Monday, September 21, 2015

Rethinking Diversification

As a financial planner, one of my favorite words is “diversification.” Diversifying a portfolio essentially ensures that we don’t have all of our investment eggs in the same basket. A properly diversified portfolio should experience fewer losses than a non-diversified portfolio as well as benefit from a reduced downside when the market decreases in value. I have a chart that I draw for clients in steps that help me illustrate the purpose and benefits of diversification.

Step one of the chart is to communicate that given enough time, the market has always produced positive returns. (The phrase “enough time” is subjective and fluctuates, but the fact that the market is worth more now than when you were born proves the point.)  Thus, given enough time, the market will eventually move from point A to point B:

Unfortunately, as we all know, the market doesn’t increase in value at a constant pace. Rather, given enough time, it ebbs and flows while moving in an upward manner:

Armed with this information, what two investments would make up the most consistently performing portfolio? Two assets that ebbed and flowed in a perfectly opposite manner while they ultimately trend upward:

A portfolio of only these two perfectly inversely correlated assets would lead to an incredibly stable and predictable rate of return with virtually no volatility:

Unfortunately, these exact investments don’t exist. However, certain asset categories sometimes (not always!) exhibit this characteristic. For instance, when stocks experience a decline, bonds often benefit as investors sell their equities while their prices are low and buy bonds in what is called a flight to quality. The increased demand for bonds causes the price of the asset to also increase. Thus, an investor who had half his money invested in stocks and half in bonds would likely experience a decrease in the value of the stock portion of his portfolio but an increase in the value of his bond holdings. This would lead to a less dramatic loss when stocks go through a rough patch. Similar relationships can also exist between other asset classes:

Obviously, the more inverse relationships that exist within a portfolio, the less volatility it is likely to experience. This is the true value of diversification.

However, there is a factor that we must return to – that the market and a diversified portfolio only make money when given sufficient time. What happens to a diversified portfolio over shorter periods of time? Does diversification still add value?

One of the implied assumptions in the charts above is that the better performing asset makes more than the worst performing asset loses during any given cycle. For instance, the best performing asset might make +15% while the worst performing category might lose -5%. If this was the case, the portfolio would average a +5% overall return. If this wasn’t the case and the best category returned +10% while the worst asset lost -10%, the portfolio’s performance as a whole would be flat (a return of 0%). Fortunately, investments tend to both make money more frequently than lose money and also make more during the years when they achieve a positive return then they lose during years when they experience a loss.*

Unfortunately, over short periods of time, this is not always the case. In fact, the relationship could be the opposite – the worst performing asset category may lose -15% while the best performing category may only make +5%, resulting in an overall portfolio loss of -5%. As the above charts assume a sufficient amount of time for the market to work, these temporary period of market declines aren’t reflected in the diagrams.

A chart consisting of only the potential disappointing short-term returns of +5% for the best investment and -15% for the worst investment would look something like this:

While the negative short-term results aren’t particularly exciting, the above chart illustrates that diversification adds value even during a bear market. If we had a non-diversified portfolio during a market correction (which would be represented by either the blue or the green line), then there are periods when our portfolio would decrease in value at a much more dramatic pace than our diversified portfolio (represented by the red line).

As this series of charts illustrates, while diversification doesn’t prevent a portfolio from avoiding losses over short periods of time, it does add value to a portfolio during environments of both increasing and decreasing market values. Further, a diversified portfolio is likely to endure both fewer and less drastic periods of short-term losses. All things considered, a diversified portfolio is very likely to produce superior returns over a non-diversified portfolio over an extended time frame.

* Virginia Retirement System study: Since 1926, in years when the S&P 500 increased in value, the average positive annual return was 21.47%. Meanwhile, the average negative annual return in down years was only -14.29%. Further, the market experienced a positive return in 73% of years, and a negative return in only 27% of years.

Friday, September 18, 2015

Back to Basics: “Invest” Means Something Different to Everyone

One day last week, I had two interactions that reminded me that there is no common definition for the word “invest.”

First, I was completing an interview with Matt Gephardt from KUTV news. During the discussion, Matt asked if it was a good time to invest. Immediately, I assumed he was referring to the volatility that the stock market has recently experienced and I provided my opinion that volatility was ultimately a good thing because it penalized short-term speculators and provided profitable opportunities for long-term investors. As I spend a lot of energy encouraging clients to focus on achieving their long-term financial goals and paying minimal attention to short-term market movements, I said I wouldn’t hesitate to invest given the current market environment.

Further, as Matt is a young individual with several decades before retirement, investing early and utilizing as much time as possible to allow his portfolio to compound would clearly be beneficial. Investors with such an extended investment time horizon will certainly experience their share of market pullbacks, corrections, and even crashes. Yet, history strongly suggests that the simplest way for young investors to achieve wealth is to get invested dollars working for them as early as possible.

It wasn’t until later that I realized Matt very well could have been asking if it would be wise to invest money now after a market pullback and hope to quickly profit from a bounce or a quick recovery. This would have certainly been a fair question as such action would clearly fall within the definition of investing. However, if I had interpreted the question in this matter, my answer would have been completely different. I would have responded that I have no idea what the market will do over the next week, month, or even year, so if you are looking to make money over the short-term I can’t say that investing now is an action that I would recommend.

The second interaction involved an email exchange with a new client who is about to transition into retirement. This individual has historically been an extremely conservative investor, having his entire nest egg invested in cash equivalents (CDs, money markets, and savings accounts) for the last several years. However, he has recently recognized that such investments won’t provide the income that he desires throughout his retirement.

I’ve worked with this individual to produce a financial plan and investment strategy that we are both comfortable with, so the next step is to put the plan into action. However, the client expressed concern about investing amid the recent volatility. While this is certainly a valid concern, it made me realize that the client and I were using the term “invest” to mean different things.

I believe when the word “invest” was used, the client logically concluded that the entire cash balance would be invested in the market immediately. This would be a huge transition and could certainly be scary.  By comparison, to me “invest” meant starting the process of slowly moving money out of his cash balance and putting it to use in more assertive assets by dollar-cost-averaging over time. This could take 12-24 months, dramatically reducing the client’s exposure to short-term market movements.

Further, it became increasingly clear that although the client and I had discussed and agreed upon an asset allocation that may consist of only 30% stocks, the client hadn’t yet incorporated the mindset that only 30% of his portfolio would be subject to the volatility of the stock market. Admittedly, if the market were to drop 10% immediately after investing your life savings, that would be a frightening experience. However, if only 30% of the portfolio was invested in stocks when the market declined by 10%, the investor’s loss would have likely been only approximately 3%. While enduring a loss is never pleasant, an immediately loss of 3% would be a lot more manageable than a 10% portfolio reduction.

With Matt, he and I may have interpreted “invest” as a way to obtain completely different goals – profiting from the current market environment vs. obtaining long-term financial goals. In my interaction with the new client, our slightly different interpretation of the word “invest” was leading us to envision scenarios with drastically different risk implications.

Of course, it is possible that both Matt and the client could have meant various other things while discussing investing in today’s market. The point is that the term “investing” is frequently not sufficient when communicating with others. What are the goals you hope to achieve with the investment? How long do you intend to hold the investment? What assets will you actually be investing in?

While these may seem like basic principles, it is possible that a commonly understood definition of the word “invest” may be lacking during some communications, whether those discussions are taking place between spouses, financial advisors and their clients, or between families and their accountants and attorneys. Every once in a while, it is probably worth ensuring that the people you work with possess an understanding of what the word “invest” means to you.

Monday, August 24, 2015

Tools For Navigating the Market Pullback

On August 24th, the Dow Jones Industrial Average opened the day decreasing in value by 1,000 points. One of the most volatile days in memory continued, with the DOW fighting back to nearly even by mid-day, down only 98 points. Unfortunately, the bounce couldn’t be maintained through the market close with the DOW ending the day down 588 points, off about -3.5%.

How are investors to deal with this level of uncertainty? First and foremost, remember that this is what diversification is for. It is easy to look at a major market index like the DOW or the S&P 500 and equate the performance of those assets to the performance of your portfolio. However, the first thing investors should remind themselves is that they don’t have a portfolio consisting of only large cap stocks, which is what is measured by both the DOW and S&P 500 index.

In fact, most investors don’t have a portfolio consisting of just stocks. Many investors who are nearing or enjoying retirement may have a portfolio that is closer to only 50% or 60% stocks. If an investor only has 50% of his portfolio invested in stocks, only 50% of the portfolio is invested in the asset that declined in value by -3.5% on August 24th, meaning the individual’s portfolio likely only decreased by about -1.75%. While a -1.75% decline is not pleasant, it is hardly catastrophic.

The next step is to remind ourselves that temporary sharp market declines are common. Morgan Housel, one of my favorite financial writers, noticed that the correction the market is currently experiencing is currently about half as bad as the correction that took place near the beginning of 2011, which no one now remembers or cares about. These market pullbacks will always come and go, and the world will continue to turn.

Additionally, it is useful to acknowledge that while we tend to remember dramatic and shocking market decreases, stocks tends to be an efficient investment over time. As Ben Carlson pointed out in his blog, when investors think of the ‘80s the first thing that comes to mind is usually the crash of ’87. However, U.S. stocks were up over 400% during the decade. Similarly, even though stocks are up 200% since March of 2009, many investors have spent the last five years trying to anticipate the next 10% - 20% correction. In retrospect, an investor would have clearly been better off riding the equities rollercoaster during both the good and bad times and ending with a 200% gain rather than being out of the market in an attempt to avoid a small temporary decline. Given a long enough investment time frame, this has always been true and will continue to be the case.

Finally, as I pointed out in a previous post, it is useful to recall that market corrections are actually a good thing for long-term investors. Fear amongst investors is what creates the equity risk premium that enables stocks to produce superior investment results when compared to investments with no risk such as CDs and money markets, which essentially experience no growth after accounting for inflation. When investors forget that equities can go both up and down in value, everyone wants to invest their money in stocks. This excess demand inflates asset purchase prices to the point that owning equities is no longer profitable. Market declines reintroduce risk to the investing public, and it is the presence of risk that makes stocks an appreciating asset. Thus, for those who don’t intend to sell their investments for 10+ years, short periods of volatility are a positive because they recreate the equity risk premium which raises rates of return over time.

These are all logical steps for mentally dealing with market corrections. For those who need it, Josh Brown proposes a less logical step for tricking your mind into embracing the market pullback. During scary market environments, Mr. Brown proposes that you identify a couple of stocks you’ve always felt you missed out on. Have you always wished you got in earlier on Apple, Google, Netflix, Chipotle, etc? A market correction like we are experiencing might be the perfect opportunity to become an owner of a great stock at an attractive price. Why not set a number for each of these stocks – say, if they drop in value by 20% - and if those targets are met you commit to buying some shares?

This strategy truly enables you to use lemons to make lemonade. It provides an opportunity to buy shares of companies that you have always wanted without overpaying for them. This mental trick can actually cause you to hope that the market correction continues because you are now hoping for a chance to buy. Rooting for a further correction can certainly make volatile market periods more tolerable.

As I mentioned, this mentality isn’t completely logical because the rest of your portfolio will likely need to decline in value in order to afford you the opportunity to purchase those coveted stocks. However, implementing this strategy is a bit of a mental hedge that enables you to get something good out of whichever direction the market turns. Think of betting money against your favorite sports team – of course you don’t want your team to lose, but even if they do you still get something positive out of it.

I’m confident that most of my clients already know that selling in the middle of a market correction is not a good idea. Still, I acknowledge that doing nothing as the market seems to be collapsing around you can be nerve-racking – even though it is the appropriate response. Hopefully these mental strategies and tricks enable you to stick to your long-term buy-and-hold investment strategy which has always proved to be profitable given a long enough time frame.

Wednesday, July 29, 2015

Why There Has To Be a Market Correction

Why do we invest in the stock market? To make money so we can improve our standard of living, right? Notice that we aren’t investing just to get our money back. If we simply wanted our money back, we would place the money in a savings account at a bank where we would likely be able to access it any time and know that we could redeem it at full value. However, making money is better than simply getting our invested dollars back, so there has to be a trade off for receiving that additional benefit.

Of course, the trade off is that investing in the market involves more risk than simply depositing money in a bank account. The additional return that is required by investors for investing in an asset that could potentially lose money is called the equity risk premium. There must be a potential downside in exchange for the larger reward that can be obtained by investing in the stock market. Otherwise, no one would ever deposit money into the more secure bank accounts and people would always invest in the stock market generating superior returns. Unfortunately, this would make things too easy, and as we have learned our whole lives, the easier a goal is the less reward we get for achieving that goal. That is why positions that can only be filled by a select few individuals with rare talents (CEOs, doctors, Lebron James) are handsomely compensated.

By now, most people know that over a sufficiently lengthy period of time, the stock market has historically produced returns of approximately 10% per year. This seems like a simple and easy way to make money, so why don’t all investors buy stocks and hold them for extended periods of time? The fact that we aren’t all rich suggests that buying stocks and allowing the market time to do its thing isn’t easy.  This is because enduring risk and suffering losses creates negative emotions that get the best of many investors, causing them to sell at the wrong time and stop investing new dollars.

Yet, when we refer back to the concept that the tougher the task the greater the reward, we should be happy that buying and holding stocks isn’t easy because it makes the strategy more profitable. For this reason, the next time the market goes through a correction or even a crash, wise investors should be grateful. Market volatility causes unsuccessful investors to sell when prices are down and increases the rewards for those who can stick with their investment strategy by holding their assets or even buying new positions.

Supply and demand suggests that when the markets are decreasing in value, more people are selling assets than buying. The people who are selling their investments at a loss create an equity risk premium for those who can endure market volatility. This increases the reward for successful investors by both providing an opportunity to buy assets when they are inexpensive, and reminding the marketplace that investing in volatile positions is unpleasant. Of course, things that are unpleasant aren’t easy to accomplish, which means there is a large benefit for achieving those things.

Thus, market corrections are great for successful investors because it is volatility and easily-rattled buy-and-sell investors that enable buy-and-hold investors to make significant profits over the long term. In fact, it wouldn’t be possible for stock market investors to make money without periodic intervals of unpleasantness as it is this discomfort which causes some investors to sell and creates an equity risk premium for the rest of us.

It has been easy for investors to buy and hold for the last six years as the market has been nothing but accommodating since early 2009. However, when things get too easy, it reduces our reward for being a long-term investor because everyone can do it. For this reason, we need the market to experience a correction at some point to shake out the unsuccessful investors, causing them to sell assets and create an equity risk premium once more.

When the next correction occurs, you can either sell assets and create a risk premium for others, or you can stay invested and take advantage of the money unsuccessful investors leave on the table. Successful investors with a sufficiently lengthy investment time horizon remind themselves of this concept frequently so that when the market experiences a decline they are not overcome by fear but rather grateful for the opportunity provided by the short-sighted.

Tuesday, July 21, 2015

Fear of Missing Out: An Investor's Worst Enemy

Fear of missing out (FOMO) is an increasingly powerful emotion in our daily lives – so much so that FOMO was officially added to the Oxford English Dictionary in 2013. Have you ever looked at your Facebook feed and been jealous of someone’s picture from a beautiful viewpoint, or enviable of a friend’s photo of their expensive dinner with a strategically placed bottle of fancy wine in the background? That is FOMO – the fear that at any given moment someone is doing something more appealing than what we are doing at the time.

A fear of missing out has always been part of life, but it has become more and more prevalent with the emergence of social media. Personally, I can’t help but check my Twitter feed every hour or so to make sure that I’m not missing out on an article published by one of my favorite financial writers. Yet, social media has increased the power of FOMO more than I realized. For example, I can honestly say that I have absolutely zero interest in horse racing – frankly, I dislike the sport. However, due to all the hype on Facebook and Twitter, I couldn’t help but watch the Belmont Stakes out of fear of missing American Pharaoh become the first Triple Crown winner of my lifetime.

FOMO is frequently a counter-productive emotion, leading to jealousy of others, dissatisfaction with our own lives, and bad decision making processes. Nowhere is the negative impact of FOMO more apparent than in some individuals’ investment strategy. For years, no one has enjoyed going to the neighborhood BBQ only to have to listen to their neighbor brag about how his portfolio has outperformed the S&P 500 index over the last six months. Not only is listening to the boasting annoying, it makes us discontent with the return our own portfolio has achieved and makes us wonder if we should adapt a different strategy (i.e. take more risk right after the market achieved a new all-time high).

Social media has expanded the impact of FOMO on investment strategies. For the last year, the internet has ensured we are aware that large cap indexes like the S&P 500, Dow Jones Industrial Average, and NASDAQ are at all-time highs and achieving appealing returns, and we wonder why our more diversified portfolio isn’t behaving in a similar fashion. It is hard to be content with our diversified strategy when every media outlet is constantly reminding us how we are missing out on the stellar performance that could be obtained if only we had a non-diversified portfolio that invested only in the asset category that is currently in the middle of a hot streak.

When it comes to investing, FOMO is significantly impacted by recency bias. Our fear of missing out becomes more and more intense after the market has just experienced an uptick. If we take a couple of steps back, it is clear why we maintain a diversified portfolio – it provides the most appealing tradeoff between maximizing returns and minimizing risk. Yet, it is hard to remind ourselves of this when it seems like everyone around us is taking advantage of the latest market trends and we are missing out. Of course, changing our portfolio to try and take advantage of a run that has already taken place would be foolish, as we would be selling assets with prices that have remained flat and may now be undervalued relative to the market in order to buy assets that have recently experience significant growth and are likely now expensive. These are the type of decisions that FOMO can cause and we would be wise to avoid this type of thinking.

We have been in this position before. In the late 1990s, people wanted to abandon their diversified portfolio and put a heavy focus on the technology stocks that were making all their neighbors rich. In the mid 2000s, everyone wanted to borrow as much money as possible and utilize the funds to buy and flip real estate. In the early 2010s, everyone was wondering if they should sell their stocks before a double-dip recession began and use the resulting funds to buy gold. In each of these scenarios we were hearing individual stories of others who had implemented these strategies and were doing better than we were. Of course, with the benefit of hindsight, we can see that changing our long-term investment strategy due to a fear of missing out on what was working for a short time period would have been a drastic mistake.

After the market has done well, recency bias and FOMO causes investors to be more afraid of missing a bull market than of suffering large losses. However, in these times, we need to remember that we chose a diversified investment strategy because it provides us with the highest probability of obtaining our financial goals while exposing us to the least amount of volatility possible. When the media and our acquaintances insist on informing us how we would have been better off placing heavy bets on the asset categories that have recently done well, we would be well served to remember that a diversified portfolio strategy will almost certainly provide us with the best chance to achieve long-term investment success.

Thursday, June 18, 2015

How To Use Deposits and Withdrawals To Rebalance Your Portfolio

The benefits of rebalancing a portfolio are well documented. Constant rebalancing forces an investor to lighten the portfolio positions that have recently performed well and use the resulting funds to buy more shares of the assets in the portfolio that have remained flat or even declined in value. In other words, rebalancing causes the investor to sell high and buy low.

Most financial professionals recommend rebalancing your portfolio at least once a year (I rebalance my clients’ portfolios on a semi-annual basis). However, the tax status of an investment account can have a significant impact on a rebalancing strategy. While investments within a tax-advantaged account like a traditional or Roth IRA can be sold without tax implications, selling appreciated assets in a taxable investment accounts will create a capital gains liability. Consequently, while rebalancing within a tax-advantaged account should be a no-brainer, investors should carefully consider the tax implications that may result from rebalancing a normal investment account.

For this reason, investors should view every deposit to or withdrawal from a taxable investment account as a chance to rebalance. Depositing new money is a free opportunity to buy more of the positions in which the portfolio is underweight. For example, suppose an investment account of $100,000 has a target asset allocation of 50% stocks and 50% bonds ($50,000 invested in both). After a year in which stocks made 10% and bonds were flat, the portfolio would consist of $55,000 of stocks and $50,000 of bonds, for a total account balance of $105,000. If at this point the investor would like to invest an additional $5,000, the entire contribution should be placed in bonds, bringing the actual portfolio allocation back to 50% stocks and 50% bonds ($55,000 invested in each).

Of course, this same strategy can be implemented regardless of the size of the additional contribution. If the investor wanted to contribute $10,000 in year two, the total account value would be $115,000 ($105k current balance + $10k new money). In order to get back to our 50% stock and 50% bond targets, we would want $57,500 in each position. With $55,000 already invested in stocks, we would only want to invest $2,500 of the new money into stocks and place the remaining $7,500 into bonds, bringing both portions of the portfolio up to their targets.

Taking withdrawals from a taxable investment account should also be viewed as an opportunity to rebalance. Rebalancing via withdrawals may not be free as it is when rebalancing is done when new funds are deposited because appreciated assets are likely sold, creating a tax liability. However, when a withdrawal is taken from a taxable account, it is still wise to sell overweight asset categories to produce the funds needed for the distribution.

Let’s return to our previous example of a 50% stock and 50% bond target portfolio that had grown to $55,000 of stock and $50,000 of bonds. If the investor then wanted to withdraw $10,000, he could take the entire distribution out of bonds which would allow him to free up the amount needed without creating a tax liability. However, the resulting portfolio would consist of $55,000 of stocks and $40,000 of bonds – a ratio of approximately 58% stocks and 42% bonds.

This is a significantly more volatile portfolio than the target 50% stock and 50% bond portfolio. For example, in 2008 a portfolio that consisted of 50% large cap stocks and 50% long term government bonds lost -7.16%. Meanwhile, a portfolio of 58% stocks and 42% bonds lost -11.93% over the same time period – a 66.6% increase in volatility.

Alternatively, I’d suggest using the $10,000 withdrawal to rebalance the portfolio, bringing the resulting $95,000 portfolio back to 50% stocks and 50% bonds ($47,500 in each). Of course, to do this, the investor would liquidate $7,500 of stocks and $2,500 of bonds. Although this could potentially create a small capital gains tax liability, this is a tax bill that will need to be paid at some point anyhow, and the investor will maintain a portfolio with the target amount of volatility.

Further, remember that the long-term capital gains rate (which applies to any capital assets held for over a year) is a favorable tax rate. For single filers with a taxable income of less than $37,450 and joint filers with a taxable income of less than $74,900, the capital gains tax rate is actually 0%! Additionally, for single filers with a taxable income of between $37,450 and $406,750 and joint filers with a taxable income of between $74,900 and $457,600, the capital gains tax rate is only 15%. Consequently, the investor can likely rebalance the portfolio back to the target allocation via the withdrawal while incurring only a nominal tax bill.

While rebalancing provides a significant increase in investment return over long time periods, tax implications should be considered when determining whether or not to rebalance a taxable investment account. However, depositing money to or withdrawing money from these accounts provides a favorable opportunity to obtain the return premium rebalancing creates while minimizing tax implications.