Investing for the Long Haul
When you invest according to our advice, you’re unlikely to ever have a quarter or year when you get sky-high returns, far above the market average; but you’re just as unlikely to ever have a quarter or year when your portfolio crashes and burns, significantly underperforming the market average. This is because we insist on a patient, disciplined approach to investing called asset allocation. We don’t believe it’s possible to consistently time the market, trying to outsmart all the other professional investors by picking the low points to buy at and high points to sell at. We don’t believe it’s possible to consistently figure out where a stock is going based simply on where it’s been recently (technical analysis); too many random and unexpected factors can influence the price. Nor do we believe that it’s possible (even though it once may have been) to identify quality stocks that are undervalued, and buy them for the long haul; too many people with too much information are trying to do this, meaning that if there is a good stock that is undervalued, it won’t stay that way for long.
So what do we do? Just give up? Not quite. Our approach is called Strategic Asset Allocation, a passive management strategy that is very effective in helping you maximize your return and minimize your expenses for whatever level of risk you choose. That all sounds rather fancy and complicated, so let’s break it down.
Efficient Market Theory
At Covenant Investment Advisors, LLC, we adhere, at least generally, to what is known as Efficient Market Theory. This theory has argued, and substantiated by years of evidence, that any relevant information about a security is so quickly transmitted in the marketplace, and so quickly reflected in the price of the security, that the vast majority of analysts and traders are unable to profit from it. It is almost impossible to find a “great buy” on an individual security, because if it really were a great buy, odds are that someone else would’ve already gotten to it first. And if you think you’ve identified just the right time and price to sell a security, odds are you’re wrong, because other folks would all be selling it and driving the price down if it really were the best time to sell.
The common half-joking illustration of this theory is that of finding a $20 bill on a crowded sidewalk: it must be a fake, because if it were real, someone would’ve already picked it up. Of course, just as this illustration is not quite true, the Efficient Market Theory is not quite true. It is possible, by careful analysis and shrewd timing, to outsmart the market, but only very occasionally. And unfortunately, though there are a few expert money managers who can do it consistently enough to make a worthwhile return, as always, there is no free lunch. By the time you’ve paid the fund for its services, whatever bonus return it may have been getting for you has evaporated.
Failure of Active Management
Indeed, the failure of actively-managed mutual funds is hardly a secret in financial literature today. Studies have shown repeatedly that, in any given year, the average actively-managed mutual fund will underperform the S&P 500. And while, of course, many funds will outperform that year, studies have also shown that this year’s outperformers will more than likely be among next year’s underperformers. More importantly, while a very few funds will consistently outperform, there is no reliable way to identify ahead of time which they will be. Why such consistent failure on the part of today’s best money managers? Well, one of the main reasons was already mentioned above—expense ratios. The average mutual fund actually needs to outperform the S&P 500 by about 1.5% a year (a hefty margin since the average market return is about 10%) for its investors to simply match the S&P, because the mutual fund charges all its investors roughly 1.5% for expenses. Moreover, because of the frequent trading that their complicated strategies require, these funds incur considerable commissions and other transaction fees, as well as an increased tax burden (since short-term gains are taxed at a higher rate). These additional burdens make it almost impossible for a mutual fund to offer its clients a return that consistently exceeds the general stock market return.
The Solution—Passive Management
A rather obvious solution to this problem presents itself—if you can’t consistently beat the general market return, then why not settle for the general market return, and consistently beat what most actively-managed portfolios are getting? This approach, known as indexing, is being followed by more and more institutional investors today. The idea is to invest in a mutual fund that simply buys and holds a portfolio that is essentially identical to the makeup of the S&P 500 Index (or whatever index you want to mimic, for that matter). The result: very low transaction costs, tax exposure, and expense ratios, and thus a return for the investor that is very nearly equal to the general market return.
Many investors, at this point in the discussion, will be feeling a bit deflated. So the best we can do is simply match the average return and risk profile of the general stock market? It’s better than falling short of the average, but one certainly wishes there were something better.
Asset Allocation—You Can Have Your Cake and Eat it Too
Thankfully, there is something better—asset allocation. See, the thing is that indexing can be used to align your portfolio with any class of securities you want—you can invest in a Bond Index Fund (short-term, long-term, corporate, sovereign, you name it), a European Stock Index Fund, a Large-Cap Stock Index Fund, a Precious Metals Index Fund, and so on. And the nice thing about all these different sorts of assets is that they tend to perform differently at different times. Normally, these various asset classes will tend to be moving in different directions at different times. Perhaps the Bond Fund and the Precious Metals Fund will be moving up, while the European and Large-Cap Funds will be moving down, and vice versa. When your portfolio is carefully and strategically allocated among various asset classes like these, your risk can be greatly reduced for any given level of return. Moreover, your overall return can actually be improved at the same time, because maintaining a balanced ratio among these asset classes in your portfolio will mean buying more of the cheap ones and selling more of the pricey ones.
Asset allocation is an extraordinarily flexible tool, and, though nothing is ever a sure thing in this business, it can be used to rather accurately determine the expected risk and return characteristics of a portfolio. At Covenant Investment Advisors, we can research and recommend the right allocation of different asset classes within a portfolio, based on each client’s growth and income needs and risk tolerance.
History and Common Sense
One other thing that we care a lot about at Covenant Investment Advisors is history. Investment professionals are in the business of trying to figure out the future, not the past, but in general, what’s happened in the past is the best guide to what’s likely to happen again, and the mistakes that have been made before can warn us against making the same again. Until very recently at least, it was common knowledge that the stock market pretty much goes up and up at a rate of about 12% a year, and that real estate prices always go up as well. But a simple study of history could have shown that both of these assumptions are quite false. At Covenant Investment Advisors, we rely on a thorough study of financial market history to make the most reliable judgments about what returns and risks we can expect in the future. Sometimes these prospects are not as rosy as investing advertisers will try to tell you, but we never want our clients to rest their financial futures on unrealistic hopes of returns that the markets can never promise. Our approach may not be the most glamorous or exciting, but we hope you’ll agree with us that our patient, disciplined, level-headed philosophy of investing will offer you the best hope of a secure financial future, so that, at the end of the day, you and your family have the savings you need.