April 29, 2016
A new book called "Multi-Asset Class Investing: A Practitioner's Framework" is not exactly a made-for-Hollywood look at the investment business like "The Big Short." However, it points out an industry practice that probably adversely affects more people than were hurt by derivatives traders during the housing crisis.
Most investment practitioners are highly compartmentalized, managing one, narrowly-defined type of asset. Investors may own multiple asset classes, but their investment policies tend to dictate that the asset mix be held within tightly defined targets. As the book highlights, this pigeonholed approach to investing misses where the real opportunities to add value and manage risk come from. The main point is asset allocation is always important.
Here are five reasons why taking a multi-asset class approach might be more relevant than ever in today's financial markets:
1. Conditions are ripe for multi-asset strategies
One of the book's authors, Pranay Gupta, makes the point that passive asset allocation is ill-suited for an environment in which the correlation between asset class returns has increased. For example, when stocks and bonds behave differently, you can reduce risk by splitting a portfolio between the two. However, if asset classes are going up and down at the same time, passive diversification is not a sufficient method of risk management.
Gupta also points out that customized financial instruments have blurred the lines between traditional asset classes. The availability of such hybrid products calls for something of a hybrid investment approach rather than a narrow, asset-class based perspective.
2. Unconventional asset behavior calls for active allocation
It is not just that stock and bond returns are more correlated than they used to be. The other challenge is that returns are running well below historical norms.
Already, the 21st century has seen two major collapses in stocks: the burst of the dot-com bubble, and the 2008 financial crisis. While stocks have struggled, abnormally low bond yields make them a less attractive alternative. Even the longest-term Treasury bonds are yielding well under 3 percent.
The point here is not just that returns have been disappointing. The other challenge from an asset allocation standpoint is that they have been behaving differently from historical returns. Passive asset allocation models are generally based on assumptions about asset class behavior based on those historical returns. When that history ceases to be indicative of how these assets are performing, it's time for a different approach.
3. The investment industry has allocation upside down
Higher asset class correlations and low returns seem to create an especially urgent need for more focus on asset allocation now, but you could argue that the investment industry has been misguided in its approach all along.
Because the industry is largely organized into asset-class specialist managers or index funds, most of the industry's focus is on managing within an asset class rather than on coordinating among asset classes.
Gupta refers to studies that have shown that roughly 80 percent of a portfolio's risk and return comes from asset allocation, and only about 20 percent comes from individual security selection. In terms of how professional investors spend their time though, the industry has those proportions upside down. He estimates that 80 percent are individual security selectors, and only about 20 percent are engaged in asset allocation.
4. Too much attention is given to stock-picking
Even if you are not an industry insider like Gupta, you can get a sense that the focus is on minutia rather than the big picture. If you watch coverage of the stock market, most of it is focused on hot tips and the day's big individual movers. When was the last time you saw one of those market gurus waving his hands about an asset allocation opportunity?
Think about it. A diversified portfolio might have 2 percent invested in a single stock. If that stock rises by 30 percent - a pretty healthy return - it will make 0.6 percent difference on the overall portfolio. Stock picking should not be ignored, but it does seem overrated.
5. Lack of flexibility takes away alternatives
Suppose you happen to be an ace stock-picker, and all your expertise and research tells you the stock market is overvalued?
An investment manager with a narrow stock mandate has no discretion to switch out of stocks under those circumstances. This is like putting someone at the helm of an ocean liner, but giving them no way of steering away from the icebergs.
Investment managers who take a fully-integrated approach to multi-asset class investing are harder to find, but they may be exactly what investors need to escape the disappointing results of pigeonholed portfolios.
Comment: How do you approach investment and asset class strategies for your portfolio?
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April 27, 2016
While the Federal Reserve decided to stand pat for the third consecutive meeting, the way economic conditions are developing suggests reason to believe the door to future rate increases may start to open.
Economic factors determining bank rate increases
The Fed has consistently reminded people that it is primarily concerned with stabilizing two factors: employment and inflation. The Fed acknowledges that continued job growth means employment has not been a problem recently, leaving inflation as the primary area of concern.
Traditionally, when the Fed had an issue with inflation it has entailed trying to stop inflation from getting out of control. However, since the Great Recession, the Fed has been grappling with the opposite problem: chronically low inflation. The Fed has set an inflation target of 2 percent, and the actual inflation rate has consistently fallen short of that.
Fed keeping an eye on inflation target
While it is easy to understand the traditional concern with keeping inflation from getting too high, this more recent concern with bringing inflation up to a minimum target is not universally embraced. Some maintain that low inflation is a symptom of general economic malaise, but not itself a root cause. Others feel that low inflation is not a problem anyway, because it helps consumers.
However, the view of the Fed and many mainstream economists is that low inflation or deflation is bad for growth because it encourages people to delay purchases. With stable or declining prices, people are in no rush to buy things because they are confident prices will be the same or even lower in the near future.
Whether or not you accept this theory, the reality is that as long as inflation remains below 2 percent, it will be a deterrent to the Fed raising interest rates. Over the past 12 months, inflation has been just 0.9 percent, though this has been largely due to a 12.6 percent decline in the energy sector. However, take out the energy sector and inflation for the past 12 months has been 2 percent - precisely the Fed's target. It seems likely that as energy prices stabilize, overall inflation will start to approach the Fed's target and no longer be an impediment to raising rates.
How the dollar's value affects future rate hikes
One factor whose influence spans both inflation and employment growth is the value of the U.S. dollar relative to other currencies. This influence has generally been working against further rate increases, but lately things have started to change.
In 2014 and 2015, the dollar rose sharply. This can be bad for jobs because it puts the U.S. at a trade disadvantage, and it is also deflationary because it make foreign goods cheaper. A dilemma the Fed has faced is that interest rate increases would likely further boost the value of the dollar.
However, the dollar has been falling since the end of February. This decline, along with stabilizing oil prices, could open the door to Fed rate increases in the months to come.
March 31, 2016
While taxes may be almost as certain as death - or so the old saying goes - that doesn't mean you have to give up a huge chunk of your income to the government each year. Instead, you can use perfectly legal means to reduce your taxes and keep more money for yourself. The solution lies with your savings accounts.
Here are six tax advantages you may not know you had with savings accounts:
1. Tax deductions for retirement savings
If you put money into a regular savings account, you won't save any money on taxes. In fact, you may pay more if you rack up enough interest.
However, the government really wants you to save for retirement so if you put that same money in a traditional 401(k) retirement plan or an individual retirement account (IRA), you'll get to deduct it from your taxable income. What's more, that money grows tax-deferred so you don't have to pay taxes on the gains until you start making withdrawals in retirement.
To sweeten the pot, some employers will match worker contributions to a 401(k), up to a certain amount.
"With those matching dollars, you can't get a better return than that," says Greg Hammer, investment advisor representative and owner of Hammer Financial Group in Schererville, Indiana.
2. Tax-free money after age 59 ½
If you'd rather have tax-free savings in retirement, skip the traditional 401(k) and IRA and look for the Roth 401(k) and Roth IRA versions instead. You don't get a tax deduction upfront with deposits in these savings accounts, but the money grows tax-free and can be withdrawn tax-free once you hit age 59 ½.
For young adults who have decades until retirement, being able to let that money grow tax-free can reap significant savings.
For example, a 25-year-old who puts $200 away every month until age 65 will have nearly $305,000 in their account when they retire, assuming a 5 percent annual return on the investment. However, they will have only contributed - and paid tax - on $96,000 of that amount. The rest is tax-free in a Roth account.
Despite the huge savings, "a lot of people out there don't understand their employee benefits," says Aries Jimenez, a financial life planner with San Diego Wealth Management.
As a result, many workers don't even realize a Roth 401(k) is an investment option in some workplaces.
3. Potential for reduced taxes both now and later
There's no need to choose whether to get tax savings now or tax savings later. The government lets you have both.
Depending on your employer's policy, you may be able to contribute to both a traditional 401(k) and a Roth 401(k) at the same time. What's more, you can split your IRA contributions between the Roth and traditional options so long as you don't exceed $5,500 in annual contributions between the two accounts.
"What we'll recommend is [workers] go get their matching contribution from their employer [401(k) plan] and after that, contribute to a Roth," says Scott Cousino, a certified financial planner and owner of Legacy Capital Planners in Grand Rapids, Michigan.
He then suggests people go back to their 401(k) to continue saving once they reach the $5,500 contribution limit.
4. State tax incentives for college savings
Maybe saving for your kid's college education is foremost on your mind. There's good news for you, too, since many states offer tax deductions or credits for money put into college savings accounts known as 529 plans.
For example, Indiana residents who put money into a CollegeChoice 529 plan get a 20 percent state income tax credit, up to $1,000. The availability and amount of deductions or credits vary by state, and you typically have to be investing in your state-run plan to get the benefit.
"If I put in $4,000 and it's worth nearly $5,000 [with the tax credit], I don't know any better plan than that," Hammer says. "When people are doing their 529 plans, they really want to investigate their state's plan."
5. Tax-free withdrawals from college savings accounts
Another bonus of 529 college savings accounts is that the money is tax-free when withdrawn, assuming it's used for qualified education expenses.
"[529 plans] are really powerful tools for those looking to contribute savings for college," Cousino says.
Coverdell Education Savings Accounts, also known as Education IRAs, have a lower contribution limit than 529 plans, but they offer tax-free withdraws for education expenses.
"You can use that money for private school, for elementary school," Jimenez notes.
6. Triple tax savings for medical expenses
Health care costs continue to climb, but those who have a qualified high-deductible health insurance plan can find tax relief by opening a health savings account.
Money deposited into the account is tax deductible immediately. That cash then grows tax-free, and it can be withdrawn tax-free for medical expenses. If you hit age 65 and still have money in your account, you can begin pulling it out for any reason, the same as you would with a traditional IRA or 401(k).
It's treated similarly to an IRA contribution, but it doesn't count toward the IRA contribution limit.
"That's a big deal," Cousino says.
If you put your money into the right savings account, you can reap the rewards of these tax advantages. If you have questions about how these tax benefits work, it's always best to consult with a professional because as Jimenez says, "That's the one thing about taxes - there are a lot of rules."
Comment: Have you experienced tax savings with these savings accounts?
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March 29, 2016
The stock market got off to a rough start in 2016, but for all the volatility, it has not yet descended into a true bear market. Actually, the reality is something that can be even more dangerous: a sideways market.
For over a year now, the U.S. stock market has essentially gone nowhere, and it has been taking its sweet time about it. Investors need to adjust.
Going nowhere slowly
There have been some jarring down days and dramatic bounce backs, but when you add it all up the stock market has essentially made no progress for more than a year and a half now. As of late January, the S&P 500 was around the 1900 mark. That index closed at around the same level way back in May 2014.
That adds up to nearly 20 months of stocks going nowhere. Unless you are satisfied with the meager 2.2 percent dividend yield on stocks, that's a long time for an investor to go with no price appreciation to show for it.
An era of low returns
This period of dead money for the stock market is felt all the more acutely because it fits into a broader context of low returns. Bond yields are well below their historical norms, as are interest rates on savings accounts and certificates of deposit (CDs). That puts the onus on stocks to provide enough growth to make up for those low yields, and for some time now, stocks have failed to come through. This is about more than a 20-month period of going sideways. Stock returns have actually been lackluster over the first 16 years of this century.
As of the end of 2015, the S&P 500 had been climbing at an average annual pace of just 2.1 percent since the beginning of the year 2000. So, while the past 20 months have exemplified the market's sideways direction, it has been stuck in a low-return rut for much longer.
Investors worry about losing money in a bear market, but losing time can also be damaging. Whether it is an individual who is saving for retirement or an endowment trying to fund its operations, investors make the assumption that their money will grow over time sufficiently to meet their future needs. They can afford temporary deviations from their plan, but when an extended era of low returns sets in, it is necessary to adjust or else they will fail to meet those needs.
How to respond
There is no magic formula for coping with a sideways market, just a number of grind-it-out measures that might help a little:
- Stay aggressive. As unrewarding as the stock market has been, don't give up on it. Having a strong allocation to stocks at least gives you a shot at better returns in the future. Going too heavily with conservative investments like bonds and savings accounts would all but condemn you to anemic returns.
- Avoid broad market indexing. A bull market is like the proverbial rising tide that floats all boats - all you need to do is own a broadly representative portfolio of stocks like an index fund, and you will do well. When broad market indexes start going sideways though, indexing has less appeal. This is a time to pursue more selective strategies because even a sideways market has its winners.
- Go for long-term winners. Speaking of winners, in a sideways market, look for quality business models built for the long-term. It may take a while for stock prices to come around, so avoid short-term trendy companies that might not succeed long enough to see their stock prices adequately rewarded.
- Be an opportunistic buyer and seller. A choppy market with no sustained trend might give you multiple chances to get in and out of the same stocks at a profit. Use a tight pricing discipline in keeping with a market that has been fluctuating within a narrow band.
- Boost your retirement saving rate. This is the harsh reality - the market is not going to bail anybody out. The surest way to be make up for sub-par returns is simply to save more money.
- Minimize credit card debt. Savings account rates may be near zero, but credit card rates are well into double-digit territory, making this a particularly costly time to be carrying a credit card balance.
You may remember that the late 1990s was a period of unusually high stock market returns. That seems a long time ago now, but it is important for investors to have a long memory. If the market ever escapes this sideways rut, remember never to take good returns for granted.
Comment: How do you approach a sideways stock market?
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March 15, 2016
The landscape for income investors is so barren it might as well be a desert. There are a few investment areas that look lush and fertile by comparison, but watch out: What looks like an oasis might turn out to be a mirage.
Those tempting-looking areas of the income landscape are high-yield bonds. Look carefully before you go that way though, because if you don't understand the potential dangers you may wish you had stuck to the territory of risk-free income.
High yield bond risks vs. reward
High-yield bonds are associated with a significant chance of default. To compensate for this risk, investors demand higher yields.
In recent months, the yield on U.S. corporate high-yield bonds has soared above 9 percent. That's a tempting yield, compared with Treasury yields of around 2 percent and investment-grade corporate yields of around 3 percent. The question is, does that additional yield provide investors with sufficient incentive to compensate for the greater default risk?
It's a given that some high-yield bonds will default. As an investor, the crucial question is which percentage of your high-yield bonds will go bad, and then how much of their value you can recover when they do. When you quantify the risk in that way, the math involved suggests the extra yield might be worth it at the moment, as detailed below.
Current yield vs. default rates
The default rate on those bonds yielding around 9 percent is currently 2.77 percent. So, if you had 2.77 percent of your bond portfolio go bad, you'd still be left with an effective return of 6.23 percent (the 9 percent yield minus the default rate.) While 6.23 percent sounds pretty good by today's standards, you'd actually do a little better if the default rate held steady.
Investors typically recover 40 percent of the value of defaulted bonds, so your actual losses would amount to just 60 percent of that 2.77 percent default rate, which comes to 1.66 percent. Subtracting that from 9 percent would leave you with a net of 7.34 percent.
Stress-testing the numbers
The above numbers are fine, but what if the default rate worsened? That would be a probable outcome during a recession, and even more so during a financial crisis.
Current default rates are well below the historical average of 4.3 percent. If default rates returned to 4.3 percent, and assuming a 40 percent default recovery rate, the net return on bonds yielding 9 percent would be reduced to 6.42 percent. That's still not bad, but during adverse circumstances default rates can soar into the double-digit range.
At a 40 percent recovery rate, a 10 percent default rate would reduce the net return on a bond at a 9 percent yield to just 3 percent. Effectively, that would leave you no better off than if you had remained in lower-risk investments.
Diversification becomes crucial
If you compare current yields with default rates and decide that you like the odds, there is one more factor to consider - diversification. The numbers work if your portfolio is broadly enough diversified for default rates to normalize. If you have just one or two bonds, a default in one or both of them would be devastating. The catch here is it is difficult to assemble a diversified portfolio without some management and trading costs, which would further reduce your net return.
Working through the math is a sensible way to compare default risk to yield, but you have to keep the exercise in perspective. There are no guarantees that historical norms will apply. If default risks exceed previous highs or recovery rates sink below normal, your return could be drastically less than you had calculated.
There are structural concerns to consider, and these concerns might go beyond the normal math of comparing yields with default frequency and severity. The low interest rate environment strongly encourages investors to look for higher-yield opportunities, which will help risky investments to attract money they otherwise wouldn't. In essence, this rewards or at least supports unsound bond issuers.
Similarly, the low interest rate environment discourages savings and encourages borrowing, which may be a poisonous prescription for a world that has been staggering from one debt crisis to another for nearly a decade now. This also makes investing in debt securities all the riskier.
In short, the math is saying that high-yield bonds may be worth the risk, but a common-sense read of the bigger picture says to keep those investments limited. No matter how good they look, to some extent the opportunity may be a mirage.
Comment: Do you invest in high-yield bonds?
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