Are Your Financial Advisor’s Fees Reasonable? A Unique Perspective – Retirees

14 Tuesday Jan 2020

Posted by wmosconi in asset allocation, Consumer Finance, Education, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial services industry, gross returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, Stock Market Returns

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I started off this examination with a brief introduction to this question. You can see that discussion by clicking on the following link:

https://latticeworkwealth.com/2020/01/13/are-your-financial-advisor-fees-reasonable-introduction/

As promised, I will start by using retirees as the individual investors. The hypothetical example is meant to get you thinking about the reasonableness of investing fees and how they affect you reaching your financial goals. Of course, I will discuss the same topic but using those individual investors who are saving for retirement. But now, let’s dive into our discussion of this topic by focusing on those individual investors already in retirement.

Example for Retirees:

If you are retired and not independently wealthy, you are in the wealth distribution phase of your life. There are some retirees that are permanently in the wealth preservation phase. Wealth preservation simply means that an investor has enough money to live comfortably, but he/she does not need to deplete his/her investment portfolio. Furthermore, this investor does not really try to increase the value of his or her investment portfolio. A retiree in the wealth distribution phase of life is the most common example. This investor is gradually depleting his/her investment portfolio to pay for living expenses on an annual basis.

Since this person is not working anymore, (thus has no income from work, and longevity keeps getting longer), he/she needs have an investment portfolio that is somewhat conservative in nature. Therefore, it is not reasonable to expect to earn 8.0% per year. A more common target return might be 5.5-6.0%. If you are working with a financial professional who charges you 1.0%, you need to earn 6.5-7.0% on a gross basis in order to get to that target net return. Now the long-term historical average of stocks is about 9.5%, so the higher your AUM fees are, the more weighting you will need to have in stocks and away from bonds and cash. Well, we have already gone over that, and most individuals that present information will stop there. I want to take this even further though.

Let’s say you are a current retiree with $1 million that you are living on an additional to Social Security income. You have a target return of 5.5% to fund your desired retirement lifestyle, and your Financial Advisor charges you a 1.0% AUM fee. Thus, you will need to earn a 6.5% return gross to reach your bogey. Now I would like to put in the twist, and I want to do a thought experiment with you. Your Financial Advisor will sit down with you and assess your risk tolerance and ensure that the investment recommendations made are not too aggressive for you. If you cannot take too much volatility (fluctuation in asset prices up and down over the short term), your financial professional will reduce your exposure to equities.

Now let’s look at our example through the lens of economic principles. If you just retired and are 65, you have one option right away. You can simply invest all your retirement money in 10-year Treasury notes issued by the Department of the Treasury. Treasury notes are free to buy. All you need to do is to participate in one of the Treasury auctions and put an indirect bid in. What is an indirect bid? An indirect bid is simply saying that you would like to buy a set dollar amount of notes, and you are willing to accept whatever the market interest rate set by the auction is. What is the yield on the 10-year Treasury Note right now? The 10-year Treasury closed at 1.85% on January 13, 2020. When you go to a financial professional, he/she is selecting investments in lieu of you simply purchasing the 10-year Treasury Note. Keep in mind that US Treasuries are among the safest investments in the world. They are backed by the full faith and credit of the US government. Stocks, bonds, real estate, gold, and other investment options all have an added degree of risk. With the additional risk, there is a possibility for higher returns though. How does this relate to your 1.0% AUM fee?

Think about it this way: why are you paying your Financial Advisor? You are paying him/her to select investments that can earn you more than simply buying a US Treasury Bill, Note, or Bond. As an investor, you do not want to just settle for that return in most cases. With that being said though, you can just start out there and forget it. You do not need to engage a Financial Advisor to simply buy a 10-year US Treasury note. This means that you are paying the Financial Advisor to get you incremental returns.

In our example above for a retiree, your target investment return is 5.5%. If you can earn 5.5% during the year, the incremental return is 3.65% (5.50%-1.85%). Remember that you are paying the Financial Advisor 1.0% in an AUM fee. Therefore, you are paying the Financial Advisor 1.0% of your assets in order to get you an extra 3.65% in investment returns. Well, 1.0% is 27.4% of 3.65%. Thus, you are essentially paying a fee of 27.4% in reality. Now your financial professional would flip if the information was presented in this way. He/she would say that it is flawed. The mathematics cannot be argued with; however, I will admit that many folks in the financial services industry would disagree with this type of presentation.

Remember that you started out with $1 million. You could have gone to the bank and gotten cash and hid it in a safe within your residence. AUM fees are always presented by using your investment portfolio as the denominator. In our example, your investment fee is 1.0% ($10,000 / $1,000,000). I urge you to think about this though. Does that really matter? Of course, the fee you pay to your Financial Advisor will be calculated in this manner. But what are you paying for in terms of incremental returns? If you want to calculate what you are paying for (the value that your Financial Advisor provides), the reference to the starting balance in your brokerage account is moot. It is yours to begin with. You have that money at any given time. Therefore, it should be removed from the equation when trying to quantify the value your Financial Advisor provides in terms of investment returns on your portfolio.

Now remember that I said your target investment return was 5.5%. The long-term historical average of stocks is approximately 9.5%. If you choose to simply allocate only enough of your investment portfolio in stocks and the rest in cash to reach that 5.5% target, you will select an allocation of 53.0% stocks and 47.0% cash (5.5% = 53.0% * 9.5% + 47.0% * 1.0%). Note that I am assuming that cash earns 1.0% and that you can select an ETF or index mutual fund to capture the long-term historical average for stocks. Now your financial professional is working with you to select an investment portfolio that achieves the 5.5% target return, and their investment recommendations will be different than this hypothetical allocation.

The hypothetical allocation achieves your target return with a simple choice of two assets (an ETF or index mutual fund and a money market). Keep in mind that you will normally have a portion of your portfolio allocated to fixed income. The 10-Year US Treasury note is trading around 1.85% as of January 13, 2020. If you allocate your portfolio to 60% stocks, 30% 10-Year Treasury Note, and 10% cash, your expected return would be 5.5% (5.5% = 49.0% * 9.5% + 41.0% * 1.85% + 10.0% * 1.0%).

Whatever your Financial Advisor is charging you in terms of fees, you need to make that percentage more in your total return on a gross basis such that your net return equals your target return. In our example above, the assumed AUM fee was 1.0%. That investment fee means that you must earn 6.5% on a gross basis because you need to pay your Financial Advisor 1.0% for his/her services. After the fee is paid, the return on your portfolio needs to be 5.5% on a net basis.

So, how much weighting do stocks need to be in your portfolio to ensure that your overall returns are 5.5% after paying your AUM fee? The answer is 62.5%. Why? The expected return of your portfolio is 6.5% (6.5% = 62.5% * 9.5% + 27.5% * 1.85% + 10.0% * 1.0%) before fees. Given the average retiree’s risk tolerance at age 65 or older, many individual investors do not desire to have a portfolio with 60.0% or larger allocated to stocks. The more salient observation is that the individual investor had to increase his/her stock allocation by 13.5% in order to pay the 1.0% AUM fee. This increased allocation to stocks significantly increases the risk of our hypothetical portfolio. And keep in mind that the historical, long-term average of stocks is just that. It is an average and rarely is 9.5% in any given year.

But what if we could find a Financial Advisor that only charges 0.5% AUM fee? How would that change our example above? So, we now need to earn a gross investment return of 6.0% rather than 6.5%. The new portfolio allocation is 55.0% * 9.5% + 35.0% * 1.85% + 10.0% * 1.0% = 6.0%. Our main takeaways here are that the allocation to stocks only increases by 6.0% (55.0% – 49.0%), and this portfolio has a stock allocation less than 60.0%.

Now let’s look at some actual historical data. The S&P 500 Index did not have a single down year since 2008 if we looked at the subsequent five years of stock returns. The returns for 2009, 2010, 2011, and 2012 were 26.5%, 15.1%, 2.1%, and 16.0%, respectively. The average return over that span was 14.9%. As of December 31, 2019, the S&P 500 Index was up 31.5% for 2019 including the reinvestment of dividends. Now I am by no means making a prediction for 2020. However, I wanted to drive home the fact that, if your Financial Advisor sets up your financial plan with the assumption that your stock allocation will earn 9.5% on average, any actual return lower than that estimate will cause you to not reach your target return. What is the effect? You will not be able to maintain the lifestyle you had planned on, even more so if there are negative returns experienced in stocks over the coming years.

Essential/Important Lesson:

Let’s look at the next five years starting in 2015. A five-year period covers 2015-2019. If you start out with $1,000,000 invested in stocks and plan on earning 9.5% per year, you are expecting to have $1,574,239 at the end of five years. Let’s say that the return of stocks is only 4.5% per year over the next five years. You will only have $1,246,182 as of December 31, 2019. The difference is $328,057 less than you were expecting. The analysis gets worse at this point though. How can it get any worse?

Well, if you were planning on 9.5% returns from stocks per year, the next five-year period 2019-2023 needs an excess return to catch up. Thus, if your starting point on January 1, 2015 is $1,000,000, your financial plan is set up to have $2,478,228 as of December 31, 2023. If you are starting behind your estimate in 2019, the only way you can make up the difference is to have stocks earn 14.7% over that five-year period which is 5.2% higher than the historical average. As you can see underperformance can really hurt financial planning. The extremely important point here is that a 1.0% AUM fee will cause you to be even further behind your goals. Remember that the illustration above is gross returns. You only care about net returns and what your terminal value is. Terminal value is simply a fancy way to say how much money is actually in your brokerage account.

Happy New Year, Beginning Thoughts, and Information for International Viewers

27 Friday Dec 2019

Posted by wmosconi in active investing, asset allocation, Average Returns, behavioral finance, benchmarks, bond market, cnbc, Consumer Finance, economics, Education, finance, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, financial planning, financial services industry, gross returns, historical returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, market timing, passive investing, personal finance, portfolio, rebalancing, rebalancing investment portfolio, risk, risk tolerance, risks of bonds, risks of stocks, S&P 500, S&P 500 Index, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Valuation, volatility

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I am looking forward to sharing more information regarding investing, finance, economics, and general knowledge about the financial services industry in 2020. I am hopeful to increase the pace with which I publish new information. Additionally, I am happy to announce that I reached viewers in 108 countries in all six continents. Countries from Japan, France, Germany, and Russia to Ghana, Colombia, and even Nepal.

Since the number of my international viewers has grown to nearly 30% of overall viewers of this blog I wanted to allocate a short potion of this post to the international community. Some of my comments are most applicable to the US financial markets or the developed markets across the globe. If you are living in a country that is considered part of the developing markets, I would strongly recommend that you seek out information in your country to see how much of my commentary is applicable to your stock or bond market and situation in general. It is extremely important to realize that tax structure, transparency of information, and illiquidity of stock and bond can alter the value of what I might say. During the course of the coming year, I will attempt to add in some comments to clarify the applicability. However, as the aforementioned statistic regarding the global diversity of viewers of this blog suggests, I would be remiss if I did not acknowledge that I will not hit on all the issues important to all international individual investors.

I encourage you to take a close look at your portfolio early on in 2020. It is a perfect time in terms of naturally wanting to divide up investing into calendar increments. As you listen to all the predictions for the New Year, I would encourage you to look at your personal portfolio and financial goals first. The second step is to always look at that economist’s or analyst’s predictions at the beginning of 2019. Now I am not implying that incorrect recommendations in the previous year will mean that 2020 investing advice will be incorrect as well.

To help you with a potential way to look at the outlook for positioning your portfolio of investments, I recently published a summary on the topic of rebalancing a portfolio. You can find the link below:

https://latticeworkwealth.com/2019/12/14/rebalancing-investment-portfolio-asset-allocation/

Now, there will always be unknown items on the horizon that make investing risky. You hear that we need to get more visibility before investing in one particular asset class or another. It usually means that the analyst wants to be even more certain how the global economy will unfold prior to investing. I will remove the anticipation for you. There will only be a certain level of confidence at any time in the financial markets.

One can always come up with reasons to not invest in stocks, bonds, or other financial assets. The corollary also is true. It can be tempting to believe that it is now finally “safe” to invest even more aggressively in risky stocks, bonds, or other assets. As difficult as it might be, you need to try to take the “emotion” of the investing process. Try to think of your portfolio as a number rather than a dollar amount. Yes, this is extremely difficult to do. But I would argue that it is much easier to look at asset allocation and building a portfolio if you think of the math as applied to a number instead of the dollars you have. Emotional reaction is what leads to “buying high and selling low” or blindly following the “hot money”; that is when rationality breaks down.

Here is an experiment for you to do if you are able. There are two shows I would recommend watching once a week. The first show is Squawk Box on CNBC on Monday which airs from 6:00am-9:00am EST. The second show is the Closing Bell on CNBC on Friday afternoon which airs from 3:00pm-5:00pm EST. You only need to watch the last hour though once the stock and bond markets are closed. Note that these shows do air each day of the week. Now depending on whether or not you have the ability to tape these shows first and skip through commercials, this exercise will take you roughly 12-16 hours throughout the month of January. You will be amazed at how different the stock and bond markets are interpreted in this manner.

When you remove the daily bursts of information, I am willing to bet that you will notice two things:

Firstly, Friday’s show should demonstrate that many “experts” got the weekly direction of the market wrong. It is nearly impossible to predict the direction of the stock market over such a short period.

Secondly, Monday’s show should illustrate what a discussion of all the issues that have relatively more importance are. However, this is not always a true statement though. Generally though, financial commentators and guests appearing on the show will have had the entire weekend to reflect on developments in the global financial markets and current events. Since the stock, bond, and foreign exchange markets are closed on Saturday and Sunday, there is “forced” reflection for most institutional investors, asset managers, research analysts, economists, and traders. The information provided is usually much more thoughtful and insightful.

I believe that the exercise will encourage you to spend less time attempting to know everything about the markets; rather, it may be more helpful to carefully allocate your time to learning about the financial markets. After you devote your time to watching CNBC in this experiment, I recommend one other ongoing personal experiment. Try picking three financial market guests that appear on CNBC during January and see how closely their predictions match reality. You might want to check in once a month or so. I think that this exercise will show you how futile it is to try and time and predict the direction/magnitude of the stock market and other financial markets too (e.g. bonds and real estate).

Best of luck to you in 2020! As always, I would encourage anyone to send in comments or suggestions for future topics to my email address at latticeworkwealth@gmail.com.

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

29 Tuesday Oct 2019

Posted by wmosconi 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 – Part 2 of 3 – Understanding and Reducing Risk

25 Wednesday Sep 2019

Posted by wmosconi 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 20^th 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).

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

18 Wednesday Sep 2019

Posted by wmosconi 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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academics, anchoring, behavioral economics, behavioral finance, Ben Graham, Bill Ruane, Capital Asset Pricing Model, CAPM, Charlie Munger, cognitive bias, Common Stocks and Uncommon Profits, David Dodd, economics, economy, Efficient Market Hypothesis, EMT, finance, invest, investing, investments, mathematics, Modern Portfolio Theory, MPT, performance, Phil Fisher, portfolio, portfolio management, Security Analysis, stocks, uncertainty, Warren Buffett

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 friend’s attention, you can ask them what the return of the DJIA was for 1987 (positive return) 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 do 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.

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

10 Tuesday May 2016

Posted by wmosconi 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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business, CAPE P/E Ratio, Cyclically Adjusted Price Earnings Ratio, economics, education, finance, financial advice, financial markets, Financial Media, Financial News, financial planning, financial services, financial services industry, individual investing, interest rates, investing, investment advice, investments, P/E Ratio, personal finance, portfolio, portfolio allocation, portfolio management, Robert Shiller, Shiller, statistics, stock market, Stock Market Valuation, stock valuation, stocks, Valuation, volatility

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.

The First Key to Successful Stock Investing is Understanding and Accepting Reality – Updated

16 Wednesday Mar 2016

Posted by wmosconi in asset allocation, Average Returns, bonds, business, college finance, Consumer Finance, Education, Emotional Intelligence, finance, finance theory, financial advice, financial goals, financial markets, financial planning, financial services industry, Geometric Returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, math, personal finance, portfolio, risk, risk tolerance, statistics, stock market, Stock Market Returns, stock prices, stocks, Uncategorized, volatility

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This particular topic is so important that I decided to revisit it again. The discussion below adds further refinements and creates an even stronger tie to behavioral finance (i.e. how emotions affect investment decisions). Additionally, for those of you who desire more in-depth coverage of the math and statistics presented, I have included that at the very end of this article. Let’s delve deeper into this topic and what is meant by “reality”.

The first key to successful stock investing has more to do with your emotions than a fundamental understanding of what causes stocks to move up or down. Emotions about money can be a powerful thing and cause people to behave in irrational ways. One of the most common phrases passed on to investors as a piece of wisdom is to “buy low and sell high”. However, study after study has shown that most individual investors fail to heed that advice. Why does this happen? Well, I would submit the real cause is behavioral and based upon incomplete information.

Most individual investors are told when they start investing in stocks via mutual funds and/or ETFs to expect an annual return of 8% to 9% per year. You will find that many financial calculators to help you plan for retirement on the Internet have that as one of the inputs to calculate the growth of your portfolio over time. While that information is not too far off the mark based upon historical returns of the S&P 500 stock index, the actual annual returns of stocks do not cooperate to the constant frustration and consternation of so many investors.

That brings us to the first key to successful stock investing: The actual yearly returns of stocks very rarely equal the average expected. The most common term for this phenomenon is referred to as volatility. Stocks tend to bounce around quite a bit from year to year. Volatility combines with the natural instinct of people to extrapolate from the recent past, and investing becomes a very difficult task. I will get deeper into the numbers at the very end of the post for those readers who like to more fully understand the concepts I discuss. I do need talk in general about annual stock returns at this point to expand upon the first key.

Below I have provided a chart of the annual returns of the S&P 500 index for every year in the 21^st century:

Year	% Return
2001	-11.90%
2002	-22.10%
2003	28.70%
2004	10.90%
2005	4.90%
2006	15.80%
2007	5.50%
2008	-37.00%
2009	26.50%
2010	15.10%
2011	2.10%
2012	16.00%
2013	32.40%
2014	13.70%
2015	1.40%

What is the first thing you notice when looking at the yearly returns in the table? First, you might notice that they really jump around a lot. More importantly, none of the years has a return that is between 8% and 9%. The closest year is 2004 with a return of 10.9%. If the only piece of information you have is to expect the historical average over time, the lack of consistency can be extraordinarily frustrating and scary. In fact, individual investors (and sometimes professional investors too) commonly look back at the last couple of years and expect those actual returns to continue into the future. Therein lies the problem. Investors tend to be gleeful when returns have been really good and very fearful when returns have been very low. Since the average never comes around very often, investors will forget what returns to expect over the long run and will “buy high and sell low”. It is common to sell stocks after a prolonged downturn and wait until it is “safe” to buy stocks again which is how the sound advice gets turned around.

I will not get too heavy into math and statistics, but I wanted to provide you will some useful information to at least be prepared when you venture out to invest by yourself or by using a financial professional. I looked back at all the returns of the S&P 500 index since 1928 (note the index had lesser numbers of stocks in the past until 1957). The actual annual return of the index was between 7% and 11% only 5 out of the 88 years or 5.7%. That statistic means that your annual return in stocks will be around the average once every 17 years. The 50-year average annual return for the S&P 500 index (1966-2015) was approximately 9.8%. Actual returns were negative 24 out of 88 years (27.9% of the time) and greater than 15% 42 out of 88 years (48.8% of the time). How does relate to the first key of stock investing that I mentioned earlier (“The actual yearly returns of stocks very rarely equal the average expected”)?

Well, it should be much easier to see at this point. If you are investing in stocks to achieve the average return quoted in so many sources of 8% to 9%, it is definitely a long-term proposition and can be a bumpy ride. The average return works out in the end, but you need to have a solid plan, either by yourself or with the guidance financial professional, to ensure that you stick to the long-term financial plan to reach the financial goals that you have set. Knowing beforehand should greatly assist you in controlling your emotions. I recommend trying to anticipate what you do when the actual return you achieve by investing in stocks is well below or quite high above the average in your portfolio. Having this information provides a much better way to truly understand and your risk tolerance when it comes to deciding what percentage of your monies to allocate to stocks in my opinion.

When you look back at the performance returns for stocks, it makes more sense why investors do what they do from the standpoint of behavioral finance. That is how emotions affect (all too often negatively) investment decisions. If an individual investor is told at the outset that he or she can expect returns of 8% or 9% per year, the actual annual returns of stocks can be quite troubling. Having that information only leads to a general disadvantage. When stock returns are negative and nowhere near the average, individual investors tend to panic and sell stocks. When stock returns are quite higher than the average, individual investors tend to be more euphoric and buy even more stocks. This affect is magnified when there are a number of consecutive years with one of those two trends. If stock returns are essentially unchanged, most individual investors become disengaged and really do not even see the point of investing in stocks at all.

I believe it is extremely important to know upfront that stocks are likely to hit the average return once every 17 years. That statistic alone is a real shocker! It lets individual investors truly see how “unusual” the average return really is. Plus, there is a better explanation for fear and greed. Stock market returns will be negative once every 4 years. Keep in mind this does not even include stock returns that are below the average yet still positive. Lastly, every other year the stock market returns will be above the average (in my case I was measuring above the average with the definition of that being a stock market return greater than 11%). It is no wonder why individual investors get greedy when it looks like investing in the stock market is so easy after seeing such great returns. Conversely, the occurrence of negative returns is so regular that it is only natural for individual investors to panic. Since the average only comes around approximately once every two decades, that is why confusion abounds and investors abandon their long-term financial plans.

I will readily admit sticking to a long-term financial plan is not easy to do in practice during powerful bull or bear markets, but I think it helps to know upfront what actual stock returns look like and prepare yourself emotionally in additional to the intellectual side of investing. Now I always mention that statistics can be misleading, conveniently picked to make a point, or not indicative of the future. Nevertheless, I have tried to present the information fairly and in general terms.

Additional Information on Stock Market Returns (Discussion of Math and Statistics):

Please note that this information may be skipped by individual investors that are scared off by math in general or have no desire to dive deeper into the minutiae. One of the first things to be aware of is what expected returns for stocks are. An expected return is what the most likely outcome would be in any particular year. Expected returns provide misleading results when there is a high degree of variability in the entire dataset. In the case of stock market returns, there is an incredible amount of variability. The industry term for variability, which is the statistical term, is volatility. Due to the fact that the expected return almost never happens, it would be wise for the financial services industry to truly and better define volatility. Most individual investors do not know that there is far more of a range of possible outcomes for stock market returns. Individual investors associate hearing average returns with some volatility from Financial Advisors or financial media in the same way as the classic “bell curve”. As discussed in further detail above, the outcomes do not even come close to approximating the “bell curve”.

One important thing to be aware of when it comes to actual performance returns of an individual’s investment portfolio is that average/expected values are not very important. In fact, they really lead to a distorted way of looking at investing. Average/expected values are based on arithmetic returns, where the overall growth in one’s investment portfolio is tied to geometric returns. The concept of geometric returns is overlooked or not fully explained to individual investors. Here is the perfect example of how it comes into play. Let’s say you own one share of a $100 stock. It goes down 50% in the first year and then up 50% in the second year. How much money do you have at the end of the second year? You have the original $100, right?

Not even close. You end up with $75. Why? At the end of the first year, your stock is worth $50 ($100 + $100*-50%) after decreasing 50%. Since you begin the second year with only that $50, that is why you end up having $75 ($50 + $50 * 50%). The average annual return is 0% ((-50% + 50%) divided by 2)) for the two-year period. Whereas your geometric return is negative 13.4%. Essentially that number shows what happened to the value of your portfolio over the entire timeframe and incorporates the ending value. Think of it as having $100 + $100 * -13.4% or $86.60 at the end of year one and then $86.60 + $86.60 * -13.4%) or $75. Note that you never actually have $86.60 as the portfolio’s value at any time, but the geometric return tells you how much money you actually earned (or lost) over the entire period and how much money you end up with, otherwise known as the terminal value of your portfolio. The geometric return will ALWAYS differ from the arithmetic return when a negative return is introduced as one of the outcomes. As an individual investor, your primary concern is the terminal value of your portfolio. That is the dollar value you see on your brokerage statement and is the actual amount of money you have.

Financial professionals forget to focus on geometric returns or even bring them up to clients. This omission is important to individual investors because negative returns have an outsized effect on the terminal value of an investment portfolio. For example, in the example above, it is quite clear that losing 50% and then gaining 50% do not “cancel each other out”. The negative percent weighs down the final value of the portfolio. That is why it is extremely important to use the geometric return of the portfolio. This result is due to the fact that the compounding of interest is not linear. It is a geometric equation which is why the geometric mean comes into play. Without going fully into the explanation of those equations, the main takeaway for investors when it comes to annual returns is that negative returns have more of an effect than positive returns.

Taken together, it is important to utilize the concept of multi-year geometric averages. Individual investors never want to simply add up the annual returns of a series of years and then divided by the number of years. That result will overstate the amount of money in the investment portfolio at the end of the period. The preferred approach is to use the geometric average which is referred to as the annualized average return. That percentage is the number most relevant to investors. Additionally, longer timeframes of these returns are best to look at given the extreme amount of volatility in yearly stock market returns. It gives a better picture of how the stock market has moved.

When looking at the stock market returns for the S&P 500 index over five-year periods using the period 2001-2015, they yield surprising yet informative results. The five-year returns from 2001-2005, 2006-2010, and 2011-2015 were 0.54%, 2.30%, and 12.57%, respectively. Valuable information comes from looking at extended periods of time using the same time increment. The overall return during 2001-2015 was 5.01%. The effect of these longer timeframes smooths the stock market return data, but even then the stock market returns vary quite a bit. Note that the overall return from the entire historical period of the S&P 500 index is roughly 9.50%. These three selected chunks show two periods of underperformance and one year of outperformance. The reason stock market returns tend to hover around the historical average is due to the fact that these returns are tied to the overall growth the economy (most commonly Gross Domestic Product – GDP) and corporate profits. In the meantime though, stock market returns can vary a lot from this expected return. However, they are unlikely to do so for incredibly long periods of time.

By incorporating the understanding of volatility and geometric returns into your understanding of the “reality” of stock market returns, you will be able to better refine your own risk tolerance and how to craft your long-term financial plan. A better grasp of these concepts makes one far less likely to react emotionally to the market, either with too much fear or too much greed.

The Top 5 Most Read Articles in my Investing Blog During 2015

29 Tuesday Dec 2015

Posted by wmosconi in asset allocation, bond market, bonds, Consumer Finance, Fed, Federal Reserve, finance, finance theory, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial services industry, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, passive investing, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, rebalancing, rebalancing investment portfolio, rising interest rate environment, rising interest rates, risk, risk tolerance, statistics, stock market, stock prices, stocks, Yellen

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The most popular articles read over the past year included some writings from a couple of years ago and were also on a myriad of topics. The listing of articles below represents the most frequent viewings working downward.

Are Your Financial Advisor’s Fees Reasonable? Are You Actually Adding More Risk to Your Ability to Reach Your Long-Term Financial Goals? Here is a Unique Way to Look at What Clients Pay For.

This article has consistently drawn the most attention from readers of my investing blog. Individual investors have learned from me and many others that one of the most important components of being successful long-term investors is by keeping investment costs as low as possible. This particular writing examines investing costs from a different perspective. In general, the higher the investment costs an individual investor incurs, the higher the allocation to riskier investments he/she must have to reach his/her financial goals.

Link to the complete article: https://latticeworkwealth.com/2013/10/26/are-your-financial-advisors-fees-reasonable-are-you-actually-adding-more-risk-to-your-ability-to-reach-your-long-term-financial-goals-here-is-a-unique-way-to-look-at-what-clients-pay-for/

2. Are Your Financial Advisor’s Fees Reasonable? Here is a Unique Way to Look at What Clients Pay For.

This article is closely followed by the previous one in terms of popularity and forms the basis for that discussion actually. The general concept contained in this writing is that most asset managers now charge investors a fee for managing their investments based upon Assets under Management (AUM). The fee is typically 1% but can be 2% or higher. The investment costs to the individual investor per year are the total balance in his/her brokerage account multiplied by the fee which is commonly 1%. However, the 1% grossly misrepresents the actual investment costs because the individual investor starts off with the total balance in his/her brokerage account. The better way to express the fees charged per year is to divide the AUM percentage by the growth in the portfolio over the year. That percentage answer will be quite a bit higher.

Link to the complete article: https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/

3) Rebalancing Your Investment Portfolio – Summary

Earlier in the year, I compiled a three-part series that examined the concept of rebalancing one’s investment portfolio. Rebalancing is an excellent investing strategy to learn about and apply at the end of the year. Rebalancing in its simplest definition is the periodic reallocation of the investment percentages in one’s investment portfolio back to an original model after a passage of time. This summary of rebalancing provides a look at rebalancing that is helpful for novice individual investors through more advanced folks.

Link to the complete article: https://latticeworkwealth.com/2015/11/25/rebalancing-your-investment-portfolio-summary/

4) How to Create an Investment Portfolio and Properly Measure your Performance: Part 2 of 2

While this article is the second part of a discussion on the creation of an investment portfolio, it is arguably the more important of the two because it looks at a topic too often not relayed to individual investors. This writing talks about the importance of measuring the performance of your investment portfolio’s investment returns. The financial media tends to focus solely on comparing your portfolio to the performance of the S&P 500 Index. That comparison is “apples to oranges” the vast majority of the time because most individual investors have many different types of investments in their portfolios. Therefore, I show you how institutional investors measure the performance of their investment portfolios. The concept is broken down into smaller parts so it is very understandable and usable for individual investors.

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

5) How Can Investors Survive in a Rising Interest Rate Environment? – Updated

Although this particular article was first published a couple of years ago, the content is even more valuable today. The Federal Reserve increased the target range for the Federal Funds Rate by 0.25% on December 16, 2015 and has indicated that more interest rate increases are likely in the future. Thus, we have entered a period in which interest rates are generally headed higher over the next several of years. Most financial pundits will bemoan this type of environment because higher interest rates mean that the prices of most bonds go down. It makes it harder to earn any investment returns from bonds. However, there are a number of investments and investment strategies that benefit from an increasing interest rate environment. This article examines six different things individual investors can do.

Link to the complete article: https://latticeworkwealth.com/2013/11/30/how-can-investors-survive-in-a-rising-interest-rate-environment-updated/

I hope you enjoy these popular articles from my investing blog. My goal is to keep on releasing more information in 2016 to assist individual investors in navigating the world of investing. Thank you to all my readers in the United States and internationally!

Rebalancing Your Investment Portfolio – Summary

25 Wednesday Nov 2015

Posted by wmosconi in asset allocation, bonds, Consumer Finance, Emotional Intelligence, finance, finance theory, financial advice, financial goals, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, personal finance, portfolio, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, Uncategorized

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With the end of the year fast approaching, it is an excellent time to discuss the concept of rebalancing one’s investment portfolio. The simplest definition of rebalancing is the periodic reallocation of an investment portfolio back to the original percentages desired. The fluctuations of the financial markets over time will inevitably alter the amount of exposure in one’s investment portfolio to different types of assets. These changes may cause the portfolio to be suboptimal given an individual investor’s financial goals and tolerance for risk. Knowing about rebalancing is so important because it is one of the most effective ways to eliminate, or at least reduce, the emotions surrounding investment decisions that affect even professional investors. Additionally, numerous academic studies have concluded that 85% of the overall return of an investment portfolio comes from asset allocation.

Recently, I published a three-part series of articles to define and explain the various nuances of rebalancing an individual investor’s investment portfolio. The first article covers the definition of rebalancing in its entirety. Furthermore, the article looks at an illustration of how rebalancing works in the real world. It offers an introduction to this important investing tool. The link to the complete article can be found here:

https://latticeworkwealth.com/2015/07/16/how-to-rebalance-your-investment-portfolio-part-1-of-3/

The second article discusses a unique way to get assistance with rebalancing an investment portfolio. Many of the largest asset managers in the financial services industry, such as Vanguard, Fidelity, and T Rowe Price, offer life cycle or target date mutual funds. These mutual funds have a predefined year that the individual investor intends to retire. Moreover, the combination of assets in the mutual fund is structured to change over time and become less risky as the target date approaches. Since these mutual funds report their holdings on a periodic basis, any individual investor is able to replicate the strategy for free. Plus, another feature is that an individual investor can be more conservative or aggressive than his/her age warrants according to the mutual fund family’s calculations. The individual investor is able to pick a target date closer than the endpoint (i.e. more conservative) or pick a target date later than the endpoint (i.e. more aggressive). For a more comprehensive discussion of this facet of rebalancing an investment portfolio follow this link:

https://latticeworkwealth.com/2015/07/29/how-to-rebalance-your-investment-portfolio-part-2-of-3/

The third and final article discusses the most advanced feature of rebalancing utilized by a subset of individual investors. The investing strategy is referred to as dynamic rebalancing in most investment circles. Dynamic rebalancing follows the general tenets of rebalancing. However, it allows the individual investor to exercise more flexibility during the rebalancing process of the investment portfolio. Essentially the individual investor determines bands or ranges of acceptable exposures to asset classes or components within the investment portfolio. For example, a lower bound and upper bound for the asset allocation percentage to stocks is set. The individual investor is free to allocate monies to stocks no less than the lower bound and no more than the upper bound. Note that the bands or ranges are normally fairly tight and applies to the subcomponents of the investment portfolio, such as small cap stocks, emerging market stocks, international bonds, and so forth. To learn more about this fairly complex aspect of rebalancing follow this link:

https://latticeworkwealth.com/2015/11/21/how-to-rebalance-your-investment-portfolio-part-3-of-3/

The articles above capture the vast majority of information individual investors need to know about rebalancing an investment portfolio. It is good to get a head start on learning about or reviewing this topic prior to the end of the year. The reason is that most rebalancing plans utilize the end of the calendar year as the periodic adjustment timeframe.

How to Rebalance Your Investment Portfolio – Part 2 of 3

29 Wednesday Jul 2015

Posted by wmosconi in asset allocation, bond market, bonds, Consumer Finance, financial advice, financial goals, financial markets, financial planning, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, personal finance, rebalancing, rebalancing investment portfolio, stock market, stocks

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In the first part of the discussion on rebalancing your investment portfolio, I outlined its definition and the most common method to do so. The web link to that particular post is listed below:

https://latticeworkwealth.com/2015/07/16/how-to-rebalance-your-investment-portfolio-part-1-of-3/

As a reminder, the definition of rebalancing is the periodic adjustment of one’s investment portfolio back to the original allocation percentagewise to the various asset classes. Over the course of time, the financial markets will vary up and down and one’s investment portfolio will change. However, the individual investor will normally have a plan on how to invest in order to reach his or her financial goals while being comfortable with the amount of risk taken by investing in the various asset classes (i.e. stocks, bonds, cash, etc.). Thus, rebalancing is simply ensuring that the investment portfolio is back in line with the original parameters of asset allocation.

In this second part of the discussion on rebalancing your investment portfolio, I will show you a different way to rebalance your investment portfolio. The same general concept applies, but, using this method, one can rely on actual published financial advice. The nice thing about this particular method is that the financial advice is free and from the most and trusted asset managers in the financial services industry. Does that sound too good to be true? Well, I invite your skepticism. That is always a healthy trait whenever someone discusses investing. Let’s delve into this a bit deeper and see if I can’t assuage your fears.

Many of the asset managers in the financial services industry offer something called target date mutual funds or life cycle mutual funds. The naming convention depends on the mutual fund company, but the financial product is the same. The idea behind these mutual funds is that they invest in a certain combination of stocks and bonds depending on when the money is needed. The mutual fund will invest more of the investment portfolio in stocks in the beginning and gradually shift that percentage to bonds and cash as the target date approaches. For example, someone who is forty years old now (2015) and wants to retire at age sixty-five would invest in a target date 2040 mutual fund. Some of the asset managers offering these financial products include Vanguard, Fidelity, and T Rowe Price. The web link to each of these mutual fund families’ offerings are listed below:

Vanguard – https://investor.vanguard.com/mutual-funds/target-retirement/#/

Fidelity – https://www.fidelity.com/mutual-funds/fidelity-fund-portfolios/freedom-funds

T Rowe Price – http://individual.troweprice.com/public/Retail/Mutual-Funds/Target-Date-Funds

Now I will not personally recommend any specific financial product; however, all these mutual fund families have excellent reputations and long track records. The benefit of this rebalancing method is that you can choose a particular target date or life cycle mutual fund that lines up with your financial goal and timeline. Each of these mutual fund offerings must periodically report their investment holdings to investors and are displayed on the mutual fund family’s website. As an individual investor, you need only replicate the recommended investments in that mutual fund. Adjusting your investment portfolio either semiannually or annually is normally sufficient. The added bonus is that you can alter the target date or life cycle mutual fund you select if your risk tolerance is different than what is offered in that portfolio. If you want to take on more risk for potential added rewards in performance returns, you can select a mutual fund with a target date later than your age would indicate. For instance, assume it is 2015 and you want to retire in 30 years, you might opt for the target date 2050 instead of 2045. Conversely, if you want to take on less risk because you are more sensitive to financial market volatility, you can select a target date closer than your age would indicate. In this case, assume it is 2015 and you want to retire in 30 years, you might opt for the target date 2040 instead of 2045. Let’s take a closer look at how this works in terms of the nuts and bolts.

For purposes of illustration only, I will utilize the product offerings of the Vanguard family of mutual funds. Assume that it is 2015 and you have 20 years until retirement (2035). Furthermore, assume that you have a normal risk tolerance for financial market volatility. If that is the case, you would select the Vanguard Target Retirement 2035 Fund (Ticker Symbol: VTTHX). The asset allocation of that target date mutual fund as of June 30, 2015 is as follows:

Asset Allocation as of June 30, 2015

Mutual Fund	Percentage
Vanguard Total Stock Market Index Fund	53.9%
Vanguard Total International Stock Market Index Fund	28.1%
Vanguard Total Bond Market II Index Fund	12.7%
Vanguard Total International Bond Market Index Fund	5.3%
Total	100.0%

Essentially you now have an investment portfolio that selects investments for your investment portfolio to achieve your financial goals without paying a Financial Advisor. Those investment advisory fees may be 1% to 2% (or higher) of your total investment portfolio each year. Using this rebalancing approach those fees are avoided, but you are still able to see what professional money managers are recommending for free. Now there are two courses of action at this point. First, it is possible to simply invest in this particular fund through the Vanguard mutual fund family. However, you will incur additional expenses for the fund family to manage the money and make the periodic percentage allocation adjustments. Those expenses do vary by fund family and are normally somewhat reasonable but are higher at some companies than others. Second, it is possible to invest monies into ETFs or index mutual funds that match the percentage allocations to the various asset classes. Admittedly, there are times when the commissions incurred to do so are higher than simply having the mutual fund family invest in the various funds for your investment portfolio. With that being said, there is a way to invest in ETFs for free.

One of the nicest offerings that not enough people know about is that Fidelity Investments offers the BlackRock iShares ETFs free of commission. While not all of the iShares are offered, there are currently 70 ETFs registered in the program. These ETFs have some of the lowest expense ratios (percentage fee charged on assets; normally 0.20% or less per year) in the business, and the range of ETFs should cover most any recommended target date or life cycle mutual fund investment pieces you might choose to use. The current list of the iShares ETFs from Fidelity that are free from commissions are as follows:

Commission-Free iShares ETFs at Fidelity Investments – https://www.fidelity.com/etfs/ishares-view-all

The reason one would use this method to build an investment portfolio and rebalance along the way is that expenses are minimized throughout the investing process. Many investors are not aware how much “seemingly small” expenses add up and compound over time. Decades and/or years worth of fees as small as 0.50% or 1.00% annually can erode thousands, tens of thousands, or more from your investment portfolio. Which makes it harder for you to reach your investment goals or necessitates taking on more risk in order to reach the goal than you might be comfortable within your investment portfolio. (For more information on that topic, you can view one of my earliest blog posts via this web link: https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/).

Here’s a summary of the usefulness of this particular rebalancing approach for your investment portfolio. You may know when your financial goal is going to come due to pay or provide for, have a general idea of the risks you are willing to take, and know a bit about the types of asset classes for investment available. However, you may lack the confidence or specific expertise to know how to create an investment portfolio and allocate percentages of money to the various asset classes. The nice thing about this method is that you can “piggyback” off of the investment ideas of some of the best money management firms in the financial services industry. You initially invest the money in your investment portfolio as is indicated on the mutual fund family’s website. Then every six or twelve months (preferably mid-year or end of the year; the most common interval is twelve months) the investment portfolio is rebalanced to exactly match the way the target date or life cycle mutual fund is currently invested in.

Latticework Wealth Management, LLC

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