"Today's investors find it inconceivable that life might be better without so much information. Investors find it hard to believe that ignoring the vast majority of investment noise might actually improve investment performance. The idea sounds too risky because it is so contrary to their accepted and reinforced actions."
So writes Richard Bernstein in his book Navigate the Noise.
Why the Noise?
At the time he provided this highly useful insight, Bernstein was Chief Investment Strategist at Merrill Lynch. What makes this a particularly interesting statement is that his then-employer (not to single out Merrill Lynch) is responsible for putting out much of the very noise Bernstein decries.
Many entities -- not just investment firms, but also magazines, broadcast media outlets, newsletter publishers and the financial media in general -- have a vested interest in investors becoming hooked on investment noise.
Why? Because greater traffic and attention helps drive their profits. The interests of the financial media are not necessarily aligned with the best interests of investors. The winning strategy for them is highly likely to be the losing strategy for you. What's more, there are far better and more important things to do with your time.
Below, we'll discuss areas in which paying attention to the noise can cause investors to stray from even a well-thought-out investment plan.
Diversification
Perhaps the most important, and most thoroughly understood, concept in the field of risk management is that diversification remains the best and simplest tool for reducing risk. Combining assets, or asset classes, where performance isn't expected to have perfect correlation can reduce the overall risk of a portfolio.
Paying attention to the often urgent noise of the moment, however, can lead investors to abandon their diversified strategy and chase the latest mania, be it social media, tech, biotech, bowling alleys (yes, there was a bowling alley bubble) or tulip bulbs. Investors also often make the mistake of believing that diversification works "by the numbers." Owning 10 different mutual funds isn't effective diversification if they all own the same group of U.S. large-cap growth stocks; that type of diversification only reduces single-stock risk.
Goal Setting: Stick to Your IPS
No good businessman would start a company without a well-thought-out plan. And no bank or venture capital firm would finance a business that didn't have one. Yet many investors begin investing without something similar. For investors, that "business plan" comes in the form of a written and signed investment policy statement (IPS) that articulates the goals and risk tolerances of the individual (or pension plan, profit-sharing plan or endowment).
The IPS should include both specific asset allocations and a rebalancing table. Most importantly, it should be signed by all the parties involved as a reminder that they have carefully thought out the plan and made a commitment to maintain the discipline required to stay the course. The plan should only be changed if the investment horizon shortens and/or risk tolerances and the need to take risk is altered due to life events (such as death, divorce, inheritance or job loss). Market noise causes investors to stray from their plan as they chase hot sectors, search for the next Google, or panic in down markets.
Risk Tolerance
Assessing one's ability, willingness and need to take risk is an important part of the IPS process. Paying attention to the noise tends to lure investors away from their carefully thought out and constructed plan. The noise can make investors think that an investment is less risky than it really is. The perfect example was the dot.com mania of the late 1990s. Many investors were so certain these companies would succeed that they threw caution to the wind, abandoning their plans and the concept of diversification of risk.
How to Screen Out the Noise: Invest by the Calendar
If you happen to be one of those investors who simply cannot tune out CNBC or other financial media outlets, I offer the following suggestion: make your investment decisions by the calendar. A good way to do that is to analyze your portfolio's actual holdings on a quarterly basis to make sure it is within the tolerance levels laid out in your rebalancing table.
A quarterly review is also a good time to check for any tax-loss harvesting opportunities. Asset allocation changes should only be made because rebalancing tolerance levels have been exceeded, or a life event has occurred that impacts your ability, willingness or need to take market risk.
The Bottom Line
Investors would do well to pay attention to the following statement by Jonathan Clements of The Wall Street Journal: "Investors spend an absurd amount of time trying to control the one thing they can do the least about, which is their raw investment performance. They attempt to pick hot stocks, find star fund managers and guess the market's direction. Yet it is extraordinarily difficult, if not impossible, to do any of these things."
Larry Swedroe is director of research for the BAM ALLIANCE. This article originally appeared on Mutual Funds.com.
Q: Does currency risk add value in the fixed income markets?
A: As interest rates on high quality bonds have remained relatively low, some investors continue to search for ways to achieve higher returns in the fixed income markets. One strategy that has been in the news frequently is the idea of purchasing non-U.S. dollar denominated bonds. The thought behind this is that taking on currency risk could potentially increase the return of a bond portfolio. The fixed income desk has looked into this strategy extensively, and when isolating for currency risk, returns do not increase, but volatility increases significantly.
The data below illustrates that a portfolio’s risk-return profile does not improve when currency risk is introduced to fixed income. When examining 25 years of data on both the unhedged and hedged versions of the Barclays Global Aggregate Bond Index, returns were essentially the same, while volatility was 42% higher for the unhedged index due exclusively to the currency risk. This leads to a significantly lower Sharpe Ratio (measure of risk-adjusted return) on the index that was exposed to currency risk.
Bottom Line: Adding currency risk to a fixed income portfolio only serves to increase volatility while providing no additional returns. If clients wish to increase the expected return on their portfolios we recommend doing this in a more efficient way by either increasing their overall equity allocation, or tilting more towards small and value stocks.
Data supplied by Barclays. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Total return includes reinvestment of dividends.
1. The Sharpe Ratio is a measure of the risk-adjusted return of an investment. A higher ratio indicates a greater return for a unit of risk. The Sharpe Ratio is calculated as the average annual portfolio return less the average annual risk-free rate (One-month T-bills) divided by the portfolio’s annualized standard deviation.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
There’s a powerful agenda behind the opposition to the rule proposed by the U.S. Department of Labor (DOL) requiring that advisors to retirement plans be fiduciaries: The securities industry wants to preserve its ability to give conflicted advice.
There’s a lot at stake.
Background Information
Fiduciaries are required to put the interests of their clients first. All conflicts must be resolved in the client’s favor.
Every registered investment advisor (RIA) is required by law to be a fiduciary. Brokers and insurance companies are not. As long as the recommendations they make are “suitable,” they can advise their clients to invest in higher-cost — and often higher-commission — investment vehicles.
I have never understood why retirement plan participants or individual investors would rely on anyone who didn’t agree, in writing, to place their interests first. I suspect it’s because most investors don’t understand the difference between the fiduciary and suitability standards. Brokers and insurance companies are not likely to educate them.
A Fiduciary Pledge
Here’s a simple way to test whether the advice you are getting is conflicted. Ask your RIA, broker or insurance agent to sign this basic fiduciary pledge. If they refuse to sign it, the advice you’re receiving may be conflicted. If you continue to do business with that individual, you do so at your peril.
Fiduciary Pledge
1. I will use my best efforts to act in good faith, with candor and always in your best interest.
2. I will proactively provide you with written disclosure prior to my engagement, and thereafter throughout the term of my engagement, of any conflicts of interest that will or reasonably may be considered to compromise my impartiality or independence.
Signed this _____ day of ______
Any RIA should be willing to sign this pledge. Most brokers and insurance agents will likely refuse to do so.
The Cost of Conflicted Advice
Providing conflicted advice — without disclosing the conflict — is big business. The securities industry is not about to give up the prospect of fattening its coffers at your expense without a fight. Its weapon of choice is the legislative lobby. By funneling vast amounts of money into these efforts, it hopes to influence members of Congress to block the DOL rule.
How profitable is the business of providing conflicted advice? Very.
One study examined data from the Oregon University system to determine the impact that brokers had on the choices participants in its defined contribution retirement plan made in their portfolios. The results were disturbing.
The study found that participants who relied on conflicted advice from brokers paid more in fees than participants who managed their own portfolios and underperformed self-directed participants by 1.54 percent annually. The authors of the study noted that their findings “highlight the agency conflict that can arise when unsophisticated investors seek investment advice from financial intermediaries.”
These findings are consistent with those of another recent study, which sought to discover why brokers recommend actively managed funds that “provide the same bundle of portfolio management and advice as broker-sold index funds, but earn significantly lower after-fee returns.” The authors conclude the most likely answer is “an agency conflict between brokers and their clients.”
Providing conflicted advice is both prevalent and lucrative. It also harms investors when their advisors recommend underperforming actively managed funds instead of lower-cost index funds with higher expected returns. By some estimates, the cost to investors in actively managed funds is a staggering $80 billion a year.
The Takeaway
Don’t believe the protestations of anti-fiduciary advocates that the proposed DOL fiduciary rule is “unworkable.” Implementation of this enlightened rule would stop the wasteful transfer of your hard-earned money from your pocket into that of your broker. The self-interest of the securities industry lies at the heart of its opposition to the rule. Your self-interest should motivate you to support it.
This commentary originally appeared July 7 on HuffingtonPost.com.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any links contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.