investment planning slides designed by rosilyn h. overton, ms

Investment PlanningInvestment PlanningSlides designed by Rosilyn H. Overton, MS, CFP®, CRPS, LTCPSlides designed by Rosilyn H. Overton, MS, CFP®, CRPS, LTCP

Text pages 381-389Text pages 381-389

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What is Investment What is Investment PlanningPlanning

From a client’s perspective, investment From a client’s perspective, investment planning is typically the main reason for planning is typically the main reason for consulting with a financial planner. consulting with a financial planner.

Unfortunately, from a planning perspective, Unfortunately, from a planning perspective, investments are normally the last step of the investments are normally the last step of the implementation process – after all of the other implementation process – after all of the other planning is complete.planning is complete.

If investment planning leads the other If investment planning leads the other decisions in the financial planning process, the decisions in the financial planning process, the entire plan is set up for failure.entire plan is set up for failure.

Obviously, the goal of investment planning is Obviously, the goal of investment planning is to achieve an expected rate of return over a to achieve an expected rate of return over a specified time period while minimizing the specified time period while minimizing the potential for loss. potential for loss.

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Six Steps in Investment Six Steps in Investment PlanningPlanning

There are six steps in the investment There are six steps in the investment planning process:planning process:

1. Ascertain the current and projected 1. Ascertain the current and projected amount to investamount to invest

2. Determine the investment time horizon2. Determine the investment time horizon

3. Coordinate investments with risk tolerance3. Coordinate investments with risk tolerance

4. Select the investments4. Select the investments

5. Evaluate the portfolio’s performance5. Evaluate the portfolio’s performance

6. Rebalance when necessary6. Rebalance when necessary

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Ascertain the current and Ascertain the current and projected amount to investprojected amount to invest

Some clients will already have a Some clients will already have a portfolio: In this case, an asset portfolio: In this case, an asset allocation appropriate to their needs allocation appropriate to their needs and risk preference must be designed.and risk preference must be designed.

If the investor does not have enough If the investor does not have enough saved to meet their needs, the saved to meet their needs, the potential investor must first make a potential investor must first make a conscious decision to save and invest conscious decision to save and invest rather than to spend.rather than to spend.

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Determine the Determine the Investment Time HorizonInvestment Time Horizon

Does the investor need to use some Does the investor need to use some portion of the investable assets in the portion of the investable assets in the near future? near future? Is the investor buying a house, retiring, Is the investor buying a house, retiring,

sending a child to college? sending a child to college? This will help identify the need for This will help identify the need for

shorter-term investments in the portfolio shorter-term investments in the portfolio or the ability to invest in longer-term or the ability to invest in longer-term investments that typically will yield a investments that typically will yield a higher expected return.higher expected return.

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Coordinate Investments Coordinate Investments with with

Risk Tolerance Risk Tolerance In order to achieve a higher rate of In order to achieve a higher rate of

return, the investor may need to be return, the investor may need to be willing to accept a higher risk. willing to accept a higher risk.

Losses, even in one year, severely Losses, even in one year, severely impact overall return. For example, impact overall return. For example, a 100% gain in one year, followed by a 100% gain in one year, followed by a 50% loss in the second year results a 50% loss in the second year results in no gain at all.in no gain at all.

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Selecting the Selecting the investments investments

Based on the information obtained in Based on the information obtained in steps one through three, the planner steps one through three, the planner can now begin the investment can now begin the investment selection process. selection process.

Care should be taken to ensure that Care should be taken to ensure that the investments truly reflect the the investments truly reflect the investor’s needs and risk tolerance.investor’s needs and risk tolerance.

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Rebalance when Rebalance when necessarynecessary

Rebalancing the portfolio is a process whereby Rebalancing the portfolio is a process whereby investors are forced to sell high and buy low. investors are forced to sell high and buy low.

A rebalancing program might call for the sale A rebalancing program might call for the sale of equities (which have done well) and the of equities (which have done well) and the purchase of bonds (which have not done as purchase of bonds (which have not done as well).well).

Because the economy is cyclical, an asset class Because the economy is cyclical, an asset class that has done well in one year quite likely will that has done well in one year quite likely will not do nearly as well in the following year, not do nearly as well in the following year, rebalancing forces movement to account for rebalancing forces movement to account for the overweighting in the appreciated asset.the overweighting in the appreciated asset.

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Life Cycle PeriodsLife Cycle Periods

Each person typically moves through Each person typically moves through five financial stages throughout his or five financial stages throughout his or her life, which are characterized by her life, which are characterized by various issues and objectives that are various issues and objectives that are distinct to each stage. As the financial distinct to each stage. As the financial planner reviews the following planner reviews the following descriptions of these various life cycle descriptions of these various life cycle stages, try to determine which stage stages, try to determine which stage best describes the planner’s or the best describes the planner’s or the client’s own situation.client’s own situation.

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Investment Allocation Investment Allocation GuidelinesGuidelines

A range of acceptable investment percentages A range of acceptable investment percentages are presented for each life cycle stage and are are presented for each life cycle stage and are allocated to the following three broad allocated to the following three broad investment categories: investment categories:

low risk, secure, and income-oriented low risk, secure, and income-oriented investmentsinvestments

medium risk, growth-type investmentsmedium risk, growth-type investments high risk, speculative investmentshigh risk, speculative investments

In addition, mutual funds are available that fit In addition, mutual funds are available that fit within each of these general classes of within each of these general classes of investments.investments.

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Low Risk InvestmentsLow Risk Investments

This category includes: This category includes: Savings accountsSavings accounts T-billsT-bills Money market fundsMoney market funds Government bondsGovernment bonds High-grade corporate bondsHigh-grade corporate bonds Participation certificatesParticipation certificates Similar types of investmentsSimilar types of investments

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Medium Risk Medium Risk InvestmentsInvestments

This category includes:This category includes: Municipal bondsMunicipal bonds Convertible bondsConvertible bonds Lower-grade corporate bondsLower-grade corporate bonds Preferred stocksPreferred stocks High-quality growth stocksHigh-quality growth stocks Similar investmentsSimilar investments

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High Risk InvestmentsHigh Risk Investments

This category includes:This category includes: More speculative growth stocksMore speculative growth stocks Most real estate investments, REITsMost real estate investments, REITs OptionsOptions Commodities and futures contractsCommodities and futures contracts Similar types of investmentsSimilar types of investments

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Investment Allocations Investment Allocations PercentagesPercentages

Which investment percentage is chosen within Which investment percentage is chosen within each class should now depend on an assessment of each class should now depend on an assessment of risk tolerance and the investment horizon.risk tolerance and the investment horizon.

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THE EFFICIENT MARKET HYPOTHESIS

The concept of random prices

Degrees of market efficiencyWeakly efficientSemi-Strong efficiencyStrong efficiency

Investment strategiesAll strategies can be classified into: Active or Passive

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Active Versus Passive Active Versus Passive ManagementManagement

The Simple Logic of Active vs. Passive Investing.The Simple Logic of Active vs. Passive Investing. Studies* have shown that over the long term, Studies* have shown that over the long term,

the average actively-managed fund has the average actively-managed fund has underperformed its appropriate passive underperformed its appropriate passive benchmark by about 1.8% per annum on a pre-benchmark by about 1.8% per annum on a pre-tax basis (taking taxes into account would tax basis (taking taxes into account would increase this figure to approximately 3%). increase this figure to approximately 3%).

Despite this evidence, the vast majority of Despite this evidence, the vast majority of individual investors invest in actively-managed individual investors invest in actively-managed funds. funds.

Only about 10% of all individual monies are Only about 10% of all individual monies are currently invested in passive funds.currently invested in passive funds.

Note: There is some evidence that indicates that these studies were flawed because they did not take into account taxes due upon distribution and increases in return due to rebalancing. For a discussion of “closing the gap” on return, see a discussion by Alliance Bernstein Vice Chairman Roger Hertog and Alliance Bernstein Director of Quantitative Research Mark Gordon at https://www.bernstein.com/Public/story.aspx?cid=1222&nid=185. Be aware of possible bias since Alliance Bernstein is an active management investment advisor.

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If “active” and “passive” management If “active” and “passive” management styles are defined in sensible ways, the styles are defined in sensible ways, the following must be the case:following must be the case: 1. 1. Before costsBefore costs – The return on the – The return on the averageaverage

actively-managed dollar will equal the return actively-managed dollar will equal the return on the average passively-managed dollar.on the average passively-managed dollar.

2. 2. After costsAfter costs – The return on the – The return on the averageaverage actively-managed dollar will be less than the actively-managed dollar will be less than the return on the average passively-managed return on the average passively-managed dollar.dollar.

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These assertions must hold for any and These assertions must hold for any and all time periods. Furthermore, their all time periods. Furthermore, their veracity does not depend on any veracity does not depend on any sophisticated statistical or mathematical sophisticated statistical or mathematical analyses or theorems, per se, but only analyses or theorems, per se, but only on the laws of simple arithmetic.on the laws of simple arithmetic.

A scholarly article that tends to refute this simplistic view is

Active versus Passive Management: Framing the Decision. By: Arnott, By: Arnott, Robert; Darnell, Max. Journal of Robert; Darnell, Max. Journal of InvestingInvesting, Spring 2003, Vol. 12 Issue , Spring 2003, Vol. 12 Issue 1, p31, 6p; (1, p31, 6p; (AN 9845319AN 9845319))

Once again, rebalancing is part of the picture. It is an interesting Once again, rebalancing is part of the picture. It is an interesting debate that still rages.debate that still rages.

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Passive InvestorsPassive Investors

Passive investors always buy every security Passive investors always buy every security from the market for their portfolios in the from the market for their portfolios in the same proportion as the securities represent to same proportion as the securities represent to the total value of the market. the total value of the market. In other words, they essentially own an index of the In other words, they essentially own an index of the

market. market. Therefore, if security A represents 2% of the value Therefore, if security A represents 2% of the value

of the securities in the market, a passive investor’s of the securities in the market, a passive investor’s portfolio will have 2% of its value invested in A. portfolio will have 2% of its value invested in A.

Equivalently, a passive investment manager will Equivalently, a passive investment manager will hold the same percentage of the total outstanding hold the same percentage of the total outstanding amount of each security in the market. amount of each security in the market.

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Active InvestorsActive Investors

Active investors are other investors who are Active investors are other investors who are not passive. not passive.

Their portfolios will differ from those of the Their portfolios will differ from those of the passive investors or managers at some or all passive investors or managers at some or all times. times. Active investors or managers usually act on their Active investors or managers usually act on their

perceptions of mispricing in the market; because perceptions of mispricing in the market; because such misperceptions usually change relatively such misperceptions usually change relatively frequently, such investors and managers tend to frequently, such investors and managers tend to trade relatively frequently. trade relatively frequently.

That is why they are called “active” investors or That is why they are called “active” investors or managers.managers.

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The Simple Logic of Active The Simple Logic of Active vs. Passive Investingvs. Passive Investing

Over all periods of time, the market’s return will be Over all periods of time, the market’s return will be a weighted average of the returns on the securities a weighted average of the returns on the securities within the market. within the market. Each passive investor or manager will earn exactly the Each passive investor or manager will earn exactly the

market return (before transactions costs) since they own all market return (before transactions costs) since they own all the securities in the same proportions as the market. the securities in the same proportions as the market.

From this, it follows by simple arithmetic that the return on the From this, it follows by simple arithmetic that the return on the average actively-managed dollar must equal the market return. average actively-managed dollar must equal the market return.

Why? The returns earned by the passive investors plus the Why? The returns earned by the passive investors plus the returns earned by the active investors must equal the total returns earned by the active investors must equal the total returns on the market. returns on the market.

If the returns earned by the passive investors on the portion of If the returns earned by the passive investors on the portion of the market they hold equals the returns on the market, the the market they hold equals the returns on the market, the average returns earned by the active investors on their portion average returns earned by the active investors on their portion of the market must also equal the market return. of the market must also equal the market return.

The market’s return must equal a weighted average of the The market’s return must equal a weighted average of the returns on the passive and active segments of the market. If the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also. This first two returns are the same, the third must be also. This proves the first assertion by using just simple arithmetic.proves the first assertion by using just simple arithmetic.

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To prove the second assertion, simply consider To prove the second assertion, simply consider the fact that the costs of actively managing a the fact that the costs of actively managing a given number of dollars will exceed those of given number of dollars will exceed those of passive management. passive management. Active managers must pay for more research than Active managers must pay for more research than

passive managers, and must pay more for trading, too. passive managers, and must pay more for trading, too. Security analysts, brokers, traders, specialists, and other Security analysts, brokers, traders, specialists, and other

market makers all take a “cut of the action.” market makers all take a “cut of the action.” Because active and passive returns are equal before Because active and passive returns are equal before

cost, and because active managers bear greater costs, cost, and because active managers bear greater costs, it must be the case that the average after-cost returns it must be the case that the average after-cost returns from active management is lower than that from from active management is lower than that from passive management. passive management.

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Managers who appear to be passive Managers who appear to be passive may not be truly passive. may not be truly passive. Some index fund managers “sample” Some index fund managers “sample”

the market of choice, rather than hold the market of choice, rather than hold all the securities in market proportions.all the securities in market proportions.

Some may even charge high enough Some may even charge high enough fees to raise their total costs to equal or fees to raise their total costs to equal or exceed those of active managers.exceed those of active managers.

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Third, and possibly most important in Third, and possibly most important in practice, the summary statistics for practice, the summary statistics for active managers may not truly active managers may not truly represent the performance of the represent the performance of the average actively-managed dollar. average actively-managed dollar.

To compute the latter, each manager’s To compute the latter, each manager’s return should be weighted by the return should be weighted by the dollars he or she has under dollars he or she has under management at the beginning of the management at the beginning of the period. period.

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Active vs. Passive Active vs. Passive InvestingInvesting

Some comparisons use a simple average of the Some comparisons use a simple average of the performance of all managers (large and small); others performance of all managers (large and small); others use the performance of the median active manager. use the performance of the median active manager.

While the results of this kind of comparison are, in While the results of this kind of comparison are, in principle, unpredictable, certain empirical regularities principle, unpredictable, certain empirical regularities persist. persist. Perhaps most important, equity fund managers with smaller Perhaps most important, equity fund managers with smaller

amounts of money tend to favor stocks with smaller outstanding amounts of money tend to favor stocks with smaller outstanding values.values.

Thus, de facto, an equally weighted average of active manager Thus, de facto, an equally weighted average of active manager returns has a bias toward smaller-cap stocks vis-a-vis the market returns has a bias toward smaller-cap stocks vis-a-vis the market as a whole. as a whole.

As a result, the “average active manager” tends to be beaten As a result, the “average active manager” tends to be beaten badly in periods when small-cap stocks underperform large-cap badly in periods when small-cap stocks underperform large-cap stocks, but may exceed the market’s performance in periods stocks, but may exceed the market’s performance in periods when small-cap stocks do well. when small-cap stocks do well.

In both cases, of course, the average actively-managed In both cases, of course, the average actively-managed dollar will underperform the market, net of costs.dollar will underperform the market, net of costs.

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Investing the Winners Investing the Winners among Actively – Managed among Actively – Managed

FundsFunds Mutual fund returns are notoriously Mutual fund returns are notoriously

inconsistent. This makes it difficult to inconsistent. This makes it difficult to select those funds that will outperform select those funds that will outperform going forward. going forward. Investors cannot predict where a fund will Investors cannot predict where a fund will

rank next period based on its performance rank next period based on its performance this period, except to say that if it ranked in this period, except to say that if it ranked in the top 25% it is very unlikely to rank there the top 25% it is very unlikely to rank there next period, and if ranked in the bottom 10% next period, and if ranked in the bottom 10% it is a flip of the coin whether it will still be it is a flip of the coin whether it will still be there next period or not.there next period or not.

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More Considerations in More Considerations in Investing in Actively-Investing in Actively-

Managed FundsManaged Funds The worst funds are throttled by high The worst funds are throttled by high

fees and, therefore, cannot gain ground. fees and, therefore, cannot gain ground. The high flying funds, on the other The high flying funds, on the other

hand, are likely to be highly-hand, are likely to be highly-concentrated and, therefore, annual concentrated and, therefore, annual returns will be volatile. returns will be volatile.

Outperforming funds are also often Outperforming funds are also often flooded with new deposits, making flooded with new deposits, making those funds more difficult to manage.those funds more difficult to manage.

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The ConclusionThe Conclusion

Investors have no way of Investors have no way of determining which funds will determining which funds will perform well next year based upon perform well next year based upon their performance this year and, their performance this year and, therefore, may incur significant therefore, may incur significant underperformance risk by selecting underperformance risk by selecting actively-managed funds.actively-managed funds.

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Study of OddsStudy of Odds The Winter 2001 issue of the The Winter 2001 issue of the Journal of Journal of

Private Portfolio ManagementPrivate Portfolio Management contained a contained a study that looked at the odds of active study that looked at the odds of active managers outperforming passive managers managers outperforming passive managers or index funds.or index funds. The study looked at all 307 large-cap funds with at The study looked at all 307 large-cap funds with at

least a 10-year history. least a 10-year history. This methodology creates what is known as This methodology creates what is known as

“survivorship bias” in favor of active management. “survivorship bias” in favor of active management. Funds that perform poorly typically close because Funds that perform poorly typically close because

of redemptions by investors, or they are merged of redemptions by investors, or they are merged out of existence by their sponsor. out of existence by their sponsor.

Thus their performance data disappears.Thus their performance data disappears.

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Study of Odds (cont.)Study of Odds (cont.) The returns of the funds were then compared to that The returns of the funds were then compared to that

of the benchmark S&P 500 Index. of the benchmark S&P 500 Index. Over the most recent 20-year period, the passive Over the most recent 20-year period, the passive

strategy outperformed over 93% of all surviving strategy outperformed over 93% of all surviving funds. funds. For the most recent 15-year period it outperformed over For the most recent 15-year period it outperformed over

99% of all surviving funds. 99% of all surviving funds. For the most recent 10-, 7-, 5-, and 3-year periods, the For the most recent 10-, 7-, 5-, and 3-year periods, the

passive strategy outperformed at least 95% of all surviving passive strategy outperformed at least 95% of all surviving active funds. active funds.

Finally, for the 61 rolling 5-year periods since the end of Finally, for the 61 rolling 5-year periods since the end of World War II, the passive strategy outperformed at least World War II, the passive strategy outperformed at least half the active funds 58 times (95%). These results were all half the active funds 58 times (95%). These results were all computed on a pre-tax basis. Based on historical data, it is computed on a pre-tax basis. Based on historical data, it is quite clear that the results would have been even worse if quite clear that the results would have been even worse if the returns had been measured on an after-tax basis.the returns had been measured on an after-tax basis.

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Choosing the Simple Choosing the Simple StrategyStrategy

Investors in actively-managed funds Investors in actively-managed funds were choosing the wrong strategy. were choosing the wrong strategy. Simply accepting market returns Simply accepting market returns would have improved their collective would have improved their collective results dramatically.results dramatically.

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Past and Future Past and Future PerformancePerformance

One example of the fallibility of relying on past One example of the fallibility of relying on past success is the findings of William Bernstein. success is the findings of William Bernstein.

He examined the performance of the top 30 He examined the performance of the top 30 funds for successive five years beginning in funds for successive five years beginning in 1970, and then compared their performance 1970, and then compared their performance against that of the S&P 500 Index through against that of the S&P 500 Index through 1998. Here is what he found:1998. Here is what he found:

Never did the top performers from one 5-Never did the top performers from one 5-year period continue to outperform in the year period continue to outperform in the subsequent 5-year period.subsequent 5-year period.

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Past and Future Past and Future Performance (cont.)Performance (cont.)

The top 30 funds from 1970 through 1974 The top 30 funds from 1970 through 1974 went on to underperform the index by 0.99% went on to underperform the index by 0.99% per year.per year.

The top 30 funds from 1975 through 1979 The top 30 funds from 1975 through 1979 went on to underperform the index by 1.89% went on to underperform the index by 1.89% per year.per year.

The top 30 funds from 1980 through 1984 The top 30 funds from 1980 through 1984 went on to underperform by 2.75% per year.went on to underperform by 2.75% per year.



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Past Performances do not Past Performances do not guarantee Future Resultsguarantee Future Results

Past performance is simply not a good Past performance is simply not a good indicator of future performance. indicator of future performance. However, with so many active funds in play, However, with so many active funds in play,

some are likely to be winners over any given some are likely to be winners over any given time frame (and must be, if there are any time frame (and must be, if there are any losers).losers).

The evidence suggests that despite The evidence suggests that despite investors’ generally-held perception that investors’ generally-held perception that skill is what causes the winning result, it skill is what causes the winning result, it appears to be much more likely that the appears to be much more likely that the winners are randomly generated and, thus, winners are randomly generated and, thus, not likely to be repeated.not likely to be repeated.

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Generate Superior Generate Superior ReturnsReturns

The conclusion to draw, once again, The conclusion to draw, once again, is that the prudent strategy – and is that the prudent strategy – and the one most likely to generate the one most likely to generate superior returns – is the passive one.superior returns – is the passive one.

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Take the Rest to Atlantic Take the Rest to Atlantic CityCity

Active management does, however, hold out the Active management does, however, hold out the hope of outperforming other actively-managed hope of outperforming other actively-managed funds and, certainly, passive investing. funds and, certainly, passive investing. This This hopehope is what Wall Street and the financial is what Wall Street and the financial

press sell. press sell. Unfortunately, the odds of winning the game have Unfortunately, the odds of winning the game have

proven to be so low that unless one attaches a proven to be so low that unless one attaches a high value to the entertainment aspect of the high value to the entertainment aspect of the effort, then it does not pay to play. effort, then it does not pay to play.

When one considers the additional costs of active When one considers the additional costs of active management (the “vigorish” or “house take” as management (the “vigorish” or “house take” as they call it in the gambling community), investors they call it in the gambling community), investors might be better off investing most of their money might be better off investing most of their money passively and then playing Black Jack with the rest passively and then playing Black Jack with the rest of it in Las Vegas or Atlantic City.of it in Las Vegas or Atlantic City.

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Active Management in Active Management in Inefficient MarketsInefficient Markets

The controversial “efficient market The controversial “efficient market hypothesis” concludes that there is no hypothesis” concludes that there is no point to fundamental or technical point to fundamental or technical security analysis because all stocks are security analysis because all stocks are fairly priced. fairly priced. According to this hypothesis, active buying According to this hypothesis, active buying

and selling of stocks adds no value – it just and selling of stocks adds no value – it just incurs additional transactions costs. incurs additional transactions costs.

Hiring a professional manager is even Hiring a professional manager is even worse because of the fees required. worse because of the fees required.

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Market EfficiencyMarket Efficiency

If markets are efficient, indexing If markets are efficient, indexing becomes a better alternative. Most becomes a better alternative. Most investors have come to accept that investors have come to accept that the big markets are pretty efficient, the big markets are pretty efficient, but what about the smaller markets but what about the smaller markets and/or foreign markets? They cannot and/or foreign markets? They cannot be as efficient as the big markets, be as efficient as the big markets, can they?can they?

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Investing is a skill-based Investing is a skill-based gamegame

As has been demonstrated above, more than As has been demonstrated above, more than half of all active mutual fund managers half of all active mutual fund managers underperform the market. underperform the market. This is often interpreted as proof of market This is often interpreted as proof of market

efficiency. But the fact is that mutual fund efficiency. But the fact is that mutual fund managers consistently underperform the managers consistently underperform the market by more than can be accounted for by market by more than can be accounted for by the extra costs of active management. the extra costs of active management.

This in fact is proof that investing is a skill-This in fact is proof that investing is a skill-based game and that active mutual fund based game and that active mutual fund managers, as a group, have below-average managers, as a group, have below-average skills.skills.

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More difficult to pull off in More difficult to pull off in small-cap and foreign fundssmall-cap and foreign funds In the small-cap arena or in foreign markets, In the small-cap arena or in foreign markets,

the proportion of active investors the proportion of active investors outperforming a small-cap index fund or foreign outperforming a small-cap index fund or foreign index fund should be even lower, on average, index fund should be even lower, on average, than in the large-cap arena because active than in the large-cap arena because active investing in small-cap and foreign equities investing in small-cap and foreign equities involves higher transaction and research costs. involves higher transaction and research costs.

This obvious logic and arithmetic, once again, This obvious logic and arithmetic, once again, contradicts conventional wisdom that active contradicts conventional wisdom that active managers can do better in the less-efficient managers can do better in the less-efficient small-cap market. small-cap market.

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Who is more successful?Who is more successful?

Which investors or investor groups are Which investors or investor groups are most likely to be in the “successful” top most likely to be in the “successful” top group in terms of skills, information, or group in terms of skills, information, or other competitive advantages? other competitive advantages? Mutual fund managers, as a group are definitely Mutual fund managers, as a group are definitely

not in the top group. not in the top group. Two other investing groups, insiders and hedge Two other investing groups, insiders and hedge

fund managers, both of which have identifiable fund managers, both of which have identifiable competitive advantages, are more likely competitive advantages, are more likely candidates to be in the top group. candidates to be in the top group.

And yet there is no empirical evidence suggesting that And yet there is no empirical evidence suggesting that even these groups can consistently outperform.even these groups can consistently outperform.

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Win more often in investing Win more often in investing passivelypassively

So on what possible grounds could virtually So on what possible grounds could virtually any individual investors feel they actually any individual investors feel they actually had a competitive advantage or above had a competitive advantage or above average skills in the large-cap market, the average skills in the large-cap market, the small-cap market, foreign markets, or any small-cap market, foreign markets, or any markets? Why play a game in which one’s markets? Why play a game in which one’s competitors have an advantage, if one can competitors have an advantage, if one can win more often than not by staying out of win more often than not by staying out of the active game and taking the average the active game and taking the average result by investing passively?result by investing passively?

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Investors are Not Always Investors are Not Always Rational Rational

More than half of all active investors, More than half of all active investors, whose only financial justification for whose only financial justification for being active is beating the index, being active is beating the index, must fail in that objective each year. must fail in that objective each year.

Although when it comes to the logic Although when it comes to the logic and arithmetic of investing, and arithmetic of investing, investors’ behavior suggests they investors’ behavior suggests they may tend to over-represent the may tend to over-represent the bottom half of that distribution.bottom half of that distribution.

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Tactical Asset Allocation Tactical Asset Allocation and Market Timingand Market Timing

This question is constantly debated. This question is constantly debated. However, the overwhelming evidence is However, the overwhelming evidence is that even professional market timers that even professional market timers cannot consistently outperform the cannot consistently outperform the market. market.

Market timing, like all active Market timing, like all active management strategies, is a “zero-sum” management strategies, is a “zero-sum” game whereas investing in the market game whereas investing in the market as a whole is a “positive-sum” game.as a whole is a “positive-sum” game.

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Timing reduces riskTiming reduces risk

The argument is sometimes made The argument is sometimes made that timing reduces risk, since one is that timing reduces risk, since one is invested in cash or T-bills a portion invested in cash or T-bills a portion of the time and in the market the of the time and in the market the rest of the time. Since T-bills are less rest of the time. Since T-bills are less risky than stocks, the argument risky than stocks, the argument goes, the overall risk is lower.goes, the overall risk is lower.

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Gains made during short Gains made during short periodsperiods

The fallacy here is in failing to The fallacy here is in failing to account for the risk of missing the account for the risk of missing the big gains in the market. big gains in the market.

Most of the gains in the market are Most of the gains in the market are made during relatively short periods made during relatively short periods surrounded by long periods of surrounded by long periods of relative stagnation. relative stagnation.

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Monthly Stock ReturnsMonthly Stock Returns

Figure 28.2 shows monthly stock returns from 1926 through 1987 on S&P 500 and small-cap stocks. All of the return for S&P 500 stocks occurred in just 6.7% of the months; for small-cap stocks, just 4% of the months account for all of the return over this period. Only 3.5% and 2.3%, respectively, of the months accounted for all of the return in excess of T-bills. In other words, if one were invested in the market 96.5% of the time, but one were out for the months of greatest gain, one would have done no better than investing in T-bills.

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Cost of not being in the Cost of not being in the marketmarket

A similar study of the bull market from 1982 to 1987 gave similar results, based on days, rather than months in the market. This study showed that if one missed just the 40 biggest days, or just 3% of the 1,276 trading days of this bull market, one would have missed 83.7% of the market’s 26.3% annual compounded return over the period.

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Invest for the Long Term Invest for the Long Term and be in the market and be in the market

consistentlyconsistently Clearly, the risk of not being in the Clearly, the risk of not being in the

market when it makes its run is very market when it makes its run is very significant, and conveniently overlooked significant, and conveniently overlooked when the market timers try to sell their when the market timers try to sell their concept. concept.

The best advice is to invest for the long The best advice is to invest for the long term and be in the market consistently. term and be in the market consistently.

No market timer can claim to be No market timer can claim to be accurate over 80% of the time, so timing accurate over 80% of the time, so timing will inevitably lead to cases where the will inevitably lead to cases where the big market runs are missed.big market runs are missed.

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Repercussions of the Efficient Market Hypothesis

1. Discount brokerage

2. Index funds

3. Much less market timing

4. Changed approach to financial planning

5. Increased global investing

investment planning slides designed by rosilyn h. overton, ms

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