How do you build an efficient and effective investment portfolio? What type of investment accounts to open? Are there other methods to build wealth over time outside your own accounts? What is the “Lump Sum versus Dollar Cost Averaging” debate?
To date, we have covered investor profiles and how they drive the target asset allocation. We have also reviewed the asset classes, different types of investment options, and whether to actively manage your assets or not. We can now take all that knowledge and begin to construct an investment portfolio.
In Episode 43, we consider the following questions:
“What type of investment accounts should I open and where?”
We discuss where you should maintain your investment accounts.
With your current financial institution, where you have your chequing account? Should you consider a speciality or independent brokerage house? Or with a mutual fund company?
“What about tax-efficient accounts?”
We look at the differences between taxable and tax-efficient investment accounts.
For most investors, annual and cumulative contribution limits are often high enough that taxable accounts are not needed. But that will vary between jurisdictions.
“Will I need a margin account?”
There are pros and cons to setting up margin accounts versus cash accounts.
A margin account allows you to leverage your portfolio. In an up market, leverage can be useful as it boosts returns. However, in a down market, or where the investment in question declines in value, that can create problems.
“What other investment options may exist?”
Often, employers provide employee pension plans. These may be defined benefit, where upon retirement you receive predetermined periodic payments from the pension plan. Or defined contribution, where the employer (and perhaps employee, as well) makes periodic monetary contributions into the plan. Upon retirement, the employee receives the value of the total contributions and investment return growth.
Employers may offer Employee Stock Purchase Plans (ESPP). Or stock options to key employees.
You may be able to invest directly with public companies, with no transaction costs. Direct Stock Purchase Plans (DSPP), convertible assets, warrants, and options, are a few examples.
Finally, there are often Dividend Reinvestment Plans (DRIP) for investments you acquire. The DRIPs allow investors to automatically reinvest any distributions (e.g., dividends) into the investment, rather than receiving cash.
I generally like the buy and hold investment strategy.
Assuming, that is, you passively invest in a well-diversified, low-cost portfolio.
But I think that a buy and hold strategy needs a little tweaking for best results.
One such tweak involves the need for periodic portfolio reviews.
There is no hard and fast rule as to the frequency of portfolio evaluations. The number of reviews should reflect a few factors. As these differ between investors and their portfolios, so too will the periodicity of portfolio assessments.
Portfolio Risk Level
The timing of evaluations should be connected primarily to the risk of the portfolio.
With a relatively low risk, well-diversified portfolio of mutual and exchange traded funds, annual reviews may be adequate.
As portfolio volatility (i.e., standard deviation) rises, you may want to increase the frequency of evaluations. Maybe semi-annual reviews for portfolios with moderate risk levels. Perhaps quarterly reviews for portfolios with high standard deviations.
For portfolios that are not well-diversified, quarterly to semi-annual assessments are prudent. This holds true even for lower risk portfolios. And the less diversification, the greater the need for more frequent reviews (the exception being for single investments in extremely low risk assets such as Treasury bills, term deposits, etc.).
The logic of increased frequency for high risk or weakly diversified portfolios is that external factors can have significant and rapid impact on highly volatile and/or non-diversified investments.
For example, perhaps you have a large concentration of investments in the Middle East. Given all the political turmoil there, you would want to monitor your assets very closely. If you wait a year to do an evaluation, you may find that the situation when you last reviewed has radically changed concerning your holdings.
General Market Volatility
Over time, certain events can cause excessive volatility in the markets. Most of these are systematic risk factors. In our Middle East example above, socio and geopolitical variables can impact individual investments.
On the down side, events may include inflation, high unemployment, political turmoil, stock market crashes, wars, natural disasters, and so on. On the positive side, there may be long bull markets due to the opposite events, such as low unemployment, low inflation, peace, etc.
The greater the general market volatility, the greater the focus should be on your portfolio.
And, in part, because a well-diversified portfolio of passive index funds should reflect the market itself. As general market volatility increases, so too does your portfolio. Therefore, you should increase your amount of reviews accordingly.
Investor Personality
Periodicity of portfolio reviews will also reflect your personality and investor risk tolerance.
Not that it should, but an individual’s personality plays a role in how they manage their assets.
If you are a detail oriented person, you will likely be more comfortable reviewing your assets monthly, or even weekly. No doubt using spreadsheets or investment software to drill down into the numbers. If you are quite relaxed about life, then even an annual check-up scribbled on the back of a napkin may feel onerous.
The same applies to one’s investor risk profile. Low risk investors will normally want to monitor their portfolios more closely than a high risk investor. The opposite of what should be done, but it ties into their personality in many cases.
Given the importance in generating adequate wealth for a comfortable retirement, I suggest you set aside any personality traits that lead you to defer reviews. Put in a little time now on performing proper evaluations and you will reap the benefits down the road.
Material Change
A material change is anything that alters your investment perspective.
That could be a systematic variable that impacts your portfolio. War, hyper-inflation, depression, etc. Factors that affect economies and have wide ranging impact on investments.
Or nonsystematic – company specific – variables. The Department of Justice in the U.S. going after Facebook or Google. An oil company you own shares in, undergoing a takeover.
Material changes also reflect your own life. Young, single, you may design a higher risk portfolio. Get married and have a child, perhaps your risk profile lessens. Life insurance becomes an interesting topic.
A material event may be far reaching in impact. Or it may relate to a specific investment. Or the world may remain the same, but features of your life change.
A material event needs to be addressed in real time, not as part of an annual review. If your mining company is being investigated for environmental destruction in January, you likely do not want to wait until December to consider the impact on your investment.
That said, there is lots of media “noise” out there, over-emphasizing variables both too good and too bad. Things that cause assets and markets to swing wildly, only to reverse back to normal in the near future. It takes a bit of experience and knowledge to sort through the wheat from the chaff.
What Next?
Okay, so you should review your investment portfolio periodically.
But how should you efficiently do a review?
And what should you do after a review?
Good questions.
We will look at portfolio benchmarking and review procedures over the next few weeks. Then we will cover what to do if your portfolio gets out of alignment with your investment plan.
A long-term buy and hold strategy can work with individual, non-diversified assets. For example, shares of Amazon or Swiss Re. Or General Electric Capital bonds. Or the Japanese Yen.
Yes, but …. I would not likely recommend buy and hold forever with individual, non-diversified assets.
Here is why.
Quality Can Change Over Time
If you find a solid company (or other non-diversified asset) with strong management and excellent long-term prospects, you can buy and hold individual assets.
However, few companies have been great investments over the very long term.
Yes, there are some, but will you be able to identify them? That is the question. At one point in time, Nortel, Bre-X, Enron, and General Motors were considered fantastic long-term plays. Industries and companies are not static. Good companies can fall and new companies can rise.
In a previous post, we looked at how Eastman Kodak was once an elite company. A Dow Jones 30 component for 74 years. In 1976, 85% of all cameras and 90% of all film sold was Kodak. Yet in 2004, Kodak’s flagging results led to its removal from the Dow Jones 30. In 2012, Kodak filed for bankruptcy.
Conversely, we also saw how Apple was down and out in the mid-1980s. Yet in the span of a few short years, Apple’s fortunes completely reversed. Today one might argue that Apple is the (less dominant) Kodak of the 1970s. Does that mean Apple may be bankrupt inside 40 years? Laughable, yes. But probably the idea of Kodak moving from a 90% market share to nothing was also laughable. Technology changes. Market demand changes. No company is ever safe.
25 years ago, there was no Google, Amazon, Facebook, Netflix, etc. Or consider the size and history of young public companies like Biogen, Nike, Starbucks, Celgene, etc. Given their track records, would they be obvious long term investments? And for every Amazon, you also had a bunch of Webvan, Pet.com, eToys, etc., that were launched in the dot com craze of the 1990s. Companies that took off, then crashed, and were never heard of again.
Hindsight is usually 20-20. If you look at newly listed companies in the last 5 years, are you confident which will be dominant in 25 years? Versus those that will be poor investments?
If you invest in individual companies, I suggest you spend more energy monitoring their performance and prospects. A good rule of thumb is that the greater the risk of the asset (i.e., standard deviation), the more frequent the monitoring.
Systematic Versus Nonsystematic Risk
That is the difficulty with investing in assets which have nonsystematic risk components. Individual risk factors can significantly impact the fortunes of non-diversified assets.
The goal is to eliminate all asset specific risks, so that only the systematic risk remains.
If you can achieve this, your portfolio will be more efficient, and likely more effective, than one that still contains nonsystematic risk components.
A Diversified Portfolio is Better
That is why a buy and hold strategy should be used primarily with diversified portfolios as opposed to single assets.
The concern over individual risks is minimized throughout the portfolio. One company may be devastated by a lawsuit, new competitor, patent expiration, departure of senior management, etc., but the impact on the entire portfolio from one of these events is small.
To some extent, this risk also exists in mutual, or exchange traded, funds.
The less the number of index components or the more that market capitalization is reflected in an index, the greater the probability that one company’s problems will impact the entire index. For a good example, google Nortel and its impact on the TSE 300 Composite Index.
While something to be careful of when investing, usually indices do have adequate breadth so that one company does not have inordinate impact on the index performance.
This is why index investing is a good way to minimize nonsystematic risks and enhance portfolio efficiency.
Indices Address Quality Change
With individual assets, you need to carefully monitor their changing risks and return prospects. A true buy and hold may not be wise. You may need to divest assets whose fortunes change and add new assets with better long-term potential.
With index investing, this process is built in to some extent.
Individual index components may change over time. As previously good companies fall, they are deleted from the index. And as new companies rise in value and prestige, they are added to their appropriate indices.
Not an exact science in any sense, as there are many factors that dictate inclusion in a specific index. And those criteria differ between indices. But over time, there is a tendency for poor quality companies to be phased out and replaced with better potential components.
We saw this with our Eastman Kodak example above. An emerging giant entered the Dow 30 in 1930. Grew until by 1976 it controlled 85-90% of its market. However, as fortunes ebbed, by 2004 Kodak was no longer in the Dow 30. Perhaps foreshadowing its continued fall towards bankruptcy in 2012.
As Kodak grew in size and importance to the economy, it joined the index. As it fell, it was replaced by the next Kodak. In 2004, the Dow 30 deleted Kodak, AT&T Corp, and International Paper. They were replaced by AIG, Verizon, and Pfizer. in 2008, AIG was replaced by Kraft Foods and the cycle of change continued.
But even though the index components adjust over time, you only own the single index fund itself. This allows you to follow a buy and hold strategy with the fund.
Weak companies will leave the fund’s portfolio and other companies on the upswing will enter. In the extreme, over a long period the entire index could change. Not likely, but possible.
Yet you can continue to hold the same index fund throughout your entire holding period.
Additionally, there is less work for you to monitor the portfolio holdings. You only need to track the fund results itself.
Conclusion
While I tend to advocate a buy and hold investment strategy, I do so in the context of my overall investment program. That is, investing primarily in low-cost index funds.
I am much less keen on buy and hold for non-diversified assets.
If you intend to invest in individual companies, ensure that you monitor their performance and expected future results. As times change, companies that appeared solid may downgrade in relative value. Be ready for quality degradation and, if you think it is permanent, do not hesitate to divest.
But for well-diversified investments, a buy and hold strategy should be effective. Especially if you incorporate a couple of tweaks to the standard methodology.
A legitimate concern with a buy and hold investing strategy is that it may underperform active management during fluctuating and bear markets.
True. But as we have seen in prior posts, the ability of active managers to correctly time market movements is questionable. So, yes, in a perfect world, active would be preferable. But in the real world, the added costs of active management and the inability to time market shifts does not tend to create alpha (i.e., outperformance by managers).
Today we will review how to protect your wealth during periods of market volatility when using buy and hold.
Long Time Horizon
One’s overall investment horizon should be relatively long-term. Of course, within that longer time horizon for retirement, there will be a few short and medium term financial objectives. But the bulk of your focus will be long term.
As stated above, in a perfect world active management may perform better than passive in volatile markets. I say “may” because who knows. Would you have bought and sold at the right times? Or would you have compounded your losses through even worse timed trading?
As we saw last week, the “experts” overwhelmingly got the Trump election economic impact wrong. In the last 5 years, you can also look at the general consensus that inflation and interest rates would increase significantly. Nope. Had you shortened fixed income duration based on this consensus, you would be worse off.
The BREXIT on June 23, 2016 was another tale of doom and gloom. The pound fell to 1.29 USD and “some commentators have warned sterling could yet slump to parity with the dollar.” Instead, the pound currently trades at 1.25 USD. Or post-BREXIT vote, the pound traded at 1.17 Euro. Today the pound trades at 1.11 Euro. And yes, in the pre-vote optimism to remain, the pound rose to 1.45 Euro. A big crash. But if you ignore the run-up to the vote in mid-2016, you will see the historic trading range for the 5 years before the vote was pretty much in a 1.15 to 1.25 trading band. Further, consider the FTSE 100 stock market index. It traded at 6338 on June 23, 2016. Currently, it trades at 7537. Not as impressive a growth rate as the U.S. stock markets, but a decent gain of 18.9% over the period (not factoring in any dividend distributions to investors). So while not wonderful, not the apocalyptic aftermath predicted by many “experts” (as they tried to scare voters into staying).
In these two examples, the “experts” got it very wrong. Had you traded based on their advice, you would be much worse off than simply staying the course. Will they get it right next time? Perhaps. Perhaps not.
Now some of you reading this are thinking, “Hey, I don’t have 20 or 30 years to invest. What can I do?”
If you recall our discussions on investor profiles and investment policy statements, you realize that your asset allocation is geared, in part, to the phase in your life cycle.
Over the course of your life cycle and ever evolving investor profile, the amounts that you allocate to cash, fixed income, and common shares will change. As you near retirement, you will be shifting more of your wealth into lower risk (i.e., less volatile) assets. For example, we saw how one’s allocation to equities changes based on the life cycle phase.
This will also address problems with general market volatility.
When young, with a long time horizon, you can handle more volatile assets in your portfolio. As your risk tolerance (and ability to withstand volatility) decreases through your life cycle, you shift into a higher percentage of lower risk asset classes. As your financial time horizon nears, portfolio risk (and impact of market volatility) lessens.
A diversified portfolio prevents you from having all your eggs in one basket. Whether that be a specific asset within a market or an individual market within the whole spectrum of investment options.
If you have 50% of your wealth in shares of Credit Suisse, your portfolio returns will reflect the results from Credit Suisse to a significant degree. Or if you have invested 80% of your assets in the U.S. equity markets, your portfolio will mirror the ups and downs of the U.S. equity markets.
Either of these may generate positive returns during bull markets, but they will create problems during down periods.
However, by diversifying throughout various asset classes, you can spread the risk of any one market throughout multiple asset classes.
Not Just Diversified, But Well-Diversified
A diversified portfolio is a collection of different assets.
A well-diversified portfolio reflects a proper mix of assets, such that you minimize asset correlations.
If you recall our discussions on asset correlations, holding assets with low or negative correlations will provide some built in protection against market volatility. As the value of one asset rises, the value of a negatively correlated asset should decline.
While you may give up some potential return by never being fully invested in rising markets, you will also never be fully exposed to falling markets.
This offers a defence against market downturns.
Dollar Cost Averaging
Another strategy I have espoused is dollar cost averaging (DCA).
If you believe over the long run that appreciating assets do, in fact, appreciate, then down markets provide buying opportunities.
We have covered the above points previously in significant detail. I reiterate them to show how we have already take steps to protect our portfolios from legitimate potential problems with employing a buy and hold strategy.
Nest time, we will look at tactics we have not previously discussed.
Buy and Hold May Not Provide Maximum Possible Returns
A buy and hold strategy is essentially as it states; you acquire an asset and hold it throughout the investment horizon.
Investment theory indicates that over time, on average, appreciating assets (such as equities) will increase in value. Granted, it may be a long time, but historically this has held true.
However, over the short and medium periods, there may be large price fluctuations in an asset. The greater an asset’s risk (aka volatility), the greater the potential price swings.
If an investor can properly time the peaks and valleys of short or intermediate price fluctuations, the investor can sell high, then repurchase the same asset when it falls. This ensures the same position at the end of the investment time frame, but by selling and buying back the investor can profit on price fluctuations.
Markets, and the assets within a market, go through down cycles. Depending on the length of time, this may be called a crash, market correction, or possibly a bear market.
A buy and hold strategy sees investors sit tight during market descents. With some bear markets, this can wipe out previous accumulated gains and/or create portfolio losses.
Smart investors shift their assets in down markets into defensive positions or alternative asset classes that protect their capital.
Again, active management can protect portfolios during down cycles. However, as linked above, the ability of active managers to correctly time market corrections is (surprisingly) poor.
As a current example, google the amount of experts who predicted U.S. interest rates would significantly rise (over the last 3-5 years). Yet interest rates have remained relatively stable versus predictions. Had you not listened to the “experts” and remained in long duration bonds (as opposed to shortening durations in anticipation of rate hikes), you would have been better off.
“It really does now look like President Donald J. Trump, and markets are plunging. When might we expect them to recover? A first-pass answer is never… So we are very probably looking at a global recession, with no end in sight.” Paul Krugman of the New York Times the day after the election.
“If Trump wins we should expect a big markdown in expected future earnings for a wide range of stocks — and a likely crash in the broader market (if Trump becomes president).” Eric Zitzewitz, former chief economist at the IMF, November 2016.
“Trump would likely cause the stock market to crash and plunge the world into recession.” Simon Johnson, MIT economics professor, in The New York Times, November 2016.
“Citigroup: A Trump Victory in November Could Cause a Global Recession”, Bloomberg Financial News, August 2016.
Pretty impressive group. Smart! And more geniuses at the link.
Yet on November 7, 2016, the night before the 2016 U.S. election, the Dow Jones Industrial Average (“Dow”) closed at 18259.60 and the S&P500 (“S&P”) at 2131.52. One year later, the Dow closed at 23557.23 and the S&P at 2590.64. Not including investor gains from dividend distributions, a price gain in the Dow of 29% and S&P of 21.5%.
On July 5, 2019, the Dow closed at 26922.12 and the S&P at 2990.41. Again, not including distributions, the price increase since the election has been 47.4% in the Dow and 40.3% in the S&P.
How was following the “experts” as a strategy? Imagine if you moved everything into cash. Or, even worse, decided to short the markets in anticipation of a crash and/or global recession.
As someone who reads financial and business articles on a daily basis, this is the norm, not the exception with experts. The personal biases, political agendas, “herd mentality”, populist takes, or the extreme opinions to generate clicks, etc. All contribute to poor recommendations.
So yes, the lack of down market protection is another legitimate concern for buy and hold. But the bigger issue is, will you be able to correctly predict major market movements?
Buy and Hold Only Works if You Are Immortal
If you adhere to modern portfolio theory, you believe that in the long run, appreciating assets increase in value based on certain factors. And, as we saw in my second link above, this has held true for the last 100 years in all major asset classes.
But that may require an extremely long holding period. One not all investors can maintain.
Many investors do not seriously begin to invest until they are in their early 40s. If they need to liquidate at 65, 20 years may not be a long enough time frame. Had you invested in the Dow Jones Industrial Average at its peak in 1929, it would have taken 25 years for the Average to recover after its losses in the early 1930s.
Additionally, almost all investors have financial objectives covering different time periods. If you are 30, you may have a 35-40 year time horizon until retirement needs arise. You can take a longer term, higher risk perspective. But you may also want to buy a home in 3 years and finance your child’s education in 15. For short and medium term time horizons, you need to factor in other variables for your portfolio and strategies.
One’s investment time frame is relevant to the potential success of a buy and hold strategy.
These three concerns are common when you read articles on buy and hold investing.
These concerns suggest that active management is better than passive. But if active tends to not outperform passive, how can you protect your portfolio in volatile or bear markets?