Dealing With Investor Anxiety: Think Long-Term

Stock prices reflect a mix of emotions, biases and rational calculations. The bond market reflects the economy. Historically, bond markets had done a better job in predicting recessions.

The two big bond stories last week were 1) the “inverted yield curve”- when interest rates on short-term bonds are higher than long-term bonds, and 2) yields below 2% on 30 year treasuries- indicating investors expect low inflation and a weaker economy for a long time.

We all remember the 2017 income tax cut that boosted the economy and produced stock markets returns of 20% or more in 2017. These tax cuts were supposed to lay a foundation for many years of high economic growth. Since mid-2018, however, the economic data has been confirming what many of us expected. The tax cuts provided a short sugar “high,” which is now over. Instead, we have trillion dollar deficits and lack of large promised business investments, including infrastructure, which never materialized. The economy has reverted to its pre-stimulus growth rate of near 2%.

This shouldn’t surprise us. No major economy is growing as fast as it was before 2008. In almost every country, the national discussion focuses on what must be done to revive growth and ignores the fact that the slowdown is happening everywhere. The working population is declining in 46 countries around the world, including Japan, Russia and China. Demographics are a key driver of economic growth. So, we can expect to see recessions (two quarters of negative growth) more likely in the future as working populations contract. BTW- the U.S. population is growing at less than 1% per year.

Over the next few decades, we will likely see more growth decline. Ruchir Sharma, author of “The Rise and Fall of Nations,” suggests that new benchmarks for economic success should be 5% growth for emerging countries, 3-4% growth for middle income countries like China, and 1-2% growth for developed countries like the U.S. and Germany.

Yes, there are uncertainties in the market, including US-China trade tensions, a weakening European economy, and concern about a recession. These produce a huge dilemma for U.S. business owners, trying to make plans for the future. So, there are lots of piles of cash, waiting for clarity. We may or may not soon have a recession. Yet all of this uncertainty produces increased volatility and anxiety. And studies show that a 3% down day, like last Wednesday, feels about ten times worse than a 1% down day. What’s an investor to do to reduce anxiety?

We understand it is difficult to think long-term, but we highly recommend it:

1) Recognize that equities will likely produce lower nominal returns in the future. However, with inflation also likely lower, the real returns of equities will likely outpace fixed income and alternatives. Equities will continue to provide the primary engine of growth.

2) Use all three asset classes. A diversified portfolio composed on equities, fixed income and alternatives has been shown to reduce risk and increase return.

3) Review your long-term financial plan and determine what rate of return you need to meet your financial goals. The expected return of your asset allocation must be sufficient to meet your goals or you need to revise your goals and plan.

4) Review your risk profile to determine your appropriate asset allocation. Using the assumption that equities could drop 40% and you can’t tolerate a loss of 10% or more in your portfolio, then your allocation to equities should not exceed 25%. Of course, this allocation would severely limit your upside.

5) Stay invested. Don’t try to time the market. A recent report from Morningstar shows that “low cost funds”, (like those used at DWM), “lead to higher total returns and higher investor returns.” First, for efficient markets, the active managers in the high-cost funds overall produce gross results equal to the benchmarks, but then the additional costs of 1% or more is subtracted. Second, studies show that active managers attempting to time the market have failed and this subtracts another ½% per year from performance. Even highly-paid active managers can’t time the market successfully.

Lastly, in this time of overall investor anxiety, fee-only total wealth managers, like DWM, are here to rescue you. Yes, we execute a detailed process to add value every day in the areas of investing, financial planning, income taxes, insurance and estate planning. Yet, one of our most important tasks we have is to protect our clients from hurting themselves in the capital markets. Investors overall have a very human tendency to do exactly the wrong thing at the worst possible moment.

We understand it’s hard to think long-term. Today’s world moves at a very fast pace. And, the news is often designed to instill fear. Don’t succumb to emotions. Reduce your anxiety. Allowing your portfolio to compound quietly over time can be boring, yet very successful.   If your allocation or the markets are making you anxious, let’s talk.

“The Two Most Powerful Warriors are Time and Patience”- Leo Tolstoy

 

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Good investing can be boring, yet effective! Specifically, investors with a long investing timeline should build a diversified, low-cost portfolio with an appropriate asset allocation and stick with it. Rebalance regularly to sell high and buy low. Don’t try to time the markets by getting in and out. Yes, this is boring, particularly with the volatility we are enduring, but it’s what it takes to generate solid returns over the long haul. Patience and time are powerful warriors and our friends.

Take a look at the average risk and returns for various asset styles over the last 20 years, which includes the 2008-09 financial crisis and 2018. The best performers, with higher returns and lower risk, are in the upper left hand corner:

 

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Bonds have relatively low risk and have produced decent returns over the period, particularly the first 15 years. Small cap and mid cap stocks have outpaced large cap stocks (e.g. Dow Jones and S&P 500) over time, with better returns and similar volatility (risk). Non-US stocks have trailed US stocks. Emerging markets stocks have produced very good returns, but with larger volatility swings. REITs have produced a 10% annual return with a risk factor about equal to U.S. stocks. The diversified composite “12 Index Portfolio” has produced a nice return of 6.8% annually (better than large cap stocks with 5.6%) with about 2/3 the risk of stocks.  Please note that during this 20 year period, the inflation rate was 3.2% per year. So, the 12 Index Portfolio produced an annual “real return” of 3.6% over the last 20 years.

Investors get in trouble when they lose faith in the markets and their allocation, react to the current market pain and go all cash or move to the “hot” asset classes for better returns. That approach generally ends badly for investors as the markets will correct themselves over time (as we have seen December 2018 losses recovered in January 2019) and hot asset classes go “cold” as the pendulum swings to the next “hot” asset style right after they jump in.

The 12 Index portfolio in this chart is composed of all the asset styles shown, equally weighted. Overall, this allocation is 50% equities, 33% fixed income and cash, and 17% alternatives; what we would term a “balanced asset allocation,’ appropriate for a “balanced risk profile.”

This balanced allocation will never be the top performer in any year. And, it won’t be the worst. It is designed to deliver middle-of-the-road, steady returns. Patience and time produce the results.

Investors need to also understand that time is their friend. “Time in the market beats timing the market.” Here’s another chart showing the growth of $1 since 1990, all invested in the S&P 500:

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The black line represents an investor who stayed in the market every day and turned her $1 into $14. The red line represents the investor who missed the 25 best days (roughly one a year) and turned her $1 into $4. The gray line represents the return an investor could have received by simply investing in five-year treasury notes, turning $1 into $4.

Getting out of the market is easy; getting back in at the right time is very difficult. In the last couple of months, for example, the equity markets (using the MSCI AC World Index) are about level from December 1, 2018 until last Friday, February 8th. However, if an investor got cold feet and got out in mid-December and waited to get back in until mid-January, they would have lost 3.5% on their equity returns. Timing the market is not a good idea- unless you own a crystal ball, can implement perfect end of day execution on buys and sells, have no transaction costs, and don’t mind paying taxes on realized gains.

Patience and Time are two powerful warriors-they are your friends. Let them do the heavy lifting.  Invest for the long-term. Yes, slow and steady wins the race. It may not make for great cocktail conversation, but boring investing can be very effective.

A True Halloween Scare: Volatility Returns to the Marketplace

Recently, we here at DWM posted a blog discussing the phenomenon that “Bull Market Runs Come in All Lengths”. Within this article, we mentioned the idea that before our current bull run ends, we may see many more pullbacks and/or corrections.

Within the current month, we have seen these types of market downturns as investor fears of upcoming mid-term elections, tariffs, rising rates,  and international economic slow-down issues have spiked levels of consumer fear (measured by the volatility index, VIX), by nearly 50% .

While this data can’t tell us whether the current bull market run is coming to an end, it opens up the opportunity to better understand just what is happening in the economy, and how we should handle times like these.

To understand the severity of market moves, there are three unique distinctions: a pullback, a correction, and a bear market, which signify downward market moves of 5%, 10%, and 20% respectively.

Over the past month, securities within all asset classes – equities, fixed income, and alternatives – have experienced one of these. On October 23rd, in fact, over 40% of the stocks in the S&P 500 were considered to be in bear market territory. Since then, markets have continued their run of ups and downs.

What can this market data tell us about the future? Unfortunately, not much. While markets tend to be cyclical in nature over the long-term, the short-term is usually marred by emotions (herd mentality, greed, and fear) rather than by solid fundamental and economic modeling. Furthermore, the risk of attempting to predict these short-term outcomes can have a serious long-term effect on the performance of an investor. Studies have shown that by missing out on only a few days strong returns in a market cycle can drastically impact the portfolio’s overall return.

Thus, in order to stay on track with long-term financial goals, one of the most successful and least anxiety-inducing ways to manage investments is to generate a financial plan, assess and re-assess risk tolerance regularly, and continually stay disciplined to these values in order to avoid making emotional and poor decisions. In conjunction with these actions, an investment portfolio needs both an appropriate asset allocation based on a client’s financial plan and has to be made up of a well-diversified portfolio that can help provide exposure to market areas, such as fixed income and alternatives, that are arenas that may still produce returns even with stocks stuck in a slowdown. The combination of these strategies can work as shields to protect both an investor’s assets, and his/her mental health during times of volatility such as today’s challenging marketplace.

At times, corrections, pullbacks, and even bear markets can actually be good things! If certain areas of the market are being overvalued, or company valuations are getting ahead of their fundamentals, pullbacks and corrections can serve as a check and balance system, to get these more in line. This makes companies, sectors, and markets more stable as they can refresh a bull market that is verging on inflating itself beyond its means.

Furthermore, a pullback, correction, or bear market move down for a certain security can provide other opportunities. For example, this month, DWM will be creating value for clients by taking advantage of tax-loss harvesting options. Tax-loss harvesting is the process of selling out of a security that has lost value since an investor first bought it, and using that loss to offset any gains that an investor realized during a tax year. This upside can serve as a nice treat to offset the “trick”-y investment arena of October.

One other somewhat notable factoid is that in the mid-term election year of October 2014, the stock market took a noticeably similar look. That of the Dow Jones down nearly 3%, rebounding, and selling off throughout, ultimately dropping into correction territory. This was quickly followed by a November post-election market boom hitting record highs for the Dow and S&P 500. Once again, while interesting to see, take these numbers with a grain of salt moving forward and looking at future returns.

All in all, keeping in mind that while volatility and uncertainty in the marketplace can be scary, maintaining a balanced, disciplined portfolio and financial plan, and staying dedicated to that plan throughout all market cycles is the key to being financially sound and minimizing the number of sleepless nights. At DWM, we proactively discuss these matters with clients, and strive to keep our clients informed, motivated, and on-target to their financial plans to help them reach their long-term financial goals. Happy Halloween!

Your “Hidden Brain” Impacts Your Politics

Hopefully, all of us will vote in the midterms on 11/6 or before. Roughly half the country will vote for Republicans (conservatives) and half will vote for Democrats (liberals.). Did you know that your choices are not only impacted by your upbringing and experiences, but also very specifically by your genes? We’re hard-wired from birth for much of our political views.

Shankar Vedantam is one of my favorite authors and commentators. He is NPR’s social science correspondent and before that a journalist at The Washington Post. His 2010 book “The Hidden Brain: How our Unconscious Minds Elect Presidents, Control Markets, Wage Wars and Save our Lives” describes how our unconscious biases influence us. I highly recommend it.

Mr. Vedantam relates the story that on a regular basis, right before an election, someone will share an article with him about how science proves that the brains of a liberal are stunted or that Republicans are less intelligent than Democrats. While those claims likely have no merit, Mr. Vedantam contends that there are “genuine psychological differences between liberals and conservatives.”

On a recent Hidden Brain telecast, Mr. Vedantam hosted political scientist Dr. John Hibbing to the show. Dr. Hibbing is co-author of “Predisposed: Liberals, Conservatives and The Biology of Political Differences.” Dr. Hibbing pointed out that differences between partisans are not limited to politics. There are generally differences in food choices, living spaces, and temperaments. Conservatives generally like meat and potatoes; liberals are more likely to prefer ethnic food. Conservatives tend to have organized rooms with things like sports memorabilia, while liberals tend to have lots more books and may not be as tidy. As far as temperament, conservatives tend to favor order and tradition and liberals tend to be more comfortable with ambiguity and change.

Then, there’s a huge difference between conservatives and liberals when it comes to threats and danger. According to Dr. Hibbing, conservatives tend to see the world with its terrorists, home invaders, drug cartels, and immigrants as a very dangerous and threatening place.   Liberals tend to believe they live in a relatively safe society.   Conservatives therefore want and need the government to help them “protect themselves and their family, limit immigration, and put lots of money into defense and law and order.” Liberals, on the other hand, are reinvigorated by immigrants coming to our country, don’t see the need to spend so much money on defense and support gun control. Conservatives and liberals read about events of the world and they simply don’t respond to them in the same way.

Mr. Vedantam chimed in: “There is a very powerful illusion that we have that the rest of the world sees the world the way we see the world. And, if they come to a different conclusion, it must be because they’re being deliberately obtuse or somehow deliberately biased, as opposed to the idea that people are actually seeing the world the same way, but reacting to it differently.” Psychologists call it a case of “false consensus” that we assume others will see the world the way we do.

People are wired differently. Roughly 30-40% of our political views come from genetics based on research by Dr. Hibbing. 60-70% comes from our environment. Mr. Vedantam has described how researchers separate the effects of biology from those of the environment. They look at fraternal and identical twins. Both sets of twins have identical initial environments, but the fraternal twins have similar but not identical genes. Data from thousands and thousands of twin pairs supports the conclusion that political views are quite “inheritable.”

Finally, brain activation patterns of liberals and conservatives are different. Dr. Hibbing has conducted tens of thousands of experiments in which he showed various pictures to individuals whose brain was being scanned. Liberals’ brains would highly activate at times much differently than when conservatives’ brains were highly active. The brain scan results alone proved “incredibly accurate in determining whether an individual was a conservative or liberal.”

Frankly, I find it very helpful to learn that political views are at least, in part, biological. Years ago, left-handers (like both my mother and father) were thought to be lazy and had their hands hit with a wooden ruler to make them write “correctly,” using their right hand. People saw left-handers as a flaw, something that needed to be driven out. Now, of course, we understand that being left-handed is very biological. Similarly with politics. Dr. Hibbing concludes: “If we recognize that others, virtually half the country, are oriented to the world in a different fashion, maybe we would be a bit more tolerant to them. This is the only way we’re going to get anywhere if we at least understand where they are coming from even if we might deeply disagree with their conclusions.”

As we approach the midterms with the vitriol rising, let’s all remember our hidden brains and those of others, particularly family and friends and show tolerance and respect to all. We may see the same world differently: our unique genes, unconscious biases and life experiences may produce different conclusions and different political preferences. Yet, we’re all Americans and we and our country will all do better if we work together.

Biases: Fluid & Fuzzy vs Rational

In a perfect world, we would all make optimal decisions that would provide us with the greatest value and satisfaction.  In economics, the rational choice theory states that when you are presented with options, you would choose that which maximizes your personal satisfaction.  This theory assumes that you make your decision by weighing the costs and benefits, without emotion and external factors.  If it were only that simple.

Enter behavioral economics.  It draws on psychology and economics to try to explain why people sometimes make irrational decisions, i.e. not following predictions of economic models based on a consistently rational, self-interested, and “utility” maximizing approach?  Psychology explains this deviation of behavior from what is expected rationally to be caused by “biases.”  Common examples of biases include:

  • Anchoring- relying too heavily on one piece of information
  • Confirmation-focusing on information that confirms one’s preconceptions
  • Endowment-demanding much more for something owned than what you would be willing to pay to acquire it
  • FOMO- Fear of missing out- paying too much to get into the “game”
  • Loss aversion- valuing the pain of losing twice as much as the satisfaction of making a gain
  • Normalcy- refusing to plan for a potential disaster that has never happened before
  • Recency- predicting the future results by expected recent results to continue

Koen Smets’s recent article in the Behavioral Scientist “There is More to Behavioral Economics than Biases and Fallacies” defines behavioral economics as the field that confronts us with our deeply potentially irrational selves.  “We are bamboozled by biases, fooled by fallacies, entrapped by errors, hoodwinked by heuristics, deluded by illusions.”  Ouch.

This brings to mind Ebenezer Scrooge’s question of the Ghost of Christmas Future:  “Are these signs of things that will happen or may happen?”  Perfect question, Ebenezer.  Actually, there is a widespread misconception that biases explain or even produce behavior.  Biases merely describe behavior that may or may not be followed.  They are simply labels for an observed behavior that contradicts traditional economics’ simplified “rational” expectations.

The conversation about biases is generally negative:  they interfere with our decision making or undermine our health, wealth and happiness.  For example, consider loss aversion.  Ten of thousands of years ago, humans were more concerned about losing a week’s food supply than gaining an extra week’s.  Today, an individual might never invest their cash because of a fear of losing money and have the purchasing power of their funds decreased by inflation.  This loss aversion is part of our evolutionary DNA, but that doesn’t mean that we have to exhibit that behavior.

Biases are tendencies that are not uniformly shared or employed.  Mr. Smet describes human behavior as “fluid and fuzzy.” These days, speed and simplification are keys and behavior based on biases is increasing.  Knowing that people are taking shortcuts, marketing has really stepped up its game.

“Heuristics” are really becoming huge. They are the various techniques we use to solve problems, learn or discover by using shortcuts.  Persuasion heuristics save us time and effort in making many of the hundreds of decisions we are confronted with each day.  Robert Cialdini, author of “Persuasion and Marketing” and political consultant, offers six key principles to persuading (or perhaps hoodwinking) a consumer using heuristics:

  • Authority-the voice or face of authority drives results. (Celebrity endorsements work)
  • Commitment and Consistency-consistent follow through establishes trust (Repetition works)
  • Scarcity-create hype based on time limits and expirations. (I see this every time I go to book a hotel room)
  • Liking-people are persuaded by others liking something. (Tripadvisor)
  • Social Proof- Show evidence of results. (People like to hear positive statistics-whether or not they are true)
  • Reciprocity-Offer discounts, free trials, sample products (people tend to “return a favor”)

We know biases exist. Some of them are in our DNA; some we learn over time.  At the same time, people and companies are aware of these potential biases as they are marketing their products, services, or suggestions.  Certainly, for many small decisions we need to make every day, there is no problem with taking a shortcut and even employing a bias.

However, when it comes to really important decisions, such as your wealth and happiness, it’s time to step up your game and move from fluid and fuzzy to rational.  These very important decisions generally take more time and require more due diligence.   You need to make sure you thoroughly and objectively understand and investigate choices and understand the likely risks and rewards of each.  To keep yourself “bias-free” at these times, you may benefit from having the expertise, skill and objectivity of a wealth manager like DWM who works with these important matters every day.  There’s a time for fluid and fuzzy and a time for rationality.  We’re here to help you when it’s time for rationality. Give us a call.

 

 

 

 

 

Nobel Prize Winner Helps Add $30 Billion to Retirement Accounts

Richard Thaler received the Nobel Prize in economics last week, principally by showing that people don’t always behave rationally and, in fact, we are systemically irrational.

Here’s an example: Two friends are given tickets to a basketball game in the Northeast.  The night of the game there is a tremendous snowstorm.  One friend calls the other and suggests there is no way they are going to the game now, in the snowstorm, and they don’t go.  But, he said “You know, if we had paid for those tickets ourselves, we’d be going.”

Studies by Dr. Thaler show that if the friends had paid for the tickets, they would likely driven through the snowstorm because they didn’t want to “lose” their money.  Classical economics would say that’s crazy, but it’s true.  People pay huge attention to “sunk costs,” often irrationally.

Because of Dr. Thaler and others, we know more about human biases and anomalies that impact our financial decisions. These include compartmentalizing (putting money in mental boxes), mental accounting (thinking differently about money in your pocket versus money in the bank) and the endowment effect (once you own something you value it more than before you owned it).

Dr. Thaler not only helped discover our biases but also identified ways to make irrational behavior work to our advantage.  Savings and retirement has always been a big area for him.  He applauds the fact that if we compartmentalize (have a “mental box”) for retirement savings we are doing a very good thing.  Putting money in a 401(k) plan makes it much “stickier” than other money and it stays there.

In 2004, Dr. Thaler and Shlomo Benartzi published “Save More Tomorrow.”  It is based on the idea that instead of asking people to save more now, ask them to save more in the future.   We tend to irrationally discount our future commitments.  Hence, we tend to put off savings because retirement is so distant, but we will commit to future savings because it is also so distant.  Dr. Thaler suggested that people save 50% of every raise.  No need to give up anything now.  And, this concept would mean that if you save 50%, then the remainder will be left for current spending, without any guilt.  Every raise therefore increases both spending and savings- a much more palatable idea than taking away some of our current income to save.

Over the past few decades, most company pension plans have been discontinued and replaced by company sponsored defined contributions plans, where employees needed to make contributions.  These voluntary accounts should have worked better.  Rational employees were expected to save and invest to meet their long-term goals.  But, it didn’t work that way-participation rates early on were very poor.   Dr. Thaler was asked about the problem and his response was that workers can be their own worst enemies- “without help, they’ll never retire.”

His solution: “Nudge” them into joining company retirement plans, using a concept known as automatic enrollment.  Rather than waiting for employees to complete paperwork, companies would automatically enroll them and workers, if they don’t want to be in, can opt out.

Last year, 58% of companies were automatically signing up workers. That’s up from 8% in 2000.  And some companies are automatically escalating the contributions or giving the employees the option to do so.  Thaler and Benartzi’s research shows, as compared to 2011 data, 15 to 16 million more people are saving.  Assuming an average contribution of $2,000 a year, that’s $30 billion a year in additional contributions.

Dr. Thaler, with his colleague Hersh Shiffrin, suggested that our mental accounting of money is often a battle in our brains between the “doer” (focused on short-term rewards) and the “planner” (focused on the long-term.)  How choices are presented to us (“the choice architecture”) makes a big difference in our decision.  Making enrollment in the 401(k) occur by default and requiring a worker to “opt out” will likely put the “planner” in control, not the “doer.”

One of our key jobs and challenges at DWM is to assist our clients by framing questions and choices in the appropriate way.  Like Dr. Thaler, we understand that wealth, health and happiness decisions are not always rational yet we do our best to find a way to “nudge” both your doer and planner parts of your brain in order to help protect and grow your assets and your legacy. We haven’t made a $30 billion impact yet, but we’re passionately working on it every day.