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Apple Pie and Ice Cream…Vanilla Ice Cream

Apple pie

Apple pie (Photo credit: Wikipedia)

From time to time we get asked by our clients and prospective clients why we manage our clients’ money the way that we do. Some even gravitate to our firm because of the way that we invest and our philosophy. Others shy away because they are looking for management that will beat the market and always make money and never lose money. Note: This is impossible. But hey, some folks still chase that illusion.

As many of our readers know our investment philosophy is pretty plain – like apple pie and ice cream. To make this summer analogy more apropos, when you go to the store to buy ice cream vanilla is generally cheaper and in more supply. As you peruse further into the freezer you start to come across more exotic flavors, combinations and brand names that not only look (and may taste) more appealing, but are also more expensive and you get less (.75 quarts instead of 1.75).

Granted these flavors look good initially, but eventually over time you’ve paid more for less.

That’s exactly why we don’t invest in actively managed funds. The main reason is that chasing the active managed funds is a zero sum game. What does this mean? It means that yes, a particular fund may do exceptionally well one year and look colorful and tasty, but its counterpart fund may tank. In other words, two actively managed large cap funds may bet on which companies will do well, and one will be correct and the other wont.

Even though a fund may “beat” the market in a given year, it becomes exceptionally difficult to repeat this feat over the long run. And generally, even if a fund does beat the market, the numbers are usually reported gross of fee – meaning that once fees are deducted investors are often below their index counterparts.

There’s also the term “closet indexing”. This means that although a fund manager will actively manage a fund and charge more in doing so, they generally pick the same stocks in same index they’re trying to beat (a large cap fund will pick the same stocks in the S&P 500). While good for the fund manager as he or she has replicated the index, “hugged” their benchmark, and preserved their job, it’s bad for investors as they could have gotten the same returns for less fees. In other words, they underperformed the index even though their fund held the same stocks.

So our investment philosophy is very vanilla, very plain and as down to earth as we can make it. We accept that markets are pretty efficient (not perfectly efficient). This means that we feel that trying to actively seek out companies that will perform better than the market or seeking managers of funds to do this for us is a losing battle. And if we were this inclined, our fees would increase substantially. We would rather own the market and diversify accordingly.

Another way to look at active management is this: Look at any large cap stock such as IBM, AT&T, Microsoft or Wal Mart. These companies are followed and analyzed but hundreds if not thousands of analysts. What good can come from our firm replicating their analysis? By the time their information reaches us, the market has already reacted and the prices are reflected immediately. That’s market efficiency.

So if we don’t actively manage money, what is it that we do? We manage our clients. This means we help them with an array of financial planning (found at our website). Just as important, we help manage emotions. This means that in times of market euphoria or depression we help our client make wise decision (such as not selling at the bottom) which can cost thousands of dollars over a lifetime and ruins financial goals.

I’ll admit there’s not a lot of glamour and prestige investing the way we do. It’s not exciting and certainly not rocket surgery (thanks Jim for the wording). But it’s a way, over time to effectively keep costs down, emotions in check, and goals accomplished.

I’ll have another scoop, please.

3 Comments

  1. AnneNo Gravatar says:

    Great analogy “sraskie”; I did not know vanilla was “more abundant”; I will always be someone who would rather get a steady lower return and sleep well at nights..!
    I understand your theory and I appreciate your thoughts; (Vanguard sounds great !)

  2. DIY InvestorNo Gravatar says:

    Research shows also that your approach has historically outperformed 8 out of 10 active managers over the longer term. A recent case in point was the Harvard endowment fund. It returned 1.7% on an average annualized basis over the 5 years ended 7/31/2013 versus the 5.2% on the Vanguard Target 2030 Retirement Fund.

    1. sraskieNo Gravatar says:

      Thank you for your comments. Would you be willing to provide a link to the research/study for our readers?

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