What happens when you hire an "expert" to pick winning stocks and to try and time the market? In South Carolina we might say, "a state pension crisis."
In 1999, South Carolina pension plans were 99 percent funded and on track to paying all promised future benefits. But recently, thanks to poor investment decisions, that all changed. According to the Post and Courier, "years of ill-timed investments and a refusal to abandon questionable strategies have left South Carolina's government pension plans on the ropes, with a massive funding gap that threatens promised benefits to future retirees."1 When it comes to your investment portfolio, active investment strategies can be tempting because doing something seems better than doing nothing, right? Well, not always. Sometimes doing something does more harm than good, especially if that something is the wrong thing. Our state pension fund is a case in point.
Almost 90 percent of mutual fund managers underperform,2 yet there are still investors, including some brokers and financial advisors, who believe they can achieve superior returns by outguessing the market or picking stocks or mutual funds. Not only are active strategies usually less effective than passive strategies, like index funds, they typically carry higher internal costs. And higher costs often translate into lower investment returns. (South Carolina pays some of the nation's highest costs among state pensions.) Some investors may feel savvy when picking stocks or making frequent changes in their 401(k)s or IRAs. Others believe someone they know can offer some unique insight to "beat the market." But one must wonder, If the 'best of the best' usually fail to achieve superior returns using active strategies, what is the likelihood I, or someone I know, can do it? Fortunately, there is a better way.
One important thing an investor can do is to have a written long-term investment plan, such as an Investment Policy Statement (or IPS). In the IPS, you and your advisor should agree on an allocation (mix of stocks and bonds, for example) that align with your long-term goals, risk tolerance, time horizon, tax situation, and liquidity needs. The IPS should show a range of expected returns, which can be extremely helpful in down markets when it may be tempting to make changes to your allocation because it seems "things are different this time." You and your advisor should also outline criteria that may warrant making changes to your portfolio. By doing this ahead of time, you can reduce the temptation to make investment decisions based on emotions or short-term market fluctuations and instead make decisions based on pre-determined, agreed-upon criteria. For example, you and your advisor might agree that significant market changes may warrant rebalancing - a strategy where you sell a specified percentage of assets that have increased in value to buy a percentage of assets that have fallen in value (think buy-low, sell-high). Unlike market timing, which attempts to outguess markets, rebalancing takes a structured approach based on what has already happened and assumes prices will at some point rise again even though we don't know when. Of course an important factor should be the types of investments you include in your portfolio. While this will depend on one's specific situation, we usually prefer low-cost, broadly diversified investments that don't attempt to "beat the market" by employing speculative stock-picking or market-timing strategies. Investors who create an IPS based on academic research and science, and then periodically review it, may have a more successful investment experience than those who lack a plan or who try to outguess the markets.
- David Slade, Post and Courier, 12/3/2016.
- SPIVA Scorecard, 2016.
Photo from Post and Courier 4/25/2017, "South Carolina Gov. Henry McMaster signs state pension bill," by Andrew Brown. http://www.postandcourier.com/news/south-carolina-gov-henry-mcmaster-signs-state-pension-bill/article_ffbaf7c0-29ca-11e7-82b9-d3bb9b1d73d9.html