Real Returns Favor Holding Stocks

Posted on October 7, 2014 | AAII Journal

Charles Rotblut (CR): You have a reputation for being bullish on the stock market, but from reading “Stocks for the Long Run,” it sounds like you’re more focused on the ability of stocks to prevent the loss of purchasing power than making a call on the direction of the market. Is that correct?

Jeremy Siegel (JS): My book emphasizes that the long-run return on stocks is between 6.5% and 7% per year after inflation (Figure 1). This return has been very stable in the long run. Over time stocks are good hedges against inflation, so they keep up with inflation and purchasing power, but even aside from that their returns are excellent compared to fixed-income assets. They dominate fixed-income assets, and particularly in today’s low interest rate environment I think the margin by which stocks will outperform bonds is even greater than it historically has been.

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Figure 1. Total Returns on U.S. Stocks, Bonds,
Bills, Gold and the Dollar, 1802–2013

Managing Cash Flow in Retirement

Posted on September 24, 2014 | AAII Journal

Combining a year’s worth of cash with a long-term investment portfolio protects immediate needs while still enabling the portfolio to grow.

Given the headwinds of inflation, return sequence, and a low return environment, what’s an investor to do?

The traditional income portfolio (i.e., one that provides annual cash flow from dividends and interest) will not work for a number of reasons. First, the current level of interest rates and dividend yields has no relationship to what would be an appropriate retirement portfolio allocation. For example, the current yield on a 20-year A-rated corporate bond is about 3.9% and the yield on the S&P 500 index is 1.8%. For a client looking to achieve a 4% cash flow, that means his portfolio allocation would have to be 100% bonds. Of course, this would be a short-lived solution, as over time the purchasing power of the nominal return from bonds would be eroded annually by inflation. Plus, the investor’s income is variable as interest rates change. Not to mention that how the investor feels and the economic reality of the value of his or her portfolio move in opposite directions, exacerbating the situation. When rates are down, portfolio income decreases and the investor feels poor, even though the portfolio value would actually be increasing. When interest rates rise, portfolio income goes up and the investor feels richer, even though the reality is his or her bond portfolio value is dropping.

A viable solution must provide consistent real cash flow in a volatile, long-term low return market environment. It was with this in mind that we created the Evensky & Katz two-bucket approach back in the early 1980s. Here’s how it works.

An investor’s nest egg is bifurcated into separate portfolios: the Cash Flow Reserve (CFR) portfolio and the Investment Portfolio (IP). When originally designed, the CFR was funded with two years of cash flow needs; subsequent research at Texas Tech University determined that a one-year reserve was optimal. Figure 1 visually describes the strategy.

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Figure 1. Evensky & Katz Portfolio Approach

An Inside Look at Exchange-Traded Funds

Posted on September 22, 2014 | AAII Journal

Exchange-traded funds (ETFs) have been one of the most successful financial innovations in recent years.

Since the introduction of ETFs in the early 1990s, demand for these funds has grown markedly in the United States, as both institutional and individual investors have increasingly found their features appealing.

In the past decade alone, total net assets of ETFs have increased nearly twelvefold, from $151 billion at year-end 2003 to $1.8 trillion as of June 2014, as shown in Figure 1.

With the increase in demand, sponsors have offered more ETFs with a greater variety of investment objectives.

Like mutual funds, ETFs are a way for investors to participate in the stock, bond and commodity markets; achieve a diversified portfolio; and gain access to a broad array of investment strategies.

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Figure 1. Total Net Assets and Number of ETFs
figure 1

Stress Hormone Alters Tolerances for Financial Risk

Posted on September 19, 2014 | AAII Journal

A sustained increase in the stress hormone cortisol leads to both a reduced tolerance for risk and an increased preference for perceived safer, but lower-return outcomes. This physiological response to stress may be a contributing cause to financial market instability, particularly during times of increased uncertainty.

A team of British and Australian researchers reached these conclusions after conducting a study on participants using a combination of cortisol dosing and computerized lottery games. The study was designed to measure risk preferences under placebo-treated, acutely elevated cortisol and chronically elevated cortisol conditions. Though the researchers had previously tested cortisol levels on London traders, this experiment allow them to test responses under controlled conditions.

The researchers focused on cortisol because long-term exposure to raised levels can impair behavioral flexibility and promote anxiety, depression and learned helplessness. The researchers said the effects associated with long-term exposure to elevated cortisol “could be expected to discourage risk taking.”

First, they looked at the average utility curve. The flatter the utility curve is, the less marginal benefit is derived from each incremental increase in the amount of benefit. In other words, a flatter utility curve implies that a person is less willing to incur greater risk in order to reap bigger potential rewards. Participants receiving acute doses of cortisol showed no significant difference in risk aversion than the control (placebo) group did. Participants with chronically elevated cortisol had a “large” increase in risk aversion, however.

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Allocate by Market Weight (And Adjust for Personal Circumstances)

Posted on September 16, 2014 | AAII Journal

Charles Rotblut (CR): I’d like to discuss allocation, starting with rebalancing. A lot of people either psychologically have a problem doing it or just won’t do it. What are your thoughts?

William Sharpe (WS): I think, by and large, people probably shouldn’t do it. In particular, rebalancing by selling winners and buying losers. Basically, if you’re going to sell your winners and buy your losers, then you have to trade with someone. And that person has to take the other side of the trades. If you’re smart doing that, then the other person must be dumb to trade with you. So the questions are: Why is that a good thing to do, and what’s the matter with the other person for trading with you?

We can’t all rebalance, because rebalancing to pre-selected proportions means selling relative winners and buying relative losers. Since we can’t all do that, the question is: If this is the obvious thing to do, with whom are you going to trade? Who is it? And why should the other person trade with you? In an efficient, sensible or informed market, such rebalancing will not be a good strategy.

I would like to see a very-low-cost index fund that buys proportionate shares of all the traded stocks and bonds in the world. Unfortunately, there are none at present. It would be good if there were one or more used by a great many investors as their main investment vehicle. While such a fund is not available, you can construct one from existing index funds, but then you have to monitor the current world values of the components—for example, the value of all the U.S. bonds for the U.S. bond index fund, the value of all the non-U.S. bonds for that fund and the value of all the world stocks for that fund. I’ve talked to my friends in the index fund business, and thus far nobody seems to be interested in producing that. It is a huge hole and individual investors could really use such a fund.

CR: What about adaptive allocation? I know you’ve written about the subject.

WS: Here is a simple way to think about this. Assume that at the moment stock values are 60% of the total value of bonds and stocks, that bond values are 40% and that you just want to have the risk and return of the average investor. Then you should invest 60% in stocks, 40% in bonds. And now, let’s say, stocks go up and bonds go down, so the market values are now 70%/30%. If you want to continue to be the average investor, you should have 70%/30% proportions. But when you look at your portfolio values, you are likely to find that they are already close to 70%/30%. And you didn’t have to do anything. This won’t be exactly the case due to new security issues and things of that sort, so you might have make some minor adjustments, probably when reinvesting dividends and bond payments. But the trades will be small. The idea is to have a policy that indicates what proportions you want when the market proportions are, say 60%/40%, and then keep your relative risk constant as market values change (Figure 1). The formula that I suggest for adaptive asset allocation works from this basic policy and indicates the proportions that you should have as market proportions change.

In the simplest case where you just want to take the risk of the average investor, the formula just says that your policy should be to hold the same proportions as the market. If you want to have a policy of being more risky than the average investor, then you have to look at the formula. But it’s a very easy formula.

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Figure 1. How Adaptive Allocation Works

An Inside Look at Exchange-Traded Funds

Posted on September 10, 2014 | AAII Journal

Exchange-traded funds (ETFs) have been one of the most successful financial innovations in recent years.

Since the introduction of ETFs in the early 1990s, demand for these funds has grown markedly in the United States, as both institutional and individual investors have increasingly found their features appealing.

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Driving Emotions From Your Investment Process: A 12-Step Program

Posted on September 5, 2014 | AAII Journal

For many years, I conducted an AAII Stock Analysis seminar in which I presented a variety of techniques for analyzing and valuing stocks.

Beyond presenting specific techniques, I also discussed ways to remove emotions from a decision process. Now that I manage money professionally and have delved into the ever-growing body of behavioral science research, I am more convinced than ever that ruthlessly driving emotions from stock-picking decisions is essential to generating superior returns. In fact, if you don’t, you cannot outperform.

There is now a large body of research showing that investors depend on emotions and anecdotal information when making decisions. You are no doubt aware of this and are familiar with the resulting cognitive investment errors. There have been numerous articles dealing with how investors can avoid such errors and, as a result, do a better job of managing investment portfolios.

Unfortunately, industry professionals apply techniques and put policies in place that encourage investors to continue making emotional decisions. So even if the investor wants to drive emotions out of the investment process, the industry is set up to encourage them to do otherwise.

To help you make this transition, I present a 12-step program to show how to ruthlessly drive out emotions and thus make it possible for you to make superior investment decisions.

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How to Safely Navigate Through Crowded ETF Waters

Posted on August 28, 2014 | AAII Journal

I once interviewed a successful exchange-traded fund (ETF) sponsor and had the temerity to offer some suggestions where some ETFs were needed.

The response from this person was: “Look, we’re not interested in filling needs as much as we are in building a business.” This made an important point: Investors must align their investments to match their needs versus the business interests of sponsors.

The market for exchange-traded funds has never been more robust and expansionary. The most prominent activity for sponsors is similar to a game of Battleship in which the winner fills all the slots before the next guy. Why? Because the “first mover advantage” to a sector and index cements their brand as “the go-to shop.”

The most important activity for investors remains focusing on those ETFs that work and matter to them versus any sponsor’s marketing campaign.

It’s hard to imagine that in 2005 we published an essay in our newsletter, the ETF Digest, entitled “The ETF Tsunami” that discussed the then-impending flood of new ETF issues about to hit the markets. Obviously, it seemed even then the sector was undergoing explosive growth, but with today’s level of issuance “tsunami” seems an understatement.

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Retirement Planning May Improve Your Health

Posted on August 25, 2014 | AAII Journal

Whether or not a person contributes to a 401(k) plan may influence his or her health. Commenting on their study of employees with access to company-sponsored wellness testing, Timothy Gubler and Lamar Pierce of Washington University said they found that “retirement savings and health-improvement behaviors were highly correlated. Individuals who had previously chosen to save for the future by making 401(k) contributions improved their health significantly more than non-contributors did, even though there were few health differences between the two groups prior to program implementation.”

The study was limited in scope, but its authors believe the results demonstrate the impact of time-discounting preferences. Time discounting refers to whether a person prefers to realize a benefit now (e.g., the payment of cash) or prefers to postpone in exchange for a better benefit in the future (e.g., a larger payment of cash). The authors opine that if discounting preferences can be changed in one domain, such as the setting aside of a portion of current pay for retirement, discounting preferences are also easier to change in other domains, such as health.

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Finding Growth Stock Winners: Focus on 8 Fundamental Factors

Posted on August 14, 2014 | AAII Journal

There are eight tried-and-true key fundamental factors that drive stellar stock price performance and have stood the test of time.

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