Many Different Objectives

Much of what people think that they know about investing is false. Demonstrably so. Some of this can be attributed directly to advocacy. Key qualifiers are left unmentioned. Over-generalization is commonplace.

Different people have different needs.

The most commonly used, misleading assertion is that nobody can beat the market. Along with this is the observation that the average investor receives the average return of the market (before taking fees and expenses into account). That might be true if everybody shared the same goals subject to the same constraints. It is not true, because the phrase beat the market has been left undefined. The market consists of lots of groups with lots of different objectives. Each can do better than the overall market in terms of its own objectives, provided only that its objectives are realistic.

Even John Bogle, who strongly advocates the position that the best the average investor can do is to match the market, draws our attention to this. He points out that many investors are interested in accumulating assets for twenty or thirty years. Their objective is to end up with the largest final balance with risk measured in terms of the final balance. It does not matter how much their portfolios fluctuate along the way, provided only that they stick with a strategy. For them, the risk-adjusted return is based on twenty or thirty years. The annual risk-adjusted return is meaningless. Toss out the efficient frontier. It is a different issue.

We cannot even stop at this juncture. Most investors are interested in something other than the total return of an initial investment left untouched for a specified number of years. During accumulation, people continue to make deposits. During retirement, people make withdrawals. In the first case, dollar cost averaging is a blessing. In the latter, it is a curse.

What is worse is how misleading such reporting can be. Many mutual funds have started out with spectacular growth in their first few years, attracting many new investors, and then done poorly. Such a mutual fund’s long-term performance continues to rank high, but only because its reported results start with an investment at the very beginning, when there were few dollars and fewer investors.

Hidden from many presentations is the issue of fees. Often, this is by necessity. Just be aware of the implications. For example, rebalancing costs money. There are always transaction fees and there may be taxes as well.

Perhaps the most complicated situation has to do with market timing. The time frame is usually left unmentioned. Great generality is claimed although the time frame is almost always restricted to one or two years. The effects of transaction costs are ignored or left unstated. It has been demonstrated that short-term market timing can beat a buy-and-hold strategy when fees are low enough. Earlier academic studies had assumed much higher transaction costs. The seemingly high potential advantage of short-term timing shrinks dramatically when models are restricted to using information available before the fact. Unstated, but important, is that a successful short-term timing model necessarily influences prices simply because its application results in large purchases and sales of securities. This limits its advantage further still.

Retirement Portfolios

As we study retirement portfolios, we place an initial screen on everything. We look at portfolio survival first. We insist upon high levels of safety.

We are still interested in portfolio balances along the way. We seek strategies that real people can live with. We adjust our approaches to improve the level of income produced and/or the final balance, but only after meeting a constraint on safety. Having such a constraint makes some important comparisons possible.

A recent example was an investigation into dividend strategies. TIPS can be used as a surrogate for high dividend stocks when it comes to safety. They cannot be used for determining the upward potential. Our investigations showed that the relative allocations between TIPS and stocks (i.e., the S&P500 index) would have been a toss up historically with TIPS interest rates of 2.5% to 3.0%. This tells us the dividend yield that we would have needed in the past. At yields of 3.0% and higher, a high dividend strategy would have been superior to an overall market strategy.

We would not have been able to reach that conclusion if it were not for the constraint on safety. There were too many cases when a final balance was higher or lower, sometimes favoring stocks in general (i.e., the S&P500 index) and sometimes favoring TIPS. The constraint limited the comparisons. In addition, an extrapolation from TIPS to high dividend stocks makes sense only when stock performance is poor and safety becomes an issue.

Our happy observation was that there are many high quality companies with dividend yields of 3.0% and higher. A dividend-based strategy is attractive even at today’s valuations.

Have fun.

John Russell