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Latticework Wealth Management, LLC

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Happy New Year, Beginning Thoughts, and Information for International Viewers

27 Friday Dec 2019

Posted by wmosconi in active investing, asset allocation, Average Returns, behavioral finance, benchmarks, bond market, cnbc, Consumer Finance, economics, Education, finance, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, financial planning, financial services industry, gross returns, historical returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, market timing, passive investing, personal finance, portfolio, rebalancing, rebalancing investment portfolio, risk, risk tolerance, risks of bonds, risks of stocks, S&P 500, S&P 500 Index, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Valuation, volatility

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I am looking forward to sharing more information regarding investing, finance, economics, and general knowledge about the financial services industry in 2020.  I am hopeful to increase the pace with which I publish new information.  Additionally, I am happy to announce that I reached viewers in 108 countries in all six continents.  Countries from Japan, France, Germany, and Russia to Ghana, Colombia, and even Nepal.

Since the number of my international viewers has grown to nearly 30% of overall viewers of this blog I wanted to allocate a short potion of this post to the international community.  Some of my comments are most applicable to the US financial markets or the developed markets across the globe.  If you are living in a country that is considered part of the developing markets, I would strongly recommend that you seek out information in your country to see how much of my commentary is applicable to your stock or bond market and situation in general.  It is extremely important to realize that tax structure, transparency of information, and illiquidity of stock and bond can alter the value of what I might say.  During the course of the coming year, I will attempt to add in some comments to clarify the applicability.  However, as the aforementioned statistic regarding the global diversity of viewers of this blog suggests, I would be remiss if I did not acknowledge that I will not hit on all the issues important to all international individual investors.

I encourage you to take a close look at your portfolio early on in 2020.  It is a perfect time in terms of naturally wanting to divide up investing into calendar increments.  As you listen to all the predictions for the New Year, I would encourage you to look at your personal portfolio and financial goals first.  The second step is to always look at that economist’s or analyst’s predictions at the beginning of 2019.  Now I am not implying that incorrect recommendations in the previous year will mean that 2020 investing advice will be incorrect as well.

To help you with a potential way to look at the outlook for positioning your portfolio of investments, I recently published a summary on the topic of rebalancing a portfolio.  You can find the link below:

https://latticeworkwealth.com/2019/12/14/rebalancing-investment-portfolio-asset-allocation/

Now, there will always be unknown items on the horizon that make investing risky.  You hear that we need to get more visibility before investing in one particular asset class or another.  It usually means that the analyst wants to be even more certain how the global economy will unfold prior to investing.  I will remove the anticipation for you.  There will only be a certain level of confidence at any time in the financial markets.

One can always come up with reasons to not invest in stocks, bonds, or other financial assets.  The corollary also is true.  It can be tempting to believe that it is now finally “safe” to invest even more aggressively in risky stocks, bonds, or other assets.  As difficult as it might be, you need to try to take the “emotion” of the investing process.  Try to think of your portfolio as a number rather than a dollar amount.  Yes, this is extremely difficult to do.  But I would argue that it is much easier to look at asset allocation and building a portfolio if you think of the math as applied to a number instead of the dollars you have.  Emotional reaction is what leads to “buying high and selling low” or blindly following the “hot money”; that is when rationality breaks down.

Here is an experiment for you to do if you are able.  There are two shows I would recommend watching once a week.  The first show is Squawk Box on CNBC on Monday which airs from 6:00am-9:00am EST.  The second show is the Closing Bell on CNBC on Friday afternoon which airs from 3:00pm-5:00pm EST.  You only need to watch the last hour though once the stock and bond markets are closed.  Note that these shows do air each day of the week.  Now depending on whether or not you have the ability to tape these shows first and skip through commercials, this exercise will take you roughly 12-16 hours throughout the month of January.  You will be amazed at how different the stock and bond markets are interpreted in this manner.

When you remove the daily bursts of information, I am willing to bet that you will notice two things:

Firstly, Friday’s show should demonstrate that many “experts” got the weekly direction of the market wrong.  It is nearly impossible to predict the direction of the stock market over such a short period.

Secondly, Monday’s show should illustrate what a discussion of all the issues that have relatively more importance are.  However, this is not always a true statement though.  Generally though, financial commentators and guests appearing on the show will have had the entire weekend to reflect on developments in the global financial markets and current events.  Since the stock, bond, and foreign exchange markets are closed on Saturday and Sunday, there is “forced” reflection for most institutional investors, asset managers, research analysts, economists, and traders.  The information provided is usually much more thoughtful and insightful.

I believe that the exercise will encourage you to spend less time attempting to know everything about the markets; rather, it may be more helpful to carefully allocate your time to learning about the financial markets.  After you devote your time to watching CNBC in this experiment, I recommend one other ongoing personal experiment.  Try picking three financial market guests that appear on CNBC during January and see how closely their predictions match reality.  You might want to check in once a month or so.  I think that this exercise will show you how futile it is to try and time and predict the direction/magnitude of the stock market and other financial markets too (e.g. bonds and real estate).

Best of luck to you in 2020!  As always, I would encourage anyone to send in comments or suggestions for future topics to my email address at latticeworkwealth@gmail.com.

How to Become a Successful Long-Term Investor – Part 2 of 3 – Understanding and Reducing Risk

25 Wednesday Sep 2019

Posted by wmosconi in asset allocation, behavioral finance, Consumer Finance, Education, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Geometric Returns, historical returns, Individual Investing, individual investors, investing, investing advice, investing tips, investment advice, investments, math, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, standard deviation, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, volatility

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Another extremely important part of being a long-term investor is to understand the concept of risk.  Financial professionals define risk in a number of different ways, and we will examine some of those definitions.  The overarching goal is to look at risk from the standpoint of the volatility or dispersion of stock market returns.  Diversification of various investments in your portfolio is normally the way that most financial professionals discuss ways to manage the inevitable fluctuations in one’s investment portfolio.  However, there is another more intuitive way to reduce risk which will be the topic of this second part of this examination into becoming a successful long-term investor.

The first part of this series on long-term investing was a look back at the historical returns of the S&P 500 Index (including the reinvestment of dividends).  The S&P 500 Index will again be the proxy used to view the concept of risk.  If you have not had a chance to read the first part of the series, I would urge you to follow the link provided below.  Note that it is not a prerequisite to follow along with the discussion to come, but it would be helpful to better understand the exploration of risk in this article.

The link to part one of becoming a successful long-term investor is:

https://latticeworkwealth.com/2019/09/23/successful-long-term-investing/

But now we will turn our attention to risk.  Risk can be a kind of difficult or opaque concept that is discussed by financial professionals.  Most individual investors have a tough time following along.  Sometimes there is a lot of math and statistics included with the overview.  Although this information is helpful, we need to build up to that aspect.  However, there will be no detailed calculations utilized in this article that might muddy the waters further.  I believe it helps to take a graphical approach and then build up to what some individual investors consider the harder aspects of grasping risk.

Risk related to investing in stocks can be defined differently, but the general idea is that stocks do not go up or down in a straight line.  As discussed in depth in part one, the annual return of the S&P 500 Index jumps around by a large margin.  Most individual investors are surprised at seeing the wide variation.  Ultimately, the long-term historical average of the S&P 500 Index from 1957 to 2018 is 9.8%.  But rarely does the average annual return end up being anywhere near that number.

The first way I would like to look at risk within the context of long-term investing is to go back to our use of “buckets” of returns.  If you have not already read part one, I used “buckets” with ranges of 5% to see where stock returns fit in.  As it relates to risk, we are only going to look at the “bucket” that includes the historical average 7% to 12% and then either side of that “bucket” (2% to 7% and 12% to 17%).  Additionally, we will look at yearly stock returns and then annualized stock returns for three years, five years, and ten years.  Here is our first graph:

Returns on Either Side of Historical Average

The main takeaway from viewing this graph is that, as the length of time increases, more stock market returns for the S&P 500 Index group around the historical average for the index of 9.8%.  Remember that part one covered the useful information that, even though the historical average to be expected from investing in stocks is 9.8%, individual investors need to know that it can take long periods of time to see that historical average.  In fact, if we look only at one-year increments, approximately 33.9% of stock returns will fall into the range of 2% to 17%.    Or, if we use our yearly equivalent, stock market returns will only fall within that range 1 out of every 3 years.  When individual investors see this graph for the first time, they are usually shocked and somewhat nervous about investing in stocks.

The important thing to keep in mind is that as the length of time examined increased many more stock returns fall into this range.  The numbers are 65.0%, 67.1%, and 81.1%, for three years, five years, and ten years, respectively.  Converting those numbers to yearly equivalents we have about 6-7 years out of ten for three years and five years.  And, as one would intuitively suspect, the longest timeframe of ten years will have stock returns falling into the 2% to 17% range roughly 8 in every 10 years.  Now that still means that 20% to 35% of long-term returns fall outside of that range when considering all those time periods.  But I believe that it is certainly much more palatable for individual investors than looking at investing through the lens of only one-year increments.

Another aspect of risk is what would be termed downside protection.  Most individual investors are considered to be risk averse.  This term is just a fancy way of saying that the vast majority of investors need a lot more expected positive returns to compensate them for the prospect of losing large sums of money.  Essentially an easier way to look at this term is that most individual investors have asymmetric risk tolerances.  All that this means in general is that a 10% loss is much more painful than the pleasure of a 10% gain in the minds of most investors.  Think about yourself in these terms.  What would you consider the offset to be equal when it comes to losing and earning money in the stock market?  Would you need the prospect of a 15% positive return (or 20%, 25% and so forth) to offset the possibility of losing 10% of your money in any one year?  Let’s look at the breakdown of the number of years that investors will experience a loss.  To be consistent with my first post, I am going to use the “bucket” of -3% to 2% and work down from there.  Here is the graph:

Returns Less than 2%

There are 61 years of stock market returns from the S&P 500 Index for the period 1957 to 2018.  If we look at the category of 1 year, stock market returns were 2% or less 38.7% of the time (17 years out of 61 years).  However, if we move to five-year and ten-year annualized returns, there were no observations in the -3% to -8%, -8% to -13%, or less than -13% “buckets”.  When looking at losing money by investing in the stock market, a long-term focus and investment strategy will balance out very negative return years and your portfolio is less likely to be worth significantly less after five or ten years.  Of course, there are no guarantees and perfect foresight is something that we do not have.  However, I believe that looking carefully at the historical data shows why it is important to not be so discouraged by years when the stock market goes down and even stays down for longer than just one year.  Hopefully these figures do provide you with more fortitude to resist the instinct to sell stocks when the stock market takes a deep decline if your investment horizon and financial goals are many, many years out into the future.

The final concept I would like to cover is standard deviation.  The term standard deviation comes up more often than not either in discussions with financial professionals during client meetings or is used a lot in the financial media.  There are many times when even the professionals use the term and explain things incorrectly, but we will save that conversation for another post.  Standard deviation is a statistical term that really is a measure of how far away stock market returns are from the mean (i.e. the average).  It is a concept related to volatility or dispersion.  So, the higher the number is, the more likely it is that stock market returns will have a wide range of returns in any given year.  Let’s first take a look at a graph to put things into context.  Here it is:

Standard Deviation

The chart is striking in terms of how much the standard deviation decreases as the time period increases.  A couple things to note.  First, I do not want to confuse you with a great deal of math or statistical jargon and calculations.  My point is not to obscure the main idea.  Second, the 25-year and 50-year numbers are just included only to cover the entire period of 1957 to 2018 for the S&P 500 Index.  These periods of time are not of much use to individual investors to consider their tolerance for risk and the right investments to include in their portfolios.  And, as one of the most famous economists of the 20th century, John Maynard Keynes, quipped:  “In the long run, we are all dead”.  My only point is that discussion of how the stock market has performed over 25 years or longer is just not relevant to how most individuals think.  It is nice to know but not very useful from a practical perspective.

The main item of interest from the graph above of standard deviation is that you can “lower” the risk of your portfolio just by lengthening your time horizon to make investment decisions on buying or selling stock.  For example, the standard deviation goes down 46.9% (to 8.95% from 16.87%) between one-year returns and three-year annualized returns.  Why do I use “lower”?  Well, the risk of your portfolio will stay constant over time and focusing on longer periods of time will not decrease the volatility per se.  However, most financial professionals tell their clients to not worry about day-to-day fluctuations in the stock market.  Plus, most Financial Advisors tell their clients to not get too upset when reviewing quarterly brokerage statements.  This advice is very good indeed.  However, I urge you to lengthen the period of your concern about volatility in further out into time.  My general guideline to the individuals that I assist in building financial portfolios, setting a unique risk tolerance, and planning for financial goals is to view even one year as short term akin to examining your quarterly brokerage statement.

Why?  If you are in what is termed the “wealth accumulation” stage of life (e.g. saving for retirement), what occurs on a yearly basis is of no concern in the grand scheme of things.  The better investment strategy is to consider three years as short term, five years as medium term, and ten years as the long term.  I think that even retirees can benefit with this type of shift.  Now please do not get me wrong.  I am not advising that anyone make absolutely no changes to his/her investment portfolio for one-year increments.  Rather, annual returns in the stock market vary so widely that it can lead you astray from building a long-term investing strategy that you can stick to when stock market returns inevitably decline (sometimes precipitously and by a large margin).  Note that all the academic theories, especially Modern Portfolio Theory (MPT), were built using an assumption of a one-year holding period for stocks (also bonds, cash, and other investments).  Most individual investors do not fall into the one-year holding period.  Therefore, it does not make much sense to overly focus on such a short time period.

Of course, the next thought and/or comment that comes up is “what if the stock market is too high and I should sell to avoid the downturn?”.  I will not deny that this instinct is very real and will never go away for individual investors.  In fact, a good deal of financial media television coverage and news publications are devoted to advising people on this very topic every single day.   It is termed “market timing”.  In the third and last article in this series on becoming a successful long-term investor, I am going to examine “market timing” with the same stock market data from the S&P 500 Index.  You will clearly see why trying to time the market and buy/sell or sell/buy at the right time is extremely difficult to do (despite what the financial pundits might have you believe given the daily commentary).

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