Recent Musings

1. When building a portfolio, you basically have two choices.

With the availability of index funds, it’s not difficult to build a portfolio. The question is, what kind of portfolio do you want to build? Or, to put it another way, what are you trying to accomplish?

Do you want to trail the market when it’s going up or when it’s going down?

You can structure your portfolio to be more aggressive than the overall stock market. That will help you when the market is going up but hurt you in down markets. Alternatively, you can structure things to be more conservative than the market, in which case you’ll trail in up markets but lose less when the market is going down. The takeaway being you can’t have it both ways.

Investment returns (in the realm of normal) are within our control. Many people worry about the stock market. It doesn’t need to be that way. If you don’t want to lose sleep worrying about the market, you don’t have to. It’s all about the asset allocation choices you make.

2. When it comes to investments, there’s no such thing as perfect.

No investment is going to be perfect, and we shouldn’t expect it to be. In traditional finance textbooks, investment decisions are presented as a tradeoff between risk and return. If you want more return, you must take more risk. But if you want less risk, you must be content with lower returns.

That is a bit over-simplistic so when evaluating investments, investors should think things through much more carefully. In addition to risk and return, consider an investment’s fees, complexity, liquidity, tax treatment and the overall level of economic certainty or uncertainty.

3. When warranted, be willing to pay more.

It’s worth paying more if you’re getting extra value. Most investors are sensitive to fees and taxes—and they should be—but this comment is a good reminder not to take this too far.

Similarly, if you own an overpriced, underperforming fund, should you hang on forever just because you would have to pay some taxes if you sold?  Of course not. Do the math and don’t be afraid of costs if you think it will pay off in the long run.

4. Don’t fall in love with an investment.

Just as there’s no perfect investment, there is no investment that you should expect to remain perfect for all time. I see this as particularly applicable to thinking about index funds—an investment that appears awfully close to perfect right now.

I believe that low-cost index and factor funds are the best way to invest—and there’s plenty of supporting data. But we should never be too comfortable. Currently, indexing works exceptionally well. But it may not work forever. Markets are dynamic. Indexing might begin to work less well or other forms of investing might begin to work better. Anything can happen, so be careful. When it comes to your investments, you don’t want to be blindsided.

CBlakely, CFP®, CTFA

Keep Taxes Low to Maximize Returns - Here's How

Portfolio research has examined the long-term impact of expenses and taxes on investment returns and concluded that, while asset allocation remains the most important factor affecting variability of returns, keeping costs and taxes low is an important factor for investors who are trying to maximize return.

Because mutual funds may distribute capital gains throughout the year, mutual fund investors are often concerned about losing investment returns to taxes. But individual stock and bond investors are vulnerable to taxes as well, depending on how they manage their investments.

Return lost to taxes sucks, but the good news is you can exercise a good deal of control here. Think about this: diversification and asset allocation are great tools for helping to reduce portfolio volatility and variability, but we're still going to be subjected to the short-term moves of the market, no matter how diligent we might be in setting up our portfolio and selecting our investments. Where we have the greatest degree of control is the area of expenses and tax-efficient implementation. Doesn't it make sense that where we can exercise the most control, we should?

Below is a table that displays where investors who want to minimize taxes may want to place their investments.

Taxable accounts	Tax-deferred accounts such as traditional IRAs, 401(k)s and deferred annuities
Here, you'd ideally place...	Here, you'd ideally place...
Individual stocks you plan to hold more than one year	Individual stocks you plan to hold one year or less
Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds	Actively managed funds that may generate significant short-term capital gains
Stocks or mutual funds that pay qualified dividends	Taxable bond funds, zero-coupon bonds, inflation-protected bonds or high-yield bond funds
Municipal bonds, I Bonds (savings bonds)	Real estate investment trusts (REITs) Private equity, partnerships (IRA only)

Also to keep fees as low as possible research index funds and index ETF's and use fee only advisors!

CBlakely CFP®, CTFA                      02/2013

Source: Schwab Insights

Revisiting the 4 Percent Spending Rule

A well-known approach to addressing prudent retirement spending is known as the “4% spending rule.” This guideline states that retirees with a diversified portfolio balanced between stocks and bonds can safely withdraw 4 percent of their initial balance at retirement, then adjusting the dollar amount for inflation each year thereafter.An inflation-adjusted withdrawal rate is intended to provide a predictable stream of withdrawals that keep up with inflation.

 

Conversely, using a percentage-of-portfolio withdrawal method, the retiree withdraws the same percentage annually from the prior year-end portfolio balance. The dollar amount will fluctuate with market performance, and while the portfolio balance and withdrawals may shrink, the portfolio is unlikely to ever be fully depleted.

In practice, retirees are likely to incorporate a hybrid spending method—spending moderately in years when the market is up and spending less when the market experiences prolonged downturns.

The factor that has the biggest impact on withdrawal rates is the retirement planning time horizon. For most people, an estimate of how long the retirement portfolio will be needed can be based on the investor’s current health and anticipated longevity, as determined by statistics, and history. An estimate of age 90 is a reasonable default given today’s longer life expectancies. For a 65-year-old married couple today, for example, there is a 72 percent chance that at least one spouse will live to age 85, a 45 percent chance that one will live to age 90, and an 18 percent chance that one will reach age 95!

With today's yields near historic lows retirees, whose dividends and interest combined are less than 4 percent are often reluctant to spend from principal to make up for the deficiency. And many are wondering whether 4 percent is still a reasonable spending goal.I feel it is a reasonable starting point for investors who follow a total-return spending approach. A total-return approach is one in which investors remain appropriately balanced between stocks and bonds, and diversified across varied asset classes so that portfolios may potentially benefit from both dividends and interest and appreciation of capital (i.e. stocks moving up in price).

Instead of changing the portfolio to chase income, by reducing equity exposure and adding bonds it may be wise to consider the total-return approach to allow for spending both from portfolio cash flow and from the potential increase in the portfolio value.This empirically decreases the odds of  outliving your portfolio.

CBlakely CFP®, CTFA                   October 2012 

 

Source: Society of Actuaries Retired Participants 2000 Mortality Table., Fiancial Planning Journal

Emerging Markets Debt – Not as Risky as You Think

Over the next several years the challenges of collecting sufficient income, due to low current interest rates, may be somewhat lessened by taking a more tactical approach to fixed income investing. Current yield is a big component of investing for income investors and there are opportunities available for investors to achieve attractive current and total returns.

The perception for years has been that emerging markets debt as an asset class had been one of high volatility of returns. But look back to the crash of 2008 and remember that emerging markets experienced less of the effect of the crash and moved out of it faster than the U.S. did.

Looking back at 10-year annualized returns for major markets, the average annual total return for emerging markets debt was over 10 percent, while its standard deviation of returns was less than 10 percent. Contrast that with long-term U.S. Treasuries with had comparable returns but with a standard deviation of about 12 percent and Large Cap Domestic Equities with a 10-year average annual return of less than 5 percent  but a standard deviation of over 15 percent.*

Another factor is that valuations for this asset class remain attractive. A typical valuation metric for bonds is to look at the yield of the security compared to the yield of a U.S. Treasury security with a like maturity date – called the spread. The median spread of high-yield debt over the past 30 years has been about 500 basis points (five percent). Currently, that spread is around 600 basis points. If the economy recovers, during good economic times that spread generally narrows to 300-400 basis point range. This is positive for the price of the bonds.

Many emerging economies benefit from a younger demographic and a fast growing middle class. Also, many of these countries live within their means and have reached a point where they are self-funding.

 Talk to an advisor for detailed information and to see whether adding this asset class to your portfolio makes sense. There are real risks associated with emerging debt, this is not a “set it and forget” it strategy.



CBlakely CFP®, CTFA 05/2012





Source: Morningstar data as of 12/31/2011
Standard deviation is a statistical measure of historical volatility, the higher the standard deviation, the greater the volatility.

Diversify Your Holdings (or not - That's Cool Too)

 Should you put all of your money in one stock or should you spread your bets across many investments? If it is the latter, how many investments should you have in your portfolio? The debate is a good one at one end is the advice that you get from the efficient markets camp: maximum diversification across asset classes, and within each asset class, across as many assets you can hold: the proverbial “market portfolio” held in proportion to its market value. At the other is the “all in” investor, who believes that if you find a significantly undervalued company, you should put all or most of your money in that company, rather than dilute your upside potential by spreading your bets.


Which Gospel? Mark or John
These arguments got media attention recently, because two high-profile investors took opposite positions. The first salvo was fired by Mark Cuban, who made his substantial fortune (estimated at $2.5 billion), as an entrepreneur. Cuban's profile has increased since, largely from his ownership of the Dallas Mavericks, last year's winners of the NBA championship. With typical understatement, Cuban claimed that diversification is for idiots and that investors, unless they have access to information or deals, should hold cash, since hedge funds have such a tremendous advantage over them. In response, John Bogle, the founder of Vanguard, countered that "the math (for diversification) has been proved over and over again. It's not just the first thing an investor should think about, but the second, the third and probably the fourth and the fifth thing investors should think about."

So, should you diversify? And if so, how much should you diversify? The answers to these questions depend upon two factors: First, how certain your assessment of value and second, how certain you are about the market price adjusting to that value within your specified time horizon.

At one limit, if you are absolutely certain about your assessment of value for an asset and that the market price will adjust to that value within your time horizon, you should put all of your money in that investment. Though this may seem like the impossible dream, there are two possible scenarios where it may play out:

1. Finite life securities (Options, Futures and Bonds): If you find an option trading for less than its exercise value: you should invest all of your money in buying as many options as you can and exercise those options to make a sure profit. In general, this is what falls under the umbrella of pure arbitrage and it is feasible only with finite lived assets (such as options, futures and fixed income securities), where the maturity date provides a endpoint by which time the price adjustment has to occur.
2. A perfect tip: On a more cynical note, you can make guaranteed profits if you are the recipient of inside information about an upcoming news releases, but only if there is no doubt about the price impact of the release (at least in terms of direction) and the timing of the news release. The problem, of course, is that you would be guilty of insider trading and may end up in jail.

At the other limit, if you have no idea what assets are cheap and which ones are expensive (which is the efficient market hypothesis), you should be as diversified as you can get.

Most active investors tend to fall between these two extremes. If you invest in equities, at least, it is inevitable that you have to diversify, for two reasons. The first is that you can never value an equity investment with certainty; the expected cash flows are estimates and risk adjustment is not always precise. The second is that even if your valuation is precise, there is no explicit date by which market prices have to adjust; there is no equivalent to a maturity date or an option expiration date for equities. A stock that is under or over priced can stay under or over pced for a long time.

How Diversified?
Building on the theme that diversification should be attuned to the precision of your valuations and the speed of market adjustment, the degree to which you should diversify will depend upon how your investment strategy is structured, with an emphasis on the following dimensions:

A. Uncertainty about investment value: If your investment strategy requires you to buy mature companies that trade at low price earnings ratios, you may need to hold fewer stocks , than if it requires you to buy young, growth companies (where you are more uncertain about value). In fact, as a general rule, your response to more uncertainty should be more diversification.


B. Time horizon: To the extent that the price adjustment has to happen over your time horizon, having a longer time horizon should allow you to have a less diversified portfolio. As your liquidity needs rise, thus shortening your time horizon, you will have to become more diversified in your holdings.


In summary, then, there is nothing crazy about holding just a few stocks in your portfolio, if they are mature companies and you have built in a healthy margin of safety, and/or you have the power to move markets. By the same token, it makes complete sense for other investors to spread their bets widely, if they are investing in young, growth companies, and are unclear about how and when the market price will adjust to value.


Bottom Line
Most investors are better off diversifying as much as they can, investing in mutual funds and exchange traded funds, rather than individual stocks. Many investors who choose not to diversify do so for the wrong reasons (ignorance, over confidence, inertia) and end up paying dearly for that mistake. Some investors with superior value assessment skills, disciplined investment practices and long time horizons can generate superior profits from holding smaller, relatively undiversified portfolios. Even if you believe that you are in that elite group, be careful to not fall prey to hubris, where you become over confident in your stock picking and market assessments and cut back on diversification too much.

CBlakely CFP®, CTFA 02/2012

Source: New York University Stern/Damodaran

Asset Allocation in a Flat World (think globally, not locally)

Global Diversification
One of the three big questions investors must consider today is: How and how much should one allocate to stocks in and outside of the U.S.? In his book, "When Markets Collide," author Mohamed El-Erian describes a multilateral economic future in which domestic demand in emerging markets is a counterbalance to U.S. growth. His recommendation is that U.S. investors be exposed to a globally diversified set of stocks, with only a third to one-half in the U.S.


If you agree, and we do, then what does "globally diversified" actually mean and how do you determine how much and where?


The difficult issue is determining a valid reference point. The obvious approach would be to start with an established benchmark as a frame of reference. A good neutral frame of reference would be the total world stock market value, except for the risk that constantly annoys capitalization weighted markets - you potentially overweight overvalued markets! A better alternative might be economic size as measured by GDP in that the weightings are not affected by short-term market momentum or overvaluations.



The total world stock market value and GDP for 2008 is as follows:
mkt. value GDP
U.S. 36% 23%
Europe 26% 36%
Asia Pacific 28% 26%
Mid East/Africa 3% 6%
Americas 4% 7%
Canada 3% 2%


Implementation


The most common approach is to achieve targeted international equity country weightings using a combination of developed international and global emerging markets strategies. Alignment with the MSCI EAFE (Europe, Australasia and the Far East) and the MSCI EM (Emerging Markets) Index will accomplish this.


These markets vary from relatively to significantly inefficient, therefore our suggestion would be to engage active portfolio managers who have the ability to create alpha (excess risk-adjusted return) consistently (keep the index funds for your short duration fixed income funds and large cap U.S. funds).


It is possible that the next ten years will bring lower correlations of international markets with the U.S., as regions like Asia decouple as they mature and become less dependent on the U.S. and continue to demonstrate growth in their domestic economies.



Christopher Blakely Sept. 2009

sources: International Monetary Fund, MSCI