Investment Approach

The Fifth Set DisciplineTM

Humans are not hard-wired to be successful investors. Studies have identified numerous systematic human biases that lead to poor investment outcomes for investors. The key to counter our human biases is to apply a disciplined, academically-based investment approach we call the Fifth Set DisciplineTM.

Twelve principles underpin the Fifth Set DisciplineTM.

Follow along as we build an approach for investment success.

"It's human nature to find patterns where there are none and to find skill where luck is a more likely explanation (particularly if you're the lucky [mutual fund] manager)."
William BernsteinPh.D., M.D., Author “The Intelligent Asset Allocator”
"Pundits forecast not because they know, but because they are asked."
John Kenneth Galbraith Professor of Economics, Harvard University
"Most people might just as well buy a share of the whole market, which pools all the information, than delude themselves into thinking they know something the market doesn’t."
Merton Miller Professor of Economics, University of Chicago, Nobel Prize Laureate in Economics, 1990
"The market is smarter than we are and no matter how smart we get, the market will always be smarter than we are."
Kenneth French Professor of Finance, Dartmouth College
"Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas."
Paul SamuelsonProfessor of Economics, MIT, Nobel Prize Laureate in Economics, 1970
"In an efficient market, at any point in time, the actual price of a security will be a good estimate of its intrinsic value."
Eugene FamaProfessor of Finance, University of Chicago, Nobel Prize Laureate in Economics, 2013
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Key Takeaway

Consistent exposure to capital markets is necessary for wealth creation over time

  • Investors gain exposure to a company’s return on invested capital by loaning money to or investing money in a business. Bondholders are lenders to a company; stockholders are equity owners in the business. 
  • Using supplied financial capital, businesses invest in new products and services that may (or may not) generate profits for the business. As providers of the financial capital, investors expect a return on their money.
  • The return on invested capital is the source of investment returns. 
  • How has this process worked out for investors? The capital markets have rewarded long-term investors: Beginning in 1926 $1 grew to $23 if invested in treasury bills, $133 if invested in long-term government bonds, $14,557 if invested in US Large Cap stocks, and $33,783 if invested in US Small Cap stocks.

Further insights

Key Takeaway

Market prices are the best estimate of a stock’s intrinsic value.  Investors are well served by acting as if current prices are correct (even if that turns out not to be the case).

  • Security markets enable competition among many market participants who voluntarily agree to transact. 
  • Every day, massive volumes of trading takes place in equity markets.  
  • This trading aggregates vast amounts of dispersed information, causing security prices to quickly adjust to reflect new information. 

Further insights

Key Takeaway

Professional money managers, on average, fail to outperform the market over time. Before you jump into individual stocks, ask what your unique edge is.

  • When you try to outsmart the market, you compete with the collective knowledge of all investors.
  • Traditional active money managers face the same headwinds.
  • The historical returns of all US-based mutual funds demonstrate that even among those with significant research capabilities, attempts to outsmart the market do not work. 
  • Over the past twenty years, only 18% of equity funds and 15% of fixed income funds both survived and outperformed the market.

Further insights

Key Takeaway

Although the vast majority of active money managers underperform their benchmarks, a handful do manage to outperform over time. Is that outperformance a result of luck or skill?  The evidence suggests luck is the primary driver of outperformance.

  • Investors, when choosing traditional active money managers, are often tempted to follow a strategy of picking the “winners” from historical data.
  • Implicit in this reasoning is the idea that winning money managers demonstrate skill that is likely to persist through time.
  • What does the evidence say about active money manager skill and success through time?  Do winners repeat?
  • Historical data demonstrate that for the period from 2013-2023, among the 25% of actively managed funds with the best performance in the previous five-year period, on average, only 22% of equity funds and 31% of fixed income funds managed to stay in the top-quartile in the following five-year period. Winners do not repeat at a higher rate than average. This is compelling evidence that winning managers are a product of luck, not skill.

Further insights

S&P 500 Index vs. Disney

Key Takeaway

Diversification (broad market exposure) reduces the risks related to specific companies and industries leaving investors with only market risk to bear. The impact of the COVID pandemic on Disney stock vs. the broad market is a perfect example of the risk benefits provided by diversification.

  • Academic research shows us that investments expose investors to two types of investment risk: systematic (market) risk and unsystematic (company-specific) risk.
  • Only market risk has a positive expected return. Investors with exposure to individual stocks take on additional risk without additional expected return. 
  • Maintaining broad market coverage enables investors to gain exposure to market risk and its commensurate positive expected return while minimizing company-specific risk.

Further insights

Key Takeaway

Investors often assume that the average historical return of individual stocks is similar to the average historical return of the broad stock market. In reality, most individual stocks underperform long-term market returns which are lifted by a relatively small number of stocks with exceptional returns. Investment strategies built around individual stock picking run the risk of missing out on the small number outperforming stocks. Only consistent broad market coverage ensures exposure to the best performing stocks over time.  

  • Most individual stocks underperform the broad market over time.  Missing out on just a small number of the best performing stocks significantly reduces realized returns.  
  • Attempting to identify the small group of future winners is a guessing game (like trying to find a needle in a haystack). 
  • Broad market coverage ensures investors capture the returns of the best performing stocks (like buying the whole haystack).

Further insights

Key Takeaway

While understandably alluring, successful market timing is much more difficult to achieve than one might expect.  Staying exposed to market risks through good times and bad is the surest way to capture long-term returns. 

  • The alure of market timing for investors is strong. Sell before the market goes down, buy before it goes up. Capture the gains, don’t take losses, avoid the pain. 
  • Research shows, however, just how difficult successful market timing is. Missing just the 25 best trading days over twenty years significantly reduced realized stocks returns to the point where an investor could have simply bought treasury bills. 
  • Discipline is the key characteristic that drives successful investing. Staying invested enables investors to capture long-term market returns.

Further insights

Expected Return "Factors"

Key Takeaway

Academic research has identified specific security characteristics associated with higher expected returns.  Systematic investing that tilts toward these ‘factors’ enables investors to capture these higher returns.  

  • Academic research points to systematic characteristics of securities that have higher expected returns. These characteristics are called expected return factors, and portfolios can be structured to target them.  
  • Expected return factors are sensible, backed by empirical evidence, and can be captured cost-effectively.
  • Compelling evidence exists for the following expected return factors for stocks:
  • Size premium – Small company stocks have a higher expected return than Large company stocks.
  • Value premium – Value (cheaper) stocks have a higher expected return than Growth (expensive) stocks.
  • Profitability premium – Stocks of more profitable companies have a higher expected return than stocks of low profitability companies.

Further insights

Examples of How Our Brains Generate Faulty Reasoning

Key Takeaway

The way we, as humans, are wired to behave can lead to investing mistakes. Awareness of our biases gives us the opportunity to prepare for market conditions that can be difficult to manage. A disciplined commitment to an evidence-based investment approach is the key to managing our human biases.
  • Known systematic human biases lead to faulty reasoning when applied to investing.
  • Ignoring our faulty mental approach to investing can lead to underperformance compared to market returns.
  • Applying investment strategies built on academic evidence creates guiderails for investors and enables them to capture long-term market returns.

Further insights

The Investor's Emotional Roller Coaster

Key Takeaway

The oldest adage in investing may be “buy low, sell high”, yet our emotional impulses often drive investors to do the complete opposite. By definition, the world likely looks the worst at the same time markets are at a low point and vice versa. Emotions make it difficult to do what is necessary to achieve investing success. Managing your emotions is a critical part of the investing process.
  • The 2020 COVID-19 market downturn offers an example of how the cycle of fear and greed can drive an investor’s decisions. 
  • Investors who sold in March 2020 locked in their losses just before the recovery began.  Selling at that time may have eased their fear but was likely replaced by the stress of missing out on the market recovery and the anxiety of deciding when to get back in. 
  • Understanding how investor emotions can cause irrational decision-making is key to developing a successful investment experience.

Further insights

Beware Financial Headlines

Key Takeaway

The media is in the business of drawing attention to its content. A media company that focused on delivering content based on academically driven investment concepts likely would not stay in business for very long. When reading headlines or hearing talking heads discuss markets, keep in mind the inherent conflict of interest underlying the content.

  • Before acting on information gleaned from a media platform, investors who might act on information from these sources should keep in mind media companies are in the entertainment business not the financial literacy business.  
  • Consider that Wall Street ‘experts’ who appear on cable news programs and make predictions about whether the market will go up or down or which stocks are the best investments are implying that they can accurately predict the future.  
  • When discussing investing with friends, neighbors, family or colleagues, remember that people are inclined to focus more on their winning investments and less so on the losers.   Keep their advice in perspective, most of it is just noise.

Further insights

Focus on what you can control

Key Takeaway

Focus on those things that matter, and you have control over.

What you can control:

  • Gain insights about markets from academic research
  • Create an investment plan that matches your goals and tolerance for risk
  • Structure portfolios using expected return factors
  • Diversify globally
  • Manage expenses, portfolio turnover, and taxes
  • Stay disciplined through all market environments

What you cannot control:

  • Markets

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Ian A. Post, CFA, CFP®
600 Mamaroneck Avenue, Suite 400
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Phone: 646-783-9717 | Fax: 646-572-8737

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