Simplicity is hard
Simplicity is a means to an end
At Birchwood Capital we believe that simplicity is superb. While trying to beat the market by utilizing a complex strategy sometimes pays off, an investment process based in simplicity is, in our experience, far more reliable, understandable, and profitable for clients.
It may seem that complex markets deserve complex solutions. Actually, an investment strategy based in simplicity lives in harmony with the complexity of markets. It rejects easy, emphatic answers to tough, intricate problems and frees us to appreciate and respond to the complex issues of contemporary markets. It provides greater transparency and understanding, whereas a complicated investment strategy tends to confuse and obscure.
Our overall philosophy of investment advice is goal-focused and planning-driven. This is different to a market-focused and current events-driven approach. We never forecast the economy, attempt to time the markets, or predict which market sectors or individual companies will 'outperform' others over the next block of time.
Investment plans are laid out in an Investment Policy Statement detailing:
- Your specific and measurable goals
- How we’ll utilize your investments to accomplish them
- How we’ll handle ourselves when (not if) the market rises or falls
We agree to review our overall investment and withdrawal strategy regularly. However, as long as your goals don’t change in the interim, we don’t expect to materially change your portfolio.
Our principles of portfolio management are as follows:
- Simplicity wins: We utilize low-cost, tax-efficient, global index funds as the foundation for our portfolios
- Simplicity is hard: Investment success is based on how you behave and how well you stick to your plan
- Simplicity is a means to an end: The only benchmark we should follow is whether you're on track to achieve your goals
A marvelous resource compiled by S&P Dow Jones Indices (SPIVA Scorecard) compares the returns of active funds and their respective benchmarks. This semiannual report shows the percentage of actively managed funds that outperform their benchmarks over 1, 3, 5, 10, and 15-year periods. The report habitually shows that over half of actively managed funds in basically every category are outperformed by their benchmark.
Endurance is also key. For those active funds that do outperform in a given year, only a very small percentage sustain their outperformance in future years, significantly below what random chance would predict. In fact, the most likely outcome for top performing funds in future years was liquidation or style change!
Second, active investing means more trading. The returns of investors who frequently trade lag behind returns of light traders or those who don’t trade at all. This is due to transaction costs (the fee paid for buying and selling an investment) and taxes. Frequent trading leads to more short-term gains being recorded which are taxed at the investors highest tax rates. Furthermore, active mutual funds distribute capital gains at the end of each year that investors pay taxes on, no matter if the investor made trades or if the fund made money that year. This frequent turnover and the regular distribution of capital gains from the funds themselves leads to less after-tax money reinvested in a new actively managed fund, further reducing the active investor’s chances at “beating the market.”
Next, costs matter. A 2016 Morningstar study confirmed that fund expenses consistently show the best predictive power. The lowest cost funds earned the highest returns across all asset classes in every tested time period.
Finally, when all else fails, common sense prevails. First, the stock market is simply the collection of all investments made by passive and active investors. The returns of all these individuals before any expenses or taxes must equal the return of the stock index. Since passive investors simply track the index, it stands to reason then that the returns of active investors are lower than the returns of the index by the amount of their expenses and taxes incurred. An active investor must first overcome transaction costs, management fees, and taxes just to get back to even before they can begin to deliver above-market returns, or as Nobel Laureate William F. Sharpe stated, “After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period.”
There are certain active managers who do outperform. However, it is extremely difficult to parse luck from skill as any outperformance would be expected from a random distribution of returns. But even if a manager had true skill, participating in that outperformance is near impossible. Once a decent track record for an emerging manager has been established or “word gets out,” any excess return gets competed away too quickly due to dollars rushing in. By the time you subtract fees, investors are left with a sub-performing fund relative to a market index.
Index funds offer the advantages of low operating and trading expenses, tax-efficiency, excellent diversification within asset categories, broad access to all segments of the market, and the highest chance of greater returns. The goal is to maximize the efficiency of portfolio returns by minimizing the costs of investment intermediation so that the client can keep more of the market return.
Simplicity is hard
Seldom in investing are there any issues of significance that will yield effortless answers. While simplicity provides an answer, it doesn’t provide an easy answer. We must also never confuse simplicity with simplism. Oversimplified answers, by their very nature, fail to perceive the rich, ordered complexity of investing and economic markets. It is essential for us to be confronted by this reality if we are to escape superficiality.
To some, utilizing index funds may be seen as radical dependence. To Birchwood, it’s not so much about throwing our hands in the air as it is about recognizing our limitations. At Birchwood, we don’t know how to predict the future, and we’re OK with that.
Markets are always surprising. Always. The moment we think we have the markets right where we want them, we’ve lost. This doesn’t sit well, as we, as humans, are driven to find causality in every event and the catalyst for future ones. We want to know answers to infinite questions.
The difficulty in simplicity is forgoing the “solutions” -- promised by those who peddle to the desires of the masses to know and find certainty about the future -- and sticking with a long-term plan. It goes against every emotional fiber of our being.
This is the cost for our style of investing, but it is the not-so-secret of success. You can have the greatest investment strategy in the world, but if you can’t stick to it then it is completely worthless. Second-guessing and making adjustments because the current portfolio “isn’t working” will cost you far more than you can ever add with a tweak here and there. Investing isn’t merely about number crunching and valuations, but about how we behave.
To be sure, the cost of simplicity is great, but the cost of complexity is greater.
Simplicity is a means to an end
As shown, simplicity provides the most reliable and efficient way to invest. But if we ended there, we’d have a half-baked result. It’s great to have a portfolio that compounds over decades - building up to a sizable amount of wealth, but if it isn’t created with an end in mind, then we might as well chase after the wind.
Simplicity isn’t about starting a trendy investment strategy, as these things come and go. It’s a principle based on the intentional promotion of the things and people you value most and the removal of anything that distracts you from them. Incessant market TV, media, and economic forecasts are unnecessary at best and maddening at worst. They can steal our time, attention and can create constant anxiety. Birchwood believes clarity and directness gets you back and centered.
We believe investments should be clear and profitable so that clients can focus on doing the greatest good for their families and communities. Clients can be free to slow down, have some friends over, spend time with grandkids, savor conversations, and donate their resources and time. While very, very important, there are better things in life than just not running out of money in retirement.