Investing Rookie (and not-so-rookie) Mistakes

Zacc Call

Investing Rookie (and not-so-rookie) Mistakes

You can’t have a perfect portfolio

Part of your portfolio will always drive you crazy. It’s true. You will always own a piece of something you wish you didn’t: a loser. This is what to expect from a well-diversified asset allocation portfolio. Let me give you a few examples of why you might even hate something in your portfolio.

Example 1: International

For the last decade it has been international and emerging market stocks. We could have done without them — for a decade!

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Example 2: Value stocks

Value stocks are those companies perceived to be reasonably priced compared to assets, dividends, and cashflow. Value stocks, compared to growth stocks (companies showing earnings growth), did incredibly well for 35 years! You may remember feeling compelled to over-weight value five to eight years ago. Since then performance has been horrid for value stocks relative to the darling style box of large cap growth.

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Example 3: The small cap anomaly

The theory is that the market is efficient, information is too quick and pricing is too immediate. In other words, you can research stocks all you want, and you won’t get any edge EXCEPT for a few anomalies. One of those secret weapons is supposedly the small cap effect. Small cap companies are those with a total company value — called “market capitalization” or “cap” — of less than approximately $5 billion. That doesn’t seem very small to most people, but it is small in comparison to the giants on Wall Street. They say, “Buy small cap and you’ll outperform the market.” You have lost almost 7% in your small cap positions compared with a gain of almost 30% in large companies for the last five years.

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You can’t just buy one asset class

The lost decade

To heck with it! We say a lot of “shoot!” and “heck!” in Utah. However, my family is from Wyoming. While farmer four-letter words don’t count in Wyoming, I’m still working on it… so heck you say! You decide to buy just the S&P 500. Remember the lost decade? The 10-year window beginning with the year 2000 was one of the few decades in which the S&P 500 made no ground from start to finish. Returns looked great in the middle, but the Great Recession reared its ugly head and all large cap gains vanished. The S&P 500 returned -9.1% for that decade from start to finish… including dividends. Sobering.

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The lost investor

That decade was not so “lost” for those with a diversified portfolio. In the next chart, you’ll see that seven out of nine of these typical portfolio allocations were positive to the tune of 32%-102% during “the lost decade.” Over an entire decade, 32% gain is nothing that exciting. That is an annual growth rate of 2.8%; however, it was not lost. The 102% gain was an average annual growth rate of 7.3% which is respectable.

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The lost decade was a rough time to be all in on the S&P 500. Large U.S. companies and developed international markets lost value during that decade. The rest of these indexes did somewhere between mildly positive to good. Some did it with a much smoother ride.

You shouldn’t just sell proportionately to fund your withdrawals

Too simple of a withdrawal plan

Ever wonder what happens when you withdraw from a 401K plan in a model portfolio? You are withdrawing proportionately across all these investments. If you could pick your asset class from which you withdraw from the chart above, wouldn’t it be nice to use the Bloomberg Barclays U.S. Aggregate (light orange)? That index is U.S. bonds.

Many advisors set your risk tolerance, buy a portfolio of all these categories, and then sell proportionately to fund your monthly withdrawals. Your 401K usually functions the same way (selling stocks each month).

Ordering withdrawals

I think a good advisor isolates enough conservative money to cover monthly withdrawals for five to 10 years. Gradually, each withdrawal will change your asset allocation as you use up your conservative money. This is where good planning happens. Your advisor and you decide at what point you backfill the conservative bucket.

The decision-making rules are:

  1. As of this moment, do you have enough conservative money to last five to 10 years?
  2. If not, could you sell stocks at a gain to backfill the conservative money?
  3. Only withdraw from the conservative money during bad markets.

Under these rules, you wouldn’t have backfilled the conservative money from 2000 to 2005. You would have seen losses on stocks. If you are diligent with annual reviews, you would have caught the opportunity in 2006 or 2007 if you determined you didn’t have five to 10 years conservative money for the future. Occasionally, a high-risk tolerant individual will not want to set up five or more years of conservative assets. That is where their tolerance for risk might have been higher than their capacity for risk. You must factor both risk tolerance and risk capacity. It doesn’t matter how well you sleep at night through the market panic if your cashflow requires you to sell stocks at losses.

What are you to do?

Build the plan

First, allocate the right amounts to conservative and growth assets based on both your capacity and tolerance for risk. There is nothing more important than this first step. But then for heaven’s sake, avoid selling stocks, if possible, during losses due to proportionate model portfolio withdrawals.

The trend will end: don’t overextrapolate

Extrapolating the last month’s 30% market haircut into the future would tell you the entire economy will be worth nothing shortly. You can only cut the market in third so many times before the exercise is pointless. You might consider only looking at long-term trends. Consider that value had better return AND risk measures (by standard deviation) from 1980 to 2015. The last five years have been a complete reversal of that trend (see previous chart for last five years and next chart for 35 years prior to that).

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Look even closer at that last chart. If you were monitoring your portfolio and making adjustments based on performance trends of three- to five-year periods, you would have loaded up on value stocks right before the peak in 2007. We continue to hear “sell the dogs” or “buy what is going up” thought processes from investors. It is a dangerous behavioral risk in investing. Your value stocks would have been crushed from 2007 to 2009.

Be self-aware: recognize your knowledge limitations

As humans, we gravitate toward confident leaders. It makes charismatic portfolio managers very attractive. We all want to feel assured that future outcomes will go exactly as planned. As your wealth advisors, our job is to save you from portfolio managers with massive blind spots. Ironically, the manager with the largest blind spots is the manager who never describes the blind spots. They sound very confident, making you want to think, “How could this go wrong?” If an investment manager cannot clearly articulate when and how their thought process will be punished, they are dangerous. If they can, they at least get a few more minutes of your time as your wealth advisor. Self-awareness is a ticket to play in professional portfolio management: without it, the conversation is over. Shouldn’t it be the same for individuals wanting to trade? If you aren’t aware of five ways your strategy could go wrong, you are in trouble. If you can identify five, realize there are 50 more you haven’t dreamed of — like COVID-19.

5 levels of capital market knowledge (totally made up by us) and their risks

  • Level 1: You know nothing, and you know you know nothing.
  • Level 2: You watch the news and hear about buy/sell recommendations on CNBC/FOX/Jim Cramer’s “Mad Money” show.
  • Level 3: You read analyst stock reports, industry newsletters, and maybe even subscribe to Value Line or other “next-level” paid research. You know enough to be dangerous, but often don’t know the danger.
  • Level 4: You do Level 3 and more. You pay for databases of research information. You build models and back test them. You’ve identified plenty of opportunities for getting an edge.
  • Level 5: You are an experienced professional who has lost many nights sleep over decisions no one knew you made. You could rattle off a thousand ways you could be wrong. Like an artist, you keep trying to touch up the overall finished product to fix little imperfections. You are so self-aware that you know the “artwork,” which is the entire portfolio composition, will never be perfect. Knowing the futility of perfectionism, you still obsess about minor allocations of 1% or less of the portfolio. Every new concept you master, you realize how many more concepts exist which you’ve never encountered. You are self-aware.
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There is no research or data to support this chart: it is my own opinion from watching thousands of households through the last 13 years. Most individuals are Level 1 to 3. Please recognize that there is so much out there that the individual or professional cannot know. In our business, every advisor goes through Levels 1 to possibly 4. They make plenty of mistakes in their own portfolios along the way. We call that “tuition.” Good advisors either continue down the path to Level 5 or outsource to Level 5 managers. I outsource to Level 5s because I prefer the financial planning discussions and Level 5s usually spend 100% of their time in front of computers and away from clients. Recognize your level.

Get over your portfolio perfectionism

Getting over portfolio perfectionism is getting over the fact that there will always be a position you hate. I trust Level 5s more than anyone to manage my money and my clients’ money. If I can’t find a good Level 5 manager at a reasonable cost, I buy index funds. Even a Level 5 behind a nasty expense ratio (and who knows what other costs embedded in a fund) is not worth it.

When you are doing it right

Let’s wrap it up with some charts, as if you haven’t seen enough already. I built 10 portfolio samples in Ycharts software. The methodology was to build a portfolio allocation at every 10% equity interval from 10% to 100%. I told the software to rebalance the portfolio quarterly. Here is the breakdown of positioning methodology:

The stock allocation:

70% U.S. stocks

a) 75% large

b) 12.5% mid

c) 12.5% small

30% foreign

a) 75% developed countries

b) 25% emerging markets

The bond allocation:

  • 80% aggregate bond
  • 20% short-term bonds.

The idea is that one should be rewarded for taking greater risk. Should is the key word there. It is not perfect for all time periods; however, the longer the time period, the more consistently the assumption works.

Here are the results of the 10 portfolios over the last 10 years. Risk equaled overall reward:

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Here are the results of the 10 portfolios from the peak of 2007 to the peak of 2020. Risk equaled overall reward:

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Here are the results of the 10 portfolios from the trough of 2009 to the trough of 2020. Risk equaled overall reward:

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Here are the results of the 10 portfolios over the five years just before COVID-19 rocked our world. Risk equaled overall reward:

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Here are the results of the 10 portfolios over the last five years through March 24, 2020. Risk inversed overall reward. Although positive for all portfolios, the lowest risk received the highest rewards. This is understandable when considering the panic selloff we have recently seen in March 2020. No one knows when we will see the bottom of the market. It might not be for a while, but my expectation is that this risk/reward relationship will correct itself. The question is, do you have enough safe money and time (capacity) and the understanding and temperament (tolerance) to wait?

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I have been overwhelmingly pleased with the plans our advisors at Capita Financial Network have implemented. It is the monitoring phase now. I have yet to hear of a football team which has chosen to throw out the playbook midgame because they are down a couple touchdowns. Don’t throw out your plan because you’re down. Even retirees have plenty of time left in the game. Talk to us if you don’t have a plan or don’t understand your plan.

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