(Just a note about my qualifications for writing what follows. I am a Certified Financial Planner (CFP®) and have been since 1993. I was involved in the investment consulting business for almost a quarter-century. I earned several sets of credentials along the way – Certified Investment Management Analyst; Certified Investment Management Consultant; Accredited Investment Fiduciary – in addition to CFP®. I also spent twelve years as a member of the Board of Trustees of the Wyoming Retirement System, a public pension fund that operated to benefit 50,000 public employees while managing a $5 billion dollar investment fund. I spent two years as chairman of the board, and 4 years as chairman of the investment committee.)
Sometimes on my drive to the Catholic Center, I will listen to a well-known financial advice-giver, doling out answers to questions about debt, budgets, investments, and money in general. But I am cautious and skeptical regarding his advice and his motives because I have heard him say things to callers that are misleading and inaccurate.
Allow me to get a little nerdy here. In my years as an investment consultant, I was constantly measuring the risk involved in the portfolios of my clients. We were able quantify investment risk using metrics derived from the market movement of various asset classes in relation to the market in general. One of the primary measurements is beta, which provides a value to how an investment moves relative to its index.
Beta is not a measure of risk in itself. Rather, it tells us that if investment A has a beta of 1.0, its movements exactly replicate that of the overall market itself. A beta lower than 1 means it moves less than the market, and greater than one more than the market. It is a way to calculate how much investment return comes from the market, and how much comes from the skill of the manager.
I bring this up because I heard the aforementioned radio host tell a caller that beta tells if an investment is risky or not, which is just not true. This isn’t something that most people would catch or bring up in casual conversation. Neither would most people have that information to challenge the radio host. For me, it makes me wonder what else he is telling his listeners that may be incomplete or misleading.
Beta can be used in conjunction with alpha, which is defined as excess return adjusted for risk. We should realize that even a term like “excess return” can cause controversy in the investment world, but it helps us move our story along. If we have an investment with alpha greater than 0 and a beta of 1.0, it means we have found an investment that has the volatility of its index but returns greater than the index. It is evidence of manager skill, or, perhaps, manager luck.
Our radio host never mentioned alpha. He never talked about indexes, either.
Indexes are unmanaged bunches of stocks or bonds that represent a particular market. The S&P 500 is an index, as is the Dow Jones Industrial Average. There are many, many more indexes which are widely used in the investment world. We can invest in indexes directly through mutual funds or exchange traded funds. This method is employed successfully by many institutions and individuals. We invest in indexes because it is efficient, inexpensive, and beats 80% of active managers in any given year.
He talks about mutual funds, too. He is an advocate for investing in four different kinds of funds – growth, growth and income, aggressive growth, and international growth. He does this, he says, because when one fund is down another one is likely to be up. It is his way of diversifying his investments. This sounds impressive, but in reality it doesn’t solve any problems of diversification.
We can tell how different one fund is from another by calculating the correlation between mutual funds and their respective indexes. A “1” means they are perfectly correlated, in which they move in tandem. A “-1” means they are exact opposites, and move as such. A “0” means there is no relationship at all, and assets move independently from each other. In reality, these four categories of mutual funds tend to have very high correlations, as in .90 +, indicating they are not very different from each other and offer very little in terms of diversification. We diversify investments to manage the overall risk to our portfolio, and buying funds in these four different classes do not help us manage our risk by providing diversification. He essentially has made the same investment four times, like buying CDs at four different banks.
He won’t buy indexes, either. He doesn’t buy them because he says they get “average” returns and he wants better than average. So does everyone else. The problem is it is nearly impossible to pick out managers who get better investment returns than indexes year-in and year-out.
Indexes get market returns, not “average” returns.
Finally, I heard him tell his listeners his funds have produced double digit returns for many years, and that the funds should be able to “stand the test of time,” and that one should look at the returns based on five, ten and twenty-year histories. There is just so much wrong with that statement that it is hard to fit it into the space people might actually read. Let’s look at three of these items.
- Returns: His returns are HIS returns, not yours. Your investment schedule and his are completely different. Your returns WILL be different.
- Test of Time: Mutual fund managers and styles change constantly. The returns generated by one manager will be far different than those generated by another manager at the same fund. Manager A may be an all-star, while manager B – at the same fund at a different time –a bench warmer. A fund with an impressive record may have generated great returns under manager A, then mediocre returns under manager B who succeeded A when A cashed in on his performance and went to a different fund.
- Track record: This is one consideration when choosing a fund, but not the most important by a long shot. Yet it is our host’s primary means of selection. In reality it means very little, because track records are what has happened in the past based on the people involved and their luck or skill in stock selection. Today, those people could well be gone, different methods of securities selection employed, and different reactions to economic factors.
There is so much more to the analysis of mutual funds than I can possibly share in this post, or a hundred more of them.
I write about these things not because this is an investment advice column, but because we are tasked by God to care for the gifts he gave us, returning them with increase.
If we are to steward the gifts entrusted to us, it is incumbent upon us to learn about the care of those things. Abdicating that responsibility to a radio talk show host who knows nothing about you is not the way to do it.