Benchmarks, Diversification & Time Horizons – Part 4 of 4

In this four-part blog series from Merriman Research, we’re offering our thoughts on the following important investment questions:

  • When evaluating your investment returns, what benchmark(s) are relevant?
  • What is the rationale for diversification?
  • How should your investment time horizon be considered?

Investors may overlook the fact that these questions are highly interrelated. To properly consider any one, you must understand the context the other two foster. We’ll just have to jump right in to explain. If you missed Part 1Part 2 or Part 3, start there and come back.

Part 4: Historic returns analysis supports diversification & longer time horizons

In this our fourth and final post of this blog series, we offer an assessment of historic index performance data.  We expect that your better understanding of this history will contribute to your appreciation of the benefits of diversification and longer-term time horizons for your financial planning. (more…)

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Benchmarks, Diversification & Time Horizons – Part 3 of 4

In this four-part blog series from Merriman Research, we’re offering our thoughts on the following important investment questions:

  • When evaluating your investment returns, what benchmark(s) are relevant?
  • What is the rationale for diversification?
  • How should your investment time horizon be considered?

Investors may overlook the fact that these questions are highly interrelated. To properly consider any one, you must understand the context the other two foster. We’ll just have to jump right in to explain. If you missed Part 1 or Part 2, start there and come back.

Part 3: Thoughts on time horizons – Define and don’t undermine

In general, the appropriate time horizon for an investor depends on when that investor may need the money. This determination can become quite complicated, depending on specific circumstances, and will likely change over time. It can even differ for various components of an investor’s wealth. For the purposes of this article, we can say that the time horizon for the vast majority of our clients can be measured in many years, and even decades – and in some cases can extend beyond an individual’s lifetime (e.g., with generational transfers). (more…)

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Benchmarks, Diversification & Time Horizons – Part 2 of 4

In this four-part blog series from Merriman Research, we’re offering our thoughts on the following important investment questions:

  • When evaluating your investment returns, what benchmark(s) are relevant?
  • What is the rationale for diversification?
  • How should your investment time horizon be considered?

Investors may overlook the fact that these questions are highly interrelated. To properly consider any one, you must understand the context the other two foster. We’ll just have to jump right in to explain. If you missed Part 1, start there and come back.

Part 2: Thoughts on diversification – Why is it a good thing?

Investors tend to appreciate diversification in bad times, but not so much in good times. Investors like the idea of diversifying to mitigate losses, but don’t like diversification when it suppresses gains. Just look back at 2013 – the S&P 500 was up 32.4%, but any version of a “diversified” portfolio would have gained much less. A balanced benchmark, along the lines of a 50%/50% stock/bond split, was up about 15% (if we just blend the returns of the S&P 500 and the Barclays U.S. Aggregate).

Why should I diversify?” a balanced client may ask. The answer is To control risk and we only need to look back to 2008 for an example. That year, the S&P 500 declined 37%, whereas a 50%/50% balanced benchmark was down only 16%. (more…)

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Benchmarks, Diversification & Time Horizons – Part 1 of 4

In this four-part blog series from Merriman Research, we’re offering our thoughts on the following important investment questions:

  • When evaluating your investment returns, what benchmark(s) are relevant?
  • What is the rationale for diversification?
  • How should your investment time horizon be considered?

Investors may overlook the fact that these questions are highly interrelated. To properly consider any one, you must understand the context the other two foster. We’ll just have to jump right in to explain.

Part 1: Thoughts on benchmarks – What’s the right yardstick for you?

For investors, a benchmark is the yardstick by which to measure the relative success of their investment returns. Broad market indexes, for both stocks and bonds, can serve well to provide a daily status report on how the investment community interprets news and developing trends on the economy, corporate profits and even international geopolitics. And, over time, broad indexes do present appropriate performance standards, which can be used to evaluate an investor’s performance in terms of both achieved return and experienced risk. (more…)

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Seahawks Secrets to Success

12Flag-1024x728Seattle is still reeling with excitement from the Seahawks winning the Super Bowl! Over 700,000 Seattleites celebrated downtown to welcome the champs coming home. No matter where your team allegiance lies, it’s easy to spot the strengths of the Seahawks both on and off the field. These lessons can be applied to multiple areas of life, including your finances.

Here are 12 things everyone can learn from the Seahawks:

1) It’s never too late: Russell Wilson was a third round draft pick but that didn’t determine his performance. No matter when you start saving and investing, there is always opportunity ahead of you.

2) Diversification is key: Every player on a team has a specific job to do, just as every investment in your portfolio has a unique purpose. It’s hard to win with a team full of quarterbacks! Design your portfolio with broad diversification to cover all types of positions.

3) Defense wins championships: There is a saying that “offense wins games and defense wins championships.” Many times it’s the team’s offense that gets all the praise and glory, but without a strong defense to hold back the competition, all of the points scored are for nothing. It’s easy to get caught up in short term performance chasing of stocks, but make sure to manage downside risk with bonds so that your returns won’t disappear in a down market.

4) Find a coach: Every team needs a coach to lead them to victory. Having a financial advisor will keep you on track toward achieving your goals.

5) Don’t compare your strategy to others: Every team has a different approach on how to win games. Your friends and family have their own ideas about investment that may be different from yours, and that’s okay. Stick with the plan you make with your financial advisor – it is unique to you.

6) Break expectations: Seahawks fullback Derrek Coleman is deaf. No one expected him to be able to play in the NFL but he didn’t let other people’s beliefs hold him back. Commit to success and don’t let others get in the way of what you want to accomplish.

7) Take a look back: Teams spend countless hours watching game footage to learn from their mistakes. Look back at historical investments to learn all you can about performance volatility throughout various market conditions.

8) Go all in: The Seahawks have an “All In” sign that they hit on their way to a workout. Often we don’t want to commit to a plan unless we know for sure it will work out…but a plan can’t work unless you commit. Go all in.

9) Never give up: Even when it looks like a team has lost, there is always a chance for a comeback late in the game. Sometimes when a portfolio is down, we are tempted to switch strategies or abandon hope. If you give up too early, you might miss the winning finish.

10)  Have fun: Football is tough work but it is also a lot of fun. Always make time for the activities you enjoy with the people you love. As we say here at Merriman – Invest Wisely, Live Fully.

11)  Give back: In the midst of practice, games, media interviews, and sponsor appearances, Russell Wilson still makes time to visit the patients at Seattle Children’s Hospital. Appreciate the gifts you have in your life and share them with others.

12)  Identify your 12s: Seattle’s fans are known as the 12th man. Even though the fans aren’t on the field, they play an important role in the game. Find fans who will support you through all your wins and losses, and recognize their contribution to your success.

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Don’t let your emotions invest for you

Monday, October 19, 1987—aka Black Monday—was a fearful day for investors across the globe. The damage exceeded 20% in stock market declines by the time the exchanges closed. In the wake of such steep declines, investors too often are driven to act by their emotions. In this case, fear. Fear that the decline will continue. Fear that their hard earned savings will be sucked dry by the markets. A more recent example of this fear was invoked by the financial crisis. In both cases the markets recovered in short order. But, the market never recovers for those who sell out of it. Clearly, fear selling is a bad idea.

Fear is not the only emotion that muddles our investment decisions. Greed is just as dangerous.

The 1990s seemed too good to be true. Investors could not lose money in technology stocks. Valuations seemed to have changed and the exponential rising prices were within the new norm. People got greedy. Some went so far as to use their home equity to purchase stocks. And then, just like that, the party was over. The end of the decade saw technology stocks come crashing down. Those who got greedy and concentrated all of their holdings in technology stocks paid the price.

Anytime the sky is falling or the markets seem too good to be true, remember the mantra—be greedy when others are fearful and fearful when others are greedy.

While fear and greed top the list of emotions that can wreak havoc on your investments, there are others: angst and excessive pride, for instance.

The issue with angst is if you wait for events to happen (government shutdown, fiscal cliff, quantitative easing, etc.) or for the markets to “normalize,” you often miss the boat.

Excessive pride can sometimes drive people to buy individual stocks. It’s the classic cocktail party conversation where someone tells you they bought Microsoft stock in the 1990s or Apple stock at the turn of the century. They do not tell you about the other 10 stocks they bought that went south. By focusing on the one home run, people subconsciously convince themselves that investing in individual stocks is a wise venture. It’s not. In fact, it’s speculation, not investing. Do not let pride get in the way of making smart investment decisions.

Clearly we cannot let our emotions guide our investment decisions. Emotional investing is not successful investing.

Follow these steps to help avoid the pitfalls:

1)     Build a plan. Write it down and stick to it. If the markets turn over, do not deviate from your plan. If anything, rebalance your accounts back to their initial targets.

2)     Turn off the news and tune out the financial pundits. In the age of information, the evening news is not going to give you a leg up on investing. That is, everyone knows everything and it is all factored into the price of securities.

3)     Do not assume things are correlated when they are not. GDP is not nearly as highly correlated to stock market returns as people think. Nor, for that matter, are political events.

4)     Diversify your portfolio. Put another way, do not put all of your eggs in one basket. Remember what happened to technology stocks in the 1990s.

5)     Focus on what you can control. You can control how much you save and whether or not you succumb to your emotions. You cannot control the markets and politicians.

Here’s the exciting part: if you can keep your emotions at bay, invest wisely and let the markets work, you can reduce your stress and increase the likelihood of a successful retirement period.

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An alternative to the financial news treadmill

Every day, financial news sites and channels provide a steady stream of conflicting opinions and predictions that often leave investors feeling confused, frustrated, and paralyzed. Don’t believe me? Please allow me to elaborate.

In addition to reading a wide range of investing and personal finance pieces each day, in the evening I often browse a site called RealClearMarkets.com to make sure I take a look at some of the interesting and/or important articles I might have missed during the day. RealClearMarkets.com is basically a consolidator of articles from a number of other sources. You might want to take a look at it just so you can see what I mean.

When I review the list of approximately 50 headlines, I always find it interesting to see how many compelling yet contradictory articles and videos are in one spot, one right after another. It’s common to see one claiming one view, with another of the exact opposite view right below it. China is imploding/China is still a sleeping giant, Gold is headed much lower/Gold will touch new highs by the end of the year, The stock market is about to re-visit the lows of 2008/The stock market is pausing before reaching new highs by year end, Stick with large cap U.S. stocks/America’s best days are behind us and one should look abroad for better investing opportunities, A bond catastrophe is upon us/Don’t believe the bond bust hype, Inflation is about to run rampant/Deflation is the new worry, Emerging market stocks and bonds are to be avoided at all costs/The long term secular growth story of the emerging markets is still very much intact. Good grief! What’s an investor to do?

We’ll continue to see these contradictions, but one does not need to feel paralyzed by them or compelled to decide which one is the better path to follow. The truth is that they all have elements of truth and quite often are written by some very bright people. This month marks my 27th year in this business, and I have seen investors get caught up wrestling with these contradictions in each and every one of those years. Please let me offer an alternative.

Rather than struggling to decide if this is the right or wrong time to hold stocks or bonds in your portfolio, or which types of each to hold, how about always holding a portion in stocks and a portion in bonds, along with an adequate cash reserve for emergencies or opportunities that may arise? Of the portion devoted to stocks, hold U.S. and foreign (including emerging markets), small  and large cap, growth and value, and also some REITs (both foreign and domestic). Of the portion destined for bonds, hold those of the highest credit quality (which tend to hold up relatively well when the stock market severely declines), and those with short- to intermediate-term maturities (which have lower interest rate risk in a rising rate environment).

With regard to cash reserves, the rule of thumb in the financial planning community is to maintain enough to cover 6 to 12 months of living expenses, depending on your situation, but often these targets tend to be on the low side. My experience has been that during periods of severe market or personal financial stress, nothing provides peace of mind like cash. Nobody ever complains about having too much cash on hand during these times. And when opportunity knocks, it’s nice to have plenty of cash on hand to take full advantage. Even when yields are as low as they are now, cash is king. The purpose of your investment portfolio is to deliver returns in excess of inflation over time. Cash is for liquidity, flexibility, and peace of mind.

The appropriate mix of these various asset classes, of course, depends on your individual circumstances and objectives. A big part of my job as an investment advisor is to help clients establish and maintain this mix in the face of unrelenting alarmist news headlines.

If all this advice sounds like nothing more than common sense and things we’ve all heard before, you’re right. But interestingly enough, many people tend to get caught up in all the predictions and hype out there, and they tend to ignore or forget these time-tested principles. As Paul Merriman once said, “There is a Grand Canyon of difference between what people know they should do and what they do.”

If you are tired of feeling confused, paralyzed, and frustrated and would like to jump off the financial news treadmill, I invite you to contact us. If you are not quite there yet, I wish you luck and a quiet mind as you continue down your path. We’ll be here when you need us.

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Risk mitigation

The return-centric environment in which we live too often gives little credence to an equally important measure – risk. Professionals and individual investors alike can often quote the return of a given stock or index, followed by silence when asked to recite its relative measure of risk. The financial crisis shouted to us the importance of understanding and controlling risk. If you did not hear the call – and hopefully you did before the fall – it’s not too late to answer it.

Two quantifiable means of controlling risk are diversification and asset allocation.

Proper diversification stretches well beyond your region and your country of residence. It has little to do with individual stock positions or individual sectors. It consists of all types of stocks – large, small, value, growth, etc., which are located all over the world. Global diversification is the goal.

Diversification is equally important for bond allocations. A bond portfolio consisting of high-yield bonds differs from one invested in U.S. treasury bonds. Obtaining an adequate amount of diversification on both sides of your portfolio is essential in controlling your risk.

Asset allocation speaks to the percentage of stocks and the percentage of bonds in your portfolio. While the specific mix has many variables, age and retirement goals are often large factors. Each investor’s situation is unique and there is no “one size fits all” solution. A good place to start is by answering the following questions:

  • At what age do I begin adding bonds? 40? 45?
  • How often do I add bonds and how much do I add?
  • What is an appropriate allocation once I am retired?

If you are struggling to answer these questions, it may be time to seek professional guidance. The answers are essential to your long-term investment success.

Investor discipline is a less tangible but equally important component of risk mitigation.

As stocks outpace bonds, a portfolio’s risk increases. At some point, there will be a need to sell the stocks to buy bonds and maintain the target allocation. In essence, this follows the golden rule of investing – that is to sell high and buy low. The same logic holds within each asset class of the portfolio, such as when international stocks outpace domestic stocks or small cap stocks outpace large cap stocks.

I can almost guarantee that when the time comes, rebalancing will not feel like the natural thing to do. Why, for example, would you want to buy into an underperforming asset class? Despite our rational brain, loading up on the winners will feel like the right thing to do at that moment. There are two questions you must ask yourself:

  • Do I have the discipline to rebalance my portfolio?
  • What mechanical process will I use to rebalance?

Your long-term investment success hinges on your answers to these questions. If you do not know how to answer them, seek guidance.

Investing is about risk and return. Understanding how much risk you can afford to take and how much risk you’re willing to take is the key. Quantitatively, two ways in which we control risk for clients is through diversification and asset allocation. Keeping clients disciplined in their goals and executing on a well thought out rebalancing process is another, less tangible means of controlling risk.

As Warren Buffet famously said, “It’s only when the tide goes out that you learn who’s been swimming naked.”

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2013 update to the ultimate buy-and-hold strategy

Every year, we update some of our core articles.

The 2013 update of The ultimate buy-and-hold strategy, which includes performance information through 2012, is now available in our Best of Merriman library.

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Investing and uncertainty

There are many things in short supply, but uncertainty is not one of them. Three economists1 have compiled an index of uncertainty, which is comprised of newspaper coverage of policy-related uncertainty, expiring federal tax code provisions and disagreement among economic forecasters. You can see the trend in Figure 1 below. The index peaked with the debt ceiling imbroglio in late 2011, fell in the early part of 2012 and then rose again.

Throughout the year there has been a great deal of focus on a number of worrisome issues, including the U.S. deficit, debt ceiling and the fiscal cliff, high unemployment, and the European debt situation. Reflecting all this angst, investors through November withdrew a net $88.9 billion from actively-managed U.S. stock mutual funds (net of inflows into U.S. stock exchange-traded funds).2 Yet for 2012, stocks were up nicely.

How could stocks have gone up while uncertainty increased? While many people naturally worry about the past and still feel burned by previous sharp plunges in stock prices, the stock market is forward looking, incorporating the perceptions of millions of investors. While national economies are still relatively sluggish, actions taken by the U.S. and European central banks to combat economic weakness are having a positive impact.

Housing, while not rosy, is seeing some welcome improvements, with 6.9% of U.S. consumers planning to buy a house in the next six months, the most since August 1999.3 Confidence among U.S. homebuilders reached a 6 ½ year high in December.4 U.S. sales of previously occupied homes increased to their highest level in three years in November.5 And home prices rose 4.3% in the twelve months ending October 2012 in the S&P/Case-Shiller 20-City Composite.6

Another positive, with major longer-term implications, is the widespread development of hydraulic fracturing (or fracking, the process of extracting oil and natural gas from shale rock). The International Energy Agency projects the U.S. will become the largest global oil producer by around 2020, and a net oil exporter by around 2030.7 While there are important environmental issues associated with fracking, including potential contamination of local water supplies and massive use of water in the process, electricity produced by natural gas gives off 43% less carbon dioxide versus coal. Due to a combination of increased use of natural gas, the weak economy and more fuel-efficient cars, America’s emission of greenhouse gases has fallen to 1992 levels and is expected to continue to fall.8 So, like any energy source, there are costs and benefits. Cheaper energy will lead to more manufacturing being done in the U.S., which is good for the economy. One analyst estimates the U.S. will add three million new jobs by the end of this decade due to the natural gas industry.9

Waiting for that perfect time to invest when there is no uncertainty could lead to cash unproductively sitting on the sidelines. Investing only after good news also means buying stocks after they have gone up. A good example of this is the S&P 500 going up by 2.54% on January 2, the day after the fiscal cliff legislation passed. Another example is the MSCI EAFE index of developed countries in Europe, Australasia and the Far East, which increased 6.57% in the fourth quarter, reflecting the relative lack of bad news, and some stabilizing events, in Europe.

While uncertainty is an uncomfortable fact of life, it is easier to handle by following a well-formulated diversified investment plan that invests in stocks and bonds, the allocation to which incorporates your risk tolerance and long-term needs.

1. Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com.
2. Wall Street Journal, “Investors Sour on Pro Stock Pickers”, 1/4/13.
3. Ned Davis Research, 12/10/12.
4. http://finance.yahoo.com/news/us-homebuilder-confidence-6-1-150113216.html
5. Wall Street Journal, 12/20/12.
6. http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff–p-us—-
7.Wall Street Journal, 11/12/12.
8. U.S. Energy Information Agency, as discussed in http://finance.yahoo.com/blogs/daily-ticker/fracking-good-economy-environment-155325507.html
9. As reported in New York Times, “Welcome to Saudi Albany”, Adam Davidson 12/11/12.
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