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

24 Sunday Jul 2016

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Four Important Lessons for Individual Investors from the Brexit Vote

10 Sunday Jul 2016

Posted by wmosconi 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:

There are very few monumental financial market events that should cause individual investors to feel inclined to immediately change their investment portfolios. Plus, they can only truly be identified by hindsight;
Investors should focus on valuation of financial assets (no emotions here), traders/speculators worry about market sentiment (emotions) and valuation (no emotions here);
The benefit of diversification can disappear or be greatly reduced during periods of extreme market volatility and financial market stress over the short term;
The surprise Brexit vote offers individual investors a valuable opportunity to see if their risk tolerances are aligned with the possibilities of short-term market declines. This real-life event can be used to redefine one’s risk tolerance to better withstand similar periods of market volatility that will inevitably occur in the future.

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

29 Tuesday Dec 2015

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

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

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

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

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

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

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

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

3) Rebalancing Your Investment Portfolio – Summary

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

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

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

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

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

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

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

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

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

How to Rebalance Your Investment Portfolio – Part 2 of 3

29 Wednesday Jul 2015

Posted by wmosconi in asset allocation, bond market, bonds, Consumer Finance, financial advice, financial goals, financial markets, financial planning, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, personal finance, rebalancing, rebalancing investment portfolio, stock market, stocks

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In the first part of the discussion on rebalancing your investment portfolio, I outlined its definition and the most common method to do so. The web link to that particular post is listed below:

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

As a reminder, the definition of rebalancing is the periodic adjustment of one’s investment portfolio back to the original allocation percentagewise to the various asset classes. Over the course of time, the financial markets will vary up and down and one’s investment portfolio will change. However, the individual investor will normally have a plan on how to invest in order to reach his or her financial goals while being comfortable with the amount of risk taken by investing in the various asset classes (i.e. stocks, bonds, cash, etc.). Thus, rebalancing is simply ensuring that the investment portfolio is back in line with the original parameters of asset allocation.

In this second part of the discussion on rebalancing your investment portfolio, I will show you a different way to rebalance your investment portfolio. The same general concept applies, but, using this method, one can rely on actual published financial advice. The nice thing about this particular method is that the financial advice is free and from the most and trusted asset managers in the financial services industry. Does that sound too good to be true? Well, I invite your skepticism. That is always a healthy trait whenever someone discusses investing. Let’s delve into this a bit deeper and see if I can’t assuage your fears.

Many of the asset managers in the financial services industry offer something called target date mutual funds or life cycle mutual funds. The naming convention depends on the mutual fund company, but the financial product is the same. The idea behind these mutual funds is that they invest in a certain combination of stocks and bonds depending on when the money is needed. The mutual fund will invest more of the investment portfolio in stocks in the beginning and gradually shift that percentage to bonds and cash as the target date approaches. For example, someone who is forty years old now (2015) and wants to retire at age sixty-five would invest in a target date 2040 mutual fund. Some of the asset managers offering these financial products include Vanguard, Fidelity, and T Rowe Price. The web link to each of these mutual fund families’ offerings are listed below:

Vanguard – https://investor.vanguard.com/mutual-funds/target-retirement/#/

Fidelity – https://www.fidelity.com/mutual-funds/fidelity-fund-portfolios/freedom-funds

T Rowe Price – http://individual.troweprice.com/public/Retail/Mutual-Funds/Target-Date-Funds

Now I will not personally recommend any specific financial product; however, all these mutual fund families have excellent reputations and long track records. The benefit of this rebalancing method is that you can choose a particular target date or life cycle mutual fund that lines up with your financial goal and timeline. Each of these mutual fund offerings must periodically report their investment holdings to investors and are displayed on the mutual fund family’s website. As an individual investor, you need only replicate the recommended investments in that mutual fund. Adjusting your investment portfolio either semiannually or annually is normally sufficient. The added bonus is that you can alter the target date or life cycle mutual fund you select if your risk tolerance is different than what is offered in that portfolio. If you want to take on more risk for potential added rewards in performance returns, you can select a mutual fund with a target date later than your age would indicate. For instance, assume it is 2015 and you want to retire in 30 years, you might opt for the target date 2050 instead of 2045. Conversely, if you want to take on less risk because you are more sensitive to financial market volatility, you can select a target date closer than your age would indicate. In this case, assume it is 2015 and you want to retire in 30 years, you might opt for the target date 2040 instead of 2045. Let’s take a closer look at how this works in terms of the nuts and bolts.

For purposes of illustration only, I will utilize the product offerings of the Vanguard family of mutual funds. Assume that it is 2015 and you have 20 years until retirement (2035). Furthermore, assume that you have a normal risk tolerance for financial market volatility. If that is the case, you would select the Vanguard Target Retirement 2035 Fund (Ticker Symbol: VTTHX). The asset allocation of that target date mutual fund as of June 30, 2015 is as follows:

Asset Allocation as of June 30, 2015

Mutual Fund	Percentage
Vanguard Total Stock Market Index Fund	53.9%
Vanguard Total International Stock Market Index Fund	28.1%
Vanguard Total Bond Market II Index Fund	12.7%
Vanguard Total International Bond Market Index Fund	5.3%
Total	100.0%

Essentially you now have an investment portfolio that selects investments for your investment portfolio to achieve your financial goals without paying a Financial Advisor. Those investment advisory fees may be 1% to 2% (or higher) of your total investment portfolio each year. Using this rebalancing approach those fees are avoided, but you are still able to see what professional money managers are recommending for free. Now there are two courses of action at this point. First, it is possible to simply invest in this particular fund through the Vanguard mutual fund family. However, you will incur additional expenses for the fund family to manage the money and make the periodic percentage allocation adjustments. Those expenses do vary by fund family and are normally somewhat reasonable but are higher at some companies than others. Second, it is possible to invest monies into ETFs or index mutual funds that match the percentage allocations to the various asset classes. Admittedly, there are times when the commissions incurred to do so are higher than simply having the mutual fund family invest in the various funds for your investment portfolio. With that being said, there is a way to invest in ETFs for free.

One of the nicest offerings that not enough people know about is that Fidelity Investments offers the BlackRock iShares ETFs free of commission. While not all of the iShares are offered, there are currently 70 ETFs registered in the program. These ETFs have some of the lowest expense ratios (percentage fee charged on assets; normally 0.20% or less per year) in the business, and the range of ETFs should cover most any recommended target date or life cycle mutual fund investment pieces you might choose to use. The current list of the iShares ETFs from Fidelity that are free from commissions are as follows:

Commission-Free iShares ETFs at Fidelity Investments – https://www.fidelity.com/etfs/ishares-view-all

The reason one would use this method to build an investment portfolio and rebalance along the way is that expenses are minimized throughout the investing process. Many investors are not aware how much “seemingly small” expenses add up and compound over time. Decades and/or years worth of fees as small as 0.50% or 1.00% annually can erode thousands, tens of thousands, or more from your investment portfolio. Which makes it harder for you to reach your investment goals or necessitates taking on more risk in order to reach the goal than you might be comfortable within your investment portfolio. (For more information on that topic, you can view one of my earliest blog posts via this web link: https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/).

Here’s a summary of the usefulness of this particular rebalancing approach for your investment portfolio. You may know when your financial goal is going to come due to pay or provide for, have a general idea of the risks you are willing to take, and know a bit about the types of asset classes for investment available. However, you may lack the confidence or specific expertise to know how to create an investment portfolio and allocate percentages of money to the various asset classes. The nice thing about this method is that you can “piggyback” off of the investment ideas of some of the best money management firms in the financial services industry. You initially invest the money in your investment portfolio as is indicated on the mutual fund family’s website. Then every six or twelve months (preferably mid-year or end of the year; the most common interval is twelve months) the investment portfolio is rebalanced to exactly match the way the target date or life cycle mutual fund is currently invested in.

How to Rebalance Your Investment Portfolio – Part 1 of 3

16 Thursday Jul 2015

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

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The first and foremost decisions for an individual investor is to determine his or her financial goals, assess his or her risk tolerance, and then develop an investment portfolio to allow one to reach those financial goals. Financial goals might be saving for retirement, a child’s college education, disbursing income while in retirement, or most any other thing that requires money to be paid in the future. Risk tolerance involves an individual investor’s willingness to take on volatility and variability in the performance returns of financial or real assets. Some investors are fine with the sometimes wild gyrations of the stock market. They might be able to withstand a 20% decline in the value of their investment portfolio and still not panic and sell. Other investors are more risk averse and do not want to see so much volatility in their investment portfolios. However, they may know they need the growth in their investment portfolio, so they reduce their exposure to stocks. Lastly, some investors may be nearing their financial goal and need to ratchet down risk in order to have enough money by not losing principal. The final step is to construct an investment portfolio that brings the two together. The financial goals can be reached but within the parameters of the investor’s risk tolerance. Note that risk tolerance in a general sense refers to the volatility of assets in one’s investment portfolio. For instance, US Treasury bills are much less volatile than stocks.

Now the financial markets will change over time as prices go up and down. Therefore, the original allocation (percentages) to stocks, bonds, cash, or other assets in the investment portfolio will be different than the one after one year goes by. It would be markedly different after five or ten years go by. That is where rebalancing your investment portfolio comes in. In this first part of this three-part discussion, I will focus on the easiest way to rebalance an individual investor’s portfolio. In the next two parts, I will expand the notion of rebalancing. In its simplest definition, rebalancing one’s investment portfolio refers to the periodic changes made to bring the investment portfolio back to the original allocation to the various investment selections. Let’s explore why this should be done.

Due to the natural ups and downs of the financial markets, an individual investor’s investment portfolio will change in composition. Remember that an investment portfolio is initially set up to allow the individual investor to reach his or his financial goals while still adhering to the amount of risk that he or she is willing to take. Well, after a year goes by, the chances are very good that the amount of money invested in stocks, bonds, cash, etc. will have changed. Thus, the investment portfolio may be more risky or less risky than intended. Moreover, the investment portfolio may not be on track to allow the individual investor to achieve his or her financial goals which is the overall goal to begin with. Additionally, rebalancing allows the individual investor to “sell high and buy low” in general. Stocks and bonds have a way of getting too expensive or too cheap as time goes by. However, the individual investor can sell the asset class that has gone up and use those funds to buy the asset class that has gone down. The technical term that you might hear is reversion to the mean. That means that over long periods of time, financial assets tend to produce an average rate of return. Hence, a rate of return much higher than the average for several years is normally followed by a period of lower returns than the average. Now let’s turn to an example with actual numbers to make things much clearer.

We can take the following scenario with various assumptions. They are as follows: the individual investor has a portfolio of $1 million at the beginning of the year, the asset allocation is 60% stocks ($600,000), 30% bonds ($300,000), and 10% cash ($100,000), during the year the stocks gain 10% ($60,000), the bonds lose 2% ($6,000) and the cash earns no interest, and, finally, the individual investor is committed to rebalancing the investment portfolio at the end of every year.

Here is the scenario:

1) Investment Portfolio at the Beginning of the Year

Type of Asset	Dollar Amount	Percentage
Stocks	$ 600,000	60.0%
Bonds	300,000	30.0%
Cash	100,000	10.0%
Total	$ 1,000,000	100.0%

2) Investment Portfolio at the End of the Year

Type of Asset	Dollar Amount	Percentage
Stocks	$ 660,000	62.6%
Bonds	294,000	27.9%
Cash	100,000	9.5%
Total	$ 1,054,000	100.0%

3) Investment Portfolio After Rebalancing

Type of Asset	Dollar Amount	Percentage
Stocks	$ 632,400	60.0%
Bonds	316,200	30.0%
Cash	105,400	10.0%
Total	$ 1,054,000	100.0%

As you will note above, the investment portfolio starts out with the intended asset allocation for this individual investor. However, at the end of the year in accordance with the rate of return assumptions, the investment portfolio is quite different. In fact, the percentages for each asset class have changed. In the scenario detailed above, the investment portfolio at the end of the year is more risky than at the start of the year. That is where the rebalancing comes into play. In order to get the investment portfolio back to the original asset allocation, stocks need to be sold and the proceeds invested in bonds and cash. It is fairly easy to come up with the necessary purchases and sales by multiplying the total balance at the end of the year by the desired percentage for the investment portfolio for each asset class. That step will show how much should be bought or sold in order to restore the investment portfolio to harmony.

Please note that the $1 million and asset allocation types and percentages were selected for the purposes of illustrating the concept of rebalancing. The scenario listed above will work with any investment portfolio dollar amount. In addition, there is no reason why more specific asset classes cannot be added to the investment portfolio to match your individual investment portfolio (e.g. large cap stocks, international stocks, emerging market bonds, etc.). As long as you have the desired percentages for your portfolio, you can go through the same process in the example above in order to rebalance your portfolio.

In summary, rebalancing on a periodic basis is a way to ensure that the individual investor is on track to achieve his or her financial goals while not taking on too much or too little risk to get there. It is a way to stay on the path to one’s financial plan. Normally individual investors will rebalance their investment portfolios once a year, typically at the end of the calendar year. However, there is no reason why the length and/or time of the year cannot be altered. For the purposes of simplicity, a hard and fast rule of each year at the end of the year is usually the best rule of thumb when it comes to rebalancing for most novice individual investors. One of the other benefits is that rebalancing allows individual investors to not try and time the market or stay with a certain type of investment too long. As a personal anecdote, I have an uncle who got caught up in the Internet Bubble of the late 1990s into 2001. He devoted more and more of his retirement portfolio to technology stocks. When the bubble burst, his investment portfolio was devastated. Unfortunately, he had to delay his retirement by nearly ten years due to this mishap. Adherence to a strict schedule and rebalancing plan acts a buffer against occurrences like this. It really helps to take much of the emotion, which most investors of all types struggle with, out of investing.

The Hidden Dangers of Active Investing for Individual Investors

04 Monday May 2015

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Summary

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

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

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

26 Wednesday Feb 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

12 Wednesday Feb 2014

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

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active investing, active versus passive, active versus passive investing debate, asset allocation, bonds, business, education, enhanced indexing, ETF, ETFs, finance, financial planning, individual investing, individual investor, investing, investments, passive investing, portfolio, portfolio management, stocks

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Not all Index Mutual Funds and ETFs are Created Equal: Part 1 of 2

28 Tuesday Jan 2014

Posted by wmosconi in asset allocation, beta, bonds, business, Education, emerging markets, finance, financial planning, Individual Investing, investing, investments, personal finance, portfolio, risk, stock prices, stocks, Suitability, volatility

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asset allocation, Bogle, bonds, EM, emerging markets, ETF, ETFs, finance, index mutual funds, passive investing, personal finance, stocks, volatility

I am definitely a big advocate of passive investing in either index mutual funds or exchange traded funds (ETFs). However, the proliferation of products over the last 10 years or so has made things quite a bit more complicated than the old days of John Bogle introducing the first large offerings of index mutual funds at Vanguard over 30 years ago. I figured it would be worthwhile to address a few topics in this regard.

There are two issues that are central to my discussion that individual investors need to be aware of. The first issue is that the underlying stock or bond holdings of these offerings can be very different even if the names sound exactly the same. The second issue is that many of the new registrations for ETFs or recently issued securities are more akin to what is termed enhanced indexing or “smart” beta. These types of choices are not active mutual funds or ETFs in the traditional sense. Moreover, they are not passive either. These newer products will slice and dice a universe of securities or use “proprietary” methods to actually beat the index. Now by definition an index investor knows that he or she will underperform the index when costs are taken into account. Any “passive” product that claims that the advisor can beat the index is therefore more akin to an active approach. There are many different terms to describe. I will postpone the discussion of that salient topic in the second part of this post though.

There is a great example in recent days of why this is important. An ETF is the best way to analyze the issue because they must be transparent daily. The holdings of any ETF are publicly available to see each day. Additionally, each ETF will hold all the components of a particular index. Therein lies the extremely vital piece that most individual investors are unaware of. There happen to be multiple indexes that attempt to capture the stock and/or bond investment performance of a particular piece of the financial markets. The definition of that universe is what matters to investors. A timely example is the stock performance of emerging markets which has been incredibly volatile of late. However, not all ETFs follow the same definition of what an emerging market country is.

The two main emerging market ETFs are offered by Vanguard and BlackRock. The Vanguard offering is through their VIPER series and is called the Vanguard FTSE Emerging Markets ETF (Ticker Symbol: VWO). The BlackRock offering is through their iShares series and is called the iShares MSCI Emerging Markets ETF (Ticker Symbol: EEM). Most individual investors (and some financial professionals) think of these ETFs as being the same. However, they are actually quite different. Why? Well, the difference in the names kind of gives the answer away. The Vanguard ETF is tied to the FTSE Emerging Markets Stock Index, while the BlackRock ETF is tied to the MSCI Emerging Markets Stock Index. Both of these ETFs invest in all the components of stocks in those two respective universes. The definition of emerging markets by these two index providers is quite different.

The main difference between the two is how they classify stocks traded in South Korea. MSCI considers South Korea to still be an emerging market and 15.8% (as of January 27, 2014) of the ETF is allocated to that country. FTSE considers South Korea to be mature enough to be thought of as a developed economy and no longer should be viewed in the same light as other countries in the emerging markets. They have reached a level of sophistication in terms of the economy, banking system, and breadth in trading of the stocks there. Thus, Vanguard does not allocate any money to South Korea. There are some other slight differences in countries within the two indexes but the aforementioned percentage is definitely significant. If you are ever confused why the total returns of the VWO and EEM ETFs do not equal even after taking into account investment fees, that is the primary reason why. Over the course of an entire year, the difference in the total return can be striking depending on the performance of the KOSPI (South Korea’s main stock index).

Investing in the Vanguard version instead of the BlackRock version can be more risky since the relatively more mature stock market of South Korea is not included. As I have mentioned in the past, I do not advocate the purchase of any particular stock, bond, index mutual fund, or ETF. With that being said though, it is important to know the differences between two similarly sounding offerings. If you want to have exposure to the emerging markets, you should not simply look at investment fees. The expense ratio on the VWO is 0.18% and the 0.67% for the EEM. Most people would say that the VWO is better because the fees are lower. However, you are not comparing apples to apples due to the South Korea inclusion issue.

The main takeaway here is to read the prospectus for any index mutual fund or ETF. Or, at the very least, you should pay careful attention to the fact sheet provided for either. You should look at what index the index mutual fund or ETF advisor is using. You can go to the link of that index provider to see what is included (in terms of individual stocks or bonds or countries, etc.), so you are aware of what you are buying. It is much easier to avoid a purchase of a particular security than to have to sell after an unexpected loss because you purchased the “wrong” thing based upon your risk tolerance and financial goals, and how that particular asset was going to complement your overall portfolio allocation.

I have included links to the major index providers for ease of reference. There are many others, but these are the major players in the passive investing world. They are as follows:

1) Standard & Poor’s – http://us.spindices.com/

2) Russell Investments – http://www.russell.com/indexes/americas/default.page

3) MSCI – http://www.msci.com/products/indices/

4) FTSE – http://www.ftse.com/Indices/

5) Barclays – https://ecommerce.barcap.com/indices/index.dxml

Latticework Wealth Management, LLC

~ Information for Individual Investors

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