By Larry Swedroe
Director of Research, the BAM ALLIANCE
It seems like investors have had plenty to worry about recently, even without considering the last few weeks of stock market volatility. After all, we’ve seen:
Now add to this list the sharp and sudden drop that equity markets have experienced since the S&P 500 peaked on September 18. If all the negative headlines have caused your stomach to produce a lot more acid, resulting in some sleepless nights, you should answer certain questions before the stress causes you to embark on a bout of panicked selling.
First, ask yourself about the reasons for your concern. Then ask if you are the only one who knows those risks exist. Obviously, the answer is no. Thus, you should acknowledge that bad news doesn’t necessarily mean markets will go lower. As I discuss in my book, Think, Act and Invest Like Warren Buffett, one of the secrets to Warren Buffett’s success as an investor is that during bear markets, he’s able to keep his head while everyone else around him is losing theirs. He understands that the market price already reflects all information that is knowable. In other words, prices and valuations have fallen because the news has been bad. Those lower valuations mean that expected returns are now higher, reflecting the heightened risks. If you bought previously, when expected returns were lower, does it really makes sense to sell now, when they are higher? This brings to mind something Buffet said in an op-ed for The New York Times, back in the bear market of 2008. He wrote: “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”
The fact that bad news is already embedded in prices means that markets can be expected to continue to fall only if future news is worse than already expected. If the news is no worse than expected, you will likely earn higher returns resulting from the lower valuations. And even if the future news isn’t necessarily good, but is better than expected, valuations will rise as the risk premium demanded by the market begins to fall. That’s often how bull markets begin.
One of the most important lessons smart investors have learned is that it’s totally irrelevant to stock prices whether news is good or bad. Failing to understand this basic tenet causes investors to overreact to the news. They become overenthusiastic when it’s good and panic when it’s bad. To be a successful investor, you need to understand that what matters is whether the news is better or worse than already expected.
One of the most basic principles of finance is that markets are forward looking, meaning that they incorporate everything that is knowable into current prices. In other words, the only thing that matters is surprises. By definition, if something is a surprise, it cannot be forecast. Since happy surprises are about as likely as unhappy ones, changes in market valuations are random, unpredictable.
The second question you should ask yourself concerns Warren Buffett’s take on selling. Not unexpectedly, the answer comes from Buffet himself. He has said that his favorite time period for owning stocks is forever. One of the reasons for his great success is that he never engaged in a fire sale. He stuck with his plan. And that’s what smart investors do. They adhere to their well-thought-out plan. Such a plan will have anticipated that bear markets were going to occur with certainty, and that it wasn’t possible to know when they would start, how long they would last, and how deep they would be. The key to success is to stay disciplined. And the only way you’re likely to do that is to make sure your asset allocation doesn’t include assuming more risk than you have the ability, willingness or need to take. Otherwise, when the risks do show up, your stomach will reach its GMO limit — the point at which it screams GET ME OUT! Not many investors can resist that siren’s cry.
Smart investors know that bear markets are inevitable, and that no one has shown the ability to successfully time them in an effort to avoid their occurrence. And they know that active managers have done at least as poorly in bear markets as they have done in bull markets. So forget about the idea that active management is likely to protect you. Only you can protect yourself, by not taking too much risk and planning for bear markets ahead of time. Great generals know what successful investors know: battles are won in the preparatory stage, not on the battlefield (or in the middle of a bear market). On the battlefield, stomachs often take over the decision making. And I’ve yet to meet a stomach that makes good decisions.
So what should you be doing? If you have a well-thought-out plan, you should be sticking to it. However, that assumes the most recent bear market has taught you the right level of confidence in your willingness to take risk. If not, it’s better to acknowledge the mistake (and lower your equity allocation to the appropriate level, although perhaps the market has already done that for you) rather than perpetuating it. Running a Monte Carlo simulation can help determine if a lower allocation will still allow you to achieve your goals. Perhaps combining that new, lower equity allocation with a commitment to save more currently or a plan to work a bit longer will still allow you to meet you goals. Even smart people make mistakes. What differentiates them from fools is that they don’t repeat them.
If you don’t have a plan, take this as a wake-up call to write one. For those interested in doing so, some helpful tools can be found in The Only Guide You’ll Ever Need for the Right Financial Plan. If you do have a plan, you might focus on some of the current economic situation’s positives, rather than only its negatives. The financial media, we know, tends to focus on the negative (like the market’s recent volatility) because bad news sells. Note that the arrival of good news doesn’t necessarily mean that the market will stop falling. Remember, just as the market incorporates the totality of bad news and risk, it also incorporates the good. Good news is embedded in the market’s prices as well.
There is Some Good News
First, since the weather-related slump in the first quarter, the U.S. economy has been growing at a faster pace than many expected. The U.S. Commerce Department’s Bureau of Economic Analysis revised its estimate of second quarter real gross domestic product (GDP) growth, which came in at 4.6 percent and surpassed the expectations of many observers. More generally, as Standard & Poor’s indicated in a recent report, “the updated official growth estimate confirmed our view that the U.S. economy is gaining momentum.”
Second, the September jobs report was stronger than expected, indicating a strengthening labor market. Throughout the past 12 months, payroll jobs have increased at a monthly clip of 220,000.
Third, with the unemployment rate now at 5.9 percent, the stage could finally be set for wage growth to begin accelerating next year. And that would stimulate consumer spending.
Fourth, the sharp drop in oil prices, now down more than 20 percent since June, will act similarly to a big tax cut and should also help stimulate other consumer spending. The sharp drop in energy prices overall will help hold down the rate of increase in the consumer price index (CPI). And the timing for lower prices couldn’t be better as we head into the crucial winter heating season. In addition, lower energy prices will provide the Federal Reserve with more leeway to extend its policy involving very low interest rates. Keep in mind that a strong dollar will not only lead to lower import prices, but should also mean that domestic producers will have to be more competitive in their pricing. That should help keep prices low in general.
Fifth, the sharp drop in interest rates will help U.S. industry by providing more opportunities to refinance debt at lower levels, thus improving profits and margins. It will also allow more homeowners to refinance, and others will be encouraged to buy homes and lock in these historically low rates.
Sixth, low interest rates could lead U.S. industry to finally begin increasing capital expenditures if the economy continues to show improvement. Standard & Poor’s noted that “whereas business investment in capital structures has typically averaged 7.6 percent of GDP during economic expansions since 1959, it has only been 4.6 percent this time around.” If companies begin to perceive stronger demand, we could see the beginning of a virtuous growth cycle — investment adds jobs, which fuels consumer spending, with obvious benefits for state and local government revenue collections, which in turn allows them to begin hiring again. Total employment by state and local governments is still about 600,000 below their August 2008 level.
Summary
It’s certainly possible that global equities markets will continue to fall even without more bad news. Unfortunately, history shows that markets tend to exhibit momentum, both positive and negative. And right now, the momentum is clearly negative. Selling often begets more selling as margin calls are issued and more investors reach their GMO point. Unfortunately, there are no clear crystal balls that will tell you when the negative momentum will come to an end. And, likewise, there are no clear crystal balls that will tell you if we are going to have negative or positive surprises (otherwise they would not be surprises). Thus, the winning strategy, over the long term, is to have a well-thought-out plan and stick to it. Avoiding panicked selling and rebalance with discipline, as Warren Buffett has done. And keep your head while others around you are losing theirs.
This article originally appeared on ETF.com. Larry Swedroe is the director of research for the BAM ALLIANCE.
Q: What are TIPS and how do they work?
A: Similar to nominal (non-inflation-adjusted) U.S. Treasury fixed income investments, TIPS are issued with fixed coupon rates and fixed maturity dates (such as five, 10 or 20 years). The key difference between TIPS and nominal bonds is that the coupon rate for TIPS is a guaranteed “real” (inflation-adjusted) return. The principal is adjusted for inflation before the interest payment is calculated. With TIPS, the coupon payments and face value will maintain purchasing power until maturity. TIPS rates are primarily higher because they compensate for expected inflation and, secondarily, for the inflation risk premium.
The principal value of TIPS is adjusted by the Treasury Department according to changes in the Consumer Price Index for All Urban Consumers (CPI-U). The semiannual interest payments vary because the fixed coupon rate is applied to the inflation-adjusted principal, as illustrated here:
|
Year |
Inflation Rate |
Amount Principal Adjustment |
Adjusted Principal Value |
Total Coupon Payment |
|
1 |
0% |
$0.00 |
$100,000 |
$3,000 |
|
2 |
2% |
$2,000 |
$102,000 |
$3,060 |
|
3 |
1% |
$1,020 |
$103,020 |
$3,090.60 |
|
4 |
3% |
$3,090.60 |
$106,110.60 |
$3,183.32 |
|
5 |
1% |
$1,061.11 |
$107,171.71 |
$3,215.15 |
Note: Example assumes an individual TIPS with a $100,000 principal value and a 3 percent coupon rate.
Benefits and drawbacks of TIPS. TIPS diversify portfolios because of their low correlation to stocks. When inflation is higher than expected, TIPS typically outperform nominal Treasuries. Because TIPS are Treasury securities, they are considered risk free. They have lower volatility than nominal Treasuries and other investments considered being hedges against inflation (such as commodities, equities, real estate).
TIPS have lower expected returns than nominal Treasuries, which take on additional risk. TIPS are expected to underperform nominal Treasuries during periods of deflation.
The tax implications of TIPS. TIPS are exempt from most local and state taxes. Interest paid on TIPS held outside of tax-deferred accounts is considered ordinary income for federal income tax purposes. Also, increases to the inflation-adjusted principal are considered taxable income in the year they occur, even though TIPS investors do not actually receive these gains until the fixed income investments mature. Because of this tax inefficiency, TIPS should generally be held in tax-deferred accounts unless the investor is in a low tax bracket.
Copyright © 2014, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
Q: What is a bond ladder?
A:A bond ladder is a portfolio of individual bonds that have different maturities. For example, a bond ladder could be constructed with equal numbers of bonds with maturities across 1–10 years, or it could consist of bonds that mature in 2–7 years. Since buying small lots of individual bonds will increase costs, the number of bonds and the number of maturities used in a ladder might be influenced by the dollars available to invest. The threshold we follow is $500,000 for tax-deferred accounts and $1 million for taxable accounts.
A ladder can help minimize risk. At least three types of risk are related to fixed income investing:
1) price risk, 2) reinvestment risk and 3) credit risk. Creating a bond ladder can minimize price and reinvestment risk. The longer the maturity of an instrument (and the greater its duration), the greater the price risk will be. Reinvestmentrisk is the risk that a bond will mature when interest rates are lower than when the bond was purchased. Thus, when an investor reinvests the proceeds from the maturing instrument, he or she could receive a lower rate of return. Minimizing price risk comes at the cost of accepting reinvestment risk, and vice versa. It is possible to reduce credit risk by purchasing bonds with higher credit quality such as U.S. government debt and upper investment-grade instruments, as well as municipal bonds rated AAA and AA from low-default sectors.
Advantages and disadvantages of ladders. Investors can match maturities to known/desired cash flow needs while avoiding the expense of a mutual fund or an active separate account manager. Tax-loss harvesting can be performed in taxable accounts. Investors can control which bonds they own, which is not possible with a bond fund. For example, investors can allocate a portion of the ladder to state-specific bonds or those with alternate-minimum tax restrictions. One thing to be aware of when building a bond ladder is the need to adhere to a buy-and-hold strategy. Selling securities before the final maturity date can have a negative impact on the desired performance of the bond ladder.
Considerations when designing bond ladders. An investor’s time horizon can be a factor when deciding the length of the ladder. If invested properly, the length will be dependent on whether the market is compensating for an extension. Also, consider risk tolerance and liquidity/income needs, which can be a factor when deciding how many bonds (rungs) to include on the ladder (for example, some investors who need a large stream of income might wish to develop a ladder that seeks to earn a specific expected yield).
Every bond ladder should be based on an investor’s specific financial objectives. Taxes should also be considered when determining the type of ladder. Federal tax brackets will dictate whether tax-free or certain taxable bonds make more sense for the client. Taxes should also be considered for certain residents who live where the state tax is high. At the same time, national diversification would help minimize credit risk. We believe state exposure should be capped at 35 percent.
Copyright © 2014, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.