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The Right Way to Invest

posted on

October 06, 2014

As financial advisors it is our goal that all of our clients have the most successful investing experience possible, but for many investors, their experience has been more confusing and overwhelming than anything else. More information is available now than ever before, yet that has only served to make the investment process even more complicated. We wanted to take this opportunity to remind you of the different types of investment management approaches and which philosophy guides our investment decisions, so that you can feel as confident in this process as we do. 
CONVENTIONAL MANAGEMENT: Conventional management can also be called “active management” and you have heard us discuss this philosophy and its shortcomings on multiple occasions. Conventional management believes that it is possible to time the market, identify winning stocks, and predict the future. Conventional managers promise investors that they have superior research and insight that will enable them to beat the market. While it is true that some active fund managers do beat their benchmarks every now and then, few have been able to do it on a consistent, long-term basis. Over the past 10 years only 19% of stock funds and 15% of bond funds actually survived and beat their index benchmarks (Mutual Fund Landscape, Dimensional Fund Advisors 2014). That is not a great track record for conventional management. 
Warren Buffett once said, “Forecasters may tell you a great deal about the forecaster; they tell you nothing about the future.” Conventional management is also expensive. It generates higher trading costs and takes on excess risk. When investors only choose certain stocks to own and certain times to be in the market, they run the risk of missing out on some of the best performing stocks and some of the best performing days, which can seriously impact their long-term return. Stock prices adjust to new information at lightning speed, and for those who are waiting for their broker to call them with the next hot tip, they can quickly be left behind. 

Index Management

Index management, also called “passive management,” believes that rather than competing with the market, investors should accept the returns the market naturally provides. Index managers simply build portfolios of stocks that follow a certain index, e.g. the S&P 500, and try to capture the same rate of return. The upsides of index management include that it is low cost and tax efficient, but there are downsides too. Index fund managers are expected to track the holdings of the index exactly–there should be zero tracking error. This means when a new stock is added to an index it must be bought immediately, and when a stock is removed from the index, it must be sold immediately. When every index fund manager does this simultaneously, it can have a dramatic impact on the price of a particular company, which eventually trickles down to the investor in the form of lower returns. Another downside of index funds is that they only own a sampling of stocks within a particular area of the market, not the entire asset class, which can also result in lower returns. 

Scientific Approach

Kenneth French, a distinguished finance professor at Dartmouth, once said, “The market is smarter than we are and no matter how smart we get, the market will always be smarter than we are.” This statement might sound discouraging but it is actually good news to us. You do not have to outsmart the market in order to have a successful investing experience; you can let it work for you. The scientific approach to investing involves identifying areas of the market with higher expected returns through the use of academic research, and structuring portfolios along these dimensions. These portfolios are designed to capture each asset class in its most complete and purest form. The most significant advancements in finance have actually come from some of the great minds of academia, finance professors and economists, some of whom have been awarded Nobel prizes for their work. Their research is based on decades of data that reveal how certain types of stocks behave and where return comes from (i.e. risk and reward). From here we can build a diversified portfolio of asset classes designed to capture the performance of global markets, while not being subjected to the limitations of index funds. It is a prudent, logical way to invest that is based on the facts of financial science, not the predictions of market prognosticators. 
We believe that the scientific approach to investing takes the guesswork out of the investment process and results in a more positive investing experience for our clients. As always, if you have any questions about our philosophy or if you would like to discuss this further, please don’t hesitate to give us a call. It is an honor and a privilege to serve as your advisors.