Now that Commissions on Stock Trades Are Zero, Should You Start Trading Stocks?

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Quite recently, Charles Schwab (an e-broker) announced that they would no longer be charging commissions on stock trades.  Shortly thereafter, TD Ameritrade, E*TRADE, Interactive Brokers, and Fidelity Investments all followed suit.  A financial technology (fintech) firm, Robinhood already offered commission-free trading.  So essentially, anywhere you open up a brokerage account to trade stocks, you will not have to pay any commissions.  The question is…….should you start trading stocks?

The aforementioned question is difficult to answer in relation to all the types of people that are reading this article.  However, whether or not you decide to trade stocks, I simply want to ensure that you are using the proper benchmark to gauge your success in terms of the performance returns you achieve.  Now I am assuming that, since you are trading stocks, the assets are held in a taxable brokerage account.  Furthermore, an active trader is likely to have a holding period for those stocks that is less than 365 days.  Therefore, the gains are fully taxable as ordinary income.  With that groundwork laid, let’s move on to a further analysis.

Trading stocks and “beating the stock market” is an extraordinarily difficult task to do.  Most of the professional asset managers fail to beat their respective benchmarks for performance returns.  Additionally, trading stocks in the short term requires two things:  gauging market sentiment correctly and the valuation of the stock based upon its fundamentals.  You have to be right on both accounts.  There are many times when a company has a ton of good announcements that should cause the stock price to increase, but other factors hinder the upward movement in the stock price.  Examples include:  negative sentiment about the stock market in general, negative sentiment about the industry the company is in, geopolitical uncertainty, poor economic data, central bank (Federal Reserve) policy, and many others.  The bottom line is that you can be exactly correct on positive news for the stock you are buying, but, if there are negative overhangs in the stock market for any reason, the stock price may not go up.

Another word of caution is just to identify what it means to trade stocks in the short term.  Trading stocks in the short term is speculation, plain and simple.  Short-term trading is not investing at all.  There are myriad reasons why, but I will not address that in this article.  Just know that you are a trader who is speculating on stocks and market sentiment related to the stocks you choose to trade.  Any holding period of a stock less than one year does not meet the bar of what investing means.  As long as you know that going in, that is fine and I will not dissuade you in any way from trading.

The important thing to remember is that you need to gauge your performance in relation to the overall stock market based upon after-tax returns and not gross returns.  Why?  At the end of the day, you only care about the terminal value of the asset in your brokerage account.  What do I mean by terminal value?  Terminal value just means the amount of money you have after paying capital gains taxes as ordinary income.  For example, if you have a 10% return in your stocks and the S&P 500 Index is only up 8%, you need to look at your taxes too.  Just for illustrative purposes, let’s assume that your marginal rate for federal and state taxes is 25%.  If we go back to the 10% amount, you will have a 7.5% (10% – 10% * 25%) after-tax gain from trading.  Yes, you beat the stock market return on a gross basis, but you end up with 0.5% less after all is said and done.

I am going to use the historical returns of the S&P 500 Index from 1957 to 2018 as the benchmark that you should be referencing when examining your success (or failure) as a result of trading.  As I have mentioned in many prior articles, I use 1957 as the starting year because the S&P 500 Index was created in that year.  Prior to 1957, the S&P Index had less constituents so going back in history further than that year does not yield an apples-to-apples comparison.  The long-term historical return of the S&P 500 Index over that period was approximately 9.8%.  Therefore, I will use that historical return to reference the gross return versus after-tax return issues.

Here is a table to look at the performance return you need to equal just to be even with the S&P 500 Index after taxes:

Gross Returns Versus Tax Equivalent Returns

As you can see, the gross return equivalents in relation to the historical return of the S&P 500 Index range from 12.3% to 16.3% for the various marginal tax rates shown.  For instance, if you are in the 30% marginal tax bracket for federal and state income tax purposes, you will need to earn 14.0% returns just to break even.  Most people add or remove monies to their brokerage accounts over the course of any given year, so you need to adjust for those cash flows.  The computations are a little trickier and beyond the scope of this discussion.

Another important thing to take into account is the types of stocks you purchase.  The stocks included in the S&P 500 Index are very large companies by market capitalization (large caps).  Market capitalization is simply the number of shares outstanding times the stock price.  If you invest in very small stocks that you deem to be good trading opportunities, you should not be using the S&P 500 Index table above to do your calculations for after-tax returns.  For example, if you tend to invest in smaller companies, you would want to use the Russell 2000 Index or the S&P 600 Index.  For any companies below $1 billion in market capitalization, you should seek out what are called microcap indexes.  The best way to build your personal table is to use a “blended benchmark” for performance returns.  A “blended benchmark” is what large institutions and high net worth individuals use, and it is the gold standard because you are truly comparing apples-to-apples.

If you want to learn more about how to create your personal “blended benchmark”, I addressed that topic five years or so ago and here is the link to that article:

https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/

In summary, if you decide to trade individual stocks because commissions are zero now or you have always done so in the past, you need to compare your after-tax return to what you would have earned if you had simply bought the S&P 500 Index via an index mutual fund or an Exchange Traded Fund (ETF).  Why?  Those performance returns would be available to you if you simply invested in one.  Note that the fees on index mutual funds and ETFs are extremely low (0.05% or less and in some cases like Fidelity Investments are free).  You always want to select your next best alternative to measure whether or not you are earning more than the stock market on an after-tax basis.  Remember that all you really care about at the end of the day is how much money you have leftover in your brokerage account minus what you pay in federal and state income taxes.

How to Become a Successful Long-Term Investor – Summary

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The discussion of how to become a successful long-term investor in my three-part series is now finished.  However, the journey is an ongoing one that takes discipline, constant learning, and monitoring your emotional reactions to fluctuations in the financial markets.  I discussed the history of stock market returns of the S&P 500 Index (dividends reinvested) from 1957-2018, the concept of risk, and also the futility of trying to engage in “market timing”.  But you may be asking yourself, why didn’t you tell me what stocks, bonds, and other assets to buy to build my investment portfolio?  That is a valid question, and there is an extremely important reason why that gets at the very heart of my overall discussion.

The best way to answer the question posed above is with an analogy.  Now my international readers will have to indulge me with this example.  My favorite sport is football which is the most popular sport in the world.  Most people in the United States refer to it as soccer and only watch if the men’s or women’s teams are competing in the World Cup.  I could tell you all about the reasons why football clubs rarely use a 4-4-2 formation.  Or I could talk about how the 4-2-3-1 formation has evolved in the Bundesliga.  We also could discuss why goalies now need to be good with their feet in order to pass from the backline.  Finally, I might even be more specific and give my rationale for why Liverpool in the Premier League uses a 4-4-3 formation given their current squad for the 2019-2020 season.

My analogy above relates to long-term investing because I would argue that you should not invest a single dollar in the stock or bond markets without knowing about the history of returns, risks and volatility, and “market timing”.  Most Financial Advisors (FAs), Certified Financial Planners (CFPs), and Registered Investment Advisors (RIAs) jump right into the discussion of how to build an investment portfolio taking into account your financial goals and risk tolerance.  This conversation is directly related to the football analogy above.  Without a firm understanding of investing at a high level (or the general way football is played first), you are likely to fail in your resolve to stick with a long-term focus while investing.  For example, when you are asked if you can tolerate a 20% decline in the stock market, how should you answer?  I would say that, if you do not have some grasp of historical returns and the level of risk, you cannot properly answer.  Remember that we covered how often you will experience negative returns (including 20% declines) in the first article.  You need to understand the “composition of the forest before deciding how to deal with the trees”.

Here are the links to the three articles to have an understanding of first prior to jumping into the mix of long-term investing strategy and building an actual portfolio of investments.

Part 1 – Understanding Historical Stock Market Returns:

https://latticeworkwealth.com/2019/09/23/successful-long-term-investing/

Part 2 – Understanding and Managing Risk:

https://latticeworkwealth.com/2019/09/25/successful-long-term-investor-risk/

Part 3 – Giving up on the Allure of “Market Timing”:

https://latticeworkwealth.com/2019/09/28/successful-long-term-investing-market-timing/

Once you have a firm grasp on these topics, you are ready to get your feet wet in the world of investing.

For those of you wanting a little bit of guidance because your intention is the manage your investments personally, I have written about this topic in the past.  I wrote a two-part series on how to build an investment portfolio and monitor the performance returns of that investment portfolio.  I have included the links below:

Part 1 – Building an Investment Portfolio:

https://latticeworkwealth.com/2013/07/16/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-1-of-2/

Part 2 – Monitoring the Performance of an Investment Portfolio:

https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/

Those two articles above will provide you with some ways to go about creating your own investment portfolio without the assistance of a financial professional.  While it does contain a lot of information and suggestions, individual investors who are complete novices may find it easier and less confusing to seek out someone to guide them with investment selection, measuring risk tolerance, and understanding the goals of their financial plan.

In summary, I appreciate you taking the time to read my thoughts in regard to successful long-term investing.  As you can see successful investing has more to do with preparation, setting realistic expectations, and knowing how you personally respond to risk.  These topics need to be studied prior to investing money yourself or before going to seek out investment advice from a financial professional.  If you have any questions, comments, feedback, or disagreements, you can feel free to let me know.

How to Become a Successful Long-Term Investor – Part 3 of 3 – The Folly of Market Timing

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This article is the third and final post in my three-part series on learning how to be a successful long-term investor.  The general theme underlying all of the topics has been developing enough of an understanding of the stock market gyrations and sometimes wild ride to form reasonable expectations at the outset.  Those expectations lead directly into to developing a long-term investment strategy and plan that you are much more likely to stick with through “thick and thin” because you know what is coming.  Of course, you will not know the order in which the ups and downs may come, but you will have a ton of information helpful to be much less likely to lose your nerve or get overly excited.

The last topic will be about “market timing”.  We will delve deeply into the concept and see how very difficult it has been in the past, and, I believe, will continue to be for the foreseeable future.  Now the discussion to follow will be entirely self-contained; however, it might be helpful to take a look at the first two articles to have additional context.  The opening topic was an overview of the history of stock market returns using the S&P 500 Index (dividends reinvested).  Here is a link to that post:

https://latticeworkwealth.com/2019/09/23/successful-long-term-investing/

The second topic was a discussion about the concept of risk.  We explored how it is normally defined, ways that you can gauge your tolerance for risk given the information from the first post, and explored some methods/mindsets to reduce risk in your investment portfolio.  Here is a link to that post:

https://latticeworkwealth.com/2019/09/25/successful-long-term-investor-risk/

So now, we will turn to the topic for the last article.  As mentioned above, we are going to take a look at “market timing”.  In general, the idea of “market timing” is to develop ways to be able to buy stocks when they are very undervalued and also sell stocks right near the market peak to avoid a big downturn.  There are certain variations where an investor is not necessarily trying to time the most opportune time but trade along with the momentum of the stock market and anticipating the next movement prior to other stock market participants.

“Market timing” is notoriously difficult to do.  But you will see considerable time devoted every day to financial market television and periodicals advising individual investors what trades to make.  I would submit that following things and pundits on a daily basis adds to “noise” and “information overload”.  Additionally, for every guest that predicts a big leg up in the market, there will be another guest later in the day who tells you that we are in a bubble and stocks will drop dramatically soon.

Another lesser talked about item is the main guests that are invited to speak on television or are quoted in financial periodicals.  Typically, the guest introduction will be prefaced by this man/woman predicted the last major move in the stock market and we are so lucky to have him/her back again.  While these guests are great to hear from, there is a severe amount of “selection bias”.  What do I mean by “selection bias”?  You will rarely see a guest brought on to be lambasted for a prediction that never came to fruition or was just flat out wrong.  The vast majority of guests on television or market experts in financial articles will be the ones who made a very prescient call on the direction of the stock market.

The promise of “market timing” is still so enticing.  It normally relates to the fear of losing money or the greed of just not wanting to miss the next big bull market trend upward in the stock market.  However, the ability to call the market tops or bottoms has proven to be pretty much a 50/50 flip of the coin (now I am being generous at that).  One of the examples that I love to give is the coining of the term “irrational exuberance”.  The former chair of the Federal Reserve, Alan Greenspan, used that new term to state that the stock market was in what he thought was a bubble.  Little do people remember, but he first gave the speech in December 1996 to refer to what would become the Dot.Com bubble and bust.  Greenspan was proven right but the top of that bubble occurred in March 2000.  I use that example because irrational activity in the markets can persist for much, much longer than you might expect.

So, now I know that some people reading this post will be able to point to experts who made the great calls or even their own calls on the direction of the stock market.  Well, I will start off the discussion by showing that “market timing” is indeed somewhat possible.  But it takes much longer periods of time than you might think at first.  Here is how we will proceed in the analysis.  I discussed how the long-term historical average of the S&P 500 Index from 1957-2018 has been 9.8%.  It would seem logical then that, if stock market returns were below that average or above that average for a certain length of time, you could just do the opposite figuring that stock market returns would eventually trend back to that average (in the jargon reversion to the mean).

The problem is, as I briefly mentioned in the last paragraph, that the time period needs to be so long that it is almost untenable for individual investors to practically implement.  In fact, we have to use 15-year annualized returns to illustrate the theory.  So, if the stock market has been below/above trend, we will buy/sell because an inflection point has to come.  Let’s take a look at it graphically to drive the point home:

Fifteen Year Correlation

In the graph depicted above, we have exactly the returns we would like to see.  The blue dots are the past 15 years of stock market returns, and the orange dots are the next 15 years of stock market returns.  The dots are what we would term to have an inverse relationship.  In fact, for all of you somewhat familiar with statistics, the correlation coefficient is -0.857.  Therefore, there is a really strong relationship here that leads us to the promise of “market timing”.  Should we give up on it so early?

The problem with “market timing” is that, for any length of time less than 15 years of annualized stock returns, there really is no relationship (at least no actionable trading of stocks for your investment portfolio).  Let’s take a look at the same concept in the first graph with a look at one-year and three-year current and then future returns:

One Year Correlation

Three Year Correlation

Using the one-year and three-year current and then future stock market returns of the S&P 500 Index, our dots just kind of do not follow a discernable pattern.  Again, for the statistically inclined folks out there, the correlation coefficients are -0.10 and -0.041, respectively.  As always, we won’t get too waded down into the mathematical weeds but a correlation coefficient close to 0 means that there is essentially no correlation/relationship between the two.  To make an analogy, you can think of what is the correlation between birds in your backyard and the number of jars of pickles for sale at your local grocery store?  Well, there should be no relationship whatsoever.  Even if there were, it would not make any sense.  In our case here, there is at least some logic underlying our premise of the most recent return on the S&P 500 Index and the future returns over that same time period.  As we see though, there is really nothing actionable to embark upon for individual investors to properly engage in “market timing”.

Before we totally give up on “market timing”, we can take a look at the same charts but extending the time periods to five years and ten years.  Let’s take a look at those two graphs:

Five Year Correlation

Ten Year Correlation

The correlation coefficient for the five-year chart is 0.028, so we cannot really use that long of a time period either.  I will admit that the ten-year chart looks a little more promising.  We have a graph that looks somewhat more like the fifteen-year graph that I started off with.  In fact, the correlation coefficient is -0.276.  And a negative number is what we want to see in order to try “market timing”.  Unfortunately, the number is really not strong enough to not get caught.  By this I mean, we can see that “market timing” would have worked from 1975-1985 and also from 1990-2001 roughly.  However, 1965-1975 has a grouping of returns that don’t work and 2002-2008 has mixed results as well.  Note that there are less data points because there needs to be at least 10 years of future returns in order to compare the current record of 10-year annualized returns with what the next 10 years of stock returns will end up being.

Overall, we have seen that “market timing” in the short term (even as defined out to five years) does not really have much, if any, predictive power.  Therefore, if you make decisions related to “market timing” based upon how the stock market has performed in any time period five years or less, it is clearly a “fool’s errand” or incredibly difficult to do.  And by the latter, I mean that you can reliably do so over more than one major change in market direction.  The majority of market pundits that you will see or read about have made one correct call which is not nearly enough to judge his/her investing acumen related to “market timing”.

I will close out the discussion of “market timing” by using the Financial Crisis and ensuing Great Recession.  Many folks correctly called (or were proven right without the reason for the bubble matching their investment thesis) this major stock market inflection point.  They correctly saw the unsustainable bubble in housing, the rise of financial stocks, and the buildup of toxic securities like subprime loans.  However, many of those same individuals never changed their investment thesis and failed to tell individual investors to return to the stock market and buy.  Essentially there are still folks that will tell you we are in a bubble.  Now I am not bold and/or grandiose enough to weigh in on the current value of the stock market.  But you need to know that most of the people who call a wicked crash in stocks or a massive bull market do not change their investment thesis prior to the next big turn.

For example, let’s say that you learned about stock investing 10 years or so ago and decided to invest $1,000.00 in the S&P 500 Index toward the end of October 2007.  And yes, this was the absolute worst time to invest in stocks.  Sadly, by March 2009, you would have lost 50% of your investment and have only $500.00 at that point in time.  You might feel great if you listened to someone who called the top and told you that the fourth quarter of 2007 was the absolute worse time to buy stocks.  But I am willing to bet that this same person would not have told you when it was “safe” to invest again.  If you knew to expect bouts of extreme volatility in the stock market beforehand, you could have kept your money in the stock market.  At the end of December 2018, you would have had $1,712.36 using our 13.1% 10-year annualized return over that time.  If the original market predictor of catastrophe told you to just keep your $1,000.00 in the bank you would have $1,160.54 (assuming generously that you could earn 1.50% over the ten years in your bank saving account).  Adjusting the hypothetical investor who simply kept his/her money in stocks back to inflation, he/she would have $1,404.73 (assuming 2.0% inflation over the last 10 years which is higher than was actually experienced).  At the end of December 2018, you would have a bit more than 21% higher in inflation-adjusted dollars than the person who just never invested (or took his/her money out of stocks right at the end of October 2007 but never returned to stocks).

Now I will admit that my hypothetical scenario would have tried the “intestinal fortitude” of the most seasoned professional investors after seeing a 50% market drop over 1.5 years.  My only point with the example is that, even if you could not have held your nerve to remain invested in stocks over the Financial Crisis, the investment pundit(s) who tells you the exact top with a brilliant prediction also needs to tell you when to invest or sell again in the future (i.e. “market timing”).  Rarely will you see such a prognosticator that can totally change their investment thesis to get the next call right.  You are much better off abstaining from “market timing” and sticking to your long-term investment strategy.  Of course, that may indeed call for selling or buying a portion of stocks at certain given points to change your investment portfolio allocation to match your risk tolerance and financial goals.  But trying to utilize “market timing” to be in and out to experience hardly any losses and capture all the gains is just not realistic, so you might as well discard the entire investment strategy of “market timing”.

How to Become a Successful Long-Term Investor – Part 2 of 3 – Understanding and Reducing Risk

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Another extremely important part of being a long-term investor is to understand the concept of risk.  Financial professionals define risk in a number of different ways, and we will examine some of those definitions.  The overarching goal is to look at risk from the standpoint of the volatility or dispersion of stock market returns.  Diversification of various investments in your portfolio is normally the way that most financial professionals discuss ways to manage the inevitable fluctuations in one’s investment portfolio.  However, there is another more intuitive way to reduce risk which will be the topic of this second part of this examination into becoming a successful long-term investor.

The first part of this series on long-term investing was a look back at the historical returns of the S&P 500 Index (including the reinvestment of dividends).  The S&P 500 Index will again be the proxy used to view the concept of risk.  If you have not had a chance to read the first part of the series, I would urge you to follow the link provided below.  Note that it is not a prerequisite to follow along with the discussion to come, but it would be helpful to better understand the exploration of risk in this article.

The link to part one of becoming a successful long-term investor is:

https://latticeworkwealth.com/2019/09/23/successful-long-term-investing/

But now we will turn our attention to risk.  Risk can be a kind of difficult or opaque concept that is discussed by financial professionals.  Most individual investors have a tough time following along.  Sometimes there is a lot of math and statistics included with the overview.  Although this information is helpful, we need to build up to that aspect.  However, there will be no detailed calculations utilized in this article that might muddy the waters further.  I believe it helps to take a graphical approach and then build up to what some individual investors consider the harder aspects of grasping risk.

Risk related to investing in stocks can be defined differently, but the general idea is that stocks do not go up or down in a straight line.  As discussed in depth in part one, the annual return of the S&P 500 Index jumps around by a large margin.  Most individual investors are surprised at seeing the wide variation.  Ultimately, the long-term historical average of the S&P 500 Index from 1957 to 2018 is 9.8%.  But rarely does the average annual return end up being anywhere near that number.

The first way I would like to look at risk within the context of long-term investing is to go back to our use of “buckets” of returns.  If you have not already read part one, I used “buckets” with ranges of 5% to see where stock returns fit in.  As it relates to risk, we are only going to look at the “bucket” that includes the historical average 7% to 12% and then either side of that “bucket” (2% to 7% and 12% to 17%).  Additionally, we will look at yearly stock returns and then annualized stock returns for three years, five years, and ten years.  Here is our first graph:

Returns on Either Side of Historical Average

The main takeaway from viewing this graph is that, as the length of time increases, more stock market returns for the S&P 500 Index group around the historical average for the index of 9.8%.  Remember that part one covered the useful information that, even though the historical average to be expected from investing in stocks is 9.8%, individual investors need to know that it can take long periods of time to see that historical average.  In fact, if we look only at one-year increments, approximately 33.9% of stock returns will fall into the range of 2% to 17%.    Or, if we use our yearly equivalent, stock market returns will only fall within that range 1 out of every 3 years.  When individual investors see this graph for the first time, they are usually shocked and somewhat nervous about investing in stocks.

The important thing to keep in mind is that as the length of time examined increased many more stock returns fall into this range.  The numbers are 65.0%, 67.1%, and 81.1%, for three years, five years, and ten years, respectively.  Converting those numbers to yearly equivalents we have about 6-7 years out of ten for three years and five years.  And, as one would intuitively suspect, the longest timeframe of ten years will have stock returns falling into the 2% to 17% range roughly 8 in every 10 years.  Now that still means that 20% to 35% of long-term returns fall outside of that range when considering all those time periods.  But I believe that it is certainly much more palatable for individual investors than looking at investing through the lens of only one-year increments.

Another aspect of risk is what would be termed downside protection.  Most individual investors are considered to be risk averse.  This term is just a fancy way of saying that the vast majority of investors need a lot more expected positive returns to compensate them for the prospect of losing large sums of money.  Essentially an easier way to look at this term is that most individual investors have asymmetric risk tolerances.  All that this means in general is that a 10% loss is much more painful than the pleasure of a 10% gain in the minds of most investors.  Think about yourself in these terms.  What would you consider the offset to be equal when it comes to losing and earning money in the stock market?  Would you need the prospect of a 15% positive return (or 20%, 25% and so forth) to offset the possibility of losing 10% of your money in any one year?  Let’s look at the breakdown of the number of years that investors will experience a loss.  To be consistent with my first post, I am going to use the “bucket” of -3% to 2% and work down from there.  Here is the graph:

Returns Less than 2%

There are 61 years of stock market returns from the S&P 500 Index for the period 1957 to 2018.  If we look at the category of 1 year, stock market returns were 2% or less 38.7% of the time (17 years out of 61 years).  However, if we move to five-year and ten-year annualized returns, there were no observations in the -3% to -8%, -8% to -13%, or less than -13% “buckets”.  When looking at losing money by investing in the stock market, a long-term focus and investment strategy will balance out very negative return years and your portfolio is less likely to be worth significantly less after five or ten years.  Of course, there are no guarantees and perfect foresight is something that we do not have.  However, I believe that looking carefully at the historical data shows why it is important to not be so discouraged by years when the stock market goes down and even stays down for longer than just one year.  Hopefully these figures do provide you with more fortitude to resist the instinct to sell stocks when the stock market takes a deep decline if your investment horizon and financial goals are many, many years out into the future.

The final concept I would like to cover is standard deviation.  The term standard deviation comes up more often than not either in discussions with financial professionals during client meetings or is used a lot in the financial media.  There are many times when even the professionals use the term and explain things incorrectly, but we will save that conversation for another post.  Standard deviation is a statistical term that really is a measure of how far away stock market returns are from the mean (i.e. the average).  It is a concept related to volatility or dispersion.  So, the higher the number is, the more likely it is that stock market returns will have a wide range of returns in any given year.  Let’s first take a look at a graph to put things into context.  Here it is:

Standard Deviation

The chart is striking in terms of how much the standard deviation decreases as the time period increases.  A couple things to note.  First, I do not want to confuse you with a great deal of math or statistical jargon and calculations.  My point is not to obscure the main idea.  Second, the 25-year and 50-year numbers are just included only to cover the entire period of 1957 to 2018 for the S&P 500 Index.  These periods of time are not of much use to individual investors to consider their tolerance for risk and the right investments to include in their portfolios.  And, as one of the most famous economists of the 20th century, John Maynard Keynes, quipped:  “In the long run, we are all dead”.  My only point is that discussion of how the stock market has performed over 25 years or longer is just not relevant to how most individuals think.  It is nice to know but not very useful from a practical perspective.

The main item of interest from the graph above of standard deviation is that you can “lower” the risk of your portfolio just by lengthening your time horizon to make investment decisions on buying or selling stock.  For example, the standard deviation goes down 46.9% (to 8.95% from 16.87%) between one-year returns and three-year annualized returns.  Why do I use “lower”?  Well, the risk of your portfolio will stay constant over time and focusing on longer periods of time will not decrease the volatility per se.  However, most financial professionals tell their clients to not worry about day-to-day fluctuations in the stock market.  Plus, most Financial Advisors tell their clients to not get too upset when reviewing quarterly brokerage statements.  This advice is very good indeed.  However, I urge you to lengthen the period of your concern about volatility in further out into time.  My general guideline to the individuals that I assist in building financial portfolios, setting a unique risk tolerance, and planning for financial goals is to view even one year as short term akin to examining your quarterly brokerage statement.

Why?  If you are in what is termed the “wealth accumulation” stage of life (e.g. saving for retirement), what occurs on a yearly basis is of no concern in the grand scheme of things.  The better investment strategy is to consider three years as short term, five years as medium term, and ten years as the long term.  I think that even retirees can benefit with this type of shift.  Now please do not get me wrong.  I am not advising that anyone make absolutely no changes to his/her investment portfolio for one-year increments.  Rather, annual returns in the stock market vary so widely that it can lead you astray from building a long-term investing strategy that you can stick to when stock market returns inevitably decline (sometimes precipitously and by a large margin).  Note that all the academic theories, especially Modern Portfolio Theory (MPT), were built using an assumption of a one-year holding period for stocks (also bonds, cash, and other investments).  Most individual investors do not fall into the one-year holding period.  Therefore, it does not make much sense to overly focus on such a short time period.

Of course, the next thought and/or comment that comes up is “what if the stock market is too high and I should sell to avoid the downturn?”.  I will not deny that this instinct is very real and will never go away for individual investors.  In fact, a good deal of financial media television coverage and news publications are devoted to advising people on this very topic every single day.   It is termed “market timing”.  In the third and last article in this series on becoming a successful long-term investor, I am going to examine “market timing” with the same stock market data from the S&P 500 Index.  You will clearly see why trying to time the market and buy/sell or sell/buy at the right time is extremely difficult to do (despite what the financial pundits might have you believe given the daily commentary).

How to Become a Successful Long-Term Investor – Part 1 of 3 – Understanding Stock Market Returns

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All financial professionals providing advice urge individual investors to have a long-term plan and orientation.  This advice is solid and has proven itself over the long term.  However, no one really explains what it means to be a long-term investor.  Most of the information dispensed is only a cursory review of the concept.  The majority of new individual investors are then left without a full understanding and a comfortable feeling that a long-term investment strategy will work out in terms of allowing them to reach their financial goals.  Since the importance of long-term investing is so integral to financial planning, I would like to delve very deeply into this topic.  Therefore, I am going to cover this information as a three-part series of posts.  This first post will discuss the nature of stock market returns.  The second and third posts will address volatility in stock market returns and the perils of market timing, respectively.

Let’s get started on this journey and talk about stock market returns over the long term.  Wherever possible I am going to use tables and graphs to better visually depict the concepts discussed in this post.  But first, we must address one of my “pet peeves”.  The proxy for this post for long-term investing will be the historical returns of the S&P 500 Index (including reinvestment of dividends).  Why is this a “pet peeve” for me?  I see too many articles in the financial press that look at historical returns for this index that go back to the 1920’s.  You might want to know why this is a problem.  Well, the S&P 500 Index was created back in March 1957.  The S&P Index was started in 1926 but only included 90 stocks.  Many articles in the financial press use the 1926 date as the starting point for analyzing historical stock market returns but that is really comparing “apples to oranges”.  Additionally, as of September 2019, the S&P 500 Index includes 505 stocks grouped into 11 different sectors.  Up until fairly recently, there were only 10 sectors but Standard & Poor’s made the decision to reclassify several of the stocks.

Now that we have dispensed with the preliminary comments, we can get back to the main discussion of part one.  As you probably know already, the value of stocks fluctuates quite a bit over the course of a year.  In fact, the financial media and financial professionals discuss these fluctuations on a daily basis.  But even on an annual basis, stock market returns vary vastly over time.  The long-term stock market return of the S&P 500 Index from 1957 through 2018 has been approximately 9.8%.  Oftentimes Financial Advisors or Certified Financial Planners (CFPs) will tell their clients that they can expect to earn 8% to 10% by investing in stocks over the long term.  While that information is true, it does not tell the entire story and subsequently leads individual investors to sell stocks during major market declines and buy stocks during periods of euphoria.  Why is that the case when individual investors know up front that stocks will earn 8% to 10% over the long term but be volatile from year to year?

The main reason is that financial advisors mostly fail to fully explain how much stock market returns will fluctuate every year.  In any given year, there will only be about 10% of stock market returns that fall into the bucket of being between 7% and 12%.  To put that number into perspective, you can think of it as saying that only 1 in every 10 years can you expect to see stock market returns around the long-term average historical return of the S&P 500 Index.  Now this information is very disheartening to both novice and more sophisticated individual investors alike.  If you were told to expect that your yearly stock market returns would only be about average every 10 years, wouldn’t that be very helpful information to have in the beginning?  My personal conjecture is that individual investors see that 90% of the time stock market returns are “abnormal” which causes them to react irrationally (or you might even say rationally since nobody told them it was likely to occur).

In order to “set the record straight”, I would like to show you a series of tables and graphs to depict what historical stock market returns of the S&P 500 Index have been over the last 61 years.  My goal is not to dissuade you from investing for the long term; rather, I hope to persuade you why you should invest for the long term.  After reviewing how stock market returns vary over different lengths of time, it is easier to understand what to expect and set more realistic expectations for your portfolio of investments.  In order to accomplish this goal, I am going to show you a series of graphics regarding historical stock market returns.  The information will show one-year, three-year, five-year, and ten-year data.  The data with timeframes longer than one year will be annualized.  “Annualized” is a fancy way of saying that the stock market returns are shown in a comparable way with yearly returns.

So, we will start off with an explanation of how I have grouped the data for stock market returns.  I have broken up the returns for any period into “buckets” with a range of 5%.  For example, there will be one “bucket” for any year where returns are between 7% and 12%.  On either side of that main historical average bucket, I will extend the range in increments of 5%.  For instance, there will be another “bucket” to capture returns between 2% and 7% and also another bucket to capture returns between 12% and 17%.  Lastly, due to the fact that stock market returns have fluctuated so much over time, there will be two “buckets” to capture more extreme returns of less than -13% and greater than 22%.  Showing how stock market returns for various periods fit into these “buckets” will be very instructive in deciding how to approach long-term investing.

The first way to view things is with a table of stock market returns.  Note that these will be supplemented by graphs below for an even better visualization.  Here are how stock market returns appear in each “bucket” as a percentage of time that they occur below:

Table of Returns

There are two main takeaways after looking at the above table.  First, the distribution of stock market returns over the course of one year are quite wide indeed.  Plus, you can see how people can get very euphoric about buying stocks when the investment returns are higher than normal.  The return of the S&P 500 Index has been greater than 22% about 29% of the time.  Let’s put that percentage into a yearly equivalent which is, that in 1 out of every 4 years the stock market return will exceed 22%.  It is hard not to get excited and want to buy more stocks when an individual investor sees that.  Second, the distribution of stock returns for five years and ten years gradually shifts away from the extremes and toward the long-term historical average.  Now this might be intuitive since the average must come about after longer periods of time are taken into account.  More importantly, neither the 5-year returns or 10-year returns have fallen into the -3% and below “buckets”.  If you have a long-term investment horizon, there will be more returns that appear within the “bucket” historical average for the S&P 500 Index.  Using 10-year returns, they fall into the 7% to 12% “bucket” 32.1% of the time.  And in our now familiar conversion to a yearly equivalent, you can expect to see any given 10-year annualized average return be just about inline with the historical average 1 out of every 3 years.  Note that, even with such a long-term period, 2 out of 3 years will be outside of the expected historical average given the last 61 years of stock market returns.

In order to better absorb the information from the table above, here are four graphs that show the breakdown by period grouping in the various “buckets”:

One Year Returns

Three Year Returns

Five Year Returns

Ten Year Returns

The four graphs above show how the number of returns gradually centers more and more around the historical average for the S&P 500 Index as the time period is lengthened from one year to ten years.  Moreover, the extreme outliers to the downside (returns less than -3%) are not present in the graphs for five years and ten years.

Now a historical side-by-side comparison makes it even easier to see that convergence to the historical average and removal of the outliers.  I have left out the graph for three years only to reduce the amount of information shown on the following graph.

Historical Returns

By carefully studying the table and various graphs depicted above, it becomes more palatable to become a long-term investor.  I am a big believer in having realistic expectations prior to investing and building a portfolio of assets to buy and hold.  Without knowing how much of a distribution there is in stock market returns from year to year, it becomes much harder to stick to that financial plan.  Now do not get me wrong here, actually experiencing periods of extreme outliers (especially to the downside) when you have money at stake is nerve-racking to put it mildly.  However, you have a much better understanding of what is “normal” in terms of annual returns.  But, always keep in mind, that past performance in not indicative of future performance.  With that being said though, it helps to have over 60 years’ worth of data to develop your investing strategy and determine your tolerance for risk (i.e. volatility of returns) going forward.

The topic of risk will be covered in the second part of this series on becoming a successful long-term investor.  That topic and the last topic are covered by most financial professionals, but I would like to show the data in a somewhat different and unique way.

Before You Take Any Investment Advice, Consider the Source – Version 2.0

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I originally wrote about this topic five years ago.  However, I think that it may even be more relevant today.  You may have heard about behavioral finance/economics and how cognitive biases plagued individual investors when making financial and investing decisions especially during volatility times in the financial markets.  Sometimes an overlooked topic is the fact that whomever provides you with financial advice will invariably be affected by those same biases.  Yes, even the professionals cannot escape them.  One of the most prevalent and insidious cognitive biases is called “anchoring”.  In layman’s terms, “anchoring” describes the tendency of people to form a particular belief and then stick with it unless there is an incredible amount of evidence to the contrary.  It is just part of human nature; we generally do not want to admit that we were mistaken or flat out wrong.

Now when I am talking about considering the source, I am not referring to the person’s qualifications such as having a Chartered Financial Analyst (CFA), Certified Financial Planner (CFP), or Chartered Market Technician (CMT) designation.  I am referring to the person’s investing paradigm.  For the most part, financial professionals are influenced greatly by the time period in which they first start out in the financial services industry.  The first several of years have an outsized impact on their investing recommendations throughout the rest of their careers.  I will give you an example in life, and then I will talk about Warren Buffett and even myself.  Take special note that I am including myself in this “anchoring” cognitive bias within the context of investing.

There have been many studies that show that the kind of music you listen to most during your teen years becomes your preferred type of music.  For example, there are many people in their early 40’s that love 80’s rock.  They would prefer to listen to that over any type of new music.  My parents are in their seventies now, and they love to listen to Peter, Paul, & Mary, the Beach Boys, Neil Diamond, Motown, and lots of one-hit wonders from the 50’s and 60’s.  Think about your own taste in music.  Does this ring a bell?  Most people fall into this category, and it is almost subconscious.  You like a certain genre of music best, and it sticks with you.  Did you have a family member that was really into music and had a collection of records?  Sometimes you get introduced to music at an even younger age, and you are drawn to it.  You listened to it during your formative years.  The same goes for investing in a rather similar way.

If we take a look at Warren Buffett, he was definitely influenced by the time period in which he started learning about investing seriously.  Buffett read Security Analysis by Benjamin Graham and David Dodd, and he knew right away that he wanted to go to Columbia to get his MS in Economics.  The themes in the book seemed to resonate with him.  I have heard stories that the value investing class with Ben Graham and Warren Buffett was really a conversation between the two of them.  The rest of the classmates just sat back and enjoyed the “show”.  Warren Buffett also learned a lot from a lesser known gentleman, Phil Fisher.  Phil Fisher wrote the classic treatise on “scuttlebutt” called Common Stocks and Uncommon Profits.  “Scuttlebutt” is essentially trying to gain every last piece of information you can about a company prior to investing.  This technique includes, not only speaking to management and reading annual reports, but talking to competitors, suppliers, current employees, past employees, and several other sources.  Warren Buffett remarked in the past that he was “15% Fisher and 85% Graham” in terms of his investing style.  Most experts on the career of Buffett would say that the percentage has shifted toward Fisher quite a bit, especially with the massive size of Berkshire Hathaway now.

I did not pick Warren Buffett because of his long-term track record of stellar performance.  I only picked him because many individuals are familiar with Warren Buffett.  Warren started out working for Graham in the early 50’s after he graduated from Columbia in 1951.  If you look back at this time in history, the stock market had finally gained back its losses from the great crash of October 1929.  The baby boom was in full swing, and the US economy was on overdrive in terms of growth.  The Securities and Exchange Commission (SEC) was set up back in 1933 after the crash once an investigation was done regarding the causes of this debacle.  There were two important promulgations from the SEC in 1934 and 1940 that were issued in order to ensure that company information was available to the public and not fraudulent.  Well, there were still scams, but they were harder to pull off.  (As an aside, the Investment Advisor Act of 1940 did not stop Bernie Madoff from stealing billions of dollars several years ago).  Buffett and Graham (and Graham’s partner, Newman) loved to get their hands on any piece of information they could.  In fact, Buffett used to read entire books on every single public company.  During that time period, information was so disjointed and hard to get.  However, it was now available to the public and professional investors who could do much more thorough analyses.  The financial markets had far more inefficiencies back then.  This time period was before the dawn of Modern Portfolio Theory (MPT), the Capital Asset Pricing Model (CAPM), and the Efficient Market Hypothesis (EMT).  Thus, there was a great deal of opportunities for individuals like Buffett who soaked up all the information he could find.

Buffett started his own investment partnership in the mid 50’s.  It was essentially a hedge fund in most respects.  Without getting into too much of the details, Buffett was able to earn 20% more on average than the Down Jones Average annually until 1969.  The stock market at this time seemed to be overpriced in his estimation, so Buffett disbanded the partnership.  He referred his partners to Bill Ruane of the famed Sequoia Fund.  Bill was a former classmate of Warren, and he amassed quite a record himself.

So if we look at Buffett’s beginning career, he saw how doing your homework really paid off.  In fact, there are even stories that Ben Graham would use examples in his lectures about companies he was going to buy.  After class let out, all the students rushed to call, or see directly, their stock brokers to buy the companies Graham presented on.  Buffett learned from Graham the importance of valuing a company based upon verifiable evidence and not market sentiment.  Fisher’s lessons showed him the benefit of accumulating information from different sources in order to truly understand a business prior to investing.  These formative years are still with Buffett.  Now Charlie Munger, Buffett’s Vice Chairman at Berkshire Hathaway, has been an influence as well.  What is little known is that they grew up together in Omaha, Nebraska, and they were able to meet during this same time period.  This introduction to investing left an indelible mark on Warren Buffett that permeates his investing career today.

Obviously I am no Warren Buffett, but I started investing in mutual funds at age 13 in November 1987.  What got me so interested in the stock market?  Obviously Black Monday on October 19, 1987 really caught my attention.  It was not really the crash that really piqued my interest though.  My father told me that the market drop of 508 points on that day was an overreaction (down over 20% amazed me).  I did not know much about stocks, but it seemed to me like the world was ending.  At least that was how the nightly news portrayed things.  My father said watch the market over the next several days.  To my absolute amazement, the Dow Jones Industrial Average (DJIA) went up almost 290 points in the next two trading sessions.  Wow!  This turn of events was really weird to me.  How could stocks move around in value so greatly?  I thought that all the big money investors in the stock market really knew what they were doing.  However, most everyone was caught by surprise by Black Monday.  The other interesting thing for me was that 1987 turned out to be a positive year for the DJIA.  If you want to get your friends’ attention, you can ask them what the return of the DJIA was for 1987 and 1988 (negative return).  Most people will get it wrong.

Well, these events left a mark on me.  When I learned more about investing and was exposed to Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMT), I really did not think it was true given my start in investing back in the latter portion of 1987.  How could the value of the entire U.S. economy be worth 20% less after one day of trading?  Now, the stock market is normally efficient and stock prices are correct, but I knew that there were inflection points in the stock market where rationality was thrown out the door.  Therefore, when I learned about Mr. Market and the vicissitudes and vagaries of the stock market from Ben Graham’s books, I liked that metaphor and way to characterize volatility in the stock market.  For better or worse, I really do not care for the academic, ivory tower analysis of behavior in the stock market.  I cling more to focus investing, value investing, and seeing the financial markets as complex adaptive systems.  I would fall into the camp of Warren Buffett and the great hedge fund investor, George Soros.  Both men have said that they would never be able to pass the Chartered Financial Analyst (CFA) exam.  The CFA is now the standard designation for all portfolio managers of stocks and bonds.  I tried studying for it, but a lot of it made little sense to me.  I guess that is why I think it is funny when Buffett says he wants to gift money to universities to install permanent chairs in business schools to teach Modern Portfolio Theory forever.

Most of the financial professionals you meet will range in age from twenties to sixties.  You should always ask them when they started investing or their career as a Financial Advisor.  Here are the ten major events that will cover those individuals:

  • The 1973-1974 severe bear market;
  • The Death of Equities article from Time magazine in 1982;
  • Black Monday in October 1987;
  • The Bond Bubble Bursting in 1994;
  • The Asian Contagion and Long Term Capital Management (LTCM) incidents in 1997-1998;
  • The Barron’s article in December 1999 that questioned the relevance of the Oracle of Omaha, Warren Buffett;
  • The Bursting of the Internet Bubble in April 2001;
  • The Financial Crisis and ensuing Great Recession of 2008-2009;
  • The “Lost Decade” of Returns from the S&P 500 from 2001-2010 when stocks averaged approximately 2% annually.
  • Managing Money is Easy. Look at my investing record over the past 10 years (2009-2018).  Note that the annualized return of the S&P 500 index over that period was 13.13%.

These major inflection points in the financial markets will have a great effect on your financial professional’s recommendations for investment portfolio allocation.  In fact, I met a Financial Advisor that tells his clients that they can expect to earn 12% annually from stocks over the long term.  He uses this return for modeling how much clients need to invest for retirement.  He was introduced to investing around 1996 which is when the stock market went gangbusters.  I know another Financial Advisor that tells his clients to never put more than 50% of their money in common stocks.  He tells this to all of his clients, even if they are in their thirties and have 30+ years until retirement.  He started advising clients in 2007, and he lost a great many clients in 2008.  Therefore, he wants to have limited downside risk for two reasons.  First, he has seen how much the stock market can drop in one year.  Second, this gentleman wants to ensure that his clients to not close accounts and flee to other financial professionals because the stocks in their portfolio go down 30-40% in a single year.

The importance today of the long, extended bull market of the past 10 years is extremely important to take into account for all individual investors.  A recent stretch of 13.13% annualized stock returns makes it seem that investing systematically over the long term is the correct investment strategy.  I would not disagree with that thought.  However, Financial Advisors with 10 years of experience or less will only tell clients what they would do hypothetically in the event of a major market decline in the stock and bond markets.  Hypotheticals and backtesting are all well and good.  But it has been my experience, that there is no substitute for actually investing during periods of extreme volatility and major stock market declines (20% or more).  For example, what was the best stock investment strategy right after the Internet Bubble implosion in terms of the asset class?  The best performing asset class for the next decade was to have a larger than normal allocation to emerging market stocks (think Ticker Symbol EEM or VWO).  Do you think that your Financial Advisor would have the stomach to recommend this investment to you after seeing the NASDAQ index fall by over 50%?

As you can see, the start of anyone’s investing career has an impact on their outlook for the financial markets and how to set up a portfolio properly.  I am not saying that any of this advice is “wrong” per se.  My only point is that you need to probe your Financial Advisor a little bit to understand the framework he/she is working with.  Thus, you can refer to the aforementioned list of ten major events in the history of the financial markets.  These events really shape the investment paradigm of all of us.  And, of course, I will admit that I am no different.

With that being said, most investment strategies recommended by Financial Advisors are borne out of those individuals first few years with the financial markets.  Some financial professionals are more bullish than others.  Others focus on downside risk and limiting volatility in investment portfolios.  Still others utilize complicated mathematics to build investment portfolios that are optimized.  Therefore, you need to understand your risk tolerance and financial goals very well.  You have your own personal experience with the market.  If your Financial Advisor is somewhat myopic and focused on the past repeating itself in the same way over and over, you need to be careful.  History does repeat itself, but the repeating events will be caused by much different factors in most cases.  Unfortunately, the financial markets and market participants are always adapting to changing investment strategies, global economic GDP growth, interest rates, geopolitical events, stock price volatility, and a whole host of other things.  You can learn from the past, but I urge you not to be “stuck” in the past with your Financial Advisor’s “anchoring” cognitive bias at the expense of setting up an investment portfolio that will allow you to reach your financial goals and match your risk tolerance.

What is Confirmation Bias? Why is it Dangerous for Individual Investors?

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There are many dangers for individual investors to be aware of when investing.  More and more of these dangers and/or complications are being recognized in the field of behavioral finance.  Behavioral finance looks at the psychological and emotional factors that influence the decision-making process of investors.  Oftentimes researchers in this field try to figure out what causes normally rational people to act irrationally.  Unfortunately, it has proven over and over again that, when money is involved, the vast majority of people let their emotions/feelings interfere with their investment decision either slightly or in profound ways.  We do these things without even knowing it which makes it even harder to address and correct.  Keep in mind that Warren Buffett says that having control of one’s emotions is just as important (or even more so) than having a superior intellect that can select excellent, long-term investments.

Confirmation bias belongs in the realm of behavioral finance, but, as many of these issues, it really first has been examined in terms of psychology.  So, what is confirmation bias exactly?  The definition of confirmation bias is “the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses” (Plous, Scott (1993). The Psychology of Judgment and Decision Making. p. 233).  Keeping in mind that confirmation bias applies to many other areas, the primary focus in the remainder of this article will be how it manifests itself in relation to investing.  Now that we have the formal definition, let’s take a look deeper into this very real danger for individual investors.

Individual investors have the natural inclination to make a decision first and then look for information that supports that initial decision.  It also applies at an even higher level than that.  The way that individual investors think they should invest in general is almost predetermined.  The easiest thing to do is to talk to people with the same thought process about investing, search through the same supporting financial media news publications and websites, and listen to the same experts.  Over time, it gets very easy to just keep doing the same thing over and over again.  Plus, it takes an incredible amount of effort to step outside of one’s comfort zone and try to prove that he/she might in fact be incorrect.  Individual investors (and even professional investors, money managers and investment advisors) are not wired to attempt to confirm why they might be wrong.  At first glance, it seems like a totally foreign and nonsensical concept.

So, what are the types of problems that can occur when individual investor does not acknowledge confirmation bias?  There is a long list here are a few to ponder.  First, a big mistake can be thinking that what has happened in the recent past will continue into the future indefinitely.  This danger is especially evident during a bull market.  It can be easy to get carried away and see how much money one made and then keep pouring money in (more than you can really risk).  The converse is true when it comes to a bear market.  After stocks have gone down for a number of months or longer, it is very easy to just give up on investing in the stock market because it seems like things will never turn around.  Second, the danger creeps in when investing by not challenging one’s assumptions.  Even if an individual investor knows at a subconscious level that an incorrect decision was made, there can be a desperate search for any shred of evidence that one can justify nonaction.  Third, there are times when listening to the investment advice of a particular expert can be “addictive”.  By this I mean that it is natural to continue to listen only to the views of that person, especially when he/she made a bold prediction about the stock market that came true.  It can be simple to forget that market timing is extremely difficult and that person could be totally wrong in terms of his/her next prediction.  Lastly, it can feel good to be part of the crowd and not think differently (or at least examine other issues).  There is safety in numbers essentially and, if your investment decision does turn out to be wrong, you can at a minimum take solace in the fact that “everyone else was doing it”.

There are a number of steps that individual investors can take to counteract the dangers of confirmation bias.  First and foremost, the fact that you are aware of the potential trap of confirmation bias is half the battle.  Periodically ask yourself if you have looked for alternative viewpoints and evidence.  Second, you can make a list of why you made a particular investment decision in the first place.  But, more importantly, you should write down what types of events could occur to make you change your mind because your investment thesis was not correct.  It is very powerful to have a written record to start with.  This recommendation actually comes from a reporter at The Wall Street Journal named Jason Zweig.  Mr. Zweig has been writing about the financial markets for decades now and still has a weekly article in the paper (usually in the weekend edition) called The Intelligent Investor.  I really urge you to take a look at this interview with him back in 2009 about confirmation bias.  Here is the link:

http://www.wsj.com/video/when-investing-consider-your-confirmation-bias/B768E62A-AA01-4B37-905F-F3EDA5C72B78.html

Third, you should make it a habit on a regular basis, maybe monthly, to go to various financial market and investing websites that do not mesh with your general investment philosophy.  You can peruse through a few articles that you might find totally different than you interpret a situation.  I urge you to read them with an open mind though and try to be objective.  Lastly, you can bounce an idea off a close friend or advisor and see what they think about your rationale.  It is far easier for them to be objective.  If you do not have anyone to consult with, I would urge you to pose the question in an investing forum.  However, you need to phrase the question in the manner that will address your possible confirmation bias.  It is very common to ask question in a positive manner like “Why should you invest in technology companies?”.  The better way to phrase it at the outset is to use language like “What are some of the reasons why you should not buy gold?”.

Now keep in mind that the advice on confirmation bias also applies to the articles I have posted on my website.  You will note that two of the main themes are using a passive investing approach to invest and striving to keep investment fees as low as possible.  I urge you to go and seek out information about why you may want to choose an active investing strategy as an individual investor.  Look for the reasons why and situations where you might have to pay additional investment fees depending on your particular circumstances.  It is very healthy and beneficial to seek out other information, and I always encourage individual investors to do so.  The one thing that I firmly hold onto is that I would avoid financial websites or sources that say I am right and the other guys are all wrong.  Things are rarely ever so “black and white”, especially in the world of financial markets and investing.

Bonds Have Risks Other Than Rising Interest Rates. Dividend Stocks are not Substitutes for Bonds.

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The main reason why Financial Advisors are recommending that individual investors sell bonds is that interest rates are likely to rise over the next 3-5 years or more.  Although those sentiments have been a familiar refrain over the last 3-5 years though.  Well, I would tend to agree that interest rates are poised to rise at some point toward the end of this decade.  However, interest rate risk is only one of the risks of bonds.  In fact, the size of the bond market dwarfs the stock market.  When Financial Advisors are talking about bonds, they tend to be referring only to US Treasury bonds, corporate bonds, and municipal bonds.  Interest rate risk greatly affects these bonds indeed.  With that being said, they tend to conflate the interest rate risk of these bonds with the entire bond market.  Remember that interest rates have dropped from 16.30% on the 1-month US Treasury bill back in 1981 to roughly 0.25% today.  Therefore, bond prices have been rising for over 35 years and most financial professionals outside of the fixed income markets have forgotten (or if they are younger than 50) how bonds normally work, especially in a rising interest rate environment.But does it even matter really? Yes.  Here is an urgent note to all individual investors:  “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”.  What I mean by this is that the volatility of stocks is far greater than bonds historically.  Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now.  However, your risk tolerance must be taken into account at all times.  While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk.  For example, as most people are aware, the S&P 500 index (which represents most of the biggest companies in America) was down over 35% in 2008.  Many of those stocks are included in the push to have individual investors buy dividend payers.  With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon.  If you handle the volatility of the stock market well, there is no need to be concerned.  However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield.  Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap.  The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities.  Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment.  While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future just taking into account normal volatility in the stock market historically (every 36 months or so in any given quarter).  Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?The purpose of this blog post is to discuss the risk factors associated with bonds in greater detail.  Most bonds, such as Treasury notes and bonds, corporate bonds, and municipal bonds, will go down in value when interest rates go up.  Conversely, they will go up in value when interest rates decrease.  This characteristic of these types of bonds is called an inverse relationship.  For a primer on how most bonds function normally, I have posted supplementary material alongside this post.  You can refer to it to brush back up on bonds and how they work, and I also provide a historical look at interest rates over the last 35 years.  Here is the link to that prior blog post:https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks-supplementary-information-on-how-bonds-work/There are many risk factors associated with investments in bonds.  A great overview of those risks can be found in Fixed Income Mathematics the Fourth Edition by Dr. Frank Fabozzi who teaches at Yale University’s School of Management.  Most fixed income traders, portfolio managers, and risk managers use his Handbook of Fixed Income Securities as their general guidebook for approaching dealing with the trading, investing, and portfolio/risk management of owning fixed income securities.  Suffice it to say that he is regarded as one of the experts when it comes to the bond markets.  Dr. Fabozzi summarizes the risks inherent in bonds on page 109 of the first text referenced above.  The risks are as follows:

  • Interest-rate risk;
  • Credit risk;
  • Liquidity risk;
  • Call or prepayment risk;
  • Exchange-rate risk.

Most of fixed income folks and myself would add inflation risk, basis risk, and separate credit risk into two components.  Bonds have two types of risk as it relates to payment of principal and interest.  The first risk is more commonly thought of and referred to as default risk.  Default risk is simply whether or not the company will pay you back in full and with timely interest payments.  Credit risk also can be thought of as the financial strength of the company.  If a company starts to see a reduction in profits, much higher expenses, and drains of cash, the rating agencies may downgrade their debt.  A downgrade just means that the company is less likely to pay back the bondholder.Here is an example to illustrate the difference more fully:  a company may have a AA+ rating from Standard & Poor’s at the beginning of the year, but, due to events that transpire during the year, the company may get downgraded to A- with a Negative Outlook.  Now the company is still very likely to pay back principal and interest on the bonds, but the probability of default has gone up.  As a point of reference, AAA is the highest and BBB- is the lowest Standard & Poor’s ratings to be considered investment grade.  You will note that the hypothetical company would need to be downgraded four more times (BBB+, BBB, BBB- to BB+) to be considered non-investment grade or a “junk” bond.   Bond market participants though will react to the downgrade though because new potential buyers see more risk of default given the same coupon.  So even though the company may not default eventually on the actual bond, the price of the bond goes up to compensate for the interest rate required by the marketplace on similarly rated bonds to attract buyers.Now I will address the full list of risks affecting bonds outlined by Dr. Fabozzi above.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.  All bonds have what is referred to as credit (default portion) risk.  Credit risk in general is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser known or thought about by individual investors is interest-rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest-rate risk relates to the fact that interest rates may rise, while you hold the bonds (spoken about at length in the beginning of this blog post).  When financial pundits make blanket statements about selling bonds, they are referring to this one risk factor normally.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation or closer to inflation from when you bought the bond, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.  Call risk refers to instances where some companies have the option to redeem your bonds in the future at an agreed upon price.  This is normally done only when interest rates fall. Prepayment risk is a more specialized case of call risk and refers to people paying their mortgages (or credit cards, home equity loans, student loans, etc.) back sooner than expected.  Most people group these two risks into a category called reinvestment risk.  Think about the concept in this manner:  many people refinanced their mortgages because interest rates went down.  They did so because they could lower their total mortgage payment.  Well, companies do the same thing if they have the option.  Companies can redeem bonds at higher interests and issue new bonds at lower interest rates.  Chances are that, if you are the owner of the redeemed bonds, you will be unable to find as high of an interest payment currently if you want to buy a bond with similar characteristics of the company issuing the bonds you own before.The other three risks I mentioned above are less commonly discussed and not quite as important.  Exchange-rate risk exists because sometimes a company issues bonds in a currency other than its own.  For example, you will sometimes hear the terms Yankee bonds or Samurai bonds.  Since the company is paying you interest and principal in a foreign currency that money may be worth more or less depending on what happens in foreign exchange markets in the future.  Liquidity risk refers to the phenomenon that there are certain crisis times in the market where very few, if any bond market participants, are willing to buy the bonds you are trying to sell.  Therefore, you might have to take a bigger loss in order to entice someone to buy the bonds given the current macro environment.  Basis risk is a more obtuse type of risk that institutions deal with.  Basis risk essentially refers to anytime when interest rates on your bond are pegged to another interest rate that is different but normally behaves in a certain way (referred to as correlation).  Now most of the time, the behavior will follow the historical pattern.  However, during times of stress like a liquidity and/or credit crisis, the correlations tend to break down.  Meaning you can think you are “hedged” but, if the historical relationship does not hold up, your end return will be nothing like what you had expected.  These two risks are not something that individual investors need to focus on for the most part, since these types of bonds are not normally owned by them.I will admit that this list is quite lengthy and, quite possibly, a bit too detailed and/or complicated.  However, I wanted to lay them all out for you.  Why?  When you hear Financial Advisors recommend that you sell a large portion of your bonds, and/or hear the same investment advice from the financial media, they normally are really only referring to interest-rate risk primarily and secondarily inflation risk as well.  As you can see from the description above, the bond market is far more complex than that to make a blanket statement.Now, as I usually say, I would never advise individual investors to take a certain course of action in terms of selecting specific bonds or not selling bonds to move into more stocks.  However, I am saying that you should feel comfortable enough to ask your Financial Advisor why he/she recommends that you sell a portion of your bonds.  If the answer relates only to interest-rate risk, I would probe the recommendation further.  You can explain that you know that is the case for Treasury notes/bonds, municipal bonds, and corporate bonds.  However, there are a whole host of other fixed income securities with different characteristics and risks.  Now I am not referring solely to Mortgage Backed Securities (MBS), although the residential and commercial markets for these are in the trillions of dollars.  There are bonds and notes that have floating interest rates which means that as interest rates go up, the interest rate you receive on that security goes up.  Not to mention that different countries are experiencing different interest rate cycles than the US (stable or downward even).The complete list is too in-depth to cover in a single blog post.  My goal was to provide you with enough information to at least ask the question(s).  Your risk tolerance and financial goals might make a move from bonds to stocks the best course of action.  With that being said, you also have the option of selling bonds and keeping the money in cash or investing in the different types of bonds offered in the fixed income markets while keeping your total allocation to fixed income nearly the same.  Thinking holistically about your portfolio, you may be increasing the riskiness of your portfolio beyond your risk tolerance or more than you are aware unbeknownst to you by moving from bonds into stocks.  This is something you definitely want to avoid.    It can turn out to be a rude awakening and hard lesson to learn one or two years from now.

Four Important Lessons for Individual Investors from the Brexit Vote

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The vote by the United Kingdom (UK) to leave the European Union (EU) caught the majority of individual investors by surprise.  In fact, the so-called Brexit was not foreseen by many of the most sophisticated professional investors and money managers all around the world.  The election results sent shockwaves through the financial markets on the Friday and Monday following the Brexit vote.  The most notable effect was the devaluation of the pound to its lowest level since 1985.  Over the course of Tuesday through Friday, the US and European stock markets gained back nearly all their losses from the two days after the Brexit vote.  This fast-moving volatility has left individual investors feeling confused, frustrated, bewildered, and a bit scared.  However, the Brexit vote results offer individual investors a unique set of key lessons to learn and understand.

The four important lessons for individual investors from the Brexit vote are as follows:

  • 1)  There are very few seminal events in financial market history that affect the future path of stocks, bonds, and other assets.

 

The difficult thing to realize about the financial markets is that there are very few consequential events that make an inflection point or major change in the direction of the financial markets.  Even more frustrating than that, these consequential events are only known with the benefit of hindsight.  In other words, what seems like a monumental event today may or may not be considered one of those major events.  Given the fact that there are so few, there is a high probability that the seemingly major events of today will not fall into the seminal event category of financial market history.

What are some of the seminal events in financial market history?  Here is a list of some of the seminal events in chronological order:  the stock market crash in October 1987, the bursting of the bond bubble in 1994, the Asian contagion of 1997-1998, the bursting of the Internet bubble in March 2000, and the Great Recession of the financial crisis starting in September 2008.  There are many more examples previous to 1987, but these are events from recent financial market history that many individual investors will remember.  Keep in mind that in between all of these events are a string of other major events that turned out to be minor blips that caused only fleeting financial market volatility or none at all.

Furthermore, these seminal events are confusing to financial market participants in and of themselves.  For example, let’s take a closer look at the stock market crash of October 1987.  The US stock market dropped over 20% in one day, and things looked very dire.  If an individual investor with a portfolio of $100,000 had sold his/her stock mutual funds (primary investment vehicle used by individuals on the day of the crash, he/she would have a portfolio worth $80,000 approximately.  That type of individual investor was likely to be very fearful and stay out the of stock market for the remainder of 1987.  If an individual investor with a similar portfolio of $100,000 had keep his/her money in stocks on the day of the crash and for the rest of 1987, he/she would actually have roughly $102,000 at the end of 1987.  Why?  Well, there are not too many investors these days that remember how 1987 really turned out for the US stock market.  The S&P 500 index ended up about 2% for the year, so US stocks recovered all of the losses from the crash and a bit more.  Here’s a little fun exercise:  Ask your Financial Advisor or Financial Planner what the return of stocks was in 1987.  The vast majority will assume it was a horrible down year for performance returns.

Another excellent example is the bursting of the Internet bubble in March 2000.  The reason it is so interesting is that individual (and even professional) investors forget the history.  Alan Greenspan, the Chairman of the Federal Reserve during that time period, gave a famous speech where he coined the term, “irrational exuberance”.  Greenspan warned investors that the Internet and technology stocks were getting to valuations that were way out of line with historical norms for valuation of stocks.  What do individual investors forget?  Well, that famous speech was actually given in December 1996.  Yes, that is correct.  Greenspan warned of the Internet bubble, but it took nearly 3 ½ years before financial markets took a nosedive.  The main point here is that smart, rationale professional money managers and economists can know that financial market valuations are out of whack in terms of valuation at any given point in time.  (Note that this can also be stock market valuations that are too low).  However, these conditions can persist for far longer than anyone can imagine.  That is why individual investors should not be so quick to sell (or buy) major portions of their portfolio of stocks and bonds when these predictions or observations are make.

For a more in depth look at this concept, you can refer to a blog post I wrote three years ago on this very subject.  The link to that blog post is as follows:

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

  • 2)  Investors focus on valuations (no emotions) while traders and speculators focus on market sentiment (emotions) and valuation (no emotions).

The majority of professionals who talk to individual investors and provide advice will explain how important it is to keep emotions out of the equation when dealing with elevated market volatility.  When the financial markets are bouncing up and down by large amounts in the short term, it can be very difficult to keep a cool head and resist the urge to buy or sell stocks, bonds, or other assets.  The frenetic pace of market movements makes it seems as though an individual investor needs to do something, anything in response.  The standard advice is to keep one’s emotions in check focus on the long term, and stick to the financial plan.  What is usually missing from that advice is a more complete explanation why.

There are two general types of financial market participants:  investors and traders/speculators.  These two groups have vastly different goals and approaches to the financial markets.  Investors are focused on investing in stocks, bonds, and other assets in order to obtain returns over time from their investments.  The long term might be defined as five years.  Thus, day-to-day fluctuations in the financial markets mean very little to them.  On the flipside, traders/speculators are focused on making gains in stocks, bonds, and other assets in the short term in order to obtain returns.  The short term for this group might be hourly, the medium term might be daily, and the long term might be weekly.  With this particular group, they need to determine both the likely direction of the financial markets due to both market sentiment and valuation.

As you might imagine, the traders/speculators have to analyze emotions or the psychology of financial market participants.  Gauging market sentiment (general short term positioning of traders/speculators in stocks, bonds, and other assets in terms of their trend to buy or sell) is all about emotions.  Additionally, they must be able to combine that with proper valuations for stocks, bonds, and other assets.  Essentially they need to be correct twice.  On the other hand, investors are focused on the long term which corresponds to valuation.  Valuation over the long term is not driven by emotions.  There is a very famous saying by Ben Graham who taught one of the most well-known investors of all time, Warren Buffett.  Graham said, “In the short term the market is a voting machine, in the long term the market is a weighing machine.”  The takeaway from Graham’s quotation is that market sentiment (i.e. emotions) can drive the financial markets wildly over the short term.  However, after a period of years, financial markets always seem to follow the path back to what their true valuations are.  Since emotions are not part of that equation, individual investors should feel more comfortable ignoring or at least subduing their emotions whenever the financial markets exhibit high levels of volatility.

A related part of the story is the financial media (both TV and print) almost always provide information for traders/speculators.  To be perfectly honest, the financial media would not have much to talk about if long-term investing was the topic.  Essentially they would recommend analyzing one’s risk tolerance, define one’s financial goals, and then build a portfolio of financial assets to reach those goals over the long term.  Yes, true investing is very boring actually.  The financial media needs to have something more “exciting” to talk about in order to have viewers (readers) and the corresponding advertising dollars that come from that.  Therefore, the stories and article appearing in the financial media are geared toward traders/speculators.  Now if you are an investor, you can either ignore this bombardment of information or take it with the proverbial “grain of salt”.  Thus, you can keep your emotions in check when all the traders/speculators are wondering how to react to the market volatility right now each and every trading day or week.

For a more in depth discussion of managing one’s emotions as it relates to investors, you can refer to one of my older blog posts.  The link to that blog post is as follows:

https://latticeworkwealth.com/2015/06/11/two-steps-to-help-individual-investors-become-more-successful-at-investing/

  • 3)  The benefit of diversification can disappear or be reduced greatly whenever there are periods are elevated volatility.

The benefit of diversification is one of the hallmarks of the proper construction of an investment portfolio for individual investors.  The basic premise (which has been proven over very long periods of time) is that investing in different asset classes (e.g. stocks, bonds, real estate, precious metals, etc.) reduces the volatility in the value of an investment portfolio.  A closer look at diversification is necessary before relating the discussion back to the Brexit vote.  The benefit of diversification stems from correlations between asset classes.  What is correlation?  To keep things simple, a correlation of 1 means that two different assets are perfectly correlated.  So a correlation of 1 means that when one asset goes up, the other asset goes up too.  A correlation of -1 means that two assets are negatively correlated.  So a correlation of -1 means that when one asset goes up, the other asset goes down (exactly the opposite).  A correlation of 0 means that the two assets are not correlated at all.  So a correlation of 0 means that when one asset goes up, the other asset might go up, go down, or stay the same.  Having an investment portfolio that is properly diversified means that the investments in that portfolio have a combination of assets that have an array of correlations which dampens volatility.  Essentially the positively correlated assets can be balanced out by the negatively correlated assets over time which reduces the volatility of the balance in one’s brokerage statement or 401(k) plan.

What does all this correlation stuff have to do with the Brexit vote?  Surprisingly, it has quite a bit to do with the Brexit vote.  Note that this discussion also applies to any situation/event that causes the financial markets to exhibit high levels of volatility.  During extreme volatility like investors witnessed after the Brexit vote, the correlations of most asset classes started to increase to 1.  Unfortunately for individual investors, that meant that diversification broke down in the short term.  Most all domestic and international stock markets went down dramatically over the course of the two trading days following the Brexit vote.  Therefore, individuals who had their stock investments allocated to various different domestic and international stocks or value and growth stocks all lost money.  When correlations converge upon 1 during extreme market shocks, there is really nowhere to “hide” over the short term.  In fact, the only two asset classes that did very well during this period were gold and government bonds.

What is the key takeaway for individual investors?  Individual investors need to realize that there is an enormous benefit to having a diversified portfolio.  However, diversification is associated with investing over the long term and thereby harnessing its benefit.  There are times of market stress, like the Brexit vote and aftermath, where diversification will not be present or helpful.  When those times come around, individual investors need to keep emotions out of the picture and stick to their long-term financial plans and investment portfolios.

  • 4)  The surprise Brexit vote provides the perfect opportunity for individual investors to evaluate their risk tolerances for exposure to various risky assets.

The two trading days after the surprise vote by the UK to leave the EU (Brexit) were very volatile and very tough to keep emotionally calm.  Individual investors were faced with a very unusual situation, and the urge to sell many, if not all of their investments was very real.  That reaction is perfectly understandable.  Now for the bad news, there will be another time when volatility is as great as or larger than the volatility that the Brexit vote just caused.  In fact, there will be many such periods over the coming years and decades for individual investors.  In spite of that bad news, the Brexit vote should be looked at as a learning experience and opportunity.  Since individual investors know that there will be another period of elevated volatility, they can revisit their personal risk tolerances.

It is extremely difficult to try to determine or capture one’s risk tolerance for downturns in the financial markets in the abstract or through hypothetical situations.  You or with the assistance of your financial professional normally asks the question of whether or not you would likely sell all of your stocks if the market went down 10%, 15%, 20%, or more.  How does an individual investor answer that question?  What is the right answer?  There is no right or wrong answer to that type of question.  Each individual investor is unique and has his/her own risk tolerance for fluctuations in his/her investment portfolio.  A better way to answer the question is to convert those percentages to actual dollar amounts.  For example, if an individual investor starts with $100,000, would he/she be okay with the investment portfolio decreasing to $90,000, $85,000, or $80,000 over the short term.  Note that the aforementioned dollar amounts sync up with the 10%, 15%, and 20% declines illustrated previously.

The opportunity from the Brexit vote is that individual investors have concrete examples of the volatility experienced in their investment portfolios.  It is far easier to analyze and determine one’s risk tolerance by looking at actual periods of market stress.  Depending on your stock investments, the total two-day losses might have been anywhere between 5% to 10%.  Let’s use a 10% decline for purposes of relating this actual volatility to one’s risk tolerance.  If an individual investor was invested 100% in stocks prior to the Brexit vote, he/she would have lost 10% in this scenario.  Let’s use hypothetical dollar amounts:  if the starting investment portfolio was $100,000, the ending investment portfolio was $90,000.  Now the vast majority of individuals do not have all of their money invested in stocks.  So let’s modify the example above to an individual investor who has 50% in stocks and 50% in cash.  In that particular scenario, the individual investor has $50,000 invested in stocks and $50,000 invested in cash.  If stocks go down by 10%, this individual investor will have an ending investment portfolio of $95,000.  Why?  The individual investor only losses 10% on $50,000 which is $5,000 not the full $10,000 loss experienced by the individual investor with a hypothetical portfolio of 100% in stocks.

The importance of the illustrations above and its relation to the Brexit vote is that one can quickly calculate the actual losses from a market decline with a good degree of accuracy.  So let’s say that you had 60% of your money invested in stocks prior to the Brexit vote.  If the overall stock market declines by 10%, your stock investments will only decline by 6% (60% * 10%) assuming the other 40% of your investment portfolio remained unchanged.  So let’s put this all together now.  If you look back at the stock market volatility caused by the Brexit vote, you need to adjust the overall stock market decline by the percentage amount you have invested in stocks.  That adjusted percentage loss will be close to the decline in your overall investment portfolio.  Now whatever that adjusted percentage amount is, ask yourself if you are comfortable with that percentage loss over the short term.  Or is that way too risky?  If the adjusted percentage is way too risky for you and makes you uncomfortable, that is perfectly fine.  The important piece of knowledge to learn is that you need to work with your financial professional or reexamine your investment portfolio yourself to reduce your exposure to stocks such that the adjusted percentage loss is reasonable for you to withstand.  Why?  Because there will be another market volatility event on the order of magnitude of the Brexit aftermath or even worse.

Keep in mind that I am not making a financial market prediction over the short term.  The important point is that the history of financial markets has shown that periods of elevated market volatility (i.e. lots of fluctuations up and down) keep occurring over time.  The Brexit vote provides a real-life example to determine if your risk tolerance is actually lower than you first imagined.  The next cause of market volatility may be a known market event similar to how the UK vote to leave the EU was.  The harder things to deal with are market volatility stemming from the unknown and unforeseeable.  These market volatility events are called “black swans” which is the term coined by Nassim Taleb in his book by the same name several years back.  A “black swan” can be a positive event for the market or a negative event for the market.  As it relates to individual investors and risk tolerance, the negative “black swan” is applicable.  Now the term “black swan” is improperly used today by many investment professionals.  A “black swan” is an event that by definition is unknown and cannot be predicted.  When it does occur though, there is a period of extreme market volatility afterward.  Thus, you can adjust your risk tolerance to be better prepared for future events that will cause market volatility, either known events like the Brexit vote or unforeseen events.  The Brexit vote aftermath should be embraced by individual investors as a golden opportunity to ensure that they are properly (or more precisely) measuring their risk tolerances.

Summary of Important Lessons for Individual Investor from the Brexit Vote:

  1.  There are very few monumental financial market events that should cause individual investors to feel inclined to immediately change their investment portfolios. Plus, they can only truly be identified by hindsight;
  2. Investors should focus on valuation of financial assets (no emotions here), traders/speculators worry about market sentiment (emotions) and valuation (no emotions here);
  3. The benefit of diversification can disappear or be greatly reduced during periods of extreme market volatility and financial market stress over the short term;
  4. The surprise Brexit vote offers individual investors a valuable opportunity to see if their risk tolerances are aligned with the possibilities of short-term market declines.  This real-life event can be used to redefine one’s risk tolerance to better withstand similar periods of market volatility that will inevitably occur in the future.

Are Stocks Currently Overvalued, Undervalued, or Fairly Valued? Answer: Yes.

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Confusing and frustrating as it may be, the answer about the current valuation of stocks will always be different depending on who you ask. Various economists, mutual fund portfolio managers, research analysts, financial news print and TV personalities, and other parties seem to disagree on this very important question.  Financial professionals will offer a wide range of financial and economic statistics in support of these opinions on the current valuation of stocks.  One of the most often cited statistics in support of a person’s opinion is the P/E ratio of the stock market at any given point in time.   Many financial professionals use it as one of the easiest numbers to be able to formulate a viewpoint on stock valuation.  However, when it comes to any statistic, one must always be skeptical in terms of both the way the number is calculated and its predictive value.  Any time one number is used to describe the financial markets one must always be leery.  A closer examination of the P/E ratio is necessary to show why its usage alone is a poor way to make a judgement in regard to the proper valuation of stocks.

The P/E ratio is short for Price/Earnings ratio. The value is calculated by taking the current stock price divided by the annual earnings of the company.  When it is applied to an entire stock market index like the S&P 500 index, the value is calculated by taking the current value of the index divided by the sum of the annual earnings of the 500 companies included in the index.  One of the very important things to be aware of is that the denominator of the equation may actually be different depending on who is using the P/E ratio.  Some people will refer to the P/E ratio in terms of the last reported annual earnings for the company (index).  Other people will refer to the P/E ratio in terms of the expected earnings for the company (index) over the next year.  In this particular case, the P/E ratio is referred to as the Forward P/E ratio.  Both ratios have a purpose.  The traditional P/E ratio measures the reported accounting earnings of the firm (index).  It is a known value.  The Forward P/E ratio measures the profits that the firm (index) will create in the future.  However, the future profits are only a forecast.  Many analysts prefer to use the Forward P/E ratio because the value of any firm (or index of companies) is determined by its future ability to generate profits for its owners.  The historical earnings are of lesser significance.

The P/E ratio is essentially a measure of how much investors value $1 worth of earnings and what they are willing to pay for it. For example, a firm might have a P/E ratio of 10, 20, 45, or even 100.  In the case of a firm that is losing money, the P/E ratio does not apply.  In general, investors are willing to pay more per each $1 in earnings if the company has the potential to grow a great deal in the future.  Examples of this would be companies like Amazon (Ticker Symbol:  AMZN) or Netflix (Ticker Symbol:  NFLX) that have P/E ratios well over 100.  Some companies are further along in their life cycle and offer less growth opportunities and tend to have lower P/E ratios.  Examples of this would be General Motors or IBM that have P/E ratios in the single digits or low teens, respectively.  Investors tend to pay more for companies that offer the promise of future growth than for companies that are in mature or declining industries.

When it comes to the entire stock market, the P/E ratio applied to a stock market index (such as the S&P 500 index) measures how much investors are willing to pay for the earnings of all the companies in that particular index. For purposes of discussion and illustration, I will refer to the S&P 500 index while discussing the P/E ratio.  The average P/E ratio for the S&P 500 index over the last 40 years (1966-2015) was 18.77.  When delivering an opinion on the valuation of the S&P 500 index, many financial professionals will cite this number and state that stocks are overvalued (undervalued) if the current P/E ratio of the S&P 500 index is above (below) that historical average.  If the current P/E ratio of the S&P 500 index is roughly in line with that historical average, the term fairly valued will usually be used in relation to stocks.  The rationale is that stocks are only worth what their earnings/profits are over time.  There is evidence that the stock market can become far too highly priced (as in March 2000 or December 2007) or far too lowly priced (as in 1982) based upon the P/E ratio observed at that time.  Unfortunately, the relative correlation between looking at the difference between the current P/E ratio of the stock market and the historical P/E ratio does not work perfectly.  In fact, it is only under very extreme circumstances and with perfect hindsight that investors can see that stocks were overvalued or undervalued in relation to the P/E ratio at that time.

Here are the historical P/E ratios for the S&P 500 index from 1966-2015 as measured by the P/E ratio at the end of the year. Additionally, the annual return of the S&P index for that year is also shown.

Year P/E Ratio Annual Return
2015 22.17 1.30%
2014 20.02 13.81%
2013 18.15 32.43%
2012 17.03 15.88%
2011 14.87 2.07%
2010 16.30 14.87%
2009 20.70 27.11%
2008 70.91 -37.22%
2007 21.46 5.46%
2006 17.36 15.74%
2005 18.07 4.79%
2004 19.99 10.82%
2003 22.73 28.72%
2002 31.43 -22.27%
2001 46.17 -11.98%
2000 27.55 -9.11%
1999 29.04 21.11%
1998 32.92 28.73%
1997 24.29 33.67%
1996 19.53 23.06%
1995 18.08 38.02%
1994 14.89 1.19%
1993 21.34 10.17%
1992 22.50 7.60%
1991 25.93 30.95%
1990 15.35 -3.42%
1989 15.13 32.00%
1988 11.82 16.64%
1987 14.03 5.69%
1986 18.01 19.06%
1985 14.28 32.24%
1984 10.36 5.96%
1983 11.52 23.13%
1982 11.48 21.22%
1981 7.73 -5.33%
1980 9.02 32.76%
1979 7.39 18.69%
1978 7.88 6.41%
1977 8.28 -7.78%
1976 10.41 24.20%
1975 11.83 38.46%
1974 8.30 -26.95%
1973 11.68 -15.03%
1972 18.08 19.15%
1971 18.00 14.54%
1970 18.12 3.60%
1969 15.76 -8.63%
1968 17.65 11.03%
1967 17.70 24.45%
1966 15.30 -10.36%

Average             18.77

The P/E ratio for the S&P 500 index has varied widely from the single digits to values of 40 or above. The important thing to observe is that very high P/E ratios are not always followed by low or negative returns, nor are very low P/E ratios followed by very high returns.  In terms of a baseline, the S&P 500 index returned approximately 9.5% over this 40-year period.  As is immediately evident, the returns of stocks are quite varied which is what one would expect given the fact that stocks are known as assets that exhibit volatility (meaning that they fluctuate a lot because the future is never known with certainty).  Thus, whenever a financial professional says that stocks are overvalued, undervalued, or fairly valued at any given point in time, that statement has very little significance.  Whenever only one data point is utilized to give a forecast about the future direction of stocks, an individual investor needs to be extremely skeptical of that statement.  The P/E ratio does hold a very important key for the future returns of stocks but only over long periods of time and certainly not over a short timeframe like a month, quarter, or even a year.

An improvement on the P/E ratio was developed by Dr. Robert J. Shiller, the Nobel Prize winner in Economics and current professor of Economics at Yale University. The P/E ratio that Dr. Shiller developed is referred to as the Shiller P/E ratio or the CAPE (Cyclically Adjusted Price Earnings) P/E ratio.  This P/E ratio takes the current value of a stock or stock index and divides it by the average earnings of a firm or index components for a period of 10 years and also takes into account the level of inflation over that period.  The general idea is that the long-term earnings of a firm or index determine its relative valuation.  Thus, it does a far better job of measuring whether or not the stock market is fairly valued or not at any given point in time.  However, another very important piece of the puzzle has to do with interest rates.  Investors are generally willing to pay more for stocks when interest rates are low than when interest rates are high.  Why?  If it is assumed that the future earnings stream of the company remains the same, an investor would be willing to take more risk and invest in stocks over the safety of bonds.  A quick example from everyday life is instructive.  Imagine that your friend wants to borrow $500 for one year.  How much interest will you charge your friend on the loan?  Let’s say you want to earn 5% more than what you could earn by simply buying US Treasury Bills for one year.  A one-year US Treasury Bill is risk free and, as of May 10, 2016 yields interest of 0.50%.  Therefore, you might charge your friend 5.5% on the loan.  Now back in the early 1980’s, one-year US Treasury Bills (and even savings accounts at banks) were 10% or higher.  If you were to have provided the loan to your friend then, you would not charge 5.5% because you could simply deposit the $500 in the bank.  You might charge your friend 15.5% on the loan assuming that the relative risk of your friend not paying you back is the same in both time periods.  It is very similar when it comes to investing in stocks.  Due to the fact that stocks are volatile and future profits are unknown, investors tend to prefer bonds over stocks as interest rates rise.  This phenomenon causes the value of stocks to fall.  Conversely, as interest rates fall, the preference for bonds decreases and investors will choose stocks more and prices go up.  Now this assumes that the future earnings of the company or index constituents stay the same in either scenario.

With that information in mind, a better way to gauge the relative valuation of stocks in terms of being overvalued, undervalued, or fairly valued, would be to look at the Shiller P/E ratio in combination with interest rates. It is most common for investors to utilize the 10-year US Treasury note as a proxy for interest rates.  Here are the historical values for the Shiller P/E ratio and the 10-year US Treasury note over the same 40-year period (1966-2015) as before:

Year CAPE Ratio 10-Year Yield
2015 24.21 2.27%
2014 26.49 2.17%
2013 24.86 3.04%
2012 21.90 1.78%
2011 21.21 1.89%
2010 22.98 3.30%
2009 20.53 3.85%
2008 15.17 2.25%
2007 24.02 4.04%
2006 27.21 4.71%
2005 26.47 4.39%
2004 26.59 4.24%
2003 27.66 4.27%
2002 22.90 3.83%
2001 30.28 5.07%
2000 36.98 5.12%
1999 43.77 6.45%
1998 40.57 4.65%
1997 32.86 5.75%
1996 28.33 6.43%
1995 24.76 5.58%
1994 20.22 7.84%
1993 21.41 5.83%
1992 20.32 6.70%
1991 19.77 6.71%
1990 15.61 8.08%
1989 17.05 7.93%
1988 15.09 9.14%
1987 13.90 8.83%
1986 14.92 7.23%
1985 11.72 9.00%
1984 10.00 11.55%
1983 9.89 11.82%
1982 8.76 10.36%
1981 7.39 13.98%
1980 9.26 12.43%
1979 8.85 10.33%
1978 9.26 9.15%
1977 9.24 7.78%
1976 11.44 6.81%
1975 11.19 7.76%
1974 8.92 7.40%
1973 13.53 6.90%
1972 18.71 6.41%
1971 17.26 5.89%
1970 16.46 6.50%
1969 17.09 7.88%
1968 21.19 6.16%
1967 21.51 5.70%
1966 20.43 4.64%

Average                19.80                          6.44%

These two data points provide a much better gauge of whether or not stocks are currently overvalued or undervalued. For example, take a look at the Shiller P/E ratio in the late 1970’s and early 1980’s.  The value of the Shiller ratio is in the single digits during this time period because interest rates were higher than 10%.  Lately interest rates have been right around 2.0%-2.5% for the past several years.  Therefore, one would expect that the Shiller P/E ratio would be higher.  Now the historical average for the Shiller P/E ratio was 19.80 over this period.  The Shiller P/E ratio was in the neighborhood of 40 during 1998-2000 which preceded the bursting of the Internet Bubble in March 2000.  The Shiller P/E ratio was at its two lowest levels of 7 and 8 in 1981 and 1982, respectively which is when the great bull market began.  However, while this Shiller P/E and interest rates are better than simply the traditional P/E ratio, there are flaws.  The Shiller P/E in 2007 was 24.02 right (and interest rates were around 4.0% which is on the low side historically) before the huge market drop of the Great Recession between September 2008 and March 2009.  In fact, the S&P 500 index was down over 37% in 2008, and the Shiller P/E did not provide an imminent warning of any such severe downturn.  Therefore, even looking at these two measures is imperfect but better than the normal P/E ratio in isolation.

To summarize the discussion, individual investors will always be told on a daily basis by various sources that the stock market is currently overvalued, undervalued, and fairly valued at the same time. One of the most commonly used rationales is a reference to the current P/E ratio in relation to the historical P/E ratio.  As we have seen, this one data point is a very poor indicator of the future direction and relative value of stocks at any given period of time, especially for short periods of time (one year or less).  The commentary and opinions provided by financial “experts” to individual investors when the P/E ratio is mentioned normally relates to the short term.  By looking back at the historical data, it is clear that this one data point is really only relevant over very long periods of time.  The Shiller P/E ratio in combination with current interest rates is a great improvement over the traditional P/E ratio, but it is even imperfect when it comes to forecasting the future returns of the stock market.  There are two general rules for individual investors to take away from this discussion.  Whenever a comment is made about the current value of stocks and only one statistic is provided, the opinion should be taken with a “grain of salt” and weighed only as one piece of information in determining investment decisions that individual investors may or may not make.  Additionally, and equally as important, if a financial professional cites a statistic about stock valuation that you do not understand (even after doing some research of your own), you should always discard that opinion in most every case.  Individual investors should not make major investment decisions in terms of altering large portions of their investment portfolios of stocks, bonds, and other financial assets utilizing information that they do not understand.  It sounds like common sense, but, in the sometimes irrational world of investing, this occurrence is far more common than you imagine.