At Birchwood Capital we believe in being straightforward. 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.

While trying to beat the market by utilizing a complex strategy sometimes pays off, a straightforward investment process is, in our experience, far more reliable, understandable, transparent, and profitable for clients.

During client meetings, we review your overall investment and withdrawal strategy at least once per year. However, as long as clients’ goals don’t change in the interim, we don’t expect to materially change portfolios.

In case you’re still wondering: we utilize low-cost, tax-efficient, global index funds (ie. Vanguard Funds) as the foundation for our portfolios.

Here’s why:

Do what works

We could go around and around in circles debating passive versus active or efficient markets versus inefficient markets. Each one has its merits and also its Achilles' heel. Here’s why we chose an index (passive) approach.

The 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 in a one-year timeframe.

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 is liquidation or style change (a growth fund becoming a value fund).

This means that while you may be able to select a top fund for one year, you’ll have to keep selecting the next top funds year after year. This turns into an impossible task of correctly predicting next years’ top performer each and every year (not to mention all the trading and tax costs of making those annual changes).

Forget it.

But by owning the index, you’re guaranteed to be in the top decile of funds over time.

***

Next, here’s why we own thousands of companies inside our index funds.

Most public companies are duds.

Since 1980, 40% of all Russell 3000 (ie. 3,000 of the largest U.S. publicly traded companies representing 98% of the investable U.S. equity market)) lost at least 70% of their value and never recovered.¹

And yet, the equity market has seen incredible growth since 1980 (and for the many decades before). Effectively a very small number of constituents have been responsible for offsetting the duds and producing fantastic market returns. These “star” companies come from nowhere to become household names and then are replaced by new stellar companies. By owning the index, you are guaranteed to own all the stars no matter who they are.

Furthermore, you don’t necessarily need tremendous returns to achieve tremendous results. Solid, average returns over a consistent period of time will result in you doing fabulously well.

You know what owning a global portfolio is really good at? Missing all the highest returns.

Yet, we gladly own a global portfolio. Yes, we miss the home runs - the sector bets in disruptive innovation technologies, for example – but we hit singles every time. Diversification creates this consistency. And consistent returns are what produces the greatest gains in the end.

***

Lastly, here is our view on market terror and chaos and how we handle them:

Good returns aren’t free. And there will come a time when the skies aren’t always blue. When markets fall, we view this as the “price” of investing, and while we try to dampen the blow, we don’t try to avoid it.

Investment writer Morgan Housel says, “You can be optimistic that the long-term growth trajectory is up and to the right, but equally sure that the road between now and then is filled with landmines, and always will be. Those two things are not mutually exclusive.”

We view a negative circumstance as opportunity throwing the door wide open. The markets will throw its tantrums and things will look dire from time to time. Actually, it is exactly because of these fits that we get the great returns that we do. With no risk, the markets wouldn’t produce good returns as everyone would hold the consensus opinion. Comfort never made anyone wealthy. Peter Bernstein wrote in 1979 that “The great buying opportunities… are never made by investors whose happiest hopes are daily being realized.”

Your success as an investor will be determined during these times of chaos, not the years spent coasting.

To help in these times of chaos, we utilize a “Guardrail Strategy” to maximize success (not running out of money) for our clients. Part of this strategy includes reducing portfolio withdrawals once a lower “guardrail” is hit. Clients know what exactly needs to happen during tough times, so their growth assets can remain fully invested and participate in the ensuing economic recovery.

Acknowledge limitations

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’re among the many who do not know what the future holds.

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.

Because this is our natural human tendency, we intentionally have to make the effort to forgo the predictions of market experts. If they displayed their past scorecards as boldly as they pronounce what’s “certain” to happen, we’d disregard it entirely due to their horrible track record.

Many advisors believe that either a) they can predict what’s in store for the markets and which asset class will do best or b) their clients expect this of them so they comply and act as if they can. Thus, portfolios are built which will earn big returns if they’re right (and be shattered if they’re wrong) or they’ll build closet-index portfolios and invest completely different from what they say they believe.

We’d rather call it like it is: we fully acknowledge our limitations of not knowing the future or what the next global macroeconomic move is.

Once we know our limits, we can put the highest priority on what we can control. These include:

• Keeping management fees low (flat-fee)
• Tax planning (asset tax location, income bracket planning, gain harvesting, limiting capital gain distributions)
• Utilizing low-cost investments (lowest cost funds earn the highest returns across all asset class)²
• Limiting trading (returns of investors who frequently trade lag behind light traders or non-traders)³
• Increasing our savings rates
• Increasing/decreasing our withdrawal rates
• Being long-term owners of equities
• Charitable giving
• Estate planning

Have room for error

With all the planning that we do, sometimes it’s not enough. Exogenous forces can overwhelm the things we can control. Whether it’s a sudden war erupting in the world or a tragic death, things happen that we never saw coming.

In other words, plan on your plan not going according to plan.

The person with enough room for error in their strategy (read: cash & bonds) to let them endure tough times in the market has an edge over the person who gets wiped out when they’re wrong.

No risk that can wipe you off the chess board is ever worth taking.

As such, in addition to emergency funds we require for clients, we keep at least 5 years’ worth of living expenses for our retired clients in cash and bonds. We call this our “war-chest” and draw from it to pay for living expenses when the markets take a hit instead of selling equities.

Is it the most optimal point on the efficient frontier? Absolutely not. When the world is precisely not black and white, academic calculations play second fiddle to common sense and prudence.

 

 

 

 

¹ J.P Morgan. The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position

² Morningstar. Fund Fees Predict Future Success or Failture.

³ Journal of Finance. Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.