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.
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.”
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.
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.’”