An investment in knowledge pays the best interest

~Benjamin Franklin

Is your wealth advisor an Investing Vulcan?

Wealth advisors often talk about biases and investments habits of investors that lead to poor investment performance. They talk about cognitive biases such as hindsight bias and mental accounting; about emotional biases such as overconfidence and regret aversion, leading to bad investment habits such as trading too much and not diversifying sufficiently. Research by Vanguard1 (the bastion of passive investing no less) among others has indeed shown these biases and habits significantly reduce portfolio performance over time. Research analysts at Vanguard believe that advisors, through financial planning, behavioral coaching and guidance can consistently provide value to their clients. They quantify the value added to be on average equal to 3% per year, net of all fees. Over time, that can add up to a very sizable difference to an investor’s portfolio.

But, what makes wealth advisors immune to these biases and habits? Listening to them talk, you would think they are like Mr. Spock from the planet Vulcan, in the sci- fi series Star Trek- living by logic and reason with little interference from emotions.

In reality, advisors suffer from the same biases and habits that they advise their clients against. Many suffer the consequences in their personal portfolios2 (Hopefully, not in their client’s portfolio). What can and does prevent them from making the same mistakes in their client’s portfolio is having a time-tested process and sticking to it.

In all the discussion about beating benchmarks and passive versus active investments, what is lost is what investors do as opposed to what they should do with their investments. What investors do with their investments in aggregate, hurts their performance and by a wide margin. You just have to look at the difference between fund returns and investor returns of mutual funds on Morningstar to see by how much3. A wealth advisor that follows a well thought out process can prevent this from happening. Further, advisors that provide financial planning services can additional value to their clients.

It is no surprise then that understanding an investment advisor’s process and his/her commitment to it, is one of the most important steps investors should take when hiring an advisor4. One of the ways that commitment can be judged is to enquire if he/she uses the same process for managing his/her wealth. At Sarsi, a majority of or personal assets are managed in the same way as we manage our client’s assets.

1. Please send us a note if you would like a copy of these research reports.

2. We have had the good fortune to work with successful investment managers that did very well for their clients but themselves needed help for their personal portfolio.

3. According to Morningstar research the average annualized difference between investor returns and fund returns for 10-year periods ended 2012 to 2015: negative 1.13%.

4. is a good website with information on what value a registered investment advisor (Such as Sarsi) can add to a client and how to go about selecting one.

Investors should accept and embrace volatility

As we discuss in our investment tenets, one of our beliefs is that volatility is a necessary evil to produce returns. Consider the two investments choices below. Which one would you invest in?

Chart 1Chart 2

Most people would of course pick Investment B attracted by the 60% return over time as opposed to a loss of 40% in investment A. In fact, both the above graphs are the returns of the S&P 500, but at different times. Investment A is the S&P 500 between October 1973 and November 1974 and Investment B is between December 1974 and November 1976. If you had invested in the S&P 500 in November 1976 encouraged by the run up, you would have gone on to lose about 20% over the next year and a half as seen below. (Which brings us to our other belief which is to never chase returns- that is a topic for another article).

The reason we picked that period is because of what happened subsequently. The S&P 500 went on to increase 18-fold over the next 20 odd years to August 2000 as seen in the chart on the right below. Along the way, it had several drawdowns including a crash of over 22% in one day on October 19, 1987. It is this volatility that earns stocks a higher return than bonds. In investment parlance, this is called the risk premium. (Please note, for this analysis we have used the S&P 500 price returns for illustration purposes as the data for the total returns, i.e price returns plus dividends is not readily available for older time periods)

Chart 3Chart 4






A similar thing happened more recently as seen in the charts below. (Here we used the S&P 500 total returns) On the left is the chart of the S&P 500 from January 2000 when the internet bubble burst, to March 2009 at the bottom of the market during the credit crisis. An investor invested in the S&P 500 would have been frustrated by a loss of 40% after almost a decade. If he were to sell at that point, he would have missed the subsequent bull market that more than doubled the original investment (almost four times from the bottom in 2009)


Chart 5Chart 6







The above analysis will no doubt tempt a few readers to question why an investor could not sell at the top of the market in 1999 and then buy again at the bottom in 2009. That is called market timing which is impossible and attempts to do that has been detrimental to investor returns (Another one of our investment tenets). As they say, nobody rings a bell at the top or the bottom of the market.

Since portfolio volatility must be tolerated by investors for investment plans to succeed, advisors need to create portfolios whose volatility are tolerable by clients. At Sarsi, the first step in our investment planning process is understanding client risk profile and return objectives.


The Foundation of a Good Financial Plan

 Congratulations! You just won a $315 Million lotto. What are the three things you will do with the money? If you choose the lumpsum payment and after taxes you will be left with about $100 Million, but that’s still a lot of money, so think big.

When I ask this question to people, I get a host of answers, some common ones, such as ‘buy a house, a car or travel the world’ and some uncommon ones such as ‘go back to school, start a school or fund a specific research area’. Nobody ever says spend everything, gamble the money away or go bankrupt. Unless they are mentally unsound, why would they?

Yet, that is what happened to Andrew Jackson ‘Jack’ Whitaker Junior after he won the $315 Milllion lotto in 2002. He started gambling, drinking heavily and carried so much cash around that he kept getting robbed. Within a few years, he was back to work. When asked about winning the lotto, he reportedly said, “I wish I had torn up that ticket”. This is not an isolated case. According to the CFP Board, almost a third of lotto winners declare bankruptcy. Some put the estimate as high as 50%.  What makes the example of Andrew Whitaker unique is that he was a successful businessman and a multi-millionaire even before he won the lotto. You would think he would have known how to manage his finances. Why do people, both the well off and the not so well off lose their way around money? We think there are two reasons – a lack of self-awareness and a lack of a financial plan.

The first and foremost step in creating a financial plan is understanding yourself. Understanding yourself is understanding your relationship with money and your values. Your relationship with money is how you view money and what you would do if you had and/or if you did not have it. Values are things that are important to you.

Money relationship: How you view money

  • —  You value money for the security it provides
  • —  You want a lot of material items, and you want then now.
  • —  Money helps you feel important.
  • —  Money is a resource to get things you need or want.
  • —  You are not concerned with money; there is no reason to worry about it.

 Examples of Values

  • —  Accomplishment
  • —  Contentment
  • —  Creativity
  • —  Culture
  • —  Esteem
  • —  Experience
  • —  Family
  • —  Fitness
  • —  Flexibility
  • —  Friendship
  • —  Honesty
  • —  Integrity
  • —  Independence
  • —  Personal Growth
  • —  Popularity
  • —  Power
  • —  Religion
  • —  Risk Taking
  • —  Security
  • —  Self Confidence
  • —  Stability
  • —  Status
  • —  Strong Convictions
  • —  Teamwork
  • —  Technical Excellence
  • —  Uniqueness
  • —  Wealth
  • —  Winning

Creating a financial plan based on your values will increase the probability of success and give you the motivation to carry out the hard decisions such as making  sacrifices in the short term to benefit over the long term. You can also have a clearer vision of your future based on your values. Having a clear vision will give you the confidence to carry out the steps needed. Based on your value and your vision you can create your mission statement (Statement of purpose) and then set your goals. A good mission statement includes your strengths, passions, gifts and the people that matter to you. Goals should include short term goals and long term goals.

These steps when completed, would provide a solid foundation to your financial plan. You can then create a plan which is consistent with the things that are important to you, which capitalizes on your strengths and consolidates your weaknesses.

Foundation of a good financial plan (Please click on the image if not clear)

Foundation of a financial plan




Immediately after winning the lotto if Andrew Jackson had been told he would soon lose it all, he would probably have laughed it off. Understanding yourself involves deep introspection and unbiased evaluation. Seeking the professional help of a qualified planner is highly recommended

Investments Tenets- Sarsi’s Approach

 1.     A focus on downside protection helps performance over the long term

Research has shown that for most investors the pain of a loss is more acute than the pleasure of an equal gain. There is more to downside protection from an investment strategy point of view: negative returns have a bigger impact on long term performance than positive returns. For example:

-50% followed by +50% ≠ 0%. It is = -25%. (This is also true for +50% followed by -50%)

To drive home the impact of negative returns on long term performance, below is a table illustrating how much and how long it takes to get to breakeven after a negative performance.

Table 1

Drawdown Return needed to recoup losses No. of years to recoup losses at 10% per year
-10% 11.11% 1.11
-20% 25.00% 2.34
-30% 42.85% 3.74
-40% 66.67% 5.36
-50% 100.00% 7.28
-60% 150.00% 9.62
-70% 233.33% 12.64
-80% 400.00% 16.89
-90% 900.00% 24.16

 Source: Sarsi, LLC analysis

It is impossible to avoid negative returns all the time, but by constructing a portfolio that, over the long term captures less of the downside and more of the upside an advisor can add considerable value. To illustrate, even if the adviser reduces the downside as much as he does the upside, he would have added value. Continuing with the above example:

-50% followed by +50% = -25%.

If an adviser reduces both upside and downside by half: -25% followed by +25% = -6.25%

However, as we will see below this objective must be achieved without too much turnover and by not attempting to time the market, which is impossible to do in a consistent and reliable manner. We attempt to mitigate the effect of large protracted drawdowns and participate in large rallies.

2. Market timing is futile

Investors as a group, are terrible at timing the markets. As seen in the figure below, they chase returns, investing in stock funds after markets have reached new highs and selling after markets decline. It takes discipline and a thoughtful, reliable process to avoid falling into this trap.

Fig 1

Market Timing Futility














   Source: Illustration by MFS Investment Management

3.     It is important to stay invested in the markets

“In risk assets you make 80% of your money 20% of the time”- A Famous Money Manager

It is imperative to be invested in the markets, as missing out a few large moves will make a huge difference to long term returns. The table below shows how an investor would have performed if she had invested in the S&P 500 over the last 5 years and how her return would have been impacted if she had missed some of the months when the S&P 500 had the best returns. Sticking to a strategic allocation based on individual risk profile enables investors to stay invested.

Table 3

S&P 500 returns last 5 years and if an investor missed the best months
5 year annualized return Value of $100,000 in five years
Invested for all periods 16.37%  $               213,387
Missed the best month returns 13.98%  $               192,373
Missed the two best months’s returns 12.15%  $               177,417
Missed the three best months’s returns 10.69%  $               166,166
Missed the four best months’s returns 9.45%  $               157,065
Missed the five best months’s returns 8.35%  $               149,329

Source: Sarsi, LLC analysis

4. A valuation based investment strategy can add value

Ideally, portfolios must be made defensive in advance of market declines. Using a metric like valuation can be an effective way of doing this. As seen in the table below, when markets are expensive, returns in the periods ahead tend to be low. However, this is not a foolproof metric and expensive markets can continue to rally. As the economist John Maynard Keynes noted, markets can remain irrational longer than investors can stay solvent. While it is impossible to get the timing exactly, investors will do well to be defensive when the valuation justifies it, even if it means being early and missing out on the last rally up before a drawdown. The converse is true when markets are cheap. Valuation based tactical allocations around a core strategic allocation enables investors to achieve this objective.

Table 3

S&P 500 returns in subsequent months/years in %: 03/1926 to 05/2014
Valuation 6 months 1 year 2 years 3 years 5 years
Above 20% -0.2 -3.6 -1.6 6.8 -0.3
Below 20% 14 19.4 30.1 47.3 65.3
Market 3.9 8 16 23.6 39.7

Source: Ned David Research, Sarsi, LLC analysis

5.     Investing for the long term increases the odds of positive performance

Most people overestimate what they can achieve in the short term and underestimate what they can achieve in the long term. The same goes for their investing performance. The need for instant gratification and the focus on short-term results leads to investors sacrificing their longer-term performance. By focusing on the long term, investors increase the odds of success and the possibility of realizing their objectives. The table below illustrates how the % of positive performance increases with time frame when looking at the returns of the S&P 500 between 1926 and 2015.

Table 4: S&P 500:1926 to 2015

S&P 500: 1926 to 2015
Time frame % of periods positive % of periods negative
Daily 54.00% 46.00%
Quarterly 68.00% 32.00%
One Year 74.00% 26.00%
5 years 86.00% 14.00%
10 years 94.00% 6.00%
15 years 100.00% 0.00%

 Source: Sarsi, LLC analysis

A related point is that to beat a benchmark, one must invest differently from a benchmark, which means there could be underperformance in the short term. Over the long term, ideally one business cycle, a good investment strategy should be able to beat the benchmark.

6.     Diversification helps mitigate drawdowns and enhances performance

Diversification has been called the ‘free lunch’ that can reduce volatility, protect portfolios from drawdowns and enhance returns. The figure below illustrates this, by considering the period between 1999 to 2015. This period was punctuated by two recessions accompanied by steep market drawdowns. A diversified portfolio of stocks and bonds would have protected investor’s wealth and performed better than an all stock portfolio.

   Fig 2












Source: Illustration by Charles Schwab


Goals based investing and asset allocation

There are two very important investment roles played by a financial adviser. The first is understanding and articulating the goals of a client. The second is selecting a suitable asset allocation to achieve the most optimal returns to realize those goals. The emphasis is not on simply maximizing returns without considering the risks. Nor is it trying to beat an index, chosen arbitrarily.

Goals based investing involves identifying client’s goals and the investment returns needed to achieve those goals. In general, the higher the return needed, the higher the risk that needs to be taken.  The financial adviser has to ensure that the risk that is taken to generate the return desired, complements the client’s risk profile. This exercise leads to either the client accepting the risk or modifying her goals or achieving the goals with other non-investment methods.

For example, if a client wants to retire early but does not have the level of savings required for it, then the portfolio will have to take relatively high risk in order to generate the returns needed to compound the value of the portfolio. But, if the client does not have the ability to take risk (perhaps because of other obligations, such as Children’s education that would need liquidity) or the willingness to take risk (maybe she has demonstrated skittishness in the face of market volatility in the past) then, the required portfolio risk does not agree with the client’s risk profile. This client will have to postpone her retirement and work longer. If the financial adviser simply focuses on generating high returns, then when the market falls the client may want to liquidate the portfolio at exactly the wrong time.

The second role is asset allocation and portfolio construction. Within a broad allocation that is suitable for the client’s objectives and risk profile, some advisors may make small tactical deviations without veering too much from the desired level of risk. Research has shown that asset allocation contributes the majority (In excess of 90%) of the portfolio returns and so this asset allocation based investing is more superior than simply trying to beat any arbitrarily chosen index.

For example, consider two portfolios. The first one is invested 100% in an equity mutual fund that is down 4% when the index is down 6%.  The other portfolio is invested 50% in equities and 50% in bonds through two mutual funds, both of which trail their benchmarks. Assume the equity fund is down 8% (When the equity index is down 8%) and the bond fund is up 10% when the bond index is up 12%. Despite both funds trailing their respective benchmark’s the second portfolio is superior in that it is up 1% (50% * (-8%) + 50%*(+10%)) as compared to the first portfolio that is down 4%. This is only a crude example but it illustrates the point well.