Category Archives: volatility

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

24 Sunday Jul 2016

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Four Important Lessons for Individual Investors from the Brexit Vote

10 Sunday Jul 2016

Posted by in Alan Greenspan, Black Swan, bond market, Brexit, Brexit Vote, Emotional Intelligence, EQ, EU, European Union, Fed, Federal Reserve, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Greenspan, Individual Investing, individual investors, Internet Bubble, investing, investing advice, investing information, investing tips, investment advice, investments, Irrational Exuberance, Nassim Taleb, personal finance, portfolio, Post Brexit, PostBrexit, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, Stock Market Returns, Stock Market Valuation, Taleb, Uncategorized, Valuation, volatility, Warren Buffett

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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:

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

  • 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:

https://latticeworkwealth.com/2015/06/11/two-steps-to-help-individual-investors-become-more-successful-at-investing/

  • 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:

  1.  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;
  2. Investors should focus on valuation of financial assets (no emotions here), traders/speculators worry about market sentiment (emotions) and valuation (no emotions here);
  3. The benefit of diversification can disappear or be greatly reduced during periods of extreme market volatility and financial market stress over the short term;
  4. 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.

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

10 Tuesday May 2016

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

16 Wednesday Mar 2016

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

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

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

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

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

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

 

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

13 Wednesday May 2015

Posted by in academia, academics, alpha, asset allocation, beta, books, college finance, finance, finance books, finance theory, financial planning, Free Book Promotion, Individual Investing, investing, investing books, investment advice, investments, Modern Portfolio Theory, MPT, personal finance, risk, stock market, stocks, volatility

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I have decided to make my recently published book FREE for several days, May 13, 2015 through May 17, 2015 (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:

  • 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
  • The Wall Street Journal Central Banks @WSJCentralBanks – Coverage of the Federal Reserve and other international central banks by @WSJ reporters
  • 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
  • Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal
  • Muriel Siebert & Co. @SiebertCo
  • Roger Wohlner, CFP® @rwohlner – Fee-only Financial Planner for individuals
  • Ed Moldaver @emoldaver – #1 ranked Financial Advisor in New Jersey by Barron’s 2012
  • Muni Credit @MuniCredit – Noted municipal credit arbiter
  • Berni Xiong (shUNG) @BerniXiong – Author, writing coach, and national speaker

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)
  • Charlie Wells @charliewwells – Reporter and Editor at The Wall Street Journal
  • Sri Jegarajah @CNBCSri – CNBC anchor and correspondent for CNBC World
  • Jesse Colombo @TheBubbleBubble – Columnist at Forbes
  • Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company
  • Investment Advisor @InvestAdvMag – Financial magazine for Financial Advisors
  • Gary Oneil @GaryONeil2 – Noted expert in creating brands for start-ups
  • MJ Gottlieb @MJGottlieb – Co-Founder of hustlebranding.com
  • Bob Burg @BobBurg – Bestselling author of business books
  • Phil Gerbyshak @PhilGerbyshak – Expert in the use of social media for sales

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

26 Wednesday Mar 2014

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

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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 for retirement on the Internet have that as one of the inputs to calculate the growth of your portfolio over time. While that information is not too far off the mark based upon historical returns of the S&P 500 stock index, the actual annual returns of stocks do not cooperate to the constant frustration of so many investors. That brings us to the first key to successful stock investing: The actual yearly returns of stocks very rarely equal the average expected. The most common term for this phenomenon is referred to as volatility. Stocks tend to bounce around quite a bit from year to year. Volatility combines with the natural instinct of people to extrapolate from the recent past, and investing becomes a very difficult task. I will get deeper into the numbers in a later post for those readers who like to more fully understand the concepts I discuss. I do need talk in general about annual stock returns at this point to expand upon the first key.

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

Year

% Return

2001

-11.9%

2002

-22.1%

2003

28.7%

2004

10.9%

2005

4.9%

2006

15.8%

2007

5.5%

2008

-37.0%

2009

26.5%

2010

15.1%

2011

2.1%

2012

16.0%

2013

32.4%

 

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 86 years or 5.8%. That statistic means that your annual return in stocks will be around the average once every 17 years. The 50-year average annual return for the S&P 500 index (1964-2013) was approximately 9.8%. Actual returns were negative 24 out of 86 years (27.9% of the time) and greater than 15% 42 out of 86 years (48.8% of the time). How does relate to the first key of stock investing that I mentioned earlier (“The actual yearly returns of stocks very rarely equal the average expected”)?

Well, it should be much easier to see at this point. If you are investing in stocks to achieve the average return quoted in so many sources of 8% to 9%, it is definitely a long-term proposition and can be a bumpy ride. The average return works out in the end, but you need to have a solid plan, either by yourself or with the guidance financial professional, to ensure that you stick to the long-term financial plan to reach the financial goals that you have set. Knowing beforehand should greatly assist you in controlling your emotions. I recommend trying to anticipate what you will do when the actual return you achieve by investing in stocks is well below or quite high above the average in your portfolio. Having this information provides a much better way to truly understand and your risk tolerance when it comes to deciding what percentage of your monies to allocate to stocks in my opinion. I will readily admit it is not easy to do in practice during powerful bull or bear markets, but I think it helps to know upfront what actual stock returns look like and prepare yourself emotionally in additional to the intellectual side of investing. Now I always mention that statistics can be misleading, conveniently picked to make a point, or not indicative of the future. Nevertheless, I have tried to present the information fairly and in general terms.

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

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

01 Saturday Mar 2014

Posted by 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 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 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.

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

07 Friday Feb 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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