Jan 26, 2016 0
There are a lot of ways to lose money in the stock market, but far fewer effective ways to make money.
Looking at two managed accounts over the same time period, one was far more profitable than the other. One had far less turnover than the other, one had no mutual fund positions, and was far less diversified. The one with fewer stocks, less turnover and no positons in funds or alternative investments showed much better returns- even in most down markets.
The account with much less turnover also had a far larger amount in unrealized gains. This means that the growth was tax deferred. The lower turnover meant less was eaten up in taxes.
If you have enough money for a managed account- at least a half million dollars, then there are few reasons to own mutual funds in that account. You are paying a management fee already. Mutual funds have another layer of expenses that should be unnecessary. In the current era of single digit returns these fees greatly hobble your return. An index fund will beat most managed mutual funds. Funds used by managers are usually specialty funds with singular purposes and high hidden fees, often with an intent to diversify into areas that the manager has no expertise of his own.
The poorer performer was much more focused on risk avoidance. They largely missed the 6 year bull market by under allocating to stocks. This led to the subject of the best way to avoid excessive risk.
While it is a common theme that index funds will outperform most money managers, it is worth knowing why. If the managers have much more than 25 to 30 stocks they are likely to mirror an index fund anyway. Mistimed allocation and increased friction costs as noted will underperform the index.
Wealth in equities is built by carefully selecting companies that compound their capital on a continuous long term basis. Such selection takes focus and discipline. And even when such companies are discovered you want to buy them when they are undervalued. I have found that few equity managers do this and if you are not one of them or currently being managed by them then yes you are much wiser to be in an index fund.
The risk profile of such companies is very low DEPENDING ON YOUR TIME HORIZON. Even in a flat market a company that continues to compound capital will show little risk on a ten year time horizon. In any two year period any of the stocks can sell off substantially or market PEs can drop due to monetary issues or alternative investment options.
Instead of risk profile questionaires your allocation should be dependent on your time horizon. This may or may not be dependent on your age. If you are 70 and you have money in a trust that you do not plan to spend then the horizon is not limited to your mortality.
Decide how much of your investment you want to access in two years and keep most of it in cash with the highest safe yield you can find. Today that number is probably less than 50 basis points. How much do you think you may need in 5 years? Perhaps – depending on where you start- that portion should be a 50/50 equity cash split. This cash may be in bonds purchased at par or less that mature in that time period.
With a ten year horizon you have a chance to build wealth with an 80/20 mix of equity and bonds. You can even get more aggressive.
Warren Buffett recommends selecting a stock that you would be comfortable holding if the market shuts down for ten years. He buys companies like an owner, not a trader. He does not panic if the stock market has a selloff and his market value declines. Usually he is sitting on billions in cash and sees such period as buying opportunities.
If you do not have access to equity managers who do their homework or if you are not so inclined yourself then definitely go with the index funds. Even if you think you have the gift put a portion of your funds in the index and compare it to your results. If you don’t beat the index over a period of at least five years then admit your shortcoming and put the rest in the index.
You can adjust your risk by keeping a portion in cash to match your risk profile.
A tip to gin up your index returns- decide what portion you want in the market. Say 60%. If the market is toppy allocate your investment over three years to avoid buying all at the top. If the market is down maybe allocate over a much shorter period. Don’t try to find a bottom, but avoid the top. Once you reach your allocated amount, just keep the rest in cash, get the most secure return without capital risk. This is boring but if you want excitement look elsewhere.
Then set a parameter of return, for example 3% per quarter (you can go higher , but no higher than 5% per quarter). If the return is between 0% and 3% in a quarter, do nothing and watch your money grow. If the market falls and your return is less than 0% then buy half the difference from your cash portion. If the gain is in excess of your top return parameter then sell half the difference and save it in cash.
Most quarters you will not make a trade, but you will improve your returns buying some when it is down and selling some amount into the up market. Most fo the time the market will fluctuate within your parameters and will just regularly compound.