investing

The Different Flavors of Risk

When we look at the performance of the investment markets so far in 2017, something seems to be missing. We know that it’s there. We can feel it. But we just haven’t seen it in a while. Our monthly and quarterly statements look pretty good, and most of the asset classes we own are doing well. So, what’s missing? We know that risk and reward are basic principles of investing. So far this year, we’ve seen reward, but risk seems to be missing.

When most people think about risk, they are thinking about market risk—the risk that their investments will lose value. Most of us still remember the harrowing years of the financial crisis that occurred a decade ago. We saw the U.S. stock markets drop more than 50% from 2007 to 2009. It was a long, painful decline, and it was a devastating example of market risk.

But risk comes in several flavors. While market risk is the boogeyman that seems to scare folks the most, it’s hardly the only risk we face as investors. One of the main reasons that we invest is to help offset inflation risk. When the prices of milk, eggs, and other living expenses go higher, it takes more money to maintain our standard of living. This flavor of risk is particularly dangerous for retirees. When you are no longer working and are living off your savings, inflation eats away at your purchasing power. The increasing costs of health care as we age are becoming a huge risk for a lot of people. What can we do? We can invest. If we can grow our investments more than the inflation rate that eats away at our purchasing power, we can stay ahead of the game. So, we end up taking on some market risk to help offset our inflation risk.

Longevity risk is the risk that we will outlive our savings. It’s another form of risk that is particularly dangerous for retirees. Thanks to the wonders of modern medicine and improvements in living conditions, we are living longer. This means that we are spending more money and putting more stress on our savings. Longevity risk is bad enough, but when it’s combined with inflation risk, it’s a double-whammy to retirees. Again, we try to mitigate these risks by taking on market risk. If we can grow our savings by investing wisely, we can help offset some of the risk of running out of money in our later years.

There are other risks that we face when investing. Concentration risk is the flavor of risk that comes from having too many of our investment eggs in one basket. If our portfolio is heavily concentrated in one type of investment, an individual stock, a bond, or even an asset class, we risk losing money if that investment does poorly. We can reduce this risk by diversifying our portfolio across many investments, industries, and countries.

Credit risk is the risk we take when we buy a bond or other type of fixed-income investment. When we buy a bond, we are basically lending our money to a company or a government. Credit risk comes from the chance that we don’t get paid back when the bond matures. Once again, this risk can be lessened by owning a diversified portfolio of bonds, or by owning a bond fund.

We can’t avoid risk, because it is everywhere in one form or another. The key to being successful financially is to balance the types of risk. That balance is different for everyone. We accept some of one type of risk to help offset another type. We all have different goals, and we all deal with the different types of risk in different ways. It’s important to find the balance that is right for each of us.

Second Verse, Same as the First

If you have a little less hair now than you’ve had in the past, or if the hair you do have is some variation of the color of silver, you might recognize the title of this post. It’s a line from the Herman’s Hermits’ 1965 hit version of the song “I’m Henry the Eighth, I Am.” The song was originally popular as a 1910 British music hall tune, and it became the second-fastest-selling song in history (up to that point) when the Hermits released their version. It was the British band’s second No. 1 hit on the Billboard 100. It was also a pretty simple song. In the Hermits’ version, it was the same chorus sung three times. Between the first and second chorus, Herman (Peter Noone) called out, “Second verse, same as the first.” It became an iconic phrase.

What does a line from a mid-1960s pop song have to do with either financial planning or investing? Well, quite frankly, not a lot. But it is what went through my head as I spent some time this weekend reviewing the most recent performance of the markets. I guess I’m really showing my age!

I’m writing this article during the Fourth of July holiday weekend, and that means we just ended the second quarter of the year. The end of a quarter is a good time to check the score and see how the asset classes that we use to build our clients’ portfolios are performing. It’s the first step in deciding whether, and how, we will need to rebalance those portfolios.

The first quarter of the year, ending in March, was a very good one for investors. All the asset classes that we use in our portfolios were higher. Stocks led the way. Emerging market stocks were the big gainers in the quarter, followed by international developed country stocks and, finally, U.S. stocks. All three of those asset classes enjoyed big gains. Real estate enjoyed modest gains, and even bonds were higher for the quarter, although not by much.

Second verse, same as the first. Or, I should say, second quarter, nearly the same as the first. The gains weren’t quite as big in the second quarter, but stocks led the way again. The international developed country stocks swapped the top spot with emerging markets, but both were nicely higher. U.S. stocks once again showed nice gains, but trailed their international counterparts. Real estate gained slightly again, and bonds managed to eke out some more small gains, except for the Treasury Inflation-Protected bonds, which finished fractionally lower for the quarter.

So, what does this mean to you? It means that unless you are rebalancing your portfolio regularly, you might have more exposure than you think to stocks, particularly international stocks. If that’s the case, then you are taking on more risk than you normally would. It might be time to bring your portfolio back into balance by selling off some of the stocks that have enjoyed big gains this year and using the proceeds to bring your bond allocation back up to where it’s supposed to be.

Remember, rebalancing doesn’t mean you are selling the entire asset class. It simply means that you sell enough to capture the gains that you’ve benefited from over the last two quarters. Buying low, selling high—that’s the way we are supposed to play this game of investing.

Consider Yourself Warned: Stocks Will Go Lower … Sometime

When (and if) it finally happens, you won’t be able to say you weren’t warned. The media has certainly been warning you. There isn’t a day that goes by that I don’t see a headline from a newspaper, a television show, or some website about the upcoming crash, correction, or bursting bubble that is coming soon in the stock market.

I can’t say that I disagree that we are due for some kind of pullback. We’ve enjoyed an eight-year bull market since the financial crisis of 2007–2009. All three of the major stock market indexes are at record highs. In fact, the current rally, at 98 months long, is the second-longest bull run since World War II. While it hasn’t been a straight run to the upside, it has been a steady upward trend since the market lows hit in March 2009.

But in the short run, since the election of Donald Trump as President of the United States, it’s been mostly a straight move higher for stocks. On Election Day last year, the Dow Jones Industrial Average, which is the most widely used measuring stick of the overall market, closed at 18,332. As I write this post, the Dow is at 21,384. That’s a gain of 3,052, or 16.6%, in seven months. Whenever we see the price of anything run up that far and that fast, we expect the price to eventually pull back a bit. Trying to predict when and how it’s going to happen is when we get into trouble.

The fact that the markets have moved higher since the election hasn’t been surprising. After all, President Trump was viewed as more pro-business than President Obama. If things are going well for businesses, profits increase, and that usually means higher stock prices. So a rally after the election wasn’t all that surprising. What has been surprising is the magnitude and velocity of the rally.

It’s especially surprising when we look at the economic reports. We seem to be in a period of slow economic growth and low productivity growth, and stocks are expensive based upon historical price-to-earnings measures. The main initiatives of the new administration—like tax reform, revamping our health insurance system, and reducing regulations—seem to be stuck in Washington’s gridlock. All things considered, it’s no wonder that the “experts” are calling for a reversal.

So, as investors, what should we be doing to protect ourselves?

The first thing we should do is review our risk tolerance. How much risk are you comfortable with? Keep in mind that most people have a higher tolerance for risk when the market is moving higher. It’s not that the tolerance for risk is actually higher—it’s that the markets seem less risky when they are moving higher. And the portfolio-damaging emotion of greed creeps in to make you think you are more risk tolerant that you really are.

We should also remember that it works the same way when stock prices are falling. When the headlines in the newspapers, on television, or on the internet are screaming about how much stocks have fallen, the other portfolio-damaging emotion—fear—creeps in, and suddenly you are not as risk tolerant as you thought. Many people learned this the hard way during the 2007–09 crisis.

You should also remember that you are about 10 years older now, and 10 years closer to the time when you will need your investment dollars. Most likely, the value of your portfolio is also substantially higher now, so you have more at risk.

Next, you should make sure that your portfolio is well-diversified by being spread across several asset classes. The Dow Jones Industrial Average and the S&P 500 are not representative of what your portfolio looks like. These indexes are made up of the stocks of large U.S. companies. A properly diversified portfolio will also include stocks of small and medium-sized companies, and a good helping of stocks from other countries. You should also hold a mix of bonds. The bond side of the portfolio should be spread across different maturities, governments, and corporations. The proper mix for you should be based on how you answer the risk tolerance question.

Remember that diversifying your portfolio will mean that you won’t enjoy the same returns as the “hot” asset class, like U.S. stocks right now. But it also means that when that hot asset class suddenly turns cold, you won’t suffer the same damage.

Finally, you need to stay disciplined. Whether things are going very well for a particular asset class, or very badly, you need to stick with your investment strategy. Don’t let the headlines, good or bad, affect the way you manage your portfolio.

OK, you’ve been warned. Sometime in the future, the markets will go down. We don’t know when, and we don’t know by how much. But whether you want to call it a crash, a correction, or a bubble bursting, now you know how to deal with it.

Work Hard, Save Your Money, and Don’t Forget to Stop and Smell the Roses

When I was a teenager, one of my favorite musicians was Mac Davis, a crossover country and pop star whose hits included “Baby, Don’t Get Hooked on Me” and “One Hell of a Woman.” I still remember one summer, when I was about 15 or 16 and working at the Ohio State Fair. He was performing at the fair, and I was lucky enough to meet him. That memory resurfaced this weekend, when I found myself thinking of another one of his hits while I was enjoying a weekend in New York City with my wife, Gina.

A couple of weeks ago, I posted “Are You Living Too Frugally?” It was a discussion about the tendency of a large number of retirees to spend well beneath their ability. They have become so accustomed to saving money and watching their expenses that they find themselves sitting on a big pile of money late in life that they are hesitant to spend. In the article, I tried to convey that while it is important to keep funds available in the event of a financial or health emergency, it’s also important to experience life. We want to make sure that we cross off our bucket list items before it’s too late.

This weekend, I thought about how important it is to live life before retirement as well. The other hit song from Mac Davis that I alluded to earlier was “Stop and Smell the Roses.” The lyrics of that song convey the message about how important it is to make sure you have a balance between your work and your personal life. Taking it one step further, it’s important to get that work/life balance in order throughout your life, not just in retirement.Before you went to work this morning in the city, did you spend some time with your family?

While Gina and I both enjoy our work, we sometimes find ourselves wrapped up in the daily tasks of running our respective businesses. We don’t work physically hard, but we do work hard and often spend the majority of our waking hours inside our business. We are both in the client service industry, so it’s important to make sure that we take care of the things that our clients expect from us. But it’s just as important for us to step away at times so that we can refresh ourselves and recharge our batteries. We are not going to do our clients any good if we end up burned out and not giving our all when we are working.

Plan for the Future, but Take Care of the Present

It’s important to make sure you take time for you and your loved ones. Life is about more than the work we do. As a financial advisor, I’m always emphasizing how important it is to save and invest for our future selves, but it’s just as important to take care of our present selves. We all hear way too many stories about someone we know who passes away at far too young of an age. We get only one shot at this life, and we need to make sure that we are making the best of it. As the saying goes, “I’ve never met someone on their deathbed who wishes they had spent more time at the office.”

This weekend, Gina and I stepped away to focus on our work/life balance. I was attending a conference in New York City, which ended on Friday. On Friday afternoon, Gina flew up to join me. We spent the weekend in Manhattan, sampling the city life. We ate at some nice restaurants, did a couple of runs through Central Park, attended a couple of Broadway shows, and toured the 9-11 Memorial in the Financial District. We didn’t do any work for the entire weekend, which is unusual for us.

We spent quality time with each other and had fun. That’s what’s really important, isn’t it? As I write this, we are on the plane heading home. It’s back to work tomorrow. And while we may be a little tired and might still be recovering from our weekend in the Big Apple, we both feel refreshed, relaxed, and ready to work.

Yes, it’s important to plan for your future and make sure you are prepared for the days when you are no longer working. Save. Invest. Make sure you and your family are protected and that your financial house is in order. Work hard and do the best you can at whatever career you have chosen. But it’s equally important to “Stop and Smell the Roses” along the way.

This Is How We Invest, and Why—Part Two: Don’t Try to Outguess the Market

The lady on the television screen seemed very smart. She had an impressive educational background and lots of experience as an analyst for a Wall Street investment firm. She was also very persuasive as she stated her case to the CNBC host that, based on her analysis of the data, the stock price of the company they were discussing was primed for a big increase.

The gentleman on the screen also seemed to be very smart. He had an equally impressive educational background and similar experience as an analyst for a different Wall Street investment firm. And he was equally persuasive as he told the same CNBC host that, based on his interpretation of the data, he was convinced the stock price of the same company would decline.

Both analysts gave their opinions within the same segment of a CNBC morning show. Both were likable and seemed to be honest and well-intentioned. And, based upon the way they presented their argument, they certainly believed in their interpretation of the data. But they obviously both could not be correct.

This scenario plays out almost every day in the world of investing. Whether the analysts are discussing a company, a sector of the economy, an asset class, or the overall market, there are always differing opinions. So, as an investor, what should you do?

Our advice? Don’t watch. If you must watch, make sure you do so for entertainment purposes only.

In Part One of our series that explains How We Invest, and Why, we discussed the efficiency of the markets and how the first step in our process is to acknowledge that we don’t know more than “the market.” When a Wall Street investment firm, or an investment manager, makes a prediction about the price of a security, an asset class, or the market, they are making a claim that they know more.

We don’t believe that they do, and we believe that their directional calls are nothing more than guesses.

This leads to the second building block in our investment process: Don’t try to outguess the market. The pricing power of the market works against investment managers who try to outsmart other market participants through stock picking or market timing. Over the 15 years ending December 2016, 82% of all U.S. mutual funds trailed their respective benchmark. An investor is better off owning the benchmark, via a low-cost index fund, and not paying the high cost of having a manager trying to pick stocks or time the market.

It’s not easy holding this view. Wall Street wants you to think that the millions of dollars that they spend on fund managers and research departments can give you an edge if you invest with their firm. And they spend millions more on advertising that tries to convince you of that “fact.” But remember, every time you, or your fund manager, makes an investment move based on their research (i.e., guesses), you face transaction costs and possible tax consequences that can negatively affect the return of your investment portfolio.

We believe, and the evidence confirms, that a much better and less costly way to invest is to own a globally diversified portfolio using asset-class-based mutual funds or exchange-traded funds (ETFs). Don’t try to guess which company is going to be better than another. Own them all. Don’t try to guess which country around the world will be the next “winner.” Own them all. By owning them all through diversified funds, you can take the guesswork out of the investment process. And you will also reduce your portfolio risk in the process.

This Is How We Invest, and Why—Part One

The investing world can be a scary place. It can also be exciting. At times, it can seem like there’s nothing to it, and at times it can seem like the most complicated thing you’ve ever done. All of the thoughts and emotions that are part of investing are enhanced because, after all, you are putting your money and your financial future at risk.

Risk and reward go hand in hand when you invest. You can be very conservative and not subject your investments to much risk, but then you are not going to get much in the way of return on your investment dollars. Or you can take a lot of risk, looking for the proverbial home run. That approach can lead to stellar returns, or it can lead to distressing losses.

So what is your strategy when it comes to investing your portfolio? Are you actively looking for that one piece of information that will give you the edge you need to catch the next wave of increasing prices of your favorite tech stock? Or maybe you suffer from “paralysis by analysis,” overwhelmed by the information flow and its potential impact on your portfolio?

There is no shortage of investment strategies that you can follow. In fact, just this morning, we learned of a new strategy. A financial podcast that we listen to discussed a strategy that will buy or sell a company’s stock based on the tweets from our Tweeter-in-Chief, President Donald Trump. If he tweets a positive comment about a company, they will buy the stock. If it’s a negative tweet, they will sell it. Sounds crazy, right? But there are thousands of money managers in the investment world, and thousands of different strategies that they use to try to get their edge.

When it comes to investing for the financial future for our clients, we can’t, and won’t, play games like that. We follow a very disciplined approach to investing, based on a Nobel Prize-winning academic strategy that focuses on controlling what we can control. And we are smart enough to know that we can’t control the markets. This article is the first in a series that will explain our approach and the science behind it.

The First Step: Humility

The first building block in the science behind our investment philosophy is the need to embrace market pricing. While that sounds a little complicated, it’s really not at all. It simply means that the financial markets are very efficient and that all of the information available on a particular stock, bond, or other investment is reflected in the current price. Millions of investors around the world buy and sell investments every day, and the information that they bring to the markets helps to set prices. When some new information affecting an investment comes out, it is immediately factored into the price of that investment.

We like to use the price of Apple stock as an example. If Apple is coming out with a new iPhone soon, you know about it, we know about it, and millions of people around the world know about it. There is no way to profit from any kind of information edge that you might think exists, even if it is only temporary. That’s why it’s not a good idea to run out and buy Apple stock when you hear the news. Years ago, there may have been some pieces of information that took time to work through the markets, but with today’s technology, that time gap has disappeared. Many of us have alerts on our smartphones that let us know in real time when some important news has been released.

So the first step in putting our “evidence based” strategy into action involves being humble enough to know that we don’t know more than “the market.” There are several more pieces that we use to fully build out our strategy. We’ll cover those in future posts.

A Teaching Moment for Teachers

Our teachers are a very special group. They work long hours for low pay, helping to shape the minds of our young. They are a very important part of our society. So why do the local governments that they serve allow them to be taken advantage of when it comes to their retirement planning?

I am lucky enough to have several clients who are either retired teachers or are planning to be one. In my work with them, I get to know their financial situation pretty well. While teachers don’t make a lot of money, they are one of the few groups who still receive a pension. If they qualify, and most do, the pension provides a monthly income for the rest of their life. But since the benefit amount is based on their income, they won’t be getting rich from the pension. When you add in any Social Security benefits, most teachers will be able to maintain a “modest” lifestyle.

But what if the teacher wants a little more? What if they can save a little from each paycheck to improve that future retirement lifestyle? In the private sector, many of us have access to a company retirement plan; most often, it’s a 401(k). We can have money withheld from our paycheck and have it invested automatically for our future. Our contributions are deducted pre-tax, and grow tax-deferred over the years. Teachers have access to a similar plan, but for them it is known as a 403(b).

In the private sector, the employer selects an investment firm to handle the administration and investing of the plan’s assets. For our teachers, the School Board selects a handful of “approved” providers from which the teachers can place their retirement funds. The problem comes from this list of “approved” providers.

It has been shown, and it just makes sense, that the costs of an investment portfolio are a huge factor in its long-term performance. At Rall Capital Management, we know that we can’t control the financial markets, so we don’t try. Instead, we work to control what we can control, one of the most important being the costs involved in managing the account.

Most of the plan providers that teachers have to choose from are insurance companies. That usually means that the retirement contributions are being invested in an annuity contract, often with layers of different types of expenses. Most of the other providers on the “approved” list are investment firms that put together a menu of funds for teachers to choose from. All too often, the funds on the menu have very high expense ratios, creating an unnecessary headwind for account performance.

The expenses in the plans that are available to our teachers are among the highest. In fact, the New York Times did a 5-part report highlighting the abuses across the country. The first part of the series is entitled, “Think Your Retirement Plan is Bad? Talk To a Teacher.” I think the title says a lot. The article says a lot more. And it showed me that the problem is not just local to Brevard County’s teachers. It’s like this across the country. Why?

I’m not trying to be conspiratorial (or maybe I am) but I would dare to say that there’s some combination of politics and money at the core of the “approval” process. This system has been in place for years and any change is now subject to inertia. There’s not enough of a rank and file movement to improve the choices because most teachers don’t know. It’s been widely reported that most people don’t know how much they are paying to have their accounts managed. Teachers are no different.

It’s so much of a problem that I will typically advise my teacher clients to stop participating. What?? Advise a client to stop contributing to their retirement plan? No; we just advise them to redirect those contributions. Instead of investing in high cost annuities or other funds, I often recommend that they fund a Roth IRA instead. Roth IRA contributions are made with after-tax money and you lose the ability to have it taken directly from their paycheck, but that’s a small price to pay for the money you’ll save.

Inside the Roth, you can invest in low-cost funds that are often 1/10th the cost of many of the 403b accounts I’ve seen from my teacher clients. A 1-2% difference in costs over a number of years will make a huge difference in the value of your retirement account years from now.

One big difference between the 403(b) plan and the Roth IRA plan is the amount you can contribute. Like the private sector 401(k), participants in a 403(b) can contribute up to $18,000/year; $24,000 if you are over 50. You can only contribute $5,500 a year into a Roth IRA, or $6,500 if you are over 50. If you do have the ability to contribute more than the Roth maximum, one option would be to direct the excess to the 403(b) plan.

To become successful financially, you must do a lot of little things right. Not paying exorbitant investment expenses is one of those things.

So, if you are a teacher, here’s your homework: evaluate whether it makes more sense to fund your 403(b) account, or whether it would be better to fund a Roth IRA. If you are not a teacher, but you know one, please forward this article to him/her. They should know this!