Q2 2016 Market Review

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How does the UK’s decision to leave the EU effect your portfolio in the long run?

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How Do We Choose the Funds We Use?

When introducing evidence-based investing, we like to begin by explaining why we feel it’s the right strategy for those who are seeking to build or preserve their wealth in wild and woolly markets. Of course sensible strategy is best followed by practical implementation, so it’s also worth describing how we select the funds we typically employ.

Round One: Speculative vs. Evidence-Based Strategy

Our selection process is like a highly personalized, single-elimination tournament. We still consider the entire mutual fund universe and its thousands of possible contenders. But it’s relatively easy to eliminate the vast majority of them in the early rounds, with only the strongest surviving as viable candidates.

In the first round, we want to eliminate speculative fund managers who are playing an entirely different game from what we have in mind.

Speculative: Speculative strategists try to forecast the upcoming performance of securities, sectors or markets and trade accordingly. Individuals may do this by gazing at funds’ “star” ratings or acting on seemingly hot tips from any number of sources. Fund managers may hire well-heeled analysts to probe the universe for secrets about to unfold, and issue buy, sell or hold recommendations accordingly. Either way, these are not exercises that are expected to beat the market, especially after the costs involved in trying.

Evidence-Based: Instead, you and your fund manager can simply hold the universe and be part of its expected expansion. Speculative fund managers may be working very hard at what they’re doing, but it’s an exercise that is more likely to detract from than benefit your goals of building and preserving durable wealth in volatile markets.

By eliminating those who are engaging in speculative tactics from our recommended playlist, we can readily knock out a wide swath of would-be fund selections in the opening round.

Round Two: Passive vs. Evidence-Based Strategy

Once we disqualify speculative fund managers, that still leaves a relatively large (and growing) collection of funds that seek to efficiently capture various dimensions of the market’s expected long-term growth without engaging in seemingly fruitless and costly forecasting.

In this category, you’ll find two broad types of funds:

  1. Index Funds: Index funds track popular benchmarks such as the S&P 500 or the Barclay’s Global Aggregate, which in turn track particular market asset classes such as U.S. large-cap value stocks or global bonds.
  2. Evidence-Based Funds: Evidence-based funds seek to wring the highest expected returns with the least expected risk out of similar market asset classes in a more flexible, but still rigorously disciplined manner.

The goals of each are similar, mind you, making it harder to choose among these second-round contestants. Each emphasizes the importance of minimizing wasted efforts and maximizing the factors we can expect to control.

Still, all else being equal we typically favor evidence-based funds for the core of our clients’ portfolios. We feel they are structured to do an even better job at participating in relatively efficient markets over time. By being freed from slavishly following a popular index benchmark and similar restrictive parameters, they can focus directly on the fund management factors that matter the most according to what the evidence has to say on the matter. This includes most effectively capturing markets’ expected returns, while aggressively managing for market risks, minimizing trading costs and dampening some of the noisy volatility along the way.

Round Three: You AND Evidence-Based Strategy

Once we’ve narrowed down our fund choices to a manageable group, the final step is to match the best funds with the most important factor of all: you and your individual goals.

This is one of many reasons why we want you to have a personalized plan in place, preferably in the form of a written Investment Policy Statement. For example, investing heavily in even the best emerging market fund may be a poor choice for you if your greatest goal is to preserve the wealth you already have accumulated. Conversely, an excellent bond fund may be best used in moderation if you are seeking aggressive growth (and are willing and able to take on some market risk to do so).

A Solid Fund Selection Strategy

Bottom line, our final round typically involves forming the remaining contenders into a unified team that is optimized to reflect your unique goals and risk tolerances. Then, you must stick by your carefully constructed portfolio, not just for a game or two, but over the seasons of your life.

When we talk about fund selection, we deliberately emphasize the qualities that decades of empirical and practical evidence have indicated are worth pursuing over time. We explicitly downplay the more typical “play by play” reactionary antics. Star performers – their glittery victories and agonizing defeats – may be interesting to read about and may seem important. But we believe that the best investment selections are the ones that help you achieve your own hopes and dreams by keeping your financial footing on solid, evidence-based ground.

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Q1 2016 Market Review

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Should Investors Sell After a “Correction”?

This is an interesting article from Weston Wellington of Dimensional Fund Advisors. Weston has a great way of keeping things in the proper perspective when the market gets volatile, when investors are tempted to sell-out in a down market.

The article is from September of 2015, after the Dow Jones fell over 1,000 points intraday in August. We feel this message is important every time there are dramatic fluctuations, like the start of 2016.

Peter Lynch, the investment manager of Fidelity Funds Magellan Funds fame, has an interesting perspective on picking the top. He said, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” An interesting view considering how many people on TV and in print claim a top is in place in the middle of a long up trend.

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Q4 2015 Market Review

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Advice That Adds Up During Down Markets

As recent global markets continue to test the patience of even some of the most stoic among us, how are you holding up? Are you finding it feasible (if not necessarily fun) to stick with your existing strategy, or have you been eying it with increasing suspicion of late?

If you fall into the latter category, we understand. In his book, “Your Money and Your Brain,” personal finance columnist and author Jason Zweig explains what is going on deep inside our heads during falling markets: “Step near a snake, spot a spider, see a sharp object flying toward your face, and your [brain’s] amygdala will jolt you into jumping, ducking, or taking whatever evasive action should get you out of trouble in the least amount of time. This same fear reaction is triggered by losing money – or believing that you might.”

In short, our amygdala, which Zweig refers to as “the hot button of the brain,” is a welcome ally in keeping us away from many of life’s threats. But it often plays against your best financial interests. Whenever you see bad market news, it’s best to assume that your instincts are going to spur you into panic mode long before rational thinking kicks in. And if you try to have a one-on-one showdown with them, your impulses just may get the better of you.

For this reason alone, one of our greatest roles as your adviser is to remind you why it is highly likely that your best reaction to market downturns is to stick to the investment plan we’ve already helped you prepare to withstand just these sorts of rough patches. As [Behavior Gap author/BAM ALLIANCE Director of Investor Education] Carl Richards once tweeted: “You don’t hire a real financial advisor because you aren’t smart enough. You hire one because you aren’t an objective 3rd party.”

If we can spare you from panic-selling at the wrong times (which [financial author/BAM ALLIANCE Director of Research] Larry Swedroe refers to as our “GMO!” or “Get Me Out!” breaking point), that alone might justify our fees.

There are other ways we add ongoing value to your financial well-being, during fair times and foul. For example, that investment plan we referenced above did not take place in a vacuum.
• At the beginning of our relationship, we worked closely with you to assess your long-term goals, and what it was likely to take to achieve them.
• Next, we built your portfolio based on your goals as well as our evidence-based understanding of which investment strategies are expected to work best, and which are more likely to fail you during scary market downturns or giddy surges.
• Since then, we’ve met with you periodically to revisit your goals and your progress. If circumstances changed, we worked with you as warranted to ratchet up your expected returns or tamp down your risk exposure (while also seeking to minimize any trading costs or tax ramifications involved).

As such, we believe that the market risk that is intentionally built into your portfolio – and that you are being forced to endure at this time – should not be taken as a sign that “something is wrong.” Rather, we believe it is a sign that your portfolio is working as planned.

Your plan was never intended to eliminate all risk or guarantee certain returns. We designed it to offer you the best, evidence-based odds for personal success. Our aim is to help you strike a reasonable balance between minimizing the market risks that you and your amygdala would rather avoid, while moving toward the financial goals you would like to achieve.

If you remain in doubt, though, we still understand. It’s possible that your risk tolerance isn’t what you thought it would be when we were planning for it in a theoretical sense. It’s also possible that your life’s circumstances have changed, and it just happens to be time to reallocate your portfolio, regardless of what is going on in the markets.

If you have questions we can explore with you about your goals, your investment portfolio and current market returns – or even if it’s just been a while since you’ve shared with us the latest goings on in your life – we would love to hear from you. Please reach out to us any time.

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Q3 2015 Market Review

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The Evidence on the Evidence: How Do You Know What (and Whom) to Heed?

There’s a reason we refer to our strategy for building durable, long-term wealth as evidence-based investing. There are a number of other terms we could use instead: Structured (getting warm), low-cost (definitely), passive (sometimes), smart beta (maybe), indexing (close, but) … the list goes on. But because the evidence is at the root of what we do, we believe it should also be at the root of what we call it.

That said, there is a great deal of evidence to consider, and some purported findings seem to contradict others. How do we know which evidence to take seriously and which are false leads?

Evidence-Based Investing: A Never-Ending Story

First, it’s worth noting that academic inquiry is never fully final, nor does it allow for absolutes in our application of it. As University of Chicago professor of finance and Nobel laureate Eugene F. Fama has said, “You should use market data to understand markets better, not to say this or that hypothesis is literally true or false. No model is ever strictly true. The real criterion should be: Do I know more about markets when I’m finished than I did when I started?” [Source]

With this caveat, there are still a number of important qualities to seek when assessing the validity of a body of academic evidence.

A Disinterested Outlook – Rather than beginning with a point to prove, ideal academic inquiry is conducted with no agenda other than to explore intriguing phenomena and report the results. It is then up to us practitioners to apply the useful findings.

Robust Data Analysis – The analysis should be free from weaknesses such as data that is too short-term or too small of a sampling; survivorship bias (wherein returns from funds that went under during the analysis period are disregarded); apples-to-oranges benchmark comparisons; or plain, old-fashioned faulty math.

Repeatability and Reproducibility – Results should be repeatable in additional studies across multiple environments and timeframes. This helps demonstrate that the results weren’t just random luck or “data mining.” As AQR fund manager and founding principal Clifford Asness describes, “If a researcher discovered an empirical result only because she tortured the data until it confessed, one would not expect it to work outside the torture zone.” [Source]

Peer Review – To ensure that all of the above and more is taking place as required, scholars are expected to publish their detailed data sets, methodologies and findings in a credible academic journal or similar forum, so their credentialed peers can review their work and either agree that the results appear to be valid or refute them if they are not.

The Alternative: Data Foolery

If our emphasis on deep and diligent peer review sounds like it doesn’t really apply to you and your tangible wealth, think again. Echoing the sentiment about lies, damned lies and statistics, when faulty conclusions are inappropriately applied, the results can send countless investors astray, with real dollars lost.

Consider this fascinating exposé by journalist John Bohannon, “I Fooled Millions Into Thinking Chocolate Helps Weight Loss. Here’s How.” The evidence-based sting operation happened to take place within healthcare, but similar lessons apply to finance.

Bohannon began by conducting a deliberately flawed “study” to serve as a glaring example of poorly done research. He intentionally used a paltry data set of 15 participants in a one-shot clinical trial, and then heavily tortured the resulting data to extract a technically accurate if essentially meaningless conclusion that chocolate consumption contributed to weight loss.

Next, Bohannon mined his familiarity with the scientific publishing industry to submit his study to several journals that had questionable reputations with respect to their screening processes. Despite full disclosure of the study’s many weaknesses, Bohannon observed that his paper “was published less than 2 weeks after [our] credit card was charged.” He and his cohorts then launched an aggressive PR campaign to a global media who was apparently more interested in printing exciting sound bites than substantiating the validity of the sources involved.

The title of his resulting exposé, tells us how the story ended. A blitz of television, Internet and print media coverage suggested to audiences around the globe that they might want to go on a chocolate diet to lose weight. Faulty evidence in, garbage conclusions out.

The Preeminence of Peer Review

The point is not to dismiss all evidence as bogus. The point is that substantive, meaningful peer review remains an essential component in separating real academic evidence from the wider glut of sloppy work that all too often occupies headline-grabbing news. Peer review also enables scholars to reference and build on their colleagues’ best work, which enables collective insights into important subjects to deepen and expand over time.

That’s why the evidence that survives the gamut of academic peer review, and has withstood the test of time is the evidence that we are most interested in applying to a set of orderly (if never certain) principles to guide our practical, evidence-based investment strategies.

The Adviser’s Essential Role: Separating Fact from Fiction

As evidence-based advisers, we are continuously scanning the work being presented to the public, filling in the due diligence that might have been missed, and translating the results with an eye toward helping investors appropriately view the big picture that emerges.

Of all the ways we can go about investing, which ones are expected to best serve our clients’ personal interests and financial goals? Equally as important, which are more likely to distract or detract from our efforts?

The evidence-based answers to these vital questions explain why we pay so much attention to qualities such as fund structure, cost management, patient trading, and global market exposure (beta) according to index-like asset classes. It’s also why we advise against trying to chase or flee current market trends or pick popular stocks, despite what seemingly erudite talking heads seem to forever be recommending.

This is evidence-based investing. This is the essential difference between building a manageable investment strategy that reflects your personalized goals versus succumbing to chaotic, nerve-wracking guess-work in an ever-noisy world of market mayhem. We choose the evidence.

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Q2 2015 Market Review

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