Since second quarter performance results were made available last week, we’ve received a few inquiries from clients asking about investment returns. Some have been surprised at the returns since the beginning of the year.

These inquiries provide an opportunity to review Springwater’s investment management philosophy.

At Springwater, we have been students of investing for several decades. We have read dozens of investing books and we have taught investing at the university level. We approach the subject from an academic perspective. There is a “science” of investing. What does the science tell us?

Asset allocation is the primary determinant of investment performance. Asset allocation is the process of allocating investment dollars across asset classes. Asset allocation is far more important than security selection (aka stock-picking) or market-timing.

An asset class is a group of securities, like stocks or bonds, that share common risk and return characteristics. Examples of asset classes include US large cap stocks, international small cap value stocks, global real estate and short-term government bonds. Springwater follows 30+ asset classes for possible inclusion in our model portfolios. We generally allocate to asset classes in proportion to their global weighting. So, for example, if US stocks make up 50% of the global market capitalization, we will typically allocate approximately 50% to US stocks.

Diversification is the process of investing in many securities within an asset class. Diversification allows us to reduce risk in a portfolio. Technically, diversification helps to reduce “unsystematic risk”, which is specific to a company, industry, sector, market, economy or country. We cannot, however, use diversification to eliminate “systematic risk”, which is risk inherent in the overall market. Very few investors have sufficiently large portfolios to invest in individual stocks or bonds and achieve adequate diversification. Mutual funds and exchange-traded funds, however, provide retail investors the ability to be well diversified within all of the asset classes that comprise a portfolio.

Asset location is the process of placing tax-efficient asset classes in taxable accounts and tax-inefficient asset classes in tax-deferred or non-taxable accounts. For example, we would most likely place US small cap stocks inside a taxable account, because they generally do not generate significant taxable income, and generate taxable capital gains only when they are sold. We would typically place bonds in tax-deferred or non-taxable account, because bonds do generate taxable income. We can minimize taxes through thoughtful and strategic asset location.

We rebalance portfolios on a systematic basis. Over time the actual asset allocation of a portfolio will deviate from the initial or target asset allocation. This happens naturally as the asset classes that comprise the portfolio perform differently over time. Springwater will rebalance the portfolio back to the target allocation by selling a portion of those asset classes that have become “overweight” and buying more of those asset classes that have become “underweight.” Typically, we do this annually. However, in periods of extreme market volatility, we will monitor asset classes for possible deviations beyond the intended “bands” we set.

We can improve performance by containing costs. Investors face several expenses: fees charged by the advisor (e.g. Springwater), fees charged by the fund manager (e.g. Dimensional Funds, Vanguard or BlackRock) and fees charged by the custodian (e.g. Charles Schwab). Our advisory fees are less than the industry average. We use fund managers that charge significantly less than the industry average. And we have negotiated trading charges for our clients with Schwab that are lower than those paid by most retail investors.

We cannot control the markets. But we can control our emotions and encourage you to control yours when the markets are not delivering the results we want. This is arguably the most challenging aspect of investing. Most investors allow their emotions to overtake their rational thoughts when the markets do not meet expectations. Disciplined, rational investors inevitably earn performance that is better than those who are ruled by their emotions.
Now, how to remember all of this? Most people find it is easier to remember something if they have tool, such as an acronym. So, try this. CRADLE.

Cost control
Asset allocation
Location (asset location)
Emotions (control your emotions)

So, CRADLE your investments.

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