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

20 Wednesday Nov 2019

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

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

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

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

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

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

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

Trend_1 = Time + 100 + 0.9 * x + eta

Trend_2 = Time +100 – 0.9 * x + eta

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

Trend_Graph_Statistics_Revised

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

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

First_Difference_Graph_Statistics_Revised

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

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

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

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

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

One Year Returns - Histogram - Non Normal

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

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

Ten Year Returns - Histogram - Non Normal

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

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

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

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

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

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

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

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

11 Monday Nov 2019

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

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

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

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

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

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

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

29 Tuesday Oct 2019

Posted by 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/

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

16 Wednesday Oct 2019

Posted by wmosconi in active investing, after tax returns, benchmarks, blended benchmark, finance, financial advice, financial markets, gross returns, historical returns, Income Taxes, Individual Investing, individual investors, investing, investing advice, investing tips, investment advice, investments, passive investing, portfolio, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, speculation, stock market, Stock Market Valuation, stock prices, stocks

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

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

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

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

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

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

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

Gross Returns Versus Tax Equivalent Returns

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

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

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

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

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

How to Become a Successful Long-Term Investor – Summary

30 Monday Sep 2019

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

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

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

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

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

Part 1 – Understanding Historical Stock Market Returns:

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

Part 2 – Understanding and Managing Risk:

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

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

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

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

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

Part 1 – Building an Investment Portfolio:

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

Part 2 – Monitoring the Performance of an Investment Portfolio:

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

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

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

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

28 Saturday Sep 2019

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

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

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

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

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

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

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

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

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

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

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

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

Fifteen Year Correlation

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

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

One Year Correlation

Three Year Correlation

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

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

Five Year Correlation

Ten Year Correlation

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

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

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

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

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

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

25 Wednesday Sep 2019

Posted by 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).

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

23 Monday Sep 2019

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

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

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

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

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

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

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

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

Table of Returns

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

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

One Year Returns

Three Year Returns

Five Year Returns

Ten Year Returns

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

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

Historical Returns

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

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

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

26 Wednesday Apr 2017

Posted by wmosconi in active versus passive debate, behavioral finance, confirmation bias, Emotional Intelligence, EQ, finance, finance theory, financial advice, financial markets, Financial Media, Financial News, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, passive investing, personal finance, stock market, stocks

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behavioral finance, confirmation bias, Emotional Intelligence, financial advice, financial markets, financial planning, individual investors, investing, investing advice, investing information, investing tips, investments, stock market, stocks

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

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

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

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

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

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

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

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

Latticework Wealth Management, LLC

~ Information for Individual Investors

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