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Aug 13

Is Your Caution Today Hurting Your Tomorrow?

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

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

 log-normal simulation using 4% assumed return and 6% volatility

Source: Insight Financial Strategists

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

log-normal simulation using an assumed 8% return and 14% volatility

Source: Insight Financial Strategists

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.

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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

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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

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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.

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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.

Apr 13

Capital Market Perspectives – April 2018

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

Capital Market Perspectives - April 2018

 

Photo by Dawn Armfield on Unsplash

The last couple of months have tested investors.  In a sense, we all got lulled by the wonderful returns of last year and any hiccup was bound to create some stress.

The talk at the end of 2017 was all about tax cuts and the short-term boost that lower tax rates would provide to consumer spending and the bottom-line of US corporations.

For the first month of the year, things couldn’t have been going better for equity investors. Bond investors while not exactly sitting in the catbird’s seat were slowly adapting to the inevitable rise in yields.

Emerging market equities, in particular, jumped ahead and the mood among global investors was one of optimism.  Market commentators were even talking about a stock market melt-up!

Two months later the mood has changed drastically. Investors are nervous and we have already witnessed two small corrections in the equity markets.

Figure 1

Source: FRED (Federal Reserve Economic Data), Insight Financial Strategists, April 2018

The first mini-correction attributed to rising inflationary expectations took the S&P 500 from a peak of 2873 on January 26 to a low of 2581 on February 8. The 11% drop while not unprecedented was keenly felt by investors accustomed to the record low levels of volatility seen in the last year. It felt like going from a newly paved highway to a dirt road without any warning signs!
 

Were rising inflationary expectations to blame for the early February stock market fall?  Our research did not support this story.  We had been seeing a slow rise in inflationary expectations for about a year but US Inflation Protected Note prices containing the market’s consensus forecast of inflation over the next 5 and 10 years did not exhibit any significant upward pressure.

Inflation in the US seems to be fairly range bound with the latest year over year reading of 2.3% (February). Inflationary expectations as of April 6 for the next 5 years stand at 2.0% and for 10 years out at 2.1%.

The market implied forecast may turn out to be too benign, but for now, our own view of economic conditions in the US is closely aligned with these market-based expectations.

A number of events could have caused the early February correction, but in the context of long-term capital market history, we think that this episode will appear as a mere blip on price charts. Rising inflationary expectations do not seem a likely culprit for this episode of equity market stress.

Figure 2

Source: Quandl, FRED, Insight Financial Strategists, April 2018

What about the most recent late March equity market drawdown? US equity market markets staged a strong recovery from the February lows with the S&P 500 having recovered all but 3% of the losses from the January 26 peak. Since early March the global markets have, however, been on a roller coaster ride.  Up one day, down big the next. As of April 6, the S&P 500 has lost over 6% since March 9.

The second mini-correction of the year has re-tested the resolve of equity investors. Volatility levels have jumped up and have risen significantly from the lows of 2017. The intraday movement of markets (the difference between the high and low of the day) has been about 2X that of normal periods and 4X that experienced last year.

Figure 3

Source: Quandl, FRED, Insight Financial Strategists, April 2018

Market volatility has been historically low over the last few years but the large intraday swings we have been seeing this year are distressing to even seasoned investors.  John Bogle in a recent interview for Marketwatch commented that he had not seen such a volatile market in his lifetime. He was referring specifically to the huge intra-day moves seen over the last two weeks.

 What has caused this recent bout of stock market volatility? As always there are many possible reasons, but this time around we see a more direct link to the uncertainty surrounding a possible global trade war.

Markets do not react well to uncertainty especially to events that are both hard to quantify in terms of the probability of occurrence and the magnitude of consequences.

Trade wars are not everyday events.  The last time wholesale tariffs were imposed in the US happened in 1930 when the Smoot-Hawley Tariff Act was passed.  While economists will debate whether the Act exacerbated the Great Depression, in general, it is acknowledged that tariffs limit economic growth.

Free-trade has been a goal of most nations for the last 50 years. Gains from free trade provide a win-win outcome enabling producers to focus on goods and services where they enjoy a comparative advantage and consumers to reap the benefits through lower costs is one of the strongest held beliefs of modern economics.

Global trade of goods and services currently accounts for 27% of worldwide output (according to the OECD). Disrupting global trade by imposing tariffs on a large number of items seems reckless.  It is especially reckless when considering that we picked a fight with the world’s largest economy – China.  China also owns 19% of the outstanding supply of US Treasuries.

No doubt Chinese trade practices are unfair to US companies. Forcing US companies to transfer technical know-how to Chinese firms seems especially egregious given the state of China’s economic development.  China is the largest global economy and many of its technology companies are already global powerhouses.

Another bone of contention for some is the under-valuation of the yuan.  An undervalued currency is a huge weapon for increasing the attractiveness of a country’s exports.  However, it is not clear that the yuan is under-valued. According to an IMF report in July of 2017, the fair value of the yuan was roughly in line with market prices and fundamentals.

At first, the tariffs proposed by the Trump administration seemed fairly innocuous – washing machines and solar panels. Then on March 1, the US proposed tariffs on steel and aluminum.  Not good especially since many traditional allies of the US (mainly Canada and South Korea) would be the primary targets. Gary Cohn, the administration’s top economic advisor, resigned in protest sending shockwaves through the financial community. The S&P 500 reacted with a 1.34% loss for the day

However what really got the capital markets in a tissy was the announcement on March 22 of tariffs on $50 billion worth of Chinese imports.  The fight was on and it did not take very long for Chinese authorities to retaliate with in-kind tariffs on US goods.

The S&P 500 dropped 2.55% on March 22 and 2.12% on the next day.  Likewise, Chinese equity markets reacted quite negatively to the possibility of an all-out trade war with the US with the iShares China Large-Cap ETF (FXI) dropping 3.8% and 2.4% respectively on those days.

 

Where is this all going to end up? In an all-out trade war like after the passage of the Smoot-Hawley Act? Or, in serious bilateral negotiations between the US and China?

Our guess is that there are enough rational agents in both the US and Chinese administrations to avert an all-out trade war, but getting the negotiations going will not be easy and will take time.  China has already requested negotiations through the WTO Dispute Settlement Mechanism. Luckily there is at least a 60 day comment period separating talk and action.

The US is not likely to be a winner in a global trade war.  Nobody is really.  The most likely outcome is lower overall global growth and increased uncertainty – not a good recipe for capital markets especially in light of current above-average valuation levels.

 

The main problem for the US is that as a nation we are not saving enough.  The current net savings rate as a function of GDP currently stands at 1.3%. This number has been steadily trending down – the average since 1947 when numbers were first compiled is 6.6%.

The US balance of payments and trade deficits are a function of the imbalance between domestic savings and our thirst to grow and consume.  In 2017, the US had merchandise trade deficits with 102 countries. China is not our only problem!

Let’s hope that cooler heads prevail and that the disruption to global trade proves minimal.  Some of the damage has already been done as uncertainty has engulfed global capital markets.

The real economic damage of a global trade war is likely to be substantial.  Both equity and bond markets would come under significant stress.  Equities would likely take the most immediate hit as earnings growth, especially for multi-nationals, would drop significantly.

Bonds are also likely to take a hit as a likely reaction by the Chinese authorities would be to decrease their investments in the US Treasury market. Interest rates in the US would likely jump up causing pain to fixed income investors as well as worsening the federal budget deficit.

 

What do we expect in the intermediate-term from capital markets? While all this talk about trade wars and inflation scares may fill our daily news capture, it is worthwhile to remember that fundamentals drive long-term asset class performance.

In the short-term, capital markets can be heavily influenced by changing investor sentiment, but over the horizons that truly matter to most investors most periods of capital market stress tend to wash out.

Our current capital market perspectives assume that a trade war will not materialize.  Our views are informed by a number of proprietary asset class models updated as of the end of March.

Our current intermediate-term views reflect:

  • A preference for stocks over bonds despite their higher levels of risk
  • A desire for international over US equity based on valuation differentials and a depreciating US dollar – we especially like emerging market stocks
  • Within the fixed income market, we favor corporate bonds as we believe that economic conditions will remain robust and default risk will be contained
  • Small allocations to commodities as this asset class gradually recovers from the bear market it’s been in since the 2008 Financial Crisis
  • A reduction in our exposure to real estate as the asset class is being heavily penalized in the markets for its interest rate sensitivity
  • Minimal allocations to cash – the opportunity cost of holding large sums of low yielding cash is high especially for investors with a multi-year horizon
  • A return of risk on/off equity market volatility– this will surely stress investors without a solid plan for navigating market turbulence

 

 What should individual investors do while politicians flex their muscles? For starters evaluate your goals, risk attitude, spending patterns and investment strategy.  Make sure that the shoe still fits.  Capital markets are not static and neither are personal situations.

A long-term orientation and tactical flexibility will be a necessity for investors as they navigate what we think will be difficult market conditions over the next decade.

Such an approach will be especially important for individuals near or already in retirement. The sequence-of-returns-risk is especially important to manage in the years surrounding retirement when the individual will start drawing down savings.

Our approach at Insight Financial Strategists explicitly deals with this type of sequence-of-returns-risk by building the individual’s portfolio around the concept of goal-oriented buckets. Each bucket has a distinct goal and risk profile.

The short-term bucket, for example, while customized for each individual, has the overriding goal of providing a steady stream of cash flow to the individual.  This is the safe money designed to exhibit minimal volatility.

The goal of the intermediate-term bucket is different – this part of the portfolio is designed to grow the purchasing power of the individual in a risk-controlled manner. A sometimes bumpier ride is the price of growth for this bucket but the rewards should be more than commensurate with the additional risk taken.

Finally, the long-term bucket is designed to maximize the long-term appreciation of this portion of the portfolio.  This bucket will be the most volatile over the short term and is suitable for individuals with time horizons exceeding ten years and able and willing to withstand the inevitable periods of capital market stress.

Apr 13

Understanding Asset Class Risk and Return – Your Pocketbook and Psyche Will Thank You

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

Investment risk is an inevitable part of capital markets.

 

Markets do not just go up as much as we wish for that to be always the case.

Sometimes capital markets experience stress and the draw-downs can be extremely uncomfortable to investors.

How investors react to periods of capital market stress is incredibly important.

Become too aggressive and you could end up with major short-term losses and your financial survival may be at stake.

On the other hand, become too cautious and you may end up excluded from any future capital market appreciation.

 

So, if risk is inevitable, what can you do about it? Being either extremely aggressive or extremely risk-averse are probably the least desirable options especially if you wait to act until there is a market meltdown.

In the first case, you may not be able to stay invested as short-term losses cripple your psyche and your pocketbook.  Even though you believe in your investments, your emotions will be tugging at you and second-guessing you.  This is the curse of being too early.

In the case where people become too risk-averse, being too cautious prevents you from making up the losses experienced during periods of capital market stress by participating in the good times. Most likely you second guess yourself and by the time you take the plunge back in you have probably already missed out on some large gains.  This is the curse of being too late.

 Investing is not easy especially when things go against you in the short-term. It is best to understand what you are getting yourself in and have a plan for when things go awry. As Mike Tyson once said, “everybody has a plan until they get punched in the nose”.

Getting punched in the nose is not an uncommon experience for stock market investors.  For bond market investors the experience is not as common but it still happens.

Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan. A great game plan is useless unless you have the ability to withstand the dark periods.

Investors are frequently confused by capital market behavior.  Over the short-term asset classes can go almost anywhere as investment sentiment is usually a strong driver of returns.  Market pundits attempt to provide some rationale for why things are moving in a certain direction, but in reality, most of what goes on from day to day in capital markets is usually nothing more than noise.

Markets are prone to bouts of over-confidence where all the bad news gets ignored and investors appear overly upbeat.  Other times, markets will be laser-focused on negative short-term events of little economic significance and investors will become overly pessimistic.  Even seasoned investment professionals feel sometimes that there is no rhyme or reason for what is happening to financial asset prices.

Over longer-term horizons, asset class fundamentals start being reflected in prices as investment sentiment becomes secondary.  Profits, valuations, profitability, growth potential become the drivers of prices.  Periods of stress are frequently forgotten and appear as mere blips on historical price charts.

One of the key tenets of long-term investing is that risk and return are inextricably tied together.   Without any risk, you should not expect any incremental returns. Investing is inherently risky as outcomes – short or long-term – cannot be predicted with total certainty.

Most investors understand that, on average, stocks do better than bonds but that the price of these higher returns is a lot more risk.  Investors also understand that longer-maturity bonds will do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.

But beyond this high-level understanding of capital market behavior, there is lots of confusion. Gaining a better understanding of key asset class risk and return relationships will help you become a better-informed consumer of investment strategies.

Understanding what you are getting yourself in when evaluating different investment strategies could significantly alter your wealth profile for the better and allow you to take advantage of market panics rather than simply react to crowd psychology like most people.

To become an informed consumer of investment strategies the first step is understanding key asset class risk and return tradeoffs.  We use a dataset kindly provided online by Professor Aswath Damadoran at NYU to look at calendar year returns on US stock, bond and bill returns.  Bond returns proxy for a 10-year constant maturity US Treasury Note and bills correspond to a 3 month US t-bill.  US stocks are large capitalization stocks equivalent to the S&P 500. Figure 1 depicts the annual asset class returns since 1937.

The first thing that jumps out from the chart is the much higher level of return variability of stocks.

The second thing that jumps out is the incredible year over year smoothness of T-bill returns.  Bonds are clearly somewhere in between with volatility characteristics much more similar to bills.

The third thing that jumps out are the rare but eye-popping large equity market meltdowns such as during 1937, 1974, 2002 and 2008.  Lastly, of notice are the very large positive spikes in equity returns during years such as 1954, 1958, 1975, 1995 and 2013.

 Figure 1

What is not entirely clear from looking at the yearly return chart is the huge cumulative out-performance of stocks relative to both bonds and bills. Table 1 provides summary statistics on calendar year returns for each asset class.

Table 1


Key highlights:

  • Over the 1928-2017 period, stocks have returned on average 12% per year with an annual standard deviation of 20% year. Bonds are next in line with an average return of 5% and a volatility of 8%. Bills have had the lowest rate of return at 3% with a volatility of 3%. These numbers correspond to the usual risk/reward relationships that investors know all about.
  • In 27% of the years between 1928 and 2017, stocks have had a negative return. The average return when the market has gone down is -14%. Nobody likes losses but even bond investors saw negative returns in 18% of the years and when they happened the average loss was -4%. The only way never to lose money in any given year is to invest in bills.
  • If one had invested $100 in December 1927 and held that investment the ending portfolio value would be $399,886 – a huge rate of growth despite the infrequent yet terrifying equity market meltdowns. Bonds don’t come even close with an ending portfolio balance of $7,310. Playing it safe with bills would have yielded a portfolio value of $2,016.
  • From a cumulative wealth perspective, stocks are clearly the superior asset class but only if the investor is able to stomach the rare but large equity drawdowns and seeing losses in over a quarter of the years.
  • If the investor is seeking stability with no chance of principal loss, T-bills are the preferred asset class. The rewards compared to stocks will be meager, but the ride will be smooth and predictable.

 

What happens when you extend the holding period out to, say 10 years? Does the spikiness of stock market returns disappear? What about the frequency of down years?

Using the same data set as before and forming rolling 10-year holding returns starting in 1927 we observe in Figure 2 that some of the volatility of stocks and bonds has dissipated. Instead of spikes we now have mountains and slopes.

Figure 2

 

The chart on rolling 10-year returns exposes the massive cumulative out-performance of stocks during most ten-year holding periods.  There are instances of negative 10-year stock returns (6% as shown in Table 2) but they are swamped by the mountain of positive returns especially when viewed in relation to bond and bill returns.

We see only three periods when equity investors would have loved to play it safe and be either in bonds or bills – the early years post the Great Depression (1937-39), the Financial Crisis (2008-9), and economic stagnation and inflationary years starting in the mid-70s through the beginning of the equity bull market of 1982.  In the first two instances, equity holders lost money.  In the latter instance, equity investors enjoyed positive returns but below those of either bonds or bills.

Table 2

Some observations are in order:

  • As one extends the holding period from 1 to 10 years some of the spikiness of one-year returns is smoothed out – not every year is fantastic and not every year is terrible, periods of stress are usually followed by periods of recovery and so on
  • Over a ten year holding period stocks do not look as scary – only in 6% of our observations do we see a negative return. When those losses occur the average loss is 10% on a cumulative basis.
  • Rolling 10-year maturity bonds every year over a decade yields no periods in our sample where the strategy exhibits a loss. The same holds true for bills.
  • Investors able to extend holding periods from short to longer maturities such as ten years significantly lower their odds of seeing negative returns as confirmed in the empirical data

 

What happens when we mix and match asset classes? Does that help lower our probability of loss? We look at some typical multi-asset class mixes over one-year holding periods:

  • The 60/0/40 portfolio composed of 60% stocks and 40% bonds – a traditional industry benchmark
  • The 40/0/60 portfolio composed of 40% stocks and 60% bonds – a moderately conservative mix
  • The 25/50/25 portfolio composed of 25% stocks, 50% bills and 25% bonds – a conservative mix for a very risk-averse investor

Mixing asset classes is usually referred to as multi-asset class investing.  The premise for such an approach is based on the diversification benefits afforded by allocating in varying proportions to asset classes with their own unique risk and return characteristics.

It turns out that over the 1928-2017 period stocks were essentially uncorrelated to both bonds and bills.  The correlation between bonds and bills was 0.3.  Building portfolios with lowly correlated asset classes is hugely beneficial in terms of lowering the volatility of the multi-asset class mix.

Table 3

 

What are the main conclusions that we can reach when mixing asset classes with widely different risk and return characteristics?

  • When combining stocks, bonds, and bills in varying proportions we arrive at portfolio results that fall between those of equities and bonds
  • The traditional 60/0/40 portfolio had a lower frequency of negative returns compared to an all-equity portfolio, significantly lower volatility and a cumulative ending portfolio value only about a 1/3 as large. What you gain in terms of lower risk, you lose in terms of compound returns.
  • The 40/0/60 portfolio which represents a lower risk alternative to the investor lowers volatility (to 9%) but at the expense of also lowering average returns (to 8%) and especially cumulative wealth (ending value of $58,090)
  • The lowest risk multi-asset class strategy that we looked at – the 25/50/25 portfolio – had the lowest average returns (6%), lowest volatility (6%) and lowest long-term growth.
  • A key implication of multi-asset investing is by combining asset classes with disparate risk and return characteristics you can build more attractive portfolios compared to single asset class portfolios
  • Comparing two traditionally low-risk portfolios – 100% bonds and the 25/50/25 portfolio – demonstrates the benefits of multi-asset class investing. The multi-asset class portfolio not only has higher average returns but lower risk. The frequency of calendar year loss is smaller (11% compared to 18%) and the long-term portfolio growth is over 2X that of the all-bond portfolio.

 

Three very significant lessons emerge from our study of asset class behavior that can vastly improve your financial health.  The first relates to the holding period.  Specifically, by having a longer holding period many of the daily and weekly blips that so scare equity investors tend to wash away.

Equity investments do not look as volatile or risky when judged over longer holding periods of say 10 years.

The second lesson relates to the power of compounding. Small differences in average returns can yield huge differences in long-term cumulative wealth.  In terms of the multi-asset class portfolios – the 60/0/40 versus the 40/0/60 – yields only a 1% average return difference but a 2X difference over the 1928-2017 period.

Seemingly small differences in average calendar year returns can result in massive wealth differences over long holding periods.

The third lesson relates to diversification. By mixing together asset classes with varying risk and return characteristics we can significantly improve the overall attractiveness of a portfolio. Lower portfolio risk is achievable with proper diversification without a proportional sacrifice in terms of returns.   Properly constructing multi-asset class portfolios can yield vastly superior outcomes for investors.

 

Every investor needs to come to terms with the risk to reward relationships of major asset classes such as stocks, bonds, and bills.  Understanding the risk and return tradeoffs you are making is probably the most important investment decision affecting the long-term outcome of your portfolio.

Some investors can stomach the sometimes wild ride offered by stocks and choose to overwhelmingly use equity strategies in their portfolios. They don’t worry much about the daily vicissitudes of the stock market.  They accept risk in return for higher expected returns.

Not everybody, however, can stomach the wild ride that sometimes comes from owning stocks despite understanding that over the long-term stocks tend to better than bonds and bills.

Some investors are willing to leave a bit of money (but not too much, please) on the table in return for a smoother ride. They may elect to hedge some of the risks.  Or they may mix in varying proportions of risky and less risky asset classes and strategies.

Yet other investors are so petrified of losses and market volatility that they will forego any incremental return for the comfort and steadiness of a safe money market account. They choose to avoid risk at all costs.

 

Which is the better approach for you? Avoid all risks, save a lot and watch your investment account grow slowly but smoothly?

Or, take some risk, sweat like a nervous high schooler when capital markets go bust and grow your portfolio more rapidly but with some hiccups?

The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses to your wealth.  If you already have a financial plan in place great. If you need help getting started or refining your plan, the team at Insight Financial is ready to share our expertise and bring peace of mind to your financial life. Book an appointment here.

Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan.  In subsequent articles, we will be exploring different ways of managing risk and structuring portfolios.