Investment Philosophy

Market Efficiency

Red Lighthouse operates under the assumption that markets are efficient(1).  To the extent that there are inefficiencies, it is very difficult to profit from these inefficiencies.  The high fees charged by many active managers create a further drag on performance.  Active management faces an even higher hurdle in taxable accounts, as most active strategies have significantly higher turnover than passive ones, and each purchase or sale represents a potentially taxable transaction. 

Importance of Asset Allocation

The structure of an investor’s portfolio, i.e. its asset allocation, is among the major factors contributing to performance.  In a groundbreaking study over 20 years ago, Gary Brinson, Randolph Hood and Gilbert Beebower first documented and quantified the importance of asset allocation.  Their study revealed that over 90% of the variability of returns among institutional investment managers could be traced to asset allocation.  Red Lighthouse typically constructs broad portfolios that are diversified both within and across asset classes.

Importance of Rebalancing

Disciplined systematic rebalancing helps to insure that a portfolio stays consistent with the asset allocation established for a particular client.  Rebalancing entails selling those asset classes that have done well and buying those that have been performing poorly, and so is not for the faint of heart, especially in times of extreme market “excess.”  For instance, selling technology stocks in the late 1990’s was not easy, just as selling Japanese securities in the late 1980’s would have seemed to contradict reason.  Similarly, buying an asset class after a severe downtown can be nerve-wracking.  After all, there are usually very well publicized reasons for the collapse of that particular asset class.  Rebalancing always requires single-minded discipline and fortitude.  The challenge is magnified in taxable accounts where substantial gains may need to be realized when selling assets.  Yet disciplined rebalancing contributes substantially to the successful performance of a portfolio over the long term.

Equity Risk Factors

Returns flow from risk.  For public equities there are three risk factors:

•Market risk - sometimes known as beta

•Size –  a company’s market capitalization

•Style –  “value” or “growth”

These three factors explain over 90% of returns.  Over long periods of time, small stocks tend to outperform large ones, and value stocks tend to outperform growth stocks.  This is true both domestically and internationally.

Investment Process

Red Lighthouse’s investment process starts with a thorough examination of your unique financial situation.  Among the factors we assess are: risk tolerance, financial knowledge, liquidity requirements, net worth and time horizon.  We also undertake a detailed analysis of your current investment holdings. 

We then prepare and review with you a personalized Investment Policy Statement and an implementation plan, which together document the meeting of the minds between you and Red Lighthouse.  We typically expose clients to each asset class and sub asset class through low-cost passive funds, and then systematically rebalance portfolios to ensure that the asset allocation remains consistent with the objectives established (See Also The Importance of Asset Allocation and Rebalancing).  We review portfolio results with you on a quarterly basis.  Periodically, or as needed, we revisit our assumptions with clients to make sure that the Investment Policy Statement keeps pace with changing circumstances.

What we don’t do

We don’t attempt to “beat the market” by actively choosing securities.  The overwhelming evidence is that virtually no one has the ability to pick the right securities consistently over long periods of time.  We also don’t try to time the market.  Once again there is precious little evidence that any investor can consistently choose when to be invested and when to be sitting on cash.  In fact, just being out of the market occasionally can be very detrimental to one’s portfolio.  This is illustrated by a Standard & Poor’s study that looked at the returns to their S&P 500 Index in the 30 years ending Dec 31, 2005.  If one was out of the market for the ten top performing months over the 360 month period, one’s returns would have been cut by two-thirds.  Another study using S&P data concluded that in the 20 years ending in 2006 missing the top 20 days accounted for 100% of the return. 

We also tend to avoid actively managed funds.  In years past, active management was the only way to gain exposure to certain segments of the market.  Today a well-constructed and cost-efficient passive approach exists for virtually all market segments.  Sure, a few managers (Warren Buffet) have amassed an impressive track record, but how can one identify that next great manager without the benefit of hindsight?  David Swensen, the highly successful Chief Investment Officer of Yale, cites a “well-constructed academic study that conservatively places… the after-tax failure rate at 86-96%.(2)”    That is, the vast majority of mutual funds fail to achieve market returns over long periods of time, in this case the study was over a 20-year period.

(1) The Efficient Market Hypothesis (EMH) posits that stock prices reflect all information known at a given time.  Empirical and theoretical studies support EMH.  See Research Center for a more detailed discussion

(2) Swensen, David F.. Unconventional Success.  Simon & Schuster, Inc. 2005.