Fee-Only Financial Planning | The 4 Most Important Decisions for Any Investor Page (2024)

1. Diversification
2. Active versus Passive
3. Asset Location
4. Fund Selection

Decision #1: Diversification is the free lunch

Why do financial advisors sound like broken records about this topic?

Diversification is about the closest thing to a free lunch in capital markets, so you may as well get a huge helping of it. ~Ken French, PhD, Dartmouth College

One of the most important investment decisions you make is in determining your asset allocation, or how you choose to divide your assets between risky and safe investments.

Diversification:

• helps you capture what global markets offer
• reduces risks that have no expected return
• may prevent you from missing opportunity
• smooths out some of the bumps
• helps take the guesswork out of investing

Diversification across securities, sectors, and countries can help investors maintain their focus, potentially allowing them to avoid extreme outcomes that may result from a more concentrated approach. Global diversification significantly lowers portfolio risk without adversely affecting return. It’s important for any investor who wants to improve the reliability of investment outcomes.

Diversification does not eliminate the risk of market loss.

Decision #2: Active or Passive?

The second key decision concerns which strategy to use when selecting the funds to implement your asset allocation plan. Should you be a buy-and-hold investor? Or should you rely on recent performance to select funds?

Active managers try to beat the market through buying what they believe to be the right investments and avoiding the wrong ones and by market timing (getting in and out of the market) at the right time. Passive managers don’t try to beat the market, but aim to capture the markets’ return. They seek to maximize diversification and focus on keeping costs low in order to achieve greater potential returns.

Historically, 90% of actively-managed U.S. stock mutual funds did not beat their market index through 2017.

Why doesn’t it pay to chase fund performance? There’s substantial evidence that a buy-and-hold strategy has been the superior performer in all nine Morningstar style boxes (asset classes). Vanguard’s study Quantifying the Impact of Chasing Fund Performance results show:

• The average outperformance by the buy-and-hold strategy was 2.8 percent, with the gap in returns between the two strategies ranging from 1.6 percentage points (for mid-cap value funds) to 4 percentage points (for mid-cap blend funds).
• The Sharpe ratios (a measure of risk-adjusted performance) for the buy-and-hold strategy were also higher in all nine style boxes, with an average outperformance of 0.12.
• The results are particularly striking when you consider that the study doesn't take into account any costs, either transaction costs or, for taxable accounts, the cost of tax payments. Moreover, for taxable accounts, we should expect to see a large advantage for the buy-and-hold strategy.

Keep in mind with all investments that past performance is no guarantee of future results.

Decision #3: Location, location, location

By locating asset classes by their tax characteristics, you can increase the tax efficiency of your overall portfolio. In a total household portfolio that has tax-deferred (401k, IRA), tax-free (Roth), and brokerage accounts, utilize asset location to separate tax inefficient securities into tax-deferred accounts while keeping tax efficient securities in taxable accounts. With the increased popularity and growing account balances of ROTH and ROTH conversions, there will be substantial opportunities for tax-efficient placement.

In general, here’s how it works:

• Tax-inefficientsecurities including high-yield bonds, corporate bonds, REITS, and value stocks.
• Tax-efficientsecurities that generally have lower tax cost in taxable accounts are growth stocks and tax exempt bonds. The growth aspect of these types of investments help an investor take advantage of lower capital gains as opposed to being taxed at ordinary tax rates (RMDs from the IRA and 401k).

However, adjusting your asset allocation based on taxation could have significant unintended consequences. Tax rates change, tax brackets change, or your tax preferences may change. What was a logical tax location one year may turn out to be a poor choice a few years later. As always, it’s recommended to work with your tax professional or financial advisor before making changes to your investments with tax implications.

Decision #4: Fund Selection

For investors who have dug into the historical data and embrace passive investing, they can address the fourth key decision by then considering a strictly Index Investing approach or Asset Class Investing.

As a fiduciary, it is our responsibility to provide guidance squarely focused on what is in our clients’ best interest. Backed up by empirical research, we believe structure along expected dimensions can provide optimized portfolio design through Asset Class Investing. We arrived at this conclusion by reviewing historical performance of asset classes and philosophies of passive-approach custodians.

Index Investing

Many custodians offers index mutual funds and exchange-traded funds that track commercial benchmarks (indexes).

Pros

• The primary objective of each index fund is to replicate the performance of a specific benchmark, such as the S&P 500 Index or the MSCI US Broad Market Index.
• Low cost and low tracking error are important factors determining their success. The custodian managing the index fund adds and subtracts companies as the indexes change, typically only once a year.
• Investors looking to replicate commercial benchmark returns can do so at a very low cost with no advisor required for access.

Considerations

• Time and expertise are required for do-it-yourself investors to set up an optimized portfolio with sub-asset classes and periodic trading to maintain diversification (i.e. rebalancing) to reduce volatility.
• Index investing is the smarter choice than buying active managed funds, but it doesn’t come with a behavior modification solution that prevents investors from jumping in and out of their funds (or more likely neglecting them altogether) any more than actively managed funds.
• Determining the most tax-efficient location for types of funds means choosing the ideal placement of higher-expected-yield versus lower-expected-yield funds in tax-deferred, tax-free, or taxable accounts (See Decision #3).

Asset Class Investing

You may take a strategicAsset Class Investingapproach to indexing through effective global diversification with tilts toward value, small cap, and profitability.

Pros

• Utilizing funds that capture market rates of return through broad diversification and low cost. Instead of strictly using conventional index funds that track commercial benchmarks, you can choose funds that target systematic risk factors: value investing, small cap investing, high profitability, and momentum.
• Avoiding a low tracking error mandate may provide Asset Class Investingcompanies such as Dimensional with a trading advantage. By not having the same urgency to trade as index funds and actively-managed funds, they are positioned to be a provider of liquidity to those funds. This position of strength can result in paying lower average prices for securities.
• Dimensional also tends to be a more aggressive lender of securities, producing income that can drive costs lower than what the stated fund expense ratio implies.
• Long-term Track Record of Dimensional Funds versus Benchmarks*

Considerations

• Most investors need an advisor to help them be objective about their money, which is why Dimensional founders decided to make their funds only available through designated advisors who encourage their clients to have the discipline essential to long-term investment success.
• If you want to benefit from the higher expected returns of value and small cap stocks in a balanced portfolio, you may also have to accept more risk, which can only be mitigated to some extent in a balanced asset class portfolio. Patience and confidence may be required. Even the most sophisticated of investors have difficulty hanging on to underperforming investments through time, so the patience piece becomes easier if its supported by a fund family or manager with a methodical academic philosophy.

Hopefully, a comparison of strategies will help you determine which passive fund family has the highest probability of success for your situation.How you invest your money for the long term could have major implications for your overall success becauseeven the smallest increase in return could make a differencefor not outliving your money.

In Summary

There’s actually a fifth decision, which could be the most important. Know thyself.

Know if you have the time and track record of sticking to a well-designed investment strategy, rebalancing, maintaining efficient tax location of funds in multiple accounts, minimizing expense ratios and transactional costs, and keeping yourself accountable for your own investment progress.

Numerous studies indicate investors who work with an investment advisor historically earn 1-5% higher returns. Why? Fees are important to overall returns, but they are not the key issue for the majority of underperformance by individual investors. The key issues come down primarily to a lack of capital to invest (or rather, capital needed for other purposes) and psychology.

Costs are important, but emotional mistakes made by investors over time are much more important. The behavior gap between investor and investment returns could make a tremendous difference in the growth and stewardship of your hard-earned money.

Here’s why we believe what we believe for the best way to invest:

• Dimensional’s core foundation in academia
• Vanguard Quantitative Study
• Dalbar Annual Study

If this sounds like a smart investment strategy for your portfolio, contact us for an initial consultation by calling (916) 333-5760 or email (hello@endeavorplanning.com).