Make New Savings Very Aggressive, and Existing Assets Well Diversified
The first secret to be shared here is that your investment portfolio’s asset allocation is always recommended by these programs and advisors to be the same for new contributions to savings as for existing lumps you have at risk. I strongly recommend that new qualified plan and other new savings contributions be invested much more aggressively than existing lumps. This is because new contributions are periodic and (compared to your existing savings) small. There is relatively little each month or payday at risk and not for very long. Hence, you should be very aggressive with new savings dollars, but use the model’s recommended and more diversified asset allocation for existing account balances. Every quarter, treat the “new contributions” as if they are old. Rebalance existing (only) funds to the asset allocation that the model recommended (it gets out of balance anyway because some funds grow or lose at different rates, requiring your existing asset allocation to be rebalanced back to whatever the model recommended for you). This technique allows you to buy new shares of aggressive funds at the lowest average cost; you get more shares when the price is low, fewer of the expensive shares. But your existing larger balance—what you must protect and grow with care—is somewhat protected by being allocated per the software’s recommended efficient allocation.
Most planning firms and brokerages ignore this because they cannot model it, and because they dislike their potential liability for you forgetting to rebalance every quarter or so. They also dislike trying to decide which of the available funds in your employer’s retirement plan is the best aggressive fund to pick; this requires predicting economic conditions—but it’s their job to hazard that educated guess! Over time, this technique will almost certainly amplify your return without added risk to the main “old money” portfolio.
The Pursuit of Alpha
Frequently, alpha can be had for the more aggressive end of the investment spectrum. Where do managers fall on their faces consistently, indicating you should not use active managers but use index funds or direct security ownership? Below mid-range of volatility, where you would find blue chip stock funds, and certainly down into insured money market and medium-duration government bond funds. Also, common mutual funds with front-end, back-end, and level commission charges all fail to beat their benchmarks anything close to “most of the time,” but managed money is a different story. So here’s the secret: If your portfolio is large enough to devote at least $100,000 to an aggressive manager (the most common minimum), then have your broker use such managers for the “upper end” of your efficient portfolio’s risk profile, but use index funds and buy-and-hold individual securities purchases (discount commission!) for the lower, more conservative end.
Which brokerages can keep commissions down and still have enough “selling agreements” with management firms to find the best picks for you? Remember our discussion of Field Marketing Organizations (FMOs), those insurance brokerages that are big enough to find the most competitive insurance products and still have hundreds of active selling agreements with carriers? The same value effect that exists for the insurance world exists for the securities brokerage world. Big is always better because these brokerages employ teams and software to evaluate and contract a large range of the best money managers. Beware of the brokerage’s own-brand products and those of their subsidiaries, though. That is a fiduciary duty breach waiting to happen, and recently JPMorgan paid a $267 million SEC fine for doing that, plus a $40 million fine to the Commodity Futures Trading Commission in a similar case. Always ask whether the brokerage owns the carrier or money manager or fund family that you’re being offered.
These large brokerages have first-rate research departments for individual securities picks and for evaluating active money managers. I have the highest respect for Wells Fargo (after their recent house-cleaning), Ameriprise, and Merrill Lynch. Edward Jones, Schwab, and Fidelity also have fine platforms and well-trained human assistance, not that you should trade frequently. That is too expensive and puts a serious drag on your return. You should trade for long-term holds that are in an asset class that the analysis found necessary for some part of that portfolio. Active traders also lose out because they get fantastic advice too late: it takes too much time for a broker to digest the “big news” or a super tip and pass it to you. Plus, by the time of execution, the “great opportunity” security has already been bid up; the dog has already been bid down. The research your broker can give you that is worth the commission is for long-term buy-and-hold opportunities that fit your prescribed asset allocation, not some escalating new stock to sell off in a month or two.
What would be disadvantageous to buy from your stockbroker? Over the years, many people, used to buying and selling off securities from securities-focused brokers, have bought insurance products from those same brokers. These consumers then got rid of the products in a brief number of years, claiming that they did not fully understand a surrender charge or showing overall buy-and-sell pattern in broker advice. This, plus regulator intrusion, has caused these stock brokerages to broker only shorter-than-usual surrender charge pattern products. Their brokers are trained to tell you “shorter surrender charge is better.” But the carrier needs to plan on long-term investing in order for it to make long-term commitments of benefits and guarantees. Regulators and stock brokerages settled on maximum 5% surrender charge products, with five- or six-year patterns as the maximum. Here’s another secret: Carriers designed products for this restriction, but in every single case, these carriers offer lower value in some form to the policyholder for these versions of their regular products. The usual disadvantage I have repeatedly seen is that the shorter the surrender charge pattern, the lower the income produced from a given premium; there are other detriments, too.
Buy zero-insurance products from stockbrokers; buy money management from large stock brokerages; buy insurance products from large FMOs. It’s really that simple.Measures of Risk
Your broker or advisor will find an “efficient” portfolio, minimizing risk for a target return needed to reach your goals. However, you might want to understand the risk measures commonly measured and published for subaccounts of variable annuities (VAs), mutual funds, individual stocks and bonds, and even managed accounts.
These measures are available online and through the broker’s firm’s software for various periods of time (five-year histories are most meaningful if you want to get a feel for consistent performance). For some funds, these measures are hard to track if the managers “drift” in their risk profile allowed by the prospectus (they change how they invest, such as leveraging more some years or using derivatives more or less over time).
Beta is a measure of how much more volatile a fund is than the predominant benchmark(s) that characterize(s) the asset classes its manager uses; this is weighted for the fact that a manager may use more than one asset class, resulting in part of the portfolio being compared to one benchmark and another part being compared to a different benchmark. A beta greater than 1.0 means that the fund experienced more volatility than the market average for the asset classes being used.
How would you use this information? If the beta is higher than 1.0 but the return is just about the same as the benchmark(s), then the managers are taking more risk than is typical for the asset classes used but are probably failing to bring shareholders alpha to compensate for that extra risk, so check alpha next; it had better be positive, or the fund is not worth the risk incurred.
Standard deviation is a measure of volatility, positive and negative, around the trend line of return or appreciation for that investment. Some advisors like it better than Beta, but the decision point really should be “Is the manager beating the benchmark(s) used?” Standard deviation can be used to compare similar funds. If two funds with the same objectives and asset classes have differing standard deviations, then the fund with the lower standard deviation is the more predictable or consistent fund of the two.
The Sharpe ratio is, in my opinion, the best measure of a manager’s likelihood of future success. The Sharpe ratio combines the standard deviation with the “risk-free rate” (short-term government bonds) to create a measure of how well the fund achieved its return while keeping ahead of the risk-free rate. The benchmark is not examined, only the return achieved above the rate you can get without taking risk; you want it to be several times better than a risk-free return, right? The higher the better, and a negative number might indicate it’s a dog (unless all funds like it are also dogs that year, and then you would see merit in the least negative). You must compare several years of history for the fund’s Sharpe ratio, not just the prior year, to become confident that it is a meaningful predictor of continued strong and risk-minimized performance.
If your broker is uncomfortable discussing these measures for funds he or she recommended, then you likely need a new broker who monitors these measures to optimize your portfolio. Insurers use these measures to hire and fire money managers in their variable insurance and annuity products but you could monitor these data for a modest fee at Zacks.com; MotleyFool.com also has these data and more. Avoid the “You can become a money manager or options trader”-type ads, though—promise me that!
Asset Allocation Bottom Line
A landmark study of investment companies and asset allocation was conducted by Brinson, Hood, and Beebower (Brinson et ux 1986). It found that most of the time, only about 6% of your investment successes (or losses) are attributable to the management firms. Although an aggressive asset class and active management do help, the study found that most of the time, 93.6% of your return is due to the asset class allocation.
Also, keep in mind the danger of driving while looking in the rear-view mirror when selecting mutual funds. Past performance is not an apt indicator of future returns! Only a thorough study, including the management team and changes in it, leverage use versus not, and fees, will enable you to make a good decision regarding which mutual fund or family to use. Rely on the broker’s selection software; this has come a long way. Bragging rights may be real but are not the only factor. I especially advise against comparing successful funds to annuity or bank or bond rates. These are all very different products that have different purposes. This is apples to oranges, and each has a place in your portfolio.
This is also why the “robo” (or human professional using) software is crucial. If you have investable assets well under $100,000, you can get good, free advice from professionals who use typical assumed rates of return for various asset classes; the simple software is usually provided to representatives at insurance FMOs. But once you get beyond this point, you have enough to justify the more expensive analysis that includes Monte Carlo analysis and continuously updated databases that feed the asset allocation models.
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher. To read other articles of this book, click here. To buy this book, click here.
