In this section you’ll find a selection of short essays on investment topics. Please select from the list below to explore a particular subject. It is my hope to help you become a better investor. If these subjects are more than you’d like to learn I’ll be happy to assist you in making informed investing decisions.
Investment Options Beyond Bonds – Utilities & Telecom Stocks
Investment Options Beyond Bonds – Foreign Bonds
Investment Options Beyond Bonds – REITs
Investment Options Beyond Bonds – Preferred Stocks
Investment Options Beyond Bonds – Dividend Paying Stocks
Bond Investment Options
Bonds Aren’t “Safe”
Limitations of Robo-Advisors
Being Ruled by Emotion
Does Your Portfolio Have the Right Amount of Risk?
Portfolio Strategy is Critical
Poorly Designed Portfolios
Is Your Portfolio Biased to the USA?
Poor Performance of Self Directed Investors
Don’t Panic in Down Markets
Does Your Portfolio Generate an Appropriate Return?
Asset Allocation Drives Portfolio Returns
Rebalancing to Buy Low & Sell High
Avoiding Losses Is More Important Than Maximizing Returns
Use ETFs (Exchange Traded Funds)
In a previous newsletter I discussed dividend-paying stocks as an alternative to bonds. Dividend-paying stocks provide an alternative source of current income, while providing upside potential as well, making them a sensible investment option for many investors.
Many investors gravitate towards the Utility & Telecom Sectors when they seek dividend-paying stocks. Historically, these have been two of the most reliable sectors for conservative and income-oriented investors. Stocks like AT&T (Ticker symbol “T” for “Telephone”) were viewed as safe, “widows-and-orphans” stocks.
While still being an option for current income investors should take a less benign view of the Utility & Telecom Sectors than they once did. Investing in individual sectors carries a greater degree of risk than being more broadly diversified. To wit, in 2014 the Utilities Sector had strong returns. But in 2015 Utilities declined. The Utilities Select Sector SPDR ETF (XLU) declined by about 8%. Despite a dividend yield of 4% Total Return was -4%.
Telecom stocks like AT&T (T) and Verizon Communications (VZ) have traded in narrow ranges for an extended period and provide attractive yields of 4.8% (VZ) and 5.5% (T). But Telecoms are no longer the regulated monopolies they once were. Today, competition among wireless providers is increasing, and companies like AT&T have attempted to grow through more speculative means. In particular AT&T’s purchase of DirecTV looks problematic given a declining satellite-TV business.
Investors may wish to use Utility & Telecom Stocks as an alternative income source to bonds, but are advised not to consider them in the same benign manner they once did. Instead of purchasing individual Utility & Telecom Stocks, or even sector-specific ETFs, income-oriented investors may wish to consider ETFs such as the iShares Core High Dividend ETF (HDV) or Vanguard Dividend Appreciation ETF (VIG). Finally, before making individual purchases speak to an investment professional to consider your personal needs.
In my last three newsletters I discussed how dividend paying stock, preferred stock and REITs may be used as alternative vehicles to bonds in order to generate portfolio income. Let’s now consider Foreign Bonds.
Foreign Bonds are, of course, just another type of bonds. But they are worthy of mention as most investors hold bond portfolios made up mostly or entirely of U.S. Bonds, whether in the form of individual issues, mutual funds or ETFs. As a result Foreign Bonds can serve as another vehicle to diversify the typical investor’s fixed income portfolio.
In part investors tend to be under-invested in foreign bonds because in the past it was difficult. Purchasing individual bonds on foreign markets involved numerous intermediaries and relationships that often did not exist for the average investor’s investment account. The advent of mutual funds and more recently ETFs (Exchange Traded Funds) took away this obstacle. A variety of options now exist for the investor seeking to purchase foreign bonds. But why invest in foreign bonds?
The first and most obvious answer is diversification. Adding foreign bonds to a portfolio dominated by U.S. holdings simply puts some of your eggs in another basket.
Second, bond returns can be expected to vary from country to country. Presently, the U.S. Federal Reserve is raising rates. Meanwhile, Central Banks in most of the world are holding rates steady or continuing to drive rates even lower. In some cases short-term rates are even negative. Varying interest rate policies will result in differing returns, so a geographically diversified portfolio of bonds will have lower volatility over time.
Third, there are considerable options for bond investors to consider that are just as “safe” as U.S. Bonds. For example, German Sovereign Debt is generally considered to be very safe. In fact, German Bond Yields for any given maturity are much lower than their U.S. Treasury Peers. Lower yields indicate a vote of confidence by investors, who deem these bonds to hold less risk. On the Corporate Side there are just as many established, global corporations that are just as safe as large US corporate issuers.
Fourth, there are options in foreign bonds, such as Emerging Markets, that offer much higher yields. Of course this does imply a higher degree of risk, and Emerging Market Debt has sold off recently as the US Fed raises rates in the United States. But for longer-term investors Emerging Market Debt offers higher yields and potential price appreciation not presently found in US Issues.
Keep in mind that foreign bonds may be issued in local currencies or denominated in other major currencies such as the Dollar, Euro or Yen. As a result, returns measured in US Dollars will vary depending on the value of the US Dollar relative to other currencies. To address this risk investors have the option to invest in foreign bonds (or mutual funds or ETFs) that are denominated in US Dollars or are hedged against changes in the value of the dollar. Hedging has a cost, so while this will reduce short-term risk it will lower yields somewhat. Many though are willing to accept this expense in order to eliminate currency risk. Longer-term investors may wish to consider unhedged foreign bond alternatives as currency swings tend to cancel each other out over time, and yields will be higher when hedging costs do not exist.
Income-oriented investors should consider foreign bonds as one additional option for a fixed-income portfolio. Be sure to consider the issues raised above to build a suitable portfolio to address your individual needs.
In my last two newsletters I discussed how dividend paying stock & preferred stock may be used as alternative vehicles to bonds in order to generate portfolio income. Let’s now consider REITs (Real Estate Investment Trusts).
REITs are a security that allows investors to invest in portfolios of real estate, indirectly in real estate through mortgages, or in a combination of the two (a “hybrid” REIT). REITs may hold a diversified portfolio of real estate, or specialize in certain types of real estate (e.g. hotels, offices, multi-family homes) or geographies. Unlike illiquid and direct real estate holdings, REITs are liquid securities that trade on major exchanges like a stock.
REITs are income-oriented. They must have at least 100 investors, and no five investors can hold more than 50% of shares between them. At least 75% of assets must be invested in real estate, cash or U.S. Treasuries, but at least 75% of gross income must be derived from real estate. REITs are required by law to pay out at least 90% of their earnings each year in the form of a dividend. Many REITs also have DRIPs (Dividend Reinvestment Plan) that allow returns to compound over time. These features make REITs a favorite vehicle for income-oriented investors.
Because REITs are income-oriented they behave similarly to bonds. They will perform better in a falling interest rate environment and perform more poorly in a rising rate environment. Like a bond, there is an inverse relationship between price and yield. And REITs will be impacted by bond yields since they are an alternative to bonds. Investors will allocate funds between REITs and bonds depending on how each is performing.
When investing in a REIT it is important to know the long-term outlook for the underlying investments of the REIT. Since REITs must pay out at least 90% of earnings each year they cannot stockpile cash to insulate themselves from poorly-performing assets if economic circumstances worsen. Consequently, it is important that a REIT hold a solid portfolio of real estate or mortgages.
The requirement that a REIT pay out at least 90% of earnings also means that an investor can expect to incur ongoing tax liabilities when owning a REIT. One cannot defer taxes by simply deferring a sale of the security, as can often be done with a stock.
REIT risk and returns will be influenced significantly by the type of holdings owned by the REIT. For example, a REIT invested in office buildings may present lower risk, since most office buildings are leased on a long-term basis. But in a strengthening economy this lower degree of risk has a cost. Office building leases will only renew after a number of years, so rents & REIT earnings rise more slowly. In contrast, a multi-family REIT holds properties that can raise rents annually, and a Hotel REIT every day (since occupants “lease” a room for as little as one night). In a worsening economic environment the situation is reversed. A Hotel REIT’s holdings will see lower rates and lower room occupancy immediately. But an Office REIT’s holdings has tenants that are locked in for years.
Geography is also important. REITs that invest in a single country, region or city will have more volatile earnings (which can be good or bad depending on events) than a geographically-diversified REIT since economic developments will more acutely impact a single area as compared with an entire region, country or the world.
Given these characteristics an investor must consider the type of holdings of the REIT (property and/or mortgages), the mix of property type, and the geographic focus of the REIT. A small investor with limited funds may be better served by investing in a more diversified REIT, while a large investor can purchase a variety of REITs with different holdings, asset type and geographies to more directly control the desired combination of risk and returns.
REITs present one more alternative to bonds for income-oriented investors.
In my last newsletter I discussed how dividend paying stock may be used as an alternative vehicle to bonds to provide income. Preferred Stock is another alternative by which investors can obtain a regular income stream. Preferred Stock has a number of characteristics that I will discuss below. Before doing so though know that preferred stock can fluctuate in value, as with any stock, although such fluctuations will generally be less acute than with common stock, given the income component of preferred shares. Preferred stocks will also be influenced to some extent by moves in interest rates, since they are viewed in part as an alternative to bonds. Now, let’s look at some of the characteristics of preferred stock.
First, Preferred Stock may be “Participating” or “Non-Participating”. Participating Preferred Stock may receive additional dividends above and beyond the specified dividend, in the event the corporation achieves defined financial goals.
Next, Preferred Stock may be “Cumulative” or “Non-Cumulative”. With cumulative preferred stock, in the event a dividend is missed (not paid) it must be paid in the future. Non-participating preferred need not receive any missed dividend payments that may occur.
Voting Rights will generally differ from Common Stock. Preferred Stock may have special voting rights, but usually Preferred Shares will have *no* voting rights.
Preferred Shares may have a preference in receiving dividends over other share classes. Also, a corporation may issue multiple classes of Preferred Shares. Each will have different terms, and there will be a specified ranking as to the claim on corporate assets in the event of bankruptcy.
Preferred Stock may or may not have a stated PAR Value. Usually, dividend payments for preferred shares will be a negotiated, fixed amount. In most cases the dividend payment will be as a percent of the PAR Value, but it could also be a stated amount.
Preferred Shares also differ from Common Stock, because they have a higher level of protection (i.e. a Higher Claim on Assets) in the event of bankruptcy. Common stock only has a residual claim on assets, and is usually last in line to be paid in the event of bankruptcy. Still, Preferred Shares will still have a lower claim vs. bond holders and other specified claimants. Consequently, if bankruptcy is a likely outcome an investor will have a higher degree of protection by holding bonds.
Investors should also be aware of the fact that preferred stock does not have the same rights to receive payments as bonds. Bonds have a contractual obligation to pay interest. If they miss a payment they default. Preferred Shares don’t have the same legal protections.
Another important consideration is that, unlike bonds, preferred stock is not rated by a ratings agency such as Moody’s or Standard & Poor’s. An investor must rely on research (his/her own or from a third party) to determine the degree of safety of a corporation’s preferred shares.
Many other features may apply to an individual preferred stock. For example, preferred shares may be convertible into regular shares. There will generally be specified terms as to when and how such a conversion may occur. In addition, preferred shares may be perpetual, meaning they cannot be retired. In other cases a corporation may create a “Supervoting” Stock that allows a small number of shareholders to retain control of a corporation. There are too many derivations to cover here. However, just know that if you are purchasing preferred shares you should research the features of that stock. Otherwise, you may not be aware of the potential eventualities that could affect your investment.
All such circumstances aside, preferred stock is another alternative that income-oriented investors may wish to consider.
When thinking of investments to generate income, many investors think of bonds, and little else. But bonds are only one of several options to generate current income. What are some other options?
In this piece we’ll discuss the first option, dividend-paying stocks. A stock may pay a dividend (usually quarterly) or not, so be sure to check before you buy stocks, if income is your goal. Recall that some stocks pay no dividend at all. Investors in these stocks hope to realize capital gains over time through selling at a higher price. Of course dividend paying stocks also may increase in price over time, but the issuer chooses to pay out a portion of the corporation’s earnings in the form of a dividend. The percentage of income paid out is known as the “payout ratio”. Generally, corporations like to keep dividends constant or increasing over time. A cut in dividends is generally considered to be a bad sign for a stock. Investors interpret this as a sign of future financial troubles for the company, and a dividend cut usually leads to a decline in the stock’s price.
Certain sectors of the stock market are known for paying dividends. Typical sectors for dividend paying stocks are utilities, telecommunications and banks. Other sectors, especially higher-growth areas like technology, usually do not pay dividends, or only pay small dividends by the larger firms in the industry. Generally, companies experiencing high growth will not pay dividends. These companies will argue that investors and the company are better served by reinvesting corporate earnings in the company, rather than paying them out as dividends. As growth slows companies are more inclined to pay dividends, as they have fewer investment opportunities for corporate earnings, and to attract investors in order to maintain the corporation’s stock price.
Investors prefer, all else being equal, a stock that has a high dividend “yield”, which represents the annual dividend payment as a percent of the stock’s price. When dividend yields fall to average or low levels it indicates that the stock’s price is elevated, and may be likely to decline. Consequently, an investor will continue to receive a dividend, but may suffer losses due to a declining stock price. Thus, the stock’s total return (yield plus capital appreciation/decline) may be flat or negative.
Investors often select dividend paying stocks, because they may rise in price over time in addition to paying a quarterly dividend. A bond holder only receives an income stream for a specified period of time, but will never benefit if the company’s stock increases in price. In contrast a stock holder can receive an income stream through dividends while also participating in the upside generated by a rising stock price.
Finally, investors may alternate between bonds and dividend paying stocks depending on which alternative pays the higher yield (payout as a percent of security value). If stock prices are high, which generally indicates that dividend yields will be low, investors may opt for bonds, as they may pay a higher yield (i.e. the bond payment as a percent of the bond’s value is higher than the dividend yield of a dividend paying stock). If stock prices are very low, the dividend yield is likely to be high. If higher than current bond yields investors may opt for dividend paying stocks over bonds. Savvy investors often compare the yields of stocks vs. bonds as an indication of future direction in stock prices and bond yields.
As you construct your investment portfolio, consider dividend paying stocks as an alternative to bonds, or as a means to diversify a bond portfolio to include other forms of income-oriented investments. This condition applies especially to investors who need current income but have many more years before retirement. These younger-to-middle-aged investors may benefit from dividend paying stocks over bonds given the potential for long-term increases in stock prices.
Bond investing may use a variety of approaches. Options include direct investments in individual bonds, bond mutual funds, and ETFs (Exchange Traded Funds) as the most obvious alternatives.
Direct investments in individual bonds has a key advantage in that a bond may be held to maturity, and the investor controls whether or not this condition occurs. In holding a bond to maturity the investor can be assured (although credit risk a.k.a. the risk of default by the issuer) that the principal value of the bond will be collected at maturity. Additionally, the investor will (except in the case of zero coupon bonds) collect interest payments over the life of the bond. If held to maturity the yield of the bond will match exactly the coupon payment, since the bond will be redeemed at maturity for par. So yield can be defined in known and fixed terms.
While other options (mutual funds or ETFs) lack these advantages, for most investors they will be a better choice. Why? Because purchasing individual bonds is problematic in several ways. First, individual bonds typically come in large denominations. At least $25,000 or $50,000, and typically $100,000 or more per individual bond. As a result the purchase of individual bonds is not generally an option except for larger investors.
Second, individual bonds are less easily bought and sold (i.e. they are less liquid) that other securities such as stocks. Markets for bonds are less efficient, inventories of bonds are typically held by large intermediaries, and bond spreads (the difference between bid and ask prices) are generally much larger than for more liquid securities. Thus, bonds sold in small denominations (e.g. under $100,000) have higher transaction costs.
Third, because of their large denominations, it is difficult for most investors to construct a well-diversified (i.e. sector, issuer, country, maturity, credit risk) portfolio of individual bonds.
Finally, bond investing is in many ways more complex than other forms of investing. A good bond manager must be highly attuned to market developments, the future direction of interest rates, and issues such as the slope of the yield curve, interest rate risk, duration, maturity, bond rating/quality, credit risk, spreads, corporates, treasuries, munis, general obligations, revenue bonds, sovereigns, and a plethora of other issues. For all but the most seasoned bond managers these are completely foreign concepts. Mastering the impact and interaction of these factors is critical to managing a well-designed fixed income portfolio. If the intricacies/terms/concepts of bond investing are Greek to you, then by all means don’t try to “do it yourself”.
Given the complexity of purchasing and managing individual bonds most investors are better served by considering purchases of ETFs or Mutual Funds. ETFs offer advantages such as low costs, the ability to trade throughout the market day, diversification (individual ETFs will generally hold large numbers of bonds and may be in multiple or all sectors of the bond market), and liquidity. But the investor must still possess a considerable degree of sophistication to be successful in constructing an efficient bond portfolio. Virtually all of the same issues as exist with purchasing individual bonds still applies.
For most investors then bond mutual funds are the most logical answer. The investor can purchase an entire sector of bonds or even the broad market in a single fund. The investor can select an active fund managed by a professional manager or team of analysts and managers. Thus, the investor need not master the complexities of managing the portfolio.
Bond mutual funds do have some disadvantages though. First, the investor will often lack knowledge as to the holdings or strategy of the bond manager. Reports on fund holdings are generally months old at best and may have little relation to current holdings of the fund. Second, the fund will control the timing of taxable events (i.e. capital distributions). Thus, the investor can face unforeseen and material tax liabilities. Third, because the mutual fund has no set maturity, but rather an indefinite life, the fund and the investor are exposed to interest rate risk. This means that movements in interest rates (not only short-term but across all maturities) will drive gains and losses in the principal value of individual bonds held by the fund, and thus the NAV (Net Asset Value) of fund shares themselves. In a declining rate environment this will lead to an increase in the value of fund shares. But in an increasing rate environment the value of the bond fund may be negative, at times even exceeding the yield (in simple terms the interest payments collected) of the fund.
Bond investors face risk in using mutual funds. But for most, given the considerable knowledge and challenges presented by the use of individual bonds or ETFs, mutual funds with their professional management, provides a good trade-off. An investor is in a better position to use ETFs or individual bonds if he/she is working with a professional financial advisor.
Investors frequently subscribe to the theory that “Bonds are ‘safe’ while stocks are ‘risky'”. This is a naïve view and one that can cause an investor to incur considerable losses.
Where did this conventional wisdom come from? Well, this benign view towards bonds has largely come about, because we’ve witnessed a three decade long bull market in bonds. Take a look at the following chart.
The chart shows how bond yields for U.S. Treasuries spiked in the early 1980’s, when inflation was high. After then Fed Chief Paul Volker raised rates to record levels, inflation was finally beaten. As inflation declined over the ensuing three decades yields on bonds continually declined. Why? Because bond investors typically want a set return over the term of a bond’s life, and the main factor that erodes those returns is inflation. As inflation came down the yield that investors demanded declined as well.
The other key factor, one often not understood by investors, is that bond yields and bond prices move *inversely*. That is to say that as rates move up bonds become less valuable, and as rates come down, existing bonds become more valuable. Why? Because investors are willing to pay more for a bond that has an attractive yield (i.e. series of interest payments). Over time the price of an existing bond with an attractive yield is bid up, until the yield offered (i.e. interest payments as a percent of the bond’s value) by the bond is equal to that of newly issued bonds. In other words investors will pay a premium (a price above par) for a bond that pays a yield above those offered by newly issued bonds.
This condition existed for over three decades. So as new bonds were issued at lower-and-lower-rates, existing bonds increased in value. This is called “rolling down the yield curve”. As shown in the chart above, it’s a phenomenon that went on for over 30 years. Not only did bond investors collect their interest payments, but the bonds themselves became more valuable as rates came down.
In such an environment investors adopted the conventional wisdom that “bonds are safe, while stocks are risky”. But this view is a dangerous one, because interest rates have now bottomed and are heading back up. It is unlikely that for most investors an environment such as we’ve seen in since the 1980s will exist again.
With rates now likely to increase going forward investors must understand that the value of existing bonds will *decrease*. In many cases reducing the value of bonds beyond the interest paid by those bonds. So total returns (interest payments plus principal value) may be reduced, flat, and in many cases even *negative*.
Don’t be fooled by the conventional wisdom. All securities, including bonds, carry risk. If you’ve been lulled into a false sense of security about bonds, you may incur losses in the years to come.
Robo-Advisors have recently become a new product offering that has attracted a lot of attention among cost-conscious investors. Their appeal centers on their low cost. Using a Robo-Advisor, an investor answers a few simple questions about one’s risk tolerance, investing goals, and investable funds. The Robo-Advisor then constructs a portfolio for the investor that is periodically rebalanced and managed with no required input by the investor.
For some investors, particularly more experienced individuals, a Robo-advisor may make sense. Especially if one’s needs and investable funds are limited. But what are the limitations of Robo-Advisors?
The primary limitation of Robo-advisors, is that they construct portfolios based solely on historical, “backward looking”, statistical information. In particular, the co-variance of individual securities in the portfolio is examined in order to construct a portfolio with the appropriate expected return and risk (i.e. volatility or variation of returns). While in theory this approach is adequate, the key problem is that the portfolio is not “forward looking” and cannot anticipate the impact of current and potential future events. Instead, only historical and statistical information is considered. Current & future eventualities are ignored.
What will be the impact on markets of the Fed’s future rate increases? How will markets react to developments in the 2016 Presidential Race? What will markets do in reaction to Russia’s (Putin’s) next steps in Syria? How will future policy decisions by China’s Leadership impact markets in 2016? The Robo-Advisor can’t anticipate any of these events, because it can only look at historical statistical information. So the Robo-Advisor constructs a portfolio in the same way that you’d drive your car if you could only use the rearview mirror to decide where to drive. A challenging technique to say the least. Extrapolating historical trends into the future is limited & flawed logic. Further, it cannot anticipate future “inflection points” (major up or down movements). The Robo-Advisor has low fees, in large part because there’s no human “behind the wheel”. The GPS may have the destination programmed into it, and tell you how to get there, but it has no eyes looking ahead to tell you that the bridge on your intended route is out, or that construction ahead requires a detour unknown to the GPS.
The other major limitation of the Robo-Advisor is that it cannot account for the reactions of the investor him/herself. Too often the problem is not the portfolio, but the investor that owns it. The Robo-Advisor may have constructed a reasonable portfolio based on historical events, which may even be suitable (assuming no unforeseen events occur) for a five, ten or twenty year investment horizon. But how will you react when the market looks over-valued, or worse sells off by 10%, 20% or 50%? The Robo-Advisor will not automatically adjust your portfolio, or take half of your “risky assets” off the table. It can’t see the bump in the road ahead, because it’s only using the rear-view mirror to drive. Will you panic and sell out just as the market bottoms? Who will you call? Will the Robo-Advisor hold your hand and interpret current and future events for you? No, because it’s software, not a person.
Robo-Advisors may seem appealing if your goal is to reduce fees. Just understand that you have a tool that can only look backwards, won’t anticipate future events, won’t adjust your portfolio using experience and intuition, and won’t talk to you when you are worried about the market. As always you get what you pay for.
Being Ruled by Emotion
Investors, particularly “self-directed” investors, typically make a number of common mistakes in managing their money. The key reason is that they are driven by emotion. Specifically greed and fear.
The first rule of making money is to “buy low and sell high”. Being led by your emotions generally means that you will “buy high and sell low”. Exactly the opposite of what you should do. This causes most investors to continually underperform the market, and too often to lose large portions of their wealth.
Why is this so? Because investors (whether dealing with stocks, homes, or any other investment) too often wait for long periods of time to convince themselves that the market is “safe”. They reach this conclusion after watching it go up for many years. Then, having concluded that the market is “safe”, they “back up the truck” and start buying stocks and other investments just shortly before the market peaks. In the worst cases, such as the “dot bomb” crash of Internet stocks starting in 2000 or the financial crises in 2008 (where individuals bought homes they couldn’t afford, started “flipping homes”, and other such moves) investors get into the market too late, and then do so with both feet. They are ruled by greed.
After the market has sold off dramatically, investors too often go on to lose money in two ways. First, they panic and sell out just as the market is bottoming. Fear takes over. Emotions once again guide the decision making, and investors sell at the bottom, before they “lose more money”. Second, having observed the sell-off they retreat to “safe investments” (e.g. bank savings or CDs that pay little or nothing). They fail to “buy low”. And the vicious cycle of emotional-based decision making starts all over again with the next cycle.
Never get emotional about money. If you can’t do that, get someone to hold your hand or to provide help.
Investors often take on too much or too little risk. Frequently, they don’t understand their risk tolerance. In many cases they invest in risky stocks, concentrate their holdings in a single company (often their employer’s stock) or a single industry (e.g. technology), or buy whatever a friend or colleague recommends. Another mistake is to buy a number of mutual funds or ETFs (Exchange Traded Funds) that all invest in similar companies, industries or markets. The investor has the illusion of being diversified, when in reality their portfolio is highly risky with little diversification.
Trying to be “safe” by taking on too little risk can be just as devastating over the long-term. With inflation in the United States recently running around 2% a year your portfolio must grow more than 2% each year just to stay even (in real purchasing power). Investors who pile into cash earn zero return on their money. Usually they fail to understand that their portfolio is decreasing in value by 2% per year, given the impact of inflation. In 20 years’ time a portfolio invested in cash will be worth only about 2/3rds of its original value, given the ravages of inflation over time. Thus, being “safe” generally will make you poor over the long-term. Since 2009 many investors held large portions of their portfolios in cash, also missing out while the markets generally doubled in value.
Contact me to evaluate your risk tolerance and the current risk score of your existing portfolio. With only 5-10 questions I can tell you where you stand, using a quantitative tool based on an economic framework that won the Nobel Prize for Economics.
Continuing with our theme of common investor mistakes, the next issue we’ll examine is the investor that has no clear strategy. This is a common phenomenon, where the investor has no clear idea of his/her needs, goals, risk tolerance, timeline or income requirements. With no clear idea of what they are trying to achieve, and how to do it, many investors are susceptible to investing in whatever some “expert”, friend, colleague or other trusted individual recommends. The resulting portfolio is a “bit of this, a bit of that”, is likely not well diversified, and may contain one or two “time-bombs” that could go off at any moment, for reasons unknown or unforeseen to the investor.
In financial industry terms such investors constitute what are referred to as being the “dumb money”. They buy securities that are being pushed by a broker or advisor (who will earn attractive commissions or other forms of compensation for the broker/advisor or his/her firm); a financial services firm (that is trying to sell a security on behalf of a corporate client, such as an IPO); or in the worst case a disreputable individual engaging in the practice of “pump and dump”, where a market is made for a security (usually a thinly-traded security) that the representative purchased earlier and is now selling to unsuspecting individuals (playing on the investor’s greed). In other cases an investor might make a purchase decision all on his or her own, but with no clear idea of what they are trying to accomplish. Usually, they just think a particular investment will “do well”.
Before you invest be sure to have a clear set of goals in mind (i.e. time frame, risk tolerance, income requirements, expected returns, etc.). Also make sure to understand what types of assets are suitable given these defined goals. Ask how the person selling you a security is compensated. If it’s via a large upfront fee be particularly careful. Also look for hidden ways the seller is compensated, perhaps in lower than usual returns to the investor for a particular type of investment (with the difference being kept by the seller). As you build the portfolio compare how an incremental investment compares and contrasts with other holdings and how it will improve the return/risk characteristics of the portfolio. Developing a clear investing strategy, with holdings that match that strategy, is critical to long-term investing success.
Several more common investor mistakes are worth examining in this and future newsletters. Today we’ll examine the mistake of “chasing performance”.
Chasing performance is the tendency of investors to buy a stock, ETF, mutual fund or other financial instrument after it has had a prolonged period of outperformance. In this way it is similar to the tendency of individual investors who buy at the top of the market. Usually, the logic is something along the lines of “Look, the XYZ mutual fund has been up an average of 17% for the last three years. I want to get in on that!” More often than not the investor does just that, buying a large holding, just before the fund (or stock, ETF, etc.) incurs a major sell-off. Worse, many investors go on to do this repeatedly.
Don’t assume that a security is a good buy, just because it has done well in recent years. Adopt a forward-looking perspective when buying a stock, fund or ETF, and purchase it based on its forward-looking outlook. Have a well-reasoned purpose in buying a security, based on a credible investment thesis. Although a strong performance of late may be reason to examine a security, don’t buy it based on historical performance alone.
A risk that commonly exists in investor portfolios stems from a concentration of holdings in a particular industry, company or market. In some cases investors are unaware of their concentrated holdings. In other cases they mistakenly believe that they are “reducing their risk” by investing in a “company (or industry, market) they know”.
Whatever the reason, holding too much of one’s portfolio in a particular stock/industry/market may result in significant volatility and losses. Today, there is generally a high degree of correlation between the movements of closely-related securities. In order to reduce this risk the portfolio should be invested in a number of asset classes that are less correlated. For example a mix of stocks and fixed income securities; equities in different geographies; or equities in different market capitalizations (e.g. large, mid & small-cap stocks).
Making the risk more acute, investors will often hold a large share of stock in their employer’s stock (in individual shares, a pension or 401K plan, or a stock option plan). In this case poor performance by a company’s stock will likely occur when the company runs into unfavorable circumstances. Just as the stock falls in value the stockholder also loses his/her job! In the worst case scenario (e.g. The Dot Com Crash in the SF Bay Area in 2000/2001) many in the tech industry simultaneously lost their jobs, home values, and value held in stock option plans.
Mitigate risk by investing in a well-diversified portfolio, with a significant portion of one’s holdings in industries and markets unrelated to one’s job, industry or home market.
Too often investors will have a poorly designed portfolio. One that is not well matched to their income requirements, investment time frame, or risk tolerance. Asset allocation may be inappropriate or non-existent.
An individual requiring current income will want to consider fixed income investments (e.g. bonds), dividend paying stocks, REITs (Real Estate Investment Trusts), and other investments designed to generate current income. The longer the time frame one has to invest the more risk one can/should generally assume. In general a portfolio with more risk will generate higher expected returns over time, and near-term volatility can be overcome as the investor is not in a position where he/she needs to sell. One’s risk tolerance should also match that of the portfolio. Commonly investors will have no understanding of the risk (too little or too much) of their portfolio, or whether this matches their personal disposition (i.e. risk tolerance). If you can’t sleep at night you will be inclined to panic when volatility hits the markets. Or you will be unaware that your portfolio generates inadequate returns, even if it is “safe”.
Portfolios should also be invested in a number of different asset classes (e.g. Equities in different markets, fixed income, commodities, real estate, alternative investments such as private equity, etc.) that deliver appropriate expected returns, have suitable risk/return characteristics for the investor, and generate the required degree of current income. Investing in different asset classes also lowers the degree of correlation between individual holdings in the portfolio, lowering the degree of volatility for a particular expected return. This makes the portfolio more “efficient” (i.e. the portfolio generates the maximum amount of return for each unit of risk).
If you’d like to know your personal risk score, or the amount of risk contained in your current portfolio, please send an email to pgaylord AT gaylordwealth.com. I’ll be happy to help you understand your current situation with no obligation on your part.
For much of the 20th Century the United States held a dominant position in the global economy. This made the USA the logical place to invest for much of the last century. The USA offered a larger and dominant economy in which to invest, well-developed capital markets, and the rule of law. This made the USA a good choice for US and Foreign Investors alike.
Things began to change in the past one-to-two generations, as Europe emerged from the ravages of World War II, Japan became a major economy, and countries like the “Four Tigers” (Hong Kong, Singapore, Taiwan and South Korea) grew to become major players on the global scene.
Political change in the 80’s and 90’s, with the end of the Cold War and the Emergence of China, have brought economic development to places like Eastern Europe and China. Meanwhile, regions such as Southeast Asia have emerged to become rapidly growing economies in countries like Thailand, Malaysia and Indonesia. India has become a significant engine of economic growth, as well as other countries such as South Africa, Turkey, Dubai (UAE), Brazil, Mexico, and many other emerging markets.
Despite these rapid changes, many investors continue to invest solely (or almost exclusively) in the United States. Doing so will cause them to miss new opportunities while concentrating risk driven by events impacting the United States. Often investors view the USA as being “safe”, and the rest of the world as being “risky”. Such a view is outdated and misguided at best. All markets contain risks and opportunities. To be successful in investing one should adopt a global view to match the realities of the 21st Century.
Investors often prefer to be “self-directed”. For some this may make sense, but for most it is very costly. Ironically, many chose this route because of concerns over fees, only to lose much more through poor performance. In earlier newsletters we have already reviewed a variety of mistakes that investors commonly make. To recap, these include habits such as taking on too much (or little) risk, lacking experience or knowledge of investment best practices, lacking a clear strategy, chasing performance, lacking diversification & concentrating risks in a particular asset class, having a poorly designed portfolio, and biasing the portfolio to the US, among other mistakes. But perhaps the biggest mistake is being driven by emotions, specifically fear and greed. This drives most investors to “buy high” (when they perceive the market as being “safe”) and “sell low” (when they panic and sell out).
The combination of these factors results in poor performance by the average “self-directed” investor. JP Morgan, utilizing the net of mutual fund sales, redemptions and exchanges, calculated that the average investor over a 20 year period from 1993 – 2012 realized an annual return of only 2.3%. Meanwhile, in the same period the S&P500 had an annual return of 8.2%. Other asset classes (i.e. REITs) achieved double-digit returns in the same period. Worse, because inflation increased at a rate of 2.5% in this period, the average investor actually lost an average of 0.2% per year in real terms (actual purchasing power) as their performance lagged behind the average rate of inflation.
Investing mistakes, a focus on fees, and the belief that they can “do it yourself” causes the “self-directed” investor to achieve poor portfolio returns.
Recent (originally published in August, 2015 following the mid-2015 mid-year sell-off) market turmoil caused many investors to panic. As we’ve discussed, it is critical that an investor match the risk of his/her portfolio to one’s personal risk tolerance. Otherwise, panic may set in and investment decisions will be driven by emotion.
Remember, in 90% of such cases the best course of action is to do nothing. Stay calm. Don’t panic. Stick to your long-term plan. If you understand your risk tolerance and have matched the risk of your portfolio to your risk tolerance, you will be fine.
If this month’s market turmoil caused you to panic or you can’t sleep at night, pay attention. Take the necessary steps now to be better prepared for future volatility.
In today’s Investor Education Section we’ll look at the subject of expected return. A portfolio should deliver an appropriate expected return given the investing goals (i.e. time frame, income needs, etc.) of the investor. In general we should expect to have a higher return for an incremental amount of risk, with risk meaning variation (above or below) the target expected return.
This risk/reward relationship can be seen in the differences of investments such as money market accounts, bonds, stocks and other investment vehicles. A money market account will have a low rate of return (or today little or no return), but its value will not vary in the short-term. As a result the money market account may be well suited to meet near-term spending requirements, but it is poorly-suited for long-term investing needs, as it will generate an inadequate return over time. At the other end of the spectrum stocks are arguably the best long-term investment vehicle (e.g. funding a retirement 30 years in the future) but poorly suited as an asset to cover immediate income needs since they can significantly decline in value with no advance notice. Most other investments fall somewhere between these two extremes.
Of course these characteristics seem immediately obvious. Yet many investors keep high concentrations of ill-suited assets in their portfolios, given their investment goals. Think of the investor that needs to fund a college education in three years, yet has a high proportion of a portfolio in private equity or stocks (hoping to have a bigger nest egg later on). A major near-term loss may make it impossible to pay a tuition bill in the near-future, given inadequate time for the portfolio to increase in value again after a major sell-off.
Meanwhile, an investor fearful of losses after events like the 2008 Financial Crises or this year’s Summer Correction keeps a large portion of a portfolio in cash, which provides inadequate or no return and shrinks in value each year (in real terms) due to inflation. Such an investor faces no near-term risk, yet has inadequate resources in the long-term to meet costly goals like retirement. Further, an investor with this approach also experiences an “opportunity cost”, as the funds are not held in another asset class that will deliver a higher return, capable of funding the long-term goal.
A well-designed portfolio must have the appropriate risk/return relationship given the goals and needs of the investor. Yet many investors fail to examine and adjust their holdings to meet their immediate needs, or allow the portfolio to “drift” over time, as the holdings are not updated to meet evolving needs and investment time-frames.
Many investors try (usually to no avail) to “beat the market” via their efforts to be a “stock picker”. They focus on finding individual stocks that will be a “ten bagger” (increase in price tenfold) or become the next Facebook or Google. Many brokers and financial advisors make a career out of providing “hot tips” that get investors to place orders. Too often the only party that gets rich from this are the brokers that collect the resulting sales commissions.
In contrast to such efforts studies have repeatedly shown that 90% of portfolio returns result from Asset Allocation while only 10% comes from Securities Selection. In light of this fact the focus for more experienced investors has shifted from picking stocks to determining the appropriate asset allocation for their portfolio.
Managing a portfolio in this manner through a process called “Strategic Asset Allocation” involves two steps. First, determining the appropriate “Asset Classes” for a particular investor’s portfolio, such as “U.S. Large Cap Equities” or “Emerging Market Debt”. Second, determining the appropriate “Allocation” or percentage of the total portfolio held in each Asset Class.
Determining the appropriate Asset Allocation is the key to generating portfolio returns over time.
Periodic Rebalancing is a key element in successful investing, used in conjunction with Target Allocations for the portfolio’s Asset Classes. Rebalancing involves the sale or purchase of securities to bring the portfolio back to the original target allocation. As an asset class increases in value periodic sales are made such that the original allocation for the asset class is established once more. Similarly, when an asset class has decreased in value periodic purchases are made to achieve the same goal. Rebalancing in such a manner takes emotion out of the equation. Further, it results in the investor buying low and selling high.
The frequency with which one rebalances may vary. More frequent rebalancing will keep the portfolio closer to its target allocations, but will result in higher transaction costs. All else being equal an investor with a smaller portfolio will rebalance less frequently, as transaction costs will be higher relative to the total portfolio value. Most investors will rebalance on a monthly, quarterly or annual basis, although any frequency that makes sense to the particular situation may be appropriate. As an example, a rapid rise or fall in a particular asset class may warrant rebalancing of a portfolio before it otherwise would be made.
Rebalancing will result in capital gains & losses. Consequently, there will be tax implications. However, it is important to consider that investment policy should drive tax considerations, and not the other way around. Failing to rebalance may result in temporary tax savings, but ultimately will take the portfolio off track resulting in greater portfolio risk and potential investment losses that outweigh any tax savings that might have otherwise been realized. Allowing tax considerations to drive investment decisions is myopic and ill-advised.
Changes in target allocations will sometimes be made based on evolving market conditions and changes in one’s long-term view. However, in-between such changes rebalancing is a key tool to help keep a portfolio on track.
Another of the key mistakes made by investors is a reluctance to admit mistakes. Of course mistakes sometimes do occur, because nobody has a crystal ball, and even well-researched and well-reasoned decisions don’t work out.
Studies have shown that the pleasure obtained by realizing a gain is less than the remorse felt by admitting a mistake. In practical terms this means most investors will not sell at a loss, because they don’t want to admit having made a “mistake”. In their mind, as long as a losing position is held there remains the hope that it will go back to the price paid for the investment, and perhaps even generate gains one day.
This phenomenon is known as “loss aversion” and the related problem of using a “reference point” (e.g. the price paid for a stock) to determine whether an investment should or should not be sold.
Loss aversion causes you to hold onto losers. Loss aversion causes you to avoid recognizing a loss, even if you could take the proceeds, and buying another investment that has better chances of future gains.
Reference points causes you to consider your purchase price to decide whether to sell a losing position. But your reference point (i.e. price paid) is of no relevance. All that matters is if the investment you now hold (at a loss) is likely to go up in the future or not. If not then sell it. Put the money to better use elsewhere. Use the capital losses to offset gains from other investment sales. The two net against one another and reduces your income tax liabilities. The tax benefit alone allows you to realize hard dollar benefits from a losing investment, even if your proceeds invested elsewhere don’t increase in value.
Finally, investments that turn out to be losers often lead to larger losses later. It is important to examine why an investment decreased in value, and what is likely to happen to it in the future. If there’s not a compelling reason to think it will go back up (again, what you paid for it is irrelevant and has no bearing on this determination) then continuing to hold onto it may lead to further losses going forward.
Many investors, with their reliance on reference points and tendency to experience loss aversion, have turned small losses into big losses. The “Dot Bomb” tech crash of 2000 is a prime example of this. Far too many investors kept expecting a rebound when their stocks went down, down, down. Losses of 20%, 30% and 40% turned into losses of 80%, 90% or even 100%.
Don’t get emotional about stocks. Don’t fall in love with your stocks. Don’t be afraid to admit losses and move on.
Investors typically focus on maximizing returns in their portfolios. Too often this drives them to take on more risky, and perhaps even speculative investments. Expectations of annual double digit returns become the norm. In contrast the stock market in the United States over the past century has generally delivered real returns (nominal returns less the rate of inflation) of 6.5%. All too often then investors have unrealistic expectations.
What many investors fail to realize is that avoiding losses is usually much more important than incremental gains. The following chart shows the major declines in the S&P500 from 1945 – 2010.
We see 13 declines in excess of 20% in this period of time or about one major decline every 5 years. Further, the worst two declines are the two most recent, with a 49% sell-off in the bursting of the Dot Com Bubble, and a 52% decline in the Financial Crises of 2008. The more speculative your investments, the time at which you buy and sell your investments, and other factors (e.g. diversification, use of margin, etc.) can make your individual losses more acute.
In simple mathematical returns, if you lose 50% of your wealth, you must realize a 100% gain just to get back to your starting point. The likelihood that you’ll face this requirement increases as your expectations for returns become more unrealistic. Double digit returns are not the norm over extended periods of time. If you think they are and you select your investments accordingly, you increase the likelihood of major losses during market downturns.
Set realistic goals when you construct your investment portfolio.
Most investors have grown up with the notion that picking the right stock is the key to solid returns in their portfolios. This view is generally favored by stock brokers and many financial advisors, who profit by selling particular financial products, or believe they can show their investment savvy by telling clients about a “hot stock”. Investors also have a tendency to remember the stocks they’ve made big gains with while forgetting their losers. This tendency makes investors feel better and their advisors look smarter.
In reality though, 90% of portfolio gains come through an optimal asset allocation, rather than security selection (i.e. “stock picking”). This reality makes the use of ETFs (Exchange Traded Funds) an attractive alternative for most investors. At a minimum ETFs can form the “core” of an investor’s portfolio, while individual securities may also be held. In so doing the portfolio will be less likely to vary widely from the performance of the broader market.
In short an ETF is a security that trades like a stock, throughout the trading day. This contrasts with a mutual fund, which are priced and bought or sold with the day’s closing price. Usually, an ETF will represent a major index, sector, country, asset class or other basket of securities. The ETF Sponsor will hold the underlying securities, but the ETF shares are separate and bought and sold between market participants. This is another major distinction from mutual funds, where the fund manager will often need to buy or sell the underlying securities if sell orders exceed available cash or purchase orders exceed redemptions. In contrast an ETF trade order will usually not require any purchase or sale of the underlying security need occur for the functioning of the ETF Market Making Process. In the majority of cases only the ETF shares themselves will trade, except when major market moves causes a disparity between the ETF share price and the value of underlying securities held by the ETF.
Recent volatility in the markets did impact some ETFs, when trading of underlying securities where temporarily halted as intraday price movements hit predetermined “circuit breaker” levels. This made it impossible for ETFs to accurate price their securities, causing some traders to get sales/purchase prices that varied materially from the ETFs actual value. As a result of these incidents it is advisable to use Limit Orders when trading ETFs rather than Market Orders.
In my last newsletter I discussed the benefits of using ETFs (Exchange Traded Funds) in a portfolio. In this newsletter I’ll quickly summarize the key benefits of ETFs in bullet format. They are as follows:
- Broad Market Exposure (e.g. country, market, index, asset class, etc.).
- Ability to trade a broad basket of securities in a single trade.
- Immediate Trade Execution. ETFs trade throughout the day.
- Low Expenses
- Transparency. Holdings are known.
- Markets are efficient. Active Managers lag their benchmarks 90% of the time.
- Control. You know exactly what the ETF owns. How current events will impact the value of the ETF.
- Liquidity. In most cases (especially with large ETFs) positions can generally be bought or sold quickly.
- Efficiency. The largest, most liquid ETFs generally have reasonably small bid/ask spreads.
- Using a single family of ETFs (e.g. iShares, Vanguard, Spyders/SSGA) eliminates the risk of overlap in fund holdings.
In certain markets, especially small/mid-cap foreign stocks and in global bond markets (including the USA) markets still lack complete efficiency. Meaning information is not disseminated immediately to all market participants. This leaves room for active managers to add value. However, in most cases in developed markets (especially in equities in the USA, Europe, Japan and other developed markets) information is ubiquitous and travels instantaneously. This fact, and the benefits outlined above, makes ETFs an attractive tool for investors to achieve their investment goals. They are well-suited to build an entire portfolio, or to build a “core portfolio”, complimented with individual stocks, bonds and other securities.
The summer sell-off of 2015 bore very little similarities with 2008. The Financial Crises of 2008 was caused by systemic failures, with an overheated housing market, combined with lax financing practices, which caused a near collapse of the world’s banking system. Quite serious indeed, but a unique situation unlike anything that had happened since the Great Depression. Clearly 2008 showed severe problems that had to be addressed, but 2015’s summer sell-off had no signs of being a systemic failure of the financial system. Rather, all indications were that it was just the type of normal correction that is usually observed every year or two in the market. In 2015 we just hadn’t seen a correction since 2011. As a result many investors over-reacted and panicked. But the proper response was to sit tight and stay calm. Those that did so have been rewarded in recent weeks.
The key take-away is that events like 2008 are memorable for a reason. Specifically, because they are uncommon and traumatic. Investors should keep this fact in mind as they assess current and future volatility in the markets. Remain vigilant, but don’t over-react to events. Assess what is driving current circumstances. But don’t assume that disaster lurks around every corner merely because one has memories of unpleasant historic events.
Keep calm and carry on.
Many investors and investment managers maintain a clear bias to the USA. It is not uncommon to find that a majority, if not all, of an investor’s holdings are in US Securities. While the rationale may have made sense even into the late 20th Century it clearly is outdated thinking for the 21st Century.
Consider that the United States today makes up less than one-fourth of the global economy. Irrespective of its relative advantages and disadvantages, investing most or all of one’s portfolio in a market that makes up less than 25% of the global economy concentrates risk in a single market. It goes against the prudent practice of diversification.
On the flip side a US-bias ignores the realities of the 21st Century, where 3/4ths of the global economy, and the majority of future growth, lies outside of our borders.
For the more risk averse investor one should consider investments in Europe, Japan, Australia, and other Developed Markets such as Hong Kong and Singapore. Dominant global corporations and brands are located throughout these nations and should be a part of most investors’ portfolios. The Debt of Nations such as Germany is often considered safer than that of the United States. Presently Germany’s 10 Year Bonds (i.e. the “Bund”) trades at yields only about one quarter that of the U.S. 10 Year Treasury. Thus, investors consider German Debt to be less risky than U.S. Debt of the same maturity. In turn they demand only ¼ of the yield for the right to hold it.
Emerging Markets are more volatile, but make up the vast majority of growth opportunities that will occur in the 21st Century. Today China makes up 14% of Global GDP and 1/3 of Global Growth. The desire of China’s Communist Party to maintain stability and keep a hold on power makes it necessary to implement continued reforms to unleash the potential of the Chinese Economy. This in turn will lead to future growth. Collectively, Asia will make up 70% of the Global Economy in 20 years. A natural consequence of holding the majority of the world’s people, younger & faster growing populations, and key developing markets such as China, India, and the ASEAN (Southeast Asia) Nations. Despite recent volatility these markets are growing at 3-7% per year rather than 1-3%. With most of the world’s economic growth taking place in Asia an investor who allocates none of his/her portfolio to this region will miss all of the future opportunities and growth offered there.
Other Emerging (e.g. Latin/South America) and Frontier (e.g. Africa) Markets hold significant investment potential, especially if economic reforms take hold.
In general an investor should probably consider placing at least 10-20% of his/her portfolio in Developed Markets and 5-10% in Emerging Markets. A small allocation to Frontier Markets should also be considered for the longer-term, growth investor. For the more globally-minded investor, allocating a larger amount overseas may make sense.
Whatever one’s risk tolerance and investment goals putting all of one’s eggs in the USA-basket, especially in the 21st Century with most growth and economic activity taking place outside of our borders, is an ill-advised, 20th Century Strategy.
Circular 230 Notice: The information presented here has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained on this website without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained on this website, and Gaylord Wealth Management, LLC, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting or refraining to act, in reliance on the information contained on this website or for any decision based on it.
Peter Gaylord, CFA
Gaylord Wealth Management, LLC
535 Mission Street
San Francisco, CA 94105
+1 (415) 971-7529
pgaylord AT gaylordwealth.com