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?Read More...
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!Read More...
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?
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!
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?
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?Read More...
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.
For many planners, passive and strategic investment management is the way to go. As such planners often point out, the evidence is mixed at best that any money manager can ever consistently generate alpha by outperforming their appropriate benchmark. Accordingly, as those planners advocate, the best path is to minimize investment costs as much as possible (since we know expenses we don't pay is more money we keep in our pockets), and investment allocation changes should only occur via a regular rebalancing process. Yet rebalancing does not always improve your returns; sometimes, it actually reduces future wealth. So if you try to come up with a "passive" rebalancing strategy that only enhances returns and doesn't ever reduce them... does that mean you're actually being active after all?
The debate about which is better - passive versus active investing - has been around for a long time. But in a world of pooled investment vehicles, especially with such a breadth of mutual funds and exchange-traded funds (ETFs), there are technically two levels on which decisions must be made: within the funds, and amongst the funds. Consequently, to describe the approach of an investment advisor, we should ultimately describe the process at both levels, to make clearer distinctions. For instance, are you strategically passive, or would strategically active be a better description. Wait, strategically active? What does THAT mean!?
If there’s one new asset class that seems to have truly caught the imagination of clients, it’s gold. Technology, real estate, and emerging markets have all caught fire for some period of time in recent years, but gold still seems to stir something emotional in us, above and beyond just the pangs of greed that have characterized the other hot investments of the decade. Perhaps it’s the fact that gold is something that theoretically performs well in times of distress; it can serve as a hedge in times of inflation, help protect against the declining value of our currency, and be a safe harbor when everything else is in trouble. Given so much client anxiety about today’s economic environment, it’s not difficult to understand the appeal. In the end, there is perhaps only one significant problem: gold doesn’t actually have any value; it can only accomplish these financial feats of strength because we believe that it can.
