Our Data-Driven Investment Process
With decades of experience in finance and financial services, we developed a highly disciplined investment process to build your wealth faster. Our proprietary research, Business Cycle Indicator (BCI), is the engine that drives our data-driven process that delivers superior results through: low-cost investments, diversification, risk management, and tax-efficient rebalancing.
We thoroughly back-tested our process going back to 1995. The above chart compares the growth of a $100,000 in the S&P 500, the Barclays Aggregate Bond Index verses each of our five investment models between January 1995 and March 2019.
Our Business Cycle Indicator (BCI) uses an advanced formula coupled with economic and financial market data to produce a real-time measure of the economy. The indicator has been tested as far back as 1968 and would have provided a warning prior to every recession. On average, the warnings came eight months prior to the start of a recession.
BCI uses six different components to track the US economy. It utilizes measures of monetary policy, corporate borrowing costs for both investment grade and non-investment grade companies, employment data, construction data, and the number of heavy trucks that are sold each month.
Historically, the largest declines in the stock market occur during recessions. Conversely, when we do not experience a recession, the stock market rises considerably. Our process is designed to remain invested during the good times, and be conservative during recessions. By avoiding big declines your investments will grow faster.
The chart below shows the historical returns of the S&P 500 based on whether or not our Business Cycle Indicator is warning of a recession.
When our Business Cycle Indicator is showing signs that are consistent with prior recessions, our models moved to the safety of bonds.
Bond Returns During Recessions
When the economy enters a recession, interest rates tend to fall primarily due to two main reasons. First, in response to the weakening economy, the Federal Reserve lowers interest rates. Bond prices move in the opposite direction of bond yields, so bond prices rise. Second, investors prefer the safety of bonds instead of other more risky assets, like equities. The result is more demand for bonds, which pushes their prices higher. Below is a chart of how two broad bond indices performed when BCI warned of a recession.
Eliminates Emotional Investing Mistakes
Human nature makes for bad investment decisions. When the stock market goes up, instinctively, you want to get in. When the stock market falls, you want to get out. As a result, you do the opposite of what you’re trying to accomplish – buy low, and sell high. Following your emotions can be hazardous to your investments.
The chart above illustrates how investors get greedy when the markets go up, and fearful when it goes down. The resulting impulse to buy or sell results in devastatingly poor performance.
The chart above illustrates how the performance of the average investor fares compared to a number of different asset classes. Due to the emotional tendencies, the average investor struggles to even keep up with inflation, let alone financial markets.
Our process is driven by data and eliminates the emotional tendencies that result in poor investor performance.
Here are a couple examples that illustrate this point. In August of 2000, the stock market had just hit an all-time high. Investors were clamoring to invest in technology stocks at the peak of what later became known as the Dotcom Bubble. That same month, BCI gave a warning that a recession was imminent and that investor should prepare for declines in the market. The data said to “sell”, while human emotion told you to “buy”. BCI provided the same warning in July 2007, just months before the stock market briefly hit new highs, then lost 57% during the 2008 financial crisis.
Anticipating a recession is half the battle, BCI also allows us to recognize when a recession transitions to recovery. BCI provided an all-clear in July of 2009. The stock market was down more than 40% from it’s high and nobody wanted to invest. Again, our data-driven process would have helped you make a better investment decision. As of March 2019, the market has nearly tripled it’s value since July 2009.
There is no shortage of investment products to choose from today. Innovations over the last 20 years have substantially reduced the cost of investing. New low-cost products are launching every month, increasing an investor’s net-of-fee return. As part of our process, we regularly evaluate the universe of investment products, selecting those with the lowest cost, and the best risk/return profile. Investing in low-cost ETFs instead of higher-cost mutual funds can have a substantial impact on an investors long-term returns.
Saving 0.63% on a $100,000 portfolio could add up to more than $40,000 over the course of 20 years (assuming $100K growing at 6% vs 6.63%).
Investing in mutual funds, or any strategy where a person actively picks investments to outperform and index, adds an additional variable into your portfolio as well as costs. Unfortunately, most active mutual funds fail to keep up with the indices they try to beat. According to S&P Dow Jones Research, 82% of large cap mutual funds failed to outperform an index fund over the past five years.
Tax Efficiency and Rebalancing
Taxes are always a consideration with any investment. Our investment process minimizes short-term capital gains by rebalancing every 365 days. Short term gains are federally taxed as ordinary income (up to 37%), while long-term capital gains are taxed at 15% or 20%, depending on your taxable income. By minimizing your tax burden along the way, our process can improve your after-tax return.
Rebalancing helps mitigate risk along the way. During periods of good stock market returns, a balanced portfolio of stocks and bonds will begin to tilt more heavily towards stocks. While this benefits returns in the short-term, it amplifies future declines during a correction. Having a diligent rebalancing schedule forces an investor to buy low and sell high within a balanced portfolio. Rebalancing involves selling securities that have appreciated the most, and buying those that have lagged or even lost value. Buy low, sell high.
Lastly, different investment products have different tax treatment. Mutual funds distribute capital gains annually. These distributions require an investor to pay taxes in the year they were distributed. In some cases, mutual funds could distribute capital gains you have to pay taxes on, even when those gains were incurred before you invested. Other investments issue K-1’s which makes tax reporting a challenge. We use exchange-traded-funds, which rarely distribute capital gains allowing your investment to remain invested and continue to grow.
Most investments don’t move in the same direction at the same time. Stocks tend to perform better when the economy is improving, while bonds have performed well when stocks fall.
Additionally, sometimes owning too much of one investment or sector exposes you to risks specific to that investment. Over-concentration in the financial sector in 2008 would have led to terrible performance. Bank stocks declined as much at 80% in 2008. The same can be said about technology stocks in 2000. Having a diversified portfolio helps minimize drawdowns, making it easier for investors to stay invested.
Through low-cost exchange traded funds, our portfolios are diversified, owning more than 3,000 underlying positions.
Our investment process reduces risk by avoiding periods that have, historically, produced the worst returns for equity investors. Those periods tend to coincide with recessions in the US economy. In fact, eight of the last ten bear markets, defined as a 20% decline in the stock market, occurred during recessions.
Using our Business Cycle Indicator to anticipate when recession risks are high, we reduce the risk in our portfolios and preserve capital. By preserving capital during these periods, our clients will have more capital to deploy after the recession ends and financial markets begin to recover.
During our extensive back-test, we measured two important risk metrics. The first, is volatility. Over the observed period, volatility was substantially reduced by avoiding recessions when volatility tends to spike.
Second, we tracked the maximum drawdown of each model. This measures how much you could have hypothetically lost if you invested at the top of the market, and sold at the lowest point during a decline. The drawdowns in our models were less than half of those incurred with a buy-and-hold portfolio with a similar asset allocation.
Putting Our Process to Work For You
We have spent years developing and refining our process. We are passionate about helping people grow their wealth and improve their lives. We would love nothing more than to start a conversation with you. Hop on our calendar at any time that is convenient for you.
*Average investor returns as measured by Dalbar & Associates 2018
Backtesting involves a hypothetical reconstruction, based on past market data, of what the performance of a particular account would have been had the adviser been managing the account using a specific investment strategy. Performance results presented do not represent actual trading using client assets but were achieved through retroactive application of a model that was designed with the benefit of hindsight. Backtested performance results have inherent limitations, particularly the fact that these results do not represent actual trading and may not reflect the impact that material economic and market factors might have placed on the adviser’s decision-making if the adviser were actually managing the client’s money.
These results should not be viewed as indicative of the adviser’s skill and do not reflect the performance results that were achieved by any particular client. During this period, the adviser was not providing advice using this model and clients’ results were materially different. The model that gave rise to these backtested performance results is one that the adviser is now using in managing clients’ accounts.
Performance results are presented net-of-fees and reflect the reinvestment of dividends and capital gains. No current or prospective client should assume that the future performance of any specific investment or strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals, and economic conditions may materially alter the performance of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s investment portfolio.
Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. There are no assurances that an investor’s portfolio will match or outperform any particular benchmark. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses.
Prepared Capital is registered as an investment adviser and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Registration as an investment adviser does not constitute an endorsement of the firm by securities regulators nor does it indicate that the adviser has attained a particular level of skill or ability.