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Know the Knowable

The past two months have certainly been unsettling for investors.  It wasn’t too long ago that the S & P 500 index was around the 2000 level.  Now the index is around 1850, about 7.5% lower.  Meanwhile, 10 year US Treasury bonds started 2014 yielding 3%.  Today (October 15th) 10 year US Treasuries are yielding around 2.05%.  As Jim Parker from Dimensional Fund Advisors recently pointed our, economists were forecasting rising interest rates for 2014.  So far the bond “experts” aren’t looking so good.

With all of this uncertainty, isn’t there someone who can see the future and get us out of investments before they go down (in this case stocks) and put our investments in something safe?  Why can’t the experts “get it right” and protect us from market fluctuations? 

Let’s back up and examine what the price of a stock or bond is.  A stock or bond (or real estate, gold, etc.) price is the sum total of all of the information (news) that affects the value of that security.  To predict the price movement of anything you must be able to predict all of the information affecting the price.  Academic research has shown that no one consistently has these predictive powers.  That is why there is no evidence that there is a guru out there who can CONSISTENTLY move you out of a security just before it declines in price, and moves you into a security just before it goes up in price.  Believing that there is such a guru is as unfounded as believing that there is someone out there who can give you the winning lottery numbers AHEAD of the drawing.  

If you accept that there is no magical person out there who can constantly and accurately forecast the future, who should you hire to help you?  Here are some guidelines that I would follow.

  • Ask the potential advisor if he is a fiduciary (someone who is legally obligated to put your interests ahead of theirs) and will he and his boss put that in writing?
  • Ask for full disclosure of all the fees that you will be charged (management fees, fund fees, commissions, 12b-1 fees, surrender fees, etc.) and get it in writing.  If they don’t list all fees in plain English, on one sheet of paper, I would wonder what they are trying to hide.
  • Does the relationship start with the advisor developing a plan (including an easy to understand Investment Policy Statement) that matches your goals with a sound investment policy?
  • Does the advisor follow the investment policy consistently?

What is a sound investment policy?  What should you look for?  David Butler, also with Dimensional Fund Advisors recently offered the following framework to guide advisors and investors.

He states, “Applying a strong framework can help you evaluate proposed investment approaches.”

Mr. Butler lists the following framework:

  1. Is there robust research to support the strategy?
  2. Does the strategy follow a process that is proven, documented, and repeatable?
  3. Can the strategy be efficiently implemented in a live setting on a daily basis?
  4. Is there a body of work or track record that connects the approach to actual results?

Investors have a choice to make when they choose who to believe when they develop an investment policy.  Do you want to waste time trying to find a guru to predict the future and save you from market volatility?  The evidence shows that it is nearly impossible to find someone who can do this consistently.  

The academic evidence, and common sense, tell the investor that a better way to invest is to “follow the facts” and invest accordingly.

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