10 Sep 2010 Are You Scared?
Whatever economists ultimately label this period in American history, no doubt fear will play a large part in their description of it. Confidence numbers among consumers, investors, voters, and businesses hit all-time lows in 2008 and are only gradually coming back. The declines in economic indicators this summer sparked new fears, including a return to recession, even deflation. The new wave of trepidation drove many investors out of stocks once again and back into the short-term safety of money markets and short Treasuries.
In my nearly thirty years in the financial industry I have never heard stories of so many so scared for their financial futures. Investors are being whipsawed by their emotions, aided by an industry rewarded by transactions, and swept along by a market capable of losing months of appreciation in a few short weeks. Thousands of new investment choices peddled by a highly competitive financial services industry combined with the constant bombardment of sensational media combine to rattle even the most stalwart of investors.
In an Advisor Perspectives article, Bob Veres examines the Three Factors of Fear. Veres’s points are based on the research of an Australian company called FinaMetrica that studies average non-professional investors’ fears. The first of three fear factors is essentially that of bravery exhibited in activities such as skydiving. This one is not significantly impacted by financial markets, so it can ignore in the context of non-professional investing. The second fear factor is an individual’s capacity for risk. Fear capacity adjusts according to the latest major event. If one just lost a significant amount of money in 2008 and now wonders if he can retire at all, he is more likely to become more conservative than he was before the event.
The third component is risk perception. This one is impacted by the trend. When markets seem to endlessly rise, the perception of risk diminishes. Investors take increasingly large stock positions and act like stocks do not carry any risk at all. When the reverse is true and stocks are trending down for an extended period, investors can see only their risk.
These latter two fears lead investors to make irrational, knee-jerk emotional decisions. The most recent Dalbar study shows that the average stock fund earned 11.6% for the 20-year period ended December 2007. However, the average investor in those funds, falling victim to behavioral mistakes, earned just 4.6%. Over 20 years a return reduction of 7% has a HUGE impact on the lifestyle options available to these investors. $100,000 invested at 11.6% for 20 years at 11.6% would be worth $898,000. Yet the average investor would see only $246,000. That $652,000 difference translates into a significant difference in lifestyle, now and later.
The average investor faces a myriad of choices when deciding to invest money. The vast majority of mutual funds available are actively managed to attempt to beat some benchmark. There are several problems with the premise, however. Most mutual funds do not beat their benchmarks. They are expensive and they create significant taxes for investors who hold them in taxable accounts. The worst problem with actively managed funds, regardless of how often they may beat their benchmark, is that they will eventually fall short of their mark. It’s the shortfalls that can get you, especially if you spend from your investments during one of them.
For example American Funds’ Income Fund of America was down 29% in 2008, 6.7% below the benchmark Morningstar assigns to the fund. Both the Income Fund and the benchmark include a heavy weighting of corporate bonds. These bonds can react similarly to stocks during periods of extreme fear. Is it a good risk management strategy to use bonds that are likely to lose value precisely when stocks are declining significantly? We use an index of 7-10 year Treasuries for our fixed income component for just that reason.
Treasuries have long been a safe haven; better than gold because they pay you while you hold them. The 7-10 year Treasury index was up 18% in 2008 while the S&P declined 28%. A portfolio allocated with 60% ICA and 40% S&P 500 was down 28.6% in 2008 while at portfolio allocated 60% 7-10 Treasury and 40% S&P 500 was up 5.6%. That kind of significant difference can make or break someone’s staying power during extreme markets.
Cashing in on the fears of those leaving the capital markets are America’s huge (government bailed) insurance companies and their legions of agents and bankers who peddle their products. These salesmen ‘help’ thousands of former capital market investors transfer large portions of their wealth to insurance company coffers in return for annuities and life policies wielding fancy clauses and ‘guarantees’ that in essence promise no more than the return of the owners’ money over the course of their lifetimes. If they live an average lifespan the policies guarantee a meager return and next to zero flexibility for the policy owner. Those living to say 110 or 112 years old (odds are next to 0), might realize returns of say 4 or 5%. A largely hidden ‘guarantee’ of annuities is that the policyholder’s heirs will receive little or nothing. While the annuity buyer sacrifices lifestyle by locking in lower returns and eliminating flexibility and estates, the salesmen get huge commissions and incentive trips to exotic locales to sell them. Who wins?
Don’t think for a minute that the actuaries who design insurance products put their companies at risk. It’s fair to say that they build in a 90 – 95% confidence of achieving a profit on their products while the company may lose money on only 5- 10% of them. And where do you think the insurance companies invest policyholders’ money? They invest it right back into the same capital markets their policyholders abandoned in fear. Add up the profits reported by insurance companies (20% in 2007) with all their expenses and you have a pretty good estimate of how much ‘lifestyle’ potential their policy holders have transferred to them. Insurance companies are expensive middle men for those who do not need their insurance and when was the last time you heard an insurance salesman say ‘you have too much insurance’?
It has been our experience that most investors are positioned by their advisors to take more risk than they need to accomplish their goals; both in their allocation of stocks to bonds and with their active management strategies. Truth is the capital markets provide sufficient returns without enhancement. Indexes make it possible to keep costs, taxes and under-market performance to absolute minimums, efficiently tracking their movement. The standard industry practice is for advisors to thoroughly gauge the risk each client can tolerate then fashion a portfolio and allocation designed to give him that amount of risk, whether he needs it or not to meet his objectives.
Before an advisor recommends any portfolio, he should thoroughly understand what his client wants to accomplish over his lifetime with his investments. Putting the client in the center of the discussion rather than his money ensures that the advice is based on the client’s goals and priorities, not those of his advisor.
The next important component of successful investing is employing a robust and reliable process that continually monitors one’s well being or confidence in meeting all of his or her goals. What replaces fear better than confidence?
Our Wealthcare process provides ongoing probabilistic oversight of investment decisions weighed against the ever present changes of markets and client goals. When confidence of success falls outside our range of comfort, we provide our client with informed objective advice that is based on and respects his priorities. Our premise is that by minimizing costs, taxes, and under-market performance and planning for what we cannot control; market uncertainty, we can provide our clients with advice that replaces fear with confidence.