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.

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

10 Tuesday May 2016

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

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

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

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

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

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

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

Average 18.77

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

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

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

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

Average 19.80 6.44%

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

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

Book Promotion on Amazon.com – A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?

14 Thursday May 2015

Posted by wmosconi in book deals, books, finance, finance books, financial advice, Financial Advisor, financial advisor fees, financial markets, financial planning, financial planning books, financial services industry, investing, investing advice, investing books, investment advice, investment advisory fees, investment books, investments, stock market, stocks

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The original blog post did not make it to all informational outlets. There is a deal on one of my books in the A New Paradigm for Investing series.

Latticework Wealth Management, LLC

Greetings to all my loyal readers of this blog. How would you like to learn a better way to seek investment advice? I list and thoroughly discuss questions you can ask prospective Financial Advisors when interviewing them. Selecting someone to assist you with the process, which is so incredibly important for you, can be a nightmare of complexity. By reading this book, you will be in the 95^th percentile of individual investors in terms of the knowledge necessary to have the tools and information to walk into those Financial Advisor meetings and understand the discussion/jargon and feel confident. This book on Amazon.com is available for download onto a Kindle. Additionally, there is a Kindle app for iPhones and Android devices which is free to download. Please feel free to check out the title below. I have provided a link to make it easier. My email address is latticeworkwealth@gmail.com should…

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Book Promotion on Amazon.com – A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?

14 Thursday May 2015

Posted by wmosconi in book deals, books, business books, finance, finance books, finance theory, financial advice, Financial Advisor, financial advisor fees, financial markets, financial planning, financial services industry, investing, investing advice, investment advice, investment advisory fees, investment books, investments, personal finance, reasonable fees for financial advisor, stock market, stocks

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book deals, books, business, business books, finance, finance books, financial advice, Financial Advisor, financial markets, financial planning, financial services, financial services industry, investing, investing books, investment advisory, investment advisory fees, investment books, investment fees, investments, personal finance, reasonableness of finance advice, stock market, stocks

The link to the book is as follows:

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

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

The book listed is normally $9.99 but I am offering it for a lower price over the course of the week (May 14, 2015 through May 18, 2015). For most of the day today, the book is $1.99 which is 81% off. The price of the book will be gradually increasing during the course of that period.

I would like to thank my international viewers of my blog as well. The blog can be located at http://www.latticework.com. I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts
The Wall Street Journal Central Banks @WSJCentralBanks – Coverage of the Federal Reserve and other international central banks by @WSJ reporters
The Royce Funds @RoyceFunds – Small Cap value investing asset manager
Research Magazine @Research_Mag – Latest industry information for wirehouses and ETFs
Barron’s Online @BarronsOnline – Weekly financial news magazine of Dow Jones
Cleveland Fed Research @ClevFedResearch
Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal
Muriel Siebert & Co. @SiebertCo
Roger Wohlner, CFP® @rwohlner – Fee-only Financial Planner for individuals
Ed Moldaver @emoldaver – #1 ranked Financial Advisor in New Jersey by Barron’s 2012
Muni Credit @MuniCredit – Noted municipal credit arbiter
Berni Xiong (shUNG) @BerniXiong – Author, writing coach, and national speaker

Followers on @LatticeworkWlth:

Tracy Alloway @tracyalloway – US Financial Correspondent at Financial Times
Vanguard FA @Vanguard_FA – Vanguard’s ETF research and education
EU External Action @eu_eeas – Latest news from the European External Action Service (EEAS)
Charlie Wells @charliewwells – Reporter and Editor at The Wall Street Journal
Sri Jegarajah @CNBCSri – CNBC anchor and correspondent for CNBC World
Jesse Colombo @TheBubbleBubble – Columnist at Forbes
Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company
Investment Advisor @InvestAdvMag – Financial magazine for Financial Advisors
Gary Oneil @GaryONeil2 – Noted expert in creating brands for start-ups
MJ Gottlieb @MJGottlieb – Co-Founder of hustlebranding.com
Bob Burg @BobBurg – Bestselling author of business books
Phil Gerbyshak @PhilGerbyshak – Expert in the use of social media for sales

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

13 Wednesday May 2015

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

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I have decided to make my recently published book FREE for several days, May 13, 2015 through May 17, 2015 (it normally retails for $4.99). The book is another installment in my A New Paradigm for Investing series. In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations. The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful. I explore the reasons why in my text. I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents. Moreover, you do not need to know about the intricacies of MPT in order to follow my logic. You would find the same information in a college textbook but in a condensed format here. It actually is quite surprising how little Financial Advisors know about MPT in general and how the ideas apply to individual investors.

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

The book is:

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

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

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

Followers on @NelsonThought:

The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts
The Wall Street Journal Central Banks @WSJCentralBanks – Coverage of the Federal Reserve and other international central banks by @WSJ reporters
The Royce Funds @RoyceFunds – Small Cap value investing asset manager
Research Magazine @Research_Mag – Latest industry information for wirehouses and ETFs
Barron’s Online @BarronsOnline – Weekly financial news magazine of Dow Jones
Cleveland Fed Research @ClevFedResearch
Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal
Muriel Siebert & Co. @SiebertCo
Roger Wohlner, CFP® @rwohlner – Fee-only Financial Planner for individuals
Ed Moldaver @emoldaver – #1 ranked Financial Advisor in New Jersey by Barron’s 2012
Muni Credit @MuniCredit – Noted municipal credit arbiter
Berni Xiong (shUNG) @BerniXiong – Author, writing coach, and national speaker

Followers on @LatticeworkWlth:

Tracy Alloway @tracyalloway – US Financial Correspondent at Financial Times
Vanguard FA @Vanguard_FA – Vanguard’s ETF research and education
EU External Action @eu_eeas – Latest news from the European External Action Service (EEAS)
Charlie Wells @charliewwells – Reporter and Editor at The Wall Street Journal
Sri Jegarajah @CNBCSri – CNBC anchor and correspondent for CNBC World
Jesse Colombo @TheBubbleBubble – Columnist at Forbes
Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company
Investment Advisor @InvestAdvMag – Financial magazine for Financial Advisors
Gary Oneil @GaryONeil2 – Noted expert in creating brands for start-ups
MJ Gottlieb @MJGottlieb – Co-Founder of hustlebranding.com
Bob Burg @BobBurg – Bestselling author of business books
Phil Gerbyshak @PhilGerbyshak – Expert in the use of social media for sales

The 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.

Does it even matter if your Financial Advisor adheres to suitability requirement or acts as a fiduciary? Resounding YES!

18 Monday Nov 2013

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, Education, Fiduciary, finance, financial planning, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, personal finance, portfolio, stock prices, stocks, Suitability

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bonds, business, compensation, education, fiduciary, finance, Financial Advisors, financial services industry, investing, investment expenses, investment fees, investments, personal finance, stocks, suitability

A great debate is raging on in the financial services industry regarding the concept of suitability and fiduciaries. In fact, many firms in the financial services industry are lobbying hard with millions of dollars to keep suitability as the “law of the land”. What is the difference even? Does it make a difference in the investments and asset allocation strategy recommended to you? Well, the financial services industry does not want to change the status quo away from suitability; I can assure you of that. In order to answer that question better, I will provide an analogy below to try to explain the concept more clearly.

Imagine that you have a son or daughter who is finishing up his or her senior year in high school. He or she has done remarkably well academically and has participated in many extracurricular activities. Your child is interesting in pursuing a degree in engineering and is not quite sure what school to go to and if mechanical or biological engineering might be the right path. A sensible and perfectly natural approach would be to consult the high school guidance counselor to get some insight. The guidance counselor may recommend the local university in town. The guidance counselor knows that they offer a degree in engineering. Let’s say your son or daughter report back with excitement at the prospect of going off to college and starting on the path to a career in engineering.

After you have that conversation, you run into a friend who you “brag” to about the news. However, that friend is an engineer and mentions that there is a well-respected engineering program only 75 miles away. That university is known as one of the best in, not only in the state, but in the region. You are still very proud of your son or daughter but cannot understand why the guidance counselor did not mention that option. You decide to go to the guidance counselor and ask what his process was when he talked to your son or daughter. The guidance counselor simply states that your child mentioned that he/she wanted to go into an engineering program. The local university offers an engineering program, and it is accredited as well. When you ask why the other university was not mentioned, the guidance counselor replies that his job was only to find a school that had the degree your son or daughter needed. It was not his job to find the best option. Needless to say, you would be extremely perturbed or worse.

That little story can serve as the backdrop for the issue of suitability and fiduciaries. There are some financial professionals that offer advice based upon suitability. Other financial professionals are considered to be fiduciaries. Suitability is more akin to the way in which the guidance counselor handled the meeting with your son or daughter. The job was only to find a school that fit the needs. Finding a better option was not really thought of or necessary. The friend actually put you on the path to how a fiduciary approaches things. A fiduciary would find the best option given all the information about your son and daughter and his/her future plans.

Now the definition of suitability and how a fiduciary must act are really complex from a legal standpoint and the corresponding requirements needed to follow either. A fiduciary has additional legal responsibilities to you as a client. In order to be a fiduciary, there are strict rules on compensation, products that meet your financial goals, investment expenses, and conflicts of interest. What might a conflict of interest be? Well, a good example is that many financial services firms have proprietary asset management arms and investment products. If that firm manages your recommended portfolio components, additional revenue goes to that firm. Another example might be that many mutual fund offerings provide the financial professional with lucrative 12b-1 fees that are referred to in the industry as trails. A trail simply means that the financial professional receives an annual amount based upon a specified percentage applied to the client accounts that he/she has with the mutual fund company. Another favorite offering is variable annuities. These types of products offer extremely high payouts which are applied to the face value of the insurance policy. It can be very tempting to offer the variable annuity with the highest payout as long as the underlying investments are acceptable (i.e. they invest in large cap stocks that were one portion of your proposed portfolio allocation).

Now I am not saying that anyone who only has to adhere to suitability requirements will automatically place you into investments that have higher fees for you or are better for his/her year-end bonus. My point is that a fiduciary must adhere to higher standards of conduct and act truly independent. A fiduciary runs the risk of additional liability if they breach their duty to you as a client. A financial professional that only has to recommend suitable products has a much lower hurdle to get over. As long as he or she recommends a mix of stocks, bonds, and alternative investments that meets your financial goals, that is all they have to do. Of course, that financial professional may suggest the exact same products that a fiduciary would. However, they are not required to recommend offerings that are the best in terms of investment fees and the best financial product available given your circumstances.

The important thing to remember is to always ask your financial professional whether or not he/she is a fiduciary. If not, you want to ask them how they come up with solutions that are suitable for you. You can even ask them if there are other options available. If you see recommendations that are heavy on the mutual funds of the firm you are dealing with or life insurance products with large amounts of legalize and complicated forms, you should delve deeper into that financial professional’s logic. You definitely should ask what form of compensation and amount he/she will receive and if any revenue goes to the firm from that financial product. Additionally, I would ask them why a more low cost, passive approach might achieve the same objective but be less expensive for you. Some of the responses might surprise you. If the answers seem to sound more like the guidance counselor, I would urge you to seek a second opinion before you choose that financial professional and start an account with that investment portfolio.

The Two Numbers the Financial Services Industry Does NOT Want You to Know Available on Amazon.com

11 Monday Nov 2013

Posted by wmosconi in asset allocation, bonds, business, Charity, Consumer Finance, Education, Fed Taper, Federal Income Taxes, Federal Reserve, finance, financial planning, Income Taxes, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, personal finance, portfolio, risk, State Income Taxes, stocks

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bonds, consumer finance, economics, expense ratios, finance, finance books, financial advice, Financial Advisor, financial planning, financial services, financial services industry, investing, investing books, investment advisory, investment advisory fees, investment fees, investments, retirement, saving for retirement, selecting a Financial Advisor, stocks

I wanted to pass along the latest installment of my book series, A New Paradigm for Investing that I have published on Amazon.com. The subtitle is The Two Numbers the Financial Services Industry Does NOT Want You to Know. Have you ever struggled with trying to determine how much value you get for the investment advice you are paying for? It can seem like everyone has the same “pitch” and the same fees. Since you are entrusting a Financial Advisor or other financial professional with a large part of your net worth and financial future, you deserve to know exactly how fees work in general. I am by no means advocating dumping the individual you have developed a relationship with. Rather, I would like to provide some insight into investment fees and how much they actually are when compared to your annual income. I assure you that, if you are utilizing a full service brokerage firm or other advisory services, these figures will astound you.

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

The link to the book is:

A New Paradigm for Investing: The Two Numbers the Financial Services Industry Does NOT Want You to Know:

http://www.amazon.com/New-Paradigm-Investing-Financial-Services-ebook/dp/B00GCQACF4/ref=sr_1_1?s=books&ie=UTF8&qid=1384183129&sr=1-1&keywords=a+new+paradigm+for+investing+by+william+nelson

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

Followers on @NelsonThought:

The Wall Street Journal Wealth Report @wsjexperts – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Pedro da Costa @pdacosta – Reporter for Reuters covering economics and the Federal Reserve

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells – Editor of the Wall Street Journal Wealth Experts

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

Latticework Wealth Management, LLC

~ Information for Individual Investors

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Does it even matter if your Financial Advisor adheres to suitability requirement or acts as a fiduciary? Resounding YES!

The Two Numbers the Financial Services Industry Does NOT Want You to Know Available on Amazon.com