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Are Your Financial Advisor’s Fees Reasonable? A Unique Perspective – Retirees

14 Tuesday Jan 2020

Posted by wmosconi in asset allocation, Consumer Finance, Education, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial services industry, gross returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, Stock Market Returns

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asset allocation, financial planning, individual investing, investing, investing tips, personal finance, portfolio, reasonable fees, reasonable fees for financial advice, reasonable fees for financial advisor, reasonable financial advisor fees, reasonable investment advisory fees, reasonable investment fees, risk, risk tolerance

I started off this examination with a brief introduction to this question.  You can see that discussion by clicking on the following link:

https://latticeworkwealth.com/2020/01/13/are-your-financial-advisor-fees-reasonable-introduction/

As promised, I will start by using retirees as the individual investors.  The hypothetical example is meant to get you thinking about the reasonableness of investing fees and how they affect you reaching your financial goals.  Of course, I will discuss the same topic but using those individual investors who are saving for retirement.  But now, let’s dive into our discussion of this topic by focusing on those individual investors already in retirement.

Example for Retirees:

If you are retired and not independently wealthy, you are in the wealth distribution phase of your life.  There are some retirees that are permanently in the wealth preservation phase.  Wealth preservation simply means that an investor has enough money to live comfortably, but he/she does not need to deplete his/her investment portfolio.  Furthermore, this investor does not really try to increase the value of his or her investment portfolio.  A retiree in the wealth distribution phase of life is the most common example.  This investor is gradually depleting his/her investment portfolio to pay for living expenses on an annual basis.

Since this person is not working anymore, (thus has no income from work, and longevity keeps getting longer), he/she needs have an investment portfolio that is somewhat conservative in nature.  Therefore, it is not reasonable to expect to earn 8.0% per year.  A more common target return might be 5.5-6.0%.  If you are working with a financial professional who charges you 1.0%, you need to earn 6.5-7.0% on a gross basis in order to get to that target net return.  Now the long-term historical average of stocks is about 9.5%, so the higher your AUM fees are, the more weighting you will need to have in stocks and away from bonds and cash.  Well, we have already gone over that, and most individuals that present information will stop there.  I want to take this even further though.

Let’s say you are a current retiree with $1 million that you are living on an additional to Social Security income.  You have a target return of 5.5% to fund your desired retirement lifestyle, and your Financial Advisor charges you a 1.0% AUM fee.  Thus, you will need to earn a 6.5% return gross to reach your bogey.  Now I would like to put in the twist, and I want to do a thought experiment with you.  Your Financial Advisor will sit down with you and assess your risk tolerance and ensure that the investment recommendations made are not too aggressive for you.  If you cannot take too much volatility (fluctuation in asset prices up and down over the short term), your financial professional will reduce your exposure to equities.

Now let’s look at our example through the lens of economic principles.  If you just retired and are 65, you have one option right away.  You can simply invest all your retirement money in 10-year Treasury notes issued by the Department of the Treasury.  Treasury notes are free to buy.  All you need to do is to participate in one of the Treasury auctions and put an indirect bid in.  What is an indirect bid?  An indirect bid is simply saying that you would like to buy a set dollar amount of notes, and you are willing to accept whatever the market interest rate set by the auction is.  What is the yield on the 10-year Treasury Note right now?  The 10-year Treasury closed at 1.85% on January 13, 2020.  When you go to a financial professional, he/she is selecting investments in lieu of you simply purchasing the 10-year Treasury Note.  Keep in mind that US Treasuries are among the safest investments in the world.  They are backed by the full faith and credit of the US government.  Stocks, bonds, real estate, gold, and other investment options all have an added degree of risk.  With the additional risk, there is a possibility for higher returns though.  How does this relate to your 1.0% AUM fee?

Think about it this way:  why are you paying your Financial Advisor?  You are paying him/her to select investments that can earn you more than simply buying a US Treasury Bill, Note, or Bond.  As an investor, you do not want to just settle for that return in most cases.  With that being said though, you can just start out there and forget it.  You do not need to engage a Financial Advisor to simply buy a 10-year US Treasury note.  This means that you are paying the Financial Advisor to get you incremental returns.

In our example above for a retiree, your target investment return is 5.5%.  If you can earn 5.5% during the year, the incremental return is 3.65% (5.50%-1.85%).  Remember that you are paying the Financial Advisor 1.0% in an AUM fee.  Therefore, you are paying the Financial Advisor 1.0% of your assets in order to get you an extra 3.65% in investment returns.  Well, 1.0% is 27.4% of 3.65%.  Thus, you are essentially paying a fee of 27.4% in reality.  Now your financial professional would flip if the information was presented in this way.  He/she would say that it is flawed.  The mathematics cannot be argued with; however, I will admit that many folks in the financial services industry would disagree with this type of presentation.

 Remember that you started out with $1 million.  You could have gone to the bank and gotten cash and hid it in a safe within your residence.  AUM fees are always presented by using your investment portfolio as the denominator.  In our example, your investment fee is 1.0% ($10,000 / $1,000,000).  I urge you to think about this though.  Does that really matter?  Of course, the fee you pay to your Financial Advisor will be calculated in this manner.  But what are you paying for in terms of incremental returns?  If you want to calculate what you are paying for (the value that your Financial Advisor provides), the reference to the starting balance in your brokerage account is moot.  It is yours to begin with.  You have that money at any given time.  Therefore, it should be removed from the equation when trying to quantify the value your Financial Advisor provides in terms of investment returns on your portfolio.

Now remember that I said your target investment return was 5.5%.  The long-term historical average of stocks is approximately 9.5%.  If you choose to simply allocate only enough of your investment portfolio in stocks and the rest in cash to reach that 5.5% target, you will select an allocation of 53.0% stocks and 47.0% cash (5.5% = 53.0% * 9.5% + 47.0% * 1.0%).  Note that I am assuming that cash earns 1.0% and that you can select an ETF or index mutual fund to capture the long-term historical average for stocks.  Now your financial professional is working with you to select an investment portfolio that achieves the 5.5% target return, and their investment recommendations will be different than this hypothetical allocation.

The hypothetical allocation achieves your target return with a simple choice of two assets (an ETF or index mutual fund and a money market).  Keep in mind that you will normally have a portion of your portfolio allocated to fixed income.  The 10-Year US Treasury note is trading around 1.85% as of January 13, 2020.  If you allocate your portfolio to 60% stocks, 30% 10-Year Treasury Note, and 10% cash, your expected return would be 5.5% (5.5% = 49.0% * 9.5% + 41.0% * 1.85% + 10.0% * 1.0%).

Whatever your Financial Advisor is charging you in terms of fees, you need to make that percentage more in your total return on a gross basis such that your net return equals your target return.  In our example above, the assumed AUM fee was 1.0%.  That investment fee means that you must earn 6.5% on a gross basis because you need to pay your Financial Advisor 1.0% for his/her services.  After the fee is paid, the return on your portfolio needs to be 5.5% on a net basis.

So, how much weighting do stocks need to be in your portfolio to ensure that your overall returns are 5.5% after paying your AUM fee?  The answer is 62.5%.  Why?  The expected return of your portfolio is 6.5% (6.5% = 62.5% * 9.5% + 27.5% * 1.85% + 10.0% * 1.0%) before fees.  Given the average retiree’s risk tolerance at age 65 or older, many individual investors do not desire to have a portfolio with 60.0% or larger allocated to stocks.  The more salient observation is that the individual investor had to increase his/her stock allocation by 13.5% in order to pay the 1.0% AUM fee.  This increased allocation to stocks significantly increases the risk of our hypothetical portfolio.  And keep in mind that the historical, long-term average of stocks is just that.  It is an average and rarely is 9.5% in any given year.

But what if we could find a Financial Advisor that only charges 0.5% AUM fee?  How would that change our example above?  So, we now need to earn a gross investment return of 6.0% rather than 6.5%.  The new portfolio allocation is 55.0% * 9.5% + 35.0% * 1.85% + 10.0% * 1.0% = 6.0%.  Our main takeaways here are that the allocation to stocks only increases by 6.0% (55.0% – 49.0%), and this portfolio has a stock allocation less than 60.0%.

Now let’s look at some actual historical data.  The S&P 500 Index did not have a single down year since 2008 if we looked at the subsequent five years of stock returns.  The returns for 2009, 2010, 2011, and 2012 were 26.5%, 15.1%, 2.1%, and 16.0%, respectively.  The average return over that span was 14.9%.  As of December 31, 2019, the S&P 500 Index was up 31.5% for 2019 including the reinvestment of dividends.  Now I am by no means making a prediction for 2020.  However, I wanted to drive home the fact that, if your Financial Advisor sets up your financial plan with the assumption that your stock allocation will earn 9.5% on average, any actual return lower than that estimate will cause you to not reach your target return.  What is the effect?  You will not be able to maintain the lifestyle you had planned on, even more so if there are negative returns experienced in stocks over the coming years.

Essential/Important Lesson:

Let’s look at the next five years starting in 2015.  A five-year period covers 2015-2019.  If you start out with $1,000,000 invested in stocks and plan on earning 9.5% per year, you are expecting to have $1,574,239 at the end of five years.  Let’s say that the return of stocks is only 4.5% per year over the next five years.  You will only have $1,246,182 as of December 31, 2019.  The difference is $328,057 less than you were expecting.  The analysis gets worse at this point though.  How can it get any worse?

Well, if you were planning on 9.5% returns from stocks per year, the next five-year period 2019-2023 needs an excess return to catch up.  Thus, if your starting point on January 1, 2015 is $1,000,000, your financial plan is set up to have $2,478,228 as of December 31, 2023.  If you are starting behind your estimate in 2019, the only way you can make up the difference is to have stocks earn 14.7% over that five-year period which is 5.2% higher than the historical average.  As you can see underperformance can really hurt financial planning.  The extremely important point here is that a 1.0% AUM fee will cause you to be even further behind your goals.  Remember that the illustration above is gross returns.  You only care about net returns and what your terminal value is.  Terminal value is simply a fancy way to say how much money is actually in your brokerage account.

Top Five Investing Articles for Individual Investors Read in 2019

09 Monday Dec 2019

Posted by wmosconi in asset allocation, Average Returns, behavioral finance, beta, bond yields, confirmation bias, correlation, correlation coefficient, economics, finance theory, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, gross returns, historical returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, market timing, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, risk, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, speculation, standard deviation, statistics, stock market, Stock Market Returns, stock prices, stocks, time series, time series data, volatility, Warren Buffett, yield, yield curve, yield curve inversion

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As the end of 2019 looms, I wanted to share a recap of the five most viewed articles I have written over the past year.  The list is in descending order of overall views.  Additionally, I have included the top viewed article of all time on my investing blog.  Individual investors have consistently been coming back to that one article.

1. Before You Take Any Investment, Advice Consider the Source – Version 2.0

Here is a link to the article:

https://latticeworkwealth.com/2019/09/18/investment-advice-cognitive-bias/

This article discusses the fact that even financial professionals have cognitive biases, not just individual investors.  I include myself in the discussion, talk about Warren Buffett, and also give some context around financial market history to understand how and why financial professionals fall victim to these cognitive biases.

2.  How to Become a Successful Long-Term Investor – Understanding Stock Market Returns – 1 of 3

Here is a link to the article:

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

It is paramount to remember that you need to understand at least some of the history of stock market returns prior to investing one dollar in stocks.  Without that understanding, you unknowingly set yourself up for constant failure throughout your investing career.

3.  How to Become a Successful Long-Term Investor – Understanding Risk – 2 of 3

Here is a link to the article:

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

This second article in the series talks about how to assess your risk for stocks by incorporating what the past history of stock market returns has been.  If you know about the past, you can better prepare yourself for the future and develop a more accurate risk tolerance that will guide you to investing in the proper portfolios of stocks, bonds, cash, and other assets.

4.  Breakthrough Drugs, Anecdotes, and Statistics – Statistics and Time Series Data – 2 of 3

Here is a link to the article:

https://latticeworkwealth.com/2019/11/20/breakthrough-drugs-statistics-and-anecdotes-time-series-statistics/

I go into detail, without getting too granular and focusing on math, about why statistics and time series data can be misused by even financial market professionals.  Additionally, you need to be aware of some of the presentations, articles, and comments that financial professionals use.  If they make these errors, you will be able to take their comments “with a grain of salt”.

5.  Breakthrough Drugs, Anecdotes, and Statistics – Introduction – 1 of 3

Here is a link to the article:

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

I kick off this important discussion about the misleading and/or misuse of statistics by the financial media sometimes with an example of the testing done on new drugs.  Once you understand why the FDA includes so many people in its drug trials, you can utilize that thought process when you are bombarded with information from the print and television financial media.  Oftentimes, the statistics cited are truly just anecdotal and offer you absolutely no guidance on how to invest.

                                       Top of All Time

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

Here is a link to the 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/

This article gets the most views and is quite possibly the most controversial.  Individual investors compliment me on its contents while Financial Advisors have lots of complaints.  Keep in mind that my overall goal with this investing blog is to provide individual investors with information that can be used.  Many times though, the information is something that some in the financial industry would rather not talk about.

The basic premise is to remember that, when it comes to investing fees, you need to start with the realization that you have the money going into your investment portfolio to begin with.  Your first option would be to simply keep it in a checking or savings account.  It is very common to be charged a financial advisory fee based upon the total amount in your brokerage account and the most common is 1%.  For example, if you have $250,000 in all, your annual fee would be $2,500 ($250,000 * 1%).

But at the end of the day, the value provided by your investment advisory is how much your brokerage account will grow in the absence of what you can already do yourself.  Essentially you divide your fee by the increase in your brokerage account that year.  Going back to the same example, if your account increases by $20,000 during the year, your actual annual fee based upon the value of the advice you receive is 12.5% ($2,500 divided by $20,000).  And yes, this way of looking at investing fees is unique and doesn’t always sit well with some financial professionals.

In summary and in reference to the entire list, I hope you enjoy this list of articles from the past year.  If you have any investing topics that would be beneficial to cover in 2020, please feel free to leave the suggestions in the comments.

Rebalancing Your Investment Portfolio – Summary

25 Wednesday Nov 2015

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

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asset allocation, finance, financial advice, individual investors, investing, investment portfolio, investments, life cycle mutual funds, personal finance, rebalancing, risk, risk tolerance, target date mutual funds

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.  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.

Recently, I published a three-part series of articles to define and explain the various nuances of rebalancing an individual investor’s investment portfolio.  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.

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.

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

26 Wednesday Mar 2014

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

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average stock returns, business, expected stock returns, finance, individual investing, investing, personal finance, risk tolerance, S&P 500, S&P 500 Index, stock returns, stocks, volatiltiy

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

Most individual investors are told when they start investing in stocks via mutual funds and/or ETFs to expect an annual return of 8% to 9% per year. You will find that many financial calculators to help you plan for retirement on the Internet have that as one of the inputs to calculate the growth of your portfolio over time. While that information is not too far off the mark based upon historical returns of the S&P 500 stock index, the actual annual returns of stocks do not cooperate to the constant frustration of so many investors. That brings us to the first key to successful stock investing: The actual yearly returns of stocks very rarely equal the average expected. The most common term for this phenomenon is referred to as volatility. Stocks tend to bounce around quite a bit from year to year. Volatility combines with the natural instinct of people to extrapolate from the recent past, and investing becomes a very difficult task. I will get deeper into the numbers in a later post for those readers who like to more fully understand the concepts I discuss. I do need talk in general about annual stock returns at this point to expand upon the first key.

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

Year

% Return

2001

-11.9%

2002

-22.1%

2003

28.7%

2004

10.9%

2005

4.9%

2006

15.8%

2007

5.5%

2008

-37.0%

2009

26.5%

2010

15.1%

2011

2.1%

2012

16.0%

2013

32.4%

 

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

I will not get too heavy into math and statistics, but I wanted to provide you will some useful information to at least be prepared when you venture out to invest by yourself or by using a financial professional. I looked back at all the returns of the S&P 500 index since 1928 (note the index had lesser numbers of stocks in the past until 1957). The actual annual return of the index was between 7% and 11% only 5 out of the 86 years or 5.8%. That statistic means that your annual return in stocks will be around the average once every 17 years. The 50-year average annual return for the S&P 500 index (1964-2013) was approximately 9.8%. Actual returns were negative 24 out of 86 years (27.9% of the time) and greater than 15% 42 out of 86 years (48.8% of the time). How does relate to the first key of stock investing that I mentioned earlier (“The actual yearly returns of stocks very rarely equal the average expected”)?

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

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

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