At some point in your life you may receive a large sum of cash, such as a pension payout or inheritance.
Many investors nevertheless choose to put the money to work over time, a systematic implementation plan that is commonly referred to as dollar-cost averaging.
History and theory support immediate investment.
On average, an immediate lump-sum investment has outperformed systematic implementation strategies across global markets. This conclusion is consistent with finance theory, as immediate investment exposes cash to (historically) upward-trending markets for a greater period of time.
Immediate investment led to greater portfolio values approximately 68% of the time based on a 60/40 portfolio). On average, immediate investment outperformed systematic implementation by a high of 2.39%. These findings are unsurprising. Stocks and bonds have historically produced higher returns than cash, as compensation for their greater risks. By putting a lump-sum to work right away, investors have been able to take advantage of these risk premia for a slightly longer period.
The research by Vanguard also shows immediate and systematic plans over shorter and longer investment intervals using the same 60/40 portfolio. As the interval increased, the immediate investment outperformed more frequently. For example, immediate investment of a lump-sum outperformed a 6-month series of investments in approximately 64% of the historical periods. Over a 36-month interval, immediate investment outperformed approximately 92% of the time.
Having said this, a systematic implementation provides some protection against regret. Systematic investment of a large sum can be thought of as a risk-reduction strategy. Such an approach can moderate the impact of an immediate market dip. Historically, however, the trade-off has been a lower return in the majority of market scenarios.
So the question to ask yourself is: are you seeking to reduce your regret or are your seeking to maximize your return? Keep in mind, that finance theory and historical evidence suggest that the best way to invest this sum is all at once.
1. Not having clear investment goals
The adage, “If you don’t know where you are going, you will probably end up somewhere else,” is as true of investing as anything else. Everything from the investment plan to the strategies used, the portfolio design, and even the individual securities can be configured with your life objectives in mind. Too many investors focus on the latest investment fad or on maximizing short-term investment return instead of designing an investment portfolio that has a high probability of achieving their long-term investment objectives.
2. Having unrealistic expectations or using someone else’s expectations
Investing for the long-term involves creating a well-diversified portfolio designed to provide you with the appropriate levels of risk and return under a variety of market scenarios. But even after designing the right portfolio, no one can predict or control what returns the market will actually provide. It is important not to expect too much and to be careful when figuring out what to expect. Nobody can tell you what a reasonable rate of return is without having an understanding of you, your goals, and your current investments.
3. Failing to diversify enough
The only way to create a portfolio that has the potential to provide appropriate levels of risk and return in various market scenarios is adequate diversification. Often investors think they can maximize returns by taking a large investment exposure in one security or sector. But when the market moves against such a concentrated position, it can be disastrous.
4. Focusing on the wrong kind of performance
There are two timeframes that are important to keep in mind: the short-term and everything else. If you are a long-term investor, speculating on performance in the short-term can be a recipe for disaster because it can make you second guess your strategy and motivate short-term portfolio modifications. But looking past near term chatter to the factors that drive long-term performance is a worthy undertaking. If you find yourself looking short term, refocus.
5. Buying high and selling low
The fundamental principle of investing is to buy low and sell high, so why do so many investors do the opposite? Instead of rational decision making, many investment decisions are motivated by fear or greed. As Warren Buffett says, “be fearful when others are greedy, and be greedy when others are fearful.” A focus on near-term returns leads to investing in the latest investment craze or fad or investing in the assets or investment strategies that were effective in the near past. Either way, once an investment has become popular and gained the public’s attention, it becomes more difficult to have an edge in determining its value.
6. Not knowing what you are invested in
Far too many investors don’t know what they are invested in. Not knowing what the specific risks of the investment are and not understanding how it does or doesn’t fit into their portfolio. Every investment should have a reason why it’s in your portfolio. Ensure that every investment in your portfolio has a reason to be there.
7. Trading too much and too often
When investing, patience is a virtue. Often it takes time to gain the ultimate benefits of an investment and asset allocation strategy. Continued modification of investment tactics and portfolio composition can not only reduce returns through greater transaction fees, it can also result in taking unanticipated and uncompensated risks. Use the impulse to reconfigure your investment portfolio as a prompt to learn more about the assets you hold instead of as a push to trade.
8. Reacting to the media
There are plenty of 24-hour news channels that make money by showing “tradable” information. It is foolish to try to keep up. The key is to parse valuable information out of all the noise. Successful and seasoned investors gather information from several independent sources and conduct their own proprietary research and analysis. Using the news as a sole source of investment analysis is a common investor mistake because by the time the information has become public, it has already been factored into market pricing.
9. Working with the wrong adviser
An investment adviser should be your partner in helping you achieve your financial goals. The ideal financial professional and financial service provider not only has the ability to solve your problems but shares a similar philosophy about investing and even life in general. The benefits of taking extra time to find the right adviser far outweigh the comfort of making a quick decision. Ask for references and check their work on the investments that they recommend. The worst case is that you trade an afternoon of effort for sleeping better at night.
10. Trying to be a market timing genius
Market timing is next to impossible. For people who are not well trained, trying to make a well-timed call can be their undoing. An investor that was out of the market during the top 10 trading days for the S&P 500 Index from 1993 to 2013 would have achieved a 5.4% annualized return instead of 9.2% by staying invested. This difference suggests that investors are better off contributing consistently to their investment portfolio rather than trying to trade in and out in an attempt to time the market.
11. Not controlling what you can
People like to say that they can’t tell the future, but they neglect to mention that you can take action to shape it. You can’t control what the market will bear, but you can save more money! Continually investing capital over time can have as much influence on wealth accumulation as the return on investment. It is the surest way to increase the probability of reaching your financial goals.
12. Taking too much, too little, or the wrong risk
Investing involves taking some level of risk in exchange for potential reward. Taking too much risk can lead to large variations in investment performance that may be outside your comfort zone. Taking too little risk can result in returns too low to achieve your financial goals. Make sure that you know your financial and emotional ability to take risks and recognize the investment risks you are taking.
13. Paying too much in fees and expenses
Investing in a high-cost fund or paying too much in advisory fees is a common mistake because even a small increase in fees can have a significant effect on wealth over the long term. Before opening an account, be aware of the potential cost of every investment decision. For example: make sure you not paying investing in mutual funds that front-loaded sales charges or 12b-1 fees. Look for funds that have fees that make sense and make sure you are receiving value for the advisory fees you are paying.
14. Not reviewing investments regularly
If you are invested in a diversified portfolio, there is an excellent chance that some things will go up while others go down. At the end of a quarter or a year, the portfolio you built with careful planning will start to look quite different. Check in regularly (at a minimum once a year) to make sure that your investments still make sense for your situation. It is shocking how many people have no idea how their investments have performed. Even if they know the headline result or how a couple of their stocks have done, they rarely know how they have performed in the context of their portfolio. Even that is not enough; you have to relate the performance of your overall portfolio to your plan to see if you are on track after accounting for costs and inflation. Don’t neglect this. How else will you know how you are doing?
15. Letting emotions or biases get in the way
Investing brings up significant emotional issues that can impede decision making. Understand how biases affect your decisions, are you over confident, do you recognize your blind spots? A good adviser will be able to help you construct a plan that works no matter what the answers to these questions are.
16. Neglecting to start or continue
Individuals often fail to begin an investment program simply because they lack basic knowledge of where or how to start. Likewise, periods of inactivity are frequently the result of lethargy or discouragement over previous investment losses. Investment management is a discipline that is not overly complex, but requires continual effort and analysis in order to be successful.
Click below to get a PDF copy.
"Invert, Always Invert", says Charlie Munger of Berkshire Hathaway.
Who is Charlie Munger and what does this quote mean? Charlie Munger is the other half of the successful duo that make up the famous partnership between Warren Buffett and Charlie Munger. Charlie Munger graduated from Harvard Law School and went on to a successful career in law, real estate development, Investing, and eventually partnered up with Warren Buffett to help build Berkshire Hathaway into one of the largest publicly traded companies in the world.
The quote "Invert, Always Invert", is Charlie Mungers belief that analyzing a problem from a different perspective can help solve many challenges. The way he solves problems is counter to how most people approach difficult situations. "Many hard problems are best solved when they are addressed backward". For example: if you want to help your company and are not sure what to do, you might ask "what is the best way to hurt my company?". By asking this question it may illuminate ways to help your company that weren't obvious before.
Charlie Munger gave a speech some years ago referring to the famous late night host Johnny Carson, in which Carson described to a graduating class all the ways a person can be miserable. Carson said while he couldn't tell the graduating class how to be happy, he could tell them from personal experience how to guarantee misery. 1. Ingesting chemicals in an effort alter mood or perception 2. Envy and 3. Resentment. Johnny Carson used the inversion principal, using the idea of not solving for X (happiness) he solved for non-X (misery)...you end up with what you really want (happiness).
While Charlie Munger is a genius by all accounts, he has said more than once, “a very effective way to be smart, is to consistently not-be-dumb.” It easier to not-be-dumb than it is to be smart since you can often simply avoid certain types of decisions and activities that are riddled with land mines. Munger says, "Just avoid things like racing trains to the crossing, doing cocaine, etc. Develop good mental habits. A lot of success in life and business comes from knowing what you want to avoid like early death, a bad marriage, etc."
So in terms of investing, if you aren't sure what do to, some inversion thinking can help. Let's say you want to retire comfortably at some point in the future. Here are some inversion questions if you aren't sure how to plan for a comfortable retirement.
Inversion Question: How do I guarantee I have no money in the future?
Answer: Spend more money than you make. Save nothing. Load up on debt.
Inversion Question: How do I make sure I do not understand how I am invested?
Answer: Do not read. Avoid doing any research. Do not ask questions of your advisor if you use one.
Inversion Question: How do I increase the likelihood of my investments not doing well?
Answer: Invest in things you don't understand. Pay a lot of money.
Most times avoiding what you don't want is extremely powerful in moving you closer to what you actually do want. Use the idea of inversion to help you not only with your finances but also with other aspects of your life. So when you face a challenge and you aren't sure how to attack it, you might try doing as Charlie Munger does, "Invert, Always Invert".
The two staples of any diversified portfolio are 1. stocks and 2. bonds. What makes these two asset classes differ is not only in the types of claims they represent (ownership vs. debt), but they also in the structure of their payments to investors.
Whereas stocks are perpetual and may make dividend payments that are unknown ahead of time, bonds exist for finite periods of time. Bonds have a maturity date when the principal is scheduled to be paid back to the investor, however, prior to the maturity date they make scheduled payments that are specified in advance, (called coupons payments).
The first paper discusses how default-free bonds are priced from market-determined yield curves. From these yield curves we can derive the prices and yields on both zero-coupon bonds and coupon bonds that are traded in the secondary market.
The second paper shows how to calculate three types of Duration: Macaulay, Modified, and Dollar Duration. The last part of the paper covers how to calculate bond convexity.
The third paper discusses how to take into account the unique features of zero-coupon bonds and coupon bonds when calculating rates of return on portfolios that hold these types of bonds.
Below are the 3 Morningstar articles referenced above.
Bull Markets Come In All Shapes and Sizes
While this analysis is informative, it’s still an incomplete picture of the anatomy of bull (and bear) markets. Below, we will examine this same data from four other perspectives:
Click here for the entire article from Newfound Research via Morningstar Magazine (PDF version).
This article originally appeared on Flirting With Models, a blog by the firm Newfound Research, a quantitative asset manager. This article also appeared in the April/May 2017 issue of Morningstar Magazine.
Who doesn't want to beat a professional at their own game? The vast majority of people don't ever have a chance of ever beating the "average" professional in their chosen field of expertise. Can you imagine running back a 60-year punt return for a touchdown? Dunking a basketball over some 7-footer in the NBA, or hitting a home run with a full count? Well, maybe you've thought of it, but then you wake up from that dream and realize that it was just a dream and will only ever be a dream. Ironically, investing is quite a different type of game. A game where the amature can most certainly beat the brightest minds on Wall Street.
How? It's quite straight forward actually.
So what's the secret, drum roll please...buy a low-cost index fund. Over the past 5-years 88% of actively managed large-cap funds UNDER-PERFORMED there respective index. If 88% isn't good enough, just hold on to your low-cost index fund for 15-years and that number rises to over 92%. That means you (the so called amature) will have beaten over 92% of professional fund managers at their own game. Can you say Cha-Ching. Don't take my word for it, read the SPIVA (S&P Indices Versus Active) report - page 8.
I know, I know what you are thinking, it's boring, I know can do better, I'm smart, and you might also be thinking but I have an edge, I know something the market doesn't know. I know this or that. I'm sorry to tell you that you don't. I'm sure you are very smart, but being smart doesn't equate to beating the market or being a successful investor. Ask Issac Newton, regarded as one of the smartest scientists the world has ever known who lost a fortune because he could not control his emotions.
So why should you be implementing a low-cost strategy. 1. Because it works, it works over all time periods, various markets, and asset classes: large-cap, small-cap, international, fixed income, etc. 2. Investing should be boring, so boring in fact that you don't want to constantly watch "the market". Because if you watch the market too closely you might be inclined to start thinking (again) that you can beat the market and fall into that virtuous loop of thinking. Our ego can be a nasty little bugger.
So the next time your neighbor, your co-worker, or your-fill-in-the-blank friend spouts off about how well their investment fund is doing, I can almost guarantee that over any significant period of time your low cost index fund will out-perform their short-term high flyer. Lastly, by implementing this approach you are proving how smart you really are - Einstein (and Newton) would be proud.
Evidence supports the idea that markets fail to properly price information about companies that experience seasonal patterns in their earnings. The authors show that the abnormal returns exhibited by the stock prices of such companies are caused by market participants affected by behavioral biases.
The idea that a company’s business is seasonal is nothing new. What is new is trying to understand why the market is not properly pricing for this seasonality. The research suggests that investors and analysts overweight the more recent lower-earnings quarter, leading to a more pessimistic forecast, and subsequently underweight the positive seasonality quarter. For those companies that exhibit seasonality in their earnings, the median analyst correctly forecasts 93% of this seasonal shift in earnings, missing only 7%. Although this finding shows that analysts are taking the seasonal nature of the earnings into account, they are not fully adjusting their forecasts and properly accounting for earnings seasonality.
The recency effect is the tendency of people to be most influenced by what they have last heard or seen. Not surprisingly, investors suffering from the recency effect will be more likely to overweight recent lower earnings compared with the higher seasonality earnings from the year-ago period. Related to the recency effect—and perhaps an additional factor contributing to the mispricing—is the availability heuristic, which operates on the notion that something that can be recalled must be important.
Consistent with the predictions of the recency effect and the availability heuristic, when recent earnings are lower, the seasonality effect is larger. The authors find monthly excess returns of 65 bps in an equal-weighted portfolio and 76 bps in a value-weighted portfolio, both significant at the 1% level.
Read the entire article here. - Paul R. Rossi, CFA
Driven by funding and actuarial considerations, state and local public pension plans have been seeking additional investment options and are increasingly using alternative investments in their portfolios. Pension fund managers are potentially motivated to invest in alternative investments by several factors: including demographic shifts, general budget challenges, and two recessions. In trying to deal with these challenges, state legislators have changed laws and state pension systems have decided to shift their allocation strategies away from traditional equity and fixed-income investments to alternative investments. These alternative investments include hedge funds, private equity, and real estate. However, is this really a good strategy?
My thoughts go back to Warren Buffett’s 2008 $1 million bet with a hedge fund manager. The bet was simple: Buffett bet $1 million that over a 10-year period, the S&P 500 Index would beat a hand-picked portfolio consisting of five hedge funds. As we head into the final year of the bet, Buffett’s bet looks most assured. He explained that the costs of active investing, despite the intelligence of hedge fund managers, are greater than the benefits to the investor. In 2014, CalPERS, the largest public pension in the United States, stated that it is no longer investing in hedge funds, stating the decision was primarily driven by costs and complexity - at least somebody is listening. While hedge funds and other so called alternative investments have the allure of producing greater returns than the stock market, history has proven otherwise.
Click here to read my entire abstract article published by the CFA Digest. - Paul R. Rossi, CFA
I've gotten a lot of demand for these documents so I thought I'd make it available to my readers. The PDF documents are a nice way to get organized (especially as tax filing deadline approaches) and stay organized.
What We Can All Learn From the Oracle of Omaha
We’ve all heard about Warren Buffett, the 86-year-old multibillionaire known for his sense of humor, his multi-billion dollar donation to the Gates Foundation, and his remarkable ability to create wealth. How does he do it?
Buffett and Berkshire Hathaway
Warren Buffett is chairman of Berkshire Hathaway, a multinational conglomerate holding company. What does this mean? Well, in simple terms, the company invests in or owns a variety of other corporations that make products sold all over the world, to put the size of the company in perspective, Berkshire Hathaway files a 30,000+ page Federal income tax return.
In the 1950s, Berkshire, which made linings for men’s suits, and Hathaway, a cotton milling company, merged. Buffett began investing in Berkshire Hathaway in 1962, becoming its Chairman and CEO in 1970. Charlie Munger, his partner, is Vice Chairman. As the textile business struggled, he eventually abandoned that segment of the business in 1985 using the cash flow to invest in marketable securities.
In the early 1990s, Buffett began to focus on owning entire businesses, and today Berkshire owns 43 major companies, the majority share of several other major publicly-traded companies and minority holdings in dozens more. Berkshire’s biggest ownership segment is in the insurance industry, owning GEICO and several smaller insurers. Berkshire also owns Burlington Northern Santa Fe Railroad, along with a trucking company and national auto dealer chain. Additionally, Berkshire owns and operates power plants, natural gas lines, hydroelectric dams, wind firms, and solar projects.
The ownership list includes:
GEICO, Applied Underwriters, General Re, Kansas Bankers Surety Company, National Indemnity Company, Central States Indemnity Company, Wesco Financial Corporation, The Pampered Chef, See's Candies, Fechheimer Brothers Company, Garan Children's Clothing, H.H. Brown Shoe Group, Justin Brands, CORT Business Services, Jordan's Furniture, Larson-Juhl, Star Furniture, Acme Brick Company, Benjamin Moore & Co., Clayton Homes, ISCAR Metalworking, Johns Manville, Precision Steel Warehouse Inc., The Buffalo News, Business Wire, Omaha World-Herald, XTRA Corporation, McLane Company, Ben Bridge Jewelers, Borsheim's Fine Jewelry, Helzberg Diamonds, Scott Fetzer Companies, NetJets, NetJets Europe, FlightSafety, CTB Inc., Burlington Northern Santa Fe Corp., Blue Chip Stamps, SE Homes, Cavalier Homes, Lubrizol, Brooks Sports and Forest River.
Berkshire also holds the majority of United States Liability Insurance Group, Dairy Queen, Fruit of the Loom, Nebraska Furniture Mart, MiTek, and Berkshire Hathaway Energy. As Buffett writes, “Our appetite for owning so many businesses increases our chances of finding sensible uses [for our cash].”
Berkshire Hathaway has been an overwhelmingly successful company. In the 52 years that Buffett has controlled the company (1965-2016), Berkshire has grown at an average rate of 20.8% annually. During this time period, the S&P 500 has averaged 9.7% each year. Buffett doesn’t just beat the market – he smashes it.
So, what are Buffett’s strategies for growing this wildly successful company?
Strategies of the Oracle of Omaha
Probably the most successful investor in history, Buffett is known as the “Oracle of Omaha” for his ability to predict an investment success through evaluating whether to buy or invest in a company.
So what’s his strategy? In a nutshell, Buffett is a value investor. A bargain hunter, he searches for stocks that are valuable but not recognized as being valuable by most other investors. Thus, he can buy a company when it stock prices are what he believes are unreasonably low.
However, Buffett isn’t especially interested in how the market treats his new stock. He chooses investments based on the overall potential of the company to generate earnings. He buys and holds stocks and companies for the long-term, with his primary concern being how well the company can make money for its shareholders. If the company does well, of course, its share value will eventually increase.
Buffett outlined one of his beliefs in his most recent Annual Shareholder Letter when he said, “…you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy.Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.”
Essentially, Buffett waits until a great opportunity presents itself, as opposed to wheeling and dealing all day with his holdings.
Can Buffett’s strategy of long-term value investing work for you?
Understanding Your Circle of Competence
Buffett’s strategy requires patience and a long-term focus, he recognizes investing is difficult and has said, “There is nothing wrong with a ‘know nothing’ investor who realizes it. The problem is when you are a ‘know nothing’ investor but you think you know something.” It's critical to stay within your circle of competence.
Pitting Index Funds vs. Hedge Funds
We’ve all heard or read about Warren Buffett, the 86-year-old multibillionaire known for his friendly demeanor, modest style of living in Omaha, and remarkable ability to create wealth. But have you heard about his million-dollar bet made almost 10-years ago? It wasn’t a bet on a company or a
recent acquisition. He bet against the entire hedge fund industry.
Warren Buffett and The Bet
In 2005 Warren Buffett issued a challenge to the entire hedge fund industry: he could pick an S&P 500 Index fund that would outperform a hand-picked portfolio of hedge funds over a ten-year period. His reasons for making the bet were rooted in his belief that hedge funds charged fees that were way too high – too high to justify their performance. (Buffett staked his own money and not any money from his company - Berkshire Hathaway
Buffett’s 2016 Annual letter to the shareholders “In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still.
I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund.”
“Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?”
“What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds.”
“I hadn’t known Ted before our wager, but I like him and admire his willingness to put his money where his mouth was. He has been both straight-forward with me and meticulous in supplying all the data that both he and I have needed to monitor the bet.”
“For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager.”
So, beginning on January 1, 2008, the bet was made – Buffett selected his index fund – the Vanguard 500 Index Fund Admiral Shares and Protégé Partners made their selections. Performance was to be measured on a basis net of fees, costs and expenses.
As of February 2017, with 10 months left on the bet, Buffett is trouncing Protégé Partners and it appears all-but-certain that he will win.
As of the end of 2016 (nine years into the bet), the five funds-of-funds chosen by Protégé Partners delivered an average of 2.2%, compounded annually. The S&P index fund picked by Buffett has delivered an average of 7.1%.
Said another way, that means $1 million invested in the index fund would have gained $854,000 so far versus just $220,000 for the hedge funds. (See table below from Buffett’s annual shareholder letter.)
The Charity Wins
When the bet was established, both Buffett and Protégé Partners agreed that the winnings would go to charity: Girls Incorporated of Omaha if Buffett wins, Friends of Absolute Return for Kids if Protégé wins. But in an interesting turn, the money in the pot – which was supposed to safe and secure – has enjoyed fantastic returns – in fact, better than the returns from Buffett’s index fund and Protégé’s hedge funds.
Turns out that both sides originally invested the “bet” into zero-coupon Treasury bonds that were structured to rise to $1 million over 10 years. But when interest rates plunged, the bonds were up to nearly $1 million in 2014. So, both parties agreed to sell the bonds and buy shares of Buffett’s company – Berkshire B-shares.
The charities saw Berkshire-B increase by 26.64% in 2014, drop 12.06% in 2015, and increase 23.43% in 2016. But irrespective of what the Berkshire-B stock price does, the winning charity is guaranteed $1 million. And if the pot remains larger than originally agreed amount, the charity gets the surplus.
This led Buffett to an early victory speech this year when he said that there is “…no doubt that Girls Inc. of Omaha, the charitable beneficiary I designated to get any bet winnings I earned, will be the organization eagerly opening the mail next January.”
The bottom line is...fees matter.
Actually quite a bit...
Research by C. Mitchell Conover, CFA, CIPM, Gerald R. Jensen, CFA, and Marc W. Simpson, CFA shows the investment benefits of dividend-paying stocks and identify three major findings.
Entire research paper is available below.
In 1973, Princeton professor Burton Malkiel wrote A Random Walk Down Wall Street, an influential stock market book that put forth a financial theory (the random walk hypothesis) that stated stock market prices follow a path that consists of a succession of random steps and therefore cannot be predicted.
Well, looking back at 2016, sure looks like a random walk, the year brought us just about everything and it sure felt like it was random. You be the judge.
But first, the numbers:
How 2016 Started and Ended Were Dramatically Different
The stock market opened with an alarming drop in the first few days of the year – in fact, it was the worst 5 days to open a year dating back to 1897. This continued through mid-February and by Valentine’s Day, the market had dropped by about 10%. But then the market came roaring back and finished the quarter up about 11% from mid-February through the end of March. For the next seven months, a lot happened, but the markets didn’t move much. In fact, for the next seven months, the market moved up about 2%. Then post- Election, the DJIA surged 1600 points and finished in very positive territory – within a whisper of 20,000. A down and then up year - or Random Walk.
The Big Winner In 2016 - Small Companies
Small-cap stocks had a terrific year. As measured by the Russell 2000 Index, small cap stocks produced a 21.6% return in 2016. Value-style stocks outpaced their growth stock counterparts – by a whopping 10 percentage points in the large-cap Russell 1000 Index and by a truly staggering 20 percentage points in the Russell 2000.
Returns from the U.S. markets outpaced all other major markets around the globe:
Along the way, there was some positive economic news:
What Else Happened
The Brexit vote and the election of Donald Trump were probably two of the more significant events
this past year – at least in terms of catching most people by surprise. Not only did pollsters, journalists and experts predict these events incorrectly, but they also predicted the consequences of these events incorrectly as well. Score two more for the Random Walk theory.
So Now What?
This is the question on everyone’s mind and one where there is no shortage of predictions. Some suggest that our current bull market – now in its seventh year – is getting long in the tooth and we are due for a major correction. And by some barometers the "stock market" could be considered expensive, using such measures as P/E, CAPE, and other relative valuation measures. While others suggest this bull market has a lot of room to run, due to the low interest rate environment and expected corporate earnings. As a financial advisor, I tend to subscribe to the Random Walk hypothesis - equity markets go up over time, but predicting the path of those returns is next-to-impossible and trying to predict these movements is a waste of time.
Instead, I remind my clients that successful investing requires a long-term approach. Many people admire the actions of Warren Buffett but very few people act like Warren Buffett. And surprisingly, you can follow what he and other successful investors do...they set a plan and stick to it during both good and bad times, because markets do seem to move in a random walk. Having a well-thought out plan will provide comfort no matter who is President, what the Fed does, whether the UK leaves the EU or any other macro event that might come out of left field.
Why trying to time the market isn't the best investment strategy - in fact it's not a strategy at all.
If 2016 taught us anything, it’s the importance of not trying to time the market and not letting so-called experts or pollsters talk you into trying to time the market.
Exhibit A - January 2016 Economists, financial writers and so-called experts had high hopes going into 2016. And then the markets gave us:
Did you sell your equity positions on January 21st because you thought the market would continue to crater? If you did, then you missed the Dow skyrocketing over 1,000 points between the lowest point on January 20th and the end of January.
Exhibit B - November 2016 Election Remember that almost all the polls said Hillary would be our next President? And remember what virtually all the so-called experts and journalists said would happen if Trump was elected? They said the stock market would go way down – maybe even crash – because it hates uncertainty.
And on Election night, markets around the world were falling as Trump racked up Electoral College votes. Japan’s markets were off by about 5%, Mexico’s peso was getting hammered and the US futures market was down by about 800 points.
So, did you again sell your equity positions on November 10th, right after it became clear that Trump would be the next President? If you did, you missed the Dow skyrocketing 1600 points from Election Day until the end of the year, closing in on that 20,000 milestone.
Would this have made you mad?
Imagine if you:
Let’s use real numbers in this scenario: Your $1,000,000 at the beginning of 2016 year is worth about $900,000. Everyone else that stayed in the market saw their $1,000,000 grow to $1,120,000. That’s a $220,000 difference or the price of a modest home!
While I will admit that market is not inexpensive currently, you should always build your investment portfolio for the long-term (assuming you have the time), and be well diversified accross mulitple asset classes. So when the next market downturn happens - as it will - you have the opportunity to take advantage of the opportunities that will present themselves.
Make 2017 a great year!
Some companies announce a share repurchase program and yet never end up repurchasing their shares. The theoretical model predicts that companies that are significantly undervalued announce share repurchase programs but never follow through, whereas companies that are trading closer to their intrinsic value do repurchase their shares.
The authors develop a model to understand why some companies that announce a share repurchase program follow through and repurchase shares and some do not. They find that companies that are significantly undervalued do not have to repurchase shares for the market to bring their share price more in line with their fundamental value. Firms whose market value is not significantly undervalued, however, do have to repurchase shares in the open market to help drive the share price up. This article is a considerable revision to Bhattacharya and Dittmar (working paper 2001) and has close links with two other papers: Oded (Review of Financial Studies 2005) and Allen, Bernardo, and Welch (Journal of Finance 2000).
Click here to read the entire abstract article published by the CFA Digest. - Paul R. Rossi, CFA
THE 1st AND MOST IMPORTANT RULE-
Start saving! If you are already saving...great job! Now let’s make sure you are saving the proper amount. To get to a million dollar retirement portfolio it’s not as hard to get to as you might think. Understand there will be ups and downs however staying the course during those down turns will pay-off over the long-term. ‘Slow and steady wins the race’. While starting to save early is always advised, it’s not always possible with prior student debt, lay-offs, children, emergencies, etc. So I made the assumption that a couple didn’t start saving until they were 40 years old, quite a bit older than many financial articles write about – albeit probably more realistic. So let’s get started...
We need to make some assumptions, of course your numbers might be slightly different, but this will give you an idea of the process to figure out what you need to do.
With the above assumptions, a couple who starts saving at age 40 saves 10% of their income for 25 years which earns an average return of 7% will reach their goal of a $1 Million retirement portfolio. I call this the 25/10/7 plan. Save for 25 years, 10% of your income, portfolio earns 7% per year.
SOME POINTS TO REMEMBER-
Click below for a 1-page PDF of this article which includes a graph which shows how much you need to save on a monthly basis depending on when you start saving.
A New York Times article discussed that a $1 million retirement nest egg isn’t what it used to be. While this is more than 90% of U.S. retirees have amassed, $1 million doesn’t go as far as you might think. That said I wanted to take a look at what it takes to provide a $100,000 income annually during retirement.
The 4% rule-
The 4% rule says that a retiree can safely withdraw 4% of their nest egg during retirement and assume that their money will last 30 years. This very useful 'rule of thumb' that was developed many decades ago, although like any rule of thumb it is just that, an estimating tool. While it is a useful estimate, do not depend on this rule alone, build a comprehensive financial plan for your retirement.
Using the 4% rule as a quick 'back of the napkin' estimating tool allows us to see how someone with a $1 million in their 401(k) and any other retirement accounts might help get them to their hypothetical goal of $100,000 (before any taxes) per year. Note this is not to say that everyone needs a $100,000 or any particular amount during their retirement, but rather this example is simply meant to illustrate the math involved.
Doing the math-
The $1 million in the 401(k)s and IRAs will yield $40,000 per year (using the 4% rule). This leaves a shortfall of $60,000 per year. A husband and wife who both worked might have Social Security payments due them starting at say a combined $40,000 per year. The shortfall is now down to $20,000
So how can you make up this potential shortfall-
Things to beware of in trying to boost your nest egg-
Traditionally, most portfolio optimization has focused on total-return analysis to the exclusion of income-oriented portfolios. Given the change in investor risk appetite as a result of the 2008 financial crisis, increased market volatility, demographic shifts, and the belief that growth rates will be lower going forward, the need and interest in income-focused portfolios is increasing.
Needing to use the income the portfolio generates while preserving the principal, investors who are at or near retirement are increasingly seeking income-generating portfolios and focusing on more predictable returns. Total-return portfolios may generate some income but may not be ideal for these investors. Yet there is only modest guidance available on how to build an efficient income-generating portfolio compared with the guidance available for total-return portfolios.
As the US population continues to age and people’s ability to accept risk (income volatility) diminishes, the demand for efficient income-oriented portfolios is becoming increasingly important. While total-return optimization is important, income-generating portfolios become more important as investors reach retirement. Read my entire CFA Digest abstract article here. - Paul R. Rossi, CFA
Differences in individual investor behavior stem from genetic predispositions and environmental factors. Several determinants play a critical role in why some individuals become value-oriented investors and others become growth-oriented investors.
Experiences in early adulthood can have profound implications on preferences later in life according to social psychology in neuroscience. A person's core beliefs seem to crystallize during this early period of great neuroplasticity and those beliefs remain consistent throughout a persons life. Researchers have shown that neural pathways and synapses can dramatically change during these formative years as a result of a persons environment, behavior, emotions and even injury.
Significant macroeconomic events that investors experience can also have long-term and persistent effects on that individual's behavior much later in life. The research shows that individual investors who experienced difficult economic conditions and crew up in lower income homes develop a more value-oriented investment style later in life. For example, people who grew up during the Great Depression subsequently favored value-oriented or 'cheaper' portfolios. These investors hold portfolios with than average P/E that is 11% lower than the median. The research also reveals that the timing of an individual's entrance into the labor market can affect that individuals future investment decisions. If an investor intern is the labor market during a severe recession, they favor more value oriented portfolios in the future.
Conversely, investors with more education with more disposable income and whose income is correlated with GDP favor growth investments. Additionally, investors who exhibit mora behavioral biases, such as the overconfidence bias, opt for growth investments. Individuals who exhibit more behavioral biases are found to have portfolios with a 10% higher P/E ratio than the medium.
Several studies contribute to and supports the growing body of evidence regarding behavioral finance, which demonstrates that life experiences, behavioral biases, and genetics have a dramatic impact on investors behavior. Click here to read my entire abstract article published by the CFA Digest. - Paul R. Rossi, CFA
CFA Institute, the global association of investment management professionals, will recognize May as the third annual Putting Investors First Month. This annual month-long, global initiative focuses on promoting the needs and rights of investors with the end goal of uniting investment professionals in a commitment to place investor interests above all others.
Throughout the month of May, many of the organization’s 147 member societies worldwide will host local events and call attention to the needs and rights of investors by sharing the Statement of Investor Rights, a list of ten rights that any investor should expect from financial service providers. In addition, the organization will spotlight A Difference That Matters, a global advertising campaign, which features CFA charterholders from around the world and aims to build a better investment management profession by raising investors’ awareness of what makes CFA charterholders different.
“Putting the investor first is critically important because investing is, and always has been, deeply personal,” said Paul Smith, CFA, president and CEO, CFA Institute. “Behind every investment transaction, there is an individual whose hopes and dreams depend on this capital, whether it’s putting the kids through college, paying the mortgage, or saving for retirement. Investment is about people, and that focus is more important now than ever before. We have an incredible opportunity as an organization; our foundation is built upon placing the interests of our clients first, second, and last, and we must never forget this.”
Putting Investors First Month Aims to Create Impact by Encouraging Ethical Behavior
According to a recent report from CFA Institute, From Trust to Loyalty: A Global Survey of What Investors Want, we see that investor loyalty remains fragile showing that the need to put investors first is greater than ever. A central focus of Putting Investors First Month is the Statement of Investor Rights, which investment management professionals are encouraged to share with their clients and communities. The list applies to financial products and services such as investment management, research and advice, personal banking, even insurance and real estate, and is intended to help investors demand that financial professionals abide by these rights. The document includes rights that investors are entitled to expect such as objective advice, disclosure of conflicts of interest, and fair and reasonable fees. To complement the Statement, CFA Institute has produced Realize your Rights: Using the Statement of Investor Rights, which provides the questions and considerations that will allow investors to evaluate the ethical commitment of their financial service providers and to ensure that their interests come first.
“The CFA Institute community worldwide is committed to good stewardship, high ethical standards, and putting investors first,” continued Smith. “Through the Statement of Investor Rights we are educating investors on their rights to a service that puts their interests first. By supporting Putting Investors First Month, we want to inspire our community to make real impact and foster a market environment where investors can thrive.”
For more information about Putting Investors First Month, the Statement of Investor Rights, and From Trust to Loyalty: What Investors Want, visit www.cfainstitute.org.
Market corrections and more severe downturns called "bear markets" are normal and are necessary—basically they serve to “clean up” what are considered prior economic excesses. Many times these downturns and bear markets offer great opportunities to buy assets at substantial discount to fair value.
During a bear market or major correction it is only natural to ask and many investors want to know, “What’s my next move?” What investors should realize is 1. Various investable markets will be volatile and understand that they will be volatile and 2. that all markets whether bull or bear markets create opportunities—often very attractive opportunities. Long before any money is invested a sound financial plan should be in place that addresses what actions should be taken under various scenarios.
Successful investing is more often about the psychological aspects of managing your money and being able to adhere to a financial strategy. It is important to understand how market conditions can create euphoria or fear in people. Market corrections and bear markets will happen…it's how you react to them that will determine your investment success. As Warren Buffett says, "Be fearful when others are greedy, and be greedy when others are fearful". Remember: bear markets prepare the way for future bull markets.
It is the long-term picture that investors need to keep in focus. If your original investment goals haven't changed, whether accumulation for retirement or funding for college education, maintaining a well thought-out financial plan coupled with a properly built portfolio will help provide comfort during volatile markets. The wisdom of the day is to remain calm, keep your financial goals in mind and use what the market presents as an opportunity rather than fall pray to it.
Analysts disproportionally cover companies whose fundamentals correlate with industry peers. These firms, designated as bellwether companies, are shown to have significant stock price effects on companies with little to no analyst coverage within their same industry.
The paper offers two propositions. The first proposition states that companies whose fundamentals are similar to those of other companies in their industry attract more analyst coverage. The second proposition states that earnings estimates of companies with a large analyst following, or “bellwether firms,” influence the returns of companies with similar fundamentals but for which information is sparse because of limited analyst coverage. These ideas are shown to have a significant impact on return and volatility characteristics. Click here to read the entire abstract. Abstract Author - Paul R. Rossi, CFA