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Evidence Based Philosophy

At Chalten we employ an evidence-based approach to investing.

Investment returns are driven by the amount and type of risk you take and our approach is built upon the following principles:

  1. Buying and holding the market (passive investing) outperforms stock picking and market timing (active investing) over the long term;
  2. Investment portfolios should be well diversified;
  3. Asset allocation should be based on risk tolerance and disciplined rebalancing; and
  4. Investment products should be selected to minimize costs and taxes.

Here we provide more explanation and evidence that gives us our conviction:

Investment Returns Are Related To Risk

Investing should yield a return commensurate with the risk of that investment. Different types of investments or “asset classes” have yielded different rates of return over long periods of time. The following chart from Dimensional Fund Advisors (DFA) shows what would have happened if you had invested $1 in various US asset classes between 1926 and 2017. Stocks generally perform better than bonds over the long term. That shouldn’t be a surprise because stocks are riskier than bonds.

Monthly growth of wealth

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.

With government bonds, where the safety of your investment is backed by the federal government, there is a strong likelihood that you’ll get your money back plus interest. Because government bonds have that safety attached to them, investors don’t require a very high rate of return on their investment. This is also why government bonds from Canada, for example, have a lower yield or interest rate than government bonds from Greece – the two countries have different levels of perceived creditworthiness so investors require different interest rates from their bonds. Stocks are riskier than bonds because they represent a share in the ownership of a company and owners are compensated only after all other stakeholders are paid including employees of the company, suppliers to the company, and those who’ve lent the company money. As the residual investor in the company, stock holders are paid last and therefore the investment carries a lot more risk. The chart above bares this out quite well. Over time, different types of investments with different risks require different rates of investment return to compensate investors.


The notion that risk and return are related goes back many years. Since the 1960s many academic studies have been conducted on the relationship between risk and return. Think of risk as a lack of certainty over how much money you'll be left with at the end of your investment period, be that one year or thirty years. Risk is related to returns because investors decide what return they require to compensate them for taking on risk. In fact it is the collective impact of this risk/return assessment being performed by all the different investors in the market that ultimately sets a price for an investment. All the market participants, or investors, use all their knowledge and information to help them make decisions about expected risk and expected return and by doing so set a price. All these millions of transactions (chart below provided by the World Federation of Exchanges) conducted daily are done between willing buyers and sellers. They agree on a price to transact based on their collective knowledge and information about each investment.

World equity trading

In fact given this vast number of buyers and sellers of investments at any given time, the market price is a very efficient and powerful mechanism for reflecting all the collective information and expectations of all the different investors around the world. It is nearly impossible for any individual investor to be as good as the market at predicting the right price for an investment at any given time. Here is a fun activity that you can try with a group of people to try to replicate the power of markets.

How many jellybeans are in the jar?

How many jellybeans are in the jar? I suspect if you try this experiment you’ll come up with something similar – while the range of estimates is very wide, the average guess is very close to the actual number – the collective knowledge is stronger than that of the individual. Sure, perhaps somebody guessed closer, even bang on the actual number, but how easy is it to guess who’s a good guesser? That’s a good transition to the next principle of our Evidence Based Philosophy – that buying and holding the market (passive investing) outperforms trying to beat the market by stock picking or market timing (active investing) over the long run.

Passive Investing Outperforms Active Investing

"Most investors, both institutional and individual, will find that the best way to own common stocks (shares) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals." — Warren Buffet in his 1996 annual report to Berkshire Hathaway shareholders

The evidence is clear. Active investing (trying to beat the market by picking stocks or by timing market ups and downs) underperforms passive investing (buying and holding the market). The charts below present evidence based on historical performance data but let’s first examine the logic. The diagram below from Vanguard Investments Canada Inc. (Vanguard) shows two hypothetical return distributions – think of a distribution as a plot of every different investor’s actual return over a given year or series of years. Some will outperform the market, some will underperform the market. Very few will do really poorly or really well and most will have returns somewhere around the average. The curve on the right shows the pattern of results before taking any costs into account. If you assume that you have to pay someone to manage your investments the whole curve shifts to the left by precisely the amount of the costs. If all investors together earn the average market return, the average actively managed stock fund has to underperform the market by the average amount they charge investors. According to Morningstar, in Canada the average annual asset weighted expense ratio paid by investors for a stock fund as of 2017 was about 2.23%, one of the highest expense ratios in the world.

Hypothetical distributions of market returns before and after costs

This hypothetical example does not represent the return on any actual investment.

So how can investors improve on this result? They either have to find a stock broker or fund manager who can outperform the average or they have to lower their costs by finding a cheaper active manager or by investing in a low cost passive fund that seeks to deliver the average market return with a high degree of certainty. The evidence shows that the track record of active fund managers trying to beat the market by picking better stocks or timing the ups and downs of the market is poor.

William Sharpe, Nobel Laureate in Economics and one of the world’s leading authorities and publishers on the subject summarized the evidence in his Financial Analysts’ Journal Article – The Arithmetic of Active Management as follows: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

Many studies that show the performance of active fund managers just look at the population of current fund managers and calculate their performance track record over a defined period of time, say five or ten years. This approach doesn't take into account fund managers that failed to survive the period under examination. The chart below (data from the Standard & Poor’s Indices Versus Active Funds Canada Scorecard, Year-End 2017 and chart from DFA) presents the evidence. It shows the survival rates for Canadian, US and International equity funds over one, three and five year periods ending December 31, 2017. Just over 47% of Canadian equity funds survived the five year period.

Fund survival rate

We believe it's a reasonable assumption that those that didn't survive weren't performing very well. The next chart from the same source shows the percentage of funds that both survived and outperformed their benchmark indices over the same one, three and five year periods.

Fund outperformance rate

Outperforming fund managers seem difficult to find. The data shown above is not secret. It is in fact widely available and we imagine lamented by the investment industry. However you won't hear it from them. In our many years of working with hundreds of institutional fund managers around the world, it was quite rare to see a marketing presentation that showed chronic underperformance.

So what about the winners? The evidence shows that picking future winners based on past performance doesn’t work. The chart below (from DFA’s 2018 The Mutual Fund Landscape) looks at US equity funds over rolling three year periods. Of the top 25% of performers in each three year period, on average only 26% of those "winners" went on to be top quartile performers over the subsequent three year period. Predicting winners based on past outperformance is difficult.

US mutual fund performance persistance

Nonetheless there are still winners. The problem is, like with counting jellybeans, it is very difficult to differentiate between luck and skill.

In his great book, "Fooled by Randomness," Nassim Nicholas Taleb tries to help us put the winners in perspective by taking the reader through a simple scenario: "Toss a coin; heads and the manager will make $10,000 over the year, tails and he will lose $10,000. We run the contest for the first year for 10,000 managers. At the end of the year, we expect 5,000 managers to be up $10,000 each, and 5,000 to be down $10,000. Now we run the game a second year. Again, we can expect 2,500 managers to be up two years in a row; another year, 1,250; a fourth one, 625; a fifth, 313. We have now, simply in a fair game, 313 managers who made money for five years in a row... Out of pure luck... a population entirely composed of bad managers will produce a small amount of great track records... In other words, the number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits."

The challenge, of course, is that the winners, even if only in the spotlight due to pure luck, tend to have the loudest voice and tend to write the most glorious stories and books about how their method is the best, how they have the secret sauce. The financial media tends to amplify these stories.

Like Warren Buffet says, it’s not worth paying someone to try to beat the market.

Investment Portfolios Should Be Diversified

Diversification helps to reduce risk. In the extreme, if you were to invest only in one stock, you would have exposure to a lot of risks. To begin with, all stocks have a certain amount of exposure to the general economic environment. For example, if global growth slows, expectations for future economic growth tend to get more pessimistic. Investors lower their forecasts for demand for goods and services which trickles down to the expected sales of goods and services for individual industries and companies. All companies share this risk. But individual companies have all sorts of other company specific risks. What if the very well respected CEO of a company suddenly leaves? What if the company suddenly faces a massive lawsuit because its main product harms someone? What if the company’s main distribution centre catches fire and cripples the operations for nine months? What if it is discovered that a company has been filing fraudulent accounting statements? Investing in only one company's stock exposes the investor to the downside risk of all of these one-off company specific types of risk.

Spreading your investment across a large number of companies mitigates the impact of company specific risk. In fact something that is bad for one company in your portfolio might even be good for another company in your portfolio. To put it another way, when the share prices of some companies zig, others zag, and vice versa. A diversified portfolio of investments can therefore provide a much smoother return profile than that of an individual investment because the zigs cancel out the zags. Two stocks might have the same overall expected return but by combining them in a portfolio you reduce the volatility of the returns, or reduce the risk. Because investors are able to diversify away company specific risk by combining stocks in portfolios, the stock market actually doesn’t compensate investors for taking company specific risk. The expected stock market returns and risk profile embedded in current stock prices assumes that investors will diversify away all company specific risk.

The illustrative chart below (from DFA ) shows how combining investments (securities) in a diversified portfolio adds stability to the overall return profile. When security returns have different patterns, it is possible that poor performance by one security is offset by good performance of another security. In fact, whenever there is anything other than perfect correlation, there can be benefits to diversification.

Combining securities in a diversified portfolio adds stability to the overall return profile

Holding a diversified portfolio of many securities is a good starting point but many Canadians, while diversified well in Canada, are not taking advantage of the benefits that can be gained by diversifying globally. The chart below (from DFA) shows the performance of the S&P/TSX Composite between 1991 and 2016. By diversifying the holdings and also holding stocks from outside of Canada you can see that not only is the annualized return higher, but the risk (standard deviation) is actually lower than if only Canadian stocks were held.

Impact of diversification

Portfolios are for illustrative purposes only. Diversification neither ensures a profit nor guarantees against loss in a declining market.

Furthermore, it’s important to diversify globally at all times because it is difficult to forecast which markets are going to outperform in any given year. The colourful diagram below (from DFA) illustrates this point. What performs well in one year might perform poorly the next year. Timing the markets is just too difficult. To capture those times when a particular market is performing well it is important to diversify across all markets at all times.

Annual returns by market

Asset Allocation Should Be Based On Risk Tolerance And Disciplined Rebalancing

Determining the correct asset allocation is one of the most important decisions to be made when establishing an investment strategy. Your asset allocation is the proportion of your investment portfolio that will be invested in each asset class. The asset allocation is the best way to adjust the level of risk you take and to target an appropriate expected rate of return. The diagram below (from Vanguard) illustrates this principle. It presents different allocations between Canadian stocks and bonds and the annual average and range of returns between 1901 and 2016 for each combined portfolio. Choosing a mix of stocks and bonds along a continuum, such as the one in the illustration, allows you to pick a specific expected risk/return profile. Note that this chart does not include the benefits of diversifying with stocks outside of Canada. As a result, at a certain point the average return of the portfolios doesn’t change that much as the asset mix is tilted more towards stocks while the risk increases (the range of outcomes gets wider). Diversifying globally would improve the return/risk profile of the portfolios weighted more towards stocks.

Returns by allocation

For illustrative purposes only. The hypothetical portfolios do not represent the return on any particular investment.

It is important to note that the relative mix of stocks and bonds in the portfolio should be determined by your own unique appetite or tolerance for risk. (Your risk tolerance is based on three elements – your (1) willingness, (2) ability and (3) need to take risk). It should not be made according to how well you believe stocks or bonds will perform in the near future. As we observed earlier, the evidence demonstrates that it is nearly impossible to time the markets. Furthermore the allocation of stocks and bonds to different regions or other risk factors should also be done based on your risk profile and diversification needs rather than on any assessment of which specific groups of stocks or bonds are likely to outperform in the future.

Once the original asset allocation has been set and becomes part of your investment policy, the next challenge is to stay disciplined. Trading should only be done to rebalance your portfolio back to your original asset allocation when it goes off by a predetermined amount. This discipline forces you to buy more of an asset when prices have fallen and sell more of an asset when prices have gone up in order to get your allocation back into balance. In many cases it will be difficult to stick to your discipline because people are generally hard wired to do the opposite of what makes investing sense. Generally money flows into stock funds after a period of strong stock performance and out of stock funds after periods of weak performance. This is because people feel good about stocks when they’re doing well. However, markets often move up and down at random and people end up chasing market performance when it is too late, with the ultimate result being significant underperformance relative to basic market indices. Good advisors keep investors disciplined and keep them invested at the right level rather than trying to outsmart the market. Staying the course takes emotional fortitude and experience. Not being disciplined and chasing market performance is a large reason why many investors have a poor track record, even relative to the funds where they invest their money. The following chart from Vanguard illustrates that the net flow of cash into Canadian equity funds trails the actual performance of the market.

Flows versus returns

Many investors took their money out of equities immediately following the market crash in 2008/2009 thereby missing the strong rebound in the markets that followed.

The chart below is from Vanguard using data from Thompson Reuters Datastream. A simple discipline of semi-annually rebalancing a portfolio of 60% Canadian stocks and 40% Canadian bonds over the 10 years through 2016 would have yielded much higher returns than if the investor had sold out of stocks on February 28, 2009 in the middle of the financial crisis.

Impact of rebalancing

This hypothetical illustration does not represent the results of any particular investment.

The emotional and reactive response pattern illustrated in the picture below is totally understandable.

Emotional and reactive response pattern

However, while understandable, falling victim to this reactive emotional cycle will most certainly lead to underperformance. The cycle can be avoided by employing an allocation strategy based on risk tolerance and strict rebalancing. This is very difficult for individual investors with limited investment experience to manage on their own. Helping investors to not fall victim to this cycle is an area where a good advisor can add significant value.

While trying to time the market, avoiding the lows and catching the highs, is alluring, in practice it is extremely difficult and very costly if it doesn’t work. The chart below illustrates that in many cases a large proportion of market returns are captured in a small number of trading days. Trying to guess when these days will occur is very difficult and missing them can lead to significant underperformance. Staying invested in the market in a disciplined way means you will capture the best of market returns every time they occur. The diagram below from DFA illustrates the impact of missing out on the best days of the market over a long period of time. Just by missing the 25 best days of returns of the S&P/TSX Composite Index between 1977 and 2017 you would have experienced dramatically lower investment returns.

Missing best days

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 not a guarantee of future results. Values change frequently and past performance may not be repeated. There is always the risk that an investor may lose money.

Minimize Costs And Taxes

Costs have an enormous impact on investment returns. If investors choose to diversify by investing in mutual funds they will have to pay the cost of the mutual fund provider. The costs associated with a mutual fund are collectively known as the Management Expense Ratio or "MER". This group of costs usually includes a management fee to pay the fund manager, all the administrative costs of the fund, the fund’s trading costs and brokerage commissions as well as any commissions paid to the people who sell the funds to investors. MERs can range from 1/10th of 1% or less for some passively managed index funds to higher than 3% for some actively managed funds. Canada has some of the highest MERs in the world. The chart below from Vanguard illustrates the effect of costs on investment returns over time. Without costs, an annual return of 6% would turn $100,000 into $574,349 over 30 years. Add an MER of something similar to what Canadians pay on the average stock fund and the $574,349 is reduced to $297,235 over the same time period. The impact of the costs is significant.

Effect of costs on investment returns over time

The portfolio balances shown are hypothetical and do not reflect any particular investment.

But shouldn’t paying higher fees lead to higher performance? Presumably paying higher fees means you’re paying more for a high quality fund manager. The evidence suggests otherwise. There are many studies that show that the strongest, in fact the only, predictor of future fund performance is costs - the higher the costs, the worse the performance. The following chart from Vanguard and Morningstar showing median fund returns in the lowest and highest cost quartile illustrates this point.

Median fund returns in the lowest and highest cost quartile

Irrespective of asset class, higher fees lead to lower performance or as the author of the great book "A Random Walk Down Wall Street" Burton Malkiel said, "The surest way to find an actively managed fund that will have top-quartile returns is to look for a fund that has bottom-quartile expenses."

Finally, active fund managers may also trade their portfolios more frequently (high turnover) than managers of passive investment funds who generally trade less frequently (low turnover). High turnover has greater tax consequences than low turnover which will also likely detract from investment performance.

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We employ an evidence based approach to investing.

Our approach contrasts that of many advisor services.

We help you feel empowered, confident and in control.

We provide independent and fairly priced advice.

Our only source of compensation is directly from you.

A good financial plan will increase your confidence.

Chalten Fee-Only Advisors Ltd.

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