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Rebalancing Your Investment Portfolio – Overview

14 Saturday Dec 2019

Posted by wmosconi in Uncategorized

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asset allocation, dynamic rebalancing, financial planning, financing plan, investing, investing tips, portfolio, portfolio management, rebalancing, stocks, target date, target date funds, year end, year end rebalancing

With the end of the year fast approaching, it is an excellent time to discuss the concept of rebalancing one’s investment portfolio.  The simplest definition of rebalancing is the periodic reallocation of an investment portfolio back to the original percentages desired.  The fluctuations of the financial markets over time will inevitably alter the amount of exposure in one’s investment portfolio to different types of assets.  The jargon in the financial services industry is your asset allocation

These changes may cause the portfolio to be suboptimal given an individual investor’s financial goals and tolerance for risk.  Knowing about rebalancing is so important because it is one of the most effective ways to eliminate, or at least reduce, the emotions surrounding investment decisions that affect even professional investors.  Additionally, numerous academic studies have concluded that 85% of the overall return of an investment portfolio comes from asset allocation.

I published a three-part series of articles to define and explain the various nuances of rebalancing an individual investor’s investment portfolio several years ago.  However, I thought that it would be a great idea to bring it back as an updated version because the end of the year is fast approaching.  The first article covers the definition of rebalancing in its entirety.  Furthermore, the article looks at an illustration of how rebalancing works in the real world.  It offers an introduction to this important investing tool.  The link to the complete article can be found here:

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

The second article discusses a unique way to get assistance with rebalancing an investment portfolio.  Many of the largest asset managers in the financial services industry, such as Vanguard, Fidelity, and T Rowe Price, offer life cycle or target date mutual funds.  These mutual funds have a predefined year that the individual investor intends to retire.  Moreover, the combination of assets in the mutual fund is structured to change over time and become less risky as the target date approaches.

Since these mutual funds report their holdings on a periodic basis, any individual investor is able to replicate the strategy for free.  Plus, another feature is that an individual investor can be more conservative or aggressive than his/her age warrants according to the mutual fund family’s calculations.  The individual investor is able to pick a target date closer than the endpoint (i.e. more conservative) or pick a target date later than the endpoint (i.e. more aggressive).  For a more comprehensive discussion of this facet of rebalancing an investment portfolio follow this link:

https://latticeworkwealth.com/2015/07/29/how-to-rebalance-your-investment-portfolio-part-2-of-3/

The third and final article discusses the most advanced feature of rebalancing utilized by a subset of individual investors.  The investing strategy is referred to as dynamic rebalancing in most investment circles.  Dynamic rebalancing follows the general tenets of rebalancing.  However, it allows the individual investor to exercise more flexibility during the rebalancing process of the investment portfolio.  Essentially the individual investor determines bands or ranges of acceptable exposures to asset classes or components within the investment portfolio.

For example, a lower bound and upper bound for the asset allocation percentage to stocks is set.  The individual investor is free to allocate monies to stocks no less than the lower bound and no more than the upper bound.  Note that the bands or ranges are normally fairly tight and applies to the subcomponents of the investment portfolio, such as small cap stocks, emerging market stocks, international bonds, and so forth.  To learn more about this fairly complex aspect of rebalancing follow this link:

https://latticeworkwealth.com/2015/11/21/how-to-rebalance-your-investment-portfolio-part-3-of-3/

The articles above capture the vast majority of information individual investors need to know about rebalancing an investment portfolio.  It is good to get a head start on learning about or reviewing this topic prior to the end of the year.  The reason is that most rebalancing plans utilize the end of the calendar year as the periodic adjustment timeframe.

Breakthrough Drugs, Statistics, and Anecdotes: Three Things Every Individual Investor Needs to Know – Statistics and Time Series Data – Part 2 of 3

20 Wednesday Nov 2019

Posted by wmosconi in asset allocation, correlation, correlation coefficient, finance theory, financial advice, Financial Media, Financial News, financial services industry, historical returns, Individual Investing, individual investors, investing, investing advice, investing tips, risks of stocks, standard deviation, stock market, Stock Market Returns, time series, time series data

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correlation, correlation coefficient, Financial Market History, financial markets, Financial Media, Financial News, invest, investing, investing tips, math, mathematics, noise, statistics, time series, time series data

The first article of this three-part series covered the broad strokes of this issues to be aware of in terms of all the “data” and “relationships” that get thrown around by the financial media (print and television).  Most of the discussion uses data points that are not statistically significant to draw any sort of conclusion.  In fact, time series data is notoriously hard to model and predict the future.  Additionally, the specific time series data of stock market returns is even more difficult.

You can refer to the link below to examine the content of the first article:

https://latticeworkwealth.com/2019/11/11/breakthrough-drugs-statistics-and-anecdotes-investing/

The task at hand for the second article is to put some “meat on the bones” of the discussion.  I realize that anything to do with math and statistics is not easy for everyone (or of interest either).  Therefore, I will be writing a supplemental article that covers the mathematics and statistics in more detail.  The goal here is to be able to identify some of the more common errors that you will encounter.

The first item to talk about is any sort of data that has a substantial trend component.  In layman’s terms, there is a data series where the line graph goes up or down in more of a straight-line manner.  You can think of the Gross Domestic Product (GDP) of the United States here.  Every year the GDP figures will generally go up unless there is a recession.  But, even after the recession passes, the trend for GDP will resume upward.  So, where does the problem come in?

I am going to give a contrived example to illustrate why it is dangerous to compare two series that are trending.  The example will consist of two different equations which are trends.  Both have the same trend component and an error term (we will call that eta).  The variables will be exactly the opposite.  More specifically, the two equations we will use are the following:

Trend_1 = Time + 100 + 0.9 * x + eta

Trend_2 = Time +100 – 0.9 * x + eta

Now the x values and eta values were simply generated by selected variables at random between 0 and 1.  The eta values were also selected at random between 0 and 1.  You can think of eta as representing the general “noise” that occurs on a daily basis when observing stock prices in the financial markets.  So, let’s graph the first 100 observations for these two equations:

Trend_Graph_Statistics_Revised

You will notice that the trend component dominates the line graphs.  However, we know by construction that the two equations which produce trend_1 and trend_2 are fundamentally different.  Now the correlation coefficient between those two equations is 0.9984.  A correlation coefficient of 1 means that the two lines move in lockstep.  Why is this important?  Why is it very dangerous?

Well, financial pundits will talk about these types of graphs all the time.  It looks like there is some relationship, but we know there is very little relationship between the two trends.  In fact, we can look at these equations by subtracting the current value from the previous value to see what changes.   Formally, this topic is called first differencing.  It will allow us to see more clearly what we already know.  Here is the graph:

First_Difference_Graph_Statistics_Revised

Now we have a totally different picture.  We can see that at many times the two trend equations are moving in exactly the opposite direction.  In fact, the correlation coefficient for the first-differenced equations is 0.2675.  There is only a slight positive relationship between the two trends.

In the example above, we can see that looking at the two trends is very deceiving.  Remember that I added the eta term to represent “noise” that is always present in financial market data.  So, anytime someone talks to you about the comparison of two trends, you should be very skeptical.  You always want to see first-differenced data or at least a comparison of changes in some manner.  Otherwise, you will mistakenly assume that there is a strong positive or negative relationship between two time series.

The second example that I am going to use is stock market returns for the S&P 500 Index from 1966 through 2018.  Why start at 1966?  Well, the S&P 500 Index started with its current number of component stocks back in 1957, and I would like to show annual stock returns and also ten-year annualized returns.  This particular topic can get messy quite quickly, so I am not going to cover it in a lot of depth with statistical and mathematical jargon.  For those of you who are interested, I had mentioned that it will be contained in a forthcoming supplemental article.

A great many individuals in the financial markets talk about stock market returns in the same breath as the normal distribution.  What is the normal distribution?  It is the old bell curve that you are familiar with.  The normal distribution is symmetrical and tails off at the end as more and more data points are gathered.  Well, stock market returns are anything but strongly normal.

Let’s first take a look at one-year stock market returns for the S&P 500 Index.

One Year Returns - Histogram - Non Normal

A useful test to see if a particular distribution is normal is the Jarque-Bera test.  Now it is not necessary to know exactly what is being calculated.  However, you should refer to the bottom of the box that reads “Probability”.  The value of 0.179 is called a p-value.  A p-value less than or equal to 0.10 means that we can reject the hypothesis that the one-year distribution of stock returns is normal.  At a value of 0.179, we would not reject the hypothesis of normality for this distribution.  However, the p-value in our case is not large enough to be totally sure and confident. But what about looking at annualized stock market returns over ten-year periods?

We can look at a similar graph to check to see if stock market returns over longer timeframes are indeed akin to the normal distribution (i.e. the bell curve).  Here is the graph:

Ten Year Returns - Histogram - Non Normal

Looking at the same “Probability” value, we have 0.489.  Therefore, we cannot reject the hypothesis that these stock market returns follow a normal distribution. Looking at ten-year annualized stock market data tells us that we can use the normal distribution as an assumption for calculating statistics.

Now why does this matter?  Well, you will here over and over again statistics that apply only to the normal distribution in relationship to actual, observed stock market returns.  We have just seen that stock market returns over the short-term stock returns weakly follow the normal distribution. On the other hand, long-term stock returns are definitely normal. Now I will not get into the technicalities, but time series data is indeed asymptotically normal.  What?  Say again?

This is just a fancy way of saying that, as the number of data points (sample size) approaches infinitely, the time series will look like the normal distribution.  Pretty much all financial market and economic data have very few data points.  In fact, you usually need several hundred data points prior to making any assumptions and using the statistics related to the normal distribution (think standard deviation or correlation coefficients).

Thus, most of the banter in the financial media is just subjective notions of what is going on in the stock market and the economy. More often than not, an assertion by someone in the financial print or television media is more of an educated guess than based on a solid mathematical foundation. That fact explains why financial pundits hedge their statements. Like I say half-jokingly, “I see the stock market going up in the next several months, but of course it might not resume its uptrend or could even take a leg downward”.

Well yes, I guarantee you that every day stocks will go up, down, or remain unchanged. This type of daily commentary in the financial press about the short-term performance of stocks (or other financial assets) is just not helpful and can be downright distracting you from investing for your long-term financial goals.

I apologize for getting too detailed in certain parts of this article.  What are the key takeaways?  First, you should be extremely leery of drawing any conclusions from the comparison of two or more data series that are trending upward or downward.  Second, you need to have several hundred observations prior to invoking any reference to the normal distribution.  So, what is left after that?  As you might imagine, there are not too many comparisons or studies that pass the muster to give you insights on investing or actionable information to make changes to your investment portfolio.

Don’t focus on the mathematics or statistics.  All you need to remember are the two takeaways above.  And, first and foremost, you should always be skeptical whenever you are presented with comparisons and statistics related to the financial market or the economy as a whole.

Breakthrough Drugs, Statistics, and Anecdotes: Three Things Every Individual Investor Needs to Know – Part 1 of 3

11 Monday Nov 2019

Posted by wmosconi in asset allocation, Education, financial advice, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, investing, investing advice, investing information, investing tips, investment advice, investments, math, personal finance, portfolio, S&P 500, S&P 500 Index, statistics, time series, time series data

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asset allocation, Financial Media, Financial News, financial planning, investing, investing advice, investing information, investing tips, noise, statistics, time series, time series data

Although the title might appear to be random at first glance, I promise that there is an underlying theme.  This article is the first in a three-part series that will discuss how individual investors are bombarded with information about what happens in the financial market.  Most of the time you might hear that, 5 out of the last 7 times “x” happened, the S&P 500 index went up by 10% or more.  I will argue that most of these types of comments might be useful trivia for the television show, Jeopardy; however, they should not impact your long-term investment plan.

So, why did I use breakthrough drugs?  Prior to any drug coming to the marketplace, the FDA does a very thorough review of the test results to ensure that the drug is safe and also its efficacy is not overstated.  What if I told you that a pharmaceutical firm came up with a possible cure for lung cancer, and there were successful trials of 10 individuals.  Does that sound like a group too small to draw any conclusions?  Would you take a drug that the testing was only done on a handful of people?  Now the FDA would never allow such a thing, and there are tons of protocols and blind or double-blind randomized testing of many individuals.  It just sounds weird if only 10 people were tested, and there was also no control group (i.e. a separate group given a placebo).

While the drug example seems a bit outrageous and contrived, I bet you can think of similar examples in the daily financial press (e.g. financial television or print media).  Whenever you hear a small number of events happening that “tend to” lead to certain financial market outcomes, you should be extremely wary.  For instance, I just heard today that, after the Singles Day huge ecommerce sale by Alibaba, the stock (Ticker Symbol:  BABA) is up 80% of the time over the course of the next two weeks.  Well, when did Alibaba start Singles Day?  The first Singles Day sale was in 2009.  Therefore, we have 10 data points to work with (2009 to 2018).  Given the information I referred to above, the comment made today simply says that the stock has been up after two weeks 8 out of the last 10 years.  Now I will try to hold in my red flags and bit of ludicrous thoughts, this type of information is not informative at all.  There are just too few observations to draw any sort of valid conclusion.

Here is the plan of attack for the next two articles.  The second part of this discussion will focus on statistics.  Yes, I know this topic is not too much fun and can get complicated very quickly.  However, individual investors need to know a bit about statistics to recognize when a quantitative quote is totally useless.  We will not get too granular though, I promise.  Essentially most financial market data is time series data.  Different rules apply in that case, and these rules are broken all the time by even the most sophisticated professional investors and commentators.  The third part of this discussion will be an in-depth examination of an actual event that grounds my argument in recent events.  I will examine what is called the inversion of the yield curve and how it normally portends a recession for the U.S. economy.  Don’t worry; I am going to explain those terms when the third part of this series rolls around.

Please join me in a critical review of all the financial market and economic data you get bombarded with.  So much of it is just “noise” or simply interesting trivia at best.  Note that the interesting trivia cannot guide or inform your particular asset allocation of investments.  As always, if you have questions along the way, please feel free to comment on this or any other article.

How to Become a Successful Long-Term Investor – Part 3 of 3 – The Folly of Market Timing

28 Saturday Sep 2019

Posted by wmosconi in Alan Greenspan, asset allocation, Average Returns, behavioral finance, bubbles, correlation, correlation coefficient, Dot Com Bubble, finance, finance theory, financial goals, financial markets, Financial Media, Financial News, financial planning, Greenspan, historical returns, Individual Investing, individual investors, Internet Bubble, investing, investing advice, investing information, investing tips, investment advice, investments, Irrational Exuberance, market timing, math, personal finance, portfolio, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Valuation, volatility

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This article is the third and final post in my three-part series on learning how to be a successful long-term investor.  The general theme underlying all of the topics has been developing enough of an understanding of the stock market gyrations and sometimes wild ride to form reasonable expectations at the outset.  Those expectations lead directly into to developing a long-term investment strategy and plan that you are much more likely to stick with through “thick and thin” because you know what is coming.  Of course, you will not know the order in which the ups and downs may come, but you will have a ton of information helpful to be much less likely to lose your nerve or get overly excited.

The last topic will be about “market timing”.  We will delve deeply into the concept and see how very difficult it has been in the past, and, I believe, will continue to be for the foreseeable future.  Now the discussion to follow will be entirely self-contained; however, it might be helpful to take a look at the first two articles to have additional context.  The opening topic was an overview of the history of stock market returns using the S&P 500 Index (dividends reinvested).  Here is a link to that post:

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

The second topic was a discussion about the concept of risk.  We explored how it is normally defined, ways that you can gauge your tolerance for risk given the information from the first post, and explored some methods/mindsets to reduce risk in your investment portfolio.  Here is a link to that post:

https://latticeworkwealth.com/2019/09/25/successful-long-term-investor-risk/

So now, we will turn to the topic for the last article.  As mentioned above, we are going to take a look at “market timing”.  In general, the idea of “market timing” is to develop ways to be able to buy stocks when they are very undervalued and also sell stocks right near the market peak to avoid a big downturn.  There are certain variations where an investor is not necessarily trying to time the most opportune time but trade along with the momentum of the stock market and anticipating the next movement prior to other stock market participants.

“Market timing” is notoriously difficult to do.  But you will see considerable time devoted every day to financial market television and periodicals advising individual investors what trades to make.  I would submit that following things and pundits on a daily basis adds to “noise” and “information overload”.  Additionally, for every guest that predicts a big leg up in the market, there will be another guest later in the day who tells you that we are in a bubble and stocks will drop dramatically soon.

Another lesser talked about item is the main guests that are invited to speak on television or are quoted in financial periodicals.  Typically, the guest introduction will be prefaced by this man/woman predicted the last major move in the stock market and we are so lucky to have him/her back again.  While these guests are great to hear from, there is a severe amount of “selection bias”.  What do I mean by “selection bias”?  You will rarely see a guest brought on to be lambasted for a prediction that never came to fruition or was just flat out wrong.  The vast majority of guests on television or market experts in financial articles will be the ones who made a very prescient call on the direction of the stock market.

The promise of “market timing” is still so enticing.  It normally relates to the fear of losing money or the greed of just not wanting to miss the next big bull market trend upward in the stock market.  However, the ability to call the market tops or bottoms has proven to be pretty much a 50/50 flip of the coin (now I am being generous at that).  One of the examples that I love to give is the coining of the term “irrational exuberance”.  The former chair of the Federal Reserve, Alan Greenspan, used that new term to state that the stock market was in what he thought was a bubble.  Little do people remember, but he first gave the speech in December 1996 to refer to what would become the Dot.Com bubble and bust.  Greenspan was proven right but the top of that bubble occurred in March 2000.  I use that example because irrational activity in the markets can persist for much, much longer than you might expect.

So, now I know that some people reading this post will be able to point to experts who made the great calls or even their own calls on the direction of the stock market.  Well, I will start off the discussion by showing that “market timing” is indeed somewhat possible.  But it takes much longer periods of time than you might think at first.  Here is how we will proceed in the analysis.  I discussed how the long-term historical average of the S&P 500 Index from 1957-2018 has been 9.8%.  It would seem logical then that, if stock market returns were below that average or above that average for a certain length of time, you could just do the opposite figuring that stock market returns would eventually trend back to that average (in the jargon reversion to the mean).

The problem is, as I briefly mentioned in the last paragraph, that the time period needs to be so long that it is almost untenable for individual investors to practically implement.  In fact, we have to use 15-year annualized returns to illustrate the theory.  So, if the stock market has been below/above trend, we will buy/sell because an inflection point has to come.  Let’s take a look at it graphically to drive the point home:

Fifteen Year Correlation

In the graph depicted above, we have exactly the returns we would like to see.  The blue dots are the past 15 years of stock market returns, and the orange dots are the next 15 years of stock market returns.  The dots are what we would term to have an inverse relationship.  In fact, for all of you somewhat familiar with statistics, the correlation coefficient is -0.857.  Therefore, there is a really strong relationship here that leads us to the promise of “market timing”.  Should we give up on it so early?

The problem with “market timing” is that, for any length of time less than 15 years of annualized stock returns, there really is no relationship (at least no actionable trading of stocks for your investment portfolio).  Let’s take a look at the same concept in the first graph with a look at one-year and three-year current and then future returns:

One Year Correlation

Three Year Correlation

Using the one-year and three-year current and then future stock market returns of the S&P 500 Index, our dots just kind of do not follow a discernable pattern.  Again, for the statistically inclined folks out there, the correlation coefficients are -0.10 and -0.041, respectively.  As always, we won’t get too waded down into the mathematical weeds but a correlation coefficient close to 0 means that there is essentially no correlation/relationship between the two.  To make an analogy, you can think of what is the correlation between birds in your backyard and the number of jars of pickles for sale at your local grocery store?  Well, there should be no relationship whatsoever.  Even if there were, it would not make any sense.  In our case here, there is at least some logic underlying our premise of the most recent return on the S&P 500 Index and the future returns over that same time period.  As we see though, there is really nothing actionable to embark upon for individual investors to properly engage in “market timing”.

Before we totally give up on “market timing”, we can take a look at the same charts but extending the time periods to five years and ten years.  Let’s take a look at those two graphs:

Five Year Correlation

Ten Year Correlation

The correlation coefficient for the five-year chart is 0.028, so we cannot really use that long of a time period either.  I will admit that the ten-year chart looks a little more promising.  We have a graph that looks somewhat more like the fifteen-year graph that I started off with.  In fact, the correlation coefficient is -0.276.  And a negative number is what we want to see in order to try “market timing”.  Unfortunately, the number is really not strong enough to not get caught.  By this I mean, we can see that “market timing” would have worked from 1975-1985 and also from 1990-2001 roughly.  However, 1965-1975 has a grouping of returns that don’t work and 2002-2008 has mixed results as well.  Note that there are less data points because there needs to be at least 10 years of future returns in order to compare the current record of 10-year annualized returns with what the next 10 years of stock returns will end up being.

Overall, we have seen that “market timing” in the short term (even as defined out to five years) does not really have much, if any, predictive power.  Therefore, if you make decisions related to “market timing” based upon how the stock market has performed in any time period five years or less, it is clearly a “fool’s errand” or incredibly difficult to do.  And by the latter, I mean that you can reliably do so over more than one major change in market direction.  The majority of market pundits that you will see or read about have made one correct call which is not nearly enough to judge his/her investing acumen related to “market timing”.

I will close out the discussion of “market timing” by using the Financial Crisis and ensuing Great Recession.  Many folks correctly called (or were proven right without the reason for the bubble matching their investment thesis) this major stock market inflection point.  They correctly saw the unsustainable bubble in housing, the rise of financial stocks, and the buildup of toxic securities like subprime loans.  However, many of those same individuals never changed their investment thesis and failed to tell individual investors to return to the stock market and buy.  Essentially there are still folks that will tell you we are in a bubble.  Now I am not bold and/or grandiose enough to weigh in on the current value of the stock market.  But you need to know that most of the people who call a wicked crash in stocks or a massive bull market do not change their investment thesis prior to the next big turn.

For example, let’s say that you learned about stock investing 10 years or so ago and decided to invest $1,000.00 in the S&P 500 Index toward the end of October 2007.  And yes, this was the absolute worst time to invest in stocks.  Sadly, by March 2009, you would have lost 50% of your investment and have only $500.00 at that point in time.  You might feel great if you listened to someone who called the top and told you that the fourth quarter of 2007 was the absolute worse time to buy stocks.  But I am willing to bet that this same person would not have told you when it was “safe” to invest again.  If you knew to expect bouts of extreme volatility in the stock market beforehand, you could have kept your money in the stock market.  At the end of December 2018, you would have had $1,712.36 using our 13.1% 10-year annualized return over that time.  If the original market predictor of catastrophe told you to just keep your $1,000.00 in the bank you would have $1,160.54 (assuming generously that you could earn 1.50% over the ten years in your bank saving account).  Adjusting the hypothetical investor who simply kept his/her money in stocks back to inflation, he/she would have $1,404.73 (assuming 2.0% inflation over the last 10 years which is higher than was actually experienced).  At the end of December 2018, you would have a bit more than 21% higher in inflation-adjusted dollars than the person who just never invested (or took his/her money out of stocks right at the end of October 2007 but never returned to stocks).

Now I will admit that my hypothetical scenario would have tried the “intestinal fortitude” of the most seasoned professional investors after seeing a 50% market drop over 1.5 years.  My only point with the example is that, even if you could not have held your nerve to remain invested in stocks over the Financial Crisis, the investment pundit(s) who tells you the exact top with a brilliant prediction also needs to tell you when to invest or sell again in the future (i.e. “market timing”).  Rarely will you see such a prognosticator that can totally change their investment thesis to get the next call right.  You are much better off abstaining from “market timing” and sticking to your long-term investment strategy.  Of course, that may indeed call for selling or buying a portion of stocks at certain given points to change your investment portfolio allocation to match your risk tolerance and financial goals.  But trying to utilize “market timing” to be in and out to experience hardly any losses and capture all the gains is just not realistic, so you might as well discard the entire investment strategy of “market timing”.

What is Confirmation Bias? Why is it Dangerous for Individual Investors?

26 Wednesday Apr 2017

Posted by wmosconi in active versus passive debate, behavioral finance, confirmation bias, Emotional Intelligence, EQ, finance, finance theory, financial advice, financial markets, Financial Media, Financial News, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, passive investing, personal finance, stock market, stocks

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behavioral finance, confirmation bias, Emotional Intelligence, financial advice, financial markets, financial planning, individual investors, investing, investing advice, investing information, investing tips, investments, stock market, stocks

There are many dangers for individual investors to be aware of when investing.  More and more of these dangers and/or complications are being recognized in the field of behavioral finance.  Behavioral finance looks at the psychological and emotional factors that influence the decision-making process of investors.  Oftentimes researchers in this field try to figure out what causes normally rational people to act irrationally.  Unfortunately, it has proven over and over again that, when money is involved, the vast majority of people let their emotions/feelings interfere with their investment decision either slightly or in profound ways.  We do these things without even knowing it which makes it even harder to address and correct.  Keep in mind that Warren Buffett says that having control of one’s emotions is just as important (or even more so) than having a superior intellect that can select excellent, long-term investments.

Confirmation bias belongs in the realm of behavioral finance, but, as many of these issues, it really first has been examined in terms of psychology.  So, what is confirmation bias exactly?  The definition of confirmation bias is “the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses” (Plous, Scott (1993). The Psychology of Judgment and Decision Making. p. 233).  Keeping in mind that confirmation bias applies to many other areas, the primary focus in the remainder of this article will be how it manifests itself in relation to investing.  Now that we have the formal definition, let’s take a look deeper into this very real danger for individual investors.

Individual investors have the natural inclination to make a decision first and then look for information that supports that initial decision.  It also applies at an even higher level than that.  The way that individual investors think they should invest in general is almost predetermined.  The easiest thing to do is to talk to people with the same thought process about investing, search through the same supporting financial media news publications and websites, and listen to the same experts.  Over time, it gets very easy to just keep doing the same thing over and over again.  Plus, it takes an incredible amount of effort to step outside of one’s comfort zone and try to prove that he/she might in fact be incorrect.  Individual investors (and even professional investors, money managers and investment advisors) are not wired to attempt to confirm why they might be wrong.  At first glance, it seems like a totally foreign and nonsensical concept.

So, what are the types of problems that can occur when individual investor does not acknowledge confirmation bias?  There is a long list here are a few to ponder.  First, a big mistake can be thinking that what has happened in the recent past will continue into the future indefinitely.  This danger is especially evident during a bull market.  It can be easy to get carried away and see how much money one made and then keep pouring money in (more than you can really risk).  The converse is true when it comes to a bear market.  After stocks have gone down for a number of months or longer, it is very easy to just give up on investing in the stock market because it seems like things will never turn around.  Second, the danger creeps in when investing by not challenging one’s assumptions.  Even if an individual investor knows at a subconscious level that an incorrect decision was made, there can be a desperate search for any shred of evidence that one can justify nonaction.  Third, there are times when listening to the investment advice of a particular expert can be “addictive”.  By this I mean that it is natural to continue to listen only to the views of that person, especially when he/she made a bold prediction about the stock market that came true.  It can be simple to forget that market timing is extremely difficult and that person could be totally wrong in terms of his/her next prediction.  Lastly, it can feel good to be part of the crowd and not think differently (or at least examine other issues).  There is safety in numbers essentially and, if your investment decision does turn out to be wrong, you can at a minimum take solace in the fact that “everyone else was doing it”.

There are a number of steps that individual investors can take to counteract the dangers of confirmation bias.  First and foremost, the fact that you are aware of the potential trap of confirmation bias is half the battle.  Periodically ask yourself if you have looked for alternative viewpoints and evidence.  Second, you can make a list of why you made a particular investment decision in the first place.  But, more importantly, you should write down what types of events could occur to make you change your mind because your investment thesis was not correct.  It is very powerful to have a written record to start with.  This recommendation actually comes from a reporter at The Wall Street Journal named Jason Zweig.  Mr. Zweig has been writing about the financial markets for decades now and still has a weekly article in the paper (usually in the weekend edition) called The Intelligent Investor.  I really urge you to take a look at this interview with him back in 2009 about confirmation bias.  Here is the link:

http://www.wsj.com/video/when-investing-consider-your-confirmation-bias/B768E62A-AA01-4B37-905F-F3EDA5C72B78.html

Third, you should make it a habit on a regular basis, maybe monthly, to go to various financial market and investing websites that do not mesh with your general investment philosophy.  You can peruse through a few articles that you might find totally different than you interpret a situation.  I urge you to read them with an open mind though and try to be objective.  Lastly, you can bounce an idea off a close friend or advisor and see what they think about your rationale.  It is far easier for them to be objective.  If you do not have anyone to consult with, I would urge you to pose the question in an investing forum.  However, you need to phrase the question in the manner that will address your possible confirmation bias.  It is very common to ask question in a positive manner like “Why should you invest in technology companies?”.  The better way to phrase it at the outset is to use language like “What are some of the reasons why you should not buy gold?”.

Now keep in mind that the advice on confirmation bias also applies to the articles I have posted on my website.  You will note that two of the main themes are using a passive investing approach to invest and striving to keep investment fees as low as possible.  I urge you to go and seek out information about why you may want to choose an active investing strategy as an individual investor.  Look for the reasons why and situations where you might have to pay additional investment fees depending on your particular circumstances.  It is very healthy and beneficial to seek out other information, and I always encourage individual investors to do so.  The one thing that I firmly hold onto is that I would avoid financial websites or sources that say I am right and the other guys are all wrong.  Things are rarely ever so “black and white”, especially in the world of financial markets and investing.

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

29 Tuesday Dec 2015

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

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asset allocation, bond market, bonds, Federal Reserve, finance, financial advisor fees, individual investors, interest rates, investing, investing advice, investing blogs, investing tips, investment costs, portfolio rebalancing, reasonable fees for financial advisor, reasonable fees for investing, rebalancing, rising interest rate environment, rising interest rates, stock market, stocks

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

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

 

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

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

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

 

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

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

3)  Rebalancing Your Investment Portfolio – Summary

 

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

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

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

 

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

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

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

 

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

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

 

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

How to Rebalance Your Investment Portfolio – Part 1 of 3

16 Thursday Jul 2015

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

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asset allocation, bonds, consumer finance, finance, financial advice, financial goals, financial markets, financial planning, individual investing, individual investors, investing, investing tips, investment advice, investments, personal finance, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, stocks

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

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

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

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

Here is the scenario:

1) Investment Portfolio at the Beginning of the Year
Type of Asset Dollar Amount Percentage
Stocks $             600,000 60.0%
Bonds                300,000 30.0%
Cash                100,000 10.0%
Total $         1,000,000 100.0%
2) Investment Portfolio at the End of the Year
Type of Asset Dollar Amount Percentage
Stocks $             660,000 62.6%
Bonds                294,000 27.9%
Cash                100,000 9.5%
Total $         1,054,000 100.0%
3) Investment Portfolio After Rebalancing
Type of Asset Dollar Amount Percentage
Stocks $             632,400 60.0%
Bonds                316,200 30.0%
Cash                105,400 10.0%
Total $         1,054,000 100.0%

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

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

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

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