Tag Archives: Investment strategy

Why market timing does not work

stock-market-timing

 

A paper published by a business professor ten years ago made this point emphatically.

The evidence from 15 international equity markets and over 160,000 daily returns indicates that a few outliers have a massive impact on long term performance. On average across all 15 markets, missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable than a passive investment. Given that 10 days represent less than 0.1% of the days considered in the average market, the odds against successful market timing are staggering.”

The odds of getting out of the market at just the right time and then getting back in at just the right time are roughly the same as winning the lottery.

This points out the reason why creating a portfolio that will allow you to invest for the long term is essential to creating wealth.  You can achieve a decent return and sleep well at night.  But in order to do this your portfolio has to match your personal risk tolerance (your Risk Number), one that differs with different people.

We are in a long-term Bull Market, but Bear Markets follow Bulls as night follows day, and some day the Bear will return.  That’s when having a properly diversified, risk-tolerant portfolio pays off.  Big time.

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How to lose $150 million

Boris Becker

We have written a lot about planning and investing.  But there’s nothing quite as instructive as learning from mistakes.  Learning from others’ mistakes is less painful than making our own mistakes.

This sets up an example of financial mistakes I learned about recently.

Sometimes the most surreal things happen. For example, anyone who remembers the 1980s’ tennis prodigy Boris Becker may be shocked to learn that last month, in a London courtroom, Becker was declared bankrupt.

After winning Wimbledon and countless other tournaments, Becker’s personal fortune was estimated to have reached $150 million. So how could this have happened? How could he have gone from $150 million to zero, and what can we learn from it?

Sports figures often find that they have developed “posses,” hangers-on who encourage extravagant lifestyles.  Fame and fortune at an early age lead to a number of personal mistakes.  These are often combined with poor investment decisions.  In the case of Becker they include things like Nigerian oil companies, and “… a sports website, an organic food business, and more notably, a planned 19-story high-rise in Dubai called the Boris Becker Business Tower, whose backers went bust in 2011.”

This is a special problem for people who become wealthy in sports and entertainment.  Too often they turn their financial lives over to agents who get them involved in complicated schemes that go sour.

The key to gaining wealth and – most especially – for keeping it is: keep it simple.  During 30 plus years of investing the biggest mistakes I have seen made is people getting involved in complex deals, partnerships, and relationships that they don’t really understand.

We provide education for our clients on investment strategy and develop portfolios that allow people to keep what they have earned.  Don’t be like Boris Becker.

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Are you taking more risk than you should?

 

We often take risks without knowing it.  There are some risks that are well known; things like texting while driving or not fastening your seat belt.  But there are other risks that are less well publicized and that can hurt you.

As financial professionals we often meet people who are not aware of the financial risks they are taking.  While there are countless books written about investing, most people don’t bother studying the subject.  As a result, they get their information from articles in the press, advertising, or chatting with their friends.

Many people have told us they are “conservative” investors and then show us investments that have sky-high risks.  This is because investment risks are either hiding in the fine print or not provided at all.  No one tells you how much risk you are taking when you buy a stock, even of a major company like General Electric.  GE is a huge, diversified global company, yet lost 90% of its value between 2000 and 2009.  Norfolk Southern is another popular stock in this area.  Do you know its “risk number?”   You may be surprised.

We have analytical tools that can accurately quantify your risk tolerance and give you your personal “Risk Number.”  We can then measure the risk you are taking with your investments.  They should be similar.  If not, you may find yourself unpleasantly surprised if the investment you thought was “safe” loses its value because you took too much risk.

We have no objection to daredevils who know the risk they are taking by jumping over the Grand Canyon on a motorcycle.  But we would caution the weekend cyclist not to try the same thing.  Contact us to find your personal “Risk Number” and then determine how much risk there is in your portfolio.

 

 

 

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The most common investment mistake made by financial advisors

Bill Miller beat the S&P 500 index 15 years in a row as portfolio manager of Legg Mason Capital Management Value Trust (1991-2005), a record for diversified mutual fund managers.  He was interviewed by WealthManagement.com about active vs. passive management.

We have written a number of articles about the mistakes individual investors make.  But what about mistakes that financial advisors make?  We are, after all, fallible and make errors of judgment.  And like all mortals we cannot predict the future.

Here’s Bill Miller’s assessment about traps that financial advisors fall into:

One problem is how they deal with risk. There is a lot more action on perceived risks, exposing clients to risks they aren’t aware of. For example, since the financial crisis people have overweighted bonds and underweighted stocks. People react to market prices rather than understanding that’s a bad thing to do.

Most importantly, most advisors are too short-term oriented, because their clients are too short-term oriented. There’s a focus on market timing, and all of that is mostly useless. The equity market is all about time, not timing. It’s about staying at the table.

Think of the equity market like a casino, except you own it: You’re the house. You get an 8-9 percent annual return. Casinos operate on a lower margin than that and make money. Bad periods are to be expected. If anything, that’s when you want more tables.

We agree.  That’s one of the reasons we are choosy about the clients we accept. One of the foremost regrets we have is taking on clients who hired us for the wrong reasons.  One substantial client came to us as the tech market was heating up in the late 1990s.  He asked us to create a portfolio of tech stocks so that he could participate in the growth of that sector.  We accepted that challenge, but it was a mistake.  When the tech bubble burst and his portfolio went down and we lost a client.  But it taught us a valuable lesson: say no to clients who focus strictly on short-term portfolio performance.  Our role is to invest our clients’ serious money for long term goals.

Like Bill Miller, we want to have the odds on our side.  We want to be the “house,” not the gambler.  The first rule of making money is not to lose it.  The second rule is to always observe the first rule.

To determine client and portfolio risk we use sophisticated analytical programs for insight into prospective clients actual risk tolerance.  That allows us to match our portfolios to a client’s individual risk tolerance.  In times of market exuberance we remind our clients that trees don’t grow to the sky.  And in times of market declines we encourage our clients to stay the course, knowing that time in the market is more important than timing the market.

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The Biggest Myth About Index Investing

Reader Mailbag: Dividend Investing vs Index Investing

John Bogle has done a great job of “selling” index investing.  He started the Vanguard group with the promise that you could invest in the stock market “on the cheap.”  It’s the thing that made the Vanguard group the second biggest fund family in the country.

Selling things based on price is always popular with the public.  It’s the key to the success of Wal Mart,  Amazon, and a lot of “Big Box” stores.

But Bogle based his sales pitch not just on price, but also the promise that if you bought his funds you would do better than if you bought his competition.  He cites statistics to show that the average mutual fund has under-performed the index, so why not buy the index?

The resulting popularity of index investing has had one big, unfortunate side-effect.  It has created the myth that they are safe.

A government employee planning to retire in the near future asked this question in a forum:

“I plan to rollover my 457 deferred compensation plan into Vanguard index funds upon retirement in a few months. I currently have 50% in Vanguard Small Cap Index Funds and 50% in Vanguard Mid Cap Index Funds and think that these are somewhat aggressive, safe, and low cost.”

The problem with the Vanguard sales pitch is that it’s worked too well.   The financial press has given index investing so much good press that people believe things about them that are not true.

Small and Mid-cap stock index funds are aggressive and low cost, but they are by no means “safe.”  For some reason, there is a widespread misconception that investing in a stock index fund like the Vanguard 500 index fund or its siblings is low risk.  It’s not.

But unless you get a copy of the prospectus and read it carefully, you have to bypass the emphasis on low cost before you get to this warning:

“An investment in the Fund could lose money over short or even long periods. You should expect the Fund’s share price and total return to fluctuate within a wide range.”

The fact is that investing in the stock market is never “safe.”  Not when you buy a stock or when you buy stock via an index fund.  There is no guarantee if any specific return.  In fact, there is no guarantee that you will get your money back.  Over the long term, investors in the stock market have done well if they stayed the course.  But humans have emotions.  They make bad decisions because of misconceptions and buy and sell based on greed and fear.

My concern about the soon-to-be-retired government employee is that he is going to invest all of his retirement nest-egg in high-risk funds while believing that they are “safe.”  He may believe that the past 8 years can be projected into the future.  The stock market has done well since the recovery began in 2009.  We are eventually going to get a “Bear Market” and when that happens the unlucky retiree may find that has retirement account has declined as much as 50% (as the market did in 2008).  At some point he will bail out and not know when to get back in, all because he was unaware of the risk he was taking.

Many professional investors use index funds as part of a well-designed diversified portfolio.  But there should be no misconception that index investing is “safe.”  Don’t be fooled by this myth.

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Why do smart people use financial advisors?

What is the real value to hiring a financial advisor, and who uses them?  What is the value proposition?  What makes one car with four doors and wheels worth $300,000 and other $30,000?  Although we might have an answer, the answer differs from person to person.

People use financial advisors for many reasons.  Some use them because they absolutely need them, others because they want them. Paying a fee for advice and guidance to a professional who uses the tools and tactics of a CFP™ (CERTIFIED FINANCIAL PLANNER™) and an experienced Registered Investment Advisor who is a fiduciary can add meaningful value compared to what the average investor experiences.

Many middle-class investors are anxious about their finances and are not interested in learning the details of managing their money.  This anxiety often results with money left on the sidelines because they don’t know what to do or are afraid of making mistakes. That means earning a fraction of 1% at the bank when the Dow Jones Industrial Average (DJIA) is up over 25% in the last 12 months.

There are others who are interested in learning about investing and may want to hire an advisor to “look over their shoulder.”  They want to hire an “investment coach.”

A third category are people who hire professionals because they are busy doing things that are more important to them: building a career or a business, being with family, or living an active retirement.  They hire an expert to manage their money the same way they hire a lawyer for estate planning, a CPA to prepare their taxes, and a doctor to keep them healthy.

A fourth category is people who were making their own investment decisions but ended up making a huge financial mistake.  This leads me to a story about a really smart, highly paid high tech executive who is very knowledgeable about investing; but he hired an advisor:

It’s not because he lacks the knowledge or interest, obviously. Rather, he figured out he had behavioral blind spots and understood he was at risk of great financial loss. He’s paying someone just to take that risk off his plate.

Determining your goals, controlling risk, managing portfolios well, and knowing your limitations – knowing you have “blind spots” – has led many smart people to hire an advisor.

Vanguard, the hugely successful purveyor or no-load mutual funds (that appeal to do-it-yourselfers) estimates that a financial advisor is worth about 3% net in annual returns.  They attribute this to the seven services that a good advisor provides:

  1. Creating a suitable asset allocation strategy.
  2. Cost-effective implementation.
  3. Rebalancing
  4. Behavioral coaching
  5. Asset location
  6. Spending strategy.
  7. Total return versus income investing.

If you have an advisor but he is not meeting your objectives, ask us for a second opinion.  If you don’t have an advisor but may want one, we offer a free one-hour consultation to see if we are compatible.

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A reader asks: what’s the difference between risk tolerance and risk capacity?

Korving -1016 RET web

That’s an interesting question and it depends on who you ask.  The investment industry measures risk in terms of volatility, taking the opportunity for both gains and losses into consideration.

I will answer with a focus on losses rather than gains because, for most people, risk implies the chance that they will lose money rather than make money.

 Risk tolerance is your emotional capacity to withstand losses without panicking.  For example, during the financial crisis of 2008 – 2009 people with a low or modest risk tolerance, who saw their investment portfolios decline by as much as 50% because they were heavily invested in stocks, sold out and did not recoup their losses when the stock market recovered.  Their risk tolerance was not aligned with the risk they were taking in their portfolio.  In many cases they were not aware of the risks they were taking because they had been lulled by the gains they had experienced in the prior years.

People who bought homes in the run-up to the real estate crash of 2008 were unaware of the risk they were taking because they believed that home prices would always go up.  When prices plunged they were left with properties that were worth less than the mortgage they owed.

This exposed them to the issue of risk capacity.

Risk capacity is your ability to absorb losses without affecting your lifestyle.  The wealthy have the capacity to lose thousands, millions, or even billions of dollars.  Jeff Bezos, founder of Amazon, recently lost $6 billion dollars in a few hours when his company’s stock dropped dramatically.  Despite this loss,  he was still worth over $56 billion.    His risk capacity is orders of magnitude greater than most people’s net worth.

The unlucky home buyer who bought a house at an inflated price using creative financing found out that the losses they faced exceeded their net worth.  As a result many people lost their homes and many declared bankruptcy.

There are some new tools available to measure your risk tolerance and determine how well your portfolio is aligned with your risk number.  Click HERE to get your risk number.

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What’s Your Risk Number?

risk

Defining how much risk someone is willing to take can be difficult.  But in the investment world it’s critical.

Fear of risk keeps a lot of people away from investing their money, leaving them at the mercy of the banks and the people at the Federal Reserve.  The Fed has kept interest rates near zero for years, hoping that low rates will cause a rebound in the economy.  The downside of this policy is that traditional savings methods (saving accounts, CDs, buy & hold Treasuries) yield almost no growth.

Investors who are unsure of their risk tolerance and those who completely misjudge it are never quite sure if they are properly invested.  Fearing losses, they may put too much of their funds into “safe” investments, passing up chances to grow their money at more reasonable rates.  Then, fearing that they’ll miss all the upside potential, they get back into more “risky” investments and wind up investing too aggressively.  Then when the markets pull back, they end up pulling the plug, selling at market bottoms, locking in horrible losses, and sitting out the next market recovery until the market “feels safe” again to reinvest near the top and repeating the cycle.

There is a new tool available that help people define their personal “risk number.”

What is your risk number?

Your risk number defines how much risk you are prepared to take by walking you through several market scenarios, asking you to select which scenarios you are more comfortable with.     Let’s say that you have a $100,000 portfolio and in one scenario it could decline to $80,000 in a Bear Market or grow to $130,000 in a Bull Market, in another scenario it could decline to $70,000 or grow to $140,000, and in the third scenario it could decline to $90,000 or grow to $110,000.  Based on your responses, to the various scenarios, the system will generate your risk number.

How can you use that information?

If you are already an investor, you can determine whether you are taking an appropriate level of risk in your portfolio.  If the risk in your portfolio is much greater than your risk number, you can adjust your portfolio to become more conservative.  On the other hand, if you are more risk tolerant and you find that your portfolio is invested too conservatively, you can make adjustments to become less conservative.

Finding your risk number allows you to align your portfolio with your risk tolerance and achieve your personal financial goals.

To find out what your risk number is, click here .

 

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Why Re-balance Portfolios?

The market rarely rings a bell when it’s time to buy or sell.  The time to buy is often the time when people are most afraid.  The time to sell is often when people are most optimistic about the market.  This was true in 2000 and 2009.

Rather than trying to guess or consult your crystal ball, portfolio re-balancing lets your portfolio tell you when to sell and when to buy.

You begin by creating a diversified portfolio that reflects your risk tolerance.  A “Moderate” investor, neither too aggressive or too conservative, may have a portfolio that contains 40 – 60% stocks and a corresponding ratio of bonds.

Checking your portfolio periodically will tell you when you begin to deviate from your chosen asset allocation.  During “Bull” markets your stock portfolio will begin to grow out of the range you have set for it, triggering a need to re-balance back to your preferred allocation.  During “Bear” markets your fixed income portfolio will grow out of its range.  Re-balancing at this point will cause you to add to the equity portion of your portfolio even as emotion urges you in the opposite direction.

If properly implemented and regularly applied, this will allow you to do what that old Wall Street sage tells you is the way to make money: “Buy Low and Sell High.”

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Diversification and Emerging Markets

A well-diversified portfolio typically includes emerging markets as one of its components.  “Emerging markets” is a generic term to identify those countries whose economies are developed, but still smaller than those of the world’s superpowers (i.e., USA, Europe, Japan).

To professional investors, a well-diversified portfolio includes many asset classes, not just the most obvious: U.S. Stocks (the S&P 500) and a U.S. bond fund.

The following illustration is a great illustration of the relative performance of some of the major asset classes.

callan-periodic-table-of-investment-returns

Here we have ten key indices ranked by performance over a 20-year period.  The best-performing index for each year is at the top of each column, and the worst is at the bottom.

It is natural for investors to want to own the stock, or the asset class that is currently “hot.”  It’s called the Bandwagon Effect and it’s one of the reasons that the average investor typically underperforms.  The top performer in any one year isn’t always the best performer the next year.

A successful investment strategy is to:

  • Maintain a portfolio diversified among asset classes,
  • Stick to an appropriate asset allocation for your particular goals and objectives,
  • Rebalance your portfolio once or twice a year to keep your asset allocation in line, essentially forcing you to sell what’s become expensive and buy what’s become cheap.

In other words, re-balance your portfolio regularly and you will benefit from the fact that some assets become cheap and provide buying opportunities and some become expensive and we should take some profits.

Which brings us to emerging markets, which have been a drag on the performance of diversified portfolios for several years.

“It was a summer of love for investment in emerging markets,” according to the latest MSCI Research Spotlight.  For example, Brazil, Taiwan, South Africa and India have all been big winners, MSCI said.

The MSCI Emerging Markets Index ended August up for the year 15 percent compared to a loss of 20 percent the prior year.

“We are seeing very strong performance,” Martin Small, head of U.S. i-Shares BlackRock, told the conference.

Emerging market equities “have outperformed the S&P so far this year by more than 800 basis points and the broader universe of developed markets by almost 1,000 basis points,” according to the October BlackRock report, “Is the Rally in Emerging Markets Sustainable?” The report said EM outperformance “is likely to continue into 2017.”

For investors who have included emerging markets in their portfolios, their patience and discipline is being rewarded this year.  For those who want to have a portfolio that’s properly diversified but don’t have the expertise to do it themselves, give us a call.

 

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