The One Number You Need

Andrew Busa:

What if I told you measuring your long-term financial success can be done by looking at just one or two important metrics? Listen to this podcast to find out what they are.

Hello, this is Andrew Busa and I’m a financial planner here at Adviser Investments. We’re here with another The Adviser You Can Talk To Podcast. And today I’m joined by my colleague Jeff DeMaso, portfolio manager.

Jeff DeMaso:

Hey, Andrew, how you doing?

Andrew Busa:

Good. Good to be back together for another episode. Now, for this week’s episode, I wanted to bring up an email that you actually sent me, what, two, three years ago maybe. I went back into the archives for this one. But it was around this concept of one big thing, and I know you always sort of like to parse through data and kind of figure out what it’s telling you. And the idea behind this one was that if you could simplify a data trend down to one piece of information, if you could boil everything down to just one really important metric, that it would tell you actually most of what you would need to know when you’re analyzing or trying to figure out what’s happening with a certain situation. Is that generally the gist? This was a few years ago, so I’m a little rusty on it.

Jeff DeMaso:

Yeah, no, you nailed it. And you’re right—I do love looking at data and digging through as much as I can, but yeah, sometimes it’s interesting just to say, “Is there one data point that cuts through all of the noise?” And so maybe let me give a nonfinancial example, or somewhat nonfinancial example, to try and set us up here. And if you’re trying to answer or measure the level of a country’s development, there’s a ton of data points you can look at. You can look at income, GDP per capita, life expectancy, crime and poverty levels, and on and on. There’s just a ton of data you can look at. But if you could just have one data point, what would you choose?

Well, for Hans Rosling, who before he passed away was a professor of international health—he was the author of Factfulness, which is a great book I highly recommend. And he also has some of the most watched TED Talks looking at stats around country development. So this was kind of his area of expertise. And for Hans, the one data point that he would look at was child mortality. And his take was that children are fragile. There’s a lot of things that can kill them. And so if you look at child mortality, that tells you a lot about the entire society. Have they figured out sanitation, food delivery, health services? So just gives you a really good sense, that one stat, of just the overall society.

Andrew Busa:

That paints a really good picture and it’s a great example to explain this concept of one big thing. And we thought it would be interesting to apply this same line of thinking to financial plans in investing and really thinking about: There’s so many data points that we can look at when we’re analyzing someone’s financial plan, when you’re thinking about investment returns over a really long period of time, looking at a mutual fund to decide if it’s worth investing in or not. So I’d ask you first, from the investment side of things, what do you view as the one big thing that determines the success or failure of an investment portfolio for an individual over a long period of time?

Jeff DeMaso:

Yeah, it’s a great question, and you’re right. There’s just a slew of economic- and financial- and market-related data to look at. But the standard kind of one big thing that determines investment success and failure for a portfolio over the long term is the asset allocation. Whether you hold stocks, bonds or cash over the next one, two, three decades is going to be the big driver of your returns and where your portfolio is going to land at the end of that time period.

So to give an example of that, I was speaking with a client who had recently come into a large amount of cash from selling a business, and we were getting into this debate about the yields on money market funds and savings accounts and different bank accounts and CDs, and we quickly realized that we were getting way into the weeds. We weren’t answering the big question of where should this money be long term. Whether he got 3.2% or 3.4% on cash isn’t really moving the needle. The big question is should that money stay in cash for the next one, three, five, 10 years, or should it be invested in a more diversified, growth-oriented portfolio? So that’s kind of the one big question that’s going to kind of determine an investor’s success or failure. But if I can already break the script from one big thing and maybe give you one and a half things.

Andrew Busa:

We’ll give you that. We’ll give that.

Jeff DeMaso:

Okay. So while asset allocation drives returns, the other side of that coin is really the investor’s behavior. When did you own stocks vs. bonds or cash, and how did you own them? So if I could have one data point that’s going to predict an investor’s behavior, it would be what’s their turnover? And generally here my framework is that the lower the turnover, the better investor behavior and hence kind of a better outcome.

Andrew Busa:

So the idea being sometimes you’re your own worst enemy when it comes to your portfolio.

Jeff DeMaso:

I mean, a hundred percent. There’s plenty of studies out there showing that we are not good at timing the market. We tend to chase things that did well and get into them right before they don’t do well, and we tend to panic out during bear markets. Now look, of course there’re going to be exceptions to this. I know there’s funds and managers out there who’ve performed well with a high level of trading. But for the most part, for most people, the lower the turnover generally the better result.

In fact, so Fidelity reportedly conducted this study of customer accounts and looked at performance and put them in the different buckets based on how much they traded. And I haven’t been able to get my hands on this report, but it’s been kind of quoted through the years. And what really caught everybody’s eye was that the best-performing group was the dead or inactive accounts, the accounts that had nothing going on, stayed the course through 2003 to 2013—includes the global financial crisis and the rebound. So it’s really those accounts that just kind of stuck to it. Again, kind of that combination of what was your asset allocation and were you able to stick to it through time?

Andrew Busa:

Yeah, and I think boiling down to those couple of metrics, just the value of a really good adviser that’s guiding you—that’s very important. Because if you’re working with a good adviser, they should be coaching you through times when you might be tempted to change your asset allocation or to create some turnover in your portfolio to try to do something. So that’s where I tie it back to. If you’re working with a good adviser and they’re helping you with those one and a half things, we’ll call it, your returns should be in theory pretty good over a long period of time.

Jeff DeMaso:

Yeah. Well, the other piece there too is there’s always a lot of upfront work when you’re starting to work with an adviser and build that relationship. And part of that’s because finding the right asset allocation for you, for your risk level, for your comfort zone, for the goals you’re trying to achieve is such an important thing that that’s a really big thing to get right upfront.

Andrew Busa:

It is, and it’s a big decision to change too. I think we’ve both been part of conversations with clients where they’re wondering, “Should I change my asset allocation?” And while it may not seem like a huge change to, say, go from a 60% equity allocation to 70% or down to 50%, those decisions do make a large impact over many, many years.

Jeff DeMaso:

So I mean, that decision though often ties into your financial plan and how it impacts your plan. So maybe that’s a good spot here to pivot and ask you what’s the one big thing that you might look for in terms of determining the success or probability of success of a financial plan?

Andrew Busa:

If I had to boil it down to one thing, and that’s always hard to do, it would be spending rate. And to quickly define that, it’s just your spending divided by your total income. And underneath that—this one might surprise you a little bit—but one anecdotal element that I’ve found that sort of drives, if you’ll pardon the pun, the trend of a plan over a long period of time is how someone spends on car purchases. So in situations where someone is replacing their car very frequently and for a high cost vs. holding a car for a long time and getting your money’s worth, so to speak—not always, but this is sometimes revealing of a larger trend of how that person approaches budgeting and spending money in general. Again, very anecdotal, but something that we’ve picked up in the many plans that we’ve run over the years.

Jeff DeMaso:

Yeah, I like that. And it’s actually one I haven’t really heard before, so I don’t know. Tell me a little bit more, kind of pulling that thread of spending.

Andrew Busa:

So if we zoom out just from the car purchases a little bit, this is generally supported by the fact that if you look at spending by category for the majority of U.S. households from the Bureau of Labor Statistics—and this is across all ages, all generations—basically housing, food and transportation for most of us takes up about 50% to 60% of what we spend on an annual basis.

So sometimes you talk about the idea of cutting certain monthly items like your Netflix subscription, your Spotify, whatever the case may be. It turns out that things like that don’t make a huge difference over time, but what you spend on a car, how often you replace it, where you live, what your mortgage payment is potentially—that’s going to make a major impact on your long-term spending rate and then, as a result, your financial plan. Because let’s keep in mind your spending rate is also going to drive your savings rate. How much are you able to put away to your retirement accounts, to your short-term and medium-term investment accounts, to hit those goals over a long period of time?

Jeff DeMaso:

Yeah. I think what stands out to me in this is that you talked about looking at car payments, and I guess my thought is that if it tells you how someone thinks about big purchases, that probably reflects how they think about all of their purchases and spending, and it kind of funnels through to some of those smaller pieces, which again, might not be moving the needle as much, but still part of the overall spending picture.

Andrew Busa:

So yeah, you can keep buying probably that latte on the weekend if you want to. We don’t have to cut that out.

Jeff DeMaso:

Guilt-free?

Andrew Busa:

Yeah, guilt-free, absolutely. Again, that concept of gauging the health of someone’s financial plan with one piece of information—difficult to do, just like on the investment side of things. But thinking about that spending rate again, if 50% to 60% of your budget is in a sense fixed, or at least very hard to move, between where you live, what you eat and what you drive, that’s like a mountain to try to change. It’s hard to move once you’ve established your lifestyle in those three things.

So we could think about that equation of your spending rate. You could play with that discretionary part of your budget, that maybe 30% to 40% where you can be a little bit more efficient potentially and find some room to save some extra dollars. But we can’t forget about the income side of the equation as well. That’s the other possibility to decrease your spending rate and therefore increase your savings rate—is to boost the income side of things. I know, easier said than done. As we were prepping for this podcast, we talked about that.

Jeff DeMaso:

If we all could make more money, we would. I think we’d all like to do that. So I mean, I think there’s two points that are really interesting to pull on there. One is, you mentioned it, kind of that lifestyle creep. As you earn a little bit more money and you move on from eating ramen first straight out of college to whatever sort of fare takes your fancy, it’s hard to go back unless you’re really forced to. Or to your point about housing, transportation. Those are really hard to move the needle unless you’re willing to pick up and move.

I live in New York. My housing and food and costs and stuff are pretty darn high, and I know I could reduce those costs pretty drastically by moving, but do I want to move? That’s a big decision, big life change. Whereas it feels a little easier to maybe not have that coffee every single weekend, but one’s not moving the needle nearly as much as the other. But then, yeah, talk to me a little bit about that income side. It’s easier said than done, but how do you think about that?

Andrew Busa:

Well, I think especially for folks who are in the accumulation phase of their financial plan—so you’re in your high-earning years or you’re about to enter those high earning years and just understanding that your earning potential is probably the most important ingredient in your long-term financial plan.

So just thinking about some things here. Invest in education and advancing your career as much as you can if there is something that you can do on that side of things. So just make sure that you’re earning what you’re worth. We’ve done episodes in the past on freelancing and a side hustle. Again, time is the most valuable commodity and sometimes there’s just not enough time in the day to do what you want to do. But I think just understanding generally what you are worth for the job that you’re doing, making sure that you’re getting paid what you should be, is very important as we think about coming back to that spending rate as part of your plan.

Jeff DeMaso:

Yeah, I think on that last point now, as we’ve actually seen earnings start to rise, the job market is pretty tight in terms of there being low unemployment rate, a higher level of jobs out there. So now’s always that time to—and you should always be doing it—but trying to understand your worth and presenting your value to your company of what you’ve accomplished and what you’re going to continue to accomplish and why you should be compensated for that.

Andrew Busa:

I wanted to ask another question to you if we have time, on the investment side of things. We spoke about what determines an individual investor’s success over a long period of time. I’m also curious: When you look at a mutual fund, an individual fund, what do you see as being the one big, or one and a half if you need to, things that determine whether or not that’s a good investment over a long period of time?

Jeff DeMaso:

The most consistent data point that predicts relative under- or outperformance is actually a fund’s expense ratio. Kind of across all the studies I’ve seen, that’s the one that always comes up: Lower expense ratio tends to relate to higher relative performance. But one that I really like looking at, and maybe if I could only have one question to ask a manager, it’s how much do you own in the fund? Are you invested alongside shareholders?

There’s been some studies that have shown that if you combine that with what’s called a high active share—but simply means that the fund looks different from the benchmark or the index or the market or however you want to term it—but to get different performance from the market, to outperform, you need to look different than the market. So the idea is to try and find a fund that looks different from the market and has a high degree of manager alignment with shareholders, and that tends to be a pretty good recipe for funds that outperform. I guess the disclosure or disclaimer in that would be within that bucket is probably where you’re also potentially going to see bigger underperformance, simply because looking different than the market doesn’t guarantee better-than-market returns. It just kind of guarantees different-from-market returns.

Andrew Busa:

Right. Yeah. It’s hard to outperform if you look exactly like the benchmark, but also theoretically easy to underperform as well. But I really enjoyed this conversation just because I think both of us—sort of the idea of the simplicity on the other side of complexity appeals to us both, and I think that’s what this concept gets at. If you look online, Googling, “How do I pick a good mutual fund,” “How do I know if my returns are going to be good over a long period of time,” or “Is my financial plan successful,” you get thousands of results. But I think identifying one or two really, really important things to focus on is critical.

Jeff DeMaso:

I completely agree. And to try and pull it together a little bit—and again, I know we say we did one big thing; we might need to rename that podcast. But okay, maybe it was two, two and a half big things. But they really do go hand in hand, and we often talk about how you can’t just save your way to meaningful wealth and to long-term success. High savings rate is great and we encourage it, but if it’s just sitting in cash and not growing, it’s unlikely to really keep up with inflation and you’re not making your money work for you.

Conversely, you can’t necessarily count on outstanding returns to bail out a low savings rate. If you’re banking on getting 20% returns per year, well, you’re banking on being one of the best investors of the generation, and that’s probably a low-probability event for you. It’s really the intersection of being a good saver and a good investor where compounding works its magic. It’s where those big leaps are made and where we think investment success long term and financial success long term comes from.

Andrew Busa:

Well, we will leave it there for the day. This has been Andrew Busa and Jeff DeMaso from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can also check us out at www.adviserinvestments.com/podcast. Your feedback is always welcome, and if you have questions or topics that you’d like us to explore for an episode, please email us at info@adviserinvestments.com. Thanks for listening.