Why You Should Want Your Advisor to Do Nearly Nothing

OK, your financial advisor should definitely do more than nearly nothing when servicing you. They should make sure you are invested using a strategy that is grounded in the fundamentals of proper asset allocation. They should help you accurately assess your ability to tolerate risk. They should educate you so you understand why you have made the decisions you have made. They should help you devise a written plan for saving during the accumulation period and managed withdrawals during retirement. They should hold your hand during periods when the market is volatile, guiding you away from making poor investment decisions driven by fear. Essentially, they should serve as the calm, confident, objective and impartial financial expert, making sure you have the best odds of achieving your retirement income dreams.

But when it comes to making buy and sell decisions for your investments, you want your financial advisor to largely leave it alone and only make adjustments when necessary. I'll use an analogy to explain why....

Your retirement portfolio is essentially the vehicle that will carry you through your retirement and provide your legacy to children or favorite cause, so let's compare it to a car. Let's say that you start with an extremely efficient well-oiled car that actually appreciates in value over time....basically this is where you would begin with a retirement portfolio invested using Modern Portfolio Theory. Imagine every time you visited a mechanic he had the next hot component or a major 'fix' for you to consider. Every change costs money and over time made your car less efficient, but there was a small outside chance these changes and 'fixes' would help the car appreciate faster than if the mechanic had just left it alone.

Your best chance of having the well appreciated car at the lowest cost is to have a mechanic that recommends only the periodic servicing and maintenance necessary to restore the car to it's original efficient well-oiled condition. Of course, the mechanic in this scenario represents the type of financial advisor you should be seeking.

There are two major reasons why advisors might not want to go down the road of minimizing adjustments to a portfolio. One, they may be compensated by the stocks or funds you buy in the form of a commission. So, they are paid to sell you something they deem suitable. If you make no changes, they get less pay. Two, they want to appear busy, appear to be 'earning' your money. Their afraid you might be thinking: "My portfolio hasn't changed in a while and I'm down 5% in the last six months. Shouldn't my advisor be doing something about that? What am I paying him for anyway?" The answer to that second question should be, you are paying them to prevent you from making a bad investment decision. It's easier for the advisor to say, "ok, you're down right now and this is what I'm going to do about it.", than it is for the advisor to say "ok, you're down right now and this is what you're not going to do about it."

To go back to the car analogy, imagine your efficient well-oiled car goes a little slower up large hills than other cars. You go to the mechanic to ask what you should do about it. The mechanic suggests you can change the fuel injection and add turbo boosters to increase the power....it will only cost you $2,000. You decide to do it and you are happy to climb hills with much more power than before, but you soon realize that you went from 45 miles per gallon to 15. Now you've added a continuous additional cost for the marginal benefit of climbing hills with greater power.

You call your mechanic to ask why he didn't stress the decrease in efficiency, but he's out of the shop enjoying a nice lunch on you.

M&M Theory

The day I first started learning about Modern Portfolio Theory and the Efficient Market Hypothesis I was sitting across the desk from Joe Madden, the President of Madden Funds Management, exploring the possibility of joining the Madden team. The pleasantries were behind us and we were now ready for a more substantive discussion. Joe contemplated for a moment, searching for the best way to unveil the fundamentals of their strategy to me. I'll never forget the four words he chose to start the conversation: "Brendan, markets are efficient."

Now, I have a background in statistics. I've studied and taught the subject. I had also used statistics in my professional career up to this moment, so his statement had a particular resonance with me. It took some time for me to more fully grasp the nuances of the strategy, but it was at that moment I realized I had been examining investing through an incorrect lens. This new lens made much more sense. Since then, I've been looking for ways to demonstrate why I believe the market is efficient, or at least highly efficient.

The answer: M&M Theory

At a previous employer, I was lucky enough to work under a truly gifted manager. One of his talents was building highly functioning teams. On the first morning of a 5-day sales training session, this manager began by placing a large glass bottle full of M&M's on the table in front of a staff of about 60 people. He asked each of us to make a guess sometime during the first 4 days as to how many M&M's were in the bottle. There were obviously hundreds.....

I think I was the only one who took a scientific approach to the problem. Apparently M&M's have a well designed shape in which they are able to occupy a great deal of the volume, leaving very little empty space. It has to do with the variety of possible orientations in which they can be situated. I found a university study on the Internet that examined the number of M&M's per unit of volume. The study came complete with an equation for me to use......all I needed was a value for volume. Fortunately, the bottle in question had the volume figure on the bottom, so I was able to confidently make my guess: 789

On the 5th day of the sales training it was revealed that the actual number of M&M's in the bottle was 782. I was happy with the result, but there was another closer guess. One of my colleagues had guessed 787. I asked him about it and he said he was just lucky and that he had simply guessed.

As I was an analyst for the business, my manager asked me to take all 60 guesses and calculate the average. The average was 784. Not only was the average of all the guesses only 2 away from the correct answer, it was closer than any individual guess. The point of the exercise was to demonstrate that as a group we were smarter than any one of us individually.

You might now be asking yourself, "What does this have to do with investing?"

In this example, the bottle of M&M's represents the true value of a company stock and the 60 people guessing represents the broad market of stock investors.

Let's take into consideration how the price of a single stock is determined. Imagine all the public information widely available and free flowing to investors this day in age. It's immense. Investors as a group take all the available information and begin to trade depending upon their evaluation of the value of a stock. In the first 3 months of 2008, The New York Stock Exchange reported 654.4 million trades across the 2,805 listed companies. This breaks down to about 3,762 trades per listed company per trading day. It is the buy/sell decisions of the investors on both sides of these trades that determine the price of a stock at any given moment.

It's important to note that for every seller there must be a buyer and visa versa. There is an equilibrium reached between the two groups. When new information becomes available (i.e. a new earnings report) this new information is quickly incorporated into the stock price as it again achieves equilibrium. So if a stock is valued at $10 dollars a share today, that value was determined by the investor group as a whole.....like the average guess of M&M's in the bottle, except on a much grander scale.

Hare investors are of the mindset that if they do enough research they will be able to capitalize on stock 'mispricings'. Essentially they believe that the market has inefficiencies that they would be able to use to their advantage. They may look at the stock valued at $10 a share and say, "I think it's really worth $12 a share." So they buy the stock. What they are really saying is, "I'm smarter than the thousands of other investors who have already collectively made their opinion known that the stock is correctly valued at $10 a share.

Tortoise investors believe that the market is highly efficient and that they would be better served working with the market as opposed to digging around to find situations where the market got it wrong.

Think of it this way, if you had to make the decision to guess every day for the next 30 years as to how many hundreds of M&M's were in a bottle where the number changed daily or alternatively accept the average guess of a large number of participants everyday for the next 30 years, which would you choose?

Switching Lanes

In the opening scene of the movie "Office Space" the protagonist Peter is stuck in traffic on his way to work. He watches the cars in the lane next to him move forward as his lane remains at a standstill, so he quickly changes lanes just in time for the free flowing lane to come to a complete stop. He then watches the lane he just left start to move. Again, his frustration gets the better of him and he decides to change lanes quickly back to his original lane....of course just in time for that lane to stop moving again. To punctuate the situation, he notices an elderly woman using a walker and moving at a relatively slow pace, pass him on the side of the road. The point is, he would have been better off staying in his original lane the whole time.

About 5 months ago a friend asked me to help him allocate his 401k. Like most 401k's he had about 15 mutual funds to choose from and I examined each of them with him. Now, I am a subscriber to Modern Portfolio Theory and the Efficient Market Hypothesis, so I had some rhyme and reason behind which funds I selected. I favored the funds with the lowest expenses and tilted the portfolio toward small cap and value funds. I helped him setup automatic rebalancing every quarter, and told him that he would probably only need to reexamine his allocation about once a year.

After 3 months, my friend called me and told me that he had just sold two of the funds I had helped him select. We were in the middle of a down market and he saw that these two funds were down the most since he had put his allocation together with me. He said, "I had to stop the bleeding." This thinking sounds logical, but essentially my friend was behaving the same way as Peter in the traffic jam example above.

The problem was the difference in our perspectives. My friend was focused on the poor performance of his portfolio over the last few months, where I was focused on the expected performance of the asset classes in his portfolio over the next 30 years. Even though he had no intention of making any withdrawals from his 401k anytime soon, he felt like he had to do something.

What my friend needed to understand is that there are going to be times when different asset classes in his portfolio are down, and those are not the times to sell off those asset classes. Instead those are the times where he could actually buy more shares per dollar than he would have before. For example, let's say that you invest $100 a month into your 401k, and you allocate 10% of your portfolio to a fund that is selling for $1 a share. That means every month you buy 10 shares. Let's say that the fund falls in price to $0.5 a share. Now your $10 dollars a month will 20 shares while the price is down. If you take the long-term view that the $0.5 price per share is temporary, you should take advantage of the low price while it lasts and accumulate as many more shares than if the price had remained the same.

Switching lanes based on recent performance, whether the recent performance is up or down, is a method of selling low and buying high. Not the best strategy for growing wealth over time, but this is the mentality of many hare investors.

Staying in your lane, taking advantage of times asset classes are down and periodically rebalancing is a method to systematically buy low and sell high. This requires discipline, patience and forward thinking....very much a trait of tortoise investors.

Does the Tortoise Investor Really Win the Race?

Aesop's fable concerning the race between the tortoise and the hare had always sounded unrealistic to me. How could the hare lose, really? This begs the question: In the case of long-term investing, is it true that the tortoise investor will win the race? The empirical data overwhelmingly suggests the answer is, Yes, most of the time. The masses want to dismiss the fable with regard to investing. The tortoise is slow and conservative and boring and the hare is quick and nimble and more exciting, essentially exchanging a smart and safer strategy for one that is speculative and more risky. To examine some of the reasons why the tortoise wins, first we must define attributes of a tortoise investor versus a hare investor.

Most investors today are hares whether they know it or not, simply by the investment options they choose to accept in their portfolio. A hare investor's objective is to beat the market, like it is some invisible adversary. Hares believe the market is relatively inefficient, creating opportunities to capitalize on security mispricings. The tortoise investor believes the market is a friend and highly efficient, meaning information is free flowing and widely dispersed, so security mispricings are rare and difficult if not impossible to capitalize upon. Tortoises strive to efficiently and reliably accept the returns the market provides.

Hare investors are more likely to move in and out of the market depending on the most recent forecast. Some hares use sophisticated computer models to look at different market cycles and trends to make buy and sell decisions, but many hares succumb to emotions such as fear and greed when making buy and sell decisions. Tortoise investors think the recent past is a poor predictor of future results and buy and hold investments for the long-run, transacting as little as possible. They are more likely to make decisions free from the emotions of fear and greed, relying more on future investment performance over the next decades as opposed to the performance of the recent past.

The biggest reason the tortoise wins is due to costs. It simply costs much more to try and beat the market than it does to accept market returns. A March 9, 2008 article in the New York Times written by Mark Hulbert entitled "Can You Beat the Market? It’s a $100 Billion Question" cites a study conducted by Kenneth French, a finance professor at Dartmouth, which concluded that in 2007 American hares spent over $100 billion in the effort to produce market beating returns.

Many former hare investors have caught on to the idea that a tortoise strategy will ultimately provide the best chances for winning results. In the same article above, Professor French calculates the proportion of the aggregate market cap invested in index funds (a tortoise strategy) has more than doubled to 17.9% from 1986 to 2006.

If you are a hare investor or think you may be a hare investor, you might want to reconsider the odds against you when racing against us tortoises.