Just the words “estate planning” can conjure up visions of laborious and complex work. Although this could be the case for larger estates, a basic will package can be relatively straightforward, attainable and something everyone should employ.
Below are the basic estate planning documents that most people will need:
- Last Will and Testament: Assets that pass through the probate process are typically distributed based on instructions set out in your will. These assets could include your home, checking account, or investment accounts. Your will appoints an Executor to be the person who will handle the closing of your estate. Wills may also create a trust upon your death to hold assets for your loved ones. A will is of particular importance if you have minor children as you will name a Guardian to care for them if you pass away before they reach age of majority.
- Financial Power of Attorney: This document allows the holder to conduct financial affairs on your behalf during your lifetime. If you are no longer able to handle your financial affairs due to an illness or injury, this document is invaluable. For example, if your spouse owns an investment account, the spouse relationship alone does not necessarily give you access to this account.
- Health Care Power of Attorney: Similar to a Financial Power of Attorney, this document gives your appointed agent the right to make health care decisions on your behalf if you are incapacitated. These powers include decisions relating to your medical needs such as a necessary surgery or a medical procedure.
- Directive to Physicians: Sometimes referred to as the Living Will, this document directs your medical provider as to how you would like to be treated if you are in a terminal condition. Do you want to continue to be sustained by life support at any cost regardless of prognosis or do you simply want to be kept comfortable?
- Declaration of Guardian: This document appoints a guardian of your person and your estate. The Guardian of the Person is the individual who will feed, clothe, and shelter you when you are not able. While the Guardian of the Estate will handle your financial affairs.
Valid wills are sometimes created by hand or downloaded from the internet. However, engaging an attorney to help you develop an estate plan is advisable to avoid potential errors and costly litigation. Any attorney can create these documents but hiring an attorney who specializes in trusts and estates is highly recommended.
A thorough review of your beneficiary forms for IRAs, 401(k)’s, and life insurance policies is also recommended. Your attorney can guide you through properly titling your financial accounts and designating beneficiaries to avoid the necessity of probate for certain types of accounts. In addition, there are other estate planning and asset protection tools that may warrant discussion such as family limited partnerships, revocable living trusts, and life insurance trusts.
Having proper legal documents will help provide and protect you during your lifetime, as well as distribute your assets according to your wishes upon your death. Those you care about will be better served because your final requests are well documented.
“I have two kinds of problems: the urgent and the important. The urgent are not important, and the important are never urgent.” Dwight D. Eisenhower in a 1954 speech to the World Council of Churches, quoting Dr. J. Roscoe Miller, the President of Northwestern University.
December’s market swoon came as a shock for many investors. After finishing the previous nine years with a positive return, December’s market selloff resulted in the first negative annual total return for the S&P 500 since 2008. The fourth quarter of 2018 also marked the fourth time in the last decade that the S&P 500 declined more than 10% over the course of a quarter. The other three times occurred in Q1 2009 (-10.9%), Q2 2010 (-11.4%), and Q3 2011 (-13.8%). There were numerous factors that seemed to contribute to investors’ fear. Among them were increasing concerns about a slowing global economy, the ongoing trade war between the U.S. and China, the Federal Reserve disappointing markets by raising rates 25 basis points in December and signaling an additional two rate hikes in 2019, uncertainty surrounding the impact of falling oil prices, and fears that corporate earnings may have peaked. Adding “agita” to the markets were comments by current Chair of the Federal Reserve Jerome Powell that the Fed’s ongoing unwinding of its balance sheet would continue on “automatic pilot.” Throw in selling pressure from investors engaged in year-end tax-loss selling and a lack of buyers over the holidays and you have the perfect recipe for a significant market correction. By Christmas Eve, the S&P 500 was less than one-half percentage point from entering a bear market (traditionally defined as a drop of 20% or more). However, equities rallied back following a Christmas break to narrowly avert an official bear market. U.S. small-cap stocks fared the worst of the major equity asset classes, losing 20.2% during the fourth quarter and bringing their year-to-date losses to 11.0%. Losses were wide spread across all equity asset classes and market sectors with virtually all equity asset classes finishing both the quarter and the year in the red.
As investors fled volatility in equity markets, many sought to allocate their capital to the relative safety of bonds. This flight to safety helped push interest rates lower in December, driving the benchmark 10-Year Treasury down to 2.69%, 55 basis points below its peak of 3.24% on November 8, and only 29 basis points above where it ended 2017. Despite interest rates mostly rising throughout the year, the December rate plunge moved broad fixed income indices back to the breakeven point or slightly into positive territory for the year. The Bloomberg Barclays U.S. Aggregate Bond Index, the broad benchmark used by many fixed income investors, finished the year with a return of 0.01%, which would be about as low as you can go and still claim a positive return. Shorter/intermediate-term municipal bonds, measured by the Bloomberg Barclays Municipal Bond 5-Year Index, finished the year up 1.7% after a strong fourth quarter rally.
Despite the pervasive pessimism that seemed to overcome markets in the fourth quarter, there are more than a few bright spots to consider as we look forward to a new year. The U.S. economy grew at an annualized rate of 3.4% in the third quarter of 2018, and growth in China is expected to be in the neighborhood of 6% in 2018. Inflation continues to be benign, with the latest report showing the CPI (Consumer Price Index) rising 2.2% year-over-year through the end of November. The unemployment rate is also low, coming in at 3.9% as of the latest report from the Bureau of Labor Statistics on January 4. Low levels of inflation combined with a strong and apparently stable labor market should continue to provide a counter to some of the worst market fears. And it seems fair to posit that investors are pricing in some fairly negative outcomes related to tariffs, trade wars, and other geopolitical concerns. Given these positive underlying economic indicators, any upward surprise in the areas with which the market has expressed so much concern could significantly improve investor psychology.
As we move into a new year, investors should continue to focus on what is important, their long-term investment plan. The investment plan should include contingencies for changing market conditions, such as portfolio rebalancing, tax-loss selling, and reassessing the asset allocation of the plan as conditions change. But we should all beware of devoting too much time to the tyranny of the urgent, never letting it distract us from that which is truly important.
What just happened?
Since 1990 the S&P 500 has declined more than 10% in a calendar month on five occasions:
- December 2018 -10.1%
- February 2009 -10.6%
- October 2008 -16.8%
- September 2002 -10.9%
- August 1998 -16.8%
U.S. and many foreign stock markets declined over 14% in the 4th quarter – the most in a quarter since the financial crisis of 2008. Because of recent declines, valuations of equity indices are nearing their long-term historic averages. Some sectors of the U.S. stock market, such as technology and financial stocks, traded 25-30% lower at year-end than they did earlier in 2018.
Interest rates increased for most of the quarter. However, over the last few weeks of the year intermediate and long-term interest rates declined as concern mounted over the prospect of slowing U.S. and worldwide economic growth. Despite the volatility surrounding the level of interest rates in 2018, high quality fixed income securities and other capital preservation strategies provided a positive return during the fourth quarter. The 10-Year Treasury yield peaked at 3.2% on November 8th before declining to 2.7% on December 31st. On the other hand, short-term rates continued to rise, due to the Federal Reserve hiking rates another 25 basis points in mid-December. This action reinforces the reality that while the Federal Reserve exerts significant influence on short-term interest rates, it is the market that sets longer term rates.
Markets appear to be going through a transition from an extended period of zero interest rates, low inflation and readily available credit to an environment of higher interest rates and more difficult credit conditions. In addition, there is a growing concern that Federal Reserve policies (raising short-term interest rates and allowing U.S. treasury securities/agencies to mature, thus reversing previous quantitative easing) over the coming year may add to the current volatility and potentially hinder 2019 – 2020 economic growth. While short-term interest rates have risen, and credit conditions are tightening, inflation continues to be benign, with the consumer price index rising at an annual rate of 2.2% as of the end of November. Low levels of inflation, along with low and stable unemployment, registering 3.9% as of January 4th, do not currently support the fears of a weakening economy, nor does the strong December jobs report of over 300,000 new positions created during the month.
Geopolitical tensions and uncertainty continue to be a driver of market volatility. Midterm elections changed the political party in control of the U.S. House of Representatives, increasing policy uncertainty going into 2019. Across the Atlantic, no viable path to ease Great Britain’s exit from the European Union, known as BREXIT, exists despite a deadline in less than three months. Additionally, tariffs and harsh trade rhetoric, specifically between the U.S. and China, escalated late into the end of the year, and are still unresolved. During what is typically a holiday-induced calm, these uncertainties played out in the markets, with significant year-end tax loss selling further pressuring equity prices.
How does the environment of 4th quarter 2018 compare to the environment of previously volatile periods?
The current level of stock market volatility, while difficult to stomach, is not that unusual. The extremely low levels of volatility seen in 2017 and other recent years are more the exception than the norm. The last time the stock market experienced this level of decline in such a short period of time occurred during the financial crisis of 2008 and, prior to that, in 2000 – 2002 following the bursting of the technology bubble market speculation.
While it may be tempting to draw parallels between the recent market sell-off and other prior sharp market declines, there are some significant differences in the circumstances surrounding each of these events:
- In 1999, the technology and internet bubble led to widespread overvaluation of companies with little, or even zero, revenue, much less profits. The entire sector was overvalued and driving the performance of the broader index. Today, the group of stocks driving the market are companies with substantial revenues, significant cash flows, healthy earnings and dominant market shares. While their valuations may be stretched, they are very different from the numerous dot.com companies and failed internet stocks that precipitated the bursting of the technology bubble.
- In 2007-2009, the financial system was extremely fragile which does not appear to be the case today. Banks and other large financial institutions are much better capitalized and the issues that led to the financial crisis do not appear to be as much of a current problem. Most analysts don’t believe a similar crisis is likely now because the financial and banking system appear to be on much firmer footing.
There are a few areas in today’s environment that are worth noting, despite the fact that some conditions that preceded previous bear markets, as mentioned above, do not appear as concerning today:
- High levels of debt on corporate balance sheets, particularly debt used for share buybacks as opposed to debt borrowed for investment and growth, may be a cause for concern in the event of a significant economic slowdown.
- Private market and asset valuations are now stretched as capital has poured into venture capital, real estate, and leveraged buy outs. In addition to elevated valuations, many of these companies/investments also carry significant amounts of debt.
- Debt levels on government balance sheets are higher than ever before. In a rising interest rate environment, this can lead to significant debt servicing costs, hampering government spending and leading to greater geopolitical uncertainty. This problem is not unique to the U.S. and has the potential to be a widespread problem.
Has the recent market volatility created opportunities for long-term investors?
In prior time periods, volatility has often provided opportunity for investors. After December’s selloff equities are trading closer to more normal historical market valuations. Some sectors, such as energy, technology, financials, and consumer staples, are becoming relatively more attractive. For investors adding to their portfolios, the entry point during this period seems to be more attractive from a valuation perspective than it has been in several years. While not all equity sectors are trading at attractive levels, some areas of interest are developing.
Investors not currently adding to or systematically withdrawing from their portfolio can rebalance and effectively take advantage of volatility while maintaining their asset allocation. And as stated, tax loss selling is an important strategy for investors in volatile markets and may contribute to the overall long-term after-tax portfolio return.
A lingering concern in the market revolves around predicting the next recession; however, US economic growth is currently running over 3% with other large economic powers such as China experiencing 6%+ annual growth rates. Given inflation levels are stable in the 2-3% annual range, the need for further interest rate hikes is diminishing.
Unemployment in the U.S. remains under 4%, a level which encourages consumer spending and should support economic growth further into 2019. Finally, U.S. median and average real incomes continue to rise at annual rates above 3%, which is well above historical averages dating back to the late 1960s.
What strategies does RGT recommend given the current environment and how are client portfolios positioned if a significant downturn occurs?
One of the guiding principles of RGT’s approach to portfolio management is that we are long-term and goal-oriented advisors. We are focused on helping our clients achieve their long-term financial goals, not simply on beating a benchmark or unmanaged index. Thus, a cornerstone of the investment process is to develop an investment policy statement and asset allocation for each client that we believe will maximize the probability of the client reaching their financial goals, while doing so in a manner that is aligned with the client’s personal tolerance for risk and ability to make sound decisions during periods of heightened uncertainty. The strategies mentioned below will be implemented in different ways throughout RGT’s client portfolios, depending upon each client’s personal circumstances. And as a result, all client portfolios will not necessarily perform in an identical fashion, particularly during periods of market volatility.
Another guiding principal that RGT utilizes in developing and managing portfolios is related to this long-term strategic approach. To achieve long-term success, we believe investors are best served by developing a broadly diversified asset allocation adjusted to best fit their particular risk tolerance. Well diversified portfolios typically maintain exposures across geographies, industry sectors, market capitalization, and investment styles. Maintaining these exposures over time through disciplined monitoring and rebalancing of the portfolio reduces the risk of portfolios becoming over allocated to any particular sector or investment style. During periods where particular investment styles or market sectors become richly valued relative to history or to other sectors or styles, maintaining this discipline helps limit exposure to these more expensive parts of the market.
Several of the strategies mentioned below are directly taken from the investment principals and long-term approach described in this section. RGT believes it is important to understand that periods of volatility, like the one experienced by investors in December 2018, are part of the normal course of events which we expect portfolios to encounter and are part of the long-term planning and strategy embodied in each client’s investment plan. Should there be any specific risks or opportunities that develop along the way, we still have the flexibility to adjust client portfolios and adapt if we believe other strategies are prudent.
The combined experience of RGT partners and employees includes over 60 previous equity cycles (“bull” & “bear” markets) dating back to the 1970’s and thus, we have experience managing through several previous volatile periods.
Prior to the most recent market decline – RGT purposefully de-emphasized and limited allocations to areas of investment which experience excessive speculation and higher risk. Thus, investment strategies which are perceived to be more “at risk” were naturally limited in portfolios.
During the current market decline – RGT continues to make progress in its due diligence efforts with managers focused on some of the most affected areas of global markets. We are starting to see some outside RGT equity managers find good buying opportunities in the latest period of volatility. Also, RGT portfolios are designed to be under-allocated to areas where valuations are high. Typically, as volatility increases, outside RGT equity managers find it challenging to outperform market indices due to “indiscriminate” selling across the board. Once markets correct for an extended period, RGT believes its managers will seek to take advantage of opportunities that have arisen during this difficult market.
If markets continue to be volatile – RGT consistently reviews areas for opportunistic investment. For example, if interest rates continue to rise, clients are able to earn more income from capital preservation/fixed income strategies given higher expected forward rates of return. Similarly, if stock markets decline further from current levels, more rebalancing opportunities will present themselves. Additionally, for the first time in several years, investors will be presented with the opportunity to consider shifting their overall portfolio allocation to a more aggressive stance at much lower valuations.
In the last 10 years there have been 4 other quarters when equities (both U.S. as measured by the S&P 500 and global equities as measured by the MSCI ACWI index) experienced similar declines as this past quarter – the 1st quarter of 2009, the 2nd quarter of 2010, the 3rd quarter of 2011, and the 3rd quarter of 2015. The recovery in equities after each of these declines was positive in the immediate twelve months following. While there are no assurances that this will occur again, the historical record points out the importance of having the discipline to remain committed to your long-term strategic investment plan.
Thank you for the opportunity to provide this information and analysis. Please contact RGT with additional questions.
“If it’s not one thing it’s another…” Rosanne Rosanna Danna SNL circa 1970 something
In view of current economic growth in the U.S. and overseas, what stands to be the largest potential areas of impact over the next 12-24 months?
The month of October has a reputation for being the cruelest of months for markets. And this reputation is well earned. During October of 1929, 1987, 1989, 1997 and 2008, U.S. stock markets experienced elevated levels of volatility, often in response to political and economic events that had been building throughout the year. On average, the S&P 500 has over 60 days each year in which it rises or declines over 1%. In 2017 there were only 8 of these days. So far, as of October 26, 2018, there have been over 40 of these days.
This increased, yet historically normal, level of market volatility has been impacted by political and economic events such as the U.S. government’s fiscal deficit, mid-term elections in the U.S., concerns about fiscal and bank solvency in countries such as Argentina and Italy, and assorted other political events in the U.S. and abroad. While tax reform and a less burdensome regulatory regime have provided meaningful economic stimulus in the U.S., the challenges mentioned above are threatening to undo this positive momentum. Additional challenges facing financial markets include the most recent announcement that the US government’s fiscal deficit was higher than some analysts expected, a heightened degree of uncertainty and unrest politically, the threat and uncertainty around rising interest rates and the potential impacts of trade conflicts and/or tariffs that may inhibit cross border exchange and dampen global economic growth.
Of all of the challenges mentioned above, those that most directly affect the global economy are most likely to have a direct impact on financial markets. Recently International Monetary Fund economists have estimated world economic growth is slowing to 2-3% annually. In addition, short-term interest rates, which have been near zero since the great recession of 2008-09 in many countries, are starting to rise, increasing the cost of capital and potentially dimming investors’ enthusiasm for risk-taking. This decreased risk appetite may impact a wide range of investments, including equities, high-yield bonds, private equity, real estate and other assets classes with higher risk and return profiles relative to cash. The lower cost of borrowing has allowed federal and state governments, companies, municipalities and individuals to access financing at attractive rates. All of this has, in turn, increased economic activity, capital spending, hiring plans and helped drive economic growth rates higher. In the U.S., stronger GDP growth (over 3% annually in the most recent quarterly reports), low unemployment (under 4%) and low inflation (under 3% annually) are partly responsible for strong corporate earnings growth in the last several years.
This equity bull market has had a long run with few interim declines, so what can investors expect?
Since the beginning of this most recent bull-market almost ten years ago in the spring of 2009, passive investment strategies such as index funds have attracted an increasing share of investor dollars. These inflows to passive funds have begun to slow in 2018 compared to 2017. In the event of a significant market correction this could present a few challenges to investment markets. Passive funds provide daily liquidity even though no cash is retained in the mutual fund portfolio. Redemptions are met through stock sales, and in order to maintain the passive nature of the fund, securities are sold on a pro rata basis, regardless of their individual investment merit. Just like many of these strategies have seen large net inflows, if outflows begin, it could pressure stocks across the entire market causing potential price declines from selling to meet these redemptions.
Monetary policy may provide another source of market volatility. The Federal Reserve is decreasing their balance sheet, thus lessening demand for the securities for which they have been buyers over the last decade. The direct impact of this policy is that bond prices fall, and interest rates rise. The low-rate environment of recent years has allowed public companies to finance the repurchase of their own stock. These corporate buybacks have helped fuel the bull market. However, rising rates may make this a less attractive strategy. When coupled with slowing economic growth and the tough earnings comps that many companies will face in 2019, it is certainly fair to be wary of the challenges facing stocks in 2019. These may be some of the drivers that have led to increased October volatility in 2018.
Through Friday, October 26, 2018 the major U.S. stock market averages such as the S&P 500 have declined 10% from recent highs as have other stock indicators. While these types of market declines have been less frequent in recent years, more normal annual volatility often includes at least one of these 10% corrections. Whether it becomes more than 10% domestically, as we have experienced in international equity markets, remains to be seen.
Diversification provides the opportunity for a smoother ride, but is the destination clear?
Among the advantages of diversified portfolio construction is one which involves reasonable straight forward math. Through allocation to strategies which will outperform at various, but usually different, times, well diversified portfolios will, in the aggregate, not go up or down as much as the most volatile individual asset class. Diversification can not only make the investment “ride” smoother, it can also increase the ultimate value of the investment portfolio.
As a simple example, assume an investor starts with $100,000 and invests it in a strategy that produces annual returns of +10%, -5%, +10%, -5%, and repeating in this pattern for ten years. After ten years, the investor has slightly less than $125,000, ignoring any income tax effect. However, if the portfolio is invested 50% in the original strategy and 50% in another strategy which earns +5% during the down years and 0% during the up years, the portfolio will be worth over $126,000 at the end of 10 years. While the increase in return is very small, the risk-adjusted rate of return is much higher, due to significantly lower volatility. The result is more money for retirement, education or other purposes. The less extreme declines hopefully lead investors to better decision making along the way. While real life investing is more complex than this simple example, over time diversified portfolios tend to provide superior risk-adjusted returns as we have outlined here. See the 2018 RGT Investment Perspectives available from our office for more information on investor behaviors.
While some years like 2018 produce a wide disparity between the best and worst performing asset classes, we believe proper diversification is still the approach that is most likely to help investors reach their financial goals.
Please contact someone from RGT Wealth Advisors to discuss these topics further.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Charles Prince, Citigroup CEO. July 2007 interview with the Financial Times.
“History doesn’t repeat itself but it often rhymes.” Aphorism often attributed (probably incorrectly) to Mark Twain.
For investors in the U.S. stock market the music is playing and investors are dancing. While other asset classes have had sell-offs and corrections, the U.S. stock market just keeps on rolling. In the third quarter the S&P 500 was up 7.7%, bringing its year-to-date return to a robust 10.6%. This quarterly return was the largest quarterly gain for the S&P 500 since the fourth quarter of 2013. U.S. small cap stocks are not missing out on the party. The Russell 2000 was up 3.6% in the third quarter and is now up 11.5% for the year-to-date. Digging below the headline numbers, however, a different story begins to emerge. The Russell 1000 Growth Index, a commonly cited benchmark for large, growth-oriented companies, increased 16.3% through September, while the Russell 1000 Value Index, the benchmark for large value stocks, increased only 5.7%. This disparity with growth stocks, primarily technology and health care stocks, outperforming value stocks has been a hallmark of this bull market over the last several years. While the U.S. bull market has roared, it has been a much bleaker picture for foreign equity markets in 2018. The MSCI-EAFE Index is down 1.4% for the year in dollar terms. And emerging markets, represented by the MSCI-EM Index, have done even worse, down 7.7% thus far in 2018.
Fixed Income markets continued to muddle along in the third quarter. The Bloomberg Barclays U.S. Aggregate Bond Index, the most commonly used index for investment grade bonds in the U.S., gained a paltry 0.02% in the third quarter and has lost 1.6% for the year. The losses sustained by bond investors are due to the steady rise in interest rates throughout the year. The increase in interest rates has occurred across the yield curve. The 6-Month U.S. Treasury yield has moved from 1.53% at the end of 2017 to 2.19% at the end of the third quarter. Likewise, the 10-Year U.S. Treasury yield has increased from 2.40% to 3.05% and the 30-Year Treasury yield from 2.74% to 3.19%. This continued upward pressure on rates in the third quarter appeared to be due to several factors. First, the Federal Reserve raised rates for the third time this year and the market consensus seems to point to a fourth raise in rates near the end of the year. In addition, the economy continued to show signs of strength through rising wages, solid economic growth, and bullish consumers and investors. Finally, there was some thawing in trade negotiations, which resulted in a lessening of trade tensions with some of our largest trading partners.
Rising oil prices contributed to positive returns in the energy sector. West Texas Intermediate Crude Oil (WTI) has risen in price from $60.46 at the end of 2017 to $73.25 at the end of the third quarter. The 21.2% price increase is a result of a classical imbalance between supply and demand – constrained global supply due to sanctions on Iranian oil exports and production bottlenecks in the U.S., combined with rising global demand.
While some investors may be disappointed with the performance of a diversified portfolio, these investors may be inadvertently dancing to a tune that is closer to its end than its beginning. We can’t know for sure when markets will turn, or the exact manner in which a reversal will happen. But while we wait for the music to stop for U.S. stock markets, it seems prudent to utilize asset classes other than just U.S. stocks. This includes (almost) any asset class other than the S&P 500. Because sooner or later the music, and the dancing, will move on to a different venue.
Another common behavioral bias is the anchoring effect. Put simply, the anchoring effect describes the tendency to rely too heavily on a singular piece of data or information when making decisions. Often the anchor is an initial piece of information or something familiar to the decision maker. Taking the concept one step further, anchoring also describes how people consistently fail to appropriately adjust to new information because they are “anchored” to an initial reference point. Exploring how this behavior plays out in everyday life and when making investment decisions will help us better understand what it is as well as avoid some of its unpleasant consequences.
There are many examples of the anchoring effect at play. Two that most people regularly experience involve restaurants and gas stations. To illustrate how anchoring occurs at a restaurant, assume one dining party enters a crowded restaurant and is told the wait time is estimated to be 20 minutes while another party enters and is told the wait time is estimated to be 40 minutes. If both parties are seated after 30 minutes of waiting, it is very likely the party that waited a shorter amount than they were told will be in a much better mood than the other party, frustrated by having to wait ten more minutes than they were told. This is because we all subconsciously anchor ourselves to the initial data point, estimated wait time, and react according to how long we wait relative to that estimate. Thus, it is no surprise that some restaurants will intentionally overestimate actual wait times, creating a better dining experience for the customers.
Another real-world example of anchoring involves gas prices. The price of a gallon of gasoline is arguably the most recognizable of all prices. Each day, drivers see the price at the pump as they travel on America’s roads. What is less well known is how those daily data points affect their psychology. A motorist having to pay $3.00 per gallon for gasoline two weeks after paying $2.50 per gallon feels very differently than a motorist paying $3.00 per gallon two weeks after paying $3.50 per gallon. The first motorist, anchored to $2.50 per gallon, feels as though he is overpaying or wasting money while the second motorist, anchored to a higher price per gallon, feels as though she is getting a bargain. Yet both motorists are paying the same price.
ANCHORING AND INVESTING
What does this have to do with investing? Anchoring can unfortunately have negative effects on one’s investment portfolio and financial life. Three examples of investment- or financial-related anchors include becoming fixated on purchase price, targeting a random level in the market before investing, and using local housing prices to gauge the value on homes in other geographies. Briefly examining each of these examples can help investors overcome the urge to be overly influenced by these anchors when making important decisions.
When an investor purchases an investment, the purchase price, known as cost basis, is often crystallized in the investor’s mind. This becomes a natural anchor on subsequent decisions related to the investment. Cost basis can become a hurdle to overcome for any investment that has declined in value but needs to be sold. Sometimes there are fundamental or market forces that change the merits of holding the investment. Even though an investment declines in value, the projected forward returns on another opportunity may be much more attractive than waiting for the original investment to recoup its value. It is very difficult for investors to take a loss and move on or use the sale proceeds to purchase a more attractive investment. This same dynamic occurs with successful investments that are sold too early because an investor is similarly anchored to her cost basis and struggles to adjust to a potential new reality. The investor may fail to see how the investment can continue to provide attractive rates of return even when a positive inflection point occurs that changes the trajectory of the investment.
Another example of anchoring occurs when investors come into new money, such as an inheritance or sale of a business, and articulate a desire to “wait for a correction” before investing. This could refer to waiting for a 10% or 20% pullback in the stock market or simply be a round number they recall from the past, such as the Dow Jones Industrial Average falling to 20,000. The market may have recently increased, and there is a tendency to anchor one’s strategy to a lower market level that, at present, seems like a bargain. History reveals this line of thinking often results in sub-optimal outcomes as it is foolhardy to predict the market will inevitably return to previous levels. The last several years of strong market performance, when many were skeptical of stock valuations, is a great example of this. If investors are always waiting for the perfect time to invest, they might miss out on receiving dividends on stocks or interest income on bonds, a significant component of total return. Investors’ long time horizons tend to dramatically dampen the effects of bad timing. Finally, if individuals invest in a balanced, diversified portfolio that exhibits much less risk than stock markets, they are much less directly exposed to a correction than they may believe.
ANCHORING AND HOME OWNERSHIP
Outside of one’s marketable investment portfolio, market participants tend to view the nation’s housing landscape through the lens of their local market. It is easy to use familiar, local home values as an anchor when looking at second homes or house hunting during a relocation. The result can be sticker shock for someone moving to more expensive housing markets, such as the West Coast or Northeast. On the other hand, someone moving from a coast to the Midwest might have a hard time passing up a much bigger house with lots of land. Using your local knowledge of one area to decide what is a reasonable price to pay for a home in another market can result in a significant financial mistake. Homes are not easily tradeable, demographic trends vary greatly, local economies grow at different rates, income levels may be wildly different, and location matters. These dynamics make viewing housing prices through a narrow lens and anchored to one’s local market potentially costly.
The anchoring effect occurs daily for almost all of us. Most of the time, the subconscious tendency to rely too heavily on an initial piece of information simply results in fleeting elation, regret, or frustration. However, the anchoring effect can lead to material differences in future outcomes when it comes to one’s portfolio and financial life. Acknowledging its existence and examining how it may influence one’s decision making are key to avoiding anchoring’s negatives. One can seek to counteract the potential negative consequences of this behavioral bias by partnering with a strong team experienced in navigating these tendencies.
“Opportunity is missed by most people because it’s dressed in overalls and looks like work.” Anonymous (though often attributed to Thomas Edison)
2018 got off to a bit of a bumpy start – volatility returned to financial markets and most asset classes posted negative returns in the first quarter. In the second quarter, investors continued to be buffeted by strong cross currents in the news. On the positive side, U.S. companies grew earnings by 26% year-over-year in the first quarter, the highest growth rate in earnings in seven years. Offsetting that good news, investors continued to fret over a potential trade war and the potential for slower economic growth as a result. This was all against the backdrop of the Federal Reserve continuing to slowly reduce its balance sheet and raise interest rates. From a performance perspective, the second quarter offered investors a bit of a reprieve as several asset classes bounced back vigorously from first quarter losses, though fixed income markets had a rough quarter as interest rates continued to creep upwards.
MLPs and REITs are two asset classes that benefitted from dramatic rebounds in Q2. By way of example, following a dismal first quarter of -11.12%, the Alerian Energy MLP, a benchmark for MLP investments, roared back in Q2 posting an 11.80% return. Similarly, following a -7.48% first quarter, Wilshire U.S. REIT, a benchmark for REIT investments, finished with a strong 9.73% return in the second quarter. In a quarter where stocks offered a mixed bag of returns and bond markets struggled, maintaining exposure to diversifying asset classes such as MLPs and REITs paid off handsomely for investors.
Performance in stock markets varied greatly depending upon country, market capitalization, and sector. The best performing equity asset class in the second quarter was U.S. Small Cap (Russell 2000), which was up 7.75%. U.S. Large Cap (S&P 500 Composite) was also up for the quarter, but a more modest 3.43%. Foreign stocks, however, posted losses for the quarter. Some of this loss was due to the strengthening of the U.S. dollar, which had a negative impact on U.S. investors allocating capital in foreign markets. From a sector perspective, energy stocks were the best performers for the quarter, up 10.2%, and financial stocks were the laggards, down 5.6%.
In bond markets, rising rates continued to be an impediment to returns. The Federal Reserve raised rates another 0.25% in June, staying on target for an anticipated one or two more rate hikes this year. The broad U.S. bond market (Bloomberg Barclays U.S. Aggregate) fell -0.16% in the quarter. Short-to-intermediate-term municipal bonds (Bloomberg Barclays Municipal Bond 5Y) held up better in the quarter, posting gains of 0.87%.
We have previously commented in these commentaries that forecasting is hard, and that basing one’s financial decisions on the ability to foretell the future is an often futile pursuit ending in a disappointing result. As an illustration of this difficulty, let’s briefly consider the impact of a rising U.S. dollar and its implications for investors. The dollar strengthening has been driven by several factors. The strong U.S. economy makes the U.S. an attractive market in which to invest, which draws foreign investors and increases demand for dollars. In addition, rising interest rates also draw capital from overseas, further increasing the demand for dollars. The stronger dollar increases purchasing power for U.S. consumers, but it can cause U.S. exports to be less competitive on price hurting U.S. companies that are reliant on exports. So while stock market investors benefit from having foreign investors buying U.S. assets and driving up equity valuations, they also suffer as many U.S. companies lose revenue, either from falling exports or from cheaper competition from imports. Investors buying U.S. bonds due to rising rates in turn drive up bond prices, which mitigates further increases in bond yields. These buyers may be partially responsible for the flattening U.S. yield curve. And all of this is occurring against a back drop of escalating trade tensions and rising protectionism. For anyone trying to develop an investment strategy based upon how this all turns out – good luck.
We’ll continue to do the hard work. Diversifying exposures across a broad range of complementary asset classes. Rebalancing portfolios when needed to maintain appropriate exposures. And remaining as tax-aware and cost-conscious as possible. It’s not as exciting or glamorous as predicting the future. But sometimes boring and reliable, even when dressed in overalls, is best.
Traditional economic theory suggests human beings behave rationally when making decisions. In other words, humans, on average, act in such a way as to maximize fulfillment of their needs and desires. Since earning wealth is assumed to be a good thing, and more wealth is assumed to be better than less wealth, it is further assumed that people make rational decisions in order to maximize their wealth. This rationally acting person is sometimes referred to as Homo Economicus (Economic Man).
However, traditional economic theory often does not match how people make decisions in the real world. Research into Behavioral Finance, led by Nobel laureates Richard Thaler (for Economic Sciences in 2017) and Daniel Kahneman (for Economic Sciences in 2002) has revolutionized the way we think about how people make financial decisions. Instead of being purely rational humans that dwell exclusively in the minds and models of economists, behavioral economists have shown that mankind’s decision making is heavily influenced by emotion and irrationality. However, the real insight isn’t that people make decisions in an emotional and irrational manner, but rather we are all predictably irrational.
Human beings crave certainty and are comforted by feeling right. When we feel certain and right we feel a sense of security and comfort. In order to get this sensation, which is called cognitive ease, we seek out information that is familiar, easy to understand, and validates our pre-existing beliefs. Humans have developed a number of mental shortcuts that help us understand the world while maintaining as much cognitive ease as possible. These good enough mental shortcuts, or heuristics, while not optimal or perfect, are often sufficient to meet our immediate goals. While heuristics ease our cognitive load, they can also lead to cognitive biases that by their very nature are distortions or errors in thinking. Heuristics allow us to experience a sense of cognitive ease, which makes us feel good, but distortions and errors they cause can actually decrease our understanding of the world.
Nobel laureate Daniel Kahneman says our brain has two systems. The first utilizes heuristics and provides fast, intuitive responses that govern most of our daily lives. The second activates cognitive effort and is much more energy intensive. System one, the conscious part of the brain, is kind of lazy and doesn’t want to work more than it has to, so it is just fine with utilizing heuristics to make decisions and explain the world. It’s more than happy to let the unconscious part of the brain do all the work. Because these heuristics and the subsequent cognitive biases they engender operate at the unconscious level, we aren’t even aware of them unless we make a diligent effort to recognize them. In fact, even when confronted with the evidence, our first reaction is to deny that we have these biases. To be human is to have cognitive biases. In this year’s Investment Perspective, we will examine several types of cognitive biases, reflect on the errors they can potentially cause, and propose several methods of dealing with and overcoming these biases which affect us all.
“I’m back baby, I’m back!” George Costanza, Seinfeld (Episode 65, Season 5)
Just when you thought market volatility was a thing of the past, it came roaring back in the first quarter of 2018. After a year of historical market quiescence, when stock market volatility was almost completely absent, volatility returned in the first quarter of 2018. In 2017 the S&P 500 had no days where it finished more than 2% higher or lower. In the first quarter it happened five times (and a sixth time on Monday, April 2). In 2017 there were only eight days the S&P 500 finished higher or lower than 1%. That happened 22 times in the first quarter. This pick up in volatility occurred despite strong economic news (low inflation, low unemployment, and strong economic growth). Some combination of tighter monetary policy, rising interest rates, high equity valuations, and good old fashioned late-cycle market jitters combined to produce financial markets that were significantly more volatile than what we experienced in 2017.
The U.S. stock market, as measured by the S&P 500, declined 0.76%, its first negative quarter since the third quarter of 2015. However, within the U.S stock market some patterns remained similar to 2017. Despite a brief sell-off at the end of March, the Technology sector was the best performing sector for the quarter, up 3.5%. The strong performance by technology stocks led to another quarter of outperformance by growth stocks with the Russell 1000 Growth (up 1.41%) besting the Russell 1000 Value (down 2.83%). Globally, the MSCI-EAFE Index, representing primarily non-U.S. developed market stocks, declined 1.53% in Q1. However, Emerging Market stocks, as measured by the MSCI-EM Index, were a bright spot, up 1.42% through March. Emerging Market stocks have been notable laggards over the last five years, returning only 4.99% annually while the S&P 500 has returned 13.30% over the same time frame.
Fixed Income markets struggled in the first quarter as interest rates continued to rise. The bell-weather 10-Year U.S. Treasury rate rose from 2.40% at the beginning of the year to 2.74% by quarter’s end. More dramatic was the rise in short-term interest rates. The 3-Month LIBOR rate soared from 1.69% at the beginning of the year to 2.31% by the end of March. Over the past year the 3-Month LIBOR rate has doubled, from 1.15% at the end of Q1 in 2017 to the aforementioned 2.31%. This rise in interest rates led to poor performance across a range of Fixed Income markets, with the broad-based Bloomberg Barclays US Aggregate Index falling 1.46% in the first quarter.
Other asset classes that have sensitivity to interest rates also fared poorly in the first quarter. REITs and MLPs both suffered through a very difficult quarter. Parsing the exact reasons behind the poor performance in REITs and MLPs is probably a fool’s errand. Suffice it to say that some combination of high valuations (REITs), concern over the consequences of tax policy (MLPs), and the impact of rising rates all were contributors. Regardless of the exact reasons, it was a difficult quarter for investments that have interest rate sensitivity.
In the last market update we counseled against assuming that 2017’s “Goldilocks” environment would continue into 2018. It only took one month for that advice to look prophetic. Moving forward, it will be important to maintain appropriate portfolio diversification, as we try to do through such strategies such as Reinsurance, Alternative Lending, and Hedge Funds, that have little to no correlation with stocks and bonds. Continued volatility may provide opportunities to rebalance portfolios. And we continue to keep an eye on asset classes that sell off dramatically and offer attractive forward-looking valuations. There’s no use in denying it. Volatility is back!