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KNOW WHAT INVESTMENTS YOU OWN AND WHY – ALL INDEXES ARE NOT CREATED EQUAL

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Overview

MOST ADVISORS AND MANY ASTUTE CLIENTS ARE AWARE OF THE FACT THAT OVER THE LAST TWENTY YEARS (ACCORDING TO THE DALBAR STUDY), EQUITY MUTUAL FUND INVESTORS HAVE NOT ONLY FAILED TO BEAT THE MARKET AS DEFINED BY THE S&P 500 BUT THEIR FUND MANAGERS HAVE ALSO TRAILED THEIR CHOSEN BENCHMARK.

This fact is undeniable and we do not refute the research that supports it. What we do take issue with is the “knee-jerk” reaction that many advisors and investors alike have taken to remedy the situation. That being, a tremendous flight from accomplished active money managers to funds that center around an indexing strategy.

ALL INDEXES ARE NOT CREATED EQUAL

Just as investors’ ability to time the moves of the market has been a failed attempt over the last twenty years, we believe that an investment strategy focused on indexing is flawed as well. Although the industry is in the process of offering alternative methods to the construction of indexes, a major percentage of indexes are still calculated using a market-capitalization method of weighting. In our paper, we present three reasons as to why this weighting scheme is flawed and thus is not an optimal investment strategy for advisors or investors alike. Lastly, we find it very interesting the fact that these new-fangled index methods of construction seem to be attempting to replicate the long-lost art of stock picking. 

Granted, a step in the right direction but we will not rest our case until every investor has complete clarity and simply knows what they own and why they own it!

As complicated as the investment industry has made everything from regulation to trading, it also has convoluted the construction of market indexes.

The first stock market index was created by Charles Dow in 1896 and has come to known as the Dow Jones Industrial Average (Dow). At the time, Mr. Dow was simply trying to construct a method of tracking the overall stock market in aggregate form. His finished product was a 12-stock index that used a price-weighting method or scheme. Although cutting-edge at the time, most view this method as antiquated in nature. We say this because only the most rudimentary of investors would build a portfolio based on the absolute price of the stock. This would be indicative of a young adult who was given $2,500 as a graduation gift and wants to begin the process of investing. They want to buy Amazon or Google, but because of the enormous share price of each stock being greater than $2,500, they can only purchase one outstanding share – not a very good method of diversification. Alternatively, they have the option of taking a more prudent course and purchasing 10 shares of SiriusXM Radio, trading at $6 per share, and 10 shares of Hive Blockchain Technologies, trading at less than $2 per share and so forth. Apple per Morningstar at https://www.morningstar.com/etfs/arcx/ivv/portfolio is the largest holding in the S&P 500 at nearly a 7% weighting. In fact, if you add-up the top 10 holdings in the S&P 500, they equate to nearly 30% of the total. This means that 2% of the holdings comprise 30% of the weighting. At first glance, some would suggest that owning Apple has been a good decision – for the most part it surely has.

Three Pitfalls of Market-Cap Weighted Indexes

1. Stock Concentration Risk

Unlike a price-weighting scheme, the market-cap method weighs individual holdings not by mere price alone but by market price times the number of shares outstanding (aka market capitalization). Some refine this method by including those shares that are just actively traded in the market, which the industry refers to as free-float. Either way, this highly popular method by its sheer construction heavily overweights those of largest stature. For example, due to its popularity, according to Morningstar (https://www.morningstar.com/etfs/ arcx/ivv/portfolio) Apple is the largest holding in the S&P 500 at nearly a 7% weighting. In fact, if you add-up the top 10 holdings in the S&P 500, they equate to nearly 30% of the total. This means that 2% of the holdings comprise 30% of the weighting. At first glance, some would suggest that owning Apple has been a good decision – for the most part it surely has. However, there lies a flaw in this mentality. As a company’s market value increases (like Apple’s) so does the company’s weight in the index, as well as the investor’s exposure to that single stock or set of stocks. Here is the catch; a market index that bases its weighting-scheme solely on size will overtime systematically (upon rebalancing) invest too much in stocks that are overbought and too little in stocks that are selling at a discount to their intrinsic value. This leads to investors increasing on a percentage basis those stocks that rise in price and reducing those that drop in price. Is this not a fancy way of saying; “Buy High and Sell?” Academics refer to this dynamic as the Representative Bias where investors flock to high-flying stocks and flee those that are unwanted. Like most behavioral biases, research has shown this systematic flaw is attributable to roughly 2% of lost return on an annual basis.

2. Sector Concentration Risk

This risk became no more apparent than it did in the late 1990’s when investors fell prey to what become known as the, “Internet Stock Bubble.” This occurs when a higher percentage of stock fund inflows move to specific industries or sectors and like the previous example of individual stock concentration risk, as the values of specific sectors rise, their respective weightings in the market index portfolio rise as well. Using the technology sector in the late 1990’s as an example as internet stock prices went up in the price, market-cap weighted indexes (S&P 500) became too heavily over concentrated in this overpriced sector and consequently too underweighted in the stocks of long-standing enterprises in less alluring industries. Simply put, this ever so popular method of weighting allocates a disproportionately higher amount of capital to indus- tries that are potentially overvalued, thus leaving investors susceptible to inevitable pullbacks in a much more concentrated manner.

3. Style Concentration Risk

This is what we refer to as the “hidden risk” of indexing, as it is not as well known as the other two. Nonetheless, its effect on performance can be as devastating as its two counterparts. For example, during a market environment where growth stocks outperform value stocks, a trend like we have had over the last five years, in a market-cap weighting scheme, said growth companies get larger and subsequently increase their percentage weightings. Because of this phenomenon, value-based investors will most likely face a relative, short-term performance drag. Feeling disillusioned they may be tempted to rotate out of underpriced value stocks and move into overbought growth plays. This sets-up another potential reversal of fortune where the investor is duped into buying high and selling low.

Like King Solomon said; “There is really nothing new under the sun.” We affirm the wise King’s age-old comment by applying it to the Investment Industry’s response to the perplexing problems the market-capitalization method of indexing has caused investors. Instead of reforming their thought process by suggesting that investor return to the four pillars of sound investing principles, Philosophy, Strategy, Transparency and Flexibility that originally drove the investment process, that have chosen to develop new index weighting schemes that in our estimation aim to replicate the approach active money managers took decades ago. Recognizing that both Price and Market-weighting methods are highly flawed academics and research departments alike have engaged their respective laboratories to cook-up new methods. With all sincerity, we applaud their efforts and granted strides of progress have been made, however we find it very ironic that as each new indexing method is created it looks more and more like an attempt to replicate an active money manager. To document our skepticism, we describe the most popular new methods created over the last five years and give our opinions on their effectiveness. However,
as we will detail, “There is really nothing new under the sun.”

Three New Methods of Indexing

1. Equally-Weighted Indexing

The easiest way to avoid the problem of owning too many overpriced stocks at the expense of owning too few discounted priced stocks (as a result of market-cap weighting) is to simply use an equal-weighting scheme. Equal-weighted indexes own the identical holdings of their market-cap weighted counterpart, they just own them in equal percentages as opposed to a owning them based on size. The pros of this approach are that stock, sector and style concentration are very much mitigated and that is a good thing. The cons become the constant re-balancing that is needed to keep each stock at a precise equal weighting. In addition to the heightened costs of this methodology, its biggest detriment is the fact that it totally strips away from the manager any flexibility whatsoever as it ties their hands to a constant equally weighting environment. The manager may desire, due to fundamental analysis to let certain positions rise and fall greater than the programmed re-balance trigger before a buy or sell decision is initiated. Under this weighting scheme, manager-flexibility is totally negated and thus we reject its usefulness.

2. Fundamentally-Weighted Indexing

This new method of indexing has been spearheaded by the academic community specifically, Jeremy Siegel who founded WisdomTree and Bob Arnott who founded Research Affiliates (RAFI). Both men are well respected and have served the industry with the utmost of integrity. Their goal in developing a fundamental scheme of weighting was to totally eradicate price in the process. They accomplished this mission as fundamentally weighted indexes use such measures as sales, book value, cash flow and dividends. Per information garnered at https://www.rafi.com/content/dam/rafi/documents/index- documents/factsheets/fundamental/fundamental-us-index-factsheet-usd.pdf the RAFI Fundamental US Index contains 40% of the Top Ten holdings that are in the S&P 500. One could make the case that the RAFI method of indexing is not indexing at all as defined by the Capital Asset Pricing Model (CAPM). William Sharpe in 1964 developed CAPM and assumed that the most efficient market portfolio combined all risky assets weighted by their market capitalization. Sharpe would say that anything that is not market-cap weighted is neither passive nor is it an index. Bottom line is that an improvement on methodology is noted however, we would refer this as a quant-driven, algorithmic-based process-driven fund (aka active management) as opposed to an index.

3. Formulaic Value Indexing

This is the newest form of indexing and relies on a methodology that uses deeply discounted value metrics, such as low Price Earnings ratios, high dividend yields, low Price-to-Book ratios, and high Enterprise Value to EBIDTA (Earnings before Interest, Depreciation and Amortization). The term ‘value indexing’ is increasingly being adopted by quantitative investment strategies that use ratios of common fundamental metrics (e.g., book value, earnings) to market price. A hallmark of such strategies is that they do not involve a comprehensive effort to determine the intrinsic value of the underlying securities. This was cited by three authors, Kok, Ribando and Sloan who wrote the paper “Facts About Formulaic Value Investing,” that appeared in the Journal of Financial Analysts in 2017. In that article they reference the DFA US Large Cap Value Fund (ticker DFLVX) as an example of a fund that attempts to use computers to extract what ultimately humans can do and that is unearth true business value. In review of the Fund we would agree as well as we note the following characteristics, as noted in https://www.morningstar.com/funds/xnas/dflvx/performance:

• The Fund is too diluted, as it holds 371 stocks
• The yield for a Value Fund is low at 1.53%
• Expense Ratio at 0.22% is elevated for a Large-Cap Index product
• Trailing one-year performance at 14.72% through 03/04/22 is decent, however, this is -256 basis points below the the stated Benchmark, the Morningstar US Large-Mid Broad Value Index

Why don’t fund companies who develop index products just explain to us in the name what the strategy
is as opposed to spinning the name into an alluring market gimmick? No doubt there has been progress in our industry and in our estimation, the pioneers of Equal, Fundamental and Rules-based indexing styles have realized the major flaws in market-cap weighted schemes and have attempted to add a component that pushes it towards active management. On the one hand we commend their efforts but much like the aforementioned two new methods of Indexing, a Rules-based scheme provides investors with very little transparency and at the end of the day investors get flustered because they don’t understand why they own what they own.

CONCLUSION

With the advent of index-based mutual funds in the 1970s and exchange-traded funds over the last decade, the industry has made several strides in attempting to offer strategies to investors that combat the results of underperformance, as documented by the Dalbar Study. We recognize their efforts but we take issue with the results.

Many investors in market-cap weighted index funds believe they know what they own and why they own it. Yes, they know that they own 500 stocks (actual current number is 505 in the S&P 500) but what they do not know is that Apple comprises nearly 7% and that the top 10 stocks are 30% of their portfolio. Additionally, investors are most likely unaware that they have a tremendous bias towards growth stocks and overvalued sectors. Source: (https://www.morningstar.com/etfs/arcx/ivv/portfolio)

As we previously stated, the answer to this conundrum is to “build a better mousetrap” as opposed to conforming to the concept of indexing as a client investment strategy. This is heavily documented in the newly fangled ETF product line where investors may KNOW WHAT THEY OWN, but they surely DO NOT KNOW WHY THEY OWN WHAT THEY OWN. Many ETF sector funds are heavily overweighed in one or two holdings that dramatically skew performance. In addition, the nuances of the security screening process are completely foreign to even the most astute investor.Seek a manager who provides complete clarity in their investment process, which is the pathway to meeting your goals.

The Compass

How Viewing Volatility as Opportunity Brings Clarity to Investing

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Summary

This timeless quote delivered by President Franklin D. Roosevelt in his first inauguration speech at the depths of the Great Depression was made not to placate or appease us. It was a rallying cry used to set an agenda as to how we as a country were to respond to what at the time was the worst economic crisis we had ever faced. Although the first part of Roosevelt’s quote has received the limelight over the decades, the latter portion, in our estimation is where the substance of his comment lies.

Fear is the only thing to be feared most certainly, however it is the backend of FDR’s quote “nameless, unreasoned and unjustified terror that paralyzes our efforts to convert retreat into advance” that has not received the proper recognition over the years and it is that section of his famous quote that we want to draw attention.

We see no industry where unjustified fear paralyzes its participants needs to convert retreat to advance more prominently than in today’s Investment industry.

This is duly appropriate when applied to how investors react to price declines in the companies they own. Unfortunately, these stock market corrections are almost always accompanied by a series of “unjustified and unreasoned” financial news stories. The news media stokes the flames of fear, usually suggesting that the current “pullback” is only the first step to a more severe market meltdown. If you want to preserve your wealth you better get out now is the rally cry following each pullback. These unreasoned and unjustified stories bombard investors with temptations to sell perfectly sound businesses at discounted prices when the more appropriate and sensible response is usually to consider investing more in the business while at a lower price. In our paper we hope to prove that just as FDR’s quote ultimately led us to victory in what was a time of great peril, so must investors take to heart in the fact that downside volatility in the price of stocks should not be a cause for fear, but can be on many occasions a chance for great investment opportunity.

Astute investors realize that when the price of a stock drops, it usually drops for one of two reasons. The first reason is most common and is usually due to an emotional reaction to a broader story associated with a macro event. This would include, geopolitical events or natural disasters. When these types of events occur, the overall market and the stocks that trade within them drop in price until what was once feared as a negative outcome of a perilous event is corrected. During this time of peril, and not due to any fundamental change within the business, prices of perfectly sound companies drop in response to this negative information. When this occurs, we refer to that drop in price as the case of a “damaged stock.” Damaged stocks create tremendous buying opportunities as they happen for no reason other than the rest of the market has dropped and to reiterate, due to short-term emotional reasons.

The second reason the price of a stock drops is a more legitimate one. This occurs when the fundamentals, such as Cash Flow, Profit Margin, Market Share, and Economic Moat, of a formerly sound business deteriorate due to major changes within the operations of that company. These types of significant changes within a business are usually directed by management mistakes and poor decision-making. Think of old-line technology businesses that did not foresee the rapid adoption of cloud-based storage or the bricks and mortar based retailers who were late in moving to an internet-based sales model. We see this type of drop in price as a more legitimate reason to consider liquidating a stock from one’s portfolio compared to one based on fear or emotions.

We firmly believe that if a perfectly sound business has not changed from a fundamental standpoint, any drop in price should be viewed as an opportunity to reinvest back into that business by buying more shares at lower prices if appropriate. Investors who have clarity in how they view business ownership and how the media often exaggerates a story when prices fall should do the following:

conclusion

Just like fear was the only thing we had to fear during the worst economic fallout this country has experienced, so is fear the only thing that we have to fear as it pertains to investing when the “market” drops based on short-term headline stories that have shallow substance. This, as FDR would call it, unreasoned and unjustified fear that paralyzes investors efforts to convert retreat (the pressure to sell) into advance (buying great businesses on sale) can only be countered when we understand the three key points we’ve discussed.

If investors know what companies they own and the reasons why they own these companies they can be less influenced by sensational news stories and therefore be less influenced by them. They can embrace stock price volatility as a potential opportunity to invest more in great business. They can stick to their investment plan, or as we like to say, “stick to the knitting”–always having a clear and sober mind and always operating under the premise of Clarity. When an investor realizes the truth in these statements they are on the Road to Clarity forming the foundation of clear understanding and judgement and can definitely see the vast and stark difference between what we refer to as a damaged stock versus a damaged company.

The Compass

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HOW INVESTING FOR YOUR GOALS AND ONLY YOUR GOALS BRINGS CLARITY TO INVESTING

summary

Just as we quoted former US President Franklin Roosevelt to make our case as it pertains to eradicating fear from our decision-making process, so we cite a quote from another US President in Theodore Roosevelt, the uncle of FDR. Theodore Roosevelt’s quote as it pertains to comparing ourselves to someone or something as the ultimate killjoy comes with bountiful wisdom no doubt. Teddy realized that comparing ourselves to others simply removes focus from the true task at hand. If we are honest about it, there will always be someone who is smarter, stronger, richer, better-looking, and more successful than each one of us – and that’s no bull-y!

Constantly reminding ourselves that comparison in those areas will only discourage us from moving forward with our own life’s goals is a must if one desires to reach a state of Clarity.

Those who have a great awareness of their own being, their unique talents and pitfalls are those that do not compare themselves to others, but rather only to their own hopes and goals. We love to reference the webpage “35 Famous People Who Were Painfully Rejected Before Making it Big” (see the link below) as to how some of life’s most successful people did not permit what others thought of them to deter them from reaching their own personal goals.

35 FAMOUS PEOPLE WHO WHERE PAINFULLY REJECTED BEFORE MAKING IT BIG

From this list here are some of our favorites:

Each of these people came from different backgrounds and fields of endeavor, but what each of them had in common was a strong self-awareness that allows them to shrug off the naysayers. In turn, this ability ultimately permitted them to pursue their own goals and dreams irrespective of what others thought about them. They knew the easy thing to do was to wallow in self-pity by comparing themselves to others who at the time were
more successful. Yet these famous people decided to follow a different path because they were determined to measure success in life on their own terms. They realized their only competition was themselves.

At Nepsis®, we believe investors should take heed to Jon Foreman’s insightful quote. Investors should eliminate the temptation to compare the results of their uniquely designed and constructed portfolios with other portfolios. And, more importantly, they should never compare their portfolio to some passive benchmark.

Other than professional athletics, there is no industry in our estimation which magnifies the mental fixation of results comparison than the Investment Industry. Whether it is the marketing departments of large fund complexes selling past performance via peer group comparisons, third-party research firms touting starratings, compliance departments mandating so-called manager benchmarks, or regulators setting guidelines on performance standards, we are programmed to think that the world around us dictates our perception of how well we are doing. The quote by Jon Foreman says it best in that; “If Comparison is the thief of joy, then our culture is being robbed blind.” And we will add, that this is especially true in the investment industry where clients hop from fund to fund and advisor to advisor in pursuit of the Holy Grail of performance-beating heaven.

In all reality, only you should determine the level of satisfaction as it pertains to your investment performance. Just as our Group of 5 Famous People did not allow the world around them to dictate their pathways or permit the naysayers to sap their joy, nor should investors permit the aforementioned industry overseers to manage our levels of joy. When it comes down to it, we must have a deeply held conviction that the only performance metric that matters is whether we are meeting our investment goals or not. That means if investors are meeting their goals and they are operating under the principle of Clarity, nothing else really matters!

CONCLUSION

Ownership – My portfolio is comprised of a unique set of businesses where I am an active owner and beneficiary to their cashflows, profits and dividends. I am not a renter of a group of collective funds that are invested in the so-called stock market but am with great pride an engaged owner in several prosperous and successful business ventures that I call my own.

Opportunity – My portfolio, because it holds liquid and tradeable assets will always be on an ongoing basis, subject to constant changes in price. As a business owner I realize that when the price drops in a company that I own that I should not react with fear. Instead I should see this as an opportunity to reinvest back in my business by buying more shares at a lower price as opposed to selling a perfectly sound asset at a discounted price to someone else.

Reality – My portfolio will no longer be subject to changes based on information spewed by market prognosticators who defy truth and reality by purporting to do something that no one can do — predict the future. I pledge awareness to immediately walk away when tempted by pursuing a story or advertisement that entices me to fall prey to get rich quick schemes or that soothes my fears by following a nonsensical trading program that allows me to participate in market gains without taking risk.

Awareness – My portfolio has been uniquely crafted and built for my satisfaction alone. Due to this, I pledge to scoff at the temptation to compare my performance to anything but my own goals and desires. I pledge to not compare my investment goals and aspirations to that of anyone else and realize that my journey on the Road to Clarity is unique. My goals can only be defined on my own terms and not by some arbitrary benchmark as dictated by the Institutional Elites.

In closing, we believe that St. Paul got it smack on when he wrote in his letter to the Church in Galatia about being leery of comparing ourselves to others.

UNDERSTANDING THE FOUR KEY PRINCIPLES…
PHILOSOPHY STRATEGY FLEXIBILITY TRANSPARENCY^®

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Overview

SINCE THE DAWN OF THE MODERN DAY MARKET, INVESTORS HAVE BEEN TRYING TO BEAT THE ODDS.

There have been many studies, theorists and practitioners who have believed they have found the answer. The simple truth however, is that the market is such a complex and volatile system that no investor is capable of beating it entirely. However, there are a number of principles that have proven through time to be effective at guiding successful investment decisions. As with all investments, there is never a 100% guarantee of success, but investing is all about hedging your bets.

THIS IS WHY WE HAVE COVERED THE FOUR KEYS TO INVESTING FOR SUCCESS; TO HELP GUIDE YOU THROUGH THE VOLATILITY AND USE IT IN YOUR FAVOR.

1. UNDERSTANDING YOUR INVESTMENT PHILOSOPHY

What lies at the heart of almost every investor’s philosophy and strategy is the principle of diversification. This really took root in 1990 when Harry Markowitz and William Sharpe were awarded the Nobel Prize in Economics for their work on Modern Portfolio Theory (MPT). The main premise of MPT was the concept that diversification and how spreading one’s risk in different directions would reduce the investor’s variability of returns (referred to as volatility). This paper is not a critique of MPT per se, but a review of how we believe it has been used out of context. For example, many say be diversified to subdue risk… don’t put all of your eggs in one basket. We say investors put their eggs in too many baskets, meaning they fall to the perils of over-diversification.

We’ve all heard industry experts expound on the benefits of diversification, and we agree with the general concept, as a stock portfolio must be diversified to some degree. After all, none of us wish to “put all our eggs in one basket” because if the basket falls to the ground the likelihood of all the eggs cracking is high. From an investment sense, if you own stocks in a single sector and that one sector suddenly drops in value, you can lose a substantial amount of your principal. But can you go too far in spreading your risk? We believe that you indeed can.

There are many studies demonstrating why diversification works. The concept is supported by the premise of combining assets with different properties that have low correlation to each other, and one ends-up reducing price volatility. That said, it’s important to remember that no matter how diversified your portfolio is, your risk can never be eliminated. You can reduce risk (standard deviation or variation of returns) associated with individual stocks called unsystematic risk, but there are inherent market risks called systematic risks, that affect nearly every stock. No amount of diversification can prevent this.

We believe to be a successful long-term investor, one must embrace systematic risk and volatility, and realize it is a beneficial component to investing, not a disadvantage.
Volatility creates the opportunity for an investor to continue to invest in great companies at lower prices over time. However, our Philosophy is also based on the idea that many investors do not like volatility because they do not have the Flexibility needed to take advantage of volatility. Additionally, if investors do not understand what they presently own in their portfolio, they also lack the means to have the conviction that is also needed to continually invest in great companies.
So, how many stocks in a portfolio are needed for it to be considered truly “diversified?” In Edwin J. Elton and Martin J. Gruber’s book “Modern Portfolio Theory and Investment Analysis”, they concluded that the average standard deviation (risk) of a portfolio of one stock was 49.2%. Furthermore, they found that methodically increasing the number of stocks in the average well-balanced portfolio could in essence reduce the portfolio’s standard deviation to 19.2% (this number represents market risk). What was remarkable was the fact that they also found that with a portfolio of 20 stocks the risk was reduced to about 20%. Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio’s risk by about 0.8%, while the first 20 stocks reduced the portfolio’s risk by 29.2% (49.2%-20%).¹

¹ From the book “Modern Portfolio Theory & Investment Analysis” by Edwin J. Elton and Gruber.

TRUE DIVERSIFICATION –
Many investors have the misguided view that risk is proportionately reduced with each additional stock in a portfolio, when in fact this couldn’t be further from the truth.
There is strong evidence that you can only reduce your risk so much at which point there is no additional benefit from diversification. The study mentioned above isn’t suggesting that buying any 20 stocks equates with optimum diversification. True diversification is only garnered when one combines assets with unlike properties (low correlation) to achieve optimal efficiency. Thus, a 20-35 stock portfolio should be diversified amongst various sectors and industries to assure that variation in returns is being reduced.

MUTUAL FUNDS – 

In our estimation most mutual funds do a pretty poor job of diversifying investor assets. What is ironic is that owning a mutual fund that invests in several hundred companies doesn’t necessarily mean that you are optimally diversified either. Many mutual fund holders suffer not from being under-diversified but rather over-diversified. Some funds, especially the larger ones, have so many assets that they literally have to hold hundreds of stocks and consequently, so are its investors. To add fuel to the fire, many investors in pursuit of perceived diversification will end up owning 10 or more stock funds that have 200+ holdings and thus have 2000+ holdings. This culminates in a portfolio that has a tremendous overlap of securities coupled with a minuscule percentage of ownership per security and thus equates to a severely inefficient portfolio. The investor gets the double-whammy of being over-diversified and ineffective at the same time. This is part in parcel why mutual fund investors tend to jump from one fund to another, and as the Dalbar Study concludes, earns substantially less than the market has to offer.

CONCLUSION – 

Diversification is like Chocolate: it’s good, but only in reasonable quantities. The common consensus is that a well-balanced
portfolio with approximately 20 stocks diversifies away the maximum amount of market risk. Knowing what you own and why you own it can only be accomplished by a limited number of holdings, as owning additional stocks takes away the potential of big gainers significantly impacting your bottom line. It is the same case with large mutual funds investing in hundreds of stocks. According to Warren Buffett: “Wide diversification is only required when investors do not understand what they are doing”. Bottom line… Understand your Philosophy!

2. EXECUTING YOUR INVESTMENT STRATEGY

Many investors may say their investment strategy is focused on attempting to lower volatility as much as possible. But, if risk is to be avoided, then volatility (which is defined as risk by MPT) should be avoided as well. Truth be told, volatility is not risk and should not be feared. Rather, it should be embraced as an ally. We declare this because the most proficient mechanism in investing today, Dollar-Cost-Averaging (DCA), requires volatility.

However, DCA can be taken an important step further. We call it, Strategic Cost Averaging® (SCA). SCA not only requires volatility, it thrives in it. Imagine that you’re given the choice between:

• Investing $1,000 in an investment with a fixed 8% annual return each year for three years, or
• Investing $1,000 in an investment that has averaged an 8% annual return over the same period, but has historically been volatile, earning a positive return in some years and a negative return in others.

Which would you choose? I’d imagine that most people would choose the one with a fixed return.

SCENARIO 1 – The following chart shows our zero-volatility
example (investing $1,000 per year with the investment earning exactly 8% per year.) As you can see, at the end of the period you would have invested $3,000 and it would have turned into $3,506.11.

SCENARIO 2 – The investment still averaged the exact same 8% annual return (i.e., started at a $100 share price and three years later had a share price of $125.97). However, the investment fluctuated in price from our 8% every-year scenario. This time, instead of the share price in Year 2 being $108, it was $88 (or $20 lower). In Year 3, instead of $116.64 it was $136.64 ($20 higher).

The return earned on actual invested dollars were 19.87% higher in Scenario 2. The conclusion: using volatility through a disciplined process, such as Strategic Cost Averaging®, can potentially enhance returns over time even when your first year’s return is negative. This is due to fact that you are automatically buying more shares when the market is low and fewer when the market is high. Of course, there are no guarantees. However, when the investment process includes investing in quality companies, Strategic Cost Averaging® can be a tremendous benefit to long-term investing.

CONCLUSION – At the end of the day, increased volatility simply creates a situation in which the market lows are lower, thereby making the investment process more effective. Hence greater volatility can equate to greater returns. Lastly, the volatility of the stock market isn’t just something you have to put up with in order to earn superior returns; it’s actually an essential factor that directly improves your returns.

3. ALLOW YOUR MONEY MANAGER UNFETTERED FLEXIBILITY

IS YOUR MONEY MANAGER CONSTRAINED TO A CERTAIN BENCHMARK, PEER GROUP OR PROSPECTUS OBJECTIVE?
Research done by the University of Denver and ICON Advisors emphatically states that “style box” investing constrains a manager’s ability to manage money and by limiting their flexibility causes severe underperformance.² Current practice has most money managers being hired to represent a particular “style box” or peer group such as Small Cap Value or International. As the aforementioned research shows this system has absolutely no empirical basis, but simply evolved out of convenience. Unfortunately, along the way assumptions essential to its validity were made and believed to be true without any support whatsoever.
These academic studies have concluded that “boxing in” a portfolio can increase volatility and reduce returns. In fact, Morningstar, which introduced its nine-box grid in 1992, has said that the boxes were never intended to construct a portfolio. The system imposed by boxes seems rational, but it lacks flexibility which is contrary to the ultimate objective of investing. Flexibility is required both to pursue compelling opportunities and to minimize risk. Money management requires a sound
philosophy and strategy, the ability to invest with unfettered flexibility and vision that extends beyond artificial boxes.These studies make several points about investing by the box. Rigid adherence to “boxes” will force managers to work toward objectives that diverge from those of the investors. Further, efforts to fit into a box (and stay there) place constraints on investment managers that can lead to poor results. (Several of these studies also indicate that diversifying among boxes does not necessarily ensure risk reduction, the often cited benefit.) Finally, Morningstar has made it clear that they never intended for boxes to constrain investment managers or drive portfolio construction.
The investment process should be driven by its philosophy and strategy and not whether it fits in a style box or not. If the portfolio management is driven by a specific Investment
Philosophy and Strategy, the Flexibility not only allows the investor to avoid “cookie-cutter” investing and the limitations set on portfolios, it also allows the power of SCA to not only potentially enhance portfolio performance, but, also allow for greater flexibility in tax efficient management (where applicable) in an investor’s portfolio.

² Based on ICON Advisors research, “The Problematic Style Grid” by Charles Howard, July 2005.

CONCLUSION –

• Style boxes are now widely used to construct and monitor portfolios — they were designed to evaluate and
  monitor investments not to be a rigid framework for asset allocation.
• Research indicates that managers constrained by style boxes underperformed “unconstrained” or more flexible managers.

• Flexibility allows for tax efficient management of a portfolio where applicable.
• Managers that focus on philosophy and strategy-based investing rather than an arbitrary “style-box” have
  greater flexibility and provide higher returns with lower volatility over the long term.

• Stock selection should be based on a company’s ability to deliver long-term value to shareholders, not on staying in a style box.
• SCA can provide the flexibility allowing stock market volatility to be an investor’s friend.

4. HIRING A FIRM THAT PROVIDES TRANSPARENCY

DO YOU KNOW THE COMPANIES YOU OWN IN YOUR PORTFOLIO? 

As an investor in a company’s stock you are an owner of that business. Yet, a majority of investors have no idea what they own in their portfolio; not even their top holding. We believe investors should know what they own and the reasons why they own it. With many of today’s portfolios being constructed with mutual funds and ETFs, there are several hundred, if not thousand, companies in an average portfolio. Knowing enough about each of those companies to understand how to make investment decisions is a daunting, if not impossible, task.

For instance, when a company’s stock price unexpectedly goes down, was it due to market forces or because of fundamental changes within the company? Is the situation one of a damaged stock or damaged company? Stocks are damaged by the stock market. Companies are damaged by the firm’s management. If an investor is not familiar with the companies behind the stocks, they are not in a position to make rational decisions.

We believe today’s investors are bedeviled by myopic time horizons. As society desires immediate gratification and short-term results, advisors, consultants and money managers are measuring performance on increasingly shorter time horizons. What causes this phenomenon? We contend that it comes from the premise that investors (and maybe some financial professionals) simply do not know what they own and why they own it.

Mutual funds are designed to not be transparent; if they were transparent, it could exacerbate front-running. The Investment Act of 1940 structured mutual funds in a way that leaves the investor uncertain as to when and why a money manager bought or sold a position. Research irrefutably states that people will by nature succumb to extreme emotions such as fear and greed when presented with the unknown or intense situations. This lack of transparency has led to extremely dramatic changes in the way people approach investing. Without knowing what they own and why they own it, their emotions take over their state of discipline and produce highly irrational outcomes such as an inordinate amount of trading and a seemingly uncanny ability to “buy high and sell low!”

Research done by Dr. KW Macro and Bogle Research in 2005 showed that as the investment world has moved to an industry consumed with “packaged products” (and thus a lack of transparency) that stock ownership based over time has dramatically been reduced. As the adjacent chart shows, in 1960 before the giant move to mutual funds, the average holding period of NYSE listed stocks was 8 years. Today it stands at 11 months.

Simply put, investors as shareholders have left the confines
of being an owner in a business to a speculator using fear and greed (because they do not know what they own and why they own it) to drive their investment decision-making process.

CONCLUSION – No one said it better than John Maynard Keynes when he opined that, “The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.” Keynes made this quote in 1936…wow…what do you think he would have to say about today?

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Overview

MANY OF TODAY’S INVESTORS HAVE LOST THEIR WAY WHEN IT COMES TO HAVING AN OWNERSHIP PERSPECTIVE ON THEIR INVESTMENTS. ADDITIONALLY, THEY LACK INTEREST IN HAVING CLARITY IN THEIR INVESTMENT APPROACH. TRAGICALLY, THEY FAIL TO REALIZE THAT THE CONCEPT OF OWNERSHIP AND CLARITY ARE PARAMOUNT TO INVESTING SUCCESS. INSTEAD OF VIEWING THEIR INVESTMENT PORTFOLIOS LIKE A BUSINESS OWNER, TODAY’S INVESTORS ACT LIKE SHORT-TERM RENTERS OF COLLECTIVE FUNDS THAT ARE PERPETUALLY SWAPPED FOR THE NEXT HOT FUND IN PURSUIT OF QUICK RETURNS.

… today’s investors hold on to stock compared to 50 years ago; eight months versus eight years, respectively.

WE BELIEVE THAT TODAY’S INVESTORS SHOULD STOP MAKING THESE EMOTIONAL MISTAKES AND START VIEWING THEIR INVESTMENT PORTFOLIOS LIKE BUSINESS OWNERS VIEW THEIR COMPANIES. IT’S A SHIFT IN MIND SET THAT HELPS YOU GAIN MORE CONFIDENCE AND CONVICTION IN YOUR INVESTMENTS, AS WELL AS PEACE OF MIND.

IT’S A SLIPPERY SLOPE… IF YOU THINK SOMETHING IS FUNDAMENTALLY MEANT TO BE USED ON A SHORT-TERM BASIS AND CAN BE EASILY REPLACED, ONE MORE READILY TURNS IT IN FOR A BRIGHT SHINING NEW ONE.

Today’s investor is void of conviction as to the components of their “rented” portfolios. When market corrections or natural fluctuations occur, they create a tidal wave of fear, causing them to capitulate and make emotional decisions on important investments they perceive as “rented.”

Investors who focus on building portfolios concentrated in mutual funds and ETFs, possess an identical cavalier and whimsical attitude. They simply don’t view themselves as business owners. This mind set is rooted in the collective ownership structure of mutual funds and ETFs. Due to the blended nature of these investment vehicles, investors feel less affinity or ownership to the underlying holdings.

It’s as if investors feel they can rent the components that are in their portfolio on a revolving basis while still gaining the advantages of active portfolio management by shifting from one ETF or mutual fund to another. This idea is supported by the dramatic change in the average time period that today’s investors hold on to stock compared to 50 years ago; eight months versus eight years, respectively. The sad fact is that these same investors view themselves as having a long-term investment perspective and time horizon.

BOTTOM LINE: INVESTORS DO NOT POSSESS THE RUDDER OF CLARITY CONNECTING THEIR INVESTING GOALS WITH THEIR LIFE GOALS. IN OUR PAPER, WE HOPE TO MAKE THIS CASE AND HAVE FOUND THAT USING THE ANALOGY OF PEOPLE WHO RENT CARS HAVING A NONCHALANT ATTITUDE TOWARDS THAT VEHICLE’S UPKEEP IS AN EFFECTIVE MEANS OF EXPLAINING THIS KEY DISCONNECT. IT’S COLLECTIVELY COSTING INVESTORS A FORTUNE AND UNLESS YOU’RE WILLING TO CHANGE THE WAY YOU VIEW YOUR PORTFOLIO, YOU WILL KEEP MAKING THE SAME MISTAKES. LET’S BREAK THIS ISSUE DOWN AND DEFINE 3 EASY WAYS YOU CAN TAKE TO HELP REMEDY THIS SITUATION.

When was the last time you washed a rental car or changed its oil? Anyone who has rented a car before has to admit that the care taken for that vehicle is nowhere near that of their own as there is little incentive to mechanically maintain a rental car, this includes keeping it clean. This is because the renter sees no future benefit from washing it as once they return it, they most likely will never see it again. Conversely, a person who actually owns a vehicle has a strong incentive to take care of it. This is due to them knowing that the future value of the car will increase with routine maintenance over the long-term.

The car rental example is worthy of comparison in that the care and affection taken in renting a car for a day or two is not remotely close to that of owning an automobile we diligently saved tens of thousands of dollars to purchase and tend to keep for many years.

For investors, pride in ownership is coming to understand that owning a stock is the same as being an owner of that business. You are not renting that company, you own it. Frequent buying and selling of these holdings may diminish their long-term potential value and have adverse tax consequences.

3 EASY WAYS TO INVEST

LIKE A BUSINESS OWNER

SO THE QUESTION IS, “HOW SHOULD A BUSINESS OWNER APPROACH THIS ENDEAVOR AND WHY IS IT IMPORTANT?” WE BELIEVE THERE ARE THREE CHARACTERISTICS THAT ALL BUSINESS OWNERS SHARE AND THAT INVESTORS SHOULD FOLLOW AS WELL:

1. CONVICTION AND CONFIDENCE

Business owners have a firmly held conviction and knowledge of why they are in business. They have a deep understanding of what they do and why they do it. Investors should take a cue from this concept by having a firm grasp on what they own and why they own it.

Research has shown that people who possess a foundational knowledge of what they can and cannot control have greatly reduced levels of fear when the unexpected occurs compared to people who do not have a firm grasp on these facts. Investors who view themselves as business owners and who understand what they own and why they own it, joyfully see price declines as opportunities to buy more shares versus fearfully selling an undervalued asset to someone else at a discounted price.

2. PERSISTENCE AND PERSEVERANCE

Business owners have a sense of stick-to-itiveness that drives them on when their operation appears to slow down or the competition intensifies. Business owners don’t quit, give in or quickly start making plans to sell the business… it’s quite the opposite. They invest back in the resources that made them successful believing the set-back to be a spring board to the next phase of the business cycle, instead of a sign of capitulation. Investors should take a cue from this concept by having a firm grasp on the inner workings of each investment in their portfolio and how they function collectively, so that in times of volatility they don’t panic and deviate from their plan.

It’s both understanding the individual components of the companies that investors hold and how they relate to one another that is key. Just like vehicle owners know that cars have brakes, tires, batteries, and drivetrains, the more important realization is how they function in allowing the driver to transport themselves from point A to point B. The driver knows that turning the key will allow the battery to be engaged to start the car which in turn engages the drivetrain to push the car forward, while placing our foot on the brake slows the car and allows it to come to a stop. They are all critical parts of one system, not mutually exclusive parts. Their value is in how they work together.

It’s both understanding the individual components of the companies that investors hold and how they relate to one another that is key.

Investors who see themselves as business owners realize how certain companies in their portfolio may react to changes in the economic cycle in a differing fashion and don’t view them independently of one another but rather from a holistic point of view. This prevents investors from selling perfectly sound businesses that may have temporarily dropped in price while other businesses are prospering at the same time. They properly see these varying reactions as a function of diversification rather than one component being better and needed or worse and not needed. The driver realizes they need the brakes as much as the battery for the car to function. The astute investor who views themselves as a business owner does the same as it pertains to the various holdings within their portfolio and has a foundational understanding of the inner workings of their portfolios, thus enhancing their pathway to Clarity.

3. CLEAR VISION OF GOALS

Business owners have a solid understanding of their vision statement and goals. They rely on this knowledge to act as a rudder in the decision-making process for everything they do. Investors should act in kind, by envisioning themselves on a purposeful road to a clear set of goals. They should view every investing and financial decision in context of its broader meaning and implications to these personal goals. Going back to our car example, just as the owner of a car realizes the importance of how the individual components function together, so do they understand how the car relates to, not only their overall plan of transportation, but their overall plan of life.

“How far will I drive my car to get to a particular destination before I decide to use air transportation?” “Is my car suited for driving in all types of weather or terrain and if not, how will I decide what other transportation I may need to take?” “How much will I decide to invest in my car as it relates to my overall finances versus that of other areas of my life?” All of these questions have to be weighed as they relate to one’s overall life plan before they can be certain that they are of most benefit to the individual.

The astute investor who views themselves as a business owner sees the companies they own in relation to their overall financial plan and how that plan aligns with their own personal moral convictions and ethical values.

CONCLUSION

CERTAINLY THERE ARE TIMES IN LIFE WHERE RENTING ANYTHING FROM LIVING QUARTERS TO A CAR TO EQUIPMENT IS APPROPRIATE, AND SOME INSTANCES IS A MUST. OUR HOPE IN WRITING THIS PAPER WASN’T TO BESMIRCH THE POSITIVE ASPECTS OF RENTING OR THOSE THAT DECIDE TO DO SO.

EVEN IN THE INVESTING WORLD, USING FUNDS ON A TEMPORARY BASIS IN THE EARLY THROWS OF WEALTH ACCUMULATION IS APPROPRIATE, NO DOUBT. WHAT WE DO FIND FAULT IN, IS WHEN SOPHISTICATED INVESTORS OF MEANS FALL PREY TO THE SHORT-TERM MENTALITY FOSTERED BY THE INVESTMENT INDUSTRY THAT LEADS TO FORMING A RENT VERSUS OWN INVESTMENT MENTALITY OR PHILOSOPHY. IN CLOSING, WE BELIEVE THE FOUNDATIONAL CONCEPT OF BUSINESS OWNERSHIP AS IT RELATES TO INVESTING IS PARAMOUNT. LET US HELP YOU GUIDE YOU ON YOUR INVESTMENT JOURNEY. CONTACT US TO SET UP AN INITIAL CALL OR MEETING WITH ONE OF OUR ADVISORS. WE’RE HERE TO HELP.

Why it is Detrimental to Your Investing Health

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Overview

WITH THE STAGGERING EVIDENCE SUPPORTING HUMANS’ INABILITY TO PREDICT THE FUTURE, WHY DO INVESTORS RELY SO HEAVILY ON USING FORECASTS TO MAKE INVESTMENT DECISIONS? MANY INVESTORS KEEP PREDICTIONS OF MARKET EVENTS AT THE CENTER OF THEIR INVESTMENT PROCESS.

ADDICTION TO PREDICTION®

Investors, like all people, are drawn to predictions; especially those that play to our natural fears of the unknown. Many of these portents and projections are intentionally constructed in a storytelling format designed to alleviate our anxiety over being uncertain.

In our industry, how many times have we been subjected to the age-old question, “What do you think the market is going to do?” Despite the fact that we actually do not know what will happen, we feel compelled to give an
answer. It may be best for us to take the advice of a famous Chinese proverb (attributable to Lao Tzu), “Those who have knowledge don’t predict and those who predict don’t have knowledge.”

This paper hopes to address investors’ fascination with forecasts and their apparent Addiction to Prediction®.
We believe that investors’ overconfidence and anchoring is what draws them to the allure of prognostication. In the end, overconfidence leads to arrogance and anchoring leads to ignorance. These are very undesirable traits whether related to investing or not.

Our goal is to provide investors and advisors alike with remedies that permit us to stop relying on this pronounced addiction for futile forecasts and to focus on the important aspects of wealth creation.

The fact is, investing is an inexact science and it will always have an aspect of uncertainty. Additionally, investors do their decision-making abilities a great disservice when they resign themselves to a state of denial concerning uncertainty in their investing. The result of this resignation is ambiguity… the polar opposite of clarity. While many feel it may be counter-intuitive to embrace uncertainty, doing so has been proven to enhance decision-making skills and far outweighs the damaging effects ambiguity can have upon investors. Ambiguity renders investors that are unable to manage the factors they can actually control; such as knowing what companies they are invested in and why. As the philosopher Confucius stated, “To know that we know what we know, and to know we do not know what we do not know, that is true knowledge”; it’s best to accept what you can and do know, as well as what you can’t and don’t know.

Why do Investors Insist on Using Forecasts in the Investment Decision-Making Process?

We propose the first reason is a result of investor ignorance. We say this because most investors do not have a clear understanding of what they own and why they own it. Thus, they harbor under the veil of uncertainty. To soothe this fear of uncertainty, they anchor their hopes or latch onto any data points, regardless of how irrelevant they may be, to substantiate their portfolio decisions. The Behavioral Bias of Anchoring permits people to continuously subject themselves to meaningless predictions despite their ineffectiveness. It was Albert Einstein, the great scientist of the 20th Century who said, “Doing the same thing over and over again and expecting different results is the definition of insanity.” Why do we continuously expect different results? We suggest two reasons: denial of uncertainty and the allure of storytelling.

Many people, especially investors, analysts and money managers, are overconfident about their ability to predict the unpredictable. While this keeps soothsayers, palm-readers and psychics in business, it is a terrible way to build an investment portfolio. Embracing uncertainty (knowing that you cannot control the future) or at least having a healthy respect for it, leads to better decision-making. We subscribe to the thought process of Daniel Boorstin, the great 20th Century American Historian who said, “The greatest obstacle to discovery is not uncertainty but the illusion of knowledge.”

Acknowledging uncertainty allows money managers to focus on the probabilities of outcomes rather than conjectures. This allows us, here at Nepsis®, to focus on the following market precepts (based on Ibbotson research) as opposed to forecasting the markets:

SINCE 1926, OWNING BUSINESSES (INVESTING IN EQUITIES) HAS BEEN THE GREATEST PATH TO WEALTH CREATION – EARNING 10.3% VS. BONDS AT 5.7%.

(Source: 1926-2012 Ibbotson Yearbook, 2021; https://office.morningstar.com/research/doc/1021794/Ibbotson-SBBI-Presentation)

SINCE 1926, THE STOCK MARKET HAS PRODUCED A POSITIVE ANNUAL RETURN 75.09% OF THE TIME.

(Source: https://www.bespokepremium.com/interactive/posts/chart-of-the-day/chart-of-the-day-the-montana-curve)

SINCE 1926, THE STOCK MARKET HAS ONLY HAD FOUR ROLLING TEN-YEAR PERIODS WHERE THE RETURN WAS NEGATIVE.

(Source: https://www.bespokepremium.com/interactive/posts/chart-of-the-day/chart-of-the-day-the-montana-curve)

SINCE 1926, THE STOCK MARKET HAS NEVER PRODUCED A ROLLING 16-YEAR, OR LONGER, PERIOD WHERE RETURNS WERE NEGATIVE.

(Source: 2018 Fundamentals For Investors)

FROM 1950-2020, DIVIDENDS MADE UP 30% OF THE TOTAL RETURN OF EQUITIES AVERAGED OVER ROLLING FIVE-YEAR PERIODS.

(Source: https://am.jpmorgan.com/content/dam/jpm-am-aem/americas/us/en/insights/market-insights/guide-to-the-markets/daily/protected/mi-daily-gtm-us.pdf?hash=8fh6h013g6j9g)

LONG-TERM INVESTING FAVORS VALUE EQUITIES. ACCORDING TO BRANDES INVESTMENT PARTNERS SINCE 1968, THE CHEAPEST ONE-TENTH OF U.S. EQUITIES RELATIVE TO PROJECTED EARNINGS HAVE OUTPERFORMED THE MOST EXPENSIVE ONE-TENTH BY 9.1% A YEAR ON AVERAGE.

(Source: https://www.brandes.com/docs/default-source/brandes-institute/2015/income-as-the-source-of-long-term-returns.pdf)

Based on the aforementioned statistics, the likelihood of generating wealth from owning companies is undeniable, especially those that are value-oriented and issue dividends. We readily admit that we do not know what the fluctuations in equity prices will be on a day-to-day, month-to-month or year-to-year basis.

The list is endless of how investors get duped into what appears to be plausible sounding stories but at the end of the day they remain mired in disappointment. Unfortunately as the research suggests we construct portfolios on appealing stories and match the story to possible decisions rather than truly weighing and evaluating the evidence. True clarity is not gathered from a whippy anecdote but by profoundly understanding the money manger’s core philosophy and strategy.

The second reason that investors rely on the pursuit of forecasting in their decision-making process is rooted in arrogance or overconfidence. According to Investopedia, the behavioral bias of Overconfidence can be defined as, “Overestimating or exaggerating one’s ability to perform a task or an overly optimistic assessment of one’s knowledge or control of a situation.” Furthermore, in a 2006 study (source: “Behaving Badly”, by researcher James Montier) found, “That 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Incredibly, almost 100% of the survey group believed that their job performance was average or better. Clearly, only 50% of the sample can be above average, suggesting the irrationally high level of overconfidence these fund managers exhibited.”

To make matters worse an extensive study by Pam Dunning and colleagues in 2004 (source: “Why People fail to Recognize their own Incompetence”) noted that the worst culprits are those that are the most inept at doing their jobs.

The study documented that the worst performers are generally the most overconfident. For example, college students who scored in the bottom 25th percentile of a course exam felt they were about average. The same held true for debate teams and medical students. Their conclusion, “such individuals suffer from a double curse of being unskilled and unaware of it.” We see this in the investment world all the time as the economists, analysts
and money managers who proclaim with bold assertion their
ability to predict the future usually are the ones who make one “lucky call” only to be followed-up with poor predictions while blaming it on outside forces.

We fully believe that this dynamic is present in the investment industry as the Montier study validates. This also can be supported by the plethora of mutual fund managers who fail to beat their own chosen benchmark over numerous time periods. Applying the Dunning Study to this construct, the worst money managers are usually the ones with the boldest “predictions” which likely comes from their state of overconfidence or arrogance.

The simplest and most obvious answer is that we need to stop relying on senseless and irrelevant forecasts because they simply do not work. A great read is Nassim Taleb’s book the Black Swan where he documents the failed attempts of Wall Street to predict future market happenings. He refers to this as the, “Scandal of Prediction” and documents numerous examples of bungled forecasts. Our favorite may have been the one where a large unnamed Investment Bank analyst who in May 2008 predicted $200 oil to be around the corner only to be followed by a revision in September 2008 down to $114/barrel when in fact oil fell to $70/barrel by that year’s end and fell to $33/barrel in May 2009. As of the drafting of this paper in May 2018 and nine years later, WTI Crude Oil sits at $68/barrel.

What really raises our ire is the fact that no one ever seems to be held accountable for these outlandish market calls. If the truth be told, economists are good at one thing and that is telling you what just occurred and why. Moreover, there is a legitimate reason that analysts/economists are not referenced as forecasters because no one would believe what they said by the mere title of their duties. The job of an analyst is to analyze factual information not postulate about the unpredictable. Other than that, employing a dearth of analysts/economists to forecast the future in our estimation is a misuse of resources.

So What Can be Done to Break this Endless Chain of Addiction to Prediction®?

Now that we have hopefully established the futility of predicting future market happenings, how do we break this deep-rooted seed of addiction to it? We suggest the following:

• First and foremost, investors and advisors need to focus on the destination rather than the journey. Investors place entirely too much emphasis on day-to-day and near-term market performance. As an investor, determine what you are trying to accomplish and align that with an advisor and money manager who both relish those same tenets.
• Stop pinning hopes on market calls, short-term tactical shifts and algorithmic machinations in generating market returns. Instead, rely on the long-term historical precedence stipulated by facts and supported by wealth generation created by owning solid businesses over the long haul.
• Locate a money manager who concentrates on a few key elements in the selection process and is able to readily and clearly articulate those to you. There are several strategies that don’t need forecasts as inputs, such as intrinsic value and dividend capturing. We call this clarity of philosophy and strategy.
• Do not believe everything you read. Hyperbole is rampant in today’s environment on both the ultra-bearish and bullish side. Detach the ripcord to spurious anchors that soothe our fears of uncertainty. Embrace uncertainty (investment world calls it volatility) and make it your ally. An honest assessment of differentiating between what we know and don’t know is emotionally healthy… remember the quote from Confucius.

Let us close by referencing our Market Outlook and our “Top Ten Predictions” for the forthcoming year. We hope you enjoy them because they will most likely be our Top Ten Predictions for the next 50 years!

1. Most predictions on where the S&P 500 will end next year will be wrong.
2. Company stock prices will move up and down irrationally—what else is new?
3. There will be opportunities to purchase great companies on sale—there always are!
4. Timing the markets will continue to be difficult.
5. Focusing on short-term performance will distract investors from making intelligent long-term investment decisions.
6. Some investors will let emotions get the best of them.
7. Investors will purchase stocks that were “top picks” and sell them too soon, once again by focusing on short-term results.
8. Smart investors will be patient with their investments—
   like we are at Nepsis®.
9. As it always does, stock market volatility will continue to scare investors while creating great investment opportunities.
10. Many investors will grow frustrated with predictions because they were wrong.