Overview

Deciphering and mastering the investment world can take a lifetime, but the difficulty is not due to what most people think. The problem isn’t about mathematics and intellectual genius, it’s actually about the years it takes to learn how to filter through the unnecessary confusion created by Wall Street marketing, Media nonsense, wishful thinking, deception, brief trends, and emotions.

In the end, the amount of knowledge the individual and professional investor needs to master is actually quite small. Below is a brief glimpse into key investment concepts that we hope you find of value.

Topics:

  • Risk Management
  • Market Sector Extremes and Underperformance
  • Investment Selection
  • Tax Efficient Investing
  • Wall Street and Media Influence
  • Asset Allocation and Market Trends

 

Risk Management

One of the more common mistakes investors make is to be stubbornly fixed to an investment style.  That means they are advocates of “Buy & Hold” investing, or “Active” investing.  At Leahy Wealth Management Group we feel strongly that both of these styles at times can be problematic for individual investors.

Fundamentally, this rarely discussed issue is mostly a problem of ideology.  Investors universally understand that diversification within a portfolio is an important aspect of managing risk.  Typically, they structure portfolios with a diversified mix of stocks, bonds, and cash – the problem is what many of them do next.  They then place the diversified assets into their ideological investment style (Buy & Hold, or Active) and often fail to appreciate the importance of diversifying between them.

At Leahy Wealth Management Group, we’ve found that individual investors are rarely well suited to be strict buy and hold investors, or active investors.  Moreover, from a performance perspective history clearly shows that neither of the investment styles should be solely relied upon.  Given this reality of performance and human nature we strive to diversify not only asset allocations, but also primary investment styles.

We ideally lean more in the direction of buy & hold, yet we know from years of managing money for real people that most investors are exceptionally vulnerable to feeling an instinctive need to act during unusual times of market turmoil like 2008.  Moreover, we feel there are ways to act intelligently during these times that may prevent clients from making costly mistakes while simultaneously meeting the need to act.

The result of  our approach are portfolios that tend to have significant core equity exposure managed with risk reduction trades during times that we identify as risky.  Our risk management focus is based on the long-term (not short-term trading) and we are most interested in unusual market sector extremes (discussed below) and the risk of near-term recession.  When risk indicators rise significantly we’ll advise a reduction in risk exposure.

In our experience, we feel this investment approach helps our clients better achieve long-term success, and inherently assists them with the most difficult challenge they’ll likely face - instinctive investment behavioral psychology - which is especially notable during market extremes in both positive and negative market cycles.

It’s important to emphasize that we are not short-term market timers, and that our approach is a big picture hybrid model.  Unless we identify a market sector extreme, or our recession indicators signal a high likelihood of a near-term recession, we’ll strive to remain invested through most dips and swoons.

 

Market Sector Extremes and Underperformance

The Boston based firm Dalbar conducts an annual study titled, “Quantitative Analysis of Investor Behavior”.  Their annual analysis has always come to the same conclusion, ”average individual investors realize a fraction of the annual total return of the S&P 500″, in both the year past, and the past 20 years.  According to Dalbar the underperformance conundrum is primarily do to “investor behavior.”

 “The investor’s chief problem – even his worst enemy – is likely to be himself.”

                Benjamin Graham

Why does the average investor perform so poorly? One of the most significant mistakes is the tendency to buy the hottest / best performing asset sector of the past few years.  Historically, as a sector experiences several years of above market performance, the media and Wall Street begin a steady drumbeat of enthusiasm that many investors (and their advisors) find hard to resist.  The longer the sector outperforms the more investors stampede to buy it.

Unfortunately, history clearly shows that an extended period of outperformance (above the market) by an investment sector will almost always be followed by below average performance, or significant losses, within a relatively short period of time.

What the Dalbar study illustrates most clearly is that the average investor underperforms because they get caught up in the extreme trends within the market. These extremes in performance at both the top and the bottom are where investors are most vulnerable to doing the opposite of what they should be doing.

In 1999, if an investor recognized the investment red flag of sector outperformance extending five years in tech and telecom they would have been exercising caution in those sectors, and likely avoided much of the losses in year 2000.  In fact, the  tech and telecom sectors lost over 70% from their 2000 market top.  To put that in perspective, consider that with a 70% loss you’d need a 233% gain just to get back to even.

The housing sector experienced broad market outperformance for five years, and then once again the pattern of outperformance proved ruinous.  You can study market history going back a 100 years, or more, and whenever you see the four or five year pattern of a sector with above broad market performance you’ll almost always see that sector experience significant underperformance in short order.

The time it takes to recoup from large losses is disastrous to investors, and it’s the reason Warren Buffet’s number one rule for investing is, don’t lose money.  His number two rule: Don’t forget rule number one.  For a related research article see: Mean Reversion and Equity Allocation

 

Investment Selection

Investment selection is where most investors make expensive and easily preventable mistakes.  Let’s consider a study from The Journal of Financial Planning titled, “Difficulty of Selecting Superior Performance.”

The study compared domestic large and mid-cap money managers with their respective index, and found that the mangers only beat the corresponding index (on average) a little more than 10% of the time during any ten-year period dating back to 1983. Furthermore, predicting in advance which manager would outperform was difficult, if not impossible, and the cost of selecting the “wrong” manager was high.”

At Leahy Wealth Management Group we take the above study and many others with the same end results to heart, and have been using Indexes and ETF’s as primary portfolio positions since 2002.  Ultimately, the investment selection process is based on odds, and when study after study shows that inexpensive  indexes easily outperform the average actively managed investment product then we would ask you to consider why anyone would buy a portfolio full of expensive financial products?

 

Tax Efficient Investing

Mutual funds and other structured investment products are very difficult to manage for tax efficiency, and likely should never be in one’s taxable accounts.  For example, you can own a mutual fund for a very short period of time, and if that fund distributes capital gains, even though you didn’t own the fund long enough to profit from those gains, you’ll still be liable to pay the tax.  That’s just one of the many problems in trying to be tax efficient with investment products.

On the other hand, Indexes and ETF’s are exceptionally well suited for tax efficient investing.  One of the most advantageous tax benefits of these vehicles is likely Tax Loss Harvesting.  Implementing tax loss harvesting and tax efficient strategies is an added effort, but as numerous studies over the years have indicated, it’s likely an important step to optimizing bottom line performance.

Tax loss harvesting may be especially beneficial during periods of extreme market events like years 2000, 2001, 2002, 2008, and 2009.

For research and articles of interest see: Active Tax Management Adds 2% Annually , Tax Loss Harvesting Tips , Tactical Tax Loss Harvesting  and  Keys to Tax Efficient Investing

 

Wall Street and Media

In the aftermath of the 2008 financial crisis one might assume that Wall Street would have been forced by consumers to change their ways, but unfortunately that’s not what happened. Today, front page financial scandals are just as common as always, and they consistently highlight the seemingly endless conflicts Wall Street has with their supposed customer.

Unfortunately, the data shows that the average investor is heavily influenced by Wall Street spokespeople and the media.  Moreover, the Dalbar study referenced above outlined the tendency of investors to chase performance, but what’s not discussed is that the media and Wall Street in general are major players in (knowingly or not) fostering a climate of confusion and bad advice.

Ultimately, the bottom line is that the centers of conventional investment wisdom have proven to be dangerous to investors financial health.  Given this reality, one of the primary objectives at Leahy Wealth Management Group is to provide our clients with consistent common sense insights to help them better cope with the counter productive Guru games and media dramas - especially during times of turmoil.

 

Asset Allocation

At Leahy Wealth Management Group we apply the concepts outlined above in our asset allocation models. The type of asset allocation that we practice is a combination of “Tactical Asset Allocation,” and the more widely used “Strategic Asset Allocation.”

With a strategic asset allocation model an investor’s risk tolerance is determined and then a fixed allocation of stocks, bonds and cash is assigned. The model is periodically adjusted so the asset weightings are very similar from one year to the next, this is a “Buy & Hold” model, and is widely used (or attempted) by many investors.

Tactical asset models (Active) work on the same premise except the asset weightings may be adjusted significantly from one year to the next, in other words, they are not blindly fixed. 

At our firm we ideally strive to be buy & hold investors, but if we identify a market extreme in a sector (4 or 5 year outperformance) we’ll avoid the sector, and if that extreme is significant enough we may allocate less to an entire asset category.  We also strive to identify recession risks, and if those risks become significant we’ll adjust client portfolios accordingly.

It’s important to note that we are not short-term market timers, and that our approach is a big picture combination model of both buy and hold, and tactical.

 

Market Trends

At Leahy Wealth Management Group we feel it’s important to try to assess the underlying long-term trend of the market.

Markets move in long-term trends called bull and bear markets. Pull-up a stock market chart going back 100 years and you’ll see the history of clearly defined bull and bear markets lasting on average 17 years.  These long-term trends are based on economic fundamentals and more importantly human nature.

Long-term bull markets, like 1982 to 2000, are marked by strong economic fundamentals and fairly consistent market performance.  After a market has done well for ten to fifteen years people gradually become conditioned to good performance and optimism. That conditioning usually lulls investors into a sense of security which leads to large scale risk taking. Both individuals and businesses tend to overextend during this period, especially in the sectors that have experienced the best returns, which eventually leads to a significant contraction - just like 2000.

Long-term bear markets are the same as the bull market just in reverse. Long-term bear markets are marked by weak economic fundamentals usually caused by the excesses of the previous bull cycle.  Bear markets are often accompanied by financial and political unrest, high debt loads, and a propensity for choppy economic growth and underlying pessimism.

It’s important to realize that during these long-term trends there are short-term cycles that run contrary to the underlying trend.  For example, during the 1982 to 2000 bull market the DOW went from 777 to 11,722, but there were four bear cycles (corrections) within the bull market that lasted on average 19 months, with losses on average of 27%.  The mirror opposite occurs during bear markets like the1966 to 1982 period when the DOW went from 748 to 777 (that’s right – 16 years of sideways movement), but there were four bull cycles within the bear market that lasted anywhere from 18 to 44 months, with gains on average of 42%.

History illustrates the benefits of identifying the long-term trend.  In fact, investors that recognized the 1982 to 2000 period as a long-term bull trend, and used a simple buy & hold index strategy outperformed most investors by a wide margin.  However, investors using the same strategy during a long-term bear trend have historically not fared as well.

It’s important to note that using market history as your oracle can be helpful, but every market period is unique in its own way, and past performance does not guarantee future results.  Different nuances will always exist, however, with that said, when it comes to the market (and extremes in particular) one of the most dangerous phrases in the world of investing is the old adage and familiar mantra from 1999 and 2007 “It’s different this time.

In Closing

For more insights please look at our 10 Reasons We’re Different.

Contact Us