Step 12: Invest and Relax

Invest, relax and stay balanced

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For an explanation of rebalancing portfolios click here.

For an explanation of tax loss harvesting click here.

12.2

Definitions

12.2.1

Registered Investment Advisers

An understanding of this 12-Step Program for Active Investors may lead investors to believe they can do it on their own. They absolutely can if they wish, but working with an investment adviser is still recommended. Taking the steps to gain a knowledge base of what works and what doesn't work in the market is critically important, and every investor owes it to himself to learn this information. Knowing that money managers cannot beat the market over the long run is essential when choosing an investment method. Many investors decide to manage their own investments through the no-load index funds now available on the market through various mutual funds.

Although indexing can be done on one’s own, there is a high value to working with a qualified Registered Investment Adviser (RIA). Many RIA’s have been registered with the Securities Exchange Commission (SEC) and can provide valuable ongoing advice and education. A study by DALBAR Financial Services found that active investors who invest on their own are more apt to attempt market timing and less inclined to stay invested in a mutual fund for an average of 2.6 years. This is where the investment advisor can help. A good investment advisor supports the process of indexing, encourages long-term buy and hold and rebalancing strategies, advises prudent investing through the ups and downs of the market, and builds a long-term relationship with the client.

There are myriad advisory options available to today’s investor. This plethora of resources can be confusing and disconcerting for the average investor. It is often difficult to know whom to trust. Many investors seek advice from stockbrokers, insurance sales reps, or commissioned financial planners. These types of advisers are customarily paid to sell products rather than help investors solve problems or make wise investment decisions. Investors often question whose best interest these advisors have in mind - their own or the investors’? A commissioned based pay structure often sets up the appearance of a conflict of interest to the prospective investor.

In comparison, a fee-only adviser keeps the best interests of the client in mind, because neither the advisor nor any related party receives compensation that is contingent upon the purchase or sale of any financial products. These advisors provide investors with comprehensive and objective financial advice for a set fee that reflects a percentage of the market value of a managed client portfolio (often 1%). Since the fee is dependent on the size of the portfolio, both the adviser and the client make more money as the portfolio grows.

Index Funds Advisors (IFA) is a fee-only independent financial advisor that provides optimized wealth management by utilizing risk-appropriate, returns-optimized, and tax-managed portfolios of index funds. IFA founder, Mark Hebner and the team at IFA have done extensive research as shown on this web site and Mark Hebner's book on index funds. This research leads our clients to the optimal money management strategy, net of our advisory fees and taxes. IFA completely avoids the futile and unnecessary cost-generating activities of stock, time, manager, and style picking.

The IFA advice is based on the highly respected research indexes designed by Eugene Fama and Kenneth French and documented in their empirical and peer-reviewed publications, including those ranked #1, 8 and 9 out of over 10 million downloads on the Social Sciences Research Network. Our current and independent advice incorporates more than 80 years of IFA Indexes and Indexfolio risk and return data, third generation index fund designs and more than 30 years of refined passive trading techniques employed by Dimensional Fund Advisors (DFA.) IFA does not accept payments from DFA or from any other recommended investments. IFA is exclusively paid by its clients for its advice on optimal wealth management.

IFA adds value through matching people with portfolios by carefully qualifying and quantifying 5 dimensions of an investor's Risk Capacity and matching it to 5 dimensions of a portfolio's Risk Exposure. This process produces investor-specific optimal returns by applying the IFA proprietary concept of 10dRisk™. IFA obtains academically identified capital market rates of returns for its clients from about 12,000 public companies in the U.S. and about 42 other countries around the world. IFA then designs highly tax-managed and low cost trading strategies, maintains ongoing proper risk exposures through rebalancing, manages cash inflows and outflows. and provides quarterly and inception to date detailed measurements of client performance relative to other IFA Index Portfolios and and S&P 500 tracking index fund. This ongoing reporting on performance, gains, income and tax reporting is exclusively available at IFA and adds significant value since measurement is essential to improvement.

In this video, Mark Hebner explains to other advisors how he built his firm and how they may be able to do the same in India.

12.2.2

Dimensional Fund Advisors

Dimensional Fund Advisors (DFA) now makes their low cost, institutional index funds available to individual investors through DFA approved registered financial advisors. This is a great opportunity for investors, because these funds were previously available only to institutional investors. DFA’s funds are designed based on the principles of efficient markets, diversification, asset allocation, and the relationship between risk and return. DFA works with many of the top academic financial economists who provide findings and strategies based on empirical research. DFA also minimizes trading costs that negatively affect portfolio performance. For a series of stories about DFA see HERE.

DFA funds provide investors with the following benefits:

• Engineered exposure to risk factors that generate higher expected returns
• Low expenses
• Low taxes, including tax-managed index funds
• Improved trading and engineering that adds value to portfolio construction
• Low turnover rates due to the passive investing approach
• Asset class persistence; no style drift

How is DFA different from Madoff?

Dimensional is regulated under the 1940 Investment Company Act of 1940. Madoff ran a hedge fund which was not regulated under the Act. Mutual funds are probably the most highly regulated investment entity in existence.
The client receives statements from Schwab or another custodian, not Dimensional. Madoff was sending his own statements out.
Schwab is independent of Dimensional. When the client places trades, that money goes to Schwab. Dimensional doesn't hold any client money. The money never comes to Dimensional.
Dimensional uses the largest independent accounting firm in the world, PriceWaterhouseCooper. Their existence relies on the integrity, diligence and accuracy of their reporting.
An Net Asset Value (NAV) is calculated every day. There was no daily NAV calculated for Madoff’s fund. PNC (for domestic) or Citibank (for international) calculates this based off of the actual holdings in the fund entity. Schwab (or any other custodian that receives money from the client) does their due diligence to be sure that the shares of the fund they are holdings actually represent interests in a fund that holds the securities.
PNC and Citibank are audited. They are commercial banks and are also highly regulated.
The assets held at DFA's custodian are separate from the custodians’ assets. If PNC were to cease to exist, the funds would still exist independent of them. The fund entity would be moved to another custodian.

Index Funds Advisors (IFA) is one of the many RIA’s approved to offer Dimensional Fund Advisors funds to individual investors. IFA provides special online services and resources that educate clients on the principles of investing, including a Risk Capacity Survey that matches individual investors with specific portfolios that yield optimal returns. This matching is achieved by carefully measuring an investor’s Risk Capacity™ and risk exposure. A Risk/Return Calculator and a Portfolio Simulator are also provided to compare the expected risk and returns of all 20 Index Portfolios to alternative investments.

12.2.3

Rebalancing Portfolios

It is important for investors to rebalance their portfolio to achieve risk control and maintain long-term investing goals. An investor’s portfolio should match their Risk Capacity™ which is best measured through a Risk Capacity Survey. As Risk Capacity™ changes with age and new life circumstances (not with market conditions), it is prudent for investors to check their risk capacity using a survey at least annually. Investors then need to take the next step to rebalance their portfolio’s asset allocation or risk exposure and to ensure that the portfolio continues to reflect the level of risk an investor has the capacity to hold.

For example, after a thorough evaluation of risk capacity, an investor may be matched to an index portfolio of 65% equities, 35% fixed income. After a year of increased equity prices, the equity portion of the portfolio rises to 75%, with fixed income at 25%. By contrast, after a market decline you may discover that your allocation is now 60% equities and 40% fixed income. These shifts in asset allocation are to be expected, as index values change at different rates. Rebalancing back to the initial or target allocation keeps the portfolio at a consistent risk exposure and therefore, at a somewhat consistent expected return. In either example, a certain set of rebalancing trades would correct the asset allocation back to 65% equities and 35% fixed income.

Rebalancing on average involves selling equities after gains and buying equities after losses. Many investors make the costly mistake of doing the opposite, buying after gains and selling after losses, resulting in a misalignment of risk capacity and risk exposure. Selling indexes that have performed well and buying more of the indexes that have performed poorly is often an emotionally difficult task for investors, as it seems counterintuitive and confusing. The counterintuitive logic of rebalancing often leads investors to either do nothing, or even worse, to follow their fight or flight instincts and sell the losers and buy more of the winners, going completely against the prudent principle of rebalancing. A portfolio that is neglected or not rebalanced appropriately takes on a less than optimal risk-return trade-off. More to the point, the investor no longer has the confidence of knowing the expected return or the potential risks of their neglected portfolio, which are keys to prudent investing.

According to Michael Rosenbald at Washingtonpost.com, an AllianceBernstein survey of 1,000 investors showed that nearly 40% of investors without an adviser did not have an approach for allocating and rebalancing investments. Some 55% of those people reported that they never got around to doing it. Most startling: 70% of investors, including those with an adviser, said they are prone to change their hairstyle more frequently than they rebalance their portfolio.

Figure 12-1

There are certain obvious times when it is wise to consider changing index portfolios because of a change occurs in the investor’s capacity for risk. These times include:

   a) when investment goals change
   b) when income level significantly changes
   c) when investable wealth significantly changes
   d) when the time horizon for spending your portfolio changes (e.g. retirement)
   e) when life conditions change - medical, emergencies, marriage, divorce, etc.

12.2.4

Rebalancing Formula

The logic behind rebalancing is that it maintains a consistent level of risk exposure. There are several rebalancing formulas that are used in the investment industry. Although rebalancing is necessary to maintain risk, it can incur transaction fees and taxes. For this reason, rebalancing is a decision that should be handled with care. No formula can be right in every situation nor should a formula be used absent thoughtful and professional reflection. Nevertheless, a good rule of thumb is to set a target percentage for each asset class and then create a percentage high and low threshold around the each target. The percentage weights of each asset class in the portfolio should be evaluated quarterly vis-à-vis the thresholds, which will alert the investor to consider a rebalance. In addition, investors should assess their risk capacity once a year or upon any significant change in their lives and adjust the target asset class weights accordingly.

What is an appropriate rule to set the high and low threshold around a target asset-class weight? One common approach is the absolute 5 percent variance (as a percentage of the portfolio) trigger. This rule states that it may be time to rebalance when a general asset class moves an absolute 5% from its original allocation percentage. For a volatile asset class that makes up a relatively small percentage of the portfolio, a relative 50% variance (as a percentage of the target allocation) would trigger a rebalance review. IFA uses a combination of the absolute 5% variance (as a percentage of the portfolio) and the relative 50% variance (as a percentage of the target allocation) depending on the asset class and target percentage within the portfolio.

IFA's rebalancing policy can be simply explained as follows: IFA has a risk scale from 1 to 100. When IFA assesses that a client's portfolio has moved 5 or more risk levels away from the targeted risk level, then IFA will normally recommend a rebalance. By far, the most common reason for the portfolio to have moved 5 or more risk levels from the target is due to a change in the breakdown between equities and fixed income by 5 or more percentage points. In order to reduce small and costly trades, IFA also requires a general asset class to be at least $3,000 from its target dollar allocation before IFA considers the general asset class out of balance. Also in order to reduce excess trades, IFA will delay rebalancing where it has knowledge of upcoming withdrawals or deposits. Where possible, IFA will also avoid realizing short-term gains by waiting for them to become long-term.

Rebalancing among several taxable and tax-deferred accounts is a very complicated process, but necessary so that all assets can be considered. Highly sophisticated software is required with many factors to be considered, such as the need for liquidity versus the need for reduced volatility. There are significant tax implications for placing index investments in Roth, traditional tax-deferred, and taxable accounts and determining which to buy and sell during a rebalance. Whenever possible you should rebalance using deposits to or withdrawals from the portfolio as it reduces trades and potentially taxable gains as well.

While IFA’s rules are useful to indicate that a portfolio should be reviewed for rebalance purposes, it should not be used without consideration to other factors. Placing rebalance trades in a portfolio ultimately depends on the objective of risk control; aligning the risk exposure of the portfolio with the risk capacity of the investor. Specifically, since risk is the source of returns, the trades should result in either:

An increase in the portfolio’s risk level back to the target allocation (which normally occurs when we sell fixed income and buy equities).
A decrease in the portfolio’s risk level back to the target allocation (which normally occurs when we sell equities and buy fixed income).

In general, selling one class of equities to purchase a different class of equities does not result in a significant change in the portfolio’s risk level, as measured by the long-term historical standard deviation of returns. Put in other terms, selling a small percentage of the portfolio’s International Equity to buy a small percentage of US Equity does not typically alter the portfolios overall risk/return characteristics, but will incur trading costs and may realize capital gains.

In summary, rebalance trades should be done in order to realign the risk exposure of the portfolio with the risk capacity of the investor, but the potential benefits of the trades must be considered against the tax consequence and trading costs.

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Disclosures for Backtested Performance

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Step 1: Active Investors

Definitions

Problems

Solutions

Step 2: Nobel Laureates

Definitions

Problems

Solutions

Step 3: Stock Pickers

Definitions

Problems

Step 4: Time Pickers

Definitions

Problems

Step 5: Manager Pickers

Problems

Step 6: Style Drifters

Definitions

Problems

Step 7: Silent Partners

Problems

Solutions

Step 8: Riskese

Definitions

Problems

Step 9: History

Definitions

Solutions

Step 10: Risk Capacity

Definitions

Problems

Solutions

Step 11: Risk Exposure

Definitions

Problems

Solutions