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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Real diversification means that you must have the discipline to add money to, and keep some money inThe discipline required to take profits from a rising investment and put the proceeds into one that seems stagnant is Olympian. Our colleagues will tell you that the toughest part of learning their profession was not taking courses in modern portfolio theory or regression analysis but cultivating the discipline to tune out the witless messages that entice them to follow the herd. Small-cap value stocks and the fund managers that bought them were another part of the market that has been ignored. They declined 4.87% in 1998 and then fell another 12.32% in 1999. Only the disciplined and the methodical took advantage of this great buying opportunity. In 2000, when the Standard & Poor s (S&P) 500 fell 9.10%, small-cap value funds rose 11.11%. In 2001, when it was hysterically claimed that a crushing bear market had set in, small-cap value stocks rose another 20.15% 2 (see Figure 3.1). The variety of styles and asset classes that comprise the twentyfirst century financial markets are like pistons in an engine. One rises only to fall as another takes its place. Real diversification means that you must have the discipline to add money to, and keep some money in, parts of the market that presently may be lagging in performance. In our business we say, You arent diversified unless you hate half of your investments. Lack of Knowledge That the stock market at the beginning of the twenty-first century is a mlange of companies of every size and description, that the most productive of these are not names with which we are most familiar, and that most new jobs are being created by an entirely new way of doing business are viewed by the investment establishment as a set of facts unrelated to the marketing process. The importance of real diversification is not pushed down the distribution channels of many banks, mutual fund companies, insurance companies, 401(k) vendors, trust companies, or brokerage houses. It did not reach most investors in time to prevent significant losses in 2000-2002. It is not reaching most investors who need to be taking advantage of the opportunities presented by the new dominant investment system. Readers who are now hearing the message of real diversification for the first time should pay particular attention to the procedures outlined in this chapter. For readers who work in a sector of the financial industry where indifference to investment methodology and technique has become commonplace, we recommend the sixth edition of Investment Analysis and Portfolio Management.3 It explores in a clear and logical manner the reasons why real diversification is so effective in maximizing returns while controlling risk. Misleading Information A cartel of some large mutual fund companies is responsible for ensuring that the assets of pension plans, retirement accounts, foundations, trusts, and personal accounts are dangerously underdiversified. We will explain by using the example of the Mass-Marketing Mutual Fund Company. The name is fictitious because the abomination of management, or lack thereof, is so pervasive among some commonly held retail mutual funds that it would be unfair to cite just one. It is likely not only that you would recognize this mutual fund companys name, but also that you might be familiar with the individual funds. They are some of the most widely held investments in the United States, so we fictionalized their names as well. What is not fiction but frighteningly real are the dates and largest holdings of each of the funds. We list each ones major stock positions at the beginning of the bull market of 1997, at the peak of the bull market in 1999, and at the onset of the formulation phase. You will see that every fund owned practically the same stocks in each year we examined. What is tragic is that many people who invested with this company through their 401(k) plans at work or for their own individual portfolios spread their money across these funds assuming that they were achieving the risk-reducing benefits of diversification. One would logically assume that each fund would own different stocks. Why else would they offer them? COMMODITIZED PORTFOLIO MANAGEMENT Mass-Marketing Mutual Fund Company Funds Top Holdings as of 9/30/1997 Duplicate holdings are in italic This is where the fantasy that we sell mutual funds, and we are here to help falls apart. Although glossy ads assure you that you will be put on the right course and that we understand what you need, and although presumably wealthy aging baby boomers gaze into the sunset in a full-page promotion of why you can trust a company to manage your estate, know that what is frequently being sold is product that flows from a single spigot, bottled and labeled like snake oil in a variety of packages intended to appeal to every need of every consumer. What you should do right now is demand of your mutual fund company, bank, insurance company, trust company, broker, or financial planner a list of the stocks in your mutual funds. The mutual fund industry is not held to many regulatory standards. There is no requirement that the information on purchases and present holdings be current. It is likely that you will be provided with old information. If this is the case, waste no time in moving your money to someone who will provide you with complete, up-to-date lists of at least the major holdings of your funds so you know where your money is going. Funds. Most people understand that the money invested in an index fund goes toward the purchase of an investment that duplicates, say, the S&P 500. What could be misleading about that? Recognize that any investment index is a computer-generated chimera. It is a virtual reality. It does not exist. In the real world a funds investors are adding and redeeming money all the time. There is no possible way to mirror a static group of stocks. Different index funds solve the problem different ways. Here is an excerpt from the April 26, 2002, Vanguard 500 prospectus: Each portfolio of the trust may utilize futures contracts, options, warrants, convertible securities, and swap agreements. Specifically each portfolio may enter into futures contracts and options . . . provided not more than 20% of a portfolios assets are invested in futures and options at any time. What these quotes reveal is that when you buy this index fund, you are buying some exotic securities, and a portion of the fund can be classified as a hedge fund. This is not a plain-vanilla basket of 500 stocks. It can be argued that index funds mislead no one. After all, we were able to obtain this quote easily from the fine print of the prospectus. Still, considering all the so-called information and promotional material that has made index funds so popular, it is surprising that we have yet to meet a single Vanguard 500 index fund investor who understands that a sizable chunk of their money may not be invested in S&P 500 stocks at all. It is undeniable that those vested in keeping the old dominant investment systems mass-marketing methods alive have been successful. Intelligent, assertive people allow themselves to be manipulated by the old investment culture in ways they would never tolerate in any other aspect of their lives. They see the stock market as crazy and unpredictable. What is crazy are the things that we are being told about the stock market, and what is unpredictable is the next scheme that will be employed to sell more product. The rest of this chapter explains the investor-friendly process of realize, capitalize, customize that must be employed to help you consistently make money over the next 12 years. As you use it, you will relieve yourself of the burden of wondering what the markets are going to do to you next. FINDING YOUR INVESTMENT ZONE BY REALIZING, CAPITALIZING, CUSTOMIZING: THE TWENTY-FIRST CENTURY INVESTMENT STRATEGY A conflict of cultures occurs at this point as you decide for yourself how your money will be handled from now on. You may be a little skeptical about how successful this new approach will be. The first step may be to resolve this issue by remembering that the process we outline next is being taught right now in the best schools of financial analysis and investment strategy in the country. Its simplicity and common sense are its best features. Step 1: Realize We have already explained how the realize process is used by Digital Dow2 companies today to test the viability of new projects and assess their effect on current cash flows and the future value of the corporation. Computers allow this to be accomplished in a virtual setting where a variety of contingencies and circumstances can be analyzed. Investors can do the same. The starting point is to decide what value ones financial assets need to be on some future date. Say, for example, that 11 years hence, enough money will need to accumulate to generate cash flow of $250,000 per year. Next, assess the current value of the assets plus how much can be contributed to achieve the target. Subtract liabilities such as inflation, taxes, mortgages, living expenses, and educational expenses and solve for an annual rate of return that will be required from the investments to achieve the desired goal. The best people to help with this process are qualified consultants at full-service financial institutions and financial planners. Many doit-yourself programs can be too simplistic. The ones that are not simplistic require input such as inflation rates; federal, state, and local tax brackets; cost of living adjustments; and social security calculations. Being off only a few percentage points on any of these will give a result that will be wrong by thousands of dollars, rendering the entire process useless. The Diagnosis By carefully inputting relevant data, a picture of ones financial self will materialize in front of the skilled practitioner. This process is no different from getting a thorough exam from a physician. Vital signs are analyzed; the viability of the metabolism is monitored; liabilities are dissected; and then a diagnosis is reached. The doctor s diagnosis may indicate that the cholesterol level must fall below 100. The financial diagnosis may be that an average return of 11% per year is required. Note: This example is for illustrative purposes only. It should not be construed as advice; nor does it provide relevant data on the allocation used in the example. The Prescription A doctor will prescribe a portfolio of remedies such as changes in diet, an exercise regimen, and medication. A financial consultant will prescribe the specific amounts of money that must be invested in each style and asset class to achieve the 11% return. A doctor will caution that the medication will have certain side effects and ask if that sounds tolerable. A financial consultant may caution that the probability is high that during one year out of the next six the portfolio may temporarily lose 9.36% and ask if that can be tolerated. If not, a different allocation will be prescribed that may deliver a lesser rate of return, but the trade-off will be a worse-case scenario of only -6.23%. The Science The laboratories of many full-service financial institutions are where the analysis of the potential return and risk characteristics of each style and asset class is made. These laboratories have become some of their firms most valued assets. Their budgets often pay the salaries of Phds and certified financial analysts who study the properties of each style and asset class and sit on asset allocation committees. It is the large financial institutions with large companies and government entities as clients that created these laboratories. They grew out of the need to have a systematic method of managing large pools of assets under rapidly changing market conditions. The revenue required to do this was spent wisely. The information generated is now being shared with entities outside the firms, such as financial planners, and by qualified financial consultants within the firms themselves who work with noninstitutional clients. Track records showing the success of recommendations should be made available upon request. The name of the process developed by these laboratories is optimization. This means constructing the portfolio that will provide the optimal return commensurate with the least amount of risk. Suppose that interest rates rise, the U.S. dollar falls in value, or emerging market stocks jump 67% in one year. Economic events like these will affect the anticipated return on each style and asset class. Future expectations must be reevaluated, and a new prescription will be required for the asset allocation. This process is called reoptimization. It is driven by changes in economic conditions. Sometimes portfolios do not need to be reoptimized for two years or more, and sometimes it is necessary two or three times a year. A financial advisor would be expected to know when optimizing is necessary and to perform the process in a timely and cost-effective manner. Step 2: Capitalize Once an investor knows exactly what he or she is trying to accomplish and the asset allocation needed to get there, the funding of the investment program can begin. It is a good idea to seek the services of a certified public accountant or a financial planner to ensure that the program is being funded in the most effective way. Home equity loans, debt consolidation, or mortgage refinancing should be analyzed from the perspectives of both tax and cash flow. Step 3: Customize The first two steps of the process have made this one easy. A portfolio is customized by investing the money according to the percentages outlined in the prescription. It is no coincidence that the portfolio that is constructed is likely to be very different from what had been done before. There is a reason why this is, in fact, very likely. Once the process of mass marketing investments had been perfected, it was discovered that greater control over market share could be achieved by mass marketing investment guidance as well. The only way this could be accomplished was to stereotype investments and stereotype investors so that so-called help could be packaged and delivered. One of the cutest of these uniformly boxed strategies was to use an investor s age as the indicator of how much money should be in bonds. The rest of the money should be in stocks. It goes like this: Never mind that a 60-year-old retiring in 1993 with over half of his or her investments going into bonds would have immediately lost 7.64% in 1997, another .87% in 1996, and another 8.74% in 1999.4 Bonds are not always conservative, and they can be as volatile as stocks. Never mind that a person investing in the stock market from 1969 to 1983 would not have made any money for 14 years. This would have been devastating to a 40-year-old trying to save for retirement who, according to the logic just presented, would have been told to keep 60% of his or her money in stocks. The egregious stereotyping of investments results in recommendations that can be totally remote from the realities of the marketplace. The only thing worse is the stereotyping of investors. We have spoken with too many upset 20- and 30-year-olds to count who were told that because of their age that they should be aggressive, that most of their money should be not just in stocks but in the riskiest stocks because they have the most growth potential. That such an investment posture was totally anathema to their temperament and lifestyle was not even considered. These individuals reacted to market declines by selling at low points and continually creating losses for themselves. At the other end of the spectrum we have plenty of 70- and 80year-old clients who tolerate volatility well, understand the investment process, and would fire us immediately if we told them to put 80% of their assets into the bond market. The labels aggressive and conservative are overused and misunderstood. Most people equate aggressive with making lots of money and conservative with sticking it under the mattress. The reality is very different. A math lesson will explain. When clients are asked which would they rather have Investment A, which offers a 7% return each year for four years, or Investment B, which offers 15% per year for three years and then declines 15% in the fourth year (a distinct probability)those that have been stereotyped as aggressive pick Investment B. They think it may be risky, but they can put up with it because they will be rewarded for it. Individuals stereotyped as conservative, because of their age or because they have fewer assets, resign themselves to picking Investment A, assuming that they will end up with less. Both investors are wrong. The conservative person selecting Investment A ends up like this: This is one reason why some people erode large sums of money or are unable to accumulate it in the first place. The impact of losses is not understood. It takes a 100% gain to make up a 50% loss, and then you will only be getting back to where you started. THE ANSWER TO LACK OF DISCIPLINE An important benefit of a customized portfolio is that it allows the use of a technique we alluded to earlier in managing the problem of discipline. This technique, called rebalancing, helps to anticipate market movements and suggests the appropriate actions that need to be taken, all without changing either the customized strategy or the attitude toward risk. It works like this: The second column shows that small-cap growth stocks are no longer 18% of the portfolio but 28% one year later. This is because small-cap growth stocks rose so much relative to the other investments. Large-cap value stocks are no longer 10% of the portfolio but only 4% because they declined relative to the other investments. The other investments have also taken up a greater or lesser percentage of the investment pie depending on their performance during the year. To rebalance the portfolio, simply take it back to its initial allocation of one year previous as shown in the third column in the following table. The third column of this table shows that in rebalancing this portfolio, 10% is taken from small cap-growth stocks. The technique forces a taking of profits from the sector that went up the most. If it goes up more, it is fine 18% of the portfolio will still benefit. The proceeds will be deposited in the areas that did not do as well during the year. This makes sense because the prices of the securities in these sectors will be cheaper. Rebalancing forces action contrary to what the mass media may be advocating. They would be touting the incredibly good performance of small-cap growth stocks. Past performance numbers would be advertised. If you bought into the sales pitch, you would be adding money at or near the top of the small-cap growth cycle. The result is predictable. Think of money as water. It will naturally seek the lowest levels. Rebalancing is the technique that helps to make the most out of this natural law of the financial markets. An experienced investment consultant should be able to provide an efficient and cost-effective way to implement this procedure. Rebalancing should be done at least annually. It cannot hurt to do it more often if the initial allocation gets out of whack. In 1998 and 1999 we rebalanced our accounts three times per year because largecap growth stocks were rising so dramatically during the discovery phase. Since the market corrections of 2000-2002 we have heard a lot more in the financial media about value stocks, value-oriented mutual funds, and diversification. This is good. The danger is that people will fall under the mistaken impression that value stocks are inherently safer. They may not understand that much of their safety stems from the fact that their performance does not correlate with growth stocks and that they are best utilized within an optimized portfolio. The remainder of the formulation phase could be characterized by a lot of performance rotation among the styles and asset classes of the markets. If the principles laid out in this chapter are utilized, there will be no looking back over ones shoulder and buying what should be sold and selling what should be bought. By employing the realize, capitalize, customize investment methodology, investors can stay a step or two ahead of the game, comfortably in their zone, taking advantage of the opportunities ahead. Someone handed us a magazine recently with a feature article titled Best Performing Funds of the Last 25 Years. The article said that any fund that has been around for 25 years has seen every kind of market and that from this the fundsmanagers can extrapolate the future. Their historic insights from two decades add depth, the article said. We have shown that not only are the last 25 years an insufficient period of time on which to base ones assumptions, but that they are the wrong 25 years. The article was off by a century. Part II explains why this is so. It provides the historic data and context for the material in this chapter. The discoveries explored in Part II inspired this book. NOTES 1. In terms of yearly performance, Wilshire Target Large Value was 11.25% in 1998 and -7.11 in 1999. Wilshire Target Large Growth was 42.21% in 1998 and 35.53% in 1999. 2. Source: Wilshire Target Indexes. 3. Frank K. Reilly and Keith C. Brown, Investment Analysis and Portfolio Management (Fort Worth, TX: Dryden Press, 2000). 4. Measurement: Lehman Brothers U.S. Treasury Index. 5. This is an example only and should not be considered a recommenda tion because personal circumstances and risk tolerance vary widely. |
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