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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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>

5 things you need to know about your Target Retirement Fund

5 things you need to know about your Target Retirement Fund

Target Retirement Funds have become a popular investment option in many workplace retirement plans such as 401k, 403b and SEP IRA. They offer a relatively simple way to invest your retirement savings as their investment approach is based on the individual target retirement dates. In this post, I will discuss the 5 things you need to know about your target retirement fund.

Nowadays, almost all investment companies offer target retirement funds – from Fidelity to Vanguard, American Funds, Blackrock, and Schwab. Although plan administrators 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.

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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 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.

 

 

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our 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 is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs) and other institutional clients. To find out 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: <a href=’https://www.123rf.com/profile_pogonici’>pogonici / 123RF Stock Photo</a>

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

Top 5 Strategies to Protect Your Portfolio from Inflation

Top 5 Strategies to Protect Your Portfolio from Inflation

Protecting Your Portfolio from Inflation

The 2016 election revived the hopes of some market participants for higher interest rates and higher inflation. Indeed, the 10-year Treasury rate went from 1.45% in July to 2.5% in December before settling at around 2.35-2.40% at the end of February 2017. Simultaneously, the Consumer Price Index, which is one of the leading inflation indicators, hit a five-year high level at 2.5% in January 2017. As many investors are becoming more concerned, we will discuss our top 5 strategies to protect your portfolio from inflation.

Higher interest and inflation rates can hurt the ability of fixed income investors to finance their retirement. Bonds and other fixed-income instruments lose value when interest rates go up and gain value when interest rate come down.

Learn more about our Private Client Services

 

Source: www.inflationdata.com

 

There were numerous articles in popular media about the “great rotation” and how investors will switch from fixed to equity investments in search for higher return. None of that has happened yet, and the related news has seemed to disappear.

However, the prospects for higher inflation are still present. So, in this article, I would like to discuss several asset classes that are popular among individual investors. I will explain see how they perform in the environment of rising inflation.

 

Cash

Cash is by far one of the worst vehicles to offer protection against inflation. Money automatically loses purchasing power with the rise of inflation. Roughly speaking, if this year’s inflation is 3%, $100 worth of goods and services will be worth $103 in a year from now. Therefore, someone who kept cash in the checking account or at home will need extra $3 to buy the same goods and services he could buy for $100 a year ago.

A better way to protect from inflation, while not ideal, is using saving accounts and CDs. Some online banks and credit unions offer rates above 1%. This rate is still less than the CPI but at least preserves some of the purchasing power.

 

Equities

Stocks are often considered protection tools against inflation. They offer a tangible claim over company’s assets, which will rise in value with inflation. However, historical data has shown that equities perform better only when inflation rates are around 2-3%. To understand this relationship, we have to look at both Real and Nominal Inflation-Adjusted Returns. As you can see from the chart below, both real and nominal stock returns have suffered during periods of inflation that is over 5% annually. Moreover, stocks performed very well in real and nominal terms when inflation rates were between 0% and 3%.

 

Source: www.inflationdata.com

 

High inflation deteriorates firms’ earnings by increasing the cost of goods and services, labor and overhead expenses. Elevated levels of inflation have the function to suppress demand as consumers are adjusting to the new price levels.

While it might look tempting to think that certain sectors can cope with inflation better than others, the success rate will come down to the individual companies’ business model. As such, firms with strong price power and inelastic product demand can pass the higher cost to their customers. Additionally, companies with strong balance sheet, low debt, high-profit margins and steady cash flows tend to perform better in high inflation environment.

 

Real estate

Real Estate very often comes up as a popular inflation protection vehicle. However, historical data and research performed the Nobel laureate Robert Shiller show otherwise.

According to Shiller “Housing traditionally is not viewed as a great investment. It takes maintenance, it depreciates, it goes out of style. All of those are problems. And there’s technical progress in housing. So, the new ones are better….So, why was it considered an investment? That was a fad. That was an idea that took hold in the early 2000’s. And I don’t expect it to come back. Not with the same force. So people might just decide, ‘yeah, I’ll diversify my portfolio. I’ll live in a rental.’ That is a very sensible thing for many people to do”.

Source: http://www.econ.yale.edu/~shiller/data.htm

 

Shiller continues “…From 1890 to 1990 the appreciation in US housing was just about zero.  That amazes people, but it shouldn’t be so amazing because the cost of construction and labor has been going down.”  Rising inflation will lead to higher overhead and maintenance costs, potential renter’s delinquency and high vacancy rates.

To continue Shiller’s argument, investors seeking an inflation protection with Real Estate must consider their liquidity needs. Real Estate is not a liquid asset class. It takes a longer time to sell it. “Every transaction involves paying fees to banks, lawyers, and real-estate agents. There are also maintenance costs and property taxes. The price of a single house also can be quite volatile.” Just ask the people who bought their homes in 2007, just before the housing bubble.

 

Commodities

Commodities and particularly gold tend to provide some short-term protection against inflation. However, this is a very volatile asset class. Gold’s volatility measured by its 42-year standard deviation is 33% higher than that of stocks and 3.5 times greater the volatility of the 10-year treasury.  Short-term inflation protection benefits are often overshadowed by other market-related events and speculative trading.

Source: www.portfoliovisualizer.com

 

Not to mention the fact that the gold and other commodities are not easily available to retail investors outside the form of ETFs, ETNs, and futures. Buying actual commodities can incur significant transaction and storage cost which makes it almost prohibitive for individuals to physically own them.

 

Bonds

According to a many industry “experts” bonds are a terrible tool to protect for inflation. The last several years after the great recession were very good to bonds since rates gradually went down and the 10-year treasury rate reached 1.47% in July 2017.  The low rates were supported by quantitate easing at home and abroad and higher demand from foreign entities due to near zero or negative rates in several developed economies. As the rates went up in the second half of 2016, bonds, bonds ETFs and mutual funds lost value. While bonds may have some short-term volatility with rising inflation, they have shown a strong long-term resilience. The 42-year annualized return of the 10-year Treasury is 7.21% versus 10.11% for large Cap Stocks. The Inflation adjusted rate of return narrows the gap between two asset groups, 3.07% for bonds and 5.85% for stocks.

Source: Lazard

 

For bond investors seeking inflation protection, there are several tools available in the arsenal. As seen in the first chart, corporate bonds due to their stronger correlation to equities market have reported much higher real returns compared to treasuries. Moving to short-term duration bonds, inflation-protected bonds (TIPS), floating rate bonds, are banks loan are some of the other sub-classes to consider.

 

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=’http://www.123rf.com/profile_stockshoppe’>stockshoppe / 123RF Stock Photo</a>
Sources:
http://www.lazardnet.com/lam/global/pdfs/Literature/EquityInvestmentsAsAHedgeAgainst_LazardResearch.pdf
http://www.lazardnet.com/lam/global/pdfs/Literature/Part2-EquityInvestmentsAsAHedgeAgainst_LazardResearch.pdf
www.inflatondata.com
http://www.econ.yale.edu/~shiller/data.htm

 

Will Small Caps continue to rally under Trump Presidency?

Small Cap stocks are a long-time favorite of many individual investors and portfolio manager. The asset class jumped 38% since the last election. Will Small Caps continue to rally under Trump Presidency? Can they maintain their momentum?

The new president Trump started with promises for domestic business growth, lower taxes, and deregulation. While details are still unclear, if implemented correctly, these policies can bring significant benefits to small size companies.

The recent growth comes after five years of sluggish performance. Before the 2016 election, the Russell 2000 had underperformed S&P 500 500 by almost 2% annually, 11.59% versus 13.44%.  Small-cap stocks have been very volatile and fragmented. As a result, many active managers have underperformed passive index strategies.

 

Low tax rates

The average US corporate tax rate is 39.1% which includes 35% federal tax and 4.1% average state tax. USA has the highest corporate tax among OECD countries, which have an average of 29% tax rate. While large multinationals with their corporate lawyers can take advantage of cross-border tax loopholes, the same is not possible for smaller businesses. Dropping the tax rate to the suggested 20% will give small caps a breath of fresh air. It will allow them to have more available cash, which they can use for hiring more talent, R&D or dividends.

Deregulation

Regulations are typically set to protect the consumer and the environment from businesses which prioritize profit margins over safety. Therefore, lifting regulations will be a tricky game. If the streamlining leads to more competition, better customer experience, less bureaucracy, and faster processing of business requests to governing bodies, then deregulation will help smaller business thrive further and be more competitive.

 Infrastructure

I drive a lot around the San Francisco Bay Area and can ensure you that every highway with “80” in the name is in dire need of major TLC. The same story is probably true for many major cities and industrial centers. If the executed correctly, the infrastructure policy can boost small business growth. Local companies can bid for infrastructure projects or participate as subcontractors. Improved infrastructure can also help goods and produce to arrive faster and safer and ultimately drive down cost.

Domestic production incentives

With the current strong dollar and liberal trading policy, the small business has struggled to compete against imports, which rely heavily on cheap labor and often on local government subsidies. Certain industries like textile and electronics are almost non-existent in the US.

Nevertheless, I think setting embargos and trade wars with other countries will be a step in the wrong direction. Alternatively, The US government should support industries that offer innovative, high quality, customized and niche products, which can dominate the global markets.

 

While the markets are currently optimistic about the success of the new economic policies, things can still go wrong. The markets had a long rally since the end of the bear market in March 2009. At the current level, both large and small-cap companies have reached rich valuations, and stock prices are factoring the proposed economic policies. The stock market may react abruptly if the new administration fails to deliver their promises.

Some of the side effects of the new policies need to be in consideration as well.

Rising interest rates

The 10-year Treasury jumped from 1.5% in July 2016 to 2.47% today. While high-interest rates have been welcomed by many market players, they can hurt the small business’ ability to get new loans. Many companies rely on external financing to fund their daily business activities, R&D, and expansions. Higher interest rates will increase the cost and affect the bottom line of those companies that traditionally use loans as part of their business and have less access to internal resources.

Another caveat in this topic is the proposed change to eliminate the interest as a tax deduction. While still up-in-the-air, this proposal will further affect those companies that depend on external loans for financing.

Inflation

Inflation is healthy for the economy when it’s a result of organic economic growth, innovation, productivity, and consumer demand. However, if let out of control, inflation will undermine the purchasing power of the dollar, push down consumer demand and increase the cost of domestic goods and services.

Strong dollar

Small cap companies are traditionally focused on the local US market. However, a strong dollar can make imports more price competitive against local products. The strong dollar also affects negatively business relying on exports. It makes US exports more expensive in local currencies.

Immigration

It’s a known fact that US firms tap into a foreign talent to fill out jobs that are not in high supply by domestic job seekers. Usually, the biggest portion of visa workers goes to larger companies. However, stricter immigration laws can still hurt the ability of small firms to hire foreign talent and compete against their larger rivals. Many tech start-ups, financial and biotech companies rely on foreign visa workers to fill out certain roles whenever they cannot find qualified US candidates. Agriculture and tourism businesses also depend on foreign workers to fill in seasonal positions. Tighter immigration rules will force these companies to increase salaries to remain competitive. Higher salaries will drive higher cost and lower profit margins.

 

Conclusion

While we are in a standby mode, the market continues to be nervous in anticipation of the direction of the new policies. For those interested in small-cap stocks, I would suggest looking for companies with an innovative business model, solid R&D and high-quality metrics like ROA and ROE. Those companies are likely to be more resilient in the long run, and less depended on policy changes.

 

Final words

If you have any questions about your existing investment portfolio, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our 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 is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out 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,

Municipal Bond Investing

Municipal Bond Investing

What is a Municipal Bond?

Municipal bond investing is a popular income choice for many American.  The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities and their related companies. Municipal bonds or “munis” are issued to fund general activities or capital projects like building schools, roads, hospitals and sewer systems. The size of the muni bond market reaches $3.7 trillion dollars. There are about $350 billion dollars of Muni bond issuance available every year.

In order to encourage Americans to invest in Municipal Bonds, US authorities had exempted the interest (coupon income) of the muni bonds from Federal taxes. In some cases when the bondholders reside in the same state where the bond was issued, they can be exempted from state taxes too.

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Types of Municipal Bonds

General obligation bonds are issued by municipal entities to finance various public projects like roads, bridges, and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality.  Usually, they do not have a dedicated revenue source. The local authorities commit their abundant resources to pay off the bonds. Municipals rely on their unlimited power to tax residents to pay back bondholders.

Revenue bonds are backed by income from a particular project or source. There is a wide diversity of types of revenue bonds, each with unique credit characteristics. Municipal entities frequently issue securities on behalf of other borrowers such as water and sewer service, toll bridges, non-profit colleges or hospitals. These underlying borrowers typically agree to repay the issuer, who pays the interest and principal on the securities solely from the revenue provided by the conduit borrower.

Taxable Bonds. There is a smaller but growing niche of taxable municipal bonds. These bonds exist because the federal government will not subsidize the financing of certain activities, which do not provide a significant benefit to the general public. Investor-led housing, local sports facilities, refunding of a refunded issue and borrowing to replenish a municipality’s underfunded pension plan, Build America Bonds (BABs) are types of bond issues that are federally taxable. Taxable municipals offer higher yields comparable to those of other taxable sectors, such as corporate or government agency bonds.

 

Investment and Tax Considerations

Tax Exempt Status

With their tax-exempt status, muni bonds are a powerful tool to optimize your portfolio return on an after-tax basis.

Muni Tax Adjusted Yield

So why certain investors are flocking into buying muni bonds? Let’s have an example:

An individual investor with a 35% tax rate is considering between AA-rated corporate bond offering 4% annual yield and AA-rated municipal bond offering 3% annual yield. All else equal which investment will be more financially attractive?

Since the investors pays 35% on the received interest from the corporate bonds she will pay 1.4% of the 4% yield to taxes (4% x 0.35% = 1.4%) having an effective after-tax interest of 2.6% (4% – 1.4% = 2.6%). In other words, the investor will only be able to take 2.6% of the 4% as the remaining 1.4% will go for taxes. With the muni bond at 3% and no federal taxes, the investor will be better off buying the muni bond.

Another way to make the comparison is by adjusting the muni yield by the tax rate. Here is the formula.

Muni Tax Adjusted Yield = Muni Yield / (1 – tax rate) = 4% / (1 – 0.35%) = 4.615%

The result provides the tax adjusted interest of the muni bond as if it was a regular taxable bond. In this case, the muni bond has 4.615% tax adjusted interest which is higher than the 4% offered by the corporate bond.

 Effective state tax rate

Another consideration for municipal bond investors is the state tax rate. Most in-state municipal bonds are exempt from state taxes while out-of-state bonds are taxable at state tax level. Investors from states with higher state tax rates will be interested in comparing the yields of both in and out-of-state bonds to achieve the highest after-tax net return. Since under federal tax law, taxes paid at the state level are deductible on a federal income tax return, investors should, in fact, consider their effective state tax rate instead of their actual tax rate. The formula is:

Effective state tax rate = State Income Tax rate x (1 – Federal Income Tax Rate)

Example, if an investor resides in a state with 9% state tax and has 35% federal tax rate, what is the effective tax rate:

Effective state tax rate = 9% x (1 – .35) = 5.85%

If that same investor is comparing two in- and out-of-state bonds, all else equal she is more likely to pick the bond with the highest yield on net tax bases.

AMT status

One important consideration when purchasing muni bonds is their Alternative Minimum Tax (AMT) status. Most municipal bond will be AMT-free. However, the interest from private activity bonds, which are issued to fund stadiums, hospitals, and housing projects, is included as part of the AMT calculation. If an investor is subject to AMT, the bond interest income could be taxable at a rate of 28%.

Social Security Benefits

If investors receive Medicare and Social Security benefits, their municipal bond tax-free interest could be subject to taxes. The IRS considers the muni bond interest as part of the “modified adjusted gross income” for determining how much of their Social Security benefits, if any, are taxable. For instance, if a couple earns half of their Social Security benefits plus other income, including tax-exempt muni bond interest, above $44,000 ($34,000 for single filers), up to 85% of their Social Security benefits are taxable.

 

Diversification

Muni bonds are good choice to boost diversification to the investment portfolio.  Historically they have a very low correlation with the other asset classes. Therefore,  municipal bonds returns have observed a smaller impact by developments in the broader stock and bond markets.

For example, municipal bonds’ correlation to the stock market is at 0.03%. Their correlation to the 10-year Treasury is at 0.37%.

 

Interest Rate Risk

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate go up, muni bond prices will go down. And reversely, as the interest rates decline, the bond prices will rise. When you invest in muni bonds, you have to consider your overall interest rate sensitivity and risk tolerance.

Credit Risk

Similar to the corporate world, the municipal bonds and the bond issuers receive a credit rating by the major credit agencies like Moody’s, S&P 500 and Fitch. The credit rating shows the ability of the municipality to pay off the issued debt. The bonds receive a rating between AAA and C with AAA being the highest possible and C the lowest. BBB is the lowest investment grade rating, while all issuance under BBB are known as high-yield or “junk” bonds. The major credit agencies have different methodologies to determine the credit rating of each issuance. However, historically the ratings tend to be similar.

Unlike corporations, which can go bankrupt and disappear, municipals cannot go away. They have to continue serving their constituents. Therefore, many defaults end up with debt restructuring followed by continued debt service. Between 1970 and 2014 there were 95 municipal defaults. The vast majority of them belong to housing and health care projects.

In general, many investors consider municipal debt to be less risky. The historical default rates among municipal issuances is a lot smaller than those for comparable corporate bonds.

 

Limited secondary market

The secondary market for municipal bonds sets a lot of limitations for the individual investor. While institutional investors dominate the primary market, the secondary market for municipal bonds offers limited investment inventory and real-time pricing. Municipal bonds are less liquid than Treasury and corporate bonds. Municipal bond investing tends to be part of a buy and hold strategy as most investors look for their tax-exempt coupon.

Fragmentation

The municipal bond market is very fragmented due to issuances by different states and local authorities. MUB, the largest Municipal ETF holds 2,852 muni bonds with the highest individual bond weight at.45%. Top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. Top 5% make up 38.14% of the assets under management.

 

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. Hs 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=’http://www.123rf.com/profile_designer491′>designer491 / 123RF Stock Photo</a>