Category Archives: asset allocation

Breakthrough Drugs, Statistics, and Anecdotes: Three Things Every Individual Investor Needs to Know – Statistics and Time Series Data – Part 2 of 3

20 Wednesday Nov 2019

Posted by in asset allocation, correlation, correlation coefficient, finance theory, financial advice, Financial Media, Financial News, financial services industry, historical returns, Individual Investing, individual investors, investing, investing advice, investing tips, risks of stocks, standard deviation, stock market, Stock Market Returns, time series, time series data

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The first article of this three-part series covered the broad strokes of this issues to be aware of in terms of all the “data” and “relationships” that get thrown around by the financial media (print and television).  Most of the discussion uses data points that are not statistically significant to draw any sort of conclusion.  In fact, time series data is notoriously hard to model and predict the future.  Additionally, the specific time series data of stock market returns is even more difficult.

You can refer to the link below to examine the content of the first article:

https://latticeworkwealth.com/2019/11/11/breakthrough-drugs-statistics-and-anecdotes-investing/

The task at hand for the second article is to put some “meat on the bones” of the discussion.  I realize that anything to do with math and statistics is not easy for everyone (or of interest either).  Therefore, I will be writing a supplemental article that covers the mathematics and statistics in more detail.  The goal here is to be able to identify some of the more common errors that you will encounter.

The first item to talk about is any sort of data that has a substantial trend component.  In layman’s terms, there is a data series where the line graph goes up or down in more of a straight-line manner.  You can think of the Gross Domestic Product (GDP) of the United States here.  Every year the GDP figures will generally go up unless there is a recession.  But, even after the recession passes, the trend for GDP will resume upward.  So, where does the problem come in?

I am going to give a contrived example to illustrate why it is dangerous to compare two series that are trending.  The example will consist of two different equations which are trends.  Both have the same trend component and an error term (we will call that eta).  The variables will be exactly the opposite.  More specifically, the two equations we will use are the following:

Trend_1 = Time + 100 + 0.9 * x + eta

Trend_2 = Time +100 – 0.9 * x + eta

Now the x values and eta values were simply generated by selected variables at random between 0 and 1.  The eta values were also selected at random between 0 and 1.  You can think of eta as representing the general “noise” that occurs on a daily basis when observing stock prices in the financial markets.  So, let’s graph the first 100 observations for these two equations:

Trend_Graph_Statistics_Revised

You will notice that the trend component dominates the line graphs.  However, we know by construction that the two equations which produce trend_1 and trend_2 are fundamentally different.  Now the correlation coefficient between those two equations is 0.9984.  A correlation coefficient of 1 means that the two lines move in lockstep.  Why is this important?  Why is it very dangerous?

Well, financial pundits will talk about these types of graphs all the time.  It looks like there is some relationship, but we know there is very little relationship between the two trends.  In fact, we can look at these equations by subtracting the current value from the previous value to see what changes.   Formally, this topic is called first differencing.  It will allow us to see more clearly what we already know.  Here is the graph:

First_Difference_Graph_Statistics_Revised

Now we have a totally different picture.  We can see that at many times the two trend equations are moving in exactly the opposite direction.  In fact, the correlation coefficient for the first-differenced equations is 0.2675.  There is only a slight positive relationship between the two trends.

In the example above, we can see that looking at the two trends is very deceiving.  Remember that I added the eta term to represent “noise” that is always present in financial market data.  So, anytime someone talks to you about the comparison of two trends, you should be very skeptical.  You always want to see first-differenced data or at least a comparison of changes in some manner.  Otherwise, you will mistakenly assume that there is a strong positive or negative relationship between two time series.

The second example that I am going to use is stock market returns for the S&P 500 Index from 1966 through 2018.  Why start at 1966?  Well, the S&P 500 Index started with its current number of component stocks back in 1957, and I would like to show annual stock returns and also ten-year annualized returns.  This particular topic can get messy quite quickly, so I am not going to cover it in a lot of depth with statistical and mathematical jargon.  For those of you who are interested, I had mentioned that it will be contained in a forthcoming supplemental article.

A great many individuals in the financial markets talk about stock market returns in the same breath as the normal distribution.  What is the normal distribution?  It is the old bell curve that you are familiar with.  The normal distribution is symmetrical and tails off at the end as more and more data points are gathered.  Well, stock market returns are anything but strongly normal.

Let’s first take a look at one-year stock market returns for the S&P 500 Index.

One Year Returns - Histogram - Non Normal

A useful test to see if a particular distribution is normal is the Jarque-Bera test.  Now it is not necessary to know exactly what is being calculated.  However, you should refer to the bottom of the box that reads “Probability”.  The value of 0.179 is called a p-value.  A p-value less than or equal to 0.10 means that we can reject the hypothesis that the one-year distribution of stock returns is normal.  At a value of 0.179, we would not reject the hypothesis of normality for this distribution.  However, the p-value in our case is not large enough to be totally sure and confident. But what about looking at annualized stock market returns over ten-year periods?

We can look at a similar graph to check to see if stock market returns over longer timeframes are indeed akin to the normal distribution (i.e. the bell curve).  Here is the graph:

Ten Year Returns - Histogram - Non Normal

Looking at the same “Probability” value, we have 0.489.  Therefore, we cannot reject the hypothesis that these stock market returns follow a normal distribution. Looking at ten-year annualized stock market data tells us that we can use the normal distribution as an assumption for calculating statistics.

Now why does this matter?  Well, you will here over and over again statistics that apply only to the normal distribution in relationship to actual, observed stock market returns.  We have just seen that stock market returns over the short-term stock returns weakly follow the normal distribution. On the other hand, long-term stock returns are definitely normal. Now I will not get into the technicalities, but time series data is indeed asymptotically normal.  What?  Say again?

This is just a fancy way of saying that, as the number of data points (sample size) approaches infinitely, the time series will look like the normal distribution.  Pretty much all financial market and economic data have very few data points.  In fact, you usually need several hundred data points prior to making any assumptions and using the statistics related to the normal distribution (think standard deviation or correlation coefficients).

Thus, most of the banter in the financial media is just subjective notions of what is going on in the stock market and the economy. More often than not, an assertion by someone in the financial print or television media is more of an educated guess than based on a solid mathematical foundation. That fact explains why financial pundits hedge their statements. Like I say half-jokingly, “I see the stock market going up in the next several months, but of course it might not resume its uptrend or could even take a leg downward”.

Well yes, I guarantee you that every day stocks will go up, down, or remain unchanged. This type of daily commentary in the financial press about the short-term performance of stocks (or other financial assets) is just not helpful and can be downright distracting you from investing for your long-term financial goals.

I apologize for getting too detailed in certain parts of this article.  What are the key takeaways?  First, you should be extremely leery of drawing any conclusions from the comparison of two or more data series that are trending upward or downward.  Second, you need to have several hundred observations prior to invoking any reference to the normal distribution.  So, what is left after that?  As you might imagine, there are not too many comparisons or studies that pass the muster to give you insights on investing or actionable information to make changes to your investment portfolio.

Don’t focus on the mathematics or statistics.  All you need to remember are the two takeaways above.  And, first and foremost, you should always be skeptical whenever you are presented with comparisons and statistics related to the financial market or the economy as a whole.

Breakthrough Drugs, Statistics, and Anecdotes: Three Things Every Individual Investor Needs to Know – Part 1 of 3

11 Monday Nov 2019

Posted by in asset allocation, Education, financial advice, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, investing, investing advice, investing information, investing tips, investment advice, investments, math, personal finance, portfolio, S&P 500, S&P 500 Index, statistics, time series, time series data

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Although the title might appear to be random at first glance, I promise that there is an underlying theme.  This article is the first in a three-part series that will discuss how individual investors are bombarded with information about what happens in the financial market.  Most of the time you might hear that, 5 out of the last 7 times “x” happened, the S&P 500 index went up by 10% or more.  I will argue that most of these types of comments might be useful trivia for the television show, Jeopardy; however, they should not impact your long-term investment plan.

So, why did I use breakthrough drugs?  Prior to any drug coming to the marketplace, the FDA does a very thorough review of the test results to ensure that the drug is safe and also its efficacy is not overstated.  What if I told you that a pharmaceutical firm came up with a possible cure for lung cancer, and there were successful trials of 10 individuals.  Does that sound like a group too small to draw any conclusions?  Would you take a drug that the testing was only done on a handful of people?  Now the FDA would never allow such a thing, and there are tons of protocols and blind or double-blind randomized testing of many individuals.  It just sounds weird if only 10 people were tested, and there was also no control group (i.e. a separate group given a placebo).

While the drug example seems a bit outrageous and contrived, I bet you can think of similar examples in the daily financial press (e.g. financial television or print media).  Whenever you hear a small number of events happening that “tend to” lead to certain financial market outcomes, you should be extremely wary.  For instance, I just heard today that, after the Singles Day huge ecommerce sale by Alibaba, the stock (Ticker Symbol:  BABA) is up 80% of the time over the course of the next two weeks.  Well, when did Alibaba start Singles Day?  The first Singles Day sale was in 2009.  Therefore, we have 10 data points to work with (2009 to 2018).  Given the information I referred to above, the comment made today simply says that the stock has been up after two weeks 8 out of the last 10 years.  Now I will try to hold in my red flags and bit of ludicrous thoughts, this type of information is not informative at all.  There are just too few observations to draw any sort of valid conclusion.

Here is the plan of attack for the next two articles.  The second part of this discussion will focus on statistics.  Yes, I know this topic is not too much fun and can get complicated very quickly.  However, individual investors need to know a bit about statistics to recognize when a quantitative quote is totally useless.  We will not get too granular though, I promise.  Essentially most financial market data is time series data.  Different rules apply in that case, and these rules are broken all the time by even the most sophisticated professional investors and commentators.  The third part of this discussion will be an in-depth examination of an actual event that grounds my argument in recent events.  I will examine what is called the inversion of the yield curve and how it normally portends a recession for the U.S. economy.  Don’t worry; I am going to explain those terms when the third part of this series rolls around.

Please join me in a critical review of all the financial market and economic data you get bombarded with.  So much of it is just “noise” or simply interesting trivia at best.  Note that the interesting trivia cannot guide or inform your particular asset allocation of investments.  As always, if you have questions along the way, please feel free to comment on this or any other article.

Individual Investors Should Treat Obtaining Financial Advice Like Buying a New Car

29 Tuesday Oct 2019

Posted by in asset allocation, behavioral finance, Consumer Finance, financial advice, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial planning books, financial services industry, Income Taxes, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, personal finance, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, risk tolerance, stock market, Stock Market Returns, stock prices

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I had a long conversation with a friend and business associate about how I think individual investors approach obtaining financial advice.  We went back and forth for almost 30 minutes.  However, I found myself stumbling upon the analogy of purchasing a new vehicle.  This analogy encapsulates how individual investors might want to think about building their investment portfolios, setting financial goals and how to obtain them, establishing their risk tolerance, and addressing any special situations that might pertain to their specific situation (e.g. caring for an elderly parent in their house).  I should state at the outset that, if you have more than $1 million in investable assets (i.e. an accredited investor), the size of your portfolio demands special attention.  If you have not amassed $1 million, please read on to the rest of this article.

First, I would like to lay out the typical new vehicle purchase scenario and then turn to its applicability in the case of financial advice.  Most people start off the process by doing a good deal of research on the available options.  After considering his/her situation, the individual will go to the vehicle dealership.  For the purposes of this particular example, let’s suppose that the vehicle dealership offers a number of different car manufacturers as options and then the various models associated with them.  Luckily today, there is a lot less haggling (well at least upfront in the process) and the vehicles’ prices are normally right around the MSRP.  However, you as a consumer need to select the car make and also the specific model.

Usually a salesperson will assist you with the process.  Even though you can do a lot of homework prior to picking out a new vehicle, it still does not fully capture actually looking at the vehicle.  Of course, you also need to sit in it and take a test drive.  The salesperson is able to translate what your needs are to try to select the best option.  For example, do you need to transport the kids to basketball practice?  What if you take turns carpooling and pick up an extra 3-6 kids?  How big should your SUV be?  What if you drive a lot of highway miles and a lease option may not work for you?  Do you like to have a decent amount of horsepower to be able to merge onto highway traffic?  What about the manufacturer’s warranty?  Does the dealership service the vehicles onsite?  What about financing options (i.e. buy or lease)?  The list of questions could go on and on.

Given the entire list of questions you might ask, the salesperson is an integral part of the vehicle buying, or leasing, process.  After the salesperson has finally answered all of your questions, let’s say you decide on a price, the financing options, and the color/options/model.  If you make the purchase, the salesperson will earn a commission.  Once you leave the dealership’s parking lot, you are then responsible for the maintenance of the vehicle.  Fingers crossed, you should only need to take car of oil changes and normal maintenance (e.g. changing the air filter, flushing the transmission fluid, etc.).  What would you do if the salesperson came over to your house and wanted to check if you were still pleased with the vehicle you selected in the second year?  Does it fit your needs and perform as expected?  Wow, that experience would be one of pretty good customer services.  But now, the salesperson’s next utterance is that you own him/her $500.  What?  Well, he/she responds that he/she helped you out and things are going according to plan.  My guess is that you would be dumbfounded and refuse to pay another commission to the salesperson in year two of ownership.

What in the world does this have to do with financial advice?  I would argue that the analogy fits quite well with the normal way financial advice is given to individual investors.  When you first sit down with a Financial Planner, Financial Advisor, or Registered Investment Advisor, he or she really walks through your entire life situation.  Additionally, that person will assess your tolerance for risk which is not always as easy as it sounds.  Usually most financial professionals will include questions that relate to your behavior under certain instances of financial market conditions.  So, you cannot simply ask only objective yes/no questions.  Other big thing that may come up are any insurance, tax planning, or estate planning needs that you have.  Another significant area is trying to find out if you might have any special circumstances.  The caring of an elderly parent was provided above.  But there are myriad other situations that might require special planning considerations unique to your family.

The vast majority of financial professionals no longer charge commissions.  Rather, they will charge a fee based upon the total asset in your portfolio of stocks, bonds, other assets, and cash.  The financial services industry calls this an AUM (assets under management) fee in the jargon, and a very typical fee that one will see is 1%.  What does that mean?  Well, to use round numbers, let’s say you have $1 million dollars in your account of financial assets.  You would then pay a fee of $10,000 ($1 million * 1%).  To be technical though, the fee is normally prorated over four quarters throughout the year and not in one lump sum.  Given all the assistance that I listed in the previous paragraph, there is no doubt that the financial professional earns his or his AUM fee.  But what happens when year two of your financial relationship begins?

For illustrative purposes, I am going to assume that your life situation does not change at all.  In the first year of your relationship with the financial professional, he or she is likely to have prepared an asset allocation for at least the next five years.  One would expect a long-term investing plan.  Of course, he or she may recommend that based, upon the price movement in the financial markets, you should reallocate your investments to either the same target allocation in year one or slightly different percentages.  He or she may even recommend that you sell a particular investment and replace it with what he or she deems to be a better performing investment vehicle for the future.  Well, to keep using round numbers, if your investment portfolio stays constant, you would pay another $10,000 (again $1 million * 1%).

The year two situation is akin to car maintenance in year two of your ownership of that vehicle from my car vehicle purchase analogy.  Now, if you blew a head gasket in your car’s engine, you would want to take the vehicle back to the dealership or go to a trusted mechanic.  The latter represents a major change in your life situation, financial goals, income tax ramifications, and other major events.  Otherwise, we have a situation where you are paying the car salesperson another commission in year two.  Now my analogy may not be entirely “apples to apples” (as my business associate said during our discussion).  However, it is close enough to get to the point that I am trying to make in terms of financial advice.  You need to be very cautious with how much money you pay in expenses for financial advice.  Why?  It really eats into the investment performance returns you will realize.  I am all for paying for financial advice when there is a complicated situation, but, if nothing of import changes, it can be hard to justify.

So, what can you do if my analogy resonates with you?  Well, there are two options that I will provide.  However, there are other avenues to proceed down.  I will discuss each in turn.

First, you can select a financial professional that charges a fee-only amount or one that charges by the hour.  The fee-only financial professional will charge you a set amount per year for financial advice, and, in almost all cases, it is significantly lower than the $10,000 in our example.  The hourly financial professional is just as it sounds.  In the second year, you might require 10 hours of financial advice throughout the year, some of which might include just coaching you through the inevitable volatility in financial markets.  Depending on the area that you reside in, you can expect to pay anywhere between $250 to $500 per hour.  Using the 10-hour amount, you would be paying anywhere from $2,500 ($250 * 10 hours) and $5,000 ($500 * 10 hours).  Using either type of financial professional with a different fee structure will lower your overall investment fees.  Note that the quality of financial advice usually does not decrease in most cases.  And yes, there are certain cases where the quality will increase markedly.

Second, you can use an external investment account at the beginning of your relationship with a financial professional that charges a percentage of assets under management (AUM).  What does this mean?  The vast majority of asset managers are large and sophisticated enough to handle this arrangement at the outset.  For example, you would establish an investment account where your financial professional is located.  Next, you would establish an investment account with another brokerage firm and allow your financial professional to have access to the investment portfolio you maintain.  Note that the access is only for purposes of preparing reports for you and not to execute actual trades of stocks, bonds, mutual funds, or any other financial asset.  For instance, you might keep 50% with the financial professional’s firm and another 50% in the external account.  You would just maintain the portfolio allocation that your financial professional would like you to have in the external account.  In order to ensure that you do not deviate from his or her investment recommendations, your monthly or quarterly investment performance reports would lump together the assets at the financial professional’s firm and your external account.

In regard to the second option, just because asset managers can easily do this reporting for you, does not mean that they will not push back.  Some asset managers and financial professionals get even confrontational.  It is understandable since the more assets you maintain at their firm the larger the investment advice fee.  But this response can be very informative for you.  If your financial professional does not handle your request of this potential option diplomatically, this may be a cue to seek financial advice elsewhere.

So, have I successfully convinced you that buying investment advice is just like buying or leasing a new vehicle?  My guess would be that you think the analogy is not a perfect one.  I will readily admit that it is not and really is not meant to be.  Rather, I wanted to get you thinking about the financial advice you receive and investment fees from another viewpoint.  Investment fees have an outsized effect on the returns that you will experience over time.

Their impact is even greater if you take into account the “opportunity cost” of investment fees.  However, that is another topic entirely that I will not delve into.  If you would like more information on the idea of “opportunity cost” and investment fees, you can refer to a previous article that I wrote.  Here is the link:

https://latticeworkwealth.com/2014/02/26/what-is-the-800-pound-gorilla-in-the-room-for-retirees-it-is-12-5/

How to Become a Successful Long-Term Investor – Summary

30 Monday Sep 2019

Posted by in asset allocation, behavioral finance, correlation, correlation coefficient, Dot Com Bubble, Emotional Intelligence, EQ, financial advice, Financial Advisor, financial goals, financial markets, financial planning, financial services industry, historical returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, market timing, math, personal finance, portfolio, risk, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, standard deviation, statistics, Stock Market Returns, stock prices, stocks, volatility

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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

28 Saturday Sep 2019

Posted by in Alan Greenspan, asset allocation, Average Returns, behavioral finance, bubbles, correlation, correlation coefficient, Dot Com Bubble, finance, finance theory, financial goals, financial markets, Financial Media, Financial News, financial planning, Greenspan, historical returns, Individual Investing, individual investors, Internet Bubble, investing, investing advice, investing information, investing tips, investment advice, investments, Irrational Exuberance, market timing, math, personal finance, portfolio, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Valuation, volatility

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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

25 Wednesday Sep 2019

Posted by in asset allocation, behavioral finance, Consumer Finance, Education, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Geometric Returns, historical returns, Individual Investing, individual investors, investing, investing advice, investing tips, investment advice, investments, math, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, standard deviation, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, volatility

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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

23 Monday Sep 2019

Posted by in asset allocation, Average Returns, behavioral finance, finance, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, historical returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, personal finance, portfolio, risk, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, volatility

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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

18 Wednesday Sep 2019

Posted by in asset allocation, Average Returns, behavioral finance, bonds, Charlie Munger, confirmation bias, Consumer Finance, emerging markets, Fama, finance, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Geometric Returns, Individual Investing, individual investors, interest rates, Internet Bubble, investing, investing advice, investing, investments, stocks, bonds, asset allocation, portfolio, investment advice, investments, Markowitz, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, risk tolerance, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Uncategorized, Valuation, volatility, Warren Buffett

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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 Business Week magazine in 1979;
  • 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.

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

24 Sunday Jul 2016

Posted by in academics, asset allocation, bond basics, bond market, Bond Mathematics, Bond Risks, bonds, Fabozzi, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, financial planning, financial services industry, Fixed Income Mathematics, foreign currency, Frank Fabozzi, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investments, math, MBS, personal finance, rebalancing, rebalancing investment portfolio, rising interest rate environment, rising interest rates, risk, risks of bonds, Search for Yield, statistics, types of bonds, volatility, yield

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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.

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

10 Tuesday May 2016

Posted by in academia, academics, asset allocation, Average Returns, business, CAPE, CAPE P/E Ratio, Consumer Finance, Cyclically Adjusted Price Earnings Ratio, Education, finance, finance theory, financial advice, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Forward P/E Ratio, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investments, Nobel Prize, Nobel Prize in Economics, P/E Ratio, passive investing, personal finance, portfolio, risk, Robert Shiller, Schiller, Shiller P/E Ratio, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Valuation, volatility

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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.