A quick online search for “Dow rallies 500 points” yields a cascade of news stories with similar titles, as does a similar search for “Dow drops 500 points.” These types of headlines may make little sense to some investors, given that a “point” for the Dow and what it means to an individual’s portfolio may be unclear. The potential for misunderstanding also exists among even experienced market participants, given that index levels have risen over time and potential emotional anchors such as a 500-point move do not have the same impact on performance as they used to. With this in mind, we examine what a point move in the Dow means and the impact it may have on an investment portfolio.

IMPACT OF INDEX CONSTRUCTION
The Dow Jones Industrial Average was first calculated in 1896 and currently consists of 30 large cap US stocks. The Dow is a price-weighted index, which is different than more common market capitalization-weighted indices.1

An example may help put this difference in weighting methodology in perspective. Consider two companies that have a total market capitalization of $1,000. Company A has 1,000 shares outstanding that trade at $1 each, and Company B has 100 shares outstanding that trade at $10 each. In a market capitalization-weighted index, both companies would have the same weight since their total market caps are the same. However, in a price-weighted index, Company B would have a larger weight due to its higher stock price. This means that changes in Company B’s stock would be more impactful to a price-weighted index than they would be to a market cap-weighted index.

The relative advantages and disadvantages of these methodologies are interesting topics themselves, but the main purpose of discussing the differences in this context is to point out that design choices can have an impact on index performance. Investors should be aware of this impact when comparing their own portfolios’ performance to that of an index.

HEADLINES VS. REALITY
Movements in the Dow are often communicated in units known as points, which signify the change in the index level. Investors should be cautious when interpreting headlines that reference point movements, as a move of, say, 500 points in either direction is less meaningful now than in the past largely because the overall index level is higher today than it was many years ago.
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Exhibit 1 plots what a decline of this magnitude has meant in percentage terms over time. A 500-point drop in January 1985, when the Dow was near 1,300, equated to a nearly 39% loss. A 500-point drop in December 2003, when the Dow was near 10,000, meant a much smaller 5% decline in value. And a 500-point drop in early December 2018, when the Dow hovered near 25,000, resulted in a 2% loss.

HOW DOES THE DOW RELATE TO YOUR PORTFOLIO?
While the Dow and other indices are frequently interpreted as indicators of broader stock market performance, the stocks composing these indices may not be representative of an investor’s total portfolio. For context, the MSCI All Country World Investable Market Index (MSCI ACWI IMI) covers just over 8,700 large, mid, and small cap stocks in 23 developed and 24 emerging markets countries with a combined market cap of more than $50 trillion. The S&P 500 Index includes 505 large cap US stocks with approximately $23.8 trillion in combined market cap.2 The Dow is a collection of 30 large cap US stocks with a combined market cap of approximately $6.8 trillion.3

Even though the MSCI ACWI IMI, S&P 500, and Dow are all stock market indices, each one tracks different segments of the market, so their performance can differ significantly over time, as shown in Exhibit 2. Since 1995, the Dow has outperformed the S&P 500 and MSCI ACWI IMI by an average of 0.5% and 3.3%, respectively (based on calendar year returns). However, relative performance in individual years can be much different. For example, in 1997, the Dow underperformed the S&P 500 by 8.4% but outperformed the MSCI ACWI IMI by 13.9%.
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It is also important to note that some investors may be concerned about other asset classes besides stocks. Depending on investor needs, a diversified portfolio may include a mix of global stocks, bonds, commodities, and any number of other assets not represented in a stock index. A portfolio’s performance should always be evaluated within the context of an investor’s specific goals. Understanding how a personal portfolio compares to broadly published indices like the Dow can give investors context about how headlines apply to their own situation.

CONCLUSION
News headlines are often written to grab attention. A headline publicizing a 500-point move in the Dow may trigger an emotional response and, depending on the direction, sound either exciting or ominous enough to warrant reading the article. However, after digging further, we can see that the insights such headlines offer may be limited, especially if investors hold portfolios designed and managed daily to meet their individual goals, needs, and preferences in a broadly diversified and cost-effective manner.
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When selecting strategies for their portfolios, investors are often tempted to seek out the latest and greatest investment opportunities. Over the years, these approaches have sought to capitalize on developments such as the perceived relative strength of particular geographic regions, technological changes in the economy, or the popularity of different natural resources. But long-term investors should be aware that letting short-term trends influence their investment approach may be counterproductive. As Nobel laureate Eugene Fama said, “There’s one robust new idea in finance that has investment implications maybe every 10 or 15 years, but there’s a marketing idea every week.”

WHAT’S HOT BECOMES WHAT’S NOT
Looking back at some investment fads over recent decades can illustrate how often trendy investment themes come and go. In the early 1990s, attention turned to the rising “Asian Tigers” of Hong Kong, Singapore, South Korea, and Taiwan. A decade later, much was written about the emergence of the “BRIC” countries of Brazil, Russia, India, and China and their new place in global markets. Similarly, funds targeting hot industries or trends have come into and fallen out of vogue. In the 1950s, the “Nifty Fifty” were all the rage. In the 1960s, “go‑go” stocks and funds piqued investor interest. Later in the 20th century, growing belief in the emergence of a “new economy” led to the creation of funds poised to make the most of the rising importance of information technology and telecommunication services. During the 2000s, 130/30 funds, which used leverage to sell short certain stocks while going long others, became increasingly popular. In the wake of the 2008 financial crisis, “Black Swan” funds, “tail-risk-hedging” strategies, and “liquid alternatives” abounded. As investors reached for yield in a low interest rate environment in the following years, other funds sprang up that claimed to offer increased income generation, and new strategies like unconstrained bond funds proliferated. More recently, strategies focused on peer-to-peer lending, cryptocurrencies, and even cannabis cultivation and private space exploration have become more fashionable. In this environment, so-called “FAANG” stocks and concentrated exchange-traded funds with catchy ticker symbols have also garnered attention among investors.

THE FUND GRAVEYARD
Unsurprisingly, however, numerous funds across the investment landscape were launched over the years only to subsequently close and fade from investor memory. While economic, demographic, technological, and environmental trends shape the world we live in, public markets aggregate a vast amount of dispersed information and drive it into security prices. Any individual trying to outguess the market by constantly trading in and out of what’s hot is competing against the extraordinary collective wisdom of millions of buyers and sellers around the world.

With the benefit of hindsight, it is easy to point out the fortune one could have amassed by making the right call on a specific industry, region, or individual security over a specific period. While these anecdotes can be entertaining, there is a wealth of compelling evidence that highlights the futility of attempting to identify mispricing in advance and profit from it.

It is important to remember that many investing fads, and indeed, most mutual funds, do not stand the test of time. A large proportion of funds fail to survive over the longer term. Of the 1,622 fixed income mutual funds in existence at the beginning of 2004, only 55% still existed at the end of 2018. Similarly, among equity mutual funds, only 51% of the 2,786 funds available to US-based investors at the beginning of 2004 endured.

WHAT AM I REALLY GETTING?
When confronted with choices about whether to add additional types of assets or strategies to a portfolio, it may be helpful to ask the following questions:

​1. What is this strategy claiming to provide that is not already in my portfolio?

2. If it is not in my portfolio, can I reasonably expect that including it or focusing on it will increase expected returns, reduce expected volatility, or help me achieve my investment goal?

3. Am I comfortable with the range of potential outcomes?

If investors are left with doubts after asking any of these questions, it may be wise to use caution before proceeding. Within equities, for example, a market portfolio offers the benefit of exposure to thousands of companies doing business around the world and broad diversification across industries, sectors, and countries. While there can be good reasons to deviate from a market portfolio, investors should understand the potential benefits and risks of doing so.
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In addition, there is no shortage of things investors can do to help contribute to a better investment experience. Working closely with a financial advisor can help individual investors create a plan that fits their needs and risk tolerance. Pursuing a globally diversified approach; managing expenses, turnover, and taxes; and staying disciplined through market volatility can help improve investors’ chances of achieving their long-term financial goals.

CONCLUSION
Fashionable investment approaches will come and go, but investors should remember that a long-term, disciplined investment approach based on robust research and implementation may be the most reliable path to success in the global capital markets.

As much as I value the unfettered access to information the internet provides, I recognize the potential harm that too much information can cause. Take, for example, a friend of mine, who was experiencing some troubling medical symptoms. Typing her symptoms into a search engine led to an evening of research and mounting consternation. By the end of the night, the vast quantity of unfiltered information led her to conclude that something was seriously wrong.

One of the key characteristics that distinguishes an expert is their ability to filter information and make increasingly refined distinctions about the situation at hand. For example, you might describe your troubling symptoms to a doctor simply as a pain in the chest, but a trained physician will be able to ask questions and test several hypotheses before reaching the conclusion that rather than having the cardiac arrest you suspected, you have something completely different. While many of us may have the capacity to elevate our understanding to a high level within a chosen field, reaching this point takes time, dedication, and experience.

My friend, having convinced herself that something was seriously wrong, booked an appointment with a physician. The doctor asked several pertinent questions, performed some straightforward tests, and recommended the following treatment plan: reassurance and education. Not surgery. Not drugs. But an understanding of why and how she had experienced her condition. The consultative nature of a relationship with a trusted professional—both when a situation arises and as we progress through life—is one of the key benefits that an expert can provide.

There are striking parallels with the work of a professional financial advisor. The first responsibility of the doctor or advisor is to understand the person they’re serving so that they can fully assess their situation. Once the plan is underway, the role of the professional is to monitor the person’s situation, evaluate if the course of action remains appropriate, and help to maintain the discipline required for the plan to work as intended.

Like my friend’s doctor, advisors may have experienced conversations with clients that are triggered by news reports or informed by unqualified sources. In some cases, all that is required to help put the client’s mind at ease is a reminder to focus on what is in their control as well as providing reassurance and (re)education that they have a financial plan in place that is helping them move toward their objectives. The benefits of working with the right advisor are demonstrated through the ability to both help clients pursue their financial goals and to help them have a positive experience along the way.

Trouble might arise when we confuse simple and complex conditions. Probably no harm is done when a person, recognizing the onset of a common cold, takes cold medicine, drinks plenty of fluids, and rests. But had my self-diagnosing friend not made an appointment with a specialist, and instead moved from self-diagnosis to self-medication, she may have caused herself real harm. Similarly, thinking that all aspects of your own financial situation can be handled through a basic internet search or casual conversation with a friend might result in a less than optimal financial outcome.
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Without the guidance of an advisor, the self-medicating investor might overreact to short-term market volatility by selling some of their investments. In doing so, they risk missing out on some of the best days since there is no reliable way to predict when positive returns in equity markets will occur.1 One might think that missing a few days of strong returns would not make much difference over the long term. But, as illustrated in Exhibit 1, had an investor missed the 25 single best days in the world’s biggest equity market, the US, between 1990 and the end of 2017, their annualized return would have dropped from 9.81% to 4.53%. Such an outcome can have a major impact on an investor’s financial “treatment” plan.

For the five-year period ending October 31, 2018, the S&P 500 Index had an annualized return of 11.34% while the MSCI World ex USA Index returned 1.86%, and the MSCI Emerging Markets Index returned 0.78%. As US stocks have outperformed international and emerging markets stocks over the last several years, some investors might be reconsidering the benefits of investing outside the US.

​While there are many reasons why a US-based investor may prefer a degree of home bias in their equity allocation, using return differences over a relatively short period as the sole input into this decision may result in missing opportunities that the global markets offer. While international and emerging markets stocks have delivered disappointing returns relative to the US over the last few years, it is important to remember that:

1. Non-US stocks help provide valuable diversification benefits. 2. Recent performance is not a reliable indicator of future returns. 

2. Recent performance is not a reliable indicator of future returns. 

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There’s a World of Opportunity in Equities
The global equity market is large and represents a world of investment opportunities. As shown in Exhibit 1, nearly half of the investment opportunities in global equity markets lie outside the US. Non-US stocks, including developed and emerging markets, account for 48% of world market capitalization and represent thousands of companies in countries all over the world. A portfolio investing solely within the US would not be exposed to the performance of those markets. 

Exhibit 1. World Equity Market Capitalization 

In addition, concentrating a portfolio in any one country can expose investors to large variations in returns. The difference between the best­ and worst‐performing countries can be significant. For example, since 1998, the average return of the best‐performing developed market country was approximately 44%, while the average return of the worst­ performing country was approximately –16%. Diversification means an investor’s portfolio is unlikely to be the best or worst performing relative to any individual country, but diversification also provides a means to achieve a more consistent outcome and more importantly helps reduce and manage catastrophic losses that can be associated with investing in just a small number of stocks or a single country. 
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A Diversified Approach
Over long periods of time, investors may benefit from consistent exposure in their portfolios to both US and non‐US equities. While both asset classes offer the potential to earn positive expected returns in the long run, they may perform quite differently over short periods. While the performance of different countries and asset classes will vary over time, there is no reliable evidence that this performance can be predicted in advance. An approach to equity investing that uses the global opportunity set available to investors can provide diversification benefits as well as potentially higher expected returns. 

​It’s almost Election Day in the US once again. For those who need a brief civics refresher, every two years the full US House of Representatives and one-third of the Senate are up for reelection.

While the outcomes of the elections are uncertain, one thing we can count on is that plenty of opinions and prognostications will be floated in the days to come. In financial circles, this will almost assuredly include any potential for perceived impact on markets. But should long-term investors focus on midterm elections?

MARKETS WORK
We would caution investors against making short-term changes to a long-term plan to try to profit or avoid losses from changes in the political winds. For context, it is helpful to think of markets as a powerful information-processing machine. The combined impact of millions of investors placing billions of dollars’ worth of trades each day results in market prices that incorporate the aggregate expectations of those investors. This makes outguessing market prices consistently very difficult.[1] While surprises can and do happen in elections, the surprises don’t always lead to clear-cut outcomes for investors.

The 2016 presidential election serves as a recent example of this. There were a variety of opinions about how the election would impact markets, but many articles at the time posited that stocks would fall if Trump were elected.[1] The day following President Trump’s win, however, the S&P 500 Index closed 1.1% higher. So even if an investor would have correctly predicted the election outcome (which was not apparent in pre-election polling), there is no guarantee that they would have predicted the correct directional move, especially given the narrative at the time.
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But what about congressional elections? For the upcoming midterms, market strategists and news outlets are still likely to offer opinions on who will win and what impact it will have on markets. However, data for the stock market going back to 1926 shows that returns in months when midterm elections took place did not tend to be that different from returns in any other month.
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Exhibit 1 shows the frequency of monthly returns (expressed in 1% increments) for the S&P 500 Index from January 1926–August 2018. Each horizontal dash represents one month, and each vertical bar shows the cumulative number of months for which returns were within a given 1% range (e.g., the tallest bar shows all months where returns were between 1% and 2%). The blue and red horizontal lines represent months during which a midterm election was held, with red meaning Republicans won or maintained majorities in both chambers of Congress, and blue representing the same for Democrats. Striped boxes indicate mixed control, where one party controls the House of Representatives, and the other controls the Senate, while gray boxes represent non-election months. This graphic illustrates that election month returns were well within the typical range of returns, regardless of which party won the election. Results similarly appeared random when looking at all Congressional elections (midterm and presidential) and for annual returns (both the year of the election and the year after).

Exhibit 1. Midterm Elections and S&P 500 Index Returns, Histogram of Monthly Returns
January 1926–August 2018

​IN IT FOR THE LONG HAUL
While it can be easy to get distracted by month-to-month or even one-year returns, what really matters for long-term investors is how their wealth grows over longer periods of time. Exhibit 2 shows the hypothetical growth of wealth for an investor who put $1 in the S&P 500 Index in January 1926. Again, the chart lays out party control of Congress over time. And again, both parties have periods of significant growth and significant declines during their time of majority rule. However, there does not appear to be a pattern of stronger returns when any specific party is in control of Congress, or when there is mixed control for that matter. Markets have historically continued to provide returns over the long run irrespective of (and perhaps for those who are tired of hearing political ads, even in spite of) which party is in power at any given time.
 
Exhibit 2. Hypothetical Growth of $1 Invested in the S&P 500 Index and Party Control of Congress
January 1926–August 2018

​Equity markets can help investors grow their assets, and we believe investing is a long-term endeavor. Trying to make investment decisions based on the outcome of elections is unlikely to result in reliable excess returns for investors. At best, any positive outcome based on such a strategy will likely be the result of random luck. At worst, it can lead to costly mistakes. Accordingly, there is a strong case for investors to rely on patience and portfolio structure, rather than trying to outguess the market, to pursue investment returns. 

​What do attorneys, psychiatrists, tax & financial professionals all have in common? While it may feel like a punchline is coming, what I’m referring to is what they offer. Their primary product is intellectual capital, something intangible that we can’t necessarily feel or touch. Patients/clients are tasked with quantifying the value of it. The question is: How? I could argue the following insight is applicable to lots of professions, but coming from a guy who runs a wealth management firm, I’ll keep this commentary on the financial side of the spectrum. Numerous studies have been conducted in an attempt to broadly measure the monetary benefits of working with an advisor. Here, I’ll walk through a simple critical thinking exercise, purely designed to help investors make informed decisions.

First, it’s important to point out the human element. Based on our experiences, we all have biases when it comes to interpreting value. Most of us possess situational skepticism’s thanks in part to a daily dosage of fly-by-night quick fixes, aimed at lightening our pockets. If you believe that all physiatrists are quacks, all lawyers are ambulance chasers, or all financial services professionals are salespeople, you probably have a preconception which will inevitably factor into how you value their advice.

Personal Due Diligence: A Litmus Test for Seeking Financial Advice

1. Do I have the experience to independently handle the complexities of my complete financial situation?
2. Do I have the time to research, apply, monitor and adjust my planning and investment portfolio?
3. Do I have the desire to do so?
4. Do I have the long-term discipline to independently make prudent decisions not based on emotion?
5. Finally, do I have confidence that a contingency (someone in place of me) has the experience, time, desire and discipline?

 
Let’s break those down a bit further.
 
Experience: The question really isn’t whether or not you can do it yourself. The question that’s more applicable is can you do it “well”? The biggest challenge I commonly see with do-it-yourself investors stems from understanding how and why financial planning and investment management are related. After analyzing thousands of portfolios through the years, here are some of the most common deficiencies in no particular order.

• A lack of relationship between asset allocation and long-term goals
• A thorough understanding of each position in the portfolio and how it interacts with other holdings
• True awareness of overall costs including internal expense ratios and trading fees
• An absence of appropriate levels of diversification needed to alleviate risk

Time: Markets and investment vehicles are constantly evolving. Therefore, investment portfolios should evolve as well. We’re always learning more about expected return and where it comes from. As we do, investment providers are quick to adapt, offering solutions with incremental improvements. The problem is, there’s lots of them. At last check, there were around 7,000 mutual funds and over 2,000 ETF’s (Exchange Traded Funds) in existence.

This underscores the importance of recognizing that financial planning isn’t a one-time thing but an ongoing event that requires adjustment with life events. Investments, taxation, insurance and estate planning all need to be working in concert. Collectively, this amounts to a lot more time than many realize, which often leads to a lack of attention.

Desire: Does the on-going, in-depth examination of your financial situation interest you or not? If you don’t enjoy working on cars, you’re probably not keen on repairing your own transmission. The concept of hiring professionals in different capacities effectively allows us to spend time doing what we enjoy, or what we do best.
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Discipline: This goes way beyond the idea of having someone there to hold your hand. Yes, psychology plays a role. However, discipline runs deeper than simply resisting reactions to every market movement. We know it applies to investing, but it must also apply to financial planning. Purchasing a home, having a child, changing jobs, marriage, college, retirement etc. are life events that require sound financial adjustments.
 
When it comes to managing your portfolio, the behavioral impact on investing is well documented. It’s easy enough to say, “disciplined investors have historically been rewarded for maintaining that discipline.” However, doing so requires not only a steady hand but also a dedicated understanding of capital markets and how a host of different scenarios affect your unique situation. We've been through around half a dozen bull and bear markets over the last 30 years. Needless to say, long-term investors are likely to experience a bunch of them over a lifetime. 

The history of mutual fund cash flows through the years paints a difficult picture for investor behavior. In 2008, we saw large outflows in equity mutual funds right around the bottom of the market. Subsequently, we saw positive cash flows in the ladder part of 2009 and into 2010 long after markets went into recovery mode. Remember the age old adage about being a successful investor “Buy Low, Sell High”? Well, the opposite often happens and emotional discipline is frequently the culprit.  

Contingency: Confidence in all of the above isn’t enough to ensure a favorable outcome. Many overlook the capacity of their heirs to make sound decisions in the event that they no longer can. Death, disability or incapacity impacts everyone. Prudence dictates an analysis of capable contingencies.

Professional Due Diligence: Aptitude, Delivery, Services, Comparatives
When weighing the value of financial advice, it’s critical to understand the substantial differences between types of financial advisors. Many lack the credentials or even legal authority qualify what they offer as advice in the first place. Brokers are not advisors and Fee-Based is not the same as Fee-Only. Here, I’ll focus on Fee-Only fiduciary advice, the industry standard for placing the clients’ interests first 100% of the time.

Aptitude: This encompasses the combination of experience, education, and reputation.
Experience: In finance, there’s little substitute for the seasoned experience an advisor receives through a variety of different market cycles and with a variety of different types of clients.
Education: Undergraduate business degree’s and MBA’s demonstrate a commitment to education. Industry designations such as CFP® (Certified Financial Planner) or CFA (Chartered Financial Analyst) further indicate levels of expertise.
Reputation: Any due diligence should begin with a baseline evaluation of regulatory history (run a background check). Also, look for specific examples of expertise. Many advisors are active contributors to media outlets. Read columns or interviews to get insight into their investment philosophy or planning approach. Tip: Start with the firm’s website.

Services: Carefully understanding what’s included and what isn’t is essential because service offerings are all over the map. Does the advisor provide one-time financial planning services, ongoing investment management services, the combination of both? How much access do you have to professionals? What types of reports and online access do you receive?

Delivery: How do you want to interact with an advisor? There’s a cost to doing business. Face to face interaction is costlier than email, phone or video. Therefore, it’s reasonable to expect a premium on face to face interaction.

Comparatives: After determining what’s included and what isn’t you can then analyze the market rate for these services.  Recent study

Conclusion
A comprehensive approach to quantifying value helps to diligently explore elements that often get overlooked. Investors should strive to understand themselves, their strengths and limitations before jumping straight into the evaluation of an advisory firm. Starting off with a basic Litmus test helps to solidify the rationale for seeking or not seeking advice. It’s about placing a timeline of personal due diligence in front of professional due diligence with the goal of making informed decisions.

​Our daily lives are crammed with punchlines and parables. Investing has a language of sayings and catchphrases of its own. Some encourage action, others espouse knowledge. This column highlights some of the more well known. Good, bad or indifferent.

The Hazardous
We begin with what Sir John Templeton called “The four most dangerous words in investing: 'this time it's different.’” There are different interpretations of the quote but most regularly it applies to ignoring history at your own peril. When in reference to the stock market, there’s always going to be unforeseen ups and downs but overtime more ups than downs. Long term disciplined investors have historically been rewarded for maintaining that discipline despite the opinions of pundits and prognosticators.

Buy low, sell high. It’s probably the most simplistic expression, yet the most difficult in practical application. Namely, buying when things appear bleakest and selling when things look great isn’t exactly a natural human inclination. In fact, looking at equity mutual fund cash flows through the years, exactly the opposite is the tendency. The last market downturn saw massive outflows in 2008, reversing course in the ladder part of 2009 well after markets went into recovery mode.

I got in early. Usually, you see this in reference to a perceived new investment idea. The issue is, it’s almost impossible to quantify the statement thanks to the speed at which information travels and is incorporated into prices. Simply put, an investor really has no way of knowing if they got in early and should most often work under the assumption that prices reflect all available information. Similarly, “Buy the rumor, sell the news” speaks to speculation on what could happen, while failing to comprehend how much of the “rumor” has already been factored into current prices.

“I’m waiting for the pullback” suggests that prices in some way are inaccurate and an investor has the foresight to time the market perfectly in order to take advantage of a subsequent uptick. The perils of attempting to time the market are well documented. The problem is making a single accurate decision isn’t nearly good enough. To be a successful an investor would have to decide when to get in and when to get out multiple times over an investment lifetime.

The trend is your friend. That is of course until it’s not, meaning- keep buying when it appears to be going up and start selling when it goes down. One of the biggest mistakes investors make is failing to recognize that markets operate on “news” which by definition is unpredictable or else it wouldn’t be news. Essentially, there’s no way of knowing what is a trend and what isn’t.

It’s a market of stocks, not a stock market. This classic day trader proverb implies that you can always make money providing you pick the right stocks. The issue with stock speculation is the evidence of long term success isn’t remotely on the side of active traders.

Bulls make money, bears make money, pigs get slaughtered. This demonstrates an active trader’s mentality that superior skill can make money in any market, but only within the confines of their own greed. Again, we see speculation on when to get in and when to get out, a short term mentality that requires the daunting task of accurately identifying when a stock is over or underpriced.  

On the flip side: Here’s some of the wisest
I’d compare stock pickers to astrologers but I don’t want to bad mouth astrologers. Rarely at a loss for words, the father of modern finance and Nobel Prize winner Eugene Fama speaks to the difficulties in identifying stock miss pricings. Based on decades of data, studies have shown that the average actively managed dollar is far more likely to underperform the average passively managed dollar.

Warren Buffet is probably the most quoted investor of our time with gems like “When the tide goes out, you see who’s swimming naked” in reference to having a lack of diversification in your portfolio when markets pull back. In these instances, concentrated exposures in any one specific investment can spell disaster for a portfolio. Other Buffet favorites include: “The most important quality for an investor is temperament, not intellect” and “Be fearful when others are greedy. Be greedy when others are fearful" both speaking to the well-known emotional tendencies of investors. Above all, patience and levelheadedness are two attributes that investors should hold in the highest regard.

John Maynard Keynes’s famous line “Markets can stay irrational longer than you can stay solvent” has been used to describe a variety of scenarios not limited to the disposition of investors and the unpredictable nature of markets. We’ve been through five different bull and bear markets over the last 27 years, each with significant variations in how long they lasted.

Author of “The Intelligent Investor,” value investing pioneer Benjamin Graham spoke to "The investor's chief problem, even his worst enemy, is likely to be himself." Most investors have emotional attachments to hard earned money, which can lead to decisions that are detrimental to long term success. He also thought that “To be an investor you must be a believer in a better tomorrow.” It’s a basic prerequisite to believe that advancements in technology, standards of living, and ultimately profits will rise over time. Without this ideology, there would simply be no reason to invest.

Index Investing pioneer and Vanguard founder John Bogle provided some simplistic advice in reference to having all your exposure to stocks "If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks". It’s critical to thoroughly understand your risk tolerance for market fluctuation. As your exposure to stocks increases, generally speaking, so does the level of risk in your portfolio. An investor should never take more risk than they can sleep with at night.  

Nobel laureate Paul Samuelson felt "Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas." There’s a difference between investing and speculating. The whole idea of being an investor is to grow assets over the long term. Aligning long term investment growth with short term entertainment isn’t a heck of a lot different than gambling.

Finally, a few warnings about the wisdom of Wall Street and giving too much credence to media pundits. “There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it.” - Peter Lynch
Many of the financial products coming out of Wall Street over the years are bought and sold on the premise of being the next hot thing. As rule of thumb, you should always know how your money is invested, complete with a thorough understanding of the potential risk, fee’s and liquidity associated with any investment vehicle.

And Ex-Daily show host John Stewart on the 2008 market downturn: “If I’d only followed CNBC’s advice, I’d have a million dollars today. Provided I’d started with a hundred million dollars.” Don’t’ put too much stock in the daily commentary from talking heads whose job is to keep you reading, listening or watching. Instead, focus on your unique situation and look for help from qualified professionals who have your best interest in mind.

It’s certainly not a comprehensive list but I hope you enjoyed it. The next time you hear one of these phrases remember to keep it in the proper context.

​This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors. To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time. In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And more than 100 years later, nine cents would only buy about seven tablespoons of milk. How can investors potentially prevent this loss of purchasing power from inflation over time?

Investing for the long term and other “tips”
As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from –0.9% before inflation to –3.4% after inflation.
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Despite some periods where stocks have failed to outpace inflation, one dollar invested in the S&P 500 Index in 1926, after accounting for inflation, would have grown to more than $500 of purchasing power at the end of 2017 and would have significantly outpaced inflation over the long run. The story for US Treasury bills (T-bills), however, is quite different. In many periods, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. After adjusting for inflation, one dollar invested in T-bills in 1926 would have grown to only $1.51 at the end of 2017.

While stocks are more volatile than T-bills, they have also been more likely to outpace inflation over long periods. The lesson here is that volatility is not the only type of risk that should concern investors. Ultimately, many investors may need to have some of their allocation in growth investments that outpace inflation to maintain their standard of living and grow their wealth.

One additional tool available to investors who are concerned about both stock market volatility and inflation are Treasury Inflation-Protected Securities (TIPS). TIPS are guaranteed by the US Treasury and as such are considered by the marketplace to have low risk of default. The Treasury issues TIPS with a variety of maturities, and these securities are easily bought and sold. Unlike traditional Treasury securities such as T-bills, TIPS are indexed to inflation to protect investors from an erosion in purchasing power. As inflation (measured by the consumer price index) rises, so does the par value of TIPS, while the interest rate remains fixed. This means that if inflation unexpectedly rises, the purchasing power of any principal invested in TIPS should also increase.[1] Although they may not offer the long-term growth opportunities that stocks do, their structure makes TIPS an effective risk management tool for investors who are concerned with managing uncertainty around future purchasing power.

Conclusion
Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. The right mix of assets for any investor will depend upon that investor’s unique goals and needs. A financial advisor can help investors weigh the impact of inflation and other important considerations when preparing and investing for the future.

​Disappearing Funds
The size of the mutual fund landscape masks the fact that many funds disappear each year, often due to poor investment performance. Investors may be surprised by how many mutual funds become obsolete over time. About half of the equity and fixed income funds were no longer available after 15 years.
 
Including these non-surviving funds in the sample is an important part of assessing mutual fund manager performance. The evidence suggests that only a low percentage of funds in the original sample were “winners”—defined as those that both survived and outperformed benchmarks.
 
Both survival and outperformance rates tended to fall as the time horizon expands. For the 15‑year period through 2017, only 14% of equity funds survived and outperformed their benchmarks.

​This chart shows survivorship and outperformance for fixed income funds. Their survival rates were similar to those of equities for the same 5-, 10-, and 15-year periods. Over time, a declining percentage of fixed income funds from the beginning sample survived, and only a fraction of those surviving funds delivered winning performance.
 
For the 15-year period through 2017, only 13% of fixed income funds survived and outperformed their benchmarks. 

The Search for Persistence
Some investors may resort to using track records as a guide to selecting funds, reasoning that a manager’s past success is likely to continue in the future. Does this assumption pay off? The research offers evidence to the contrary.

The exhibit shows that among funds ranked in the top quartile (25%) based on previous three-year returns, a minority also ranked in the top quartile of returns over the following three-year period. This lack of persistence casts further doubt on the ability of managers to consistently gain an informational advantage on the market.

For example, in 2017, only 29% of equity funds were ranked in the top quartile of performance in their category in both the previous period (2012–2014) and subsequent period (2015–2017). Over the 12 years through 2017, top-quartile persistence of three-year performers averaged 26% for equity funds.

Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, potentially leaving many investors disappointed.
​
Conclusion
The results of this study suggest that investors are best served by relying on market prices. Investment methods based on a manager’s ability to outguess market prices have resulted in underperformance for the vast majority of mutual funds.

Despite the evidence, many investors continue searching for winning mutual funds and look to past performance as the main criterion for evaluating a manager’s future potential. In their pursuit of returns, many investors surrender performance to high fees, high turnover, and other costs of owning the mutual funds.

We believe the underperformance of most US mutual funds highlights an important investment principle: The capital markets do a good job of pricing securities, which intensifies a fund’s challenge to beat its benchmark and other market participants. When fund managers charge high fees and trade frequently, they must overcome high cost barriers as they try to outperform the market.

​Choosing a long-term winner involves more than seeking out funds with a successful track record, as past performance offers no guarantee of a successful investment outcome in the future. Moreover, looking at past performance is only one way to evaluate a manager.

In the end, investors should consider other aspects of a mutual fund, such as underlying market philosophy, robustness in portfolio design, and attention to total costs, all of which are important to delivering a good investment experience and, ultimately, helping investors achieve their goals.

I get a lot of questions about income distribution during retirement. How much can I take? How should my assets be positioned? What types of assets produce the most income? Total return income planning is a holistic approach that takes into consideration your entire portfolio, focusing on the primary drivers of investment growth.

​The Determinants of Return
Obviously, we want our investment to grow over time. The principal we contribute, either initially or periodically through the years serves as the basis for future growth. Return on investment is determined by the combination of interest received from fixed income instruments (bonds, cd’s, money market accounts), stock profit sharing (otherwise known as dividends) and lastly by the gains or appreciation in value. When the time comes to begin generating income from investments, a total return approach looks holistically at the entire picture to systematically deliver an ongoing income stream.

Income Requirements
First, it’s essential to determine how much income is required, a question that cannot be answered without financial planning/analysis. In one form or another, it begins with figuring out expenses and cost of living during retirement. Next, comes integrating any recurring income from social security, pensions, annuities, etc. The difference between those two numbers represents a basic estimate of the income replacement needed from other investments. The simplicity of this example should not understate the potentially significant impact of things like taxation, inflation, and other estate planning considerations.

The next question: Can the principal value of my portfolio plus its future growth through interest, dividends and capital appreciation (i.e. total return) make up the difference? Answer: “It depends.”

Total return income planning incorporates a future expected rate of return to a portfolio which is further defined as “all investment accounts and their overall allocation to equity/stock and fixed income/bonds.” Lots of considerations come into play such as the total value, the equity to fixed income ratio; risk/return characteristics etc. Behavior can also have an impact on returns. Therefore, none of these points matter if the portfolio doesn’t fit with the investor's risk tolerance.

The Act of Creating Income
To supplement the need for income, cash is made available on a periodic basis (usually monthly, quarterly, or annually), by placing trades in one or a variety of the accounts. Tax efficiency is often stressed when determining whether the funds come from Traditional IRA’s, 401(k)’s, Roth IRA’s, taxable Individual/Joint Brokerage accounts or a combination thereof.

The process of creating an ongoing income stream continues by following the same steps to replenish the funds needed for living expenses. It’s important to remember that today’s money won’t buy the same amount of goods/services as it will 10 years from now. Therefore, funds not required for current living expenses are efficiently left to grow in order to satisfy future inflation-adjusted income needs.

Conclusion
Growth and income may be the two most ambiguous financial terms that get thrown around. Total return essentially represents the most holistic incorporation of both. It provides the flexibility for both tax efficient distribution and unforeseen income needs. It also presents the opportunity to reduce cost, as opposed to many accurately maligned investment products containing multiple layers of hard-to-find fees and expenses.

​Check out this outstanding video illustrating the dangers of paying too much attention to financial media pundits. This comes from our partners at DFA, a company as dedicated to research and empirical evidence as we are.

​With stock indices continuing to set new highs, does this mean negative returns for stocks are on the horizon? When addressing this question, it is helpful to keep the following in mind:

• Every day, stocks have a positive expected return regardless of whether markets are at an all-time high or not.
• While expected returns are always positive, positive realized returns are never guaranteed and may deviate from expectations.

The reason we can expect positive returns, regardless of the current market level, is attributable to the mechanism by which markets set prices. Stock prices are the result of the interaction of many willing buyers and sellers. Current prices reflect the discounted value of future cash flows expected by those buyers and sellers. But, there is uncertainty around these future cash flows for stocks, and investors bear the risk of potential losses. If the buyer of a stock views the future cash flows as more uncertain, they will likely want to pay a lower price for the stock. They will only transact when the price reaches a level where they expect to earn a positive return. For these reasons, we expect stock market prices to be set to a level at which the required rate of return for investing in stocks is positive, whether the market is at a new high, a new low, or something in between. Otherwise, why would buyers in the marketplace willingly transact at a given price?

​History can help illustrate this point and show us that a market index reaching an all-time high has not necessarily provided actionable information for investors.

Exhibit 1 measures monthly closing levels of the S&P 500 Index from the beginning of 1926 to the end of 2017. Of the 1,103 months observed, almost one-third represented new closing highs for the index. This may not be surprising for some. Since markets generally tend to go up over time, new highs should be a relatively common occurrence. Considering this, it is worth posing the question: If prices increasing over time was a troubling development, what would be the point of investing at all?

​This data also shows that looking ahead on a one-, three-, and five-year basis, the percent of cases when the index was higher or lower after a new market high is about the same when compared to any other previous price level. In other words, positive and negative returns tended to make up a similar proportion of returns after the fact, regardless of whether a new high was reached or not. For example, for a three-year look-ahead period, the index was higher around 84% of the time both after hitting a new closing high as well as after any other previous level. Additionally, this data shows us that the average return experienced after those highs vs. any other level is also quite similar. For example, for the three-year look-ahead period, the average cumulative return after a new high was 51.1% vs. 51.8% for any other level. These results indicate that new index highs have historically not been useful predictors of future returns.

Another reason investors should be cautious about reevaluating their approach at an all-time high is the potential opportunity cost of switching in and out of the market. Last year, the S&P 500 Index returned more than 20%, and yet 2017 started with three new market highs during the first 20 trading sessions.[1] The opportunity cost paid by investors reacting to the new highs by selling stocks could have been substantial. There is no reliable way to predict when stock returns will be positive or negative, and while the long-term average return of the US stock market[2] has been around 10% since 1926, year-to-year results often deviate markedly from the historical average.[3] Investors looking to capture what the equity markets offer over the long term are likely well served by sticking with their approach rather than making changes based on short-term noise.
​
Conclusion
The question of whether new market highs portend a fall in stocks can often be translated to another, more general question: “Is now a good time for me to be invested?” The evidence suggests that the current state of the market is not helpful in answering this question. Rather, an appropriate answer is highly dependent upon an investor’s unique situation and their risk and return objectives. For investors concluding stock market exposure is appropriate, a disciplined approach with a long-term view is likely a more prudent course of action than reacting to new market highs.
​

​
Source: Dimensional Fund Advisors LP.
Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.
There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.
[1]. S&P 500 Index data © 2018 Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
[2] As measured by the S&P 500 Index.
[3]. For more on this topic, please see “The Uncommon Average” from October 2017. 

NINE EXPERTS
Each January, a well-known financial publication invites a group of experienced investment professionals to New York for a lengthy roundtable discussion of the investment outlook for the year ahead. The nine panelists have spent their careers studying companies and poring over economic statistics to find the most rewarding investment opportunities around the globe.

Ahead of 2017, the authors of the publication’s report were struck by the “remarkably cohesive consensus” among the members of the group, who often find much to disagree about. Not one pro expressed strong enthusiasm for US stocks in the year ahead, two expected returns to be negative for the year, and the most optimistic forecast was for a total return of 7%. They also found little to like
in global markets, citing “gigantic geopolitical issues,” including a Chinese “debt bubble” and a “crisis” in the Italian banking system. 

The excerpts below summarizing the panel’s outlook presented a less than optimistic view of the year ahead in January 2017.

“This could be the year when the movie runs backwards: Inflation awakens. Bond yields reboot. Stocks stumble. Active management rules. And we haven’t even touched on the coming regime change in Washington.”1

The outcome of these predictions: Zero-for-four, although some might point out that at least they got the direction right regarding the inflation rate.

• Inflation barely budged, moving to 2.17% for the January–November 2017 period, up from 2.07% for the year in 2016.2
• The yield on the 10-year US Treasury note did not move up but instead slipped from 2.45% to 2.40%.
• Stocks moved broadly higher around the world, in some cases dramatically. Twenty out of 47 countries tracked by MSCI achieved total returns in excess of 30%.3 
• According to Morningstar, the average large blend mutual fund underperformed the S&P 500 Index by 1.39 percentage points, and the average small company fund underperformed the S&P 600 Index by 1.35 percentage points.

The above-mentioned panel was no aberration. Among 15 prominent investment strategists polled by USA TODAY, the average prediction for US stocks for 2017 was 4.4%, while the most optimistic was 10.4%.4 Expert or not, there is little evidence that accurate predictions about future events, as well as how the market will react to those events, can be achieved
on a consistent basis.

FOUR SURPRISES

• What do you get when you combine a tumultuous year for a new US president and divisive political trends in many global markets? Answer: a new record. For the first time since 1897, the total return for the US stock market (the CRSP 1-10 Index and, prior to 1926, the Dow Jones Industrial Average) was positive in every single month of the year. During the year, a great deal of media coverage was focused on markets at all-time highs, and some investors braced themselves for a sharp drop in stock prices. Not only did the much anticipated “correction” never occur, financial markets remained remarkably calm. Out of 254 trading days in 2017, the total return of the S&P 500 Index rose or fell over 1% only eight times. By comparison, in a more rambunctious year such as 1999, it did so 92 times.5
• North Korea issued threats of a nuclear missile strike throughout the year and boasted that even mainland US cities were vulnerable to its newest warheads. Next-door neighbor South Korea would seem to have the most to lose if such a catastrophe occurred, but Korean stocks were among the top performers in 2017, with a total return of 29.5% in local currency and 46.0% in US dollar terms.6
• To many experienced researchers, Chinese stocks appeared alarmingly vulnerable. A gloomy November 2016 article7 warned that “China’s debt addiction could lead to a financial crisis.” In the article, a prominent Wall Street strategist observed: “It’s scary that China seems to be continuing its debt binge to achieve its unrealistic growth targets.” And a global fund manager noted: “We are the most underweight China we have been since launching the fund five years ago.” The outcome: China was the third best-performing stock market in 2017 with a total return of 51.6% in local currency and 50.7% in US dollar terms.8
• The seven-year string of increasing US auto sales finally ended in 2017. Domestic sales fell 1.0% at Ford Motor, 1.3% at General Motors, and 10.7% at Fiat Chrysler.9 Anticipating the sales slump, a Wall Street Journal columnist warned investors in January 2017 to avoid the stocks.10 Good advice? Ford Motor had a total return of 8.7%, which was in fact below the 21.8% return of the S&P 500 Index. However, General Motors returned 22.5%, and Fiat Chrysler’s total return came in at an impressive 96.3%, even with more than a 10% drop in sales.11

While some of these examples may seem counterintuitive, the above “surprises” from 2017 reinforce the challenge of drawing a direct link between positive or negative events in the world and positive or negative returns in the stock market.

THE MILLION DOLLAR BET
Last year saw the conclusion of a 10-year wager between Warren Buffett, chairman of Berkshire Hathaway Inc., and Ted Seides, a New York hedge fund consultant. Seides responded to a public challenge issued by Buffett in 2007 regarding the merits of hedge funds relative to low-cost passive vehicles. The two men agreed to bet $1 million on the outcome of their respective investment strategies over the 10-year period from January 1, 2008, through December 31, 2017. Buffett selected the S&P 500 Index, Seides selected five hedge funds, and the stakes were earmarked for the winner’s preferred charity. The terms were revised midway through the period by converting the sum invested in bonds to Berkshire Hathaway shares, so the final amount is reported to be in excess of $2.2 million.

The 10-year period included years of dramatic decline for the S&P 500 Index (–37.0% in 2008) as well as above-average gains (+32.4% in 2013), so there was ample opportunity for clever managers to attempt to outperform a buy-and-hold strategy through a successful timing strategy. For fans of hedge funds, however, the results were not encouraging. For the nine-year period from January 1, 2008, through December 31, 2016, the average of the five funds achieved a total return of 22.0% compared to 85.5% for the S&P 500 Index.12 (Results for 2017 have not yet been reported.)

Having fallen far behind after nine years, Seides graciously conceded defeat in mid-2017. But he pointed out in a May 2017 Bloomberg article that in the first 14 months of the bet, the S&P 500 Index declined roughly 50% while his basket of hedge funds declined less than half as much. He suggested that many investors bailed out of their S&P 500-type strategies in 2008 and never participated in the recovery. Hedge fund participants, he argued, “stood a much better chance of staying the course.” 

Seides makes a valid point—long run returns don’t matter if the strategy is abandoned along the way. And there is ample evidence that some mutual fund investors sold in late 2008 and missed out on substantial subsequent gains. But do hedge funds offer the best solution to this problem? We think educating investors about the unpredictability of capital market returns and the importance of appropriate asset allocation will likely prove more fruitful than paying fees to guess where markets are headed next. A hypothetical global diversified allocation of 60% equities and 40% fixed income13 still outperformed the hedge fund basket over the same nine years (56.6% vs. 22.0% in total returns).

Over any time period some managers will outperform index-type strategies, although most research studies find that the number is no greater than we would expect by chance. Advocates of active management often claim that this evidence does not concern them, since superior managers can be identified in advance by conducting a thorough assessment of manager skills. But this 10-year challenge offers additional evidence that investors will most likely find such efforts fail to improve their investment experience. 

EXPECT THE UNEXPECTED
Financial markets surprised many investors in 2017, but then again they have a long history of surprising investors. For example, from 1926–2017, the annualized return for the S&P 500 Index was 10.2%. But returns in any single year were seldom close to this figure. They fell in a range between 8% and 12% only six times in the last 92 years but experienced gains or losses greater than 20% 40 times (34 gains, six losses). Investors should appreciate that many times realized returns may be far different from expected returns.

For a number of investors, 2017 was a paradox. The harder they tried to enhance their results by paying close attention to current events, the more likely they failed to capture the rate of return the capital markets offered.

New Year’s resolution: Keep informed on current events as a responsible citizen. Let the capital markets decide where returns will be generated.

The last days of the year produced the most significant tax overhaul in decades, with far-reaching ramifications for most investors. Originally intended to be a simplification of the tax code, the bill turned out to be a series of tweaks and adjustments to both personal and corporate income taxes for 2018. While it is always advisable to consult your tax professional on these changes, here is a brief summary of how the bill impacts taxpayers.

• ​The bill retained the 7 tax brackets, but did provide for new lower rates of 10%, 12%, 22%, 24%, 32%, 35% and 37%. 
  
• The Standard Deduction almost doubled to $24,000 for married filing jointly and $12,000 for single filers.
• Personal exemptions which used to be $4,050 per person were eliminated entirely but the child tax credit doubles to $2,000 per dependent child under age 17.
• Limits to state and local taxes ("SALT"). Under the bill, you may only deduct up to $10,000 in state and local taxes, including sales, income, and property taxes. This deduction was not previously subject to limitation.
• Mortgage interest deductions for current homeowners are still allowed, but it caps the interest deduction at $750,000 in mortgage debt for homes bought in 2018 and beyond.
• 529 College Savings Plans can now make qualifying distributions for the use of primary and secondary schools, including private schools.
• Medical deductions are expanded. Current law allows for the deduction of medical expenses over 10% of adjusted gross income (AGI). The bill lowers the threshold to 7.5%. 
• All miscellaneous itemized deductions, including payment of tax preparation and investment advisory fees, are eliminated.
• The impact of the Alternative Minimum Tax (AMT) is greatly reduced, with a higher exemption limit ($109,400 from $86,200 for married filers) and a higher phase out.
• The corporate tax rate is significantly reduced to 21%.
• Pass through businesses such as sole proprietors, partnerships, S-Corps and LLC’s will be able to deduct 20% of their business income from taxable income. There are some restrictions on the type of business and income thresholds that should be addressed with a tax professional to determine if the business qualifies.
• The Estate and Gift tax exemptions doubled up to $11 million for individuals and $22 million for couples.
• The individual mandate for health insurance and the accompanying penalty as part of the Affordable Care Act is repealed effective 2019.

 
Market Summary
News of tax reform didn’t overshadow another strong year for markets. Major equity asset classes around the globe all posted double digit gains. Emerging markets led the way +37.28% for the year. International Developed markets were up +25%. The S&P 500 posted another great year +21.83% and US small caps gained 14.65%. US Bond markets also fared reasonably well, turning in a positive 3.54% return. 

Last year around this time all the buzz was about the United Kingdom's vote to leave the European Union, the surprise election of Donald Trump, and how global markets would respond. One could have easily made the argument that such uncertainty would have had a negative impact. Now that the results are in, talk turns to whether stocks are overpriced or underpriced and how much longer this bull market can continue.
 
The fact of the matter is, predicting the next bear market isn’t necessary for the success of long term diversified investors. Most of us will see numerous bull/bear market cycles throughout our investment lifetime (We’ve seen 5 changes in the last 27 years.) Things like behavioral discipline, rebalancing, and making intelligent financial planning decisions are always going to be far more important to long term success. ​

Cryptocurrencies such as bitcoin emerged only in the past decade. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and no regulator or nation state stands behind it.

Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet. In the case of bitcoin, there is a finite supply of 21 million,[1] of which more than 16 million are in circulation.[2] Transactions are recorded on a public ledger called blockchain.

People can earn bitcoins in several ways, including buying them using traditional fiat currencies[3] or by “mining” them—receiving newly created bitcoins for the service of using powerful computers to compile recent transactions into new blocks of the transaction chain through solving a highly complex mathematical puzzle.

For much of the past decade, cryptocurrencies were the preserve of digital enthusiasts and people who believe the age of fiat currencies is coming to an end. This niche appeal is reflected in their market value. For example, at a market value of $16,000 per bitcoin,[4] the total value of bitcoin in circulation is less than one tenth of 1% of the aggregate value of global stocks and bonds. Despite this, the sharp rise in the market value of bitcoins over the past weeks and months have contributed to intense media attention.

What are investors to make of all this media attention? What place, if any, should bitcoin play in a diversified portfolio? Recently, the value of bitcoin has risen sharply, but that is the past. What about its future value?

You can approach these questions in several ways. A good place to begin is by examining the roles that stocks, bonds, and cash play in your portfolio.

EXPECTED RETURNS
Companies often seek external sources of capital to finance projects they believe will generate profits in the future. When a company issues stock, it offers investors a residual claim on its future profits. When a company issues a bond, it offers investors a promised stream of future cash flows, including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain but greater amount of expected cash in the future. One important role these securities play in a portfolio is to provide positive expected returns by allowing investors to share in the future profits earned by corporations globally. By investing in stocks and bonds today, you expect to grow your wealth and enable greater consumption tomorrow.

Government bonds often provide a more certain repayment of promised cash flows than corporate bonds. Thus, besides the potential for providing positive expected returns, another reason to hold government bonds is to reduce the uncertainty of future wealth. And inflation-linked government bonds reduce the uncertainty of future inflation-adjusted wealth.

Holding cash does not provide an expected stream of future cash flow. One US dollar in your wallet today does not entitle you to more dollars in the future. The same logic applies to holding other fiat currencies — and holding bitcoins in a digital wallet. So we should not expect a positive return from holding cash in one or more currencies unless we can predict when one currency will appreciate or depreciate relative to others.

The academic literature overwhelmingly suggests that short-term currency movements are unpredictable, implying there is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency. So why should investors hold cash in one or more currencies? One reason is because it provides a store of value that can be used to manage near-term known expenditures in those currencies.

With this framework in mind, it might be argued that holding bitcoins is like holding cash; it can be used to pay for some goods and services. However, most goods and services are not priced in bitcoins.

A lot of volatility has occurred in the exchange rates between bitcoins and traditional currencies. That volatility implies uncertainty, even in the near term, in the amount of future goods and services your bitcoins can purchase. This uncertainty, combined with possibly high transaction costs to convert bitcoins into usable currency, suggests that the cryptocurrency currently falls short as a store of value to manage near-term known expenses. Of course, that may change in the future if it becomes common practice to pay for all goods and services using bitcoins.

If bitcoin is not currently practical as a substitute for cash, should we expect its value to appreciate?

SUPPLY AND DEMAND
The price of a bitcoin is tied to supply and demand. Although the supply of bitcoins is slowly rising, it may reach an upper limit, which might imply limited future supply. The future supply of cryptocurrencies, however, may be very flexible as new types are developed and innovation in technology makes many cryptocurrencies close substitutes for one another, implying the quantity of future supply might be unlimited.

Regarding future demand for bitcoins, there is a non‑zero probability[5] that nothing will come of it (no future demand) and a non-zero probability that it will be widely adopted (high future demand).

Future regulation adds to this uncertainty. While recent media attention has ensured bitcoin is more widely discussed today than in years past, it is still largely unused by most financial institutions. It has also been the subject of scrutiny by regulators. For example, in a note to investors in 2014, the US Securities and Exchange Commission warned that any new investment appearing to be exciting and cutting-edge has the potential to give rise to fraud and false “guarantees” of high investment returns.[6] Other entities around the world have issued similar warnings. It is unclear what impact future laws and regulations may have on bitcoin’s future supply and demand (or even its existence). This uncertainty is common with young investments.

All of these factors suggest that future supply and demand are highly uncertain. But the probabilities of high or low future supply or demand are an input in the price of bitcoins today. That price is fair, in that investors willingly transact at that price. One investor does not have an unfair advantage over another in determining if the true probability of future demand will be different from what is reflected in bitcoin’s price today.

WHAT TO EXPECT
So, should we expect the value of bitcoins to appreciate? Maybe. But just as with traditional currencies, there is no reliable way to predict by how much and when that appreciation will occur. We know, however, that we should not expect to receive more bitcoins in the future just by holding one bitcoin today. They don’t entitle holders to an expected stream of future bitcoins, and they don’t entitle the holder to a residual claim on the future profits of global corporations.

None of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of bitcoins. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries, although these effects may take some years to emerge.

When it comes to designing a portfolio, a good place to begin is with one’s goals. This approach, combined with an understanding of the characteristics of each eligible security type, provides a good framework to decide which securities deserve a place in a portfolio. For the securities that make the cut, their weight in the total market of all investable securities provides a baseline for deciding how much of a portfolio should be allocated to that security.

Unlike stocks or corporate bonds, it is not clear that bitcoins offer investors positive expected returns. Unlike government bonds, they don’t provide clarity about future wealth. And, unlike holding cash in fiat currencies, they don’t provide the means to plan for a wide range of near-term known expenditures. Because bitcoin does not help achieve these investment goals, we believe that it does not warrant a place in a portfolio designed to meet one or more of such goals.

If, however, one has a goal not contemplated herein, and you believe bitcoin is well suited to meet that goal, keep in mind the final piece of our asset allocation framework: What percentage of all eligible investments do the value of all bitcoins represent? When compared to global stocks, bonds, and traditional currency, their market value is tiny. So, if for some reason an investor decides bitcoins are a good investment, we believe their weight in a well-diversified portfolio should generally be tiny.[7]
Because bitcoin is being sold in some quarters as a paradigm shift in financial markets, this does not mean investors should rush to include it in their portfolios. When digesting the latest article on bitcoin, keep in mind that a goals-based approach based on stocks, bonds, and traditional currencies, as well as sensible and robust dimensions of expected returns, has been helping investors effectively pursue their goals for decades.

​The most powerful driving force behind free and open capital markets has historically been the dissemination, consumption and interpretation of news. Since the inception of public news consumption, misinformation has been an issue. Different terminology comes and goes, “fake news” being the latest label, magnified by the president’s usage of it. Today, in an era when fact checking through multiple sources seems low on the list of journalistic priorities, have we reached a point where an impact can be felt from the publication of fake news?

Recently, ABC News anchor Brian Ross reported that former National Security Advisor Michael Flynn was prepared to testify that during the campaign Donald Trump had personally directed him to make contact with Russians. Following his on-air statement, ABC News tweeted about the report which subsequently received 25,000 retweets. As you can imagine, word began spreading like wildfire to most of the major media outlets, many crediting ABC News for breaking the story. However, there was one minor problem. It happened to be false.    
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Effects came quickly as investors and by extension financial markets began interpreting the future implications of this new development. Ross’s live TV broadcast took place at approximately 11:00 AM eastern time, by 11:30 the Dow Jones Industrial Average reacted sharply, falling around 350 points. 

​Interestingly enough Michael Flynn wasn’t the days only headline news. December 1st also included initial signals that the much talked about tax reform bill had enough votes to pass in the Senate. By market close, the Dow had recovered most of the day’s losses finishing just 41 points lower than the previous day. It wasn’t until later that day when ABC issued an apology in addition to suspending Ross 4 weeks for his inaccurate reporting:

"We deeply regret and apologize for the serious error we made yesterday. The reporting conveyed by Brian Ross during the special report had not been fully vetted through our editorial standards process," ABC said in a statement. "As a result of our continued reporting over the next several hours ultimately we determined the information was wrong and we corrected the mistake on air and online."

Fortunately, or unfortunately we live in a 24-hour news cycle. With the current volume of sensationalized, half-baked journalism out there, it’s understandable for markets to react irrationally at times. The events of December 1st are a reminder that short-term volatility or “noise” as the pundits like to call it, is often a factor when news is being interpreted. In this instance, markets reversed course quickly, incorporating the newly released information into prices.   
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Headlines often jolt us, perhaps even more regularly than we care to admit. Does fake news impact the market? The answer would have to be yes…but then again, all varieties of news from stone cold factual journalism to supermarket tabloids have an impact. It’s critical to remember that although noise exists, markets tend to get things right over time. We should use these cases as opportunities to reflect on the larger body of evidence that supports disciplined long-term investing over emotional short-term speculation.

Whether you’ve been investing for decades or are just getting started, at some point on your investment journey you’ll likely ask yourself some of the questions below. Trying to answer these questions may be intimidating, but know that you’re not alone. While this is not intended to be an exhaustive list it will hopefully shed light on a few key principles, using data and reasoning, that may help improve investors’ odds of investment success in the long run.

1. What sort of competition do I face as an investor?
The market is an effective information-processing machine. Millions of market participants buy and sell securities every day and the real-time information they bring helps set prices. This means competition is stiff and trying to outguess market prices is difficult for anyone, even professional money managers (see question 2 for more on this). This is good news for investors though. Rather than basing an investment strategy on trying to find securities that are priced “incorrectly,” investors can instead rely on the information in market prices to help build their portfolios (see question 5 for more on this).

2. What are my chances of picking an investment fund that survives and outperforms?
Flip a coin and your odds of getting heads or tails are 50/50. Historically, the odds of selecting an investment fund that was still around 15 years later are about the same. Regarding outperformance, the odds are worse. The market’s pricing power works against fund managers who try to outperform through stock picking or market timing. One needn’t look further than real-world results to see this. Based on research*, only 17% of US equity mutual funds and 18% of fixed income funds have survived and outperformed their benchmarks over the past 15 years.

3. If I choose a fund because of strong past performance, does that mean it will do well in the future?
Some investors select mutual funds based on past returns. However, research shows that most funds in the top quartile (25%) of previous five-year returns did not maintain a top-quartile ranking in the following year. In other words, past performance offers little insight into a fund’s future returns.

4. Do I have to outsmart the market to be a successful investor?
Financial markets have rewarded long-term investors. People expect a positive return on the capital they invest, and historically, the equity and bond markets have provided growth of wealth that has more than offset inflation. Instead of fighting markets, let them work for you.

5. Is there a better way to build a portfolio?
Academic research has identified these equity and fixed income dimensions, which point to differences in expected returns among securities. Instead of attempting to outguess market prices, investors can instead pursue higher expected returns by structuring their portfolio around these dimensions.

6. Is international investing for me?
Diversification helps reduce risks that have no expected return, but diversifying only within your home market may not be enough. Instead, global diversification can broaden your investment opportunity set. By holding a globally diversified portfolio, investors are well positioned to seek returns wherever they occur.

7. Will making frequent changes to my portfolio help me achieve investment success?
It’s tough, if not impossible, to know which market segments will outperform from period to period.
Accordingly, it’s better to avoid market timing calls and other unnecessary changes that can be costly. Allowing emotions or opinions about short-term market conditions to impact long-term investment decisions can lead to disappointing results.

8. Should I make changes to my portfolio based on what I’m hearing in the news?
Daily market news and commentary can challenge your investment discipline. Some messages stir anxiety about the future, while others tempt you to chase the latest investment fad. If headlines are unsettling, consider the source and try to maintain a long-term perspective.

9. So, what should I be doing?
Work closely with a financial advisor who can offer expertise and guidance to help you focus on actions that add value. Focusing on what you can control can lead to a better investment experience.

• Create an investment plan to fit your needs and risk tolerance.
• Structure a portfolio along the dimensions of expected returns.
• Diversify globally.
• Manage expenses, turnover, and taxes.
• Stay disciplined through market dips and swings.

410 days…That’s all it took to create one of the seven wonders of the modern world. Over 3,000 masons, architects, steelworkers, and skilled laborers worked together on the Empire State Building. For nearly forty years it stood as the tallest building on earth, an undeniable example of efficiency, produced through the collective use of knowledge. It’s a simple concept that can be applied to just about any industry and it underpins the basic idea of why markets work.

The functionality of financial markets, like any market, is based on open and ongoing participation in an environment where decisions are made based on an opinion of value. Market efficiency isn’t a new idea. The concept of exchange for equal or greater value is enshrined in our DNA. For every buyer, there must be a seller and vice versa. In order to execute a trade, each side has to at least initially feel like they’re getting a good deal. So, what makes markets efficient?

Decision Making: Groups Vs. Individuals
At any given moment, a single person acting independently is capable of making an uninformed decision. Individuals are at a distinct disadvantage in the decision-making process because they often draw conclusions from their own limited set of data. Groups on the other hand, while still capable of exhibiting poor judgment, are less likely to make mistakes due to the benefits of collective brain power. You’ve probably heard the old adage a thousand times “two heads are better than one.”
Financial markets operate on the same premise, acting at the will of millions of participants who make judgments through the active buying and selling of companies based upon massive quantities of information. In a sense, they’re voting with their dollars. The act of buying or selling effectively moves stock prices in one direction or another until it reaches an equilibrium. Therefore, the current price that a stock trades at should represent a good estimate of what that company is worth because it captures the sentiments of millions of buyers and sellers. 

The Judgment of the Masses is Hard to Beat.
Markets don’t trade on yesterday’s information, or even today’s. Alternately, they look toward the future, and trade based on the collective masses interpretation of tomorrow’s value. So, if two heads are better than one, millions of heads are most assuredly better than two. This is the main reason why stock mispricings are so hard to identify. A speculator would have to believe that they know something that everyone else doesn’t already know about a company because the current stock price is a reflection of all voting participants, i.e buyers, and sellers. In a world where news travels at the speed of light, what are the chances of that? Even if they did know something, and for argument’s sake let’s say a speculator was in possession of information that wasn’t already reflected in prices. What are the chances they can act on this information fast enough to benefit from any price change? In a 24-hour news cycle, it’s hard to keep much of anything a secret. As word spreads, the value of information is depleted by the second.

​With instant access to breaking news in the palm of our hand, information has never been so readily available as it is today. Collectively, the way we interpret information empowers us to freely evaluate the value of things, including companies we choose to invest in. In most every instance investors should operate under the assumption that prices are fair and accurate. Markets work because they are a global reflection of what we think works.

It will soon be the 10-year anniversary of when, in early October 2007, the S&P 500 Index hit what was its highest point before losing more than half its value over the next year and a half during the global financial crisis.
Over the coming weeks and months, as other anniversaries of major crisis-related events pass (for example, 10 years since the bank run on Northern Rock or 10 years since the collapse of Lehman Brothers), there will likely be a steady stream of retrospectives on what happened as well as opinions on how the environment today may be similar or different from the period leading up to the crisis. It is difficult to draw useful conclusions based on such observations; financial markets have a habit of behaving unpredictably in the short run. There are, however, important lessons that investors might be well-served to remember: Capital markets have rewarded investors over the long term, and having an investment approach you can stick with—especially during tough times—may better prepare you for the next crisis and its aftermath.

BENEFITS OF HINDSIGHT
In 2008, the stock market dropped in value by almost half. Being a decade removed from the crisis may make it easier to take the past in stride. The eventual rebound and subsequent years of double-digit gains have also likely helped in this regard. While the events of the crisis were unfolding, however, a future of this sort looked anything but certain. Headlines such as “Worst Crisis Since ’30s, With No End Yet in Sight,”[1] “Markets in Disarray as Lending Locks Up,”[2] and “For Stocks, Worst Single-Day Drop in Two Decades”[3] were common front page news. Reading the news, opening up quarterly statements, or going online to check an account balance were, for many, stomach-churning experiences.

While being an investor today (or during any period, for that matter), is by no means a worry-free experience, the feelings of panic and dread felt by many during the financial crisis were distinctly acute. Many investors reacted emotionally to these developments. In the heat of the moment, some decided it was more than they could stomach, so they sold out of stocks. On the other hand, many who were able to stay the course and stick to their approach recovered from the crisis and benefited from the subsequent rebound in markets.

It is important to remember that this crisis and the subsequent recovery in financial markets was not the first time in history that periods of substantial volatility have occurred. Exhibit 1 helps illustrate this point. The exhibit shows the performance of a balanced investment strategy following several crises, including the bankruptcy of Lehman Brothers in September of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year that it occurred or peaked.
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Exhibit 1. The Market’s Response to Crisis
Performance of a Balanced Strategy: 60% Stocks, 40% Bonds (Cumulative Total Return)

Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses immediately following most of these events, financial markets did recover, as can be seen by the three- and five-year cumulative returns shown in the exhibit. In advance of such periods of discomfort, having a long-term perspective, appropriate diversification, and an asset allocation that aligns with their risk tolerance and goals can help investors remain disciplined enough to ride out the storm. A financial advisor can play a critical role in helping to work through these issues and in counseling investors when things look their darkest.

CONCLUSION
In the mind of some investors, there is always a “crisis of the day” or potential major event looming that could mean the beginning of the next drop in markets. As we know, predicting future events correctly, or how the market will react to future events, is a difficult exercise. It is important to understand, however, that market volatility is a part of investing. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times. A well‑thought‑out, transparent investment approach can help people be better prepared to face uncertainty and may improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets. 

The Dart Board
Exhibit 1 shows the components of the Russell 3000 Index (regarded as a good proxy for the US stock market) as of December 31, 2016. Each stock in the index is represented by a box, and the size of each box represents the stock’s market capitalization (share price multiplied by shares outstanding) or “market cap” in the index. For example, Apple (AAPL) is the largest box since it has the largest market cap in the index. The boxes get smaller as you move from the top to the bottom of the exhibit, from larger stocks to smaller stocks. The boxes are also color coded based on their market cap and whether they are value or growth stocks. Value stocks have lower relative prices (as measured by, for instance the price-to-book ratio) and growth stocks tend to have higher relative prices. In the exhibit, blue represents large cap value stocks (LV), green is large cap growth stocks (LG), gray is small cap value stocks (SV), and yellow is small cap growth stocks (SG).

For the purposes of this analogy you can think of Exhibit 1 as a proxy for the overall stock market and therefore similar to a portfolio that, in aggregate, professional money managers hold in their competition with their simian challengers. Because for every investor holding an overweight to a stock (relative to its market cap weighting) there must also be an investor underweight that same stock, this means that, in aggregate, the average dollar invested holds a portfolio that looks like the overall market.[1]
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Exhibit 1.   US Stocks Sized by Market Capitalization

Exhibit 2, on the other hand, represents the dart board the monkeys are using to play their game. Here, the boxes represent the same stocks shown in Exhibit 1, but instead of weighting each company by market cap, the companies are weighted equally. For example, in this case, Apple’s box is the same size as every other company in the index regardless of its market cap. If one were to pin up pages of newspaper stock listings to throw darts at, Exhibit 2 would be much more representative of what the target would look like.
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When looking at Exhibits 1 and 2, the significant differences between the two are clear. In Exhibit 1, the surface area is dominated by large value and large growth (blue and green) stocks. In Exhibit 2, however, small cap value stocks dominate (gray). Why does this matter? Research has shown that, historically over time, small company stocks have had excess returns relative to large company stocks. Research has also shown that, historically over time, value (or low relative price) stocks have had excess returns relative to growth (or high relative price) stocks. Because Exhibit 2 has a greater proportion of its surface area dedicated to small cap value stocks, it is more likely that a portfolio of stocks selected at random by throwing darts would end up being tilted towards stocks which research has shown to have had higher returns when compared to the market.
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Exhibit 2.   US Stocks Sized Equally

​So…throw away?
This does not mean, however, that haphazardly selecting stocks by the toss of a dart is an efficient or reliable way to invest. For one thing, it ignores the complexities that arise in competitive markets.

Consider as an example something seemingly as straightforward as a strategy that holds every stock in the Russell 3000 Index at an equal weight (the equivalent of buying the whole dart board in Exhibit 2). In order to maintain an equal weight in all 3,000 securities, an investor would have to rebalance frequently, buying shares of companies that have gone down in price and selling shares that have gone up. This is because as prices change, so will each individual holding’s respective weight in the portfolio. By not considering whether or not these frequent trades add value over and above the costs they generate, investors are opening themselves up to a potentially less than desirable outcome.

Instead, if there are well-known relationships that explain differences in expected returns across stocks, using a systematic and purposeful approach that takes into consideration real-world constraints is more likely to increase your chances for investment success. Considerations for such an approach include things like: understanding the drivers of returns and how to best design a portfolio to capture them, what a sufficient level of diversification is, how to appropriately rebalance, and last but not least, how to manage the costs associated with pursuing such a strategy.
 
The Long Game
Finally, the importance of having an asset allocation well suited for your objectives and risk tolerance, as well as being able to remain focused on the long term, cannot be overemphasized. Even well-constructed portfolios pursuing higher expected returns will have periods of disappointing results. A financial advisor can help an investor decide on an appropriate asset allocation, stay the course during periods of disappointing results, and carefully weigh the considerations mentioned above to help investors decide if a given investment strategy is the right one for them.

Conclusion
So what insights can investors glean from this analysis? First, by tilting a portfolio towards sources of higher expected returns, investors can potentially outperform the market without needing to outguess market prices. Second, implementation and patience are paramount. If one is going to pursue higher expected returns, it is important to do so in a cost-effective manner and to stay focused on the long term. 

By now most informed investors are at the very least aware of the rationale behind index investing. It’s a simple argument really. Thanks to millions of buyers and sellers the market does a good job of translating information into prices. Indexers stay on the bench because they know the perils of playing the “find the next best stock” game.

The evidence for buying and holding the index vs. attempting to beat it is long and well founded. There’s nothing new to this argument and maybe that’s the point. It’s been made for over 40 years. Vanguard founder John Bogle is perhaps the most vocal and consistent messenger. In fact, I might argue that he’s saved investors more money than any single financial persona in history due to the size and scope of the company he built. Here’s the problem. Few index investors understand that the same academics responsible for its groundbreaking research, see it as the maiden version of factor based investing.

In the scientific community Eugene Fama is revered as the father of modern day finance. He won the Nobel prize in 2013, but he’s still probably not what you would consider a household name. His seminal work on market efficiency laid the foundation for the main argument that index investors make daily “It’s hard to beat the market…So just own it.

When compared to other scientific areas of study, it’s fair to say that modern day financial science is a newer discipline, coming of age when we first began tracking securities prices with the help of computers. The discovery that stock prices tend to follow a random walk theory, moving independent of trends, may have been one of the first transcendent ideas to come from this research. Now, over 50 years later we know much more about empirical factors that help to explain where investment returns come from.

In 1992 Fama, along with colleague Kenneth French went on to publish one of the most widely sourced academic papers in all of finance. The “Fama-French Three Factor Model” documented the historical evidence behind the tendencies for stocks to outperform bonds, small companies to outperform large companies and value companies to outperform growth companies. Since then, academia has continuously searched to identify ways to improve upon what we already know about the movement of prices. Momentum and other factors that have rigorous academic backing embody these efforts.
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In 2017 “objectivity” is the common buzzword that gets thrown around all too lightly. Choosing to build a market cap weighted index portfolio doesn’t strike me as an objective approach to portfolio management given the decades of research compiled since the efficient markets hypothesis.
 
Evidence and research aside, that doesn’t mean all strategies are created equal. The financial industry hasn’t done investors a lot of favors with the marketing of factor based investing and maybe that’s the reason it’s so grossly misunderstood. Smart beta, active indexing, and fundamental indexing are just a few of the invented alias’s. Any fund or strategy claiming the backing of empirical research should be carefully vetted for how the factor/factors are being targeted, fees and also how its inclusion interacts with the rest of the portfolio.      
 
It’s not bad or wrong to simply own the market, but I would argue that if you believe in index investing, you should believe in factor based investing if for no other reason than the initial architects of such research do. It represents the best empirical understanding we have of what drives investment performance. 

Should stock investors worry about changes in interest rates?
Research shows that, like stock prices, changes in interest rates and bond prices are largely unpredictable.[1] It follows that an investment strategy based upon attempting to exploit these sorts of changes isn’t likely to be a fruitful endeavor. Despite the unpredictable nature of interest rate changes, investors may still be curious about what might happen to stocks if interest rates go up.

Unlike bond prices, which tend to go down when yields go up, stock prices might rise or fall with changes in interest rates. For stocks, it can go either way because a stock’s price depends on both future cash flows to investors and the discount rate they apply to those expected cash flows. When interest rates rise, the discount rate may increase, which in turn could cause the price of the stock to fall. However, it is also possible that when interest rates change, expectations about future cash flows expected from holding a stock also change. So, if theory doesn’t tell us what the overall effect should be, the next question is what does the data say?

Recent Research
Recent research performed by Dimensional Fund Advisors helps provide insight into this question.[2] The research examines the correlation between monthly US stock returns and changes in interest rates.[3] Exhibit 1 shows that while there is a lot of noise in stock returns and no clear pattern, not much of that variation appears to be related to changes in the effective federal funds rate.[4]
 
Exhibit 1.     Monthly US Stock Returns against Monthly Changes in Effective Federal Funds Rate,
August 1954–December 2016

For decades we’ve known about the existence of factors that help to explain expected investment return. “Factor based investing” isn’t a new concept, but it is new to many investors. For one reason or another the terminology, which is widely recognized in financial academia, struggled to find mainstream adoption. Now, for the first time things are beginning to change. Unlike the relentless stream of jargon invented by the financial industry, factor based investing describes an investment approach that’s grounded in science, as opposed to many others which are created to support Wall Street sales pitches.

The easiest way to understand factor based investing is to first think about investment management in a very basic sense of either passive or active. The two styles occupy separate ends of a decision spectrum which represents not only the level of activity, but also the type of activity. Factor based investing really sits at the intersection of passive and active management, but in order to truly understand it, we must further define the opposite ends of the spectrum.

Pure Passive Index Investing
A pure passive approach applies the most simplistic form of expected return predictability. The goal is to closely track the market index in order to replicate its performance while mitigating as many fees as possible throughout the process. Basically, buy it and hold it forever with virtually no activity or human intervention.
 
The predominant passive indexing approach used today hasn’t evolved much over the last 40 years. Market cap weighting or cap weighted indexing assigns a company’s exposure in the index by its overall size in the marketplace. The number of outstanding shares times the share price gives us a company’s market cap, which is then used to determine what % of exposure it gets in the index. Therefore, the largest companies have a bigger impact on index performance than the smallest. For example: The S&P 500 index represents that largest 500 companies in the United States. Apple is just one company yet; it accounts for nearly 4% of the index.   
 
Conventional Active Investing
​Historically, we think about active investing in the context of predicting stock or asset class behavior based upon a number of fundamental or technical indicators. This type of forecasting places a high level of subjectivity in the hands of managers who are charged with making decisions that add value (or alpha as it’s known in the industry), above and beyond what the investor could have received had they invested in the passive index. The managers goal is to outperform. Doing so over long periods of time usually results in a fair amount of stardom and large fund inflows coming from return chasing investors.

Passive index style investing has seen a significant popularity growth in recent years largely due to the evidence suggesting a failure of speculative active managers. Yet, it’s inaccurate to portray inactivity as a sound investment strategy based on this fact alone. Our understanding of capital markets and the factors that explain investment return has evolved significantly since the advent of index investing over 40 years ago. Every time a decision is made to adjust a portfolio in some way, even if the decision is to simply rebalance, the investor makes an active decision to move away from the pure passive end of the management spectrum.

Factor Based Investing
​Factor based investing seeks to answer the question: What are the INTELLIGENT active and passive decisions that can be made to improve the risk/return profile of a portfolio?
 
This is where financial science comes in. Factor based investors believe in making decisions based on the evidence reflected in large amounts of historical data. The conventional active investor believes in the possession of a superior skill or intellect which can be used to outsmart the market by seeing things others have missed. The issue with a conventional active approach is that at some stage in the decision making process, the outcome must be interpreted as a reasonable guess, hunch, or gut feeling. In contrast, a factor based approach is always able to reference the historical data and only the data as evidence of rational, thereby removing much of the subjective human element from the decision making process.

Factor based investing positively pulls from both active and passive sides of the spectrum. Like passive, it strongly agrees with the idea that attempting to time the market is routinely impossible. Unlike a pure passive indexing, factor based investing recognizes the evolution in our understanding of capital markets and factors that help to explain investment returns. Thus, it actively structures investments in the optimal way to compensate investors for taking risks that are historically worth taking.

The supporting evidence
Factors such as the following help to explain the reward investors receive for the amount of exposure they maintain to the MARKET as a whole, VALUE companies, SMALL companies and HIGH PROFITABILITY companies. The data going as far back as the 1920’s is reveals these effects which exist not only in domestic markets as listed below, but also across geography and asset classes around the globe. As time elapses over different 1,5,10 and 15 year periods, we begin to see the undeniable effect.

Historical Performance of Factors over Rolling Periods

These examples make a strong case for structuring portfolios in a manner to target some specific factors. However, one point that’s often left out of the discussion is the importance of diversification. If the research is interpreted to suggest that due to the historical likelihood of value stocks outperforming growth and small to outperform large, a portfolio should therefore ONLY own small and value companies, it has been sorely misinterpreted. The diversification benefits of owning a large number of companies which fall across the growth, value and size spectrum, in addition to fixed income is of critical importance to most investors in order to reduce overall portfolio volatility.
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Research Pioneers
In its purest form factor based investing holds true to objective ongoing research that turns a blind eye to the name or even reputation of any single company. Pioneers of this movement such as Nobel Laureates Harry Markowitz, William Sharpe, Eugene Fama and Kenneth French are unlikely household names to the average investor, but they’re undoubtedly giants of modern finance. They, along with forward thinking industry titans like Vanguard’s Jack Bogle and Dimensional Fund Advisor’s David Booth have helped make the practical application of empirical research possible. 

The current level of activity and new product development has never been higher. Perhaps the most important thing to understand about factor based investing is that today’s research stands on the shoulders of yesterday. “Eureka” moments are few and far between with most new developments coming in the form incremental improvements to well-founded ideas. I would issue a word of caution, and even a healthy level of skepticism of the financial industry which regularly rushes products to market, citing new research, without fully understanding its validity. Remember, Nobel Prizes don’t grow on trees.

Factor based investing isn’t purely active and it isn’t purely passive but a marriage of intelligent research backed ideas from both disciplines. It’s about taking what financial science has given us, evaluating the strongest ideas and filtering through thousands of solutions to find the best translation of those ideas.

It used to be a strategy reserved only for the wealthy sophisticated few. Today, I can proudly say that with the help of firms like WealthShape investors from all walks of life have access to evidence based investment solutions that are built on reason, not speculation.

Since the 1950s, there have been numerous breakthroughs in the field of financial economics that have benefited both society and investors.

One early example, resulting from research in the 1950s, is the insight that diversification can increase an investor’s wealth. Another example, resulting from research in the 1960s, is that market prices contain up-to-the-minute, relevant information about an investment’s expected return and risk. This means that market prices provide our best estimate of a security’s value. Seeking to outguess market prices and identify over- and undervalued securities is not a reliable way to improve returns.

This long history of innovation in research continues into the present day. As academics and market participants seek to better understand security markets, insights from their research can enable investors to better pursue their investment goals. In this article, we will focus on a series of recent breakthroughs into the relation between a firm’s profitability and its stock returns. As we will see, an important insight Dimensional drew from this research is how profitability and market prices can be used to increase the expected returns of a stock portfolio without having to attempt to outguess market prices.

DIFFERENCES IN EXPECTED RETURNS
The price of a stock depends on a number of variables. For example, one variable is what a company owns minus what it owes (also called book value of equity). Expected profits, and the discount rate investors apply to these profits, are others. This discount rate is the expected return investors demand for holding the stock. The impact of market participants trading stocks is that market prices quickly find an equilibrium point where the expected return of a stock is commensurate with what investors demand.

Decades of theoretical and empirical research have shown that not all stocks have the same expected return. Stated simply, investors demand higher returns to hold some stocks and lower returns to hold others. Given this information, is there a systematic way to identify those differences?

OBSERVING THE UNOBSERVABLE: CURRENT AND FUTURE PROFITABILITY
Market prices and expected future profits contain information about expected returns. While we can readily observe market prices as stocks are traded (think about a ticker tape scrolling across a television screen), we cannot observe market expectations for future profits or future profitability, which is profits divided by book value. So how can we use an unobserved variable to tell us about expected returns?

A paper by Professors Eugene Fama and Kenneth French published in 2006[1] tackles this problem. Fama and French have authored more than 160 papers. They both rank within the top 10 most-cited fellows of the American Finance Association[2] and in 2013, Fama received a Nobel Prize in Economics Science for his work on securities markets.

Fama and French explored which financial data that is observable today contain information about expected future profitability. They found that a firm’s current profitability contains information about its profitability many years hence. What insights did Dimensional glean from this? Current profitability contains information about aggregate investor’s expectations of future profitability.

MEASURING PROFITABILITY
The next academic breakthrough on profitability research was done by Professor Robert Novy-Marx, a world-renowned expert on empirical asset pricing. Building on the work of Fama and French, he explored the relation of different measures of current profitability to stock returns.

Profits equal revenues minus expenses. One particularly important insight Dimensional took from Novy-Marx’s work is that not all current revenues and expenses have information about future profits. For example, firms sometimes call a revenue or expense “extraordinary” when they do not expect it to recur in the future. If those revenues or expenses are not expected to recur, should investors expect them to contain information about future profitability? Probably not.

This is what Novy-Marx found when conducting his research. In a paper published in 2013,[3] he used US data since the 1960s and a measure of current profitability that excluded some non-recurring costs so that it could be a better estimate for expected future profitability. In doing so, he was able to document a strong relation between current profitability and future stock returns. That is, firms with higher profitability tended to have higher returns than those with low profitability. This is referred to as a profitability premium.

Around the same time, the Research team at Dimensional was also conducting research into profitability. They extended the work of Fama and French and found that in developed and emerging markets globally, current profitability has information about future profitability and that firms with higher profitability have had higher returns than those with low profitability. They also found that this observation held true when using different ways of measuring current profitability. These robustness checks are important to show that the profitability premiums observed in the original studies were not just due to chance.

Their research indicated that when using current profitability to increase the expected returns of a real-world strategy, it is important to have a thoughtful measure of profitability that provides a complete picture of a firm’s expenses while excluding revenues and expenses that may be unusual and therefore not expected to persist in the future.

THE CUTTING EDGE: NEW RESEARCH
Many papers documenting profitability premiums globally have been written since 2013. An exciting forthcoming paper[4] by Professor Sunil Wahal provides powerful out-of-sample US evidence of profitability premiums. Wahal is an expert in market microstructure (how stocks trade) and empirical asset pricing.

Fama, French, and Novy-Marx’s research on profitability used US data from 1963 on. Why? Because when they conducted their research, reliable machine-readable accounting statement data required to compute profitability for US stocks was only available from 1963 on. Hand-collecting and cleaning accounting statement data and then transcribing it in a reliable fashion is no easy task and presents many a challenge for any researcher.

Wahal rose to those challenges. He gathered a team of research assistants to hand-collect accounting statement data from Moody’s Manuals from 1940 to 1963. By applying his (and his team’s) expertise in accounting, combined with a great deal of meticulous data checking, Wahal was able to produce reliable profitability data for all US stocks from 1940 to 1963. Using this data to measure the return differences between stocks with high vs. low profitability, Wahal found similar differences in returns to what had been found in the post-1963 period.

This research provides compelling evidence of the profitability premium pre-1963 and is a powerful out-of-sample test that strengthens the results found in earlier work.

THE SIZE OF THE PROFITABILITY PREMIUM
So how large has the profitability premium been historically? Large enough that investors who want to increase expected returns in a systematic way should take note. Exhibit 1 shows empirical evidence of the profitability premium in the US and globally. In the US, between 1964 and 2016, the Dimensional US High Profitability Index and the Dimensional US Low Profitability Index had annualized compound returns of 12.55% and 8.23%, respectively. The difference between these figures, 4.32%, is a measure of the realized profitability premium in the US over the corresponding time period. The non-US developed market realized profitability premium was 4.51% between 1990 and 2016. In emerging markets, the realized profitability premium was 5.21% between 1996 and 2016.

Most professions have a measuring stick to quantify a reputation or skill set. Medical degrees, law degrees and teaching certificates represent recognizable benchmarks for their professions. Our proud service men and women use a chain of command that instantly indicates their level of responsibility. So why is it so difficult to determine whether or not a financial advisor is worth their salt?
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The term “Financial Advisor” may very well be one of the most misrepresented professional titles. Reason being: Almost anyone can call themselves one. Don’t get me wrong, the financial services industry puts numerous exams and stipulations in place to license and track advisors, but just like any standardized test a passing score isn’t necessarily a great barometer for quality. According to WalletHub there are over 250 thousand advisors across the country. Thankfully, there are ways to help you to determine the background, experience and type of advisors out there.

Professional designations such as the CFP® (Certified Financial Planner), CFA (Chartered Financial Analyst®) and the already recognizable CPA, (Certified Public Accountant) give consumers a basic understanding of the training someone has endured. In any vetting process, educational background combined with a professional designation is one of the first things to look for. It’s not to say the absence of one is bad. I know many advisors who do a good job for their clients and don’t have letters after their name, which brings me to my next point.

Experience. Type can often be more valuable than tenure. While it’s comforting to see lots of years in the industry, that experience may not add up to a whole lot of knowledge. Here’s a shocker: Some financial services organizations allocate more resources to sales training than education.

A good way to decipher experience from fluff is to interview. Just like any job interview, pointed open-ended questions help to uncover details. What types of clients have you worked with? What is your investment philosophy and why? Situational questions such as, “tell me about the message you were sending to your clients back in 2008 and 2009 during the financial downturn,” provide a window into what the experience and expectations could look like.

Background. Finance is one of the most regulated industries on the planet largely because it involves money management. A background check is a great way to examine an advisor’s experience, licensing and whether or not any complaints have been filed against them. FINRA (Financial Industry Regulatory Authority) provides a great reference tool.
Hint: It will also help you to recognize the different types in the next topic.
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There’s a difference between suitability and fiduciary. Similar to the Hippocratic oath to do no harm that a licensed physician takes, a fiduciary is bound by law to act in your best interest. Believe it or not, this isn’t a requirement for most financial advisors. Reason being; if they sell commissionable products, the only obligation is to make sure that the product is suitable for the investor. The phraseology here is interesting. If you were to ask an investor which they would prefer: something that was in their best interest or something that was merely suitable for them, you would likely receive resounding support for the former.
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Consider the idea of a doctor being solely compensated based upon the treatments or medicines they recommended. The conflict of interest would instantly be apparent. Entering into an engagement with an advisor, whose compensation was based upon the commission from a product sale, isn’t a heck of a lot different from this scenario. The incentives often work in the opposite direction of what's in your best interest, even if they're trying to do the right thing.

As fiduciaries, Fee-Only Registered Investment Advisors receive zero commissions because the only product they have to sell is their expertise, something that is quantifiable and transparent, as opposed to sales commissions which are often wrapped into the complexities of a financial products expenses.

It’s important to point out the dilemma that Fee-Based Advisors face. Namely, when is it appropriate to sell products to a client based on a standard or suitability, and when is it appropriate to provide advice as a fiduciary acting in their best interest? Many see this as a contradiction. Why wouldn’t someone want to act in my best interest all the time? It’s the critical question that should be asked of every financial professional.

Hopefully this sheds some light on a confusing topic. A word of advice would be to know what type of advisor you are speaking with before you even interact with them. Due diligence up front is key because in a business populated by a litany of salespeople, judgment can sometimes get cloudy after a face to face meeting.

Financial professionals are always being mischaracterized partly due to an industry that intentionally blurs the lines. Most true Fee-Only Financial Advisors loathe being inadvertently called Brokers, and Brokers often do little to clarify that they aren’t actually acting in a fiduciary capacity. I’m not sure if we’ll ever get away from blanket terminology, but I am sure that individual investors are better served when they’re empowered with the knowledge to make informed choices.