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How the Market Works… and What It Means for Your Portfolio April 2010 Bradley A. Reed, CFA S tt M. Scott M Keller K ll 4901 Hunt Road | Suite 200 | Cincinnati, OH | 45242 | 513.792.6648 PH | 513.792.6644 FX | TruepointInc.com Today’s Agenda What is Conventional Investment Wisdom How the Market Works What It Means for Your Portfolio 2 Conventional Investment Wisdom Conventional investment wisdom suggests that smart people, working diligently, can discover which stocks are mispriced p by y the market. Conventional wisdom also says y that these informed investors can time the market. This is what the practice of active management is all about - stock picking and market timing. Th The success off stock-picking t k i ki and d market k t titiming i are myths th perpetuated t t db by th those who stand to profit from them the most – Wall Street and the media Wall Street and the media uphold the myth that investing should be exciting and d dynamic i Rational voices advocating prudent investment practices receive very little attention in world of entertainment masquerading as advice 3 How the Market Works Who is “The Market” Today 90% of all New York Stock Exchange trades are made by investment p professionals The market is considered “efficient” – not perfect, but sufficiently efficient that wise investors will recognize they cannot expect to regularly exploit mispricings Everything currently knowable is already incorporated into prices - stock prices move only in response to new information unexpected, movements in stocks, stocks and Since surprises are by definition unexpected movements in the stock market overall cannot be identified in advance It’s been said that there are only two kinds of people in the world – those who don’tt know where the market is headed don headed, and those who don’t don t know that they don’t know “Trading individual stocks is like playing tennis against an invisible opponent; what you d ’t realize don’t li iis th thatt you are volleying ll i with ith th the Willi Williams sisters.” i t ” – William Bernstein, PhD, MD, Financial Author and Theorist 4 How the Market Works Implications p for Active Management g The basic assumption that most investment managers can outperform the market is false – these investment managers are the market Given the cost of active management, three quarters of investment managers have and will continue over the long have, long-term, term to underperform the overall market To achieve better than average active management results, a manager must discover and exploit the mistakes of other investment managers As a result of the efficiency of the market and the high cost associated with active investing, active management has become a “loser’s game” 5 How the Markets Work The Benefits of Passive Management g “After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period. period ” —William F. Sharpe, 1990 Nobel Laureate Domestic Mutual Fund Expense Ratios International Mutual Fund Expense Ratios 1.59% 1.45% 1.01% 0.91% 0.94% 0.73% 0.26% 0.16% Average of Weighted Average, All Funds Based on Fund Assets Average of Weighted Average, All Funds Based on Fund Assets Active Passive Average of Weighted Average, All Funds Based on Fund Assets Active William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9. Mutual fund expense ratios as of February 6, 2009. Asset weighting based on net assets as of December 31, 2008. Data provided by Morningstar, Inc. Average of Weighted Average, All Funds Based on Fund Assets Passive 6 How the Market Works Daniel Kahneman “What’s What s really quite remarkable in the investment world is that people are playing a game which, in some sense, cannot be played. There are so many people out there in the market; the idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it and full of other people who believe them. This is one of the great mysteries of finance: Why do people believe they can do the impossible? And why do other people believe them?” – Daniel Kahneman, 2002 Nobel Laureate and Behavioral Economics Expert 7 How the Markets Work The Failure of Active Management g Percentage of Active Public Equity Funds That Failed to Beat the Index July 2004-June 2009 % of Active e Funds Thatt Failed to Outpe erform Bench hmark 100% 80% 70% 90% 87% 90% 73% 71% 68% 63% 60% 60% 50% 40% 30% 20% 10% 0% US Large Cap US Mid Cap US Small Cap Global International International Small Emerging Markets Equity Fund Category Source: Standard & Poor’s Indices Versus Active Funds Scorecard, August 20, 2009. Index used for comparison: US Large Cap—S&P 500 Index; US Mid Cap—S&P MidCap 400 Index; US Small Cap—S&P SmallCap 600 Index; Global Funds—S&P Global 1200 Index; International—S&P 700 Index; International Small—S&P Developed ex. US SmallCap8 Index; Emerging Markets—S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database. How the Markets Work Non-Surviving g Active Equity q y Funds 2004-2008 28.5% Total Universe of 3 662 Funds in 2004 3,662 Percentage of Cumulative Non-Survivors On average, 5.7% of the actively managed equity fund universe disappeared each year. During 2004, 6.8% of the fund universe disappeared. By the fifth year, 28.5% of the fund universe (1,043 funds) had disappeared. Reasons for non-survival likely include closure due to poor investment results. 24.0% 18.1% 12.5% 6.8% 2004 2005 2006 2007 2008 Data provided by CRSP Survivor-Bias-Free US Mutual Fund Database. Sample includes mutual funds existing as of 12/2003. Returns analyzed for the five-year period from 2004-2008. For funds with multiple share classes, only the share class with the most assets at the beginning of the sample (12/2003) is included. Index funds, inverse funds, and leveraged funds are excluded. 9 How the Markets Work Few Consistent Active Equity q y Winners 2004-2008 Surviving funds did not outperform their respective category benchmark in most years or over the entire five-year period. Only about one-third (33.2%) of actively managed US equity funds outperformed their benchmark in 2004. Five years later, only 1.4% of th surviving the i i ffunds d (38 outt off 2,619) had outperformed the benchmark every year. 33.2% Surviving equity funds that beat their category benchmark consistently. 23.3% 5.9% 4.1% 1.4% 2004 2005 2006 2007 2008 Data provided by CRSP Survivor-Bias-Free US Mutual Fund Database. Sample includes mutual funds existing as of 12/2003. Returns analyzed for the five-year period from 2004-2008. For funds with multiple share classes, only the share class with the most assets at the beginning of the sample (12/2003) is included. Index funds, inverse funds, and leveraged funds are excluded. 10 What It Means for Your Portfolio Prudent Process for Portfolio Construction Winning a loser’s game means avoiding error and protecting against serious, permanent loss p Poor asset allocation, ill-considered active management, and perverse markettiming lead the list of damaging errors made by individual investors The appeal of security-trading and the allure of market-timing leads investors to focus on unproductive and expensive portfolio activities The real opportunity to achieve superior investment results lies not in attempting to outperform the market, but in establishing and adhering to an appropriate long-term investment strategy 11 What It Means for Your Portfolio Prudent Process for Portfolio Construction and Management g Investment wisdom begins with the recognition of two key principles: Risk and return are inextricably related – investors cannot earn attractive returns without taking risks, and expected returns can only be increased by assuming additional dditi l risk i k Long-term returns are the only returns that matter 12 What It Means for Your Portfolio Long-Term g Objectives j The key to success is to determine what long-term investment policy will have the best chance of producing the desired result. Thoughtful policy targets, carefully implemented and steadfastly maintained, create the foundation for investment success. Step 1. Determine Risk and Return Objectives Time horizon and cash flow expectations are the most important factors in determining long-term long term portfolio objectives Need, ability, and willingness to take risk should be analyzed 13 What It Means for Your Portfolio Optimal p Asset Mix Portfolio management is investment engineering - good portfolio design eliminates avoidable and unintended risk and maximizes expected returns Step 2. Determine the Appropriate Asset Allocation In constructing a portfolio, the focus should not be on rate of return but on the managementt off risk i k Determining the appropriate balance between stocks and bonds allows an investment plan to address three key financial risks: − Market risk – the risk that stock prices will decline − Inflation risk – the risk of losing long-term purchasing power − Longevity risk – the risk of completely depleting the portfolio The essence of portfolio construction is to combine assets that occasionally move in different directions 14 What It Means for Your Portfolio The Importance p of Market Diversification World Market Capitalization - $28.6 Trillion In US dollars. Map reflects countries in the MSCI Provisional All Country World Index, MSCI All Country World Small Cap Index, and MSCI Frontier Markets Index. Market cap data is free-float adjusted. MSCI data copyright MSCI 2009, all rights reserved. Vietnam data provided by MFMI. Many small nations not displayed. Totals may not equal 100% due to rounding. Dimensional makes case-by-case determinations 15 about the suitability of investing in each emerging market, making considerations that include local market accessibility, government stability, and property rights, before making investments. For educational purposes; should not be used as investment advice. What It Means for Your Portfolio Select Specific p Investment Vehicles Step 3 3. Investment est e t Vehicle e c e Se Selection ect o Most investors concentrate their attention on stock selection rather than focusing on the much more important allocation decisions Passive investors accept market returns by investing in index funds and their similar, but more sophisticated, versions known as passive asset class funds In an efficient market, no additional return can be expected over the market rate of return by assuming unnecessary individual-stock risk 16 What It Means for Your Portfolio The Benefits of Diversification Strong performance among a few stocks accounts for much of the market’s return each year. Compound Average Annual Returns: 1926-2008 All US Stocks Excluding the Top 10% of Performers Each Year Excluding the Top 25% of Performers Each Year 9.4% There is no evidence that managers can identify these stocks in advance—and attempting to pick them may result lt iin missed i d opportunity. t it 6.0% Investors should diversify broadly y and stay y fully y invested to capture expected returns. -1.0% 17 Results based on the CRSP 1-10 Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago. What It Means for Your Portfolio Maintain Discipline p and Consistently y Rebalance the Portfolio Rebalancing to long-term policy targets plays a central role in the portfolio management process Step 4. Make modifications and adjustments to ensure maintenance of originally stated objectives Disciplined rebalancing manages portfolio risk by ensuring that the portfolio does not deviate significantly from the thoughtfully developed long-term allocation targets Real-time rebalancing (as opposed to calendar-based) directly links the frequency of rebalancing to market volatility - as a result, real-time rebalancing creates a buy buy-low low and sell-high sell high opportunity each time the market exhibits volatility 18 What It Means for Your Portfolio Maintain Discipline p and Consistently y Rebalance the Portfolio Maintaining discipline plays a critical role in portfolio success While representing supremely rational behavior, rebalancing forces the investor to move in a direction opposite that of the crowd The hardest work in investing is not intellectual; it’s emotional It is the ability to ignore our instinctive responses of fear and greed that determines, as much as anything else, which investors end up with the highest returns 19 What It Means for Your Portfolio Summaryy By investing in passively managed funds and adopting a simple buy, hold and rebalance strategy, you are guaranteed to not only earn the market rates of return, but you will do so in a low-cost and relatively tax-efficient manner You are also virtually guaranteed to outperform the majority of professional and individual investors. Our role as advisors is to help each client identify identify, understand understand, and commit consistently to long-term investment objectives that are both realistic and appropriate 20