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We often take for granted the factors in our life that are going “right.” We set them on cruise control and focus on areas that aren’t quite as “smooth.” If we are lucky, everything is going as expected, and we sit back and relax. But, things change. What was in the back of our minds jumps to the forefront and needs our attention.

Lulled into complacency?

The S&P 500 Index has not suffered an annual loss since 2008. The index has briefly reached correction territory (10%) since 2008, but each setback recovered before falling into bear territory; defined as a 20% decline from its peak.

Other major indices (foreign developed stocks, emerging market stocks, and bonds) had positive returns in 2017 and 2016. With positive returns across the primary indices, most portfolios remained positive even if not keeping up with S&P 500 returns.

In 2017, the primary drag on performance came from bonds. The iShares Bond Aggregate was up 3.52%. Developed countries (EFA) returned 24.94%, emerging markets (EEM) returned 36.42%. The S&P 500 Index gained 21.69%.  

As we review year to date (YTD) returns in 2018, the S&P 500 is the only major index showing a positive return. Foreign developed (EFA) is down 2.84%; emerging markets (EEM) is down 7.44% and the iShares Bond Aggregate (AGG) is down 1.64%. None are down substantially, but they aren’t positive either.

Can we discuss?

I shouldn’t be surprised when I received a meeting request last week. “Can we schedule a time to discuss the decline in my accounts?” The lull of complacency had been lifted.

The request reminded me it might be a good time to review performance. When I think about performance, there are a few comments I believe are worth reviewing…before we are emotionally involved.

Diversification is accepted when everything is going up

When one asset class outperforms the other major asset classes for an extended period or by a significant percentage (think Tech stocks in the late 90s), some (media and others) begin to question why diversify? People understand and believe in diversification until they don’t.

The most infamous example was a Business Week article titled “the death of equities (August 13, 1979).” With the benefit of hindsight (makes everything so clear), the call could not have been made at a worse time.

After the Dot.com bubble, there was a push to own real estate. Theory voiced the opinion that real estate was, well real. You could touch it and understand it. Investors wouldn’t be fooled by “paper profits” again. Of course, we know how that ended.

When I was at Schwab, I remember a customer asking why anyone would own anything other than Tech stocks? They do nothing but go up...until they didn’t. There were times when people said you shouldn’t hold any stocks.

After a “lost decade”, multiple people voiced the opinion that perhaps stocks were too risky. Maybe everyone should just hold bonds. The “lost decade” for U.S. stocks ended in 2009. Again, we know what happened next.

There may be a time when you start to hear stories or opinions about what we heard in the past. Reviewing now (without emotions) is a good time to consider and discuss if we should adjust our belief in diversification. My answer...we shouldn’t. The logic behind diversification remains sound; especially when measuring performance as it applies to you (more on that later).

Won’t happen again

Before 2008, I would refer to the Dimensional Fund Matrix book. It showed the worst historical performance for various allocations. A common response was…” that was the Great Depression, it won’t happen again.” They were right. 2008 was the second worst year in history when considering stock performance, but not by much.

Today, I don’t need to pull out the Matrix book. People are aware of the pain suffered during what was named the “Great Recession.” I am not saying we will repeat 2008 (at least I hope not), but it is important to discuss that level of negative performance now...before emotions alter logic.

When reviewing your financial plan, we run and review what the program calls...Bad Timing. This scenario basically tests a potential worst-case scenario (retiring into a market like 2008). You receive the worst performance at the worst time (when you retire and start withdrawing money). Again, this is intentional. We want to review and discuss that scenario before we are emotionally involved.

Entire portfolio

A final consideration is the comparison of various accounts. This doesn’t happen as often as I saw at previous firms. Many years back, I noticed an advisor had the same allocation in every account. To me, this isn’t logical for various reasons, which include cash flows, taxation of gains and trading costs. The advisor didn’t disagree. Instead, he said he got sick of explaining why one “account” did better than another account.

When considering cash flow, taxation and cost; it makes sense that certain accounts would perform better than others (which would be reversed in a different market). As I look back, I realize that the advisor didn’t provide financial planning. They were investment managers. Their conversation was solely focused on market performance. We measure financial success differently.

Looking forward to returning to the lull of a standard schedule

It is hard to believe summer is over for Stephanie. She entered sixth grade on Monday and I get back to a standard work schedule. The past few weeks have taken their toll. She took cooking classes from noon to 2pm at Sur La Table (I can’t pronounce it). That messed up the whole day.

She made some good dishes. The “parental units” could sample. The cooking was so good, I went to the final day even though I didn’t have to pick her up. I walked away with an ice cream maker (I may never buy ice cream from the store again). Stephanie walked away with her first knife and cutting board. Her mother walked away with a homemade pasta maker. When I say walk away…I mean we bought. And yet when I ask what’s for dinner, she doesn’t volunteer to cook.

She spent the last week of her summer in New York (the city this time). She went to see multiple shows including a musical about Sponge Bob Square Pants. Huh? I don’t ask.

Moving forward with performance

I have struggled with performance reporting since creating Disciplined Money. I questioned the status quo (as I have done with many decisions). My first question was why quarterly? I asked other advisors. The best answer I got was reporting once a year was too infrequent.

Then came the first quarter of 2016 (one of the correction tests during this bull run).

The calendar was our friend if reporting quarterly. If reports were run in early February, reports would have shown a 10% loss on the S&P 500. By the end of March, the index was positive 2%. At that point, I really struggled with formal performance reporting. Is quarterly reporting just noise? It is likely too short of a period to have much impact. So, I got lulled into a period of less measurement and with markets going up, there wasn’t an urgency to change.

Fancy charts are costly

The industry has an abundance of performance reporting choices. As we reviewed various performance software, we saw some nice programs. They created beautiful graphs and charts. They could do many things (but no homemade ice cream). But, they are expensive. Some of the fanciest offerings cost more per month than I pay in rent.

Fancy graphs and charts create a temporary wow factor, but they don’t address the most important measurement of performance…whether you are moving closer to your goals. I believe this is the only measurement that matters. We address this during financial plan updates. We compare the “goal return” with the actual return. We focus on what is controllable and review if we are moving towards your desired outcome.

We are financial planners first. Performance is important as it is one component of your success. There are multiple choices that have a greater impact. More importantly, you have greater control over those choices.

But, perhaps I need to get out of my lull of complacency as well. I am not willing to buy a fancy performance reporting software program (and pass the cost on to you). I consider quarterly reporting to be too frequent and annual reporting too sparse. So, we will report twice a year going forward.

I can’t fix the calendar issue, so we will settle on a rolling year calculation at mid-year and year-end. We are working through performance calculations and will be sending the results to those for whom we manage assets.

In the meantime, I think it is important to take performance (both positive and negative) in stride. If we knew with certainty which asset class would outperform, we would only invest in that one. Why stop there? If we knew which asset class was going to outperform, why not choose only the best performing stock in that asset class? And maybe…leverage that position. Your portfolio would hold options on one company. A little too risky? I agree.

We’ll continue to focus on the most important performance measurement. Markets and asset classes will have good and bad days, weeks, months and years. We recognize this and test for it. We also have a plan if markets fall.

By the way, we calculated the performance for the meeting. Performance is exactly as expected. The portfolio has a small loss (less than 2%) for the year. Given current market returns, we would expect that return.

We do not seek the highest returning asset class or stock. We build a portfolio that provides the best probability of success after accounting for other choices. A good follow up post may include consideration the loss that would make you stand up and take notice. This is a question that should be discussed before the fact. As mentioned earlier, we run a Bad Timing scenario for a reason, but perhaps, the scenario is discounted when we are lulled into complacency.

As explained in the meeting with the client. If a 2% drawdown raises concern, we need to talk. We will have drawdowns greater than 2%. There is an industry created that focuses on this type of client. Unfortunately, they forget to share the costs and risks of protecting the downside.

Maybe, this post is unnecessary. Maybe, all asset classes will be positive going forward and we live in market performance complacency forever…probably not.

Photo by Markus Spiske on Unsplash