Transcript
The difference between the evidence of investing and the act of selling investments
Marcus Schafer (00:05)
Hey Pat, I got a quote for you today. The farther you look back, the farther forward you are likely to see. Let me just say that one more time. The farther back you look, the farther forward you are likely to see. That’s a Winston Churchill quote. I do not have a cool accent or cigar in my mouth to really make it memorable. But I think that’s a great starter for how we think about it.
Patrick Collins (00:06)
another.
Marcus Schafer (00:35)
we have to look back in order to inform how we expect our performance to be going forwards.
I’ll let you maybe kick it off with a little bit of your background and then we’ll go from there.
Patrick Collins (00:53)
Yeah, just on that that front, the quote that you mentioned, I think it’s really interesting. I think it really does. It’s a great visual of our or description of our investment approach because it’s very evidence driven. I think if you look at a lot in the industry, it’s very forward looking. We think this is going to happen. This is why we’re going to invest that way. We tend to be much more data driven and data. It’s typically backwards looking. You want to look and see what happened over history and
because that does tend to, as Churchill said, does tend to repeat. So I’m excited about getting into this today. Just a little bit about my background. As founder of Greenspring, I’ve been really involved in the investment process here since the very beginning. I’ve chaired the investment committee over a number of years. But prior to that, I started at an organization at a really big bank that was…
a little bit different and as far as how they invested, it was more of a sales, how do we sell products to clients? So there was typically a story or a narrative that they really focused on. I saw, part of the reason I left that environment was I just saw that it didn’t work very well. And so one of the things that was really interesting to me was what actually works if you really get into the data and the research and how can we bring those types of solutions to our clients? So
For me, the last 25 years of my career for the most part has kind of gotten me to that point. Although maybe the last 15 to 20 years have been really focused on the data and the evidence and really digging deep. But I think that came out of an environment where I saw things not working and I wanted to try to fix that. So that’s kind of, that’s my back.
Marcus Schafer (02:34)
Yeah, it’s it’s seeing both sides of the equation. And my background, spent about a decade at an institutional asset manager. So helping to understand the research, right? We worked with Nobel prize winners and then go out there and implement the research, but that’s at the highest level. And there’s kind of this, this dichotomy. There’s a, how do you build a portfolio of not knowing anything about the end client?
And that’s one thing. then there’s kind of what we do here at Greenspring, which is how do we take all the science and all the evidence, like you mentioned, that we’ve learned, but then how do we build the perfect portfolio for you and keep that portfolio on track every single day? So maybe before we jump into how we invest, probably the most important thing is why do we invest? I’ll tee you up to maybe talk about why investing is so important.
Why We Invest – Having your money work as hard as you do to live your ideal life
Patrick Collins (03:34)
Thanks. I think really it comes down to our core purpose, which is to help every person live their ideal life. And for most people, they need resources to be able to kind of do the things that they want to do, whether that’s retire one day, send their kids to college, know, buy that second home, whatever, whatever their goals may be, leave a legacy. And typically you want to have some level of wealth to be able to do that. And, you know,
there’s things that work against you like inflation that erodes that well. So we need to make sure that our clients are keeping up or hopefully exceeding the cost of everything going up in this economy. So investing is the best way that we know how to do that. And while there’s the elements of financial planning that I think we can talk about at another day, this is gonna be once you start saving your money, what do you do with it? How do you make sure you keep pace with inflation? How do you make sure you can accomplish your goals with it? And investing is really one of the keys there.
And so that’s really why we do it.
Marcus Schafer (04:34)
Yeah, think it’s a, know, how do you have your money work as hard as you work, right? Cause if you think about your life cycle, it’s very early on. A lot of your value is your future earnings. as you progress through your, through your life cycle, what you’re thinking about is, well, I’m going to have less future earning going forward and I have to have more capital built up in order to live the life that I want, provide for my family.
do all these different things. So investing is the function that gets you there. And I kind of think we live in the golden age of investing. There’s so many different products available. There’s so many different tools. There’s so many different options and they’re lower cost than they’ve ever been. what comes with all those options creates a bunch of different hurdles. And you got to try and sort through a what’s
What’s the best for me, not for the person selling your product, which is kind what you alluded to at the very beginning. And it’s maybe one of the traps of the industry. So let me just turn it back to you and think about what is our investment philosophy.
Markets Work¹ – The evidence overwhelmingly suggests following an approach where the price is the best estimate of value
Patrick Collins (05:51)
think it starts with a really what seems to be simple premise that has, I think, far reaching implications. So the simple premise is that we truly believe that markets work. And so most people, when they hear that, nod their heads and they go, I agree with you. But they tend to act totally different to that. So let me explain kind of what markets work means. We believe
that the price of a security, you know, as you’re looking at the stock market, whether it’s an individual stock or an index or whatnot, we believe that the price is the best reflection of the value of that company. Because when you think about it, you have a market working to set that price. have millions of people every single day that are buying and selling and trading that security at a certain price. And over time, that should average out to be a fair value of that stock. So
when I look at Apple and I see it’s trading at $220 a share, I’d say I think that’s the best value for Apple because I know there’s buyers and sellers that are setting that price every single day and they have lots and lots of information about what’s going to happen with Apple in the future. Where kind of the difference is there is mostly in the industry, kind of the traditional way that I was brought up and realized there are some flaws in this is
more of the kind of the talking heads and the active managers that are out there that are basically saying, you know, I know Apple’s trading at $220 a share. I think it’s underpriced. It’s a buy right now. It’s gonna go up in value. Or, side is it’s way overpriced. It’s gonna come down in value. When people say that, and most people take it for a kind of gospel. hear somebody, they say, oh, they have a good narrative, a good story there. One of the issues is what they’re saying is,
I think the price is wrong. The millions of people that are setting this price are wrong. I, as one person, am right. initially that might be an okay way to think about things. The nice thing is that we have a tremendous amount of data now to take a look and see, can people that are trying to guess the price and buy or sell based on what they believe to be under or overvalued securities, how do they do? These are kind of what the industry calls active managers that are buying and selling.
And the data is pretty damning. know, when you get into lots of different studies, whether it’s be the S &P or Morningstar, they all kind of say the same thing, which is 60, 70, 80 % of all managers in a given year fail to underperform the benchmark or an index. So I think what we see is that markets do tend to work over time. It doesn’t mean that prices are always exactly right. It’s just our best.
estimate of what prices should be. don’t know a better way of doing it. it leads to really trying to avoid managers and investment strategies that are all about picking the best stock, getting into the market at the right price or getting out at a different price. It’d be one thing if you could find somebody or you could do it effectively over time. We just have not seen anybody do that. So we believe that markets work and we invest accordingly.
Marcus Schafer (09:09)
Yeah, and to your point, it is a very freeing philosophy. We’re in the process of buying a row house. And I was talking with somebody and they said, Hey, did you get a good deal? I don’t know. I got the fair price. Somebody else bought a different row house that looks exactly like ours for the exact same price three months ago. And like, it’s one of the biggest purchases you’re going to make in life. And you can live free knowing. I don’t, I got.
I got the price. didn’t have to fight for a great deal. I didn’t have to go through this effort. I could go and I can live my life. And you kind of talked about the underperformance of active managers and it’s, yeah, on average in any given year they’re underperforming. 60 % of them underperform. When you start stretching out that time horizon, it gets incredibly damning. It goes to like 90 % underperform.
Right, only 10 % are outperforming out to 20 years. And that’s only, that’s on a pre-tax basis, if tax pool investor gets even worse. But there’s this framework that I find is like incredibly helpful to think about how to build a portfolio. And that’s the three sources of alpha. And alpha is finance speak for outperformance relative to your next best investment option, which is always kind of an index fund.
an experience that most people can invest long and get a great outcome. So there’s kind of these three sources of alpha. There’s the traditional stock-picking alpha, which is what you talked about. The evidence is very clear. It’s an incredibly tough game and it’s only getting tougher as information moves quicker. It’s tougher to compete on informational advantages. The second is what Bob Martin calls risk-based alpha. So this is
The Three Sources of Alpha²– Nobel Laureate Robert Merton’s framework for the three ways to beat the market.
Can you take a risk that some other investor doesn’t want to take? And that’s source of alpha relative to your next best option. And then the last is financial services alpha. So this is thinking about, can you avoid a cost that everybody else has to bear? These are things like taxes and implementation costs. And that’s something that as advisors, we can think about how to build portfolios.
and implement really well every single day. But there’s these three different sources of alpha, and this is what everybody’s focused on. But I always go back to this one quote that I think is so powerful, it’s Morgan Halsall, he’s an author, he’s an investor. And it kind of says his investment strategy is to be average for an above average holding period.
Skill vs. Luck in Investing³,⁴ – Skill is repeatable, luck is not
And what he means by that is since most people are out there trying to underperform,
outperform and they’re actually underperforming. If I can just aim to be average, but I can do that every year, I’m going to end up being one of the best investors out there. And he kind of gives this example that Howard Marks gives, who’s a famed investor and it’s talking about one of his friends that over a 14 year period was never in the top 25 % of investors.
but at the end of that 14 year period, he was the top four of investors. So he’s never in that elite group, but because he could stay invested over time, you can end up having these fantastic results.
Patrick Collins (12:48)
great great great quotes great examples I think just to expand a little bit about about the three sources of alpha that you mentioned the one being that we tend to avoid which is trying to pick stocks or market time basically get in and out of the market at opportune times just a quick story on that I mean I think the challenge with that is a doing it or
be trying to pick maybe more likely for most investors, pick a manager who has done it in the past or thinks they could continue to do it. Most people will pick managers based on their track record. That’s a typical way to do it. That’s how I was taught at a big bank was choose managers that have great track records. That’s an easy sell to a client is this is somebody has done in the past should do it in the future. And it really comes back to is
is the outperformance that you’re looking at in the past, is that based on luck or skill? That it’s a really important concept for people to think about. My kids, a few years ago, one of my boys did the stock market game in high school and he picked two stocks and he did amazingly well. I can’t remember what stocks they were quite honestly, but there were stocks you never heard of. They were like penny stocks and they went up and it was over the course of about a month.
and obviously he thought he was a genius. think anybody looking at this objectively would say that is pure luck. He knew nothing about the stock market, but he had outperformance. if you were looking at his track record over the last month, if you were just looking at track record, you would say, wow, this person is really good at investing. At what point does it move to skill where you would say, this person is really, really skillful? Well, there’s been a bunch of research on this and
and statistical analysis. And it usually takes dozens and dozens of years and decades. And for most managers, they don’t have that long of a track record to even work. So it is really, really tough to distinguish skill from luck. So I think that’s the first thing there is when you’re looking at a manager, if you’re thinking about, want to try to help perform by picking a manager that can pick stocks or whatnot, really dig into the data and the evidence of is it skill or luck?
that this comes from. The second part of your alpha that you were discussing was these kind of risk factors, if you will, which is are there areas of the market that tend to do better than maybe the broad market itself? And there’s actually a lot of data and evidence that we can point to and we can look at to of to exploit that part of investing. So
Probably the biggest ones that have been around for a while are things like small companies versus large companies. Small companies over history, over time, the last 100 years in the US at least, have had a higher return than large companies. And another one would be value or companies that are cheap relative to some earning, some metric like earnings or sales or things like that, compared to the expensive companies. Cheap companies tend to do better.
If you can buy them at a cheap price, better than expensive companies. I think those things are important to understand those concepts when you’re building portfolios for clients is if I want to avoid kind of the thing that doesn’t have a great track record, which is managers that trying to pick stocks. OK, that’s one thing. But if I want to try to enhance returns and maybe outperform even the market.
what do I focus on? It’s these things that have a long-term track record of outperformance. And I’ll just use a quick example of small companies versus large, maybe to kind of express this. And this is just more of a thought experiment, but let’s just say, I’ll use that example I was using before Apple, is maybe one investment that you could choose as an investor.
Risk Factors – Not all investments have the same expected return
And let’s say I gave you $100,000 to invest. And I said, you had to pick one.
investment. Apple’s your one option. That’s going to represent the large company. And then I’m to use an extreme. Let’s say you had a friend that had a startup company and they are looking for capital to help grow. That’s your other option. And if they both came back to you and said, Marcus, we really need your capital to help us grow and grow and expand. We’re going to give you a 10 % return if you invest with us. Well,
You would probably think about that for maybe 30 seconds and you would say, well, if I’m to get the same return, Apple’s been around for a long time. I think it’s going to be around for a long time. I’m going with Apple. Your friend’s startup could be out of business next month. You’re not going to, you know, if that’s the same return, you’re not picking that investment. Now your friend may know this and may say to you, you know, to attract your capital, I’m going to offer you a 20 % return to invest with us.
you might start to think about it at that point now, because you might say, well, okay, I understand it’s a lot more risk associated with this, but I’m getting a higher return or higher potential return. And so that’s really kind of how, why things like risk factors work is that, you have this, in this example, large and small companies, you could get a higher return with small, it doesn’t come for free. You have to accept higher volatility, higher potential risk of loss. But,
That’s a decision point that from an investor standpoint and we as a firm really focus on is what’s the right mix of small companies versus large because we know it’s going to impact returns, but we also know it’s going to impact risk. And we have to deal with that within the context of our clients risk tolerance and things like that. But that’s an important area where I would say there’s a lot of evidence to suggest that that is a factor that will help us outperform. We’re going to focus on that versus the areas that
might be fun to talk about, like which is the best stock to invest in, but don’t really have any evidence about performance.
Marcus Schafer (19:02)
Yeah, it’s such a great example to think about the theory, right? Why would we expect, we wouldn’t expect all stocks to have the same return. So why do you expect different stocks to have different returns? And then you go out there and you study it with as much data as you have. And we have over a hundred years of US stock market data where we can look at these trends. We have a thousand years of interest rate data.
We can look at the Bank of England’s loans back to the 1100s. So we have these massive time periods where we can try to understand what drives returns. And then the question that it really leads to is, how do we stay invested to capture these returns when we don’t actually know what’s going to happen tomorrow? Because it hasn’t existed. There’s going to be some news that comes into the markets that’s going to affect the price.
and then we’re going to have to figure out a way to move forward.
The Three Reasons Why Active Managers Underperform – Costs, risks, and taxes
So maybe kind one of the things you alluded to was you have to think about risk as, well, it is a little bit riskier, so how do you manage that? And that kind of gets into three kind of primary drivers around why active management has underperformed to such a significant degree. And those three kind of
Primary things are costs, they’re expensive, risks. They take highly concentrated risks where in your example it’s like, I might take Apple at 10 % over a startup at 20 % because I still think in 10 years Apple will be around. have no idea about the startup, right? So you got to think about, okay, well maybe I have to invest in 100 startups at risk. And then the last is taxes, which I think is a secret of the investment industry.
that everybody shows pre-tax performance, but that’s not what most investors care about. They care about after-tax wealth. And it’s this massive disparity between the numbers they’re showing and the numbers people are realizing. And if you’re not looking at that, to evaluate somebody, the returns an actual investor kind of consumes in economic parlance, it’s not effective. there’s three things, costs, risk,
taxes, let’s dive into each of them. What are the major costs that you see from the investment landscape?
Costs Matter – How explicit and implicit costs are connected to performance
Patrick Collins (21:38)
So, you know, there’s a number of, guess I’d call it explicit costs that you can see. You’re going to see it in your portfolio. And then I think there’s implicit costs that are harder to see and harder to understand. So maybe we start with easier ones, explicit costs. Those are going be things like trading commissions. If I’m buying and selling and I’m paying a commission, that’s going to be an explicit cost. I’ll see it right on my statement. Here’s what I paid. You’re going to have expense ratios of any
funds, ETFs, mutual funds that you are investing in. And that will be not as explicit because you’re not going to see it on your statement, but you can go onto Morningstar.com or any other website and find the expense ratio and it’s going to be stated as a percentage. And that’s a percentage of your assets that the manager is taking to manage those assets. So those are probably the big explicit costs.
that you would tend to see. Also, if you’re working with an advisor, you’re gonna have an advisory fee that would also be factored in. Some of the implicit costs will be things like the bid-ask spread, which sounds kind of complex, but really what that means is if I’m using Apple as an example, and I see that it’s trading at $220 a share, well, there’s a bid and an ask, and I’m going to pay the higher price, the bid versus ask, and the seller is paying kind of the
getting the lower price and that spread between the two is how the broker’s making money when they’re doing that. in certain investments, there’s a very narrow spread. You’re not losing a whole lot from a cost perspective. In others, we’ve been talking mostly about stocks here, but if you get into things like bonds, especially, you can have really wide spreads and if you don’t understand that, you can lose a lot of your returns from this cost, this implicit cost of the spread.
So you see it in stocks, see it in bonds. Those are some of the implicit costs. Anything else that I’m missing there or any other thoughts?
Marcus Schafer (23:40)
Yeah,
well, I think just kind of expanding on how big some of those implicit costs can be, the difference between the bid and the ask. Apple, it’s probably going to be pretty tight where you’re only going to run into issues if you’re really frequently trading, if you’re a day trader. If you expand to other things that people are day trading, things like options, near to expiration, you could be looking at it
13 to 25 % of the value of the investment could be between the bid and the ask in that. If you’re thinking about bonds, municipal bonds, it could be multiple percentages. And what’s crazy about the bonds is if something’s yielding 3%, and it costs you 1%, 2 % to trade that, that’s kind of your whole year expect return being eaten up on.
one trade and it’s just intricacies of each market. You got to kind of understand, how does this factor in to each market? And then the more esoteric you get, the weirder these costs become, right? And you kind of mentioned expense ratio, but what you might also see is, especially in the private market space, you’re going to see a lot more fund to fund fees that are titled different things.
So if you have a fund that’s investing in another fund, you’re going to pay some of those fees as well on top of the fees you’re paying. And so it kind of just stacks. If you think about leverage, I’ll give an example. If you’re buying into a strategy and the expense ratio is 2%, but there’s 50 % leverage, you have to ask yourself, what is the expense ratio being applied to?
that being applied to just the money I put in or the money I put in plus the leverage. Because in a sense, your fees could be about 50 % higher. So there’s all these different considerations. And then maybe the last one I would point out that I think is really, really critical, and that’s this concept of closet indexing, which means, are you paying a high fee?
for somebody to invest in something very, very similar to an index. And in a sense, you’re paying maybe a percent, maybe half a percent, but half your portfolio is something that you could do for .02%, right? 1.25th, 1.50th of the cost. And so the question you have as an investor is, why would I not choose to separate those two things? And this all gets to the complexity
all the different options that are out there. So there’s a bunch of different costs, cost map.
Patrick Collins (26:43)
one of the things that I hear probably most often from clients and investors is, you know, I don’t mind paying a high fee if I can get a high return, you know, and the return that I get exceeds kind of that fee that I would get, that I would pay. And that’s a pretty common refrain I hear from most people is, I don’t mind paying the fees if I’m getting high returns. And I think there’s a little bit of a flaw with that, which is kind of goes all the way back. And this is why some of this philosophy is important in the why.
is it builds upon itself as you start to think about what do we truly believe? Well, if you believe that markets work and it’s really hard to outperform, what that doesn’t say is there won’t be managers that outperform. It doesn’t mean that there will be managers that outperform. The question is, is it luck or skill that we believe and nearly almost all the cases it’s luck. So should you be paying a high fees for someone who’s been lucky in the past?
that has no real evidence that they are going to continue that. So I’d rather control what I can control, which is fees. And I know over time, those things are going to probably work themselves out. That manager that’s had high performance, on average, you would expect that they would start to kind of look more like the average over time. And those fees will really start to eat in to their overall returns. But that’s an important distinction, I think, when you’re looking at performance and you’re looking at fees.
is this idea that, I’ll just pay more. I don’t mind paying more because his manager’s outperformed. One of the best examples, we’re here in Baltimore, and there was a manager that outperformed the S &P 500 for 15 years in a row. I remember, you know, he was just a staple here in the community. He still probably is to a degree. Everybody knew he was, everybody owned his fund. But the fees were approaching 2 % towards the end of his tenure, of his run against the S &P.
He turned around the next few years, he basically gave all of his performance back and then some. And it turned out it would have been, five years later, it would have been so much better had you just owned the index. But a lot of that was around the fees. mean, 2 % compared to, like you said, 0.02 % is just a massive difference. And it doesn’t sound like much, but when you start to compound that, it is a really, really big deal over a long period of time.
Marcus Schafer (29:05)
Yeah, and the last thing I would say is luck first skill because it’s a very emotional
If you say, hey, you’ve only achieved your success because you’ve gotten lucky. You look jealous. I don’t like that. But the question is, is it repeatable? And I think, let’s say it is skill. How important am I as the investor to that?
I’m not. Right? Who’s important is the person that has the skill. And actually my money is very cheap to them. If I don’t invest, they’re going to find somebody else who will because they have a bunch of actual skill. Right? So in that sense, one of the real dangers is let’s assume they do have skill. They’re going to be the ones to capture the upside because they have the scarce resource. Not me. because there’s a lot of different people of my net worth that they could turn.
to fund their enterprises. So let’s jump to kind of the second key consideration, which is risk. Risk matter. And kind of the way to think about this is if you break apart all the different pieces of the market, they’re all riskier than the market itself. So how you think about taking risks and probably the best hedge against
uncertainty of investments is diversification. It’s kind of like referred to as the only free lunch in investing is the ability to diversify. So Pat, when you hear diversification, what jumps into your head around what’s the proper amount of diversification?
Risks Matter – Diversification is the only free lunch in investing
Patrick Collins (30:51)
Yeah, so I think there’s a couple of levels you can think about diversification on. So let me talk about maybe first at the portfolio level of just asset classes. And the last few years been a great example of this, where if you took an asset that was considered to be the safest asset, which is bonds, and you were having invested that over the last three to five years.
you would be approaching a negative return somewhere right around flat to slightly negative returns over the past several years. Whenever you put all of your eggs in one basket, I don’t care what that basket is, there is risk associated with that, even if it’s in the safest investment that you could find. So I think that’s important. I’ve often told clients, even if you want to be, you know, have the lowest volatility with your portfolio, most likely that’s going to have some element of equities in it.
because the last few years, a great example, you had this rising interest rate environment, falling bond prices, and anybody that was 100 % invested in bonds have had a really terrible return. Now at the same token, the last three to five years in the stock market, it’s done very well. So I do think having diversification amongst asset classes that are very dissimilar from each other is gonna be important. When you get down to the portfolio level,
of, I’m sorry, the kind of asset class level, then let’s just maybe look at stocks. Well, now you have a lot of different options on how you invest here. Some people might take the approach of, I’m gonna pick the best 50 stocks that I can find, and that’s gonna be diversified. Well, there’s literally tens of thousands of stocks that you can invest in. We’re a believer that you should invest in most of those. Why not? Concentrating your assets in just a small percentage of those or
and maybe in a region, maybe only in the US or only if you’re living in Canada, maybe only in Canada or something like that, there’s risk associated with that as well. Markets are gonna move differently. There’s different currencies. There’s so much diversification value you get. So we’re a believer that you should invest in the majority of the equities out there. There’s definitely cases where you’d wanna avoid some and we do, but for the most part, our portfolios have…
over 10,000 securities that are kind of, were to pop the hood of the funds that we own, it’s gonna have a lot of securities in them. And we believe that we can diversify out any single stock risk, which is really important. You know, when I think about our portfolios, we’re gonna have, I don’t know what the percentage is, but some, not zero number of companies that go bankrupt every year in our portfolio, go to zero. And…
our clients will never know it because it’s such a small percentage of their portfolio. On the other side of it, they’re going to have investments that go up hundreds of percent per year in a given year, and they’re also not going to know it because it’s a small percentage. So you’ve basically diversified out all of the risk of owning a single stock or a small kind of concentration of stocks. And now I just own the market. And again, if we’re looking to try to get higher returns, instead of trying to concentrate our wealth, which is
which is a high level of risk. We don’t think you get compensated for that because how do we know which stocks to buy or sell if we believe markets work? So we’re looking at it saying, let’s own all of those stocks and we’re gonna own them in percentages that allow us to be able to capture things like small company returns over large and value company returns over growth. And we can do that over a portfolio of thousands of stocks so we’re not taking massive risks and being concentrated.
Marcus Schafer (34:31)
Yeah, and you know, to build off of that, think there’s some other interesting components where a lot of times mentally it’s helpful to bucket things, right? So I show up to my job every day and I work hard and then I invest. And in reality, a lot of those are correlated. So it’s like, you also have to think about, hey, what’s the riskiness of my job and how do I want to tie that to my investments, right?
whole point of your investments is so that at some point in time you can spend that money. That’s why we’re actually growing it so you can do more things with it. So if you have all your money in the US, then what happens if the US happens to have a tough time period and your job also has a tough time period? It’s helpful to think about what’s my whole financial picture as well. And then last thing that is I think one of the magical things about markets work
and risk is it helps you understand relative to the market’s definition of risk, how much am I over weighting this company, right? So when we see portfolios come in, there’s a few things we might see. We might see a bunch of different managers, but when you look at the underlying stocks, you might see a ton of concentration, right? Different names on the portfolio doesn’t mean that they’re not holding the same thing.
And then what you could do is you can look at those actual underlying holdings compared to the market weight and you have a reference point for how much do you really believe in this idea? And if you’re starting to see holdings jump to five or 10 times the representative market weight, it gives you a good sense like, we are taking a ton of risk here relative to what everybody else in the world thinks is the appropriate amount of risk for this name. Like that’s just something.
to consider. And then just kind of wrapping up on risk and jumping to the last one, which I mentioned was like the hidden feature of investment sales. Nobody talks about taxes from portfolios. And that is huge. There’s research out there that shows it’s about one or 2 % typically per year for these active funds.
that you kind of don’t see until you invest in it. And that’s another major hurdle that you have to be super cognizant of as an investor.
Taxes Matter⁵ – One of Wall Street’s hidden secrets is reporting pre-tax performance when investors care about after-tax wealth
Patrick Collins (37:06)
Yeah, taxes, no one talks about them and clients don’t typically even understand it until maybe they get the end of the year, the following year they get their 1099 from their broker and it says, you you have, you know, whatever it is, $50,000 of capital gain distributions that you’re going to need to now pay taxes on. So it’s tough for investors to measure that and figure out exactly what am I losing to taxes. But to your point, there’s been research out there.
and it does show that it’s significant. And so there are things that we’re doing as the advisor to try to really minimum. We can’t avoid taxes completely if the portfolios are going up in value, but we can do our best to really minimize that. And maybe I talk about a few different strategies that we employ to try to be able to do that. So first off, the vehicles that you use are really, really important. If you are using
vehicles that are less about trying to buy and sell stocks all the time, and that’s the act of managers. They’re gonna be trying to select the best investments and sell the ones that they think are gonna be, you know, not gonna do well in the future. Depending on their strategy, they may be doing that daily, they might be doing that monthly, but over time, they tend to be doing it. And therefore, they’re creating gains or capital gains inside their portfolios that have to be passed through.
to shareholders of those funds. So we’re trying to avoid those funds, these vehicles that tend to be much more efficient from a tax perspective, whether it be the structure of those vehicles or how they’re investing those funds. So our hope is that we can really avoid paying capital gains taxes on something that we haven’t even sold in the portfolio. Now, obviously if a client is in a situation where they are withdrawing money from their portfolio or
we’re in a situation where the portfolio has become out of balance and we really believe that it makes sense to sell the security to get it back into balance, to rebalance a portfolio. We’re looking to do that in the most efficient way possible. We want to match up gains and losses. We just got through the end of the year. That was a very big kind of push for us is making sure we’re minimizing taxes wherever possible. And then the other one that takes a little bit more time and effort to really understand is
where you own your assets. So you have certain investments that are really inefficient from a tax perspective. When I own a bond, for example, almost all of my gains are gonna come from the interest income off of that bond. So when I’m looking at maybe I’m earning four or 5 % on a bond, if 100 % of my gains are gonna be taxable to me, I’d probably rather own that inside of a tax deferred account where I don’t have to pay the tax on that every year.
So that’s typically a pretty basic strategy on where do we want to own an asset. There’s other assets that are really tax efficient. So if I own a stock fund and I’m not planning on selling it, if that’s fund I buy for $10 and it grows to $14, I’ve made $4. Well, if I don’t sell it, I don’t have to pay any taxes. I can own that inside of a taxable account. And so I can control when I buy and sell that.
that hopefully will control the overall tax ramification. it’s a interesting, there’s kind of the philosophy around how we do it. There’s also every client’s gonna be unique in this situation because they’re gonna have different tax circumstances, not just as a client, but every year too. You could have a client that loses a job one year and they have a stretch maybe for six or eight or 12 months where they don’t earn a whole lot of income.
Well, there’s all sorts of strategies we’re doing around that to try to optimize the portfolio for taxes. And I think that’s really important. So there is kind of some broad tax strategies that we’re using internally for every client. And then on an individual basis, our advisors are working with their clients each year to make sure we’re taking advantage of their particular circumstances. So taxes are the one thing that are going to be unique to every client. Everything else, if you buy a fund, if I buy Fund A,
and some other investor buys it as well, they’re gonna get the same pre-tax return, but we’re gonna have different after-tax returns as investors based on our own circumstance.
Decisions and Outcomes – The importance of focusing on making good investment decisions based on the knowledge at the time, not the outcomes
Marcus Schafer (41:28)
Yeah, and I think what you’re also leading to is one of these challenges. think when somebody’s thinking about investments, they’re thinking about what’s that one amazing decision you made, right? What’s that one stock that you bought that happened to do really well and all the focus is on there. But kind of what we’ve learned looking at all the research is that when you focus on those one decisions, you ignore
all the little decisions that you have to make every single day. And in actuality, it turns out that there’s more value to be had by focusing on each of those small decisions every single day. I’ll give an example. You think about an investor that did very well with Nvidia. Okay, that’s fantastic. And we’re very happy that you had a great outcome.
They’re thinking about this question, luck for skill, and they’re wondering, how do I repeat the success of NVIDIA? So what are you going to do? You’re going to build up your cash to go find your next NVIDIA. Well, that whole time you’re having cash track on the portfolio, right? Your cash is maybe keeping up with inflation and taxes if you’re lucky, probably not. And these are the costs that are very hidden to the individual investor because it’s tough to think about, well, what’s the opportunity cost?
of that cash, we could have been investing it in the broad market, which has also gone up a ton, not as much as Nvidia, but a ton as well. So there’s so many small decisions on the portfolio management that you can take every single day to better your portfolio positioning and kind of reduce some of these hidden costs that might not be as clear.
Patrick Collins (43:19)
Yeah, I agree. There’s kind of sticking with the costs and the risks theme of kind of these things that we want to be looking at regularly and probably go into your example a little bit. One of the things I tend to see a lot is people misunderstanding the idea of making a good decision, decisions and outcomes, let’s put it that way. So.
I’m not really a gambler, but every once in while I play poker or whatnot. Maybe the best example is if you’re playing blackjack and you get a really, you know, get a dealt a five, for example, and the dealer is showing the same, something like that. There’s certain things that you do that are going to be the right decision there.
You may lose. The outcome is somewhat, you have to be careful of divorcing. You should be divorcing the decision making with the outcome because I can make the right decision, but lose. Also, I can make the wrong decision and win. And to your point, sometimes when somebody’s buying an individual stock, we would say, and they’ve had a great outcome.
you kind of have to look back and say, it the outcome because I made a really great decision here or maybe not great decision, I just kind of got lucky and had a good outcome. and that’s a really tough thing for people to understand because most people are going to equate outcomes and decisions the same way. going say, if I had a good outcome, I made a really good decision. And if I had a bad outcome, I made a bad decision. That is not always the case. Our goal as investors
is to make consistently make really, really good decisions over time. It doesn’t mean every decision is going to one year later, you’re gonna look at and say, I had a great outcome. But if you do it over time, you are gonna be successful. And if you do at the flip side is if you make bad decisions over time, you’re gonna have some good outcomes. But I would expect over time that there’s the aggregate of all that is gonna be worse than somebody who consistently makes good decisions. trying to kind of.
look at things based on what’s the best decision right now to make versus judging outcomes only is really, really important.
Marcus Schafer (45:46)
Yeah, and I think the true question is, is this repeatable? If I made a decision and I had a great outcome, can I evaluate my decision making process to figure out, can I make that same decision again to have the same outcome? And that’s really the difference between luck or skill. If you can’t repeat the process, it’s luck. If you can repeat the process, it’s skill.
And when thinking about investments, there is things that are repeatable, right? Putting tax efficient investments in taxable accounts, putting tax inefficient investments in non-taxable accounts. That’s a repeatable skill. Making sure your cash is invested. That’s a repeatable skill. What’s less repeatable, and this is not our opinion, this is what the research shows, is trying to predict
what companies are going to do great in the future. There’s this concept of pricing and perfection where certain companies have done great, their earnings have risen tremendously. The new price reflects that, right? It doesn’t reflect a new shock to their earnings. It reflects where their earnings are at today. So trying to think about luck for skill, maybe that’s one way, but repeatable versus non-repeatable is another way.
Patrick Collins (47:13)
And I think one other thing to keep in mind is as we are, and this kind of goes back to philosophy, when we’re thinking about how we add investments or make changes to the portfolio, one of the things we’re looking at again is, is this repeatable? And so if an investment requires manager skill for it to be successful.
we typically will not invest in that investment. So if it requires a manager to be really good at picking investments, we don’t believe that’s repeatable. So all the investments we have, if you had manager A and they decide to retire one day and you slot in manager B, they have a systematic way that they do it. And it doesn’t really matter who’s in that portfolio manager chair, if you will. We think that’s really important because
managers don’t last for, you if you’re picking a manager or a fund that has a track record because of a great manager skill, at some point that manager is going to leave. You’re going to have to then decide, do I get out? Do I stay with this new manager that’s in? It doesn’t have any track record. If I do decide to get out, now I have costs associated with just changing my portfolio, taxes, trading costs. So think all that’s really important when you’re thinking about your strategy, because it’s going to, you know, when you start
thinking about those types of things creates turnover and whatnot and it does degrade performance.
The Golden Age of Investing – The traits that make great investors might surprise you
Marcus Schafer (48:40)
Yeah, I’ll go back to something we kind of talked about at the beginning, is kind of live in this golden age of investing. think we’ve learned so much around.
what drives returns, what you can’t expect, what you can’t expect, what you can control, what you can’t control. And really it’s just about, we implement that every single day? Which, you know, kind of gets us to this one point, which is if there’s one behavior, I think, you can have that will make you a great investor, it’s not having this trait. And that trait is the fear of missing out.
Somebody else is doing really good and so therefore I have to do the same thing as what they’re doing. If I had to ask you this question Pat, what is one trait you think leads to a great investor? Maybe that’s what we’ll end on.
Patrick Collins (49:38)
Yeah, if I had to pick just one, think it’s somebody that has the confidence to stick with an investment strategy over a long period of time. I think almost every strategy, as long as it’s rooted in some level of evidence and research, I think almost every strategy can work. So having the confidence in a strategy that it will work, and I’m gonna stick through this, all the inevitable bad times,
because no strategy is always good. There’s going to be times when the market goes down and your investment portfolio is gonna go down or whatnot, or there could be times when some investment strategy that you’ve selected goes out of favor. But over time, probably the best investment strategy for you is one that you can live with so that you don’t get out of it at a bad time. The behavioral part doesn’t get in the way of your success. So I guess confidence in your strategy would probably be my answer to that.
Marcus Schafer (50:38)
Yeah, it’s an amazing point because there’s probably one truism in the world, is in order to achieve risk and return are related. So in order to achieve a return, you have to take commensurate levels of risk. And I think one of the confusing parts about markets is risk is one of these things where it’s always there, but it only shows up sometimes. So it’s really tough to visualize what that
future risk will be, but the risk of the stock markets tends to be under performance for longer than people would expect based upon their past investing experience. Now, we hope that doesn’t happen. Oftentimes it doesn’t, but the risk is always there. And so whenever it comes, you have to be ready to stick with it. I think that’s such a great closing thought. Control what you can control, know yourself.
And if you do those two things, you can have a great investment experience.
Patrick Collins (51:43)
Great talking to you. Glad we were able to dive into this a little bit more deeply.
Marcus Schafer (51:47)
Yep, great talk to you, Pat.