Comments on recent market volatility

The recent increase in market volatility has been caused primarily by two factors: 1) recent renewed concerns about Europe’s economy and debt problems, and 2) intensified concerns over the U.S. fiscal cliff. With respect to the European situation, our read is it has not changed substantively from our last commentary we provided to you in September. Europe is in the painful throes of a long process of addressing its debt and economic problems.  Europe is in a recession and more recently the recession appears to be having a greater impact on Germany, which has been fairly immune up to now.  Within the past week, the Greek debt crisis has resurfaced because Greece has a major debt payment due this month which, of course, it cannot make without further IMF loans. Also, this week the economic outlook for France has come into question. All of this has raised concerns for investors, but none of it is really “new” or particularly unexpected.

We have believed and still believe that Europe will continue to make slow progress in addressing its debt and economic problems, but that the process will a) take years and b) will be turbulent from time to time. As we have stated previously, we are encouraged by recent moves by the IMF and ECB to provide increased liquidity to the Euro monetary system as well as a backstop facility for debt held by major European banks. This will help to buy time as Europe continues to wrestle with its debt problems.

The problem of the U.S. fiscal cliff is not “news”. We pointed out in our September commentary that we expected increased investor focus on the cliff following the election and that this would result in increased market volatility. This has occurred. The concern for investors is the increased risk of economic havoc and recession should the cliff issue not be addressed or addressed too late. We were encouraged by President Obama’s comments on November 14 in which he went out of his way a couple of times to acknowledge the opposition view, which may intimate a greater willingness to make a pragmatic compromise.

We think a compromise on the fiscal cliff can and will be reached, hopefully by Christmas, for the following reasons: 1) a newly re-elected President is in a stronger position to broker a deal; 2) we believe President Obama wants to leave a strong legacy and will be motivated to make a reasonable compromise happen; 3) it is highly politically risky for Republicans in the House to remain overly obstructionist; 4) given the gravity of the cliff, there is and will be significant pressure on both the House and President to reach a compromise.

While we expect market volatility to continue for a while (and the market may go down a bit further) we remain optimistic on the ultimate outcome of the cliff issue. We therefore continue to advocate staying the course and we do not feel now is the time for drastic changes in strategy. We would also reiterate that trying to time the market to play short term trends is not only extremely difficult but is also risky because it can place a well-designed portfolio strategy and financial plan at risk should short term guessing on market direction prove to be incorrect. Also, quality, large-cap stocks remain attractive with underlying support found in reasonable valuations, strong cash flows, and our expectations for continued earnings growth in 2013. As always, we are monitoring these events and we are prepared to take action if we believe events so warrant.

 

Arcane Economic Indicator Could Affect You

Recently, there has been increasing discussion and debate in the financial community about a concept in economics known as “monetary velocity” (or “MV”). MV is rather arcane and is not something most of us think about every day. But it is important to you and me. Here’s why.

MV measures the turnover or cycling of money within the economy. Economists are interested in how fast money “turns over” within the economy because it provides a measure of how efficiently money is being used to support economic growth. It also tells us something about the behavior of the economy.  MV normally increases in periods of economic growth and declines during and for a while following recessions. The efficiency (or “power”) of money within our economy can have an important impact on both economic growth and inflation.

What is most interesting now is MV has recently been hitting new record lows. The Federal Reserve Bank of St. Louis recently issued data showing velocity of M2 (currency in circulation plus checking accounts and money market funds) declining to 1.58, a reduction of over 30% from levels achieved in the late 1990s and well below the long-term average of about 1.8.

So who besides economists cares about 1.58 or whatever the number is? To the extent velocity is low and remains low, it may imply that money within the economy may not be as effective as it could otherwise be in supporting growth. It is also part and parcel of where we are with our economy now: slow, low spending, low investment, etc. Low MV has a few other implications: in addition to restraining economic growth, it can reduce the effectiveness of monetary policy and it can act to restrain inflation, which remains low. Some economists suspect the low MV we are currently experiencing may be blunting the impact of the Federal Reserve’s recent massive monetary stimulus program (aka “quantitative easing”). Our sense is low MV will be with us for a while due to such factors as demographics, below-average job growth, and a new era of constrained credit.

So much for the economics lesson. How might low MV affect financial planning and investments? To the extent one believes low MV may portend continued slow economic growth, this could support an investment strategy that emphasizes higher portfolio income as well as increased exposure to investments in faster-growing economies and growth stocks that are less reliant on the economy. From a financial planning standpoint, while we can achieve these “tilts” in portfolio investments, we advocate that it be done as part of a well diversified portfolio structured to achieve client goals while minimizing risk (volatility). This can be achieved through exposure to multiple asset classes and favoring sectors that would offer the greatest probability for above average returns.

60/40 At Record Low Yield

We recently reviewed an interesting analysis of the history of the yield on a 60/40 portfolio going back to 1878. This portfolio is allocated 60% to stocks (equities) represented by the S&P500, and 40% to fixed income (bonds) represented by the 10-year U.S. Treasury bond. “Yield” is a measure in percentage terms of the cash flow generated by the portfolio (from interest and dividend payments) relative to total portfolio assets. It is not the same as total portfolio return, which includes both yield as well as capital appreciation (or loss). A 60% equity, 40% fixed income portfolio has been long-used as a “benchmark” or default allocation for retirement investing.

Here is what is interesting: the median yield on this portfolio going back 134 years is 4.2%. On August 31 of this year, the yield on this portfolio reached a record low of 1.98%. The last peak yield in this portfolio was in 1983 at about 9.8% (interestingly about the same level as the peak in 1932).

Why is this so fascinating?  Because 1) it offers an important historical perspective, and also 2) because it has several important implications for investing looking forward, which include:

§  Bond yields, now at record lows, offer very poor return option currently. They may still be required as a means of preserving capital but at a high opportunity cost.

§  Because bond prices move inversely to interest rates, current low bond yields combined with  declining bond prices when rates go up could result in the forward returns on a passively managed 60/40 portfolio below that of the past ten-years’ actual annualized return of 6.9%.

§  In order to achieve higher portfolio returns, investors may have to incur (and tolerate) higher  risk by increasing their holdings of equities and embracing greater flexibility in asset allocation.

Expected portfolio return is an important element in financial planning.  It has an important bearing on the outcome and probability that one will have enough capital to fund their retirement through life end. The current historic low bond yields are a conundrum. Several ways in which we can work to offset the lower bond returns is through utilization of higher yielding bond “surrogates” such as utility stocks or preferred stocks. There are also options for investing in higher yielding foreign bonds, particularly those of stronger emerging market economies. Also, conservative higher yielding equities, such as telecommunications or certain energy stocks, can also offer yields that can help to improve forward portfolio returns without incurring significantly increased risk. Holding higher-yielding equities can also offer some hedge against inflation as companies can raise dividends on stocks, but cannot raise the interest payment on a bond.

60 Years and Counting

We were encouraged to see recently that John Bogle, the founder of Vanguard Funds, has come out with a new book entitled “The Clash of the Cultures”. Bogle has been in the investment industry for 60 years. He has seen it all, the good and the bad. He was an early advocate of low-cost index fund investing, which was the premise on which he founded Vanguard Funds. It is a good thing for our industry that people like John Bogle and Warren Buffett have lived so long and experienced so much and are willing to share their experience and insights with us.

Bogle’s book is highly critical of the financial services industry, primarily because of what he believes has been a) too great an emphasis on short-term thinking (meaning “trading” or speculating over sound fundamentally-based investing), and b) the industry placing too great an emphasis on its own profit at the expense of the investor. This has come into particularly stark focus in the wake of the events of the past 5-10 years. Some of the investment insights he points out in his book are important:

               

·         Despite the problems our economy is now experiencing, Bogle believes long term investors need to hold stocks to capture growth.

·         The outlook for bonds is abysmal, but alternatives are hard to find.

·         Investors need to have a long-term view and stay the course. Trying to time or second-guess the markets is a losing proposition.

·         Everyone in the industry needs to adopt a fiduciary standard that puts the interests of the client first.

From a financial planning perspective, we could not agree more with Bogle. The abuses of our industry over the past ten years have hurt not only individual investors but the economy as a whole, and while as a nation, we have started to make some progress on addressing these issues, the healing process will take many more years. With respect to investing, we agree with Bogle that diversification and a long-term view are critical elements of successful investing. As financial planners, we believe adequate diversification of client portfolios is a cornerstone of good investing to not only reduce volatility but also capture returns of multiple market sectors. Fundamental research is important not only in identifying attractive investments, but also in maintaining and supporting the fiduciary standard which Bogle advocates: basing decisions on reasoned logic and avoiding speculation. We also believe that time mitigates risk, which supports the importance of long-term investing. Why? Because data on long-term economic trends allows us to place greater confidence in developing a financial plan and investment roadmap and incorporating that confidence into the discipline that a sound financial plan provides.

A “New Paradigm” ?

The Wall Street Journal recently ran an interesting op ed written by Burton Malkiel entitled “Even Amid the Current Turmoil, Stocks Still Beat Bonds”. Malkiel is the Princeton prof who wrote the book “A Random Walk Down Wall Street” and is considered one of the pillars of the Efficient Market Hypothesis (EMH). EMH states that the stock market is completely efficient, discounts all that is known about a stock in the current price, and that it is impossible to outperform the market through trading or investment schemes.

To be sure, EMH has come under question in recent years but Malkiel has been around a long time and is well respected in our industry and I believe his opinions carry some weight. The important points about Malkiel’s article were these:

1.       He believes equities today are more attractive relative to bonds than at any other time in history.

2.       He believes fixed income investments will never earn the returns necessary to meet retirement or pension fund planning objectives.

3.       He believes “the only hope” for generating returns necessary to meet retirement planning goals is to increase investment allocation to equities.

While we agree with Malkiel, the notion of holding more equities at or near retirement flies in the face of a long-held “law” of retirement planning, namely that one should hold a large fixed income allocation at or near retirement. While holding more equities may increase long-term returns, higher equity weightings will result in greater portfolio volatility which increases investment risk.

So for us as financial planners, we are sort of in a “new paradigm”: while increasing equity weightings for retirees may now present a more expedient strategy, the question becomes how do we mitigate the risk of higher volatility which would accompany higher equity exposure? We do this in a number of ways:

§  Make sure client portfolios are adequately diversified both by asset class and market sectors

§  Emphasize income in our investment model as higher portfolio income helps to reduce volatility

§  Take care to understand the risk tolerance of our clients and how this translates to their investments

§  Base investment decisions on fundamental research and reasoned logic

§  Identify and invest in undervalued sector opportunities

§  Make sure all clients have a sound financial plan that keeps them on the proper roadmap particularly with regard to their investments. This reduces the risk of emotionally-driven decisions that can destroy the effectiveness of a sound financial plan.

“It’s All Doom and Gloom……”

I ran into a friend at the gym yesterday morning. He is retired and is one of those types that looks at and worries about his portfolio every day. So he stops me and exclaims “Bob….did you see [xyz morning financial show] this morning?! It’s all doom and gloom ! We’re hosed!....”  Of course, this gentlemen, whose intelligence I respect, is pretty much entirely in cash now and has been for some time.

So why is my friend all in cash? Fear. True, the xyz morning financial show was highlighting all the negatives that morning: Europe, Greece, Spain, fiscal cliff, high unemployment, etc. We agree these are serious issues, but the media always highlights the negative, and why not? Negativity sells, it provokes anxiety that keeps people watching….and that sells commercials (remember, the financial news media is in business to make money selling commercials, not providing quality investment advice).

Now, I am not saying my friend is wrong to be primarily in cash. If he sleeps better at night that is important and he may be correct that it is the end of the world. But we doubt it. A few points we would make with respect to all this:

1.       Recent investor surveys reflect a very low level of bullish sentiment currently, levels that many times in the past have proven to be a bullish contrary indicator for stocks.

2.       Stock valuations are not excessive and many sectors in the market remain attractively valued.

3.       Monetary conditions, namely Federal Reserve policy, remain accommodative, which historically has been positive for stocks.

4.       The U.S. corporate sector, reflected in profit margins and cash flow, is very healthy currently, and corporate earnings are forecast to grow this year and next.

5.       We believe Congress will address the fiscal cliff issue.

6.       We believe Europe will find a way out of its ugly morass.

7.       No question, the general risk environment is higher than normal, but ‘twas ever thus…..there are always risks in investing and no one has a perfect crystal ball, but historically the best time to invest is when there is rampant fear and uncertainty.

So should we all be like my friend and be all in cash now? From a financial planning perspective, we believe there are ways to capture what we believe is an attractive risk/reward for stocks while being able to sleep at night. How?

1.       Have a solid financial plan that provides sound spending, savings, and investment roadmaps.

2.       Diversify your investment holdings in order to capture returns of multiple market sectors and also reduce portfolio volatility.

3.       Establish an asset allocation that allows you to capture the growth opportunity in equities while also reflecting your risk tolerance.

4.       Focus your equity investments on quality, dividend-paying and undervalued sectors of the market.

5.       If you are baffled by the market and are uncomfortable with handling your own investments, seek the advice of a qualified and experienced financial planner or advisor.

Growth vs. Value

Part of our daily research includes reviewing financial news that may impact our firm’s investment strategy. We recently came across an interesting article discussing the current disparity in relative valuation of growth stocks compared with value stocks (the link to the article can be found below). “Value” stocks are generally considered to be lower P/E, lower growth, higher-dividend paying stocks, while “growth” stocks are generally considered to be higher P/E, faster-growing companies that pay little or no dividend. The article notes that valuations for growth stocks are now quite low relative to historic relationship to value stocks (this is also supported by work from some of our other research sources).

So what’s the big deal about the valuation disparity of growth vs. value? Answer: the disparity may provide a strategic investment opportunity in favor of growth. Over the past several years, many investors have been favoring high-dividend, primarily large-cap stocks for obvious reasons: fear of volatility associated with smaller-cap stocks; an alternative to declining bond yields for those seeking income; reduced risk tolerance on the part of many investors. This has resulted in compression in valuations for growth relative to value and, hence, has led to the valuation disparity.

From a financial planning perspective, we advocate a diversified portfolio approach; we can and do adjust our allocations to growth and value based on relative valuations and relative performance; and we also seek the higher risk-adjusted returns. As an example of this, we recently changed our mid-cap equity exposure in favor of growth vs. value in order to capture what we believed is a valuation disparity noted above. Because mid-cap stocks are larger in market cap and, as a group, pay higher dividends than small cap stocks, favoring mid-cap stocks over small caps offers the benefit of both higher portfolio income and reduced portfolio volatility. At the same time, holding a diversified index of mid-cap growth stocks as part of a larger, well-diversified portfolio helps our clients achieve their long-term goals by capturing the return of this sector (which has significantly outperformed the S&P500 over the past 5 years) and thereby targeting a superior risk-adjusted return.

Link to article: http://finance.yahoo.com/video/sponsored-26302475/growth-stocks-are-a-coiled-spring-says-nuveen-s-mullinix-30110011.html#crsl=%252Fvideo%252Fsponsored-26302475%252Fgrowth-stocks-are-a-coiled-spring-says-nuveen-s-mullinix-30110011.html

How Long ?

There has been a lot of talk in the financial media lately about the notion that stocks may be in an “extended trading range” like that of the 1970s. What that means is the market remains essentially flat for an extended period, perhaps a couple of years or longer, while churning up and down within a wide price range. The case for this view is based on the belief in an extended period of very slow economic growth (or no growth) which results in very slow or no growth in corporate earnings.

One big question being asked now is “how long will this trading range environment last”? It is interesting to note that the market, as measured by the S&P500, has more than doubled since March 2009 bear market low. It has done this in three waves accompanied by some rather unnerving corrections. Corrections are normal for the stock market: the median decline for the stock market in any given year over the past 85 years has been about 13.5%. So pullbacks of 5, 10, or 15% are quite normal and do not mean we are in a “trading range”.

There are a number of reasons to believe the “extended trading range” scenario may be too pessimistic. First, we think there will be tremendous pressure on Congress and the President (whoever that is) to take action in 2013 to address the fiscal cliff issue and place the U.S. on a stronger footing financially. We also expect improved clarity on government policy particularly with respect to health care. These actions would provide companies more confidence in forward planning which should improve the pace of hiring in the U.S. Also, the current financial health of large U.S. companies is a factor working in the economy’s favor because of their ample resources available to accelerate investments and hiring under the right conditions.

Whatever your view on the extended trading range question, the strategy should not change from a financial planning perspective. We believe the current environment still calls for investing in diversified, balanced portfolios of high quality stocks and bonds, favoring equities now, and with adequate geographic diversification to capture faster growth of markets outside the U.S. We would also emphasize the importance of sticking with a sound financial plan. While markets will fluctuate as they always do, sticking with a sound plan will 1) keep you on track relative to your investments; 2) help keep you from the temptation of trying to time the market or make emotionally-based decisions that can sink a plan and an investment portfolio; and 3) provide the peace of mind of knowing you have a roadmap which reduces guesswork, conjecture, and flip-flopping on your investment strategy, all of which adds unnecessary stress to your life.

A New Marshall Plan

How long will it take the Europeans to figure it out? Watching the day to day events coming out of Europe is like the drip of water torture. No wonder the financial markets are facing such day-to-day volatility. It is clear what the Eurozone members need to do and do fast: craft a master bailout plan to 1) backstop the government debt of the PIIGS (Portugal, Ireland, Italy, Greece, Spain) and 2) shore up the capital of the healthiest banks and let the weakest banks go. How could this happen ?

Obviously financial resources of all G-20 countries would be required: $3, $4, $5 trillion?? The current Euro bailout facility of about $1.6 trillion is not adequate. The capital is available amongst the G-20 central banks. The new facility would be a larger reserve that would backstop the debt of the PIIGS as a long-term workout plan is implemented. A comprehensive workout plan, including austerity measures, could serve almost as a second Marshall Plan (the first was implemented to re-build a decimated Europe after World War II). A comprehensive plan like this would go a long way to restore confidence in the capital markets. 

Our belief is the Eurozone members will eventually work out a plan that has some of the elements described above, but timing and structure remain highly uncertain. We believe the Europeans understand the gravity of the situation, but of course, political pressures can affect decision-making, timing, and ultimate outcomes. In the meantime, from a financial planning perspective, we continue to advocate investing in a highly diversified portfolio that provides exposure to global growth opportunities and delivers above average income. Both the diversification aspect and higher income component of the portfolio will help to reduce its volatility while providing opportunity for return in a “trading range” environment. While slower growth may be with us for a while longer, appropriate asset allocation and diversification with a tilt towards higher income will help investors weather this slower growth period and be positioned for improved market conditions, which we expect eventually.

Let’s Get Radical

We’ve noted a number of articles lately about the prospects for rising retirement ages for the baby boomer generation. It’s all over the media these days. Some articles now estimate many boomers may be working well into their 70s. To anyone who has given it much thought recently, this should come as no surprise. The facts are pretty sobering:

§  The Federal Reserve recently reported that the median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed to maintain its standard of living in retirement.

§  The Fed reported that the median 401(k) plan held only $149,000, according to the Center for Retirement Research, an amount that would be virtually impossible to retire on.

§  AARP recently reported that one in four older workers exhausted all their savings during the recession with a growing number of older Americans facing bankruptcy.

§  Recent studies have estimated Social Security will run out of money by 2033.

This situation has several implications from a financial planning perspective:

1.        It is obvious that extending the retirement age will have to be an option for many Americans and that the notion of an easy life of leisure after age 65 is probably now a pipe dream for many if not a majority of baby boomers (one problem with this: it is unlikely the economy can create enough jobs to support all the boomers who will need one). 

2.        “Radical” notion: traditional asset allocation models may be a thing of the past.  The traditional strategy of transitioning a portfolio to bonds in retirement will not provide the returns necessary to enable retirees to meet their spending goals. People will need more growth investments in retirement, which means holding more equities in retirement than has traditionally been the case. This implies retirees are going to have to stomach greater portfolio volatility which many may find distressing.

3.       Global balance with emphasis on large, quality companies. The not so radical notion from an investment perspective is to increase portfolio emphasis on large, quality, globally diverse companies that can capture growth of faster-growing economies and translate that into higher earnings, dividends, and cash flow for investors.

4.      Increase cash flow from your investments. Cash flow has become a new mantra in the investing world and for good reason: it pays the bills. Creating greater cash flows in portfolios can accomplish several things at once: a) increase spendable income; b) reduce portfolio volatility; c) create a rising income stream through dividend increases.

5.       Another “radical” notion: save more, spend less. Granted, this is easier said than done, but this discipline will have to be embraced given the prospect of lower stock returns and Social Security cutbacks. Without a grasp of what is realistic, the American “dream” is turning into a nightmare for many. With proper planning and renewed saving and spending discipline, many people can achieve a comfortable retirement. But the boomers have always changed the rules, and this generation will probably change the rules that have defined “traditional retirement”.

Europe Again ?

The stock market has taken a bit of a breather during April due to concerns over corporate earnings, moderation in economic growth, and concerns over the potential for a repeat of the last two years in which the market peaked in April. So far this month, corporate earnings have been good with about 80% of reporting companies exceeding analyst forecasts. Also while some recent economic indicators have been a touch softer, it is normal for economic data to modulate throughout a cycle and the data would not portend a new recession or serious slowdown.

The other problem? Investors have begun to fret again over the European financial situation. This started several weeks ago when both Spain and Italy experienced a significant increase in interest rates in issuing sovereign bonds. Spain recently indicated that its fiscal deficit this year would be higher than expected. Greece downgraded its forecast for economic growth. Political developments in France have raised concerns that potentially new leadership there would not be as supportive of austerity regimes in Euro countries.

While investor concerns regarding Europe are warranted, in our opinion, they may be overdone. Let’s look at a few facts:

1)      U.S. combined import/export trade with EU countries is about 4% of U.S. GDP and about 13% of total U.S. import/export trade. These are not levels which have the potential to dramatically impact U.S. growth or drag us into another recession by itself.

2)      The U.S. economy is large, diverse, and resilient enough to generate self-sustaining growth without high levels of demand from Europe.

3)      The U.S. is experiencing rising export demand from developing and emerging economies.

4)      The IMF and World Bank have recently boosted the European financial rescue fund to $1.7 billion (increasing protection for European banks).

5)      Many economists believe Europe could emege from recession by early 2013.

6)      The outlook for corporate earnings in both the U.S. and many developing countries remains positive.

From a financial planning perspective, one of the best ways to insulate against the risk of the European crisis is to properly diversify portfolios by both asset class and by country and industry sectors. Underweighting exposure to the Euro countries is still appropriate, in our view. Overweighting exposure to areas like emerging Asia, Latin America, and the U.S. can provide portfolios adequate exposure to growth. Also, a good financial plan takes into account the fact that there will undoubtedly be good and bad periods for which one can plan. In addition to proper portfolio diversification, tools like Monte Carlo analysis and gaining a deeper understanding of client risk tolerance can increase confidence in a plan during periods of volatility while capturing returns in more attractive market and geographic sectors.

The Income Conundrum

We recently held our first quarter investment committee meeting. From a macro perspective, we continue to believe the near term outlook for interest rates and inflation remains relatively benign. While we believe inflation will eventually accelerate, given continued high unemployment, low wage growth, accommodative Federal Reserve policy, and slack capacity utilization, we believe the prospect for a significant acceleration in inflation is still a ways off.

With respect to equities, we remain generally positive. We see further evidence of improvement for the U.S. economy reflected in recent employment growth, retail sales, consumer confidence, and durable goods orders. Additionally, the U.S. housing market appears to be in a bottoming process and Europe’s recession appears to be milder than expected. Large corporations continue to generate high profit margins and cash flow, which we believe will continue to support capital investment, dividend increases and share buybacks, all positive for U.S. equities. A couple of macro risks that bear watching include the potential for an escalation of the situation in Iran as well as slowing of the economy in China.

An interesting feature of the current environment is the very low yield on bonds. This has created a conundrum from a financial planning perspective for people who have counted on bonds to deliver a steady stream of retirement income. With yields so low for bonds, alternatives to bonds may have to be considered. These alternatives include equity securities such as preferred and utility stocks, high dividend stocks, and high yield bonds, all of which entail higher volatility (risk).

So the question becomes “are we in an environment in which people must take on more risk to achieve their income goals?” Perhaps, but there are ways to improve portfolio income (and growth) without having to take on significantly more risk. How can this be done? In a word, “diversification”. Through diversification a portfolio can be structured that is appropriately allocated with respect to major asset classes (stocks, bonds, real estate, etc.) but that also provides a higher income component through incorporation of higher dividend stocks and higher income alternatives to bonds.  In this way, the potential for higher volatility arising from holding more equity-type investments can be offset by asset class and geographic diversification and by holding a diversity of asset types that have low correlation to each other.

Warren Buffett: Stocks Are The Safest Asset ??

Warren Buffett recently penned an interesting article for Fortune Magazine discussing his thoughts on why stocks present a better long-term opportunity than gold or bonds.  The article was such as gem because it provides great insight into Buffett’s way of thinking about investments. His point in a nutshell is this: the most important element of a sound investment is its ability to enable the owner to maintain long-term purchasing power (i.e., stay ahead of inflation). He also points out that the “risk” of an investment should not be measured by its volatility but rather by the probability that it fails to maintain or increase purchasing power over the expected holding period. This is not the way most people look at investments.

He believes owning stocks of quality, dividend-paying businesses (both public and private) are the best way to achieve the objective of maintaining long-term purchasing power. Gold can’t do this because it does not produce anything, such as a cash dividend. Bonds can’t do it now because of the fixed nature of their cash flows and very low returns currently. Therefore, to Buffett, stocks offer the “safest” investment because they have the highest likelihood of delivering returns that will maintain or increase the owner’s long-term purchasing power.

For financial planners, Buffett’s concept of investing has important implications. One of the most important objectives in planning and investing for clients is maintaining purchasing power over long periods, in many cases, decades. We do this through owning equities (common stocks), just as Buffett points out, because they deliver the elements important in maintaining purchasing power. We also invest in stocks because they are highly liquid and provide flexibility in customizing and fine-tuning portfolio investments and providing adequate diversification. Another important aspect of Buffett’s philosophy is the need to plan and think for the long term. By thinking long-term, as Buffett does, the client has a much-improved chance of achieving his/her financial goals and mitigating the impact of short-term market fluctuations.

We would hasten to point out, however, that as financial planners, we do believe bonds and commodities, such as gold, play an important role. Why? Because these assets have low correlations with stocks and thereby offer the benefits of diversification. By incorporating stocks and bonds together in a diversified portfolio, you can provide the growth necessary for a successful plan, while reducing the volatility of the portfolio.

If you have a chance to read the article, we would highly recommend it. Here is a link to it: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/

.

20-Somethings Worried About Retirement ????

……………In Our Continuing Series: “Am I Prepared?”

CNBC ran an interesting article recently that discussed concerns surrounding retirement savings for young people in their 20s and 30s. A few of the key findings in the article:

·         Gen X’ers (people in their 30s and 40s) are less prepared for retirement than baby boomers

·         Young workers do not have a great deal of knowledge about the basics of investing

·         Many younger people are not confident about investing their money or the ability to grow their retirement assets through investments (or should they even invest at all ?)

Given the worrisome projections for social security, the weak economic recovery, and watching their parents’ portfolios implode twice in the past 12 years, the concerns of this age group are understandable. But despite the recent negatives, the options are not as “dire” as many in this age group may currently believe. Here are few reasons why:

·         Time is on their side: people in their 20s and 30s have investment horizons of 30-40 years. This long time horizon mitigates risk by ameliorating the impact of short term market volatility.

·         Most of the world is still focused on growth and prosperity. Global growth of capital investment and business should be positive for global stocks, which provide a source of growth for investments.

·         Valuations for quality stocks are now at multi-decade lows. This implies that the risk/reward for investing in equities is attractive.

·         Despite the market volatility of recent years, over the long-term, planned and intelligent investing has delivered good returns (for example, over the past 100 years, large-cap stocks have delivered annual returns of about 10%).

·         There are many resources available both on-line and off that can help these individuals better understand their options for retirement savings and investments.

Now, about that plan………

Just as in starting a business or performing at your job, creating a simple plan can make a big

difference in getting you closer to achieving your retirement goals. What can you do to get into action ?

·         Start saving now: do a simple budget and determine what you truly need to live on and what you can save. The goal of saving 10% of your gross income is a good one. If you can’t save 10%, try for 5%.

·         Educate yourself. There are many resources now available on line that can provide a good basic understanding of the fundamentals of investing. Investopedia.com has some great information and investing tutorials that are very helpful in gaining a basic understanding of investing.

·         Contact your plan sponsor. If you have a 401k plan at work, the plan sponsor is required to provide ongoing education to its plan participants. Education should be available to you through your plan sponsor’s website or service representative or your HR department.

·         If you truly cannot get help or are completely befuddled as to where to start, you may want to contact a financial professional in any number of venues such as banks, brokerage firms, or financial advisory firms.

As financial planners, we design and implement comprehensive financial plans for all our clients. True, most of our clients are further along in their “investment lives” and may be older and have different needs than people in their 20s and 30s. However, the discipline of having a strong financial plan (or a “plan”) and sticking to that plan for the long term is essential for our clients to reach their goals. The benefit of having a plan is no different for someone in their 20s and 30s. That age is a great time to begin investing and there is every reason to be optimistic that by spending a little time educating oneself and establishing a savings and investment plan in one’s 20s and 30s, they will reap the long-term rewards they are seeking.

Another way in which we at our firm can help a younger investor is through a concept we call “vertical planning”. This is where we will take on as a client a relation or family member of an existing client even if the new clients’ assets fall significantly below our minimum. The established relationship with the existing client (who is a family member) gets them “in the door”. If a young person has a relative or family member that has an existing relationship with a financial advisor, this may be an avenue for that person to obtain assistance and education in beginning a life-long investment program and financial plan.

In our next post, we will elaborate a bit more on the importance of portfolio diversification, asset allocation, and investment horizon and how these impact the retirement and investment planning process and outcome.

Improving Transparency

The Federal Reserve today, for the first time, provided guidance on interest rates and an official estimate of inflation as part of its regular FOMC meeting. The Fed announced that, given its expectations for continued sluggish economic recovery and elevated unemployment, it does not expect to raise interest rates until 2014. The Fed also provided for the first time a specific inflation target of 2%.

There are a few important messages in this announcement. From a purely economic perspective, it is clear the Fed remains concerned about the pace of economic recovery and, at least for now, it does not view inflation as a problem. From the perspective of “communications”, there are also a couple of important messages. The Fed is trying to provide improved “transparency” to investors which, in turn, it believes will increase confidence in businesses’ willingness to make capital investments and hire new employees. Improved transparency should foster a higher level of trust in the Fed, or at least reduce the level of conjecture and uncertainty surrounding Fed policy which has greatly added to market volatility over the years. The idea here is improved transparency may reduce systematic risk to some degree.

So if the Fed is correct in its forecast for interest rates, there are number of issues that come up from a financial planning perspective. Sustained low interest rates reduce returns available from bonds which hurts individuals who may need higher levels of bonds in their portfolios. Lower returns may also force investors to rely more on certain equities for income, which could increase portfolio risk

As financial planners we can mitigate these risks in a number of ways. Investing in bonds issued by certain foreign countries can be a source of higher yields. For example, bonds issued by certain emerging market countries offer good credit quality at significantly higher yields than investment grade U.S. bonds or Treasury bonds. Certain categories of corporate bonds can also offer higher yields than U.S. Treasury or agency bonds. Investing in certain sectors of the equity market, such as preferred stocks, utility stocks, REITs, and quality high dividend-paying equities can also be a way to enhance portfolio cash flow or meet portfolio income requirements in the situation of very low bond yields, which we are experiencing now.

Striving for improved transparency has implications for financial planning as well as Federal Reserve policy. Greater transparency of things like plan goals and objectives, investment strategies, custodial relationships, financial statements, and accessibility, goes a long way to enhancing trust between client and financial planner. Given the headlines of the past few years, we can understand why people would be looking for greater transparency from their financial advisors. As the Fed is realizing, improved communication with important constituencies can not only increase trust, but also reduce risk.

Risk Management

……In Our Continuing Series “Am I Prepared?”

The past several years have been trying for many people planning for or entering retirement. The volatility of the financial markets has created angst and fear as people have watched the value of their capital fluctuate. Additionally, many peoples’ portfolios have not recovered fully from the 08-09 bear market. What these conditions have really driven home is the element of risk in investing, in this case, downside volatility. The great bull market of 1980s and 1990s created an environment in which risk was all but forgotten or downplayed. The focus then was a pro-risk, gain or greed environment, typical of bull market psychology. Now the focus is on risk avoidance driven out of fear of capital loss.

What is risk ?

Most of us would consider “risk” in the context of potential for downside or loss, in this case capital. There are a numerous factors that contribute to risk in investing, not all of which can be easily quantified. Some of the more common “macro” risks include economic risk, geopolitical risk, country risk or industry sector risks, interest rate risk, currency risk, inflation/deflation risk, valuation risk, etc. On a more “micro” level, some of the more common risks include company-specific risks or portfolio exposure risks. All of these factors create volatility in the markets.  

How do we deal with risk ?

 As financial planners, one of our most important responsibilities to our clients is to properly assess and manage risk in their investment portfolios. We do this by taking time to understand clients’ needs, goals, and lifestyle preferences, and carefully assessing their attitude and tolerance towards risk. This has an important bearing on the allocation of the assets in their portfolios which, in turn has an important impact on portfolio volatility (or risk).

Other ways in which we assess and address risk include: diligence in studying and understanding the overall market environment and the economic factors driving the markets; portfolio diversification; reducing exposure to company-specific risk through the use of index and/or exchange traded funds; portfolio hedging; and developing a sound financial plan. As we’ve said before, a sound plan helps to keep a client’s investments on course to achieve long term goals and reduces the risk of buying or selling at exactly the wrong time (otherwise known as “human emotions” risk).

Risk is part of investing, there is no way to get around this (even bank CDs have risk, albeit small). And there are always going to be major events and surprises that none of us can predict. In the end, the best way to mitigate risk is through proper portfolio allocation, understanding your risk tolerance, understanding and accepting what you don’t know, having a plan and sticking with it, and working with a professional you trust. By the way, you might want to ask your financial advisor how he/she is managing risk in your portfolio and have him explain it in a way that you understand and that makes sense to you.