Almost all of the modern investment industry is built on the idea that smart investors can use today's limitless informational resources, powerful analytical tools and the opinions of experts to beat the market.
It makes sense: by picking the right stocks, the right broker, the right manager or the right time to buy or sell investors can earn returns that not only beat the averages, but also beat their less informed, less discerning peers.
We agree that it's an appealing, even reasonable, concept. But we do not believe it.
We do not believe that investors (neither individuals managing their own portfolios nor professional money managers) can systematically beat overall market returns over any significant time period. In fact, it appears that the harder they try to do so, the less likely they are to be successful.
What We Believe
At Peston & Sons Securities, we have clear convictions about the nature of markets and what it means for portfolio creation and management:
We believe that markets price securities so efficiently that it is not possible to systematically earn above-market returns by buying and selling based on currently available information like earnings reports, past performance, or economic data.
Markets around the world have a history of rewarding investors for the capital they supply. In the ever-expanding global economy, companies compete with each other for investment capital, and millions of investors compete with each other to find the most attractive returns. Together, they create movement of prices to fair market value. In other words, all available information is already reflected in the price of a stock, which means that only unknown and unpredictable information can change its price.
For an investor, this indicates that no one can determine reliably and consistently where the stock market is going. Therefore, it is a futile exercise to invest based on predictions and market outlooks. Since markets are efficient and consistently beating them is impossible, we construct our clients’ portfolios (and our own) with low-cost, passive funds and alternative investments. This allows our clients to “own” the market and capture market returns depending on their particular need, willingness and ability to take risk.
"Prediction is very difficult, especially if it's about the future". Niels Bohr
Diversification is Key
We believe that holding a broadly diversified portfolio representing many different asset classes reduces overall risk and allows favorable performance in a variety of market conditions.
Diversification allows investors to capture the return from the whole market instead of taking a risk on specific sectors, individual securities or market predictions. Contrary to what some believe, simply owning an index fund or having “a lot of stuff” in a portfolio does not necessarily indicate diversification.
In order to understand real diversification, we need to take a step back.
Capital markets are comprised of many different kinds of securities, including stocks, bonds and mutual funds both domestic and international. An asset class is defined as a group of securities (i.e. stocks or bonds) that share similar characteristics. There are numerous asset classes, all with different price movements. Because asset classes have different price movements, investors benefit by structuring a portfolio that takes advantage of as many of those classes as possible. By focusing on the portfolio as a whole instead of analyzing each part independently, investors realize that a diversified portfolio adds up to more than the sum of its components.
Costs and Taxes Matter
We believe that the erosion of returns caused by transaction costs, management fees and tax exposure is far greater than most investors realize.
Costs - Controlling costs is essential to producing desirable investment outcomes. Simple arithmetic explains that market return minus costs equals net investor return. Therefore, by reducing costs, net investor returns are effectively increased. The problem is, most investors do not realize the extent to which fees are being incurred on their investments and consequently decreasing potential returns. This is critical because a difference of 1% in annual fees, for example, can be translated into hundreds of thousands of dollars in foregone returns over the long term.
It is important to note:
• Our management fee structure is completely transparent. We do not receive payments from anyone other than our clients thereby aligning our interests with theirs.
• We utilize no-load, passive, structured funds and their expenses are typically one third of comparable actively-managed funds.
• Structured passive funds tend to have much lower turnover ratios (the percentage of holdings that are bought and sold annually) which significantly reduces the transaction costs that are ultimately passed on to the investor.
Taxes - While it’s possible that Benjamin Franklin may have overlooked a few things when he wrote that “in this world, nothing is certain but death and taxes,” those two items require our attention. We believe that by accepting and planning for these certainties, investors can spend more time focusing on the things that truly matter to them.
With our expertise in personal and estate taxes, we integrate key tax issues when preparing a financial plan. Often seemingly attractive investment strategies have hidden tax consequences that significantly alter their relative performances. By strategically allocating assets among taxable and non-taxable accounts and recognizing opportunities to capture the tax benefit of losses (tax loss harvesting), we are able to lessen the impact of unavoidable taxes. Our focus is on after-tax growth of wealth rather than phantom gross gains.
Risk and Return are Related
We believe that exposure to risk factors, not selection of individual securities, is the primary determinant of expected return. Over time, riskier assets provide higher expected returns as compensation to investors for accepting greater risk.
Financial research has demonstrated that risk is best minimized by holding assets over time and by diversifying with low-correlation assets. We manage portfolios in a manner that seeks to minimize principal fluctuations within realistic market expectations consistent with the stated objectives and the chosen asset allocation over the established horizon.
Investors must understand that risk is inherent in investing and results could be better or worse than initially anticipated. There will be times when negative short-term performances must be tolerated in order to meet longer-term objectives as a result of expected long-term returns.
It is also very important to remember the risk that inflation poses. If a portfolio is not designed to outpace inflation, it effectively looses purchasing power because of the eroding effects of inflation.