Friday, April 24, 2015

Attention Investors: Don't Get Soft

Do you realize how easy investors have had it lately? There is almost always something happening in the world that can serve as justification for selling investment positions or not investing new dollars. Yet, there hasn’t been many spooky events impacting the markets during the last several months. Let’s examine the investment environment we’ve recently enjoyed.

There is almost always geopolitical current events that are capable of scaring investment markets. While this generation will always have concern about ISIS, North Korea, Iran, Afghanistan, and terrorism, we haven’t recently experienced the kind of negative political event that has immediately sent the stock market into a tailspin. Even stories regarding missile strikes in Gaza have been few and far between. The most relevant international political event of late is the United States’ increased cooperation with Raul Castro and Cuba -- a positive event.

Global economic situations also have the ability to increase volatility in the stock market. Yet, we haven’t recently been bombarded with headlines about excessive debt in Argentina or other countries on the doorstep of financial collapse. Actually, international markets are the big investment story thus far in 2015, with Europe, Asia, and emerging markets outperforming U.S. stocks.

Social tragedies also have the ability to move the markets. I believe the most dominant story regarding social issues of late has been the horrific stories of potential racism and excessive police violence. Of course, these events are shocking and unfortunate, but they aren’t usually the type of stories that impact investment markets. Fortunately, I’m not aware of any school shootings, mass suicides, or broad violent attacks on U.S. soil that have caused a national mourning in 2015. 

Further, there have been relatively few natural disasters such as hurricanes, earthquakes, or tornados that have significantly set back a geographic area or the nation as a whole. In fact, the Weather Channel announced that the tornado count is 59 percent below average year-to-date. There were some large snow storms in the North-East earlier this year, but they had a nominal impact on the direction of the stock market.

Even the U.S. economy hasn’t produced any data that has been particularly frightening to investors. It was all the way back in October that the Federal Reserve announced the ending of its quantitative easing (QE) program, which caused some to wonder if the economy would start to dry up (it hasn’t…). The concern about potentially higher interest rates has been present for so long that it is now old news, and people seem less and less convinced that higher interest rates would significantly stall the economy. Meanwhile, the unemployment rate continues to decline.

Lastly, the stock market itself has hardly provided reason for heartburn. The total return of the S&P 500 has been positive every year since 2008. The index hasn’t even had a temporary pullback of more than -7.27% (9/18/14 – 10/16/14) since 2011, even though the market historically goes through a -10% correction approximately once per year, on average. In fact, the biggest investment concern of 2014 was that small cap and international stocks didn’t make as much as large cap stocks, causing most diversified portfolios to under-perform the larger market indexes such as the S&P 500 and Dow Jones Industrial Average. If your largest investing disappointment is that every part of your diversified portfolio didn’t perform as well as the best performing asset category in the market, you should really focus less on your portfolio and more on enjoying life as a whole.

When we examine the factors that typically lead to volatility in the market, we’ve had a relatively tame past couple of months. My purpose in pointing out this fact is not to imply that the market is in a prime position to continue to do well nor on the verge of dropping drastically when the next sign of uncertainty appears. I simply hope to remind investors that the stock market is not always such a smooth ride.

The most counter-productive action an investor can take is to liquidate their positions after the market drops. I believe the best way to avoid this mistake is to constantly remind yourself that you are investing for long-term results and that short-term (and potentially drastic) volatility is certain to occur. Reminding yourself of this fact now, before the volatility arrives, is likely to increase the probability that you will be able to stick to your long-term investment strategy during both the good and bad periods of market performance.

As Carl Richards points out in his new book The One-Page Financial Plan, no skydiver would try to figure out how a parachute works after jumping out of a plane. Sooner or later, an unfortunate event that will negatively impact the stock market is certain to occur. At that time, remember that just as it always has, the world will continue to turn. Further, remember that the longer you allow the world to turn, the more positive your investment results are likely to be. Don’t let this unusually quite investment period make you more susceptible to short-term instability once it returns.

Monday, April 20, 2015

Living and Dying on Averages

Never forget the six-foot tall man who drowned crossing the stream that was five feet deep, on average.

We want to abide by averages because they make our lives simple and manageable. A couple on a date night assumes a movie will be an average of two hours long so they know when to schedule dinner with friends. The entrepreneur wants to think in terms of making an average profit of $100,000 per year so he has a guideline regarding the standard of living he can enjoy. The 65-year old retiree wants to assume he will live to the average age of 84.3 so he knows at what pace he can enjoy his nest egg.

However, when we rely too heavily on averages, our planning can go awry. If the movie runs longer than two hours, the couple will be late for their dinner date. If the entrepreneur has a slow year and earns less than $100,000, he may end up taking out short term debt to pay his bills. If the retiree lives past age 84.3, he may outlive his money.

The use of averages is essential in financial planning. A range of assumptions is required in the development of a financial plan – how long will you live, how much will you spend each year, what rate of return will your investments achieve, what tax rate will you pay, what will the rate of inflation be, etc. Without these assumptions, retirement projections can’t be constructed. Further, the best method for making these assumptions is to use averages – an average life expectancy, an historical average rate of return, an historical average inflation rate, etc.

So how do we prevent the use of averages from destroying us? By allowing enough time and repetitions for the law of averages to come into effect. Just because a basketball player shoots free throw shots at a 90% success rate doesn’t mean he will necessarily make the next free throw shot he takes. It does, however, mean that if he shoots 100 free throws he is likely to make 90 of them.

A financial plan may assume you achieve an average annual rate of return of 7% per year. Of course, this doesn’t mean it is impossible that your portfolio will actually lose 10% over the next 12 months. It is critical to remember that the financial plan assumes you achieve a 7% return over the entirety of your retirement, which may be 30 years. Consequently, if a loss of 10% occurs in the first year of retirement, your portfolio still has another 29 years to achieve returns that average out to 7% per year. Thus, a 10% loss is far from catastrophic to your retirement projections.

In fact, the primary way a 10% loss could become catastrophic to your portfolio is if it motivated you to make changes to your investments that would prevent the law of averages from applying. If an investor sold their portfolio after suffering the 10% loss, it would essentially guarantee that the anticipated average rate of return won’t be achieved, and consequently, the financial plan would be likely to fail.

For this reason, while it is true that over an extended period of time the market has averaged an annual return of 10%, we should always remember that there is a significant chance of the market taking a loss during any given year (or three-year) period, and it is possible that the market could endure a decade without any significant gains (similar to the 2000’s). Still, if the financial plan requires an average investment return over an extended period of time such as a 30-year retirement, even these setbacks are far from certain to dislodge your secure retirement as long as time is granted for the average to work itself out.

As famed writer and investor Howard Marks said, “We can’t live by the averages. We can’t say ‘well, I’m happy to survive, on average.’ We gotta survive on the bad days. If you’re a decision maker, you have to survive long enough for the correctness of your decision to become evident. You can’t count on it happening right away.” The use of averages has a purpose in financial planning, and in other aspects of life. We simply need to be confident that the figures we use for our averages are achievable over time, and allow time the opportunity to prove us right.

Tuesday, March 24, 2015

How To Make Your Family Line Rich

Have you heard the story behind the invention of chess?

The inventor brought the chess board to the emperor of China, and the emperor was so impressed he said he would grant the inventor one wish. The inventor had the simple wish of receiving one grain of rice for the first square on the chess board, two grains for the second square, four grains for the third square, eight grains for the fourth square, and so forth. Sounding like a fair and modest proposal, the emperor agreed. However, it turns out that filling the last 10 squares on the chess board would have required 35 quintillion grains of rice – more than enough to bury the entire planet. Unamused, the emperor had the inventor beheaded.

Who knows whether the story is true, but the point is that with compounding, grains seem small at first, modest in the middle, then suddenly overwhelming. In the investment world, what enables compounding? Time.

Let’s review the rule of 72. The rule of 72 states we can divide the number 72 by the rate of return we achieve, and the resulting number will tell you how many years it will take your money to double. For instance, if we obtain a 9% rate of return, it will take eight years (72 / 9) for our investment to double in value.

So what rate of return can we expect when we invest in the market? From 1920 thru 2014, the S&P 500 (a typical measure of the stock market) has returned an average annualized rate of return of 10.31%.* Coincidentally, 72 divided by 10.31 equals 6.9835. Thus, if we had invested in the S&P 500 in 1920, our money would have doubled every 7 years.

What would happen if on the day your child, grandchild, or great grandchild was born, you invested $1 in the S&P 500 but kept it a secret. Assuming the infant lived to age 84, the dollar would be worth:

$2 at age 7
$4 at age 14
$8 at age 21
$16 at age 28
$32 at age 35
$64 at age 42 (still not a big deal, right?)
$128 at age 49
$256 at age 56
$512 at age 63
$1,024 at age 70
$2,048 at age 77
$4,096 at age 84

Over one life span, $1 grew into $4,096. Impressive! Now let’s add three zeros to all figures mentioned. In this scenario we invest $1,000, and after 84 years of the child’s life, you would have $4,096,000 in the investment account. Of course, I suppose you could invest $10,000 rather than $1,000…

The key, of course, is time. The child will have many urges to withdraw and spend the accumulated amount throughout his life. For this reason, the chances of success for this project likely increase if you can find a way to not tell the child for as long as possible.

How fun would this be? Imagine 84 years down the road, long after you are gone, the young heirs in  your family line – who may have very ordinary finances at the time – suddenly get such a massive infusion of assets that they could then use to maintain the family’s stability for generations to come. All due to an amazing, mysterious great, great grandparent with the incredible financial foresight to take advantage of compounding. Now, imagine you stipulate that the heirs can have access to the funds only if they take a fourth of the resulting investment account and repeat the process!

Think of compound interest as a bunch of tiny personal employees that work extremely hard for you both day and night, and mate like crazy!

Tuesday, March 10, 2015

Is the Stock Market Rigged?

I recently had dinner with a friend who abruptly asked “is the stock market rigged?” As I attempted to fully understand his question and address his concern, he ultimately said “if someone makes money by conducting a trade he wins, and if someone wins, doesn’t someone have to lose?” This viewpoint was preventing my friend from investing in his employer’s 401k plan or an individual retirement account.

While I can see the logic in my friend’s viewpoint, I don’t think it is accurate. Many people are reluctant to invest because they don’t want to be on the losing side of an investment, opposite a more experienced and skilled investor. This hesitancy likely stems from the fact that investing in the market requires the purchase of an intangible asset. However, I believe the same reasons that make purchasing a more tangible asset like a home worthwhile also apply to investing in the market.

When an individual purchases a home, he does so for a reason – he needs a place to live. For most people, the need to put a roof over his head is more of a driving force to buy the home than because he believes the current price is lower than the home’s actual value. The person only sells when his needs are no longer matched by the home – perhaps because the individual has retired and wants to move to a warmer climate or have a yard that doesn’t require much maintenance. When he sells, assuming enough time has passed since the house was purchased, the individual hopes to sell the home for more than he paid for it.

Assuming the individual does sell the house for more than he paid for it, does that make him the winner and the new purchaser of the home a loser? Of course not. The new purchaser is buying the home to fill a need, just as the original purchaser did. Similarly, assuming the new purchaser owns the home for a long enough period, chances are pretty good that he too, one day, will sell the home for a profit.

When we examine the purpose of investing in the market, it is very similar to why we purchase a home. First, we invest in the market because we have a need – to not outlive our assets. Again, for most people, the need to save for retirement is the primary reason we invest, not because we believe the market is particularly undervalued. Similarly, we only sell our investment when it no longer matches our needs – perhaps because we need to convert the asset to a more liquid and tangible asset (cash to buy a car), or because the investment has become more risky than we are willing to tolerate later in life. Just as the home provides a benefit (a place to live) while it is owned and is later sold at a higher price after enough time elapses, our investment in the market provides a benefit (dividends) while it is owned and is later likely sold for a higher price after the passage of time.

Again, just because the selling market investor sold the asset for more than he paid for it doesn’t make the purchasing investor a loser. The purchasing investor will benefit from the same dividends the first investor collected, and if he holds the investment long enough, will also likely sell at a profit when the investment no longer meets his needs. When the market continues to increase in value after the first investor sells, it doesn’t make the seller a loser. He is still a winner in that he made a profit from investing in the market and was later able to exchange the intangible investment for a more tangible asset like a new car, an exotic vacation, or simply the ability to not outlive his money.

There is, however, a factor that can potentially cause a winner/loser scenario with both the purchase of a home and an investment in the market – time. After buying a home, we are much less certain that the home’s value will have increased after only a month as compared to ten years. The impact of time is the same when investing in the stock market. We can be far from certain that the market will increase in value after only a day, month, or even a year. However, you’d be hard pressed to find a ten-year period when a diversified investment portfolio didn’t increase in value to some degree. Consequently, while both buying a home or investing in the stock market to make a quick profit is far from certain, history tells us that doing either to fill a need and with a long-term investment horizon is likely to yield a win-win situation.

Tuesday, February 24, 2015

The Best Investment of the Last 50 Years

One of my favorite writers, Morgan Housel, recently pointed out the most profitable stock since 1968 in his article titled “The Extraordinary Story of America’s Most Successful Industry." Any guesses what it might be?

The company with the best performing stock must have revolutionized the world in some way. The product must have been innovative, like computers or a cure for a dreaded disease.  Perhaps it was a small shop that became an international rage. Maybe it was a company that has been on the cutting edge for the last five decades.

As sound as those assumptions are, they are all incorrect. The best performing stock since 1968 is Altria, the cigarette company. While $1 invested in the S&P 500 in 1968 would now be worth $87, $1 invested in Altria at the same time would now be worth $6,638. That is an annual return of 20.6% for a 47 year period. Not bad!

I mention Altria not to discuss the impact of buying an addictive substance or the role of ethics in investing, but as a perfect example of the benefits of diversification. 

When thinking about the process of investing, it is human nature to think of the factors mentioned in our guesses – the sexy ingredients to success like technology or the garage shop going global. These are typical descriptions of growth-style companies. Growth companies usually utilize their profits to improve their systems, reach, or products. Further developing their infrastructure and merchandise allows them to grow faster and generate more revenue, and ultimately, more profits. This benefits investors in that the price of the company’s stock increases as its ability to generate additional profits increases.

Value-style companies are different. Value companies sell products and services that no longer require significant ongoing innovation. Consequently, rather than using profits to continue to expand, value companies payout the majority of their profits in the form of dividends to shareholders. While growth companies are new and exciting, value companies are frequently old and quite boring. As you might imagine, cigarettes are essentially the same today as they were 50 years ago.  However, since the tobacco industry hasn’t required a large expense to continually upgrade their product, an unusually high proportion of revenues have been paid out to owners of the stock. 

Clearly, an exciting new product that everyone must have and quickly generates tremendous profits makes a good growth company.  A good value company, on the other hand, is a company that earns mediocre profits for an extended period of time. Remember, to be effective compound interest requires long holding periods. Thus, Altria is a perfect example of a value-style company.

So is investing in value stocks a more profitable strategy than investing in growth companies? As always when investing, the answer is “it depends.” As Fidelity points out, value stocks did in fact outperform growth stock for the 30 year period ending in 2010, with large cap value earning an average annual return of 11.66% while large cap growth earned 9.91% annually over the same time period. Further, large cap value stocks endured less volatility over this period, with a standard deviation of 15.78 as opposed to the standard deviation of 21.89 for large cap growth stocks.

However, since 1990, large cap growth has made more than 34% during a calendar year six times, while large cap value has accomplished that feat only once, and we don’t want to miss out on all those exciting growth companies that are on the cusp of changing the world, right? Fortunately, the point of diversification is to hold uncorrelated assets in our portfolio so that when one asset category goes through rough times, other asset categories might maintain or even increase in value. Investing in assets that respond differently to various market events ultimately reduces volatility in our portfolio as a whole, and thus, reduces risk. For this reason, growth stocks are a wonderful compliment to value stocks.

The Dow Jones US Large Company Growth Index has performed surprisingly different from the Dow Jones US Large Company Value Index in various market environments since 1990:

Large Growth
Large Value

Large Growth
Large Value

While investing in companies on the verge of changing the world is exciting and worthwhile, don’t forget about the dull value companies with a tried-and-true business model and established market for their products or services. Due to lower expenses and higher dividend payout ratios, these value companies can be just as lucrative as those sexy growth investments. Fortunately, the benefits of diversification make holding both of these positions together more value than owning either by itself.