Stewart is in his late 30’s and is a successful entrepreneur and business owner. His current business develops and sells software that is used by small to mid-size retail companies streamline their online sales systems and processes.
Business has been very good the past few years allowing Stewart to start saving some significant money. He really had not thought a lot about retirement until recently when his youngest daughter started high school and he realized retirement could sneak up on him somewhat quickly.
Stewart has had an interest in business from an early age and naturally became engaged in trading stocks early in his career when he had a little money to invest. Stewart likes doing research on companies and their stocks and feels like he is good at it given his knowledge and success in business. He trades his stocks through an account at Morgan Stanley with a broker who likes to pick stocks and feeds Stewart research and ideas. Stewart believed this investment strategy was working well for him.
Stewart was introduced to Patton Funds when Mark Patton spoke to a business group that Steward belongs to. Mark covered many topics during the 3-hour workshop but two in particular captured Stewart’s curiosity. The first was on the topic of index funds and the fact that professional stock pickers, managers of the mutual funds, generally do not perform as well as the indexes. Stewart considered his own investment experience and believed he was generally picking stocks that did well. He was surprised to hear that professionals were not beating the performance of index funds and found it hard to believe he was not doing so.
The second topic that got his attention was about diversification. A lightbulb went on for Stewart realizing he had virtually no diversification. This fact was far easier for him to understand. Quite simply, his portfolio was 100% U.S. stocks and some cash.
During Mark’s presentation to Stewart’s business group, Mark offered to do a comprehensive review of the group members’ portfolios. Stewart accepted this offer. Generally, all Mark needs to do a review are copies of the most recent investment statements showing the current holdings in the portfolio. Normally this review is designed to determine how his current portfolio is allocated, its fees, and resulting expected risk and return. In Stewart’s case, though, he was interested in figuring out exactly how his account has performed over the past 5 years. This required Stewart providing balances on his account at the end of each year as well as the dates and amounts of any deposits he had made during that time.
During the past 5 years that Stewart had been seriously engaged in trading stocks it had been a bull market for stocks. Stewart knew he was making money but his brokerage statements never reported returns. As we dug in and did our portfolio analysis, we determined Stewart had made a return of nearly 11% compounded annually. This is a good return of course but the issue is that the stock market produced a return of better than 13% compounded annually during this same time. Therefore, a low cost index fund would have produced this 13% return as compared to Stewart’s 11%.
These performance results were difficult for Stewart to believe. We reviewed the results and calculations at length together and concluded the calculations were correct. I explained that these returns are very similar to the average mutual fund that has a professional tasked with picking stocks. The reason, I believe, stock-pickers generally cannot perform as well as a simple low-cost index fund has to do with intelligence, education, work ethic, and resources.
We must understand that there are tens of thousands of professionals picking stocks for a living. These people tend to be VERY intelligent, VERY well educated, EXTREMELY hard working, and have nearly unlimited resources to do research. The challenge is that this is the case for many of them and they are all competing against one another, generally using the same information everybody else has (otherwise it is likely illegal), and they are trying to outguess each other. It just doesn’t work. On average, they get average returns less the fees and other costs associated with the process. The result tends to be a return that is a couple percent below the indexes.
Stewart realized him picking stocks was not a great long-term investment strategy. Not only was he not getting the return he deserved for the risk he was taking but it was also somewhat time-consuming. The other issue that was uncovered in the portfolio analysis was the high tax cost of Stewart’s strategy. This was due to the frequency of trading resulting in many short-term holdings. His challenge is that he enjoys it! I reminded him that picking stocks was not nearly as much fun during bear markets.
After gathering the facts regarding Stewart’s portfolio, he quickly decided he wanted an investment strategy that would stack the odds in favor of his success instead of against him (as his stock picking was). We built a Super-Diversified portfolio for Stewart that meaningfully increased his expected long-term return and very substantially reduced his risk. Stewart did decide to keep some “play money” in a separate account so that he could still periodically buy and sell stocks but does so infrequently and is focused more on growing his business.