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Understanding your unique perception of risk

Investment risk comes in many forms and is talked about so frequently within the industry, that every type of risk has it’s own name. Just a few are longevity risk, inflation risk, interest rate risk, liquidity risk, political risk, and market risk. This post is not about the risks themselves, rather, it is about the factors that affect our response to the risk and why it may differ from our spouse’s risk tolerance – It’s what contributes to your unique perception of risk.

Usually, when spouses disagree over how aggressive or conservative they want to be with their portfolio, the disagreement can boil down to a few key factors that can influence risk. Below are a list of some of the most common factors that influence our feelings toward risk in general.

Trust: The more trust an investor has in their financial plan, their advisor, the markets, their specific holdings, etc, the less afraid they will be.

Risk/benefit: investors who can weigh the benefits of taking on certain level of risk., the investor may be less fearful of the perceived risks if the perceived benefit outweighs the risks. Millions of people living along the ocean are taking a risk of having their homes flooded. And yet they are highly desirable pieces of property.

Control: The more control or the feeling of control an investor has over the outcome, the less likely they are to be fearful.

Choice: Risk that is imposed on us tends to cause more fear than risk we chose for ourselves.

Uncertainty: This comes as no big surprise, not knowing the likelihood of the risk occurring can cause more fear than actually knowing the likelihood.

Natural/man made: Risk related to a natural event (storms, floods, snow) tend to cause less fear than man-made events (wars).

Horror: The scarier the event, the more fear it causes. A traumatic death is much scarier than a death caused by a sudden heart attack.

Catastrophic/Chronic: Temporary events that cause lots of damage to a small population causes more fear than small amounts of damage caused over time to a large population. Think about how much more damage is caused by pollution or heart disease, and yet we are more afraid of a house fire, car accident, or terrorism. Many investors are more concerned about the sudden market drops, yet completely unaware of the bigger and ever present issue of inflation.

New/familiar: A new risk tends to cause more fear than a risk we’ve been subject to for years. Over time and with more experience and familiarity, the fear of the risk can subside.

Personalization and fairness: risks that affect people we know, children, the poor or the vulnerable tend to evoke a strong negative response.

Awareness: Lastly, simply being aware of the risk raises the level of fear. Knowing that it could happen after reading about it in the news, tends to elevate fears.

These perceptions are constantly changing based on our experiences and as events unfold. As you read this, you may find yourself thinking that a few of these perceptions affect you more than the others, but a whole new set of perceptions could become important if the markets changed.

It is our experience that many of these perceptions have a negative effect on investment decisions. All too often, these perceptions cause investors to sell out at the bottom of a temporary market decline. Investors make their decisions out of fear and emotions rather than facts. Understanding the root cause or key characteristic that drives investor fear and then finding a way to overcome and solve that fear is the first step a fearful investor should take when thinking about getting back into the market.

 

Trend Updates: May 2013

The Active Asset Allocation Portfolio utilizes a trend following strategy by buying and selling securities based on established price trends in each asset class. Below is a snapshot of the current trends we are following:

US Equities:

The trends in US Equities have continued a positive trajectory and have strengthened even further. Kiplinger believes that “the underlying fundamentals are sound” but admit that the“pace of gains is bound to slow” and “a correction is due”. The trend will most likely not continue at this pace, although we expect this trend to be positive for the rest of year..

We are watching a few opportunities develop within certain sectors. Specifically, we have recently added to the technology sector of our existing holdings.

Foreign Equities:

This asset class is starting to show signs of a positive trend developing throughout the asset class. We recently wrote (LINK) about a divergence in the performance between emerging markets and developed markets – where emerging markets were declining while developed markets improved. But for the last month or so, these two markets have at least been moving in the same direction, bucking the unusual trend we have seen develop at the end of 2012.

If the trend in emerging markets continue to strengthen, we would likely add a small position.

Bonds:

The trend continues to remain flat, which we noted at the end of the 1st quarter (LINK) and last month (LINK). While the threat of rising interest rates looms over us, it probably won’t happen this year. But If interest rates were to rise, we see bonds responding in different ways.

1) The value of the existing bonds would decline and, given how the markets have been performing, interest rates will likely go up rather than stay put (they can’t get much lower, either).

2) Municipal bonds could offer more protection and can provide tax benefits, although their value could go down quickly.

3) GNMA securities, mortgage pools guaranteed by the government, could be a better option compared to the previous two.

4) Corporate bonds, including “junk” bonds have performed the best over the past few years, although it tends to correlate with the stock market.

5) Emerging market debt continues to be an attractive option as it diversifies our bond holdings. We’ll be touching upon this more next week.

Bottom line, there are a lot of moving parts..

The indexes and ETFs we track have been bumping around the 200 day moving average. Many of our specific holdings in the portfolio have held up well, showing less volatility than the passive indexes due in part to their diverse nature and active management. We are fully invested in this asset class at this time.

Real Estate:

One of our longest held positions continues to perform very well. This asset class has had a few bumps in an otherwise positive trend that has existed for a few years.

Recently, this positive trend has even outpaced that of the overall market.

Commodities:

Our holdings at this time are minimal. Most commodities have been in a negative trend for a few months. We have recently sold out of our positions in gold.

This trend has continued to weaken due in part to the improving U.S. economy. Investors are not fleeing to the safety of precious metals like they have for the past few years. Rather, they are pulling out of gold and other precious metals to go into equities.

How can a positive news cycle impact the markets?

The news cycle, which usually is designed to stoke investors’ fears and panic, is actually turning more positive now. The storylines are changing to observations of “a slow but continuing economic recovery”.

We need the psychology to change to the positive to make up for the ongoing bad news out of Europe, and as PIMCO’s El-Erian says, to offset the “headwinds of Congressional dysfunction”.

Economic Momentum

Hopefully, this news cycle can help repair investor confidence.

Misperceptions of Risk

Below is the outline of a recent talk given by Nick Murray. For those unfamiliar with his message, it is one of extreme optimism. He is renowned within the industry for his ability to look past all the noise and point out the truths of why now is the best time to invest… in a rather direct and blunt approach.

Investing is easy. there are only two outcomes:

1) You will outlive your money.

2) Your money will outlive you.

It’s that simple.

Investors have two misperceptions of risk:

1) Investors are concerned about loss of principal.

why is this a misperception?

The real concern is loss of purchasing power NOT principal.

Purchasing power is inflation.

3% inflation rate over 30 years of retirement means that you will need $125,000 in 30 years to buy $50,000 worth of goods in today’s dollars.

The problem is erosion of purchasing power.

Every year, everything you need to buy will cost more.

Investors can not invest in a retirement they can’t imagine.

To solve this problem, investors need rising income to account for inflation.

Fixed income is like a rattle snake, it warns you before it bites. It’s fixed like the name implies.

Solution: invest in the great companies both domestic and foreign and own for the rest of your life. The dividends produced rise over time and may help reduce inflation risk.

2) Investors can’t distinguish between volatility and loss

All too often, investors mistake temporary declines for permanent loss and sell out before it returns.

Why is this a misperception?

Stock market is not the source of all ruin

Most parents of baby boomers were born during the depression and the baby boomer’s thoughts on the stock market are based on their parents perceptions of the market.

News does not equal truth

News does not think in 30 year clips

Solution: turn off the TV and stop listening to the noise.

 

Indexing Strategy Will Work… Until It Doesn’t

Indexing is all the rage these days. Investors are realizing that they are paying a lot of fees to fund companies to provide average rates of return (below average in some cases). They’ve done the math and see that they can do better by investing in cheap no load ETFs and similar products that track the index. Vanguard has been pushing this strategy for decades now and has really seen traction grow in this area over the last 15 years or so, along with the growth of ETFs (not a coincidence).

As this strategy gains more traction and becomes even more common, I start asking a lot of questions to myself. Will it have an effect on the markets? Will it cause mispricing? Could the stocks in an index respond differently simply because they are part of an index? Could this strategy inadvertently increase risk and volatility if it became too popular?

Could this be the start of an Index Bubble? Everyone flocked to real estate, then flocked to bonds. Are investors now moving to indexes?

The problem is not the tools used to construct the portfolio (ETFs in this case). In fact, ETFs and other low cost, passive investments offer unique advantages that allow investors to access markets in a way they never could before. There seems to be an ETF for just about everything out there.

I see the problem in using passive investments with a passive strategy, or in other words a “buy and hold” strategy using low cost Index ETFs with periodic rebalancing to a specific allocation. For example, you have a portfolio consisting of 5 specific ETFs that are rebalanced annually to a specific percentage.

Never before have investors had the opportunity to completely remove judgement from investment decisions and be completely passive. Just 10 years ago, many investors used active investments (mutual funds where the fund manager is selecting investments) with a passive strategy (buy and hold).

It’s too early to tell how this will unfold and how this could affect the individual investor.

This strategy will work for many investors, but it may be the popularity of the strategy that ultimately leads to its downfall.

Social Security Strategies

If you are retiring soon, don’t expect the Social Security Administration (SSA) to give you the best advice on how to start collecting your benefits.  In fact, they have been known to give out poor advice.  I recently heard a story of the SSA sending a letter to a 65 year old, who was not currently collecting social security, which said something to the effect of the following:

“Did you know you could have taken social security at the age of 62? We are offering a lump sum to you for the three years of payments you have missed.”

On the surface it seems great – It sounds like free money. But as you continue to read the letter, you learn that future benefits going forward would be based on if the individual were 62 (about a third less than if the person waited until their full retirement age).

The SSA is doing this to lower their obligations and many individuals will take the SSA up on their offer, only to realize that it was a mistake.

Here are few strategies to help you maximize your social security benefits, but please consult with your financial advisor before you make any decisions.  This is a complicated situation that you should not try to navigate on your own.

1) Instead of looking at maximizing the monthly benefit, look to maximize the total benefit over your lifetime and your spouse’s lifetime. This will help you compare the different options you will develop and determine which one will be best for your situation.

2) To do this you’ll need to approximate how long you and your spouse will live. SSA’s calculator can help link to article. But use your own intuition – if your family has a history of living longer, then factor that into your thinking.

3) Calculate the total benefits using a few different scenarios: Both collect at age 62, both collect at full retirement age (FRA), and both collect at 70, are the easiest to calculate. Hybrid options become more difficult and can best be described as follows: The lower earner collects his or her own reduced benefits at age 62, and unreduced spousal benefits at FRA, while the higher earner collects at age 70. In order for this to work, the higher earner must file and suspend at FRA. There are limitations to this example, so be sure to consult with a financial advisor.

4) With numbers in hand, you can compare the options.  Look at total benefits and the breakout between husband and wife.  You may realize that between two options with similar total benefits, one is better if there is an early death or one lives until 100.  That will be the hardest part as you will see that the longevity assumptions are very important to consider.

It may be wise to enlist the support of a financial advisor who can help in putting together these strategies and determining which one is most appropriate.  We have recently started using a third-party program that illustrates this clearly for our clients.  Email us and we can help run some of the numbers for you.