Tag Archives: Investments

What is your plan for the next significant market decline?

Posted on March 2, 2012 | Leave a comment

A common question in surveys that attempt to judge an investor’s risk tolerance inquires about the person’s assumed response to a significant market decline. It generally asks: If your investments declined sharply, would you:

A) sell and wait for better market conditions

B) stay the course and hope the decline is temporary, or

C) invest more at lower prices

Up until 2000, comforted by historical precedent that markets recover and go on compounding gains before too long, many investors were happy to stay the course. But since then, investor patience has been tested because it is unclear how much time staying the course actually requires to recapture previous market highs.

This presents a challenge when the recovery does not match the time frame of a retiring or already retired investor. The three options presented in the risk tolerance question also do not present a meaningful response to address the situation in the context of your goals and your financial security.

Michael Kitces, a CERTIFIED FINANCIAL PLANNER™, and frequent conference speaker in the financial advisor industry, presents a more meaningful way to plan for the possibility of a significant decline in assets. He revises the question, as follows:

“If your portfolio experienced a sharp decline and you were concerned it might not recover in time, would you

(A) spend less and save more now,

(B) spend less in retirement so you don’t need as much in assets, or

(C) delay your retirement date”

These options present a real, proactive response to an unexpected crisis. And Kitces notes, “it is simply based on what you would do if you were CONCERNED that the portfolio might not recover in time.” If your time horizon is still long and there is less concern that’s one thing. But it’s best to address concerns before they become problems and the only options remaining are to make unwelcome lifestyle changes.

The way to understanding the potential impact of market events, or significant changes to income and saving ability, is to have a thorough plan that goes beyond the ideal investment mix for your prescribed level of risk tolerance.

With the plan in place you will be less likely to fall victim to the whims of a moody market and react repeatedly to the shifting landscape of the global economy. The plan gives you the ability to apply “what if?” considerations (revising the timing or size of goals, working longer, waiting to claim Social Security, etc.) so that you can make informed decisions when the world around you deviates from your ideal scenario.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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Emerging middle class resides mostly in Asia

Posted on January 24, 2012 | Leave a comment

The world population reaching seven billion people has gained a lot of media attention over the past several months. While the population rises due to longer life expectancy, there is a parallel growth in the middle class. Certainly poverty still exists in numbers that are far too large but the middle class is expanding quickly.

Most of the growth in middle class standards of living is coming in the Asia Pacific region. The pattern is expected to expand as this chart from the American Funds New World Fund annual report suggests.

 

Under the assumption that the emerging middle class will increasingly join the global economy as consumers, it’s clear that investing in companies that do business in Asia may be worthy of more emphasis in your portfolio over the long-term.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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Apple vs. Circuit City, individual stocks as Chance cards in the game of life

Posted on November 26, 2010 | Leave a comment

This post at mint.com prompted some thought about the boom or bust possibility of investing in individual stocks.

The idea here is what if you purchased a company’s stock instead of its products? The example that stands out the most to me is what if you went back to 1997 and had two choices for stocks to invest in:

  • Circuit City, an electronics retailer that had stock returns 18.5 times greater than the broad market over the prior 15 years and would be featured prominently in Jim Collins’ 2001 business best seller Good to Great.
  • Apple, more a personal computer company back then than a handheld personal electronic device innovator. Apple had plenty of history with the Macintosh computer but was struggling in 1997.

You could have purchased the new Power Macintosh G3 Minitower in 1997 for $3,000. You would now likely be on your third or fourth next generation PC since then. If instead you invested the $3,000 in Apple stock at that time, it would be worth over $300,000 today.

Of course, most people, given the relative attractiveness of the two companies in 1997, would have chosen to invest in Circuit City. As it turns out, Circuit City went from Good to Great to Bankrupt trying to keep pace in the retail electronics market.

For every Apple that you invest in at the right time, you can afford to also invest in many duds and still make nice progress toward your goals. But the timing is critical and the ride may be turbulent along the way.

~ Gary Brooks, CFP®, Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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Stocks are undervalued, stocks are overvalued ― depending on direction you look

Posted on July 21, 2010 | Leave a comment

The significant lack of consensus outlook for U.S. stock markets comes largely from the direction at which differing parties view the market. Those looking forward, basing market valuation on estimated future company earnings believe that markets could be 25+% undervalued.

Those who prefer to use trailing actual figures to evaluate current stock prices, believe nearly the opposite, that the recovery rally went too far and will correct more than the 16% dip in the S&P 500 between April 23 and July 2.

The Bullish View

Jeremy Siegel is a professor and author whose viewpoint is widely followed. He has tracked stock market performance back over 200 years. He believes in reversion to the mean – over time, no matter whether markets race ahead of fair value to overly correct below it, they will self correct and return to long-term mean returns.

In a July 8 interview, he said: “When I draw that line over 200+ years of return data, I find we are about 25% to 30% under trend. But trend lines are only one aspect of it. There has got to be a valuation behind that. That is very much what supports the position that stocks are undervalued. When I look at earnings going forward on the S&P 500, for instance projections for 2010 and 2011, we are looking at either 13-times earnings this year or 11-times next year’s earnings. In this interest rate environment, that is unprecedented and, again, demonstrates around a 25% or 30% undervaluation in the market.”

Siegel goes on to explain that even if he takes a pessimistic view of future earnings that current prices remain undervalued, just not to the same extent.

Jeremy Grantham, a money manager historically bearish in his outlook, leaves open the possibility for stocks to rally strongly. “Despite growing nervousness and a slowing economy, there is still a 45 percent chance, thanks to low interest rates, that the S&P 500 will rise above 1,400 (1,083 on July 21, 29% increase to reach 1,400) by October of next year, accompanied by a speculative spin. High-quality stocks have been cheap for five years, and may spend most of the next several years underpriced, bouncing back up to fair value from time to time.”

The Bearish View

Other analysts and economically-focused investment managers are more pessimistic given the mix of a rear view of real company earnings in tandem with fairly dreadful economic expectations.

Economist and mutual fund manager John Hussman hasn’t found a reason for a promising outlook.

“I continue to urge investors to have wide skepticism for valuation metrics built on forward operating earnings and other measures that implicitly require U.S. profit margins to sustain levels about 50% above their historical norms indefinitely,” Hussman wrote July 19. “I can’t emphasize enough that when you hear an analyst say ‘stocks are cheap based on forward operating earnings’ it would be best to replace that phrase in your head with ‘stocks are cheap based on Wall Street’s extrapolative estimates of a misleading number.’ ”

While Hussman thinks that expectations for 25% U.S. stock market gains are misguided, he does not predict extended negative returns. His forecast in the second quarter outlined a scenario where U.S. markets could log 7% average annual returns over the short-to-intermediate term. While that would be a third lower than long-term market returns, 7% annually will still build wealth, especially in a period where inflation is tame.

Others do leave open significant likelihood of negative returns from U.S., and likely European, stocks.

Yale economist Robert Shiller uses a backward-looking calculation of 10-year average actual net earnings and concludes that U.S. stocks are substantially overvalued.

Everyone is right at some point

For another perspective, consider this graph from Morningstar. It charts collective over or undervaluation of the 1,700 stocks that Morningstar rates. This view is of the past year, suggesting a lightly undervalued market in general. It’s important to remember that individual stocks can get wildly undervalued or overvalued with no relation to the overall market.

What do we think?

The tug-o-war between forward-looking optimists and backward-looking pessimists is at a point where each side maintains a lot of strength. It could be that both sides are right. We may see a lot of up and down moves without a clear winner from either viewpoint.

One may be right in the short term but the other over a more meaningful longer term.

We favor evidence over expectations. That leads us to believe that the U.S. stock market is unlikely to add 25% or 30% to its value in the next year. Multi-national companies able to pay increasing dividends and established emerging markets companies appear most attractive. U.S. Treasuries are least attractive.

While we accommodate for occasional tilts in emphasis within our clients’ portfolios, we still operate from a core asset allocation that is globally diversified. This is the best way to remain aligned with client goals that will endure beyond the uncertainty of today.

– Gary Brooks, CFP®

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The Key to Investing Success — Don’t Look

Posted on July 2, 2010 | Leave a comment

William Bernstein is unquestionably more intelligent than the average investor. He was a practicing neurologist before he turned his attention to investment management and authoring books about investing and global economic history.

Jonathan Clements, a long-time Wall Street Journal personal finance columnist calls Bernstein the smartest person he knows.

With the education and experience of a neurologist, Bernstein pays close attention to how our brain dictates the emotional mindset around money.

In his latest book The Investor’s Manifesto – Preparing for Prosperity, Armageddon, and Everything in Between, he writes briefly about how human nature causes people to weight negative events or experiences more heavily than positive experiences.

Where investments are concerned, behavioral finance research suggests that one day of investment losses offsets two days of gains in our psyche. Therefore, Bernstein writes, we should refrain from monitoring investment results too frequently in order to feel emotionally better about the journey toward the goal.

If you looked at the daily results of the Dow Jones Industrial Average from 1929 through 2008, you would see positive returns 51.6% of the time and declines 48.4% of trading days. If one negative day outweighs two positive, we would be significantly net negative emotionally when viewing performance daily.

If we review gains or losses monthly, the percentage of ups and downs don’t change significantly – 57.5% of all months between 1929 and 2008 experienced market gains, 42.5% losses.

Over a full year, there were 52 positive years and 28 losing years. This difference is not quite enough to offset a 2-to-1 impression of negativity.

Most people prefer to monitor investments more frequently than once per year but if they did, their decisions would likely be more positively aligned with their goals and the opportunity presented by the market.

Short-term reactions often have unintended long-term impact on investment success.

“It is the ability to ignore these dysfunctional instinctive responses that determines, as much as anything else, which investors wind up with the highest returns,” Bernstein writes.

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The ‘Sad Conclusion’ of Do-it-Yourself Investing

Posted on July 2, 2010 | Leave a comment

In The Investor’s Manifesto, William Bernstein particularly puts down the idea that individual investors can successfully manage individual stock portfolios. “Trading individual stocks is like playing tennis against an invisible opponent; what you don’t realize is that you are volleying with the Williams sisters.”  He writes this to explain how there is a buyer and seller for every stock transaction. In many cases, the buyer or seller on the opposite end of your trade knows way more than you about that company and its future earnings prospects. That’s because the majority of participants in stock trades are sophisticated institutions, corporate insiders and other professional investors.

Bernstein further makes his point by reprinting a quote attributed to Charles Ellis in the June 2001 edition of Money magazine.

“Watch a pro football game and it’s obvious the guys on the field are far faster, stronger and more willing to bear and inflict pain than you are. Surely you would say, ‘I don’t want to play against those guys!’ Well, 90% of stock market volume is done by institutions, and half of that is done by the world’s 50 largest investment firms, deeply committed, vastly well prepared—the smartest sons of bitches in the world working their tails off all day long. You know what? I don’t want to play against those guys either.”

For much of the past, Bernstein regularly professed that an average person can be a successful do-it-yourself investor. He wasn’t referring to trading stocks, but instead, building diversified portfolios with index mutual funds. But having experienced challenging global stock markets consistently in the decade since he wrote his first book, he’s changed his mind.

“Successful investing requires a skill set that very few people possess,” he writes. “This is difficult for me to admit; after all, I have written two books premised on the idea that anyone, given the proper tools, can turn the trick. I was wrong. … I have come to the sad conclusion that only a tiny minority will ever succeed in managing their money even tolerably well.”

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Successful Tendencies of Brain-Damaged Investors

Posted on June 5, 2010 | Leave a comment

I read some interesting research findings today in market commentary from a mutual fund firm, O’Shaughnessy Asset Management.

Behavioral finance research is a growing topic on college campuses. Much of this work can help us understand decision making when risk is involved.

One fascinating study sheds light on people’s behavior in markets like this one and highlights why now is the time to buy, not sell, equities. In the study, originally reported in a Wall Street Journal article entitled “Lessons from the Brain-Damaged Investor” and led by researcher Baba Shiv of Stanford University, a group of 41 participants played an investment game where each was given $20 to start and asked to make 20 rounds of one dollar investment decisions based on a coin toss. They would choose either “invest” or “don’t invest.” If they chose “don’t invest,” they kept their dollar. If they chose “invest,” the researcher took the one dollar and flipped a coin. If it came up heads, the dollar was lost but if it came up tails, the investor was rewarded with $2.50. Clearly the most profitable strategy would be to play every round, as the expected value of each one dollar “invested” is $1.25. The twist in the study was that one group of participants had suffered brain damage which affected key emotional centers in the brain such as the orbitofrontal cortex, the amygdala, or the insula. The other participants had either no brain damage at all or brain damage that affected non-emotional centers of the brain.

Those without any emotional brain damage invested just 58 percent of the time ending with $22.80 on average. Those participants with brain damage outperformed their healthy counterparts by 14.5 percent investing 84 percent of the time and ending with an average of $25.70. The main reason participants with normal brains did so poorly was because of their behavior after a loss. Instead of recognizing the very simple positive expected value of choosing “invest”, the normal group was scared of losing twice in a row and as a result invested just 41% of the time after a loss. The damaged group maintained their overall percentage after a loss, investing 85% of the time. This study illustrates that fear, loss, and risk avoidance act as a tax on our portfolios if we do not take action to circumvent their influence.

There are many studies like this that demonstrate ability of non-emotional participants to make more rational, logical decisions. In many respects, this circumstance relates the average investor to the law of unintended consequences. In trying to reduce risk by judging patterns and expectations amid moving market conditions, many people miss opportunity and create an unintended drag on investment performance.

Please see more of our thoughts on managing risk in the previous post on June 2.

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Managing Risk; The Most Important Part of the Plan

Posted on June 2, 2010 | Leave a comment

Each of us thinks about the risks that we take in our own way. Some people have no difficulty taking risk in their personal lives but are more risk averse in their financial decisions. Others are just the opposite.

We focus our efforts on helping our clients’ better understand the balance between financial risk and their progress toward life goals.  We think about financial risks from two perspectives:

  1. Minimizing threats to financial security by using a prudent amount of insurance to protect against untimely death, disability or long-term care requirements.
  2. Understanding the amount of investment risk that each client is comfortable taking to achieve a financial goal.

Thinking about risk in both of these ways helps us make recommendations that may increase the likelihood that our clients will achieve their goals.

Insuring against risks is usually clear and less complicated. Defining and responding to investment risks is a different story.

Some clients have sufficient assets and guaranteed income streams (pension, Social Security, property income) to have a nearly bulletproof retirement plan, given their lifestyle preferences. They aren’t reliant on growth of their assets to meet their goals so they choose a conservative investment approach.

Others in the same situation, particularly entrepreneurial folks accustomed to taking risk, prefer to strive for growth beyond their basic income and asset needs. They have a “go for it” mentality to increase their personal wealth.

Then there are folks who have lifestyle ambitions or early retirement visions that aren’t as adequately funded. They may perceive little choice but to have investment returns do the heavy lifting required to meet their outsized goals.

Often, this leads to a misinterpretation of investing vs. speculating. As financial advisors, we think that investing should be done with an expectation of a margin of safety around the expected outcome over a full market cycle. This margin is thin or non-existent if you are speculating.

Speculating may be lucrative. In fact, the greatest fortunes in the world have come from speculating or concentrating investment in a single idea. But speculating comes with potential consequences that can be disastrous, especially if you don’t have a significant time horizon to make up for the setback.

In a rational investment world, you can differentiate between investing and speculating. But clearly, global markets don’t always act rationally and even “good” investments over the past decade have delivered returns that exposed downside risk and appeared more speculative.

As psychologist Paul Slovic is quoted in The Intelligent Investor, Benjamin Graham’s classic book on investing: “risk is brewed from an equal does of two ingredients—probabilities and consequences.”  As advisors, it’s important to us to be realistic about our probability of being right and understand how clients could react to the consequences of markets not behaving as expected.

The difficulty in predicting responses to market fluctuation lies in the tough-to-judge emotional responses tied to money. We find that one way to understand the impact of risk and therefore better predict how people will actually respond to market downturns is to measure their loss cushion. How much could they see their assets decline and still be able to support goals, such as a 30-year stream of retirement income, at an acceptable level.

People with relatively little loss cushion need to be far more aware of the risk in their portfolio.  This is a fundamental tenant of our financial planning philosophy.

Regardless of our clients’ mentality, it is our role as a Registered Investment Adviser firm, and as Certified Financial Planners, to act as fiduciaries in the clients’ best interest.

As fiduciary advisors, we are careful to manage investments prudently. We ask ourselves:

  • Are there unintended risks/consequences in a portfolio—like having too many bonds of one type or too much exposure to any specific country, currency or industry?
  • Are our expected returns too low or high?

When evaluating expected returns, we feel it’s important to:

  • look beyond long-term averages which create an inaccurate sense of security
  • consider fluctuation in historical returns and sequence of those returns, to understand realistic moves from year to year, their depths and their heights
  • evaluate attractiveness of investments by fundamental measures, regardless of the present direction of markets

With the answers to those questions, we work to create investment portfolios for our clients that help them manage both their risk levels and return expectations. We focus on:

  • Understanding their short- and long-term goals
  • Being sensitive to their tolerance for market fluctuation (risk!)
  • Knowing  the likely holding period of the portfolio
  • Working to manage both the expenses and tax implications of the investment portfolio
  • Diversifying holdings to mitigate some risk

We understand that from time to time, our assumptions and the probabilities we assign to expected outcomes will be wrong. But as long as we are generally correct in our direction and not precisely wrong with speculation, we will help our clients achieve financial security.

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