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

24 Sunday Jul 2016

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

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The main reason why Financial Advisors are recommending that individual investors sell bonds is that interest rates are likely to rise over the next 3-5 years or more. Although those sentiments have been a familiar refrain over the last 3-5 years though. Well, I would tend to agree that interest rates are poised to rise at some point toward the end of this decade. However, interest rate risk is only one of the risks of bonds. In fact, the size of the bond market dwarfs the stock market. When Financial Advisors are talking about bonds, they tend to be referring only to US Treasury bonds, corporate bonds, and municipal bonds. Interest rate risk greatly affects these bonds indeed. With that being said, they tend to conflate the interest rate risk of these bonds with the entire bond market. Remember that interest rates have dropped from 16.30% on the 1-month US Treasury bill back in 1981 to roughly 0.25% today. Therefore, bond prices have been rising for over 35 years and most financial professionals outside of the fixed income markets have forgotten (or if they are younger than 50) how bonds normally work, especially in a rising interest rate environment. But does it even matter really?

Yes. Here is an urgent note to all individual investors: “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”. What I mean by this is that the volatility of stocks is far greater than bonds historically. Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now. However, your risk tolerance must be taken into account at all times. While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk. For example, as most people are aware, the S&P 500 index (which represents most of the biggest companies in America) was down over 35% in 2008. Many of those stocks are included in the push to have individual investors buy dividend payers. With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon. If you handle the volatility of the stock market well, there is no need to be concerned. However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield. Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap. The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities. Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment. While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future just taking into account normal volatility in the stock market historically (every 36 months or so in any given quarter). Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?

The purpose of this blog post is to discuss the risk factors associated with bonds in greater detail. Most bonds, such as Treasury notes and bonds, corporate bonds, and municipal bonds, will go down in value when interest rates go up. Conversely, they will go up in value when interest rates decrease. This characteristic of these types of bonds is called an inverse relationship. For a primer on how most bonds function normally, I have posted supplementary material alongside this post. You can refer to it to brush back up on bonds and how they work, and I also provide a historical look at interest rates over the last 35 years. Here is the link to that prior blog post:

https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks-supplementary-information-on-how-bonds-work/

There are many risk factors associated with investments in bonds. A great overview of those risks can be found in Fixed Income Mathematics the Fourth Edition by Dr. Frank Fabozzi who teaches at Yale University’s School of Management. Most fixed income traders, portfolio managers, and risk managers use his Handbook of Fixed Income Securities as their general guidebook for approaching dealing with the trading, investing, and portfolio/risk management of owning fixed income securities. Suffice it to say that he is regarded as one of the experts when it comes to the bond markets. Dr. Fabozzi summarizes the risks inherent in bonds on page 109 of the first text referenced above. The risks are as follows:

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

Most of fixed income folks and myself would add inflation risk, basis risk, and separate credit risk into two components. Bonds have two types of risk as it relates to payment of principal and interest. The first risk is more commonly thought of and referred to as default risk. Default risk is simply whether or not the company will pay you back in full and with timely interest payments. Credit risk also can be thought of as the financial strength of the company. If a company starts to see a reduction in profits, much higher expenses, and drains of cash, the rating agencies may downgrade their debt. A downgrade just means that the company is less likely to pay back the bondholder.

Here is an example to illustrate the difference more fully: a company may have a AA+ rating from Standard & Poor’s at the beginning of the year, but, due to events that transpire during the year, the company may get downgraded to A- with a Negative Outlook. Now the company is still very likely to pay back principal and interest on the bonds, but the probability of default has gone up. As a point of reference, AAA is the highest and BBB- is the lowest Standard & Poor’s ratings to be considered investment grade. You will note that the hypothetical company would need to be downgraded four more times (BBB+, BBB, BBB- to BB+) to be considered non-investment grade or a “junk” bond. Bond market participants though will react to the downgrade though because new potential buyers see more risk of default given the same coupon. So even though the company may not default eventually on the actual bond, the price of the bond goes up to compensate for the interest rate required by the marketplace on similarly rated bonds to attract buyers.

Now I will address the full list of risks affecting bonds outlined by Dr. Fabozzi above. Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest. All bonds have what is referred to as credit (default portion) risk. Credit risk in general is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default). What is lesser known or thought about by individual investors is interest-rate risk and inflation risk. These two risks are usually missed because investors tend to think that bonds are “safe”. Interest-rate risk relates to the fact that interest rates may rise, while you hold the bonds (spoken about at length in the beginning of this blog post). When financial pundits make blanket statements about selling bonds, they are referring to this one risk factor normally. Inflation risk means that inflation may increase to a level higher than your interest rate on the bond. Thus, if the interest rate on your bond is less than inflation or closer to inflation from when you bought the bond, your purchasing power goes down. The prices of goods and services go up faster than the interest you earn on the bond. Call risk refers to instances where some companies have the option to redeem your bonds in the future at an agreed upon price. This is normally done only when interest rates rise. Prepayment risk is a more specialized case of call risk and refers to people paying their mortgages (or credit cards, home equity loans, student loans, etc.) back sooner than expected. Most people group these two risks into a category called reinvestment risk. Think about the concept in this manner: many people refinanced their mortgages because interest rates went down. They did so because they could lower their total mortgage payment. Well, companies do the same thing if they have the option. Companies can redeem bonds at higher interests and issue new bonds at lower interest rates. Chances are that, if you are the owner of the redeemed bonds, you will be unable to find as high of an interest payment currently if you want to buy a bond with similar characteristics of the company issuing the bonds you own before.

The other three risks I mentioned above are less commonly discussed and not quite as important. Exchange-rate risk exists because sometimes a company issues bonds in a currency other than its own. For example, you will sometimes hear the terms Yankee bonds or Samurai bonds. Since the company is paying you interest and principal in a foreign currency that money may be worth more or less depending on what happens in foreign exchange markets in the future. Liquidity risk refers to the phenomenon that there are certain crisis times in the market where very few, if any bond market participants, are willing to buy the bonds you are trying to sell. Therefore, you might have to take a bigger loss in order to entice someone to buy the bonds given the current macro environment. Basis risk is a more obtuse type of risk that institutions deal with. Basis risk essentially refers to anytime when interest rates on your bond are pegged to another interest rate that is different but normally behaves in a certain way (referred to as correlation). Now most of the time, the behavior will follow the historical pattern. However, during times of stress like a liquidity and/or credit crisis, the correlations tend to break down. Meaning you can think you are “hedged” but, if the historical relationship does not hold up, your end return will be nothing like what you had expected. These two risks are not something that individual investors need to focus on for the most part, since these types of bonds are not normally owned by them.

I will admit that this list is quite lengthy and, quite possibly, a bit too detailed and/or complicated. However, I wanted to lay them all out for you. Why? When you hear Financial Advisors recommend that you sell a large portion of your bonds, and/or hear the same investment advice from the financial media, they normally are really only referring to interest-rate risk primarily and secondarily inflation risk as well. As you can see from the description above, the bond market is far more complex than that to make a blanket statement.

As I usually say, I would never advise individual investors to take a certain course of action in terms of selecting specific bonds or not selling bonds to move into more stocks. However, I am saying that you should feel comfortable enough to ask your Financial Advisor why he/she recommends that you sell a portion of your bonds. If the answer relates only to interest-rate risk, I would probe the recommendation further. You can explain that you know that is the case for Treasury notes/bonds, municipal bonds, and corporate bonds. However, there are a whole host of other fixed income securities with different characteristics and risks. Now I am not referring solely to Mortgage Backed Securities (MBS), although the residential and commercial markets for these are in the trillions of dollars. There are bonds and notes that have floating interest rates which means that as interest rates go up, the interest rate you receive on that security goes up. Not to mention that different countries are experiencing different interest rate cycles than the US (stable or downward even).

The complete list is too in-depth to cover in a single blog post. My goal was to provide you with enough information to at least ask the question(s). Your risk tolerance and financial goals might make a move from bonds to stocks the best course of action. With that being said, you also have the option of selling bonds and keeping the money in cash or investing in the different types of bonds offered in the fixed income markets while keeping your total allocation to fixed income nearly the same. Thinking holistically about your portfolio, you may be increasing the riskiness of your portfolio beyond your risk tolerance or more than you are aware unbeknownst to you by moving from bonds into stocks. This is something you definitely want to avoid. It can turn out to be a rude awakening and hard lesson to learn one or two years from now.

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.

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”)?

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 First Key to Successful Stock Investing is Understanding and Accepting Reality

26 Wednesday Mar 2014

Posted by wmosconi in business, Education, finance, financial planning, Individual Investing, investing, investment advice, investments, math, personal finance, portfolio, risk, statistics, stocks, volatility

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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 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 in a later 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	-11.9%
2002	-22.1%
2003	28.7%
2004	10.9%
2005	4.9%
2006	15.8%
2007	5.5%
2008	-37.0%
2009	26.5%
2010	15.1%
2011	2.1%
2012	16.0%
2013	32.4%

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 86 years or 5.8%. 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 (1964-2013) was approximately 9.8%. Actual returns were negative 24 out of 86 years (27.9% of the time) and greater than 15% 42 out of 86 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 will 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. I will readily admit it 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.

As previously mentioned, I will be writing another related blog post that will discuss the numbers in more detail with math and statistics. I have separated these discussions so that those intimidated by math or who do not want to get into all the details can skip that part. However, I will be providing some advice on how to use the information I have provided to assist you in moving past the first key to successful stock investing.

A New Paradigm for Investing on 50 year-old Investment Advice Available on Amazon.com

01 Saturday Mar 2014

Posted by wmosconi in asset allocation, beta, business, Consumer Finance, Education, Fama, finance, financial planning, Free Book Promotion, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, Markowitz, math, Modern Portfolio Theory, MPT, passive investing, personal finance, portfolio, risk, Sharpe, sigma, statistics, stock prices, stocks, volatility

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I have decided to make my recently published book FREE for today only, March 1, 2014(it normally retails for $4.99). The book is another installment in my A New Paradigm for Investing series. In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations. The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful. I explore the reasons why in my text. I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents. Moreover, you do not need to know about the intricacies of MPT in order to follow my logic. You would find the same information in a college textbook but in a condensed format here. It actually is quite surprising how little Financial Advisors know about MPT in general and how the ideas apply to individual investors.

Note that this book is available for download onto a Kindle. Additionally, there is a Kindle app for iPhones and Android devices which is free to download. Amazon.com Prime Members can borrow the book for FREE as well. I have provided a link below to make it easier. My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The book is:

1) A New Paradigm for Investing: Is Your Financial Advisor Creating Your Portfolio with a 50 Year-Old Theory?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00FQQ0CKG/ref=sr_1_1?s=books&ie=UTF8&qid=1381520643&sr=1-1&keywords=a+New+paradigm+for+investing+by+William+Nelson

I would like to thank my international viewers as well of my blog that can be found at https://latticeworkwealth.com/. I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would strongly recommend following for their content and insight):

Followers on @NelsonThought:

– The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts

– Institutional Investor @iimag

– The Royce Funds @RoyceFunds – Small Cap value investing asset manager

– Research Magazine @Research_Mag – Latest industry information for wirehouses and ETFs

– Barron’s Online @BarronsOnline – Weekly financial news magazine of Dow Jones

– Cleveland Fed Research @ClevFedResearch

– Euromoney.com @Euromoney

– Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal

– Muriel Siebert & Co. @SiebertCo

– Roger Wohlner, CFP® @rwohlner

– Ed Moldaver @emoldaver

– Sylvia Maxfield @sylviamaxfield – Dean of the Providence College of Business

– The Shut Up Show @theshutupshow

– Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

– Tracy Alloway @tracyalloway – US Financial Correspondent at Financial Times

– Vanguard FA @Vanguard_FA – Vanguard’s ETF research and education

– EU External Action @eu_eeas – Latest news from the European External Action Service (EEAS)

– Direxion Alts @DirexionAlts

– Charlie Wells @charliewwells – Editor at The Wall Street Journal

– Jesse Colombo @TheBubbleBubble – Columnist at Forbes

– Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company

– AbsoluteVerification @GIPStips

– Investment Advisor @InvestAdvMag

– Gary Oneil @GaryONeil2

– MJ Gottlieb @MJGottlieb

– Bob Burg @BobBurg

– TheMichaelBrown @TheMichaelBrown

– Phil Gerbyshak @PhilGerbyshak

– MuniCredit @MuniCredit

What is the 800-Pound Gorilla in the Room for Retirees? It is 12.5.

26 Wednesday Feb 2014

Posted by wmosconi in active investing, active versus passive debate, asset allocation, bonds, business, Education, Fiduciary, finance, financial advisor fees, financial planning, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, math, passive investing, personal finance, portfolio, risk, stocks, volatility

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bonds, business, Certified Financial Planners, CFP, finance, Financial Advsiors, financial planning, individual investing, investment advisory fees, investments, personal finance, Registered Investment Advisors, retirement, RIA, stocks, volatility

The 12.5 I am referring to is 12.5%, and it relates to investment advisory fees. I have discussed the effects of investment advisory fees at length in previous posts. In general, most individual investors pay fees to financial services firms that are too high in comparison to the value provided in many cases. For example, the vast majority of individual investors do not need complex, strategic tax planning, estate planning and legal advice, or sophistical financial planning. However, the firms that most people invest with offer those services within the fee structure. There is very little in the way of options to select a larger wealth management firm that will provide only asset allocation advice at a reduced fee because the individual investor does not need the other services when it comes to tax, legal, and sophisticated financial planning. I wrote an article several months ago in regard to how you can look at the value added by your financial professional. It is worth a review in terms of what he/she can do for you that you cannot simply do yourself using a passive investing strategy. Here is the link:

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/

I would like to focus on a different way of looking at investment advisory fees. My primary focus will be on retirees; however, the logic directly applies to those in the wealth accumulation phase of life trying to save for retirement. As I have mentioned previously, the standard fee for investment advisory services is normally 1% of assets under management (AUM). This structure simply means that an individual investor pays $1 in fees for every $100 invested. Another way to look at it is that you will pay $10,000 annually if your account balance is $1,000,000 ($1,000,000 * 1%). I would like to go through an illustration to show what this means in terms of your investment performance, overall risk profile, and the ability to reach your long-term financial goals.

Most individual investors do not write out a check to their financial professional. Rather, they have the investment advisory fees paid out of the investment returns in their portfolios. My example does not make any difference how you pay your fees, but it can be somewhat hidden if you are not writing out a check. The fees just appear as a line item on your daily activity section of your brokerage statement; most investors skim over it. In order to make the mathematics easier to follow, I am going to use a retiree with a $1,000,000 account balance and a 1% AUM fee annually. My entire argument applies no matter what your account balance is or your AUM fee. You just need to insert your personal account balance and AUM fee which may be higher or lower. So let’s get started.

In my hypothetical scenario of a $1,000,000 portfolio subject to a 1% AUM fee, this retiree will have to pay $10,000 to his/her financial professional for investment advisory services rendered. Well, we can look at this fee from the standpoint of the portfolio as a whole in terms of investment performance necessary to pay that fee. The portfolio will need to increase by at least 1% to pay the fee in full. Now most financial professionals will tell clients that they can expect to earn 8% per year by investing in stocks. So using that figure (which is close to the historical average), we can get to the fee by allocating $125,000 of the overall portfolio to stocks in order to increase the portfolio on average by 8% to be able to pay the $10,000 fee ($125,000 * 8% = $10,000).

What does that mean in terms of your overall portfolio allocation to stocks? You can imagine that, whatever your total allocation to stocks is, 12.5% of that amount is invested simply to pay fees. For example, if you are just starting out in retirement at age 65 and have 60% allocated to stocks, 12.5% of the expected return (8%) from stocks in your total portfolio will go to pay your annual investment advisory fees and 47.5% of the expected return (8%) from stocks in your total portfolio will add to your account balance.

The math works out this way: $1,000,000 * 60% = $600,000 // $600,000 (invested in stocks) * 8% (expected return from stocks) = $48,000 // $48,000 – $10,000 (AUM fee at 1%) = $38,000. An alternative way to do the math is to take the total allocation to stocks and subtract the necessary allocation to stocks to pay the AUM fee, and that result is the investment return for the year that remains in your account balance which is $38,000 (So take 60.0% – 12.5% = 47.5% // $1,000,000 * 47.5% * 8% = $38,000).

The paragraph above has major impacts for your portfolio. Firstly, it illustrates how much additional risk you are taking on in your portfolio as a whole. In order to breakeven net of fees, you need to invest 12.5% of your portfolio into stocks. Retirees are in the wealth distribution phase of life, and most are living off the investment account earnings (capital gains, dividends, and interest) and principal. Since retirees have no income from working and will not be making any additional contributions, they are impacted greater than other investors in the way of volatility. Stocks are more volatile investments than bonds but offer the promise of higher returns. It is the simple risk/reward tradeoff. Second, it shows that the higher the fees for retirees the more vulnerable they are to volatility as a whole. Since retirees need to withdraw money on a consistent/systematic basis, a higher allocation of their portfolio to riskier investments are more vulnerable than other investors that have longer timeframes prior to retirement (wealth accumulation phase). If there are major downturns in the stock market, retirees still have to withdraw from their accounts in order to pay living expenses. They do not have the luxury of not selling. Yes, a retiree could sell bonds instead of stocks but then the allocation of stocks has to rise by definition as a percentage of the entire portfolio.

There is a way to rethink the investment strategy for a retiree. In today’s investing environment, there are many more investment offerings that offer financial products at much lower expenses than traditional active mutual fund managers. These include ETFs and index mutual funds. The expenses typically are less than 0.20% (in fact, most are significantly lower than this). Additionally, there has been the proliferation of independent Registered Investment Advisors (RIAs) and Certified Financial Planners (CFPs) over the past 10-15 years who charge fee-only (hourly) or flat fee. Most of these financial professionals charge significantly lower fees than the traditional 1% AUM fee. In fact, it is possible to cut your fees by 50% at least. Now the flipside may be that you might not have the ability to consult with some about certain sophisticated tax, legal/estate, and financial planning strategies. However, most retirees do not need that advice to begin with. The average retiree only needs a sound asset allocation of his/her investment portfolio given his/her risk tolerance and financial goals. To learn more about independent RIAs and CFPs, I have included these links:

1) RIA – http://www.riastandsforyou.com/benefits-of-an-ria.html

2) CFP – http://www.plannersearch.org/why-cfp/Pages/Why-Hire-a-Certified-Financial-Planner.aspx

The main benefit in terms of reducing fees is not only that the retiree keeps more money, but, more importantly, he/she can reduce the overall risk of the portfolio. Let’s go back to our hypothetical example of a retiree with a $1,000,000 who is charged a 1% AUM fee or $10,000 per year. If the total investment advisory fees are reduced by 50%, the total annual fee is 0.5% or $5,000 per year. What does this mean? In our first example, the retiree had to allocate 12.5% of his/her portfolio of stocks to pay the $10,000 annual AUM fee (assuming an 8% expected return). If the fees are 50% less, the retiree now only has to allocate 6.25% of the portfolio to stocks in order to pay the annual investment advisory fees ($1,000,000 * 6.25% = $62,500 // $62,500 * 8% = $5,000).

Now if we go back to the longer example of a simple 60% stock and 40% bond portfolio, the retiree in this case is able to invest 53.75% in stocks and 46.25% in bonds and still pay the annual investment advisory fees. The math is as follows: ($1,000,000 * 53.75% = $537,500 // $537,500 * 8% = $43,000 // $43,000 – $5,000 new annual fees = $38,000). You will note that the retiree has $38,000 in his/her portfolio after the annual fees are paid out. This dollar amount is equal to the other hypothetical retiree who had to pay a 1% AUM fee. The example illustrates that both investors have the same expected increase to their portfolio but the retiree with the lower fees is able to get to that figure with a portfolio that is less risky because he/she is able to allocate 6.25% less to stocks.

Another way to look at this scenario is that the retiree in the second case with 50% lower fees could have alternatively chosen to reduce his/her stock allocation by 5%. For example, the retiree could have started with a portfolio allocation of 55% instead of using the 53.75% stock allocation. In this example, the retiree would have an expected return after fees that is $1,000 higher than the retiree from the first example and take less risk. The math is as follows: ($1,000,000 * 55% = $550,000 // $550,000 * 8% = $44,000 // $44,000 – $5,000 = $39,000 // $39,000 – $38,000 = $1,000). The retiree in this example would have a higher expected return from his/her entire portfolio of 0.1%. While this figure might not sound like much, the more important point is that this return is achieved with less risk (only 55% allocation to stocks versus a 60% allocation to stocks).

A financial professional might argue that he/she is able to create an asset allocation model for an average retiree that will end up having investment returns higher than that recommended by the independent RIA or CFP. Of course, this might be the case. However, in order to have the retiree be indifferent between the two scenarios, the portfolio recommended by the financial professional charging a 1% AUM fee must be able to return 0.5% more annually at an absolute minimum. Now this does not even consider the riskiness of the retiree’s portfolio. In order to have a portfolio earn an additional 0.5% per year, the client will have to accept investing in riskier asset classes. Therefore, given the additional risk, the retiree should require even more than an additional 0.5% overall return to compensate him/her for the potential for higher volatility.

As you can see, the level of fees makes a big difference. The more you are able to cut the fees on your retirement account (and any account for that matter) the less risky your portfolio can be positioned. In the aforementioned example, the overall reduction in the exposure to stocks can be a maximum of 12.5% to stocks. Now the average retiree will most likely not want to forgo any investment advice from a financial professional. However, in the case of person able to lower his/her investment fees by 50%, he/she was able to reduce his/her investments in stocks by 6.25% (12.5% * 50%). In fact, you can figure out the possible reduction in exposure to stocks by multiplying the 12.5% by the reduction in fees you are able to achieve. For example, let’s say that you are able to reduce your investment fees by 70%. You would be able to reduce your allocation to stocks by 8.7% (12.5% * 70%).

The entire point of this article is to show you how you can be able to reduce the volatility in your portfolio and not sacrifice overall investment returns. If investing in stocks during your retirement years makes you nervous, this methodology can be used to help you sleep better at night because you have less total money of your entire retirement savings allocated to stocks. However, you are not sacrificing investment returns. Always remember that in the world of investment advisory fees, it truly is a “zero sum game”. All this means is that the investment advisory fees are reducing your net investment portfolio gains. The gain in the value of your portfolio either goes to you or your financial professional. The more you learn about how investment advisory fees, the types of financial professionals available to advise you offering different fee schedules, and how the financial markets work, the more gains you will keep in your portfolio.

The Results are in for my January CNBC Experiment: It Proves Nothing and Everything. What?

07 Friday Feb 2014

Posted by wmosconi in asset allocation, beta, bonds, business, Consumer Finance, currency, Education, EM, emerging markets, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, foreign currency, forex, fx, Individual Investing, interest rates, investing, investments, math, NailedIt, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility, Yellen

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bonds, business, cnbc, currency, education, EM, emerging markets, finance, financial planning, forex, fx, individual investing, interest rate risk, interest rates, investing, personal finance, rising interest rates, stocks, thought experiment, volatility

Sometimes the most important lessons in the individual investing sphere are complicated and simple at the same time. At the very beginning of January, I recommended a little experiment that related to the financial market coverage on CNBC. The specific details of this “thought experiment” can be found in the original blog post from January 1st:

https://latticeworkwealth.com/2014/01/14/happy-new-year-beginning-thoughts-and-information-for-international-viewers-2/

The brief version of the exercise related to watching Monday and Friday coverage of the current events in the global financial markets during the month. The simple exercise was to watch CNBC’s Squwak Box every Monday during the course of the month. The second part was to watch the last hour of the Closing Bell segment. What was the logic? The Monday show is a three-hour program, and there are many current issues considered and opinions from various market participants (e.g. traders, money managers, economists, investment strategists, research analysts, etc.). Monday is critical due to the fact that the market participants cannot trade on Saturday and Sunday. You might think of it as “forced” time to think and/or reflect about how current events are affecting investment opportunities and risks. Friday’s reflections from the same market participants is focused more on trying to explain the “vagaries and vicissitudes” (i.e. volatility of the stock market and changing opinions) of the markets ups and downs over the course of the week. Furthermore, many commentators and guests try to explain why the predictions on Monday did not or did match up with the ideas expressed at the beginning of the week.

The overall point of this experiment was to “drive home” the fact that trying to time the market or predict its direction over the short term is extremely challenging and can seem hopeless. Toward the end of December, the general investment thesis for the majority of money managers was that the stock market was poised to have a very positive January due to the fact that the financial markets did not really dive after the Federal Reserve announced the reduction of the tapering program, commonly referred to as QE (quantitative easing). Additionally, the main belief was that bonds were one of the least attractive investments to own. Most people assumed that the 10-year US Treasury Note was headed up to the 3.0% level. Things seemed pretty simple and not too many headwinds in the near future. So what happened during January?

The main event that most people remember was the currency difficulties of a number of emerging market countries. The financial media focused a lot on the Turkish lira (TRY) and the Argentine peso (ARS). Turkey had political problems, and Argentina has a huge problem as it relates to political leadership (or the absence thereof) and dwindling currency reserves. There were other currencies that experienced trouble as well like the South African rand (ZAR). The other important development was that the Japanese yen (JPY) reversed its direction and strengthen versus the US dollar (USD). Oddly enough, the Argentine Merval stock index was one of the best performers over the course of the month. No one saw this coming to such an extent. You might term this an exogenous event as anything that occurs outside of your current model to build a portfolio or invest in individual stocks/bonds. It is largely unknown and hard to predict. (As an aside, this is NOT the same thing as a “black swan”. That term is overused and conflated with many other things. Refer to Dr. Nassim Taleb for a further definition of the termed that he famously coined years ago). These events tend to be unknowns and have a greater impact because the general level of the perception of risk changes almost instantly and affect market sentiment and momentum. Market participants need to alter their models rather quickly in order to account for the occurrence of these events.

The other big event was the movement of the yield on the 10-year US Treasury note. Instead of following a general path of rising, the interest rate actually fell. The yield on this instrument drifted down roughly 40 basis points (0.4%) from the 3.0% level. What most people fail to realize is that interest rates go down if economic data turns out to be worse than expected normally (e.g. December jobs of 70,000 and the lowest labor force participation rate since the 1980s), but, more importantly, there is a “flight to quality” phenomenon that occurs over and over again. There tends to be a bit of a “mini panic” when unexpected and impactful events occur. If all else fails, institutional investors like hedge fund managers tend to buy US Treasury bills, notes, and bonds for safety. The additional demand causes bond prices to go up and, by definition, yields will go down.

The combination of bad economic data and dealing with the currency woes in the emerging markets causes many short-term traders and speculators to buy these risk-free assets and figure out how to trade later. It is sort of an example of reflexivity. The bottom line for individual investors is that many sold bonds and purchased dividend stocks instead. The exact opposite happened: bond yields went down and dividend stocks sold off. The worst short-term investing strategy was to search for yield in the stock market rather than the bond market due to rising interest rates. For more information you can refer to one of my former posts on how to look at the various risk factors associated with bonds. Trust me, there is a lot more to bonds than simply interest rate risk. Here is the link to a former blog post that addresses this very issue:

https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks/

There were many other smaller events that happened over the course of the month that affected the general volatility experience in the financial markets. At the end of the day, even the “experts” had a monumental task trying to explain all the macroeconomic events, currency movements, and interest rate implications throughout January. If the task was so difficult for them, it is normally advisable for individual investors to not follow the market daily and get caught up in temporary “greed and fear” of traders and speculators. Investment ideas and predications can change from day to day and even minute to minute in the short term. It is much more important for individual investors to develop a long-term financial plan that will allow them to reach future financial goals. You then blend that with your risk tolerance. For example, how likely would you have been to sell the positions in your portfolio given the volatility experienced during the course of January? An outlook of five years is normally a great start for that plan. If you look out into the future with a longer timeframe like an annual basis in terms of adjusting the components of your asset allocation, you are less likely to constantly trade the securities in your personal portfolio. The frenetic pace of traders/speculators and the volatility of the stock and bonds markets makes it seem that you MUST do something, anything!

If you would like to learn a bit more about behavioral finance, you can refer to this blog post from last year (note context of examples referred to is from August 2013 when the piece was published):

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

One of the most important things to learn in investing is how to control your emotions. It is easy to map out your investment strategy and risk tolerance on paper. Many asset managers who have experienced a multitude of secular bull and bear markets refer to this phenomenon as your EQ versus your IQ. Thus, when actual “money” is involved, volatility and uncertainty in the financial markets brings forth challenges that even the best money managers have a hard time keeping up their nerve. The other takeaway is that people’s investment recommendations can change on a dime. Market participants can be very hopeful on one day and think the sky is falling the next day. Trying to time the market is so difficult that you end up developing a portfolio allocation for your investments that assumes that general events with transpire. All the planning in the world cannot account for all possibilities of geopolitical and global events that might really cause the market to go down more than normal in a short time period.

The whole point of this “thought experiment” was to encourage you to take a long-term view of investing in the financial markets. It is a lot less stressful, less complicated, and tends to lead to better overall investment returns (i.e. you do not “sell low and buy high” as much because everyone tells you to). For more information on stepping back and thinking about the long term, I have included a final blog post. You always need to remember that your financial professional (or yourself if you manage your own investments) who advises you about investment decisions is forever impacted by the start of their investment career. They tend to be biased and make investment recommendations based upon how things used to be when they started in the business. It is very hard to separate your “biases” from the present day. Here is the link:

https://latticeworkwealth.com/2013/08/18/before-you-take-any-investment-advice-consider-the-source/

Well, I hope you learned a few things by participating in my experiment and maybe even had a little bit of fun. Please feel free to leave a comment or send me an email directly at latticeworkwealth@gmail.com with more specific feedback and/or questions. Sometimes you can learn a great deal just by being an observer of financial market volatility. What is the nothing part of this learning journey? The moral of the story is that everyday guests appearing on CNBC or other commentators will let you know that the stock market with either go up, go down, or stay unchanged. Obviously everyone knows that simple concept to begin with. Thus, it is hard to choose who to listen too because of so many divergent opinions. Lastly, you should realize that this same experiment would have worked with the other business networks and large financial news publications like the Wall Street Journal, Financial Times, Barron’s.

A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?

01 Wednesday Jan 2014

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, Education, Fed Taper, Fed Tapering, Federal Reserve, finance, financial advisor fees, financial planning, Individual Investing, investing, investment advisory fees, investments, math, Modern Portfolio Theory, MPT, Nobel Prize in Economics, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility

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Amazon book deals, asset allocation, books, business, education, finance, Financial Advisors, financial planning, individual investing, investing, investment advsiory fees, Modern Portfolio Theory, MPT, reasonable investment advisory fees, retirement

Greetings to all my loyal readers of this blog. How would you like to start off the New Year of 2014 by reevaluating your investment portfolio and how you get investment advice? This book on Amazon.com is available for download onto a Kindle. Additionally, there is a Kindle app for iPhones and Android devices which is free to download. Please feel free to check out the titles below. I have provided links to make it easier. My email address is latticeworkwealth@gmail.com.

The link to the book is as follows:

A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?

http://www.amazon.com/New-Paradigm-Investing-Financial-Questions-ebook/dp/B00F3BDTHW/ref=sr_1_3?s=books&ie=UTF8&qid=1388595896&sr=1-3&keywords=a+new+paradigm+for+investing+by+william+nelson

The book listed is normally $9.99 but available but I am offering it for a lower price over the course of the next week. For most of the day today, the book is $3.99 which is 60% off. The price of the book will be gradually increasing during the course of that period.

I would like to thank my international viewers as well. I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Chloe Cho – @chloecnbc – CNBC Asia Anchor for Capital Connection show

Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield – Dean of the Providence College of Business

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells – Editor at The Wall Street Journal

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

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

01 Wednesday Jan 2014

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, Education, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, Individual Investing, interest rates, investing, investments, math, Modern Portfolio Theory, MPT, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, volatility

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asset allocation, bonds, economics, finance, financial planning, individual investing, investing, investing ideas for 2014, investments, stocks, volatility

I am looking forward to sharing more information regarding investing, finance, economics, and general knowledge about the financial services industry in 2014. I am hopeful to increase the pace with which I publish new information. Additionally, I am happy to announce that I reached viewers in 40 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 20% 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 markets 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 2014. 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 2013. Now I am not implying that incorrect recommendations in the previous year will mean that 2014 investing advice will be incorrect as well. However, the important takeaway is that trying to account for the entire unknown factors both endogenous (speed of the Fed taper) and exogenous (geopolitical risk in the Middle East and Asia) affecting the global financial markets with a high degree of precision is exponentially difficult and challenging.

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. It is not necessary and, more importantly, will negate the experiment if you watch them every day. 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. Now 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.

Best of luck to you in 2014. As always, I would encourage anyone to send in comments or suggestions for future topics to my email address at latticeworkwealth@gmail.com.

A New Paradigm for Investing on 50 year-old Investment Advice Available on Amazon.com

03 Tuesday Dec 2013

Posted by wmosconi in alpha, asset allocation, Bernanke, beta, bonds, business, Consumer Finance, Education, Fama, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial advisor fees, financial planning, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, Markowitz, math, Modern Portfolio Theory, MPT, Nobel Prize, Nobel Prize in Economics, portfolio, rising interest rate environment, rising interest rates, risk, Schiller, Sharpe, sigma, statistics, stock prices, stocks, volatility, Yellen

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alpha, asset allocation, Bernanke, beta, bonds, business, consumer finance, economics, education, Fama, Fed, Fed taper, Fed Tapering, Federal Reserve, finance, investing, investments, math, Modern Portfolio Theory, MPT, Nobel Prize, Nobel Prize in Economics, personal finance, portfolio, portfolio management, Schiller, Shiller, statistics, stocks, volatility, Yellen

I am happy to announce that I have published another book on Amazon.com. I have decided to make it FREE for the rest of the week through Saturday, December 7^th(it normally retails for $4.99). The book is another installment in my A New Paradigm for Investing series. In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations. The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful. I explore the reasons why in my text. I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents. Futhermore, you do not need to know about the intricacies of MPT in order to follow my logic. You would find the same information in a college textbook but in a condensed format.

Note that this book is available for download onto a Kindle. Additionally, there is a Kindle app for iPhones and Android devices which is free to download. Amazon.com prime members can borrow the book for FREE. I have provided a link below to make it easier. My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The book is:

1) A New Paradigm for Investing: Is Your Financial Advisor Creating Your Portfolio with a 50 Year-Old Theory?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00FQQ0CKG/ref=sr_1_1?s=books&ie=UTF8&qid=1381520643&sr=1-1&keywords=a+New+paradigm+for+investing+by+William+Nelson

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

30 Saturday Nov 2013

Posted by wmosconi in asset allocation, bank loans, Bernanke, bonds, business, Consumer Finance, Education, Fed, Fed Taper, Federal Reserve, finance, financial advisor fees, financial planning, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, LIBOR, math, MBS, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility, Yellen

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asset allocation, bank loans, Bernanke, bonds, Fed, Fed taper, Fed Tapering, Federal Reserve, fixed income, fixed income securities, interest rate swaps, interest rates, investing strategies, investments, LIBOR, MBS, portfolio management, retirement, rising interest rate environment, rising interest rates, syndicated bank loans, volatility, Yellen

I probably get this question asked of me more than any other these days, especially by retirees. Investors were once able to place money into bank certificate of deposits (CDs) or into money market funds and easily earn more interest than the rate of inflation. Unfortunately, the financial crisis of 2008 changed all that in a major way. While the events surrounding the dark days of the close of Lehman Brothers, the bailout of AIG, and the nearly $800 billion TARP program, were not the sole cause of this phenomenon, they certainly did not help. The Federal Reserve (Fed) led by the chairman, Ben Bernanke, had to lower interest rates to avoid the credit and liquidity crisis of that time period. The Fed brilliantly avoided a meltdown and depression. The side effect is that financial market participants have gotten used to low interest rates. You will hear the term “taper” thrown about now. The Fed is not going to raise interest rates yet; rather, they are going to slow their purchase of Treasury instruments and mortgages on the open market. They are not raising the Fed Funds rate (do not worry about what that is exactly), but, since they were buying approximately 70% of all US Treasuries issued, bond market investors are worried that this demand/supply imbalance will naturally cause interest rates to rise (interest rates have already gone up). Well, if interest rates will be higher, shouldn’t that be better for bond investors?

An urgent side note to all investors is as follows: “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”. What I mean by this is that the volatility of stocks is far greater than bonds historically. Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now. However, your risk tolerance must be taken into account at all times. While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk. For example, as most people are aware, the S&P 500 (which represents most of the biggest companies in America) was down over 35% in 2008. Many of those stocks are included in the push to have individual investors buy dividend payers. With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon. If you handle the volatility of the stock market, there is no need to be concerned. However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield. Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap. The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities. Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment. While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future. Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?

The short answer is no to the question posed at the end of the first paragraph. Before we can answer that question and look at some investment strategies and potential purchases, we need to review how a bond works. Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest. All bonds have what is referred to as credit risk. Credit risk is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default). What is lesser know is interest rate risk and inflation risk. These two risks are usually missed because investors tend to think that bonds are “safe”. Interest rate risk relates to the fact that interest rates may rise, while you hold the bonds. Inflation risk means that inflation may increase to a level higher than your interest rate on the bond. Thus, if the interest rate on your bond is less than inflation, your purchasing power goes down. The prices of goods and services go up faster than the interest you earn on the bond.

How do bonds work in terms of prices? Most bonds are issued at a price of 100 which is referred to as par. Corporate bonds and Treasury notes/bonds are usually sold in increments of $1,000, and municipal bonds are sold in increments of $5,000. The value of a bond is calculated by taking the current price divided by 100 and then multiplied by the number of bonds you own. Bonds are sold in the primary market (when first sold to retail and institutional investors) such that the coupon (interest rate) is equal to the current interest rate prevailing in the marketplace at that time (sold at par which is 100). Bonds can be bought and sold after that issue date though. If interest rates rise or fall after issuance, how does the price of a bond adjust? If interest rates go up, bond prices will go down. If interest rates go down, bond prices will go up. Why? It is referred to as an inverse relationship. Think about it this way. If you own a bond that has a 6% coupon and interest rates rise to 8%, will you be able to see that bond to other investors? The answer is no if you decide to hold firm to a price of 100. Why should another bond investor buy a 6% bond when he/she can just buy a bond with very similar characteristics as yours and earn 8%? The only way that you can sell your bond is to lower the price such that the bond investor will earn 8% over the course of that bond’s life until maturity which is when the company or other entity has to pay the money back in full). Luckily for you, the process works in reverse as well though. If interest rates go down to 4%, you have the advantage. If you hold a bond with a 6% coupon as in the aforementioned example, bond investors will pay more than 100 in order to get that higher interest payment. How much more? Bond investors will bid the price up until the bond earns an equivalent of 4% until maturity. Why is this important to you as an investor today?

Let’s take a quick look at history. Most financial professionals are not old enough to remember or have been in business long enough to remember the interest rate environment back in the early 1980s. In the early 1980s, interest rates on bonds were incredibly high compared to today. The economy was stuck in a rut of higher inflation and low or no growth which was called “stagflation”. How high were interest rates? The interest rate on a 3-month Treasury bill was 16.3% back in May 1981, and the prime rate topped out around 20.5% soon after. For more information on the interest rates of this time period, please refer to this link: http://www.mbaa.org/ResearchandForecasts/MarketEnvironment/TreasuryYields&BankRates,1980-83.htm. The Federal Reserve chairman back then, Paul Volcker (Fed chairman prior to Alan Greenspan and the same gentleman as the so-called “Volcker rule” of today), instituted a monetary policy based upon the teachings of the famous economist, Milton Friedman, from the University of Chicago. Friedman was really the start of monetarism. Monetarism is simply the effect of the money supply in any economy on interest rates. In general, as more money in the economy is available, interest rates will go down. As less money is available, interest rates will go up. Why? Think about it in this manner. If you have to get a loan from a family member and you are the only person asking for a loan, chances are your interest rate will be lower than if that same family member is asked by 15 different individuals. So the Fed of that time period began buying all types of bonds on the open market. The hope was that, as the money supply grew, interest rates would fall. As interest rates fell, it would give more incentive to companies to take out loans to buy equipment and build plants and also to incent consumers to take out mortgages and buy homes or purchase consumer goods with credit cards. Needless to say, the policy eventually worked. It started what most refer to as the great bull market in bonds in roughly 1982.

There are only two ways you can make money when you own a normal bond. First, you earn money from the coupon paid over the life of the bond. Second, in a falling interest rate environment, you earn money by selling your bonds at a higher price. Therefore, you can earn money from interest and capital gains. In a rising interest rate environment, you can only earn money from the coupon. What individual investors, and some money managers even, fail to realize is this simple fact of finance. The yield on a 3-month US Treasury bill today is roughly 0.06%. No, that is not a misprint! The yield on these bills has gone down over 16% over the past 30 years or so. The bond market has never seen such an extended period of falling interest rates. Now interest rates did not fall in a straight line, but the trend has been toward lower interest rates for decades now. That anomalous occurrence is coming (has come) to an end. What can individual investors do then?

There are a number of things you can do to deal with the specter of rising interest rates. I do not recommend any specific securities to purchase. However, these investment strategies are something to consider. They are as follows:

1) Purchase an ETF that invests in floating rate fixed income securities

Investors are accustomed to bonds issued with a fixed coupon. Yes, that is the most common. However, there are other bonds that have an interest rate which is variable over the life of that bond. Why would a company want to consider this? There are two reasons why. The first reason is that some companies need to borrow money from financial market participants constantly and for short periods of time. The second reason is that certain companies that have liabilities which float over time. Why? They may have revenues that float over time as well. It is much more complicated than that, but I do not want to get too bogged down into the details. The most commonplace is a financial instrument known as commercial paper (CP) which is an example of the first reason. CP is any financial instrument with a maturity of up to 270 days. Firms, such as General Electric or Goldman Sachs, will sell CP to institutional investors for purposes of raising working capital. It might be to pay short-term bills, or it might be to fund operations until money comes from previous sales at a later date. Whenever CP is issued, the current interest rate prevails. There are ETFs out there (only a few right now though, such as the iShares Floating Rate Note ETF – Ticker Symbol: FLOT) that invest in CPs or other variations thereof. The ETF will hold these fixed income securities with very short maturities.

2) Purchase a target maturity bond ETF

When you purchase a bond mutual fund, you are pooling your money with other investors. You do NOT own the bonds that the mutual fund invests in. The mutual fund firm will calculate the value of their bond holdings each day and divide it by the number of shares outstanding to arrive at the net asset value (NAV) of the mutual fund. The mutual fund will allow mutual fund investors to buy additional shares at that price or sell shares at that price. Isn’t that just semantics and really is the same thing? Absolutely not! When you own a bond mutual fund, the holdings of the mutual fund are constantly changing. You will see an SEC yield quoted and a weighted average maturity (WAM) of the bond mutual fund show in years. If interest rates rise and you need to sell, the NAV of the bond mutual fund will go down. Since the bond mutual fund needs to earn as much interest for its bond investors as possible, they will constantly take new inflows from investors, interest payments, and principal payments to invest in bonds issued today. Therefore, the NAV of the bond mutual fund has to go down. Since you are never holding the actual bonds to maturity, in a rising rate interest environment, you will receive interest payments from the bond mutual fund, but the value of the bonds held by the bond mutual fund will fall gradually, ceteris paribus.

Since interest rates have been falling for so long, most individual investors do not know this. How do you combat that? Well, BlackRock and other ETF providers have developed a new type of ETF which is based upon a target maturity. How do they work? You can purchase an ETF that might be in existence for five years, for example. The ETF will invest in bonds with five years to maturity and then disband the ETF after five years. Thus, as a bond investor, you are only subject to default risk. As you will recall, default risk is the risk that an entity will not pay back the principal and interest on the bond.

3) Purchase a floating rate instrument directly with a credit enhancement

There are fixed income securities sold which have interest rates that are set very frequently. One of these instruments is known as a put bond or floater. Put bonds or floaters are fixed income securities that are sold with an interest rate that is “reset” (i.e. adjusted to reflect current interest rates) on a periodic basis. For example, they might be reset daily, weekly, or monthly. Therefore, if you own a floater and interest rates go up, you will earn that new interest rate. If interest rates go down, you will earn that interest rate. You do not lose your original principal. The interest rate is always chosen such that the floaters will sell at par. Now owning a floater that is tied directly to a company, non-profit, charter school, municipality or other entity is a risky proposition. You are subject to the credit risk of that entity, and they might default. However, you can get around being exposed to the credit risk of that entity. It is possible to purchase floaters (most are actually issued this way) which have a credit enhancement. A credit enhancement is something that the obligor (i.e. the entity that issues the bonds and needs the money) purchases. The types of credit enhancements are not that important; the concept is more significant for individual investors. A floater with a credit enhancement means that, if the obligor defaults, the entity providing the credit enhancement will pay the principal and interest then. Banks and bond insurers offer credit enhancements. Therefore, when you purchase a floater with a credit enhancement, you are essentially exposed to the credit risk of the entity providing the credit enhancement and not the issuer (i.e. obligor). Yes, you still have credit risk.

With that being said, there are floaters out there which have a credit enhancement from Bank of America, JP Morgan, US Bank, Wells Fargo, or Assured Guaranty. The interest rate will be lower than the interest rate that the company itself would be able to get by accessing the bond market directly. However, it will save you the time of trying to do a credit analysis of a small manufacturing firm with $50 million in annual revenues. You can contact a middle market or larger full service brokerage firm to see if they offer put bonds or floaters for sale. If they say no, but they offer Auction Rate Securities (ARS), it is not the same thing at all. ARS have very different characteristics which rear their ugly head during liquidity crises like the financial crisis of 2008.

4) Purchase mortgage back securities (MBS)

MBS may have a bad name from the financial crisis of 2008. I am not referring to MBS that invest in subprime loans. Subprime loans are speculative in nature. I am talking about mortgages issued to individuals with good credit scores. You can purchase an MBS issued by GNMA (Ginnie Mae), FNMA (Fannie Mae), or the FHLB (Freddie Mac). The GNMA is a government sponsored enterprise (GSE), and FNMA and FHLB are sometimes referred to as “quasi” in nature. These MBS essentially purchase thousands of mortgages that meet certain requirements in terms of size of the loan and credit of the borrower. The mortgages are pooled together and sold to investors.

These securities are essentially pass through instruments. Pass through instruments mean that the principal and interest payments flow through to the owners of the MBS. Why might you want to own these? In a rising interest rate environment, people with mortgages will not refinance their mortgages. Why would you get rid of your 4% 30-year fixed rate mortgage and change to a 5% 30-year fixed rate mortgage? As interest have been falling over the past several decades, it has been advantageous to refinance ones mortgage to a lower rate. There are bond mutual funds that invest in MBS. However, they fall subject to the same phenomenon that I mentioned above. You are investing in a pool and do not own the MBS directly. If interest rates go up and you need to sell that bond mutual fund, the NAV on the bond mutual fund will go down. You can inquire at your local brokerage firm about MBS. Now if your broker or Financial Advisor talks to you about collateralized mortgage obligations (CMOs) being the same thing basically, that is not the case. CMOs do offer different characteristics which may be attractive, but they are much harder to analyze.

5) Purchase bank loan ETFs with a floating rate

Most corporations borrow money from banks with a floating interest rate. The interest rate adjusts at certain points and is calculated as a spread over some benchmark interest rate. The most common benchmark is LIBOR and specifically 3-month LIBOR since many bonds reset quarterly. Banks will package these loans together and sell them as syndicated loans to various interested institutional investors. The advantage of these securities is that the interest rate will move up in a rising interest rate environment. Additionally, most corporate treasurers will enter into an agreement, called an interest rate swap, to change the corporation’s payments into essentially a fixed interest rate. The complexity of the interest rate swap is not important to discuss in great detail. The point is that the corporation will then have a fixed interest payment and knows how much they will have to pay over time. Thus, there will be no surprises if interest rates spike. Therefore, you are exposed to the credit risk of the corporation for each bank loan. Remember though that there is diversification in each of these syndicated bank loans because the ETF’s investment advisor will buy many bank loans to diversify the default risk of any one corporation. One example of an ETF is offered by PowerShares and is called the PowerShares Senior Loan Portfolio ETF (BKLN). A number of closed-end mutual funds offer similar products. However, you should always be aware of the management fee assessed by the advisor overseeing the investments. The expense ratio for many of these closed-end mutual funds is significantly above 1% which tends to offset the benefit of owning such a security because your investment returns will be lower as a result.

6) Consider purchasing bonds issued by international firms or different countries

International firms and different countries have bonds that sell at different interest rates. The nice thing about these bonds is that they are affected by different factors or the economy may be in a different stage than the US. It is akin to the multiverse concept of Mohammed El-Erian of PIMCO. El-Erian tells investors that the global economy is not simply something that is changing in one direction or in one way. Rather, he states that different countries or regions can be moving in the same or opposite directions at any given time. Furthermore, bonds issued outside of the US provide diversification to your investment portfolio. It is the concept of not “having all your eggs in one basket”. It is one other option for you. There are countries which are in the process of lowering interest rates, so you can benefit from the interest rate payment and capital gains then.

One other thing you can do is to just reduce your duration. Duration is simply the time it takes for your bonds to mature. Under normal market conditions, bonds with shorter maturities have lower interest rates than bonds will longer maturities. Believe it or not, that is not always the case though. When short-term interest rates are lower than long-term interest rates, bonds with shorter maturities are less sensitive in terms of price movement than longer maturities. I do not consider this an investment strategy really. It is just a way of lowering risk. As previously mentioned, when you hear financial professionals speak about searching for yield in other ways like investing in dividend stocks or MLPs (master limited partnerships), that is not investing in fixed income securities. Given your risk tolerance, you should have a set allocation to fixed income securities. You might decide to replace some of that allocation with a higher level of other stocks or other instruments. However, that is a choice, and you are normally increasing the risk of your portfolio. I am not saying that is good or bad. I am simply saying that implementing this strategy comes with tradeoffs.

Latticework Wealth Management, LLC

~ Information for Individual Investors

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