A note on our "Passively-Active" investment strategy

While each client requires a unique investment strategy (based on circumstances, cash flow needs, capacity and tolerance to bear risk etc.), the underlying principles of that strategy are a result of our belief system. Our investment principles are based on our experience and education.  They are similar to the principles defined in the school of value investing, made famous by Benjamin Graham, and more modern investors such as Howard Marks, George Soros, Sit John Templeton and Warren Buffet.

In a world where conventional wisdom seems to be leaning toward a passive “set it and forget it” approach, we don’t believe our clients should be entirely married to the market.  Instead, we choose to chart an independent course, possibly even going against the grain of whatever trend is driving the market at a given time.

When you start out with a belief in a largely rational and efficient market where price fluctuations are random and unpredictable, the logical extension is an investing philosophy that mainly seeks to ride the stock market. In the words of John Bogle, the founder of Vanguard and an early advocate of passively managed index funds, the investor’s aim should be modest: to capture his or her “fair share” of the long-term rising tide of the stock market.

We (Grow), on the other hand, believe that market inefficiency and irrationality are far more prevalent than the EMH School acknowledges. Irrationality may not be the rule but it is hardly the rare exception. We contend that human psychology is a major factor in the ups and downs of the market—and is often the driving force behind the bubbles and panics that have created and then destroyed so much wealth in recent decades. While specific price fluctuations may not be predictable, the human response to them is predictably irrational.

Passive investing will leave an investor vulnerable to the manic-depressive mood swings of the market. We know it isn’t a good idea to try to forecast the market: but it is possible to take the general temperature of the market; to identify irrational herd mentality, and at the very least avoid the mistakes of others; and ideally, to profit from them.

Fundamentally Focused

There are two general approaches to outperforming the market on a risk-adjusted basis.  One is geared to the technical analysis of things like timing anomalies and the analysis of patterns and trends of price movements.  It is a study of the behavior of the market, not the merits of a certain investment. While there are some important insights that can be gleaned from technical analysis, it can all too easily lead to over-trading and to disastrous attempts to try to “time” the market, and we don’t have the interest or the capacity to employ such methods.

The other approach focuses on fundamentals, an assessment of the underlying value of a particular investment and the market. Its essence is simple: An investing decision must start with an assessment of the underlying or intrinsic value of a stock or other asset, and then consider that value in relation to its current price. For a variety of reasons (most of them involving institutional impediments to trading, human psychology and irrationality), an investment can at a given time be priced well below its intrinsic value. It is these undervalued assets that are our primary interest, because while irrationality can result in under and overpricing in the short term, the market will eventually reflect real value.

Effective Diversification

One of the central tenets of the modern investment theory is the importance of diversification.  The basic principle of diversification is not to put too many eggs in one basket: to spread risk across a variety of investments in order to reduce the negative impact of any single investment going south. There is considerable merit to the idea of diversification, and we don’t entirely dismiss it. But the more diversified a portfolio is, the more likely it is to mirror the market, and that isn’t always the goal. A broadly diversified portfolio is one without much concentration. And some of our clients, by contrast, may have a good deal of concentration in their portfolios.

While each client requires a unique strategy, we aren’t afraid to employ discipline and stick to highly selective, concentrated portfolios, with 10-15 individual securities, and 1-3 ETFs[1]. While we understand the benefits of concentration[2], that doesn’t mean we abandon diversification altogether. Regardless of how many securities a client holds, their investments are in different industries, sectors, geographic regions and operate under different political systems. The indisputable truth at the heart of diversification isn’t necessarily the number of securities held but the benefit of owning investments that respond differently to given market conditions.

Millennials have unique advantages and we take pride in our ability to identify and diminish the risks that harm Millennials most.  We like to say we "Millennify" our clients portfolio to the point where they are exposed to the risks that maximize return while being protected against the ones that don't. 

Long-Term Yet Dynamic Mindset

We believe in adjusting asset allocation (the make-up of a portfolio) in response to changing market conditions. More so, we do so in response to changing life conditions. Because your life and financial goals, and thus your asset allocation strategy, will go through different cycles over the course of your life, we will need to continually adapt your portfolio as needed. A designed portfolio will be different for a client with significant short-term cash flow needs than a client that’s simply hiring us to save for retirement.

We believe that fostering a “set it and forget it” mentality, can instill a false sense of security. While we consider ourselves “long-term” investors, we periodically take the “temperature” of the market and analyze what it means for our client’s portfolios.  If we sense extreme behavior, we will adjust our client’s portfolio accordingly (often by adjusting client’s allocation towards risky/low-risk assets).  We believe we can be prudent and responsible without locking ourselves into a rigid approach that doesn’t allow for flexibility and adaptability. Auto-pilot approaches tend to assume stable markets with a normal range of volatility, and that may or may not always be the case. Bear markets and bull markets demand different approaches and different kinds of asset allocation—and purely automatic strategies won’t allow us to adjust accordingly.

Most successful investors acknowledge that it is impossible to predict precisely when the market will swing one way or another. We agree.  Yet assessing the general mood can be very instructive—providing us clues as to when it’s a good time to be cautious and when the time is right to be more aggressive. Different market moods carry different risks.

Substantial and possibly permanent loss of capital is the greatest risk faced by any investor. Keeping this in mind, also realize that sometimes we win simply by not losing. If you’re down 10% one year and then up 10% the following year, you’re still behind. The bigger the loss, the harder it is to make up. A 40% loss requires a 67% gain just to come out even; a 50% loss, a 100% gain.

Yet, the next biggest risk for young investors is playing it too safe and remaining on the sidelines of the investing game.  Call it the risk of inaction. So, while not putting your money to work may appear to be a cautious move, it is in fact quite risky: you are putting your long-term financial security at risk.  While we must be smart about risk, we must take “some” to be compensated in return.

For clients that are investing a specific portion of their income on a period basis, the risk of “timing” likely isn’t significant until that client begins to generate a material amount of investable wealth.  Since we remain dynamic, our investment strategy will adapt as our client’s portfolio grows.

For client’s that invest a lump-sum of money, we exercise caution with putting that money to work.  We believe one of the secret weapons of great investors is patience: knowing when to sit on the sidelines and hold cash and liquid assets like short-term Treasuries.

Low Cost (Tax Efficient)

The reason that a smart investor can build long-term wealth is largely due to the miracle of compound interest: even modest returns can, over time, produce an impressive nest egg down the road. The self-reinforcing dynamic of compound interest is the basic building block of any sound investment strategy. But working against that strategy, and eating away at that building block, is the phenomenon of what we might call compound cost.

We do our best to minimize our client’s costs.  Costs relevant to individual investors include those from emotional trading, taxes, management expenses (from investing in passive or managed mutual funds and ETFs), bid-ask spreads and transactions.

But the biggest bite out of your investment returns is going to come courtesy of the taxman. Effective tax management is largely a result of optimal asset location: being mindful about which assets you put where. We think in after-tax returns and any asset that might expose you to a higher tax burden is termed tax inefficient and will be kept in a tax-protected account.

We limit transaction costs and minimize spreads by remaining true to our convictions and avoiding the temptation to constantly tinker with our client’s portfolios, in spite of the ups and downs of the market. We don’t engage in the losing game of overtrading. We don’t invest in expensive actively managed mutual funds or Separately Managed Accounts (SMA) unless there is a clear benefit for doing so.

Investment Process

Based on (but not exempt to) our client’s circumstances, cash flow needs, and capacity and/or tolerance to bear risk, we create an investment strategy based on a capital allocation to the following objectives.  Some investors might have all four objectives, and it’s a matter of which are more or less important. For other investors, one or two of these objectives will be dominant.

1. Preserving Capital for the Short-Term – This is likely to be part of the mix for all investors. We may recommend having three to six months of expenses available in assets that are both liquid and extremely low risk: cash, money market funds, short-term bonds, etc.

2. Preserving Capital for the Mid- to Long-Term – This might be money for goals that aren’t immediate but come with a relatively short time frame. (For example: a recently-married couple who wants to make a down payment on a house in five years.) This category might also apply to people with a decent nest egg who would like additional growth, but most of all want to avoid significant loss. Here, the objective is modest returns with low to moderate risk.

3. Accumulating Capital for the Long-Term – This is the “in it for the long haul” objective of most young investors.

4. Building a Fortune – There’s no getting around it: to build a fortune, to beat the market, you need to be willing to take some chances. A classically diversified portfolio built around mutual funds or ETFs won’t get you there. Investors who have successfully built a fortune do so by taking aggressive positions on individual stocks and have a portfolio characterized by a good deal of concentration. We’re often okay with our clients requesting to hold 5-10% of their portfolio for speculation purposes.  As mathematician and market strategist Nassim Nicholas Taleb says “be “90% accountant and 10% rock star”.

It’s important to note that very few of our clients goals will fall exclusively under just one of these categories. The typical young investor will have some stake in all four objectives. Your circumstances and investor personality will determine the exact mix. The other thing to note is that your mix of these objectives, your investor personality, will change and evolve over time.

Your “investor personality” is on some level a matter of what is commonly referred to as your tolerance for risk. But risk is a tricky and slippery concept and it’s important to define our relationship to risk in precise terms, based on personality and circumstances.

Risk tolerance is a useful notion—but should be seen as subjective and variable. It is largely a question of temperament, of your individual psychological make-up. To put it very simply: How well can you sleep at night when the stock market is going on a roller coaster ride? That quality varies from individual to individual and often depends on circumstances. In a bull market, for example, an investor might describe themselves as having a fairly high tolerance for risk. But, in a bear market, that same investor will give a very different answer. Risk tolerance, in other words, is subjective, individual, and often emotion-driven.

It’s good to know your psychological make-up and the degree to which you can or cannot tolerate risk. But, in most cases it is more important to understand your capacity for risk. Risk capacity is a much more objective question. Basically, it comes down to this: Given your current financial condition, your goals, and the time frame for those goals, how much risk can you afford to expose yourself to? For example, psychologically you may be very tolerant of risk— but if you’re hoping to buy a house in two years, your wife is pregnant, and you’re going to be the primary wage earner for a while, you can’t afford to adopt an investment strategy with too much risk of short-term loss. In other words, while you as individual might able to handle a good deal of risk, your real- life circumstances dictate a strategy with less risk and lower volatility.

Security Selection

Our client’s portfolios consist of but are not limited to the following types of securities.

Domestic Stocks – For most Millennial clients, stocks or equities should be at the heart of your portfolio. In spite of their short-term ups and downs, over the long haul they will be the real engines of building wealth. We’ll invest in them individually, through funds and ETFs, or a combination of these approaches[3]. U.S. domestic stocks will likely make up the bulk of most client’s equity holdings.

Foreign or International Stocks – Many investors are reluctant to stray too far from home and explore the international market. In the past, Americans had a good excuse for being highly concentrated in U.S. stocks. There were few affordable and accessible ways for the average investor to invest overseas; there were concerns about the financial accounting of foreign firms and it was more difficult to research distant markets. Now however, international accounting standards and a range of affordable options make it far easier for average investors to broaden their horizons.

There are a number of reasons for investing overseas. Many of the world’s fastest-growing companies are in other countries. And, although the U.S. still has the world’s largest economy, in 2014 it accounted for only 22% of global GDP, down from 33% in 2001. Most important, because foreign stocks respond to very different economic conditions abroad, they tend to be negatively correlated to domestic stocks, often moving in opposite directions. For example, while the U.S. stock market took a nosedive in 2009, emerging market stocks prospered in the years immediately following the financial crisis, meaning that a portfolio with a healthy dose of foreign stocks would have done a better job of weathering the storm. Conversely, foreign stocks lagged in 2014 while domestic stocks soared.

Bonds and Fixed-Income Securities – Fixed-income investments are used primarily to create a smoother return path (which aids the power of compounding).  Their negative correlation with stocks, and with one another make them useful for diversification benefits.

There are arguments to be made for the merits of corporate bonds, domestic and foreign, and for municipal bonds.  Some have made substantial profits in high-risk “junk” bonds. But it’s likely you are not going to build long-term wealth through bonds. Their purpose in your portfolio is to add stability and diversification. And, on those grounds, most experts agree that U.S. Treasury bonds offer the most reliable safe haven against the stormy ups and downs of the stock market[4].

While some experts lump all fixed-income investments together, we classify Treasury Inflation-Protected Securities (TIPS) as an asset class unto themselves, based on their very different relationship with inflation. Bonds have a unique connection with inflation. Assuming other factors stay equal, if inflation is higher than anticipated, bond performance will suffer, if it’s lower, bonds will thrive. TIPS, however, have exactly the opposite relationship, protecting you against higher than expected inflation. Therefore, a mix of TIPS and regular Treasury bonds in your fixed-income portfolio will help you weather economic and market downturns, and unexpected volatility with inflation.

Real Estate – Real estate is just one of many investments that fall into the broad category of commodities[5]. And while there are those who argue for the merits of investing in non-real estate commodities, and every few years someone seems to make a new case for investing in gold, the volatility and speculative quality of these assets makes them unsuitable, in our opinion, for the many investors.

Real estate—easily purchased through the pooled investment vehicle called a Real Estate Investment Trust, or REIT, however—is a valuable addition to any portfolio. It offers returns that are at times competitive with equities but with a low to moderate correlation with other assets. Moreover, it is positively correlated with inflation which makes it a good hedge against it. Finally, REITS are required to return the bulk of their earnings to shareholders in the form of dividends—which can either be reinvested or serve as a source of regular income.

Cash is often thought of as dead weight in an investor’s portfolio: money that’s just sitting there, under-utilized. In a low-interest environment such as the one we’ve experienced in recent years, cash (whether in savings or money market accounts) may fail to keep up with inflation and lose purchasing power over time.

Yet cash can come in handy as well. Cash might lose a small amount of purchasing power against inflation and it’s certainly not going to help you build wealth over time. But it will protect you against an investor’s biggest risk: the permanent loss of capital and it will allow you to invest a larger portion of money when investments are less expensive. During some periods, we may keep a substantial amount of cash reserves—not only to preserve capital but as spending money (dry powder) to tap into when bargains present themselves.

Keeping Score & Maintenance

What's not measured, can't necessarily be improved.  We follow a strict benchmarking approach that ensures short-term pressures don't create impediments to creating value for our clients.  

1. We measure the success of our strategies by the risk-adjusted performance of your portfolio as a whole over 10-year periods. We don’t get caught up in the short-terms fluctuations of individual holdings.

2. We don’t monitor your portfolio’s performance on a daily basis because we don’t want to get caught up in what we call the “noise” of short-term price movements, and the speculation in the financial press that goes along with them. Instead, we establish a schedule where we check your portfolio periodically.

3. We keep a long-term focus and stick to longer holding periods. Generally, it makes sense to hold a stock for at least 5-10 years and, in some cases, even longer. With value stocks in particular, it can take a while for the price to reflect underlying value, and we have to be patient.

A competent investment strategy needs to be dynamic and adaptable. In the world of investing, we call this “rebalancing” and the basic principle is fairly straightforward. Let’s say (to make things very simple) the asset allocation you’ve chosen for your portfolio is 70% stocks and 30% bonds. If over the course of the year your stock funds have gained 10% and your bond funds only 3%, your asset allocation will change as one piece of the pie grows faster than the other. As a result, your portfolio balance might have shifted to, 75% stocks and 25% bonds. (In the business we call this “portfolio drift.”) Rebalancing your portfolio would require us to sell off some of your stocks and reinvest them in bonds or another low-risk vehicle like a money market fund, bringing you back to your target 70/30 split.

If you have any questions or would like to find out more information, contact us here.

Jason Kirsch, CFP®

President, Grow, LLC