Investment Planning Chapter 28 Tools & Techniques of Financial Planning Copyright 2007, The National Underwriter Company1 What is Investment Planning From.

Investment Planning Chapter 28Tools & Techniques of

Financial Planning

Copyright 2007, The National Underwriter Company 1

What is Investment Planning

• From a client’s perspective, investment planning is typically the main reason for consulting with a financial planner.

• Unfortunately, from a planning perspective, investments are normally the last step of the implementation process – after all of the other planning is complete.

• If investment planning leads the other decisions in the financial planning process, the entire plan is set up for failure.


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The Goal of Investment Planning

• Obviously, the goal of investment planning is to achieve an expected rate of return over a specified time period while minimizing the potential for loss.

• The client must understand what their investments must return in order to meet their goals. – They need to have a grasp of their current and projected

lifestyle as well as their ability to save. – Completing a multi-year, multi-scenario cash flow projection

with varying assumptions is the best way to fully understand the client’s situation and to pass that understanding on to the client.


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Six Steps in Investment Planning

There are six steps in the investment planning process:1. Ascertain the current and projected amount to invest

2. Determine the investment time horizon

3. Coordinate investments with risk tolerance

4. Select the investments

5. Evaluate the portfolio’s performance

6. Rebalance when necessary


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Ascertain the current and projected amount to invest• Some clients will already have a portfolio: In this

case, an asset allocation appropriate to their needs and risk preference must be designed.

• If the investor does not have enough saved to meet their needs, the potential investor must first make a conscious decision to save and invest rather than to spend.


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Determine the Investment Time Horizon

• Does the investor need to use some portion of the investable assets in the near future? – Is the investor buying a house, retiring, sending a child to

college?

• This will help identify the need for shorter-term investments in the portfolio or the ability to invest in longer-term investments that typically will yield a higher expected return.


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Coordinate Investments with Risk Tolerance

• In order to achieve a higher rate of return, the investor may need to be willing to accept a higher risk.

• Risk is simply the volatility of the investments. • Volatility has a dramatic impact on an investor’s ability

to reach his or her goals. The more risk inherent in an investor’s portfolio, the greater the potential for gains – but also for losses.

• Losses, even in one year, severely impact overall return. For example, a 100% gain in one year, followed by a 50% loss in the second year results in no gain at all.


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Selecting the investments

• Based on the information obtained in steps one through three, the planner can now begin the investment selection process.

• Care should be taken to ensure that the investments truly reflect the investor’s needs and risk tolerance.

• Asset allocation and portfolio management are covered in detail in Tools and Techniques of Investment Planning.


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Evaluating the portfolio’s performance

• Investment planning is a dynamic process, just like financial planning.

• However, outside forces have a material impact on the potential for success. – The economy, federal and international governments, taxes, etc.

all can change an investment from being suitable at one time to being completely against the investor’s needs or philosophy at a different point in time.

• Compare the portfolio’s performance to the appropriate benchmark. For example, a portfolio made up of one-half bonds and one-half equities should not be compared to the S&P 500 Index alone.


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Rebalance when necessary

• Rebalancing the portfolio is a process whereby investors are forced to sell high and buy low.

• A rebalancing program might call for the sale of equities (which have done well) and the purchase of bonds (which have not done as well).

• Because the economy is cyclical, an asset class that has done well in one year quite likely will not do nearly as well in the following year, rebalancing forces movement to account for the overweighting in the appreciated asset.


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Life Cycle Periods

Each person typically moves through five financial stages throughout his or her life, which are characterized by various issues and objectives that are distinct to each stage. As the financial planner reviews the following descriptions of these various life cycle stages, try to determine which stage best describes the planner’s or the client’s own situation.


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Early Career

• Early career – age 25-35a) Often newly married and

have young childrenb) Establishment of employment

patterns for one or both, spousesc) Accumulation of income for home purchased) Creation of college education funds for childrene) Accumulation of income/assets for starting one’s own businessf) Little consideration given to retirement planning, particularly in the

early years of this period


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Career Development

Career development – age 35-50a) enhancement of career, upward career

mobility, or rapid growth in income from profession or business

b) accumulation and expenditure of funds for children’s college education

c) integration of employee benefits with investment strategyd) employee-benefit coordination between spousese) retirement income planning (financial independence)f) purchase of vacation home, travel beginning of general wealth

building beyond basic objectivesg) geographic relocation


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Peak Accumulation

Peak accumulation – age 50-62 (approximately)a) Peak of career with possible lessening of work-related activities.b) These are the years for maximum wealth accumulation in

excess of needs for specific objectives.c) Basically a continuation of:

1. retirement income planning2. coordination of benefits from employment with investment strategy;

also integration for retirement planning3. vacation home, travel4. beginning of some reduced investment risk as portfolio begins to

emphasize income production for retirement (particularly near the end of this period)

5. concerns about minimizing income and taxes


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Pre-Retirement Years

Pre-retirement years – 59-70 (3-5 years prior to planned retirement age)

a) Winding down of career and incomepotential

b) Restructuring of portfolio to reduce risk and enhance income

c) Further tax planningd) Integration of plan-distribution

options with income needs and tax consequences


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Retirement

Retirement (age 62 to 70 onward)a) hoped-for enjoyable life style

b) adequacy of retirement income

c) preservation of purchasing power

d) new job (paid or volunteer)


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Investment Allocation Guidelines

A range of acceptable investment percentages are presented for each life cycle stage and are allocated to the following three broad investment categories:

– low risk, secure, and income-oriented investments

– medium risk, growth-type investments

– high risk, speculative investments

In addition, mutual funds are available that fit within each of these general classes of investments.


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Low Risk Investments

This category includes: – Savings accounts

– T-bills

– Money market funds

– Government bonds

– High-grade corporate bonds

– Participation certificates

– Similar types of investments


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Medium Risk Investments

This category includes:– Municipal bonds

– Convertible bonds

– Lower-grade corporate bonds

– Preferred stocks

– High-quality growth stocks

– Similar investments


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High Risk Investments

This category includes:– More speculative growth stocks

– Most real estate investments, REITs

– Options

– Commodities and futures contracts

– Similar types of investments


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Investment Allocations Percentages

Which investment percentage is chosen within each class should now depend on an assessment of risk tolerance and the investment horizon.


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Active Versus Passive Management

The Simple Logic of Active vs. Passive Investing.– Studies* have shown that over the long term, the average

actively-managed fund has underperformed its appropriate passive benchmark by about 1.8% per annum on a pre-tax basis (taking taxes into account would increase this figure to approximately 3%).

– Despite this evidence, the vast majority of individual investors invest in actively-managed funds.

– Only about 10% of all individual monies are currently invested in passive funds.

Note: There is some evidence that indicates that these studies were flawed because they did not take into account taxes due upon distribution and increases in return due to rebalancing. For a discussion of “closing the gap” on return, see a discussion by Alliance Bernstein Vice Chairman Roger Hertog and Alliance Bernstein Director of Quantitative Research Mark Gordon at https://www.bernstein.com/Public/story.aspx?cid=1222&nid=185. Be aware of possible bias since Alliance Bernstein is an active management investment advisor.


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• If “active” and “passive” management styles are defined in sensible ways, the following must be the case:1. Before costs – The return on the average actively-managed

dollar will equal the return on the average passively-managed dollar.

2. After costs – The return on the average actively-managed dollar will be less than the return on the average passively-managed dollar.


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• These assertions must hold for any and all time periods. Furthermore, their veracity does not depend on any sophisticated statistical or mathematical analyses or theorems, per se, but only on the laws of simple arithmetic.

A scholarly article that tends to refute this simplistic view is

Active versus Passive Management: Framing the Decision. By: Arnott, Robert; Darnell, Max. Journal of Investing, Spring 2003, Vol. 12 Issue 1, p31, 6p; (AN 9845319)

Once again, rebalancing is part of the picture. It is an interesting debate that still rages.


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Selecting the Market

• First a market must be selected – the stocks in the S&P 500, for example, or a set of “small” stocks. – Each investor who holds securities from the selected market

or asset class must be classified as either active or passive.


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Passive Investors

• Passive investors always buy every security from the market for their portfolios in the same proportion as the securities represent to the total value of the market. – In other words, they essentially own an index of the market. – Therefore, if security A represents 2% of the value of the

securities in the market, a passive investor’s portfolio will have 2% of its value invested in A.

– Equivalently, a passive investment manager will hold the same percentage of the total outstanding amount of each security in the market.


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Active Investors

• Active investors are other investors who are not passive.

• Their portfolios will differ from those of the passive investors or managers at some or all times. – Active investors or managers usually act on their

perceptions of mispricing in the market; because such misperceptions usually change relatively frequently, such investors and managers tend to trade relatively frequently.

– That is why they are called “active” investors or managers.


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The Simple Logic of Active vs. Passive Investing

• Over all periods of time, the market’s return will be a weighted average of the returns on the securities within the market. – Each passive investor or manager will earn exactly the market return

(before transactions costs) since they own all the securities in the same proportions as the market.

• From this, it follows by simple arithmetic that the return on the average actively-managed dollar must equal the market return.

• Why? The returns earned by the passive investors plus the returns earned by the active investors must equal the total returns on the market.

• If the returns earned by the passive investors on the portion of the market they hold equals the returns on the market, the average returns earned by the active investors on their portion of the market must also equal the market return.

• The market’s return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also. This proves the first assertion by using just simple arithmetic.


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• To prove the second assertion, simply consider the fact that the costs of actively managing a given number of dollars will exceed those of passive management. – Active managers must pay for more research than passive

managers, and must pay more for trading, too. • Security analysts, brokers, traders, specialists, and other

market makers all take a “cut of the action.” – Because active and passive returns are equal before cost,

and because active managers bear greater costs, it must be the case that the average after-cost returns from active management is lower than that from passive management.


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“Zero-Sum” Game

• Although the market as a whole is not a “zero-sum” game, active trading is a “zero-sum” game.

• Every gain by one market player who does not hold his proportionate share of the assets in the market is exactly and equally offset by losses by other market players who take the opposite position.

• And, since trading involves more transaction costs than a passive strategy, active management is actually a “negative-sum” game.

• On average, active traders as a whole must lose relative to passive investors after transaction costs.


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• Managers who appear to be passive may not be truly passive. – Some index fund managers “sample” the market of choice,

rather than hold all the securities in market proportions.

– Some may even charge high enough fees to raise their total costs to equal or exceed those of active managers.


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• Second, active managers may not fully represent the “non-passive” component of the market in question.

• Even if one accounts for all the active managers, that may still exclude active holders of securities within the market (e.g., individual investors).

• It is, of course, possible for the average professionally or institutionally actively-managed dollar to outperform the average passively-managed dollar, after costs. – For this to take place, however, the non-institutional, individual

investors must be foolish enough to pay the added costs of the institutions’ active management via inferior performance.


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• Third, and possibly most important in practice, the summary statistics for active managers may not truly represent the performance of the average actively-managed dollar.

• To compute the latter, each manager’s return should be weighted by the dollars he or she has under management at the beginning of the period.


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Active vs. Passive Investing

• Some comparisons use a simple average of the performance of all managers (large and small); others use the performance of the median active manager.

• While the results of this kind of comparison are, in principle, unpredictable, certain empirical regularities persist. – Perhaps most important, equity fund managers with smaller amounts of

money tend to favor stocks with smaller outstanding values.– Thus, de facto, an equally weighted average of active manager returns

has a bias toward smaller-cap stocks vis-a-vis the market as a whole. – As a result, the “average active manager” tends to be beaten badly in

periods when small-cap stocks underperform large-cap stocks, but may exceed the market’s performance in periods when small-cap stocks do well.


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Active vs. Passive Investing

• In both cases, of course, the average actively-managed dollar will underperform the market, net of costs.

• Thus, the average actively-managed fund underperforms the average passively-managed fund. – That means that over any given period about half of the

actively-managed funds outperform the average of actively-managed funds and a somewhat smaller percentage of actively-managed funds are likely to outperform the average of the passively-managed funds.


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Investing the Winners among Actively – Managed Funds• Mutual fund returns are notoriously inconsistent. This

makes it difficult to select those funds that will outperform going forward. – Investors cannot predict where a fund will rank next period

based on its performance this period, except to say that if it ranked in the top 25% it is very unlikely to rank there next period, and if ranked in the bottom 10% it is a flip of the coin whether it will still be there next period or not.


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More Considerations in Investing in Actively-Managed Funds• The worst funds are throttled by high fees and,

therefore, cannot gain ground.

• The high flying funds, on the other hand, are likely to be highly-concentrated and, therefore, annual returns will be volatile.

• Outperforming funds are also often flooded with new deposits, making those funds more difficult to manage.


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The Conclusion

• Investors have no way of determining which funds will perform well next year based upon their performance this year and, therefore, may incur significant underperformance risk by selecting actively-managed funds.


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Study of Odds

• The Winter 2001 issue of the Journal of Private Portfolio Management contained a study that looked at the odds of active managers outperforming passive managers or index funds.– The study looked at all 307 large-cap funds with at least a 10-

year history. – This methodology creates what is known as “survivorship bias”

in favor of active management. – Funds that perform poorly typically close because of

redemptions by investors, or they are merged out of existence by their sponsor.

• Thus their performance data disappears.


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Study of Odds (cont’d)

• The returns of the funds were then compared to that of the benchmark S&P 500 Index.

• Over the most recent 20-year period, the passive strategy outperformed over 93% of all surviving funds. – For the most recent 15-year period it outperformed over 99% of all

surviving funds. – For the most recent 10-, 7-, 5-, and 3-year periods, the passive strategy

outperformed at least 95% of all surviving active funds. – Finally, for the 61 rolling 5-year periods since the end of World War II,

the passive strategy outperformed at least half the active funds 58 times (95%). These results were all computed on a pre-tax basis. Based on historical data, it is quite clear that the results would have been even worse if the returns had been measured on an after-tax basis.


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Choosing the Simple Strategy

Investors in actively-managed funds were choosing the wrong strategy. Simply accepting market returns would have improved their collective results dramatically.


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Past and Future Performance

One example of the fallibility of relying on past success is the findings of William Bernstein.

– He examined the performance of the top 30 funds for successive five years beginning in 1970, and then compared their performance against that of the S&P 500 Index through 1998. Here is what he found:

– Never did the top performers from one 5-year period continue to outperform in the subsequent 5-year period.


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Past and Future Performance (cont’d)

– The top 30 funds from 1970 through 1974 went on to underperform the index by 0.99% per year.

– The top 30 funds from 1975 through 1979 went on to underperform the index by 1.89% per year.

– The top 30 funds from 1980 through 1984 went on to underperform by 2.75% per year.




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Past Performances do not guarantee Future Results• Past performance is simply not a good indicator of

future performance. – However, with so many active funds in play, some are likely

to be winners over any given time frame (and must be, if there are any losers).

– The evidence suggests that despite investors’ generally-held perception that skill is what causes the winning result, it appears to be much more likely that the winners are randomly generated and, thus, not likely to be repeated.


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Generate Superior Returns

• The conclusion to draw, once again, is that the prudent strategy – and the one most likely to generate superior returns – is the passive one.


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Take the Rest to Atlantic City

• Active management does, however, hold out the hope of outperforming other actively-managed funds and, certainly, passive investing. – This hope is what Wall Street and the financial press sell. – Unfortunately, the odds of winning the game have proven to

be so low that unless one attaches a high value to the entertainment aspect of the effort, then it does not pay to play.

– When one considers the additional costs of active management (the “vigorish” or “house take” as they call it in the gambling community), investors might be better off investing most of their money passively and then playing Black Jack with the rest of it in Las Vegas or Atlantic City.


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Active Management in Inefficient Markets

• The controversial “efficient market hypothesis” concludes that there is no point to fundamental or technical security analysis because all stocks are fairly priced. – According to this hypothesis, active buying and selling of

stocks adds no value – it just incurs additional transactions costs.

– Hiring a professional manager is even worse because of the fees required.


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Market Efficiency

• If markets are efficient, indexing becomes a better alternative. Most investors have come to accept that the big markets are pretty efficient, but what about the smaller markets and/or foreign markets? They cannot be as efficient as the big markets, can they?


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Identify Mispricings

• Perhaps not. However, for most investors, an “inefficient stock market” (i.e., one with frequent mispricings) makes the case for indexing even stronger.

• Assuming that in fact stock prices are sometimes wrong, at least in some markets, what does that imply about competition among investors attempting to identify these mispricings?


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How good are you at hitting the Bull’s Eye?

If the stock market is assumed to be a skill-based game, those with the skill and resources to identify and act on market inefficiencies will probably do well.

– Consider a dart-throw competition in which one gets a dollar for every dart one puts in the bull’s eye.

– Alternatively, instead of actively participating in the game, one can take the average score of those who do play the game.

• Passive investing is essentially the same as sitting on the sideline and taking the average score.


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Playing the game

• In this game, everyone who thinks they have lower than average skills should rationally choose to sit out and let the better players shoot. – They would do better by just taking the average of the better half of the

dart-throwers. – Of course, everyone who believes they are better than average has to

realize this is the rational approach for the bottom half in skill, so they must now assess whether they are in the top quarter of the top half in dart-throwing skill.

– That means that everyone who believes they fall below the top 25% in skill rationally should sit out.

– But then, of course, the top 25% rationally have to follow the same logic, so that only the top 12.5% actually throw the darts.


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Most active investors would be better off indexing

• Ultimately, if everyone behaves rationally, only the best player would eventually shoot and everybody else would get that score as well.

• Unfortunately, investors clearly do not see the logic involved in the dart game when it is applied to the markets. – In fact, they argue that in the markets where skill may actually be a

factor, active participation is the way to go. – The logical conclusion is that investors tend to be overconfident in

their abilities. • However, it is irrefutable that at least half of all active

investors would be better off indexing.


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Investing is a skill-based game

• As has been demonstrated above, more than half of all active mutual fund managers underperform the market. – This is often interpreted as proof of market efficiency. But

the fact is that mutual fund managers consistently underperform the market by more than can be accounted for by the extra costs of active management.

– This in fact is proof that investing is a skill-based game and that active mutual fund managers, as a group, have below-average skills.


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More difficult to pull off in small-cap and foreign funds• In the small-cap arena or in foreign markets, the

proportion of active investors outperforming a small-cap index fund or foreign index fund should be even lower, on average, than in the large-cap arena because active investing in small-cap and foreign equities involves higher transaction and research costs.

• This obvious logic and arithmetic, once again, contradicts conventional wisdom that active managers can do better in the less-efficient small-cap market. – However, the percentage of players that mathematically must

underperform any given index is dictated by the range of performance outcomes and active management costs, not the informational efficiency of the market that the index tracks.


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Who is more successful?

• Which investors or investor groups are most likely to be in the “successful” top group in terms of skills, information, or other competitive advantages? – Mutual fund managers, as a group are definitely not in the

top group. – Two other investing groups, insiders and hedge fund

managers, both of which have identifiable competitive advantages, are more likely candidates to be in the top group.

• And yet there is no empirical evidence suggesting that even these groups can consistently outperform.


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Win more often in investing passively

• So on what possible grounds could virtually any individual investors feel they actually had a competitive advantage or above average skills in the large-cap market, the small-cap market, foreign markets, or any markets? Why play a game in which one’s competitors have an advantage, if one can win more often than not by staying out of the active game and taking the average result by investing passively?


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Indexing is better if the market is not efficient

• Once again, the conclusion is the same, even though the underlying assumptions are quite different.

• If prices in a market are not efficient and investing is a skill-based game, then low-skilled investors will consistently lose to players with a competitive advantage.

– If, on the other hand, one assumes that a market is perfectly efficient, then the less-skilled players have the same less-than-even chance of beating the index as everyone else.

– Market efficiency protects the less-skilled players from routinely making bad investments.

– There is no such protection in an inefficient market, and so the active investing majority that underperforms the index will tend to be the same every year.

• The argument for indexing is even stronger for most investors if the stock market is not efficient.


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Investors are Not Always Rational

• More than half of all active investors, whose only financial justification for being active is beating the index, must fail in that objective each year.

• Although when it comes to the logic and arithmetic of investing, investors’ behavior suggests they may tend to over-represent the bottom half of that distribution.


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Tactical Asset Allocation and Market Timing

• This question is constantly debated. However, the overwhelming evidence is that even professional market timers cannot consistently outperform the market.

• Market timing, like all active management strategies, is a “zero-sum” game whereas investing in the market as a whole is a “positive-sum” game, as described above.


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Timing reduces risk

• The argument is sometimes made that timing reduces risk, since one is invested in cash or T-bills a portion of the time and in the market the rest of the time. Since T-bills are less risky than stocks, the argument goes, the overall risk is lower.


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Gains made during short periods

• The fallacy here is in failing to account for the risk of missing the big gains in the market.

• Most of the gains in the market are made during relatively short periods surrounded by long periods of relative stagnation.


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Monthly Stock Returns

Figure 28.2 shows monthly stock returns from 1926 through 1987 on S&P 500 and small-cap stocks. All of the return for S&P 500 stocks occurred in just 6.7% of the months; for small-cap stocks, just 4% of the months account for all of the return over this period. Only 3.5% and 2.3%, respectively, of the months accounted for all of the return in excess of T-bills. In other words, if one were invested in the market 96.5% of the time, but one were out for the months of greatest gain, one would have done no better than investing in T-bills.


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Cost of not being in the market

A similar study of the bull market from 1982 to 1987 gave similar results, based on days, rather than months in the market. This study showed that if one missed just the 40 biggest days, or just 3% of the 1,276 trading days of this bull market, one would have missed 83.7% of the market’s 26.3% annual compounded return over the period.


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Invest for the Long Term and be in the market consistently• Clearly, the risk of not being in the market when it

makes its run is very significant, and conveniently overlooked when the market timers try to sell their concept.

• The best advice is to invest for the long term and be in the market consistently.

• No market timer can claim to be accurate over 80% of the time, so timing will inevitably lead to cases where the big market runs are missed.

Investment Planning Chapter 28 Tools & Techniques of Financial Planning Copyright 2007, The National Underwriter Company1 What is Investment Planning From.

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