Investments

As interest rates remain low, investors - especially retirees - struggle to find yield wherever they can. Unfortunately, though, the necessity of earning a required return to fund financial goals becomes the mother of invention for a wide range of investment strategies, both legitimate and fraudulent. A recent offering of rising popularity is structured settlement annuity investing, often offering "no risk" rates of return in the 4% to 7% range. In general, the opportunity for "high yield" (at least relative to today's interest rates) and "no risk" is a red flag warning. But the reality is that with structured settlement annuity investing, the higher returns are legitimately low risk; the appealing return relative to other low-risk fixed income investments is not due to increased risk, but instead due to very poor liquidity. Which means such investment offerings can potentially be a way to generate higher returns, not through a risk premium, but a liquidity premium. But the caveat, however, is that the investments are so illiquid and the cash flows so irregular, they probably should at best only ever be considered for a very small portion of a client's portfolio anyway.

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One of the most common criticisms to the use of Monte Carlo in financial planning is its typical assumption that investment returns are normally distributed, when in reality the market appears to go through environments that may be more volatile than a normal distribution would predict, as highlighted by the events of the financial crisis. In the last four months of 2008 alone, the market experienced 20 high-volatility trading days with a standard deviation varying from 3.5 to almost 10... each of which should not have occurred more frequently than once per millenia to once per several billion years. Yet when we look at those returns on an annual basis, we see a very different picture - the one-year decline to the bottom in March of 2009 was a "mere" 2.5 standard deviation event, which is uncommon but entirely probable under a normal distribution. Which raises the question - are "black swans" just a short-term phenomenon that average out by the end of the year, and are we focusing too much on impossibly rare black swans instead of the rare-but-entirely-probable 2 standard deviation decline? Continue reading "Are Black Swans Just A ... »

As the popularity of tactical asset allocation and using market valuation to inform investment decisions rises, so too do the criticisms to such methodologies. In the long run, this is part of a healthy dialogue that shapes the ongoing evolution of how we invest. But much of the recent criticism to being tactical in particular seems to suggest that if we can't get the timing exactly right, or calculate a valuation that works precisely to predict returns in all environments, that it should be rejected. In reality, though, even just participating in a few booms, or avoiding a handle of extreme busts, can still create significant long-term benefits for achieving client goals. Which raises the question - if we're really focused on the long term for clients, are we expecting too much from market valuation in the short term? Continue reading "Adjusting Portfolios Based ... »

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A common complaint about the use of tactical asset allocation strategies - which vary exposure to bonds, equities, and other asset classes over time - is that they are "risky" to the client's long-term success. What happens if you reduce exposure to equities and you are wrong, and the market goes up further? Are you gambling your client's long-term success? Yet at the same time, the principles of market valuation are clear: an overvalued market eventually falls in line, and like a rubber band, the worse it's stretched, the more volatile the snapback tends to be. Which means an overvalued market that goes up just generates an even more inferior return thereafter. However, greedy clients may not always be so patient; there's a risk that the planner may get fired before valuation proves the results right. Which raises the question: is NOT reducing equity exposure in overvalued markets about managing the CLIENT'S risk, or the PLANNER'S? Continue reading "Who's Really At Risk When ... »

In the ongoing search for more diversification - and especially, low correlations as a potential for stabilizing returns in a difficult stock environment - advisors have increasingly shifted in recent years towards "alternative" investments. From real estate and REITs to gold and other commodities to more, a recent FPA survey on Alternative Investments found that 91% of advisors are using some form of alternative investments. Sadly, though, the focus on finding investments that have a low correlation - according to FPA's survey, the number one criteria for choosing an alternative investment - has grown to such an obsession, that we're willing to name anything that has a low correlation as "a new asset class." But the reality is that while some alternatives really are investments that truly have their own investment characteristics unique from stocks and bonds as asset classes, others alternatives - like managed futures - simply represent an active manager buying and selling existing asset classes. Which means it's about time for us to start distinguishing between a real alternative asset classes (e.g., commodities or real estate), and the real value of managed futures.

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Diversification is a fundamental principle of investing - examples of the concept date back as far as Talmudic texts estimated to have been written over 3,000 years ago, stating "Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve." The diversification principle received a further boost in the recent era when Harry Markowitz's Modern Portfolio Theory supported the notion that the volatility of a portfolio may be less than the volatility of its parts, such that the introduction of even a high-return high-risk asset to the portfolio may improve the portfolio's risk-adjusted return (or even outright reduce its volatility). Yet at the same time, both the rabbis of the Talmud and Markowitz would probably agree that the first step of investing your assets is even more basic: make sure you own stuff that has a reasonable expectation of providing a useful return in the first place. Unfortunately, though, we seem to have lost sight of this rule in recent years! Continue reading "Diversification Should Not ... »

Investors in the U.S. have become increasingly numb to the reality of investing here - a world where stocks pay a dividend barely over 2%, and short-term bonds or CDs give a yield barely more than 0%. Accordingly, we have few options for return aside from investing in risk-based assets to seek - or at least, hope for - capital appreciation. Yet the ultra-low returns on everything in the U.S. - necessitating a significant amount of appreciation just to generate a reasonable total return - is not the norm for U.S. investing historically, nor even currently around the world outside of the U.S., as I was reminded during my recent trip to Australia. In fact, I was somewhat shocked while I was there to wonder: how would investing in the U.S. be different if we, too, could get local short-term bank CDs that paid nearly 6%!? Continue reading "Perspectives on Investing in ... »

Psychologists Daniel Kahneman and Amos Tversky won the Nobel prize in economics for developing a theoretical framework to show how we make often irrational decisions when faced with real life economic trade-offs. As a part of their prospect theory research, they showed that we are naturally loss averse; this means we experience more negative feelings associated with a loss, than we do positive feelings for a comparable gain. For instance, we feel worse about losing $100, than we feel happy for winning $100. Yet despite the recognition that this research has received, are we ignoring it in the financial planning world? Simply put: If our clients feel worse about a loss than they feel good about a comparable gain, shouldn't we be more proactive about protecting them from losses, even at the risk of giving up more gains? Continue reading "If Clients Are Naturally ... »

The prevailing wisdom in financial planning is that clients should stay the course... always. It's "never" appropriate for clients to get out of stocks (even a little bit), and the eternal chiding to any so-called market timer is that even if you can figure out when to get out, you'll never figure out when to get back in again, and you'll miss any rally that might follow a market decline. But does this miss the point? If you actually sell BEFORE a severe market decline (as opposed to after), you don't even NEED to get back in until the market recovers anyway! Continue reading "Why Is It ALWAYS Bad To Get ... »

Unless you manage to purchase an index fund that produces zero tracking error, at some point the investments you own will deviate from their associated benchmark. Whether it's the tracking error of an index fund, or the relative under- or out-performance of an active fund manager, returns can vary over time. And while most of us don't fret over small deviations from a benchmark - nor do we mind when the deviation is due to outperformance! - but at some point, a fund may underperform its relevant benchmark by enough, and for a long enough period of time, that you have to question whether it's time for a change. But the caveat is... what IS a big enough underperformance deviation, and how long must it persist, before you actually do decide to make a change? What is the best practice for deciding when a fund has lost its Mojo?

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With the Federal Funds rate as close to "zero" as it can feasibly get, it would seem that interest rates have only one directly to go: up. And given the mathematics of bond investing - as interest rates rise, bond prices fall - many advisors and their clients have decided that the only prudent course is to wait for rates to rise before investing into the bond markets. Yet the truth - as a recent white paper points out - is that there is a cost to waiting, in the form of earning lower returns while waiting for interest rates to rise. Which means to say the least, if you're engaging in a strategy of waiting on bonds for interest rates to rise... you better be right about when and how much they actually do increase!

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In the standard framework of portfolio management, changing a client's exposure to risk is essentially analogous to changing their overall exposure to risk assets. Want conservative growth? Invest in a portfolio with 40% equities and 60% fixed. Want a more moderate growth portfolio? Increase to 60% equities. More aggressive growth? Allocate your portfolio further towards an equity tilt. At its core, the proposition is pretty straightforward: increase your overall portfolio allocation increasingly towards risk assets to increase the overall risk (and hopefully, return) profile of the portfolio. But what if there was another way to increase overall risk? What if, rather than increasing overall risk by adding a little risk to the whole portfolio, the risk was increased by adding a lot of volatility to a very small portion of the money?

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As the terms "being tactical" or "tactical asset allocation" become increasingly popular, more and more advisors now must decide whether they, too, are "tactical" or not when describing their investment process and philosophy to current and prospective clients. Traditionally, the dividing line was simply whether one was active or passive, a determination that could be made pretty clearly by looking at the portfolio: were there a bunch of actively traded stocks and bonds, or a series of actively managed mutual funds that did the same thing? With tactical, though, it's no longer sufficient to simply look at whether there are stocks and bonds in the portfolio, or actively managed mutual funds; instead, some tactical investors implement their strategies by selecting only passive index funds, but still utilize them in an active, tactical process. Which begs the question: where exactly do you draw the line on being tactical? Continue reading "What Does It Take To Be ... »

Rebalancing is a investing staple of the financial planning world. The execution of a rebalancing strategy helps to ensure that the client's asset allocation does not drift too far out of whack, as without such a process a portfolio holding multiple investments with different returns would eventually lead to a portfolio that increasingly favors the highest return investments due to compounding. Yet in practice, most financial planners often discuss rebalancing not only as a risk-reduction strategy (by ensuring that higher-return higher-volatility assets do not drift to excessive allocations), but also as a return-enhancing strategy. However, in reality, there is nothing inherent about rebalancing that would be anticipated to generate higher returns... unless you get the market timing right.

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