Deception in the Financial Service Industry

To be blunt, there is deception all around us. The primary presidential elections are a perfect example – whether it is Republicans debating with Republicans, Democrats questioning other Democrats, or Republicans and Democrats fighting each other, there is so many half-facts and conflicting information that it is impossible for everything said to be true.

There is an equal amount of deception in the financial service industry. Whether you are watching CNBC, reading Forbes Magazine, or listening to a local salesperson promote his financial product, it is hard to believe we are ever getting the complete story from an unbiased perspective regarding any personal finance issue.

Deception is frequently used to strengthen one’s agenda. An agenda can be supported by drawing attention to specific facts, or reinforced by drawing attention away from less desirable facts.

Hiding Good News in Deceit

The reality is there are always some parties that don’t want us to know the good news happening around us. For example, financial television mediums are dependent on constant viewers in order for their business plan to succeed. Frankly, they can’t go on the air and tell viewers that there is nothing to worry about and that their time would be better spent outside on a bike or with friends and family. Instead, they must consistently remind viewers of all possible downsides to insert a fear that at any moment something could happen that would restrict our ability to meet our financial goals. This is an example of utilizing deceit to take attention away from the good news that is more reflective of our environment.

Another example of using excessive information to conceal good news is the emergence of ultra-responsive investment strategies. Study after study has concluded that the best way to make money investing in the market is to buy and hold long-term positions. That is great news because it is fairly simple and can potentially be accomplished by anyone (at least in principle). However, this great news is frequently concealed by investment institutions who offer a responsive solution to every possible market scenario. Even though research suggests that an investor is better off not reacting to variables impacting the daily market, some financial institutions still promote such a strategy so they can charge higher fees due to a more frequent level of involvement.

Hiding Bad News in Deceit

In some situations, some parties may hide the bad news within their agenda amongst an abundance of less relevant information. As you might have noticed, most annuities are overly complex and not easily understood. The contracts accompanying these products are commonly the size of a book and written in such a manner that even the most experienced financial planners have a hard time comprehending. Meanwhile, the excessive fees and outlandish surrender periods of these products are something that are frequently not discussed by the advisor promoting the product. This is an example of using BS to make something overly complicated to conceal their negative features.

A second example of burying bad news in deceit is the way non-publicly traded REITs (real estate investment trusts) are sold. As millions of investors have learned over the last 20 years, non-publicly traded REITs are not a liquid investment, and if an investor wants to quickly sell their holding they frequently need to do so at a steep discount (commonly less than 50% of the purchase price). Clearly, this is bad news. However, the financial salespeople offering these investments claim that not listing the product on a public exchange enables the product to endure less volatility because investors can never get online and see their investment’s value go down. Of course, just because investors can’t see the daily fluctuations in their investment’s value doesn’t mean that the price of the investment will be stable when the investor wants to sell, and most owners of non-publicly traded REITs ultimately eat their shirts.

The Best Solution Available

In all aspects of life, it is useful to question one’s agenda and examine the use of deception to achieve that agenda. This is as true in the financial service industry as it is anywhere else. Simply looking for scenarios where the use of excessive or non-relevant information might be used to conceal facts that are either good or bad for you is likely to sharpen your decision making skills.

Further, I’d suggest that working with a fee-only financial advisor is likely to minimize situations where someone else’s agenda might conflict with what is in your best interest. Fee-only financial planners are restricted from recommending financial products that reward them for doing so. Further, fee-only financial planners are held to a fiduciary standard, which means they are required by law to make recommendations that are in your best interest. These two factors are likely to limit the amount of deceit you’ll need to sort through.

Why Constantly Updating Retirement Projections is Vital

New retirement projections should consistently be created to reflect changing circumstances. While short-term fluctuations in retirement plan outcomes should be anticipated and not cause an over-reaction, long-term implications should receive attention and be addressed.

Base Scenario

Consider a 65-year old retiree who would like to withdraw the inflation-adjusted equivalent of $20,000 of after-tax dollars per year from his investment account until age 90. This individual’s nest egg consists of a $500,000 IRA, and his financial plan estimates an average annual investment return of 6%, an effective tax rate of 18%, and an inflation rate of 3%. According to these assumptions, the individual’s financial plan indicates a high probability of success. A Monte Carlo analysis, which accounts for varying sequences of returns (because a flat 6% return isn’t achieved every year but rather achieved on average over time), calculates a success rate of 85%.

Impact of the 2000’s

Now, consider this same individual with one adjustment – that it is the year 2000 and we are about to enter what is now looked at as the “Lost Decade.” During the next 10 years, the S&P 500 averaged an annual return of less than 1%. Let’s assume the investor had a diversified portfolio, which would have generated superior returns to a 100% large cap stock portfolio, and achieved an average annual return of 2% during the decade. Of course, the individual would have still been withdrawing the inflation-adjusted equivalent of $20,000 of after-tax dollars per year during this time period.

At the end of the decade and when the investor is 75 years of age, his nest egg would have been depleted to $301,784. By contrast, if the investor had achieved the anticipated annual return of 6%, his nest egg actually would have increased in value over this time period, ending the decade at a value of $521,185. Unfortunately, the unexpected lower rate of return has severally reduced the success rate of the individual’s retirement plan to an unacceptable 39%.

Note that in this situation, the investor didn’t do anything wrong. With the benefit of retrospect, we can see that an extended period of essentially no growth in the stock market was unavoidable. This illustrates the importance of paying more attention to variables that we can impact (such as spending) and less attention to factors that are out of our control (such as short-term market returns).

Benefit of Plan Updates

Without adjustments, this individual now has a high probability of outliving his money – the ultimate failure of retirement planning. For this reason, updates need to be made to the individual’s financial plan so these issues can be identified and addressed. An analysis of the investor’s new circumstance at age 75 can discover that if annual portfolio withdrawals are reduced to an inflation-adjusted equivalent of $17,700 of after-tax dollars, the financial plan’s success rate bounces back up to 85%. While spending less than the investor’s goal is not ideal, it is certainly better than running out of money.

It is also worth noting that the 6% long-term investment return anticipated by the investor’s financial plan at age 65 may still very well come to fruition, even after enduring a 10-year period with such a low growth rate. Just as it was possible for returns to be unusually low for the “Lost Decade,” it is equally possible that returns will be above average for an extended period of time in the future. In fact, this scenario has actually played out as the S&P 500 is already up over 100% since 2010. Consequently, it is possible that our hypothetical investor would have only needed to reduce spending for a short period of time and that the quick market recovery would have enabled him to return to his previous withdrawal goals relatively quickly. Of course, frequently retirement plan updates would identify when the individual would be able to return to his more comfortable level of spending.

Frequent Updates are Preferable

Lastly, it is important to note that even a quick market recovery can’t save an investment plan if there is no money left in the portfolio to experience the bounce. For this reason, it would be better if our hypothetical investor actually reduced spending during the period of slow market growth as opposed to after the extended period of lackluster returns. This is exactly why I’d recommend updating your financial plan at least annually – so issues can be identified quickly and adjustments can be made efficiently and when they have the most impact.

Unanticipated factors that affect retirement planning occur frequently. These variables range from market declines, to higher inflation rates, to changes in the tax structure, to surprise healthcare expenses, to new rules involving Social Security. Frequently updating your financial plan will help identify some of these issues – which are frequently out of our control – and allow us to address shortcomings by focusing on factors that we can adjust.

Major Changes to Social Security Filing Strategies (Updated!)

After the market crash of 2000, Congress passed the Senior Citizens Freedom to Work Act. This law was intended to enable people who had previously retired and claimed their Social Security benefit to stop receiving their monthly check while they returned to work and continued earning retirement credits. Doing so would enable the worker to earn more income from employment while increasing their future Social Security benefit.

An unintended consequence of this adjustment was that it enabled U.S. citizens to explore and take advantage of various strategies to maximize their Social Security benefits that were outside the intentions of the law. These strategies became known as the “file and suspend” strategy and the “restricted application” strategy. This morning President Obama and Congress passed the Bipartisan Budget Act of 2015, which is intended to prohibit people from utilizing these strategies going forward.

Let’s dive into the differences between the “file and suspend” and the “restricted application” strategies as well as the steps you may need to take if currently utilizing one of these strategies.

File and Suspend

The file and suspend strategy is when Spouse 1 files for Social Security and then immediately suspends the benefit. This can be beneficial because it could possibly enable Spouse 2 to begin collecting a spousal benefit based on Spouse 1’s work history. Further, it would enable Spouse 1 to collect delayed retirement credits until age 70, getting an 8% per year raise in monthly Social Security payments.

The U.S. government has concluded that this strategy is abusive of the Social Security system in that it is essentially double dipping, as it allows a couple to begin collecting a benefit based on one spouse’s work history while at the same time collecting delayed retirement credits on the same work history.

At this time, it appears this strategy will no longer be allowed after April 30, 2016 -- six months from the signing of the law. However, couples who have begun this strategy within the six-month deadline will be allowed to complete the process. By comparison, after April 30, 2016, couples will no longer be allowed to start collecting a spousal benefit for Spouse 2 unless Spouse 1 is also collecting a benefit.

Steps to Take If This is You

Suppose your spouse is currently collecting a spousal benefit based on your work history, although you are not currently collecting your own Social Security benefit. This would be a scenario resulting from the use of the file and suspend strategy.

If this is reflective of your current situation, you will likely be grandfathered into the program and be allowed to complete the process. Alternatively, if this situation is representative of the Social Security strategy you intend to utilize in the future, you will no longer be allowed to execute this approach unless you start the process by April 30, 2016. Since you must be at least full retirement age to suspend benefits, this option is only available to people who will reach age 66 on or before April 30, 2016. If age 66 is obtained after April 30, 2016, you will either need to start claiming your own benefit in order for your spouse to receive their spousal benefit, or your spouse will not be allowed to collect a spousal benefit until you file to receive your own benefit.

On the other hand, some people who intend to take advantage of the “file and suspend” approach can actually accelerate their implementation of the strategy in order to begin the process before the six-month deadline arrives.

Restricted Application

The restricted application strategy is slightly different from the file and suspend strategy in that Spouse 1 files for his own benefits and never stops collecting that benefit. However, this may allow Spouse 2 the opportunity to begin collecting a spousal benefit immediately while delaying her own benefit until she reaches age 70. Again, this can be beneficial in that it allows Spouse 2 to collect one form of Social Security (the spousal benefit) as soon as Spouse 1 files but also allows the same spouse to continue collecting delayed retirement credits on her own work history. Upon reaching age 70, Spouse 2 can then switch from collecting the spousal benefit, which was based on Spouse 1’s work history, to collecting their own Social Security benefit which has been building delayed retirement credits even during the years when a spousal benefit was being collected.

Again, with a file and suspend strategy, Spouse 2 is collecting a spousal benefit even though Spouse 1 immediately suspended his benefit and is currently collecting delayed retirement credits. With the restricted application strategy, Spouse 1 never needs to suspend the collection of his own benefit and Spouse 2 still gets to collect a spousal benefit while earning delayed retirement credits on her own work history. Going forward, the U.S. government would like to ensure that each spouse is either collecting a benefit (either their own or a spousal benefit) or earning delaying retirement credits, but not both.

However, the restricted application strategy is being phased out over a different time span than the file and suspend strategy. Quite simply, as long as an individual reaches ages 62 before the end of 2015, they will be allowed to utilize the restricted application strategy at any point in the future. Conversely, people who will not reach age 62 before the end of the year will have no opportunity to take advantage of the restricted application strategy.

Steps to Take If This is You

As long as both spouses are at least age 62 before the year ends, then your strategy will likely not be interrupted. However, if one spouse isn’t age 62 before year-end, then your strategy will likely need to be reconsidered.

Speak to Your Financial Planner

If you have any questions regarding how these changes will impact your Social Security benefit, please speak to your financial advisor.

During every financial plan review over the next six months, I will be examining your situation and determining whether these changes affect you. If this law impacts you, I will be exploring any adjustments that need to be made. In the meantime, please don’t hesitate to reach out to me if you have any questions.

Breaking News: Major Changes Coming to Social Security Filing Strategies

After the market crash of 2000, Congress passed the Senior Citizens Freedom to Work Act. This law was intended to enable people who had previously retired and claimed their Social Security benefit to stop receiving their monthly check while they returned to work and continued earning retirement credits. Doing so would enable the worker to earn more income while increasing their future Social Security benefit.

An unintended consequence of this adjustment was that it enabled U.S. citizens to explore and take advantage of various strategies to maximize their Social Security benefits that were outside the intentions of the law. These strategies became known as the “file and suspend” strategy, and the “restricted application” strategy.

As part of the 2016 budget, President Obama and Congress intend to prohibit people from utilizing these strategies going forward. At the time of this publication, these proposed changes are not yet law. Although both the House of Representatives and the executive branch have signed off on these bills, they still need to be approved by the Senate before the laws go into effect. However, this is expected to occur with minimal modifications within the first week of November.

Let’s dive into the differences between the “file and suspend” and the “restricted application” strategies as well as the steps you may need to take if currently utilizing one of these strategies.

File and Suspend
 
The file and suspend strategy is when Spouse 1 files for Social Security and then immediately suspends the benefit. This can be beneficial because it could possibly enable the individual’s spouse to begin collecting a spousal benefit based on Spouse 1’s work history. Further, it would enable Spouse 1 to collect delayed retirement credits until age 70, getting an 8% per year raise in monthly Social Security payments.

The U.S. government has concluded that this strategy is abusive of the Social Security system in that it is essentially double dipping as it allows a couple to begin collecting a benefit based on one spouse’s work history while at the same time collecting delayed retirement credits on the same work history.

At this time, it appears that this strategy will no longer be allowed beginning six-months from the date the law is passed. Further, it is currently unclear what action will be taken against those who have already utilized this strategy. It currently appears possible that couples who have already started this strategy will be allowed to complete the process. Alternatively, it is possible that couples who have started this process will no longer be entitled to the spousal benefit they are currently receiving until Spouse 1 begins claiming his Social Security benefit, at which time the spousal benefit for Spouse 2 would continue. In a worse-case scenario, it is possible that the U.S. government may attempt to recollect any benefits that are no longer allowed from couples who have already taken advantage of this strategy. (I believe this is the least likely result, as it would be hard to take money away from people who have already collected it.)

Steps to Take If This is You

Suppose your spouse is currently collecting a spousal benefit based on your work history, although you are not currently collecting your own Social Security benefit. This would be a scenario resulting from the use of the file and suspend strategy.

If this is reflective of your situation, then significant adjustments might need to be made as this law becomes more concrete. It is possible that you will either need to start claiming your own benefit in order for your spouse to continue receiving their spousal benefit, or your spouse will need to stop collecting any benefit until you file to receive your own benefit. Again, these kind of adjustments will likely be implemented six months after the bill is finalized.

Alternatively, and depending on how the law is agreed upon, it is possible that some people who intend to take advantage of the “file and suspend” approach actually accelerate their implementation of the strategy in order to begin the process before the six-month deadline arrives.

Restricted Application

The restricted application strategy is slightly different from the file and suspend strategy in that Spouse 1 files for his own benefits and never stops collecting that benefit. However, this may still be beneficial in that it allows Spouse 2 the opportunity to begin collecting a spousal benefit immediately while delaying her own benefit until she reaches age 70. Again, this can be beneficial in that it allows Spouse 2  to collect one form of Social Security (the spousal benefit) as soon as Spouse 1 files but also allows the same spouse to continue collecting delayed retirement credits on her own work history. Upon reaching age 70, Spouse 2 can then switch from collecting the spousal benefit, which was based on Spouse 1’s work history, to collecting their own Social Security benefit which has been building delayed retirement credits even during the years when a spousal benefit was being collected.

Again, with a file and suspend strategy, Spouse 2 is collecting a spousal benefit even though Spouse 1 immediately suspended his benefit and is currently collecting delayed retirement credits. With the restricted application strategy, Spouse 1 never needs to suspend the collection of his own benefit and Spouse 2 still gets to collect a spousal benefit while earning delayed retirement credits on her own work history. Going forward, the U.S. government would like to ensure that each spouse is either collecting a benefit (either their own or a spousal benefit) or earning delaying retirement credits, but not both.

However, the restricted application strategy is being phased out over a different time span than the file and suspend strategy. Quite simply, as long as an individual reaches ages 62 before the end of 2015, they will be allowed to utilize the restricted application strategy. Conversely, people who will not reach age 62 before the end of the year will have no opportunity to take advantage of the restricted application strategy.

Steps to Take If This is You
 
As long as both spouses are at least age 62 before the year ends, then your strategy will likely not be interrupted. However, if one spouse isn’t age 62 before year-end, then your strategy will likely need to be reconsidered.

Speak to Your Financial Planner
 
If you have any questions regarding how these changes will impact your Social Security benefit, please speak to your financial advisor.

During every financial plan review over the next six months, I will be examining your situation and determining whether these changes affect you and exploring any adjustments that need to be made. In the meantime, please don’t hesitate to reach out to me if you have any questions.

Who Are the Best Predictors of Stock Market Performance?

Every day CNBC airs dozens of “financial professionals” making market forecasts. Similarly, every financial publication has multiple pieces regarding the future of the stock market. With so much information, how is it possible to determine who is worth listening to and what information to incorporate into your investment strategy?

Without dropping any names, I’d suggest that the more confident a market pundit is about his or her prediction, the more you should question their advice.

People who make strong, unwavering forecasts are interesting to watch and appear as intelligent, appealing leaders whose advice is worth following. Meanwhile, people who frequently say phrases such as “it depends,” “maybe,” or even “I don’t know” don’t seem to be adding much value and don’t appear to be any more knowledgeable than the average investor. Yet, I’d suggest you tune out the stanch forecaster pounding his fist on the table as he speaks and rather listen closely to the individual who is less willing to make firm predictions.

Stock market performance is clearly not a result of any singular factor such as whether or not companies will generate more profits than expected. If this was the case, making market predictions would be easy – one could simply guess the answer to be yes or no and have a 50% chance of being correct. Rather, hitting profit targets is only point A on a long list of factors impacting stock market performance.

Point B may be whether or not the Federal Reserve will raise interest rates during their next meeting. Again, our market forecaster could guess yes or no to this question and have a 50% chance of being correct. However, when considering both factors A and B, now our market forecaster has to be right twice on two issues where there is only a 50% probability of being correct on each. Simple math tells us there is only a 25% chance that this will occur (50% x 50% = 25%).

Point C may be whether the republicans or the democrats win the 2016 election. Again, there is a 50% chance of either possibility. Now there are three factors in play, each with a 50% probability, so the probability that the market pundit will get all three factors correct is 12.5% (50% x 50% x 50% = 12.5%).

Point D may be whether the US dollars strengthens or weakens when compared to other currencies. Again, there is a 50% chance of getting this right, so when we consider all four factors, there is now a 6.25% chance of getting it right (50% x 50% x 50% x 50% = 6.25%).

There are hundreds of factors that go into this equation. Will Greece have another economic crisis? Will the price of oil go up or down? Will a war breakout with Russia? This is exactly why forecasting market performance is so difficult!

For this reason, the people who make the best forecasters are people who say phrases such as “perhaps,” “however,” and “on the other hand” a lot. Doing so illustrates that the individual has looked at the situation from a lot of different perspectives and realizes that everything may not go according to plan. These types of people also tend to admit when they are wrong more willingly and update their analysis utilizing the latest information available, even if the new information doesn’t reflect what they previously anticipated. Their thought process is likely: “I got point A wrong, so I need to adjust my thinking on point B, which will have an impact on point C, so how does this change my perspective on point D.” We’ll call this a point-A-to-point-B-to-point-C-to-point-D mentality.

By comparison, the forecaster who makes the strong prediction while staring into the camera likely utilizes more of a point-A-to-point-D mentality. They are less likely to admit that there are more factors affecting market performance than can be managed, and less likely to incorporate new information that doesn’t coincide with his previous prediction when making forward-looking forecasts. Their thought process is likely: “I may have gotten point A wrong, but that doesn’t matter. All that matters is point D and I believe I got that right when making my prediction.” This approach is obviously less logic-based than the approach taken by the forecaster who knows there are too many factors to enable an individual to make a confident prediction.

While people who make confident predictions regarding market performance are entertaining to watch and provide advice that is simple to follow (he said buy, so I’ll buy), their advice is not likely to be any more accurate than other market pundits. In fact, if they are unwilling to admit when they get any potential factor concerning market performance wrong, their advice may be more damaging then useful.  By comparison, market forecasters who utilize phrases such as “however,” “it is hard to say,” and “I’m not sure” provide advice that may come off as unhelpful or impossible to follow, but it is these people who provide logic-based nuggets of information that are likely to benefit your investment portfolio.

Rethinking Diversification

As a financial planner, one of my favorite words is “diversification.” Diversifying a portfolio essentially ensures that we don’t have all of our investment eggs in the same basket. A properly diversified portfolio should experience fewer losses than a non-diversified portfolio as well as benefit from a reduced downside when the market decreases in value. I have a chart that I draw for clients in steps that help me illustrate the purpose and benefits of diversification.

Step one of the chart is to communicate that given enough time, the market has always produced positive returns. (The phrase “enough time” is subjective and fluctuates, but the fact that the market is worth more now than when you were born proves the point.)  Thus, given enough time, the market will eventually move from point A to point B:

Unfortunately, as we all know, the market doesn’t increase in value at a constant pace. Rather, given enough time, it ebbs and flows while moving in an upward manner:

Armed with this information, what two investments would make up the most consistently performing portfolio? Two assets that ebbed and flowed in a perfectly opposite manner while they ultimately trend upward:

A portfolio of only these two perfectly inversely correlated assets would lead to an incredibly stable and predictable rate of return with virtually no volatility:

Unfortunately, these exact investments don’t exist. However, certain asset categories sometimes (not always!) exhibit this characteristic. For instance, when stocks experience a decline, bonds often benefit as investors sell their equities while their prices are low and buy bonds in what is called a flight to quality. The increased demand for bonds causes the price of the asset to also increase. Thus, an investor who had half his money invested in stocks and half in bonds would likely experience a decrease in the value of the stock portion of his portfolio but an increase in the value of his bond holdings. This would lead to a less dramatic loss when stocks go through a rough patch. Similar relationships can also exist between other asset classes:

Obviously, the more inverse relationships that exist within a portfolio, the less volatility it is likely to experience. This is the true value of diversification.

However, there is a factor that we must return to – that the market and a diversified portfolio only make money when given sufficient time. What happens to a diversified portfolio over shorter periods of time? Does diversification still add value?

One of the implied assumptions in the charts above is that the better performing asset makes more than the worst performing asset loses during any given cycle. For instance, the best performing asset might make +15% while the worst performing category might lose -5%. If this was the case, the portfolio would average a +5% overall return. If this wasn’t the case and the best category returned +10% while the worst asset lost -10%, the portfolio’s performance as a whole would be flat (a return of 0%). Fortunately, investments tend to both make money more frequently than lose money and also make more during the years when they achieve a positive return then they lose during years when they experience a loss.*

Unfortunately, over short periods of time, this is not always the case. In fact, the relationship could be the opposite – the worst performing asset category may lose -15% while the best performing category may only make +5%, resulting in an overall portfolio loss of -5%. As the above charts assume a sufficient amount of time for the market to work, these temporary period of market declines aren’t reflected in the diagrams.

A chart consisting of only the potential disappointing short-term returns of +5% for the best investment and -15% for the worst investment would look something like this:

While the negative short-term results aren’t particularly exciting, the above chart illustrates that diversification adds value even during a bear market. If we had a non-diversified portfolio during a market correction (which would be represented by either the blue or the green line), then there are periods when our portfolio would decrease in value at a much more dramatic pace than our diversified portfolio (represented by the red line).

As this series of charts illustrates, while diversification doesn’t prevent a portfolio from avoiding losses over short periods of time, it does add value to a portfolio during environments of both increasing and decreasing market values. Further, a diversified portfolio is likely to endure both fewer and less drastic periods of short-term losses. All things considered, a diversified portfolio is very likely to produce superior returns over a non-diversified portfolio over an extended time frame.

* Virginia Retirement System study: Since 1926, in years when the S&P 500 increased in value, the average positive annual return was 21.47%. Meanwhile, the average negative annual return in down years was only -14.29%. Further, the market experienced a positive return in 73% of years, and a negative return in only 27% of years.

Back to Basics: “Invest” Means Something Different to Everyone

One day last week, I had two interactions that reminded me that there is no common definition for the word “invest.”

First, I was completing an interview with Matt Gephardt from KUTV news. During the discussion, Matt asked if it was a good time to invest. Immediately, I assumed he was referring to the volatility that the stock market has recently experienced and I provided my opinion that volatility was ultimately a good thing because it penalized short-term speculators and provided profitable opportunities for long-term investors. As I spend a lot of energy encouraging clients to focus on achieving their long-term financial goals and paying minimal attention to short-term market movements, I said I wouldn’t hesitate to invest given the current market environment.

Further, as Matt is a young individual with several decades before retirement, investing early and utilizing as much time as possible to allow his portfolio to compound would clearly be beneficial. Investors with such an extended investment time horizon will certainly experience their share of market pullbacks, corrections, and even crashes. Yet, history strongly suggests that the simplest way for young investors to achieve wealth is to get invested dollars working for them as early as possible.

It wasn’t until later that I realized Matt very well could have been asking if it would be wise to invest money now after a market pullback and hope to quickly profit from a bounce or a quick recovery. This would have certainly been a fair question as such action would clearly fall within the definition of investing. However, if I had interpreted the question in this matter, my answer would have been completely different. I would have responded that I have no idea what the market will do over the next week, month, or even year, so if you are looking to make money over the short-term I can’t say that investing now is an action that I would recommend.

The second interaction involved an email exchange with a new client who is about to transition into retirement. This individual has historically been an extremely conservative investor, having his entire nest egg invested in cash equivalents (CDs, money markets, and savings accounts) for the last several years. However, he has recently recognized that such investments won’t provide the income that he desires throughout his retirement.

I’ve worked with this individual to produce a financial plan and investment strategy that we are both comfortable with, so the next step is to put the plan into action. However, the client expressed concern about investing amid the recent volatility. While this is certainly a valid concern, it made me realize that the client and I were using the term “invest” to mean different things.

I believe when the word “invest” was used, the client logically concluded that the entire cash balance would be invested in the market immediately. This would be a huge transition and could certainly be scary.  By comparison, to me “invest” meant starting the process of slowly moving money out of his cash balance and putting it to use in more assertive assets by dollar-cost-averaging over time. This could take 12-24 months, dramatically reducing the client’s exposure to short-term market movements.

Further, it became increasingly clear that although the client and I had discussed and agreed upon an asset allocation that may consist of only 30% stocks, the client hadn’t yet incorporated the mindset that only 30% of his portfolio would be subject to the volatility of the stock market. Admittedly, if the market were to drop 10% immediately after investing your life savings, that would be a frightening experience. However, if only 30% of the portfolio was invested in stocks when the market declined by 10%, the investor’s loss would have likely been only approximately 3%. While enduring a loss is never pleasant, an immediately loss of 3% would be a lot more manageable than a 10% portfolio reduction.

With Matt, he and I may have interpreted “invest” as a way to obtain completely different goals – profiting from the current market environment vs. obtaining long-term financial goals. In my interaction with the new client, our slightly different interpretation of the word “invest” was leading us to envision scenarios with drastically different risk implications.

Of course, it is possible that both Matt and the client could have meant various other things while discussing investing in today’s market. The point is that the term “investing” is frequently not sufficient when communicating with others. What are the goals you hope to achieve with the investment? How long do you intend to hold the investment? What assets will you actually be investing in?

While these may seem like basic principles, it is possible that a commonly understood definition of the word “invest” may be lacking during some communications, whether those discussions are taking place between spouses, financial advisors and their clients, or between families and their accountants and attorneys. Every once in a while, it is probably worth ensuring that the people you work with possess an understanding of what the word “invest” means to you.

Tools For Navigating the Market Pullback

On August 24th, the Dow Jones Industrial Average opened the day decreasing in value by 1,000 points. One of the most volatile days in memory continued, with the DOW fighting back to nearly even by mid-day, down only 98 points. Unfortunately, the bounce couldn’t be maintained through the market close with the DOW ending the day down 588 points, off about -3.5%.

How are investors to deal with this level of uncertainty? First and foremost, remember that this is what diversification is for. It is easy to look at a major market index like the DOW or the S&P 500 and equate the performance of those assets to the performance of your portfolio. However, the first thing investors should remind themselves is that they don’t have a portfolio consisting of only large cap stocks, which is what is measured by both the DOW and S&P 500 index.

In fact, most investors don’t have a portfolio consisting of just stocks. Many investors who are nearing or enjoying retirement may have a portfolio that is closer to only 50% or 60% stocks. If an investor only has 50% of his portfolio invested in stocks, only 50% of the portfolio is invested in the asset that declined in value by -3.5% on August 24th, meaning the individual’s portfolio likely only decreased by about -1.75%. While a -1.75% decline is not pleasant, it is hardly catastrophic.

The next step is to remind ourselves that temporary sharp market declines are common. Morgan Housel, one of my favorite financial writers, noticed that the correction the market is currently experiencing is currently about half as bad as the correction that took place near the beginning of 2011, which no one now remembers or cares about. These market pullbacks will always come and go, and the world will continue to turn.

Additionally, it is useful to acknowledge that while we tend to remember dramatic and shocking market decreases, stocks tends to be an efficient investment over time. As Ben Carlson pointed out in his blog, when investors think of the ‘80s the first thing that comes to mind is usually the crash of ’87. However, U.S. stocks were up over 400% during the decade. Similarly, even though stocks are up 200% since March of 2009, many investors have spent the last five years trying to anticipate the next 10% - 20% correction. In retrospect, an investor would have clearly been better off riding the equities rollercoaster during both the good and bad times and ending with a 200% gain rather than being out of the market in an attempt to avoid a small temporary decline. Given a long enough investment time frame, this has always been true and will continue to be the case.

Finally, as I pointed out in a previous post, it is useful to recall that market corrections are actually a good thing for long-term investors. Fear amongst investors is what creates the equity risk premium that enables stocks to produce superior investment results when compared to investments with no risk such as CDs and money markets, which essentially experience no growth after accounting for inflation. When investors forget that equities can go both up and down in value, everyone wants to invest their money in stocks. This excess demand inflates asset purchase prices to the point that owning equities is no longer profitable. Market declines reintroduce risk to the investing public, and it is the presence of risk that makes stocks an appreciating asset. Thus, for those who don’t intend to sell their investments for 10+ years, short periods of volatility are a positive because they recreate the equity risk premium which raises rates of return over time.

These are all logical steps for mentally dealing with market corrections. For those who need it, Josh Brown proposes a less logical step for tricking your mind into embracing the market pullback. During scary market environments, Mr. Brown proposes that you identify a couple of stocks you’ve always felt you missed out on. Have you always wished you got in earlier on Apple, Google, Netflix, Chipotle, etc? A market correction like we are experiencing might be the perfect opportunity to become an owner of a great stock at an attractive price. Why not set a number for each of these stocks – say, if they drop in value by 20% - and if those targets are met you commit to buying some shares?

This strategy truly enables you to use lemons to make lemonade. It provides an opportunity to buy shares of companies that you have always wanted without overpaying for them. This mental trick can actually cause you to hope that the market correction continues because you are now hoping for a chance to buy. Rooting for a further correction can certainly make volatile market periods more tolerable.

As I mentioned, this mentality isn’t completely logical because the rest of your portfolio will likely need to decline in value in order to afford you the opportunity to purchase those coveted stocks. However, implementing this strategy is a bit of a mental hedge that enables you to get something good out of whichever direction the market turns. Think of betting money against your favorite sports team – of course you don’t want your team to lose, but even if they do you still get something positive out of it.

I’m confident that most of my clients already know that selling in the middle of a market correction is not a good idea. Still, I acknowledge that doing nothing as the market seems to be collapsing around you can be nerve-racking – even though it is the appropriate response. Hopefully these mental strategies and tricks enable you to stick to your long-term buy-and-hold investment strategy which has always proved to be profitable given a long enough time frame.

Why There Has To Be a Market Correction

Why do we invest in the stock market? To make money so we can improve our standard of living, right? Notice that we aren’t investing just to get our money back. If we simply wanted our money back, we would place the money in a savings account at a bank where we would likely be able to access it any time and know that we could redeem it at full value. However, making money is better than simply getting our invested dollars back, so there has to be a trade off for receiving that additional benefit.

Of course, the trade off is that investing in the market involves more risk than simply depositing money in a bank account. The additional return that is required by investors for investing in an asset that could potentially lose money is called the equity risk premium. There must be a potential downside in exchange for the larger reward that can be obtained by investing in the stock market. Otherwise, no one would ever deposit money into the more secure bank accounts and people would always invest in the stock market generating superior returns. Unfortunately, this would make things too easy, and as we have learned our whole lives, the easier a goal is the less reward we get for achieving that goal. That is why positions that can only be filled by a select few individuals with rare talents (CEOs, doctors, Lebron James) are handsomely compensated.

By now, most people know that over a sufficiently lengthy period of time, the stock market has historically produced returns of approximately 10% per year. This seems like a simple and easy way to make money, so why don’t all investors buy stocks and hold them for extended periods of time? The fact that we aren’t all rich suggests that buying stocks and allowing the market time to do its thing isn’t easy.  This is because enduring risk and suffering losses creates negative emotions that get the best of many investors, causing them to sell at the wrong time and stop investing new dollars.

Yet, when we refer back to the concept that the tougher the task the greater the reward, we should be happy that buying and holding stocks isn’t easy because it makes the strategy more profitable. For this reason, the next time the market goes through a correction or even a crash, wise investors should be grateful. Market volatility causes unsuccessful investors to sell when prices are down and increases the rewards for those who can stick with their investment strategy by holding their assets or even buying new positions.

Supply and demand suggests that when the markets are decreasing in value, more people are selling assets than buying. The people who are selling their investments at a loss create an equity risk premium for those who can endure market volatility. This increases the reward for successful investors by both providing an opportunity to buy assets when they are inexpensive, and reminding the marketplace that investing in volatile positions is unpleasant. Of course, things that are unpleasant aren’t easy to accomplish, which means there is a large benefit for achieving those things.

Thus, market corrections are great for successful investors because it is volatility and easily-rattled buy-and-sell investors that enable buy-and-hold investors to make significant profits over the long term. In fact, it wouldn’t be possible for stock market investors to make money without periodic intervals of unpleasantness as it is this discomfort which causes some investors to sell and creates an equity risk premium for the rest of us.

It has been easy for investors to buy and hold for the last six years as the market has been nothing but accommodating since early 2009. However, when things get too easy, it reduces our reward for being a long-term investor because everyone can do it. For this reason, we need the market to experience a correction at some point to shake out the unsuccessful investors, causing them to sell assets and create an equity risk premium once more.

When the next correction occurs, you can either sell assets and create a risk premium for others, or you can stay invested and take advantage of the money unsuccessful investors leave on the table. Successful investors with a sufficiently lengthy investment time horizon remind themselves of this concept frequently so that when the market experiences a decline they are not overcome by fear but rather grateful for the opportunity provided by the short-sighted.

Fear of Missing Out: An Investor's Worst Enemy

Fear of missing out (FOMO) is an increasingly powerful emotion in our daily lives – so much so that FOMO was officially added to the Oxford English Dictionary in 2013. Have you ever looked at your Facebook feed and been jealous of someone’s picture from a beautiful viewpoint, or enviable of a friend’s photo of their expensive dinner with a strategically placed bottle of fancy wine in the background? That is FOMO – the fear that at any given moment someone is doing something more appealing than what we are doing at the time.

A fear of missing out has always been part of life, but it has become more and more prevalent with the emergence of social media. Personally, I can’t help but check my Twitter feed every hour or so to make sure that I’m not missing out on an article published by one of my favorite financial writers. Yet, social media has increased the power of FOMO more than I realized. For example, I can honestly say that I have absolutely zero interest in horse racing – frankly, I dislike the sport. However, due to all the hype on Facebook and Twitter, I couldn’t help but watch the Belmont Stakes out of fear of missing American Pharaoh become the first Triple Crown winner of my lifetime.

FOMO is frequently a counter-productive emotion, leading to jealousy of others, dissatisfaction with our own lives, and bad decision making processes. Nowhere is the negative impact of FOMO more apparent than in some individuals’ investment strategy. For years, no one has enjoyed going to the neighborhood BBQ only to have to listen to their neighbor brag about how his portfolio has outperformed the S&P 500 index over the last six months. Not only is listening to the boasting annoying, it makes us discontent with the return our own portfolio has achieved and makes us wonder if we should adapt a different strategy (i.e. take more risk right after the market achieved a new all-time high).

Social media has expanded the impact of FOMO on investment strategies. For the last year, the internet has ensured we are aware that large cap indexes like the S&P 500, Dow Jones Industrial Average, and NASDAQ are at all-time highs and achieving appealing returns, and we wonder why our more diversified portfolio isn’t behaving in a similar fashion. It is hard to be content with our diversified strategy when every media outlet is constantly reminding us how we are missing out on the stellar performance that could be obtained if only we had a non-diversified portfolio that invested only in the asset category that is currently in the middle of a hot streak.

When it comes to investing, FOMO is significantly impacted by recency bias. Our fear of missing out becomes more and more intense after the market has just experienced an uptick. If we take a couple of steps back, it is clear why we maintain a diversified portfolio – it provides the most appealing tradeoff between maximizing returns and minimizing risk. Yet, it is hard to remind ourselves of this when it seems like everyone around us is taking advantage of the latest market trends and we are missing out. Of course, changing our portfolio to try and take advantage of a run that has already taken place would be foolish, as we would be selling assets with prices that have remained flat and may now be undervalued relative to the market in order to buy assets that have recently experience significant growth and are likely now expensive. These are the type of decisions that FOMO can cause and we would be wise to avoid this type of thinking.

We have been in this position before. In the late 1990s, people wanted to abandon their diversified portfolio and put a heavy focus on the technology stocks that were making all their neighbors rich. In the mid 2000s, everyone wanted to borrow as much money as possible and utilize the funds to buy and flip real estate. In the early 2010s, everyone was wondering if they should sell their stocks before a double-dip recession began and use the resulting funds to buy gold. In each of these scenarios we were hearing individual stories of others who had implemented these strategies and were doing better than we were. Of course, with the benefit of hindsight, we can see that changing our long-term investment strategy due to a fear of missing out on what was working for a short time period would have been a drastic mistake.

After the market has done well, recency bias and FOMO causes investors to be more afraid of missing a bull market than of suffering large losses. However, in these times, we need to remember that we chose a diversified investment strategy because it provides us with the highest probability of obtaining our financial goals while exposing us to the least amount of volatility possible. When the media and our acquaintances insist on informing us how we would have been better off placing heavy bets on the asset categories that have recently done well, we would be well served to remember that a diversified portfolio strategy will almost certainly provide us with the best chance to achieve long-term investment success.