You turn on the news and you hear the stock market is up. Then, you look at your investment statements and you see what appears to be minimal account balance gains.
So what's going on? Don't I pay someone a lot of money to generate impressive portfolio returns?
This can be frustrating.
To understand what's going on, we need to examine the combination of factors that influence your rate of return.
WHAT YOU HEAR ABOUT VS. WHAT YOU OWN
When you hear stocks are up or down, almost always they're referring to the Dow. The Dow Jones Industrial Average is 30 companies we've all
heard of; McDonald's, Nike, Verizon, etc. We call these large cap stocks.
If your portfolio is even a little bit diversified beyond U.S. large caps (surprisingly, many aren't), the other asset classes you own are likely to produce different returns than U.S. large caps.
The degree of diversification directly influences the variance in return of your portfolio compared to the Dow. In years when the Dow is cranking, like last year, a diversified portfolio is going to produce a return that is lower than the Dow.
For example, here is how my diversified portfolio performed last year (I own the exact same funds as my clients if you are wondering):
In every quarter, my returns (green bars) lagged U.S. stocks (yellow bars). With the exception of the 3rd quarter, I trailed the U.S. stock benchmark because either my bonds and/or international stocks tapered the returns I would've achieved had I only owned U.S. large caps.
My clients often hear me say you're never going to be happy with 100% of a diversified portfolio. I'm in the same boat.
REBALANCING
In 2021, U.S. stocks returned 25.5% as measured by the Russell 3000 ETF (ticker: IWV).
In addition to diversification affecting returns, the timing and scope of trading activity also influence how your portfolio performs.
During years when the stock market appreciates, financial planners trim a portion of the gains and redistribute those gains into other parts of the portfolio. The idea behind this strategy is to maintain a target percentage of stocks vs. bonds.
We call this rebalancing. You can read more about the benefits of rebalancing HERE if you're interested.
If I were to ignore the natural shifting of a client's asset allocation and simply let things ride, they would experience a better return during appreciating stock markets.
Mechanically, rebalancing removes overexposure to asset classes that have done well while simultaneously increasing exposure to asset classes that haven't done as well.
Rebalancing in prolonged rising markets translates into lower growth compared to simply leaving the portfolio alone.
Take last year for example. By mid-year, U.S. stocks were up 14.5%. The stock portion of our portfolios grew compared to the bond portion. Rebalancing returned clients to their targets, and then the stock market went on to achieve almost double-digit returns in the 2nd half of the year.
Essentially, I tapped the brakes and I know what you're thinking.
Why would we purposely reduce risk when times are good?
The problem is that no one can reliably predict future stock market returns with any consistency. If I had a crystal ball, I would know exactly when to let it ride and when to remove risk.
The other issue here is that behavioral finance suggests investors feel the pain of loss more than they celebrate the victory of gains.
Hypothetically, what if I hadn't rebalanced and the stock market experienced a negative return in the 2nd half of 2021? In this scenario, my clients would have lost more than normal by being overexposed to stocks due to my inaction.
Rebalancing works to both our advantage and disadvantage. Ask anyone who owned Treasury bonds in 2000, 2001, 2002, 2007, 2008, 2009, 2018, early 2020, or right now how they felt about this decision and they'll tell you how thankful they held these relatively stable assets.
The theme with all of this is that when you rebalance during an appreciating market to manage risk, you're reducing your expected return.
ACTIVE MANAGEMENT
Here's a Morningstar graph I covered during a client review meeting a few weeks ago.
The blue line represents the biggest holding in the client's portfolio (ticker: DSI). The red line represents the benchmark.
Notice how the returns of the index fund I've been using closely mirror the benchmark? This is a fundamental benefit a financial planner provides to clients; ensuring that an account captures the returns of the market over time.
Check out the yellow line representing the returns of the "Category". In this case, the category is "large blend". Morningstar category constituents can include mutual funds, ETFs, variable annuity subaccounts, and Separately Managed Accounts.
Think of category returns as a measurement of performance against a fund's peers.
Yikes! That's a lot of consistently lost returns over time.
I've said it 100s of times. It's not logical for asset managers to consistently pick winning stocks prior to those stocks' outperformance. It's also not logical to think we can consistently pick winning asset managers in advance of their benchmark beating performance.
Stay away from actively managed strategies and accept market returns via Index Funds.
EXPENSES
Portfolio costs come in three basic forms:
Advisory fees (what you pay your financial advisor).
Investment fees (what you pay inside your funds).
Brokerage platform fees (what you pay for trading capabilities).
Advisory fees are extremely difficult to assess since there is no central reporting website we can go to compare one advisory firm versus another.
The best we can do is estimate. Here is a sample fee structure:
Get out your calculator, because you'll need it to figure out how much you're actually paying for advice. Whenever you see the phrase "next" or "tier" in advisory fee schedules, it means you pay different rates on the same bucket of money.
For example, in the schedule above, the client pays 1.45% on the first $50,000 of invested dollars, 1.3% on the next $49,999, 1.15% on the next $199,999, etc.
The most important concept to get straight when paying for advice is that you feel like you're receiving a good value for the cost. At the same time, recognize that whatever advisory fees you pay represent a direct drag on returns.
Investment fees, typically found in the form of a fund "expense ratio", also represent a drag on returns.
Morningstar's quarterly Active/Passive Barometer report measures the success of actively managed funds against passively managed index funds found in the same category. According to the latest October 2021 report:
The cheapest funds succeeded about twice as often as the
priciest ones (a 35% success rate versus a 17% success rate)
over the 10-year period ended June 30, 2021.
Essentially, the lower the expense ratio, the more likely the fund will do better against passively managed index fund peers.
Don't start thinking that cheap actively managed funds are good. The report goes on to say that even "the cheapest actively managed funds still failed to beat their passively managed peers 65% of the time over the last 10 years".
The takeaway here is that actively managed funds, especially the more expensive ones, just don't perform that well.
The last type of expense you're up against is what your brokerage platform charges for access and/or trading.
Brokerage firms either assess a percentage-based platform fee or attach a commission whenever an investor trades. Most brand-name big box brokerage firms offer a choice between these two costs that advisory firms select on behalf of their clients.
Percentage-based platform fees are difficult to track down but usually lie somewhere in the neighborhood of 0.15% to 0.30%.
If the financial advisor you work with trades frequently, an asset based brokerage custodial fee might be the more cost-effective way to go.
Usually though, in today's world of lower trading commissions, paying by the trade is typically the most efficient. For example, at TD, Schwab, and Fidelity, U.S. stocks and ETFs trade free.
Zero commissions might make you think brokerage firms are behaving altruistically. I promise Wall Street hasn't gone non-profit.
They make plenty of money on margin account interest rates, the spread between the interest rate on cash they pay you vs. what they lend it out for, and Order Flow Routing.
All of these revenue streams represent profit sources for the brokerage firm, indirectly robbing you of return.
OWNING INDIVIDUAL STOCKS
TRIGGER ALERT!!!! The data I'm about to present is going to run counter to what you think is reality.
Last year, Morningstar published some research documenting their findings that show that the majority of stocks underperform Treasury bonds.
You read that correctly. You can read a summary HERE if you like.
Over the last decade, out of the 5,000 largest publicly traded U.S. stocks you could have invested in, 58% of the stocks either 1. were acquired, 2. went bankrupt, or 3. lost value.
Out of the remaining 42% of stocks that finished the decade with gains, only a portion of those actually beat the market.
Conclusion: during an almost uninterrupted decade-long bull market, only about half of all stocks rewarded investors and only a small minority of stocks were responsible for the majority of gains of "the market".
Still think you can win by picking a few winners? The odds are definitely not in your favor no matter how strong your convictions are.
OK, WHAT SHOULD I DO?
Here is a short(ish) list summarizing how to maximize returns.
Understand your approach to rebalancing. According to research*, you should only rebalance when a position breaches a 20% relative upper or lower threshold. For example, if a fund's target in a portfolio is 10%, leave it alone unless it grows to more than 12% or less than 8%.
Adjust your return expectations to reflect your actual portfolio, not what you hear on the news or your friend who claims they made a killing on some exotic, highly speculative position.
Buy and maintain a globally diversified portfolio. This means domestic large/medium/small stocks, growth stocks, value stocks, international stocks, emerging market stocks, short-term bonds, intermediate-term bonds, green bonds, global bonds, TIPs, and a healthy dose of Treasuries. You never know which asset class is going to do well and when.
You don't have a crystal ball and neither do I. Don't change your asset allocation because you think a particular outcome is likely. You'll mess up more than you're correct.
It's unreasonable to believe a financial advisor can identify an asset manager in advance of their outperformance, just as it's equally unreasonable to believe an asset manager can identify stocks in advance of their outperformance. Buy index funds and accept the market's return.
Ask your advisor if they're doing everything to reduce costs? Do you qualify for fee breakpoints? How can they minimize trading costs? Can you pay your Roth IRA fees from another account? When and how should you or they execute Tax Loss Harvesting, if at all?
Assess the value of financial advice you receive for the price you pay. Do this with at least some regularity. Just because you like someone doesn't mean they feel the same way about you or have your best interest in mind. Are there tangible benefits you can measure? To what degree do you feel good about paying a fee for the intangible benefits of having someone else do research on your behalf. Does your advisor worry as much as you about whether or not you'll run out of money? Ask yourself if you're better off with this advisor, doing everything yourself, or rolling the dice with another advisor?
Don't let politics, your friends, the news, or that one article you came across in your social media feed dictate or even influence your investment strategy. Be open to new ideas from a competent financial planner that's willing to take the time to share where they researched the advice they've given you.
Stop convincing yourself that you're going to accelerate your goals by buying individual stocks. Sure, you or someone you know might have done well with a particular stock at one time or another. That doesn't mean you can replicate success. Own several hundred, if not thousands, of stocks via index funds. P.S. I've never personally bought an individual stock and neither should you.
Last, get out of your own way. We all have our hangups and baggage. Do your best to recognize your financial shortcomings and work to better yourself. You're never going to score a perfect grade with your finances, so commit to improvement and measure that progress over time.
Ok, it wasn't a short list. Whatever... Do these things anyway!
* Opportunistic Rebalancing: A New Paradigm for Wealth Managers, Daryanani, Journal of Financial Planning, Jan 2008.