Ep 29: Your Investing Process – Part 3

Ep 29: Your Investing Process – Part 3

The Smart Take:

Your asset allocation recipe is the most important portfolio decision, and there are a few different flavors of asset allocation. Listen to Kevin describe the differences and what the evidence shows works best.

Click the below links to subscribe to the podcast with your favorite service. Prefer to read? No problem, show transcription is below too.

The Host:

Kevin Kroskey – AboutContact

Intro:                                     Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions and get educated about the financial world. It’s time to retire smarter.

Walter Storholt:                Welcome to another edition of Retire Smarter. Walter Storholt here alongside Kevin Kroskey, president and wealth advisor at True Wealth Design. Kevin, what’s going on with you this week? How are you, sir?

Kevin Kroskey:                  Walter, I think I owe you an apology.

Walter Storholt:                You apologize too much. You have nothing to apologize for, ever.

Kevin Kroskey:                  Well, I realize that I fibbed to you and I said the last two podcasts episodes that we did were a two-part series. I decided I’m going to change that into a four-parter. So, I was listening to myself and well, I’ll tell you what, Walter, as someone who’s been on the radio and podcasting for many years, do you listen to yourself, or was that something you maybe did early in your career and you don’t do it any longer?

Walter Storholt:                Yes, it’s definitely hard to listen to yourself. I would say I definitely do it less now, although it’s always a good thing to do. Because you pick up on bad habits that you’ve fallen into and that you wouldn’t catch when you’re in the moment, but then you listen to it and go, “Oh my gosh, that’s annoying,” or, “I could really shut up there for 15 minutes,” or that kind of thing. So yes, it’s good to listen to yourself. In the industry, it’s definitely a good thing to do.

Kevin Kroskey:                  I’ve heard the saying that we’re all our own worst critic, and it’s not uncommon that when we sign off from doing our conversations that I’ll have a moment where like, “You sound stupid. Why’d you say that?”, or something. Where I’m just not as confident and maybe my clarity in communicating and then I listen to myself and I’m like, you didn’t sound as stupid as you initially thought. And so I guess that’s an improvement.

Walter Storholt:                In my sports broadcasting days, I definitely had a few. There was in fact, one game in particular I can think of, where I thought it was so bad I should just quit. I need to get out of the industry. I’m just done. I’m never going to improve any better than this. This was my worst broadcast ever. I really didn’t have my stuff together today. And that particular broadcast, I got like four or five comments from people that were like, “Man, you did such a great job on that game yesterday. The way you painted the picture and the built the excitement up. Oh, it was just so good.” And you’re just like, all right, well I guess I’m being too harsh here.

Kevin Kroskey:                  So I was listening to myself earlier, in the podcast part two, for your investing process and I’m like, “Hey, I set this up and I said I was going to talk about two things” and I never got to the second thing. So I kind of wrote the script for the content today and I didn’t even know it. I thought through something else I think would complete the story a little bit more clearly for the listeners. So that’s where we ended up today. Me being my own worst critic and listening back, but I think it’s going to tell a more complete story. So, we’re going to extend to parts three and four over the next two episodes.

Walter Storholt:                All right. So parts one and two, we dove a lot into talking about what your investing process looks like. The building blocks of an investing process. Kind of looking into some of the factors that go into the science that kind of determine and look at different stock and bond options and then how that fits into the equation. We talked about the tech bubble and how that kind of plays into our minds as we shape things these days. You touched on kind of a lot of that history. We’ve been talking about the recipe and the ingredients of the investing process. You’ve kind of given us this baseline through these first two episodes. Take us from there.

Kevin Kroskey:                  Will do. So, always makes sense to repeat rule number one, and rule number one is your financial plan is the purpose and the objective of your investment plan. So, I’d never want to lose sight of that. You know, whether we’re investing for, you know, this is the retire smarter podcast, so we’re talking about retirement and in this case we’re accumulating money for our working careers and then we turn off the paycheck spigot. Now all of our savings investments has to make up anything that we’re not going to receive in a pension or social security or different compensations. So, meeting those cash flows to go ahead and supplement our retirement income and to maintain our lifestyle and do the things that we want to do, is the objective of every single investment plan. At least it should be. So that’s where it starts.

Kevin Kroskey:                  I never want to lose sight of that. I certainly don’t [inaudible 00:04:15]. Anybody that’s listening should write that down in Sharpie marker. But when you go beyond that again, you kind of set it up pretty nicely about some of the things we talked about. We talked about a process, talked about some of the things that go into the process. And now, one of the things I forgot to mention was, we talked about asset allocation, which the analogy is, that’s the recipe and the underlying investments are the ingredients and the science shows that the recipe actually matters more than the ingredients in terms of the returns that you’re going to receive from your investment portfolio over time. And that’s been documented in studies going back to about the mid eighties or so. One thing, I didn’t say this, I want take a quick aside here, but asset allocation is not stock picking.

Kevin Kroskey:                  So this study that I’m referencing, and it’s called the Brinson, Hood and Beebower study. I think I’ll go from memory here, but it’s somewhere around 1986 that it was published in the journal of finance. And how you allocate your assets is going to explain more than 90% of the return that you’re going to have over time from your portfolio. Stock picking was a factor, but it was actually a negative factor. So, thinking individual stocks actually subtracted from the total return that you’re receiving from the asset allocation. Asset allocation is not stock picking. I didn’t mention that and either of the prior parts. That is something that’s very important to know. We had a gentleman that reached out to our office last week and he said, “I don’t like mutual funds, I want to pick stocks”. I said, “That’s great. We don’t do that, can’t help you out”.

Kevin Kroskey:                  So again, we kind of believe in that science based approach and certainly diversification is a big healthy dose of that. When you think about asset allocation though, there are a few different types of asset allocation and these were the three things that I said I would mention in part two and didn’t. So I’ll take care of that now. The first type is, I would just call it static. So you can kind of say it’s you set it and you kind of forget it. The only thing that you would probably do is, you bring it back into target if it drifts too far from where you want to be. So simple example, say my asset allocation, very simply, is 50% stocks and 50% bonds. I’m just going to roll with that. I’m not going to make changes to it. Oops, stocks have done pretty well over the last few years. Now maybe they’re 60% of my portfolio and the bonds are 40 because the bonds haven’t done nearly as well as the stocks. I’ll go ahead and rebalance or bring things back to a 50/50 target that I set out.

Kevin Kroskey:                  So, this static allocation is something that I know a lot of people that do it. I have a friendly competitor just down the road that manages a few hundred million dollars. I don’t think they’ve changed their portfolio allocations in probably 20 or 30 years. It’s just, here you go. We’re just going to kind of keep you disciplined, maybe do some financial planning and there you have it. Personally, that’s what we used to do. We’ve kind of evolved a little bit beyond that, but that’s certainly a good starting point.

Kevin Kroskey:                  I’ll go to the other book end now. So on one hand we have static allocation, very passive, not a lot of trading, just really some rebalancing to bring things back to target. On the other end, and there’s a big variance between these two, but I would call it market timing. Lots of active trading. You’re making bets on sectors, on asset classes or on countries. Maybe you’re going from stocks all the way to cash and getting out of the market and then trying to time it to get back in.

Kevin Kroskey:                  It sounds great. Who wouldn’t want to go ahead and only get the ups of the market and avoid the downs? But in practice, virtually it’s impossible. I mean the evidence, which we always referred to, is quite poor when it comes to market timing. A lot of the listeners probably have seen different articles or maybe even seen something that I’ve written or spoken about. But when you look at some of the returns, if you start missing just like the 10 best days of the market over the course of say a year or 10 years, you really start losing a lot of the returns from the market.

Kevin Kroskey:                  The corollary to that is, well, what if I just missed the 10 worst days? Well that’s great too. But again, kind of getting in and getting out really doesn’t work that well. I wrote an article back in 2013 after a gentleman by the name of Martin Zweig had passed away and he was actually from the Cleveland area, kind of in our backyard here in Northeast Ohio. He went on to be in New York city and he was very famous for calling the crash of 1987. And Walter, as I was listening to the prior podcast, I said I was going to start throwing you some fast balls rather than soft balls to hit, in terms of questions. So I don’t know if this is a fast ball, but it may be a curve.

Walter Storholt:                I was born in 1987. Yes. So I’ve got the answer right, right?

Kevin Kroskey:                  All right, so.

Walter Storholt:                No, not quite.

Kevin Kroskey:                  Not quite. So 1987, Black Monday, how much did the stock market fall on Black Monday?

Walter Storholt:                Oh man. 32 percent. No, That’d be a lot. That would be a lot of one day, right? Lets go 12 percent in one day.

Kevin Kroskey:                  You know what? You know what they say? If you think back when you were in school, maybe studying for the SAT or the ACT, they usually said in terms of test taking strategy…

Walter Storholt:                If you don’t know the answer, don’t answer it.

Kevin Kroskey:                  [crosstalk 00:09:20] First guess is the best guess, right? And it was just a smidge below 30%.

Walter Storholt:                Whoa. Hey. Something was rattling around the old noggin up there.

Kevin Kroskey:                  Yes. Too bad you changed your answer, you get no credit.

Walter Storholt:                That’s right.

Kevin Kroskey:                  So, if you think about that, 30% in a day. A single day, just, I can’t even fathom it. You know, you were just being born in ’87 I was the quarterback of my championship midget football team, had long blonde flowing hair and here we are today and I won’t even go there because it’ll quickly get depressing.

Walter Storholt:                I’m having trouble picturing the long blonde flowing hair. We may need a picture to correspond the blog post of this episode to prove that.

Kevin Kroskey:                  Yes, there’s plenty of embarrassing collateral that I have out there, so I can certainly share some of that. But Martin Zweig, his fund, he was kind of prognosticating this. He was saying that hey, the market’s doomed to go down, go down a lot. I can’t recall why he was foretelling this, but he was managing a fund that was pretty flexible in terms of its asset allocation.

Kevin Kroskey:                  So he would follow this market timing approach, this tactical asset allocation approach. And he had more than 50% of funds, money and in cash on that day. He only went down about 6%. So nobody likes to lose money, but rest assured, losing 6% is obviously better than losing 30. What happened with Martin Zweig after that? Well, hey, this guy can see into the future, right? He’s the crystal ball. He’s the guy that can kind of save us from this falling knife or this big market decline. And guess what? I mean, of course he got a lot of praise for that. It was written about it in the press. He received a lot of money coming into his fund after that and he ran that fund for many, many decades afterwards. Again, he passed in 2013.

Kevin Kroskey:                  While he was very prescient back in 1987 and he did quite well, only losing about 6%, whereas the stock market went down 30% that day; when you look at the return from his fund from the inception in October ’86, all the way through the end of January of 2013, the return was just a little bit less than 6%. Over the same time period, however, the return for the S&P 500 was just a smidge under 10%.

Kevin Kroskey:                  So roughly 6, roughly 10. It may not sound like a big difference, 4%, but when you’re compounding that year in, year out, over the numbers of years. Frankly, this is one math problem I can do in my head, but when you look at the entire growth of wealth, I mean we’re talking about several times over more money by just owning the S&P 500, compared to the very prescient, or at least once prescient Martin Zweig fund. Or even if you go ahead and say, hey, maybe it’s not all stocks. He was investing in different asset classes, maybe hit a little bit less risk.

Kevin Kroskey:                  So if you just blend, say 70% of US stocks and 30% in Aggregate US bonds, the return for that mix, that 70/30 stock bond mix, was about 8%. So, he still underperformed by 2% per year, even though he got off to a great start. Again, the fund inception date was in 1986 and then he avoided the big decline just a year later in October of ’87. So, he had quite a headstart because of his prescient ability. But, when you look at it over time, his long term track record wasn’t that good. And as a matter of fact, if you look at, I mean, I’m not trying to pick on him, but he’s one of these really good examples. But there’s many, many, many others that are out there. And in fact, there are many studies that are done by firms such as Morningstar. S&P is another one that does what they call an active passive scorecard.

Kevin Kroskey:                  And we’ll talk more about these active and passive sorts of investments in the next part of the sequence. In short, as the name implies, passive is a little bit more of the set and forget it. It’s more of an index type approach. And active is basically using some sort of act or strategy. It could be somewhat active, where maybe they’re not going from stocks to cash, but maybe they’re actively picking stocks or increasing stocks within a certain range or what have you. There’s a whole continuum between say, set it and forget it and very active tactical market timing sort of approach. But the results of all these studies, whether from Morningstar or from S&P, is that the active managers, in general, do not meet or exceed the passive benchmarks.

Kevin Kroskey:                  And again, Martin Zweig’s one of these examples. There’s many, many others and we’ll talk more about this in the next episode. So just a quick recap here, on one hand you have again, static asset allocation. Kind of set and forget it. Maybe that’s, say if your certain percentage in US stocks, certain percentage in international, certain percentage in bonds.

Kevin Kroskey:                  You can keep going down with some different kind of slicing and dicing. Gross stocks, value stocks, large stocks, small stocks. But really you’re just kind of rebalancing it back to target. You’re not using any sort of forward looking estimations or any sort of market timing, getting in or getting out, to go ahead and drive that asset allocation. Then on the other hand, the much more active hand, you have this tactical asset allocation, and again it could be very active, it could be somewhat active, but you’re making these active bets on stocks, sectors, countries, getting in, getting out of the market. All those sorts of things. Then thirdly, now this may be a softball, Walter, so I’ll let you try to redeem yourself here. So, if you want to take a guess what the third one is?

Walter Storholt:                Oh no, the third…

Kevin Kroskey:                  Third type of asset allocation?

Walter Storholt:                Oh gosh. Now this was much more of a hard ball. I’m trying to read your mind and see where you’re going. And this will be one where I can kick myself after I miss the answer. You said active versus passive and then…

Kevin Kroskey:                  I said static.

Walter Storholt:                Static.

Kevin Kroskey:                  And I said tactical.

Walter Storholt:                Tactical. Static, tactical and Oh, I’m falling off the spot. You got me.

Kevin Kroskey:                  [crosstalk 00:15:24] I kind of gave you the two book ends and so I guess…

Walter Storholt:                We’ll call it the hybrid in the middle.

Kevin Kroskey:                  Yes. I call it dynamic.

Walter Storholt:                Dynamic. Okay, there you go. That’s right. That was the magic word.

Kevin Kroskey:                  Yes, it’s a blended approach. I call it dynamic asset allocation. But you could certainly argue that it’s just a mixture of the two. I view it as three distinct ones. I do think tactical, a lot of times, when you’re getting in and getting out of the market a lot, going from stock to cash or something like that, that’s an incredibly different paradigm and one that just invokes a lot more risk in many, many ways. But when I think of dynamic, and what a lot of financial researchers think of, is rather than just using kind of past relationships of how asset prices move together or in a dissimilar fashion, you know, stock versus bond relationships, big company versus small company, value versus growth, you know, things like that. You’re actually going to look to make some sort of forecast about the future.

Kevin Kroskey:                  The way that I think of this is, when you think of tactical, you know typically it’s more short term forecasts. Like literally. Getting in, getting out of the market. It could be over a matter of days or months. But when I think of dynamic, extend the time horizon some, and it’s more what I think of over an intermediate term. Maybe a market cycle. So, market cycle being in the entire ups and down, and kind of back to where it was, if you will, or a business cycle. Generally speaking, call out about 5 to 10 years. And so, what the math shows behind this and some of the research is that, when you use different ways to go ahead and value assets, they perform terribly in the short term and nothing really works that well in terms of short term market timing.

Kevin Kroskey:                  But if you can look at an asset, look at its relative value, say compared to itself and compared to other asset classes, generally speaking, if you favor the ones that are undervalued and own less of the ones that are overvalued, you’re going to do better over time. And over time you’re hoping that that’s going to play out that way. Certainly things that are expensive can get more expensive and things that are cheap can get cheaper. But in general, the basic rule of investing is buy low and sell high.

Kevin Kroskey:                  So, if you’re buying things that are low and you have some margin of safety, then typically that will work out fairly well. It’s not perfect. Nothing is. It’s investing, investing involves risk. But that dynamic approach, taking a look over more of a medium timeframe, intermediate timeframe, does have a correlation, if you will, to making smarter investment decisions in terms of buying less expensive assets that are likely to do better and avoiding some of the more expensive ones that have appreciated in price but probably aren’t going to do as well going forward.

Walter Storholt:                My sort of big takeaway, I know that the comparison of the different styles here, the indifferent processes that we’re talking about is the central focus today, but I kind of keyed in on something with that particular story that you had about what was the, Zweiger?

Kevin Kroskey:                  Martin Zweig.

Walter Storholt:                Zweig. Zweig. Zweiger. That’s from a movie or something like that. From his story is, there’s so much focus out there in the financial media about the next crash. It’s everybody’s question, is it going to crash? When’s the next crash going to be? It’s going to decimate my portfolio. And people who lived through 2008 certainly felt that impact of a big down market. I’m not saying that that’s not important to focus on that, but based on what you’re talking about, that longterm performance and absorbing the hit of a market crash in the longterm, it’s really not as big of a deal maybe as it’s made out to be.

Walter Storholt:                And is it getting undue focus from the media, in many ways? The worry that goes into the crashes and having the right plan to handle a crash. Based on your illustration from that story of 1987, in the grand scheme of things over the long term, it didn’t end up helping him beat just sort of the everyday sort of dynamic approach that you’ve lined out.

Kevin Kroskey:                  Yes, and that’s what all the studies show. You know, there’s something else that, again Morningstar, everybody’s probably familiar with. A lot of mutual fund research, a lot of research on investor behavior. They do something that’s called here’s kind of the fund return, and then they look at what is called an investor return. So what are the returns that the investor actually receives? The fund reports returns as if you’re invested consistently throughout the course of, say a calendar year and then you string multiple years together. And in fact, what we find and what studies find, DALBARs another large study that finds the same thing, is that inevitably the fund returns are higher than the investor returns. Let me say that again. The fund returns are higher than the returns the investors actually receive. And on first glance you may say, well, how’s that possible?

Kevin Kroskey:                  And then when you think about it for a minute, it comes down to this market timing, this more of a tactical approach. If somebody is looking at and saying, “Hey, this fund and this Martin Zweig fund looking at it and say the fall of 87 after he only lost 6% when the market went down 25, I’m going to go ahead and put my money in that fund because that guy’s smart and he’s going to make good decisions and he’s going to save me from the next bearer market”.

Kevin Kroskey:                  And that historically does not end up very well. DALBAR does the same thing and shows that inevitably, investors do worse than any investments that they buy because it’s bad behavior, largely attributed to these timing decisions that they’re using to go ahead. And sometimes they’re trying to, it’s all in good intent and purposes, but it just doesn’t work that well. If I go ahead and say I listen to Walter on the radio and I say, “Man, Walter would be a great co-host for the Retired Smarter podcast. Walters ability, his wit, his funniness, his knowledge of financial”.

Walter Storholt:                Don’t forget good looks. Don’t forget good looks. Very important in the radio and podcasting.

Kevin Kroskey:                  I’m giving you, I see your head growing. But that his ability is going to translate it. He’s going to come over and he’s going to be a great co-host for me here. Or, sports is another one. You bring in, I mean the Cleveland Browns bring in Odell Beckham Jr., who’s a great wide receiver for the New York Giants. So far he’s looking pretty gosh darn good for the Cleveland Browns. So his performance is persisting.

Kevin Kroskey:                  But in the investment markets it doesn’t really work out that way. Just because somebody had good past performance, does not mean that it’s going to repeat. And in fact, when you look at the advertisements in money magazine or online or whatever it may be…

Walter Storholt:                That’s the famous saying, isn’t it? Past performance doesn’t predict future results or whatever. Something like that.

Kevin Kroskey:                  You got it. They completely disclaim that. So, where it works in so many other areas of our lives, be it in the workplace or be it in sports or there’s some sort of testing that’s done, ultimately it’s just proven that it really does not work when it comes to investing. And honestly this is going to be a perfect way to go ahead and leave a carrot dangling, because we’re going to talk more about this in the next episode.

Walter Storholt:                I love it and I kind of feel like the mutual fund, this mutual fund has done so well over the last X amount of years, and then they dropped the past performance doesn’t predict future results. It’s kind of equivalent to the weight loss ad that’s, this person lost 75 pounds, this one 100, this one 150 pounds, and at the end of the ad or in the small print down below, “Results not typical”.

Walter Storholt:                Sort of the same parallel there between those two. The other thing that sticks with me from today’s episode too, is that the recipe is more important than the ingredients. Kind of like the whole is greater than the sum of its parts. I think that really resonated with me today, as well. It’s about how those ingredients come together, more important than the ingredients themselves. And I think there’s a lot of wisdom, when you kind of peel the layers back of that analogy and of that saying as well. Based on what we’ve talked about.

Walter Storholt:                So there you go. Good foundation is part three of our series, our extended series, now. Two to four on this series about your investing process breaks down. Come back, listen to the fourth part. If you’re listening to this right after it releases, part number four will be essentially in a exactly two weeks from part three. So, be sure to come back and listen to that episode.

Walter Storholt:                If you’ve got any questions for Kevin in the meantime, about your financial life, your financial plan, want to run something by him, you can reach out 855-TWD-PLAN is the number to call. That’s (855) 893-7526. He’s got an office in Northeast Ohio, in Akron. Another one in Canfield, as well. You can meet with a member of the True Wealth Advising Team by clicking the “are we right for you” button on truewealthdesign.com, and schedule a 15 minute call with an experienced advisor on the team. Just go to truewealthdesign.com to do that and we’ll put links to that in the description of today’s episode as well, to make it easy for you to find.

Walter Storholt:                Kevin, appreciate the guidance and good luck to the Browns, right? And we’ll talk to you next time around for part four and finish the conversation on your investing process. Maybe, I don’t know, you might extend it to six parts.

Kevin Kroskey:                  We’ll see, we’ll see. Thank you Walter.

Walter Storholt:                We’ll leave that with a cliffhanger. For Kevin Kroskey, I’m Walter Storholt. Thanks for taking some time out to join us. Hope you enjoyed the show. We’ll see you back for part four. Next time on Retire Smarter.

Disclaimer:                          The information provided is for informational purposes only and does not constitute investment, tax or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.