Category Archives for "Investment Planning"

Nov 18

Seven Year End Wealth Management Strategies

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

Photo by rawpixel on Unsplash

Seven Year End Wealth Management Strategies

As we approach the end of a lackluster year in the financial markets, there is still time to improve your financial position with a few well placed year-end moves .

Maybe because we are working against a deadline, many year-end planning opportunities seem to be tax related .  Tax moves, however, should be made with your overall long-term financial and investment planning context in mind. Make sure to check in with your financial and tax advisors.

Here are seven important moves to focus your efforts on that will help you make the best of the rest of your financial year .

1) Harvest your Tax Losses in Your Taxable Accounts

As of[ October 26, the Dow Jones is up 1.65%, and the S&P500 is up just 0.98% ]for the year. Unfortunately, many stocks and mutual funds are down for the year. Therefore you are likely to have a number of items in your portfolio that show up in red when you check the “unrealized gains and losses” column on your brokerage statement.

You can still make an omelet out of these cracked eggs by harvesting your losses for tax purposes . The IRS individual deduction for capital losses is limited to a maximum of $3,000 for 2018.  So, if you only dispose of your losers, you could end up with a tax loss carryforward, i.e., tax losses you would have to use in future years. This is not an ideal scenario!

However, you can also offset your losses against gains. For example, if you were to sell some losers and hypothetically accumulate $10,000 in losses, you could then also sell some winners. If the gains in your winners add to $10,000, you have offset your gains with losses, and you will not owe capital gain taxes on that joint trade!

This could be a great tool to help you rebalance your portfolio with a low tax impact. Beware though that you have to wait 30 days before buying back the positions that you have sold to stay clear of the wash sale rule.

2) Reassess your Investment Planning

Tax loss harvesting is a great tactic to use for short-term advantage. As an important side benefit, it allows you to focus on more fundamental issues. Why did you buy these securities that you just sold? Presumably, they played an important role in your investing strategy. And now that you have accumulated cash, it’s important to re-invest mindfully.

You may be tempted to stay on the sideline for a while and see how the market shakes out.  Although we may have been spoiled into complacency after the Great Recession, the last month has reminded us that volatility happens.

No one knows when the next bear market will happen , if it has not started already. It is high time to ask yourself whether you and your portfolio are ready for a significant potential downturn.

Take the opportunity to review your goals, ensure that your portfolio risk matches your goals and that your asset allocation matches your risk target..

3) Check on your Retirement Planning

It is not too late to top out your retirement account!  In 2018, you may contribute a maximum of $18,500 from your salary, including employer match to a 401(k), TSP, 403(b), or 457 retirement plan, subject to the terms of your plan. Those who are age 50 or over may contribute an additional $6,000 for the year.

If you have contributed less than the limit to your plan, there may still be time! You have until December 31 to maximize contributions for 2018, reduce your 2018 taxable income (if you contribute to a Traditional plan), and give a boost to your retirement planning.

Alternatively to deferring a portion of your salary to your employer’s Traditional plan on a pre-tax basis, you may be able to contribute to a Roth account if that is a plan option for your employer. As with a Roth IRA, contributions to the Roth 401(k) are made after tax, while distributions in retirement are tax-free.

Many employers have added the Roth feature to their employee retirement plans. If yours has not, have a chat with your HR department!

Although the media has popularized the Roth account as tax-free, bear in mind that it is not. Roth accounts are merely taxed differently . Check in with your Certified Financial Planner practitioner to determine whether electing to defer a portion of your salary to on a pre-tax basis or to a Roth account on a post-tax basis would suit your situation better.

4) Roth Conversions

The current tax environment is especially favorable to Roth conversions . Under the current law, income tax rates are scheduled to go back up in 2026; hence Roth conversions could be suitable for more people until then.

With a Roth conversion, you withdraw money from a Traditional retirement account where assets grow tax-deferred, pay income taxes on the withdrawal, and roll the assets into a Roth account. Once in a Roth account, the assets can grow and be withdrawn tax-free, provided certain requirements are met. If you believe that your tax bracket will be higher in the future than it is now, you could be a good candidate for a Roth conversion .

Read more about the new tax law and Roth conversions

5) Pick your Health Plan Carefully

It is health insurance re-enrollment season! The annual ritual of picking a health insurance plan is on to us. This could be one of your more significant financial decisions for the short term. Not only is health insurance expensive, it is only getting more so.

First, you need to decide whether to subscribe to a traditional plan that has a “low” deductible or to a high deductible option.  The tradeoff is that the high deductible option has a less expensive premium. However, should you have a lot of health issues you might end up spending more.  High deductible plans are paired with Health Savings Accounts (HSA).

The HSA is a unique instrument. It allows you to save money pre-tax and to pay for qualified healthcare expenses tax-free. Unlike Flexible Spending Accounts (FSAs), balances in HSAs may be carried over to future years and invested to allow for potential earnings growth. This last feature is really exciting to wealth managers: in the right situation clients could end up saving a lot of money.

If you pick a high deductible plan, make sure to fund your HSA to the maximum. Employers will often contribute also to encourage you to choose that option.  If you select a low deductible plan, make sure to put the appropriate amount in your Flexible Spending Account. FSAs are used to pay for medical expenses on a pretax basis. Unlike with an HSA, you cannot rollover unspent amounts to future years.

 

Gozha net on Unsplash

6) If you are past 70, plan your RMDs

If you are past 70, make sure that you take your Required Minimum Distributions (RMDs) each year. The 50% penalty for not taking the RMD is steep. You must withdraw your first minimum distribution by April 1 of the year following the year in which you turn 70 ½, and then by December 31 for each year after.

Perhaps you don’t need the RMD? You may want to redirect the money to another cause. For instance, you may want to fund a grandchild’s 529 educational account. 529 accounts are tax-advantaged accounts for education. Although contributions are post-tax, growth and distributions are tax-free if they are used for educational purposes.

Or, you may want to plan for a Qualified Charitable Distribution from the IRA and take a tax deduction. The distribution must be directly from the IRA to the charity. It is excluded from taxable income and can count towards your RMD under certain conditions.

7) Plan your charitable donations

Speaking of charitable donations, they can also be used to reduce taxable income and provide financial planning benefits. However, as a result of the Tax Cut and Jobs Act of 2017 (TCJA), it may be more complicated than in previous years. One significant difference of the TCJA is that standard deductions went up to $12,000 for individuals and $24,000 for married filing jointly. Practically what that means is that you need to accumulate $12,000 or $24,000 of deductible items before you can feel the tax savings benefit.

In other words, if a married couple filing jointly has $8,000 in real estate taxes and $5,000 of state income taxes for a total of $13,000 of deductions, they are better off taking the standard $24,000 deduction. They would have to donate $7,000 before they could start to feel the tax benefit of their donation.  One way to deal with that is to bundle your gifts in a given year instead of spreading them over many years.

For instance, if you plan to give in 2018 and also in 2019, consider bundling your donations and giving just in 2019. In this way, you are more likely to be able to exceed the standard deduction limit.

If your thinking wheels are running after reading this article, you may want to check in with your wealth manager or financial planner: there may be other things that you could or should do before the end of the year!

 

Check these other wealth management posts:

Is the TCJA an opportunity for Roth conversions?

New Year Resolution

How to Implement a New Year Resolution

Tax Season Dilemna: Invest ina Traditional IRA or a Roth IRA 

 

 

 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented.  To determine investments that may be appropriate for you, consult with your financial planner before investing. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions.

We make no representation as to the completeness or accuracy of information provided at the websites linked in this newsletter. When you access one of these websites, you assume total responsibility and risk for your use of the websites to which you are linking. We are not liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, websites, information, and programs made available through this website.  

Sep 18

3 Simple Ways to Avoid Ruining Your Retirement

By Eric Weigel | Investment Planning , Retirement Planning , Sustainable Investing

3 Simple Ways to Avoid Ruining Your Retirement

 

Photo by Melvin Thambi on Unsplash

 

What’s your “Probability of Ruin”?

Many people considering retirement or in the early phases of this new stage in life worry about outliving their assets.  

These individuals no longer have the luxury of a steady paycheck, and unless they are one of the lucky ones with a defined benefit plan and/or a large portfolio of liquid investments, they will have to dip into their 401k’s and savings to fund their lifestyle.

Somebody in the de-accumulation phase will naturally worry about how long their money will last and whether they can maintain their lifestyles.

People are living longer these days and it is not unheard of for a newly minted retiree to live another 30 years.  

Let’s look at the data. According to the Social Security Actuarial Life Table (2014) estimates, life expectancy for a 65 male is 17.81 years and for a female 20.36 years.  Somebody in above average health may live even longer – these are just median numbers. If you want to conduct your own calculations, you can refer to How Long Will You Live?

David Blanchett of Morningstar uses the 2012 Society of Actuaries annuity table to estimate the likelihood of living to a certain age using the methodology outlined in his 2013 FPA journal article. This cohort of individuals comes from a higher than average socio-economic group and tends to live longer than average.

Table 1 highlights the calculations from the perspective of a 65-year-old. There is a 50% chance that a male lives to age 89 with a female living to age 91.

Table 1

 Life Expectancy

Source: David Blanchett, Morningstar

The point of these projections is that most people should plan for a long period in retirement. The good news is that we are living longer today but the bad news is that we need to make our retirement savings last longer if we are to maintain a certain lifestyle.

Some people retire with very healthy nest eggs that, barring a cataclysmic event, will provide plenty of cash to fund their lifestyles.  They need not worry much as long as assets vastly outstrip expenses.  They have a high margin of safety.

For most retirees, however, the margin of safety provided by their financial assets in relation to their expenses is slimmer.  They do need to worry about how much they are spending, how their investments are performing and how long they may need their portfolio assets to last.  They may have other sources of income such as Social Security but still need to make their investment portfolios work hard to bridge the gap between lifestyle expenses and sources of income.

Most people in retirement face a balancing act

They can control their expenses to some extent (putting off non-essential expenses).  They can plan and make sure that their investment portfolios are structured in accordance with their appetite and need for risk-taking (maybe requiring the help of a financial professional). But what they can’t control are capital market returns and how long they need to tap into their retirement accounts (how long they will live).

One way to identify the various trade-offs required to ensure the sustainability of an investment portfolio is to come up with a CHRIS, a Comprehensive Holistic Retirement Investment Strategy with the help of a financial professional.  A good plan should clearly outline what actions you need to take and what type of minimum portfolio return you will need to achieve to ensure that the probability of running out of money before you or your partner/spouse die is within your comfort zone.

Another alternative is to forego a formal financial plan and utilize some sort of rule of thumb such as William Bengen’s 4% rule. According to this highly popular rule published in 1994, you can safely withdraw 4% of your capital every year in retirement.  The research contains a number of key assumptions (such as a 50/50 stock/bond allocation) often ignored in the popular press, but the Bengen rule is not only well known but popular among many retirees.

Should one just jump ahead in and rely on the Bengen 4% rule? Our view is that before you do so, you really should understand the probability of running out of money.

Milevsky and Robinson provide a simple approach in their highly touted article A Sustainable Spending Rate without Simulation to calculating what they call the “probability of ruin.”

Milevsky and Robinson identify three important factors: your rate of consumption, the risk/reward structure of your portfolio, and how long you live. Visually, these concepts can be illustrated in a Retirement Finances Triangle as depicted in Figure 1.

Without going into the mathematics of the Milevsky and Robinson approach for calculating a “probability of ruin” lets us think a bit more deeply about what makes retirement planning complicated in the first place.

 Figure 1

The first aspect that makes retirement planning difficult is the uncertainty surrounding how long you and your spouse/partner are going to live. People are living longer, on average, than in previous generations. But an average does not necessarily help you.  Your physical and mental health could be dramatically different from the “average” individual.

The other variable that is highly uncertain and makes retirement planning more difficult relates to the variability of investment outcomes on your retirement portfolio.  While history is a guide as to what to reasonably expect in terms of key asset class returns and risks over the long-term, in any given year returns could fall within a wide range.

As most people already know, stock returns exhibit more variability in outcomes than bonds.  The “probability of ruin” calculation using the Milevsky and Robinson formula incorporates the ability of individuals to evaluate the implications of various forms of asset allocation with varying levels of expected risk and return.

As you have probably figured out by now, calculating the “probability of ruin” is extremely important in planning your retirement.

The Setting:

To make the situation more realistic let’s look through the eyes of George and Mandy, both aged 65 and about to retire from their corporate jobs.  They have saved diligently over the years and now have a portfolio worth $1,000,000 that they will tap to fund their lifestyle in retirement.

The Problem:

George and Mandy estimate that they will need $90,000 a year to maintain their lifestyle.  Their Certified Financial Planner has also told them that their Social Security income will be $50,000 a year.  They face an annual gap of $40,000. They expect to tap into their retirement portfolio to fund this gap.

They are in reasonably good health and based on discussions with their financial planner they assume that they will live to age 90. To be safe, they assume a retirement horizon of 30 years.

Their starting portfolio value is $1,000,000 and they wish to withdraw $40,000 a year to fund their living expenses.

Capital Market Assumptions:

We assume that inflation will run 3% per year, on average.  Currently, inflation is running a bit lower than 3% in the US but the historical average is only slightly north of 3%.

What sort of investment risk and return assumptions should people use to calculate the probability of running out of money under this scenario?

Past returns are often a poor guide in forecasting returns and George and Mandy decide as a starting point to use the current Insight Financial Strategists long-term capital market assumed risk and return numbers as outlined in Table 2. These numbers are derived from expected long-term growth, profitability and starting valuation relationships.  They should be viewed as purely hypothetical and subject to great variation.

For illustrative purposes only, Insight Financial Strategists has aggregated all the asset class risk and return numbers into six multi-asset class strategy portfolios according to investment risk – Conservative, Moderate Conservative, Moderate, Moderate Aggressive, Aggressive and the industry convention of a 60/40 balanced strategy.

Table 2

Source: Insight Financial Strategists

Let’s start out gently – the Case of No Uncertainty:

It always helps to start off with a hypothetical scenario where all decision elements are known with certainty up front. We assume that George and Mandy own a 60/40 portfolio returning 4.9% per year and an annual inflation rate of 3%.

If they were to withdraw the equivalent of $40,000 a year in inflation-adjusted terms what would the required distribution look like over their retirement years?

Figure 1

Source: Insight Financial Strategists

The red line in Figure 1 depicts what would happen to their expenses in retirement if inflation were to rise every year by 3%.

What started off as a withdrawal of $40,000 turns into a much larger number over time. For example, after ten years they would need to withdraw $52,000 each year to fund their lifestyle (assuming that their Social Security checks are adjusted annually for inflation as is the current practice).

After 20 years they would need to withdraw $70,000 from their portfolio each year and after 30 years (their last year in their calculations) the number would increase to $94,000 annually. Inflation can sure take a bite!

In terms of George and Mandy’s portfolio, the assumption is that it will yield 4.9% per year or in inflation-adjusted terms, 1.9% per year. After withdrawals are taken out of the portfolio by George and Mandy to fund their lifestyle net of portfolio returns (the assumed 4.9% nominal return per year) the assumed value of the portfolio is depicted in Figure 2.

 Figure 2

Source: Insight Financial Strategists

At the end of the 30th year, the portfolio is expected to be worth $277K.  As long as George and Mandy only live 30 years in retirement and the assumed inflation and portfolio returns prove spot on (accurate) then things should be ok.  They will glide through retirement and even have some assets left over.

The problem occurs if either George and/or Mandy live past age 95. According to the actuarial data in Table 1, there is a 25% chance that George will live to age 99 and Mandy will live to age 101.

Now what? Their current $1,000,000 portfolio is now insufficient to fund their retirement expenses past the age of 97.  They will run out of money and not be able to rely on portfolio income anymore.

What could they do to prevent such an unpleasant outcome?

For starters, they could spend less. For example, they could cut back their annual spending to $30,000.

They could also shoot for higher portfolio returns by taking on a bit more investment risk.  George and Mandy understand that higher portfolio returns are not generated out of thin air.  Higher prospective returns are tied to higher risks.

But does the real world work like this?

Is it just a matter of pulling some levers here and there and voila you have wished for the perfect outcome?

Unfortunately, referring to the Retirement Finances Triangle depicted in Figure 1 although there are some things that George and Mandy can control such as their expenses but when it comes to how long they will live and how their portfolio will actually perform over their retirement years there are lots of unknowns.

Let’s deal with the real world – Introducing Uncertainty:

What if George and/or Mandy live longer than the assumed 30-year lifespan? This is what professionals refer to as longevity risk.  Living a high quality, long life is a very noble and common goal. Outliving your assets is a real fear.

What if portfolio returns do not measure up to our assumed returns? This is referred to as investment risk. What happens if investment returns are significantly below expectations and portfolio income proves insufficient to maintain your desired lifestyle?  Most retirees seek some margin of safety in their investments for this exact reason.

The Milevsky and Robinson formula is designed to take these uncertainties into account by modeling the likely distribution of portfolio returns and longevity.  The end output is a probability of running out of money at some point in time over the retirement horizon.  They refer to this number as the “probability of ruin”.

Let’s start by looking at the implications of the various portfolios strategies presented in Table 1. The Conservative strategy is the least risky approach but also has the lowest prospective returns. This strategy is exclusively composed of bonds.

The Aggressive strategy is exclusively composed of equities and is expected to have the highest returns as well as the highest risk of all of our strategies.

The 60/40 strategy falls along the middle in terms of prospective portfolio returns and risk.

What do the different risk and return profiles of the strategies imply in terms of the probability of ruin of George and Mandy’s portfolio?

Figure 3 depicts graphically the output from the Milevsky and Robinson formula.

Figure 3

Source: Insight Financial Strategists

What immediately jumps out from the bar charts is that the probability of ruin for the various portfolios is quite high. No longer assuming that everything is perfect creates, not surprisingly, more difficult likely outcomes.

For example, if George and Mandy were to employ the Conservative strategy yielding an assumed 2.3% annual return there is an 80% probability of them running out of money at some point in retirement.  Being conservative has its drawbacks!

What if they had the internal fortitude to employ the all-equity Aggressive strategy yielding a prospective return of 6.8% with a volatility of 17%? Their probability of ruin would drop to 37%.

Even if they employed the conventional 60/40 strategy, their probability of ruin would still exceed 45%.

What if the probability of running out of money is too high? 

Well, for starters they could reduce their rate of consumption, i.e. spend less. Maybe not what they wanted to hear but possible.

Let’s assume that instead of taking out $40,000 a year from their investment accounts they withdraw only $30,000? Let’s also assume that they invest in the traditional 60/40 portfolio. The only thing that has changed from the previous scenario is that now George and Mandy are spending only 3% of their initial portfolio to fund their lifestyle.

By spending less and thus depleting their investment assets at a slower rate, they lower their probability of running out of money at some point over their remaining lives to 30%. George and Mandy start thinking that maybe searching for a more inexpensive vacation option makes sense and allow them to worry less about outliving their assets.

 Figure 4

Source: Insight Financial Strategists

 

What else can they do to shift the odds in their favor?

Besides spending less, another option is to work a bit longer and postpone their retirement date. Let’s say they both work five years longer than originally planned.   What would happen assuming that they still intend to withdraw $40,000 in portfolio income and they invest in the 60/40 strategy?

Figure 5

Source: Insight Financial Strategists

By delaying retirement for five years George and Mandy lower the probability of running out of money to below 38%. Not bad but maybe not quite to their satisfaction.

Could George and Mandy restructure their investment portfolio to improve their odds?

Yes, that is certainly a feasible approach as we already outlined in Figure 3.  Higher return strategies carry higher risk but when held over the long-term tend to lower the probability of running out of money.

But not everybody is equally comfortable taking investment risk even if it is likely to result in higher ending portfolio values over the long-term.

Is there another approach to design a more suitable retirement portfolio?

While risk and return are inextricably intertwined, recent financial research has identified the “low volatility” anomaly where lower volatility stocks outperform their higher volatility cohorts on a risk-adjusted basis.  See this note for an introduction to the low volatility anomaly.

Let’s say that instead of assuming a 10.4% volatility for the 60/40 portfolio we are able to utilize a mixture of similar investment vehicles designed to exhibit lower levels of volatility but equivalent returns. Say the volatility of this strategy is now 8.4% and uses a range of lower volatility fixed income and equity approaches plus possibly an allocation to a guaranteed annuity.

Figure 6 illustrates the implications of using the lower volatility investment strategy.  The probability of ruin goes down marginally to below 42%.  Good but not great in the eyes of George and Mandy.

Figure 6

Source: Insight Financial Strategists

What else can George and Mandy do? 

After all, they have evaluated the impact of lowering their expenses, deferring their retirement date and structuring a more suitable investment portfolio and they still are uncomfortable with a probability of ruin in the 30% range.

The short answer as in many areas of life is to do a bunch of small things.  They could elect to just lower their spending from 4% to 3% and the probability of running out of money would drop to about 30%.

But George and Mandy realize that they could do even better by doing all three things:

  • Spending less
  • Working a bit longer
  • Structuring a more suitable investment portfolio

Figure 7 highlights the various alternative courses of action that they could take to increase the odds of not running out of money in retirement.

Figure 7

Source: Insight Financial Strategists

There are no guarantees in life, but spending less, delaying retirement and designing a more suitable portfolio lowers the probability of running out of money to about 20%.

While we all strive for control, George and Mandy are comfortable with this approach and the sacrifices required. To them leading a fulfilling life in retirement is more than just about money and sacrificing a bit in order to gain peace of mind is a worthwhile trade-off.

_________________________________________________________________________

What does calculating the probability of running out of money in retirement teach us?

Is the trade-off that George and Mandy are making appropriate for you? Maybe, but maybe not. At the very least, understanding your own circumstances and your own probability of running out of money may lead to vastly different choices.

Your retirement could extend for 30+ years. Having enough resources to fund your retirement is important to maintain your lifestyle and achieve peace of mind.

While much of life is beyond our control, everybody can still exert some influence over their retirement planning.  In this article we highlighted three general strategies:

  • Adjusting your spending
  • Delaying when you tap your retirement resources
  • Designing an investment portfolio that suitably balances risk and reward

As people enter retirement, they can’t eliminate either longevity or investment risk. What they can do is manage the risks and remain open to adapting their plan should things change.

At Insight Financial Strategists we don’t believe in shortcuts. A CHRIS, a Comprehensive Holistic Retirement Income Strategy, gives you the best chance of full understanding your circumstances and what needs to happen to fund your lifestyle in retirement.

Barring a full financial plan, at a minimum people should evaluate the likelihood of running out of money. Applying the Milevsky and Robinson formula represents a starting point for an in-depth conversation about your needs, goals and especially your attitude toward risk and capacity to absorb losses.

Interested in having the professionals at Insight Financial Strategists guide you? Please request a complimentary strategy session here.

______________________________________________________________________________

Disclaimer:

Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including the risk of loss.

 

Aug 13

Is Your Caution Today Hurting Your Tomorrow?

By Eric Weigel | Financial Planning , Investment Planning , Retirement Planning , Sustainable Investing

Photo by Goh Rhy Yan on Unsplash

A Hypothetical Case of Fear vs Greed Tradeoffs

How our brain works:

We all think that we are fully rational all the time but in reality the way our brains operate that is not always the case.

One of the key functions of the brain is self-defense. When the brain perceives danger it makes automatic adjustments to protect itself.  When it perceives discomfort it seeks to engage in an action that removes the stress.

In his book “Thinking Fast and Slow” Nobel Prize Winner Daniel Kahneman explains how we all have a two way system of thinking that we use to make decisions.  He labels the two components as System 1 (Thinking Fast) and System 2 (Thinking Slow).

System 1 is automatic, fast responding and emotional. System 2 is slower, reflective and analytical.

Think of your System 1 as your gut reaction and your System 2 as your conscious, logical thought.

While we all like to think that our key life decisions are governed by our logical thought (System 2) research has shown that even major decisions are often driven by our gut feel.

Which System do we use to make a decision? That depends on the problem. If we have seen the problem many times before such as what to do when see a red light we default to our automatic System 1 thinking.

When we face a challenge or issue that we have not seen before or maybe infrequently we tend to use System 2, our more reflective and analytical capabilities.

Kahneman’s research shows that we spend most of our time in System 1. While most people think of themselves as being rational and deliberate in their decision making, the reality is that we often employ “short-cuts” or heuristics to make decisions.

Most of the time, these “short-cuts” work just fine but occasionally for more difficult or complex problems the impressions arrived from System 1 thinking can lead us astray.

Why? Above all else, System 1 thinking seeks to create quick and coherent stories based on first impressions.  These impressions are a function of what our brain is sensing at that moment in time.

According to Kahneman, conclusions are easily reached despite often contradictory information as System 1 has little knowledge of logic and statistics. He calls this phenomenon – WYSIATIfor “what you see is all there is”.

The main implication from WYSIATI is that people often over-emphasize evidence that they are familiar with and ignore evidence that may be much more relevant to the problem at hand but that they are not fully aware of.

System 1 conclusions therefore may be biased and lead to decision “short-cuts” or heuristics that seriously impair the quality of a decision.

What makes making “money” decisions so hard?

When it comes to investing people often rely too much on System 1 or automatic thinking. The research shows that we are not infallible and we in fact often make behavioral mistakes. Sometimes we over-rely on our gut feel without properly evaluating the consequences of our actions.

Often our brain perceives of the dangers first and sends us a warning signal to be careful.  Losing money puts us on red alert.

Behavioral finance research (for example in the book Nudge) has shown that losing money makes you twice as miserable as gaining the same amount makes you happy. People are loss averse.

Loss aversion makes people overvalue what they have due to a reluctance to incur any losses should they make a change. What they give up, sometimes unknowingly, is potential upside.

Loss aversion creates inertia. Inertia often works against investors that overvalue the attractiveness of their current holdings.

There are different degrees of loss aversion.  According to Prospect Theory, all investors value gains less than losses but some exhibit an extreme dislike for potential losses that significantly hinders their long-term wealth creation potential.

Nobody likes to lose money, but taking on risk in order to compound your hard earned savings is an integral feature of how capital markets work.  You don’t get a higher reward unless you take additional risk.

Most investors know that stocks do better than bonds over the long-term but that the price of these higher returns is more risk.  Investors also understand that bonds do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.

But knowledge stored in your logical and analytical System 2 thinking does not always make it through in the face of stress or uncertainty.

People can become too risk averse for a couple of reasons:

  • Case A: They let their fears and emotions guide their investment decision making and give disproportionate importance to avoiding any losses
  • Case B: They fail to calibrate their expectations to the likely frequency of outcomes.

In Case A, investors seek the perceived safety of bonds often not realizing that as interest rates go up bonds can lose money.  Or they simply pile into CD’s not realizing that their returns most often fail to keep up with inflation. Stocks are frowned upon because you can lose money.

Investors in Case A let their decisions be driven by emotion and fear and will over-value the importance of safety and under-value the importance of future portfolio growth.  Their account balances will not go down much when capital markets experience distress, but neither will they go up much during equity bull markets.

In Case B investors mis-calibrate their expectations for various investment outcomes and the consequences can be as dire as in the first situation.  Behavioral finance research has shown that investors frequently over-estimate the likelihood and magnitude of extreme events such as stock market corrections.

Investors often become fixated on what could happen should an equity market correction occur, but they fail to properly evaluate the likelihood and magnitude of such a correction in relation to historical precedents.  They also importantly fail to properly calibrate the probability of observing a recovery after going through such a correction.

What are the implications for investors playing it too safe?

Let’s consider the case of investors currently working and saving a portion of their income to fund a long-term goal such as retirement. These individuals are in the accumulation phase of their financial lives.

Somebody in the accumulation phase will naturally worry more about how fast they can grow their portfolio over time and whether they will reach their “number”.  People in the accumulation phase care primarily about their balances going up year after year. They are in “growth” mode.

The Hypothetical Setting:

To better illustrate this situation let’s look through the eyes of a recent college grad called Pablo earning $40,000 a year. Pablo is aware of the need to save part of his salary and invest for the long-term.  He just turned 22 and expects to work for 40 years.

Pablo will also be receiving annual 2.5% merit salary increases which will allow him to save a greater amount each year in the future.

The Problem:

Pablo faces two key decisions – what percentage of his salary to save each year and the aggressiveness of his portfolio which in turn will determine its most likely return.

He is conflicted. He has never made this much money before and worries about losing money. He also understands that he alone is responsible for his long-term financial success.

Pablo knows that there is a trade off between risk and return but he wants to make a smart decision. His System 1 thinking is saying play it safe and don’t expose yourself to potential loses.

At the same time his rational and informed System 2 thinking is influenced by a couple of finance and economics classes he recently took while in college.

Pablo can succumb to automatic System 1 thinking and invest in a very conservative portfolio. Or he can rely on his System 2 thinking and invest in a higher risk and commensurately higher return portfolio.

 

One Alternative – Save 10% of his Income and play it safe investing

For simplicity sake assume that Pablo decides to put 10% of his salary into an investment fund. The fund consists primarily of high grade bonds such as those contained in the AGG exchange traded fund.

From the knowledge gained in his econ and finance classes Pablo estimates that this portfolio should return about 4% per year – a bit below the historical norm for bonds but consistent with market interest rates as of August 2018.

Pablo also understands that such a portfolio will have a bit of variability from year to year. He estimates that the volatility of this portfolio is likely to be about 6% per year. Again, this estimate is in line with current bond market behavior as of August of 2018.

He knows that this is a low risk, low return portfolio but the chances of this portfolio suffering a catastrophic loss are negligible. He is petrified of losing money so this portfolio might fit the bill.

How large could his portfolio be expected grow to over 40 years of saving and investing in this conservative manner?  We built a spreadsheet to figure this out. We assumed a 4% portfolio return on principal, 2.5% annual salary increases and a half year of investment returns on annual contributions also at 4%.  Remember that this is a hypothetical example with no guarantee of returns.

At the end of 40 years Pablo’s salary is assumed to have grown to $107,403 and his portfolio, invested in this conservative manner, would have a balance of $575,540.  The growth of this portfolio (identified as 10_4) is shown in Figure 1. The naming convention for the portfolios corresponds to the savings rate followed by the assumed hypothetical rate of return on the strategy.

Figure 1

Source: Insight Financial Strategists, Hypothetical Example

Pablo knows that his portfolio will not exactly return 4% every year. Some years will be better, other years much worse but over the next 40 years the returns are likely to average close to 4%.

But Pablo does not feel comfortable just dealing in averages.  If things go bad, how bad could it be?

Given the volatility of this conservative portfolio there is a 10% chance of losing 3.6% in any given year. These numbers are calculated by Insight Financial Strategists based on an approximation of a log-normal simulation and are available upon request. Not catastrophic but nobody likes losing money.

Figure 2 shows the 90th and 10th probability bands for this conservative portfolio. These bands are estimated based on the expected average return of the portfolio and its volatility.

The actual portfolio return would be expected to lie about 2/3 of the time within these bands. In the short-term, say 1 to 2 years out, the portfolio returns are more unpredictable.  Over longer horizons, the average return to this conservative portfolio should fall within much tighter bands given the assumed risk and return numbers in the log-normal simulation.

Based on the calculations, the average returns over ten years should range between 6.3% and 1.4% per annum. Clearly, even this conservative portfolio has some risk especially in the short-term, but over longer holding periods returns should smooth out.

Figure 2

Source: Insight Financial Strategists, log-normal simulation using 4% assumed return and 6% volatility

Another Alternative – Save 20% of his Income and continue investing in a conservative portfolio

Assuming the same 2.5% annual salary increases, the final salary would have been the same but his nest egg would have grown to $1,151,080. Pablo keeps looking at Figure 1 (the 20_4 line representing a 20% savings rate invested at an assumed 4%) and starts thinking that maybe a bit of extra saving would be a very good thing.

He still has a 10% probability of being down 3.6% in any given year, but if his budget allows, he feels that he can forego some frills until later.

Now, Pablo is starting to get excited and wonders what would happen if he invested more aggressively, say in a variety of equity funds?

Yet Another Alternative – Keep saving the same amount but invest more aggressively

The likely returns would go up but so would his risk. He estimates that based on current market conditions and the history of stock market returns (obtained from Professor Damodaran of NYU) that this more aggressive portfolio should have about an 8% annual rate of return with a volatility of around 14% per year. These estimates are both a bit lower than the 1926-2017 average reflecting higher current (as of August 2018) valuations and lower levels of overall market volatility.

He is thinking that maybe by taking more risk in his portfolio during his working years he will be able to build a nest egg that may even allow him for some luxuries down the road.

He also knows that things do not always work out every year as expected. Pablo is pretty confident that 8% is a reasonable expectation averaged over many years, but how bad could it be in any given year?

A log-normal simulation was conducted using the assumed risk and return numbers – same approach as before.

Figure 3 shows the 90th and 10th percentile bands for this portfolio.

Figure 3

Source: Insight Financial Strategists, log-normal simulation using an assumed 8% return and 14% volatility

Given the volatility of this equity-oriented portfolio, there is a 10% chance of losing 9.2% in any given year (based on the simulations). Ouch, the reality of equity investing is starting to sink in for Pablo.

But Pablo is also encouraged to see that his returns in any given year are equally likely to be about 26% or higher. That would be nice!

Especially when it comes to equities there is a wide range of potential returns but over time these year by year fluctuations should average out to a much narrower range of outcomes. While our best estimate is that this portfolio will return on average 8% per year over a ten-year window the range of expected outcomes should be between a high of 12.9% and a low of 1.6%.

Pablo decides to research the history of stock, bond, and cash returns by reading our April Blog on Understanding Asset Class Risk and Return and looking at a chart of long-term returns from Morningstar (Figure 4).

Figure 4

Source: Morningstar

He is surprised to find that over the long-term equities do not seem as risky as he previously thought. He is also quite surprised by the wide gap in wealth created by stocks versus bonds and cash.

The research makes Pablo re-calibrate his expectations and he starts wondering whether the short-term discomfort of owning equities is worth it in the long run.

____________________________________________________________________

The “Aha!” Moment:

Pablo’s System 1 thinking is on high alert and his first thought after seeing how much he could lose investing in equities is to run back to the safety of the bond portfolio.

But something tells him to slow down a bit and think harder. This is a big decision for him and his System 2 thinking is kicking in. Before he throws the towel in on the equity-oriented portfolio he glances again at Figure 1 to see what might happen if he invests more aggressively.

What he sees astounds him. It is one thing to see compounding in capital market charts and yet another to see it in action on your behalf. Small differences over the short term amount to very large numbers over long periods of time.

If Pablo were to invest in the more aggressive portfolio there would be more hiccups over the years but his ending account balance should be $1,440,075 if he consistently put aside 10% of his salary every year.

If he saved 20% the ending portfolio balance would double in size.

Decision Time – Picking among the alternatives

Pablo is now faced with a tough decision.  Does he play it safe and go with the conservative portfolio? Or, does he go for more risk hoping to end up with a much larger nest egg but knowing that the ride may be rough at times?

Beyond the numbers, he realizes that he needs to look within to make the best possible decision.  His System 1 thinking is telling him to flee, but his System 2 thinking is asking him to think more logically about his choices.  He also needs to deal with how much he is planning to save from his salary.

Fear versus Greed:

He needs to come to terms with how much risk he is willing to take and whether he can stomach the dips in account balance when investing in riskier assets.  As Mike Tyson used to say, “Everybody has a plan until they get hit in the face”.

In structuring his investment portfolio Pablo needs to balance fear with greed.  Paying attention to risk is absolutely necessary but always in moderation and in the context of historical precedents.  If Pablo lets his fears run amuck he may have to accept much lower returns.

With the benefit of hindsight, he may come to regret his caution. On the other hand, the blind pursuit of greed and a disregard for risk may also in hindsight come back to bite him.  Pablo needs to find that happy medium but only he can decide what is right for him. Risk questionnaires can help in this regard. Try ours if you like!

Consumption Today versus Tomorrow:

Pablo also needs to come to grips with how much current consumption he is willing to forego in order to save and invest.  We live in an impulse oriented society. Spending is easy, saving is hard.

Saving is hard especially when you are starting out.  On the other hand, over time the saving habit becomes an ingrained behavior.  The saving habit goes a long way toward ensuring financial health and the sooner people start the better.

Will Pablo be able to save 10% of his salary? Or, even better will he be able to squeeze out some additional expenditures and raise his saving to 20%?

If possible Pablo should consider putting as much money in tax-deferred investment vehicles such as a 401(k). He should also have these contributions and any other savings automatically deducted from his paycheck. That way he won’t get used to spending that money. Pablo may come to see these deductions from his paycheck as a “bonus” funding future consumption.

 

“The greatest mistake you can make in life is to continually be afraid you will make one”

— ELBERT HUBBARD

___________________________________________

Lessons Learned:

This has been an eye-opening experience for our hypothetical friend Pablo.  He was not expecting such a difference in potential performance.  He now realizes the importance of maximizing saving for tomorrow as well as not succumbing to fear when investing for the long-term.

He has learned several invaluable lessons that also apply to individuals in the accumulation phase of their financial lives

Lesson 1: The Importance of Saving

  • Delaying consumption today allows you fund your lifestyle in the future
  • Saving even small amounts makes a big difference over the long-term

Lesson 2: The value of patience and a long-term perspective

  • In the early years you may not notice much of a difference in portfolio values
  • Keep saving and investing – disregard short-term market noise and stick to a plan

Lesson 3: Small differences in returns can amount to huge differences in portfolio values

  • Seemingly tiny differences in returns can result in large differences in portfolio values
  • Compounding is magic – take advantage of it when you can

Lesson 4: The importance of dealing with your fear of losing money

  • Letting your first instinct to avoid risky investments dictate what you own will work against you
  • Investing involves risk – best to manage rather than avoid risk
  • The pain and agony of losing money in any given year is alleviated over the long term by the higher returns typically accruing to higher risk investments

Lesson 5: Investing in your financial education pays off

  • Gaining a proper understanding of capital market relationships is an invaluable skill to possess
  • Leaning on financial experts to expedite your learning is no different than when athletes hire a coach

____________________________________________________________________

Now what should you do?

Avoid all risks, save a lot and watch your investment account grow slowly but smoothly? Or, take some risk and grow your portfolio more rapidly but with some hiccups?

Are a couple of restless night’s worth the higher potential returns in your portfolio? On

Also, are you willing to delay some current consumption in order to invest for the future?

The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses.

Interested in having the professionals at IFS identify your risk tolerance, time horizon, and financial needs? Please schedule a complimentary consultation here.

____________________________________________________________________

Disclaimer:

Much of the data used in these illustrations comes courtesy of Professor Aswath Domodaran from NYU and covers US annual asset returns from 1928 to 2017. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including risk of loss.

 

Jul 19

Post-Divorce Investments – What do I need to plan for now?

By Eric Weigel | Divorce Planning , Investment Planning , Portfolio Construction , Risk Management

Making Your Post-Divorce Portfolio Reflect the New You

Divorce is the final step of a long process. Whether the marriage was long or short, the end of marriage brings about the conclusion of an important phase of your life.

Divorce is an emotional event sometimes anticipated years in advance and at other times coming totally out the blue.

In all cases whether anticipated or not, divorce is a stressful event. According to the Holmes-Rahe Life Stress Inventory Scale divorce ranks as the second most stressful event that a person can experience in a lifetime.

Typically when you divorce you end up with an investment portfolio that is ½ of your old couple’s portfolios. Invariably, your new portfolio will not be suitable anymore.  If you haven’t been the “financial” person in your marriage you may not even know what you own.

Most likely you will need to make changes to your portfolio to suit your new situation. You are now also solely responsible for your financial health.

Your post-divorce portfolio should reflect your updated needs, objectives and comfort level with investment risk.  This may not be what you bargained for or you may feel ill-prepared to handle this on your own.  You may feel that your life is out of your sync, but aligning your financial assets to your new situation is entirely under your control.

Why do you need a new portfolio once you divorce?

For one, the dollar amounts are less than before and your current investment strategy reflects your goals as a couple rather than your own objectives going forward.

Moreover, most likely your confidence is a bit shot and your desire to take much investment risk is lower than before.

Ok, are you with me? You can control this aspect of your new life. What steps should you take to get the ball rolling?

We suggest an approach rooted in our P.R.O.A.C.T.I.V.E methodology.

The first step involves thoroughly examining your new situation from a non-financial standpoint.  Where do you want to live? What type of lifestyle are you looking for? If you have children what type of issues do you need to account for?

The second step is to re-evaluate your comfort with taking investment risk.  Now that you are solely in charge of your financial life how do you feel about taking on risk? Are you comfortable with the inevitable stock market swoons that occur periodically? Are you able to think as a long-term investor given your recent divorce?

The next step is really important. Your post-divorce portfolio needs to work for you. Establishing a hierarchy of financial objectives will drive the type of strategy that is most appropriate for you.

Is your primary objective to save for retirement? Do you have any major objectives besides retirement? Maybe you need to fund college tuition for your two kids.  Maybe you plan on buying a new home in 2 years once your life has settled down?

Next you need to deal with the nitty gritty of figuring out exactly what you own and cash flow budgeting.  What you own should not be difficult to figure out as you have just gone through the divorce process.

The second part of cash flow budgeting is often highly sensitive for people not used to budgeting during their marriage.  If you have never had a budget or stuck to one this step seems like a major imposition. But unless money is so plentiful you have no choice.

At least for a period of time you will have to keep track of your expenses and gain an understanding of where the money is going. The reason this is important is that you may need to tap into portfolio gains to fund your living expenses. If that is the case, your portfolio should be structured to write you a monthly check with a minimal amount of risk and tax consequences.

The next step in the P.R.O.A.C.T.I.V.E process is to evaluate your tax situation. If you are in a high tax bracket you might want to favor tax-advantaged investments such as municipal bonds. If your income is going to be taking a hit post-divorce you probably will end up in a lower tax bracket increasing the attractiveness of a Roth conversion to your traditional individual retirement account.

The last three steps all involve figuring out how best to construct your investment portfolio.  Going from your pre-divorce portfolio to something that fits your needs and goals will usually require some major re-adjustments in your strategy.

Going through our P.R.O.A.C.T.I.V.E process or a similar approach is probably the last thing you want to do on your own.  Most likely you will need the help of an advisor to work through this.

Keep in mind that the reason you are doing this is to regain control over your financial life. You sought the help of a lawyer during your divorce. Now is the time to move forward and seek the help of financial professionals with an understanding of your situation and new set of needs.

What is the best way to implement a portfolio strategy for newly divorced people?

The most important aspect of post-divorce portfolio is that it fits you and your new circumstances and desires.  Using our P.R.O.A.C.T.I.V.E methodology as a framework for evaluating your needs and desires we suggest implementing a portfolio structure that encompasses three “buckets”.

A “bucket” is simply a separate portfolio and strategy that has a very specific risk and return objective. Each bucket in our approach is designed to give you comfort and clarity about its role in your overall portfolio.

What is the role of these “buckets”?

Each “bucket” has a very specific role in the overall portfolio as well as very explicit risk and reward limits.

We label our three “buckets” as the Safe, the Purchasing Power and the Growth portfolios.

The role of the Safe Bucket is to provide liquidity and cash flow to you to meet your short-term lifestyle needs. How much you have invested in your Safe portfolio is a function of how much money you need to fund your lifestyle over the next few years.

The second bucket – the Purchasing Power portfolio – is designed to allow you to enhance your lifestyle in terms of real purchasing power.  What this means is that every year your portfolio should have a return exceeding inflation.

Finally, the third bucket – the Growth portfolio – is designed to grow your portfolio in real terms. This portfolio is designed to maximize your returns from capital markets and will be almost exclusively invested in higher risk/higher reward equity securities.

Conclusion:

Going through divorce is one of the most stressful situations anyone can face. Transitioning to a new beginning may take a short term for some but for most people the period of adjustment is fraught with uncertainty and doubt.

People often worry about their finances and whether they can maintain their lifestyle.  A life event such as divorce also tends to shorten people’s horizon as their outlook in life often lacks clarity.

The implications from an investment standpoint are primarily a temporarily diminished desire to take on portfolio risk and a shortening of time horizons.  In English this translates to searching for greater certainty and not looking too far out.

As wealth managers our first goal is to first understand the client’s circumstances and needs once the divorce is finalized. Our P.R.O.AC.T.I.V.E process serves as the framework for initiating and exploring client concerns and issues.

Our P.R.O.A.C.T.I.V.E approach is designed to make your money work for what you deem important.  Divorce is difficult and transitioning to a new beginning takes time.  As you adjust to your post-divorce life your financial assets will also need to be managed consistent with the new you.

At Insight Financial we are experts at guiding you through this difficult adjustment period and transition into a new beginning. To read our full report on our approach for managing your post-divorce investments please click here.

Our wealth management team at Insight Financial Strategists is ready to help you in your transition.  To set up an initial consultation please book an appointment here.

 

Other posts you may find interesting

Pension Division in Divorce

4 Risks of Pension Plans in Divorce

Post-Divorce Investments 

 

 

Jun 14

3 Mistakes DIY Investors Are Prone to Making in a Crisis

By Eric Weigel | Investment Planning , Portfolio Construction , Risk Management

Photo by Robert Metz on Unsplash

Do-It-Yourself (DIY) Investors have been cropping up everywhere since the end of the 2008 Financial Crisis.

DIY investors tend to be well-educated professionals of reasonable means that prefer to build their own portfolios without the help of an investment professional.

They educate themselves about investing by reading a number of investment books (here is a popular one for Bogleheads) and subscription-based services espousing the benefits of the DIY approach.

 

A lot of DIY investors identify strongly with Jack Bogle, the founder of Vanguard for his dedicated approach to index investing.

One thing that distinguishes today’s crop of DIY investors from the original crop back in the 90’s is that today’s investors are much more focused on exchange-traded funds (ETF) as compared to individual stocks.  A large number of inexpensive and liquid ETF’s have made this possible.

The primary appeal of DIY investing revolves around gaining control over your portfolio.

You are in charge and make all decisions. From selecting a specific ETF to all buy and sell decisions.  A secondary appeal of DIY investing is cost – if you are the manager of your own portfolio you save yourself the fee that would have gone to your investment advisor. Typically this fee amounts to about 1% of the value of your portfolio.

DIY investors tend to do well when capital markets exhibit low volatility and the trend in price is well established.  Everybody loves up-trending markets that don’t fluctuate much.  But as Humphrey Neill, a famous contrarian investor used to say “Don’t confuse brains with a bull market”.

The analogy I like to use is that of a pilot. When everything is calm even a novice will look good. But when the friendly skies become turbulent, a novice pilot will likely tense up and the odds of making a mistake will increase significantly.

DIY investors face the same situation. During periods of calm, portfolio decisions will come easily. The cost of a poor decision is not likely to have major consequences in such a benign environment.

But when the capital markets get dicey, the implications of one’s actions increase dramatically.  A poor decision could decimate the value of your portfolio and seriously harm your overall financial health.

My contention is that when the rubber hits the road, many DIY investors are ill-equipped to deal with extreme capital market uncertainty. 

Stock market corrections are not fun for anybody, but experienced investment managers have the real benefit of having seen a movie of the same genre before.

I have lived through the 1987, 2000-2002 and 2008 stock market meltdowns.  None of these were fun but I learned valuable lessons in each of these crises.  Mainly I learned not to panic but also ways to course correct once it became clear that action was required. A key insight is that changing fundamentals require changing portfolio compositions.

Many DIY investors have not seen a real crisis in their investment lifetimes.  While everybody can read about stock market crashes unless you live through such a period it is hard to truly assimilate their impact both on your pocketbook but more importantly on your psyche.

A crisis such as 2008 is extremely disorienting even for professional investors, but the advantage that experience and knowledge of capital market behavior afford you is a game plan honed by the school of hard knocks.

Without the benefit of having lived through previous periods of real capital market stress and the knowledge of how markets typically behave, DIY investors are at a significant disadvantage.

The potential for errors during a crisis goes up exponentially.  Three common reactions or mistakes that we have seen from DIY investors involve:

1. Selling Everything in a Panic

No questions asked, just get rid of everything that is taking a hit before it gets even worse.  Taking action by selling everything may give the DIY investor a sense of relief.  But making decisions in a highly charged emotional state is asking for trouble.

If the decision to sell is based on solid research and is well thought out, fine.  But if it is based on impulse and an immediate need to get rid of the stress then it is most likely that the portfolio was not appropriate for the individual in the first place.  Investing comes with volatility, there is no way around this!

Oftentimes when an investor sells in a panic the most troubling decision is when to buy in again. Even worse if the decision to sell turns out to be wrong, the investor will endlessly question themselves and lose confidence in their ability to navigate on their own.

DIY investors tend to focus on the initial portfolio composition or asset allocation but often fail to plan ahead should market conditions change.  And if there is one thing that holds true is that change is inevitable and an ongoing part of financial markets. Planning ahead for changing market conditions is an integral component of a well-designed investment plan.

Fortunately, most DIY investors know that impulsively selling everything in a panic is not a good wealth creation strategy. But don’t kid yourself – in a market meltdown you will want to sell everything and more!

You will have to control your emotions and have the stomach to weather the inevitable periods of market turbulence.

Photo by Goh Rhy Yan on Unsplash

 

2. Becoming extremely risk-averse and freezing up even if action is clearly needed

Most market corrections are short-lived and while painful in the short-term they barely register on the long-term map. For example, in 2018 we have already had a couple of equity market corrections but in each case, the market recovered its losses fairly quickly.

No harm, no foul! Doing nothing or standing pat works just fine when markets recover.

The bigger problem for investors is when corrections take on a bigger life and become outright market crashes.  For example, the S&P 500 was down three straight years from 2000 to 2002.  What do you do when the roof seems to be caving in?

Many DIY investors close their eyes and pretend that this is not happening to them. They get frozen and choose to ignore reality.  This is not an abnormal reaction at all for us humans, but we also know that small problems many times lead to big problems if we do not address the underlying issue.

Wishing the problem away does not work.  From the field of behavioral finance, we know that investors tend to hang on to their losing investments way too long.  The flipside is that research has also shown investors to sell their winners way too soon. This effect is known as the disposition effect.

The price of financial assets such as stocks is a function of fundamentals (growth and profitability), the fair price of those fundamentals (investment multiples) and the sentiment of buyers and sellers.

During a period of crisis, the tendency of DIY investors is to focus almost exclusively on sentiment. When sellers want out now and buyers are scarce the price will automatically come down.

You observe falling prices and you get more and more uncomfortable.  But is there any real economic information in investor sentiment?

Experienced investors while not immune to the same feelings of fear will look at the underlying fundamentals and the value of those fundamentals. Experienced investors know that investor sentiment is fickle and lacks much predictive ability.

Has something changed recently to warrant this drop in market values? Are growth rates and profitability permanently impaired, or is the market overreacting? Are investors reacting to the perception of market over-valuation? These are all questions that require some real expertise and most importantly an understanding of context.

There is no cookie cutter way to analyze market action making the experience in similar conditions coupled with knowledge of historical market behavior all that much more valuable.

DIY investors often lack an understanding of context and an assessment of prospective fundamentals in the face of wildly fluctuating capital market conditions. The tendency by many is to stand pat, but what if changing market fundamentals require a change in portfolio positioning?  Intentional investing often requires action.

3. Failing to assess the changing risk levels of their portfolios

A frequent mistake made by DIY investors is to focus almost exclusively on returns and ignore the risk and correlation structure of their portfolios.

Much of the thought behind DIY investing hinges on ideas derived from Modern Portfolio Theory (MPT) but somehow you hardly ever hear DIY investors justify changing allocations based on the volatility structure and composition of their portfolios.

A related mistake is to often assume diversification benefits that often are not there when you need them most.  A good read on “fake diversification” can be found here.

Ignoring changing asset volatility and correlation is a serious mistake made by many non-professional investors.  In fact, one could say that by ignoring the volatility structure of portfolios DIY investors are ignoring some of the lowest hanging fruit available.

As Nobel Prize Winner Harry Markowitz once said: “diversification is the only free lunch provided by capital markets”.

As capital markets change over time so will the risk characteristics of a portfolio even if rebalanced periodically to static weights. 

In a study done a couple of years ago on portfolio rebalancing, I showed just how much stock and bond volatility and correlations can change over time.

Figure 1

Source: Global Focus Capital LLC

Stock volatility, in particular, can move quite a bit around. Bond volatility while still variable shows much lower variability.  And, correlations between stocks and bonds can move between positive and negative values implying large changes in diversification potential for a portfolio.

Say, a DIY investor has a portfolio composed of 60% US stocks and 40% US Bonds. The DIY investor diligently rebalances this portfolio every month so that the weights stay in sync. What would this 60/40 portfolio look like in terms of volatility?

Using the above study over the 2000 to 2016 period, the average volatility of this 60/40 portfolio would average 8%.  Assuming that the average volatility would not change much would be a mistake. The range of volatility goes from 4% to 15% as shown in Figure 2.

Even the old standby 60/40 portfolio exhibits wildly fluctuating levels of portfolio risk.  A 4% volatility level implies a much lower level of potential downside risk compared to a portfolio with a volatility of 15%.  Experienced investment professionals inherently understand this and often seek to target a narrower pre-defined range of portfolio volatility.

Figure 2

Source: Global Focus Capital LLC

DIY investors do not often construct portfolios targeting an explicit range of risk. Instead, the often hidden assumption is that over the long-term asset returns, volatilities and correlations will gravitate toward their “normal” levels. These assumptions are not supported by the empirical evidence.

For DIY investors, changing levels of volatility and correlations can cause significant changes to the risk/returns characteristics of their portfolios. For example, volatility tends to spike up during periods of capital market stress and remain low when markets are trending up.

Also, correlations among investments within the same asset class (broadly speaking equities, bonds and alternatives) tend to also jump up during periods of crisis leading many to question the benefits of asset diversification.  What investors should be questioning instead is why they did not re-adjust their portfolios to reflect the changing conditions.

_________________________________________________________________________

 

Conclusion:

DIY investing is here to stay. Many non-investment professionals have educated themselves as to the virtues of retaining control over their portfolios. After all, DIY investors are saving themselves the fee that they would normally pay their advisor for managing their portfolio.

When markets trend up and volatility is low, DIY investors will typically fully participate in the gains.

But there is another “cost” that DIY may be incurring on their own that often rears its ugly head especially during periods of capital market turbulence.

We are all human and we suffer from the same biases and fears. The difference is that experienced professional investors have the advantage of having seen similar periods of capital market stress before and possess a more nuanced perspective of normal capital market behavior.

DIY investors tend to make three types of mistakes during a crisis – they chuck it all in a panic, they freeze up and do nothing, and, lastly, they ignore changing levels of portfolio volatility.

Professional investors while prone to the same fears as the DIY crowd are better positioned to focus their attention on the fundamentals of investment performance -growth, profitability & valuation – that ultimately drive portfolio values.

Experience and knowledge gained over many market cycles are at a premium when your portfolio most needs it.  At Insight Financial Strategists we are experts in integrating your financial planning needs with your investments.

You do not have to go at it alone and compete against the pros.  Our investment approach is rooted in the latest academic research and implemented using low-cost investment vehicles.

Interested in talking? Please schedule a complimentary consultation here.

 

May 15

5 Symptoms of “Fake” Portfolio Diversification

By Eric Weigel | Investment Planning , Portfolio Construction , Risk Management

5 Symptoms of “Fake” Portfolio Diversification

Photo by Alex Holyoake on Unsplash

What You Need To Do Immediately Diversification is one of the core concepts of investment management yet it is also one of the least understood .

In many ways diversification is like apple pie and motherhood – good for you and always taken at face value without any real introspection.

Investors throw out lots of platitudes about their portfolios being diversified.  Financial literature often contains allusions to diversification but do Main Street people really understand this important concept?

Understanding the portfolio diversification concept is not an academic nicety. Proper diversification is crucial for growing your wealth and managing through the inevitable ups and downs of financial markets .

Think of portfolio diversification benefits in the same way you think about insurance on your house. When nothing bad happens you go on and maybe for a second you think about whether you really need this form of protection.

But when something bad happens like a stock market crash or a tree falls on your garage, you do not even think for a nano second as to what you paid for the protection.  Whatever the price was, it was well worth it!

The portfolio diversification concept is, however, different from typical insurance in some important ways.  When you buy insurance on your house you have a contract regarding the conditions under which the insurer will pay, how much, and importantly a maximum out of pocket deductible.

With portfolio diversification there is no such contract and especially there is no set deductible capping your losses.  When somebody says “my portfolio is diversified” it can mean a million things .  But does it mean what you think it does?

The devil is always in the details, right?  You may think that your portfolio is diversified because nothing bad has happened yet. Or, you may think that your portfolio is diversified because your advisor said so. Who knows?

Or maybe you read a mutual fund advertisement stating that the fund you own has investments in a large number of industries.  Sometimes people think sprinkling their money across a large number of funds with different names means that they are diversified .

Why the confusion? Without getting too technical, diversification can mean a whole lot of different things depending on the context.

Properly understanding the context and what diversification means is difficult for non-financial people to wrap their hands around.  And that is a big problem and why investors often fail to capitalize on what Nobel Prize winner Harry Markowitz once called the only free lunch in financial markets .

When typical investors hear the word diversification they think protection against portfolio losses. If you are diversified, your losses will be less than if you are not diversified, right? During a stock market meltdown such as 2008 your diversified portfolio should do ok, right?

_________________________________________________________

Should you just assume that you are diversified?

Probably not. Remember the old saying – assume makes an a** out of you and me!  Better be safe than sorry when it comes to your financial health.

Let’s start with some basics. Very simply put, diversification means that you are not exposed to any one investment type determining the bulk of your portfolio returns.  One investment will neither kill nor make your whole portfolio.

A diversified portfolio contains investments that behave differently. While some investments zig, others zag.  When one investment is up big, you might have another one that is down.  Your portfolio ends up in the middle somewhere.  Never as high as your best performing investment and never as low as your worst nightmare investment.

Asset classes such as bonds and stocks have very different behavior patterns. Sometimes these differences get lost in jargon such as risk and return or the efficient frontier concept.

You don’t need a PhD from MIT or Chicago to understand the concept of diversification but pay attention as the details are important.

Why do you own stocks in your portfolio? Why do you own bonds and, say, real estate? Why do you have some money stashed away in an emergency fund at the local bank?

I know these questions may  seem a bit sophomoric but knowing the “why” for each of your investments is important to understanding how well prepared you are to withstand periods of financial market stress.

Most people already know that when economic times are good, stocks will typically go up more than bonds but when there is a crisis the reverse will often occur.

The whole point of owning stocks, bonds and potentially other major asset classes as a mix is to protect your portfolio from bad things happening.

Sure we would all love to get the upside of stocks without any downside but in reality nobody has the foresight to tell us in advance (please avoid subscribing to that doom and gloom publication that just popped up in Facebook) when stocks will collapse and when they will thrive.  Anybody up to buying some snake oil?

Diversification is not necessary if you have a direct line to the capital market gods. If you are a mere mortal proper diversification is absolutely necessary to ensuring you remain financially healthy.

Spreading your bets around, mixing a variety of asset classes, hedging your bets, not putting all your eggs in one basket – whatever your favorite phrase is you also need to live it. Diversification is one of those good habits that you should practice consistently!

With that warning in mind, what are 5 telltale signs that your portfolio may let you down when you need it the most?

__________________________________________________

Symptom 1: Your portfolio is nothing more than a collection of funds you have accumulated over time  

Accumulating investments over time is a very common practice.  People sometimes get enamored with a certain investment type such as tech in the late 90’s and when things don’t pan out they are reluctant to sell the investment.

Not dissimilar to hanging on to that old dusty treadmill in the basement or that collection of Bennie Babies in the attic.  Many individual investors are hoarders without admitting it.

Sometimes it is as simple as when people change jobs leaving behind a 401(K).

Solution: Research each one of your funds. For example if you own the Alger Large Cap Growth fund (ACAAX) use a free tool such as Morningstar to do some basic research.

But let me warn you – looking only at past returns will tell you much about the past but virtually nothing about the future.  Ruthlessly eliminate funds that you don’t understand, have high fees or simply do not fit the style that you’re looking for. Don’t eliminate funds based solely on past performance.

Symptom 2: The more funds and strategies the more diversified my portfolio  

Some people think that if you own a lot of different funds or investments you are automatically diversified. A bit of this and a bit of that. Some growth, some value, a sprinkling of emerging markets and a Lifestyle fund thrown in the mix.  There is no rhyme or reason for any of this, but many people use this approach, right?

This is a very common mistake of investors.  A lot of funds of the similar ilk does not make a diversified portfolio. It makes for keeping track of many more things, but not necessarily things that matter to your financial health.

Owning a large number of investments does not mean that you are diversified.  It probably means that you or your advisor are confused about how to construct a portfolio. You can actually be much more diversified with a small number of uncorrelated investments – the number of investments is immaterial.

Solution: Less is often better when it comes to your investments. Too many funds means extra confusion.  Simplify to a small number of funds that will serve as your core portfolio holdings.  Think of these funds as the pillars holding up your financial house.

Choose low cost funds that you will be comfortable holding for decades.  Hint – focus on a small number of broad based index funds covering stocks and bonds.

Photo by Natalie Rhea Riggs on Unsplash

Symptom 3: Your portfolio contains lots of investments with the same “theme”

Sounds like you have a fun portfolio when things go well but a nightmare when they don’t.  People fall in love with investment themes all the time.  They ride the theme hard not properly understanding that market sentiment is often fickle and can change on a dime.

In the late 90’s it was all about the internet.  Many people loaded up on the sector and lost their shirt soon after.

We have had more biotech booms and busts than probably for any other sector over the last 30 years .  Many of the biotech stars of old unfortunately were sold for cents on the dollar despite promising early findings.

Starting in mid-2017 the buzz was all about cryptocurrencies.  Many investors especially those too young to have experienced a stock market meltdown went head first into the craze and now probably are licking their wounds.

Solution: Theme investing is risky. Identifying the next emerging technology or the next Amazon or Google has a very low probability of success. Even the most seasoned venture capital firms thread lightly when it comes to the “new, new” thing.  You should too!

If you really understand a theme think about how long it will take for the mainstream to adopt it in mass.   Invest only a small percentage of your portfolio. For the rest of us, best to keep our greed in check and just say, no!

Symptom 4: All your investments are in the same asset class

This is a variation of the previous issue.  Sometimes you hear people say, “I am just a bond guy”. Or, maybe they say “I am a stock jockey”. People come to identify with their investments as a badge of honor without realizing the consequences to their financial health.  As my mother would say, “do things in moderation”. I still think that this is great advice whether it is about eating or investing.

The problem with just owning investments in one asset class is that you do not get the main course of the free lunch. You get the appetizer, but then you are shooed out of the room.

Diversification within an asset class such as stocks or bonds is not nearly as powerful as diversification across divergent asset classes

What do you mean?

Let’s take the case of stocks. In any given day, most stocks tend to move up or down together.  When the overall equity market (say the S&P 500) is up big for the day, you only find a very small percentage of stocks down for the day.  Similarly, when the broad equity market experiences a meltdown you will unfortunately only find a handful of stocks that went up for the day.

Same applies to bonds but the herding effect is even stronger.  Take the case of US bonds of a similar maturity, say 10 years.  This cohort of bonds moves in a pack all taking their lead from the 10 Year US Treasury.  If the 10 Year Treasury moves up, the vast majority of bonds move up in lockstep.  Same on the downside. Just like sheep.

Sure, some stocks or bonds will do better than others. Overall, securities within an asset class tend to move up or down together.  Call it a sister or brotherhood, while major asset classes relate to each other more as distant cousins.

Solution: For most people it makes sense to hold investments in all the key asset classes.  The three main asset classes that you should own are stocks, bonds and real estate.

Don’t get too cute. If you own a home you probably already have enough real estate exposure.

Why should you own stocks? For growing your nest egg over the long-term.  Sure stocks can be incredibly volatile, but if you plan to hold your stock investments for say longer than 10 years, history tells us that you can potentially maximize the growth of your portfolio. For a good review of the long-term power of stock investing read our recent