This tale is part of LARRY SWEDROE’s Investor Tales series. Unless otherwise specified, the tales are hypothetical scenarios, designed to educate the reader on investment principles.
In early 2000, Cathy called Brenda to invite her to an investment seminar sponsored by her CPA. She told Brenda the seminar was part of a series. She had enjoyed the prior sessions and thought Brenda would too. Brenda was sceptical; her experience was that investment seminars were really sales presentations. Cathy assured her this seminar would be purely educational. With that assurance, Brenda agreed to join her.
The speaker began by stressing the importance of developing an investment plan before any investment decisions are made. She emphasised this point by explaining that without a plan it would be impossible to properly evaluate how any decision would impact the overall risk, and the likelihood of success, of an investment strategy.
She then explained how important it is to understand there is no one “right” plan. Each plan should be based on an investor’s unique ability, willingness and need to take risk. The plan should take into account such factors as the stability of the investor’s earned income, their investment horizon and their current level of wealth relative to their need for investment income. She also stressed the importance of diversification and the need to avoid the “too many eggs in one basket” syndrome.
She then explained that the only effective way to build a truly globally diversified portfolio is through mutual funds or exchange traded funds. She emphasised that having a well-developed plan was only the necessary condition for investment success. She presented the evidence on the failure of market-timing efforts to deliver on the promise of superior returns and the inability to avoid bear markets. Thus, the sufficient condition for investment success is to be a disciplined, patient, long-term, buy-and-hold investor.
After the seminar, Cathy introduced Brenda to her CPA, Erica. They both thanked Erica for an entertaining and educational program. Cathy noted that she was particularly impressed by the slides on the failure of efforts to successfully time the market—too much of the returns occurred over brief and obviously random periods.
Brenda said she’d been told early in her career that the winning strategy was to be a buy-and-hold investor, and she was particularly proud she’d been investing with Fidelity Magellan Fund for more than 20 years and had never sold any shares. The conversation proceeded as follows.
Erica: I’m glad both of you enjoyed the seminar. There’s one point I believe is worth going over. Unfortunately, many investors make a mistake when implementing a buy-and-hold strategy. There’s really only one way to ensure that your investment plan, or asset allocation, remains what you want it to be. That way is to invest in only passively managed funds such as index funds and other funds that invest systematically in a transparent and replicable manner.
Investors who use actively managed funds to implement their asset allocation often have their strategy undermined by market-timing efforts and the resulting style drift that accompany active management. So, Brenda, while you were being a disciplined, patient, passive investor, holding your Fidelity fund for more than 20 years, the fund manager was active, undoing your buy-and-hold strategy. Let me explain.
The charters of most actively managed mutual funds give their portfolio managers the freedom to shift allocations between asset classes at their discretion. Investors in such funds not only lose control of their asset allocation decisions but also end up taking unintended risks by unknowingly investing in markets, or types of instruments, they wanted to avoid. For example, a large-cap fund might invest in small-cap stocks. Or a domestic fund might decide to buy international stocks. Ironically, perhaps the best example of this problem (but one that is in no way unique) is the fund you own, the Fidelity Magellan Fund. Do you recall what happened to the fund in 1996?
Brenda: I do remember it wasn’t exactly a great year. In fact, I think the manager was fired due to poor performance.
Erica: Your memory is good. Let me explain what happened and why it’s so crucial to learn from that experience. Over the years many investors have placed the equity portion of their portfolio in Fidelity Magellan. Unfortunately, in February 1996, Magellan’s asset allocation was only 70 percent in equities, 20 percent in bonds and 10 percent in short-term marketable securities (data from Portfolio Visualizer).
Magellan’s investment manager at the time, the highly regarded Jeffrey Vinik, was obviously making a big bet — with your money — that long-term bonds and short-term marketable securities would outperform stocks.
To illustrate why that’s a problem, I’m going to create an example demonstrating how Vinik’s decision impacted your investment strategy. Let’s assume that at that time your portfolio had a total value of $100,000 and your plan was to have an 80 percent equity/20 percent fixed-income allocation. You would have had $80,000 invested in Fidelity Magellan. However, as this table I’m creating shows, due to Vinik’s strategy, you actually would have had only $56,000 ($80,000 x 70 percent) invested in equities.
Unbeknownst to you, your allocation was subjected to what is called “style drift” — your 56 percent exposure to the equity markets was less than the desired 80 percent. By placing funds with an active manager, you allowed someone else to modify your strategy.
It’s essential to note that, for me, the key issue wasn’t the outcome of Vinik’s decision. Instead, it was your having lost control of the asset allocation process, which means you lost control of the risk and expected return of the portfolio. You may not remember, but the market subsequently soared to new highs. To make matters worse, the bonds Magellan had bought fell in value. And as you correctly recalled, the fund manager moved on, as they say, “to pursue other career alternatives”.
This was such a compelling story that it led Peter Bernstein, in his wonderful book Against the Gods: The Remarkable Story of Risk, to analyse the composition of the Fidelity Magellan Fund. For the period February 1985 to June 1995, he noted that its composition “varied over time to such a degree that it would have been virtually impossible for investors to determine the asset classes in which they were investing, or the risks to which they were being exposed.”
The Fidelity Magellan example is by no means a unique one. There is really only one way for you to avoid this type of risk and the damage it can cause. You must use only passively managed funds. However, even this is only a necessary condition for successful buy-and-hold investing. The sufficient condition is to rebalance the portfolio on a regular basis. Since asset classes change in price by varying percentages, it’s necessary to rebalance the portfolio on a regular basis to restore it to its desired asset allocation. Otherwise, the market will cause the same type of style drift that active managers cause.
Brenda: That was a helpful explanation. Thanks again for inviting me. I have a lot to think about.
The moral of the tale
There is only one effective way to implement a passive, buy-and-hold investment strategy — both the investor and the vehicles in which they invest must be passive. And even that is not sufficient. The investor must periodically rebalance the portfolio to avoid allowing the markets to cause it to style drift (alter their asset allocation).
Important Disclosure: The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. While reasonable care has been taken to ensure that the information contained herein is factually correct, there are no representations or guarantees as its accuracy or completeness. No strategy assures success or protects against loss. The story about Cathy, Brenda and Erica is hypothetical and should not be interpreted as representative of any individuals actual experience.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
Want to read more of Larry’s insights? Here are his most recent articles published on TEBI:
For every buyer there must be a seller
Cost a huge factor in endowment performance
Even a crystal ball won’t help
Unique insight or common knowledge?
What investors can learn from Moneyball
PREVIOUSLY ON TEBI
Here are some other recent posts you may have missed:
The only way to be a buy-and-hold investor
Why active will continue to underperform
Five ways to boost your financial resilience
For every buyer there must be a seller
FIND AN ADVISER
Investors are far more likely to achieve their goals if they use a financial adviser. But really good advisers with an evidence-based investment philosophy are sadly in the minority.
If you would like us to put you in touch with one in your area, just click here and send us your email address, and we’ll see if we can help.
© The Evidence-Based Investor MMXX
