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Investment Strategies Aren’t Consistent–But Yours Should Be

Posted by Emmett Maguire III, CFA®

How to Avoid the Behavior Gap with an Investment Strategy That’s Not Trendy, but Tailored

In 10+ years of evaluating investment strategies of all kinds I’ve found precisely zero that work 100% of the time. Sometimes, value outperforms growth. Sometimes, it doesn’t. There are years when hedge funds outperform public market indices–and there are years when they don’t. Large buyout private equity funds have had great historical returns, but that doesn’t mean they will in the future.

What do these inconsistencies mean? That trying to chase the hottest strategy is a losing battle. Yet, chasing the hottest strategy is exactly what many investors do.

The Behavior Gap

This pattern is displayed over and over in what is referred to as the behavior gap[1]. This categorization is quantified in Dalbar’s 23rd Annual Quantitative Analysis of Investor Behavior.

Investment Strategies Aren’t Consistent–But Yours Should Be

The average equity investor underperformed the S&P 500 Index by a margin of 4.70% in 2016. At the same time, the average holding period for equity funds decreased, from 4.1 years to 3.8 years. During the 20 years ending December 2016, the average equity investor trailed the S&P 500 by 2.89% annualized by trading in and out of five different funds. That’s a difference of $184,323 on initial investments of $100,000 after 20 years of compounding.

The equity analysis from Dalbar’s work is just one example of this persistent and problematic issue in financial services. These statistics are consistent across fixed income and asset allocation funds as well. Turning over your portfolio and jumping from strategy to strategy is potentially the worst approach to managing your investments.

What Diets and Investing Have in Common: Jumping from Strategy to Strategy

If jumping from strategy to strategy is a good way to decrease your odds of success, then avoiding that mistake will help increase your odds of success. In other words, the best strategy for you is the one you are most likely to stick with over the long term.

A recent NY Times article makes the same point in reviewing what leads to success in dieting. The yearlong study examined low-carb versus low fat diets across individuals with different genetic make-ups. At the end of the well-designed 12-month trial, the data was examined across those variables. Ultimately, the different diets didn’t create statistically different results. But the biggest explanatory variable in weight loss results was having the discipline to stick to the diet, regardless of which diet it was. The best diet for you is the one you are most likely to stick with.

Have Some Grit

An alternative model for thinking about this concept comes from Angela Duckworth, who is best known for her work on “grit”, which is the personality trait of perseverance that is used to explain that success of individuals and teams across a wide swath of activities. Grit is a combination of long-term thinking, having a growth mindset, and remaining steadfast–despite delays or difficulties in achieving success.

As many of us are told from a young age, success isn’t a straight line. There are setbacks and triumphs along the way to achieving your ultimate long-term goals. Managing an investment portfolio is no different. Staying the course is imperative, but not easy. The hard part is how you deal with the setbacks.

Performance versus Expectations

In an investment context, setbacks boil down to unmet expectations.

Expectations versus actual results play a large part in either achieving satisfaction or a lack thereof. Consider this scenario: The last time your expectations were not met (by your spouse, a product you purchased, or your portfolio, for example) were you disappointed? I’d be willing to bet that you were.

The behavioral finance point of view on this topic starts with what is known as loss aversion. All of us, myself included, experience loss more drastically than we experience a gain of an equal amount. Behavioral economists have estimated that the severity of loss experience to gain experience is a ratio of roughly 2 to 1. So, losses hurt 2 times as much as gains are enjoyed.

The effects of this experience aren’t constrained to losses in an absolute sense. The same dynamic plays out on a relative basis, which is where expectations versus actual results creep back into the picture and why you get disappointed when your expectations are not met. It’s all about your frame of reference. If your expectations are not met, you will be disappointed, and having poorly-calibrated expectations can lead to disappointment when it’s not called for. Without an understanding of what you can realistically expect from your portfolio relative to another asset, you run the risk of disappointment.

In a nutshell, if you expect to have the best-performing strategy each year, you’re falling victim to the precise problem outlined in the first section of this article: It’s not a realistic expectation and is detrimental to your returns.

Reframing Your Investment Expectations

It’s hard to overstate the importance of a clearly-defined objective. Clear, agreed-upon goals set the stage for success in a variety of situations. Research on high-performing teams indicates that alignment on objectives is one of the main ingredients that sets a high-performing team apart from the average. Similarly, spousal relationships can come undone when partners aren’t aligned on the long-term goals for their family. You must be pulling in the same direction. Without a mutual understanding of the goal, a relationship is built on a shaky foundation.

Your relationship with your advisor is no different. The best advisors available to you aren’t focused on selling you the next performance-leading strategy. They’re focused on customizing their investment process to meet your specific and unique objectives.

In a nutshell, progress toward your objectives serves as a better reference point for assessing results.

Customization = Confidence

While there is no single “best” strategy in the investment business, there is one that is best for you, and it’s the one you’re most likely to stick with over the long term. Even then, you’ll still have to weather periods of disappointing returns from time to time without falling victim to the behavior gap. As everyone has their own world view and experiences that form their expectations, you need the right strategy to help you set sensible expectations and manage them accordingly.

The right strategy, is unique to each family and requires an advisor who understands their clients. This is why our process at Lake Street Advisors starts with questions. A thorough understand of your unique needs is the launching point for building bespoke portfolios designed to help you handle setbacks and increase your odds of long term success. This approach allows us to account for your world view and values–it’s deliberately designed to meet your specific objectives.

The result is a long-term strategy that you understand and have confidence in–not because performance was great last year, but because it was built specifically for you.

[1] Behavior Gap art is copy written material and property of

What Would Be the Effect of a Reduction in Corporate Taxes?

Posted by Emmett Maguire III, CFA®

According to History, Not Much

Over the past few months, much has been made of tax reform–corporate tax reform in particular–and its implications for markets. The talking heads on CNBC bat around “what if” scenarios like callers on sports radio approaching a trade deadline. As we inch toward approval, consensus opinion has it that lower taxes lead to higher earnings, which will produce higher stock prices. But there is some variability in potential outcomes. If tax reform is approved and the corporate tax rate is lowered, forecasters’ predictions about the outcome range from no effect to materially positive (mid to high single digits in most cases we’ve seen). If not approved, forecasters’ predictions range from no effect on markets to a potential crash1, according to Treasury Secretary Steven Mnuchin.

The problem with all these predictions, beyond not having any way to verify how accurate these forecasters have historically been, is that they cannot be measured for success. They are simply an exploration of various outcomes that could happen in the short term. But does this really matter in the context of a long time horizon?

To answer that question, we set out to examine the history of the top corporate tax rate since 1936 and its effects on public equity returns. As seen below, the tax rate for corporations rose from 15% in 1936 to 52.8% in 1969. From that point, the top tax rate for companies has fallen to 35%, with some plateaus along the way. In the first period, 1936-1969, the average annualized return for the S&P 500 index was 10.6%. From 1970 to 2016, a period of falling corporate tax rates, the average annualized return for the S&P 500 was 10.3%, lower than the rising corporate tax regime.


Historical averages indicate that the direction of corporate tax rates (increasing vs. decreasing) makes little, if any, difference to long-term average returns. But what about the level of taxes? Would that tell a different story? The average tax rate2 over our sample period is 40.8%. Using that to cut the data set into “high tax years” vs. “low tax years”, we then calculated the average calendar year return in those periods. Interestingly, the results were again counterintuitive as seen below.

Source:, FactSet, Lake Street Advisors

Our conclusion, in the context of managing a diversified portfolio designed to achieve the long-term objectives of clients, is that the direction and level of corporate tax rates does not matter to the returns generated from U.S. public equities. While the media hypes up these seemingly important and uncertain events with opinions from a swath of experts, a more informative exercise might be asking why this potential reduction in corporate tax rates would be different from what has happened in the history of corporate taxes.

2Simple average of top corporate tax rate by calendar year


Evaluating and Selecting Active Investment Managers Based on Skill

Posted by Emmett Maguire III, CFA®

What Makes an Active Manager Skilled

It’s easy to recognize skill. When an individual does something well, whether it be playing golf or knowing all the answers on Jeopardy, you can see they are skilled.

The deeper question is what defines their skill? What makes them so effective on the golf course? And how does the assessment of their skill change when you add or subtract other skilled individuals from the equation?

When it comes to building a portfolio using active management, skill plays a big role. In my last article, I discussed how success in selecting active investment managers is rooted in three conditions; one of which was good “fishing holes”, or identifying the markets with the most opportunity.

Doing so requires skill–but identifying that skill means understanding it first.

The Two Types of Skill

At Lake Street Advisors, the definition of skill starts with a distinction between absolute skill (examination of skill in isolation) and relative skill (examination of skill in relation to others). It would be hard to argue that Jon Lester, the former Red Sox and current Cubs lefthander, is not exceptionally talented when it comes to throwing a baseball. Absent other information, the casual fan would probably recognize him as an MLB pitcher, acknowledge that it’s a rare achievement, and agree he is a very skilled pitcher. This is assessing skill in isolation.

Now, if you were building a pitching staff for an MLB team, it’s highly unlikely you would evaluate talent in this way. Your objective would be to assemble the best pitching staff from the pool of available pitchers to achieve the lowest possible ERA (or whatever your favorite pitching sabermetric may be). To do this, you’d have to make an evaluation on a relative basis. Based on the 2017 regular season, who was the better pitcher, Clayton Kershaw (2.31 ERA) or Jon Lester (4.33 ERA), post season aside? The data would indicate Kershaw was the more skilled pitcher, relative to Lester, and thus more valuable to your regular season pitching staff.

Applying Relative Skill to Active Portfolio Management

Assembling a portfolio of active investment managers is not all that different from building a pitching staff. It’s an assessment of the available options by evaluating relative skill.

The catch is that just like building a pitching staff, it’s not enough to look at a single data point as proof of skill. Just like looking only at past ERAs isn’t going to be the only considerederation when building a strong rotation, you cannot look only at what a manager has produced for returns.

You have to build conviction by understanding where the performance came from. As a savvy GM would evaluate velocity, movement, and command (the qualitative characteristics that produce low ERAs and make one pitcher better than another), manager selection should isolate and examine the aspects of an active manager that offer opportunities for a competitive edge, and subsequently lead to attractive returns over a long time horizon.

The Skill to Effectively Assess Active Managers

Ultimately, the work of active investment managers can be distilled down into the following broad categories:

Whether and how a manager chooses to execute on these categories and the resources used impacts their performance, and represents a potential opportunity to gain on the competition. Or, in other words, improve their relative skill.

Focusing on the “how” and “why” behind these broad categories sheds light on the repeatability of a manager’s process and the amount of effort expended in it’s overall design. Repeatability and deliberate design are not only desirable characteristics in isolation, but also improve insight into how a portfolio manager thinks and what their intrinsic motivations are.

If you are invested in an active manager because their returns for the past five years have been attractive, what are you going to do when they hit a pocket of underperformance? Without an understanding of how a strategy works and a thesis for why you are invested, how will you know if it’s time to sell or add?

To maintain conviction in a recommended active manager and ride out the ebbs and flows of performance over the long term, investors should focus on the manager’s competitive advantages and if they still exist.

By combining an emphasis on good fishing holes with attention to the skill that we believe offers a competitive edge, we gain conviction in our recommended managers–conviction we may not attain if we focus too heavily on performance.

Active or Passive Management? A Closer Look

Posted by Emmett Maguire III, CFA®

There’s no shortage of investment professionals who’ve weighed in on the active vs. passive investment management debate over the years. Most of these points of view approach the question as a black and white, right or wrong proposition. Proponents of active management like to talk about downside protection in bear markets and their abundant experience as long-term investors. Indexing enthusiasts point to the considerably lower cost of passive investing and its notable success relative to active managers in aggregate. My answer to the question of whether it’s better to hire an active manager or go the passive route of indexing is “it depends.”

Successful active investing depends on three distinct conditions. First, there must be an opportunity/inefficiency for an active investor to exploit. Second, an active investor must have the skills necessary to take advantage of and profit from that opportunity. Third, you or your advisor must have the ability to identify the best, most highly skilled active managers. In this article we will discuss the first condition: opportunity/inefficiency.

The objective of active management is to exploit mispriced securities in a given market and produce returns in excess of the market average. In order to do this well enough to justify the fees charged and taxes generated by the active manager, the target market must have ample mispricing to leverage. Theoretically, as the graphic below shows, a larger frequency and magnitude of mispriced securities equates to an attractive opportunity set (what we refer to internally as an excellent “fishing hole”) for a given strategy whereas a low frequency and small magnitude of mispriced securities translates to an unattractive opportunity.

Source: Lake Street Advisors

The point here is that all the investment skill in the world is effectively useless if there aren’t any attractive opportunities to make use of it.

Turning to a real life example, let’s examine the US Small Cap universe, which is often cited as an opportunity rich market for an active manager. The “go to” narrative here is that these stocks are more inefficient because there is less sell side research coverage relative to larger cap stocks, which is true, but does that really matter when there are close to 500 US Small Cap mutual funds1? That equates to a ~4-to-1 stock to investment team ratio across the investable universe of ~2,000 stocks. This ratio also ignores the sell side research coverage as well as hedge funds actively investing in the US Small Cap space. How can that possibly lead to pricing inefficiencies large enough to justify fees and expenses? The answer, as I see it, is that it doesn’t. There is simply too much competition for exploiting the difference between calculated intrinsic value and market prices to justify the fees paid and taxes generated by an active equity strategy in US Small Cap, as typically executed.

The chart above helps illustrate my point. The data is based on 5-year rolling returns calculated quarterly. Over the last ~25 years, the number of managers has steadily grown and the excess return from the median and 25th percentile manager in the US Small Cap space have diminished. Where you once were rewarded with ~4.4% in annualized excess return, on average, from selecting an active manager in the 25th percentile in the 1990s, you now average a small fraction of that at around 1.6% annualized (ten years ending 6/30/2017), pretax. This also assumes that you have selected a manager in the top quartile, a topic we will discuss in a future article. In short, investors and allocators are better off focusing their time and energy on more promising opportunities and employing a passive option in US Small Cap, especially for a taxable investor.


For investors of substantial wealth, it’s not enough to treat the active vs. passive decision as a black and white proposition. Advisors who embrace the shades of gray and understand what it takes to be successful in manager selection can provide their clients with better opportunities to meet their long-term objectives. By starting with first principles and taking a logical approach to capital allocation within client portfolios, we build diversified portfolios combining passive strategies with active managers where the three conditions outlined above have been met. For more on this topic, feel free to reach out. We enjoy the questions and discussion.

1 Per the Lipper Database on US Small Cap mutual funds, there are 494 funds filtered for primary share classes only.

The Repeatable Investment Approach of Robo-Advisors

Posted by Emmett Maguire III, CFA®

Rules-Based Decision Making and What Wealth Advisors Can Learn from Robo-Advisory Solutions

A lot is being made of robo-advisors these days. Custodians and brokerage firms like Charles Schwab, TD Ameritrade, JPMorgan, and Goldman Sachs have joined the likes of Betterment and Wealthfront in offering low-cost, automated solutions to rebalancing and tax loss harvesting. The growth in robo-advisory solutions and the AUM in them is impressive and makes sense–as the millennial demographic enters the wealth accumulation phase of their careers and lives, their familiarity with and preference for technology-based solutions points to this trend continuing.

For advisors, the ability to leverage these tools to automate transactions and processes will lend scale and efficiency to their investment management operations.

Following the Investment Algorithm

One common thread among robo-advising solutions is the usage of rules-based decision making, or algorithms in computer science terms. An algorithm is a process or set of rules to be followed in calculations or other problem-solving operations. So, given a certain level of risk tolerance, robo-advisors set an asset allocation, rebalance over time to the asset class targets determined in the previous step, and harvest tax losses–all based on a set of pre-determined rules and inputs. They all have simple, highly-repeatable investment processes. And a repeatable process is exactly what you want from your investment manager.

This approach may sound perfectly reasonable at face value, but it begs the question as to why. The answer lies in the field of behavioral science where decades of research into probabilistic reasoning have exposed the extent to which people routinely base their forecasts and judgements on flawed rules of thumb as opposed to careful examination of evidence. In other words, everyone’s brains are subject to what are now commonly referred to as cognitive biases. What a repeatable investment process helps to do is “de-bias” some of these flaws and improve the accuracy of judgements and forecasts, sharpening one’s decision making.

Overcoming Cognitive Bias in Real Life

Long before receiving the Nobel Prize in Economics, Daniel Kahneman was a psychology officer in the Israeli Defense Force, where some might argue he made his first big discovery. In this role, he and his team were charged with the task of predicting those soldiers who would make the best officers in the Defense Force, as well as which recruits were best suited to the different branches of the military. After tracking the intuitive predictions of himself and his team, he found them to be worthless, so he tried something different.

Kahneman went on to create a “personality test,” listing the traits to be evaluated, with specific questions to ask for each trait, and a predetermined system for rating each characteristic one at a time. He made his best attempt to create an algorithm; a structured process for forecasting a future outcome. The results of this approach? Despite the strong distaste from those doing the interviewing, the predicted likelihood of success in any branch of the military was increased. In fact, this approach has proven so successful that the Israeli military continues to use it today, with only minor adjustments1.

Additionally, these results, where algorithms (rules-based decisions) outperform raw human intuition and judgement, have been replicated many times over in a variety of fields. Studies have shown that more structured approaches outperform in hiring employees2 for your business, for example. In fact, research on this phenomenon goes all the way back to the 1950s, where Paul Meehl’s book Clinical versus Statistical Prediction showed 20 cases of algorithms outperforming unaided expert human judgement.

Combining the Strengths of Human and Algorithm

By building and adhering to a repeatable investment process, an advisor, robo or human, will produce better results with higher consistency over the long term. This does not mean that robo-advisors and rigid algorithms are a silver bullet solution to investment management problems. Understanding and measuring causal factors, finding historical data, and assessing how well the current state of the world resembles the past are still the job of human advisors and investment managers. The lesson is to take one’s accumulated expertise and ensure that it is systematically applied in a uniform way over time.

So while the future of robo-advisors and their impact on the industry continues to be a popular topic in the financial media, the underappreciated aspect of their approach is the integration of highly repeatable processes. Traditional human advisors would be well-served to apply these lessons throughout more segments of their investment efforts. Combining the strengths of both human and algorithm is the way ahead for forward-thinking advisors.

Here at Lake Street, we continue to emphasize investing client capital according to a continuously improving, repeatable investment process grounded in evidence-based decision making. This involves a bias toward cost and tax efficient rules-based passive allocations, a continuous search for highly process-oriented active managers in markets with clear opportunities for attractive returns, and systematic portfolio rebalancing/loss harvesting. For more on our approach, visit us at or contact us directly.




1. According to Reuven Gal’s comments in The Undoing Project by Michael Lewis, the Israeli military tried to change the system once but it turned out to be worse, so it was changed back.