Tag: Returns

Cash is not returning much more than 1% these days and financial markets are volatile and overvalued, portending lower future returns. Many homeowners wonder if they should use their surplus cash to more aggressive pay down their home mortgage. There are qualitative and quantitative factors to consider and the answer really depends on each person’s unique situation and attitudes.

Reasons you would want to consider paying off your mortgage

  • You want the sense of freedom obtained from not having a mortgage payment.
  • You want to pay off their home mortgage prior to retirement to reduce your fixed living expenses.
  • You think the stock market will have a lower return than your mortgage interest rate over the balance of your mortgage.
  • You have excess cash sitting in low-yielding money markets or savings accounts. Paying off a mortgage with a 4.5% interest rate, for example, will be a guaranteed higher rate of return than the cash and may even exceed what you could get on your investment portfolio over the next few years.
  • You are already maximizing your savings to your retirement accounts and have paid off other high-interest debt.
  • You have a relatively small balance and few remaining years on your mortgage.
  • You have a hard time saving extra money and adding extra principal payments to your mortgage will be a ‘forced’ savings program.
  • Your payment and or interest rate are high.
  • You anticipate a declining income.

Reasons you may not want to accelerate you mortgage payoff.

  • You have low cash reserves.
  • You have other loans with high-interest rates than need to be paid off.
  • You have a low-interest rate are young and plan on living in the home for the foreseeable future. Over time, your inflation-adjusted mortgage payment will seem extremely affordable.
  • You want to leverage your money. By taking on debt for your home, you can free up money to be invested in the stock market.
  • You expect stock market returns to exceed the interest rate of your mortgage over the remaining term of your mortgage.
  • You need to maximize your liquid assets. Don’t be house rich and cash poor. Those with a high home value relative to their other liquid investments don’t want to pour all of their extra funds into the home as they will have minimal liquid assets to live off of. This is particularly an issue during retirement.
  • Your payment is low and affordable.
  • You plan on moving to another residence in the next few years.

Taxes are also a consideration. But I don’t normally encourage that clients make major debt decisions based solely on taxes. If you are in a higher tax bracket, the mortgage deduction has more value, but note that there is a good chance that future Congressional action may completely eliminate this deduction or limit it to lower income levels.

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Investors are well aware that financial markets go up and down.  That is the essence of business and economic cycles.  What is difficult for individual investors to master is how to act in the face of market advances and declines.  Unfortunately, most people become very tolerant of risk and increase their exposure to the stock market when the market is advancing.  Similarly, they avoid risk and clip their exposure to stocks when markets are declining, or after a large correction.  It is human nature and “recency bias” that create this visceral response to market perturbations.  Recency bias occurs when investors believe that the most recent performance of their investment portfolios will continue indefinitely in the future.  It is just one factor that results in investors consistently underperforming the stock market.

Brad M. Barber  and Terrance Odean, in their 2011 study “The Behavior of Individual Investors,” conclude that individuals routinely underperform benchmarks through 1) selling winning investments and holding losing investments, 2) being heavy influenced by most recent past returns (repeating investment behavior that coincides with pleasure and avoiding behavior that is painful), and 3) holding undiversified portfolios.

Dalbar studies have also shown that most individual investors typically trail the market rate of return, and they typically do so by a fairly wide margin.

The message from Dalbar since its first study in 1994 is that investment results are more dependent on investor behavior than fund performance and that mutual fund investors who tend to buy and hold are more successful than those who attempt to time the market.

Investors who attempt to time the market are often acting irrationally out of fear of a potential loss.  Stocks and investment funds happen to be the only assets that people buy less of when they become less expensive. Let’s think about buying food at the supermarket, if the price of steak rose considerably, you would be more inclined to reduce your purchase of steak or buy something else, but if the supermarket suddenly reduced the price of the steak by 30%, you would stock up.  However, you do the opposite when it comes to stocks and other investments.  The stock market can foster a gambling mentality.  When you are on a roll you hate to stop, but that is exactly when you should cash some chips in.

So how does an investor counteract the tendency to time the market and invest based on most recent results?  Rebalancing is great way to fight the effects of recency bias.  Rebalancing to your target asset allocation is a mechanistic and unemotional way to fight these counterintuitive emotions.  I sometimes get an odd look from my clients when I suggest that they rebalance after a market run-up.  “Why would I want to do that, the market is hot?” might be a typical comment.  But that is exactly why rebalancing is so important.  It removes the emotions, market noise, and other extraneous factors, and reminds the investor of their original financial plan and goals.

The best value-added proposition a financial advisor provides is to set the target allocation and then monitor and adjust it based on the client’s personal goals and life events.  The asset allocation is set within the investment policy statement and the portfolio is rebalanced yearly, or as needed, after large market advances or declines.  The asset allocation is revisited periodically, at least every 3 years, and is adjusted in response to a client’s retirement goals, change in health or marital status, or market valuations.

Rebalancing in this way, will not only help the client attain rates of return closer to the respective benchmarks for his or her portfolio, it can actually be a source of additional return.  In a recent article in Financial Planning magazine, “Portfolio Rebalancing: Get It Right,” Allan Roth underscores the incremental benefit of rebalancing.  His analysis shows that “over the past 15 years, the portfolio that stuck to its allocation earned 1.54 percentage points more each year than the average portfolio that tried to time asset classes.”

Rebalancing is just one area where advisors add incremental return and why it is essential for our clients to commit to the annual review and rebalance exercise.   Emotions can be hard to control, let your re-balancing take them out of the mix, so you can maximize your long range returns.

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Not everyone is born from a royal family that has a legacy from generation to generation. Having inheritance is not necessarily able to be managed well so that it is not in vain or just used up. After becoming parents, many young couples who already have insight about how important education funding for their children later. When a baby is born, most parents already think about the cost of their education later. And indeed there are a variety of investments made by their parents in order to prepare their children’s education funding needs later which of course will be different 5 years or 10 years to come.

There are many investment offers for your child’s education fund. But before considering that it’s a good idea to read the following tips.

1. Set aside Revenue

The first step that must be done is to save as early as possible from the money set aside from income. The earlier you start, the more money you will collect. Of course, the challenge you have to face is the temptation to use this money. But it’s good you choose to save it in investment savings where you can not withdraw it within a certain period.

2. Research before investing

Many insurance companies have savings solutions for your child’s higher education costs. Before you invest your hard-earned income into these products, you need to identify your financial targets first. You should also know the average rate of return on your policy, how much money you can comfortably set aside, and how much financial risk you can face when buying investment products. Examples of investment options available are mutual funds, trust funds, bonds and stock investments.

3. Adjusting the Budget to the Number of Children

Indeed, having only one child with more than one child has a different amount of budget. Talk well with your partner, how many children do you plan because it will affect the amount of their education savings.

4. Don’t put all the eggs in one basket

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If you are an investor who is reluctant to take risks and tends to choose the type of low-risk investment, the disadvantage you will face is the low return on investment. This is not good if you still have to cover a lot of shortcomings to achieve your financial goals. Start thinking about diversifying your portfolio by putting some of your assets in instruments that provide higher returns, for example buying shares that will provide dividends. With the principle of spreading eggs in different baskets, you increase your overall investment return and at the same time maintain a moderate/moderate level of risk.

5. Avoid Borrowing Money to Fund Your Child’s Education

The best way is money that comes from your savings or investment returns. That is why it is very good if you start early to prepare your child’s savings. If they do not have sufficient funds, parents may be tempted to borrow money to pay for their children’s tuition. If indeed the amount of money borrowed is relatively small, then this might not have a bad impact, but if the amount of money borrowed is large, then parents need to be careful about the payment system in the future.

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If you have planning to invest your money in the stock market, you need to read this carefully. It cannot be denied that every investment has its own risk. Today’s article gives an overview of the situation in the stock market today and the prediction about what will happen in the future.

Client meetings over the past year have been quite sanguine. Investments and assets are up. People seem to feel better about job security. The housing market is slowly recovering, and retirement projections look rosier. Strong stock market performance is good, in that it gets us closer to our goals; however, it can also breed a false sense of complacency.

Valuations are high and reaching points not seen since 2007, 1929, and by some metrics, even 2000.

Overvalued Stock Market

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Stock markets become overvalued when stock prices rise at a much faster rate than earnings, which is what has occurred for the past several years due to the belief that the Federal Reserve’s quantitative easing policies will continue to force investors into stocks in order to get a decent return on their money; low-interest rates punish savers and cause them to seek yield by investing in increasingly speculative investments. But even members of the Federal Reserve are warning about frothy segments of the market as they tiptoe toward shutting off the quantitative easing spigot.

debt is increasingly being purchased on the basis of yield rather than the careful evaluation of repayment prospects. John Hussman Hussman Funds

The Cycles In Financial Markets

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It is important to remember that financial markets move in cycles, and just because this multiyear stock market advance has been rewarding, it does not mean that it can continue indefinitely. In fact, the longer it persists, the greater the chance of a severe correction.

One way to evaluate whether or not the market is expensive is to look at the current PE10 or CAPE ratio. This valuation method was developed by Robert Shiller from Yale, and it historically has been helpful in forecasting market crashes as well as future rates of return.

This article in the WSJ “Yes, Virginia, You Can Time the Market” explains that, although no one can time the market with precision, using the Shiller PE as a method to modify your stock exposure by overweighting or underweighting by up to 30 percentage points has resulted in stellar returns since 1926.

The Prediction of Bubbles

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It is a strategy, however, that requires patience. A high CAPE ratio can persist for years. It tends to have a better success rate for predicting 10-year future returns and is less accurate in predicting returns less than 5 years out. In fact, in 2000 it was over five years early in diagnosing an overvalued market. The article acknowledges that extreme market timing by moving all of your assets in and out of the market based on certain parameters is very difficult and not a recommended strategy. Using Shiller’s ratio, though, can provide some guidance in dialing down equities when markets are overvalued and dialing up exposure when markets are undervalued, thus protecting investors from large corrections and enhancing long-range returns.  See the chart to the left.

John Hussman has been warning about stock valuations for years as the Shiller PE, as well as his additional proprietary methods, indicate that returns over the next decade will be roughly 2%, before inflation. His weekly commentaries are a must-read.

He makes this powerful assertion in, Yes, This Is An Equity Bubble:

Make no mistake – this is an equity bubble, and a highly advanced one. On the most historically reliable measures, it is easily beyond 1972 and 1987, beyond 1929 and 2007, and is now within about 15% of the 2000 extreme. The main difference between the current episode and that of 2000 is that the 2000 bubble was strikingly obvious in technology, whereas the present one is diffused across all sectors in a way that makes valuations for most stocks actually worse than in 2000.

The question a rational and prudent investor should as himself is this, “ is it prudent for me to take additional risk in the stock market at this juncture, given such dismal future returns?” This is a particularly important consideration for those people who are looking to retire in the next 7-10 years, as well as those how have recently retired.

For more information on the Shiller PE and market valuations you may want to read the following:

Market Valuation Overview- Yet More Expensive

The Mystery of Lofty Market Valuations by Robert Shiller

Is the CAPE Ratio Good at Predicting Future Returns? (Yes) Is it Perfect? (No)

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It’s clearer than ever that finances have pla[censored] , and still play, one of the most important roles in the evolution of society and individual behaviour. Nevertheless, when it comes to actually managing finances, each and every one of us has his/her own individual approach. Therefore, is some are savers, other are spenders, and others are somewhere in between. This continuum can be perceived as a paradigm that is used to frame differences in the way people approach money. However, as different as money is perceived by every person, there comes a time when money accomplishes the same function: tax. Of course, this short yet torturing word hasn’t come alone in our lives but accompanied by many friends: income taxes, property taxes, business taxes, tax returns, capital gains taxes, sales taxes, and the list may go on indefinitely. The bad news is that everyone is subject to taxation, be it an organization or company or an individual.

What does subject to income tax exactly mean? It only means that people and companies must report their income and calculate their tax on a regular basis. Certainly some non-profit organizations can be exempted from tax. In this case, they have to file a return; if they fail to meet certain criteria, their tax-exempt status could be revoked. Moreover, a general definition would state that tax returns are required for self-employment including business partnerships, controlling company director, ministers of any religion, persons who possess significant incomes from untaxed savings and investments or from big properties and so on. As expected the amount of taxes you owe is directly connected to your income which means that people who earn more income have higher taxes than those who earn less. Tax rates must be paid throughout the year or to be more specific, on a pay-as-you-go system. Nevertheless, the tax system doesn’t hosts only negative aspects, it also offers benefits and facilities as well. Thus, to turn this situation in your favour, it is essential to take control of your tax situation. Needless to say, calculating your tax return isn’t as easy as it may seem on a first contact, particularly if you already have an overwhelming schedule on your hands. Thus, the best allay you can have in this situation is a specialized financing company and implicitly, an experienced Steuerberater.

The services of this type of companies can be customised to meet your particular case and ultimately, to accomplish your requirements and needs seamlessly. Moreover, these experts can also represent you before Tax Authorities during assessment procedures. To complete this image, most of these companies have extended their expertise area to other major financial fields such as insurances. Thus, in order to support their customers and their future financial situation, these companies offer direct access to a proficient versicherungsmakler who uses free-of-charge analysis and independent insurance comparison tables to indicate ideal insurance offers. The best part is that technology hasn’t limited its intervention only at financial software and techniques but it has continued its series of advancements by offering full access to information, online financial services and sources.

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Springtime has finally arrived! As you start to enjoy the long, warmer days and put aside a day for spring cleaning, make sure that you give your finances a spring cleaning as well!

Start by addressing those dusty old boxes or files full of well-aged financial documents that you no longer need. It’s finally time to throw out those yellowed cancelled checks, decade-old credit card and bank statements and former apartment leases with addresses that you can barely still remember. Holding on to tax returns from 2002 or earlier? It’s generally safe to get rid of your old returns and associated records if they are at least seven years old. Make sure that you shred sensitive documents to protect yourself from identity theft! (For a clear and simple guide on how long you need to retain financial documents download our free guide on What to Keep and What to Shred.)

If you rent a safe deposit box that you have not visited in a while, this is a great time to swing by your bank to make an annual inventory of its contents. Original titles, deeds and negotiable securities (i.e., older bond certificates) are best kept here. Store your original will in the box, but make sure that you have a copy at home as well. However, keep only copies of government-issued IDs and insurance policies in the vault. Make sure that an inventory of the box’s contents, as well as the keys, are in a place where your family could find them in case of an emergency. Put with it an emergency contact list for financial issues, which may include names and phone numbers for your insurance agents, estate planning attorney and investment manager.

Next, it’s finally time to track down any stray investment and bank accounts. I recently checked-in on a long-forgotten savings account and was excited to discover $200 sitting in it. However, I was shocked to discover that the bank had started charging a $5 fee each month, which far out-paced the meager 1% interest I was earning, so I immediately closed the account. If you have changed jobs in the past few years, you may still have retirement accounts sitting in your previous employer’s plan, so take the time to transfer these funds to a retirement account that you can more actively monitor and manage.

Moving on to more fun tasks, gather up any gift cards that have been taped to refrigerator since last Christmas (or the Christmas before that) and put them to use! Spending them on something for yourself is the easiest solution, but if you are never going to use that $25 gift card to the Mitten Hut from Grandma then donate it, re-gift it, or sell it on eBay or to a gift card reseller like Plastic Jungle.

Finally, incorporate a financial aspect to clearing clutter out of your home, too. Dedicate the funds you’ll earn from a garage sale to a fun activity like a night on the town or a day at the ballpark. It makes it easier to part ways with your long un-used snowboard and will help to keep you motivated as you clean out your house in celebration of springtime!

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Investors are well aware that financial markets go up and down.  That is the essence of business and economic cycles.  What is difficult for individual investors to master is how to act in the face of market advances and declines.  Unfortunately, most people become very tolerant of risk and increase their exposure to the stock market when the market is advancing.  Similarly, they avoid risk and clip their exposure to stocks when markets are declining, or after a large correction.  It is human nature and “recency bias” that create this visceral response to market perturbations.  Recency bias occurs when investors believe that the most recent performance of their investment portfolios will continue indefinitely in the future.  It is just one factor that results in investors consistently underperforming the stock market.

Brad M. Barber  and Terrance Odean, in their 2011 study “The Behavior of Individual Investors,” conclude that individuals routinely underperform benchmarks through 1) selling winning investments and holding losing investments, 2) being heavy influenced by most recent past returns (repeating investment behavior that coincides with pleasure and avoiding behavior that is painful), and 3) holding undiversified portfolios.

Dalbar studies have also shown that most individual investors typically trail the market rate of return, and they typically do so by a fairly wide margin.

The message from Dalbar since its first study in 1994 is that investment results are more dependent on investor behavior than fund performance and that mutual fund investors who tend to buy and hold are more successful than those who attempt to time the market.

Investors who attempt to time the market are often acting irrationally out of fear of a potential loss. Stocks and investment funds happen to be the only assets that people buy less of when they become less expensive. Let’s think about buying food at the supermarket, if the price of steak rose considerably, you would be more inclined to reduce your purchase of steak or buy something else, but if the supermarket suddenly reduced the price of the steak by 30%, you would stock up. However, you do the opposite when it comes to stocks and other investments. The stock market can foster a gambling mentality. When you are on a roll you hate to stop, but that is exactly when you should cash some chips in.

So how does an investor counteract the tendency to time the market and invest based on most recent results? Rebalancing is great way to fight the effects of recency bias. Rebalancing to your target asset allocation is a mechanistic and unemotional way to fight these counterintuitive emotions. I sometimes get an odd look from my clients when I suggest that they rebalance after a market run-up. “Why would I want to do that, the market is hot?” might be a typical comment. But that is exactly why rebalancing is so important. It removes the emotions, market noise, and other extraneous factors, and reminds the investor of their original financial plan and goals.

The best value-added proposition a financial advisor provides is to set the target allocation and then monitor and adjust it based on the client’s personal goals and life events. The asset allocation is set within the investment policy statement and the portfolio is rebalanced yearly, or as needed, after large market advances or declines. The asset allocation is revisited periodically, at least every 3 years, and is adjusted in response to a client’s retirement goals, change in health or marital status, or market valuations.

Rebalancing in this way, will not only help the client attain rates of return closer to the respective benchmarks for his or her portfolio, it can actually be a source of additional return. In a recent article in Financial Planning magazine, “Portfolio Rebalancing: Get It Right,” Allan Roth underscores the incremental benefit of rebalancing. His analysis shows that “over the past 15 years, the portfolio that stuck to its allocation earned 1.54 percentage points more each year than the average portfolio that tried to time asset classes.”

Rebalancing is just one area where advisors add incremental return and why it is essential for our clients to commit to the annual review and rebalance exercise. Emotions can be hard to control, let your re-balancing take them out of the mix, so you can maximize your long range returns.

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Can We Still be Smart Investors?

Any other week would be a better one in which to write a financially-themed article. While this article will be in the November issue, the context from which I write is immediately following the announcement that the House of Representatives voted NO on the Bailout plan. We all know that this sent the stock market tumbling, causing many people to feel fear— perhaps the first real time in our generation’s adult life (except maybe some from the dot com bust but that was “fun money” before we had families!!).

While a revised Bailout Plan will likely pass and a few more banks may fall by the time this is published, the events of the past few weeks have made many people question whether or not they are handling their money the “smartest” way.

As a fee-based financial planner who does not manage portfolios, I cannot recommend individual stocks or funds to buy and sell. Nor do I think that will help the families with whom I work at this juncture. I can, however, help you take a macro-perspective on what is smart for you and your family.

“Smart” begins with the basics:

  1. What is your family’s vision and what are you creating?
  2. What is your relationship with money? How do you handle fluctuations? How anxious are you?
  3. What are your financial goals? When do you need the money?

VISION:

You’ve heard me say it time and time again if you read my column with regularity. What is the life you want to create for your family? What does it look like? How do you define success?

Are you living in a hillside cottage with a large yard or do you have an apartment with a home in Tahoe? Do you pick a new country to visit with your children every year? Do you want to settle into a community where you will root for the next 20+ years? Do your children walk to the locale public school or will they be attending a private school?

The vision you create for your family trickles down to the types of investments you make also called an investment vehicle (such as stocks, bonds, mutual funds). Before you can decide into which vehicle you will invest, you need to know for what you want the money.

YOUR MONEY PERSONALITY:

A fascinating area of financial planning is how people relate with money. This alone can fill pages upon pages of articles and keep me reading for weeks (I am endlessly intrigued by this topic). At the very fundamental level, you have to know what is commonly talked about in the financial planning world as your “risk tolerance.” I find that concept hard to grasp, so with my clients I like to hear more about what keeps them up at night. What makes them anxious?

Is it any negative movement in a 401k or is it not having enough money in cash in a savings account? Do they ride out the drops like the one on Sept 29th with grace and ease saying “it’ll come back” or “this is expected” or do they run for the bank and hide their money in their mattress? Everyone is different and understanding your level of anxiety with investment fluctuations is an imperative input factor to deciding how to invest.

YOUR FINANCIAL GOALS:

Taking your vision and translating it into financial goals is where I find the financial planning process helps the couples with whom I work the most. This makes the softer airy vision a dollars and cents reality. Smart investing requires that you know:

The amount the goal will cost
The Time horizon over which you are investing (that is, when do you need the money)?
The amount of money you are starting with for the goal
The amount you are contributing along the way

All of these factors will let you know what the return you need for your money will be. To say that another way, it will tell you how much you have to make each year on the investment to reach the goal. And different investment vehicles offer different possibilities for returns. Holding investments in cash will probably stay within a few % points, while stocks can jump all over the chart — in both directions. To get higher returns, you also will take on higher risk. The return you need combined with your personal tolerance for fluctuations will determine the investment vehicle.

For example:
If you already have $100,000 that you want to put toward a home down payment in one year, you only need a very conservative investment vehicle. Keeping that cash in a money market account would give you the best assurance that your money will be there when you want it.

I see many clients who come to me with next year’s house down payment in stocks or equity mutual funds. Perhaps that is how they built up the money or maybe they just like to participate in the market. In a week like the ones of late, however, a portfolio may drop 10%, making a $100,000 down payment now a $90,000 one. For the exceptionally daring individual, this may be okay, but as a financial planner, I advise people to match their investment vehicles with their time horizons.

If you want access to your money soon, keep it in a cash-equivalent vehicle. This way the market can jump all over the place and you can rest assured that you have what you need when you need it (caveat from the recent events: up to the FDIC insured limits of $100,000 – or more if you set up a certain kind of account designed to expand this limit) . The longer you have before you need the money, the more fluctuations you can likely tolerate. So while you may not be thrilled that your 401k invested in a mix of mutual funds, for example, has decreased, you will likely have more tolerance if you do not need the funds for another 30 years.

PARTNER FOR SUCCESS:

Granted there are those among us who will feel compelled to switch to other asset classes if ours are not performing just because of their personality and risk tolerance. Whether or not this is the smart way to go depends on your personal situation only. To help you handle the next bump, I encourage you to be prepared to act with knowledge and not emotion. The best way to do this is to partner with a financial professional who can help you ride out these rough times and stick with a “system” that works for your anxiety level and your goal achievement timeline. With a plan in place, you can approach the times when everyone else seems to panic with the desired calmness that comes with real knowledge of your own smart investing strategy.

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The economy appears to be making strides as it emerges from critical condition and enters into rehabilitative mode. Some positive signs include increasing bank lending, auto sales, and consumer confidence. Unemployment is also declining, especially for skilled labor. Both the US budget deficit and state budgets are improving. Corporate infrastructure such as plants, buildings, and equipment are overdue for upgrades, suggesting substantial future increases in capital expenditures.

Headwinds from the Euro debt crisis have subsided to a large extent, with credit spreads collapsing. In fact, spreads seem unusually tight given that Spanish bond yields are currently lower than US Treasury yields. This is quite unusual, and likely due to the European Central Bank’s announcement that they will engage in more aggressive monetary easing policies to halt disinflation and spur growth.

Japan and China are still muddling through their own economic malaise attempting to establish equilibrium. In short, the global financial landscape seems eerily quiet, especially given the growing geopolitical pressures. Increased tensions in the Ukraine, civil war in Iraq, and continued presidential scandals have failed to disrupt financial markets. The US stock market, in particular, is experiencing reduced volatility. We are now going on almost three years with no correction of 10% or more (since August of 2011).

The current situation reminds me of my garden. This year I made a vow to finally grow vegetables. I decided to start with something easy and small. I filled a cement container with soil and compost and planted two tomato plants. The plants grew tall quickly; and before I knew it, I had about 15 shiny green tomatoes. I was so excited that I started to plan my recipes, who I would share my bounty with, and what I was going to add to my garden next year. Then one day when I went to check my plants; I found a shriveled up tomato and one that had brown rot on the bottom. Uh, oh. I researched the disease online and now realize that I may not be able to save my tomatoes. I am taking steps to reduce the risk of further rot, but I am concerned that I may be fighting a losing battle.

I may lose a lot of my tomatoes, or I may be able to minimize the losses and still have plenty of tomatoes for weeks to come. The same may hold true about the financial landscape. Although the economy is starting to improve, the stock market seems to have gotten a bit ahead of itself. The market appears frothy, with little room for future growth, but a correction may come in days, months, or maybe years.

Why are stocks and investors so complacent?

The Fed Reserve’s policy of printing money has resulted in a massive increase to their balance sheet from $800B in 2007 to over $4.5T today.

This massive flood of money into the system has drastically devalued the dollar and has forced investors to put their cash in riskier investments. This has been the main reason for the overly ebullient markets since the Great Recession of 2008. In this zero interest rate world, desperate retirees and savers are reaching for yield in risky areas of the market in order to get more return on their money. This has resulted in overvalued fundamentals. Valuations are rich for US equities using metrics that have traditionally been highly correlated to market performance.

Using the CAPE (Cyclically adjusted PE) ratio developed by Robert Shiller from Yale University, the market may be signaling that US stocks are possibly overvalued by 50%, as the ratio is approximately 51% above its average (arithmetic mean) of 16.5.

Of course, valuations can’t be used as market timing techniques, as markets can stay overvalued or undervalued for long periods of time. But at these levels, it does suggest that loading up on equities, especially if you are a new or soon to be retiree, may not be a good long-term move.

According to John Hussman, “The median price/revenue multiple for S&P 500 constituents is now significantly higher than at the 2000 market peak.” He is currently forecasting weak returns over the next decade with negative returns for period of 7 years or less.

Similarly, James Montier from GMO expects that large U.S. stocks will have a return of -1.6% a year for the next seven years.

Mebane Faber in a recent conference suggested that not only US stocks, but particularly dividend stocks are severely overvalued. He also warned that “home bias” skews our portfolios in favor of our own country’s stocks. Right now international markets, especially certain emerging market countries, have better valuations.

The point is that shocks occur when you least expect it. They are often caused by some triggering exogenous factor and are met with disbelief, which in turn leads to unpredictable human behavior.

We need to prepare for inevitable corrections as they are part and parcel of business cycles.

Since this rally is particularly long in the tooth and has created severe overvaluations, it may be a time to mentally and financially prepare for a market setback. While I do not espouse market timing, I do think it is prudent to reduce exposure by 10-20% in the event of extended markets, impending retirements, or in the event that you have reached or surpassed your target financial goals.

Times like these also underscore the importance of re-balancing your portfolio. Re-balancing is the best way to keep yourself unemotional, since you invest based on your target allocation as opposed to market noise. This is why I always urge my client’s to be faithful regarding their annual reviews.

When you re-balance or take some actions to reduce risk, you not only enhance your awareness of your financial well being, but you feel more in control of your situation. When it comes to investments, we can’t control the economy or the direction that the markets will turn, but we can and should control the things that we can, such as reducing costs, planning to avoid tax spikes, and maintaining an exposure to the stock market that is consistent with our risk profile and market valuations.

In order to reduce the risk of losing more tomatoes to disease, I bought some gypsum and added it to the soil in my tomato plant container. I don’t know if it will work, but I at least feel better that I did all that I could to help prevent the spread of the disease. I hope to have an abundant garden this summer, but only time will tell.

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We are now experiencing the fifth most powerful bull market in stocks since 1900. The Federal Reserve, through its quantitative easing program, has lowered interest rates to near zero, thereby forcing investors to search for income in nontraditional places. In response, dividend yielding stocks and high yield “junk” bonds have soared in price. If you review the trajectory of the S&P 500 over the past year, it appears that the market is advancing without any significant corrections.

The market continues to shrug off risks. Despite poor economic data, decelerating growth in China, still unresolved European debt woes, and increasing tensions between Russia and her neighbors, the market continues on its march upward. The only data the market seems to respond to are signals from the Federal Reserve that they may increase interest rates. For now, the stock market assumes that new Federal Reserve Chair Jerome Powell “has its back.” The dovish Powell appears to be an advocate of an accommodative policy through 2018.

Investors can become complacent believing that this pattern will last indefinitely. To wit, the flow of money into stock funds reached an all-time high in 2013-2017 as memories of the crisis of 2008 faded. The belief that market gains can be achieved consistently with no apparent risk of correction is not only naive, but dangerous. Investors in Bernie Madoff’s fund were likewise transfixed by the steady, impressive returns that seemed to move with no correlation to the financial markets. Sometime when things seem to be too good to be true…..
We only need to look back to the more recent examples of complacency and calls of “this time it’s different,” to remind ourselves of the dangers that can result from this mentality.

In the 2000 tech implosion, the market finally came to the reality that stocks with non-existent earnings and lofty prices were not necessarily a good buy. We were told that “earnings did not matter” and that this was “the new paradigm.”

In 2007, when everyone was buying second homes, flipping “spec” homes, and loading up on a McMansions they could not afford, the party line was that, “housing is an investment that never goes down in value.”  The financial crisis was created in part due to this mentality, and we are still feeling the painful repercussions.  In this article , Peter Schiff discusses the implications of the massive debt the US has incurred post 2008.  He states,

America is trying to borrow its way out of recession. We are creating debt now in order to push up prices and create the illusion of prosperity.

He opines further that:

 “The red flags contained in the national and global headlines that have come out thus far in 2014 should have spooked investors and economic forecasters. Instead the markets have barely noticed. It seems that the majority opinion on Wall Street and Washington is that we have entered an era of good fortune made possible by the benevolent hand of the Federal Reserve. Ben Bernanke and now Janet Yellen have apparently removed all the economic rough edges that would normally draw blood. As a result of this monetary “baby-proofing,” a strong economy is no longer considered necessary for rising stock and real estate prices.”

It is important for investors to remind themselves of the following:

Markets are cyclical

Corrections are normal consequence of business cycles:  We can’t predict when they will occur, but we should prepare mentally for their eventuality.

Market timing is extremely difficult.

Who would have predicted that in 2013 the S&P 500 would increase over 30%?  This occurred despite the debt ceiling and budget showdowns, sluggish economic growth, and other geopolitical events.  Few if any analysts, predicted this incredible performance, giving further credence to the notion that the so called “experts” are not particularly prescient.

Chasing performance can lead to pain

Investors have a tendency to pile into segments of the market that have recently performed well , buying more of the recent winners and eschewing the “dogs” that underperformed.  But short term performance is not indicative of longer term returns.  Overexposure to one asset class, say large-cap US stocks, will reduce your portfolios diversification, thereby increasing the overall volatility of your investment mix. Discipline in the form of rebalancing would be a better tactic. In this related article, Craig Israelsen discusses this behavioral tendency and how it can be avoided through proper diversification.

Looking at traditional measures of valuation, the current stock market is overvalued.  According to John Hussman, current valuations suggest that equities are poised to deliver paltry returns of roughly 2.3% before inflation over the next 10 years.  Even the Fed’s own Richard Fisher, president of the Federal Reserve Bank of Dallas, recently said he was concerned about “eye-popping levels” of some stock market metrics warning that the Fed must monitor the signs carefully to ensure bubbles were not forming.

In irrational times like this, it is important to maintain perspective; we don’t know exactly what the stock market will do in the short run.  We can’t control inflation, taxes, political turmoil, the weather, our health or major geopolitical events.  We must instead focus on the things we can control like the following:

Our emotions– It is essential that we have a portfolio of investments that we can stick with through thick and thin.

Review your investment policy statement that was prepared as part of you plan; and specifically; revisit the potential decline for your investments based on your target allocation to the stock market to see if it is still palatable

Rebalancing –After a large market advance, it is important to prune our winners and reinvest proceeds in losing asset classes.

Most recently, that would mean selling stocks and buying bonds. While this is counter to our  behavioral instincts, it is a powerful way to maximize long-range investment returns.

Costs–Given that future stock market returns are likely to be lower, costs becomes especially important.

Employing no-load, passive, low-cost funds and ETF’s will help maximize your gains.  The money you save due to low fees will compound for you over time.  This has an exponential effect on the growth of your portfolio.  Costs are reflected in your funds’  expense ratios.  Low cost investment advice helps to further reduce the overall cost of your investment management.

Diversification–resist the urge to follow performance and load up on yesterday’s star asset classes

Just because US stocks have been stellar performers doesn’t mean that this will continue. We never know in advance which portion of the portfolio will be the star performer. As this periodic table of asset class performance indicates, the stars of one year can easily turn to dogs the next. It is also important to remember that cash, CDs, and high-quality bonds, while they possess frustratingly low yields, are still an essential component of your portfolio, as they act as shock absorbers in periods of market turmoil.

Risk– if you’re planning to retire in the next five years or recent retiree, you may want to adjust your portfolio to position yourself more conservatively.

Recent studies suggest that minimizing your exposure to stocks, five years before and five years after retirement  and then increasing your stocks allocation slowly over time, may be a prudent way to maximize spending in retirement as well as avoid outliving your funds.

In summary, the market over the past few years may convince you that risk will be rewarded with little chance of loss. But remember, what goes up must go down, and invariably, a tipping point emerges that changes the course of the market.  History does repeat itself.  Be realistic and stick to a prudent plan so you are well equipped to weather any market storm.

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