Episode: 07-25-2023 | Investing Philosophy and Mechanics

Hosted by Kevin J. Zywna, CFP® Dollars & Common Sense · Investing: Philosophy and Mechanics Investing Unpacked Most of our show is dedicated to financial planning and financial planning topics because that is where we feel we can add the most value for our clients and for our listeners. And literally, as we sit there […]

Hosted by Kevin J. Zywna, CFP®

Investing Unpacked

Most of our show is dedicated to financial planning and financial planning topics because that is where we feel we can add the most value for our clients and for our listeners. And literally, as we sit there with clients and go over their deep analytical financial planning, based on strategies we can come up with, or techniques that we can use, we literally can come up with sometimes 10s of hundreds or even millions of dollars of additional net worth over time, if we have enough time ahead of us and we’re working with enough money. So financial planning is an incredibly valuable component of financial advice. But you know, what else is, investment management.

We say at the top of every show, expert investment management is part of our service offering. And so last show, I talked about why anyone should invest anyway, and a little bit about how it works. The main reason that we invest and when I say invest, I typically mean investing in US common stocks, or perhaps companies and stocks and companies overseas, internationally, so forth. But the most common form of investment stocks, mutual funds, ETFs (exchange traded funds), is because it’s the simplest, most efficient and least expensive method of building wealth and income over time.

Investments Are Proven Wealth Growth Vehicles

So why wouldn’t you take advantage of that if you want to build and build and maintain financial security over a lifetime? That’s why we invest. And the reason that we can be so sure that the stock market or the underlying stocks that make up the stock market can, over time, deliver generous rates of return for your portfolio is because the earnings of these companies grow over time. The average of eight, nine, 10% per year, obviously, not every year, not during a recession.

In fact, on average, about once every six or seven years, there’s enough of a decline in earnings, that it can cause what’s known as a bear market, we would define that is 20% decline from some peak to trough, 20% or greater. And it’s that fear, that uncertainty, that comes about those sharp dramatic market turn-downs that usually turn a lot of people off from investing. But for the last 100 plus years, the stock market, the S&P 500, the major US corporations have delivered somewhere between eight and 12%, average annual rate of return, depending on which index you look at, which companies you analyze, and so forth.

Why Investments Are Proven Wealth Growth Vehicles: US Population Growth

It’s difficult to even argue that the long term growth rates of US common stocks are anything but positive. In fact, you go back over the last 100 years, and if we take the S&P 500 index as a measuring stick, then over that last 100 years, the S&P 500 has compounded, on average, almost 10% per year. 10% growth rate per year, on average, out of the 500 largest companies in the United States. That’s the statistically factual statement.The reason those earnings grow so reliably over time, is predominantly three main reasons. Number one, population growth. In the US, over the last period of time, we have steadily increased our population over the last 100 years – more people means more stuff to buy, means more economic activity means more profit for the companies that produce those reliably and economically for their consumers.

Why Investments Are Proven Wealth Growth Vehicles: Productivity of the American Workforce

That means you people who have invested for a long period of time in US common stocks have outpaced the rate of inflation, long term rate of inflation, which is 3% by 7% per year, on average. And it’s important to always compare your rate of return on any investment to the inflation rate. Because as the price of goods and services is inflating, is incThen also, the productivity of the American worker. Despite all our problems in this country, the American worker is one of the most productive workers per capita on the planet. And if there’s one thing that we are good at, it’s being very diligent at showing up to work every day doing a decent job, producing a profit for our employer and our shareholders and getting paid correspondingly for it. A lot of other cultures are not geared towards a sort of work first place, play second, like in the US. Other cultures are play first work second, and hey, that’s not a bad way to go through life, I’m not knocking it, I’m just saying, from an investment perspective, the American worker is one of the most productive and efficient workers on the planet.

Why Investments Are Proven Wealth Growth Vehicles: American Capitalist System Drives Innovation

And then thirdly, and perhaps most importantly, earnings, consistent, reliable earnings growth is delivered through innovation, constant, incremental innovation, brought about by the American capitalist system, where he or she who can build the better mousetrap will reap the rewards and riches from doing that. So there’s a huge incentive built into the capitalist system to find a faster, cheaper, higher quality way of delivering your goods and service. And if you do that, then more people will beat a path to your door, which means you’ll sell more of your widgets and you’ll make more profit, and your earnings will grow. And so you take those three things together, population growth, productivity, and innovation. In the US, it’s largely unmatched. And it’s the reliability of those characteristics that consistently grows earnings over time. And that’s why we invest. That’s a little recap of the last show.

Investment Philosophies And Proper Investment Approaches

Tonight, though, I want to take the next step, and talk more about investment philosophy and mechanics. And so once we buy into the idea that we should invest, now let’s talk about how we invest and the proper way to invest and I probably got some radical ideas here compared to conventional wisdom that might be of interest to you.

Investment Management Is Process Driven

Tonight we’re talking about investing philosophy and mechanics. So there’s about 1000 different ways to do Investment Management. That might be somewhat evident to people who watch CNBC or read Yahoo Finance, or Bloomberg, or other investment-centric shows, everyone seems to have an opinion. And everyone seems to have their own way of doing Investment Management. I will say that at Wealthway Financial Advisors, we believe that investment management is process driven. It’s formulaic, and it’s systematized. So there’s structure around the investment management process. It is not hot stock tips at the water cooler at work. It is not Cramer, on the nightly version of CNBC. It’s not your brother in law at the company at the family reunion. It’s a system that has to be maintained in order for it to keep the integrity to ensure you have a high probability of getting the results you’re looking for, namely, a long run rate of return somewhere between eight and 12%. Hopefully, with as little volatility, we call it as possible so that the ride is as smooth as can be while achieving those long run numbers.

Understand Investor Behavior And Asset Allocation

So the way we start out by doing that is that we believe that investor behavior and asset allocation are the primary drivers of long term investment performance, not security selection, or market timing. And that is in direct contrast to what I would say is probably 80 to 90% of the investment world. Most people who are investment advisors or financial advisors want you to believe that they have a secret formula or a crystal ball in order to make the right hot stock picks and can jump in and out of the market at the right times in order to ensure that you buy low and you sell high and then you do it again with another investment. No, that is not good investment management. It’s a form of investment management.

But it’s not a reliable form of investment management. And yet the majority of news outlets, financial press, financial television shows and actual purveyors of investment advice behave that way. Security selection and market timing are what they do and what they’re good at. We don’t believe that at Wealthway Financial Advisors. At Wealthway we believe it’s investor behavior and asset allocation.

Impact of Investor Behavior In the Investing Process

So what does that mean investor behavior? Well, first of all, it starts with you, the person. Are you committed to an investing process? Are you going to take money from your paycheck or from the bank and subject it to the short term volatility of the US stock market and the stocks that make it up? Are you going to intake money and actually invest it? Only about half of Americans have any connection to the stock market whatsoever and that includes whether it’s in your 401 K plan, the TSP. You do it outright, you do it through somebody.

Only half of Americans take advantage of one of the greatest wealth creation machines ever generated in human history. And that is a fractional share of common stock of large publicly traded companies. So half the country isn’t even touching the investment market. And there’s a reason for that. Obviously, a lot of it could be well, they don’t have any disposable income to do that. But that’s not an excuse for everyone. Most people just don’t understand it, are scared of it and don’t know where to even begin. And that’s a shame. Because there’s an entire industry out here, US, willing and able to help people take advantage of this.

So investor behavior, whether you invest or not. And when you invest what you do when you invest, if you don’t have a system if you don’t have a process, and you are the one who is trying to pick hot stocks, and buy and sell and market time, and change allocation, and tactically maneuver your stock holdings. Or you saw a commercial for a company, like us all, that’s a good idea, let’s buy stock, that’s random and haphazard. And that behavior, all of those things taken together, can work against you.

But human behavior or investor behavior can work for you. If you work a system, you develop a system. So number one, how you approach investing is by far and away the biggest determinant in your long run performance, more than any other factor. And so most people don’t know that. And most people don’t believe it, even though I’m saying that it’s true.

Impact of Asset Allocation In the Investing Process

So secondly, after investor behavior, asset allocation then becomes the most important factor in determining the success of your investing process and the strength of your investment portfolio. Asset allocation is a little bit of a technical term. For those who aren’t aware, asset allocation is the different categories of investments that you can use to build your investment portfolio. And I guess I should define portfolio. Portfolio is simply all the holdings all the investments, or all your money attributable to the holdings that are considered investments. Opposed to say bank assets, which are savings, those aren’t investments.

So your portfolio deals with investments, asset allocation, the biggest determinant now asset allocation. The different categories that make up a typical investment portfolio can be wide and varied depending on the philosophy of the investment manager. At Wealthway Financial Advisors, the main investment categories we use, well, the meta categories, stocks, bonds, cash, those are like the three biggies. And there’s a whole bunch more yet. There’s stock options. There’s private equity. There’s all kinds of other types of categories or asset allocation, asset classes.

What Are The Different Types Of Stocks

But at Wealthway Financial Advisors, we stick with US common stocks, international stocks, or companies in developed nations. And right now developed nations are considered Europe, and Japan primarily. So companies headquartered overseas in Europe and Japan. Some other international style stocks or emerging market stocks. China, India, Taiwan, South Korea, Brazil is in there. Russia used to be in there, but they’re on the no invest list now for obvious reasons. So companies in emerging economies, which have the ability to grow faster, because they’re smaller and younger, can also be much more volatile.

Commercial Real Estate As An Investment

Some other factors that are long term drivers of corporate profitability are the fact that US population has grown by Commercial real estate is another category that we use, an asset class to build our investment portfolio. A lot of times people think commercial real estate, and think office buildings, and right now, and that is a component of commercial real estate. Office buildings are seeing a significant decline in value because they’re losing tenants because there’s more people working from home, and they’re not demanding as much office space. So well, that’s a component of commercial real estate. There’s much more that goes into it. There’s an industrial form of real estate – factories and shipyards, that type of thing. Self-storage units you see all over the place. That’s a real estate play. The people who own those things are making money temporarily off the storage units, till they wait for the land to become more valuable until they sell it out to a developer. So self-storage, data set, data centers, where they keep server farms for the cloud, hospitals, apartment complexes, hotels, all that and more make up commercial real estate. A very viable asset class that we use on behalf of our clients.

Natural Resources As An Investment

Now, I will concede, you buy individual shares of an individual company, there is more risk at play there. A company can go out of business, which means its stock will go to zero. Stay there, and you’ve permanently lost that money. And that’s

Then natural resources. So those are the companies that manufacture or mine or create natural resources. So oil and gas, coal, the precious metal miners, timber, agriculture, livestock. Those are great inflation hedges, and we think that natural resources are a good addition to portfolios.

Tonight we’re talking about investments, philosophy and mechanics. And the first part of the show I went over the primary drivers of long run investment performance and that is investment, investor behavior, and asset allocation. Then we went into more detail on what asset allocation means. What it is and the different categories that we use at Wealthway Financial Advisors to build portfolios for our clients. I should add a little bit more detail in there. You know, US common stocks was one of the categories. That is the main category that we use, where we have most of our clients’ assets invested.

US Common Stocks Sub-Categories

Why does the stock go up? On a daily basis about the only reason you can give on why stock why stocks go up is that there were more buyers and sellers. On a daily or a short term basis, there were more buyers and the sellers, you can’t r

But even there, there’s subcategories. So within US common stocks, there are large companies, midsize companies, and small companies. It’s important to diversify your investments across not just a range of asset classes, but a range of company sizes. Because typically large companies are more stable, more reliable, but more slow growing. Smaller companies are more emergent, more volatile, can be riskier, but can also have much larger payoffs in the long term as well. So by spreading your investment money, between sizes of company in US common stocks, you can sometimes help enhance your overall performance while reducing your long term risk.

Distinguishing Between Investing Styles

And then there is a discussion within the investment community about investing styles between growth style investing and value style investing. We’re not going to get into that tonight. But just know that there are two different philosophies. Each one, from time to time one is always in favor, but they are sort of trading places over time between growth and value style investing. So we also diversify our client portfolios between those styles as well. So investor behavior and asset allocation, are the most important determinants in long run investment performance. Not security, not selection, and not market timing. Overwhelmingly, most of the investment community profession wants you to believe that security, selection, and market timing are the most important. They are not. All right. So what we do when we build portfolios at Wealthway Financial Advisors is that the portfolios are goal-focused and planning-driven. We compare our portfolio performance to long-term financial planning needs. We do not compare performance to an index.

Importance Of Measuring Investments Against A Rate Of Return

Now, one of the things we do that most large brokerage companies still don’t do is provide our clients with a rate of return. We do the math on all your holdings, on all your accounts, on all the investments and all the accounts. We pull them together. And we have sophisticated portfolio management software that does math. And then we can tell you exactly how the investments are performing over say, a one year, three year, five year, 10 year hold period so that there’s no guesswork to figure out how am I doing? Exactly how you’re doing in percentage terms, and also in dollar terms.

There’s no ambiguity about the investment performance. We know exactly what it’s doing, thanks to software. I think the reason it is not shown on most brokerage statements that you get from the large brokerage houses is that they don’t want you to know what your rate of return is. We want our clients to know. We are transparent in everything we do. And that number is important from a planning standpoint.

And so we don’t compare performance to an index like the S&P 500, or the Dow Jones Industrial, because it doesn’t matter. It’s an arbitrary benchmark of investment performance. Sometimes your portfolio is doing better than the S&P 500. Sometimes it’s lagging the S&P 500. But none of that really matters to your long term financial objectives. What does matter is how is the portfolio growing over time? At what speed? Or what rate of return? Is it growing over time? And how quickly can you get to your goal of retiring at age 60, or buying that vacation house down at the beach at the Outer Banks or making sure your kids have enough money to go to college or making sure you have enough income to last your lifetime  when you do retire? Those are lifetime financial planning objectives, that those are the ones that we integrate into our financial planning with our investment management. And we’re able to compare the performance of the portfolio to the timing of those long term objectives. That’s what is important.

Measuring Investments Against A Rate Of Return Vs A Benchmark

Remember what I was saying before the break about how a lot of people get their investing wrong, and they don’t stay invested through the occasional temporary downturns. They get scared in to selling by the rest of the media. The financial news media doesn’t help with this. CNBC does not help with this. CNBC, I like to say, is hazardous to your wealth. It causes people to make bad decisions. There’s a host of financial products that are in the marketplace that are Another misconception in investing is the idea that we invest to beat a benchmark. That we invest to beat the S&P 500. Well, if the S&P 500 is down 20% in a given year, and you’re down 18%, do you feel any better? You beat the benchmark; you were down less than the benchmark. We don’t invest to beat an arbitrary benchmark that doesn’t help us accomplish our objectives. We invest to grow our net worth reliably, over time, to have the money we need to live the lifestyle that we desire. All of us have our constraints of income, how much we can earn in our current occupation. But we grow, we invest to grow our net worth to live a lifestyle that maximizes our quality of life. So, at Wealthway Financial Advisors, all the investment portfolios are goal-focused and planning-driven. We do not compare it to an index because that is not what is important.

Importance of Rebalancing Your Investments

Another good tenant of investment philosophy and mechanics is the rebalancing process. And that means when you get your asset allocation set up, remember those categories, and you’re going to put certain percentages of your investment portfolio in those certain categories. You might have 15% in US large company stocks, you might have 5-10% in US small company stocks, maybe have 10% in international, 5% in emerging markets, 10% in commercial real estate, you know, all those percentages.

Once you set those percentage targets, then you want to stay true to it for the foreseeable future. You do not want to tactically reallocate your portfolio. Some investment houses will have you believe you do not want to try to market time jump in and out based on the whims of the stock market or the tea leaves that some TV prognosticator is trying to sell. Once built, an asset allocation should remain relatively static or true. And so over time, and it’s usually like a year, at least, maybe longer, there’s going to be drift from those different asset classes. Some asset classes are going to perform better than the others, and some perform worse than the others. And that’s all normal and natural.

After a reasonable period of time, it used to be considered monthly or quarterly that  we’ve learned through the years is too frequent. It’s probably annually. Once every between one and three years is really sufficient to rebalance your portfolio because you’ve got to let your winners run for a little while. You don’t want to sell off too soon. But once the portfolio starts to get out of whack, it starts to drift from those percentage holdings that you initially set up, then it is appropriate to want to sell some of the investments that have done well and now occupy a larger percentage of the portfolio. Sell some of those good performing stocks and buy with the proceeds areas of the portfolio that were underperforming.

That seems counterintuitive to most people. They’re like, wait a minute, but this asset class is doing so much better than the rest. I don’t want to sell that. I want to keep it going. Well, you do. That’s why you don’t want to rebalance too frequently. But after a while, you want to take some of that, that outperformance and then buy the areas of your portfolio that is underperforming, that is de facto doing exactly what you should be doing from an investment standpoint, buying low selling high within the allocation of the portfolio, not trying to sell your entire portfolio out and then buy low when the market goes down. That’s market timing.

Talking about staying invested in all your asset classes. But trimming them up over time to, in effect, sell high and then buy low, which is exactly what you should be doing. If you do that reliably, consistently, then that is a performance enhancer over time. So rebalancing is important to the portfolio, but you do not modify your investment allocation due to short term market fluctuations. And by short term we mean one or two years. So the market is having a bad year, that is no time to try to sell out of your portfolio or radically alter your asset allocation. No, that’s  the time to do some rebalancing. Once an asset allocation is built because of its appropriate nature for your life goals, then you need to stick to it if you want to have a high probability of achieving your long run performance objectives. If you keep changing your asset allocation dramatically over time, it’s like chasing a moving target. And when you do that, that’s almost always a recipe for underperformance.

Tonight we’re talking about investment philosophy and mechanics, the way we do it at Wealthway Financial Advisors and the way we think everyone should do it. Because we do think we have a highly reliable investment process. Many of the principles that it is based on come from an investor you may have heard of. He operates out of the Midwest, predominantly Nebraska, by the name of Warren Buffett. Probably one of the world’s most successful investors, who espouses many of the philosophies that we have integrated into our investment management process and into the way we do things at Wealthway.

So before the break we were talking about the importance of rebalancing and staying true to your original asset allocation in order to have a reliable, high degree of probability, high degree of predictability of future investment outcomes. So if investor behavior and asset allocation are the primary drivers of long term performance, not security, selection, or market timing, but eventually, we’ve got to get down to security selection. So after committing to the investment process, we train our behavior to be investors. And then we develop our asset allocation. And we hold true to the different categories that we set up in our investment portfolio.

Selecting Investment Asset Categories That Match Your Investment Categories

Now we’ve got to select the investments that match or make up those different investment categories, those different asset classes. And there’s a lot of ways different ways of doing that. At Wealthway Financial Advisors we choose, primarily, to use a blend of low cost exchange traded funds, ETFs and some actively managed mutual funds. We generally do not use individual stocks or bonds. And we never use expensive, complicated, opaque instruments like hedge funds, limited partnerships, private placements. None of that is necessary at most individual level investing.

Those more complicated instruments can have some applicability. If you’re a university endowment, or hospital endowment, or if you’re a pension fund, then you can afford to take some bigger risks with those other complicated vehicles. But for most people, exchange traded funds, and mutual funds are the simplest, easiest and most cost effective way of getting exposure to the US equity market or the international equity market as well. And you don’t need to get overly complicated or complex, we purposely choose to generally not use individual stocks, because a company can go out of business, which means its stock will go to zero, stay there and you’ve permanently lost that money.

So we take that risk right off the table by using ETFs and mutual funds as our preferred investment vehicles because each one of those vehicles, each one mutual fund and each one exchange traded fund is a basket. And within that basket can be anywhere between 25 to over 1000 individual stocks. So if one of those stocks in your mutual fund basket goes out of business, then might not even feel it, you know, because there’s 500 other ones in there that didn’t go out of business. So, the individual security investing or individual company investing, it can be viable. But I would say for most individual investors, it’s not something that you should attempt by yourself. Unless you’re maybe working with a professional investment advisor, who he himself or she herself has their own reliable Systematic Investment Management process.

So we use low cost exchange traded funds to get exposure to asset classes that we think are important in the portfolio. But not where a manager active management can’t add much value. So for example, US large company stocks, the most studied and analyzed area of the investment world, very difficult for active managers to outperform, gain an advantage. So, we don’t attempt to get exposure to them to an ETF for a very low cost. It is unmanaged, very tax efficient, and boom, there you go. We do use active management, which does cost a little bit more those costs embedded in the mutual fund.

They do cost a little bit more, but it’s okay to pay more for something if you’re going to get more or you think you’re going to get more or there’s a high reliability of getting more. And so in in less scrutinized areas of the market, US small company stocks, international investing, emerging markets, commercial real estate, which is always like ebbing and flowing.

That’s where we do use active managers. Because active managers can add value over time. And by time, I mean usually at least five years, probably closer to 10. So when we make an investment decision into a mutual fund or an ETF it’s a long term hold decision unless something goes on in the interim. But we give our managers and vehicles a long runway so that their skill can develop can prove itself over time and we do see those typically in our long run numbers of 10 year hold periods but that’s how long we’re talking so buying and selling ETFs you know on a monthly basis is not going to get done.

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