Should I Still Invest in a Crappy Economy?

20 09 2011

By Jon Castle, CFP®, ChFC®

It does not seem to matter who the potential investor is – whether they are already retired, are nearing retirement, or are a younger person with quite a bit of time until retirement… the question is often the same.  With interest rates being so low… with the markets unpredictible and volatile – what should I do?  The questions aren’t even really so straight forward as, “why should I invest my money now,” or “should I pay off debt first,” or even any of the other questions that, as a financial advisor for more than 15 years now, I’m used to getting.  The questions I am hearing now seem to have taken on the tone of confusion, despair, and a lack of direction, versus the questions I used to get such as “how should I invest,” or”what type of account – a Roth or a traditional IRA – should I have?”

Yesterday, when talking to a rather successful, nearly retired client on the telephone, she mentioned that she feels that she always has to take two steps backward for every three steps forward, and ideally, she would rather not see her account fluctuate at all once she retires next year.  “Isn’t there just something we can do with our money to earn a steady 6-8% or so with no risk?”  Unfortunately, the answer is NO.  While there might be many product salesmen out there who will try to convince you otherwise – the answer is still NO.   If there were -then all the institutions and large organizations in the world, who spend millions and millions of dollars trying to find or design such assets would have already found them.  A classic example of people and institutions trying to get outsized returns with no perceived risk is the recent mortgage debacle, and we saw how that turned out.

So – back to the original question – With the Economy on shaky footing (to say the least) and with the markets being… unusually volatile, to put it lightly – what should I do?

To answer this question, I had to turn to the history books, tenured academic research, and even some new research – but I think I found the answer.  Do EXACTLY what you have been told to do throughout the years.  Live below your means – save a portion of your income (assuming you are working and saving for retirement) and invest in a fully diversified portfolio designed specifically for your risk tolerance.  In fact – it is having the GUTS to invest during times like these that separate the winners from the… folks who wish they had as much money as the winners.

Last year, Dimensional Fund Advisors tapped into the database held at the Center for Research in Security Prices (CRSP) at the University of Chicago – the nexus of more Nobel-Prize winning research in economics than any other institution on the planet – to identify IF there was a direct correlation between a poor economy (as defined by low GDP) and poor investor returns.  In other words – SHOULD I STILL INVEST IN A CRAPPY ECONOMY?”

The Dimensional Study started by taking all of the world’s developed economies, examining their annual GDP growth from 1971 – 2008, and dividing them into two groups – High Growth, or Low Growth – for each year.  Clearly, much of what we hear on the news is about GDP growth – is our economy growing or not?  The higher the economic growth, the better – as this means reductions in unemployment, increases in personal wages, and, generally, a feeling of well-being, versus the cloud of general malaise that seems to have decended upon the world as of late.

Once the economies were divided into High Growth and Low Growth – the performance of their stock market indices was compared to their GDP Growth.  The question:  Does a poor economy (low GDP Growth) accurately predict poor investor returns?  The question was not – can an investor perform poorly during low-growth times (of course, we know that is possible) – but is there a clear and determinable correlation between a bad economy and a bad investor experience?

Oddly enough – the answer is NO.

                              AVG GDP                      AVG RETURN              Risk (Std Dev)

High Growth               0.92                             12.90%                          23.07

Low Growth               -4.02                            13.52%                          23.04

The data for Emerging Markets was similar, but quite honestly, the data for Emerging Markets only went back to 2001, and I felt this was just too short a time period to draw any reasonable conclusions.

When I first saw the data, I thought… well… this might be a sales pitch just to keep investors invested… we are still looking back only as far as 1971.  What about other periods of lousy growth?  And what about for the US in particular?  I wanted to check the data myself.  So, I delved into the CRSP database myself, using the French and Fama indices that go back as far as 1926, and to the Bureau of Economic Analysis (BEA.GOV) and compared hypothetical investor returns to the GDP growth (or lack thereof) during the 1970’s and during the Great Depression.

One particular period of interest to me was the years from 1972 to 1982.  Yes, this was after 1971, but I wanted to look at it further and in more depth from a portfolio manager perspective instead of just looking at the stock market.  How did it feel?  Remember the oil embargo?  Our defeat in Vietnam? The Cold War?  Carter’s “Misery Index?”  Double Digit Inflation?  During this period of time, the average GDP Growth was only 2.7% – well below the historical average of 3.4%.

The second period of interest was the period of the Great Depression.  Now the Great Depression itself lasted from 1929 to 1941 – but for this particular exercise, I wanted to look at the period starting about 2 and a half years AFTER the crash – starting with the summer of 1932 until the attack on Pearl Harbor, or December 1941 – the long, grinding years of the Depression.  During that period of time, our average GDP Growth was only 2.0% – the longest and weakest period of below-average growth on record for the United States.

My question was – how could today’s investors, using a properly designed, diversified portfolio,  have done during that time?  Were these two periods of time – arguably the worst periods (economically) in the past hundred years – a bad time to be invested?

Assume a relatively simple, domestic portfolio:  T-Bills (15%), 5-Year Treasuries (15%), US Large Stocks (11%), US Large Value, or underpriced, dividend paying stocks (21%), US Small Value Stocks (18%), US Small Stocks (10%), and Very Small, or Micro-Cap Stocks (10%).

Looking at the indices only (remember – there were VERY few mutual funds at the time of the Depression, and certainly no ETF’s,) we can get an idea of how an investor might have done.  The following numbers do NOT account for any fees, commissions, taxes, etc – but we can still draw conclusions.

From the period of 1932 – 1941, the above, simple, diversified portfolio (indices only) would have achieved an AVERAGE ANNUAL return of… wait for it… 19.29%!!  In fact one dollar invested as described above in the summer of 1932 would have grown to about $4.50 by December of 1941.  During the Great Depression!!

From the period of 1972 to 1982, the above, simple, diversified portfolio (indices only) would have achieve an AVERAGE ANNUAL return of… 14.82%!!  One dollar invested as described above in December of 1972 would have grown to about $3.49 by December of 1982.  During the Carter Years and the Misery Index!!

Were there periods of volatility, market corrections, and even stagnation in the investor’s portfolio?  Absolutely – in particular, a sharp market correction in 1936 would have scared out many undisciplined investors, and a particularly unpleasant 18 month bear market from 1973-1974 would have tested investor mettle.  But the facts remain – a fully diversified, properly balanced investor would have been able to achieve significant returns during those times.  In fact – there are a number of economic theories that suggest that investors who have the GUTS to invest (and remain invested) during these uncertain times are the ones who enjoy the GREATEST rewards.  These are the riskiest, most emotionally draining times to invest – as a result, the Capital Markets reward those investors more readily and more predictibly than the comparatively “timid” investors who only remain invested during the “good” times.

Today, the Fed and the International Monetary Fund (IMF) are projecting the US economy’s GDP growth to be about 2.7% for the next two years.  The media harps daily on the miserable shape of our economy, and politicians are using the economy as opportunities to further their agendas.  These are things that we must endure as a people, or change with our votes.

However – it is critical to SEPARATE our concerns about the economy – from our own INVESTMENT POLICY.  The two are NOT necessarily correlated.  A miserable economy – historically – does NOT mean miserable returns for an investor who is disciplined, creates a sound, diversified, low-cost investment STRATEGY with strict risk controls, and then implements it with courage and discipline.  In fact – it is EXACTLY these types of investors who have historically been the winners over the long term.


This blog article does not constitute legal, tax, or personal financial advice.  Please consult your own financial professional for personal, specific information.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP(R), CERTIFIED FINANCIAL PLANNER(tm) and federally registered CFP (with flame logo) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Investment advisory services provided by Paragon Wealth Strategies, LLC., a registered investment advisor.

High Unemployment… Debt Crisis… Inflation… Tsunami… why does the market keep going up?

5 05 2011

By Jon Castle, CFP®, ChFC®

Many times, while working with clients, we get the question,  “WHY are you generally bullish on the market?  All the news I hear is BAD.  How can you possibly think the market is going to keep going up?”

I will get around to answering this question – but bear with me a moment as I wax philosophical.  It has been my experience in working with individual investors saving and working toward retirement – that the most successful investors develop an investment philosophy – a set of guiding principles and beliefs that shape an investor’s decision making process.  This set of principles essentially guides the investor during the darkest times so they can remain disciplined during times of economic and market volatility.

“I think the market is going to go up – so I want to be invested NOW – but not if it goes down,” is NOT an investment philosophy!  An investment philosophy guides an investor’s decisions consistently, based upon their fundamental beliefs about the way markets work.  For example, MY own investment philosophy (not necessarily the right one – just what I happen to believe) can be summed up as follows:

1)  Capitalism – perhaps best described as “Pay Upon Results,” ultimately drives the financial markets.  It creates the impetus for new developments and for entrepreneurs to take risks, to create new businesses or opportunities, to hire people to do work, to think up new goods and services that people will buy.  Without capitalism, there is no opportunity for reward, so no one will take undue risk – and the economy will languish as it did in the old Soviet Union.  Sometimes capitalism gets a little out of control… and can be cruel… thus the need for prudent regulation.  However, it is the best economic system invented so far and is amazingly efficient.

2)  Capital Markets work.  With all of the competition to outdo the other guy – millions upon millions of investors seeking the highest reward for the lowest possible risk creates an environment of extreme efficiency in our Capital Markets.  Just about all known information – and the probabilities of all imagined outcomes- about any particular stock or bond – is very quickly factored into that security’s price.  Any “surprise” information that can significantly give one investor an advantage over another is factored into the price very quickly – usually within seconds of that information becoming public knowledge.  Therefore – most of the time – doing tons of research about any particular stock or bond is a waste of time because the market prices the information faster than you (or a mutual fund manager, hedge fund manager, or other money managers) can do the research.

3)  I do believe that there are those few who have the “gift” and have been able to outperform the general market by some margin.  However, this “gift” is usually fleeting  – numerous studies show if someone has outperformed the market in the past – the odds of them continuing to outperform in the future are miniscule.  More often than not, managers who outperformed merely increased the risk within the portfolio, and pay for that risk later in under-performance.  Picking a money manager (or a mutual fund) who will outperform the market – in advance – is extremely unlikely.

4)  Successful investors focus on what they CAN control instead of what they cannot.  We cannot control fund manager performance.  We cannot control the Fed’s actions, nor can we control the markets.  However, we CAN control costs, the structure of our portfolio, and our own behavior.  So, in general, better and more predictable performance can be achieved by capturing the movement of the entire market and its various sectors – through the use of lower-cost ETF’s, index funds, and institutional “total market” funds – than through individual stock picking, trying to hop in and out of the market based upon tips or media input –  or by using more expensive mutual funds where managers try to beat the market while enduring higher risks, tax inefficiencies, and trading costs.

5)  Above all – manage risk.  If the market gets bumpy and shakes you loose from your philosophy – you have failed.  Likely, you took too much risk and will probably never recoup that risk by reaping the rewards the market has historically given those who structure their portfolios so they can ride out the market’s bumps.  Risk tolerance is best described as the amount of money in your account you can watch disappear (through market fluctuation) without changing your philosophy.  If the market drops 20% – but you freak out if your account drops 10% – then you need to structure your account so it will most likely only drop 9% when the market drops 20%, instead of gambling on when the market will go up and when it won’t.  More often than not your gamble will be wrong.

OK, so that was my investment philosophy in a nutshell.  Now – back to the original question.

With all the bad news – why does the market keep going up?  Aren’t we just setting ourselves up for another disaster?   Personally, I think not.  I could be wrong, but I believe my logic is sound.

First – much of the “bad” news is sensationalized.  Right now, as I write this, the media is just about going bonkers trying to get the Obama administration to release photos of the dead Osama Bin Laden.  Now let’s think about this for a minute.  What real purpose would that serve?  Suppose the photos ARE released:

1)  He isn’t any less dead with the pictures than without.

2)  Pictures can be faked.  People (and countries) who don’t believe he is dead, will believe the pictures are faked.

3)  People who believe he is dead will still believe he is dead.

4)  If the photos are released, the media would get more people either watching their shows, reading their magazines, or logging into their websites to see the pictures.  This would sell more magazines (with the photos), and allow them to charge more money for advertising in those magazines, sell more web banners, and charge higher rates for their commercials!

AHA!  The net worldwide effect of the administration releasing the photos would likely be – the MEDIA MAKES MORE MONEY!!!!  Hmm…

So… let’s apply this logic to the stock market and the economy.  What if the media were absolutely unbiased and did not sensationalize anything?

Responsible Media:  “The preponderance of the data shows that the economy is slowly recovering.  Unemployment is slowly going down.  Generally, economic activity is increasing while housing still continues to lag.  Corporate earnings are healthy and corporations are sitting on mountains of cash which they will likely continue to invest over the next 5 years in new production, jobs, advertising, commerce, or in the stock market.  The Federal Reserve will likely, very slowly, reduce the amount of stimulus in the economy to try to control inflation – but must do it carefully in order not to derail the economic recovery.  (They know this, by the way, since they all have PhD’s in economics and finance).  The dollar is weakening a bit – but a weakening dollar can be good for America because it creates jobs at home (versus being sent overseas) and it allows us to sell American goods overseas more competitively.”  (REPEAT EVERY DAY OVER AND OVER with tiny adjustments… )

BOOOOORRRRRIIINNNNGGGG!  After about the third day, no one would watch that show anymore!  And of course, that show and its network would make no money in advertising.

Now – compare that with OUR MEDIA:

1) “Tsumani causes Nuclear Disaster!!!!  Will this cause a global stock market crash?!?”

2)  “Osama Bin Laden Killed.  EXPECT TERRORIST ATTACKS which may cause a global stock market crash!!!!”

3)  “Initial unemployment claims increased by 0.005% last month!!! Is the economic recovery DOOMED?”

4)  Fed to reduce Quantitative Easing.  Is the economic recovery DOOMED?!?!

5)  Fed did Quantitative Easing which boosted the economy.  Oh, No, we’ve got DEBT!  Is the economic recovery DOOMED?!?!

You get the picture.

 The simple reason the market keeps going up is this:  Investors seek investments which give the highest reward for every unit of risk.  Currently, cash is paying virtually nothing.  Bonds are trading at the highest prices (and lowest yields) in most of our lifetimes – so very little new money is moving into bonds.  There is a TON of cash sitting on the sidelines – and it has to go somewhere.  Slowly, it is making its way to the stock market.  The stock “Market” is driven by supply and demand.  As demand increases, the prices go up to reflect that demand.  Expect occasional bumps as unforeseen events unfold – but in general, our economy is expanding and is likely to continue to recover over the next several years.  The stock market is a “leading” indicator of the economy (investors invest for the future, not for the now), so it will generally rise BEFORE recoveries and will generally fall BEFORE recessions.  This is not new – it is basic economics.

It can be helpful to remember that the stock market NEEDS some uncertainty to do well.  Only when there is cash sitting on the sidelines (as a result of worry or uncertainty) can the markets continue to go up.  It is this very “worry cash” that gets the fed into the markets over time, which, in turn, drives the markets up.  OF COURSE investing is risky – why in the world would there be any significant reward without any risk??  The problem is – once everyone FEELS great about the market – once the last investor FEELS great about the economy and goes “ALL IN,” – then there is no additional cash left on the sidelines.  Thus – there is no further demand to continue to drive the market up.  THAT is when we need to really worry… that event occurred in March of 2000 – at the very height of the tech bubble… when all was well, the economy was booming… monkeys with dart boards could outperform professional money managers… and we all know what happened next.

Disclaimer:  This blog article is not personal tax advice.  Please consult your tax professional for personal, specific tax information.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP(R), CERTIFIED FINANCIAL PLANNER(tm) and federally registered CFP (with flame logo) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Investment advisory services provided by Paragon Wealth Strategies, LLC., a registered investment advisor.


Will there be a herd mentality to “sell bonds” causing bond funds to suffer more than balanced funds?

21 01 2011

As with any financial market or product there is the possibility that investors will “sell bonds” as a herd, but there are a few things to consider.

First thing to think about is – what are balanced funds?  Many “balanced” funds are made up of a few different bond and equity funds, the blend depending on their ultimate goal and risk.  Others invest directly in stocks and bonds to create their portfolio.  What that means is that while they do hold some bonds in their portfolio, they also own equities, and since these asset classes don’t typically move together, balanced fund portfolios will most likely suffer less than a bond-only fund if there were a hard bond sell-off.

In the event of a bond sell-off, it can be helpful to picture where in the market the moeny that is currently in bonds would be reinvested.  Is it likely the “herd” is moving into cash, into equities, or into another asset class?  If you believe that the money from the bonds is moving to equities, then balanced funds will almost certainly perform better in this situation.

Additionally, it is important to consider what kind of bonds are suffering the sell-off.   The behavior of municipal bonds, for example,  is very different than the behavior of high yield bonds; the behavior of long term bonds is generally very different than that of short term bonds.  It is similar to trying to discern if stocks will suffer- without knowing if you are talking about emerging markets, developed foreign markets,  or US stocks. Each will behave differently under different interest rates, currency valuations, and economic conditions.

As with equities, you need to have a firm understanding of why you are holding any particular bond investment.  If you are looking for extreme safety of principal,  then most investors would hold short duration, high quality bonds; but but at the expense of a competitive yield.  If you are looking for a higher yield in bonds, in the current market environment you are going to have to take some additional risk to your principal to get it.  Whether that risk is best taken by holding a longer term bond (more interest rate sensitivity), or a lower quality bond (higher risk of default), typically seems to be an individual preference.

The ultimate answer for most investors is to find a mix of assets that you are comfortable with and stick with them.  If there is one thing the markets have proven time and time again, it’s that the patient, well diversified, properly allocated investor will typically fare better over the long run than the investor who is constantly making changes to his investments based on daily news and the “hot pick.”

Information in this article does not constitute a recommendation or solicitation for any product mentioned.  Mutual funds may only be sold by prospectus.  Past performance is no guarantee of future performance.  Consult your financial advisor for specific recommendations.


Investment Myths and Realities

3 10 2009

By Jon Castle, CFP®, ChFC®

Myth:  A story made up to explain a phenomenon beyond the science of the day. 
As human beings, we all have a tendency to want to believe in myths, legends, or heroes of some sort.  Something about the idea that another person can accomplish superhuman feats strikes an adventurous chord in our breasts.  Imagine what it must have been like to hear stories of the great Babe Ruth, Audy Murphy, Wyatt Earp, and others – back when all we knew of someone or something was what we heard from other people or what we read in books – before television and the internet and a swarm of expose’- hungry media exposed the frailties and failings of even great men and women as soon as they came into the public eye!  Even today, we look for myths and legends and heroes – there is just something romantic and exciting about believing in heroes… and the Loch Ness Monster and Sasquatch and Santa Claus…
I think the fact that we want to believe in myths has a tendency to work against us as investors – causing us to act on beliefs and rules of thumb that often are not true.  Sadly, these actions may be more damaging to our financial futures than we realize.  In this article, I am going to briefly examine 3 of the most common investment myths, discuss the investment truths that academic research has discovered, and discuss our role as financial coaches for our clients as we pursue these financial truths together.
MYTH # 1:  Investment advisors (including mutual fund managers) can add value by exercising “superior skill” in stock selection.  Unfortunately, this is generally FALSE.  According to Morningstar, most money managers do NOT beat their index.  This is not because they aren’t smart or because they don’t work hard, but rather because today’s markets are so efficient that all known information – plus the probabilities of all known outcomes for a company or a stock – are continuously factored in to the price of the stock at any given time.  Rare is the man who can out-think the collective intelligence of millions of investors and consistently identify underpriced securities so as to beat the market.  As a result – depending upon the asset class – anywhere from 60-90% of money managers underperform their benchmarks.
MYTH # 2:  Finding money managers with a great track record  is a reliable method of figuring out which funds will do well in the future.  This too is FALSE.  Unfortunately, according to Morningstar and Baird Research, getting a 4th or 5th “star” rating is often the kiss of death for a mutual fund or money manager.  88% of all mutual funds that were rated a “top” fund (ie awarded their 4th or 5th star) went on to perform below average in the next 10 years.  66% of “top” funds actually performed in the bottom quarter of their peers during the next 10 years!  So picking the managers with the best past performance or the highest “star” rating actually gives us nearly a 90% chance of owning the poorest performers, not the best performers.
MYTH # 3:  Money managers – including investment advisors – are able to utilize market timing to effectively predict up and down markets.  Oh, how I wish this were true.  Unfortunately, it just isn’t.  If the loss of trillions of dollars in the markets during 2008 isn’t convincing enough that market conditions are often unpredictible and even the wisest of money managers do not effectively time the market – consider this:  If you had invested directly in the S&P500 (which you can’t – but suppose you could) from January 1, 1989 to December 31, 2008 – you would have achieved a long-term rate of return of 8.43%. In this scenario, $10,000 would have grown to over $50,000.  However – out of those 5040 trading days – if you missed only the best 5 market days – your return dropped to 6.27%, and your pot shrinks to $33,700.  If you missed only 20 of the best days, your return is now a paltry 2.58% and your $10,000 grows to only $16,600.  Consider the math on this – you could be right 99.6% of the time – and have done better in a savings account!1  The fact that the best days usually followed on the heels of the worst days – makes timing the market even more difficult.  To date – no one has ever been able to successfully and consistently time the market – ever.  Yet every day, financial talk show hosts ask their ‘expert’ guests, “So… what will the market do next?”
This discussion begs the question, “OK, if all these myths are false – then how ARE we supposed to make investment decisions?” 
Beginning soon, PARAGON will begin an exciting series of investor education events – fun, engaging events for our clients and their guests where we examine the most common investor pitfalls, discover the determinants of investor success, and offer the opportunity for all who would like to be a part of this journey to come along for the ride. We will examine each of these myths – and many more – and spell out exactly the steps an investor needs to take in order to shift their personal experience of money and investing from a scarcity mode – characterized by worry and frustration – to an abundance mode – characterized by clarity, focus, and hope for a bright financial future! 
1  Source:  Chartsource, Standard & Poors Financial Communications.  The S&P 500 is an unmanaged index that is generally considered representative of the U.S. stock market.  Past performance is not a guarantee of future events.

This blog is for informational purposes only.  This is neither an offer to purchase nor sell any securities.  All investing involves the potential of loss – including invested principal.  Indices quoted are general barometers of security price movement.  You cannot invest directly in an index.  All information is obtained from sources deemed reliable but not guaranteed.  Past performance is not a guarantee of future performance.  No tax or legal advice is given nor intended.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP(R), CERTIFIED FINANCIAL PLANNER(tm) and federally registered CFP (with flame logo) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Investment advisory services provided by PARAGON Wealth Strategies, LLC, a registered investment advisor. 

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