HOW CAN I COST JUSTIFY YOUR MANAGEMENT Fees vs. LOW-FEE OPTIONS?
Many online firms are selling “low fee” or “smart portfolio management” services. Therefore, it is prudent to ask:
How did a portfolio based on low-fee index funds perform during a devastating bear market?
Let’s assume you are 25-40 years old and you have signed up for an automated online management service. You answer some questions about your age, time horizon, and risk tolerance and the “intelligent” service places you in an allocation that is heavily weighted toward stocks, similar to the allocation shown below.
An allocation comprised of a diversified stock index (45% in SPY), a diversified technology index (40% QQQ), and a diversified bond index (15% VBMFX) lost 50.51% between the bull market peak in March 2000 and the bear market bottom in October 2002.
LOW-COST "SMART" PORTFOLIOS MAY NOT LOOK SO SMART
Let's assume you invested $1,000,000 in the allocation above during the 2000-2002 bear market and the advice and council that came from your low-cost provider was "hang in there, stocks always come back". Hanging in there means you would have lost 50.51% of your $1,000,000 or $505,100.
value of downside protection
It is pretty easy to cost justify an additional management fee of 0.50% or 0.75% per year given portfolio drawdowns can be over 50% during a bear market. On a $1,000,000 portfolio, an additional management fee of 0.50% comes to $5,000 per year, which is quite a bit smaller than the "smart" portfolio's drawdown of $505,100. It would take over 100 years of "smart, low-fee" investing to cover a one-time bear market drawdown of $505,100 that occurred in just 29 months.
While fees are an extremely important part of any investment program, they pale in comparison to the hard-to-recover from damage that can be done to your net worth in a bear market.
Many online robo-advisors focus on low-fees and automatic rebalancing, but there is no exit strategy for future bear markets similar to the periods 1929-1932, 2000-2002, and 2007-2009. Sound money management has two major objectives:
Prudently grow capital in favorable markets.
Prudently protect capital in unfavorable markets.
WHAT ABOUT AUTO-REBALANCING?
As noted in detail in the auto-rebalancing FAQ, the long-term results for portfolios that are rebalanced periodically are not materially different from a buy-and-hold strategy.
BUT, MY ALLOCATION IS HIGHLY DIVERSIFIED
The other thing many low-cost investment portfolio investors may not be aware of is the strong correlation between all stock-related ETFs and mutual funds, even when foreign stocks are included. This false diversification FAQ shows the damage that was done in the financial crisis bear market to a "diversified" portfolio comprised of ten different investments.
HOW LONG CAN IT TAKE FOR STOCKS TO COME BACK?
Many online advisors use expressions such as "over the long-term" and "staying the course". However, it is prudent to understand how long it can take for stocks to come back after normal and to be expected bear markets. The answer can be found here.