By: Paul Sutherland, CFP ®
We are wired to underestimate how much we will change in the future. Social psychologist Daniel Gilbert has spent a large part of his career studying affective forecasting. His research has concentrated on three main areas: 1) Happiness; 2) Why we often forecast in a way that is totally inaccurate; and 3) How we weigh external situations and how we expect to feel about them in the future. Naturally, I relate Gilbert’s research to how people invest and behave in the world of commerce.
Consider the phrase, “new and exciting.” Though this may be appealing for things like cars, vacations or soap, it fascinates me that some people actually see it as smart investing. Early in my career, you could buy 15% long-term government bonds. Imagine that: locking in 15% for 30 years with government backing! Were these bonds popular? Not in the least. Back then; the popular press disparaged them and exalted gold. A rate of 15% was quite an enticement compared to today’s U.S. debt yields at less than 3.25%. Today, dollars are pouring into bond funds because investors are still cautious from the 2008 global financial collapse that for a short period devastated nearly any liquid or illiquid investment. Most investors who got hurt by that collapse did so because they sold – and not held – their assets. Imagine if someone offered to buy your home for one-half of its value today, or an appraisal came in valuing your home at one-half of its value? Would you sell? Most likely not, telling yourself, “It’s a bad time to sell, we have a credit crisis, a recession … I will wait.” But with stocks many people panicked and sold, and they were the ones who suffered. I am not picking on stocks, every asset class – from gold to treasury bills to municipal bonds – experienced wild swings in value. Today’s hot products are bond funds, ETFs, (exchange-traded funds) and index funds. They are attracting assets at a torrid pace.
Assets in exchange-traded products grew by approximately $0.25 trillion in 2012 to around $1.36 trillion (ETF Daily News). Bond funds, despite record low yields, grew by a record-setting $480 billion in 2012 (Bloomberg). Money fund inflows hit a four-year high last year (CFO Journal). What is most interesting to me is that stock funds ended 2012 with a 20th consecutive month of outflows (Wall Street Journal).
Wisdom and Senselessness
As a professional investor I see this data differently than most. Despite record low rates, people purchased bonds and locked themselves into worthless yields while simultaneously pulling assets out of stocks that were at bargain levels. Pure silliness. As you are aware, stocks were up last year. The average U.S. stock fund was up 13.9% in 2012, and the average international fund was up 17.8%, according to the Lipper unit of Thomson Reuters.
What’s interesting to me is that the average investor seems to just sit and passively wait until deciding to sell low and buy high. Again, in 2012, stocks nearly everywhere had significant gains, even though U.S. mutual fund investors were net sellers of stocks. Imagine when the buyers of bonds and money markets start to think, “How can I possibly live on a 3% bond or .03% money market yield in a 4% inflation world?” They will have to flow back into stocks and repeat the sell low, buy high scenario.
When this happens, there is a real chance for another speculative bubble in stocks, but we are not there today. Of course there will be losers among the 53,000 available stocks and certain sectors will bubble and bust, but that is typical. Speculation is part of investing. We feel that the largest speculative risk today is in a wide range of product du jour specialty ETFs, and particularly those focused on the corporate bond market.
An Industry that Pretends and Says If
The investment industry has few barriers to entry. Anyone can put up a shingle and say they are an “investment consultant,” “adviser,” “guru” or “investing expert.” All it takes is a sign, some cards and a box of stationery to look official. Jazz it up with a website and a few smart-looking white papers and you’re able to get business. Statistically it appears that the experts do not outperform the average investor, which makes sense for two reasons: 1) The rearview mirror approach: You have advisers with no track record, no experience and nothing but a compelling story in the business. They’ll often tell you, “If you had done this … you would have that”; 2) They are part of a sales organization that has taught them to sell what is hot, sounds good, and “what the customer will buy” not what an investor needs. As you know, at FIM Group we have no salespeople, we get no commissions. Most salespeople in the “investment industry” are driven by transaction compensation, so they are incentivized to sell products that generate the biggest commission. They appear to be in the business to make people money when really they are in the business to sell. This is a major cause of market fluctuation and is probably the source of the old adage: “If it sounds too good to be true, it probably is.”
When asked why they hired us, FIM Group clients consistently say that it boils down to common sense. It’s common sense to want a transparent, proven performer, with a genuine history and track record, that doesn’t work on commission or sell products that cause conflicts of interest or compromise values.
Years ago I wrote and submitted to an industry publication an article called “Truth in Performance” in which I explained how every adviser should commit to revealing to both their prospective and existing clients actual performance experience – not the rearview mirror approach. To me it seemed very logical, straightforward and imbued with common sense that advisers should show their actual numbers. To my surprise, the editors thought it was too controversial an idea and turned down the manuscript. This prompted me to create the website www.truthinperformance.com to promote this concept. It serves as a transparency tool for investors who need advice on hiring a financial adviser.
The End of History
As we discussed in past newsletters, investors fail because they do not embrace the fact that we are wired to invest in ways that are not productive. These behavioral factors – endowment behavior, recency effect, etc. – basically boil down to realizing that: 1) The future is not the past, and hindsight is not foresight; 2) Investment success stories are like lottery success stories; 3) Fear and greed are both terrible guides for investors (if you did not read our newsletter on “Emotional Intelligence,” call for a free copy or download it from our website – www.fimg.net); 4) Control-oriented people: If you don’t enjoy it you will just do a poor job of it.
I love watching great athletes being interviewed. Do you know why they are successful? Because they are not only talented, they love the sport. To them, it’s getting paid to do their “dream job.” To be good – really good – at something, you need to love it. By the way, we love our careers here at FIM Group.
In January of 2007, my dear friend unexpectedly passed away, and later that year Amy and I were married. We have since added two boys, Patrick (5) and Henry (3), to our family, and in April, I will be the father of my fourth son, joining my eldest son Keeston (18). My 21-year-old daughter, Akasha, told me recently she is very happy to be the oldest and only girl. When I think back over these years, I reflect on the enormous changes. In some ways, it seems normal or even predictable with 20/20 hindsight. But had you asked me in 2005 if I would have had a clue that my life would be as it is today – I would have thought, “No way.” I knew I would still be working because I like my job, and I knew life would go on in one form or another. But these are rather dramatic changes, to be remarried and have five children instead of two in just five years!
It turns out, I wasn’t alone in 2005 in how I predicted my future life might be today. According to research, our predisposition is to just sort of straightline our future lives, by assuming our future likes, dislikes, location and such will be constant. This is just not the way it works. When I have discussed with friends and clients about this concept, they tend to see the truth of it in their lives, yet still have a hard time imagining such great changes are in store for the upcoming decade as they experienced in the preceding time period. So the “end of history,” as scholars put it; relates to the fact that changes in our past don’t seem to correlate to the predictions for change/development in our futures.
We also tend to assume that at each age we are at the top of our game. I love the humble, wise expression, “I wish I were as smart as I was 15 years ago.” In some industries experience wins. Off the top of my head I would say that professions like investment management, counseling, coaching, consulting, chefs, artists, writers, journalists, business management, teaching and such favor experience. In other words, “Time spent learning and doing increases competency.” Experience and aging in a career is beneficial. But I believe this is true only if the saw is sharpened every day. People who don’t grow in their careers, even after 20 years, are the ones who don’t stay sharp. Those who do the same thing day after day, month after month, year after year. I call these folks “Groundhog Day” professionals – time in but no wisdom gained. When investing, realize that today is not the end of history, and that change, often dramatic change, happens and is as normal as the sun setting in the West. As Gandhi said, “Live like you will die tomorrow, but learn like you will live forever.”
By: Barry Hyman, MBA
From a Client:
Lately I have been hearing nothing but the buzz of how 2013 is the year that everything is going to crash – stock market, economy, employment, etc. I normally do not pay much attention to this kind of stuff, but for some reason this time seems a bit more real. Why shouldn’t I take all my investments and move them to the safest means such as money markets or CDs and know that, if this does occur, I have secured my future financial foundation? If it doesn’t happen, I can still gradually move funds back into slightly higher-risk adventures in the future as more promising reports are presented. Why should I not do this and what are the impacts if I did?
Wow, there is a lot of stuff packed into this seemingly common question. I’ll try to address it one part at a time.
Q: Many experts are predicting a market crash. How bad are things really?
A: From a macroeconomic perspective the main concern is how Western economies and governments are going to resolve the stresses and crises resulting from decades of too much borrowing and insufficient funding of entitlement programs and pensions. Different countries are addressing these issues with differing combinations of austerity and stimulus. The wealthier countries like the United States have the luxury of going very light on the austerity and very heavy on the stimulus. Most economists agree that the current “recovery” has been anemic relative to historic cycles. Job recovery has been slower than past recoveries, and total U.S. debt is higher now than it was before the 2008-2009 crisis. The result of which is likely a prolonged path back to prosperity From an investor’s perspective, paltry interest rates render negative after inflation future returns on high-quality bonds. So many investors have been herding into the largest perceived “blue chip” companies (pushing their prices higher and increasing their future return risk) and have frankly pushed prices of many of them to “overvalued” levels. As a result, it is logical that from current levels, investments in broad stock markets will have a tough time generating above-average returns in the years ahead. Thankfully, our team has the flexibility to invest “without borders” so we proactively position portfolios with expected return characteristics very different from what we believe to be unattractive U.S. stock and bond market valuations.
Q: What’s the likelihood of a significant market "correction"?
A: This depends on the definition of "correction." The classic definition of a "correction" is a 10% decline and a "bear market" is a 20% decline. Stock markets contract by 10% very frequently, something like once every year or two on average. 20% declines happen on the order of two to three times a decade on average. Europe experienced two 20% declines in the past two years (as measured by the EURO STOXX Index). The Asian region experienced one in 2011 (as measured by the MSCI Asia APEX 50). The U.S. hasn’t experienced one since 2008. The likelihood of a 20% or so bear market within the next few years would be perfectly in line with historical norms and is a real possibility.
Q: What’s the likelihood of a catastrophic crash?
A: Stock market crashes of 40% or more happen about once every decade or two. The decade of the 2000s experienced two such crashes. But both were somewhat unique circumstances: The 2000-2002 crash was indeed a “correction” in the truest sense of the word. At the peak in 2000, stocks were priced at astronomical valuations. The 100-year average price-to-earnings ratio of large U.S. stocks has been around 16. That measure exceeded 40 for the S&P 500 and 100 for the NASDAQ at the year 2000 peak. Those were the highest valuations on record and thus the ensuing market crash was completely logical (and ultimately healthy). Valuations of broad U.S. stock market indexes are currently around their historic averages by some measures and somewhat above average by other measures. So it is not likely that there will be a valuation-driven catastrophic crash. The crash of 2008-2009 was unique in that it resulted from less extreme overvaluation levels, but was exacerbated by a combination of excessive debt and an ensuing liquidity or credit crisis. In the U.S., the last similar confluence of factors like that happened in 1929 and before that in the 1840s. In the period since 2008-2009, banking, corporate and personal balance sheets have improved as governments have taken on some of that debt and are uniformly determined to unleash massive fire hoses of liquidity to stave off any such event in the future. So the likelihood of a credit-driven crash is low in our opinion.
Q: So you are saying the likelihood of a crash is low, but that a correction in the next few years would be quite normal. What options are available to investors who want to avoid volatility, and what are the impacts of those options?
A: One option is to “go to cash” with the intention to reinvest once the risks and problems are somewhat alleviated. In addition to transaction costs and the lost income (dividends and interest) from converting to 100% cash, the primary problem with doing so is that most investors who take such drastic action are unlikely to “get back in” when markets are best priced to do so. After markets have fallen (and stocks become better values) the headlines are usually more dire than prior to the drop, so it is highly unlikely an investor who got out would be any more comfortable and probably less so. It is more likely that by the time comfort returns, prices will be higher. Stocks are a leading indicator, meaning they rise and fall in advance of positive or negative business performance. By the time risks abate, prices have already recovered.
The reality is that there are always risks. This is not to say one should always remain fully invested and throw caution to the wind. But by the same token one shouldn’t “go to cash” out of fear expecting that there will be an obvious time to get back in, especially if there is no crash. Imagine the person who “got out” in the early 1990s for the reasons that existed then, Desert Storm, the nasty political climate, the then proposed health reform, terrorist attacks on embassies and U.S. military ships, a recession, and so on. When would such an investor have “gotten back in”? The prices of many global stocks tripled or more during the decade of the 1990s.
Another option is to lock in the perceived safety of long-term fixed income via long-term bonds or fixed annuities. The problem with doing so is that at current yields it would lock in a nearly certain erosion of wealth and income to the effects of inflation. The cost to undo such a decision can be extremely high. As I mentioned in prior articles, a 1% increase in interest rates will cause a 9% decline in the market value of a 10-year Treasury bond. A 3% increase (back to more historically normal levels) would cause a 27% decline in market price of those bonds. If you hold such bonds to maturity, you will earn 1.8% per year in interest, likely less than inflation, and the principal returned in 10 years will have lost a significant amount of value to inflation.
A third option is to follow prudent planning guidelines of: a) keeping an adequate amount of assets in cash or cash equivalents to sustain your spending needs through any period of market weakness; b) investing your long-term assets in a prudent mix of varying strategic levels of cash and rigorously researched, proactively managed investments that should provide favorable long-term income and growth of income; and c) accepting the reality of volatility with your long-term assets.
Q: What do you recommend?
A: Obviously option three above. But keep in mind it does not have to be an “all cash” or “pedal to the metal” bipolar option. Investing the bulk of your long-term assets in longterm securities does not mean to put it all in “the stock market” and “let it ride”. Doing so is speculative and pure gambling. Instead you have hired FIM Group to handselect investments that have a high probability of generating favorable and growing long-term income and a low probability of permanent loss, actively managing them and allocating your nest egg across a wide array of investments, including varying strategic portions of cash, hard asset-related investments (including precious metals, commodities, real estate…), currencies, fixed income, hybrid income/equity investments and traditional equities.
One cannot count on that combination of favorable long-term growing income with a low probability of permanent loss from simply investing in the stock market and certainly not at current market prices. Many stocks in the stock market are indeed speculative and risky in terms of a likelihood of permanent long-term loss. But the companies you own in your FIM Group portfolio can be typically characterized as those with low or no debt, strong financial position, and sustainable businesses priced at well below their fair or private market value. That is not to say FIM Group portfolios will not experience fluctuations. They have. They do. They will! Unfortunately investors cannot achieve favorable long-term returns without accepting a reasonable level of volatility. Periods of volatility are necessary speed bumps in the road to prosperity.
Q: Okay, so if you are not recommending going to all cash, how do you decide on how much cash is prudent given the current environment?
A: First, based on your personal situation, you should have enough liquidity that you will not be forced to sell anything in a weak market. That level varies from person to person, and your FIM Group planner is happy to help you determine what is appropriate for you. It depends on factors such as your monthly cash flow and your expected future cash needs. Then within your long-term “managed” assets, I mentioned the term “varying strategic portions” of cash. In a longterm portfolio we view cash as a strategic tool as opposed to an idle passive asset. In addition to having sufficient levels of cash for your withdrawal needs, having some dry powder available is ideal when investment opportunities come along. We will let cash build up when we have sold investments and not yet identified compelling replacement investments, when prices of markets rise to frothy levels, when macro conditions give us extra reason for pause and under various other circumstances. Cash can also dampen overall portfolio volatility, so we use cash and cash equivalents in varying degrees depending on a portfolio’s composition and its risk parameters.
By: Jeff Lokken, CFP®
After what seemed to be a perpetual and quite obnoxious news cycle about the economic risks of going over the “fiscal cliff,” Congress has finally passed a new tax law. Much to the “relief” of tax planners, the American Taxpayer Relief Act is now the tax law of the land. We recently conducted a webinar for clients on the new law, and a replay can be viewed at www.fimg.net. Here is a summary of some of the points of the new law:
- Federal income tax rates are 10%, 15%, 25%, 28%, 33%, 35% and 39.6%
- Federal income tax rate levels are the same except for those above certain thresholds: $400,000 for single individuals, $450,000 for married couples filing joint returns, and $425,000 for heads of households
- Employee Social Security tax was 4.2% for the past two years and was not extended for 2013
- Social Security tax will return to 6.2% for employees
- Increases the top rate for qualified capital gains (long-term) and dividends to 20%
- 20% capital gain rate will apply to the extent that a taxpayer’s income exceeds the $400,000/single, $425,000/head of household and $450,000 married filing jointly thresholds
- 15% rate will continue to apply to all other taxpayers (in some cases, zero percent for qualified taxpayers within the 15%-or-lower income tax bracket)
- Revives limitations on itemized deductions: Reduces the total amount affected taxpayer’s itemized deductions by 3% of the amount by which the following exceeds AGI thresholds.
- Also revives the personal exemption phase-out. Total amount of exemption is reduced by 2% for each $2,500 by which AGI exceeds the following threshold. Itemized Deduction and Personal Exemption Income Tested Thresholds (AGI) - $300,000/married - $275,000/heads of households - $250,000/unmarried - $150,000/married filing separately
- Permanently provides a maximum 40% tax rate on estates above $5,000,000 (annually adjusted for inflation)
- Makes estate credit portability between spouses permanent ($10,000,000 for married persons). Portability allows the estate of a decedent who is survived by a spouse to make a portability election to permit the surviving spouse to apply the decedent’s unused exclusion to the surviving spouse’s own transfers during life and death.
- For individuals age 70½ and taking required minimum distributions, you may directly transfer distributions, up to $100,000, to a public charity in 2013. Distributions to charity are not included in income and are not an itemized deduction. This may help avoid the 3.8% Medicare tax by not increasing
Over the next few months we’ll include in the newsletter more information and details of the new law and discuss several planning opportunities it affords.
There is no Spotlight for this issue.