Jeff Buckner, CFP®, AIF®, Co-Chief Investment Officer
This is the final post of a series on the BrightPlan investment philosophy, our game plan to help you reach your goals. To see the rest of the series check out:
Part 1 - Introduction to Evidence Based Investing
Part 2 - Don't Try to Outguess the Market
Part 3 - Let the Market Work For You
Part 4 - Practice Smart Diversification
Much to my chagrin, I can’t control many things in life. I can’t control the weather, traffic on my way to work, or most diabolical of all, cats. I wish I could control gas prices, the movements of my investment portfolio, and whether Steph Curry hits the game-winning shot by yelling at my TV. Sadly, issuing commands to a screen is only a reliable predictor of my wife laughing at me.
This may sound backwards, but acknowledging the things I can’t control gives me power. Focusing on situations that are out of my control leads to frustration and disappointment. Naming what I can’t control helps me to focus on the things I can control. In investing, as in life, increased power comes when we narrow our attention to the elements we can control.
Tenet #6: Focus on What You Can Control
If you followed the advice of our previous evidence-based investing posts, a few major obstacles to building wealth have been cleared. You’ve stopped trying to trade your way to wealth and removed many of the frictional costs incurred for buying and selling stocks. Then, you decided not to trust active investment managers to help you to reach your goals. You know these managers often charge high fees for worse performance.
Finally, you learned that by diversifying broadly you can invest to reach your goals at a comfortable level of risk. You’re crushing it! But there’s still a problem with your plan. That problem is… you. While we’ve addressed some of the issues that keep investors from building wealth and reaching their goals, some issues remain and only you can solve them.
Below are three specific decisions you can make, the variables you can control. If you fail to consider them your plan will be in jeopardy. However, committing to these few decisions can give you a huge head-start toward building wealth.
Three Critical Choices
Choice #1 - “I will avoid market timing.”
Market timers attempt to predict the future by buying investments when prices are low, and then selling when prices are high. Like any attempt to predict the future, market timing is notoriously difficult and the success rate is typically low. Really low.
John Bogle, the founder of Vanguard and longtime champion of passive investing said it best, “I do not know of anybody who has done market timing successfully and consistently. I don't even know anybody who knows anybody who has done it successfully and consistently."¹
The chart below² ranks the performance of various asset classes between 2006 and 2016. As you can see, the winner one year was rarely the winner the next. The checkerboard look of the chart demonstrates just how difficult it is to predict winners year after year.
Don’t focus on trying to time the market; instead, build a plan that suits your needs and stick with it. Historically a disciplined, diversified, buy and hold investor has been rewarded. By committing to a good financial plan you let markets work for you and follow the old adage: It’s not timing the market, but time in the market that counts.
Choice #2 - “I will not invest based on emotions.”
Money is intricately tied to our emotions. Remember the pride you felt when receiving your first paycheck or the rush of joy from an unexpected bonus? What about the sinking feeling when you heard the cost of replacing your car’s transmission or when you opened a major medical bill?
While emotions may serve as useful guides for life, emotional decision making is downright dangerous when it comes to investing. The ups and downs of stocks take investors on an emotional rollercoaster. Some even argue that market peaks and pits are exaggerated by emotional decision making as traders panic sell in times of fear and aggressively buy during times of irrational exuberance.
Emotional investors often succeed at the opposite of market timing. They lock in losses at the worst times (the lows), and buy up shares after markets rise just to watch them plummet. The research firm Dalbar shows with their annual study of investor behavior just how much emotional investing can cost.
The 2016 report found over the previous twenty year period the S&P 500 had returned 8.19%, but the average investor only captured returns of 4.67%!³ While some of the difference can be accounted for by high fees (see choice #3 below) and mutual fund underperformance, the study clearly states the main factor,
“Investment results are more dependent on investor behavior than on fund performance… If one looks at the returns of the average investor against the returns of the overall market, it is clear that the consequence of this investor behavior is serious and detrimental to long-term financial goals.”4
At BrightPlan we obsess over helping you reach your financial goals, so helping clients avoid this behavior gap is critical. While we can’t control your emotions, we can coach you to make thoughtful decisions about your money. Our online tools help you focus on what you can control:
- Building a solid investment plan to reach your goals
- Diversifying to manage risk
- Investing for the long term, not the short term
- Counteracting emotionally-charged market commentary
- Rebalancing when your portfolio mix materially changes
Committing to a goal-based investment plan gives you a defense against irrational choices. With a personalized plan guiding your decisions you gain confidence to stay the course, even when the market corrects. When you feel stressed you won’t have to speculate; you’ll know from a glance at your goal dashboard whether you are on track to reach each of your goals.
If you do fall off track, clear data-driven advice will advise you on how you can get back on target. These are just a few of the ways we will coach you to manage your emotions and find success where the average investor fails.
Choice #3 - “I will reduce my investment costs.”
If you’re riding shotgun in high fee investment vehicles, you’re driving toward your goals with a flat tire.
Fees matter. And unlike with unpredictable investment returns, you have considerable control over the fees you pay. Every layer of fees you avoid means more money in your account to grow as long as possible. Conversely, each dollar paid to a mutual fund manager, in trading commissions, or toward taxes loses its growth potential forever.
While a one or two percent annual fee may not sound like much, the cost of fees compounds over time. The chart below shows the wealth-destroying impact of various levels of fees over time on a hypothetical portfolio earning 6% annually.
“But” you may be thinking, “I’m paying extra in fees in order to get better returns! My manager makes up for his fees many times over.” That is likely what you’ve been told, especially by financial salespeople incented to sell higher fee products. But high fees don’t always lead to superior returns.
Russel Kinnel, the head of manager research at Morningstar, found the opposite in a 2016 study. Over a five year time period his research found that mutual funds with the lowest fees had the best net performance. His conclusion: “The expense ratio is the most proven predictor of future fund returns.”
Think of it this way: the higher a manager’s fees relative to peers, the bigger the hurdle he must overcome to beat them. On the other hand, his paycheck and his firm’s profits depend on those same fees, so they’re unlikely to go down as long as investors continue to overlook the expenses.
So what is the solution? Warren Buffett gave sage advice on the subject in his 2016 letter to shareholders,
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”5
While you have many goals, I doubt the list includes enriching portfolio managers. Low-cost funds have historically offered better returns than their counterparts by minimizing fees and taxes. That’s why BrightPlan portfolios are constructed from low cost, tax-efficient funds.
It’s time to look at your investment accounts and start asking the hard questions. What fees are you paying? Are the investment vehicles you’re using taking you where you want to go? Fix that flat tire and accelerate toward your goals!
It’s Time to Take Control
While you still can’t control cats, you now know some key financial decisions to give you greater control. Focus on what you can control: avoid market timing, invest based on reason, and reduce investment costs. By doing so you’re positioned to be an evidence based investor and, more importantly, to reach your financial goals.
This is the final post of the Evidence Based Investing series, our game plan to help you reach your goals. To see the rest check out:
Part 1 - Introduction to Evidence Based Investing
Part 2 - Don't Try to Outguess the Market
Part 3 - Let the Market Work For You
Part 4 - Practice Smart Diversification
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1) Bogle, John C. Common Sense On Mutual Funds. 10th ed. Hoboken, N.J.: Wiley, 2010. Print.
2) In US dollars. US Large Cap is the S&P 500 Index, provided by Standard & Poor’s Index Services Group. US Small Cap is the Russell 2000 Index. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. US Real Estate is the Dow Jones US Select REIT Index, provided by Dow Jones indices.. Emerging Markets is the MSCI Emerging Markets Index (gross dividends). MSCI data copyright MSCI 2017, all rights reserved. One-Year US Fixed is the BofA Merrill Lynch One-Year US Treasury Note Index; copyright 2017 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Five-Year US Government Fixed is the Bloomberg Barclays Treasury Bond Index 1–5 Years. Bloomberg Barclays data provided by Bloomberg. Five-Year Global Fixed is the Citi World Government Bond Index 1–5 Years (hedged), copyright 2017 by Citigroup. Indexes are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
3) The method used for computing the Dalbar analysis of investor behavior has been challenged. But even if the study exaggerates poor investor behavior, the same phenomenon can be seen when comparing mutual fund total returns to investor returns. Morningstar includes data on investor returns for most mutual funds and this article summarizes the gap well.
4) Emphasis added.
5) Berkshire Hathaway 2016 Letter to Shareholders, 2016. page 24.