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Here is the last article related to our discussion of observations by the financial media with only a handful of observations, statistics, and time series data. The goal here is to provide an actual example to see what some of the pitfalls are. Prior to starting that discussion, I wanted to provide links to the first and second articles:
The first article laid the groundwork for the idea that there are many misuses of statistics and related items which appear most everyday in the print and television financial media. Here is a link:
The second article focused more on time series data and using the normal distribution to make conclusions and predictions about the financial markets. As promised, I will be posting a more detailed mathematical article as a supplement. However, the point of this article is only to make you aware of what to look for in general. You do not need to feel the need to get very granular. The audience that really wants more information has contacted me offline and is very small. Here is a link:
Now let’s begin our journey to sum up these two articles by using the specific example of a “yield curve inversion”. First, what exactly is the yield curve? Okay, we are going to keep this explanation simple. The point of this article is not to become an expert on bond yields. The yield curve is simply the interest rate (referred to as “coupon” in the financial jargon) of bonds at certain maturities. For U.S. Treasury issues, you normally look at the interest rate on one-month, three-month, and six-month U.S. Treasury Bills. Then you add in one-year, two-year, three-year, five-year, seven-year, and ten-year U.S. Treasury Notes. And finally, you have the thirty-year Treasury Bonds (otherwise referred to as the “long bond” in financial jargon). Why bills, notes, and bond? It is simply a naming convention for all U.S. Treasury debt less than twelve-months is a bill, between one-year and ten-years is a note, and anything greater than ten-years is a bond. Once you know all those interest rates, you draw a line that connects all of those interest rates from one-month U.S. Treasury Bills all the way to thirty-year U.S. Treasury Bonds.
Why do people focus on this? Well, first, you would expect that interest rates for one-month bills to be lower than thirty-year bonds. Think of it like this: if your friend borrowed $20 and was going to pay you back at the end of the week or in three years. What interest rate would you charge him/her? Now a totally altruistic person would say nothing. But let’s say you are trying to teach your kids the value of money. Most people would charge a greater amount of interest for three years compared to one week. The U.S. Treasury debt market works very similarly. People who loan the government money for one month normally demand a lower interest rate than those people who are going to have to wait thirty years to get their money back. When the economy is growing normally, the yield curve is called steep. It goes from lower interest rates and gradually moves higher. But that is not the only shape of the yield curve possible.
The other two are flat and inverted. A flat yield curve simply means that interest rates all along the various maturities are pretty much the same. Now, as our article will shift to, an inverted yield curve means that closer maturities actually have a higher interest rate than the very long-term maturities. Why does this happen? Well, most economists and financial professionals will tell you that the economy is slowing down and a recession is coming. Why? The last 7-8 recessions were preceded by a yield curve inversion. Let’s take a look at the yield curve over time by comparing two-year U.S. Treasury Notes with ten-year U.S. Treasury Notes. Keep in mind that we are taking a look at the difference between the two. A number that is positive means that interest rates are higher for ten-year bonds and a negative number means just the opposite.
Here is a daily comparison from June 1, 1976 through November 6, 2019:
Here is the same comparison but on a monthly basis:
I used a graph of the month difference (“spread”) to smooth out some of the volatility. Now if you remember your economic history, you will notice that there are negative “spreads” that occur prior to a downturn in the U.S. economy. Let’s focus on the yield curve inversion prior to the Financial Crisis. As you can see, the yield curve was inverted at various times over the course of 2006 to 2008. It took approximately two years from the yield curve inversion before the Financial Crisis hit in full force in September 2008. Because this pattern has occurred before, economists and financial professionals appearing on television or writing articles have pointed to the yield curve inversion just recently.
But you should take a closer look at the latest inversion of the yield curve. It is only a small difference and only lasted for a short period of time. I will blow it up to investigate and will show November 1, 2018 through October 31, 2019:
I had to use a one-year timeframe to even be able to get the difference in interest rates to show up. So, for a period during August 2019 and September 2019, there were a plethora of financial markets’ articles and television commentators who talked about how soon a recession would take place in the U.S. economy. In fact, there were days when over 25% of the day’s coverage of financial market news focused only on this yield curve inversion. Now, will the U.S. economy go into recession in the next 12-24 months? Well, that is still an open question. The main point is that the financial news media focus on things that have similar patterns for only a brief period of time. Even worse though, financial “experts” who know very little about the bond market and economics start making predictions. And, as I have said many times in the past, the financial news media rarely, if ever, invites guests back or has another article written about how wrong they were.
Lastly, you will sometimes here people say that there is a 30% chance that the U.S. economy will enter a recession in the next 12-24 months. Where does that percentage come from? Oftentimes, it is a “best guess”. Unless you hear that same financial professional talk about a probity econometric model that came up with that percentage of recession probability, you should take the comment with a “grain of salt”. Trust me though, most financial professionals are not running probit models when they tell you their opinion on this matter (related to an inverted yield curve or due to another topics/event). In the supplemental article that is forthcoming, I will actually discuss a panel probit model that the Bank of International Settlements (BIS) just ran to look at the phenomenon of yield curve inversion preceding a recession in an economy. It is not that the percentages derived are “correct” per se. The important point is that they are not “pulled out of a hat” by someone.
I hope that this series of articles has been helpful in covering this important topic. The main takeaway is that, whenever you hear or read about a financial market prediction, you should always look to see how many examples (observations) are being used. If it is less than 30, you should not take it very seriously at all. Additionally, any time series data that is trending upward or downward cannot be used to talk about the financial markets. Remember you need to first-difference the time series data or adjust it in some other manner. Why? Otherwise, there may be correlations between two or more time series that just are not really there because the trend dominates. (Please refer to the second article for more information in this regard). So, please be more aware and skeptical of what you hear or read. It is not that the information/prediction is totally wrong. The salient thing is that it should be based on sound statistics and mathematics.
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I originally wrote about this topic five years ago. However, I think that it may even be more relevant today. You may have heard about behavioral finance/economics and how cognitive biases plagued individual investors when making financial and investing decisions especially during volatility times in the financial markets.
Sometimes an overlooked topic is the fact that whomever provides you with financial advice will invariably be affected by those same biases. Yes, even the professionals cannot escape them. One of the most prevalent and insidious cognitive biases is called “anchoring”.
In layman’s terms, “anchoring” describes the tendency of people to form a particular belief and then stick with it unless there is an incredible amount of evidence to the contrary. It is just part of human nature; we generally do not want to admit that we were mistaken or flat out wrong.
Now when I am talking about considering the source, I am not referring to the person’s qualifications such as having a Chartered Financial Analyst (CFA), Certified Financial Planner (CFP), or Chartered Market Technician (CMT) designation. I am referring to the person’s investing paradigm.
For the most part, financial professionals are influenced greatly by the time period in which they first start out in the financial services industry. The first several of years have an outsized impact on their investing recommendations throughout the rest of their careers.
I will give you an example in life, and then I will talk about Warren Buffett and even myself. Take special note that I am including myself in this “anchoring” cognitive bias within the context of investing.
There have been many studies that show that the kind of music you listen to most during your teen years becomes your preferred type of music. For example, there are many people in their early 40’s that love 80’s rock. They would prefer to listen to that over any type of new music. My parents are in their seventies now, and they love to listen to Peter, Paul, & Mary, the Beach Boys, Neil Diamond, Motown, and lots of one-hit wonders from the 50’s and 60’s.
Think about your own taste in music. Does this ring a bell? Most people fall into this category, and it is almost subconscious. You like a certain genre of music best, and it sticks with you. Did you have a family member that was really into music and had a collection of records? Sometimes you get introduced to music at an even younger age, and you are drawn to it. You listened to it during your formative years. The same goes for investing in a rather similar way.
If we take a look at Warren Buffett, he was definitely influenced by the time period in which he started learning about investing seriously. Buffett read Security Analysis by Benjamin Graham and David Dodd, and he knew right away that he wanted to go to Columbia to get his MS in Economics. The themes in the book seemed to resonate with him. I have heard stories that the value investing class with Ben Graham and Warren Buffett was really a conversation between the two of them. The rest of the classmates just sat back and enjoyed the “show”.
Warren Buffett also learned a lot from a lesser known gentleman, Phil Fisher. Phil Fisher wrote the classic treatise on “scuttlebutt” called Common Stocks and Uncommon Profits. “Scuttlebutt” is essentially trying to gain every last piece of information you can about a company prior to investing. This technique includes, not only speaking to management and reading annual reports, but talking to competitors, suppliers, current employees, past employees, and several other sources.
Warren Buffett remarked in the past that he was “15% Fisher and 85% Graham” in terms of his investing style. Most experts on the career of Buffett would say that the percentage has shifted toward Fisher quite a bit, especially with the massive size of Berkshire Hathaway now.
I did not pick Warren Buffett because of his long-term track record of stellar performance. I only picked him because many individuals are familiar with Warren Buffett. Warren started out working for Graham in the early 50’s after he graduated from Columbia in 1951. If you look back at this time in history, the stock market had finally gained back its losses from the great crash of October 1929. The baby boom was in full swing, and the US economy was on overdrive in terms of growth. The Securities and Exchange Commission (SEC) was set up back in 1933 after the crash once an investigation was done regarding the causes of this debacle.
There were two important promulgations from the SEC in 1934 and 1940 that were issued in order to ensure that company information was available to the public and not fraudulent. Well, there were still scams, but they were harder to pull off. (As an aside, the Investment Advisor Act of 1940 did not stop Bernie Madoff from stealing billions of dollars several years ago). Buffett and Graham (and Graham’s partner, Newman) loved to get their hands on any piece of information they could. In fact, Buffett used to read entire books on every single public company.
During that time period, information was so disjointed and hard to get. However, it was now available to the public and professional investors who could do much more thorough analyses. The financial markets had far more inefficiencies back then.
This time period was before the dawn of Modern Portfolio Theory (MPT), the Capital Asset Pricing Model (CAPM), and the Efficient Market Hypothesis (EMT). Thus, there was a great deal of opportunities for individuals like Buffett who soaked up all the information he could find.
Buffett started his own investment partnership in the mid 50’s. It was essentially a hedge fund in most respects. Without getting into too much of the details, Buffett was able to earn 20% more on average than the Down Jones Average annually until 1969. The stock market at this time seemed to be overpriced in his estimation, so Buffett disbanded the partnership. He referred his partners to Bill Ruane of the famed Sequoia Fund. Bill was a former classmate of Warren, and he amassed quite a record himself.
So if we look at Buffett’s beginning career, he saw how doing your homework really paid off. In fact, there are even stories that Ben Graham would use examples in his lectures about companies he was going to buy. After class let out, all the students rushed to call, or see directly, their stock brokers to buy the companies Graham presented on.
Buffett learned from Graham the importance of valuing a company based upon verifiable evidence and not market sentiment. Fisher’s lessons showed him the benefit of accumulating information from different sources in order to truly understand a business prior to investing. These formative years are still with Buffett.
Now Charlie Munger, Buffett’s Vice Chairman at Berkshire Hathaway, has been an influence as well. What is little known is that they grew up together in Omaha, Nebraska, and they were able to meet during this same time period. This introduction to investing left an indelible mark on Warren Buffett that permeates his investing career today.
Obviously I am no Warren Buffett, but I started investing in mutual funds at age 13 in November 1987. What got me so interested in the stock market? Obviously Black Monday on October 19, 1987 really caught my attention. It was not really the crash that really piqued my interest though. My father told me that the market drop of 508 points on that day was an overreaction (down over 20% amazed me). I did not know much about stocks, but it seemed to me like the world was ending. At least that was how the nightly news portrayed things. My father said watch the market over the next several days.
To my absolute amazement, the Dow Jones Industrial Average (DJIA) went up almost 290 points in the next two trading sessions. Wow! This turn of events was really weird to me. How could stocks move around in value so greatly?
I thought that all the big money investors in the stock market really knew what they were doing. However, most everyone was caught by surprise by Black Monday. The other interesting thing for me was that 1987 turned out to be a positive year for the DJIA. If you want to get your friend’s attention, you can ask them what the return of the DJIA was for 1987 (positive return) and 1988 (negative return). Most people will get it wrong.
Well, these events left a mark on me. When I learned more about investing and was exposed to Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMT), I really did not think it was true given my start in investing back in the latter portion of 1987. How could the value of the entire U.S. economy be worth 20% less after one day of trading?
Now, the stock market is normally efficient and stock prices are correct, but I knew that there were inflection points in the stock market where rationality was thrown out the door. Therefore, when I learned about Mr. Market and the vicissitudes and vagaries of the stock market from Ben Graham’s books, I liked that metaphor and way to characterize volatility in the stock market.
For better or worse, I really do not care for the academic, ivory tower analysis of behavior in the stock market. I cling more to focus investing, value investing, and seeing the financial markets as complex adaptive systems. I would fall into the camp of Warren Buffett and the great hedge fund investor, George Soros. Both men have said that they would never be able to pass the Chartered Financial Analyst (CFA) exam.
The CFA is now the standard designation for all portfolio managers of stocks and bonds. I tried studying for it, but a lot of it made little sense to me. I guess that is why I think it is funny when Buffett says he wants to gift money to universities to install permanent chairs in business schools to teach Modern Portfolio Theory forever.
Most of the financial professionals you meet will range in age from twenties to sixties. You should always ask them when they started investing or their career as a Financial Advisor. Here are the ten major events that will cover those individuals:
- The 1973-1974 severe bear market;
- The Death of Equities article from Business Week magazine in 1979;
- Black Monday in October 1987;
- The Bond Bubble Bursting in 1994;
- The Asian Contagion and Long Term Capital Management (LTCM) incidents in 1997-1998;
- The Barron’s article in December 1999 that questioned the relevance of the Oracle of Omaha, Warren Buffett;
- The Bursting of the Internet Bubble in April 2001;
- The Financial Crisis and ensuing Great Recession of 2008-2009;
- The “Lost Decade” of Returns from the S&P 500 from 2001-2010 when stocks averaged approximately 2% annually.
- Managing Money is Easy. Look at my investing record over the past 10 years (2009-2018). Note that the annualized return of the S&P 500 index over that period was 13.13%.
These major inflection points in the financial markets will have a great effect on your financial professional’s recommendations for investment portfolio allocation. In fact, I met a Financial Advisor that tells his clients that they can expect to earn 12% annually from stocks over the long term. He uses this return for modeling how much clients need to invest for retirement. He was introduced to investing around 1996 which is when the stock market went gangbusters.
I know another Financial Advisor that tells his clients to never put more than 50% of their money in common stocks. He tells this to all of his clients, even if they are in their thirties and have 30+ years until retirement. He started advising clients in 2007, and he lost a great many clients in 2008. Therefore, he wants to have limited downside risk for two reasons.
First, he has seen how much the stock market can drop in one year. Second, this gentleman wants to ensure that his clients do not close accounts and flee to other financial professionals because the stocks in their portfolio go down 30-40% in a single year.
The importance today of the long, extended bull market of the past 10 years is extremely important to take into account for all individual investors. A recent stretch of 13.13% annualized stock returns makes it seem that investing systematically over the long term is the correct investment strategy. I would not disagree with that thought.
However, Financial Advisors with 10 years of experience or less will only tell clients what they would do hypothetically in the event of a major market decline in the stock and bond markets. Hypotheticals and backtesting are all well and good.
But it has been my experience, that there is no substitute for actually investing during periods of extreme volatility and major stock market declines (20% or more). For example, what was the best stock investment strategy right after the Internet Bubble implosion in terms of the asset class? The best performing asset class for the next decade was to have a larger than normal allocation to emerging market stocks (think Ticker Symbol EEM or VWO). Do you think that your Financial Advisor would have the stomach to recommend this investment to you after seeing the NASDAQ index fall by over 50%?
As you can see, the start of anyone’s investing career has an impact on their outlook for the financial markets and how to set up a portfolio properly. I am not saying that any of this advice is “wrong” per se.
My only point is that you need to probe your Financial Advisor a little bit to understand the framework he/she is working with. Thus, you can refer to the aforementioned list of ten major events in the history of the financial markets. These events really shape the investment paradigm of all of us. And, of course, I will admit that I am no different.
With that being said, most investment strategies recommended by Financial Advisors are borne out of those individuals first few years with the financial markets. Some financial professionals are more bullish than others. Others focus on downside risk and limiting volatility in investment portfolios. Still others utilize complicated mathematics to build investment portfolios that are optimized.
Therefore, you need to understand your risk tolerance and financial goals very well. You have your own personal experience with the market. If your Financial Advisor is somewhat myopic and focused on the past repeating itself in the same way over and over, you need to be careful.
History does repeat itself, but the repeating events will be caused by much different factors in most cases. Unfortunately, the financial markets and market participants are always adapting to changing investment strategies, global economic GDP growth, interest rates, geopolitical events, stock price volatility, and a whole host of other things.
You can learn from the past, but I urge you not to be “stuck” in the past with your Financial Advisor’s “anchoring” cognitive bias at the expense of setting up an investment portfolio that will allow you to reach your financial goals and match your risk tolerance.
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The vote by the United Kingdom (UK) to leave the European Union (EU) caught the majority of individual investors by surprise. In fact, the so-called Brexit was not foreseen by many of the most sophisticated professional investors and money managers all around the world. The election results sent shockwaves through the financial markets on the Friday and Monday following the Brexit vote. The most notable effect was the devaluation of the pound to its lowest level since 1985. Over the course of Tuesday through Friday, the US and European stock markets gained back nearly all their losses from the two days after the Brexit vote. This fast-moving volatility has left individual investors feeling confused, frustrated, bewildered, and a bit scared. However, the Brexit vote results offer individual investors a unique set of key lessons to learn and understand.
The four important lessons for individual investors from the Brexit vote are as follows:
- 1) There are very few seminal events in financial market history that affect the future path of stocks, bonds, and other assets.
The difficult thing to realize about the financial markets is that there are very few consequential events that make an inflection point or major change in the direction of the financial markets. Even more frustrating than that, these consequential events are only known with the benefit of hindsight. In other words, what seems like a monumental event today may or may not be considered one of those major events. Given the fact that there are so few, there is a high probability that the seemingly major events of today will not fall into the seminal event category of financial market history.
What are some of the seminal events in financial market history? Here is a list of some of the seminal events in chronological order: the stock market crash in October 1987, the bursting of the bond bubble in 1994, the Asian contagion of 1997-1998, the bursting of the Internet bubble in March 2000, and the Great Recession of the financial crisis starting in September 2008. There are many more examples previous to 1987, but these are events from recent financial market history that many individual investors will remember. Keep in mind that in between all of these events are a string of other major events that turned out to be minor blips that caused only fleeting financial market volatility or none at all.
Furthermore, these seminal events are confusing to financial market participants in and of themselves. For example, let’s take a closer look at the stock market crash of October 1987. The US stock market dropped over 20% in one day, and things looked very dire. If an individual investor with a portfolio of $100,000 had sold his/her stock mutual funds (primary investment vehicle used by individuals on the day of the crash, he/she would have a portfolio worth $80,000 approximately. That type of individual investor was likely to be very fearful and stay out the of stock market for the remainder of 1987. If an individual investor with a similar portfolio of $100,000 had keep his/her money in stocks on the day of the crash and for the rest of 1987, he/she would actually have roughly $102,000 at the end of 1987. Why? Well, there are not too many investors these days that remember how 1987 really turned out for the US stock market. The S&P 500 index ended up about 2% for the year, so US stocks recovered all of the losses from the crash and a bit more. Here’s a little fun exercise: Ask your Financial Advisor or Financial Planner what the return of stocks was in 1987. The vast majority will assume it was a horrible down year for performance returns.
Another excellent example is the bursting of the Internet bubble in March 2000. The reason it is so interesting is that individual (and even professional) investors forget the history. Alan Greenspan, the Chairman of the Federal Reserve during that time period, gave a famous speech where he coined the term, “irrational exuberance”. Greenspan warned investors that the Internet and technology stocks were getting to valuations that were way out of line with historical norms for valuation of stocks. What do individual investors forget? Well, that famous speech was actually given in December 1996. Yes, that is correct. Greenspan warned of the Internet bubble, but it took nearly 3 ½ years before financial markets took a nosedive. The main point here is that smart, rationale professional money managers and economists can know that financial market valuations are out of whack in terms of valuation at any given point in time. (Note that this can also be stock market valuations that are too low). However, these conditions can persist for far longer than anyone can imagine. That is why individual investors should not be so quick to sell (or buy) major portions of their portfolio of stocks and bonds when these predictions or observations are make.
For a more in depth look at this concept, you can refer to a blog post I wrote three years ago on this very subject. The link to that blog post is as follows:
- 2) Investors focus on valuations (no emotions) while traders and speculators focus on market sentiment (emotions) and valuation (no emotions).
The majority of professionals who talk to individual investors and provide advice will explain how important it is to keep emotions out of the equation when dealing with elevated market volatility. When the financial markets are bouncing up and down by large amounts in the short term, it can be very difficult to keep a cool head and resist the urge to buy or sell stocks, bonds, or other assets. The frenetic pace of market movements makes it seems as though an individual investor needs to do something, anything in response. The standard advice is to keep one’s emotions in check focus on the long term, and stick to the financial plan. What is usually missing from that advice is a more complete explanation why.
There are two general types of financial market participants: investors and traders/speculators. These two groups have vastly different goals and approaches to the financial markets. Investors are focused on investing in stocks, bonds, and other assets in order to obtain returns over time from their investments. The long term might be defined as five years. Thus, day-to-day fluctuations in the financial markets mean very little to them. On the flipside, traders/speculators are focused on making gains in stocks, bonds, and other assets in the short term in order to obtain returns. The short term for this group might be hourly, the medium term might be daily, and the long term might be weekly. With this particular group, they need to determine both the likely direction of the financial markets due to both market sentiment and valuation.
As you might imagine, the traders/speculators have to analyze emotions or the psychology of financial market participants. Gauging market sentiment (general short term positioning of traders/speculators in stocks, bonds, and other assets in terms of their trend to buy or sell) is all about emotions. Additionally, they must be able to combine that with proper valuations for stocks, bonds, and other assets. Essentially they need to be correct twice. On the other hand, investors are focused on the long term which corresponds to valuation. Valuation over the long term is not driven by emotions. There is a very famous saying by Ben Graham who taught one of the most well-known investors of all time, Warren Buffett. Graham said, “In the short term the market is a voting machine, in the long term the market is a weighing machine.” The takeaway from Graham’s quotation is that market sentiment (i.e. emotions) can drive the financial markets wildly over the short term. However, after a period of years, financial markets always seem to follow the path back to what their true valuations are. Since emotions are not part of that equation, individual investors should feel more comfortable ignoring or at least subduing their emotions whenever the financial markets exhibit high levels of volatility.
A related part of the story is the financial media (both TV and print) almost always provide information for traders/speculators. To be perfectly honest, the financial media would not have much to talk about if long-term investing was the topic. Essentially they would recommend analyzing one’s risk tolerance, define one’s financial goals, and then build a portfolio of financial assets to reach those goals over the long term. Yes, true investing is very boring actually. The financial media needs to have something more “exciting” to talk about in order to have viewers (readers) and the corresponding advertising dollars that come from that. Therefore, the stories and article appearing in the financial media are geared toward traders/speculators. Now if you are an investor, you can either ignore this bombardment of information or take it with the proverbial “grain of salt”. Thus, you can keep your emotions in check when all the traders/speculators are wondering how to react to the market volatility right now each and every trading day or week.
For a more in depth discussion of managing one’s emotions as it relates to investors, you can refer to one of my older blog posts. The link to that blog post is as follows:
- 3) The benefit of diversification can disappear or be reduced greatly whenever there are periods are elevated volatility.
The benefit of diversification is one of the hallmarks of the proper construction of an investment portfolio for individual investors. The basic premise (which has been proven over very long periods of time) is that investing in different asset classes (e.g. stocks, bonds, real estate, precious metals, etc.) reduces the volatility in the value of an investment portfolio. A closer look at diversification is necessary before relating the discussion back to the Brexit vote. The benefit of diversification stems from correlations between asset classes. What is correlation? To keep things simple, a correlation of 1 means that two different assets are perfectly correlated. So a correlation of 1 means that when one asset goes up, the other asset goes up too. A correlation of -1 means that two assets are negatively correlated. So a correlation of -1 means that when one asset goes up, the other asset goes down (exactly the opposite). A correlation of 0 means that the two assets are not correlated at all. So a correlation of 0 means that when one asset goes up, the other asset might go up, go down, or stay the same. Having an investment portfolio that is properly diversified means that the investments in that portfolio have a combination of assets that have an array of correlations which dampens volatility. Essentially the positively correlated assets can be balanced out by the negatively correlated assets over time which reduces the volatility of the balance in one’s brokerage statement or 401(k) plan.
What does all this correlation stuff have to do with the Brexit vote? Surprisingly, it has quite a bit to do with the Brexit vote. Note that this discussion also applies to any situation/event that causes the financial markets to exhibit high levels of volatility. During extreme volatility like investors witnessed after the Brexit vote, the correlations of most asset classes started to increase to 1. Unfortunately for individual investors, that meant that diversification broke down in the short term. Most all domestic and international stock markets went down dramatically over the course of the two trading days following the Brexit vote. Therefore, individuals who had their stock investments allocated to various different domestic and international stocks or value and growth stocks all lost money. When correlations converge upon 1 during extreme market shocks, there is really nowhere to “hide” over the short term. In fact, the only two asset classes that did very well during this period were gold and government bonds.
What is the key takeaway for individual investors? Individual investors need to realize that there is an enormous benefit to having a diversified portfolio. However, diversification is associated with investing over the long term and thereby harnessing its benefit. There are times of market stress, like the Brexit vote and aftermath, where diversification will not be present or helpful. When those times come around, individual investors need to keep emotions out of the picture and stick to their long-term financial plans and investment portfolios.
- 4) The surprise Brexit vote provides the perfect opportunity for individual investors to evaluate their risk tolerances for exposure to various risky assets.
The two trading days after the surprise vote by the UK to leave the EU (Brexit) were very volatile and very tough to keep emotionally calm. Individual investors were faced with a very unusual situation, and the urge to sell many, if not all of their investments was very real. That reaction is perfectly understandable. Now for the bad news, there will be another time when volatility is as great as or larger than the volatility that the Brexit vote just caused. In fact, there will be many such periods over the coming years and decades for individual investors. In spite of that bad news, the Brexit vote should be looked at as a learning experience and opportunity. Since individual investors know that there will be another period of elevated volatility, they can revisit their personal risk tolerances.
It is extremely difficult to try to determine or capture one’s risk tolerance for downturns in the financial markets in the abstract or through hypothetical situations. You or with the assistance of your financial professional normally asks the question of whether or not you would likely sell all of your stocks if the market went down 10%, 15%, 20%, or more. How does an individual investor answer that question? What is the right answer? There is no right or wrong answer to that type of question. Each individual investor is unique and has his/her own risk tolerance for fluctuations in his/her investment portfolio. A better way to answer the question is to convert those percentages to actual dollar amounts. For example, if an individual investor starts with $100,000, would he/she be okay with the investment portfolio decreasing to $90,000, $85,000, or $80,000 over the short term. Note that the aforementioned dollar amounts sync up with the 10%, 15%, and 20% declines illustrated previously.
The opportunity from the Brexit vote is that individual investors have concrete examples of the volatility experienced in their investment portfolios. It is far easier to analyze and determine one’s risk tolerance by looking at actual periods of market stress. Depending on your stock investments, the total two-day losses might have been anywhere between 5% to 10%. Let’s use a 10% decline for purposes of relating this actual volatility to one’s risk tolerance. If an individual investor was invested 100% in stocks prior to the Brexit vote, he/she would have lost 10% in this scenario. Let’s use hypothetical dollar amounts: if the starting investment portfolio was $100,000, the ending investment portfolio was $90,000. Now the vast majority of individuals do not have all of their money invested in stocks. So let’s modify the example above to an individual investor who has 50% in stocks and 50% in cash. In that particular scenario, the individual investor has $50,000 invested in stocks and $50,000 invested in cash. If stocks go down by 10%, this individual investor will have an ending investment portfolio of $95,000. Why? The individual investor only losses 10% on $50,000 which is $5,000 not the full $10,000 loss experienced by the individual investor with a hypothetical portfolio of 100% in stocks.
The importance of the illustrations above and its relation to the Brexit vote is that one can quickly calculate the actual losses from a market decline with a good degree of accuracy. So let’s say that you had 60% of your money invested in stocks prior to the Brexit vote. If the overall stock market declines by 10%, your stock investments will only decline by 6% (60% * 10%) assuming the other 40% of your investment portfolio remained unchanged. So let’s put this all together now. If you look back at the stock market volatility caused by the Brexit vote, you need to adjust the overall stock market decline by the percentage amount you have invested in stocks. That adjusted percentage loss will be close to the decline in your overall investment portfolio. Now whatever that adjusted percentage amount is, ask yourself if you are comfortable with that percentage loss over the short term. Or is that way too risky? If the adjusted percentage is way too risky for you and makes you uncomfortable, that is perfectly fine. The important piece of knowledge to learn is that you need to work with your financial professional or reexamine your investment portfolio yourself to reduce your exposure to stocks such that the adjusted percentage loss is reasonable for you to withstand. Why? Because there will be another market volatility event on the order of magnitude of the Brexit aftermath or even worse.
Keep in mind that I am not making a financial market prediction over the short term. The important point is that the history of financial markets has shown that periods of elevated market volatility (i.e. lots of fluctuations up and down) keep occurring over time. The Brexit vote provides a real-life example to determine if your risk tolerance is actually lower than you first imagined. The next cause of market volatility may be a known market event similar to how the UK vote to leave the EU was. The harder things to deal with are market volatility stemming from the unknown and unforeseeable. These market volatility events are called “black swans” which is the term coined by Nassim Taleb in his book by the same name several years back. A “black swan” can be a positive event for the market or a negative event for the market. As it relates to individual investors and risk tolerance, the negative “black swan” is applicable. Now the term “black swan” is improperly used today by many investment professionals. A “black swan” is an event that by definition is unknown and cannot be predicted. When it does occur though, there is a period of extreme market volatility afterward. Thus, you can adjust your risk tolerance to be better prepared for future events that will cause market volatility, either known events like the Brexit vote or unforeseen events. The Brexit vote aftermath should be embraced by individual investors as a golden opportunity to ensure that they are properly (or more precisely) measuring their risk tolerances.
Summary of Important Lessons for Individual Investor from the Brexit Vote:
- There are very few monumental financial market events that should cause individual investors to feel inclined to immediately change their investment portfolios. Plus, they can only truly be identified by hindsight;
- Investors should focus on valuation of financial assets (no emotions here), traders/speculators worry about market sentiment (emotions) and valuation (no emotions here);
- The benefit of diversification can disappear or be greatly reduced during periods of extreme market volatility and financial market stress over the short term;
- The surprise Brexit vote offers individual investors a valuable opportunity to see if their risk tolerances are aligned with the possibilities of short-term market declines. This real-life event can be used to redefine one’s risk tolerance to better withstand similar periods of market volatility that will inevitably occur in the future.
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This particular topic is so important that I decided to revisit it again. The discussion below adds further refinements and creates an even stronger tie to behavioral finance (i.e. how emotions affect investment decisions). Additionally, for those of you who desire more in-depth coverage of the math and statistics presented, I have included that at the very end of this article. Let’s delve deeper into this topic and what is meant by “reality”.
The first key to successful stock investing has more to do with your emotions than a fundamental understanding of what causes stocks to move up or down. Emotions about money can be a powerful thing and cause people to behave in irrational ways. One of the most common phrases passed on to investors as a piece of wisdom is to “buy low and sell high”. However, study after study has shown that most individual investors fail to heed that advice. Why does this happen? Well, I would submit the real cause is behavioral and based upon incomplete information.
Most individual investors are told when they start investing in stocks via mutual funds and/or ETFs to expect an annual return of 8% to 9% per year. You will find that many financial calculators to help you plan for retirement on the Internet have that as one of the inputs to calculate the growth of your portfolio over time. While that information is not too far off the mark based upon historical returns of the S&P 500 stock index, the actual annual returns of stocks do not cooperate to the constant frustration and consternation of so many investors.
That brings us to the first key to successful stock investing: The actual yearly returns of stocks very rarely equal the average expected. The most common term for this phenomenon is referred to as volatility. Stocks tend to bounce around quite a bit from year to year. Volatility combines with the natural instinct of people to extrapolate from the recent past, and investing becomes a very difficult task. I will get deeper into the numbers at the very end of the post for those readers who like to more fully understand the concepts I discuss. I do need talk in general about annual stock returns at this point to expand upon the first key.
Below I have provided a chart of the annual returns of the S&P 500 index for every year in the 21st century:
What is the first thing you notice when looking at the yearly returns in the table? First, you might notice that they really jump around a lot. More importantly, none of the years has a return that is between 8% and 9%. The closest year is 2004 with a return of 10.9%. If the only piece of information you have is to expect the historical average over time, the lack of consistency can be extraordinarily frustrating and scary. In fact, individual investors (and sometimes professional investors too) commonly look back at the last couple of years and expect those actual returns to continue into the future. Therein lies the problem. Investors tend to be gleeful when returns have been really good and very fearful when returns have been very low. Since the average never comes around very often, investors will forget what returns to expect over the long run and will “buy high and sell low”. It is common to sell stocks after a prolonged downturn and wait until it is “safe” to buy stocks again which is how the sound advice gets turned around.
I will not get too heavy into math and statistics, but I wanted to provide you will some useful information to at least be prepared when you venture out to invest by yourself or by using a financial professional. I looked back at all the returns of the S&P 500 index since 1928 (note the index had lesser numbers of stocks in the past until 1957). The actual annual return of the index was between 7% and 11% only 5 out of the 88 years or 5.7%. That statistic means that your annual return in stocks will be around the average once every 17 years. The 50-year average annual return for the S&P 500 index (1966-2015) was approximately 9.8%. Actual returns were negative 24 out of 88 years (27.9% of the time) and greater than 15% 42 out of 88 years (48.8% of the time). How does relate to the first key of stock investing that I mentioned earlier (“The actual yearly returns of stocks very rarely equal the average expected”)?
Well, it should be much easier to see at this point. If you are investing in stocks to achieve the average return quoted in so many sources of 8% to 9%, it is definitely a long-term proposition and can be a bumpy ride. The average return works out in the end, but you need to have a solid plan, either by yourself or with the guidance financial professional, to ensure that you stick to the long-term financial plan to reach the financial goals that you have set. Knowing beforehand should greatly assist you in controlling your emotions. I recommend trying to anticipate what you do when the actual return you achieve by investing in stocks is well below or quite high above the average in your portfolio. Having this information provides a much better way to truly understand and your risk tolerance when it comes to deciding what percentage of your monies to allocate to stocks in my opinion.
When you look back at the performance returns for stocks, it makes more sense why investors do what they do from the standpoint of behavioral finance. That is how emotions affect (all too often negatively) investment decisions. If an individual investor is told at the outset that he or she can expect returns of 8% or 9% per year, the actual annual returns of stocks can be quite troubling. Having that information only leads to a general disadvantage. When stock returns are negative and nowhere near the average, individual investors tend to panic and sell stocks. When stock returns are quite higher than the average, individual investors tend to be more euphoric and buy even more stocks. This affect is magnified when there are a number of consecutive years with one of those two trends. If stock returns are essentially unchanged, most individual investors become disengaged and really do not even see the point of investing in stocks at all.
I believe it is extremely important to know upfront that stocks are likely to hit the average return once every 17 years. That statistic alone is a real shocker! It lets individual investors truly see how “unusual” the average return really is. Plus, there is a better explanation for fear and greed. Stock market returns will be negative once every 4 years. Keep in mind this does not even include stock returns that are below the average yet still positive. Lastly, every other year the stock market returns will be above the average (in my case I was measuring above the average with the definition of that being a stock market return greater than 11%). It is no wonder why individual investors get greedy when it looks like investing in the stock market is so easy after seeing such great returns. Conversely, the occurrence of negative returns is so regular that it is only natural for individual investors to panic. Since the average only comes around approximately once every two decades, that is why confusion abounds and investors abandon their long-term financial plans.
I will readily admit sticking to a long-term financial plan is not easy to do in practice during powerful bull or bear markets, but I think it helps to know upfront what actual stock returns look like and prepare yourself emotionally in additional to the intellectual side of investing. Now I always mention that statistics can be misleading, conveniently picked to make a point, or not indicative of the future. Nevertheless, I have tried to present the information fairly and in general terms.
Additional Information on Stock Market Returns (Discussion of Math and Statistics):
Please note that this information may be skipped by individual investors that are scared off by math in general or have no desire to dive deeper into the minutiae. One of the first things to be aware of is what expected returns for stocks are. An expected return is what the most likely outcome would be in any particular year. Expected returns provide misleading results when there is a high degree of variability in the entire dataset. In the case of stock market returns, there is an incredible amount of variability. The industry term for variability, which is the statistical term, is volatility. Due to the fact that the expected return almost never happens, it would be wise for the financial services industry to truly and better define volatility. Most individual investors do not know that there is far more of a range of possible outcomes for stock market returns. Individual investors associate hearing average returns with some volatility from Financial Advisors or financial media in the same way as the classic “bell curve”. As discussed in further detail above, the outcomes do not even come close to approximating the “bell curve”.
One important thing to be aware of when it comes to actual performance returns of an individual’s investment portfolio is that average/expected values are not very important. In fact, they really lead to a distorted way of looking at investing. Average/expected values are based on arithmetic returns, where the overall growth in one’s investment portfolio is tied to geometric returns. The concept of geometric returns is overlooked or not fully explained to individual investors. Here is the perfect example of how it comes into play. Let’s say you own one share of a $100 stock. It goes down 50% in the first year and then up 50% in the second year. How much money do you have at the end of the second year? You have the original $100, right?
Not even close. You end up with $75. Why? At the end of the first year, your stock is worth $50 ($100 + $100*-50%) after decreasing 50%. Since you begin the second year with only that $50, that is why you end up having $75 ($50 + $50 * 50%). The average annual return is 0% ((-50% + 50%) divided by 2)) for the two-year period. Whereas your geometric return is negative 13.4%. Essentially that number shows what happened to the value of your portfolio over the entire timeframe and incorporates the ending value. Think of it as having $100 + $100 * -13.4% or $86.60 at the end of year one and then $86.60 + $86.60 * -13.4%) or $75. Note that you never actually have $86.60 as the portfolio’s value at any time, but the geometric return tells you how much money you actually earned (or lost) over the entire period and how much money you end up with, otherwise known as the terminal value of your portfolio. The geometric return will ALWAYS differ from the arithmetic return when a negative return is introduced as one of the outcomes. As an individual investor, your primary concern is the terminal value of your portfolio. That is the dollar value you see on your brokerage statement and is the actual amount of money you have.
Financial professionals forget to focus on geometric returns or even bring them up to clients. This omission is important to individual investors because negative returns have an outsized effect on the terminal value of an investment portfolio. For example, in the example above, it is quite clear that losing 50% and then gaining 50% do not “cancel each other out”. The negative percent weighs down the final value of the portfolio. That is why it is extremely important to use the geometric return of the portfolio. This result is due to the fact that the compounding of interest is not linear. It is a geometric equation which is why the geometric mean comes into play. Without going fully into the explanation of those equations, the main takeaway for investors when it comes to annual returns is that negative returns have more of an effect than positive returns.
Taken together, it is important to utilize the concept of multi-year geometric averages. Individual investors never want to simply add up the annual returns of a series of years and then divided by the number of years. That result will overstate the amount of money in the investment portfolio at the end of the period. The preferred approach is to use the geometric average which is referred to as the annualized average return. That percentage is the number most relevant to investors. Additionally, longer timeframes of these returns are best to look at given the extreme amount of volatility in yearly stock market returns. It gives a better picture of how the stock market has moved.
When looking at the stock market returns for the S&P 500 index over five-year periods using the period 2001-2015, they yield surprising yet informative results. The five-year returns from 2001-2005, 2006-2010, and 2011-2015 were 0.54%, 2.30%, and 12.57%, respectively. Valuable information comes from looking at extended periods of time using the same time increment. The overall return during 2001-2015 was 5.01%. The effect of these longer timeframes smooths the stock market return data, but even then the stock market returns vary quite a bit. Note that the overall return from the entire historical period of the S&P 500 index is roughly 9.50%. These three selected chunks show two periods of underperformance and one year of outperformance. The reason stock market returns tend to hover around the historical average is due to the fact that these returns are tied to the overall growth the economy (most commonly Gross Domestic Product – GDP) and corporate profits. In the meantime though, stock market returns can vary a lot from this expected return. However, they are unlikely to do so for incredibly long periods of time.
By incorporating the understanding of volatility and geometric returns into your understanding of the “reality” of stock market returns, you will be able to better refine your own risk tolerance and how to craft your long-term financial plan. A better grasp of these concepts makes one far less likely to react emotionally to the market, either with too much fear or too much greed.
asset allocation, finance, financial advice, individual investors, investing, investment portfolio, investments, life cycle mutual funds, personal finance, rebalancing, risk, risk tolerance, target date mutual funds
With the end of the year fast approaching, it is an excellent time to discuss the concept of rebalancing one’s investment portfolio. The simplest definition of rebalancing is the periodic reallocation of an investment portfolio back to the original percentages desired. The fluctuations of the financial markets over time will inevitably alter the amount of exposure in one’s investment portfolio to different types of assets. These changes may cause the portfolio to be suboptimal given an individual investor’s financial goals and tolerance for risk. Knowing about rebalancing is so important because it is one of the most effective ways to eliminate, or at least reduce, the emotions surrounding investment decisions that affect even professional investors. Additionally, numerous academic studies have concluded that 85% of the overall return of an investment portfolio comes from asset allocation.
Recently, I published a three-part series of articles to define and explain the various nuances of rebalancing an individual investor’s investment portfolio. The first article covers the definition of rebalancing in its entirety. Furthermore, the article looks at an illustration of how rebalancing works in the real world. It offers an introduction to this important investing tool. The link to the complete article can be found here:
The second article discusses a unique way to get assistance with rebalancing an investment portfolio. Many of the largest asset managers in the financial services industry, such as Vanguard, Fidelity, and T Rowe Price, offer life cycle or target date mutual funds. These mutual funds have a predefined year that the individual investor intends to retire. Moreover, the combination of assets in the mutual fund is structured to change over time and become less risky as the target date approaches. Since these mutual funds report their holdings on a periodic basis, any individual investor is able to replicate the strategy for free. Plus, another feature is that an individual investor can be more conservative or aggressive than his/her age warrants according to the mutual fund family’s calculations. The individual investor is able to pick a target date closer than the endpoint (i.e. more conservative) or pick a target date later than the endpoint (i.e. more aggressive). For a more comprehensive discussion of this facet of rebalancing an investment portfolio follow this link:
The third and final article discusses the most advanced feature of rebalancing utilized by a subset of individual investors. The investing strategy is referred to as dynamic rebalancing in most investment circles. Dynamic rebalancing follows the general tenets of rebalancing. However, it allows the individual investor to exercise more flexibility during the rebalancing process of the investment portfolio. Essentially the individual investor determines bands or ranges of acceptable exposures to asset classes or components within the investment portfolio. For example, a lower bound and upper bound for the asset allocation percentage to stocks is set. The individual investor is free to allocate monies to stocks no less than the lower bound and no more than the upper bound. Note that the bands or ranges are normally fairly tight and applies to the subcomponents of the investment portfolio, such as small cap stocks, emerging market stocks, international bonds, and so forth. To learn more about this fairly complex aspect of rebalancing follow this link:
The articles above capture the vast majority of information individual investors need to know about rebalancing an investment portfolio. It is good to get a head start on learning about or reviewing this topic prior to the end of the year. The reason is that most rebalancing plans utilize the end of the calendar year as the periodic adjustment timeframe.
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. Let’s dig into that statement a little further and reveal the key as well.
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…
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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 firstname.lastname@example.org 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?:
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
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:
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:
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.