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

26 Wednesday Apr 2017

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

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

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

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

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

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

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

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

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

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

10 Tuesday May 2016

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

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

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

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

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

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

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

Average 18.77

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

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

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

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

Average 19.80 6.44%

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

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

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

29 Tuesday Dec 2015

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

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

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

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

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

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

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

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

3) Rebalancing Your Investment Portfolio – Summary

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

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

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

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

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

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

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

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

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

How to Rebalance Your Investment Portfolio – Part 3 of 3

21 Saturday Nov 2015

Posted by wmosconi in asset allocation, finance, financial advice, financial goals, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, passive investing, personal finance, portfolio, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market

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This rebalancing discussion is the last installment of a three-part series. The first discussion defined what is commonly referred to as rebalancing one’s investment portfolio. Rebalancing is in simplest form is realigning an investment portfolio to a desired asset allocation after time inevitably changes its composition due to the normal fluctuations in the financial markets. Rebalancing is normally done at set intervals of time of which once a year is the most common. The link to the full discussion of part one can be found here:

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

The second discussion outlined a relatively easy way to come up with an allocation for an investment portfolio and how it is rebalanced. This particular method is to rely on what are commonly referred to as target date or life cycle mutual funds. These mutual funds offered by some of the largest asset managers in the financial services industry recommend a given asset allocation for an investment portfolio based upon the year one is retiring. The mutual funds are carefully crafted to take into account risk levels in addition to reaching financial goals. Additionally, these mutual funds are periodically adjusted over time to keep the investment portfolio aligned with a desired asset allocation. Bottom line, the asset manager does all the work for you and can be a nice way for novice investors to get their “feet wet” when it comes to investing. Note that the discussion also outlines how to increase or decrease one’s risk profile (meaning take on more risk to capture possibly higher investment returns or take on less risk to possibly lower the amount one’s investment portfolio might go down by) while still using this approach. The link to the full discussion of part one can be found here:

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

The third and final part of the rebalancing discussion will focus on what I define as dynamic rebalancing. Dynamic rebalancing may be called by different names depending on the investment professional, but the concept is generally the same. Dynamic rebalancing is reserved for more advanced individual investors. An individual investor needs to be comfortable with understanding the different investment options available and follow the financial markets more closely. Dynamic rebalancing still has the basic definition of rebalancing at its core. However, there is a bit more flexibility involved when realigning one’s investment portfolio.

Let’s dig a bit deeper into dynamic rebalancing and why it is an option for a subset of more advanced individual investors. In order to start we need to go back to the original definition of rebalancing. Rebalancing is looking at one’s investment portfolio at set intervals (usually coincides with the end of the year) and moving monies between asset classes. For instance, stocks may perform better than bonds in a certain year so the investment portfolio has a higher exposure to stocks at the end of the period. In order to realign the investment portfolio back to its original composition, the investor would need to sell stocks and buy bonds. The amounts to sell and buy are calculated such that the end result is that the percentages invested in stocks and bonds are at their original levels of the beginning of the period. As long as one’s financial goals and risk tolerance have not changed, the original percentages are used. It is a hard rule meaning that there are no exceptions for the final asset allocation to stocks, bonds, and cash. The percentages are set in stone such that the individual investor does not get emotional by any short-term financial market volatility and drift away from his/her desired financial plan.

Dynamic rebalancing still has percentages for the investment in certain asset classes, investment styles, or industry sectors but a band of acceptable percentages is utilized. For example, an individual investor would rebalance the investment portfolio at the end of the year, but he/she might decide whether to have anywhere between 65% – 70% invested in stocks. Why would any individual investor want to use such an approach? Well, if one looks back on financial market history, the ebbs and flows of asset classes rarely line up with calendar years. For instance, small cap stocks might outperform other domestic stocks for two years instead of just one. What usually ends up happening in the financial markets is that financial assets become overvalued or undervalued relative to each other as time passes. Other investors will bid up certain stocks or bonds and sell other stocks and bonds because of the perceived likelihood of investment performance returns. However, at a certain point in time, the scales of value tip and it becomes better to invest in the “unloved” stocks and bonds that were being sold so much in the past. This phenomenon will hardly ever occur exactly in one-year increments.

The most important thing to remember about dynamic rebalancing is that the individual investor has financial flexibility in the asset allocation percentages, but he/she is not allowed to engage in “market timing”. “Market timing” is when any investor believes he/she knows exactly the right time to buy or sell financial assets. In fact, the financial media will always have financial pundits being interviewed or write investment articles predicting when the stock market will peak or when the market is at the lowest level it can go so investors just have to buy. Professional investors might predict one or two tops or bottoms of the financial markets, but there are only a handful of them that can make a living at this approach. If it is too hard for the professional, institutional investors to do so, individual investors should not have the hubris to think that they can.

Here is an illustration of dynamic rebalancing to make things much clearer. An individual investor will have defined percentages to invest in certain asset classes for the investment portfolio, but he/she will also have a band of acceptable percentages. The following is a hypothetical investment portfolio of $1,000,000 using dynamic rebalancing:

1) Investment Portfolio at the Beginning of the Year

Type of Asset	Dollar Amount	% in Port	Overall
Large Cap Stocks	$300,000	30.0%
Mid Cap Stocks	125,000	12.5%
Small Cap Stocks	100,000	10.0%
International Stocks	200,000	20.0%
Emerging Market Stocks	25,000	2.5%	75.0%
Domestic Bonds	150,000	15.0%
International Bonds	50,000	5.0%	20.0%
Cash	50,000	5.0%	5.0%
Total	$1,000,000	100.0%	100.0%

Type of Asset	Low – Band	High – Band
Large Cap Stocks	30.0%	40.0%
Mid Cap Stocks	10.0%	20.0%
Small Cap Stocks	10.0%	15.0%
International Stocks	15.0%	25.0%
Emerging Market Stocks	0.0%	5.0%
Domestic Bonds	15.0%	30.0%
International Bonds	5.0%	15.0%
Cash	5.0%	25.0%


2) Investment Portfolio at the End of the Year after Assumed Market Fluctuations

Type of Asset	Dollar Amount	% in Port	Overall
Large Cap Stocks	$275,000	26.6%
Mid Cap Stocks	150,000	14.5%
Small Cap Stocks	160,000	15.5%
International Stocks	175,000	16.9%
Emerging Market Stocks	10,000	1.0%	74.4%
Domestic Bonds	175,000	16.9%
International Bonds	40,000	3.9%	20.8%
Cash	50,000	4.8%	4.8%
Total	$1,035,000	100.0%	100.0%

Type of Asset	Low – Band	High – Band
Large Cap Stocks	30.0%	40.0%
Mid Cap Stocks	10.0%	20.0%
Small Cap Stocks	10.0%	15.0%
International Stocks	15.0%	25.0%
Emerging Market Stocks	0.0%	5.0%
Domestic Bonds	15.0%	30.0%
International Bonds	5.0%	15.0%
Cash	5.0%	25.0%


3) Steps Taken to Dynamically Rebalance the Investment Portfolio

Type of Asset	Dollar Amount	Buy or Sell
Large Cap Stocks	$35,000	Buy
Mid Cap Stocks	0	No Action
Small Cap Stocks	(40,000)	Sell
International Stocks	5,000	Buy
Emerging Market Stocks	(10,000)	Sell
Domestic Bonds	(20,000)	Sell
International Bonds	25,000	Buy
Cash	5,000	Buy
Total	$0


4) Investment Portfolio After Dynamic Rebalancing

Type of Asset	Dollar Amount	% in Port	Overall
Large Cap Stocks	$310,000	30.0%
Mid Cap Stocks	150,000	14.5%
Small Cap Stocks	120,000	11.6%
International Stocks	180,000	17.4%
Emerging Market Stocks	–	0.0%	73.4%
Domestic Bonds	155,000	15.0%
International Bonds	65,000	6.3%	21.3%
Cash	55,000	5.3%	5.3%
Total	$1,035,000	100.0%	100.0%

Type of Asset	Low – Band	High – Band
Large Cap Stocks	30.0%	40.0%
Mid Cap Stocks	10.0%	20.0%
Small Cap Stocks	10.0%	15.0%
International Stocks	15.0%	25.0%
Emerging Market Stocks	0.0%	5.0%
Domestic Bonds	15.0%	30.0%
International Bonds	5.0%	15.0%
Cash	5.0%	25.0%

Here are the salient pieces of information to note when reviewing the hypothetical scenario above. At the beginning of the year, the individual investor allocates the investment portfolio amongst a number of options. The options are large cap stocks, mid cap stocks, small cap stocks, international stocks, emerging markets stocks, domestic bonds, international bonds, and cash. Note that the individual investor has opted to define bands for acceptable percentage exposures to these investment options. The investment amount of the asset allocation in each category is within the band. Additionally, assume the individual investor has established acceptable and desired percentage exposures to the overall asset class. The percentage allocation to stocks is between 70.0% – 80.0%, to bonds is between 20.0% – 30.0%, and to cash is between 0.0% – 15.0%. Note that the sum of the bands will not equal 100.0%; however, the investment portfolio at any given time will always add up to 100.0%. In the third part of the hypothetical scenario, there are changes to the investment portfolio in terms of buying, selling, or doing nothing because of the dynamic rebalancing process (in part because some of the bands are violated). When reviewing the fourth part, the balances and percentage allocations reflect those changes and the percentages do not match the percentage allocations from the first part. They do not need to as long as the rules for the bands are followed at an overall level and specific-component level.

The hypothetical scenario can be adapted to any investment portfolio size and number of components in the investment portfolio. Furthermore, the bands of acceptable exposure to asset classes overall or more specific investments can be lower or wider. The main point of the bands is that the individual investor has more control over the asset allocation of the investment portfolio. With that being said, the individual investor is not allowed to become too greedy or too fearful. There are times when a certain type of investment performs extraordinarily well and becomes an ever larger portion of the investment portfolio. If the percentage allocation exceeds the band though, the amount invested must be reduced to limit risk. On the other hand, there are times when a certain type of investment performs quite poorly and becomes a rather low portion of the investment portfolio. It might be tempting to sell the entire portion of the investment portfolio. Generally speaking though, an individual investor should have exposure to a number of investment components and not try to determine when it is right to avoid one altogether to remain diversified.

In summary, one will note that dynamic rebalancing is much more complicated than using hard and fast rules for the absolute value of percentages allocated to each investment component. It should really only be used by more advanced individual investors. Thus, I would urge caution before deciding to implement the dynamic rebalancing approach to your investment process. I would mention that it is very important to shy away from any investing strategy in general that is too complex to understand. It is easy to be confused even more as time passes and make critical investing errors in the future. As it relates to rebalancing, an individual investor may want to start with the standard usage of rebalancing discussed in parts one and/or two of this three-part series. Dynamic rebalancing might be an option for the future, or you may even start your own hypothetical paper portfolio with this method to learn more. Lastly, dynamic rebalancing does not need to be used. I only offer it as a tool that is appropriate for a subset of individual investors. Therefore, you should not view dynamic rebalancing as an investment strategy that must be utilized in the future once rebalancing is fully understood. It is perfectly acceptable to stick with normal rebalancing and never even begin using dynamic rebalance as an investment strategy. Moreover, some individual investors using dynamic rebalancing get carried away and start trying to “time the market” which would be a far worse result.

The Hidden Dangers of Active Investing for Individual Investors

04 Monday May 2015

Posted by wmosconi in active investing, active versus passive debate, asset allocation, Consumer Finance, finance, financial planning, investing, investments, passive investing, portfolio, stocks

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The typical discussion surrounding active investing relates to a comparison with passive investing. Active investing is normally defined as investing money with money managers that select individual stocks or bonds with the overall goal of beating the performance of the stock or bond market indexes. An example might be a large cap stock mutual fund that attempts to have a total return better than the S&P 500 index. Passive investing is normally defined as investing money in an index mutual fund or ETF that simply selects the individual stocks or bonds within a particular stock or bond index. There is no attempt to beat that index. Why would an individual investor choose this route? While it may seem that settling on a strategy to be only average is “giving up” on great returns, it has been shown in numerous studies that active money managers achieve lower returns than their index over long periods of time. In fact, if you look up this particular topic on the Internet, there will be a plethora of articles and information that looks at this topic in much greater depth. However, I would like to look at this topic from a different standpoint. The topics discussed below still relate to active investing, but the view looks more at an individual investor’s entire portfolio. Well, let’s dig into the details.

Active money managers may not be fully invested in the stocks or bonds that you expect at all times.

Most individual investors think that the active money managers they choose are always fully invested. In fact, that is not normally the case when it comes to mutual funds. Mutual funds will be used for the purpose of our discussion since they are the most common investment held by individual investors when it comes to active investing. A lot of portfolio managers decide that the stock or bond market may be poised to decline at any given time. Since they have this belief in the future direction of the market, they sell stocks or bonds and raise cash in the mutual fund. Thus, they do not hold 100% of the assets in the mutual fund in the stated investments for the investment strategy. Why does this matter? It is easiest to see within the context of an example.

We can examine what happens using a hypothetical portfolio for an individual investor. Let us assume that an individual investor has a $1,000,000 portfolio. Further assume that this investor devotes 40% of this total to large cap stocks (i.e. stocks from the S&P 500 index). That assumption would mean that the total portfolio holds $400,000 ($1,000,000 * 40%) worth of large cap stocks. Now we assume that the individual investor chooses one active mutual fund to invest with. What if that active money manager decides that a large decline is coming in large cap stocks, so he/she reduces the exposure of the mutual fund to 70% invested in large cap stocks and 30% invested in cash? The individual investors’ portfolio now has $280,000 ($400,000 * 70%) invested in large cap stocks and an additional $120,000 ($400,000 * 30%) in cash. The portfolio is now 28% large cap stocks and 12% more in cash. Why is this important for the individual investor?

The consequences are enormous. When this investor initially decides on his/her portfolio allocation and tolerance for risk in relation to achieving financial goals, he/she is assuming that the portfolio will be 40% in large cap stocks. In the aforementioned example, unbeknownst to this investor, he/she has a lot less exposure to large cap stocks and a lot more of the portfolio in cash. The important thing to remember here is that when an individual investor embarks upon a passive investment strategy he/she is assured that the exact percentage of any given type of investment is selected. Another thing to remember is that the individual investor could have chosen to invest only 28% in large cap stocks and an extra 12% in cash to begin with. The decisions of the active portfolio manager thwart the individual investor’s attempts to build a portfolio of investments that meets his/her needs. The active portfolio manager is timing the stock or bond market, and the individual investor does not know to what extent that money manager is doing at any given time.

2. Active money managers have great latitude in the investments they choose and may not be invested in the stocks or bonds an individual investor thinks.

Most individual investors do not look at the prospectus for the mutual fund that they invest in. The prospectus is a document required by the SEC to be given to all investors. It includes many pieces of information like expenses of the fund and all sorts of legalese components that are very hard to understand. One important section of the prospectus is the section that discusses the types of investments the mutual fund may choose. Since the portfolio manager does not want to be handicapped during times of market turmoil or when unusual investment opportunities present themselves, the types of investments allowed is very broad. For a stock mutual fund that invests in technology stocks, this section will still include the option to invest in different sectors of the stock market. This practice is not uncommon in the industry. What does this mean for your portfolio?

The most important consequence for your portfolio is that you may own stocks or bonds that you do not expect, or you may own the same investment in two or more different active mutual funds. As it relates to the former, you might own an active stock mutual fund that invests in US stocks. However, if the portfolio manager decides that an international stock is a great investment, he/she may invest in that stock as long as it has been disclosed in the prospectus as being allowable. As an investor, you may not want to take on the extra risk of investing in international stocks. As it relates to the latter, there are times when an active portfolio manager invests in a stock or bond that begins in one category of investment and morphs into another over the holding period of that stock or bond. An example here would be in the case of a small cap mutual fund. Most people define a small cap stock as a company with a market capitalization of $1 billion to $5 billion. There are times when an active mutual fund invests in a larger small cap company that does well over time and becomes a mid cap stock by definition. Why is this important? Well, if an individual investor selects the desired percentages of particular stocks or bonds he/she wants to have exposure to, he/she may have overlap between different stocks or bonds in different mutual funds without knowing. A great way to determine how pervasive this phenomenon is within your portfolio is to use the Instant X-Ray feature of Morningstar. Here is the link:

http://portfolio.morningstar.com/NewPort/Free/InstantXRayDEntry.aspx

You will be able to see how many stocks or bonds are included in two or more mutual funds that you own. The great advantage of using a passive investing strategy is that the index mutual funds and ETFs are totally transparent. Individual investors are able to ensure that they never invest in stocks or bonds they do not want or invest extra amounts in the same investment.

3. Some active money managers engage in “window dressing” their mutual funds.

The term window dressing is applied whenever an active money manager adds the best performing stocks or bonds to the mutual fund right before the end of the quarter or prior to a report being issued. There are times when an active money manager is underperforming relative to his/her benchmark index. One of the things he/she can do is to add stocks or bonds that have done particularly well during that time period. Thus, the mutual fund did not own that investment for the entire period. However, it looks great to investors because they assume that the portfolio manager is making savvy investment decisions. How does this occur? The main reason this occurs is that mutual funds do not report the purchase date of any stock or bond. They are only required to show how many shares/bonds are owned and the corresponding market value when applied to the closing price at the end of the time period. The only way to check to see if window dressing happens is a messy process. The individual investor must look back at prior reports to see if the stock or bond was actually owned then. Even using this method is imperfect because the portfolio manager may indeed have purchased the security in question at the beginning of the period. The main point is that window dressing is simply a shell game that misrepresents the portfolio manager’s stock or bond selection ability over the time period.

4. Performance returns presented by mutual funds are only on a gross basis. The taxes an individual investor pays on dividends and capital gains are not reflected which provides a net basis of the actual performance return.

The first thing to point out is that this particular discussion only applies to taxable accounts. If you have your investment in a 401(k), 403(b), Traditional or Roth IRA, or other tax-exempt accounts, you are not subject to income taxes. Therefore, there are no tax consequences at this point in time that reduce your gross basis performance returns. If you only have tax-exempt accounts, you can skip this discussion or read on simply for your own knowledge.

Now it is not the fault of mutual funds for neglecting to present net basis performance returns after tax. Why? Well, each individual investor is in a different tax bracket and may have different tax situation. With that being said, it is important to note that active mutual funds almost always have more taxable items than any passive index mutual fund or ETF. The reason for this occurrence is due to turnover of the mutual fund. What is turnover? The definition of turnover is how many times a mutual fund (or any investment vehicle for that matter) buys and sells the entire grouping of stocks or bonds during any given year. The simplest example is a turnover of 100%. A turnover of 100% means that the mutual fund bought and sold all stocks or bonds during the year. Another way of putting it in more simple terms is that the mutual fund held the stocks or bonds for one year on average prior to selling. A turnover of 200% means that the average holding period was six months. A turnover of 50% equates to an average holding period of two years.

Higher turnover in the mutual fund means that there are more capital gains (and capital losses too). Thus, there are more tax consequences to the individual investor. Recent studies have shown that the average turnover for an active mutual fund is roughly 80%. When you contrast that with passive index mutual funds or ETFs, the turnover is low by definition. The index providers usually only make changes to the members of that index annually. There are usually only a small number of stocks or bonds added to or deleted from the index. This means that turnover is very low; it can be 10%-20%. The main thing to remember for individual investors is that gross returns are all right for a baseline of performance. However, he/she really should focus on after-tax performance returns of the mutual fund. It is the money you have left in your brokerage account.

Summary

The hidden dangers of active investing touched on within this article are the main ones. The importance of these hidden dangers is mainly that, if an individual investor uses active money managers to build his/her investment portfolio, it is nearly impossible to do with any degree of confidence. When you create an investment portfolio yourself or with the guidance of a financial professional, you are doing two things. You are looking at your tolerance for risk and determining what your financial goals are for your lifetime. The second step is deciding what types of investments should be included in your portfolio and what percentages are appropriate to allocate to each type of investment. As we have seen above (especially in the first three dangers), there are constant forces working against an individual investor when using active money managers to keep the portfolio as designed. If you choose the passive route to investing via index mutual funds or ETFs, you are assured of obtaining the percentages within each investment category that you desire.

The argument of the merits of active investing or passive investing will go on and on. However, that discussion usually looks at a single type of investment vehicle choosing stocks or bonds for individual investors. Did this mutual fund beat its benchmark index this year? When it comes to individual investors, it is far more important to decide on the proper investment allocation of his/her portfolio in order to achieve one’s financial goals. The cross currents and confluence of having numerous active mutual funds makes it infinitely more complex to set up a portfolio. Passive investment vehicles are transparent at all times, so the individual investor is able to choose the exposure to large cap stocks, small cap stocks, international stocks, domestic bonds, international bonds, emerging market stocks, and so on that may be appropriate given his/her risk tolerance and financial goals. An individual investor can try to establish a portfolio using active managers. However, the discussion points (hidden dangers) above show the difficulty in this approach. First, the active money manager may not be fully invested. Second, the active money manager may invest in stocks or bonds that the individual investor does not intend or replicate holdings by different money managers. Third, the active money manager may engage in window dressing making it difficult to measure that money manager’s ability to choose the best performing stocks or bonds.

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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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.

Not all Index Mutual Funds and ETFs are Created Equal: Part 2 of 2

12 Wednesday Feb 2014

Posted by wmosconi in active investing, active versus passive debate, asset allocation, bonds, business, Consumer Finance, Education, enhanced indexing, finance, financial planning, Individual Investing, investing, investments, passive investing, personal finance, portfolio, risk, stocks, volatility

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The exponential growth of passive investment vehicles over the past ten years has been astonishing since the infancy of index investing that Vanguard made so famous back in the early 1980s. In the first part of this discussion, I spoke at length about the need to really read the prospectus or fact sheet of an Exchange Traded Fund (ETF) or an index mutual fund. Two similarly sounding investments may actually have quite different underlying components. I utilized two different emerging market stock ETFs to demonstrate the difference, and they were the iShares MSCI Emerging Markets Stock ETF (Ticker Symbol: EEM) and the Vanguard FTSE Emerging Markets Stock ETF (Ticker Symbol: VWO), respectively to show why this is true. The main issue in this case was that one considers South Korea to be a developing economy (EEM), and the other (VWO) does not. Therefore, a large component of your investment allocation in your portfolio to emerging market stocks may be more heavily weighted toward South Korea than you at first thought (over 15% in fact). For the details of the discussion, you can click on this link:

https://latticeworkwealth.com/2014/01/28/not-all-index-mutual-funds-and-etfs-are-created-equal-part-1-of-2/

The second issue that I hinted at in part 1 relates to the definition of passive investing. The active management versus passive investing debate has been raging on for over 30 years with proponents on both sides of the fence. In its most general form, passive investing is choosing to invest in all stocks or bonds tied to a particular index, such as the S&P 500 Index, Russell 2000 Index, MSCI EAFE Index, or the Barclays Aggregate Bond Index. The investor in this case decides that he/she would rather participate in the investment performance of all the components of the index rather than picking the best stocks or bonds themselves. Active managers strive to beat the investment performance of a particular index by scouring the quantitative and qualitative data about each particular stock or bond. These professionals believe that they have the ability to make superior investment choices and do better than average (i.e. just settling for the investment returns of the index less the expenses of the ETF or index mutual fund). I spoke at length about active and passive investing in one of my earliest blog posts. Here is the link to that more involved discussion to get further detail:

https://latticeworkwealth.com/2013/07/05/difference-between-active-and-passive-investing/

A new type of investment vehicle has sprung up during the development of the ETF industry, and it is referred to as “enhanced indexing”. The idea is that you can approach the debate by using a hybrid view of sorts. Enhanced indexing is investing in a particular index but not investing in all the stocks or bonds or choosing to weight the stocks or bonds differently than the index does. These ETFs offer the ability to use the asset manager’s proprietary strategy to pick the “best” members in the index. There are many managers that do this, and two of the most popular are offered by the WisdomTree company and Dimensional Fund Advisors. The ETF and mutual funds offered by these companies follow a similar philosophy with different approaches. However, each company strives to outperform the index that their portfolio managers select.

There is nothing wrong with any of the offering of these companies. In fact, many of their investment vehicles have had superb performance over the years. This salient point is that they are really “blurring” the line between active and passive investment philosophies. Using a more strict definition of passive investing, the investor knows at the outset that they will underperform the index by the amount of fees (and “tracking error” – a concept I will not go into specifically in this post) assessed to the ETF or index mutual fund. However, they will not significantly underperform because all the components of the index are always held. An active investment vehicle has the ability to outperform or underperform an index after fees are assessed each year. Investors in enhanced indexed ETFs or mutual funds fall into the latter category. Once the asset manager makes a decision to pick the “best” components of a particular index, they are moving into the realm of active management. One of the appeals of this investing strategy to individual investors is that you can still beat the index. With that being said though, you are taking the chance that the investment will underperform what the passive ETF or index mutual fund delivers in terms of investment returns.

Enhanced indexing may seem like a great way to “have your cake and eat it too”, but, at its core, active management (either by way of a proprietary computer algorithm, back tested studies, qualitative metrics, or some other method) nonetheless. Many individual investors fail to recognize that they are really choosing an active strategy, although some professionals would argue that it is more sophisticated than the approach of traditional active managers. As long as you are aware of this fact at the beginning, there is nothing wrong with that. In fact, many investment advisors use a combination of active and passive investment vehicles when building a portfolio for their clients. For example, it has been shown that there may still be inefficiencies in micro cap (normally stocks with a market capitalization below $1 billion) stocks because very few Wall Street analysts follow the companies and provide investment recommendations. On the other hand, there are a plethora of Wall Street analysts who follow the largest companies in the US, so it becomes much harder to know more than other investors. Thus, some financial professionals will advise a certain portfolio allocation to passive ETFs and another piece of the portfolio will go to active managers. This type of approach is a hybrid approach.

In the case of enhanced indexing (or “smart beta” funds – similar type of concept that I will not elaborate more on in this discussion), the individual investor is allowing the asset manager to make active selections which is much more akin to active investing. The key is to know that you run the risk of two things. First, the particular investment vehicle may do worse than the corollary strictly passive ETF or index mutual fund in terms of investment returns. Second, the asset manager may not always be fully invested in the index at all times as well. Therefore, you may have a higher allocation to cash than you initially wanted. Now if the asset manager sells stocks to raise cash before a downturn in stock prices, the individual investor will not lose as much as other market participants. The flipside is that the individual investor fails to participate fully in any stock market rally. This second part is emphasizing that the asset manager may lag the investment performance of the benchmark index even more so than the passive ETF or index mutual fund.

The important thing is to simply know up front that passive investing involves average underperformance at the outset. However, you are assured of at least capturing the lion’s share of the investment returns. Any other investment vehicle may do better or worse over the long term which is the main concern of an individual investor. If the enhanced indexing investment strategy yields lower long-term investment returns for your portfolio, you have paid money to “lose” money on a relative basis. What I mean by this is that, as an individual investor, you could have just invested in the entire index of stocks or bonds at a very low cost by doing absolutely nothing. If the enhanced index manager outperforms the index after fees are taken into account, that investment decision was a wise one. However, history has shown that active managers tend to lag their proper benchmark over the long term (usually defined as 5 years or more).

It may be enticing to try to combine the best features of the passive investing and active investing philosophies. With that being said, individual investors need to realize that any departure from the strict definition of passive investing increases the odds that the manager will have an investment return different than the index. If your investing time horizon is 5, 10, 15, 20 years or more, the active mangers (either in its pure form or via enhanced indexing) has a more difficult time outperforming the index year in and year out to provide the individual investor with performance above and beyond what the “stodgy”, old passive ETFs or index mutual funds offer. I would characterize this more as “buyer beware”. The main takeaway is not that these are “bad” investments at all; rather, it is a conscious choice to depart from the passive world of investing and move to the active side.

Latticework Wealth Management, LLC

~ Information for Individual Investors

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Not all Index Mutual Funds and ETFs are Created Equal: Part 2 of 2