"Where do you think the markets are heading?"

This is a common question I get.  Barry Ritholtz on June 18th blogged on the response to this question.  His answer is a great one.  That said, I would like to opine on this a little bit.

Probably the best take within this post was the position that there is a difference between what people WANT to hear and what they NEED to hear.  This likely is a big reason that some folks are reluctant to take a more passive strategy and watch CNBC (Disclosure:  I watch Bloomberg and haven't watched CNBC in  a couple of years).  People do this all the time they do what is URGENT but not IMPORTANT.  They do what they WANT to do, not what they NEED to do.  The Book Likeonomics focused on this gap.

So how do we get people to listen and do what they need to do with their investments?  I am currently focusing on the risk management side of things in my four way test:

Compared to a passive index like SCHB or VTI, for equities:

1) Is the expense ratio lower?  The answer is no, nearly all the time.  So given that it is higher...
2) Does it increase diversification or decrease risk?  The answer to this is 'yes' in some instances.  Small Caps would increase your exposure to US Companies since less of the revenue comes from oversees.  Value stocks can reduce the risk associated with inflated market caps.  Companies that buy back their stock or pay dividends tend to be better at cash management.  International Stocks would diversify your portfolio against US risks.  So the answer is yes, but the times this occurs is less than you may think.  You must look at the correlation.  I use assetcorrelation.com frequently.

Let's look at VARIX.  This is a S&P 500 index that is made up of the 9 sectors.  It basically turns on and off various sectors based on some risk attributes.  The cost is 0.88%.  Let's say that this is 10% of your portfolio of $500,000.

Is it worth it to pay 8 basis points or $400 a year to avoid a $15,000 loss?  This is a different argument that will VARIX beat VTI in performance, because you can make the calendar work so that either win.  This depends on the individual and where we are in the market cycle. My job is to present the opportunity and the math and to give my recommendation.  One thing that many don't think about are the Capital Gain Distributions that they may face with VARIX.

3) Will it remain tax efficient?  This is where placement and the entire portfolio come into play.  Take an investment like BKLN - this is a floating bank rate corporate bond that provides some risk management of interest rate sensitivity, but it doesn't provide coverage from other risks.  The yield on this is around 4.6%.  Where do you want this holding (if at all), especially if you make more than $250K per year?

4)  Will in increase performance?  This comes back to Barry Ritholtz's post on the markets.  Mr. Ritholtz doesn't know and I don't know.  So what is the answer in general or with any particular holding or allocation.

• Market forecasts aren't forecasts, they are opinions.  Your opinion likely won't change based on my opinion, but I can provide you with contextual relevance and data that will give you information or affirmation - depending on your psychology and biases.
• We are in a post-financial crisis recovery that is typically sub-par in terms of its trajectory.
• Pick a date and the data and I can make this recovery look as good or as bad as I want.
• Monetary policy is really pulling the weight of our lack of fiscal policy and much of that monetary policy isn't getting where it needs to.
• Most data shows markets are not cheap or expensive and many indicators are stable and not trending one way or another.  Either way, markets and the economy are not correlated, so it matters less than you think.

#4 I can't control, but we can control how we deal with this lack of control.

This example is just for equities.  Do these answers change with bonds?  Surprisingly little.  That said,  I do believe that limiting your bond exposure to US Treasuries like IEF is a sort of concentration risk that is dangerous.  You must be as diversified in bonds as stocks.  Corporates, Bank Loans, Currencies, International, Munis need to be part of the equation.  Additionally, Bond investing will be more challenging that equities after a 30 year bull run, so professionals that have studies this may have less risk.

Of course, if you answer questions 1-4 correctly, you necessarily answer the most important question:  Does it meet the clients needs?