5 reasons to leave your robo-advisor and work with a real person

Leave your robo-advisor

Leave your robo-advisorRobo-advisors have grown in popularity in the last 10 years, offering easy and inexpensive access to professional investment management with human interaction.  Firms like Vanguard, Betterment, Personal Capital, and Wealth Front use online tools and algorithms to build and manage your investment. These digital advisors attract new customers with cutting-edge technology, attractive websites, interactive features, low fees, and cool mobile apps. The rising adoption of robo-advisors and various digital platforms allows the financial industry to become more accessible and consumer-friendly.

Unlike traditional portfolio management firms, most robo-advisors offer their automated investing service with low or no account minimums. You will answer an online questionnaire. Your answers will place you in a specific risk tier group. As a result, the robo-advisor will invest your assets according to your risk profile. The typical digital advisor offers automated portfolio rebalancing and tax loss harvesting. Some may even offer you financial planning advice for an additional fee.

If you have read one of my Investment Ideas articles (here and here), you know that I am a big believer in FinTech, mobile payments, and digitization of the financial industry. The covid outbreak created a massive tailwind for this trend to continue in the next decade. You will experience a complete digital transformation in all aspects of your financial life.

With all that in mind, why someone like yourself will decide to abandon their digital advisor service? So here we go.

Receive personalized advice

Life changes. Often you will be at crossroads in your life trying to make important financial decisions. You will need to talk to someone who understands your situation and can give you personalized advice with your best interest in mind. Unfortunately, digital advisor services rarely, if never offer personalized advice. Algorithms cannot understand your emotions and feelings.

Surely, you can do the research and the hard lifting yourself. There is nothing more rewarding than reaping the benefits from your hard work. However, there is nothing wrong with asking for help. You do not have to do it alone. Working with a fiduciary financial advisor who understands your circumstances will save you time and grievance. Moreover, it will save you and make you money in the long run. And most importantly, it allows you to enjoy what matters most to you.

Build a relationship

Finding a good financial advisor is like finding a personal doctor or a hairstylist who cuts your hair just the way you wanted. Would you ask a robot to cut your hair? Then, why would you leave your wealth and retirement savings to an algorithm? Having a trusted relationship with a fiduciary financial advisor will give you access to objective, unbiased, and reliable financial advice when you need it most. Your financial advisor can point your financial blind spots and recommendations on how to resolve them before they escalate.

I frequently work with clients coming from large robo-advisors. Almost always, their biggest complaint is that they were not able to get answers to their questions. They were calling customer service, waiting in line, and speaking with a complete stranger on the other side.

Building wealth is a marathon, not a race. Why not working with a trusted partner who understands your unique needs and has your best interest in mind.

Invest with purpose

Have you asked yourself, does your investment portfolio represent your philosophy and values?

For many of you, investing is a way to make a meaningful impact on your favorite causes.

Furthermore, most robo-advisors offer a limited number of generic ETFs in various asset classes. However, they do not provide a way to customize your investments according to your core values.  The only you can achieve your purpose is through a customized investment portfolio that represents what you believe.

Impact Investing

Impact investing is about MAKING A DIFFERENCE. It is a philosophy that seeks to achieve sustainable long-term returns by investing in companies that create positive and measurable social, governance, and environmental impact. If you are an impact investor, your goal is to invest your money in areas that match your core beliefs and values.  By choosing the path of impact investing, you will provide the necessary support to address the world’s most urgent challenges in areas such as sustainable agriculture, clean energy, gender equality, social justice, food conservation, microfinance, and affordable access to housing, healthcare, and education.

Thematic investing

Thematic investing is a path to achieve higher long-term returns by investing in specific economic and secular trends caused by structural shifts in our society. It is about CHANGE. The thematic investing strategy relies on megatrends that are changing the way we live. Several of my favorite trends include climate change and renewable energy, 5G and cybersecurity, digital payments and e-commerce, blockchain and digital revolution, the rising power of women, and population growth.

Have a plan

Life is complicated.  As a result, your circumstances will change. You will start a new job, move to a new place. Start a family. Buy a new house. Exercise those stock options that you received when you started your last job. Above all, you must prepare for everything that life has to give.

Once you do the groundwork, it’s easier to update your plan than create a new one from scratch every time your life changes. Your plan will make you feel confident when making complex financial decisions about your future.

According to Vanguard itself, working with a financial advisor can bring you up to 3% average additional return. The advisor alpha comes from value-added services such as behavioral coaching, tax-smart investing, asset allocation, and rebalancing.

Get a customized tax strategy.

Let’s admit it. The US has one of the most complex tax systems in the world. We all get tangled with terms such as AMT, marginal tax bracket, capital gain tax, 401k, step-up basis, tax-deferred and exempt income. With the ever-rising budget deficit, there is no doubt that your taxes will only go higher. Paying taxes is part of life but managing your future tax bill is your responsibility.

One popular way to measure the efficiency of your tax strategy is your tax alpha. Tax Alpha is the ability to achieve an additional return on your investments by taking advantage of all available tax strategies as part of your comprehensive financial planning. Unlike robo-advisors,  our firm can offer a wider range of tax planning tools that can help you realize higher long-term after-tax returns.  For instance, for us, achieving Tax Alpha is a process that starts on day 1.  As a result, we will craft a comprehensive strategy that will maximize your financial outcome and lower your taxes in the long run.

Successful strategies for (NOT) timing the stock market

Timing the stock market

Timing the stock market is an enticing idea for many investors.  However, even experienced investment professionals find it nearly impossible to predict the daily market swings, instant sector rotations, and ever-changing investors’ sentiments. The notion that you can perfectly sell at the top of the market and buy at the bottom is naïve and oftentimes leads to bad decisions.

The 24-hour news cycle is constantly bombarding us. The speed and scale of information could easily bounce the stock market between desperation, apathy, and fear to euphoria, FOMO, and irrational exuberance.

In that sense, the market volatility can be unnerving and depressing. However, for long-term investors, trying to time the market tops and bottoms is a fool’s errand. Constantly making an effort to figure out when to get in and get out can fire back. There is tremendous evidence that most investors reduce their long-term returns trying to time the market. Market timers are more likely to chase the market up and down and get whipsawed, buying high and selling low.

The hidden cost of timing the stock market

There is a hidden cost in market timing.  According to Fidelity, just missing 5 of the best trading days in the past 40 years could lower your total return by 38%. Missing the best 10 days will cut your return in half.

Source: Fidelity
Source: Fidelity

For further discussion on how to manage your portfolio during times of extreme market volatility, check my article on “Understanding Tail Risk

Rapid trading

Today’s stock market is dominated by algorithm trading platforms and swing traders with extremely short investment horizons.  Most computerized trading strategies hold their shares for a few seconds, not even minutes. Many of these strategies are run by large hedge funds. They trade based on market signals, momentum, and various inputs built within their models. They can process information in nanoseconds and make rapid trades. The average long-term investors cannot and should not attempt to outsmart these computer models daily.

Reuters calculated that the average holding period for U.S. shares was 5-1/2 months as of June 2020, versus 8-1/2 months at the of end-2019. In 1999, for example, the average holding period was 14 months. In the 1960s and 1970, the investors kept their shares for 6 to 8 years.

Timing the stock market
Timing the stock market

 

The market timing strategy gives those investors a sense of control and empowerment, It doesn’t necessarily mean that they are making the right decisions.

So, if market turmoil gives you a hard time, here are some strategies that can help you through volatile times.

Dollar-cost average

DCA is the proven approach always to be able to time the market.  With DCA, you make constant periodic investments in the stock market. And you continue to make these investments whether the market is up or down. The best example of DCA is your 401k plan. Your payroll contributions automatically invest every two weeks.

Diversify

Diversification is the only free lunch in investing. Diversification allows you to invest in a broad range of asset classes with a lower correlation between them.  The biggest benefit is lowering the risk of your investment portfolio, reducing volatility, and achieving better risk-adjusted returns.  A well-diversified portfolio will allow your investments to grow at various stages of the economic cycle as the performance of the assets moves in different directions.

Rebalance

Rebalancing is the process of trimming your winners and reinvesting in other asset classes that haven’t performed as successfully.  Naturally, one may ask, why should I sell my winners? The quick answer is diversification. You don’t want your portfolio to become too heavy in a specific stock, mutual fund, or ETF. By limiting your exposure, you will allow yourself to realize gains and buy other securities with a different risk profile.

Buy and hold

For most folks, Buy and Hold is probably the best long-term strategy. As you saw earlier,  there is a huge hidden cost of missing out on the best trading days in a given period. So being patient and resilient to noise and negative news will ultimately boost your wealth. You have to be in it to win it.

Tax-loss harvesting

If you are holding stocks in your portfolio, the tax-loss harvesting allows you to take advantage of price dips and lower your taxes. This strategy works by selling your losers at a loss and using the proceeds to buy similar security with an identical risk-reward profile. At the time of this article, you can use capital losses to offset any capital gains from the sale of profitable investments. Furthermore,  you can use up to $3,000 of residual capital loss to offset your regular income. The unused amount of capital loss can be carried forward in the next calendar year and beyond until it’s fully used.

Maintain a cash reserve

I advise all my clients to maintain an emergency fund sufficient to cover at least 6 months worth of expenses. An emergency fund is especially critical If you are relying on your investment portfolio for income. The money in your emergency fund will help you withstand any unexpected market turbulence and decline in your portfolio balance. A great example would be the rapid market correction in March 2020 at the onset of the coronavirus outbreak. If you needed to sell stocks from your portfolio, you would be in tough luck. But if you had enough cash to keep afloat through the crisis, you would have been in a perfect position to enjoy the next market rebound.

Focus on your long term goals

My best advice to my clients who get nervous about the stock market is to focus on what they can control.  Define your long-term goals and make a plan on how to achieve them. The stock market volatility can be a setback but also a huge opportunity for you. Follow your plan no matter what happens on the stock market. Step back from the noise and focus on strengthening your financial life.

Understanding Tail Risk and how to protect your investments

Understanding tail risk

What is Tail Risk?

Tail Risk is the possibility of suffering large investment losses due to sudden and unforeseen events. The name tail risk comes from the shape of the bell curve. Under normal circumstances, your most likely investment returns will gravitate in the middle of the curve. For long term investors, this will represent your average expected return. The more extreme returns have a lower probability of occurring and will taper away toward the end of the curve.

Understanding tail risk
Source: Pimco

The tail on the far-left side represents the probability of unexpected losses. The far-right represents the most extreme outcomes of substantial investment gains. For long-term investors, the ideal portfolio strategy will seek to minimize left tail risk without restricting the right tail growth potential.

Why is tail risk important?

Intuitively, we all want to be on the ride side of the bell curve. We want to achieve above-average returns and occasionally “hit the jackpot” with sizeable gains.

In real life, abrupt economic, social, and geopolitical events appear a lot more frequently than a rational human mind would predict. Furthermore, significant market shocks have been occurring about every three to five years resulting in “fatter” tails.

Also known as “Black Swans, they are rare and unique. These “one-off” events impose adverse pressure on your investment portfolio and create risk for outsized losses. Tail risk events bring a massive amount of financial and economic uncertainty and often lead to extreme turbulence on the stock market.

The Covid outbreak, Brexit, the European credit crisis, the collapse of Lehman Brothers, the Enron scandal, the US housing market downfall, and the 9/11 terrorist attacks are examples of idiosyncratic stock market shocks. Very few experts could have predicted them. More notably, they caused dramatic changes to our society and our economy, our consumer habits, and the way we conduct business.

Assessing your tail risk exposure

Retirees and those close to retirement, people who need immediate liquidity, executives, and employees holding a large amount of corporate stock are more susceptible to tail risk events. If you fall into one of these categories, you need to review your level of risk tolerance.

Investing is risky. There are no truly risk-free investments. There are only investments with different levels of risk. It is impossible to avoid risk altogether. The challenge for you is to have a reasonably balanced approach to all the risks you face. Ignoring one risk to help you prevent another risk does not mean you are in the clear.

Winners and losers

It is important to remember that every shock to the system leads to winners and losers. For example, the covid outbreak disproportionately hurt leisure, travel, retail, energy, and entertainment businesses. But it also benefited many tech companies as it accelerated the digital transformation. As bad as it was, the global financial crisis damaged many big and small regional banks. But it also opened the door for many successful fintech companies such as Visa, Mastercard, PayPal, and Square and exchange-traded fund managers like BlackRock and Vanguard. The aftermath of 9/11 drove the stock market down, but it led to a boost in defense and cybersecurity stocks.

Know your investments

The first step in managing your tail risk is knowing your investments. That is especially important if you have concentrated positions in a specific industry, a cluster of companies, or a single stock. Black Swan events could impact different stocks, sectors, and countries differently. For instance, the Brexit decision mostly hurt the performance of the UK and European companies and had no long-term effect on the US economy.

Know your investment horizon

Investors with a long-term investment horizon are more likely to withstand sudden losses. The stock market is forward-looking. It will absorb the new information, take a hit, and move on.

I always give this as an example. If you invested $1,000 in the S&P 500 index on January 1, 2008, just before the financial crisis, you would have doubled your money in 10 years. Unfortunately, if you needed your investment in one or two years, you would have been in big trouble. It took more than three years to recover your losses entirely.

Diversify

Never put all your eggs in one basket. The most effective way to protect yourself from unexpected losses is diversification. Diversification is the only free lunch you will ever get in investing. It allows you to spread your risk between different companies, sectors, asset classes, and even countries will allow your investment portfolio to avoid choppy swings in various market conditions. One prominent downside of diversification is that while you protect yourself from the left tail risk, you also limit the right tail potential for outsized returns.

Hold cash

Keeping cash reserves is another way to protect yourself from tail risk. You need to have enough liquidity to meet your immediate and near-term spending needs. I regularly advise my clients to maintain an emergency fund equal to six to twelve months of your budget. Put it in a safe place, but make sure that you still earn some interest.

Remember what we said earlier. There is no risk-free investment – even cash. Cash is sensitive to inflation. For instance, $100,000 in 2000 is worth only $66,800 in 2020. So, having a boatload of cash will not guarantee your long-term financial security. You must make it earn a higher return than inflation.

Furthermore, cash has a huge opportunity cost tag. In other words, by holding a large amount of money, you face the risk of missing out on potential gain from choosing other alternatives.

US Treasuries

US Government bonds have historically been a safe haven for investors during turbulent times. We have seen the demand for treasuries spiking during periods of extreme uncertainty and volatility. And inversely, investors tend to drop them when they feel confident about the stock market. Depending on their maturity, US treasuries may give you a slightly higher interest than holding cash in a savings account.

While offering some return potential, treasuries are still exposed to high inflation and opportunity cost risk. Also, government bonds are very sensitive to changes in interest rates. If interest rates go up, the value of your bonds will go down. On the other hand, when interest rates go down, the value of your bonds will decrease.

Gold

Gold is another popular option for conservative investors. Similar to treasuries, the demand for gold tends to go up during uncertain times. The faith for gold stems from its historical role as a currency and store of value. It has been a part of our economic and social life in many cultures for thousands of years.

As we moved away from the Gold standard, the Gold’s role in the economy has diminished over time. Nowadays, the price of gold is purely based on price and demand. One notable fact is that gold tends to perform well during periods of high inflation and political uncertainty.

In his 2011 letter to shareholders of Berkshire Hathaway, Warren Buffet described gold as an “asset that will never produce anything, but that is purchased in the buyer’s hope that someone else … will pay more for them in the future…..If you own one ounce of gold for an eternity, you will still own one ounce at its end.”

Buying Put Options to hedge tail risk

Buying put options om major stock indices is an advanced strategy for tail risk hedging. In essence, an investor will enter into an option agreement for the right to sell a financial instrument at a specified price on a specific day in the future. Typically, this fixed price known as a strike price is lower than the current levels where the instrument is trading. For instance, the stock of XYZ is currently trading at $100. I can buy a put option to sell that stock at $80 three months from now. The option agreement will cost me $2. If the stock price of XYZ goes to $70, I can buy it at $70 and exercise my option to sell it at $80. By doing that, I will have an immediate gain of $10. This is just an illustration. In real life, things can get more complicated.

The real value of buying put options comes during times of extreme overvaluation in the stock market. For the average investor, purchasing put options to tail risk hedging can be expensive, time-consuming, and quite complicated. Most long-term investors will just weather the storm and reap benefits from being patient.

Final words

Managing your tail risk is not a one-size-fits-all strategy. Black Swam events are distinctive in nature, lengh, and magnitude. Because every investor has specific personal and financial circumstances, the left tail risk can affect them differently depending on a variety of factors. For most long-term investors, the left tail and right tail events will offset each other in the long run. However, specific groups of investors need to pay close attention to their unique risk exposure and try to mitigate it when possible.

Investment ideas for 2020

Investment ideas for 2020

Investment ideas for 2020 and beyond. Learn what trends will drive the stock market in the next decade.

Disruption creates opportunity

 2020 has been challenging in multiple ways. The global pandemic changed our lives. We have adapted rapidly to a brand new world. Six months through the outbreak, it is almost unthinkable to go back to where things were before. The covid pandemic accelerated many habits and trends that we were making strides in our lifestyle.

With the world getting closer to a covid vaccine, I want to offer you several investment ideas based on how our life we look like after the pandemic. Technology is bringing a lot of changes. It opens opportunities that have been unimaginable before. All these secular tailwinds make me feel optimistic about the future of the U.S. economy and the stock market since we are already leaders in technology, healthcare, and financial services.

Digital everything

Firstly, my strongest investment idea for 2020 is digital expansion. From online shopping through mobile banking to remote learning, home fitness, and telemedicine, the digital transformation is here to stay. Moreover, we can order our groceries online. And get our dinner delivered at our front door.  Talk to our doctor over Zoom. Take an online fitness class. And deposit our checks on our phone. You can even buy a new house or get a mortgage refi without leaving your home. My two-year-old son knows how to use my laptop by now.

E-commerce has been steadily growing over the years. From merely 4% in 2010, e-commerce now has a 12% share of the total U.S. retail sales in 2020. Even after the covid pandemic, e-commerce has barely scratched the surface and has a massive runway for expansion. Furthermore, besides the U.S. and China, e-commerce is just beginning to spread in the rest of the world. Digital opportunities are still limitless.

The businesses that can rapidly adapt to these changes will become the next industry leaders in their respective fields.

Same day delivery

For all of you, Amazon, Walmart, Costco, and Target fans out there, same-day delivery will become an industry-standard sooner than you think. All major retailers are moving in this direction, and smaller competitors must catch up very quickly to stay in the game.

Instacart, who is the pioneer of same-day delivery, has existing relationships with Walmart, Safeway, Costco, CVS, Kroger, Loblaw, Aldi, Publix, Sam’s Club, Sprouts, and Wegmans. Amazon is already in the running, while more competitors such as Uber and DoorDosh are starting to make strides in the same direction.

Distribution and logistics

With commerce moving quickly from physical retail to online shopping, your local Sears, JC Penny, Neiman Marcus, and Stein Mart will become distribution centers for the e-commerce giants. I visited our local Nordstrom store for the first time in 8 months. Half of their first floor was covered with shipping boxes. Make your own conclusions.

Retailers of all sizes will need to master the art of logistics. They will need to learn how to move goods quickly and cost-efficiently around to country to meet customer demands.

Digital payments

Digital payments is one of our strongest investment ideas for 2020 and the next decade. Major card payment networks comprise barely 12% of the total world payments. Still, 29% of all these payments are in cash, while the remaining 59% are made through bank and wire transfers. I see an enormous opportunity in the growth of digital payments. Within the next decade, the physical credit card will become archaic. Coming soon, we will simply make our payments through digital wallets, Q.R. codes, voice control, and even face recognition.

Cloud computing

The digital transformation requires an enormous amount of data storage and I.T. infrastructure. Every single day, the humankind sends 500 million tweets, 294 billion emails, and 65 billion messages on WhatsApp. We make 5 billion Google searches a day. In 2020 the digital universe is going to reach 44 zettabytes. By 2025, experts estimate that the world will create 463 exabytes of data each day. That’s the equivalent of watching 212,765,957 DVDs per day!

To support this data demand, the global annual spending for cloud computing will grow from $371.4 billion in 2020 to $832.1 billion in 2025. That is 17.5% average yearly growth in the next five years.

Cybersecurity

Cybersecurity is no longer optional. It is a necessity for both individuals and businesses. The digital growth is bringing bad actors looking to profit from our fears and weaknesses. Protecting your data is critical for safely navigating the digital universe.

Here are some numbers. The 2019 U.S. President’s budget added $15 billion for cybersecurity. Microsoft has committed to spending $1 billion annually for safeguarding their customers’ data. The size of the cybersecurity market was at $161.07 billion in 2019. It will reach $363.05 billion by 2025, with an annual growth of 14.5%. Therefore, cybersecurity becomes one of my best investment ideas for 2020 and beyond.

Automation and robotics

There are currently almost 6 million job openings in the U.S. and 1.2 million in Germany. In Japan, there are 1.5 vacancies for every job applicant. Therefore, with labor shortages around the world, there is a strong case for more manufacturing automation and robotics. Companies will push for more automation to provide faster service, better quality control, enhance job safety, meet unexpected demand surges, and keep profit margins high. Today’s general-purpose robots can control their movement to within 0.10 millimeters. The future generation will have a repeatable accuracy of 0.02 millimeters and could go even lower. Advanced sensor technologies and data connectivity will therefore allow robots to take on tasks that are not currently available in real-time.

5G

Another investment idea for 2020 is 5G. The 5G is the next-generation mobile network and the new global wireless standard. For us, the consumer, the 5G, will bring higher speed, better responsiveness, and more reliability to our phone calls, text messaging, video conferencing, and home internet. Initial projections estimate that we will have a 10X higher speed than current levels. Moreover, 5G will take the world of connected devices to the next level. For instance, the growing network of smart homes, devices, smartwatches, speakers, cameras, and connected cars can dramatically change the way we interact with the rest of the world.

Autonomous driving

One of the primary beneficiaries of 5G will be autonomous driving. Driverless cars require a huge amount of real-time data – sensors, GPS, traffic, weather, vehicle to vehicle, and vehicle-to-infrastructure communication. The 5G network alongside cloud computing capabilities will accommodate more driverless cars on the road. Several companies, above all, are pioneering the autonomous driving efforts – from Tesla to Google and Uber. While still unproven and controversial, I could envision early adoption of driverless cars in smaller communities such as college campuses, assisted living communities, and amusement parks. Furthermore, the second wave will expand to robotaxis and commercial short- and long-haul vehicles.

Work from home (anywhere)

You probably got a taste of working from home during the covid lockdown. While WFH is quite popular in California, but it was not as common in other parts of the country. Google, Twitter, Facebook, and other big tech companies are not calling their employees back to the office until the Summer of 2021.

During the Spring and Summer of 2020, we saw a huge spike in housing demand in suburban areas near large metropolitan cities – Marin and Contra Costa County near San Francisco, The Hamptons and Fairfield County, CT near New York City. Furthermore, we also saw a massive demand for remodeling, gardening, and various house improvement projects. Home fitness apps such as Peloton have more doubled their active users in just one year. Athletic apparel giants like Nike and Lululemon continue to attract new customers and gain market share.

Working from home is here to stay. Both public organizations and private companies will have to adapt to this trend. New leaders will emerge, and old vanguards will vanish. To survive in the WFH economy, the new office will turn from a cubicle maze to a collaborative space.

Employers can look for talent not only in the local communities but everywhere in the world. Workers will avoid being in traffic for 2 – 3 hours. Productivity will get an enormous boost by improving work-life balance and remote team collaboration.

Socially responsible investing

Socially responsible investing has been building a strong base in the past decade. It is no longer a niche investment endeavor for altruistic investors. According to Global Sustainable Investment Alliance, strategies that take a company’s environmental, social, and governance factors into consideration — grew to more than $30 trillion in 2018 and expected to grow to $50 trillion over the next two decades.  For example, reporting transparency, green technologies, community support, sustainable operations, carbon neutrality, employee satisfaction, and customer wellbeing will become flagship criteria by how corporate managers will be evaluated in the future. Furthermore, the Security and Exchange Commission is evaluating a playbook to standardize the sustainability disclosure between various sectors and public companies. We will continue to see a steady push towards organic farming, renewable energy adoption, electric vehicle expansion, and community engagement.

 

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.

Date Dow Jones Index Change % Change
12-Mar-20 21,200.95 -2,352.27 -9.99%
11-Mar-20 23,553.22 -1,464.94 -5.86%
10-Mar-20 25,018.16 1,167.14 4.89%
9-Mar-20 23,851.02 -2,013.76 -7.79%
6-Mar-20 25,864.78 -256.50 -0.98%
5-Mar-20 26,121.28 -969.58 -3.58%
4-Mar-20 27,090.86 1,173.45 4.53%
3-Mar-20 25,917.41 -785.91 -2.94%
2-Mar-20 26,703.32 1,293.96 5.09%
28-Feb-20 25,409.36 -357.28 -1.39%
27-Feb-20 25,766.64 -1,190.95 -4.42%
26-Feb-20 26,957.59 -123.77 -0.46%
25-Feb-20 27,081.36 -879.44 -3.15%
24-Feb-20 27,960.80 -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.

Retirement Calculator

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

Ticker CAGR St Dev Best Year Worst Year Max. Drawdown Sharpe Ratio US Mkt Correlation
VYM 12.86% 11.16% 30.08% -5.91% -11.84% 1.09 0.95
SDY 13.07% 11.15% 30.07% -2.74% -11.00% 1.11 0.92
VIG 12.63% 11.30% 29.62% -2.08% -14.18% 1.06 0.96
DVY 12.96% 10.60% 28.85% -6.32% -10.08% 1.15 0.88
FVD 13.18% 10.21% 26.77% -3.48% -11.11% 1.21 0.91
SPY 13.44% 12.44% 32.31% -4.56% -16.23% 1.04 1.00

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 of market turmoil and uncertainty, dividend growth ETFs offer extra income and lower volatility

 

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 [email protected] 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 [email protected] 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.

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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%.

Name Ticker Morningstar Rating Morningstar Analyst Rating AUM Expense
Vanguard Target Retirement 2045 VTIVX 4-star Gold $18.1 bil 0.16%
T. Rowe Price Retirement 2045 TRRKX 5-Star Silver $10.2 bil 0.76%
American Funds 2045 Trgt Date Retire R6 RFHTX 5-Star Silver $4.8 bil 0.43%
Fidelity Freedom® 2045 FFFGX 3-Star Silver $3.5 bil 0.77%
American Century One Choice 2045 AROIX 4-star Bronze $1.7 bil 0.97%

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 

Name Ticker Cash US Stock Non-US Stock Bond Other
Vanguard Target Retirement 2045 VTIVX   1.11      52.98         34.91     9.77   1.23
T. Rowe Price Retirement 2045 TRRKX   2.87      58.98         28.48     9.05   0.62
American Funds 2045 Trgt Date Retire R6 RFHTX   3.66      53.21         29.02     9.77   4.34
Fidelity Freedom® 2045 FFFGX   5.79      57.58         32.07     3.93   0.63
American Century One Choice 2045 AROIX   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

Name Ticker Cash US Stock Non-US Stock Bond Other
Vanguard Target Retirement 2025 VTIVX   1.44      38.05         25.09   34.30   1.12
T. Rowe Price Retirement 2025 Fund TRRHX   3.35      45.64         22.06   28.23   0.72
American Funds 2025 Trgt Date Retire R6 RFDTX   4.12      39.60         19.36   33.65   3.27
Fidelity Freedom® 2025 FFTWX   8.99      41.70         24.31   24.46   0.54
American Century One Choice 2025 ARWIX   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

Return Standard Deviation
Name Ticker 3-Year 5-Year 10-Year 3-Year 5-Year 10-Year
American Funds 2025 Trgt Date Retire R6 RFDTX    5.71     9.36      5.88    6.78     7.48    12.83
American Funds 2035 Trgt Date Retire R6 RFFTX    6.73   10.43      6.44    8.70     8.84    13.81
American Funds 2045 Trgt Date Retire R6 RFHTX    6.99   10.67      6.56    9.09     9.10    13.96
American Funds 2055 Trgt Date Retire R6 RFKTX    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
Name Ticker 3-Year 5-Year 10-Year 3-Year 5-Year 10-Year
Vanguard Target Retirement 2045 VTIVX    6.24     9.50      5.70    9.42     9.51    14.63
T. Rowe Price Retirement 2045 TRRKX    6.54     9.92      6.20    9.68     9.80    15.80
American Funds 2045 Trgt Date Retire R6 RFHTX    6.99   10.67      6.56    9.09     9.10    13.96
Fidelity Freedom® 2045 FFFGX    6.50     8.95      4.82    9.83     9.64    15.25
American Century One Choice 2045 AROIX    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

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.

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%.

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”.

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.

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.

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 the 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

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 [email protected] 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 Americans.  The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities, and related businesses. 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 has reached 3.7 trillion dollars. There are about $350 billion of Muni bond issuance available every year.

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

Types of Municipal Bonds

Municipal entities issue general obligation bonds 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 borrowers such as water and sewer services, 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 significantly benefit 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 than 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 are certain investors flocking into buying muni bonds? Let’s have an example:

An individual investor with a 35% tax rate is considering an AA-rated corporate bond offering a 4% annual yield and an AA-rated municipal bond offering a 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.

 The 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 the 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. The 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 in 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 taxable. 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 a 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 goes 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

Like the corporate world, municipal bonds and bond issuers receive a credit rating from 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 is 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 are 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 seek 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%. The top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, a 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. The top 5% make up 38.14% of the assets under management.

10 Ways to reduce taxes in your investment portfolio

10 Ways to reduce taxes in your investment portfolio

Successful practices to help you lower taxes in your investment portfolio

A taxable investment account is any brokerage or trust account that does not come with tax benefits. Unlike Roth IRA and Tax-Deferred 401k plans, these accounts do not have many tax advantages. Your contributions to the account are with after-tax dollars. This is money you earned from salary, royalties, the sale of a property, and so on. All gains, losses, dividends, interest, and other income from any investments are subject to taxes at the current tax rates.  In this post, we will discuss several successful practices that can help you lower taxes in your investment portfolio

Why investors put money into taxable accounts? They provide flexibility and liquidity, which are not available by other retirement accounts. Money is readily accessible for emergencies and unforeseen expenses. Many credit institutions take these accounts as a liquid asset for loan applications.

Since investment accounts are taxable, their owners often look for ways to minimize the tax impact at the end of the year. Several practices can help you reduce your overall tax burden.

1. Buy and Hold

Taxable investment accounts are ideal for buy and hold investors who don’t plan to trade frequently. By doing that investors will minimize trading costs and harvest long-term capital gains when they decide to sell their investments. Long-term capital gains are taxable at a favorable rate of 0%, 15% or 20% plus 3.8% Medicare surcharge. In contrast, short-term gains for securities held less than a year are taxed at the higher ordinary income level.

Individuals and families often use investments accounts for supplemental income and source of liquidity. Those investors are usually susceptible to market volatility. Diversification is the best way to lower market risk. I strongly encourage investors to diversify their portfolios by investing in uncorrelated assets including mid-cap, small-cap, international stocks, bonds, and real assets.

2. Invest in Municipal Bonds

Most municipal bonds are exempt from taxes on their coupon payments. They are considered a safer investment with a slightly higher risk than Treasury bonds but lower than comparable corporate bonds.

This tax exemption makes the municipal bond suitable investment for taxable accounts, especially for individuals in the high brackets category.

3. Invest in growth non-dividend paying stocks

Growth stocks that pay little or no dividends are also a great alternative for long-term buy and hold investors. Since the majority of the return from stocks will come from price appreciation, investors don’t need to worry about paying taxes on dividends. They will only have to pay taxes when selling the investments. 

4. Invest in MLPs

Managed Limited Partnerships have a complex legal and tax structure, which requires them to distribute 90% of their income to their partners. The majority of the distributions come in the form return on capital which is tax-deferred and deducted from the cost basis of the investments. Investors don’t owe taxes on the return on capital distributions until their cost basis becomes zero or decide to sell the MLP investment.

One caveat, MLPs require K-1 filing in each state where the company operates, which increases the tax filing cost for their owners.

 5. Invest in Index Funds and ETFs

Index funds and ETFs are passive investment vehicles. Typically they track a particular index or a benchmark. ETFs and index funds have a more tax-efficient structure that makes them suitable for taxable accounts. Unlike them, most actively managed mutual funds frequently trade in and out of individual holdings causing them to release long-term and short-term capital gains to shareholders.

6. Avoid investments with a higher tax burden

While REITs, taxable bonds, commodities, and actively managed mutual funds have their spot in the investment portfolio, they come with a higher tax burden.

The income from REITs, treasuries, corporate and international bonds is subject to the higher ordinary income tax, which can be up to 39.6% plus 3.8% Medicare surcharge

Commodities, particularly Gold are considered collectibles and taxed at a minimum of 28% for long-term gains.

Actively managed funds, as mentioned earlier, periodically release long-term and short-term capital gains to their shareholders, which automatically triggers additional taxes.

7. Make gifts

You can use up to $14,000 a year or $28,000 for a couple to give to any number of people you wish without tax consequences. You can make gifts of cash or appreciated investments from your investment account to family members at a lower tax bracket than yours.

8. Donate 

You can make contributions in cash for up to 50% of your taxable income to your favorite charity. You can also donate appreciated stocks for up to 30% of AGI. Consequently, the value of your donation will reduce your income for the year. If you had a good year when you received a big bonus, sold a property or made substantial gains in the market, making donations will help you reduce your overall tax bill for the year.

9. Stepped up cost basis

At the current law, the assets in your investment account will be received by your heirs at the higher stepped-up basis, not at the original purchase price. If stocks are transferred as an inheritance directly (versus being sold and proceeds received in cash), they are not subject to taxes on any long-term or short-term capital gains. Your heirs will inherit the stocks at the new higher cost basis.  However, if your investments had lost value over time, you may wish to consider other ways to transfer your wealth. In this case, the stepped-up basis will be lower than you originally paid for and may trigger higher taxes in the future for your heirs.

10. Tax-loss harvesting

Tax-loss harvesting is selling investments at a loss. The loss will offset gains from other the sale of other securities. Additionally, investors can use $3,000 of investment losses a year to offset ordinary income. They can also carry over any remaining amounts for future tax filings.

 

 

Introduction to portfolio diversification

Introduction

Portfolio diversification is one of the main pillars of retirement planning. The old proverb “Never put all your eggs in one basket” applies in full strength to investing.

Even the Bible talks about diversification. Ecclesiastes 11:2 says “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.”

Wealth and asset managers use diversification as a tool to reduce overall portfolio risk. Diversification of investments with little correlation to one another allows the portfolio to grow at various stages of the economic cycle as the performance of the assets moves in different directions.

What is portfolio diversification?

According to the Securities and Exchange Commission (SEC): “The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.” – https://www.sec.gov/investor/pubs/assetallocation.htm

By combining low correlated and uncorrelated assets in a portfolio and being disciplined over an extended period, you aim to achieve the highest return per certain level of risk.

Diversification reduces your exposure to a single company or an asset class. As assets move up and down each year, a diversified portfolio will allow you to build a cushion for losses and avoid being dependent on one security in case it loses its value or has a rocky year.

The financial history remembers many examples of fallen stocks, such as Enron and Lehman Brothers. The employees of these companies who invested heavily in their employer’s stock without diversifying lost a significant amount of their retirement savings.

Correlated Investments

Correlated investments move in similar fashion driven by related factors. Owning two or more securities from the same industry or with similar risk profile does not contribute to your portfolio diversification. Hence, these securities will concentrate your exposure to the same market factors. 

These three pairs are an example for correlated stocks – Coca-Cola and Pepsi, Target and Costco, Verizon and AT&T. While there are some differences in their business model and historical performance, the pairs are exposed to the same economic factors, industry drivers, and consumer sentiments.

Uncorrelated Investments

The combination of uncorrelated investments decreases the overall portfolio risk

The classic example of uncorrelated investments is stocks, bonds, and gold. Historically these large asset categories have moved independently from each other.  Their returns were influenced by different events and economic drivers.

Even within the equity space alone, investors can significantly improve their portfolio diversification by looking at companies in various industries and exposure to regional and international markets.

The pair – Amazon and PG&E is a model for uncorrelated companies. Amazon is a global online marketplace that sells discretionary consumer items. Amazon business is dependent on the economic cycle and consumer spending sentiments. PG&E is a California-based utility company that provides electricity and gas to its customers. PG&E customers (being one of them) have a limited choice for service providers. Amazon competes with many large and small-size, local and foreign companies. PG&E has virtually no competition apart from renewable sources. Amazon has expansive market potential. PG&E growth is constrained to its local market. Therefore the difference between their core business models reflects on their historical price performance and risk profile. Their shares’ price depends on different factors and hence fluctuates independently.

Sharpe Ratio

Before we continue, I want to introduce a key performance metric in asset management called Sharpe Ratio. The ratio got its name from its creator the Nobel laureate William F. Sharpe.

The Sharpe ratio measures the excess return per unit of risk of an investment asset or a portfolio.  It is also known as the risk-adjusted return.

This is the formula:

Sharpe Ratio

 

 

 

Where:

Rp is the Return of your security or portfolio.

Rf is the risk-free return of a US Treasury bond

σp is the standard deviation of your portfolio. Standard deviation measures the volatility of your portfolio returns.

 

The Sharpe ratio allows performance comparison between separate portfolios and asset classes with different return and risk. As a rule of thumb, the Sharp metric penalizes portfolios with higher volatility.

Take a very simplified example; portfolio ‘A’ has 5% return and standard deviation of 10%. Portfolio ‘B’ has 6% return and standard deviation of 15%. The risk-free rate is 1%

‘A’ portfolio: Sharpe Ratio is equal to (5% – 1%)/10% = 0.4

‘B’ portfolio: Sharpe Ratio is equal to (6% – 1%)/15% = 0.33

Portfolio ‘A’ has the higher Sharpe ratio and therefore the higher risk-adjusted return. Despite its lower return, it benefited from its lower volatility.

Even though ‘B’ had a higher return, it was penalized for having a higher risk.

 

Test 1

We will continue the explanation of the benefits of diversification with an example with real securities.

We will use two ETFs – SPY which tracks the US Large Cap S&P 500 Index and IEF, which follows the performance of the 10-year US Government bond. Let’s create three portfolios – one invested 100% in SPY,  second invested 100% in IEF and third with 50%/50% split between both funds. Each portfolio starts with hypothetical $1 million. We track the performance for ten years (January 1, 2006, to December 31. 2015).

 

One key assumption is that at the end of each year we will rebalance the 50/50 portfolio back to the original target. We will sell off the excess amount over 50% for the overweight ETF, and we will buy enough shares from the underweight ETF so we can bring it back to 50%.

Results

Ticker Initial Balance Final Balance Average Return Standard Deviation Best Year Worst Year Max. Drawdown Sharpe Ratio US Market Correlation
IEF $1,000,000 $1,698,866 5.44% 6.46% 17.91% -6.59% -7.60% 0.68 -0.30
50/50 $1,000,000 $2,002,079 7.19% 7.11% 13.11% -9.45% -20.14% 0.86 0.87
SPY $1,000,000 $2,010,149 7.23% 15.23% 32.31% -36.81% -50.80% 0.47 1.00

Diversification2_1

 

The 100% SPY portfolio has the highest return of 7.23% and best overall final balance ($2.01m). The SPY portfolio has the largest gain in a single year, 32.3% but also the biggest yearly loss of -36.8%. It also has the highest measure of risk. Its standard deviation is 15.2%.  Its risk-adjusted return (Sharpe ratio) has the lowest value of 0.47.

IEF has the lowest return of the three portfolios, 5.44% but also has the “best” worst year, -6.6% and the lowest risk, 6.5%. Sharpe ratio is 0.68, higher than that of SPY.

The  50/50 portfolio has an average return of 7.19%, only 0.03% less than SPY alone. It has a standard deviation of 7.1%, only 0.65% higher than that of the 100% EIF. its market correlation is 0.87. Most importantly, the 50/50 portfolio has the highest risk-adjusted return, equal to 0.86.

The 50/50 portfolio illustrates the benefits of diversification. It provides almost the same return as the 100% large-cap portfolio with much lower risk and better returns consistency.

Test 2

In the second example, we will introduce two more portfolios.

Portfolio #4 holds 100% GLD. GLD is the largest and most liquid  ETF in the gold market.

In portfolio #5, we will split SPY and IEF into 45% each and will add 10% in Gold ETF. Same rules apply. Once a year we rebalance the portfolio to the original target allocation 45/45/10.

Results

Ticker Initial Balance Final Balance Average Return Standard Deviation Best Year Worst Year Max. Drawdown Sharpe Ratio US Market Correlation
IEF $1,000,000 $1,698,866 5.44% 6.46% 17.91% -6.59% -7.60% 0.68 -0.30
50/50 $1,000,000 $2,002,079 7.19% 7.11% 13.11% -9.45% -20.14% 0.86 0.87
SPY $1,000,000 $2,010,149 7.23% 15.23% 32.31% -36.81% -50.80% 0.47 1.00
GLD $1,000,000 $1,967,041 7.00% 19.20% 30.45% -28.33% -42.91% 0.39 0.07
45/45/10 $1,000,000 $2,028,238 7.33% 7.05% 13.92% -8.01% -16.75% 0.88 0.81

 Diversification4

 

The GLD portfolio has the highest volatility. Its standard deviation is 19.20%. It has the lowest risk-adjusted return of 0.39 and a second-lowest return of 7%.

Let’s look at our fifth portfolio – 45% SPY, 45% IEF and 10% GLD. The new portfolio has the highest return of 7.33%, the highest final balance of $2.28m, second lowest standard deviation of 7.05% and the highest risk-adjusted return of 0.88. It also has a lower correlation to the US market, 0.81.

Recap

Portfolio #5 is the clear winner of this contest. Why? We build a portfolio of uncorrelated assets, in this case, gold, 10-year Treasury, and large-cap stocks. Subsequently, we not only received an above average annual return, but we also achieved it by decreasing the risk and minimizing the volatility of our portfolio.

These hypothetical examples illustrate the benefits of diversification. Among them are portfolio risk mitigation, reduced volatility, higher risk-adjusted return, and more efficient capital preservation.

 

Asset correlation

So how do you determine the relationship between assets? Any financial software can provide you with this data.

If you are good at math and statistics, you can do parallel performance series for your securities and find the correlation between them.

There are a couple of free online tools, which you can use as well.

Beta

One easy way to get a sense of the correlation of your securities to the general stock market is Beta. Most financial websites like Google Finance and Yahoo Finance will give you this metric. Beta shows you the stock volatility compared to S&P 500. That said, the beta of S&P 500 is always 1. So for instance, if the beta of your stock is 2, you should expect twice as much volatility of your stock as compared to S&P 500. If the beta is 0.5, you would expect half of the volatility. If the beta is -0.5, then your stock and S&P will be negatively correlated. When one goes up, the other one will go down.

A quick search in Good Finance brought me these results for the securities we discussed earlier.

Beta for IEF is -0.20, SPY is 1, GLD is 0.07, Coca Cola, 0.51, Pepsi, 0.44, Target, 0.63, Costco, 0.55, Verizon, 0.22, AT&T, 0.29, Amazon, 1.1 and PG&E, 0.17,

Few other companies and ETFs of interest are: TLT, 20-year T-bond Index, -0.59, VNQ, REIT Index, 0.81, VYM, Vanguard High Dividend ETF, 0.81, USMV, iShares Low Volatility ETF, 0.68,  Google, 1.03, Facebook, 0.76, Wal-Mart, 0.19, Starbucks, 0.80, McDonalds, 0.51. Walt Disney, 1.32, Bank of America, 1.74.

The beta of the stocks can vary depending on market conditions, economic and business cycles. I recommend using in combination with other metrics like standard deviation, R-square, and Sharpe Ratio. This approach will help you gauge the expected volatility of your stock.

How many assets should you ideally keep in your portfolio?

Some theories call for 7-10 broad asset classes. This method is ideal for smaller-size portfolios. It will help control trading and rebalancing costs.

Other theories call for 20-25 asset classes. This approach is best suitable for large-size portfolios with more complex structure.

A regular portfolio should include these three groups with their subclasses.

Equity includes Large Cap, Mid Cap, Small Cap, Micro Cap, International Developed and Emerging Markets. In addition to that, you can add growth, value, dividend, low volatility, and momentum strategies.

Fixed Income includes US Treasuries, Municipal Bonds,  Investment Grade Corporate Bonds, High Yield, Preferred Stock, International, and Emerging Market Bonds

Alternative Investments include Real Estate, Precious Metals, Commodities, Infrastructure, Private Equity, Hedge Funds.

 

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. Image copyright: 123RF.com