Is the Market Overheated?

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The S&P 500 is up over 15% YTD through yesterday. Chances are, if you have ever read anything about investing, you have heard that the stock market averages 10%[i] over the long term. Increasingly, as we’ve trudged upwards this year, I’m being asked if the market is overheated.

With the already announced reduction of the Fed’s money printing program this month along with the increasing speculation that they will probably raise rates in December, it does look like some of the easy money tailwinds we've seen for nearly a decade may finally be subsiding. Mix in a history of some pretty awful past Octobers (1929, 1987, 2008), and it isn’t the craziest notion to have concerns about the market running about 50% hotter than its long-term average.

Care to venture a guess how many times the S&P 500 has had a yearly return 15% or more over the last 90 years or so?[ii]

A)      Once

B)      Ten

C)      Twenty

D)      Forty

The correct answer is D. In fact, in only six years over that span has the market even finished within two percentage points of 10%.

Exhibit 1[iii] shows calendar year returns for the S&P 500 Index since 1926. The shaded band marks the historical average of 10%, plus or minus 2 percentage points. The S&P 500 had a return within this range in only six of the past 91 calendar years. In most years the index’s return was outside of the range, often above or below by a wide margin, with no obvious pattern. For investors, this data highlights the importance of looking beyond average returns and being aware of the range of potential outcomes.


Exhibit 1.       S&P 500 Index Annual Returns 1926–2016

In US dollars. The S&P data are provided by Standard & Poor's Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Index returns do not reflect the cost associated with an actual investment.

In US dollars. The S&P data are provided by Standard & Poor's Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Index returns do not reflect the cost associated with an actual investment.

 

So, am I concerned? Considering I typically don’t make charge fees in months that the market drops, I’d say…yes. Always.

But I also believe in the power of markets, and that all available information is incorporated into the current price of every stock. The market reflects all that information, and we assume no investor willingly has risked capital they expect to lose.

I haven’t been around for all of 40 of the years we’ve seen 15%+ returns over the past 90 years or so, but I’ve fielded similar questions every time stocks have had a better than average run during the quarter century that I’ve been doing this. Admittedly, it’s easier to convince clients to stay the course in good years, but when our belief in markets is tested during the next correction (10% downturn) or bear market (20% decline), I will offer a similar response.

Despite our inability to consistently predict what the markets will do in advance, we are all well served to remember that keeping a long-term perspective gives us the best chance of having a positive outcome with our equity investments. Exhibit 2[iv] shows the historical frequency of positive returns over rolling periods of one, five, 10, and 15 years in the US market. The data shows that, while positive performance is never assured, investors’ odds improve over longer time horizons.


Exhibit 2.       Frequency of Positive Returns in the S&P 500 Index
Overlapping Periods: 1926–2016

From January 1926–December 2016 there are 913 overlapping 15-year periods, 973 overlapping 10-year periods, 1,033 overlapping 5-year periods, and 1,081 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. In US dollars. The S&P data are provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not an indication of future results.

From January 1926–December 2016 there are 913 overlapping 15-year periods, 973 overlapping 10-year periods, 1,033 overlapping 5-year periods, and 1,081 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. In US dollars. The S&P data are provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not an indication of future results.

There aren’t any free lunches when it comes to investing. To earn returns that exceed the risk free rate of cash or short term government bonds, we must take some risk. Managing that risk (and our emotions) during the ups and the downs can be easier when we have an understanding of how markets work and have behaved in the past. If you are having trouble sleeping at night because of your portfolio, you probably should work to align your asset allocation with the amount of risk you can tolerate. Get in touch if you could use some help.

 

 

 

[i] As measured by the S&P 500 Index from 1926–2016.

[ii] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

[iii][iv] Source: Dimensional Fund Advisors LP.

 

There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Diversification does not eliminate the risk of market loss.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

 

Q3 2017 Market Review

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Fall is here, and while the leaves will be changing soon, the US stock market has seemingly been evergreen, posting its eighth consecutive quarter of positive returns. These gains have continued despite saber rattling from North Korea, two major hurricanes hitting the US mainland, a surprisingly gridlocked government, and even kneeling football players. We haven’t seen a winning streak this long since 1997, for those that are keeping track. The S&P 500 ended the quarter at a record high, as did the small cap Russell 2000 index. As the economy has expanded (3.1% GDP in Q2), growth stocks have outpaced value stocks while small stocks outperformed larger ones.

The Federal Reserve made no changes to monetary policy during the quarter but did announce that they would begin normalizing their balance sheet in October, by not reinvesting up to $10 billion of monthly interest and maturing principal. Expect more noise in Q4 as speculation increases on whether the FOMC will raise rates at their December meeting and who will replace Janet Yellen when her term expires next January.

As good as domestic markets were, developed and emerging international markets were even better. Commodities and REITs, while positive, again were laggards. Bond yields were largely unchanged.

This has been a remarkable market. Maybe it is due to the Goldilocks economy of “just right” growth and low inflation? Perhaps it's the belief that a GOP Senate, House, and White House will finally agree on something (like tax reform)? Could it even be due to the average live weight price of turkeys? Every expert seems to have an explanation of why we keep going up. How many of them do you recall predicting this kind of bull run? Just keep in mind that markets seem to have a way of proving the largest number of people wrong at the most unexpected times.

We’ll continue to hope, as we did at the end of Q2, that the next quarter produces another green screen in Q4. We’ll also continue to adjust portfolios that drift from their target allocations to keep clients in line with their capacity for risk while taking advantage of the benefits of diversification.

Sometimes I'm asked, "Why sell winners to buy less successful investments?" The answer is that having discipline when greed prevails is just as important as when fear rules the day. If you are feeling either emotion, it may be time to get together and do a portfolio review and/or discuss your financial plan. Otherwise, enjoy the Q3 2017 Market Review.

ATX Portfolio Advisors Will Donate $500 for Every New Client

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As a long time supporter of the Eanes Education Foundation, I am thrilled to announce that ATX Portfolio Advisors will donate $500 to EEF (or equivalent organization) for every new Accountable Wealth Management client that opens an account by year-end. 

If you or someone you know would be interested in learning more about our Fee-Only (When You're Up) Wealth Management, now is a great time to get in touch.

Feel Lucky? How to Handle a Pension Buyout

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Chances are, this week’s topic only applies to a few readers. Feel lucky?

According to the 2016 Federal Reserve Survey of Consumer Finances, only 13% of non-union private sector workers are currently participating in a defined benefit (DB) pension plan. You remember those, right? You work at a company for decades, retire when you hit your 60’s, take your gold watch, and start collecting checks every month for the rest of your life.

But the percentage of private sector workers covered by pensions has dropped by half in just over the last decade or so. This has happened for a variety of reasons. For a while, companies that had overfunded plans were sought out in mergers so that the acquiring company could take out the excess. This was the premise for Gordon Gecko buying out Bluestar Airlines in the 1987 film, Wall Street.

More recently, many companies with underfunded plans have had to be bailed out by the Pension Benefit Guarantee Corporation (PBGC). In the 2008 recession, many real airlines did this to shed obligations. So many companies have done this, in fact, that the PBGC itself is now on shaky ground.

One of the results has been that the PBGC has had to raise their insurance premiums on existing plans. That, in turn, has made more companies consider terminating their pension plans due to the higher expenses and the liability reductions on their balance sheets.

If you are one of the few private sector employees left standing that still enjoys a DB plan, don't be surprised if your company offers you a buyout. I personally experienced this when my old employer terminated their plan during the financial crisis in 2008. Just in the last few months, I’ve helped clients from Accenture and Shell review similar offers, as well.

If you are unfortunate and your company hands your plan over to the PBGC, you won’t have many choices to make. They will continue your benefit, but almost certainly at a lower amount than was originally promised by the plan. However, if your company isn’t making changes under duress, you may be offered incentives to go away. The incentives I was offered, as well as those clients that I have recently analyzed, had certain similarities.

Here is a typical example. A 45-year-old female is offered three choices:

  1. An immediate monthly check of $420.
  2. A delayed monthly check beginning at age 69 of $1544.
  3. A lump sum payment today of $100,000.

For the purposes of today’s article, I will not include survivor options in the analysis, mainly because those decisions should be secondary to determining which of the three payout choices to take.

Immediate Monthly Check

Taking either of the monthly payment options provides the comfort of knowing that you can’t outlive the income. With the immediate option, you can start enjoying the money today, but that doesn’t mean there aren’t risks. Failure of the insurance company, inflation eating up the value of your check, or the inability to cash out early if you have an emergency are all potential downsides.

Also, it may be helpful to understand how a monthly payment for an annuity is calculated. The insurance company looks at the annuitant’s life expectancy (the period where 50% of a population are expected to survive)  and interest rates (typically high-quality bonds) they can earn to calculate the amount they feel is reasonable to payout while remaining solvent.

Since we know that the immediate payment amount is $420 and that the lump sum amount is $100,000, we can calculate the return if the annuitant lives to certain ages.

Calculating the internal rate of return (IRR) for the annuitant dying at various ages results in the following:

Age IRR
50=  -45.06%
65=        .08%
75=      2.97%
         (Current 30 Yr US Treasury Bond @ 2.87%)
84=      3.96%         (IRS Life expectancy for a 42-year-old)
90=      4.32%

When the annuitant dies, the checks stop. The longer you live, the higher your return.

Delayed Monthly Check

All the factors mentioned for the immediate check apply to the delayed option except, by waiting, you will get a bigger check. I have found that understanding how much it would cost to produce a similar income stream today can be helpful in determining if waiting makes sense. Since we don’t know what it will cost in 24 years to produce a lifetime monthly payment of $1544, we can use what it costs a 69-year-old today in order to get an estimate. (Understanding that interest rates and mortality tables may be different then.)

Using USAA’s Immediate Annuity Quote tool, I received a quote of $284,121 for our hypothetical 69-year-old female taking a monthly check of $1544 for life. Knowing this, we can do a similar analysis as we did with the immediate check. 

Age IRR
74= -37.66%

87=     1.82%              (IRS life expectancy for a 69-year-old)

With that estimate, we can also do some analysis on the third option, the lump sum.

Lump Sum

Taking the lump sum and rolling it into an IRA or employer sponsored retirement plan maintains liquidity and maximum flexibility. Market risk is probably the most apparent downside to taking the lump sum today, as you would have to grow it so that it could produce income in the future. This is where the annuity quote comes in handy, as we can now simulate how likely it is that we can grow the $100,000 lump sum to the $284,121 estimate that will be needed to produce the income.

First, I calculated that a 4.44% compound annual return is needed to grow to our target amount over 24 years. Then, I looked at the likelihood of that happening. Using financial planning software from MoneyGuidePro®, I ran a Monte Carlo simulation of a 60% equity, 40% fixed income portfolio. Monte Carlo simulations model different outcomes based on varying sequences of expected returns. Think of it as having a deck of cards with each card representing a possible yearly return for a 60/40 portfolio. Deal the top 24 cards and then use those returns in that order to calculate how much money you have at the end. Shuffle the deck and deal 1000 more times, and you can get a pretty good idea of likely outcomes.

In this case the median outcome was $362,163, with the highest result being $921,735 and the lowest $133,461. With that information, you can make an informed decision about how much market risk the lump sum decision may involve.

In any event, there is no right or wrong answer. Some will be drawn to the comfort of a steady monthly check today or tomorrow, while others will prefer to shuffle the deck and deal. For all the choices, it comes down to a simple question.

Feel lucky? Get in touch if you could use some help with your financial plan.

Shooting Down a Fallacy, Technically

Do you believe in technical analysis or market timing? 
No.

The question above was number 13 in the “The 19 Questions to Ask Your Financial Adviser” that were suggested recently by Wall Street Journal columnist, Jason Zweig. The response was my answer in last week’s “Answers to…” those questions.

Admittedly, I didn’t provide much color to that particular answer. Subsequently, I received several questions as to why I so readily dismiss those popular trading tactics. Seriously? Questioning my judgement? I'll tell you what, let's grab a couple of six-shooters and step outside.

Don't worry, no one will get hurt. We'll have an old fashioned shooting match that should illustrate my point. I'll even let you pick the rules from the two choices below.

  1. We will put targets up on the side of barn. We’ll each take 3 shots and the one with the most bullseyes wins.
  2. We will each take 6 shots at the barn, then we’ll draw a circle around the tightest groupings. The one with the 3 closest shots in a circle wins.

Which approach makes sense?

While option one will probably result in the best marksman winning, the second option will likely demonstrate what is known as the Texas Sharpshooter Fallacy. This approach leads to false conclusions characterized by ignoring differences in data while stressing similarities. By discounting errant shots and only choosing the ones that yield the desired result, we might as well flip a coin to determine who is the better shot.

This is also how technical analysis, or using charts to predict future prices, frequently works. Adherents will insist that they can successfully predict how an investment or market will perform based on easily recognized patterns formed by charting the historical prices of those assets. My personal observation has been that chartists are remarkably skilled at explaining why things happened after they occur, but are no better than random chance if those predictions are made in advance.

The subjective nature of what constitutes a buy or sell chart shape has resulted in sparse academic research on the topic, but there is some. A 2003 study by economist Gerwin Griffioen concluded that: "for the U.S., Japanese and most Western European stock market indices the recursive out-of-sample forecasting procedure does not show to be profitable, after implementing little transaction costs."[i] 

Another 1996 study of "momentum strategies" concluded that even small transaction costs would lead to an inability to capture any excess from such strategies.[ii]

To be fair, there is also some research that suggests there may be some value in these approaches, but keep in mind that correlations can be found in all manner of data. Random correlations, however, don’t necessarily lead to sound decision making. For example, should we do away with lawyers based on the following parellels observed by Spurious Correlations?

Sorry, bad question (and apologies for the low blow to my attorney friends). Hopefully, you can see that a determined artist (or "analyst") can paint just about any picture. If you would like your portfolio managed with more science and less art, get in touch.

 

 

[i] Griffioen, Technical Analysis in Financial Markets

[ii] Chan, L.K.C.; Jegadeesh, N.; Lakonishok, J. (1996). "Momentum Strategies". The Journal of Finance. The Journal of Finance, Vol. 51, No. 5. 51 (5): 1681–1713.

Answers to "The 19 Questions to Ask Your Financial Adviser"

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Sometimes, it takes a jarring event, such as the Equifax hack that resulted in about half of the people in the country having their SSN’s, DOB’s, names, and addresses stolen, to realize that it’s not just what you don’t know that can hurt you. Rather, it’s what you don’t know that you don’t know that can really leave a mark. With so many of us potentially exposed to identity theft through no fault of our own, perhaps it is time to start asking more questions. For example, if you don’t know what ATX Portfolio Advisors® does to protect your privacy, you can read our policy here.

If you are wondering what else you don’t know that you don’t know, Wall Street Journal columnist, Jason Zweig, recently wrote about “THE 19 QUESTIONS TO ASK YOUR FINANCIAL ADVISER”. All of these questions will help you to know your advisor a little better, and possibly learn some things you didn't even think to ask. I've included the questions and my answers to them below:

  1. Are you always a fiduciary, and will you state that in writing? Yes, and I do.
  2. Does anybody else ever pay you to advise me and, if so, do you earn more to recommend certain products or services? No.
  3. Do you participate in any sales contests or award programs creating incentives to favor particular vendors? No.
  4. Will you itemize all your fees and expenses in writing? Only when your account balance is higher than the previous month. (Otherwise, there are no fees to itemize).
  5. Are your fees negotiable? Everything is negotiable.
  6. Will you consider charging by the hour or retainer instead of an annual fee based on my assets? We offer three fee-only pricing models, including hourly and retainer.
  7. Can you tell me about your conflicts of interest, orally and in writing? Absolutely. While I strive to minimize conflicts wherever possible, the fact that I am a for profit enterprise inherently presents a conflict that all customers should be aware. However, our Fee-Only (When You’re Up) approach not only offers clients a good value, but it squarely aligns our interests.
  8. Do you earn fees as adviser to a private fund or other investments that you may recommend to clients? Never.
  9. Do you pay referral fees to generate new clients? Never.
  10. Do you focus solely on investment management, or do you also advise on taxes, estates and retirement, budgeting and debt management, and insurance? As a wealth management business, I focus on your particular needs and offer advice accordingly in all of these areas, and more.
  11. Do you earn fees for referring clients to specialists like estate attorneys or insurance agents? Never. Nor do I offer any incentives for professional referrals to ATX Portfolio Advisors®.
  12. What is your investment philosophy? Markets work, focus on evidence-based approaches, keep costs down.
  13. Do you believe in technical analysis or market timing? No.
  14. Do you believe you can beat the market? Not without taking more risk than the market, there is no free lunch. Studies consistently show that the majority of active managers underperform the market. However, I believe that building portfolios that emphasize factors shown through academic research to produce higher expected returns coupled with innovative portfolio management and trading approaches can result in better outcomes than most other approaches.
  15. How often do you trade? Not often. Rebalancing trades occur when accounts drift away from their models by certain tolerances, and occasionally a new strategy will be incorporated if there is academic evidence to support it.
  16. How do you report investment performance? I use a vendor call Blueleaf to send weekly performance information to all clients, and to offer a performance reporting dashboard.
  17. Which professional credentials do you have, and what are their requirements? I am a CFP®, which requires a bachelor’s degree from an accredited college or university, 3 years of full-time personal financial planning experience, completion of a CFP-board registered program, and 30 hours of continuing education every 2 years. Additionally, I am a member of the National Association of Personal Financial Advisors (NAPFA), which requires an additional 30 hours of bi-annual continuing education. I have passed the NASAA Investment Advisers Law Examination (Series 65) and maintain that registration. In the past, I have also held various FINRA and state licenses including The General Securities Representative Qualification (Series 7), The General Securities Sales Supervisor Qualification (Series 9, 10), The Uniform Securities Agent State Law Examination (Series 63), and Texas and California Life Insurance licenses. 
  18. After inflation, taxes and fees, what is a reasonable estimated return on my portfolio over the long term? This depends on your asset allocation, which is determined by understanding your goals and risk tolerance and asset location, as well as your personal tax situation. When doing financial plans, the expected returns I use are more conservative than actual historical returns, while the risk and inflation estimates are more reflective of actual experience.
  19. Who manages your money? I manage all of my personal investments in the same model portfolios that I invest my clients’ money in.

Do you have other questions? Get in touch.

Freezing Out "Protection" Rackets, Like Equifax (et al)

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I’ve got a great idea for a new business. I’ll offer banks and other companies interested in individual consumers’ credit histories access to that information if they will provide me all of their customers' personal information. First, I'll sell the banks a quick and easily accessible database of virtually every person in the country. Then, I’ll offer those consumers “protection” to guard against bad guys stealing the information that the banks give me. 

Oh, and what if I lose some of your information? I’ll offer monitoring and protection for free for the next 12 months, if you’ll just give me your credit card number. I’m sure you’ll remember to cancel the monthly subscription when it starts hitting your statement for $19.95 per month next year. Right?

There is one slight flaw in my business plan, however. Consumers could just freeze their credit. A freeze makes it impossible for new credit accounts to be opened in your name. The cost can be up to $10 per credit reporting agency, but it’s not recurring and may even be waived in some circumstances. A freeze will make it more cumbersome to apply for credit, but it is the best protection against identity theft. Unfortunately for me, it may ruin my perfectly planned protection racket.

If you want to know the next steps to implementing a freeze on your credit, the Federal Trade Commission has a Credit Freeze FAQ that is a good place to start. If you’ve already decided to act, you can contact each agency at the links or phone numbers below:

TransUnion

Equifax

Experian

An Economics Lesson from "The Crisis"

Image from Imgur

Image from Imgur

Did you survive the gasoline crisis of last week? If you were out of town for the weekend, you may have missed that as word got out about a bunch of Houston area refineries being inundated by Hurricane Harvey, drivers all over Texas scrambled to top off their tanks. This led to an economics lesson for all of us.

The lesson? Markets work, just not perfectly.

Even though Texas produces more oil than any other US state, that crude oil still needs to be refined into various petroleum products, such as gasoline. It was estimated that flooding from Harvey reduced US gasoline production by about 2 million barrels per day, which was about a 21% drop from the week before.        

When demand suddenly spikes for any good or service and the price remains unchanged, shortages are almost certain to happen. In this age of social media, it took just a few Tweets and Facebook posts of lines at some gas stations to incite hysteria. The demand spiked before many gas retailers realized what was happening, resulting in their pumps running dry before being able to adjust prices.

Personally, I knew something was out of the ordinary when my wife called to tell me to go get gas. When I asked why, she said a friend had just emailed that a tanker was pulling into a neighborhood convenience store and that I better hurry if I wanted to fill up. The friend, who is a wonderful person by the way, has probably never pumped a drop of her own gas. Something was definitely amiss.

By then, however, the market had already started to allocate resources effectively. The gas station in question raised their prices as the cars following the tanker lined up at the pumps to wait their turn. In some isolated cases, prices doubled or even tripled, leading to some misguided complaints of price gouging. (Note: In Texas, price gouging laws only apply in designated disaster areas.)

At the same time, distributors realized they could divert deliveries from neighboring states, where prices were lower, into Dallas and Austin and make a nice profit. The higher prices made it less likely that as many folks would succumb to the urge to fill an already half full tank. Thus, more fuel was available for those that really had a need , like those that had a couple of empty 55 gallon trash cans that needed filling.

Here we are a week later and every station in town is apparently stocked and prices have already started coming back down. Whew, we survived!

For some thoughts on surviving the next market crisis, I’ve included this month’s Issue Brief from Dimensional Funds titled Lessons for the Next Crisis. Now, does anyone know where I can get a “I survived the Harvey Gasoline Crisis of last Thursday” t-shirt?


Lessons for the Next Crisis

September 2017

It will soon be the 10-year anniversary of when, in early October 2007, the S&P 500 Index hit what was its highest point before losing more than half its value over the next year and a half during the global financial crisis.

Over the coming weeks and months, as other anniversaries of major crisis-related events pass (for example, 10 years since the bank run on Northern Rock or 10 years since the collapse of Lehman Brothers), there will likely be a steady stream of retrospectives on what happened as well as opinions on how the environment today may be similar or different from the period leading up to the crisis. It is difficult to draw useful conclusions based on such observations; financial markets have a habit of behaving unpredictably in the short run. There are, however, important lessons that investors might be well-served to remember: Capital markets have rewarded investors over the long term, and having an investment approach you can stick with—especially during tough times—may better prepare you for the next crisis and its aftermath.

BENEFITS OF HINDSIGHT

In 2008, the stock market dropped in value by almost half. Being a decade removed from the crisis may make it easier to take the past in stride. The eventual rebound and subsequent years of double-digit gains have also likely helped in this regard. While the events of the crisis were unfolding, however, a future of this sort looked anything but certain. Headlines such as “Worst Crisis Since ’30s, With No End Yet in Sight,”[1] “Markets in Disarray as Lending Locks Up,”[2] and “For Stocks, Worst Single-Day Drop in Two Decades”[3] were common front page news. Reading the news, opening up quarterly statements, or going online to check an account balance were, for many, stomach-churning experiences.

While being an investor today (or during any period, for that matter), is by no means a worry-free experience, the feelings of panic and dread felt by many during the financial crisis were distinctly acute. Many investors reacted emotionally to these developments. In the heat of the moment, some decided it was more than they could stomach, so they sold out of stocks. On the other hand, many who were able to stay the course and stick to their approach recovered from the crisis and benefited from the subsequent rebound in markets.

It is important to remember that this crisis and the subsequent recovery in financial markets was not the first time in history that periods of substantial volatility have occurred. Exhibit 1 helps illustrate this point. The exhibit shows the performance of a balanced investment strategy following several crises, including the bankruptcy of Lehman Brothers in September of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year that it occurred or peaked.


Exhibit 1.       The Market’s Response to Crisis

Performance of a Balanced Strategy: 60% Stocks, 40% Bonds (Cumulative Total Return)

In US dollars. Represents cumulative total returns of a balanced strategy invested on the first day of the following calendar month of the event noted. Balanced Strategy: 12% S&P 500 Index,12% Dimensional US Large Cap Value Index, 6% Dow Jones US Select REIT Index, 6% Dimensional International Marketwide Value Index, 6% Dimensional US Small Cap Index, 6% Dimensional US Small Cap Value Index, 3% Dimensional International Small Cap Index, 3% Dimensional International Small Cap Value Index, 2.4% Dimensional Emerging Markets Small Index, 1.8% Dimensional Emerging Markets Value Index, 1.8% Dimensional Emerging Markets Index, 10% Bloomberg Barclays Treasury Bond Index 1-5 Years, 10% Citigroup World Government Bond Index 1-5 Years (hedged), 10% Citigroup World Government Bond Index 1-3 Years (hedged), 10% BofA Merrill Lynch 1-Year US Treasury Note Index. The S&P data are provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2017 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Citigroup Indices used with permission, © 2017 by Citigroup. Bloomberg Barclays data provided by Bloomberg. For illustrative purposes only. Dimensional indices use CRSP and Compustat data. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Not to be construed as investment advice. Rebalanced monthly. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance. See Appendix for additional information.

In US dollars. Represents cumulative total returns of a balanced strategy invested on the first day of the following calendar month of the event noted. Balanced Strategy: 12% S&P 500 Index,12% Dimensional US Large Cap Value Index, 6% Dow Jones US Select REIT Index, 6% Dimensional International Marketwide Value Index, 6% Dimensional US Small Cap Index, 6% Dimensional US Small Cap Value Index, 3% Dimensional International Small Cap Index, 3% Dimensional International Small Cap Value Index, 2.4% Dimensional Emerging Markets Small Index, 1.8% Dimensional Emerging Markets Value Index, 1.8% Dimensional Emerging Markets Index, 10% Bloomberg Barclays Treasury Bond Index 1-5 Years, 10% Citigroup World Government Bond Index 1-5 Years (hedged), 10% Citigroup World Government Bond Index 1-3 Years (hedged), 10% BofA Merrill Lynch 1-Year US Treasury Note Index. The S&P data are provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2017 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Citigroup Indices used with permission, © 2017 by Citigroup. Bloomberg Barclays data provided by Bloomberg. For illustrative purposes only. Dimensional indices use CRSP and Compustat data. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Not to be construed as investment advice. Rebalanced monthly. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance. See Appendix for additional information.

Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses immediately following most of these events, financial markets did recover, as can be seen by the three- and five-year cumulative returns shown in the exhibit. In advance of such periods of discomfort, having a long-term perspective, appropriate diversification, and an asset allocation that aligns with their risk tolerance and goals can help investors remain disciplined enough to ride out the storm. A financial advisor can play a critical role in helping to work through these issues and in counseling investors when things look their darkest.

Conclusion

In the mind of some investors, there is always a “crisis of the day” or potential major event looming that could mean the beginning of the next drop in markets. As we know, predicting future events correctly, or how the market will react to future events, is a difficult exercise. It is important to understand, however, that market volatility is a part of investing. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times. A well‑thought‑out, transparent investment approach can help people be better prepared to face uncertainty and may improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets.

Appendix

Balanced Strategy 60/40

The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor’s decision making if the advisor were actually managing client money. The balanced strategies are not recommendations for an actual allocation.

International Value represented by Fama/French International Value Index for 1975–1993. Emerging Markets represented by MSCI Emerging Markets Index (gross dividends) for 1988–1993. Emerging Markets weighting allocated evenly between International Small Cap and International Value prior to January 1988 data inception. Emerging Markets Small Cap represented by Fama/French Emerging Markets Small Cap Index for 1989–1993. Emerging Markets Value and Small Cap weighting allocated evenly between International Small Cap and International Value prior to January 1989 data inception. Two-Year Global weighting allocated to One‑Year prior to January 1990 data inception. Five-Year Global weighting allocated to Five-Year Government prior to January 1990 data inception. For illustrative purposes only.

The Dimensional Indices used have been retrospectively calculated by Dimensional Fund Advisors LP and did not exist prior to their index inceptions dates. Accordingly, results shown during the periods prior to each Index’s index inception date do not represent actual returns of the Index. Other periods selected may have different results, including losses.

Index Descriptions

Dimensional US Large Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th‑largest company whose relative price is in the bottom 30% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Large Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th‑largest company whose relative price is in the bottom 20% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.

Dimensional US Small Cap Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market‑capitalization‑weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the Eligible Market. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

Dimensional US Small Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 35% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 25% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.

Dimensional International Marketwide Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Marketwide Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index.

Dimensional International Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. July 1981–December 1993: It Includes non-US developed securities in the bottom 10% of market capitalization in each eligible country. All securities are market capitalization weighted. Each country is capped at 50%. Rebalanced semiannually. January 1994–Present: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Prior to July 1981, the index is 50% UK and 50% Japan. The calculation methodology for the Dimensional International Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

Dimensional International Small Cap Value Index is defined as companies whose relative price is in the bottom 35% of their country’s respective constituents in the Dimensional International Small Cap Index after the exclusion of utilities and companies with either negative or missing relative price data. The index also excludes those companies with the lowest profitability within their country’s small value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Created by Dimensional; includes securities of MSCI EAFE countries in the top 30% of book-to-market by market capitalization conditional on the securities being in the bottom 10% of market capitalization, excluding the bottom 1%. All securities are market-capitalization weighted. Each country is capped at 50%; rebalanced semiannually.

Dimensional Emerging Markets Index is compiled by Dimensional from Bloomberg securities data. Market capitalization-weighted index of all securities in the eligible markets. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008.

Dimensional Emerging Markets Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional Emerging Markets Value Index was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Fama/French Emerging Markets Value Index.

Dimensional Emerging Markets Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. January 1989–December 1993: Fama/French Emerging Markets Small Cap Index. January 1994–Present: Dimensional Emerging Markets Small Index Composition: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Source: Bloomberg. The calculation methodology for the Dimensional Emerging Markets Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

 

 

 

 

 

 

 

 

 

 

 

Source: Dimensional Fund Advisors LP.

There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Diversification does not eliminate the risk of market loss.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

 

 

 

[1]. wsj.com/articles/SB122169431617549947.

[2]. washingtonpost.com/wp-dyn/content/article/2008/09/17/AR2008091700707.html.

[3]. nytimes.com/2008/09/30/business/30markets.html.

Recovering From Harvey

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It’s been a rough week in the Lone Star State.

Seven days ago, as I was putting the finishing touches on last week’s Accountable Update, Hurricane Harvey was rapidly strengthening into the strongest storm to hit the Texas coast in over 50 years. In the article, I took some pot shots at the “breathless TV meteorologists” that seemingly relish presenting worst case scenarios when making predictions.

In hindsight, at least in this instance, those dire prognostications proved to be more right than wrong. Perhaps I owe our local weather folks an apology for my skepticism and should direct my sardonic comments to the national media and politicians that are already politicizing our fellow Texans’ tragedy while many are still in harm’s way. On the other hand, maybe we all should expend our energy on helping those in need.

It has been difficult to sit idly by while our families, friends, and customers have experienced the devastation of Harvey first hand. However, it has been heartening to witness our state and country rally to help. There are many worthy recipients of assistance, but if you are looking for an idea, check out TD Ameritrade’s offer to our customers to match contributions made to the American Red Cross. Matching donations can be made through this link.

You can stretch your giving dollars further if you happen to own appreciated stocks in a taxable account. By gifting the property directly to a charity or through a Donor Advised Fund, you get the benefit of being able to make a tax deductible gift up to 30% of your adjusted gross income while also avoiding paying capital gains taxes.

If you have suffered losses from the storm, you have probably seen some of the reports in the media that there was some urgency to make your insurance claims by yesterday. The urgency stemmed from reports about House Bill 1774, which was a tort reform law that came out of the recent 85th Texas Legislature that sought to limit excessive lawsuits resulting from “forces of nature”, primarily hail storms.

The law reduces some of the penalties that insurance companies may be subject to if found to act “in bad faith” resulting from a civil court judgement.  In other words, the law only applies to people suing their insurance company. There should be no impact on making claims under existing insurance policies. It’s also worth noting that losses covered by the National Flood Insurance Program or the Texas Windstorm Insurance Association are not impacted by the new law.

Hopefully, that is one less thing for victims to worry about as they focus on recovery.

Weather often offers similes for investors. We rebuilt smarter portfolios after the major storm of the Great Recession, as we will construct better buildings in Harvey’s wake. We got back on the bull to share in the market’s gains, as we will head back to the bays to angle for trout and redfish.

Then we can get back to discussing why anyone would want to invest in unicorns run by eccentric billionaires or live in places with high taxes, earthquakes, or snow. In the meantime, let's roll up our sleeves and start cleaning up Harvey’s mess.

God Bless Texas!

Build a Financial Ark to Weather a Storm

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“Predicting rain doesn’t count, building arks does.”
-Warren Buffet
— https://www.brainyquote.com/quotes/quotes/w/warrenbuff701497.html

Mother Nature is having a heck of a week. She started off Monday by blotting out the sun, or at least about 65% of it here in Austin. You may think she would be satisfied with scheduling a total blackout for 2024, but she decided to keep us entertained this weekend (or terrified) by whipping up a little disturbance down in the Gulf of Mexico.

If you have watched any of the breathless TV meteorologists this week, you probably are aware that Hurricane Harvey is barreling down on the Texas coast and is expected to make landfall this evening. As with most things in the media, the business of getting you to watch is based upon grabbing your attention and holding it for as long as possible. That leads to sensational predictions and worst-case scenarios being presented, which frankly can be quite frightening.

But if you know someone that owns coastal property, you may be surprised by their attitude towards the risks associated with these events. Take, for example, ATX Portfolio Advisors® client and Rockport,TX homeowner David Fournier. When I asked him about his level of concern, he responded, “Because I grew up in New Orleans, storms are common for me. They just don’t worry me that much. Besides, that’s why I buy insurance.” 

“Because I grew up in New Orleans, storms are common for me. They just don’t worry me that much. Besides, that’s why I buy insurance.”  
-David Fournier
— 8/24/2017 Interview with Jeff Weeks

How common are they? Data from the National Oceanic & Atmospheric Administration’s Hurricane Research Division shows the actual number of storms that have hit the Texas coast since 1851 is 63, or about one every 2.6 years.  Major storms, also referred to as Category 3 or greater, were much less common. In fact, there were only 19 of them over that 166 year period, or one every 8.5 years. If you split the coastal regions of Texas into three geographic zones (North, Central, and South), the average zone has had a little over 6 major storms since a decade before the Civil War. That equates to one major hurricane every 26 years hitting a particular area of coastline.

For those that live or own property in coastal communities, spending a lot of time and effort worrying about something that happens once a generation may not rank high on the list of concerns, but that doesn't mean they shouldn't prepare for the worst. As Warren Buffet once said, “Predicting rain doesn’t count, building arks does.”

Building arks seems like hard work. A close inspection of the text of the book of Genesis in the Bible estimates that it took Noah, his wife, his three sons, and their wives between 55 – 75 YEARS to build their boat.

Fortunately, financial arks are not quite as, well, biblical in proportion.

In fact, you can build yours in three relatively easy steps.

  1. Establish ample liquidity. This can be an emergency fund of cash or credit availability (can be a line of credit or even a credit card), anything that can help you avoid having to sell assets at inopportune times. For example, how would you like to have been forced to sell stocks to replace your home's HVAC in August 2008? The amount needed can vary based on your personal circumstances, but a good rule of thumb is to have 3-6 months of expenses readily accessible for those unplanned rogue waves.
  2. Diversify. Allocating assets to investments across asset types, countries, and industries isn’t going to insure against losses, but can greatly reduce or even eliminate un-systemic risks. Bonds, for example, may not be very appealing due to low interest rates today, but when combined with a stock portfolio they can offer relative safe havens from the occasional volatility inherent to equities. That anchor can be very reassuring when the water gets choppy.
  3. Insure against catastrophe. Even though major storms don’t hit that often, when they do, the results can be catastrophic. Buy insurance for these events, such as premature death, disability, long-term care, or even longevity, to provide you (or your family) the resources to weather the worst storms.

I hope that everyone in Harvey's path finds shelter and protection, and that your property survives intact. If you need help planning for or building your ark for the next storm, get in touch.

3 Ways to Avoid 9 Mistakes

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Yesterday, the Dow Jones Industrial Average fell 1.2%, the S&P 500 shed 1.5%, and the Nasdaq Composite dropped 1.9%. It marked the end of a 63-day stretch where volatility has been remarkably absent. In fact, the last time we saw a streak of trading days with fewer 1% moves in either direction was in 1995.

Whether this is the start of a new period of increased volatility, or just a temporary blip on the screen, the tendency can be to react. That’s why it can be helpful to also study the history of mistakes that investors tend to make and the lessons we have learned.

Back in 2010, the Library of Congress’s Federal Research Division prepared a report titled Behavioral Patterns and Pitfalls of US Investors. The report identified common investment mistakes as cited by academics and professionals across several fields including business, economics, finance, psychology, and sociology.

The report identified nine common mistakes, which were also used as the basis for an Investor Bulletin from the SEC in 2014. The good news is that I think you can avoid making all nine of these mistakes in three relatively easy ways.

First, let's look at the mistakes.

The Mistakes

  1. Active Trading:  An investor using an active trading investment strategy engages in regular, ongoing buying and selling of investments.  This kind of investor purchases investments and continuously monitors their activities in order to take advantage of profitable conditions in the market.  The Report concludes that active trading generally results in the underperformance of an investor’s portfolio.
  2. Disposition Effect:  The disposition effect is the tendency of an investor to hold on to losing investments too long and sell winning investments too soon.  In the months following the sale of winning investments, these investments often continue to outperform the losing investments still held in the investor’s portfolio.
  3. Focusing on Past Performance of Mutual Funds and Ignoring Fees:  When deciding to purchase shares in a mutual fund, the Report indicates that some investors focus primarily on the mutual fund’s past annualized returns and tend to disregard the fund’s expense ratios, transaction costs, and load fees, despite the harm these costs and fees can do to their investment returns.
  4. Familiarity Bias:  Familiarity bias refers to the tendency of an investor to favor investments from the investor’s own country, region, state or company.  Familiarity bias also includes an investor’s preference for “glamour investments;” that is, well-known and/or popular investments.  Familiarity bias may cause an investor’s portfolio to be inadequately diversified, which can increase the portfolio’s risk exposure.
  5. Manias and Panics:  Financial “mania” or a “bubble” is the rapid rise in the price of an investment, reflecting a high degree of collective enthusiasm or exuberance regarding the investment’s prospects.  This rapid rise is usually followed by a contraction in the investment’s price.  The contraction, or “panic” occurs when there is wide-scale selling of the investment that causes a sharp decline in the investment’s price.
  6. Momentum Investing:  An investor using a momentum investing strategy seeks to capitalize on the continuance of existing trends in the market.  A momentum investor believes that large increases in the price of an investment will be followed by additional gains and vice versa for declining values.
  7. Naïve Diversification:  Naïve diversification occurs when an investor, given a number of investment options, chooses to invest equally in all of these options.  While this strategy may not necessarily result in diminished performance, it may increase the risk exposure of an investor’s portfolio depending upon the risk level of each investment option.
  8. Noise Trading:  Noise trading occurs when an investor makes a decision to buy or sell an investment without the use of fundamental data (that is, economic, financial, and other qualitative or quantitative data that can affect the value of the investment).  Noise traders generally have poor timing, follow trends, and overreact to good and bad news in the market.
  9. Inadequate Diversification:  Inadequate diversification occurs when an investor’s portfolio is too concentrated in a particular type of investment.  Inadequate diversification increases the risk exposure of an investor’s portfolio.

Three Ways to Avoid Them

1. Let the markets work for you. Outsmarting other investors is tough, especially when you add in transaction costs. Invest in the broad markets, keep your transaction costs down, and structure your portfolio around expected dimensions of returns.

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2. Diversify smartly. Diversification reduces risk that don't add to expected returns. Nearly half of the world's opportunities are outside the US.

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3. Have a plan. Investors are people that are subject to normal emotions. Having a plan in place that you can review when the going gets tough can make the difference in achieving your goals or not. Markets reward discipline.

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That's it, employ those three solutions and you will be well on your way to being a successful investor. Need help? Get in touch for a free review of your plan and portfolio.

Preparing to Get Hit by Life

Life is what happens to you while you’re busy making other plans,” John Lennon sang in a verse of Beautiful Boy. Mike Tyson put it more bluntly, “Everybody’s got plans…until they get hit.”[i]

I think back to my early 30’s when the .com bubble was expanding. Business was good in the financial trades, with stocks rising 20% every year and customers literally standing in line to invest. Retirement seemed a certainty by the time I was 40. Along the way, a new baby, a move to California, a “once in a generation” bear market, another baby, a move back to Texas, another “once in a generation” bear market, and a foolish notion to start a new business now have me approaching 50 and planning to work for the foreseeable future.

While some may argue differently about the bear markets, most would probably agree that none of those life events were catastrophic. But what if something had happened that truly altered my plans, or those of my family?

Probably the most obvious catastrophe that most people think of is an untimely demise. The odds of that happening are pretty low when you are in your 30’s. For example, according to the Social Security Administration's cohort life tables, a 30-year-old male has a 98.5% chance of living to age 40, 95.5% chance of making it to 50, and a 90.5% probability of reaching his 60th birthday. Ladies have even higher odds of reaching the golden years, with nearly a 94% chance. With odds that high, it isn’t surprising that term life insurance is relatively affordable.

Insurance works best when it is used to protect against low probability but high impact events, such as premature death. Nevertheless, paying an insurance company for 20-30 years of protection that is very unlikely to be used isn’t high on the list of expenses most folks look forward to paying. But the thought that our families would have to move because they can’t afford the mortgage or that the kids would be forced into debt to pay for college are enough to motivate me to write that check each year.

But there are other risks that are more likely to impact you than an early death. According to the SSA’s Disability and Death Probabilities, a male born in 1996 has about a 20% chance of becoming disabled before retirement age. Unlike death, with a disability you not only lose your earning potential but continue to need to support your family AND yourself.

Both life and disability insurance are important tools for protecting yourself from a knockdown blow, but they will cost you. How much you should buy can vary based on your personal goals, attitude towards risk, and family situation. An independent financial advisor may be your best resource for helping you answer the question of how much and then find solutions that suit you.

In addition, other steps to protect you and your family from a potential KO are:

Establish liquidity. An emergency fund with several months’ worth of expenses set aside is the easiest solution, but establishing credit before it is needed can also be effective. A line of credit or a credit card may be difficult to obtain or more expensive to use if you wait until the primary breadwinner has stopped winning bread.

Review the beneficiaries on your accounts and insurance policies. These designations work very efficiently to transfer assets after death without going through probate. However, failing to name them, or having the wrong ones (i.e. ex-spouses, minor children) can complicate or ruin your plans.

Write a will. Clearly state who should inherit your property and take care of your minor children, pets, etc. Appoint an executor that is willing and able to execute the will when the time comes.

Consider trusts. There is a myriad of trust types that accomplish different objectives. They can help avoid probate, protect assets from creditors, and insure they ultimately pass to the heirs or causes of your choosing.

Set up health care directives. Living wills, medical power of attorney, and HIPPA authorizations spell out your desires, who can make decisions, and who can even talk to doctors about your condition. These tools can insure that your wishes are followed in the event you aren’t able to communicate and help avoid emotional conflicts between well-meaning family members.

Establish durable power of attorney. In case you are unable to make financial decisions, having a trusted person (spouse, child, etc.) appointed as your attorney-in-fact that can handle your affairs can make life much easier on your family.

Title your assets correctly. All the steps previously mentioned can be voided or made more complicated by not titling assets correctly. On a financial statement, it is helpful to list the registration of all your assets so that your financial planner or attorney can help identify potential disconnects with your plans.

Finally, it’s also a good idea to put a recent copy of your financial statements, wills, trusts, insurance policies, deeds, and other important documents in a place where they can easily be accessed by your attorney-in-fact or executor.

Don’t know where to start? Get in touch to discuss your plans.

 

 

[i] https://www.brainyquote.com/quotes/quotes/m/miketyson379007.html?src=t_plans

Is the Market Due for a Wrench?

July marked the ninth consecutive month of positive returns in US stock markets. Rising tides lift all boats, but that hasn’t stopped some from taking credit.

Whose fault will it be when the inevitable downturn occurs? There will be plenty of blame offered, but you can be certain that at least one character won’t accept any of it. Believe me!

Since 1987, August has been the worst month for the S&P 500®, according to the Stock Trader’s Almanac. Also noted in the Almanac is that volatility typically picks up around this time of year. Given that the CBOE Volatility Index (also known as the VIX) hit its lowest level since 1990 last month, it wouldn’t be a shock to see some red numbers in the near term.

What also won’t be surprising is that someone will get credit for being the portfolio manager or trader that “predicted the selloff”, even though there is scant evidence of anyone consistently able to outguess the markets. In fact, in his 1973 book, A Random Walk Down Wall Street, Burton Malkiel argued, “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”

But perhaps Mr. Malkiel was just observing (unknowingly) that expected returns actually increase by using this method to manage a portfolio. Sound crazy? Then check out this month’s Issue Brief from DFA titled Quit Monkeying Around!

Come to think of it, that might also be a suitable response to a certain Tweeter in Chief after his next late-night tirade. Rest assured, if the market wilts in the August heat, it may not be our fault but we’ll be right by your side with our Accountable Wealth Management. Get in touch if you would like to discuss.


Quit Monkeying Around!

August 2017

In the world of investment management there is an oft-discussed idea that blindfolded monkeys throwing darts at pages of stock listings can select portfolios that will do just as well, if not better, than both the market and the average portfolio constructed by professional money managers. If this is true, why might it be the case?

The Dart Board

Exhibit 1 shows the components of the Russell 3000 Index (regarded as a good proxy for the US stock market) as of December 31, 2016. Each stock in the index is represented by a box, and the size of each box represents the stock’s market capitalization (share price multiplied by shares outstanding) or “market cap” in the index. For example, Apple (AAPL) is the largest box since it has the largest market cap in the index. The boxes get smaller as you move from the top to the bottom of the exhibit, from larger stocks to smaller stocks. The boxes are also color coded based on their market cap and whether they are value or growth stocks. Value stocks have lower relative prices (as measured by, for instance the price-to-book ratio) and growth stocks tend to have higher relative prices. In the exhibit, blue represents large cap value stocks (LV), green is large cap growth stocks (LG), gray is small cap value stocks (SV), and yellow is small cap growth stocks (SG).

For the purposes of this analogy you can think of Exhibit 1 as a proxy for the overall stock market and therefore similar to a portfolio that, in aggregate, professional money managers hold in their competition with their simian challengers. Because for every investor holding an overweight to a stock (relative to its market cap weighting) there must also be an investor underweight that same stock, this means that, in aggregate, the average dollar invested holds a portfolio that looks like the overall market.[1]

Exhibit 1.       US Stocks Sized by Market Capitalization

For illustrative purposes only. Illustration includes constituents of the Russell 3000 Index as of December 31, 2016, on a market-cap weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Please see Appendix for additional information.

For illustrative purposes only. Illustration includes constituents of the Russell 3000 Index as of December 31, 2016, on a market-cap weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Please see Appendix for additional information.

Exhibit 2, on the other hand, represents the dart board the monkeys are using to play their game. Here, the boxes represent the same stocks shown in Exhibit 1, but instead of weighting each company by market cap, the companies are weighted equally. For example, in this case, Apple’s box is the same size as every other company in the index regardless of its market cap. If one were to pin up pages of newspaper stock listings to throw darts at, Exhibit 2 would be much more representative of what the target would look like.

When looking at Exhibits 1 and 2, the significant differences between the two are clear. In Exhibit 1, the surface area is dominated by large value and large growth (blue and green) stocks. In Exhibit 2, however, small cap value stocks dominate (gray). Why does this matter? Research has shown that, historically over time, small company stocks have had excess returns relative to large company stocks. Research has also shown that, historically over time, value (or low relative price) stocks have had excess returns relative to growth (or high relative price) stocks. Because Exhibit 2 has a greater proportion of its surface area dedicated to small cap value stocks, it is more likely that a portfolio of stocks selected at random by throwing darts would end up being tilted towards stocks which research has shown to have had higher returns when compared to the market.

Exhibit 2.       US Stocks Sized Equally

For illustrative purposes only. Illustration includes the constituents of the Russell 3000 Index as of December 31, 2016 on an equal-weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Please see Appendix for additional information.

For illustrative purposes only. Illustration includes the constituents of the Russell 3000 Index as of December 31, 2016 on an equal-weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Please see Appendix for additional information.

So…Throw Away?

This does not mean, however, that haphazardly selecting stocks by the toss of a dart is an efficient or reliable way to invest. For one thing, it ignores the complexities that arise in competitive markets.

Consider as an example something seemingly as straightforward as a strategy that holds every stock in the Russell 3000 Index at an equal weight (the equivalent of buying the whole dart board in Exhibit 2). In order to maintain an equal weight in all 3,000 securities, an investor would have to rebalance frequently, buying shares of companies that have gone down in price and selling shares that have gone up. This is because as prices change, so will each individual holding’s respective weight in the portfolio. By not considering whether or not these frequent trades add value over and above the costs they generate, investors are opening themselves up to a potentially less than desirable outcome.

Instead, if there are well-known relationships that explain differences in expected returns across stocks, using a systematic and purposeful approach that takes into consideration real-world constraints is more likely to increase your chances for investment success. Considerations for such an approach include things like: understanding the drivers of returns and how to best design a portfolio to capture them, what a sufficient level of diversification is, how to appropriately rebalance, and last but not least, how to manage the costs associated with pursuing such a strategy.

 

The Long Game

Finally, the importance of having an asset allocation well suited for your objectives and risk tolerance, as well as being able to remain focused on the long term, cannot be overemphasized. Even well-constructed portfolios pursuing higher expected returns will have periods of disappointing results. A financial advisor can help an investor decide on an appropriate asset allocation, stay the course during periods of disappointing results, and carefully weigh the considerations mentioned above to help investors decide if a given investment strategy is the right one for them.

Conclusion

So what insights can investors glean from this analysis? First, by tilting a portfolio towards sources of higher expected returns, investors can potentially outperform the market without needing to outguess market prices. Second, implementation and patience are paramount. If one is going to pursue higher expected returns, it is important to do so in a cost-effective manner and to stay focused on the long term.


Appendix

Large cap is defined as the top 90% of market cap (small cap is the bottom 10%), while value is defined as the 50% of market cap of the lowest relative price stocks (growth is the 50% of market cap of the highest relative price stocks). For educational and informational purposes only and does not constitute a recommendation of any security. The determinations of Large Value, Large Growth, Small Value, and Small Growth do not represent any determinations Dimensional Fund Advisors may make in assessing any of the securities shown.

 

[1]. For more on this concept, please see “The Arithmetic of Active Management” by William Sharpe.

Time for a New Pickup?

This summer has been a rough one for my old pickup. In early May, as the thermometer starting rising, my air conditioner went kaput. That cost me about $600 to make the repairs. Then, last week, alarm bells starting ringing and a red light shaped like a battery flashed on the dash. Unfortunately, it wasn’t a relatively affordable battery that needed replacing. Rather, it was a much more expensive alternator. After forking out another $500, the thought crossed my mind that it may be time to look for some new wheels.

New vehicles are probably the worst “investments” we make. It is not unusual to see the value decline by 50% in the first four years after driving off the dealer’s lot. That knowledge has led me to adopt a philosophy that I will drive our cars and trucks until “the wheels fall off” before buying a new one. As my unexpected repair expenses have accumulated though, some reminders of how expensive new cars can be helped to scratch that new car (or truck) itch.

I started with a quick visit to Kelley Blue Book® to see roughly what a new 2017 Ford F150 Platinum edition (the same model of my current pickup) would cost. $53,383 was the “Fair Purchase Price” that was indicated. Ouch, that was about all I needed to realize I am probably doing the right thing by continuing to drive my old pickup a while longer. But I can’t write an Accountable Update without analyzing it further, so I started checking out the values of older models, too.

I saw that a used 2013 model in good condition has a trade-in value around $26,000, which would be a pretty good indication of its actual value. Compared to the new price of $46,100 back in 2013, according to an article I found on Autotrader.com, it looks like the value has fallen just under half over the last four years. Of course, when you add in the approximate $3,400 of tax, title, and license costs in Texas (per this calculator on Carmax.com), plus whatever else you let the F&I guy talk you into at the dealership, and a 50% decrease per presidential term appears to be a good estimate.

That translates to a -15.91% annual rate of return. Put in dollar terms, a new $53,383 pickup would drop the following amounts over the next ten years assuming annual depreciation at that rate:

Depreciation.jpg.png

Depreciation Illustration

$53,383 pickup with annual depreciation of -15.91%.

 

In the first three years, that’s a total of $21,641 of lost value versus only $12,868 over the next three. If you put 12,000 miles a year on the vehicle in this example, the depreciation cost per mile is 60.11 cents in the first three years versus 35.74 cents for the next three.* Consider that the IRS mileage rate in 2017 for business is only 53.5 cents per mile. You could also supplement your income by driving for Uber, but their base mileage rate starts at $1.06 per mile, and you would still need to buy gas! 

Remember that commercial that showed a guy driving an old car that spit change out of the air conditioning ducts? Driving a new car is like that, but exactly the opposite.

Some potential good news, especially if you are in the market for a new car, is that “…millions (of) cars that were leased two or three years ago, many of them used compact and midsized cars with low mileage, are heading toward auction lots and used car dealerships. That surge in supply threatens to depress prices for new and used vehicles…”, according to an Autonews.com article from earlier this month.

Some may be asking if a lease may make more sense than buying, but the lease amount incorporates the expected depreciation, taxes, and interest into the payment. At the end of the lease, you would then start the whole process over again, insuring that you are always paying the highest amount of depreciation. Plus you typically add in mileage penalties and wear and tear charges. 

There is nothing quite like that new car smell, except that you may find adding to your retirement account, the kids’ college, or travel funds are even sweeter. You can certainly reduce the amount of depreciation each year by driving a new vehicle longer, but buying the used pickup in the example above would mean you could add an extra $3,000 per year towards goals that may make you a lot happier.

If you would like to discuss any of those plans, get in touch.

If you are in the market for a car, it looks like your timing could be pretty good. As for me, I think I’ll stick with my old pickup for bit longer.

 

*Arithmateic error corrected from earlier version 

Quick Announcement

I'm taking a break from the Accountable Update this week due to a travel conflict, but I do have an announcement to share. Taigon Chen is the newest addition to the team at ATX Portfolio Advisors, beginning this week as my first intern.

Taigon is a sophomore at the University of Texas, majoring in Aerospace Engineering and Business Administration. He is from Sugarland where he was Valedictorian of William B. Travis High School. In his spare time, he enjoys trading stocks, designing and building airplanes and computers, and playing the guitar. 

Taigon will be focused on learning about investments and financial planning, as well as some of the technology and operational aspects of the business. Please join me in welcoming Taigon!

Getting What You Don’t Pay For

Please consider the investment objectives, risks, charges, and expenses carefully before investing in Mutual Funds. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Does that sound familiar? If you scroll to the bottom of this webpage, you will see this common language encouraging you to read the prospectus of any mutual fund you are considering for purchase. But even if you heed the call to read this legally required disclosure, you probably aren't seeing the whole picture.

For example, did you know that funds also produce another document that discloses how much the fund pays in trading commissions? Those expenses are not included in the fund's expense ratio and are typically expressed as a dollar amount on a financial statement that can be found in the Statement of Additional Information (SAI).

This is just one example of the type of diligence that you, or an advisor on your behalf, should be conducting when considering the inclusion of mutual funds and Exchange Traded Funds(ETFs) in your portfolio. Funds and ETFs are required to produce these disclosures in prescribed formats. Throw in holdings reports, typically produced semi-annually but sometimes more frequently, and you have the information you need to start making informed decisions.

This week I share the July 2017 Issue Brief from DFA titled Getting What You Don't Pay For. It provides a quick insight into why the information found in documents such as prospectuses and SAIs matters. Enjoy the short read and have a great weekend!


Getting What You Don’t Pay For

Costs matter. Whether you’re buying a car or selecting an investment strategy, the costs you expect to pay are likely to be an important factor in making any major financial decision.

People rely on a lot of different information about costs to help inform these decisions. When you buy a car, for example, the sticker price tells you approximately how much you can expect to pay for the car itself. But the sticker price is only one part of the overall cost of owning a car. Other things like sales tax, the cost of insurance, expected routine maintenance costs, and the potential cost of unexpected repairs are also important to understand. Some of these costs are easily observed, and others are more difficult to assess. Similarly, when investing in mutual funds, different variables need to be considered to evaluate how cost‑effective a strategy may be for a particular investor.

Expense Ratios

Many types of costs lower the net return available to investors. One important cost is the expense ratio. Similar to the sticker price of a car, the expense ratio tells you a lot about what you can expect to pay for an investment strategy. Exhibit 1 helps illustrate why expense ratios are important and shows how hefty expense ratios can impact performance.

This data shows that funds with higher average expense ratios had lower rates of outperformance. For the 15-year period through 2016, only 9% of the highest-cost equity funds outperformed their benchmarks. This data indicates that a high expense ratio is often a challenging hurdle for funds to overcome, especially over longer horizons. From the investor’s point of view, an expense ratio of 0.25% vs. 0.75% means savings of $5,000 per year on a $1 million account. As Exhibit 2 helps to illustrate, those dollars can really add up over longer periods.


Exhibit 1.       High Costs Can Reduce Performance, Equity Fund Winners and Losers Based on Expense Ratios (%)

Exhibit 2.       Hypothetical Growth of $1 Million at 6%, Less Expenses

The sample includes funds at the beginning of the 15-year period ending December 31, 2016. Funds are sorted into quartiles within their category based on average expense ratio over the sample period. The chart shows the percentage of winner and loser funds by expense ratio quartile; winners are funds that survived and outperformed their respective Morningstar category benchmark, and losers are funds that either did not survive or did not outperform their respective Morningstar category benchmark. US-domiciled open-end mutual fund data is from Morningstar and Center for Research in Security Prices (CRSP) from the University of Chicago. Equity fund sample includes the Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Small Blend, Small Growth, Small Value, and World Stock. For additional information regarding the Morningstar historical categories, please see “The Morningstar Category Classifications” at morningstardirect.morningstar.com/clientcomm/Morningstar_Categories_US_April_2016.pdf. Index funds and fund-of-funds are excluded from the sample. The return, expense ratio, and turnover for funds with multiple share classes are taken as the asset-weighted average of the individual share class observations. For additional methodology, please refer to Dimensional Fund Advisor’s brochure, The 2017 Mutual Fund Landscape. Past performance is no guarantee of future results.

For illustrative purposes only and not representative of an actual investment. This hypothetical illustration is intended to show the potential impact of higher expense ratios and does not represent any investor’s actual experience. Assumes a starting account balance of $1,000,000 and a 6% compound annual growth rate less expense ratios of 0.25% and 0.75% applied over a 15-year time horizon. Taxes and other potential costs are not reflected. Actual results may vary significantly. Changing the assumptions would result in different outcomes. For example, the savings and difference between the ending account balances would be lower if the starting investment amount was lower.


While the expense ratio is an important piece of information for an investor to evaluate, what matters most when gauging the true cost‑effectiveness of an investment strategy is the “total cost of ownership.” Similar to the car example, total cost of ownership is more holistic than any one figure. It looks at things that are readily observable, like expense ratios, but also at things that are more difficult to assess, like trading costs and tax impact. It is important for investors to be aware of these and other costs and to realize that an expense ratio, while useful, is not an all‑inclusive metric for total cost of ownership.

Trading Costs

For example, while an expense ratio includes the fund’s investment management fee and expenses for fund accounting and shareholder reporting (among other items), it doesn’t include the potentially substantial cost of trading securities within the fund. Overall trading costs are a function of the amount of trading, or turnover, and the cost of each trade. If a manager trades excessively, costs like commissions and the price impact from trading can eat away at returns. Viewed through the lens of our car analogy, this impact is similar to excessively jamming your brakes or accelerating quickly. By regularly demanding immediacy like this when it may not be necessary, the more wear and tear your car is likely to experience and the more fuel you will end up using. These actions can increase your total cost of ownership. Additionally, excessive trading can also lead to negative tax consequences for the fund, which can increase the cost of ownership for investors holding funds in taxable accounts. The best way to try to decrease the impact of trading costs is for funds to avoid trading excessively and pay close attention to effectively minimizing cost per trade. Employing a flexible investment approach that reduces the need for immediacy, thereby enabling opportunistic execution, is one way to potentially help accomplish this goal. Keeping turnover low, remaining flexible, and transacting only when the potential benefits of a trade outweigh the costs can help keep overall trading costs down and help reduce the total cost of ownership.

Conclusion

The total cost of ownership of a mutual fund can be difficult to assess and requires a thorough understanding of costs beyond what an expense ratio can tell investors on its own. A good advisor can help investors look beyond any one cost metric and instead evaluate the total cost of ownership of an investment program—and ultimately help clients decide if a given strategy is right for them.


 

Source: Dimensional Fund Advisors LP.

There is no guarantee investment strategies will be successful. Diversification does not eliminate the risk of market loss. Mutual fund investment values will fluctuate and shares, when redeemed, may be worth more or less than original cost. The types of fees and expenses will vary based on investment vehicle. Investments are subject to risk including possible loss of principal.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Q2 2017 Market Review

As summer heats up, the US stock market stayed hot by posting its seventh consecutive quarter of positive returns. Much of that growth recently was led by large growth stocks, such as Facebook, Amazon, Netflix, and Alphabet (formerly known as Google); but small company growth stocks provided plenty of heat, too. Value stocks trailed growth stocks across all size ranges.

The Federal Reserve made no changes to monetary policy during the quarter but did start to release some of their discussions about how they may wind down the $4.5 trillion of bonds they bought with printed money following the Great Recession. While US and global bonds turned in a positive quarter, the tightrope between deflation and inflation that policy makers will be forced to traverse while unwinding the world central banks' unprecedented balance sheets would make even the Flying Wallendas nervous. All eyes are certain to be glued to Ms. Yellen and her global peers in coming months.

International markets, both developed and emerging, outperformed domestic markets, while commodities and REITs lagged. Longer maturity bonds and high yield corporates were the strongest performers in the fixed income markets, but the increasing noise about quantitative tightening has led to increased volatility.

It has been a good ride over the last couple of years. Long ago, I gave up trying to predict what the next short term moves in the market may be, but we should react to what market prices are telling us from time to time. Recently, we have rebalanced some portfolios due to drift from target allocations and aligned our models more closely to global equity weightings. While we all hope that Q3 produces a screen as green as Q2, at some point we will see red. By taking some gains off the table now, we hope to keep our clients in step with their risk tolerance and capacity while taking advantage of the benefits that diversification can provide.

If you have concerns about your portfolio or level of diversification, get in touch for a free review. In the meanwhile, stay cool and enjoy the Q2 2017 Market Review!

4 Letters Worth Repeating...Again

In early 2016, I was watching one of the cable business channels when a guest predicted that the stock market would crash on a particular day the following month. He even narrowed it down to what time of day the crash would occur.  

After discussing last week how different folks can arrive at very different conclusions when viewing the same data or charts, I was reminded of this article I wrote for the Accountable Update last year. The original, 4 Letters Worth Repeating, T-I-M-E, was good enough that I find it worth repeating, again. I did fix some questionable syntax and updated the charts with data through 2016. 

The article may be easier to read on ATXAdvisors.com than the email version due to the way some of the slides are formatted. Enjoy between the fireworks and BBQ this weekend and have a safe and Happy Independence Day! 


4 Letters Worth Repeating

This week, there was a story on a major "financial" network that predicted not only that the US stock market would peak on a particular day in March, but that it would happen after lunch. Appropriately, that network refers to itself with a 4-letter word.

But really, how considerate of them? With that level of detail, we should all be able to ride our unicorns down to Wall Street after sleeping late and enjoying a nice brunch, with time to spare to put in our sell orders before the bottom falls out.

I can think of a couple of 4-letter words for that kind of "news".

John Maynard Keynes is credited with uttering, “The market can stay irrational longer than you can stay solvent.” The famous (or infamous to some) economist made that observation after he had lost most of his money in ill-timed currency trades using borrowed money in early 1920. He was supposedly betting against the German Deutschmark as Deutschland struggled to recover after The Great War. Of course, in hindsight, he was right to see the black clouds building over the Weimer Republic that ultimately ended in hyperinflation and the rise of the National Socialist German Workers' Party (also known as the Nazis).

It turns out he was right about everything but, WHEN.

Decades later, investing legend Peter Lynch observed, "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." I suppose, though, that practical advice is much less likely to keep you glued to your TV set.

The reason it is so hard to know in the short run how any asset may perform is that the market reflects the aggregate expectations of all market participants, all the time. Folks that are willing to buy an asset are competing with folks who want to sell. When they agree on a price, they both feel that they are making the best deal. The buyer anticipating the asset will increase in price faster than other investment alternatives, the seller that the money will be more effectively invested elsewhere.

At ATX Portfolio Advisors, we believe that while the market incorporates all available information to drive stocks to fair value, we also believe that stocks may have different expected returns. In other words, there are certain characteristics that have resulted in returns that are greater than average that have persisted over time and across markets.

For stocks, there are four characteristics, or dimensions, that compelling evidence shows persistently over time. First is the market itself—stocks have higher expected returns than T-bills. Other characteristics include—company size (small vs. large), relative price (value vs. growth), and profitability (high vs. low).

The chart below documents the historical premiums that the size, relative price, and profitability dimensions have produced over time frames that reliable data is available. As you can see, the premiums have persisted over long time frames across different types of markets.

The next set of charts show the yearly relative performance of dimensions in US, Developed International, and Emerging Markets stocks. The blue bars indicate years in which the market, small cap, value, and profitability premiums were positive. The red bars indicate years in which the premiums were negative. A positive premium indicates out-performance (e.g., small cap stocks outperform large cap stocks); a negative premium indicates under-performance (e.g., small cap stocks under-perform large cap stocks).

Over these periods, positive premiums have occurred more frequently than negative premiums across all dimensions. BUT, the premiums can and do vary widely from year to year and can experience extreme and prolonged negative relative performance. In other words, there is no free brunch.

This is why we say you should take a longer-term view and stay disciplined during periods of volatility or under-performance of any premium. Over longer periods however, we have observed a higher frequency of positive premiums.

This next set documents the relative 5-year annualized performance of return dimensions in the different markets. When looking at longer time spans, observations of premiums are more consistent compared to one observation in any given year.

As you can see, there are fewer negative (red bars) 5-year periods versus positive (blue bars) periods. The difference is even more pronounced in historical observations of 10-year premiums as illustrated below.

Please remember that despite the higher frequency of positive premiums, outperformance may not be consistent, even over longer periods of time. Long-term investors should consider that premiums are never guaranteed and can undergo periods of negative returns in both relative and absolute terms.

All we have to do is look at the last 10-year period to remind ourselves of these facts, as many of the premiums have been smaller than historical averages.

10 Yr Dimension Performance.jpg

If the first several slides show why we stick to our strategy of owning the total market with weightings tilted to those dimensions that have demonstrated historical premiums, it is the last set that illustrates why our philosophy isn't likely to change when short term divergences from historical averages occur. They clearly show that the longer our investment period was, the more likely we were to see a premium in all of the dimensions. That's not nearly as exciting as screaming about market tops or bottoms, but it is pretty compelling evidence to stay the course no matter how loud the carnival barker chorus.

If nothing else, all of this reminds us of the old adage, “Time in the market is more important than timing the market.” T-I-M-E, now that's a 4-letter word worth worth repeating.

If you or someone you know lacks the time to plan and manage your portfolio, let's get acquainted.


Index descriptions available here.

Ink Blots or Evidence? Research Shows Profitability Matters

What Do You See.jpg

My morning routine, after coffee and exercise, is to review customer accounts for any needed actions, check emails, and if time allows, surf through several financial web sites. I look for news, insight, opinions, and occasional inspiration for Accountable Update articles. Yesterday, these two headlines stood out on one popular site:

  1. “This chart shows that stocks may be primed for a pullback”
  2. “Top strategist sees screaming 'buy' signal for stocks, here's the chart”

QUIZ: Can you guess which story the following charts were part of? (Answers can be found below)

Chart A

1498077814_20493351_TN_DIGITAL_CHART_LINE_A_BUY_v2.jpg

Chart B


It never ceases to amaze me that perfectly intelligent people believe that these financial Rorschach interpretations can somehow predict the future, despite overwhelming evidence that these techniques are only reliable at earning some active managers extra fees. What shouldn’t surprise anyone are the lengths people will go to convince others to pay them for no good reason, such as the ability to see illusory correlations in data.

Investing in the broad markets while overweighting investments with observable and persistent “premiums” is the type of evidence based investing I believe in. While chartists will tell you that recognizing repeatable patterns is a reliable way to determine when to buy or sell, I have yet to see any credible evidence suggesting that is the case. The headlines above illustrate the anecdotal nature of these techniques, as one of these “strategists” will certainly proclaim they were right, eventually.

A preferable approach, at least for me, is to start with well-diversified portfolios, then emphasize areas of the market with higher expected return potential. I can't make heads or tails (or is it shoulders?) from ink blots, but I did enjoy this Issue Brief from Dimensional that shows how one of these areas of higher potential, stocks that are currently profitable, was identified and tested through academic research.

Enjoy the slightly wonky read and get in touch if you would like an analysis of your portfolio that doesn’t involve a psychologist.

(Quiz Answers: Headline 1 goes with Chart B; Headline 2 goes with Chart A)


Evolution of Financial Research:
The Profitability Premium

Since the 1950s, there have been numerous breakthroughs in the field of financial economics that have benefited both society and investors.

One early example, resulting from research in the 1950s, is the insight that diversification can increase an investor’s wealth. Another example, resulting from research in the 1960s, is that market prices contain up-to-the-minute, relevant information about an investment’s expected return and risk. This means that market prices provide our best estimate of a security’s value. Seeking to outguess market prices and identify over- and undervalued securities is not a reliable way to improve returns.

This long history of innovation in research continues into the present day. As academics and market participants seek to better understand security markets, insights from their research can enable investors to better pursue their investment goals. In this article, we will focus on a series of recent breakthroughs into the relation between a firm’s profitability and its stock returns. As we will see, an important insight Dimensional drew from this research is how profitability and market prices can be used to increase the expected returns of a stock portfolio without having to attempt to outguess market prices.

DIFFERENCES IN EXPECTED RETURNS

The price of a stock depends on a number of variables. For example, one variable is what a company owns minus what it owes (also called book value of equity). Expected profits, and the discount rate investors apply to these profits, are others. This discount rate is the expected return investors demand for holding the stock. The impact of market participants trading stocks is that market prices quickly find an equilibrium point where the expected return of a stock is commensurate with what investors demand.

Decades of theoretical and empirical research have shown that not all stocks have the same expected return. Stated simply, investors demand higher returns to hold some stocks and lower returns to hold others. Given this information, is there a systematic way to identify those differences?

OBSERVING THE UNOBSERVABLE: CURRENT AND FUTURE PROFITABILITY

Market prices and expected future profits contain information about expected returns. While we can readily observe market prices as stocks are traded (think about a ticker tape scrolling across a television screen), we cannot observe market expectations for future profits or future profitability, which is profits divided by book value. So how can we use an unobserved variable to tell us about expected returns?

A paper by Professors Eugene Fama and Kenneth French published in 2006[1] tackles this problem. Fama and French have authored more than 160 papers. They both rank within the top 10 most-cited fellows of the American Finance Association[2] and in 2013, Fama received a Nobel Prize in Economics Science for his work on securities markets.

Fama and French explored which financial data that is observable today contain information about expected future profitability. They found that a firm’s current profitability contains information about its profitability many years hence. What insights did Dimensional glean from this? Current profitability contains information about aggregate investor’s expectations of future profitability.

MEASURING PROFITABILITY

The next academic breakthrough on profitability research was done by Professor Robert Novy-Marx, a world-renowned expert on empirical asset pricing. Building on the work of Fama and French, he explored the relation of different measures of current profitability to stock returns.

Profits equal revenues minus expenses. One particularly important insight Dimensional took from Novy-Marx’s work is that not all current revenues and expenses have information about future profits. For example, firms sometimes call a revenue or expense “extraordinary” when they do not expect it to recur in the future. If those revenues or expenses are not expected to recur, should investors expect them to contain information about future profitability? Probably not.

This is what Novy-Marx found when conducting his research. In a paper published in 2013,[3] he used US data since the 1960s and a measure of current profitability that excluded some non-recurring costs so that it could be a better estimate for expected future profitability. In doing so, he was able to document a strong relation between current profitability and future stock returns. That is, firms with higher profitability tended to have higher returns than those with low profitability. This is referred to as a profitability premium.

Around the same time, the Research team at Dimensional was also conducting research into profitability. They extended the work of Fama and French and found that in developed and emerging markets globally, current profitability has information about future profitability and that firms with higher profitability have had higher returns than those with low profitability. They also found that this observation held true when using different ways of measuring current profitability. These robustness checks are important to show that the profitability premiums observed in the original studies were not just due to chance.

Their research indicated that when using current profitability to increase the expected returns of a real-world strategy, it is important to have a thoughtful measure of profitability that provides a complete picture of a firm’s expenses while excluding revenues and expenses that may be unusual and therefore not expected to persist in the future.

THE CUTTING EDGE: NEW RESEARCH

Many papers documenting profitability premiums globally have been written since 2013. An exciting forthcoming paper[4] by Professor Sunil Wahal provides powerful out-of-sample US evidence of profitability premiums. Wahal is an expert in market microstructure (how stocks trade) and empirical asset pricing.

Fama, French, and Novy-Marx’s research on profitability used US data from 1963 on. Why? Because when they conducted their research, reliable machine-readable accounting statement data required to compute profitability for US stocks was only available from 1963 on. Hand-collecting and cleaning accounting statement data and then transcribing it in a reliable fashion is no easy task and presents many a challenge for any researcher.

Wahal rose to those challenges. He gathered a team of research assistants to hand-collect accounting statement data from Moody’s Manuals from 1940 to 1963. By applying his (and his team’s) expertise in accounting, combined with a great deal of meticulous data checking, Wahal was able to produce reliable profitability data for all US stocks from 1940 to 1963. Using this data to measure the return differences between stocks with high vs. low profitability, Wahal found similar differences in returns to what had been found in the post-1963 period.

This research provides compelling evidence of the profitability premium pre-1963 and is a powerful out-of-sample test that strengthens the results found in earlier work.

THE SIZE OF THE PROFITABILITY PREMIUM

So how large has the profitability premium been historically? Large enough that investors who want to increase expected returns in a systematic way should take note. Exhibit 1 shows empirical evidence of the profitability premium in the US and globally. In the US, between 1964 and 2016, the Dimensional US High Profitability Index and the Dimensional US Low Profitability Index had annualized compound returns of 12.55% and 8.23%, respectively. The difference between these figures, 4.32%, is a measure of the realized profitability premium in the US over the corresponding time period. The non-US developed market realized profitability premium was 4.51% between 1990 and 2016. In emerging markets, the realized profitability premium was 5.21% between 1996 and 2016.


Exhibit 1: The Profitability Premium

Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. See “Index Descriptions” in the appendix for descriptions of Dimensional and Fama/French index data. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.

Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. See “Index Descriptions” in the appendix for descriptions of Dimensional and Fama/French index data. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.

CONCLUSION

In summary, there are differences in expected returns across stocks. Variables that tell us what an investor has to pay (market prices) and what they expect to receive (book equity and future profits) contain information about those expected returns. All else equal, the lower the price relative to book value and the higher the expected profitability, the higher the expected return.

What Dimensional has learned from its own work and the work of Professors Fama, French, Novy-Marx, and Wahal, as well as others, is that current profitability has information about expected profitability. This information can be used in tandem with variables like market capitalization or price-to-book ratios to extract the differences in expected returns embedded in market prices. As such, it allows investors to increase the expected return potential of their portfolio without trying to outguess market prices.

 

[1]. Eugene Fama and Kenneth French, “Profitability, Investment, and Average Returns,” Journal of Financial Economics, vol. 82 (2006), 491–518.

[2]. G. William Schwert and Renè Stulz, “Gene Fama’s Impact: A Quantitative Analysis,” (working paper, Simon Business School, 2014, No. FR 14-17).

[3]. Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics, vol. 108 (2013), 1–28.

[4]. Sunil Wahal, “The Profitability and Investment Premium: Pre-1963 Evidence,” (December 29, 2016). Available at SSRN: ssrn.com/abstract=2891491.

 

GLOSSARY

Book Value of Equity: The value of stockholder’s equity as reported on a company’s balance sheet.

Discount Rate: Also known as the “required rate of return” this is the expected return investors demand for holding a stock.

Out-of-sample: A time period not included or directly examined in the data series used in a statistical analysis.

Market Microstructure: The examination of how markets function in a fine level of detail, this can include areas of inquiry such as: how traders interact, how security orders are placed and cleared and how information is relayed and priced.

Empirical Asset Pricing: A field of study that uses theory and data to understand how assets are priced.

Profitability Premium: The return difference between stocks of companies with high profitability over those with low profitability.

Realized Profitability Premium: The realized, or actual, return difference in a given time period between stocks of companies with high profitability over those with low profitability.

 

 

INDEX DESCRIPTIONS

Dimensional US Low Profitability Index was created by Dimensional in January 2014 and represents an index consisting of US companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three low-profitability subgroups. It is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat.

Dimensional US High Profitability Index was created by Dimensional in January 2014 and represents an index consisting of US companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three high-profitability subgroups. It is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat.

Dimensional International Low Profitability Index was created by Dimensional in January 2013 and represents an index consisting of non-US developed companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization of each eligible country. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three low-profitability subgroups. The index is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: Bloomberg.

Dimensional International High Profitability Index was created by Dimensional in January 2013 and represents an index consisting of non-US developed companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization of each eligible country. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three high-profitability subgroups. The index is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: Bloomberg.

Dimensional Emerging Markets Low Profitability Index was created by Dimensional in April 2013 and represents an index consisting of emerging markets companies and is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization of each eligible country. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three low-profitability subgroups. The index is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: Bloomberg.

 

Dimensional Emerging Markets High Profitability Index was created by Dimensional in April 2013 and represents an index consisting of emerging markets companies and is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization of each eligible country. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three high-profitability subgroups. The index is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: Bloomberg.

 

Source: Dimensional Fund Advisors LP.

The Dimensional Indices have been retrospectively calculated by Dimensional Fund Advisors LP and did not exist prior to their index inceptions dates. Accordingly, results shown during the periods prior to each Index’s index inception date do not represent actual returns of the Index. Other periods selected may have different results, including losses. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains.

There is no guarantee investment strategies will be successful. Diversification does not eliminate the risk of market loss.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Eugene Fama is a member of the Board of Directors for and provides consulting services to Dimensional Fund Advisors LP. He is a professor of finance at the University of Chicago, Booth School of Business. In 2013, he received a Nobel Prize for his work on securities markets.

Ken French is a member of the Board of Directors for and provides consulting services to Dimensional Fund Advisors LP. He is a professor of finance at the Tuck School of Business at Dartmouth College.

Robert Novy-Marx provides consulting services to Dimensional Fund Advisors LP. He is a professor of finance at the University of Rochester, Simon Business School.

Sunil Wahal provides consulting services to Dimensional Fund Advisors LP. He is a professor of finance at Arizona State University, Carey School of Business.

 

 

 

[1]. Eugene Fama and Kenneth French, “Profitability, Investment, and Average Returns,” Journal of Financial Economics, vol. 82 (2006), 491–518.

[2]. G. William Schwert and Renè Stulz, “Gene Fama’s Impact: A Quantitative Analysis,” (working paper, Simon Business School, 2014, No. FR 14-17).

[3]. Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics, vol. 108 (2013), 1–28.

[4]. Sunil Wahal, “The Profitability and Investment Premium: Pre-1963 Evidence,” (December 29, 2016). Available at SSRN: ssrn.com/abstract=2891491.

 

Age Gaps, the Fed, and the Landscape

Recently, I was interviewed by Money magazine regarding planning for couples that have large age gaps. I apparently said something cogent, as I was quoted in the June 14 article titled Money, Marriage and a Big Age Gap: 6 Ways to Make Sure Your Retirement Is Safe. Check it out!


Also this week, in a widely anticipated move, the Federal Reserve raised its benchmark lending rate by a quarter point to 1.25%. Given that the rate increase wasn’t a surprise, it probably isn’t the reason traders saw fit to take profits in the stock market over the last couple of days, especially in some of the hotter sectors. Perhaps the bigger news was the announcement that they may start allowing some of the principal and interest payments on the $4+ Trillion (that’s 4 million MILLIONS) of US Treasury Bonds and mortgage-backed securities to roll off their balance sheet and not be reinvested.

The effect of allowing the Fed’s bond holdings to shrink will be to take some cash out of the economy which will likely keep a lid on growth. If they get it right, maybe we’ll be back to “normal” in the next few years. Get it wrong and perhaps the doom and gloom predictions of either a deflationary death spiral or rampant runaway inflation will come to pass. No pressure, right?

The bond market certainly has not behaved as if it believes we’ll be needing wheelbarrows to cart our cash to HEB any time soon. In fact, interest rates are holding near all-time lows, which points more to an anticipated slowdown versus the economic expansion that recent equity returns seem to indicate.

I can’t provide any insight into what the markets will do tomorrow, next month, or even next year. I can remind you, though, that rarely has one come out better over ten-year periods by betting against stocks. Just look at the last decade for a reminder.

In June of 2007, the bond market saw interest rates spiking while the S&P 500® was peaking, albeit about 40% below today’s levels. If you had owned a fund approximating the index, you would have seen your account balance drop by nearly half in the following couple of years although you would have been rewarded with dividend payments around 2% a year. On the other hand, you could have just played it safe and just bought a 10-year Treasury Bond around a 5% yield to maturity. Had you done that and reinvested your interest and dividends, you would have had a much smoother ride but today you would have about half as much as the equity fund owner, as illustrated in Exhibit 1.

Exhibit 1. Chart created in Kwanti Portfolio Lab. Past performance is not indicative of future results. You cannot invest directly in an index.

Exhibit 1. Chart created in Kwanti Portfolio Lab. Past performance is not indicative of future results. You cannot invest directly in an index.


Finally, my friends at Dimensional Funds have released their 2017 Mutual Fund Landscape. In this annual report, they analyzed US mutual fund returns and accessed manager performance relative to their benchmarks. This year’s edition, like previous years’, shows strong evidence that most fund managers fail to outperform their benchmarks. Not only that, but the fact that some have fleeting success doesn't seem to predict they can repeat the performance, as seen in Exhibit 2.

Exhibit 2

Exhibit 2

If you're concerned that your plan may not address unique situations such as an age gap, or if the current market has you worried, get it touch for a review.