Navigating the market turmoil after the Coronavirus outbreak

Navigating the market turmoil after the Coronavirus outbreak

Here is how to navigate the market turmoil after the Coronavirus outbreak, the stock market crash, and bottom low bond yields.

The longest bull market in history is officially over. Today the Dow Jones recorded its biggest daily loss since the October crash in 1987.  Today will remain in the history books. After the Dow Jones index dropped more than 20% from its February 2020 high, we are formally in a bear market.

Navigating the market turmoil after the Coronavirus outbreak
S&P 500 12 year performance

Investors’ flight to safety has pushed 10-year Treasury rate to 0.8% and 30-year treasury to 1.4%, all-time lows.

Navigating the market turmoil after the Coronavirus outbreak

Where are we standing

The coronavirus outbreak is spreading globally. The virus fears are halting public events and forcing companies to change the way they conduct business. The US has imposed travel restrictions on China and the European Union. Many countries in the US are imposing border control restrictions on their neighbors. While the virus outbreak in Wuhan is officially contained according to the Chinese government, large parts of the country remain in lockdown.
The inability of governments around the world to contain COVID-19 spooked investors. We are now observing the worst stock market selloff since the financial crisis of 2008. In certain ways, the daily market conditions are more brutal and unpredictable than a decade ago. Currently, close to 80% of the stock trading is generated by computer algorithms who can send thousands of trades in milliseconds.

DateDow Jones IndexChange% Change
12-Mar-2021,200.95-2,352.27-9.99%
11-Mar-2023,553.22-1,464.94-5.86%
10-Mar-2025,018.161,167.144.89%
9-Mar-2023,851.02-2,013.76-7.79%
6-Mar-2025,864.78-256.50-0.98%
5-Mar-2026,121.28-969.58-3.58%
4-Mar-2027,090.861,173.454.53%
3-Mar-2025,917.41-785.91-2.94%
2-Mar-2026,703.321,293.965.09%
28-Feb-2025,409.36-357.28-1.39%
27-Feb-2025,766.64-1,190.95-4.42%
26-Feb-2026,957.59-123.77-0.46%
25-Feb-2027,081.36-879.44-3.15%
24-Feb-2027,960.80-1,031.61-3.56%

The virus fears initially caused by a meltdown in travel-related stocks. Many airline and cruise ship stocks are now trading at a multi-year low. The heightened concerns for the global recession and the lowered commodity demand from China pushed the price of the oil down significantly. After failed negotiations between OPEC and Russia, Saudi Arabia decided to lower the sale prices of oil by 20% and increase its daily output. In turn, the prices of US oil companies collapsed due to fears that US oil producers can not maintain profitable operations at these low levels. During the previous in 2016, many small oil producers shut down or filed for bankruptcy. The expectation is that many more will follow the same faith soon.
Since the oil and gas and travel-related industry make up for more than 10% of the US GDP, it’s easy to understand that lower revenues and potential job cuts can trickle down to the rest of the US economy.

Are we in a recession?
We wouldn’t know the exact figures until April. The likelihood that the US economy will be in recession in Q1 and Q2 of 2020 is very high. The best-case scenario is for a sluggish economy. We started the year on a strong footing with low employment and strong job growth and housing sales, low price of oil and low-interest rates. However, the crisis in US travel, entertainment, and the energy sector can push the economy down.

What can you do now?

Focus on what you can control.

Have a plan
Having a robust financial plan will help you ensure that you are following of your long-term financial goals and staying on track. The investment performance of your portfolio is a key component of your future financial success but it’s not the most important factor. Be disciplined, patient and consistent in following your long-term goals while putting emotions aside
If you don’t have a financial plan, this a perfect time to initiate it. A holistic financial will help you create a comprehensive view of your personal and financial life and have a clear understanding of core risks and abilities to achieve financial independence and confidence.

Do not read the headlines

Wall Street resides in its own bubble and often overreacts to news whether that is good or bad. Right now, all news is bad news. The only thing that will provide confidence in the market is finding a treatment against the COVID-19, which is probably months or weeks away or drop in virus cases in both the US and Europe. A coordinated effort between the Fed, the Congress and the current administration can provide some stability. Let’s hope that all interested parties can come together and create a working plan.

Assess your risk tolerance
Risk tolerance is how we measure our emotional ability to accept market volatility. It’s not always easy to quantify emotions with numbers. As humans, we are always more likely to be risk-averse during market turbulence and more risk-tolerant when the stock market is going higher. If you want to know how you would feel when the stock market drops 20%, open your investment account today. When you are willing to accept short losses, then your risk tolerance is high. If losses are unacceptable then your risk tolerance is very low.

Review your investment portfolio

Perhaps not today, but soon, you should review your investment portfolio in connection with your long-term financial plan and risk tolerance. Make sure that your investments are aligned with your financial goals and needs.

Do not drop your 401k

One of the biggest mistakes you could possibly make now is to drop and stop contributing to your 401k plan. Many people gave up on their retirement savings during the financial crisis and never restarted them. As a result, we have a generation of people with no retirement savings. As a 401k participant, you make regular monthly or semi-monthly payments to your plan. Despite current losses, you benefit from dollar-cost averaging and buying stocks at lower prices.

Invest now

It may sound crazy but if you are a new investor there is no better time to start investing than now. Stocks rarely go on sale. This is one of those opportunities that come only once in a decade. Remember Warren Buffet’s famous quote:

Be fearful when others are greedy and to be greedy only when others are fearful”

Check my blog for guidance and ideas

  • In late January I posted “How to Survive the Next Market Downturn”. I didn’t think that we will need my guide so soon but here we are. I offer nine steps on how to navigate any stock market crash.

 

  • If you are a conservative investor, who mostly invests in bonds, you were probably somewhat sheltered from the March Market Madness. However, the future for income-seeking investors is cloudy. Current bond yields cannot support future bond investors and will likely deteriorate the economy. For more information on how to traverse from here, read my article on “Why negative interest rates are bad for your portfolio

 

  • Amid market volatility and uncertainty, dividend growth ETFs can provide some shelter. In my latest article “Top 5 Dividend Growth ETFs” I discuss five ETF strategies that offer lower volatility and extra income.

Final words
If you have any questions about your investments and how to update your financial plan, feel free to reach out. if you are worried about finances I am here to listen and help.

Top 5 Dividend Growth ETFs

Dividend Growth ETFs

Dividend growth ETFs offer a convenient and diversified way to invest in companies that consistently grow their dividends. Certainly, dividend-paying stocks provide a predictable stream of cash flows to investors looking for extra income. Companies that steadily grow their dividends year over year are known as dividend aristocrats. Investors often view high dividend blue-chip companies as financially stable and less volatile than growth companies. Above all, the extra cash from dividends provides a buffer from market volatility. Many retirees use dividends to supplement their income during retirement. In the current low-interest environment, dividend growth ETFs are a compelling low-cost option for investors looking for extra yield. With a 10-year US treasury paying below 1%, income investors will need to look elsewhere for income. Furthermore, compared to mutual funds, exchange-traded funds offer an inexpensive and tax-efficient way to invest without worrying about annual capital gains distributions.

Our top Dividend Growth ETF picks

I have prepared a list of my favorite five dividend growth ETFs. Besides their shared focus, these dividend ETFs have a different approach in constructing their underlying portfolio. Depending on your goals, each ETFs will give you a different exposure and dividend payout.

Dividend Growth ETF Performance 2010-2019

TickerCAGRSt DevBest YearWorst YearMax. DrawdownSharpe RatioUS Mkt Correlation
VYM12.86%11.16%30.08%-5.91%-11.84%1.090.95
SDY13.07%11.15%30.07%-2.74%-11.00%1.110.92
VIG12.63%11.30%29.62%-2.08%-14.18%1.060.96
DVY12.96%10.60%28.85%-6.32%-10.08%1.150.88
FVD13.18%10.21%26.77%-3.48%-11.11%1.210.91
SPY13.44%12.44%32.31%-4.56%-16.23%1.041.00

Source: portfoliovisualizer.com

Vanguard High Dividend Yield ETF – VYM

Vanguard High Dividend Yield ETF, VYM, tracks the FTSE High Dividend Yield Index. The index selects high-dividend-paying US companies and weights them by market cap. The underlying index excludes real estate investment trusts (REITs).

VYM ETF offers a low-cost, diversified, conservative exposure to high dividend yield large-cap stocks. Vanguard High Dividend Yield ETF charges 0.06% fee and currently pays a 3.2% dividend yield.

The ETF selects its holdings by ranking companies by their forecast dividends over the next 12 months. Only the stocks in the top half are selected. The remaining stocks are weighted by market capitalization. Due to its methodology, VYM tends to hold a large basket of large-cap value stocks.

SPDR® S&P Dividend ETF – SDY

SPDR® S&P Dividend ETF, SDY, tracks a yield-weighted index of dividend-paying companies from the S&P 1500 Composite Index. SDY uses dividend sustainability screens and only holds companies that have increased dividends for the past 20 years. The highest yielding firms are then weighted by dividend yield.

Many tech companies do not meet the strict requirements of paying dividends in the past 20 years. Therefore, SPDR® S&P Dividend ETF has minimal exposure to technology stocks.  Nevertheless, SDY is one of the few dividend growth ETFs that provides exposure to REITs.

SPDR® S&P Dividend ETF charges 0.35% fee and pays a 2.6% dividend yield. Unlike VYM, which ranks its holdings by market capitalization. SDY has a slight tilt towards mid-cap stocks. Investors looking for a broader exposure to the US dividend-paying stocks may find this ETF compelling despite its higher fee.

Vanguard Dividend Appreciation ETF – VIG

Vanguard Dividend Appreciation ETF, VIG, is the most growth-oriented ETF on our list of Dividend growth ETFs. VYM is the largest fund by assets under management (AUM). It tracks a market-cap-weighted index of US companies that have increased their annual dividends for ten or more consecutive years. VIG charges a 0.06% fee and pays a 1.8% dividend. Notably, this ETFs dividend yield is a tad smaller than the yield on the S&P 500.

VIG focuses on dividend growth rather than dividend yield. The fund selects firms that have increased their dividend payments for the past ten years and market-cap-weights its holdings. VIG has the biggest exposure to large-cap and mid-cap growth stocks. In conclusion, investors looking for exposure to high-quality dividend-paying large-cap stock may wish to consider VIG for their portfolios.

iShares Select Dividend ETF – DVY

iShares Select Dividend ETF offers the highest dividend yield on our list of Dividend growth ETF.  DVY pays 3.7% in dividends and charges 0.39% in fees. DVY tracks a dividend-weighted index of 100 US companies. The index selects dividend stocks from the Dow Jones broad market-cap index, excluding REITs.

DVY offers exposure to the US high-dividend stocks that skews towards large, mid, and small-cap value firms paying consistent dividends. DVY’s methodology has a strict sustainability screen, designed to select companies that pay steady and rising dividends. The screening process includes companies with at least $3 billion of market capitalization. Further on, the ETF selects stocks with five-year dividend growth, a coverage ratio of 167 or higher, positive trailing 12-months earnings per share, and high trading volume. The DVY portfolio has significant sector bets towards utilities and financial services.

First Trust Value Line® Dividend ETF – FVD

First Trust Value Line® Dividend ETF, FVD, aims to track an equal-weighted index of dividend-paying companies. The ETF uses a proprietary screening process that only includes companies with more than $1 billion in market cap. FVD has the highest fee on our list. It charges 0.7%, and it pays a 2.1% dividend.  FVD has the best 10-year performance and has reported a slightly lower risk of all five ETFs. Despite its higher than average performance, it produces one of the lowest yields in the group.

FVD creates its portfolio in two steps. First, it uses Value Line’s proprietary ‘safety rating’ system to select low-beta stocks from companies with strong balance sheets. Then it chooses the stocks with above-average yields and weights them equally. The methodology includes REITs and foreign ADRs. As a result, FVD has the highest exposure to international stocks in our list of Dividend growth ETFs. FVD makes big sector bets towards utilities and financial services.

Additionally, it has a slight tilt towards mid-cap stocks. Despite its higher than average performance, FVD produces one of the lowest yields in the group.  In conclusion, investors willing to accept the high cost of FVD may like to use it as an alternative to the more popular dividend growth ETFs.

Dividend Growth ETF Summary

As a group, dividend growth ETFs offer a steady income for yield-hungry investors. Even though none of them have outperformed the S&P 500 in absolute terms, most of these ETFs reported better risk-adjusted returns. In times market turmoil and uncertainty, dividend growth ETFs offer extra income and lower volatilty.

Disclaimer
Past performance does not guarantee future returns. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is the sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. Before investing, you have to consider your risk tolerance, investment objectives, asset allocation, and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

How to Survive the next Market Downturn

How to survive a market downturn

Everything you need to know about surviving the next market downturn: we are in the longest bull market in US history. After more than a decade of record-high stock returns, many investors are wondering if there is another market downturn on the horizon. With so many people saving for retirement in 401k plans and various retirement accounts, it’s normal if you are nervous. But if you are a long-term investor, you know these market downturns are inevitable. Market downturns are stressful but a regular feature of the economic cycle.

What is the market downturn?

A market downturn is also known as a bear market or a market correction. During a market downturn, the stock market will experience a sharp decline in value. Often, market downturns are caused by fears of recession, political uncertainty, or bad macroeconomic data.

How low can the market go down?

The largest-ever percentage drop by the S&P 500 index occurred on October 19, 1987 (known as The Black Monday), when the S&P 500 dropped by -20.47%. The next biggest selloff happened on October 15, 2008, when the S&P 500 lost –9.03%. In both cases, the stock market continued to be volatile for several months before reaching a bottom. Every time, the end of the market downturn was the start of a new bull market. Both times, the stock market recovered and reached historic highs in a few years.

What can you do when the next market downturn happens?

The first instinct you may have when the market drops is to sell your investments. In reality, this may not always be the right move. Selling your stocks during market selloff may limit your losses, may lock in your gains but also may lead to missed long-term opportunities. Emotional decisions do not bring a rational outcome.

Dealing with declining stock values and market volatility can be tough. The truth is nobody likes to lose money. The volatile markets can be treacherous for seasoned and inexperienced investors alike. To be a successful investor, you must remain focused on the strength of their portfolio, your goals, and the potential for future growth. I want to share nine strategies that can help you through the next market downturn and boost the long-term growth of your portfolio.

1. Keep calm during the market downturn

Stock investors are cheerful when the stock prices are rising but get anxious during market corrections. Significant drops in stock value can trigger panic. However, fear-based selling to limit losses is the wrong move. Here’s why. Frequently the market selloffs are followed by broad market rallies. A V-shape recovery often follows a market correction.

The hypothetical table below looks at the performance of $10,000 invested in the S&P 500 between January 4, 1988, and December 31, 2018. It’s important to note this hypothetical investment occurred during two of the biggest bear markets in history, the 2000 tech bubble crash and the 2008 global financial crisis. If you had missed the ten best market days, you would lose 2.4% of your average annual return and nearly half of your dollar return.

As long as you are making sound investment choices, your patience, and the ability to tolerate paper losses will earn you more in the long run.

2. Be realistic: Don’t try to time the market

Many investors believe that they can time the market to buy low and sell high. In reality, very few investors succeed in these efforts.

According to a study by the CFA Institute Financial Analyst Journal, a buy-and-hold large-cap strategy would have outperformed, on average, about 80.7% of annual active timing strategies when the choice was between large-cap stocks, short-term T-bills and Treasury bonds.

3. Stay diversified

Diversification is essential for your portfolio preservation and growth. Diversification, or spreading your investments among different asset classes (domestic versus foreign stocks, large-cap versus small-cap equity, treasury and corporate bonds, real estate, commodities, precious metals, etc.), will lower the risk of your portfolio in the long-run. Many experts believe that diversification is the only free lunch you can get in investing.

Uncorrelated asset classes react uniquely during market downturns and changing economic cycles.

For example, fixed income securities and gold tend to rise during bear markets when stocks fall. Conversely, equities rise during economic expansion.

4. Rebalance your portfolio regularly

Rebalancing your portfolio is a technique that allows your investment portfolio to stay aligned with your long terms goals while maintaining a desired level of risk. Typically, portfolio managers will sell out an asset class that has overperformed over the years and is now overweight. With the proceeds of the sale, they will buy an underweighted asset class.

Hypothetically, if you started investing in 2010 with a portfolio consisting of 60% Equities and 40% Fixed Income securities, without rebalancing by the end of 2019, you will hold 79% equities and 21% fixed income. Due to the last decade’s substantial rise in the stock market, many conservative and moderate investors are now holding significant equity positions in their portfolio. Rebalancing before a market downturn will help you bring your investments to your original target risk levels. If you reduce the size of your equity holdings, you will lower your exposure to stock market volatility.

5. Focus on your long-term goals

A market downturn can be tense for all investors. Regardless of how volatile the next stock market correction is, remember that “this too shall pass.”

Market crises come and go, but your goals will most likely remain the same. In fact, most goals have nothing to do with the market. Your investment portfolio is just one of the ways to achieve your goals.

Your personal financial goals can stretch over several years and decades. For investors in their 20s and 30s financial goals can go beyond 30 – 40 years. Even retirees in their 60s must ensure that their money and investments last through several decades.

Remain focused on your long-term goals. Pay of your debt. Stick to a budget. Maintain a high credit score. Live within your means and don’t risk more than you can afford to lose.

6. Use tax-loss harvesting during the market downturn

If you invest in taxable accounts, you can take advantage of tax-loss harvesting opportunities. You can sell securities at depressed prices to offset other capital gains made in the same year. Also, you can carry up to $3,000 of capital losses to offset other income from salary and dividends. The remaining unused amount of capital loss can also be carried over for future years for up to the allowed annual limit.

To take advantage of this option, you have to follow the wash sale rule. You cannot purchase the same security in the next 30 days. To stay invested in the market, you can substitute the depressed stock with another stock that has a similar profile or buy an ETF.

7. Roth Conversion

A falling stock market creates an excellent opportunity to do Roth Conversion. Roth conversion is the process of transferring Tax-Deferred Retirement Funds from a Traditional IRA or 401k plan to a tax-exempt Roth IRA. The Roth conversion requires paying upfront taxes with a goal to lower your future tax burden. The depressed stock prices during a market downturn will allow you to transfer your investments while paying lower taxes. For more about the benefits of Roth IRA, you can read here.

8. Keep a cash buffer

I always recommend to my clients and blog readers to keep at least six months of essential living expenses in a checking or a savings account. We call it an emergency fund. It’s a rainy day, which you need to keep aside for emergencies and unexpected life events. Sometimes market downturns are accompanied by recessions and layoffs. If you lose your job, you will have enough reserves to cover your essential expenses. You will avoid dipping in your retirement savings.

9. Be opportunistic and invest

Market downturns create opportunities for buying stocks at discounted prices. One of the most famous quotes by Warren Buffet’s famous words is “When it’s raining gold, reach for a bucket, not a thimble.” Market selloffs rarely reflect the real long-term value of a company as they are triggered by panic, negative news, or geopolitical events. For long-term investors, market downturns present an excellent opportunity to buy their favorite stocks at a low price. If you want to get in the market after a selloff, look for established companies with strong secular revenue growth, experienced management, solid balance sheet and proven track record of paying dividends or returning money to shareholders.

Final words

Market downturns can put a huge toll on your investments and retirement savings. The lack of reliable information and the instant spread of negative news can influence your judgment and force you to make rash decisions. Market selloffs can challenge even the most experienced investors. That said, don’t allow yourself to panic even if it seems like the world is falling apart. Prepare for the next market downturn by following my list of nine recommendations. This checklist will help you “survive” the next bear market while you still follow your long-term financial goals.

10 Behavioral biases that can ruin your investments

10 Behavioral biases that can ruin your investments

As a financial advisor, I often speak with my clients about behavioral biases. Our emotions can put a heavy load on our investment decisions. In this article, I would like to discuss ten behavioral biases that I encounter every day. It’s not a complete list, but it’s a good starting point to understand your behavioral biases and how to deal with them.

We have to make choices every day. Often our decisions are based on limited information or constrained by time. We want to make the right call every single time. But sometimes we are wrong. Sometimes we can be our worst enemy. Stress, distraction, media, and market craziness could get the worst of us.

Behavioral finance

In 2018 Richard Thaler won the Nobel prize for his work in behavioral economics. In his 2009 book “Nudge” and later on in his 2015 book “Misbehaving: The Making of Behavioral Economics,” Thaler reveals the architecture of the human decision-making process. He talks about behavioral biases, anomalies, and impulses that drive our daily choices.

In another study about the value of the financial advisor or the advisor alpha, Vanguard concluded that clients using a financial advisor have the potential to add 1.5% of additional annual returns as a result of behavioral coaching. Further on, Vanguard concludes that because investing evokes emotion, advisors need to help their clients maintain a long-term perspective and a disciplined approach.

 

Afraid to start investing 

Social Security is going into deficit by 2035. And most employers moving toward Defined Contribution Plans (401k, 403b, SEP-IRA). It will be up to you and me to secure our retirement by increasing our savings and investments. However, not everybody is in tune. For many people, investing is hard. It’s too complicated. Not all employers provide adequate training about retirement and investment options. And I don’t blame anyone. As much as I try to educate my blog readers, as well as many colleagues, we are outnumbered by the media and all kinds of financial gurus without proper training and credentials. If you are on the boat and want to start investing, talk to a fiduciary financial advisor, or ask your employer for educational and training literature. Don’t be afraid to ask hard questions and educate yourself.

“This time is different.”

How many times have you heard “This time is different” from a family member or the next financial guru, who is trying to sell you something? Very likely, it’s not going to be any different. As a matter, it could be worse. As humans, we tend to repeat our mistake over and over. It’s not that we don’t learn from our mistakes. But sometimes it’s just more comforting staying on your turf, not trying something new, and hoping that things will change. So, when you hear “This time is different,” you should be on high alert. Try to read between the lines and assess all your options.

Falling for “guaranteed income” or “can’t lose money” sales pitch

As many people are falling behind their retirement savings, they get tempted to a wide range of “guaranteed income” and “can’t lose money” financial products. The long list includes but not limited to annuities, life insurance products, private real estate, cryptocurrency, and reverse mortgage. Many of these products come with sky-high commissions and less than transparent fees, costly riders, and complex restrictions and high breakup fees. The sales pitch is often at an expensive steakhouse or a golf club following a meeting in the salesperson’s office where the deals are closed. If someone is offering you a free steak dinner to buy a financial product that you do not fully understand, please trust me on it – you will be the one picking the tab in the end.

Selling after a market crash

One of the most prominent behavioral biases people make in investing is selling their investments after a market crash. As painful as it could be, it’s one of the worst decisions you could make. Yes, markets are volatile. Yes, markets crash sometimes. But nobody has made any money panicking. You need to control your impulses to sell at the bottom. I know it’s not easy because I have been there myself. What really helps is thinking long-term. You can ask yourself, do you need this money right away. If you are going to retire in another 10 or 20 years, you don’t need to touch your portfolio, period. Market swings are an essential part of the economic cycle. Recessions help clean up the bad companies with a poor business model and ineffective management and let the winners take over.

You may remember that the rise of Apple coincided with the biggest recession in our lifetime, 2008 – 2009. Does anyone still remember Blackberry, Nokia, or Motorola, who were the pioneers of mobile phones?

Keeping your investments in cash

Another common behavioral bias is keeping your investments in cash…..indefinitely. People who keep their 401k or IRA in cash almost always miss the market recovery. At that point, they either have to chase the rally or must wait for a market correction and try to get in again. As a financial advisor, I would like to tell you that it is impossible to time exactly any market rally. By the time you realize it. It’s already too late.

To understand why timing the markets and avoiding risk by keeping cash can be harmful, see what happens if an investor misses the biggest up days in the market. The hypothetical table below looks at the performance of $10,000 invested in the S&P 500 between January 4, 1988, and December 31, 2018. It’s important to note this hypothetical investment occurred during two of the biggest bear markets in history, the 2000 tech bubble crash and the 2008 global financial crisis.

10 Behavioral biases that can ruin your investments - Keeping Cash

As you can see, missing the ten best days over between 1998 and 2018 meant earning nearly 2.5% less on an annual basis and leaving half of the potential absolute gains on the table. Here’s the kicker: Six of the 10 “best days” in the market were within weeks of the worst days in the market. In other words, some of the best days often happen as “v-shaped” bounces off the worst days. Going to cash on a big negative day means increasing the risk of missing a big positive day which, as can be seen from the table above, can have a substantial impact on your returns over time.

Chasing hot investments

One of the most common behavioral biases is chasing hot investments. People generally like to be with the winners. It feels good. It pumps your ego. There is a whole theory of momentum investing based on findings that investors buy recent winners and continue to buy their stock for another 6 to 12 months. We have seen it time and time again – from the tech bubble in 2000, through the mortgage-backed securities in 2008, to cryptocurrency and cannabis stocks in 2018. People like highflyers. Some prior hot stocks like Apple, Google, and Amazon dominate the stock markets today. Others like Motorola, Nokia, and GE dwindle in obscureness. If an investment had a considerable run, sometimes it’s better to let it go. Don’t chase it.

Holding your losers too long

“The most important thing to do if you find yourself in a hole is to stop digging.” – Warren Buffett. 

In a research conducted in the 1990s by professor Terrance Odean, he concluded that investors tend to hold to their losers a lot longer than their winners. A result of this approach, those investors continue to incur losses in the near future. Professor Odean offers a few explanations for his findings. One reason is that investors rationally or irrationally believe that their current losers will outperform. A second explanation comes from the Prospect Theory by Kahneman and Tversky (1979). According to them, investors become risk-averse about their winners and risk-seeking to their losers.

When it comes to losing bets, they are willing to take a higher gamble and seek to recover their original purchase price. A third theory that I support and observed is based on emotions. The pain from selling your losers is twice as high as the joy from selling your winners. We don’t like to be wrong. We want to hold on to the hope that we made the right decision. After all, it is a gamble, and the odds will be against you. At some point, we just need to make peace with your losses and move on. It’s not easy, but it’s the right thing to do.

Holding your winners too long

There is a quote by the famous financier Bernard Baruch – “I made my money by selling too soon.” Many people, however, often hold on to their winners for very long. Psychologically, it’s comforting to see your winners and feel great about your investment choices. There is nothing wrong with being a winner. But at some point, you must ask yourself, is it worth it. How long this run can go for and should you cash in some of your profits. What if your winners are making up a large part of your investment portfolio? Wouldn’t this put your entire retirement savings at risk if something were to happen to that investment?

There is no one-size-fits-all answer when it comes to selling your winners. Furthermore, there could be tax implications if you realize the gains in your brokerage account. However, it’s prudent to have an exit strategy. As much as it hurts (stops the joy) to sell the winners, it could lower the risk of your portfolio and allow you to diversify amongst other investments and asset classes.

Checking your portfolio every day

The stock market is volatile. Your investments will change every day. There will be large swings in both directions. So, checking your portfolio every single day can only drive crazy and will not move the needle. It could lead to irrational and emotional decisions that could have serious long-term repercussions. Be patient, disciplined, and follow your long-term plan.

Not seeking advice

Seeking advice from a complete stranger can be scary. You must reveal some of your biggest secrets to a person you never met before. It’s s big step. I wish the media spends more time talking about the thousands of fiduciary advisors out there who honestly and trustworthy look for your best interest.

My financial advisory service is based on trust between you as a client and me as the advisor . So, do not be afraid to seek advice, but you also need to do your homework. Find an advisor who will represent you and your family and will care about your personal goal and financial priorities. Don’t be afraid to interview several advisors before you find the best match for you.

Final words

“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.” – Warren Buffet.

Investing is an emotional act. We put our chips on the table and wish for a great outcome. We win, or we lose. Understanding your emotions and behavioral biases will help you become a better investor. It doesn’t mean that we will always make the right decisions. It doesn’t mean that we will never make a mistake again. We are humans, not robots. Behavioral biases are part of our system. Knowing how we feel and why feel a certain way, can help us when the markets are volatile, when things get ugly or the “next big thing” is offered to us. Look at the big picture. Know your goals and financial priorities. Try to block the noise and keep a long-term view.

Reach out

If you have questions about your investments and retirement savings, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit my Insights page, where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA, founder of Babylon Wealth Management

Stoyan Panayotov, CFA, MBA is a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning, retirement planning, and investment management for growing families, physicians, and successful business owners.

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Latest Articles

Why negative interest rates are bad for your portfolio

Why negative interest rates are bad for your portfolio

Quantitative Easing

Ever since the financial crisis of 2008-2009, central banks around the world have been using lower interest rates and Quantitative Easing (QE) to combat to slow growth and recession fears. In the aftermath of the Great Recession, all major central banks cut their funding interest rate to nearly zero.

The QE policy led to the longest US economic expansion in history. As the US economy improved, the Federal Reserve started hiking rates in late 2015 and continued hiking until December of 2018. The Fen fund rate reached 2.4% in the early months of 2019. In the meantime, the European and Japan Central Banks hovered their interest rates near zero. In 2016, for the first time, we registered negative interest rates in Europe and Japan.

The trade wars

Escalating fears for slowing global growth and trade war threats had forced the Fed to announce its first rate cut since the financial crisis. While widely expected, the rate cut triggered a chain of events. First, President Trump imposed an additional 10% import tax on $300 billion of Chinese good. In return, the Chinese central bank lowered the target exchange rate between US dollars and yuan to 7.0039, the lowest level since April 2008. Losing confidence for a quick trade resolution the equity markets sold off by 3%. The 10-year Treasury fell to 1.7%, one of the lowest levels since the financial crisis.

Negative interest rates

Fearing that the intensifying trade war between the US and China could adversely impact the global economy, many Central banks around the world cut their funding rates to zero or even negative levels. Most recently the Reserve Bank of New Zealand lowered its rate from 1.5% to 1%. Furthermore, the New Zealand Governor said, “It’s easily within the realms of possibility that we might have to use negative interest rates,”

In Germany, the 30-year government bond turned negative for the first time last week. In Japan, the 10-year government bond yields -0.2%.

As we stand today, there is $15 trillion in government bonds that offer negative interest rates, according to Deutsche Bank. In short, European investors are paying to own EU government bonds. 

In addition, there are 14 European below investment grade bond issuers trading at negatives rates. Conventionally, the junk bonds are issued by risky borrowers with weaker balance sheets that may struggle to pay back their loans. The typical junk-bond offers a higher income to compensate investors for taking the higher risk of not getting paid at all.

So why negative interest rates are bad for your portfolio

Traditionally, retired and conservative investors have used government bonds as a safe-haven investment. Historically, US treasuries have had a negative correlation with stocks. When the equity markets are volatile, many investors move to US government bonds to wait out the storm. Therefore, many portfolio managers around the world use government bonds as a diversification to lower the risk of your investment portfolio.

So, let’s imagine a conservative investor whose portfolio is invested in about 40% in Equities and 60% in Fixed Income. This person has a low-risk tolerance and would like to use some the extra income to supplement her social security benefits and pension. With ultra-low or negative interest rates, 60% of the portfolio is practically earning nothing and potentially losing money. Let’s break it down.

Lending free money

Investors in negative-yielding bonds are effectively giving the government free money and receiving nothing in return. With $15 trillion worth of negative-yielding bonds, many institutional investors might be willing to take the “deal” since they have legal restrictions on a target amount of fixed income instruments they must own.

No risk-reward premium

The interest rate is the risk-reward premium that the lender is willing to take to provide a loan to a borrower. The higher the risk, the higher the interest rate. Simple. If the risk-reward relationship is broken, many creditors will choose not to lend any money and have the risk of going out of business. Why would a bank give you a negative interest mortgage on your home?

Can’t supplement income

Going back to our imaginary investor with 60% in negative-yielding bonds. This portfolio will not be able to provide additional income that she will need to supplement their pension or social security benefits. What if our investors could not rely on guaranteed benefits, and her portfolio was the sole generator of income? In that case, she will have to spend down the portfolio over time. She would have to adjust her lifestyle and lower her cost so she can stretch the portfolio as long as she could.

Need to take more risk to generate higher income

What if our investor wants to protect her principal? To generate higher income, our conservative investor will ultimately have to consider higher-risk investments that offer a higher positive yield. She will have to be willing to take more risk to receive a higher income from her portfolio.    

Subject to inflation risk

The inflation risk is the risk of lower purchasing power of your money due to rising prices. In a simple example, if you own $100 today and the annual inflation is 2%, the real value of your money will be $98 in a year. You are essentially losing money.

With the US inflation rate at around 1.6% as of June of 2019 and Eurozone inflation rate hovering about 1.2%, there is a real risk that the ultra-low and negative rates will reduce the real value of your investments. Investments in negative-yielding bonds will end up with lower purchasing power over time 

Subject to interest rate risk

In the fixed-income world, rising interest rates lead to a lower value of your bonds. The reason is that older bonds will have to sell at a lower price to match the yield of the newly issued bonds with a higher interest. Just about a year ago when the Fed was hiking rates by 0.25% every quarter, fixed income investors were rightly worried that their bond holdings would lose value. Many bonds funds ended up in the negative in 2018. Even with lower or negative interests, this risk is looming out there.

Promote frivolous spending and cheap debt

It’s not a secret that lower interest rates allow more individuals, corporations, and governments alike to borrow cheap credit. While everybody’s situation is unique, cheap credit often leads to frivolous and irresponsible spending. With US consumer debt reaching $13.51 trillion, total US corporate debt at $15.5 trillion, and Federal debt pushing above $22 trillion, the last thing we need is banks and politicians writing blank checks.

Create asset bubbles

Cheap credit leads to asset bubbles. Artificially low interests allow phantom companies with negative earnings and weak balance sheet to borrow cheap credit and stay afloat. 

The financial crisis of 2008 – 2009 was caused by lower interest rates, which increased the value of US real estate. Many borrowers who otherwise couldn’t afford a mortgage took on cheap loans to buy properties around the country. This led to a real estate bubble which burst soon after the Fed started hiking the interest rates.

One bright spot

The lower interest rate will allow millions of Americans to refinance their mortgage, student debt, or personal loan. If you have borrowed money in the last three year, you might be eligible for refinancing. Be diligent, talk to your banker, and assess all options before taking the next step.

Reach out

If you need help with your investment portfolio or have questions about generating income from your investments, reach out to me at stoyan@babylonwealth.com or 925-448-9880.

You can also visit my Insights page, where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA, MBA is a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning, retirement planning, and investment management for growing families and successful business owners.

Subscribe to get our new Insights delivered right to your inbox

The Rise of Momentum Investing

The Rise of Momentum Investing

The Rise of Momentum Investing

While the momentum theory has been around for two decades, we had to wait until 2017 to see the rise of momentum investing. The largest momentum ETF (MTUM) is up 35% YTD. And unless something dramatic happens in the remaining few weeks, momentum will crush all major market-cap weighted indices and ETFs.

About this time last year, I posted my first article about momentum investing in Seeking Alpha. You can see my article here. At that time MTUM had only $1.8 billion of AUM and trailed the S&P 500 2016 returns in the range of 5% versus 12%. Eleven months later, MTUM is up 35% versus 16.5%. I can’t take any credit for calling this wide margin in performance, but it certainly grabbed the attention of investors. MTUM is currently at $4.8b AUM and possibly growing even more down the road.

Learn more about our Private Wealth Management services

What is momentum investing

So what is momentum and why do we keep hearing about it a lot more lately?

The momentum investing is a pure behavioral play. Not surprisingly the rise of momentum investing coincided with Richard Thaler’s Nobel award for his work on how human behavior and finance play out together.

Momentum investing exploits the theory that recent stock winners will continue to rise in the near-term. The strategy is based on the 1993 Journal of Finance research “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” by Narasimhan Jegadeesh and Sheridan Titman

Their research discovers a pattern that buying stocks that have performed well in the past and selling stocks that have performed poorly generate significant positive returns over 3- to 12-month holding periods. Furthermore, the research discusses that the success of this strategy is due to behavioral finance factors.

Investors commonly overact on the news and therefore overbuy the winners and oversell the losers.

Many investors consider the momentum strategy as a substitute for growth investing. However, the momentum theory embraces both value and growth stocks as long as they have risen in the past 6 to 12 months.

While the momentum theory has been around for over 20 years, the strategy has not received a wide acceptance amongst investors. Despite its academic fundamentals, momentum strategy has experienced contradictory practical interpretations amongst fund managers, which has reported a massive variability of returns.

Fortunately, the growing popularity of market-cap and smart beta ETFs made the momentum strategy widely available to retail investors. Further down, I will discuss how to take advantage of the momentum theory by using MTUM – iShares Edge MSCI USA Momentum Factor ETF. This ETF has been around since April 2013. It has a dividend yield of 1.12% and an expense ratio of 0.15%.

MTUM replicates the MSCI USA Momentum Index. MSCI USA Momentum Index uses a multi-step process to filter for stocks that fit the momentum criteria. The composition process starts with selecting companies with the highest 6- and 12- month performance. The performance is later weighted by their 3-year standard deviation and given a momentum score. The final weight in the momentum index is given by multiplying the momentum score by the market capitalization weight in the parent index. In this case, the parent index is MSCI USA Index, which has 616 constituents and covers about 85% of the US market cap. Company weights for MSCI USA Momentum Index are capped at 5%. The index is rebalanced semiannually. However, spikes in market volatility can trigger ad-hoc rebalancing.

 

Performance and risk

MSCI USA Momentum Index has consistently outperformed MSCI USA and S&P 500 since its inception. The index has achieved a cumulative return of 531% versus 400% for MSCI USA and 423% for S&P 500 since October 2002.

In annualized terms, MSCI USA Momentum Index posted 9.07% 10-year return and 13.65% return since its inception in 1994.

The index beat its parent in 9 out of the past 15 years and underperformed in six – 2003, 2006, 2008, 2009, 2012 and 2016.

It is an interesting observation that the Momentum strategy underperformed in the years following a significant market pullback or sluggish return (02-03, 05-06, 08-09 and 11-12). It takes a two-year cycle for the Momentum Index to start outperforming again after experiencing a negative period. The composition of the index is somewhat reactive, which naturally doesn’t allow it to take advantage of market rallies in specific sectors.

MSCI USA Momentum Index Performance

Source: MSCI

 

Counterintuitively to what some may think, the MSCI Momentum Index has reported lower standard deviation (risk) than its parent index for the past 3-year and slightly higher standard deviation for the 5- and 10-year period. The risk-weighted methodology described earlier helps the index cap its volatility despite high turnover.

Higher returns and capped volatility has allowed the momentum index to report consistently high risk-adjusted returns. Its 10-year Sharpe ratio is 0.59 versus 0.51 for MSCI USA and 0.53 for S&P 500. Since inception, the Momentum Index posted the impressive 0.72 versus 0.54 MSCI USA and S&P 500.

MSCI USA Momentum Index Risk Adjusted Returns

Source: MSCI

 

MTUM ETF

Going back to the iShares Edge MSCI USA Momentum Factor ETF, it has been around since April 2013. Since inception, its performance has been consistent with the index. MTUM posted 17.3% return versus 13.4% for S&P 500 and 15.32% for IWF, Russell 1000 growth ETF.

MTUM Performance Since inception

MTUM has reported a Sharpe ratio of 1.61 vs. 1.33 for S&P 500 and 1.41 for IWF.

Few other interesting facts for investors looking to diversify. The US market correlation is equal to 0.87. Beta is 0.90. Alpha is 4.7%, and R2 is 73.7%. In other words, the momentum strategy achieved its return not only with less risk but a lot lower correlation to the total market, which is critical for portfolio diversification.

MTUM Holdings

Momentum investing is a dynamic strategy with quarterly rebalancing. Due to its 114% turnover, it is extremely cost ineffective for the average retail investor to replicate it

Currently, MTUM overweights Financials, Technology, and Industrials which have primarily driven the market since the beginning of 2017. Simultaneously, the ETF underweights Consumer Cyclical, Utilities, and Energy. Its main holdings include Microsoft, Bank of America, JP Morgan, Apple, United Health Group, NVIDIA, Home Depot, Comcast, and Boeing. Just to illustrate the dynamic nature of this strategy, a year ago its top holdings were in Technology and Utilities with leading names such as Facebook, Amazon, Google, and Nextera.

 

Final thoughts

  1. The momentum strategy has outperformed the broad market in the past 22 years.
  2. While being in the public eye for over two decades and posting impressive long-term absolute and risk-adjusted returns, the momentum strategy is still not a highly popular trade and has mostly been a theoretical exercise with conflicting practical results.
  3. Only lately, the rise of ETFs had made the strategy available to regular investors.
  4. The momentum strategy tends to lean towards sectors with a recent high
  5. Like any factor strategy, the momentum can underperform the broad market for extended periods

 

 

About the author: Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm. Babylon Wealth Management offers highly customized Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans and other institutional clients. To learn more visit our OCIO page here.

Holdings disclaimer: I own MTUM and we regularly invest MTUM for our clients

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

 

Will Emerging Markets Continue to Rally

Will Emerging Markets Continue to Rally

Will Emerging Markets Continue to Rally

Emerging Markets are up 26% so far year. But can they sustain the rally?

If you invested in one of the large EM ETFs like EEM (iShares MSCI Emerging Markets ETF) or VWO (Vanguard FTSE Emerging Markets Index Fund ETF Shares) ten years ago, you would have earned nearly zero as of September 29, 2017. At the same time, you would have doubled your money if you invested in S&P 500 (SPY) as long as you stayed put during the market crisis of 2008 – 2009.

So is this just a fluke? Or maybe after a lost decade of volatile price swings, EM stocks are finally ready to turn the page. While we recognize the long-term opportunity in EM, we also understand this could be a bumpy ride.

Learn more about our Private Wealth Management services

 

What is an Emerging Market?

In the investment world, the countries are divided into three main categories – developed, emerging and frontier. Developed countries include countries with developed capital markets and relatively high GDP per capita. The list consists of USA, Canada, Japan, UK, Australia, Germany, Italy, France and several others. Emerging markets have some similarities with the developed economies including functioning capital markets and a banking system, but they lack certain characteristics including lower market liquidity and transparency. They also have more political influence and less strict accounting standards.

The list of Emerging economies includes Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and UAE.

Just to make things a little more complicated, FTSE  indices classify Korea as a developed economy. However, other index providers such as MSCI and Dow Jones include Korea in the EM group.

What makes the emerging markets an attractive investment?

Economic growth

EM has been characterized by higher growth than most developed economies. According to IMF, emerging markets GDP is expected to grow by an average of 4.7% in 2017. Furthermore, despite the recent slowdown, next year projections are the first time in six years when we see an acceleration in the growth forecast.

For comparison, US GDP is expected to grow at 2.6% in the next two years, while EU is projected at 1.7%.

Also, according to World Bank consumption growth per capita in emerging is expected to grow by an average of 5.5% versus 1.5% for developed markets.

This growth differential provides an opportunity for companies with strong presence in these markets to benefit and increase their revenues as a result of the expected economic growth.

Population trends

According to Euromonitor, developing countries account for 90% of the world population under 30.  For instance, the average age of the Philippines is 24, India is 26, Mexico is 27, and Brazil is 31. For comparison, the median age in the USA is 37.2. Japan and Germany are at 46.1.  Emerging economies have a young population base which will help them support future economic and consumption growth. In fact, developing markets now account for more than 75% of global growth in output and consumption, almost double their share in just two decades.

Attractive Valuations

With US stocks equities almost fully priced, investors are starting to look for better opportunities abroad. At 16x current price-to-earnings, emerging market equities (EEM) are considerably cheaper than US large cap-equities.  For comparison, SPY currently trades at 23.7 times price-to-earnings. Furthermore, Emerging Market price-to-book ratio is 1.63x versus 2.85 for SPY.

Even with the 25% return so far this year, EM stocks are still trading at nearly 50% discount to US large cap stocks. This valuation gap creates opportunities for investors to transfer some of their assets to less expensive assets.

Diversification

For investors looking to diversify some of their risks, EM represents a compelling alternative. EM stocks traditionally have a lower correlation to the US equity markets.

For instance, a broad EM ETF such as EEM has a correlation of 0.80 to the S&P 500, while its R-squared (explained returns) ratio is 62.7%. As a comparison, a US Small Cap stocks (IJR) have a 0.92 correlation ratio and 78.7% R-squared to the large US cap index.

 

What are some of the risks?

Volatility of returns

Owning EM stocks comes with a lot of risks. The EM equity performance has been inconsistent for the past ten years. $1,000,000 invested in EEM ETF in Jan 1, 2007 would have produced $ 1,005,620 by Dec 2015 and $1,433,727 by Sep 2017. This is the equivalent of 0.06% and 3.45% annualized rate of return. As a comparison, the same one million invested in SPY would have made 1,735,171 in 2015 and 2,215,383 in Sep 2017 or an average of 6.31% and 7.68% respectively.

This return volatility shows the unpredictability and large swings of returns in EM stocks, which brings us to the next point.

Furthermore, investors who are willing to invest in EM have to stomach the higher volatility associated with these stock. To illustrate, EEM has a beta of 1.29 vs. 1 for S&P 500 and 10-year Standard deviation of 24.59% vs. 15.74% for S&P 500. The maximum drawdown of EEM was -60.44% versus -50% for SPY.

Company concentration

A handful of large corporations and conglomerates are consistently dominating all EM country indices. For example, the top 5 holdings in the China Large-Cap index make up 38% of the entire market. In Korea, top 5 companies make up 33%, with Samsung dominating the market with 20%. In India, top 5 companies’ weight is 36%, in Russia, 35% and Mexico, 40%.  As a comparison, top 5 stocks in the S&P 500 index (SPY) make up 11% of the total.

This high concentration leaves the Emerging markets exposed to the fortunes of the handful of companies dominating their markets.

Political instability

Another risk associated with emerging economies is their heavy dependence on local politics. Just in the past few years, we saw North Korea nuclear threats, political scandals in Brazil, sanctions against Russia, the war in Syria. Changes in political power or any geopolitical turmoil will significantly impact the emerging economies and their neighbors.

 

 

About the author: Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm. Babylon Wealth Management offers highly customized Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans and other institutional clients. To learn more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing, Copyright: www.123rf.com

 

5 Myths and One True Fact about passive investing

5 Myths and One True Fact about passive investing

The passive investing in ETFs and index funds has experienced a massive influx of money in the past ten years. The US ETF market is quickly approaching $3 trillion in assets under management. As of March 29, 2017, the total AUM for US ETFs was equal to $2.78 trillion. The value is still dwarfing the $16-trillion mutual fund business. However, it is growing at a steady pace of $300-400 billion annually and slowly catching up. Inevitably, passive investing will continue to grow while active investing will shrink over time until they reach some equilibrium. A lot has been said and written in the media about the benefits of passive investing and indexing. However, I would like to point out 5 Myths and One True Fact about passive investing.

1. Passive investing is cheap

One of the main slogans of the passive investing campaign is that is cheaper than active investing i.e mutual funds. Indeed, the large US ETFs are now charging as low as 0.04% while many active managers are still asking for 1% – 1.5% in management fees.

However, some less obvious costs remain hidden and misunderstood by the average investor. ETFs have two large expense categories – transaction and holding costs.

Transaction costs include trade commissions, bid-ask spread, and market impact. Holding costs include management fees, index tracking error, and taxes.Without getting too technical, holding larger and more liquid ETFs like SPY and VTI will minimize these costs. While, trading smaller ETFs can drive higher hidden costs due to poor trade execution, higher fees, significant index tracking error, and even taxes.

2. Passive investing always beats active investing

According to a recent study by PIMCO, 46% of all active equity fund managers and 84% of all active bond managers over performed their median passive peers in the past five years. In practice, passive investing will perform very well in efficient market segments such as large cap stocks where most companies receive a good amount of publicity and research coverage. On the other hand, active managers will do better in less efficient asset classes like small-cap, emerging markets, and fixed income. These markets have a lot bigger room for mispricing and price discovery due to fragmentation of market players and lower research coverage.

3. Passive investing gives you control

Intuitively it makes sense to think that passive investing provides more control over your investment decisions. After all, you are not paying an active manager to pick and choose your stock holdings. But, and there is always but, most passive investment strategies are market cap weighted. That means whether you invest in S&P 500 (SPY) or Total Equity Market (VTI), a significant portion of your money will go to companies like Apple, Microsoft, Exxon Mobile, Amazon, Johnson and Johnson, General Electric, JP Morgan and Wells Fargo. In fact, you have no choice. The top 10 companies in S&P 500 make up 19% on the index and the remaining 490 stocks make up 81%. Indices are already set and you will follow their performance. 

4. Passive investing is less risky

Investing comes with risk.  And passive investing is as risky as any other form of investing. Passive investors are equally exposed to losses during bear markets, sudden market corrections or just following the wrong index.  In fact, many ETFs are becoming a popular tool amongst traders and hedge fund managers to park extra cash or quickly get in and out of certain positions. Sudden large inflows and selloffs can impose significant risks to smaller retail investors due to an imbalance of trading volume between ETFs and underlying securities.

I also want to point out the increasing presence of Exchange Traded Notes, leveraged, inverse, commodity and volatility ETFs. They carry significant risk to investors and should not be used for long-term retirement planning.

In contrast to that, many active managers use risk-adjusted measures like Sharpe ratio, information ratio, Treynor Ratio and Alpha when assessing their performance to their respective benchmark. Furthermore, many iconic active mutual funds lost a lot less than similar ETFs during the last bear market in 2008-2009 mainly because of their strong risk management policies.

5. Passive investing is efficient

ETFs trade daily and have intra-day pricing like any other stock on the exchange. Naturally, ETFs were designed as a vehicle to provide liquidity and transparency in the marketplace.

However, there have been numerous occasions of significant ETF market mispricing, On August 24, 2015, due to a flash sale, several ETFs lost more than 40% – 50% of their value in a matter of seconds before they recover.

More recently, on March 20, a computer glitch on the largest ETF Exchange, NYSE Arca, caused significant delays and mispricing of thousands of ETFs.

6. The act of choosing passive investing is, in fact, active investing

While the “passive” in the name implies a lack of involvement in the investment decision making, in reality, there is no true passive investing. Passive investing is a type of active investment management. Choosing between passive and active funds is an active choice. Selecting which index to follow is an active decision. Allocating between different asset classes is an act of investment election. Even, the process of deciding when to buy and when to sell an index fund or an ETF is an active decision.

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing, Copyright: <a href=’https://www.123rf.com/profile_vadymvdrobot’>vadymvdrobot / 123RF Stock Photo</a>

Everything you need to know about your Target Retirement Fund

Everything you need to know about your Target Retirement Fund

Target Retirement Funds are a popular investment option in many workplace retirement plans such as 401k, 403b, 457, and TSP. They offer a relatively simple and straightforward way to invest your retirement savings as their investment approach is based on the individual target retirement dates.

Nowadays, almost all employers and 401k providers offer target retirement funds – from Fidelity to Vanguard, American Funds, Blackrock, and Schwab. Although employers and advisors have a choice amongst several fund families, they will typically select one of them for their plan. Multiple target fund families are readily available in individual brokerage accounts or self-directed IRAs.

Workplace plan participants typically have to choose one fund from a single family with target retirement dates in 5-year increments – 2025, 2030, 2035, 2040, 2045, and 2050. Often, plans with auto-enrollment features will automatically assign a target retirement fund based on the estimated year of retirement. Manual enrollment programs will have the fund series in their fund line-up, which could consist of a mix of index, actively managed and target retirement funds.

The base assumption of the target retirement funds is that younger investors have a long investment horizon and higher risk tolerance, therefore, they should have their target retirement assets in more risky investments such as stocks. Inversely, older investors will have a shorter investment horizon and lower risk tolerance. Therefore, the majority of their target retirement money will be in more low-risk investments such as bonds.

Despite their growing popularity, target retirement funds have some limitations and are not identical.  They have substantial differences that may not always appeal to everybody. In this post, I would like to explain some of those nuances.

Style

Target funds utilize two main investment styles – passive indexing and active management. Passive Target Retirement Funds like Vanguard and BlackRock LifePath primarily invest in a mix of index funds. The second groups including T. Rowe Price, Fidelity, American Century, and American Funds pursue an active strategy where investments are allocated in a mix of active mutual funds typically managed by the same firm.

Fees

The fund investment style will often impact the management fees charged by each fund. Passive funds tend to charge lower fees, usually around 0.15% – 0.20%. On the other hand, active funds typically range between 0.40% – 1%.

NameTickerMorningstar RatingMorningstar Analyst RatingAUMExpense
Vanguard Target Retirement 2045VTIVX4-starGold$18.1 bil0.16%
T. Rowe Price Retirement 2045TRRKX5-StarSilver$10.2 bil0.76%
American Funds 2045 Trgt Date Retire R6RFHTX5-StarSilver$4.8 bil0.43%
Fidelity Freedom® 2045FFFGX3-StarSilver$3.5 bil0.77%
American Century One Choice 2045AROIX4-starBronze$1.7 bil0.97%

If you have any doubts about how much you pay for your fund, double-check with your plan administrator or Human Resource. Not to sound alarming but I recently read about a case where a 401k plan contained a fund listed as “Vngd Tgt Retrmt 2045 Fund.” whose sole investment was Vanguard Target Retirement 2045 Fund. However, instead of charging an expense ratio of 0.16%, the fund was taking a whopping 0.92%.  The only purpose of this sham is to deceive participants into believing they are investing in the real Vanguard fund and marking up the expense ratio exponentially.

Asset allocation

The asset allocation is the most critical factor for investment performance. According to numerous studies, it contributes to more than 90% of the portfolio return.  As a factor of such significance, it is essential to understand the asset allocation of your target retirement fund.

While comparing five of the largest target retirement families, we see some considerable variations between them. Vanguard has the highest allocation to Foreign Equity, while T. Rowe has the largest investment in US Equity. Fidelity has the highest allocation to Cash and Cash Equivalents while American Century has the biggest exposure to Bonds. And lastly, American Funds has the largest distribution to Other, which includes Preferred Stocks and Convertible Bonds.

 

2045 Series 

NameTickerCashUS StockNon-US StockBondOther
Vanguard Target Retirement 2045VTIVX  1.11     52.98        34.91    9.77  1.23
T. Rowe Price Retirement 2045TRRKX  2.87     58.98        28.48    9.05  0.62
American Funds 2045 Trgt Date Retire R6RFHTX  3.66     53.21        29.02    9.77  4.34
Fidelity Freedom® 2045FFFGX  5.79     57.58        32.07    3.93  0.63
American Century One Choice 2045AROIX  2.04     55.38        20.32  21.36  0.90

It is also important to understand how the target asset allocation changes over time as investors approach retirement. This change is known as the glide path. In the below table you can see the asset allocation of the 2025 target fund series. All of them have a higher allocation to Bonds, Cash and Cash Equivalents, and a lower allocation of US and Foreign Equity.

2025 Series

NameTickerCashUS StockNon-US StockBondOther
Vanguard Target Retirement 2025VTIVX  1.44     38.05        25.09  34.30  1.12
T. Rowe Price Retirement 2025 FundTRRHX  3.35     45.64        22.06  28.23  0.72
American Funds 2025 Trgt Date Retire R6RFDTX  4.12     39.60        19.36  33.65  3.27
Fidelity Freedom® 2025FFTWX  8.99     41.70        24.31  24.46  0.54
American Century One Choice 2025ARWIX  7.18     40.01        11.88  40.01  0.92

 

 Keep in mind that the target Asset Allocation is not static. Moreover, the fund managers can change the fund allocation according to their view of the market and economic conditions.

Performance

After all said and done, the performance is what matters for most investors and retirees. However, comparing performance between different target funds can be a little tricky. As you saw in the previous paragraph, they are not the same.

So let’s first look at a comparison between different target-date funds from the same family. The return figures represent a net-of-fees performance for 3, 5 and 10 years. Standard Deviation (St. Dev) measures the volatility (risk) of returns.  As expected, the long-dated funds posted higher returns over the near-dated funds. However, the long-dated funds come with higher volatility due to their higher allocation to equities.

 

Target Date Performance Comparison by Target Year

ReturnStandard Deviation
NameTicker3-Year5-Year10-Year3-Year5-Year10-Year
American Funds 2025 Trgt Date Retire R6RFDTX   5.71    9.36     5.88   6.78    7.48   12.83
American Funds 2035 Trgt Date Retire R6RFFTX   6.73  10.43     6.44   8.70    8.84   13.81
American Funds 2045 Trgt Date Retire R6RFHTX   6.99  10.67     6.56   9.09    9.10   13.96
American Funds 2055 Trgt Date Retire R6RFKTX   7.33  11.32   9.13    9.15

 

The comparison between different fund families also reveals significant variations in performance. The majority of these differences can be attributed to their asset allocation, investment selection, and management fees.

Target Date Performance Comparison by Fund Family

Return  Standard Deviation
NameTicker3-Year5-Year10-Year3-Year5-Year10-Year
Vanguard Target Retirement 2045VTIVX   6.24    9.50     5.70   9.42    9.51   14.63
T. Rowe Price Retirement 2045TRRKX   6.54    9.92     6.20   9.68    9.80   15.80
American Funds 2045 Trgt Date Retire R6RFHTX   6.99  10.67     6.56   9.09    9.10   13.96
Fidelity Freedom® 2045FFFGX   6.50    8.95     4.82   9.83    9.64   15.25
American Century One Choice 2045AROIX   5.79    8.63     5.73   8.38    8.41   13.50

How they fit with your financial goals

How the target retirement fund fit within your financial goals is an important nuance that often gets underestimated by many. Target retirement funds assume the investors’ risk tolerance based on their age and the estimated year of retirement. Older investors will automatically be assigned as conservative while they could be quite aggressive if this is a part of their inter-generational estate planning. Further, young investors default to an aggressive allocation while they could be more conservative due to significant short-term financial goals. So keep in mind that the extra layer of personal financial planning is not a factor in target retirement funds.

 

Final words

Target retirement funds come with many benefits. They offer an easy way to invest for retirement without the need for in-depth financial knowledge. Target funds come in different shapes and forms and bring certain caveats which may appeal to some investors and not to others. If you plan to invest in a target retirements fund, the five questions above will help you decide if this is the right investment for you.

6 Essential steps to diversify your portfolio

6 Essential steps to diversify your portfolio

Diversification is often considered the only free lunch in investing. In one of my earlier blog posts, I talked about the practical benefits of diversification. I explained the concept of investing in uncorrelated asset classes and how it reduces the overall risk of the investments.  In this article, I will walk you through 6 essential steps to diversify your portfolio.

 

1. Know your risk tolerance

Risk tolerance is a measure of your emotional appetite to take on risk. It is the ability to endure volatility in the marketplace without making any emotional and spur of the moment investment decisions. Individual risk tolerance is often influenced by factors like age, investment experience, and various life circumstances.

Undoubtedly, your risk tolerance can change over time. Certain life events can affect your ability to bear market volatility. You should promptly reflect these changes in your portfolio risk profile as they happen.

 

2. Understand your risk capacity

Often your willingness and actual capacity to take on risk can be in conflict with each other. You may want to take more risk than you can afford. And inversely, you could be away too conservative while you need to be a bit more aggressive.

Factors like the size of savings and investment assets, investment horizon, and financial goals will determine the individual risk capacity

 

3. Set a target asset allocation

Achieving the right balance between your financial goals and risk tolerance will determine the target investment mix of your portfolio. Typically, investors with higher risk tolerance will invest in assets with a higher risk-return profile.

These asset classes often include small-cap, deep value, and emerging market stocks, high-yield bonds, REITs, commodities and various hedge fund and private equity strategies. Investors will lower risk tolerance will look for safer investments like government and corporate bonds, dividends and low volatility stocks.

In order to achieve the highest benefit from diversification, investors must allocate a portion of their portfolio to uncorrelated asset classes. These investments have a historical low dependence on each other’s returns.

The US Large Cap stocks and US Treasury Bonds are the classic examples of uncorrelated assets. Historically, they have a negative correlation of -0.21. Therefore, the pairs tend to move in opposite direction over time. US Treasuries are considered a safe haven during bear markets, while large cap stocks are the investors’ favorite during strong bull markets.

See the table below for correlation examples between various asset classes.

Asset Correlation Chart
Source: Portfoliovisualizer.com

4. Reduce your concentrated positions

There is a high chance that you already have an established investment portfolio, either in an employer-sponsored retirement plan, self-directed IRA or a brokerage account.

If you own a security that represents more than 5% of your entire portfolio, then you have a concentrated position. Regularly, individuals and families may acquire these positions through employer 401k plan matching, stock awards, stock options, inheritance, gifts or just personal investing.

The risk of having a concentrated position is that it can drag your portfolio down significantly if the investment has a bad year or the company has a broken business model. Consequently, you can lose a substantial portion of your investments and retirement savings.

Managing concentrated positions can be complicated. Often, they have restrictions on insider trading. And other times, they sit on significant capital gains that can trigger large tax dues to IRS if sold.

 

5. Rebalance regularly

Portfolio rebalancing is the process of bringing your portfolio back to the original target allocation. As your investments grow at a different rate, they will start to deviate from their original target allocation. This is very normal. Sometimes certain investments can have a long run until they become significantly overweight in your portfolio. Other times an asset class might have a bad year, lose a lot of its value and become underweight.

Adjusting to your target mix will ensure that your portfolio fits your risk tolerance, investment horizon, and financial goals. Not adjusting it may lead to increasing the overall investment risk and exposure to certain asset classes.

 

6. Focus on your long-term goals

When managing a client portfolio, I apply a balanced, disciplined, long-term approach that focuses on the client’s long-term financial goals.

Sometimes we all get tempted to invest in the newest “hot” stock or the “best” investment strategy ignoring the fact that they may not fit with our financial goals and risk tolerance.

If you are about to retire, you probably don’t want to put all your investments in a new biotech company or tech startup. While these stocks offer great potential returns, they come with an extra level of volatility that your portfolio may not bear. And so regularly, taking a risk outside of your comfort zone is a recipe for disaster. Even if you are right the first time, there is no guarantee you will be right the second time.

Keeping your portfolio well diversified will let you endure through turbulent times and help your investments grow over time by reducing the overall risk of your investments.

 

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing, Copyright: www.123rf.com