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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.

How Risky Are Stocks? Do You Understand Volatility? Part 2 of 2

20 Friday Sep 2013

Posted by wmosconi in asset allocation, bonds, business, Charlie Munger, Education, finance, financial planning, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, personal finance, portfolio, risk, statistics, stock prices, stocks, volatility, Warren Buffett

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asset allocation, bonds, business, Charlie Munger, education, Fed taper, finance, financial planning, investing, investments, long term investing, mathematics, Modern Portfolio Theory, MPT, portfolio, retirement, risk, statistics, stocks, Warren Buffett

In the first part of this discussion, I talked at length regarding the volatility of stock prices.  Most investors are fearful of stock prices jumping all around for seemingly random or unknown reasons.  Many times extreme volatility can be explained.  Other times different news sources will attribute these fluctuations to totally different or even opposite reasons.  No wonder it is frustrating for individual investors.  Now traders and speculators need volatility to make money.  Additionally, Wall Street trading desks generate purchase and sale orders if stock prices are constantly in flux.  However, if you have a longer timeframe for holding the underlying components of your portfolio, it is quite easy to get hung up in this daily “circus”.  It is hard to have what I term “intestinal fortitude”, which is a fancy way to say guts, in the face of this environment of information overload.

Most financial professionals will construct a portfolio and recommend purchases/sales based upon Modern Portfolio Theory (MPT).  If you have heard the terms beta, alpha, r-squared, and tracking error, you are already familiar with MPT.  I will not get into the history behind the construction of MPT, but it started over 50 years ago.  Harry Markowitz is credited with creating the outline of the theory, and there has been a plethora of academic work done since then by some of the greatest academicians of all time.  With that being said, coming up with an academic theory and applying it to the real world are two different stories.  In brief, MPT talks about how to create a portfolio on the efficient frontier which maximizes return and minimizes risk (where risk is defined as the volatility of stock prices).  The portfolio consists of a combination of the risk free asset (Treasury debt) and an additional percentage of stocks.  However, there are a number of assumptions which underlie the theory.  In order to get the mathematics to work, a number of simplifying assumptions need to be made.  Otherwise, the calculations are so difficult that only a handful of mathematicians and statisticians would be able to understand the theory.  For some background information on the issue of stock price volatility, I encourage you to reread the first part of this article:  https://latticeworkwealth.com/2013/09/08/how-risky-are-stocks-do-you-understand-volatility-part-1-of-2/.

Let’s take a look at the six key underlying assumptions of MPT as described by Dr. John C. Hull who is the Maple Financial Group Chair in Derivatives and Risk Management at the Joseph L. Rotman School of Management, University of Toronto in his book entitled Risk Management and Financial Institutions Third Edition.  As an aside, most students with an MBA in Finance or MS in Financial Engineering will recognize Dr. Hull’s name from his book on Options, Futures, and Other Derivatives, which is a standard text in most programs:  http://www.amazon.com/Options-Futures-Derivatives-DerivaGem-Package/dp/0132777428/ref=sr_1_1?ie=UTF8&qid=1379691849&sr=8-1&keywords=john+hull+options+futures+and+other+derivatives+9th .  Dr. Hull lays out the assumptions on pages 10-11 of the aforementioned book.  They are as follows:

1)       Investors only care about the expected returns and the standard deviation of their portfolios assuming the standard normal distribution (bell curve).  He admits that many academics and practitioners believe that the expected returns of stock prices are non-normal and exhibit skewness and excess kurtosis.  Without giving a formal definition of the two, suffice it to say that skewness depicts whether or not more observations are above or below the average.  Kurtosis is simply whether or not there are observations than the simple bell curve would not predict.  Investors are more concerned with extreme negative returns above and beyond what the bell curve would predict;

2)      The second assumption is that stock price changes are not correlated to each other.  However, think about the industry factors that affect Apple and Samsung.  It is likely to be that global demand for smartphones will affect both these stocks in similar ways;

3)      The time horizon for all investors is one period which is typical one calendar year;

4)      All investors can borrow and lend at the same risk free interest rate;

5)      All investors are taxed at the same rate in all locations;

6)      All investors make the same calculations about the estimated expected returns, standard deviations, and correlations between returns for all investments available to investors.

We can clearly see that these assumptions severely limit the practical application of MPT to constructing a portfolio of investments that will provide a satisfactory rate of return given ones risk tolerance and financial goals.  Why are these assumptions made?  Well, I can assure you that even with these assumptions the math gets quite complicated.  For example, ask your Financial Advisor how William Sharpe proved that you can eliminate the covariance between stocks in order to come up with portfolios that lie on the efficient frontier to “simplify” Markowitz’s original theory.  Note this is just one “easy” part of coming up with the expected return of a portfolio composed of percentages of the risk free asset and all stocks.  If your Financial Advisor can explain that concept to you, you need not read any further.  I would be quite impressed and listen more to what he/she says.  If not, I would urge you to continue reading.

If some or all of the six assumptions do not apply to you, why would you want a portfolio custom made for you that uses a 50 year-old theory?  Personally, I do not know either.  So let’s proceed with how it relates to individual investors.  I will concentrate on investors in or near retirement or saving for retirement in my discussion below.

If your time horizon is longer than one year, you can make some modifications to MPT in order to fit your financial goals, risk aversion, and timeframe.  How?  Well, if you are an individual investor, you can choose to see the world in a different manner when it comes to investing.  The day-to-day and even quarterly fluctuations of stock prices should not concern you too much.  Yes, I realize it is easier said than done.  However, you can choose to make tactical and strategic decisions about the composition of your portfolio.  Most financial professionals would tell you to invest for the long term anyway, right?  Well, tactical decisions should be made in the context of an annual review of your portfolio.  Strategic decisions should be made with an outlook on the next five years or so.  This is probably what you have heard anyway.  Here is the twist though:  if you look at the stock price fluctuations of the S&P 500 index over the last 50 years, there will be some scary results.  If we take the period April 1, 1957 through June 28, 2013 and use MPT statistics, you can expect that 1 out of every 10 quarters your quarterly return from the S&P 500 index will be less than -11.5% or greater than 15.1%.  Note the returns are based upon quarterly fluctuations.  You can expect to experience a return in any given quarter which is less than -11.5% every 5 years or so.  Given your risk tolerance, how would you feel if your portfolio lost this amount in a single quarter?  Most investors, especially retirees, would have a difficult time accepting this volatility in expect returns.  Should you sell all your stocks at this point?  Well, I try never to give portfolio advice, but, if you are fearful of losing more than 10% of your money investors in stocks, I think you should strongly reconsider your risk tolerance.  That negative return is any given quarterly window is not too extraordinary in the real world.

I talked about the standard deviation of stocks on an annual basis at great length in the first part of this article.  How can we use the same statistical techniques to look at a portfolio over the long term?  Your Financial Advisor is used to speaking with you once a quarter and at the end of the year to review the performance of your portfolio.  What if you are wondering what you should do over the next five years? If you are 43 years old, why should you worry about daily stock price returns in 2014?  You should think about stock price returns but not to the extent of watching the stock market every single day, month, or quarter to try to glean magical insight into the future direction of stock prices.  I have been investing in the stock market since 1987, and the history of the stock market is littered with incorrect predictions about the stock market.  In fact, it can be dangerous to listen to some of the market prognosticators of “gloom and doom”.  For example, if you hear that you should buy gold because the entire financial system is going to collapse, I would ask you to perform a thought experiment.  If the financial system breaks down such that we are bartering for goods with gold and silver coins, ask yourself how long that money will last.   How long will it be until there is a scene out of NBC’s television show Revolution?  If there is an armed gang of thugs roaming the streets, I am pretty sure that your coins will not be in your possession for very long.  Note that is my personal opinion, but, if you construct your portfolio based upon extreme scenarios, you have to perform extreme scenarios to “stress” your portfolio.  I think it is a better use of time to think about uncertainty as being an ongoing component of investing.  There will never be 100% certainty about economic and financial events.

We can use the same statistics invoked by the academicians who created MPT to our advantage if the time horizon is extended to five year increments.  For example, over the time period 1961-2010, the average annual return for stocks in the S&P 500 index over each five-year period was 9.7% per year.  Now the minimum and maximum annual returns for each five-year increment were 0.5% (2001-2005) and 18.2% (1996-2000), respectively.  Now please observe that the annual returns of 1973, 1974, 1987 (as shown in part 1 of 2 was actually positive), 2001, and 2008 are included in that time series.  How does this occur?  The extreme increases and decreases of stock returns are smoothed out over a long period of time.  We had the Internet Bubble in 2001 which was preceded by the period of time in the late 1990’s which former Federal Reserve Chairman, Alan Greenspan termed irrational exuberance (note that this term was coined by him in December 1996; please refer to this link for Greenspan’s famous speech:  http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm).  The fluctuation of stocks over a particular year can be quite volatile and can persist for much longer than expected by top-notch economists and asset managers.  However, if you look at these observed returns, you come up with much smoother results.  Your financial professional encourages you to invest for the long term, so why don’t you look at the expected returns over the long term for stocks when creating your portfolio?  If you are making tactical (medium term) and strategic (long term) changes to your portfolio, doesn’t it make sense to ignore the daily changes in stock prices?  To me, these are rhetorical questions.  Given the financial advice you receive or information you receive from the financial media now, does it sound like they consider these questions to be rhetorical?

The last point I will leave you with is a brief look at the annual returns you might expect over any five-year holding period in stocks.  Looking at the ten observations of five-year annual returns between 1961-2010 for the S&P 500 index, you can expect that 1 year in every 100 your five-year annual return will be outside -5.9% and 25.2%.  Therefore, every 200 years, there should be a five-year annual return less than -5.9% which is otherwise thought of as downside risk.  The worst five-year annual return for stocks since 1931 was 1936-1940 in which the average annual return was a bit less than -0.5%.  The five-year annual return for stocks between 1931-1935 was 2.2% which incorporated the height of the Great Depression.  Therefore, I would argue that you are thinking about investing as a long-term exercise in helping you reach your financial goals, stocks may be less risky than you think.  Or at the very least, you should ask your Financial Advisor why they do not use annual and five-year annualized (geometric basis of course) expected returns for stocks when recommending how you should position your portfolio.  It is a valid question if you are a long-term investor.  Note that I did not even include diversification in this discussion.  Since you are able to choose small cap stocks, international stocks, high yield bonds, and real estate, you can look at an individual portfolio in an even more positive light.

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