Slow but steady wins the race.

-Aesop's Fable "The Tortoise and the Hare"

Towards the end of the 1990s and the first part of 2000, it was very difficult to resist the 50, 60, 70+ percent returns that we all heard about in the technology sector. Some even believed that the "New Economy" could justify these returns and that they could go on indefinitely. The latter part of 2000, 2001 and most of 2002 showed us otherwise, decimating the high-flying, tech-heavy NASDAQ by more than 75%. Did you know that it will take more than three years at a 50% return a year to get back to the peak in March of 2000. At a modest 10% return it will take almost fifteen years to reach those levels again. Who do you think won this race? The tortoise or the hare?

Aesop's fable about the tortoise and the hare holds as true for investing as it does in many other walks of life. Although at moments we'd like to invest in the high-flying market sector of the day, in the end, a slow, steady approach gets you where you NEED to go. Your need may be a new car, a down payment on a home or your retirement income. Your investment approach is tailored around your REAL needs and not some fantasy of earning 35% a year forever. Using this philosophy, we'll create a balanced portfolio that will get you to your goal at the right time.

General Approach

Before any of your money is invested, we determine your investment profile by reviewing investment goals, risk tolerance, as well as considering your age, income needs and earnings potential. Generally, we feel that a good strategy for long-term investing should balance growth while limiting volatility. In many cases we recommend an equity allocation that may approach 60-90%, depending on your profile. Obviously, a more conservative portfolio is appropriate for some people, while a more aggressive portfolio is appropriate for others. We will structure a investment policy that is appropriate for your situation and we can always adjust your allocations according to your needs.

Asset Allocation

We are strong believers in asset allocation. What does this mean? It means that we believe all market sectors experience both good and bad years and that we can't predict ahead of time which sector will be good or bad this year. Do you know where most new investors were putting there money at the beginning of 2000? Unfortunately for them, it was the technology sector. We all know what happened after that.

Did you know that there are no statistically validated market timing techniques for the general equities markets. Sure, with every large movement in the market there are those that do predict it correctly. Will they be correct in predicting when the market will turn around? Probably not. In all likelihood there will be somebody else correctly predicting the next major move in the market. So, how do you predict which Guru will be correct next time? The answer is simple, you don't!  Instead, you create an investment policy and stick with it.  A good investment policy will have you selling off some of your winners and buying into areas that have under performed recently.  This approach keeps your investments balanced and allows you to cash in on some of your winners while they are still winners.

Asset allocation is about dividing up your investments amongst the different asset classes (large cap, small cap, value, growth, international, commodities, etc...) and staying the course. You're banking that on the whole, these investments will grow over time at a 10-15% rate of return. A well diversified portfolio during the 2000-2002 downturn may have lost only 5,10 or 15%, in comparison with many who lost 50% or more. The downside of asset allocation is that when the general market (S&P 500) is going up 30% a year, your portfolio may lag this performance by 10% or more per year. However, because of the reduction in volatility in your portfolio, you should experience fewer bumps and bruises along the way and your long-term rate of return may equal or even exceed the rate of return of the general market.

Mutual Funds

Miceli Financial Planning exclusively uses "No-Load" mutual funds to construct your diversified portfolio. As an Institutional Investor with TD Ameritrade, we have the ability to buy over 5,000 mutual funds without any load.  Many of the funds we buy would be loaded funds for a retail investor, saving upwards of 4-6% on many purchases.  As fee-only planners we also have the ability to buy Dimensional Fund Advisors (DFA) Institutional Investor funds.  These funds are not available to the retail investors or any investment advisors who aren't exclusively "fee-only".  DFA has championed the use of passively managed small capitalization and value stocks in institutional portfolios. Go to their website at www.dfafunds.com to learn more about their philosophy.  As a fee-only planner I  have not and will never earn commissions on the purchase or sales of your funds. My only interest is creating a well diversified portfolio that will suit your needs over time.

Index Funds vs. Actively Managed Funds – The Great Debate?

The great debate between most investment managers who utilize mutual funds for their client’s investment portfolios is whether to use passively managed funds like index funds, to use actively managed mutual funds like the Janus fund group or Fidelity, or to use a combination of both.    Although I personally prefer the passively managed approach, I still think it’s important to understand that there are pluses and minuses to each method.

Active Management

Actively managed funds have real people making real decisions on a day-to-day basis about the value of the stocks they hold in their portfolio.  They buy stocks when they feel the prospects of real growth outweigh the chances of loss.  They sell when they feel the stock is over valued.  In a bear market some managers may stash more of their assets in cash, thereby minimizing portfolio loss.  Hopefully, in a bull market,  they’re 100% invested in stocks.  Great mutual fund managers have done this in the past and there are sure to be those that consistently do it in the future.  Conversely, passively managed fund will not change their cash allocation based on the market conditions.  They’re very close to 100% in their stated asset class, all of the time.

Two great successes that immediately come to mind are Peter Lynch and Warren Buffett.  Even though it is easy to argue, statistically, that out of the thousands of mutual fund managers, a few would surely rise to the top, I don’t know anyone who believes that their success was pure chance.  Most everyone would agree that their success could be attributed to their keen ability to pick undervalued stocks.  The major difficulty with using actively managed funds is finding the next Peter Lynch or Warren Buffett.  

Passive Management

Passively managed funds are by their definition Passive.  The term passive is not exclusive to index funds (i.e. S&P 500 index); rather it is used to describe the buy sell process.  Some passively managed funds don’t track any know index; instead they track their own pre-defined asset class.  For instance, Dimensional Fund Advisors Large Cap Value fund tracks the highest 10% Book to Market ratio stocks of the largest 90% domestic stocks.  This is clearly not a published index.  What makes this a passively managed fund is the funds strict (and simple) decision-making process to either buy or sell a stock that falls within the criteria.  Passively managed funds save you money by not employing hundreds of analysts to pour over thousands of stocks every day.  The decision to buy or sell a stock is actually decided by the stocks themselves.  So, when a stock moves into the S&P 500 Index, all S&P 500 index funds purchase this stock.  There is no decision, no debate, or time and money lost in reaching this conclusion.  

Passively managed funds provide targeted asset class exposure that does not drift in time.  When designing a portfolio, one of the key determinants to its success is what asset classes are chosen and how much of each asset class is in your portfolio.  Many actively managed funds have what is known in the industry as style drift.  For example, in the mid-1980’s you may have purchased the Fidelity Magellan fund in your portfolio to represent a mid-cap exposure.  By the late-1990’s this fund looked much more like a large cap fund than a mid-cap fund.  Your mid-cap exposure has vanished (and consequently, so has Magellan's returns).  Passively managed funds exhibit very little style drift since they are by definition tracking an asset class.  They buy when stocks meet their criteria, and they sell when they no longer meet it.

Passively managed funds are usually 0.5% to 1.0% cheaper to own per year.  Given that your expected long-term rate of return for stocks is only about 10%, a 1% difference represents about 10% (annually) of your total return.  For example, if you have a $1,000,000 portfolio invested for 20 years earning 10% per year after expenses for a passively managed fund.  This fund would be worth about $6,730,000.  A similar actively managed fund after expenses would’ve only returned 9% per year and would be worth about $5,600,000.  Your passively managed fund is worth 20% more at the end of 20 years.

Your chances of achieving market returns using passively managed funds are close to 100%.  That is, if you invest 50% of your portfolio in the an S&P 500 index fund, and 50% a Russell 2000 index fund, your returns will match that of those indexes.  You won’t do better and you won’t do worse.  If you use actively managed funds in the same scenario, you would have a 25% chance of outperforming the market, 50% chance of getting market returns, and a 25% chance of underperforming the market.  If you increase your asset classes from two to eight, your chances of picking eight great managers diminish significantly.   Some will outperform and some will underperform and you will likely get market returns.  If you take into account the increased fees in actively managed funds, your chances of outperforming the market decrease even further and your chances of underperforming increase.  In other words, your chances of underperforming the market are greater than outperforming. 

Passively managed funds are usually 100% invested in their asset classes at all times.  This is both good and bad.  The bad is usually seen during a bear market when stock prices are trending downward.  If none of your assets are in cash, then this fund will fall harder than a mutual fund that has some assets in cash.  Conversely, when the market turns around, the passively managed fund is 100% in stocks, which is what you want.  So, during bear markets you can expect actively managed funds to outperform, and during bull markets, passively managed funds should do better.  In the long run, they should come out about even.

Summary

The idea behind using passively managed mutual funds to create a well diversified portfolio isn't new.  It has been time tested and used by pension fund managers all over the world.  Pension managers  know that the secret to investment success isn't picking the hottest stock or mutual fund manager, or chasing the latest "fad" asset class.  Rather, it is created by investing fixed percentages into multiple asset classes around the globe and then periodically rebalancing.  Using this approach, the Financial Planner/Investment Manager is able to focus on the real job at hand, helping clients reach their goals.  This means understanding why the client is investing, when they really need the money, and how willing they are to accept the risk of investing.  Only when an Investment manager really understands the client can they construct a suitable portfolio for them.