Merriman

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.”

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.

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.

A few weeks ago, four Merriman advisors got together for a round table conversation to review themes that came up during meetings with their clients. Aaron Spencer, Mark Metcalf, Paresh Kamdar and Tyler Bartlett all provided insights on the most common questions that investors are asking. Over the 40 minute conversation, you’ll hear their take on the following themes:

• International exposure
• Diversification
• Bond rates being at an all-time low
• Inflation
• DFA and the value they add

Enjoy!

Podcast: Play in new window | Download

Merriman does not include a specific allocation to gold in our standard portfolios. This article, by Bryan Harris of Dimensional Fund Advisors, discusses why gold has not been an ideal long-term investment. It includes the following key concepts:

• Gold has done well since the year 2000 and in the 1970s, and can potentially be a safe haven during times of political and economic stress. However, for the entire period of 1971 – 2011 gold performed worse than the S&P 500, U.S. small-cap stocks and non-U.S. stocks on an inflation-adjusted basis.
• From 1980 – 1999, gold experienced a negative return after inflation of -6.5%, vs. strong positive returns for stocks.
• While gold has held its value against long-term inflation, there have been extensive periods when gold did worse than inflation. Gold is also much more volatile than inflation, and can add substantial volatility to a portfolio.
• Unlike stocks, which are productive assets which generate growing levels of income and dividends over time, gold has no cash flow and costs money to own.

For more detail and some illuminating graphs, please see the article.

During periods of significant volatility in the capital markets, investors can lose patience and/or perspective and draw the conclusion that long term risk/return dynamics no longer apply because somehow “it’s different this time.”

I’ve been in this business for over 25 years, and time and again I have seen investors come to this conclusion, making big portfolio shifts because of it, only to regret these decisions later.

I vividly recall conversations with folks in the 1980s who insisted that Asian stock funds should constitute the bulk of one’s portfolio since America was in decline and Asia was rising. In the1990s, it often was very difficult to have meaningful conversations about asset allocation and thorough diversification when so many genuinely felt that all they needed was a few technology stocks or technology stock funds. In 2008 and early 2009, few had the stomach to trim their nicely performing government bond funds and add to their stock funds during the worst stock market environment since 1932.

In each of these examples, the phrase ‘it’s different this time’ crept into many conversations. Obviously, none of the above decisions worked out well.

At Merriman, we’ve always maintained the portion of clients’ accounts invested in stocks at 50% US and 50% foreign. This has served our clients well for many years. We invest this way because the US represents less than 50% of the world stock market capitalization, and because maintaining this kind of allocation can serve to increase returns while lowering overall portfolio risk.

Lately, foreign stocks have been significantly underperforming US stocks, and this has been causing some people to ask if maintaining our desired 50/50 US/foreign split still makes sense. And once again, we are starting to hear the ‘it’s different this time’ comment again. It is human nature to think this way, but history would suggest that one should not make a big shift in allocation because of it, other than some routine portfolio rebalancing.

Keep this in mind: While it’s always a different set of circumstances driving the capital markets, rarely is it wise to conclude that a paradigm shift is at hand and make major portfolio shifts in response. As legendary investor Sir John Templeton used to say, “The four most dangerous words in investing are ‘it’s different this time.’”

Some of our clients occasionally express concern about the situation in Europe. Here’s what our Director of Research, Larry Katz, has to say about Merriman portfolio exposure to those markets:

Europe’s ongoing debt problems have prompted many investors to consider their European exposure, especially to the euro zone’s weaker countries. While there certainly could be global impacts emanating from any area of the world, a major benefit of true global diversification is the controlled direct exposure to the problems of any given geography.

For example, one of our major portfolios is MarketWise Tax-Deferred, a globally diversified, buy-and-hold portfolio with a value and small-cap tilt.  Half of the stock exposure of this portfolio is in the United States. The other half is distributed throughout the world.

Of the 50% overseas exposure, as of the end of March 2012 just over 22% was in Europe. Notably, most of that exposure was to the stronger European countries. The top six European countries by exposure (United Kingdom, France, Germany, Switzerland, Sweden and the Netherlands) comprised almost 18% of the total invested in Europe. The weaker countries of Greece, Ireland, Portugal, Spain and Italy totaled only 1.73%.

So a 60/40 stock/bond portfolio had just over 1% exposure to these five troubled countries.

Every portfolio has to incur various risks to generate returns. The key is to intelligently diversify so that, under a variety of market conditions, those risks remain under control.

I have read Paul Merriman’s book, Live It Up Without Outliving Your Money and watched some of Paul’s videos and listened to his podcasts. I have a question that hasn’t been addressed: What’s the best way to transition a portfolio from individual stocks to index funds and ETFs?

I would like to make the change quickly, but I’m worried that my timing might turn out to be all wrong. Should I do it all at once, or gradually over a period of time?

We believe that the move you are describing is a good way to reduce your risk and potentially improve your return, because index funds and ETFs will give you much greater diversification. I recommend you follow the recommendations that you’ll find in Paul Merriman’s article “The Ultimate Buy and Hold Strategy.”

Once you have made this decision, I cannot see any good reason to spread it out. If you do it all at once, you will get it over with quickly so you can focus on other things. I recommend you sell all the stocks in a single day. Stock trades typically take three business days to settle, so there will be a short delay before you can reinvest the proceeds.

During that brief period while your money is in cash, the market may go up or it may go down – or it could remain largely unchanged. You can’t control that, so you will have to accept it as an unknown price you’ll have to pay (if you must reinvest at higher prices) or an unknown bonus you receive (if you reinvest at lower prices). Either way, make the change and get it over with.

If you try to control this, you’ll have to predict or guess future stock prices, and that’s likely to lead to second-guessing your plan and not getting it accomplished.

There’s an exception to that advice. If the stocks you own are in a taxable account, it’s important that you consult your tax advisor before you move forward. Tax consequences in some cases should dictate the timing of your sales.

Most people can benefit from the help of a financial advisor, either on an occasional basis or in a lasting relationship. But not all advisors are created equal. In this section of our online workshop, I’ll explain what to look for and how to avoid financial help that may lead you down the wrong path.

Watch Section 5: Finding the right financial advisor now.