The Importance of Portfolio Management Discipline


“Discipline is the bridge between goals and accomplishment.”

If you are like most, you’ve likely heard those internal voices… eat your vegetables, get some exercise, carve out time to reflect.  Here’s one to add in the mix – maintain portfolio discipline.  Most things that we know are good for us require a certain amount of self-imposed discipline and a periodic reminder of why it’s in our best interest to do those things.  It’s especially true with portfolio management.  We feel it is important to re-iterate why we structure portfolios for the long term and for resilience in the face of the most visible asset class, U.S. Large Cap Stocks, continuing its dominance in performance and media coverage. 

It is easy to succumb to natural human emotion, such as fear and greed, in investing.  Research shows that most often those natural human emotions, if acted upon, lead to poor investment outcomes.  This is why we believe it is important to educate our clients about the science of investing; leaning on the wide body of empirically-based academically validated research to help our clients bring rationality into their investment decisions in order to manage human emotion. 

Research has consistently proven that it is foolish to attempt to outguess the markets with stock picking or market timing. Historical data points to only 14% of U.S. equity mutual funds and 13% of fixed income funds that have survived and outperformed their benchmarks over the past 15 years:


Investors who “chase” the hot fund du jour typically end up disappointed.  Investors who try to time markets and chase the “hot” asset class also typically end up disappointed.  One will never know in advance which market segments will outperform from year to year. Notice the randomness of returns:


As U.S. markets have been strong relative to international markets over the past few years, one can be tempted to abandon global diversification and focus on U.S. markets.  However, when one takes a longer- term focus, one quickly realizes that there is a benefit to a globally diversified portfolio.  By holding a globally diversified portfolio we are well positioned to achieve returns wherever they occur; and global diversification broadens the investment universe. Holding just the S&P 500 is very risky, as illustrated by the last recession when that index was down over 50%!  It is wise to diversify not just into many more equities but also fixed income because mitigating negative volatility in portfolio returns is just as important as achieving the desired long term expected return.  The key to long term success is to realize as little negative volatility as possible for the realized return. 


Benjamin Graham, widely considered the father of value investing, pioneered the notion of buying unpopular stocks – those with discernible value but selling at deep discounts because they are out of favor – and holding them until the broader market recognizes their underlying worth.  This notion is how people often think of “value investing”. Many believe value investing is a defensive tactic, a strategy used to weather bear markets, or an approach that will protect against steep losses – but won’t provide much in terms of long-term gains. However, from a historical perspective, returns for value stocks have been exceptional – and have been achieved with lower risk than “growth” stocks.

Our portfolio management approach is based on extensive financial research and evidence of what has worked well over many business cycles. The evidence points to a better investment experience by maintaining discipline with a globally diversified portfolio with factor tilts to value, size, and profitability, active rebalancing, asset location, and cash management strategies.  Years of academic research has identified “factors” that can be utilized to craft the desired expected portfolio return and risk levels.  The  following are the equity and fixed income factors or dimensions of expected returns that can be used in portfolio construction:


As we construct portfolios, we use these factors to craft a portfolio with the desired long-term expected return and risk.

The financial markets have rewarded long term investors; and equity and bond markets have provided growth of wealth that has more than offset inflation over the long run. We let the markets work for our clients’ portfolios:


The securities markets are effective information processing machines and each day world equity markets process billions of dollars in buy and sell orders, which help set prices based on the information available at the time:


Globally Diversified Portfolios are underperforming the broadly reported indices in the U.S. so far in 2018, since U.S. stock returns have been well above international developed and emerging market stock returns. At the same time, the value factor premium is negative for 2018, after also falling behind during 2017, which means growth is well ahead of value.

How far ahead is growth? The valuation of Large Growth stocks (P/E of 27.5) is now at the largest difference to Large Value stocks (P/E of 15.95) since December 2001. What happened the last time the relative valuation was so far tilted toward growth? Following December 2001, value outperformed growth 10.9% to 2.9% annually over the subsequent five-year period, according to a recent report from BlackRock (data as of 6/30/18) and illustrated here:


No one can reliably time when the relative valuation of growth to value will revert back to historical levels, we only know it is not a good time to abandon value and chase the growth stock story. Even though Facebook (FB) dropped 20% on July 26th, after disappointing earnings, and it appeared the growth run was at an end; Apple became the first trillion-dollar market cap stock after its strong earnings announcement on July 31st. Right now, growth is an easy story to sell (playing on the emotion of greed and the fear of missing out), since so many investors and traders are attracted to attempting to outperforming the broad market in the short term. During every time period there is a new technology or discovery that one can say changes the rules of competition. Amazon and Tesla are two examples. Amazon trades at 149x trailing earnings and 75x forward earnings. Tesla does not have past earnings but trades at 107x forward earnings (consensus estimates of next four quarters). The broad large cap stock market (S&P 500) trades around 17x forward earnings. In other words, Amazon and Telsa are selling at a tremendous premium.  As long as this swing for the fence mentality exists, there will continue to be a value premium available to the investors who are patient and disciplined.

To be a successful long-term investor, it is important to resist chasing past performance since past performance provides little insight into a fund’s future returns. For example, most funds in the top quartile (25%) of previous three-year returns did not maintain a top-quartile ranking in the following three years:


The value factor premium is significant for U.S. large cap and small cap stocks. From 1926 through 2016, U.S. large cap value stocks returned an average of 12.2% annually, while U.S. large cap growth stocks returned an average of 9.6% per year; and U.S. small cap value stocks returned an average of 15.1% annually, while U.S. small cap growth stocks returned an average of 8.7% annually. Similar to the size premium, the value premium also has long periods of underperformance and was negative during the 1990s as the internet bubble was inflating. Overall the value premium was positive for 20 countries and on a worldwide basis, positive 2.1% per year. The important conclusion derived from this data is to maintain discipline with exposure to the factors in order to capture the excess return over time, even in the face of long periods of under-performance. Historically, the factor premium returns happen very quickly and are not predictable and cannot be “timed”.

As for globally diversified portfolios, consider the following chart:


We can point to many past periods where the S&P 500 under performed a globally diversified portfolio. However, 2018 continues the 10-year trend illustrated above where the US has out-performed international equities.  As of the August 10th market close, the S&P 500 large cap index is up 7.2% with dividends for this year and the Russell 2000 small cap index is up 10.6%, while the MSCI EAFE large cap international index is down -3% and the MSCI EM index is down -9.3%.

Investors that lack discipline to maintain factor tilts in their portfolios will miss the factor premiums, since no one knows when the premiums will show up in advance. It is only obvious in hindsight, which brings this insightful quote to mind:

“You will never always be motivated. You have to learn to be disciplined.”

We will always recommend that you focus on what you can control….your spending and saving habits first and foremost.  Our job is to ensure our clients have a comprehensive financial plan tied to goals, a portfolio with an expected return and volatility that is matched to the financial plan that provides the highest probability of long term success in goal achievement (structured with factor tilts, low expenses, turnover and taxes and the discipline of staying invested through market swings and dips), a risk management plan to protect and preserve wealth if the worst happens, and an estate plan that reflects the legacy our clients want to leave behind.  It is critical to avoid emotional reactive investing, especially to the latest financial news, which leads to poor investment decisions and maintain discipline. 


We help our clients develop investment discipline and invest their portfolios for the long term.  With the help of the factor tilts, we expect portfolios with asset location and an appropriate rebalancing strategy to outperform the widely reported broad asset class indices over time with reduced volatility.  The challenge is for us to educate our clients so they can maintain long term discipline in a world geared toward instant gratification.  We know that if our clients are going to be successful, we must successfully navigate this challenge. 

If you have any questions, please contact your LTWM Financial Planner. 



1.  Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities.  Diversification does not guarantee investment returns and does not eliminate the risk of loss.  

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Principal Risks:

The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.

Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.

The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.

Fixed Income Portfolios:

The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.

Risk of Banking Concentration:

Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.

The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities.  The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such.  The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information. 

Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements.  Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time.  Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.

Lake Tahoe Wealth Management, a Registered Investment Advisory Firm with the Securities Exchange Commission.

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