Bolen | Dodson & Associates’ asset management philosophy is based on rigorous, analytical research and the result of our twenty three plus years in the real world investment business.
Our process is logical, systematic and disciplined. It is long term in nature and is tax efficient. As fee only, independent Registered Investment Advisors, we are always looking out for your best interests.
We seek the very best investment vehicles available. By knowing the limitations imposed by the market’s efficiency, coupled with a research driven, systematic and disciplined investment approach, we stack the odds in our favor to produce acceptable risk-adjusted returns over the long term, net of all costs and fees.
How Markets Work
We believe, and evidence indicates, that markets are largely efficient. That is, markets do a good job of setting prices for the buyers and sellers of securities and rapidly discounting available information into the marketplace. Investors can expect to receive a reasonable reward for taking risks over time. It is difficult to generate returns in excess of the broad market or sector averages consistently, net of fees, transaction costs and taxes over the longer term. This does not mean markets are always rational or correctly factor information into prices, but that it does a reasonably good job if it and that it is quite difficult to profitably exploit inefficiencies on a consistent basis.
This expected reward is not tied to picking the right stocks or determining the best time to enter or exit the market. Rather, it is the reward for supplying capital that companies need to fund their growth. The research shows that the number of successful long-term “active” managers is no greater than what would be expected by chance.
A stock’s price is determined by three factors: expected company earnings and/or dividends, the expected earnings growth rate, and a desired, expected rate of return. Notice how all three factors are “future” oriented. The stock market is forward looking. A changing outlook for any of the three factors will cause the stock price to rise or fall. Notably, the desired rate of return will rise as risks rise to compensate investors for accepting a higher level of risk. Market pressures move the stock price to reflect the aggregate opinions of market participants.
The broad stock market has produced an average annual return of about 10% over the longer term with a standard deviation (a statistical measure of volatility) of plus or minus 20%. Statistically speaking, this means that about 2/3rds of the time the market will produce an annual return somewhere between -10% and +30%. About 95% of the time returns will be between -30% and +50% and fully 99% of the time returns will be between -50% and +70% in any given year.
This volatility is the reason we can expect 10% average annual returns over time. Confidence in the power and efficiency of markets has important implications for investors and helps stay the course during times of increased market volatility. Rather than trying to outguess the capital markets, we let the markets work for us by capturing the sources of risk and return in client portfolios through a structured, strategic approach.
Fixed income investments also exhibit volatility, but to a lesser degree. Annual returns over the longer term have averaged about 6% with a standard deviation of about 8%. The fixed income market has seen an almost 30 year bull market due to falling interest rates and falling inflation. Currently, inflation adjusted interest rates are about zero.
Fixed income investing can play an important role in managing overall portfolio risk. Generally speaking, the performance of all fixed income securities are dependent on when the bonds mature, known as term risk, and the risk of default.
Fixed income is a tool best used to dampen volatility in a diversified portfolio and to generate a dependable stream of income.
As noted, risk and return are inexorably related. Investors who want to earn higher expected returns must accept higher levels of risk. But all risks are not created equal. Some risks come with expected rewards, some do not. Individual company risk can be diversified away through owning many companies. Investors are not paid an expected return to bear this risk because it can be diversified away. Market risk cannot be diversified away so investors receive an expected return as compensation for bearing it.
Eugene Fama and Kenneth French are Nobel Laureates in finance that have researched the “risk factors of market returns” and have written extensively on their findings. Through their research, they discovered three causal determinants that explain 95% of the variation of market returns. Over the period from 1927 through 2010: 1) Stocks outperformed Treasury bills by about 8% per year, on average; 2) Small company stocks outperformed Large company stocks by 3.75% per year, on average and 3) Lower-priced “value” stocks, as defined by a higher book-to-market ratio (low price to book), outperformed Growth type stocks by 4.9% per year, on average.
Smaller companies are generally riskier than larger companies and thus, investors are rewarded with a higher expected return. Similarly, Value stocks, as defined, are typically more cyclical and/or have disappointed investors such that, prices have declined relative to book value. There is greater uncertainty surrounding value stocks and thus, investors demand a greater expected return to own them.
Fama and French’s “multifactor model” research has revolutionized asset management, bringing a scientific, evidence-based approach to investing. Bolen | Dodson embraces this investment and portfolio management philosophy.
The Bolen | Dodson & Associates Asset Management Approach
We believe in longer term, strategic asset allocation that is consistent with your goals, time horizon, and ability to handle interim volatility. We construct diversified portfolios of marketable securities of low cost equity and fixed income funds that meet your needs. This “Goals Based” approach is a key element to successfully managing portfolios. Given the market’s volatile tendency, it is imperative to know when you plan on using the funds allocated to the stock market. Only funds needed five or more years in the future are appropriate for equity investing. This gives the market time to sort it self out, recover from any temporary declines and regain its positive longer term footing.
Our primary partner in this process is Dimensional Fund Advisors. DFA has pioneered the integration of the Fama and French academic research with real world application. DFA offers numerous low cost domestic and international equity mutual funds, real estate and commodity funds, and fixed income funds.
Diversification across 7-8 low-correlation asset classes’ is an important component of a properly constructed portfolio. Low correlation means some things are going up while some may be going down, but over a market cycle, each component pulls its own weight. As such, it helps to lower overall portfolio volatility while attaining reasonable, risk adjusted returns over time.
The first investment decision is your percentage of equities and fixed income. After that, we use the multifactor model framework to help us strategically design your investment strategy. We use size and style dimensions to control risk and best capture expected return. This model brings purpose and focus to an otherwise chaotic investment process. It offers a frame of reference that helps us navigate tough market conditions, and set and manage expectations, apply logic, and reinforce discipline.
Costs are a drag on performance and are thus an important consideration when constructing portfolios. Transaction costs, taxes and fund management fees all impact net returns to investors. We seek to lower costs through prudent use of Exchange Traded and Index Funds. Index Funds are less expensive than actively managed mutual funds and are typically more tax efficient.
Beyond the core multifactor model approach, DFA also applies state of the art trading methodologies that work to further lower costs and improve returns. For example, DFA excludes thinly traded securities, recent IPO’s, distressed securities, etc. DFA also acts as “buyer of last resort” providing liquidity to the marketplace and thus buying many securities on the bid side of the market.
One of the axioms of investing is that markets will always, eventually revert to their long term average returns. Throughout history, every time markets have declined, they have subsequently rebounded and moved higher then before. This has happened without exception. To capture the return from this volatility, it pays to simply rebalance portfolios opportunistically and thus take advantage temporary dips and longer term advances. Location Optimization refers to holding a given security in the most tax efficient account, whether taxable or tax deferred, Roth or Traditional IRA. We use technology to help us add value through rebalancing and location optimization strategies, which can add 0.5%-1.0%+ annually to net returns.
We look forward to discussing these or any investment thoughts you may have.
