We wanted to highlight a few bits of knowledge we’ve recently read …
- One of the most frequent questions we are asked at the Coffeehouse Investor is, “what happens if everyone starts passive investing?” Larry Swedroe discusses this and the actual impact index funds have on the market.
- Learn the art of saying “no” and how to take back your own driver’s seat.
- Why a “bunny market” and volatility could be a good thing for investors.
In my last post, I discuss what happens when the valuations of large companies are driven to unsustainable levels and end up retreating to market-level valuations, otherwise known as “reversion to the mean.” Ignoring this investment concept can often lead a beginner or even the most experienced investor, astray.
I dedicate an entire website page to this concept because I want investors to understand the relatively basic idea of what goes up is likely to come down, and that what goes down is likely to bounce back, in other words, it “reverts back to the average.”
Here’s a visual to explain the idea:
It is at this point, when C is outperforming the average and A is underperforming the average, that many investors sell A in favor of C.
Reversion to the mean causes lots of problems for lots of investors because almost everyone begins by choosing A, that is, they choose a mutual fund or a sector with a good track record.
Then, when A reverts to the mean, or goes underwater, these same investors must decide whether to hang on to the underperforming A or switch to C.
Most people invest in sectors or mutual funds that have had a good track record (after all, that’s the most logical way to choose mutual funds). Unfortunately, because of the powerful force of reversion to the mean, investors inevitably become disappointed with their selection and are on to the next hot fund or sector.
If you want to be a successful investor of common stocks, forget about conventional wisdom and focus instead on reversion to the mean.
In 1976, The Vanguard Group, led by its founder John Bogle, created the first retail index fund. Although slow to capture the attention of investors, this fund, initially labeled the S&P 500 Index Investment Trust, has grown to become the largest mutual fund in the industry today.
With a focus on simplicity, in 1992 Vanguard created the Total Stock Market Index Fund to include mid-cap and small cap stocks – one fund that essentially represents ownership in all the publicly traded U.S. companies.
With a common stock portfolio consisting of one “Total Stock Market Index fund,” some might consider ownership of “all” the publicly traded companies as the ultimate in diversification, and for many investors, it is.
While we can’t argue with the premise of one low-cost, tax-efficient portfolio as the ultimate in simplicity, looking at the stock market from a different perspective offers significant benefits of diversifying beyond a Total Stock Market Index fund. Let’s take a closer look at the data.
Traditionally, most index funds have been constructed on a “capitalization weighted” basis. This means that the market capitalization (number of shares outstanding times price per share) determines its weight within the fund. As a result, even though Vanguard’s Total Stock Market Index fund reflects the collective price movement of “all” the publicly traded companies, in essence, its performance is impacted by the largest of the large cap stocks, with its top 10 holdings representing 18% of the portfolio. In other words, the Total Stock Market fund is basically an S&P 500 Index fund, and its performance confirms the same.
From a diversification standpoint, the goal isn’t to simply own thousands of companies in one mutual fund. It is to identify different components of the market that move dissimilar to each other, at least in the short run, and build a portfolio on this premise. Academic research reveals that the most effective way to accomplish this is to identify value stocks and small stocks to complement ownership in the large cap stocks of the S&P 500 Index.
The benefit of this approach to diversification can be found as recently as the 2000-2007 timeframe. Reflecting on the beginning of that era, large cap stocks of the dot.com boom had driven the price to earnings (P/E) valuation of the S&P 500 index to over 30, far outside its traditional range of 15-20.
Over the next eight years, various dimensions of the market produced the following annualized returns (represented by the corresponding Vanguard funds):
The above data serves as a reminder that for investors who embrace only domestic large cap stocks, they face the almost impossible task of “staying the course” for an extended time when these stocks underperform by a wide margin, as they inevitably do through normal market cycles.
There is another compelling benefit for investors to consider in diversifying beyond large cap stocks. Because large companies tend to be the “darling” of both institutional and retail investors (in 2000 a few names that come to mind are Intel, Microsoft, and Cisco – today, it is the likes of Apple, Amazon, Google, and Facebook) the valuations of these companies are driven to unsustainable levels. As a result, future returns tend to be muted on these companies as P/E ratios retreat to market levels.
This “retreating” to market-level valuations, also known as “reversion to the mean,” is one of the most powerful forces at work in capital markets. This mean reversion theory persists across all global markets and all time periods. Thus, one can conclude that a basket of stocks with cheap valuations relative to the market will consistently outperform stocks with expensive valuations over time, and the research shows this to be true.
Overlapping periods: July 1926 – December 2016
With current market valuations expensive by any measure, we feel that the persistence of a “value” premium in both large cap and small cap stocks will play an increasingly important role in the total return of clients’ portfolios. In addition, these dimensions of the market provide the necessary diversification and much-needed motivation to “stay the course” in all types of market environments.
Performance numbers shown above were published from www.vanguard.com and www.dfaus.com. The performance data shown represents past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so that investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
“Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin, 1789
And in this world, where we try to minimize taxes, we need to stay updated on the newest tax laws and the recent changes in many of our paychecks. Recently, the IRS released a revised withholding calculator to help verify allowances and ensure you aren’t getting too much or too little of a pay bump. You may want to review the new numbers and avoid a few surprises when you file your taxes in 2019.
In my column this month, I remind readers to get their fair share of the market and then move on. When your energy is focused on one specific hot stock, you miss the whole point of passive investing as discussed in my book, The Coffeehouse Investor. You miss out on the things you should be focused on – getting on with your life.
Published 20 years ago, the Coffeehouse principles still ring true.
“When you accept that your common stock portfolio will do no better or worse than the broad indices tracked, you are putting the pursuit of performance in its place.”
When we meet with clients who are approaching retirement, we always discuss the next chapter. Ensuring a client is financially prepared for retirement is one thing, but what’s often ignored is the mental preparation required for retirement. It can be an alarming adjustment when the working life abruptly stops.
Have you penciled out how you intend to spend your time and energy during retirement? Take this quiz to give you some insight on where your attention should be directed.
As you carefully build long-term financial plans, you need to consider your own personal retirement plans. Hopefully, these plans encourage you to continue growing and pursuing dreams, even after the day job ends.
A few important takeaways from the new tax bill signed into law include:
- With the increase in the standard deduction ($12,000 for individuals and $24,000 for married filing joint), the limitation on the deduction for real estate and state income taxes ($10,000 per year), and the elimination of certain miscellaneous itemized deductions, fewer people will itemize, and instead choose to take the standard deduction.
- Individuals with little or no mortgage interest will most likely take the standard deduction unless they have substantial charitable contributions or medical expenses.
- Going forward, if individuals don’t generally itemize and they wish to maximize the deduction for charitable contributions, it may make sense to bundle several years of contributions into one year or fund a donor-advised fund.
- If you are over age 70 ½, it becomes even more beneficial to make charitable contributions directly to your charity from your IRA. These contributions, which are limited to $100,000 per year, are not reflected in your income and also satisfy the required minimum distribution (RMD) requirement.
- You can now distribute up to $10,000 per year from a 529 education plan for K-12 expenses. This should be considered in your long-term education plan, if applicable. In addition, this could be another way for grandparents to help save and pay for their grandchildren’s education.
- (Applicable to Washington) Though the Federal Estate Tax exemption has been doubled, it is still important to remember that Washington State’s estate tax has an exemption of $2,193,000 (2018) per person. Even if you are under the federal exemption, estate planning is still important if you are in the range of the Washington State estate tax.
Working with a tax professional or financial advisor can help you work through many of these new details. If you want to invest in a more tax-efficient manner or build your long-term financial plan, let’s connect.
If you have spent any time on our website, you may have played the game “Outfox the Box.” We thought it was time we reviewed the concept again in case you were thinking about derailing your investment plans.
Are you interested in the entertainment value of the stock market, or is your primary goal to maximize returns and minimize your risk in an effort to reach your long term financial goals?
It is as simple as that.
The Coffeehouse philosophy of investing can be summed up in a quick game called “Outfox the Box.”
Are you ready? You are the contestant in this game. There are ten boxes, and you know how much is in each box. These are your choices, it looks something like this….
Which box will you choose? (Remember, you know how much is in each box)
This is not a trick question. Anyone would choose the $10,000 box. The choices you make when building a diversified portfolio are just as easy.
This time let’s change the rules a little. This time only the $8000 box is shown. It looks something like this….
Now which box will you choose?
The answer is also obvious – you would choose the $8000 box.
Because the chance of increasing your winnings is not worth the risk of choosing an amount substantially less, unless of course you are a gambler, in which case, you are probably at the wrong website, and should be here instead.
With the stock market average consistently beating 75% to 85% of all mutual funds, it is a testimony to the gargantuan advertising budget of the financial industry that so many investors forego a sure thing of the $8000 box in search of something better.
While you’re at it, do you feel lucky? Scroll down to the bottom of this page and try your luck at Outfox the Box.
Wall Street spends $20 billion dollars a year in advertising dollars trying to convince you to forego the $8000 box in search of something better.
Sometimes we need to step back from the clutter and fray and ask ourselves…
Is it worth the risk?
Is it worth my time?
Is it worth my money?
Wall Street says it is. (What else are they going to say?)
The next time you ponder these questions, remember how quickly you chose the $8000 box.
With the new year fast approaching, it’s time to purge, cleanse, and refocus on what’s important. The same goes for your finances. Take this time of year to simplify finances, rebalance your portfolio if necessary, and revisit your long-term financial plan. Are you on track to accomplish your goals? Here’s a great list to get you started.
Don’t forget to do a little housekeeping and verify security measures, update passwords, and order your free credit report. If you were involved in the Equifax security breach, make sure you took all necessary steps to secure your personal information.
Organizing the minutia and creating financial clarity for yourself will provide peace of mind to enjoy 2018 and beyond. Happy New Year!
Still looking for the perfect give for your favorite investor? The Coffeehouse Investor book provides a wealth of advice on investing in a tax-efficient manner, the importance of creating a financial plan, and how to get on with your life while ignoring Wall Street. Bill’s quick wit and simple strategies are perfect for the beginning investor or the “expert” who continues to try and beat the market.
Besides sharing a wealth of knowledge on investing and the markets, Bill includes stories about summiting mountains, growing up on a wheat farm on the Washington Palouse, and his infamous pumpkin pie recipe to savor your taste buds.
Give the gift of common sense investing this year, you won’t regret it.