The IvyVest philosophy of "unapolgetically rational investing" is derived from nine empirically supported observations about the timeless principles of how financial markets operate and what makes for successful investing.
1. The 95:5 Rule of Investing. Asset Allocation is investing, the rest is just details.
Managers of large projects may be familiar with the Pareto Principle, or 80-20 rule, which says that 80% of the effects of something usually come from 20% of the causes. Examples abound: 80% of your company's profits probably come from 20% of its customers, 80% of your stress comes from 20% of your daily activities, 80% of your time is spent on 20% of your to-do list.
The Pareto Principle suggests an obvious route for improving your productivity: devote more of your time to the 20% of your tasks that really matter and less to the 80% that don't.
Investing has a similar principle, but instead of 80-20 it is more like 95-5, as in 95% of the benefits of investing come from things that most investors spend less than 5% of their time thinking about.
The 5% of investing that leads to 95% of outcomes is asset allocation. If you accept the need to own a diversified portfolio, then it neatly follows that the thing that is really important is not the exact details of whether you own Coke or Pepsi, but the composition of your portfolio in different asset classes like US Stocks, European Stocks, Japanese Stocks, Bonds, Real Estate, and commodities. Studies show that in real-world diversified portfolios, asset allocation can account for about 95% of the difference between one portfolio and another. The endless individual stock debates that most investors spend 95% of their time thinking about and discussing produce only negligible 5% differences in outcomes. So efficient investors will spend all of their time thinking about getting the asset allocation right, and little to none thinking about the individual stocks that they own.
2. Beating the market is a zero-sum game.
Every time you buy or sell a stock, there is someone on the other side of that trade. It is easy to lose sight of this because you will never meet that person, or even know who he or she is, but this is nonetheless true, every transaction has to have two parties by definition. So if you are buying a stock because you think the price is too low, that means that someone somewhere else is selling it because he or she thinks the price is too high. One of you has to be wrong.
As an individual investor, this has some pretty far-ranging consequences. There are some pretty smart people involved in the stock market. Many of them work at money-management firms where it is their full-time job to analyze the markets and try to find the slightest discrepancy that they can exploit in order to make money. Many of them have access to exclusive information and resources because of the amount of money their firm manages. Some of them may even (illegally) have access to inside information about how a company is doing. These are the kinds of people that are likely to be on "the other side of the trade" from you, and when you actively trade stocks you are making a bet that you know more than them. There are certainly cases that this might be true, but if you don't know what your "edge" is before you make a trade, you are very likely a sucker.
But for people who do not have significant time to devote to getting an edge in the stock market, there is a clear alternative. Focus on "meeting the market" rather than beating the market, and use a system that incorporates the latest research in the science of how people make decisions and how the markets work to develop an "edge" at asset allocation - the 5% of investing that drives 95% of results.
3. The only sure thing in investing is the costs you are paying.
If you decide not to manage money yourself, you might turn it over to a professional mutual-fund manager to take care of. There are two problems with this. First, as mentioned above, most market participants are also professionals, and there is no guarantee that "your" professional will be smarter than the other professionals and generate returns above the rate of the market. Studies show that most professionals cannot pick stocks any more reliably than the proverbial blindfolded monkey throwing darts at a newspaper.
Two, you will have to pay the mutual-fund company a substantial fee to manage your money. Actively-managed funds can charge annual fees of 1% of your money or more. Unlike the excess returns that you may or may not receive, this fee will be charged like clockwork every month, slowly depleting the size of your account. Over a twenty or thirty year horizon, studies show that the loss in your wealth from fees can add up to more than the size of your initial investment. So if you invest $100,000 in a mutual fund, you might be effectively paying more than $100,000 in fees over the course of your lifetime.
On top of this, if use you use a financial advisor, he or she will charge another fee for his or her expertise in picking the funds you are invested in. This fee is variable, but usually amounts to another 1% of your assets (or more for smaller accounts).
In contrast, our portfolios use low-cost ETFs. The all-in expense ratio for our flagship All-Weather portfolio is only .12% + $8 a month, vs. the 2% or more that most investors pay.
4. Diversification is wildly underrated.
There are not many universal truths in investing, but one of them is that diversification is one of the only free lunches you will ever get. Turning down free lunches is generally not a good idea - in life or in investing.
Diversification is a free lunch because it allows you to decrease the risks you face in investing without decreasing your expected returns. To see why, imagine you are considering two investments, both of which are expected to appreciate at 10% on average, but which have a 1 in 5 chance of going down in value by as much as 50%. If you buy just one of these investments, there is a 20% chance that you will lose half of your money. But if you buy them both (assuming they are uncorrelated), the chance of losing half of your money falls to only 4%, while your expected return is still 10%. Why? Because only rarely do they both have bad years in the same year.
But the benefits of diversification go beyond that. Diversification is also one of the few risk management techniques that we can use to protect our portfolios from the inherent uncertainty of the future. There is no way we can know what tomorrow will bring, and it is easy to imagine historically unprecedented scenarios that could cause huge inflation, a depression, or a significant fall in stock prices. Models based on history are of no use in dealing with historically unprecedented events. Our only refuge is to own a wide variety of assets and try to balance assets that will do one in one type of economy - such as the high growth and low inflation 1990s - with other assets that will do well if the future takes a different course, like lower than expected growth and higher than expected inflation.
5. Trust Data, Not "Predictions."
Many people approach investing as a series of "predictions," like "I just have this feeling that the stock market is going to go up in the next six months." The problem with this is that even the so-called "experts" have a horrendous record at making these kinds of predictions about the direction of the market. To put it charitably, they are wrong more often then they are right.
Suffice it to say that none of the evidence suggest that it is wise to pay too much attention to the average commentator's "feelings" about the stock market.
An alternative approach is to try to avoid making predictions and to invest based on what the data tells us and what we know to be true about the markets. For instance, we know the kinds of portfolios that have performed the best in the past, we know that the returns we get from buying an asset in the future will be inversely related to the price we are paying to get it, and we know something about the way that markets work. We can compile all of these "truths" and data into a framework that will let us make rational decisions about what to invest in without the need to make any hand-waving predictions.
6. Invest for 2017, not 1973.
We think it is basic common sense that the best portfolio to own in 2017 is different than the best portfolio in 1999 or in 2008. Surprisingly, many seem to disagree.
Many firms that practice what they call "passive investing" use something called modern portfolio theory, or MPT, to pick investments for their clients. Contrary to its name, MPT is no longer very modern (it comes from the 1970s) nor much of a theory (it has been discredited by research in behavioral finance and market anomalies), but it does provide investment firms with a compelling marketing message, and, maybe more importantly an easy "answer" to feed to their clients.
MPT prescribes a mathematical way of determining the best portfolio for each investor, complete with accuracy to the tenths of a percentage point. The rub is that to use MPT in a practical sense, you need to input the expected returns and risks of every different asset class, as well as the degree that you think they will be correlated with one another in the future. Unfortunately nobody has the foggiest clue about any of that.
Because "future expected returns" are not something that are printed in the newspaper, most firms get around this pesky questions by just plugging in data from the past. So the bet they are making is that the past will repeat itself, that today's market is fundamentally no different than 1973's market, and that the 40 years of academic research that have happened since never really occurred.
The alternative is to look at the returns we are likely to get in the future from today's markets, using what we have learned about the markets in the 40 years since the discovery of MPT to build a model to truly understand the markets.
7. Markets Are Driven by Psychology.
In the 1970s, professors used to believe that the stock market should instantaneously incorporate all known information, so that prices would adjust to reflect everything immediately. We now know based on extensive research in behavioral finance that this is not the case (smart traders have known this for decades - it took the academics a while to catch up).
The markets are composed of a collection of human beings who all bring their own biases to the table. So we end up with herding, momentum, and extreme shifts in sentiment more often then we "should" based on fundamentals alone.
We take these behavioral effects into account in selecting the asset allocation of our model portfolios. By systematically measuring where we are in the course of a market cycle - such as whether people are still rushing into stocks or whether there is a danger that the rush for the exits might start any day now - we can manage risk and improve performance over the course of a cycle. Assuming everyone else is rational never seemed like a very rational thing to do to us...
8. Manage Risk Above All Else.
The magic of compound interest is pretty impressive. If you can generate an 8% average return for 9 years, you will double your money. In 18 years your money will quadruple. In 27 years it will increase in value by a factor of 8. In 36 years it will increase in value by a factor of 16.
But compound interest has a downside as well. If you sit through a bear market and your portfolio takes a 50% decline, then you need a 100% increase to make up for this. If your portfolio falls by 75%, then you need a 300% increase just to break even. This could take decades. But it could be worse. If you invest 100% of your portfolio in the next Enron and lose everything, you will never break even. You will never recover from a 100% loss.
It is tempting to say then, that the first rule of investing is don't lose money. But of course, you have to be willing to accept the possibility of a short-term loss in exchange for a long-term gain. But it is essential to understand the size of the risks that you are taking and to actively manage your portfolio to avoid "falling off a cliff" at the wrong time.
Our portfolios accomplish this in two ways. First, they remain diversified at all times, since this increases the chance that something in a portfolio will do well no matter the external environment. Second, they actively control the volatility (size of the swings from a day to day, week-to-week, and month-to-month basis) and make adjustments if this goes outside our expected range. Managing risks prudently comes first; if we can do that right, the returns will follow.
9. Thoughts are Fragile, Systems Last.
Many people, objectively speaking, "know" how to invest. The basics of the subject are not that difficult to understand, and anyone can buy good mutual funds or ETFs from a discount broker like Vanguard, ETrade, or Charles Schwab. Yet despite this, many of these same people achieve returns that fall far short of their potential. Research from Dalbar shows the average investor in the stock market struggles to keep pace with inflation - this in a market that has gone up an average of 10% a year over the last century.
The reason most investors fail is simple: inability to execute.
Two things tend to fall in the way of even the best-laid investment plans.
The first thing that trips up even well-informed investors is inattention. Many people have great intentions when it comes to investing. And then life happens. Kids come along, work heats up, other side-projects or hobbies come along that seem more interesting for a Saturday afternoon than re-balancing a portfolio. The result is that too often people end up in undiversified portfolios that are in dire need of a re-balancing, or - worse yet - not even knowing what they are invested in or where to go to do anything about it.
The second is psychological mistakes. The human brain came into its present form millennia ago in a hostile environment of lions, tigers, and warring tribes. The "impulses" that we get through our intuitions may have worked very well in this kind of environment, but they frequently do us harm in the modern-day financial markets. So in the time they do spend on their investments, individuals too often end up making decisions that cause them active harm, like pulling money out of the markets at a low in 2002 and putting it back in at a high in 2007.
Luckily, there is a clear solution that makes it easy to execute: use a system. Taking a systematic approach to investing ensures that you need to spend only a limited amount of your own attention monitoring your investments, because you will only have a set list of things to do every few months. Even better, using a system can take the emotions and impulses out of investing, since you will do your "thinking" at the time of creating the system, rather than in the heat of the moment when you are more likely to make a mistake.
The Ivyvest approach systematizes most of the key aspects of investing. We have a clear plan, defined buy and sell criteria, and we use our computers to monitor the markets on a 24/7 basis both so that we do not miss anything, and so that we can take emotions out of the process as much as possible. Best of all, we can use our system to alert you whenever you need to do something with your investments, so you can spend your Saturday afternoons doing things that are more interesting than rebalancing your portfolio.