Disciplined Investors Win Again
The third quarter certainly had its fair share of stress for investors. As the quarter came to a close, it was clear the federal government would undergo a partial shutdown on October 1. As if that was not enough, the debt ceiling deadline loomed. There was concern the federal government might default on Treasury bond principal and interest payments or other financial commitments if Congress and the White House failed to act before October 17. Both of these issues ultimately ended up being resolved.

Stressful periods like these inevitably lead some investors to wonder whether staying the course is the right approach, but abandoning a well-thought-out plan during such periods is likely to be far more damaging over the long term than most any crisis could be. These three reasons help explain why.

First, the world continually faces any number of events that could be deemed crisis worthy. Reacting to each and every one would incur significant costs and likely lead to subpar results. There will almost certainly never be a period when an investor can look around and determine everything is “safe” and now is the time to invest. To make this point, simply think back on major news events over the past handful of years. The world has experienced an economic malaise that continues on, a European debt crisis, significant turmoil in the Middle East and a 2011 downgrade of the U.S. credit rating.

Second, research has shown that the vast majority of investors who attempt to time markets have failed. One of the simplest explanations for this: In addition to overcoming the costs associated with trying to time market, investors must be right twice. They must correctly time both the exit from the market and the re-entry. The past few years again illustrate how difficult this is to do.

Many investors bailed out of the stock market well into the 2008–2009 decline — that is, they incorrectly timed the exit, only to avoid the market completely from there forward or miss a substantial amount of the rebound that occurred later in 2009 and into 2010. These types of actions no doubt did long-term damage to many investment plans.

Third, through all the world’s crises, stock and bond markets have generally rewarded a disciplined and diversified investment approach. For example, long-term stock market data (for the period 1900–2012) shows that stock markets have outperformed inflation by about 5 percent per year. These returns occurred in the face of a Great Depression, two catastrophic world wars and countless other geopolitical crises. This result illustrates the fact that market prices usually reflect the risks of investing and tend to reward investors for those risks.

How Often Does the Government Shutdown?
One might think that government shutdowns are a rare occurrence but they have actually happened several times. Since 1976, when the modern congressional budgeting process began, there have been 18 government shutdowns.

In the 1970s, there were six cases. The 1980s saw eight different shutdowns while there were only three cases in the 1990s.

Since 1996, there had not been any cases until the most recent shutdown. In most instances, the shutdowns lasted only a few days with exceptions being the December 1995 shutdown that lasted 21 days, ending in January 1996, and the recent shutdown that lasted 16 days.

Dancing on the Ceiling

Jim Parker

Investors have grown weary with the periodic debt showdowns in Washington, each one miraculously resolved at the 11th hour. Some are asking whether they should wait in a safe harbor until “certainty” returns.

In the fourth such showdown between the White House and Congress over public funding in less than three years, the US federal government was shut down for 16 days in October and hundreds of thousands of federal workers were furloughed.

Congress finally came to a deal just one day before the US borrowing authority was due to lapse. The agreement prevented a potential default on US debt. But it provided only another temporary fix, funding the government until January 15, 2014, and raising the debt ceiling only until February 7.

Most people around the world are rightly worried about what the political controversy means for their long-term investments and ability to fund their own retirements.

The answer is that uncertainty is part and parcel of investing. You can never eliminate it simply because no one can ever be sure about the future. Tying your investments to an opinion about the outcome of the US fiscal situation or the euro zone or any other flash point in the news is a recipe for madness.

One advisor in recent weeks had to fend off a client asking whether it made sense to switch a significant proportion of his retirement fund to cash until the situation in Washington “settled down.” The downside was slightly lower returns, but this was protection against a potential catastrophe.

The advisor responded by saying that maybe this was a good idea, but would one month be enough? Perhaps the client could wait a year or so. That might be sufficient time for the situation to be resolved. But what if it weren’t?

Perhaps, he said, a better idea might be to examine more closely the crises of recent decades and the long-term impact they might have made on his portfolio—such as the oil crisis of 1973, Japan’s bust in the early 1990s, the Asian currency crisis of the late ’90s, the tech wreck in 2000, and so on.

Past performance is no guarantee of future results. Indices are unavailable for direct investment.

Without wanting to downplay the real pain that these crises caused—in both financial and human terms—the advisor asked his client what, in retrospect, he could have done to spare himself their worst effects. Beyond, of course, diversifying his portfolio, rebalancing occasionally, and keeping his own long-term needs in mind.

What if he had “waited out” the aftermath of the 1987 Black Monday crash? When would he have gotten back into the market? Was there an obvious re-entry point when Thailand, Indonesia, and South Korea came off their currency pegs in 1997-98? What expertise did he (or his advisor) have that would have gotten that timing right?

Back to the present. While newspapers wrote thousands of words and TV stations aired hours of coverage about the latest debt ceiling showdown, many equity markets around the world have reached record or at least multi-year highs.

This is not to assume smooth sailing in the future. But, as investors, we need to acknowledge that living with short-term uncertainty is the price we pay for the premium we receive by putting our long-term capital at risk.

Crises will come and crises will go, as we have seen. Politics is, by definition, about the conflict between different ideas and values. Each of us can have an opinion about likely outcomes. But we can do ourselves a disservice if we base our investment decisions purely on forecasts about politics, economics, or anything else.

Keeping your investment feet grounded in your own life circumstances and needs is preferable to dancing on somebody else’s ceiling.

Jim Parker is a vice president at Dimensional Fund Advisors in Sydney, Australia. Jim spent 25 years in journalism and served as a senior editor for the Australian Financial Review. He holds an economic history degree from Deakin University and a journalism degree from Auckland Technical Institute.

The post In Context Newsletter – Fall 2013 appeared first on JMF Capstone Wealth Management.

Why Have Bond Markets Been So Volatile?
Interest rates have risen significantly in 2013 with the five-year Treasury rate up 0.67 percent through the end of the second quarter. To put this increase in perspective, from the end of 1962 through 2012, there were 17 other years when interest rates increased this much or more over an entire year. The recent increase in interest rates has led to questions about why they have risen so substantially and what the implications are.

The U.S.’s central bank, the Federal Reserve, continues to be the dominant influence on interest rates, and it has aggressively acted to keep them down since 2008–2009. The Federal Reserve has done so by keeping the federal funds rate low and purchasing enormous quantities of bonds. The thinking was that lower interest rates would help improve the economy and bring down unemployment. While no one would say the economy is back to full health, the Federal Reserve has indicated it believes it will be healthy enough in the near future to begin slowing down portions of its policy efforts.

On June 19, Chairman Ben Bernanke indicated that he expects the Federal Reserve will begin to reduce the amount of bond purchases later this year and end them by next year. This is generally believed to be the reason interest rates increased during the second quarter. It is important to keep in mind that the Federal Reserve still expects to keep the federal funds rate (which is the primary way it influences interest rates) low for some time to come.

While no one knows whether interest rates will move higher or fall again, the recent increases are actually good news for bond investors with long time horizons and relatively short- and intermediate-term bond holdings. Although the value of those types of holdings has generally gone down in 2013, the long-term returns investors can now expect from bonds are higher than they were at the start of the year. Regardless of which direction interest rates move, investors are better served when they keep an emphasis on short- and intermediate-term bonds and bond funds with high credit quality in the fixed income portion of their portfolio.

What Happened in Detroit?
When the city of Detroit filed for Chapter 9 bankruptcy on July 18, the municipal bond market and ratings agencies were well aware of its troubles. Its general obligation bonds had been rated below investment grade since January 2009. They had been trading at very high yields relative to high-quality municipals over the past few years, which is a clear sign of financial stress.

Some have wondered whether Detroit’s bankruptcy has broader implications for the municipal market and whether it is a harbinger of further defaults. At this point, Detroit’s default and other defaults have been due to special circumstances and sporadic in nature. Predictions of a wave of defaults (on rated bonds at least) can be considered extreme, particularly given the pricing of Aa-rated and Aaa-rated municipal bonds in the marketplace, which is hardly suggestive of high default risk.

While there is no way to eliminate all exposure to municipal market credit risk, keys to mitigating this risk include broad geographical and issuer diversification, focusing purchases in the general obligation and essential services sectors, and high underlying credit ratings. Following these criteria would mean that positions like those of the city of Detroit generally would not be purchased.

Advancements in Research
Over the past 50 years, academic research has identified variables that appear to explain differences in average returns among stocks. The variables (or premiums) that have stood up to rigorous testing are considered dimensions of expected returns.

Single-Factor Model

During the 1960s, William Sharpe and others conducted asset pricing research that led to the development of the capital asset pricing model (CAPM), which proposed the market as a dimension of expected return. Known also as the single-factor model, CAPM reinforced the value of diversification and provided a simple, rational approach to measuring investment risk and expected returns relative to the market.

Size Effect

Advancing research during the 1970s identified additional factors in stock performance. In 1981, Rolf Banz observed that small company stocks tended to have higher returns than large company stocks, as measured by their market capitalization. The size effect provided a more detailed framework for understanding the dimensions of equity performance.

Value Effect

In a highly influential paper published in 1992, Eugene Fama and Kenneth French synthesized much of the previous research on asset pricing and found that stocks with low relative prices (or high book-to-market ratios) offered higher average returns than companies with high relative prices (low book-to-market ratios). They concluded that company size (small vs. large) and relative price (value vs. growth) were strong determinants of stock performance and, when combined with the market, explained most of the average differences among stock returns.

Expected Profitability

More recently, Fama, French and other academics have identified expected profitability as a dimension of expected returns. When controlling for size and relative price, research shows that more profitable firms have higher expected returns than less profitable firms.

In summary, financial science continues to provide a refined, clarifying view of the global equity markets. Advancements in academic research also have practical implications. The discovery of the size and value premiums led to the creation of low-cost mutual funds designed to capture these premiums. These funds have improved the range of allocation options that investment advisors and their clients can choose from.

Perspectives
This sketch from Carl Richards, author of The Behavior Gap (2012) and director of investor education for the BAM ALLIANCE, puts market movements in perspective. Sometimes we forget that the market goes up AND down. That’s why we put emotional guardrails (a financial plan) in place to keep us from overreacting when fear attempts to make us pull over or when greed tries to convince us to take a detour. Both extremes can be avoided, but it requires keeping focus on our financial plan, which is based on our goals.

The post In Context Newsletter – Summer 2013 appeared first on JMF Capstone Wealth Management.

Stock Market Perspective
After the bear markets of 2000–2002 and 2008, we seem to have entered an era in which investors wonder whether a market collapse is right around every corner, even following new market highs. The S&P 500 Index achieved a new high at the end of the first quarter, closing at 1,569 after beginning the year at 1,426, but has experienced considerable volatility surrounding the events in Boston. So, is it reasonable to fear a severe market downturn given this generally good performance in tandem with recent events?

Longer-Term Perspective
Over longer periods of time, we know that the world’s stock markets have generally gone up. Over the period of 1900–2012, stocks outperformed inflation by about 5.0 percent per year. From a simple point of view, this means that new stock market highs have been the norm and not the exception. In one way, this reflects the triumph of capitalism and the general improvement in living standards the world has enjoyed as time has marched on.

Specific to the current market, the S&P 500 hit its previous high of 1,565 in October 2007. Prior to that, it had hit 1,527 in the early 2000s. This underscores one other reason why recent market highs do not imply markets are due for a correction. Namely, it is important to realize that the first quarter stock market high was barely higher than levels the stock market reached more than 10 years ago. Said differently, while the stock market did achieve a new high at the end of the first quarter, from a longer-term point of view, the market has barely gone up for more than a decade. In fact from the high of the early 2000s through the end of the first quarter, the S&P 500 returned just 2.1 percent per year. This is hardly indicative of a market that is “clearly” due for a correction.

With respect to recent volatility, virtually every year has a period of time when markets do poorly and volatility increases. For example, during the great stock market performance of the 1990s, the S&P 500 had quarters when it was down by 13.7 percent, 9.9 percent and 6.2 percent. So, periods of higher volatility do not always precede poor performance.

Reasonable Expectations
Investors are wise to factor in their risk tolerance when determining how much to allocate to stocks. They should set reasonable expectations for long-term stock market performance when planning for retirement and other financial goals.

While stocks have outperformed bonds by about 8 percent per year over the long-term history of the U.S. market, the general consensus is that investors should plan for stock returns to be around 4–5 percent higher than bonds on a forward-looking basis. Investors who assume returns will be significantly higher than this will likely be disappointed.

Standard & Poor’s 500 Index
Historically, the Dow Jones Industrial Average, which is composed of just 30 stocks, has received more popular media attention than the S&P 500.

Within financial circles, however, the S&P 500 is considered to be a superior gauge of U.S. stock market performance because it includes more stocks and it weights stock by the value of the included companies instead of the stock prices of the constituent companies. The history of the S&P 500 Index traces to 1923 when Standard & Poor’s introduced a stock index that covered 233 companies. The index expanded to 500 companies in 1957 and has henceforth been known as the S&P 500 Index. At the end of 2012, the companies included in the S&P 500 represented $12.6 trillion of stock value. As of that same time, Dimensional Fund Advisors placed the total value of world equities at $37.5 trillion in its annual world market capitalization analysis.

Clearing Up Misconceptions About Social Security Benefits

With Tiya Lim

Should people who are receiving Social Security benefits, or who will begin to receive benefits in the next few years, be concerned that benefits will stop?
Since the program began, the precedent has always been if there are any changes to Social Security benefits, it will occur with the benefits of future generations. For example, in 1983, Congress decided to increase the full age of retirement but did so for beneficiaries who had 20 years or more until retirement. The increase did not affect those receiving current benefits.

Something that could change is increasing tax revenues, which affects both current and future recipients. However, current beneficiaries are usually retired, and the majority of tax revenue comes from current and future working populations. There also is a current White House budget proposal that would change the calculation for cost-of-living adjustments for Social Security, which is another possible change.

Are the financial problems with the Social Security program the same as they were a few years ago?
Yes, they are the same. When Social Security was created in 1935, life expectancy was 65–70 years old. They didn’t expect to pay out benefits for a very long time. Now you have people living into their 90s and beyond, and Social Security is still paying out benefits at around the same rate as it did when the program started. So, more people are taking money out for a longer period of time while fewer dollars are going into the system due to the recession and smaller workforce. That’s causing a lot of the drain on the Social Security system.

The problems are the same as before, and the same earlier predictions still stand — around 26 years from now is when the Social Security Trust will run out of money. But that doesn’t mean all benefits would stop. It just means that if nothing is done, such as increasing tax revenues or changing the full retirement age, people receiving benefits at that time would receive reduced benefits, perhaps 75 percent of their promised benefit.

But there’s still time to address these issues for future benefit recipients. In principle, these are easy fixes — you could increase the money going into the system through taxation, or you could decrease the money going out by changing benefits or increasing the full retirement age.

What is the outlook for Social Security?
People fear it’s going to go away completely, but there are contingencies in place to keep Social Security functioning fully. Social Security is a revenue-generating system, so it can be self-sustaining if Congress can get serious about fixing some of the flaws. While no one has a clear crystal ball, economists and academics have provided guidance in ongoing discussions about repairing the program. Research has found that Congress has a great deal of flexibility in triggering different levers in the program, all with the intention of creating a more sustainable program.

Tiya Lim is a strategic thought leader for the BAM ALLIANCE. She focuses much of her study on Social Security and other retirement-related strategies. Her work on Social Security has been featured on CBS MoneyWatch.com and cited in the Journal of Financial Planning.

Perspectives

Perspectives features different viewpoints on improving our quality of life. This sketch from Carl Richards, author of The Behavior Gap (2012) and director of investor education for the BAM ALLIANCE, points out how hard it is to see into the future. However, when we concentrate on what we can control, like identifying our goals and creating an Investment Policy Statement that guides our decisions from month to month and year to year, it improves the odds that we’ll make a successful transition from today to tomorrow.

The post In Context Newsletter – Spring 2013 appeared first on JMF Capstone Wealth Management.

Upcoming Budget Discussions

With the eleventh hour passage of the American Taxpayer Relief Act of 2012, some might think we have put the fiscal cliff behind us. Unfortunately, this is not the case. While the federal government has temporarily suspended the debt limit until May, without government action the mandatory spending cuts associated with the fiscal cliff will begin in March. With this continued level of uncertainty, it might seem like an unnerving time to remain invested and tempting to try to outguess the market.

Investors should keep two important themes in mind. First, they should think twice before assuming they know more than the market already knows about how future events will affect the market. The record is poor for investors who have made this faulty assumption.

Recent data points that confirm this are: 1) the historical performance of hedge funds, considered by many to be managed by the best and brightest, and 2) the overall performance of endowments that manage billions of dollars of investable assets. Yet, both generally have been unable to outperform simple low-cost, broadly diversified investment strategies. Over the past 10 years, hedge funds as a group have underperformed the S&P 500 Index by almost 81 percent over a period when the S&P 500 itself did not perform extremely well. Vanguard recently studied the performance of endowments and found that while there have been a handful of very large endowments that have achieved good returns, smaller- and medium-sized endowments (generally endowments with less than $1 billion of assets under management) would have achieved better risk-adjusted returns by using lower-cost, diversified stock and bond strategies.

Second, investors should keep in mind that there is a reason stocks have outperformed safer fixed income investments by a large margin over most longer periods of time. They are riskier and that risk encompasses political risk as well as more economically oriented risks.

We continue to believe that maintaining a low-cost and well-diversified portfolio that reflects your ability, willingness and need to take risk is the most appropriate way to achieve investment success. There is little in the current environment that warrants changing from that view.

Understanding the Debt Ceiling

The first aggregate limit on U.S. government debt, now commonly referred to as the debt ceiling, was enacted in 1939 when President Franklin D. Roosevelt and Treasury Secretary Henry Morgenthau asked Congress to replace the old system of separate limits on different types of debt with the aggregate limit. Since the limit was enacted, it has been increased or decreased 91 times with the most recent change in late 2011 when it was increased by $2.1 trillion.

The issue of whether the government should have a debt limit is a hotly contested topic. A debt limit may in some way help limit spending, but it can lead to substantial financial market uncertainty. Further, some argue that not agreeing to raise the debt limit means the government has essentially decided not to pay expenses that it had previously agreed to incur. For now, regardless of the debate, it looks like the debt limit is here to stay.

2012 in Review: Economy and Markets

In 2012, investors watched eagerly for signs that the U.S. recovery was gaining steam. The current expansion, which started in mid-2009, has been deemed the weakest in postwar history.

While there was continued weakness in consumer confidence, job growth and real wages in 2012, positive news also surfaced. Throughout the year, this news included healthy corporate earnings and strong balance sheets, continued low inflation, historically low mortgage rates, a strengthening housing market, and upticks in auto sales and manufacturing activity late in the year.

In September, the Federal Reserve announced its third round of quantitative easing to push long-term interest rates lower and encourage more borrowing and investment. In September and October, the Bank of Japan announced measures to provide monetary stimulus through 2013 in response to slowing economic activity.

Many have credited central banks with boosting investor confidence, and in the case of the European Union, helping avert a euro breakup. The injection of liquidity into the respective economies also helped mute volatility between currencies.

Although U.S. economic indicators sent mixed signals, the economy reportedly expanded at a 3.1 percent rate for the third quarter — the fastest pace since late 2011. Mortgage rates reached historical lows, and year-over-year home prices rose for the first time since the beginning of the financial crisis.

Despite a steady diet of bad news, most markets around the world climbed the proverbial “wall of worry” to log strong returns. Major market indices around the globe delivered double-digit total returns. All major U.S. market indices were up substantially for 2012. The market’s strong performance came with lower volatility, as gauged by the CBOE Volatility Index, which had its largest annual decrease since 2009.

Perspectives

It’s smart to think about how we spend money. But we should be careful that we don’t get carried away in the process. It’s all right to spend money we’ve budgeted on the things we value.

This sketch by Carl Richards, author of The Behavior Gap (2012) and director of investor education for the BAM ALLIANCE, was featured last summer on The New York Times’ Bucks blog on NYTimes.com.

The post In Context Newsletter – Winter 2013 appeared first on JMF Capstone Wealth Management.

Planning in an Uncertain World

For the majority of 2012, events both economic and political have left Americans with more questions than answers. Most investors would agree that recent times have been fraught with uncertainty. How should we approach the uncertainty associated with financial matters, such as what will tax rates be in 2013, or when and how will the Eurozone crisis be resolved? Investors can approach this from three different perspectives.

First, without uncertainty, investors could not expect to be rewarded. Imagine a world where we all knew exactly the earnings that companies would generate and how the global economy would do in 2013. In this fictional world, risk has been eliminated and, with it, reward. A large part of the reason why stock market investors have been rewarded over most longer periods of time is because stock prices incorporate the possibility that downside risks may show up. The longest evidence that we have, covering 1900–2010, shows that stocks have outperformed bonds by 5.9 percent per year.

Second, focus your energy and time on the elements of uncertainty that matter and can be controlled. On the investing side, these include whether your portfolio is well diversified, its tax efficiency and how much risk you have chosen to take. It does not include speculating whether stock markets or interest rates will be up or down in a year and adjusting your portfolio accordingly.

On the planning side, factors include properly titling your assets and ensuring that your estate plan reflects the goals that you have for your wealth. When investors focus their effort in these areas, the end result is better wealth management outcomes more often than not.

Finally, investors can turn to academic and practitioner research to reduce investment uncertainty. For example, there is research that has found value in modestly extending the maturity of the bonds in a portfolio when interest rates are significantly higher on intermediate-term bonds compared to short-term bonds. This advice may seem counterintuitive because interest rates have generally been low, and it certainly flies in the face of many articles published in the past few years. This is just one example of applying investment science to reduce uncertainty. This quarter’s sidebar “The Science of Investing” outlines other ways to apply the science of investing to a portfolio.

The journey to find clarity may continue into 2013. Still, the personal and financial goals you have set do not change because the world around you is in flux, unless you decide to change them. One thing is certain: Your goals and the investment plan built to accomplish them are still standing firm against whatever lingering doubts remain.

The Science of Investing

The amount of research on financial markets and investing rivals that of medical research. Largely starting in the 1950s, finance began its transition from a neglected area within economics to a legitimate field of study.

Looking back, we can now identify many seminal pieces of research that have fundamentally changed investing. Two that continue to have influence are Eugene Fama and Kenneth French’s 1992 paper “The Cross-Section of Expected Stock Returns” and Mark Carhart’s 1997 paper “On Persistence in Mutual Fund Performance.” Fama and French’s paper documented the historical outperformance of small-cap stocks compared with large-cap stocks and value stocks relative to growth stocks. Carhart’s paper found that most mutual fund managers underperformed the market and that few persistently outperformed it.

Today, newer areas of stock market research are being explored. This research indicates that stocks that have done well over the past year tend to do well over the next six months and that profitable companies tend to outperform less profitable companies. Termed the momentum premium and profitability premium, both may well affect how portfolios are diversified in the future.

The Top 10 Money Excuses
By Jim Parker

Human beings have an astounding facility for self-deception when it comes to our own money. We construct the façade of a logical-sounding argument, which is often an elaborate, short-term excuse that we use to justify behavior that runs counter to our own long-term interests.

Here are 10 of these excuses:

1) “I just want to wait till things become clearer.”
It’s understandable to feel unnerved by volatile markets. But waiting for volatility to “clear” before investing often results in missing the return that can accompany the risk.

2) “I just can’t take the risk anymore.”
By focusing exclusively on the risk of losing money and paying a premium for safety, we can end up with insufficient funds for retirement. Avoiding risk can also mean missing an upside.

3) “I want to live today. Tomorrow can look after itself.”
Often used to justify a reckless purchase, it’s not either-or. You can live today and mind your savings. You just need to keep to your budget.

4) “I don’t care about capital gain. I just need the income.”
Income is fine. But making income your sole focus can lead you down a dangerous road. Just ask anyone who recently invested in collateralized debt obligations.

5) “I want to get some of those losses back.”
It’s human nature to be emotionally attached to past bets, even losing ones. But, as the song says, you have to know when to fold ‘em.

6) “But this stock/fund/strategy has been good to me.”
We all have a tendency to hold on to winners too long. But without disciplined rebalancing, your portfolio can end up carrying much more risk than you bargained for.

7) “But the newspaper said …”
Investing by the headlines is like dressing based on yesterday’s weather report. The news might be accurate, but the market usually has reacted already and moved on to worrying about something else.

8) “The guy at the bar/my uncle/my boss told me …”
The world is full of experts, many who recycle stuff they’ve heard elsewhere. But even if their tips are right, this kind of advice rarely takes your circumstances into account.

9) “I just want certainty.”
Wanting confidence in your investments is fine. But certainty? You can spend a lot of money trying to insure yourself against every possible outcome. While it cannot guard against every risk or possible outcome, it’s cheaper to diversify your investments.

10) “I’m too busy to think about this.”
We often try to control things we can’t change — like market and media noise — and neglect areas where our actions can make a difference — like the costs of investments. That’s worth the effort.

Jim Parker is a vice president at Dimensional Fund Advisors in Sydney, Australia. Jim spent 25 years in journalism and served as a senior editor for the Australian Financial Review. He holds an economic history degree from Deakin University and a journalism degree from Auckland Technical Institute.

Perspectives

Perspectives features different topics of interest that offer viewpoints on improving quality of life. This quarter, Carl Richards, author of The Behavior Gap (2012) and director of investor education for the BAM ALLIANCE, discusses the process of getting from X to Y.

Goals are important, but sometimes, we get so attached to goals that we forget to live. When that happens, it is beneficial to find a healthy balance between living the goal and living life. The process of wealth management involves setting goals, establishing a direction and making decisions to head that way.  That’s how we get where we want to go.

The post In Context Newsletter – Fall 2012 appeared first on JMF Capstone Wealth Management.

Putting the Global Economy and Markets in Context

The financial and economic environment of the past few years has been challenging. To name just a few headline-grabbing items, investors have had to stare down a ratings downgrade of U.S. Treasury bonds by Standard & Poor’s, the European debt crisis (see sidebar on this page), high unemployment report after high unemployment report and very low rates of interest on bond investments. With all of these stories, which are incessantly focused on negative developments, it can be easy for investors to miss the good news. With the turbulent financial markets of 2008 and early 2009 now several years past, we can begin to put these developments in context.

Over the period of 2009 through June 2012, stock market investors and fixed income investors have generally experienced great results if they had the discipline to the stay the course and implement sensible, low-cost strategies. The S&P 500 Index is up 63 percent over this period, and five-year Treasury bonds have returned 15 percent. No doubt there have been some periods of high volatility, but the investment results have been much better than one might guess given the headlines mentioned above, and they reinforce the importance of maintaining discipline regardless of environment.

Those who have studied the long-term histories of financial markets and global economy have noted how similar the aftermath of the 2008 financial crisis has been to other financial crises of similar magnitude. In their 2009 book, This Time Is Different: Eight Centuries of Financial Folly, professors Carmen Reinhart and Kenneth Rogoff found it is not uncommon to see substantial depreciation of real estate prices and stubbornly high unemployment following financial crises. While this information doesn’t necessarily provide comfort to those that have had difficulty finding work or been directly affected by the 2008 financial crisis, it does show the world has been through similar episodes and that it has ultimately recovered.

Looking forward, there are positive aspects to highlight as well. Even though fixed income rates are low, expected returns on diversified stock portfolios are well within the historical norm. Risks could materialize, but market pricing appears to have accounted for those risks. As one example, international stocks have fallen by more than 13 percent over the year ending in June 2012, which is exactly what you would expect to see as the risks associated with the European debt crisis became evident to the marketplace: Prices adjusted downward, and expected returns were therefore adjusted upward.

An Update on Europe

The second quarter saw numerous important developments in Europe. In mid-June, Greece held elections that were won by pro-bailout parties, which eased fears that Greece exiting the Euro currency was an imminent possibility.

Further, an agreement was reached to supply Spain with approximately $125 billion to help recapitalize its banking system. It is important to note, though, that these funds will have to be paid back and will add to the debt burden facing Spain’s government. Finally, the most recent development of note was an agreement to allow the Eurozone rescue funds to directly recapitalize banks.

There are still many details to be worked out to put the framework of this agreement into practice. Also, it is not yet clear whether this most recent agreement will affect the terms of Spain’s bailout. What remains clear is there are no easy fixes to the troubles of Europe, which faces a long road to economic recovery.

Determinants of Happiness

By Thomas Gilovich

Which purchases give people the greatest satisfaction? The answer is likely to be different for a married couple in their 20s than for a recent retiree. Nevertheless, a very clear guideline has emerged from our recent research on the determinants of happiness: Spend your money on experiences.

That is, if you’re conflicted about whether to buy a material good (a new sofa or the latest electronics) or to finance a personal experience (a trip to Europe or tickets to a play), research has found that you’ll get more satisfaction — and much more enduring satisfaction — if you choose the experience. For example, when people were asked to recall their most significant material purchase and their most significant experiential purchase over the past five years, they reported the experiential purchase brought them more joy and enduring satisfaction, and it was clearly “money well spent” compared with the material purchase.

Many people find this surprising. When faced with an experiential-material trade-off (such as, take the kids to Yosemite or trade in the old car for this year’s model), many people convince themselves they should opt for the material good because “it will still be there” long after the experience would have been enjoyed. That’s correct in a purely material sense, but psychologically, it’s the reverse. We quickly habituate to the material good: The new car is fun for a while, but soon it feels no different than the car you traded in. The experience, however, tends to live on. It persists in the memories we cherish, the stories we tell and the very sense of who we are.

Experiences are often more satisfying because we tend to evaluate them on their own terms, not in comparison with what others have. Imagine you’ve just come back from 10 days in New Zealand to learn that a neighbor spent less money for two weeks there in undeniably superior accommodations. This wouldn’t be pleasant to hear, but chances are you’d get over it quickly. You have your memories, your photos and your time with loved ones — experiences you’d be unwilling to trade for your neighbor’s nominally superior trip.

Essential items aside, if you are torn between a material good and an experience, don’t make the material purchase based on the argument it will last longer. Instead, opt for the experience. Our research has shown that people’s most common regrets over material goods are regrets of action — buying something that now seems unwise or impulsive. Their biggest regrets about experiential goods tend to be the opposite — regrets of inaction, or not seizing an experiential opportunity that presented itself.

Thomas Gilovich is a professor of psychology at Cornell University. He has written more than 100 articles for professional and academic journals, including several articles published in 2010 on experiential and material purchases. He co-authored the book Why Smart People Make Big Money Mistakes — and How to Correct Them (2nd edition, 2010). Gilovich holds a PhD from Stanford University and a bachelor’s degree from the University of California, Santa Barbara.

Perspectives

This quarter, Perspectives features an interview with Carl Richards, author of The Behavior Gap (2012).

Carl became an accidental artist with his simple sketches that make complex financial concepts easy to understand.

Q. Why did you begin to draw sketches?

A. Talking with investors, I began to notice how their eyes would glaze over as I tried to describe investment theory. One day, I drew a few shapes to explain the concepts, and the conversation changed. I kept drawing sketches, and that led to one sketch a week for The New York Times and then the book.

I had no idea how strong the reaction would be.

Q. Having meaningful conversations about money is prevalent in many of your sketches. Why do we overlook the value of having good conversations?

A. Most of the topics surrounding money are emotional, but we expect it to be like learning an equation or reading a spreadsheet. What we’re really talking about is freedom, flexibility, security, peace of mind and our most cherished dreams for ourselves and our family.

We don’t have these conversations often because when we touch these topics, it’s like touching the third rail, we get shocked. Try setting aside a regular time and place to have such conversations. Once a month, go to a café no one likes and have a discussion to review goals and go over new issues. Slowly, the conversation will change from heated discussions around money to discussions about money.

Q. In your book, you relate a story in which you decide to give away your collection of specialized skis in favor of one pair that has consistently served you well. How did you arrive at this decision, and how does it translate to money and investing?

A. I live in an area where we take skiing pretty seriously. It’s not unusual for someone to have three or four pairs of skis for different conditions. After years of following what everyone else does, I found that I didn’t like that approach.

What I like to do is grab a pair of skis and go. For me, the enjoyment is the skiing. For other people, part of the enjoyment is that process of looking at the conditions, deciding which pair of skis to use and going out to test that assumption.

The story is really about the why of money: Why am I investing this way? Why am I saving for this? Is it right for me? We need to start questioning some of our assumptions about why we do certain things and what it is that actually makes us happy. It’s about asking why.

Q. Are people wary of simplicity in their lives?

A. We say we want things simplified. But how often are people disappointed when the doctor’s only prescription is to go home, get some rest and take some over-the-counter medication?

When we are dealing with big, important decisions and the answer is simple, we sometimes feel the answer needs to be more complex. That is the challenge we are faced with as investors: To get the few, relatively simple things correct, and the most difficult part is to continue to do that over a relatively long period of time.

The post In Context Newsletter – Summer 2012 appeared first on JMF Capstone Wealth Management.

Last year was challenging for globally diversified stock portfolios. While the S&P 500 Index was up 2.1 percent in 2011, the MSCI EAFE Index, which is basically the international equivalent of the S&P 500, was down 12.1 percent. The MSCI Emerging Markets Index was down 18.4 percent.

In the face of 2011 (and other years when international equities have underperformed U.S. equities), some pundits have been quick to dismiss the value of global diversification. Our view that investors should globally diversify is based upon a longer-term view of global diversification and the size of the international equity market compared with the U.S. equity market (profiled in the sidebar).

In a piece in the May/June 2011 issue of the Financial Analysts Journal, Cliff Asness, Roni Israelov and John Liew examined the long-term benefits of global diversification in their article entitled “International Diversification Works (Eventually).” They found that while local stock portfolios (described as portfolios in which an investor owns only home country equities) and globally diversified stock portfolios tend to perform similarly over shorter down-market periods, the advantage of global diversification begins to shine as the time horizon lengthens.

For example, they found that the worst five-year holding period returns for locally diversified stock portfolios averaged –57 percent while the globally diversified stock portfolios lost –39 percent during its worst five-year period. While both lost substantial amounts (which is expected because this analysis looked at the worst five-year holding period returns for each portfolio), this shows that global diversification significantly lessened the size of the loss.

The other primary finding of this study is that globally diversified stock portfolios tend to do relatively well over longer holdings periods when local portfolios are doing poorly. During the periods of the worst five-year losses for the local portfolios, the globally diversified stock portfolios lost only 16 percent, mitigating the risk of the investor’s home country stock market.

One other data point illustrating the long-term value of global diversification is the historical returns of U.S. stocks and international stocks. Over the period of 1970–2011, the average annual returns of the S&P 500 and the MSCI EAFE were 11.3 percent and 11.3 percent, respectively. So over the longer term, we have seen almost identical returns to U.S. and international stocks.

Instead of focusing solely on the short term (such as looking at 2008 or the third quarter of 2011), investors should view international diversification as a long-term addition to their portfolio. As research has found, over longer holding periods, a globally diversified stock portfolio tends to experience less severe losses than a local stock portfolio and tends to do relatively well when a local stock portfolio is doing poorly.

Global Equity Markets

One reason for global diversification in a stock portfolio is the amount of the world’s stock market value that is now located outside of the United States. In past decades, the United States represented more than 50 percent of the value of the world’s stock markets. That is no longer the case.

As of March 2012, the U.S. stock market represented just 46 percent of the value of the world’s stock markets. Developed market international stocks represented 41 percent of the world’s stock market value, and emerging market stocks represented 13 percent. Thus, an investor who chooses to invest in only U.S. stocks is ignoring 54 percent of the value of the world’s stock market.

Because investors have collectively assigned a great value to international and emerging stock markets, it is not prudent for U.S. investors to ignore more than half of the value of the world’s stock markets. Having exposure to the entirety of the world’s stock markets is a more defensible strategy.

The Good Old Days?

By Jim Parker

While not seeking to downplay the very real anxiety generated by global events that took place in 2011, particularly in relation to their effects on investment portfolios, it’s worth reflecting critically on our often secondhand memories of the "good old days."

A brief review of the history of the 20th century would be dominated by world wars, civil wars, pandemics, natural and nuclear disasters, terrorist attacks, and economic crises in the way of labor shortages, the failure of monetary systems and financial crises.

Taken in sum, it seems fairly clear that tragedy and uncertainty will always be with us. But the important point to take away from it is that previous generations have stared down and overcome far greater obstacles than we face today. And while it is easy to focus on the bad news, we mustn’t overlook the good either.

Alongside the wars, depressions and natural disasters of the past century, there were some notable achievements for humanity — like women’s suffrage, the development of antibiotics, civil rights, economic liberalization, the spread of prosperity and democracy, space travel, advances in our understanding of the natural world, and enormous advances in telecommunication. (Oh, and the Beatles.)

Today, while the United States and Europe are gripped by tough economic times, much of the developing world is thriving. Populous nations such as China and India are emerging as prosperous nations with large middle classes. And smaller, poorer economies are making advances too.

The United Nations in the year 2000 adopted a Millennium Declaration that set specific targets for ending extreme poverty, reducing child mortality, and raising educational and environmental standards by 2015. In East Asia, the majority of 21 targets have already been met or are expected to be met by the deadline. In Africa, about half the targets are on track, including those for poverty and hunger.

Alongside these gains, new communications technology is improving our understanding of different cultures and increasing tolerance across borders while providing new avenues for the spread of ideas in education, health care, technology and business.

Through forums such as the G20 and APEC, international cooperation is increasing in the field of trade, addressing climate change and lifting the ability of the developing world to more fully participate in the global economy.

Rising levels of education and health and work force participation also mean the foundations are being built for a healthier and peaceful global economy, dependent not on debt, fancy derivatives and fast profits but on sustainable, long-term wealth building.

Anxiety over recent market developments is completely understandable, and it is quite human to feel concerned about events in Europe. But amid all the bad news, it is also clear that the world is changing in positive ways that provide plenty of cause for hope and, at the very least, gratitude for what we already have. These are ideas to keep in mind when we scan the news and long for the "good old days."

Jim Parker is a vice president at Dimensional Fund Advisors in Sydney, Australia. Jim spent 25 years in journalism and served as a senior editor for the Australian Financial Review. He holds an economic history degree from Deakin University and a journalism degree from Auckland Technical Institute.

Perspectives

Perspectives features different topics of interest that offer viewpoints on improving quality of life. This quarter, Carl Richards, author of The Behavior Gap: Simple Ways to Stop Doing Dumb Things With Money (2012), discusses why tomorrow’s market probably won’t look anything like today’s. The following was featured February 13 in The New York Times’ Bucks blog on NYTimes.com.

Every day we rely on habit to get a lot of things done. We commute the same way to work every day, we eat at the same restaurants and we shop at the same stores.

We rely on habit to help us make things easier because few people want to reinvent their lives every day. But this habit of forming habits also does something else. In academic circles, it’s called the recency bias, and it can trick us into making decisions we might not make otherwise.

The recency bias is pretty simple. Because it’s easier, we’re inclined to use our recent experience as the baseline for what will happen in the future. In many situations, this bias works just fine, but when it comes to investing and money it can cause problems.

When we’re watching a bull market run along, it’s understandable that people forget about the cycles where it didn’t. As far as recent memory tells us, the market should keep going up, so we keep buying, and then it doesn’t. And unless we’ve prepared for that moment, we’re shocked and wondered how we missed the bubble.

When the market is down, we become convinced that it will never climb out so we cash out our portfolios and stick the money in a mattress. We know the market isn’t going back up because the recency bias tells us so. But then one day it does, and we’re left sitting on a really expensive mattress that’s earning nothing.

The point isn’t that you should have predicted the timing of the bubble or the upswing but that you should have considered both possibilities as potential outcomes and planned accordingly. Instead of taking the long view and considering as many factors as possible (the market goes up AND down), we settle into a rut and keep behaving as though nothing will ever get us out of it.

Being prepared and recognizing that the bias exists costs very little. I think of it like the winter weather kit anyone who lives in the mountains should keep in their car. Even though I’ve never been stranded traveling in the winter, I know I should have a kit in the car with water, food and other stuff to help me survive if I do. We’ve got to get over this idea that because something has never happened (not in the last six months anyway) that it won’t happen in the future.

All things considered, it’s pretty easy to put some plans in place to help see us through the ups and downs. So quit letting yesterday be the only thing to determine what you do tomorrow with your money.

The post In Context Newsletter — Spring 2012 appeared first on JMF Capstone Wealth Management.