Friday, October 17, 2014

Market Correction? Remember the Ace Up Your Sleeve



After the historic growth the stock market has experienced since early 2009, many investors have felt that a health pullback may not be a completely negative thing. After all, we certainly don’t want another bubble, or stock prices that are clearly out of line with the earning potential of the underlying companies.

Unfortunately, market corrections never feel healthy when they occur. People get uncomfortable when the market declines, the media fans the flames by giving investors reason after reason to be afraid, and worries that this is the beginning of the next crash begin to develop.

While many investors admit that a 5% pullback is manageably unpleasant, concerns expand when the market decline hits 10% -- right when the media can officially throw around the word “correction.” As of market close on 10/17, the S&P 500 is still only off less than 6% from its high on 9/18. Consequently, we still have a ways to go before we touch the “correction” mark. Of course, we have no idea whether the drop will reach 10%, but why not mentally prepare ourselves by exploring what has traditionally happened to stock prices once that 10% decline is crossed?

The Data

Ben Carlson, an institutional investment portfolio manager, looked at the S&P data going back to 1950, and found that there have been 28 instances when stocks fell by 10% or more. Thus, on average, the market has entered an official correction every 2.25 years. The last market correction occurred in 2011, so another 10% drop at this time would correlate pretty close to the average amount of time between corrections.  Of course, the market has done pretty well since that last temporary correction in 2011. Clearly, such a drop is quite normal and far from historically concerning.

 

As you can see, the average market correction lasts just under 8 months and the median total loss was 16.5%. Of the 28 times the S&P 500 decreased by 10%, the market suffered a loss greater than 20% only 9 times (32% of the time), and a loss greater than 30% only 5 times (18%). The data confirms that although these types of large losses do occur, they really are the exception -- even after enduring a 10% loss that feels like the beginning of the end.

Your Advantage

Are you thinking “I don’t think I can stomach that median loss of 16.5%?” Then it’s time to pull out the ace up your sleeve.  Remember that the data above represents the historical performance of the S&P 500 – an index that is composed of 100% stocks. A capable financial planner would ensure you have an asset allocation mix between stocks, bonds, and cash that represents your tolerance for risk. Consequently, your portfolio likely isn’t 100% stocks. In fact, the appropriate allocation for an average investor approaching or already enjoying retirement might be closer to only 50% stocks. This means that on average, your portfolio should decline only half as much as the S&P 500 during market downturns.

This ace may bring the loss endured by our sample investor with a 50% stock portfolio down to around 8.25% during the median decline.  Are you now back in the “manageably unpleasant” range? If so, you likely have an appropriately constructed portfolio. If not, your risk tolerance may need to be reevaluated to ensure you are not exposing your nest egg to a larger loss than you can afford.

Although the recent market pullback produces what seems like a foreign feeling, we’ve been here before. The S&P 500 declined in value by 18.64% over a 5 month period in 2011. However, an investor with a 50% stock portfolio likely only saw their account values drop around 9%-10% -- still not fun, but manageable. Of course, we don’t know whether the market is about to bounce back or continue to drop into official correction territory. If you continue to hear about the broad markets declining, remember that the average historical correction has been far from catastrophic, and that you have the ace of an appropriate asset allocation up your sleeve.

Monday, September 29, 2014

Is It Time to Reduce the Bond Exposure in Your Investment Portfolio?

For the last half-decade, investors have been continually concerned about rising interest rates and the effect they may have on the bond portion of their investment portfolio. The fear is that if interest rates rise, the bonds currently held by investors will be outdated and provide investment returns that are less than what new bonds issued at the higher yields would return.

There is validity to this concern – if an investor could buy a bond yielding 4% on the open market, why would anyone buy a bond that yields only 3%, unless they could do so at a significant discount? Given that today’s interest rates are considerably lower than historical averages and expected to rise in the future, would now be a good time to sell some of the bonds in your portfolio?

Consider the Timing 

First, let’s consider one of the most basic principles of investing – that markets are unpredictable. Are we certain that interest rates will rise, and are we confident this rate increase will happen soon? I’d contend the answer to both questions is no. Actually, the majority of investors have believed interest rates would rise since the first round of quantitative easing took place in 2009, and have suspected rates would rise in every calendar year since.  Quite simply, this has not happened. In fact, interest rates are currently lower than they were during the majority of 2009 despite five years of buzz about interest rate hikes.

During this five-year period, how have bonds performed? From 2009 through 2013, the Barclays Aggregate Bond Index (AGG) returned 5.93%, 6.54%, 7.84%, 4.22%, and -2.02%, respectively. Bonds only declined once during the five-year period, by a relatively nominal -2.02%, and still averaged a compound rate of return of 4.86%—not bad for the conservative portion of a portfolio.

Additionally, various bond categories have done even better than the Aggregate Bond Index, which consists of just U.S. government and corporate bond holdings. For instance, emerging market bonds (EMB) achieved a compounded return of 9.30%, while high yield bonds (HYG) returned 12.26% annually over the same five-year span. An investor whose bond portfolio was diversified among a range of asset categories has far from suffered since the expectation of a rate increases began.

Will You Miss the Stability of Bonds?
 
Let’s also consider the consistency of bonds. Since 1980, the Aggregate Bond Index has achieved a positive return an astonishing 31 out of 34 years (91% of the time!). Given this data, perhaps bonds aren’t as likely to decline in value as some investors think.

Equally amazing, although the bond index has achieved an annual return as high as 32.65% during this time period (in 1982), the largest loss it ever suffered in a calendar year over the same period was just -2.92% (in 1994). Over the entire 34-year period, the index obtained an average annual gain of 8.42%. Bottom line: Over the last 34 years, bonds have offered a lot of return for relatively little risk.

Diversification: the Most Important Factor

Not putting all your eggs in one basket is another basic principal of investing, and the primary motivation for having a significant portion of your portfolio allocated in bonds. It is important to remember that for an investor with a long-term perspective, equities will likely provide the majority of investment growth and return in a portfolio while bonds are needed to reduce volatility and risk. For example, while a portfolio that was 100% stocks suffered a 38.6% loss in 2008, a portfolio that was 50% stocks and 50% bonds suffered a loss of only 14.5% the same year—still not pleasant, but much more manageable.

Bonds reduce risk in a portfolio because their return has a low correlation to the return of stocks. How low? Since 1928, both the S&P 500 and the 10-year treasury note have lost value during a calendar year only three times (in 1931, 1941 and 1969). That is less than 4% of all annual periods!

Further, since the Barclays Aggregate Bonds Index was created in 1973, the index has never decreased in value in the same year as the S&P 500. Amazing, but true. Clearly, bonds are fulfilling their role as a diversifier and reducing the volatility in your portfolio.

There is Always a Role for Bonds

Despite the continuous threat of rising interest rates, bonds have continued to perform. More importantly, history illustrates that mixing bonds with stocks smoothes out the investment results of your portfolio. Don’t get sucked in by the media buzz. Bonds are too valuable an asset to disregard.


*I originally published this article on NerdWallet's Advisor Voices.

Who Knows What The Stock Market Is Doing?

There are two questions I’d like you to consider. First, would you say you have thought about your investment portfolio more, less, or the same amount as usual during the last five months? Second, do you know how much the stock market has either increased or decreased in value over the last five months?

Of course, there will always be certain investors who take pride in following the market meticulously or simply just enjoy doing so. But I’d contend that a high percentage of investors have thought less about their portfolio during the last five months than they normally would. Further, I’d argue that more investors than usual are unaware of whether the market has gone up or down during the last five months and by how much.

Why is this? Have our work or retirement schedules kept us busier than normal over the last five months? Not likely. We’ve certainly been concerned about ISIS, hurricanes, what Scotland would do, and wars in Israel, Iraq and Ukraine, but is it the additional anxiety from those events that has prevented us from following the stock market? Probably not. So why are fewer of us than normal aware of what the market has done lately?

A common adage is that negative events happening over a short period of time capture the headlines, while progress happening over an extended period of time commonly goes unnoticed. How many headline-worthy days of large market movements have occurred during the last five months?

Amazingly, between April 17 and Sept. 23 (110 trading days), the S&P 500 has either increased or decreased in value by more than 1% during only four trading days:

Date                       S&P 500 Return
7/17/14                 +1.19%
7/18/14                 -1.03%
7/31/14                 -2.02%
8/08/14                +1.11%

That’s a period of more than five months during which the market experienced a significant movement (defined as 1% or more either up or down) only four times, or only 3.6% of the time! A period of such low volatility is especially rare in today’s market environment. By comparison, since 1950, the S&P 500 has moved more than 1% by the end of 20% of all trading days. Moreover, all four significant movements during the last five months occurred within an approximately three-week time frame, between July 17 and Aug. 8. If we exclude that three-week period, we would have four and a half months during which the market had no trading days resulting in significant movements.

It’s interesting to recognize that although the market hasn’t experienced many significant daily movements over the last five months, it has changed in value considerably over the time period as a whole. In fact, from April 17 through Sept. 22, the S&P 500 has actually increased in value by 7.28%. Simply, a low volatility environment where the market consistently obtains small daily positive returns has been quite advantageous for investors, despite having few days of large gains.

So what investing lessons can be taken from this pleasant five-month period? First, I’d encourage investors to not get too comfortable. Remember that the last five months have been a period of unusual stability in the investment markets and such low levels of volatility cannot continue in perpetuity.

Of course, this is not necessarily a bad thing—we expect a level of risk when investing in stocks, and it is ultimately the presence of risk that enables appealing returns in the long run. Consequently, the return of volatility should not frighten investors and certainly should not be interpreted as a signal to alter your long-term investment strategy.

Finally, allow me to pose one last question: Regarding financial and investing matters, have you been more, less, or equally happy compared to the norm during the last five months? Studies indicate that if you have been thinking less about your portfolio, you have likely enjoyed reduced levels of stress and increased levels of happiness. Why not learn from this experience and attempt to think less about your investment portfolio when a normal amount of volatility returns to the market?

Remember that your portfolio was constructed with a focus on the long-term and that short-term volatility is ultimately inconsequential. Consequently, regardless of day-to-day market movements, you should worry less about your portfolio and focus on the things that make you happy.


*This article was originally published on NerdWallet's Advisor Voices.

Tuesday, August 26, 2014

Dear World: Pause and Recognize How Fortunate We Are...



As the media consistently reminds us, the world is currently full of war, debt, hatred and despair. From missile strikes in Gaza, to war in Ukraine and Iraq, to excessive debt in Argentina and England – these things are all real and they are horrible. Current events can wear on the human spirit and create a feeling of hopelessness. 

Every once in awhile it is useful to remind ourselves that journalists report the clouds in every silver lining. Similarly, it is refreshing to take a moment to focus on the things that are going right in the world. Upon examination, we find that the world as a whole is currently wealthier, healthier, and happier than it has ever been.

Matt Ridley, a journalist referring to himself as the rational optimist, recently focused on all the reasons we are luckier than those who lived before us. Here are some of the highlights of his research (click here to see his article in its entirety): 

  • The average person on the planet earns roughly three times as much as he or she did 50 years ago, adjusted for inflation. If anything, this understates the improvement in living standards because it fails to take into account many of the incredible improvements in the things you can buy with that money. However rich you were in 1964 you had no computer, no mobile phone, no budget airline, no Prozac, no search engine, no gluten-free food. The world economy is still growing every year at a furious lick — faster than Britain grew during the industrial revolution. 
  • As for inequality, the world as a whole is getting rapidly more equal in income, because people in poor countries are getting richer at a more rapid pace than people in rich countries. That has now been true for two decades, but it has accelerated since the great recession. The GDP per capita of Mozambique is 60 percent higher than it was in 2008; that of Italy is 6 percent lower. A country like Mozambique has been out of the headlines recently and now you know why: things are mostly going right there. 
  • The amount of food available per head has gone up steadily on every continent, despite a doubling of the population. Famine is now very rare. 
  • The death rate from malaria is down by nearly 30 percent since the start of the century. HIV-related deaths are falling. Measles, yellow fever, diphtheria, cholera, typhoid, typhus — they killed our ancestors in droves, but they are now rare diseases. 
  • We think we are getting ever more selfish, but it is not true. We give more of our earnings to charity than our grandparents did.  
  • Violent crimes of almost all kinds are on the decline — murder, rape, theft, domestic violence. So are capital and corporal punishment and animal cruelty. We are less prejudiced about gender, homosexuality and race. Paedophilia is no more prevalent, just hushed up less.
Morgan Housel, columnist at Motley Fool, also recently wrote a column titled “50 Reasons We’re Living Through the Greatest Period in World History.” Mr. Housel notes that we tend to ignore progress, which is the really important news because it happens slowly, but we obsess over trivial news because it happens all day long. Here are some of my favorite thoughts from the article (click here to view the entire piece):
  • In 1900, 1% of American women giving birth died in labor. Today, the five-year mortality rate for localized breast cancer is 1.2%. Being pregnant 100 years ago was almost as dangerous as having breast cancer is today. 
  • U.S. life expectancy at birth was 39 years in 1800, 49 years in 1900, 68 years in 1950, and 79 years today. The average newborn today can expect to live an entire generation longer than his great-grandparents could. The average American now retires at age 62. Enjoy your golden years -- your ancestors didn't get any of them. 
  • Infant mortality in America has dropped from 58 per 1,000 births in 1933 to less than six per 1,000 births in 2010, according to the World Health Organization. In 1952, 38,000 people contracted polio in America alone, according to the Centers for Disease Control. In 2012, there were fewer than 300 reported cases of polio in the entire world. The death rate from strokes has declined by 75% since the 1960s, according to the National Institutes of Health. Death from heart attacks has plunged too. 
  • According to the Federal Reserve, the number of lifetime years spent in leisure -- retirement plus time off during your working years -- rose from 11 years in 1870 to 35 years by 1990. Given the rise in life expectancy, it's probably close to 40 years today. Which is amazing: The average American spends nearly half his life in leisure. If you had told this to the average American 100 years ago, that person would have considered you wealthy beyond imagination. 
  • Worldwide deaths from battle have plunged from 300 per 100,000 people during World War II, to the low teens during the 1970s, to less than 10 in the 1980s, to fewer than one in the 21st century, according to Harvard professor Steven Pinker. "War really is going out of style," he says. 
  • According to the Census Bureau, only one in 10 American homes had air conditioning in 1960. That rose to 49% in 1973, and 89% today -- the 11% that don't are mostly in cold climates. Simple improvements like this have changed our lives in immeasurable ways. 
  • In 1900, African Americans had an illiteracy rate of nearly 45%, according to the Census Bureau. Today, it's statistically close to zero. In 1940, less than 5% of the adult population held a bachelor's degree or higher. By 2012, more than 30% did, according to the Census Bureau. 
  • The average American work week has declined from 66 hours in 1850, to 51 hours in 1909, to 34.8 hours today, according to the Federal Reserve. Enjoy your weekend. 
  • More than 40% of adults smoked in 1965, according to the Centers for Disease Control. By 2011, 19% did.
  •  The percentage of Americans age 65 and older who live in poverty has dropped from nearly 30% in 1966 to less than 10% by 2010. For the elderly, the war on poverty has pretty much been won. 
  • If you think Americans aren't prepared for retirement today, you should have seen what it was like a century ago. In 1900, 65% of men over age 65 were still in the labor force. By 2010, that figure was down to 22%. The entire concept of retirement is unique to the past few decades. Half a century ago, most Americans worked until they died. 
  • No one has died from a new nuclear weapon attack since 1945. If you went back to 1950 and asked the world's smartest political scientists, they would have told you the odds of seeing that happen would be close to 0%. You don't have to be very imaginative to think that the most important news story of the past 70 years is what didn't happen. Congratulations, world. 
  • You need an annual income of $34,000 a year to be in the richest 1% of the world, according to World Bank economist Branko Milanovic's 2010 book “The Haves and the Have-Nots.” To be in the top half of the globe you need to earn just $1,225 a year. For the top 20%, it's $5,000 per year. Enter the top 10% with $12,000 a year. To be included in the top 0.1% requires an annual income of $70,000. America's poorest are some of the world's richest.
  • Only 4% of humans get to live in America. Odds are you're one of them. We've got it made. Be thankful.