Sign up with your email address to be the first to know about new products, VIP offers, blog features & more.

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.

Up is Up

The stock market is running. The economy … not so much. So what is going on?

A quote I wrote down months ago (but not the author). It sums it up:

“we expect robust flows … to dominate fundamentals.”

In a perfect world one invests in the stocks of well-managed companies that are growing sales and earnings in a sound and strong economy. However, this bull market is not that. Yes, well-managed companies are growing sales and earnings. Yes, the price of the stock market relative to its underlying earnings, although rich, is not excessive. However, it is not a sound and strong economy.

What is driving this market is: liquidity.

“Credit is super-abundant and stock market behavior is conditioned not so much by the fundamental performance of its underlying companies but by increasing doses of monetary Ritalin.” (link)

Our Federal Reserve is pushing a reported $85 billion of newly created cash in the banking system every month and dropping interest rates to near zero. Much of this new cash is buying stocks. Also, savers that are faced with near zero CD rates, are searching for some return and buying dividend stocks.

Furthermore, the European Central Bank appears to be no longer backstopping their citizen’s bank deposits. Money is moving out of Europe and finding a home here (Link). Japan with its aggressive yen devaluation plan is also a benefit to our stock market (Link).

Robust inflows of cash are driving this stock market higher without concern for the economic uncertainty all around us. The psychology of Birinyi’s bull market cycle is in full swing (see below). The stock market is running. Up is up.

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.

Tweaking a Buy and Hold Strategy

One of the most common investment strategies is called “Buy and Hold”, which usually consists of mutual funds or other securities held for the long term and rebalanced occasionally.  These funds are held during the best and worst performing years.  The theory is that you can never predict the future performance of the market or time your trades to sell at the top or buy at the bottom. Instead you ride the waves, knowing that there will be ups and downs.

After the recession of 2008 and 2009, the “Buy and Hold” strategy started to lose favor.  Investors could not tolerate such significant declines in their portfolio. It caused many investors to give up on their strategy, sell out of their portfolios at the wrong time (the bottom) and move to cash to wait for better days, more optimism and more clarity.

And so they sat. and sat. and sat.

Here we are, four years later and the S&P 500 has now returned a total of 130% (3/9-12/12). There is a pattern here. American Funds released a newsletter that has a chart on page 2. It highlights the returns for the subsequent 10 years following the major declines of 1939 and 1974. The returns for those two ten year periods were in the 15% range, well above the 11% average for the S&P 500.

It turns out, this sort of return is not unique when compared to historical performance.

For those investors that stayed invested, they are watching their portfolios return to previous levels and grow even more. But, unfortunately many investors are still sitting on the sidelines wondering how to get it.

Maybe “Buy and Hold” is not dead after all!  Although, it may not be right for everyone.

If you are one of the millions of investors who sold out close to the bottom and still reluctant to get back in, consider these strategies:

1 – Limit the amount of news you watch. So much of it is noise and simply a distraction.  Take it with a grain of salt.

2 – Periodically review your statements and make calculated decisions.  It’s easy to react quickly if you see a bad news report and then review your statement.

3 – Keep the course.  Despite all the voices in your head that tell you to sell, hold on to your strategy. It may be hard, but that’s why you have a strategy in the first place.

4 – Stay diversified.  Invest in different asset classes to spread your risk out.  If you are holding too much in one specific stock or mutual fund, consider moving some of it elsewhere.

5 – Consider dollar cost averaging.  If you’re trying to time when to get back in the market or when to make contributions, dollar cost averaging may help.  With most fund companies and broker/dealers, you can establish rules to invest a specific amount each week/month. That may reduce the risk of buying a security only to see it drop shortly after you purchase it. It allows you to ease back into the markets, instead of jumping in.  Keep in mind, this method does not ensure a profit and does not protect against loss in a declining market, so investors should consider their willingness to continue purchases during a declining or fluctuating market.

6 – Get help. It is becoming more and more complicated to invest with more options and increasingly complex products that may not be right for you unless you talk to a professional.

But if you read this, and you feel that even with those changes, you can’t stomach another decline like before then you may need a new strategy all together.  We had several client that express their concern and have developed a model portfolio to meet their needs. It looks to capture profits when trends within a variety of asset classes are positive and sit in cash when the trends are negative.  You can read more about it here.

Finding a Trend in Emerging Market Equities

In reviewing asset class trends for The Active Asset Allocation Portfolio, I saw a divergence of two asset classes – emerging markets and developed markets. I wanted to explore why this is happening.

We find this to be a rather unique situation, as emerging markets tend to be the more volatile cousin of the developed markets. Emerging market highs are higher than developed markets and their lows are lower. But this time is different. Emerging markets had a brief period where their trends were positive compared to the 200-day moving average but struggle to stay above the moving average for a sustained period of time, while the developed markets continue to their positive trend. They’re not moving together, an unusual occurrence. What’s causing the emerging markets to act the way they are is tough to pinpoint, but below are a few obstacles that could be contributing to their sluggish performance.

Obstacles facing emerging markets:

– The United States is re-gaining a competitive advantage by leveraging technology in manufacturing. This is forcing businesses to reevaluate the cost effectiveness of manufacturing in China and other countries that once had a low-cost connotation associated with them. (Source) and (Source)

– The unintended consequences of currency devaluations are effects that can spill over into other countries. In this case, emerging markets are affected by the currency devaluation happening in developed countries, leading to increased wages and possibly increasing inflation. If the Japanese Yen loses value then its exports become cheaper and more attractive than goods from emerging markets. (Source)

– Exports continue to lag as demand remains low. Developed economies have seen growth in health care, industrials, consumer discretionary and consumer staples, none of which are especially strong industries in the emerging markets. (Source)

Advantages for emerging markets:

– The obstacles mentioned above could be be affecting emerging markets on the short term. Many of the sources listed above remain bullish on this asset class for the long term. Maybe this is a buying opportunity?

– If you look at some of the largest emerging market ETFs, you’ll see about 40% of their holdings are in companies located in China, Brazil and Taiwan. Finding a more diversified security or one that minimizes volatility may be an option to consider, such as a low volatility ETF.

Currently, we see no confirmed trend in the Emerging Markets. The BRIC’s, the largest and most commonly thought of Emerging Markets, have not been performing well for reasons mentioned above. But these are not the only emerging markets in the world. There are plenty of others and some of those may be worthy investments either now and in the near future.

Our Take on the “4% Rule” for Retirement Withdrawal

Many advisors tell their clients, as a rule of thumb, a client can withdraw about 4% of their portfolio each year, without it affecting the principal. We have been telling our clients this for years. In fact, this rule of thumb dates back a few decades and was determined after a lot of research.

And then a few weeks ago, an article written in the WSJ called into question the validity of the rule of thumb. Its premise is quite simple: if you retire and then your portfolio drops like it did in 2008, then a withdrawal rate of 4% of the original balance would most likely not be able to sustain you through retirement. You would then need to reduce your withdrawal rate. In the investment and financial community, this was quite a statement to make and has caused many individuals to question their current withdrawal rate.

It’s important to consider a few points that the article touches upon, but are overlooked:

1) The “4% Rule” is a rule of thumb, a guide, a rough figure to help investors determine how much they can withdraw from their portfolio in retirement.

2) A client should only take what they need from their portfolios. They should keep as much invested as possible, so their assets can continue to appreciate. An extra $1,000 sitting in a checking account earning next to nothing, should probably stay in invested where it can generate a decent return.

3) The “4% Rule” does account for some of the long tail risks. When this rule of thumb was calculated in the 90’s, it did use data points going back to the depression. Of course, there are scenarios where the “4% Rule” will not work, but these are the outlier scenarios. They are economic situations that happen every 75 years or so. Fortunately, we are recovering from one of them right now.

The most important point to take away from this post and the article is to remember that the “4% Rule” should be renamed “4% Rule of Thumb”. Maybe then investors will understand that withdrawals will have to fluctuate depending on market conditions and their needs.

If you’re interested in some additional information on this topic, Vanguard has a few interesting pieces on the topic.