no control over what the fund holds. Trading disadvantage When the new list is released, managers must buy and sell at the same time to keep their portfolios (and returns) in line with the index. This updating process is known as rebalancing or index reconstitution. Everyone knows what the index fund is holding and when the index manager will rebalance. The index provider has shown the cards to the marketplace, and the index fund manager will have to trade with urgency along with other managers who follow the index. This puts the managers at a trading disadvantage, which usually results in higher costs.
- Style drift Security prices change every day to reflect the market’s latest expectations, but indices rebalance only once or twice a year. As new information is incorporated into market prices and securities start to exhibit different characteristics, the indexed portfolio can move away from its target universe or asset class. This is referred to as style drift, and it happens to indices between reconstitution dates, leaving investors to hold stocks they many not want to own.
- We apply a different investment approach. It is informed by financial science and the view that market prices reflect all available information. We also believe that different securities can have different expected returns. Guided by this perspective, this approach looks to academic research to gain insight into the dimensions that drive those expected returns, then integrates this knowledge into strategies designed and implemented to add value in competitive markets.
- Rather than viewing the market universe in terms of individual stocks and bonds, an investment manager can define the market along the dimensions of expected returns to identify broader areas or groups that have similar relevant characteristics. This approach relies on academic research and internal testing to identify these dimensions, which point to differences in expected return.
- Research shows that some market areas have higher expected returns than others. In the stock market, the dimensions are size (small cap vs. large cap), relative price (value vs. growth), and profitability (high vs. low). In the bond market, these dimensions are credit quality and term. The return differences between stocks and bonds can be considerably large. So can the return differences among a group of stocks or bonds. To be considered a dimension, it must be sensible, backed by data over time and across markets, and capturable in diversified, cost-effective portfolios.
- So, if there are systematic differences in expected returns and research has identified them, how can the insight be applied to practical investing? We select broadly diversified portfolios that emphasize areas offering the potential for higher expected return. The strategies can emphasize securities with higher expected returns by overweighting them compared to their market cap weight. One way to visualize overweighting is to think about an ice cube tray with sections that are shallower and deeper. In a portfolio, each section holds many stocks that compose a market area, and those with greater return potential are overweighted, just like the large ice cubes. In a dimensions-based approach, capturing returns does not involve predicting which stocks, bonds, or market areas are going to outperform in the future. Rather, the goal is to hold well-diversified portfolios that emphasize dimensions of higher expected returns and have low turnover.
- Now, let’s consider how to bring it all together in a practical investment strategy.
- We have discussed the importance of formulating an investment strategy that is informed by financial science. But a solid market philosophy and strong research are not enough. Good ideas are not enough. An investment manager must put those ideas to work each day in a competitive market. This requires an approach that dynamically integrates the research with portfolio structure and implementation. This is where science meets investing.
- Design and implementation require careful balancing of tradeoffs under which the returns are pursued. Research can provide abundant data on investment dimensions. Without considering the tradeoffs, however, what may look good on paper and in the data won’t be as compelling in practice. Here’s a simple example to help showcase the importance of tradeoffs: Consider two investment opportunities—A and B. They have the same expected return, but capturing that return occurs under very different conditions. Approach A involves patient and flexible trading, resulting in lower turnover and better diversification. Approach B requires urgent trading and offers less flexibility, resulting in higher turnover and lower diversification. One approach incurs lower costs and the other approach incurs higher costs. Which approach would you choose? Given the same expected return, approach A enables you to capture more of the return identified in the research. An investment manager can apply this framework to the design of its strategies and also consider these kinds of tradeoffs in real time when executing in dynamic, complex markets. Remaining patient and flexible leads to lower implementation costs and helps with other investment considerations, such as diversification. The result is potentially higher net performance.
- Flexibility enables patient trading, which renders the freedom to add value. Shopping for a car offers a familiar example of how flexibility can enhance negotiating power. Setting your eyes on one specific make, model, and color, and needing to buy immediately provides little flexibility to bring down the dealership’s asking price. But having multiple options and lots of time to buy enables you to negotiate a better price. Managers can approach securities trading in the same way. By targeting dimensions of the market rather than specific securities, they do not have to buy any stock at a particular time and can easily substitute one stock for another when they have similar expected returns.
- To have a better investment experience, people should focus on the things they can control. It starts with an advisor creating an investment plan based on market principles, informed by financial science, and tailored to a client’s specific needs and goals. Along the way, an advisor can help clients focus on actions that add investment value, such as managing expenses and portfolio turnover while maintaining broad diversification. Equally important, an advisor can provide knowledge and encouragement to help investors stay disciplined through various market conditions.