Are Your Investments Doing What They’re Supposed To?

Paul Winkler: Welcome. This is “The Investor Coaching Show.” I’m Paul Winkler, talking about money and investing. We help you relax about money because the more you understand this stuff, the more you can relax, I believe, and not worry so much about if you are making the right decision or if something is in the right place or not in the right place.

I actually had a situation this week meeting with somebody for the first time. They came in and I got into a conversation with them and they said, “Hey, I’d like you to take a look at something that we’ve got going on. I just want to get your opinion on this.” And I said, “Sure, let’s take a look at it. Let me see what you’ve got going on.”

And he said, “Well, I’ve been dealing with this company for a long time, a big company.” Then I just kind of put it out there and said, “Hey, if it’s a really big company then they probably know what they’re doing.”

And I further said, “Yeah, that’s kind of what people tend to believe. If it’s a really big company, it’s a well-known company, they just know what they’re doing. And a person doesn’t have to worry about anything.”

But he said, “Yeah, I’ve been doing this for 20 years, and I just don’t feel like it’s done what it probably should have done over that period of time.” I said, “That makes you completely normal. That is a very normal problem that people have.”

Are Your Investments Doing What They Should?

Well, I haven’t talked about this for a while, but I think it’s probably high time to talk about this simply because there are a lot of people sitting there going, “I don’t know whether to think this is good or not.” And when you get into retirement, you need to know whether things are going okay or not.

And there’s water under the bridge in the past, as far as whether it did what it was supposed to do, but if it hasn’t done what it’s supposed to do in the past, you can probably look at it and see that it’s probably not going to do what it’s supposed to do in the future either.

So, there probably needs to be a change made, and it is worth looking at.

Investments need to do what they are meant to do.

What do you look at when you’re determining whether your investments are doing what they’re supposed to be doing? Well, there are a lot of things, but one of the first things I tell people to decide is: How much is in stocks versus bonds?

The first decision as an investor that you make is how much to have in stocks versus bonds. If I have a long time, then I can go a long period of time without worrying about having bad returns. I mean, let’s face it, you can go through market conditions where you go through long periods of time without returns.

Now, in the dead decade, from 2000 through 2012, people said they had no returns. I remember that was the verbiage that was used constantly. Obama, in one of his speeches, actually talked about the dead decade. And I thought it shouldn’t have been a dead decade.

Had you invested properly, there were areas of the market that did very, very well from 2000 through 2012. That was not a bad period of time in many areas in the market. But most people in America didn’t own those areas, so it was a dead decade for most investors.

So, the president of the United States said that and most people were sitting there listening to it and thinking they felt that pain and that what he described was what they went through.

A Lesson You Shouldn’t Learn

All the while, I sat there thinking, “No, that’s not what you should have gone through.” But there are periods of time where you can have a dead decade. I mean, we would have to go back to the Depression to find a period of time that was like that.

But if there is any period in history that can be like that, you make the determination that it can happen, so if it does happen, it doesn’t throw you for a loop. Because what are you going to do after 10 years, if you’ve gone through a period of time like the Depression and have had no return? What are you going to do?

Make sure the financial lessons you learn are the right ones to learn!

You’re going to do what people did during the Depression, which was bail out. They got out of the stock market. There were an entire generation of people that never got back in again, ever, because of what happened during the Depression. The lesson that they learned was the wrong lesson.

They learned that the stock market is no good and you should not invest in it. There are a lot of people that when it came down to what their kids inherited and their grandkids inherited, it was a fraction of what they should have inherited, a tiny, tiny fraction of what they should have inherited, because of the bad lesson learned during the Depression.

So, hence, you do look at this and you know whether or not you could handle going a period of time with no return. Recognize that it can happen so it doesn’t make you go, “Oh, the baby, let’s throw it out with the bathwater. It’s all bad.” No, if you knew that it could happen, then when it does happen, it’s not such a shock that you go and sabotage everything.

But in most periods in history, you don’t see where all stock portfolios had a bad return or a flat return like they did in the Depression. So, that would be one time horizon to look at.

Factors to Consider in Determining Investment Success

Another time horizon might be six to nine years. You could have a portfolio that’s 75% stocks. And you could have had a period of time of seven years where there was no return.

Now, if you didn’t know that going in with that type of an asset mix, if you didn’t know that could happen, when it does happen, what do you do? Again, you sabotage your portfolio.

So, knowing your time horizon is really important and knowing that your portfolio mix is dictated by the time horizon is valuable. Now, if you know that your time horizon is three to five years, you’re going to spend every dime of your money in three to five years.

You could have had about half stocks and half bonds historically, which was not unforeseen at that period of time, and had less than a flat return.

It could have happened that you’d have had a flat return over three to five years with a half-stock, half-bond mix. But it would be a very, very, very . . . did I say very? Yes, a very rare occasion.

Knowing what to look for and what to prepare for helps you maintain discipline.

So, knowing that going in is helpful for keeping discipline. So, I want to make sure you get that point right there. That’s the first thing. Stocks versus bonds, your time horizon dictates that.

Now, if we drill down a little bit deeper. If you look at an asset mix, now you say, “Well, wait a minute, I had a portfolio mix like that that didn’t have much of any return over the past 10 years.”

Well, there might be a problem. Because that period of time lasted 10 years, and that shouldn’t have happened.

So, you’ve got to find some other way of determining whether there’s something going wrong. You can’t just look at that time horizon because you quite frankly may not know whether the last 10 years or the period of time that we’re talking about was one of those periods where the returns should have been bad. You just don’t know that.

Another Method for Determining Investment Success or Failure: Benchmarking

So, there’s another thing that I teach people to help them determine whether everything is okay. It’s a little bit easier to actually use than that criteria of period of time with no return, because it is too hard to do that.

But that is something that it would take someone that really knows markets to help you through that first method of determining whether everything’s going is okay.

The second method is a lot easier and it is called benchmarking. Benchmarking is one of those things that you do where you compare different components of a portfolio to different areas of the market that they actually abide by or that they are comparable to.

The example I like to use when teaching this concept is crash tests for cars. Now, if I take two vehicles that are alike, I can compare them in a crash test and see how they do. I can look at a very small car and compare it to another very small car and go, “Okay, how did one car do versus the other?

The occupants of the vehicle in the first car would be decimated. The second one would’ve survived the crash. Okay, well, the second car is clearly better.” So, that would be pretty easy.

I can compare two bicycles and say, “How fast can I go on one versus the other?” But in comparing the bicycle to a motorcycle, that’s not a comparison. You don’t make that comparison because it wouldn’t make any sense or be helpful to you.

So, benchmarking is where you’re comparing similar things. What you do is ask: What’s an investment portfolio?

Well, an investment portfolio is, by definition, a collection of different investments. Now, a lot of people don’t think about this.

By definition, an investment portfolio is a collection of investments, with different components, factors, and expectations.

People just build a portfolio. They don’t think about what it’s made up of. It’s going to be made up of different components that have different return expectations.

A Look at What Has Happened Historically

For example, if I look at large U.S. stocks and I go back 70 years, I can see that large U.S. stocks have a good rate of return. If I look at that and compare large U.S. companies, big companies that are well-known and well-liked, to large, well-known international companies over the long run, lo and behold, the rate of return over that period of time, which is 70 years, is actually very similar. British large companies and U.S. large companies had very similar rates of return.

So, I can look at them and see that it would have been indifferent over the past 60 to 70 years to have had money in large U.S. companies or large international companies. Money would have doubled about every seven years on average historically in either one of them.

Every 7 years, if I look at 70 years, I mean, good grief, it doubled 10 times. A dollar went to $2, then to $4, then $8, then $16, $32, $64. And that’s only 6 periods that I just named.

And it was the same in either one of them. So, if you looked at it, you would have thought that they were both good.

Now, why would a person own both of them? And why would someone own them separately, more importantly? Why would you want to own U.S. stocks separately from international?

There will always be periods of time when owning one stock over another looks better, but the key is not to be fooled into only owning one over another.

Well, you will have periods of time, like recently, when the dollar strengthens. This is when U.S. stocks look way better than international stocks. Then you look at periods of time in the last decade where international trounced U.S. because the dollar was weakening.

Then you look at the decade before that and U.S. stocks looked really good. And the decade before that, international stocks looked good.

So, you look at them both and go, “Oh, they both have merit in the portfolio.” Why? Because they don’t move in tandem with each other and they do really well at different periods of time. So, I hope that makes sense.

Don’t Let Familiarity Control Which Stocks You Choose

Okay, so how do I judge how much to put in one versus the other? Well, a lot of times that judgment is based on the time horizon. It’s going to be well beyond what I’m going to talk about here.

But in general, I like to see a more even weighting between U.S. and international stocks than what I normally see. What I normally see is a way, way too much of an over-weighting in U.S. stocks.

It’s because we’re familiar with U.S. companies and we’re really comfortable with them, but if you go back some decades, there were periods of time where international companies did better for two decades.

Remember, I said that there were two decades in a row that international companies did better. Well, then I saw an over-weighting in international stocks.

Why? Because people look at recent past performance. They look at it and they think one fund did way better than another fund. So then they don’t want one fund because it did not do so well compared to the other fund.

It gets put in there and you don’t recognize that you’re over-weighting international stocks, which just happened to do better in a more recent period of time.

In the late 1980s, when I got into this business, I was taking my securities test and people around me, older guys in their sixties were saying, “Paul,” patting me on the back, “Congratulations passing your securities test. Don’t put your clients in any U.S. stocks. It’s not worth messing with.”

Don’t let the past performance of certain companies fool you.

Of course, they were dead wrong because the next decade, U.S. stocks did better. But what happened there? What were they thinking?

They were making the mistake that so often financial advisors make, which is looking at recent past performance. Past performance can go back for two decades.

You Won’t Know Ahead of Time What Will Happen

When we talk about market returns, I want as much data as I can possibly get. And it can happen that international companies will do better than U.S. or U.S. companies will do better than international companies in a certain period of time.

You won’t know ahead of time what is going to do better. It’s not that international or U.S. had no return, but that international simply did better. So, it wasn’t that it was the biggest mistake in the world to have U.S. in the portfolio during the 1970s and 1980s.

It wasn’t a huge mistake not having any U.S. in the 1990s, but it was a big mistake because U.S. did so much better. So, you look at this and see that you should hold both of these things.

Now, if I look at, remember I said, long-term, I look at the S&P 500 and ask what the return is of large U.S. stocks as measured by the S&P 500?

You’ll hear me say that if you look at longer periods of time, it’s about 10%, somewhere in that neighborhood.

If I look at my portfolio and ask what the return was over the last year, was it 10% the year before and has it been 10% so far this year, that will not help any, because large U.S. stocks won’t have that return. It just doesn’t happen.

You can’t predict when it’s going to be higher or lower than the 10% expected return. You hear me use that term, expected return. So, if you go back and ask, “Well, what would’ve happened in a year like 1976?”

If large U.S. stocks went up about 24%, S&P went up about 24%. What I would do is if I own a fund that is investing in large U.S. stocks, I would look at it to determine whether everything’s going the way it ought to be going.

Was my return 24%? That’s the question I ask myself. If it was, or if it was in that neighborhood, very close to that, I would say, “Okay, everything’s going okay.”

If You Gamble, You’re Sure to Miss Something

Now, the next year I would look at it and go, “Well, what happened in 1977?” Well, the S&P went down 7% and I would look at my fund or my investment that’s investing in large U.S. stocks that is like the S&P 500 and I would go, “I expect you to be down 7%. If you are not down 7%, then we have a problem.”

That means you gambled and maybe you had a worse return, but let’s say you had a positive return. That means you gambled and missed a downturn.

If you gamble and miss a downturn, you’re likely going to gamble and miss an upturn because nobody can time the market.

So, that’s how I determine whether everything went the way it was supposed to go.

In 1978, if I had bailed out, remember, I had a negative return in 1977. If I had bailed out, I missed about a 7% return positive the next year, and an 18% return positive the year after that and a 32% return the year after that.

So, if you look at that and go, “Wow, most of those returns were positive,” and I was walking you through the 1980s. Remember I said, the international actually did better than the U.S., but U.S. stocks weren’t terrible, as you just heard.

In reality, if I match those market returns and I know that through trying to pick stocks and time the market, the likelihood of beating that is pretty stinking slim, but I know if I match it, I’m in pretty rarefied territory.

What I mean by that is if you look at most professional managers, they’re not getting returns that are better than that. Since they’re not getting returns that are better than that, if I’m matching market returns, I’m probably beating somewhere in the neighborhood of 90% of professional managers.

A Quick, Helpful Tip

So, if I look at these big fund companies and when I look at the portfolio, I go, “Oh my goodness. This fund that they had you in underperformed the market by 5% or 10%.”

Now we know what the problem is on a micro level. I call this micro analysis because macro would be looking at the whole portfolio and seeing what happened over the period of time that you were there with that asset mix.

It’s a lot easier for you to start off and just look at what area of the market the fund is investing in. How do I know that?

One of the simple things that I tell people to do is to look at the fund benchmark, if you can find that. If you can’t find the fund benchmark, you can look at what’s called the style box.

It looks like a tic-tac-toe box and you’ll see a certain box is going to be filled in.

Now, this isn’t foolproof because you better know what you’re doing here. But for those of you that feel a little bit confident regarding this, I’ll just tell you quickly what it is.

You’re looking at the style box. And if the top three boxes are filled in, it’s probably focusing more on large stocks, large companies, in general. If the bottom three boxes are filled in, it’s small. If the far left-hand side is filled in, it’s value. If it’s the far right, it’s growth.

So, if it’s the top left, it’s large, because it’s the top. And if it’s at the left, it’s value. So it’s a large value.

This is something that we do with people when they first walk in the door, just to help them get an objective view on whether things are going the way they ought to be going. It is really the only way to objectively tell whether there’s a problem, because everybody’s going to tell you, “I’m a better investment manager than the person you’re working with.”

So, how do I know that?

If we look at the fund and see that the fund is actually capturing market returns then there may not be a problem.

That is the first step in determining whether things are going the way they ought to be going as an investor. That answers a very common question I often get.

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Historical Performance of Indices

Advisory fees charged to Paul Winkler Inc. (PWI) clients, whether directly or indirectly through a mutual fund, are described in PWI and Matson Money’s Form ADV Part 2A. Past performance is no guarantee of future results. Portfolios cited are PWI 60/40 diversified and 95/5% stock v. bond portfolios.

This Presentation includes historical performance information from various global stock market indices. Market performance information is included in this presentation solely to demonstrate the potential benefits historically associated with diversification of asset classes and does not represent or suggest results PWI would or may have achieved when managing client portfolios. Investors cannot invest in a market index directly, and the performance of an index does not represent any actual transactions.

Historical stock market information is derived from returns software created by Dimensional Fund Advisors LP (DFA). DFA is a registered investment adviser that, among other things, specializes in and sells statistical market research and mutual fund management. DFA obtains some of its market data from the Center for Research & Security Pricing (CRSP), part of the University of Chicago’s Booth School of Business (Chicago Booth).

Backtested Historical Performance

This Presentation includes historical performance information from various global stock markets and registered open-end investment companies or “mutual funds”. Some slides describe hypothetical portfolios that are derived from various market indices described more fully in the References to Indices section of the endnotes.

Why Does PWI Utilize Hypothetical Backtested Performance?

Slides that depict hypothetical backtested performance are used by PWI for pedagogical or educational purposes only and are intended only to demonstrate how the market (or various segments of the market) has historically behaved as well as the benefits of diversification. PWI also seeks to educate investors on the general strategy of focusing on capturing market returns, utilizing various asset classes to remain broadly diversified, and highlighting the benefits of eliminating stock picking, track record investing, and market timing. In some cases, PWI may utilize backtested historical performance to depict what the firm feels investors should seek to avoid (namely, stock picking, track record investing, and market timing). PWI does not configure, alter, or otherwise use hypothetical back-tested model portfolios in an attempt to artificially enhance or impair performance, does not link hypothetical performance with actual performance, and attempts to apply the hypothetical data based on objective criteria consistently applied throughout the presentation.

Limitations of Backtested Historical Performance.

PWI did not begin managing client funds until 1999 and any hypothetical portfolios utilized in this presentation (whether prior to this period or after this period) are not intended to and does not reflect the performance of actual account managed by PWI and do not represent any PWI-managed client portfolios. Back-tested performance has inherent limitations, including, but not limited to:

Each hypothetical portfolio or sample asset class mix shown was designed recently with the benefit of hindsight after the performance of the markets during the relevant time period was already known. Backtested historical performance do not show the results of actual trading by PWI of clients’ assets, nor are the returns indicative of PWI’s skill in managing a client’s account. No inference is made that clients would have had the same or similar performance results if PWI managed their assets for any part of this period. Because back-tested performance does not represent actual trading in client accounts, it may not reflect material economic and market factors, as well as the impact of cash flows, liquidity constraints, investment guidelines or restrictions and fees and expenses that would apply to actual trading.

Most presentations that utilize backtested historical performance will be used to educate investors on the general strategy of focusing on capturing market returns, utilizing various asset classes to remain broadly diversified, and highlighting the benefits of eliminating stock picking, track record investing, and market timing. This general strategy was available during most time periods, however, certain asset classes may not have been easily accessible by the average investor. Index funds were not available until the 1970s and access remained limited to retail investors until the 1990s.

Backtested results presented here assume that asset allocations would not change over time or in response to market conditions, which might have occurred in the case of actual account management. PWI asset allocations strategies have not changed significantly since the firm was created in 1999, however, there has been some updates as additional economic research becomes available, and new investment products make investing in certain segments of the market possible.

The annual return information of the hypothetical portfolios assumes the reinvestment of dividends, but does not include the deduction of fees or expenses which would reduce returns. Hypothetical or sample portfolio returns generally exceed the results of client portfolios managed by PWI due to several factors, including the fact that actual portfolio allocations differed from the allocations represented by the market indices used to create the hypothetical portfolios over the time periods shown, new research was applied at different times to the relevant indices, and index performance does not reflect the deduction of any fees and expenses.

Both the backtested hypothetical portfolios and PWI’s own asset allocation formulas may change as additional economic research becomes available, and new investment products make investing in certain segments of the market become available.

Hypothetical allocations do not include fees. Although the hypothetical portfolios are not intended in any way to be viewed as model performance of PWI, you should understand that actual client portfolios are subject to the deduction of various fees and expenses which would lower returns. For example, if a 2.0% advisory fee was deducted quarterly (0.5% each quarter) and your annual return happened to be 10.00% (approximately 2.0% each quarter) before deduction of advisory fees, the deduction of advisory fees would result in an annual return of approximately 8.0%, due, in part, to the compound effect of such fees. Advisory fees charged to PWI clients, whether directly or indirectly through a mutual fund, are described in PWI’s Form ADV Part 2A.

It is possible that the markets will perform better or worse than shown in the hypothetical backtested model, and that the actual results of an investor who invests in the manner PWI recommends may lose money.