Enlightened Financial Planning

Fewer Stocks, Missed Opportunities      August 21st, 2014

Investment pundits and gurus have been pouring over an interesting chart, reproduced here, that was published last year in the Financial Analysts Journal. The chart shows that, despite the recent high returns for stocks, investors, in aggregate, actually held only 37% of their portfolios in stocks at the end of 2012. Follow up research has shown that even with five-year returns of 18% or more since the Great Recession of 2008, that percentage has hardly budged.

If you want to translate these statistics into real money, the research strongly suggests that many people didn’t reap the full benefits of the recent stock market boom, and their portfolios today hold far fewer stocks than in 1959, when the data-set begins.

What’s going on? You can see a few clues from the chart itself. The stock ownership percentage went down dramatically from 1999–when equities made up a near-record 62% of the average investor’s portfolio–to 2002, when the Tech Wreck market decline sent investors scurrying to the sidelines and drove stock allocations below 45%. These timid investors moved back into the market over the next four years, taking their equity allocations above 50%, just in time for the market to crash all over again.

“Twice burned, quite shy” is one explanation for why so many investors have missed out on the strong returns we’ve experienced recently. Many have moved into bonds, which currently make up 57% of the aggregate investor portfolio today.

In addition, an unprecedented number of other investments are competing for space in an investor’s portfolio–certainly more today than in the 1960s or 1980s. Hedge funds and private equity firms now hold 9% of investors’ aggregate portfolios. Gold and commodities have become increasingly popular investments, as have real estate investment trusts.

The markets are impossible to predict, in part because the behavior of people–in aggregate as well as individually–is impossible to predict. But it is possible that the high fees and disappointing returns of hedge funds might cause some investors to rethink some of their more exotic allocations, and any rise in interest rates could startle the investor herd away from their record-high allocation to bonds. One possible future scenario would have the next data point on the chart show a return to stocks. Since higher levels of demand are one engine that drives stock prices higher, we could experience more years of high returns, which could, in turn, bring about one of those cycles that feeds on itself.

Until, of course, the next downturn–which, alas, is also unpredictable. The tragedy is how many people have largely missed out on the recovery returns since 2008. It is the nature of markets that they frighten people off while long-term investors enjoy their best years, and lure people back in as stock prices are just about to go over a cliff. The first part of this unhappy tale seems to have played itself out as usual.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and information for leading practitioners in the financial planning profession.

 

A “Guaranteed” Loser      August 13th, 2014

Why would any investment “opportunity” guarantee a negative return to its investors, who happen to be some of the shrewdest minds in the banking industry?

This situation actually exists today–and the story is interesting. The European Central Bank has recently dropped its bank deposit rate to -0.1%. That means that if European based lending institutions invest their assets in the Central Bank’s money fund, they are guaranteed to receive less money when they take it back out again. The fund is a guaranteed loser.

The comparable number in the U.S.–the return offered by the U.S. Federal Reserve to banks that want to park their excess capital in an interest-bearing account–is 0.25%. That isn’t very much, but many banks find it preferable to, for example, giving you a 30-year mortgage at around 4% (current rates, in other words) when the Fed’s own economists expect the Fed Funds rate to reach 4% sometime in the next year or two.  This explains why $4.34 trillion in bank reserves are sitting on the sidelines at a time when our economy sorely needs an investment boost. (You can see a graph of total reserve assets here: http://research.stlouisfed.org/fred2/series/WALCL). And it also explains why people with excellent credit scores are having trouble finding a bank willing to finance their home purchase.

So why has the ECB dropped its own rate below zero? By making it actually painful to park banking reserves, it wants to shake that sleeping money out of its accounts and back where it belongs: into the European economy. The strategy appears to be working; the graph below shows that reserves have dropped–very suddenly, since the announcement–to their lowest point since 2011. This may be the only example in history where billions of dollars were invested in an investment “opportunity” that was absolutely, positively guaranteed to lose money.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and

information for leading practitioners in the financial planning profession.

How to Afford Retirement      August 5th, 2014

What are the factors that you find in those fortunate people who are on track to funding an affordable retirement, vs. those who are not? An ongoing study by a mutual fund organization, drawing on data from 4,100 working adults age 18 to 65, found that the answers might be simpler than we realize.

On average, the study found that households are on track to replace 61% of their preretirement income during retirement–basically living on a little more than half of what they were making before they entered their Golden Years. But the study found that this number (again, on average) jumps to 82% for Americans who are participating in some form of defined contribution (401(k) or 403(b)) pension plan at work, and the average reaches 98%–basically, full lifestyle replacement–for people who are in plans with automatic enrollment and automatic escalation features. The automatic escalation provision takes some of the money that workers receive from future raises and puts it aside in the tax-deferred plan–before that extra money ever hits their checking account.

It is important to note that people earning low wages are replacing those low wages, and high earners are replacing much higher incomes; this study simply talks about replacing the pre-retirement income. But it appears that automated, steady savings over a worker’s lifetime, plus long-term tax-deferral, can have a powerful impact on whether or not people can afford retirement. The study also noted that people who are deferring up to 10% of their total income will (again, on average) actually live better in retirement than before; on average, they will have 111% of their pre-retirement income to spend in their golden years.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and information for leading practitioners in the financial planning profession.

 

Don’t Fear the Correction      July 28th, 2014

At of the end of June, the Standard & Poors 500 index has completed 32 full months without a correction of 10% or more.  We are living in a remarkably long bull market; the average time span without a full-blown correction is just 18 months.  Since the last correction in September of 2011, the S&P 500 has gained 75%, threatening the remarkable 100% advance that began in March of 2003 and lasted until the market peaked in October of 2007.

 Today, as the S&P moves near the 2,000 level, as the small cap Russell 2000 and the Nasdaq index both reach record highs, it may be a good time to prepare for that inevitable correction down the road.  It may take the market down 10% or, worse, reach the technical definition of a full market correction, which is a downward move of 20% or more.

 Prepare how?  First, it helps to recognize that every market has pullbacks, and that these are a normal part of stock market behavior.  Since the Great Recession lows in March 2009, the S&P index has experienced nine different corrections, ranging in magnitude from 6% to more than 21%. 

Second, it helps to recognize that these pullbacks are almost totally unpredictable.  Knowing there will be a pullback doesn’t tell us when or help us maximize returns.  If we take money out of the market today, on the certainty that a pullback is coming, we are just as likely to miss another year or two of upward movements as we are of sidestepping an immediate downturn.  Nor do we know how long the downturn will last.  Add in trading costs and taxes, and the decision to guess when to step out of the market, and back in gain, is not likely to add value in the long run.

 Third, recognize now that the next unpredictable correction will look blindingly obvious in hindsight.  It will seem like everybody but you knew in advance what was coming and when.  In reality, what you’ll be hearing is reporters quoting the same few people over and over again, people who confidently predicted that a downturn was nigh and turned out to be right.  Look a bit more deeply than the reporters do, and you’ll find that this small number of people had been predicting that the end was nigh over and over and over again for years.

 Finally, realize that inaction is actually taking strong and unusual action.  People who simply kept their money in stocks during each of the market downturns ended up seeing the indices reach new highs once the correction had run its course.  Strong long-term investors benefit from the incremental daily, weekly, monthly efforts of millions of workers who come into the offices, factories and warehouses and build the value of their companies. 

 People will change their opinions about what stocks are worth, but in general, over time, the value of most companies will rise to the extent that those workers add value during their workdays.  When people lose faith in that value, as they will when the next correction hits, it will put stocks on sale and give the rest of us an opportunity to buy in at lower prices–if we have the courage to separate ourselves from the herd.

 

By Bob Veres, publisher of Inside Information - the premier publication of financial industry trends and information for leading practitioners in the financial planning profession

 

 

Evidence for Time Diversification      July 2nd, 2014

One area where many professional advisors disagree with academics is whether stock investments tend to become less risky as you go out in time.  Advisors say that the longer you hold stocks, the more the ups and downs tend to cancel each other out, so you end up with a smaller band of outcomes than you get in any one, two or five year period.  Academics beg to disagree. They have argued that, just as it is possible to flip a coin and get 20 consecutive “heads” or “tails,” so too can an unlucky investor get a 20-year sequence of returns that crams together a series of difficult years into one unending parade of losses, something like 1917 (-18.62%), 2000 (-9.1%), 1907 (-24.21%), 2008 (-37.22%), 1876 (-14.15%), 1941 (-9.09%), 1974 (-26.95%), 1946 (-12.05%), 2002 (-22.27%), 1931(-44.20%), 1940 (-8.91%), 1884 (-12.32%), 1920 (-13.95%), 1973 (-15.03%), 1903 (-17.09%), 1966 (-10.36%), 1930 (-22.72%), 2001 (-11.98%), 1893 (-18.79%), and 1957 (-9.30%).

Based purely on U.S. data, the professional advisors seem to be getting the better of the debate, as you can see in the accompanying chart, which shows rolling returns from 1973 through mid-2009.  As you can see, the outcomes in any one year have been frighteningly hard to predict, ranging anywhere from a 60% gain to a 40% loss. But if you hold that stock portfolio for three years, the best and worst are less dramatic than the best and worst returns over one year, and the returns are flattening out gradually over 10, 15 and 20 years. No 20-year time period in this study showed a negative annual rate of return.

But this is a fairly limited data set. What happens if you look at other countries and extend this research over longer time periods? This is exactly what David Blanchett at Morningstar, Michael Finke at Texas Tech University and Wade Pfau at the American College did in a new paper, as yet unpublished, which you can find here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2320828.

The authors examined real (inflation-adjusted) historical return patterns for stocks, bonds and cash in 20 industrialized countries, each over a 113-year time period. The sample size thus represents 2,260 return years, and the authors parsed the data by individual time periods and a variety of rolling time periods, which certainly expands the sample size beyond 87 years of U.S. market behavior.

What did they find? Looking at investors with different propensities for risk, they found that in general, people experienced less risk holding more stocks over longer time periods. The only exceptions were short periods of time for investors in Italy and Australia. The effect of time-dampened returns was particularly robust in the United Kingdom, Japan, Denmark, Austria, New Zealand, South Africa and the U.S.

Overall, the authors found that a timid investor with a long-term time horizon should increase his/her equity allocation by about 2.7% for each year of that time horizon, from whatever the optimal allocation would have been for one year. The adventurous investor with low risk aversion should raise equity allocation by 1.3% a year. If that sounds backwards, consider that the timid investor started out with a much lower stock allocation than the dare-devil investor–what the authors call the “intercept” of the Y axis where the slope begins.

Does that mean that returns in the future are guaranteed to follow this pattern? Of course not. But there seems to be some mechanism that brings security prices back to some kind of “normal” long-term return. It could be explained by the fact that investors tend to be more risk-averse when valuations (represented by the P/E ratios) are most attractive (when stocks, in other words, are on sale, but investors are smarting from recent market losses), and most tolerant of risk during the later stages of bull markets (when people are sitting on significant gains). In other words, market sentiment seems to view the future opportunity backwards.

Is it possible that stocks are not really fairly priced at all times, but instead are constantly fluctuating above and below some hard-to-discern “true” or “intrinsic” value, which is rising far more steadily below the waves? That underlying growth would represent the long-term geometric investment return, more or less–or, at least, it might have a relationship with it that is not well-explored. The old saw that stocks eventually return to their real values, that the market, long-term, is a weighing machine, might be valid after all.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and information for leading practitioners in the financial planning profession.