Investments that are Good on Paper, Bad in Practice

Don’t ask me why I know this, but there’s an episode of “Sex and the City” when the women discuss dating people who “look good on paper.” They explain that a “good on paper guy” is someone who offers great credentials, good manners, and financial stability. He seems like a great match – but only on paper, because in the real world the chemistry simply isn’t right.

Isn’t it similar in investing? There are plenty of strategies that look really good on paper, but when financial advisors implements them, the real-world application is disappointing at best and disastrous at worst.

When I think of “good on paper investments,” a few immediately come to mind – and so does the corresponding “but.”

A buy-and-hold strategy

Good on paper. Whether it involves holding an index fund that tracks the S&P 500 or constructing a traditional 60/40 model that’s regularly rebalanced, this approach looks good on paper because of its simplicity. You buy, you hold, and maybe you rebalance periodically or stepdown equity exposure every five years. Even one of the most sophisticated versions of this strategy, a target-date fund, is still something clients will readily understand.

But… While on paper the U.S. equity market has recovered from all major declines, asking clients to ride through several 50% or greater drawdowns is a hard pill to swallow. The “hold” can quickly turn into HODL (hold on for dear life!). Catastrophic drawdowns take years to recover from, which might be OK for some clients, but often has devastating effects for those nearing retirement.

ARK Innovation ETF (ARKK)

Good on paper. The dating analogy works well with ARKK, with good-on-paper attributes that include:

• A manager with global investing experience, publicity, and credentials
• The low-ish fee and less tax drag advantages associated with ETFs over mutual funds
• Transparency – in 2014, it wasn’t common for ETF managers to invite any John Doe to subscribe to email alerts anytime a trade was made, but Cathie Wood was doing just that

And then there’s the sexiness of an ETF focused in disruptive innovation areas like autonomous technology, genomic revolution, and digital payments.

ARKK had a meteoric rise in 2020, becoming the largest actively managed ETF and offering a 150%+ return.

But… Starting in early 2021, poor performance (which even went negative) led to huge outflows and sparked liquidity fears due to much of the fund’s holdings being in relatively hard-to-exit companies.

The honeymoon was over, and suddenly a spotlight was shone on ARKK’s lack of risk management and opaque process for portfolio decisions.

REITs

Good on paper. Real estate is often a favorite of financial advisors who seek to protect client portfolios by diversifying away from any one asset class becoming dominate. The reasoning is easy to understand: diversification reduces exposure to individual asset risk, and as a hard asset, real estate has a fundamental value that’s tangible and easy for clients to understand.

But… Upon further inspection, real estate is highly correlated to stocks and therefore offers fewer diversifying characteristics than first meets the eye. We saw this in 2021, when real estate was a top performer in a year where the market was up well above average.

The consequences of correlation can be particularly difficult during market drawdowns. For example, since 2000, the Wilshire US REIT Index experienced a more severe maximum drawdown (over 75%) than several other traditional diversification strategies, including Treasuries, corporate bonds, or the value factor.

Amazon.com (AMZN)

Good on paper. Little explanation is needed here because an investment doesn’t get much better looking on paper than a 31.1% annualized return over the past 30 years, diversified business lines, and a foothold in areas of the market that show tremendous growth potential.

But… There’s no such thing as a free lunch, and the “price” paid for such a good-on-paper return is volatility – which comes with its own emotional toll.

Investors who have captured this exceptional return have also had to ride through three separate occasions when Amazon lost more than half of its value, plus a 94% decline during the tech bubble. (Reminder: a 1,567% return is needed to breakeven after a 94% decline.)

That’s an enormous psychological price. It takes a lot of intestinal fortitude to hang on.

Gold

Good on paper. Gold has long been used as a hedge strategy because it usually demonstrates “safe haven” attributes during periods of market crisis or inflation.

As a risk-management strategy, it performs well, offering enhanced risk-adjusted and cumulative returns over full market cycles that include at least one bull and bear. Since performance is correlated to an asset rather than stocks, gold can provide portfolio diversification in a way that’s not possible in direct equity investments.

But… The attributes that can make gold attractive during times of market volatility may mean it’s equally unappealing when the stock market is strong and calm. Often there’s a negative carry during these times, when the cost of holding the hedge exceeds its benefit.

Clients may compare gold’s performance to their preferred benchmark – be it the S&P, Dow, or Nasdaq (even though we all know these aren’t fair benchmarks for all investment products…I digress) – conclude gold offers paltry returns with no yield, and become impatient.

Due to the optics of underperforming during strong markets, advisors must continually remind clients of the role gold plays in achieving long-term financial goals. But, the potential lack of investor commitment can lead to abandoning the plan at precisely the time risk management is needed most.

Behavioral Finance: The ‘Chemistry’ of Investing?

In our view, the reason the chemistry simply isn’t quite right for each of these good-on-paper investments relates to behavioral finance: each lacks sufficient behavioral friendliness.

When I say “behavioral friendliness,” I’m talking about attributes that increase the chances an average investor (your client) will be able to stick with a particular investment approach during times of euphoria and fear.

Behavioral finance is a one of those “talk the talk, walk the walk” things, in my opinion. There’s plenty of talk within financial services (some would say TOO much talk), but there’s not enough action.

For example, traditional investment evaluation usually stops after the quantitative analysis of risk/return metrics. At Blueprint Investment Partners, we think this is short-sighted because it misses a key consideration: How are an advisor’s clients going to FEEL about the investment’s performance in both up and down markets? As an advisor, this is often your cost to bear.

We focused on behavioral friendliness when we designed our process and systematic investing strategies. Behavioral finance is also a common theme in our “A Systematic Walk Down Wall Street” blogs and research.

In a primer on the topic of risk management, “An Advisors’ Guide to Downside Protection,” we went as far as prescribing a “behavioral score” to 11 traditional, hedge, and tactical/alternative strategies that are commonly used as an “insurance policy” to protect a portfolio during market downturns. The score combined the quantitative and the qualitative measures that can be strong indicators of whether, and for how long, an investor will stick with an investment:

A detailed explanation of the “behavioral score” methodology is available in the primer.

How Can Financial Advisors Optimize for Behavioral Finance?

My friends in compliance will be happy to see me leading with this statement: Obviously there’s no truly perfect match. But, I think advisors increase the odds of keeping clients anchored to their financial plans when they use investment strategies that are characterized by a disciplined process and transparency.

The two go hand-in-hand. Because a disciplined process has the power to eliminate uncertainty for the advisor – and their client – when the rules driving the strategy are openly available and communicated.

A transparent process with pre-determined rules that answer all questions about what, when, and how much to buy and sell creates an environment for an advisor to:

• Know what to expect
• Proactively communicate with clients
• Independently verify harmony between expectations of the stated objectives for the strategy and the reality of how it is executed

An example of the power of a rules-based process combined with transparency was shared with me by one of our client advisors earlier this month. One of the advisor’s clients had emailed following the late-April market decline and said something to the effect of, “Aren’t you proud I haven’t called you to ask about how we’re going to respond to the latest market activity?” The point is this: The client was able to understand and appreciate the process driving his portfolio; thereby, this individual could let go of the emotional reaction provoked by the market.