August 01, 2017
A Different Way to Invest
We are constantly reading insights from industry professionals whose views and experience we respect. For me, one such is Lance Roberts of Clarity Financial who edits the Real Investment Advice website. Perhaps I admire Lance because he has similar views to my own and possibly expresses them even better? Two recent articles by Lance re-emphasized an important theme I wrote about some time ago in A Different Point of View. I want to give you another take on this theme – plus some additional insights – with several quotes from Lance Roberts taken from The Big Lie of Market Indexes and 7 Myths of Investing, but I will take issue with his statement that “markets don’t compound”.
First, Roberts writes: “The ‘Big Lie’ is that you can ‘beat an index’ over an extended period of time. You can’t ever.” He provides a number of reasons, but the two main ones are that you may have a shorter investment horizon than the market and possibly a lower risk tolerance. On the first point, Roberts shows that while “the commonly perceived myth that investors ‘average 8%’ annually in the stock market”, there can be quite long periods with almost no return, such as the 12 years following 2000 (assuming you bought the index then and simply held on). Adjusting for inflation, the market offered no real return over the 16 years following 2000.
Here I will counter his observation that the market does not compound. In fairness, Roberts is looking at buying and holding “the market”, which would not do anything for you for 12-16 years if you bought in the year 2000. However, my clients have made reasonable returns over periods like this by holding income portfolios and using their monthly cash flow to reinvest and thereby compound, especially by buying more during market declines. Of course, these client portfolios do not try to be representative of the overall market as they are concentrated in income securities. And this strategy works better in registered accounts where there are no taxes to be paid on any income or realized gains. So this is a special case. It does not detract from Roberts’ general observations about investing in equities, especially that you can’t beat the market over time.
Unfortunately, “beating the market” is what most investors think they should be able to do if they can find the right investment advisor and that is how they tend to evaluate their portfolio performance. Therefore, money managers often claim that they can “outperform”. Although I can say that investing in income securities and compounding regular cash flows provided higher returns than an equity market index during periods like 2000 to 2012, it is also true that this strategy would probably underperform in a strong bull market even though it would continue to generate positive returns.
Next, Lance Roberts next makes a key point I agree with and could not have said any better:
The index is a mythical creature, like the Unicorn, and chasing it takes your focus off what is most important – your money and your specific goals. Investing is not a competition and, as history shows, there are horrid consequences for treating it as such. So, do yourself a favor and forget about what the benchmark index does from one day to the next. Focus instead on matching your portfolio to your own personal goals, objectives, and time frames. In the long run, you may not beat the index but you are likely to achieve your own personal goals. But isn’t that why you invested in the first place?
Then Lance brings up another really important consideration that often is overlooked, which is the time frame for investing. “You can replace lost capital – but you can’t replace lost time.” Also, “most individuals lack the time necessary to truly capture 30 to 60-year return averages”. He ends his paper on the 7 Myths this way:
In the end, only three things really matter in investing for the ‘long-term’:
The price you pay.
When you sell, and;
The ‘risk’ you take.
I want to expand on this and I am sure Lance would agree with my re-interpretation his words. I think there are actually four things that matter, because the first one is “when you buy”. The market was expensive and valuations exceedingly high in 2000, but stocks were cheap and under-valued in 2008. Many studies, such as the excellent work of Ed Easterling at Crestmont Research, show that subsequent 10-year returns are minimal when price-to-earnings ratios are at historical highs (25x or more) and that subsequent 10-year returns can be much greater than the long-term average return for equities if you buy when P/E’s are down to single digits, as they were in the late 1970s. The price you pay refers to valuation. That can vary considerably between different individual stocks but for the overall market index, the price you pay is a function of timing.
When you sell is important because it defines your investment time frame. You may have some choice about when to buy, but you have to begin to reap value from your portfolio once you retire and start to depend on your investments to fund your retirement. For most people, the number of years between when they buy and when they plan to retire is their investment time horizon. This is a key reason why every client is different – they have their own individual investment time frame. This, together with their starting assets and career income expectations, will define their portfolio strategy – one that will enable them to reach their own specific goals without taking an inappropriate degree of risk. And risk means the possibility of a permanent loss of capital, which also implies losing some of your investment time frame. That is quite different from “beta” (the volatility of individual securities relative to the market), as risk is commonly defined in Modern Portfolio Theory. Risk can be mitigated through security selection and asset allocation, but especially by heeding Lance Roberts when he urges us not to chase an expensive market in a vain attempt to outperform an index.
If you would like to explore a different approach to investing, call me to arrange an appointment.
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