Unconventional Success

1. Diversification and equity orientation are fundamental to successful investing

Finance theory and common sense support three long-term asset-allocation principles—the importance of equity ownership, the efficacy of portfolio diversification, and the significance of tax sensitivity.

Diversification reduces risk. By spreading investments across various asset classes, investors can mitigate the impact of poor performance in any single area. This "free lunch" of investing allows for potentially higher returns with lower overall risk.

Equity orientation drives long-term growth. Stocks have historically outperformed bonds and cash over extended periods, despite higher short-term volatility. This higher expected return is compensation for the increased risk of equity ownership.

• Key principles:
  • Allocate 5-30% to each core asset class
  • Maintain 70% or more in equity-like assets
  • Consider tax implications of investment decisions

2. Core asset classes provide essential building blocks for a well-structured portfolio

Core asset classes share a number of critical characteristics. First, core asset classes contribute basic, valuable, differentiable characteristics to an investment portfolio. Second, core holdings rely fundamentally on market-generated returns, not on active management of portfolios. Third, core asset classes derive from broad, deep, investable markets.

Core assets form the foundation. These asset classes include domestic equities, foreign developed equities, emerging market equities, U.S. Treasury bonds, U.S. Treasury Inflation-Protected Securities (TIPS), and real estate.

Market-driven returns are key. Core assets rely on broad market performance rather than active management, providing more reliable long-term results. This reduces the risk of underperformance due to poor manager selection or strategy.

• Characteristics of core asset classes:
  • Provide distinct portfolio benefits
  • Derive returns from market performance
  • Trade in liquid, well-established markets

3. Non-core asset classes often fail to deliver promised benefits and should be approached cautiously

Non-core asset classes fail to meet at least one of the three criteria that define core asset classes: contribution of a basic, valuable, differentiable characteristic to a portfolio; fundamental reliance on markets, not on active management, to generate returns; and representation in a broad, deep investable market.

Be wary of complex strategies. Many non-core assets, such as hedge funds, private equity, and complex derivatives, rely heavily on active management and may not provide reliable diversification benefits.

Hidden risks abound. Non-core assets often come with higher fees, less transparency, and greater potential for conflicts of interest. These factors can erode returns and increase overall portfolio risk.

• Common issues with non-core assets:
  • Dependence on manager skill
  • Limited liquidity
  • High fees and expenses
  • Lack of long-term performance data

4. Market timing is a risky strategy that rarely pays off for individual investors

Market timing requires taking relatively few, generally undiversifiable positions. Timing decisions involve the large questions of asset-class valuation, forcing short-term asset allocators to develop views on an impossibly broad range of factors.

Predicting market movements is extremely difficult. Even professional investors struggle to consistently time market entries and exits successfully. For individual investors, the challenge is even greater due to limited information and resources.

Emotional decision-making leads to poor outcomes. Fear and greed often drive market timing decisions, causing investors to buy high and sell low. This behavior can severely impact long-term returns.

• Risks of market timing:
  • Missed opportunities for gains
  • Increased trading costs and taxes
  • Heightened portfolio volatility
  • Deviation from long-term investment goals

5. Chasing performance leads to buying high and selling low, eroding returns

By chasing yesterday's hot prospect and shunning today's also-ran, investors lost billions of dollars in technology mutual funds.

Past performance doesn't guarantee future results. Investors often flock to recent top-performing funds or asset classes, only to be disappointed when the trend reverses. This behavior results in systematically buying at high prices and selling at low prices.

The tech bubble illustrates the danger. During the late 1990s and early 2000s, investors poured money into technology-focused mutual funds at their peak, only to suffer massive losses when the bubble burst. Many sold at the bottom, locking in their losses and missing the subsequent recovery.

• Consequences of performance chasing:
  • Higher than necessary taxes due to frequent trading
  • Increased fund expenses from high turnover
  • Missed opportunities in out-of-favor asset classes
  • Amplified market volatility in investor portfolios

6. Rebalancing is crucial for maintaining desired risk levels and enhancing returns

Rebalancing involves taking action to ensure that the current portfolio characteristics match as closely as is practicable the targeted portfolio allocations.

Maintain target allocations. Regular rebalancing forces investors to sell assets that have appreciated and buy those that have underperformed, effectively "buying low and selling high." This discipline can enhance long-term returns while keeping risk levels in check.

Overcome emotional biases. Rebalancing often requires contrarian actions, such as selling recent winners and buying recent losers. This can be emotionally challenging but is essential for long-term success.

• Benefits of rebalancing:
  • Helps maintain desired risk profile
  • Can enhance returns through systematic buying and selling
  • Forces disciplined, unemotional decision-making
  • Provides opportunities to harvest tax losses

7. Active management in mutual funds typically underperforms passive strategies

Finance theory teaches that active management of marketable securities constitutes a negative-sum game, as the aggregate of active security-selection efforts must fall short of the passive alternative by the amount of the fees, commissions, and market impact that it costs to play the game.

The odds are stacked against active managers. After accounting for fees and expenses, the majority of actively managed mutual funds underperform their benchmark indices over long periods. This underperformance is particularly pronounced after considering taxes for taxable investors.

Costs erode active returns. High management fees, trading costs, and potential tax implications of frequent trading create a significant hurdle for active managers to overcome. These costs compound over time, leading to substantial underperformance.

• Factors contributing to active management underperformance:
  • Management fees (typically 0.5% to 1.5% annually)
  • Trading costs (commissions and market impact)
  • Potential tax inefficiency due to high turnover
  • Difficulty in consistently picking winning stocks

8. Hidden costs and conflicts of interest plague the mutual fund industry

Mutual funds win, Wall Street wins, and investors lose.

Incentives often misalign. Many practices in the mutual fund industry, such as revenue sharing, soft dollar arrangements, and market timing, benefit fund companies and Wall Street firms at the expense of individual investors. These hidden costs can significantly erode returns over time.

Transparency is lacking. Many of these practices are either poorly disclosed or hidden entirely from investors. This lack of transparency makes it difficult for individuals to make fully informed investment decisions.

• Examples of hidden costs and conflicts:
  • Revenue sharing ("pay to play") arrangements with brokers
  • Soft dollar commissions used to purchase research and services
  • Market timing and late trading by favored clients
  • Excessive portfolio turnover to generate commissions

9. Tax considerations significantly impact investment returns and should not be ignored

Taxes matter. Since payments to the tax man represent a direct diminution of investor assets, careful investors structure portfolios to avoid or defer as much tax as possible.

Tax-efficient investing boosts after-tax returns. For taxable investors, the impact of taxes on investment returns can be substantial. Strategies that minimize taxable events and defer gains can significantly enhance long-term wealth accumulation.

Many mutual funds are tax-inefficient. High portfolio turnover in actively managed funds often results in frequent capital gains distributions, creating tax liabilities for investors even in years when the fund's overall performance is poor.

• Tax-efficient investing strategies:
  • Utilize tax-advantaged accounts (e.g., IRAs, 401(k)s)
  • Prefer long-term capital gains over short-term gains
  • Consider municipal bonds for taxable accounts
  • Use index funds or ETFs for better tax efficiency

10. Low-cost, passively managed index funds offer superior long-term results for most investors

In the case of investment management fees, agent and principal objectives clearly diverge as high fees augment agents' incomes and deplete principals' assets.

Index funds eliminate many conflicts of interest. By simply tracking a market index, these funds avoid the pitfalls of active management, including high fees, excessive trading, and potential conflicts of interest.

Low costs compound over time. The cost advantage of index funds—typically charging 0.1% to 0.3% annually versus 1% or more for actively managed funds—compounds dramatically over long investment horizons. This cost difference is a key driver of index funds' long-term outperformance.

• Advantages of index funds:
  • Low expenses and fees
  • Broad diversification within asset classes
  • Tax efficiency due to low turnover
  • Transparency of holdings and strategy
  • Consistent exposure to desired market segments

Last updated: October 23, 2024