the independent advisor - the fiduciary group€¦ · 2015, but global monetary conditions should...

Quarterly Newsletter of The Fiduciary Group®

THEINDEPENDENT ADVISOR

By Malcolm Butler, [email protected]

Conventional wisdom in the investment advisory world has typically been that retir-

ees should gradually reduce their equity exposure during retirement. One popular rule of thumb is that equity allocations should be annu-

ally rebalanced based on a formula of 100 less the retiree’s age. For example, a 70 year old retiree should have 30% equity (100-70) under this formula, and each successive year that exposure would be reduced by 1%. The rationale for this approach is that retirees should not assume excessive risk of stock market declines in their investment portfolios. Recent research suggests that the optimal asset allocation for retirees, however, may actually be the complete opposite of the allocation contemplated by conventional wisdom.

While attending an investment confer-ence in November, I

heard a presentation by Michael Kitces, a national expert on financial planning. He has extensively researched the most optimal retirement asset allocation strategy. In the course of his research, he discovered that it is best if the equity exposure increases gradually each year in retirement. He terms this approach a “rising equity glidepath” because the portfolio equity allocation glides higher each year during re-tirement. In his research, he employed 10,000 Monte Carlo simulations and he varied the capital market assumptions so that all types of market cycles were included in the study.

In the chart below, Kitces shows the probability of success of various beginning and ending allocation strategies, as-suming a 4% withdrawal rate and using the following histori-cal returns: average annual compound real growth rate of 6.5% for stocks and 2.4% for bonds. The starting equity allocation is found on the vertical axis, and the ending al-location (assuming 30 years in retirement) is on the horizon-tal axis. For example, if you started retirement with a 70% equity exposure and ended with a 70% equity exposure, the probability of success is 92.2%. However if you started with a 30% equity exposure and increased it gradually to 70% over the 30-years, your probability of success is 95.1%.CONTENTS

Rising Equity Glidepath in RetirementMalcolm Butler, JD

Charts & Perspectives for 2015Joel Goodman, CFAScott McGhie, CFA, CPA

Social Security: Making Sense of Spousal BenefitsAndrew Clark, MBA, CFP®

Putting the Brakes on the Emotional RollercoasterJulia Butler, JD, MBA

Rising Equity Glidepath in Retirement

JANUARY 2015

conserve. plan. grow.®

Star

ting

Allo

catio

n

30-Year Retirements, Historical Average Capital Market ExpectationsSuccess Rate for a 4% Withdrawal Rate

Ending Allocation

Source: Kitces, Nerd’s Eye View (9/25/14)

The second chart looks at how many years the portfolio lasts in the event the portfolio experiences the lowest 5th percentile of market conditions (a “really bad” investment outcome scenario). Kitces stress-tested how long the portfolios would last under the various beginning and end-ing allocation strategies in the 5% worst market scenarios. The glidepath portfolio that starts with 30% equity expo-sure and increases to 70% lasts 30 years, compared to the constant 70% portfolio, which is depleted in 26 years in the worst 5th percentile market environment.

Kitces also tested his theory under an assumption that returns over the next 30 years will be diminished relative to historical standards. The chart below shows the glidepath results with the conservative (“worst case”) return assump-tions that Harold Evensky recommends for the Mon-eyGuidePro financial planning software package: arithme-tic real returns of 5.5% for equities and 1.75% for bonds.

Under the assumption of a reduced return environment, all the scenarios faced earlier failure points (the “best” is only 23.1 years at the 5th percentile). The optimal glidepath be-comes even more conservative, starting at 10% and rising to only 50%. Kitces concludes: “Nonetheless, in this envi-ronment the rising glidepath effect is still present; in fact, the conservative rising glidepath lasts almost 20% longer at the 5th percentile than the static 60/40 portfolio.”

For many retirees, the thought of increasing equity alloca-

tions in retirement seems quite risky. Kitces suggests that one way retirees may get more comfortable with increas-ing equity exposure is to think of it as a “bucket” approach. The bucket strategy assumes that the portfolio is broken out into three buckets. One is a pool of short term invest-ments that might cover spending for the first three years of retirement, another portion is invested in intermediate term bonds that will handle the next 5-7 years of expenses, and the remaining portion is invested in equities that will cover spending that is a decade away. By spending out of

these buckets in this sequential manner, the equity allocation of the portfolio will sequentially rise each year as the fixed income assets are spent down.

Kitces recognizes that the bigger risk to retirement portfolios is the sequenc-ing of returns. A bear market in the early years of retirement can have a detrimental impact, notwithstanding the average returns of the portfolio over time. Kitces’ research shows that gradually increasing equity exposure

is effective whether the early years of retirement are marked by good markets or bad markets. If it turns out that stock markets experience strong performance in the early years of retirement, the early portfolio appreciation will negate any later downturn in equity returns (not to mention that the appreciation in the stock portion of the portfolio will naturally increase the relative allocation of stocks in the overall portfolio). The retiree will likely end

up with more wealth than anticipated, and a more conservative equity alloca-tion may then be an appropriate option in the later years of retirement.

Kitces explains why increasing equity exposure in retirement, even in a bear market in the early years, makes more sense than decreasing equity exposure: “[T]he reality is simply that if market returns are poor throughout the first half of retirement, a rising equity glidepath is the equivalent of systematically dollar

cost averaging into the market (with all the benefits that entails), while decreasing exposure [to stocks] amounts to reverse dollar cost averaging out of a bad market (with all the adverse results that apply).” And for retirees who endure a poor stock market in the early years of their retire-ment, the rising equity glidepath will rescue the portfolio as the stock market returns rise through the second half of their retirement. As Kitces concludes, the rising equity glidepath is a “heads you win, tails you ‘don’t lose’” asset allocation approach.

Star

ting

Allo

catio

n

Ending AllocationNumber of Years Income is Supported at the 5th Percentile of the Distribution for a 4% Withdrawal Rate

Star

ting

Allo

catio

n

Ending AllocationNumber of Years Income is Supported at the 5th Percentile of the Distribution for a 4% Withdrawal Rate



The momentum in the U.S. equity market contin-ued in 2014 as the S&P 500 index reached 53 record highs during the year on its way to a gain

of 13.7%. As in 2013, when the S&P 500 index advanced 32%, the market was able to digest a number of items without a significant correction, including geopolitical conflicts in Russia/Ukraine and the Middle East, a global Ebola scare, the end of the Federal Reserve’s (“Fed”) quantitative easing (QE) program, and a 47% decline in the price of oil. Volatility stayed surprisingly low as the maximum drawdown of the S&P 500 index during 2014 was 7%, making it difficult for actively managed funds to keep pace with the passive index. In addi-tion, a strengthening U.S. dollar magnified the returns of domestic indices relative to global indices for U.S. based investors. As has become our custom in this end of year note, we turn our attention to 2015 to share our perspective through charts and commentary on what we see are the important issues facing the equity and bond markets. We frame our discussion around the following viewpoints:• The Federal Reserve is on course to transition

(slowly) away from its zero interest rate policy during 2015, but global monetary conditions should remain supportive of risk assets as the European Central

Bank (“ECB”) and Bank of Japan (“BoJ”) are expect-ed to keep their policy rates under 1%.

• The U.S. economy is leading the global recovery and should continue to be a source of strength in 2015. The Euro area and Japan should generate modest growth, supported by easy monetary policy.

• Corporate fundamentals remain sound with profit margins at historic peak levels. Greater confidence in the business outlook should result in more merger and acquisition activity and higher spending on capi-tal expenditures.

• Equity valuations are less compelling than they were at the start of the bull market, but earnings growth and low interest rates provide a reasonable basis for valuation levels to be maintained or move modestly higher. Global growth concerns have kept bond yields low. We expect rates to rise, but the magni-tude and pace will depend on economic growth and the influence of central banks.

• Even with the domestic market reaching new highs, investor sentiment is not exuberant (yet). A healthy dose of skepticism will be important to sustaining the bull market.

• Be prepared for market volatility and maintain your long-term perspective.

Charts & Perspectives for 2015

The Federal Reserve completed its third, and likely final, asset purchase program since 2009 during the fourth quarter as its balance sheet reached $4.5 trillion in U.S. Treasury bonds and mortgage-backed securities. This was a significant milestone in the Fed’s move toward a more normal policy as the Fed will no longer be increas-ing the size of its balance sheet. It also sets the stage for a tightening cycle to begin. Market participants expect the central bank will wait until sometime during the sec-ond half of 2015 to adjust its policy rate higher, but Fed communication points to a slow and measured pace. At its recent Dec. 17th meeting, the Fed indicated it would be “patient in beginning to normalize the stance of

monetary policy.” The latest U.S. economic data support the notion that it’s time for the Fed to withdraw stimulus. While the Fed is shifting gears, weak economic prog-ress in the Eurozone and Japan will likely translate into continued efforts by the ECB and BoJ to support growth through easy money policies. The key takeaway for in-vestors is global central bankers will continue to provide ample stimulus for financial markets during 2015, but Fed moves may produce short-term anxiety for traders. The collective commitment is evidenced by the chart on the following page which shows the growth in global central bank assets since 2007.

Joel Goodman, CFAChief Investment [email protected]

Scott McGhie, CFA, CPASenior Investment Manager

[email protected]

3

Fed in Transition but Global Central Bank Liquidity Continues

Corporate fundamentals remain sound with profit margins at historic peak levels (see chart on the follow-ing page). While profit margins have historically been a fundamental data point which reverts to its long-term av-erage, margins have remained elevated for an extended period of years. As economies have historically moved towards their peaks, margins have been pressured by rising interest and labor costs, neither of which has materialized with any significance during this recovery. Given this continued backdrop of low interest and labor

costs, we expect 2015 profit margins will continue to be a source of fundamental strength and support for the equity markets.

Record profit margins are supplying corporations with stockpiles of cash. With improvement in the domes-tic economy and hope for improvement in the global economy, companies will likely seek growth through mergers and acquisitions as well as through increased internal investment.

Growth in Global Central Bank Assets ($ trillions)

Source: Bloomberg

It has taken time, but the economic recovery in the U.S. has been gaining traction. Gross domestic product (GDP) grew at a 5% annual rate in the third quarter, the largest advance since the third quarter of 2003. Person-al consumption, which represents 68% of GDP, has been buoyed by an improving employment picture, lower gasoline prices, and higher stock prices (which have led to record household net worth). The Conference Board’s consumer confidence index reached a seven-year high in December, as the unemployment rate declined to 5.8% from 6.6% at the beginning of 2014. Wage gains have been stubborn, but are beginning to emerge, and could provide more fuel for growth.

In contrast, the Euro area and Japan have been mired in recession and must rely on fiscal and monetary stimulus in order to jumpstart their economies. Japan’s Prime Minister has announced a number of initiatives in order to achieve growth, the most recent of which is a plan to cut the tax rate on corporate income by 3% over the next two years to encourage companies to increase capital spending and employee wages. In addition, we expect both the ECB and BoJ to engage in asset purchase pro-grams, similar to the Fed’s quantitative easing program, in order to combat weak growth.

U.S. Leading Global Recovery

Corporate Fundamentals Remain Strong

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

$7.0

$8.0

$9.0

$10.0

2007 2008 2009 2010 2011 2012 2013 2014

Federal Reserve

European Central Bank

Bank of Japan

$4.5 T

$2.6 T $2.5 T

$9.6T

It is becoming more difficult to make the case that stocks are inexpensive as the current bull market’s duration ex-tends to 69 months and with the S&P 500 index having appreciated over 200% from the trough in March 2009. During this period, price/earnings (P/E) multiples on stocks have expanded from 13.7 times trailing earnings per share (EPS) to the current level of 18.5 times EPS, as compared with the 20-year historical average of 19.2 times EPS. We believe that incremental multiple expan-sion is possible as stocks are not trading at extreme valuation levels, but earnings growth and low interest rates will be key to further equity gains. Stocks still offer relative value as compared with bonds, and a low inflation environment has historically been positive for valuation. In addition, as the chart below indicates, bull markets often run past historical estimates of fair value as sentiment swings from fear to greed. The bar graphs

below depict market recoveries from trough to peak.

Bond yields defied expectations during 2014 as many investors (including us) thought that the end of the Fed’s QE program would bring higher rates because it would signal a healthier economic outlook and reduce de-mand for long-dated Treasuries. However, weak global growth, geopolitical uncertainty, and liquidity from the world’s central banks have kept rates low (see chart on the following page). We, again, expect rates to rise, but acknowledge that comparatively lower yields in major developed markets outside of the U.S. may sustain demand for U.S. Treasuries. Alternatively, inflation ex-pectations are contained but could move higher if wage pressure builds as labor markets tighten. We favor short to intermediate duration fixed income as a hedge against rising interest rates.

S&P 500 Profit Margins At Historic Highs

Source: Bloomberg

Source: JP Morgan Asset Management 5

S&P 500 Performance and Average Valuation in Market Recovery Cycles

Equity Valuations Less Compelling But Still Relatively Attractive

0%

2%

4%

6%

8%

10%

12%

14%

16%

'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14

Dec. 2008 8.6%

Dec. 2014 13.9%

29% 49% 73% 121% 59% 180% 101% 201%

15%

16%

30%

49%

4%

83%

0%

?%

0%

50%

100%

150%

200%

250%

300%

1966 1970 1974 1982 1987 1990 2002 2009 Returns from trough to average valuation Returns from average valuation to peak price

But, we also see skepticism in asset allocations by both individual and institutional investors, who have been wary of the equity market. According to data from J.P. Morgan Asset Management, since 2007, investors have contributed $1.4 trillion into bond funds and fixed income exchange traded funds (ETFs), compared with only $600 billion for equity funds and ETFs. Endowments and pen-

sion funds have been decreasing equity exposure over the last few years, choosing instead to increase weight-ings to alternative investments such as private equity, real estate, and commodities. As the chart on the fol-lowing page shows, university endowments and founda-tions’ fund allocations to equity have declined from 50% in 2002 to 34% in 2013.

Global 10-Year Government Bond Yields

Calendar Year Returns vs Intra-year Declines

Source: Bloomberg

Source: Bloomberg

Investor psychology is hard to quantify, but nonetheless plays an important role in markets. Well-regarded inves-tor Sir John Templeton was once quoted as saying, “Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” As we reflect on the stage of the current bull market, our best guess is

that it is somewhere on the continuum near “maturing on optimism,” and a fair distance away from “euphoria.” We see signs of complacency, such as the lack of a signifi-cant intra-year decline in the S&P 500 index since 2011 (see chart below).

Investor Sentiment

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14

U.S. 2.19%

France 0.82%Germany 0.54%Japan 0.33%Switzerland 0.32%

26

-10

15 17

1

26

15

2

12

27

-7

26

4 7

-2

34

20

31 27

20

-10 -13

-23

26

9 3

14

4

-38

23

13

0

13

30

11

-17 -18 -17

-7 -13

-8 -9

-34

-8 -8

-20

-6 -6 -5 -9

-3 -8

-11

-19

-12 -17

-30 -34

-14 -8 -7 -8 -10

-49

-28

-16 -19

-10 -6 -7

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14

Calendar Year Return Intra-year Decline

We have said before, but think it bears repeating, that it is easier for investors to maintain a long-term perspec-tive when markets are cooperating. In fact, it is com-mon for investors to lengthen investment horizons when returns are good and shorten them when markets go down. Equity volatility has been low over the last few years, and it seems that whenever nerves overtook the market, the Fed was quick to respond with words or stimulus in support of financial asset prices.

There are a number of concerns that could induce greater volatility in 2015, including the Fed’s policy rate decision, weaker than expected global growth, and a continued drop in oil prices that contributes to instability in commodity producing countries, among others. As it

pertains to the Fed’s decision, we have included a chart that shows the performance of the S&P 500 index be-fore and after the first tightening for the past six rate hike inception periods. Somewhat surprisingly, the index has on average rallied before and after the first rate rise.

It is challenging to forecast the potential risks that may oc-cur, but we can be certain that unforeseen events will hap-pen with consequences that are tough to handicap. Mar-ket pullbacks are healthy for the market, and we expect 2015 will include them. Our advice is to make sure your investment strategy is properly aligned with your financial ability and willingness to withstand portfolio declines so when volatility arises, you are able to take advantage of it rather than letting it take advantage of you.

7

Endowments Asset Allocation (Dollar-Weighted Average)

S&P 500 Performance Before & After First Fed Tightening

Source: Strategas, NACUBO-Commonfund Study of Endowments (‘09-’13) and NACUBO Endowment Study (‘02-’08)

Source: Strategas

Maintain Long-Term Perspective

2002 50.0% 23.0% 24.0% 2.0%

2003 49.0% 21.0% 27.0% 2.0%

2004 51.0% 17.0% 28.0% 4.0%

2005 48.0% 17.0% 32.0% 3.0%

2006 48.0% 15.0% 35.0% 2.0%

2007 47.0% 13.0% 37.0% 2.0%

2008 40.0% 13.0% 46.0% 1.0%

2009 32.0% 13.0% 51.0% 4.0%

2010 31.0% 12.0% 52.0% 5.0%

2011 33.0% 10.0% 53.0% 4.0%

2012 31.0% 11.0% 54.0% 4.0%

2013 34.0% 10.0% 53.0% 3.0%

Year Equities Fixed Income Alternatives Cash/Other

Date of First Raise -6 Months -3 Months +3 Months +6 Months +12 Months

Mar-83 27.0% 8.8% 9.9% 8.6% 4.1%

Jan-87 0.2% 7.9% 19.1% 21.2% 2.6%

Mar-88 -19.8% 4.1% 6.0% 5.4% 13.3%

Feb-94 4.7% 2.7% -3.9% -2.4% 1.9%

Jun-99 11.7% 6.7% -6.6% 7.0% 6.0%

Jun-04 2.6% 1.3% -2.3% 6.2% 4.4%

Average 4.4% 5.3% 3.7% 7.7% 5.4%

Social Security: Making Sense of Spousal Benefits

Andrew Clark, MBA, CFP®

Chief Planning Officer & Senior Investment [email protected]

Social Security Spousal Benefits are often misunder-stood. Spousal benefits were originally conceived as something of a housewife’s benefit to provide

retirement benefits for women who had not entered the workforce. Spousal benefits would allow them to receive benefits at their Full Retirement Age (FRA) or a reduced benefit at age 62, as well as receive Medicare benefits at 65. While most households now include two workers, the basic benefit still exists, providing many options for those who do the proper retirement planning. A spouse who has worked may still find it preferable to use spousal benefits–at least for some of his or her retirement years—depending on a number of factors.

How does the basic benefit work? For purposes of this discussion, we will call the “spouse” the one who takes advantage of the spousal benefits, and the other one we will refer to as the “higher earning spouse.”

Your Spouse is Full Retirement Age (FRA): the spousal benefit is equal to one-half of your full retirement amount.

Your Spouse is under her FRA: if she qualifies for Social Security retirement benefits on her own, she will receive those. If, however, she is eligible for a spousal benefit that is higher than hers, she will receive a benefit that is a combination of both.

If you take retirement benefits earlier than your FRA you will permanently lock in a reduction of your benefits for life. This also holds true for the spousal benefit. This reduction is based on the number of months until the spouse would have reached her full retirement age. Bear in mind that spousal benefits do not reduce the higher earning spouse’s retirement benefits.

File and SuspendThe real power with regard to spousal benefits is to provide a benefit for one of the spouses in question so that his or her traditional retirement benefit can continue

to grow. Your benefits continue to increase in value until age 70, and you can receive approximately 132% of your FRA benefit by waiting. For higher wage earners, this can represent as much as a 6-7% compounding rate of return on your money while you wait.

One strategy is for a spouse to claim benefits based on the spousal benefit, thereby allowing the higher earning spouse’s traditional retirement benefits to continue to grow until age 70. At age 70 the spouse can switch from the spousal benefit to his or her own. In order for this to work, at FRA the higher earning spouse that wants to defer would apply for social security and then immedi-ately suspend payments. The spouse could then claim a spousal benefit. This strategy is known as File and Suspend. It is also sometimes called “Voluntary Suspen-sion” or “Claim and Suspend.” Some important things to remember about this strategy:

• The spouse cannot claim the spousal benefit until the main beneficiary applies for benefits.

• Applying for the spousal benefit before your FRA will trigger the Social Security Administration to assume you’ve also applied for your own personal retirement benefits. They will then test to see whether your reduced retirement benefit or your spousal benefit is higher. Either way you will lock in a lower payment for life than you would have received if you had waited until your FRA.

• The spousal benefit is based on the age of the spouse applying for the spousal benefits, not the spouse on whom the benefit is based.

Divorced SinglesIf you are divorced, have not remarried, and were married for 10 years or more, you are eligible to receive spousal benefits based on your former spouse’s benefit base. You can begin using this strategy at age 62, but remem-ber that if you do so you will reduce your benefits for life. For most divorced folks it will pay to wait until your FRA. These benefits are available to you whether or not your former spouse has filed for benefits, and regardless of whether he or she has remarried (or even if they have had multiple marriages). One caveat: if your spouse has not filed for benefits you must wait at least 2 years after the date of the divorce before you can apply for the spousal benefit. If you remarried in the interim, you can still apply for the spousal benefit as long as that marriage ended by death, divorce or annulment.

The spousal benefit offers married couples and even for-mer spouses a variety of options when it comes to Social Security planning. At The Fiduciary Group we have tools to help you model and maximize your Social Security ben-efits in order to help you meet your retirement goals.

Case Study: DivorceJane was married to John for 15 years and is currently single.

Her salary at retirement is $35,000 while John’s is $175,000. Jane files at 67 for the spousal benefit which is $1321, half of John’s $2642. At 70, she files for her own benefit which will have grown from the $1378 she would have received at her FRA of 67 to $1709. In order to allow her Social Security to continue to grow until age 70, Jane is eligible to file for the spousal benefit based on Jack’s benefits. Note that she can receive benefits even if John has not started taking his benefits. In this scenario, each year that Jane waits to take her own retirement benefits, her benefits will go up $1,116.00.

Consider the following case study:

Case Study: File and SuspendJack is born in 1950, and Jill was born in 1951.

Jack’s salary at retirement is $200,000 and Jill’s is $35,000.

His monthly benefit at FRA will be $2642; hers will be $1378.

At 67 and one month, Jack would apply for Social Security and then choose to suspend his payments.

Jill is 66. Jill would apply for the spousal benefit and receive $1321 per month – note if she waited until her FRA, she would receive a greater benefit.

When Jack turns 70, he resumes his Social Security benefits and begins receiving around $3487 per month.

When Jill turns 70, she applies for her own Social Security Benefits, which will be around $1819.

Source: AARP Social Security Calculator

This strategy can also be used if the lower earning spouse is already collecting benefits before his or her FRA. The higher earning spouse could file for the spousal benefit at his FRA, so that they are both receiving benefits, while one continues to increase until age 70. At age 70, the higher earning spouse elects to receive his or her ben-efits. This arrangement may not result in the maximization of benefits because the lower earning spouse has locked in a lower payment for life, but it may allow the couple to achieve some of their financial goals in early retirement.

Claim Now, Claim LaterIn this strategy instead of filing for traditional benefits and then suspending them, you reach FRA and apply only for a spousal benefit. This allows you to receive the spousal benefit while your benefit base continues to grow. This works for couples where both worked and where the older spouse is the higher earner. This works even if the spouse on which you are basing your spousal benefits has started taking payments at a younger age, say 62, because the spousal benefit is based on the age of the applicant.

Social Security: Making Sense of Spousal Benefits

9

Putting the Brakes on the Emotional RollercoasterJulia Butler, JD, MBAChief Operating & Compliance OfficerDirector of 401(k) Advisory [email protected]

invested. Unfortunately, the emotions of desperation and defeat often drive investors to “get out” at market lows, thereby locking in losses. As the markets rebound, investors become hopeful and may begin to invest again, but at higher price levels than those at which they sold. Some investors feel regret, taking an “I’ll wait till the markets come back down” approach, and sit on the side lines during rising markets.

Riding the emotional rollercoaster can lead to self-de-feating behavior. Each year the independent research firm DALBAR publishes the returns of the “average” mutual fund investor versus the indices. The disparity in returns, particularly over the long-term, is significant. Over the last 20 years, the annualized return for the av-erage equity fund investor was only 5.02% compared to the S&P index average annual return of 9.22%.

Source: DALBAR, Quantitative Analysis of Investor Behavior, 2014(based on data ending 12/31/2013)

DALBAR’s research showed that the results were more dependent on investor behavior than on fund per-formance. Mutual fund investors who hold on to their investments are more successful than those who try to time the market. DALBAR reported that the greatest losses occur after a market decline. Investors tend to sell after experiencing a “paper loss” (a drop in the valuation of their portfolio in their quarterly statement)— the clas-sic “sell low” behavior—and start investing only after the markets have recovered their value— the classic “buy high” behavior. The harmful result is participation in the downside while being out of the market during the rise. This is what leads to a discrepancy between “investment returns” and “investor returns.”

Emotions can cause investors to do the wrong thing at the wrong time. We all know, rationally, we should buy low and sell high. Yet emotions can

cause investors to do just the opposite.

Source: Carl Richards, The Behavior Gap

Market cycles—and the emotions that they incite—can feel like a roller coaster ride.

Source: John Hancock Investments, Take the Emotion Out of Investing

When the stock market is rising, investors feel confi-dent and want to pile in. As prices reach all-time highs, euphoria sets in, leading investors to feel that prices will just continue to rise. However, what goes up will inevi-tably go down. As prices fall, investors become nervous and fearful. The low point of a market cycle is often the best time to make money, but only if the investor stays

What happened?

What’s going on?

Negative

Mar

ket P

erfo

rman

ce

CONFIDENT

EUPHORIC

DESPERATE

NERVOUS

DEFEATED

HOPEFUL

Riskiest Time

Best opportunityto make moneyPositive

I’ve already made money. This is great!

I should quit my job and do this full-time! Look at the Money I’m making!

There’s no point in selling now -

I’ve lost too much.

There go my dreams of an

early retirement.

Things seem like they’re turning

around.

Investor Returns

Inflation S&P 500

Barclays Aggregate

Bond Index

Equity Funds

Asset Allocation

Funds

Fixed Income Funds

Since QAIB Inception 3.69 1.85 0.70 2.80 11.11 7.67

20 Year 5.02 2.53 0.71 2.37 9.22 5.74

10 Year 5.88 2.63 0.63 2.38 7.40 4.55

5 Year 15.21 7.70 2.29 2.08 17.94 4.44

3 Year 10.87 6.26 0.70 2.07 16.18 3.27

12 Months 25.54 13.57 -3.66 1.52 32.41 -2.02

Emotions are not rational, so it’s hard to counter them with logic. However, there are three actions we can take to better manage our response to emotions so that they don’t jeopardize our investment success: embrace volatility; make a plan and stick to it; and stay focused on the long-term.

Embrace VolatilityWe tend to think of volatility as a bad thing. But volatility has two sides. Volatility to the upside is welcome. It’s really only downside volatility that gets us upset. Volatil-ity—seen as our friend rather than foe—offers opportu-nity as well as risk. When markets are down, prices are cheap and it’s a good time to buy. When markets are up, it’s a good opportunity to sell and take some profits.

Let’s take a look at the volatility in short-term returns over the last 10 years in the major stock and bond indi-ces. The charts below plot the quarterly returns of the S&P 500 and the Barclay’s Aggregate Bond index from 2005 through the end of 2014. The red horizontal line running through each graph is the 10-year annualized return for that time period. The green horizontal line is the average quarterly return for that time period.

10 Year Quarterly Equity Returns

10 Year Quarterly Fixed Income Returns

Over the last 10 years stocks were significantly more volatile than bonds, meaning the returns from period to period had larger swings, the highs were higher, and the lows were lower. However, stocks had a higher annual-ized (average annual compounded) return for that time

period: 7.67% for stocks compared to 4.71% for bonds.The picture from the last 10 years is not radically differ-ent from historical norms. Historically, the S&P 500 has returned long-term a nominal annualized return of about 9% with high volatility. Bonds have had a long-term nominal annualized return of about 5% with relatively low volatility.

Embrace volatility as a normal and natural part of invest-ing. Get your arms around the fact that the portion of your portfolio that is invested in stocks will return very erratic returns over shorter time periods—sometimes high and sometimes low—but in the long run those investments should lead to average annualized returns of 8-9%. The portion that is in bonds will be much less volatile, and over the long term should return between 4-5% on an annualized basis. If you really know what to expect, and embrace it—getting neither euphoric when prices are up or defeated when prices are down—you’ll be better able to ride it out.

Have a PlanHaving a strategic plan is the starting point for managing risk and avoiding impulsive behavior. The key pillars of an investment plan are diversification, asset allocation, and rebalancing.

Asset allocation means deciding how much of your portfolio to invest in the different asset classes: stocks, bonds, and cash. Determining the right asset allocation involves thinking about the goals you have for the different portions of your investment account, the time horizon for those goals, and the risk you can afford to take in valuation swings relative to those goals. For example, is a portion of the money in your investment account to be used in the near term to buy a home or pay for a child’s education? Is the account to provide income for life in retirement? Maybe the goal is to leave a legacy for children or charities?

The portion of your account that is for longer-term goals (10 years+) should be allocated primarily to stocks be-cause growth is the priority and short-term volatility does not pose as much of a risk. The portion of your account intended for goals which are to be realized in the medium-term (the next 5-10 years) may favor stocks but incorpo-rate some bonds to moderate volatility. Assets intended to satisfy goals that are to be reached in the next 2-5 years may be weighted more to bonds to moderate vola-tility, but with some portion of stocks for growth. Finally, the portion of the portfolio intended for use in the next 2 years should be short-term fixed income and cash equiva-lents, as preservation of capital is key.

Diversification refers to how you divide up your invest-ments among and between investments within each of those broad classes. For example, within 11

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Q1

20

05

Q

2 2

00

5

Q3

20

05

Q

4 2

00

5

Q1

20

06

Q

2 2

00

6

Q3

20

06

Q

4 2

00

6

Q1

20

07

Q2

20

07

Q3

20

07

Q4

20

07

Q1

20

08

Q

2 2

00

8

Q3

20

08

Q

4 2

00

8

Q1

20

09

Q

2 2

00

9

Q3

20

09

Q

4 2

00

9

Q1

20

10

Q2

20

10

Q3

20

10

Q4

20

10

Q1

20

11

Q2

20

11

Q3

20

11

Q4

20

11

Q1

20

12

Q2

20

12

Q3

20

12

Q4

20

12

Q1

20

13

Q2

20

13

Q3

20

13

Q4

20

13

Q1

20

14

Q2

20

14

Q3

20

14

Q4

20

14

Quarterly Return S&P 500 Annualized Return Average Quarterly Return

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Q1

20

05

Q

2 2

00

5

Q3

20

05

Q

4 2

00

5

Q1

20

06

Q

2 2

00

6

Q3

20

06

Q

4 2

00

6

Q1

20

07

Q2

20

07

Q3

20

07

Q4

20

07

Q1

20

08

Q

2 2

00

8

Q3

20

08

Q

4 2

00

8

Q1

20

09

Q

2 2

00

9

Q3

20

09

Q

4 2

00

9

Q1

20

10

Q2

20

10

Q3

20

10

Q4

20

10

Q1

20

11

Q2

20

11

Q3

20

11

Q4

20

11

Q1

20

12

Q2

20

12

Q3

20

12

Q4

20

12

Q1

20

13

Q2

20

13

Q3

20

13

Q4

20

13

Q1

20

14

Q2

20

14

Q3

20

14

Q4

20

14

Quarterly Return U.S. Barclays Aggregate Annualized Return Average Quarterly Return

Source: Bloomberg, The Fiduciary Group


The returns pictured in the purple graph were actually the S&P returns from the year 2011. Now, just expand your view to the 10-year period from 2005 through 2014. The impact of being invested in 2011 is completely different when seen within the outcome of staying invested over a longer time frame. During the years 2005-2014, you would have experienced a lot of volatility (including the fi-nancial crisis in 2008). But now, viewed in the context of a full investment cycle of 10 years, the volatility would seem

worth it. In that 10-year time period your portfolio would have returned an average annual return of about 7.7%.

In conclusion, the best way to put the brakes on the emotional roller coaster is by practicing the following:• Accept that short term volatility is a normal and natu-

ral part of investing. Embrace it and seek to exploit the opportunities it provides;

• Make and stick to a sound investment plan, which means investing in an appropriately allocated, glob-ally diversified portfolio that is systematically rebal-anced to your targets; and

• Ignore the noise and short-term market swings. Stay focused on the long-term results and whether those results are reasonable risk-adjusted returns in line with the goals for which those funds are intended.

Office: 310 Commercial Drive • Savannah, Georgia 31406

Mailing: P.O. Box 13688 • Savannah, Georgia • 31416

T 912-303-9000 • F 912-303-9001

WWW.TFGINVEST.COM

the portion being allocated to stocks, you want to divide the investments appropriately between different geogra-phies (domestic, international, emerging), market capital-ization (large, mid, and small cap), and strategies (growth, value, blend). The chart below shows how diversification can smooth out the volatility in returns of the different individual asset classes. The diversified portfolio used in the example below is a balanced growth strategy (70% stocks and 30% bonds).

Rebalancing is the best way to give yourself the highest likelihood of buying low and selling high in a systematic, unemotional way. Rebalancing means returning your portfolio to its original target allocations. For example, if your target allocation is 70% in stocks and 30% in bonds, following a downturn in the stock market the actual por-tion that stocks comprise of your portfolio might have slipped to 60 or 65%. When you rebalance, you sell bonds (whose price went up relative to stocks) and buy stocks (whose price is down) so that your portfolio again returns to a 70/30 split. Rebalancing can be done on a calendar basis (for example, at the end of every quarter), and/or when the portfolio allocations stray more than a designated percentage from their target.

Stay Focused on the Long TermExpanding our view from short term returns and short-term volatility to the longer term results gives us an en-tirely different outlook on our portfolio and the risk/return reward. Take a look at the following returns of an invest-ment in the S&P 500. If you viewed only the volatility you endured during the period of that investment and the fact that at the end, you weren’t any better off (in fact, slightly behind where you started), you would not feel very good about that investment and probably want to get out of it.

Emerging Markets34.0%



Foreign Bond14.5%


Small Cap26.9%

Aggregate Bond 7.8%


Small Cap38.8%

Large Cap13.7%

International15.0%

International26.2%

International12.9%

Aggregate Bond 5.2%

International34.4%


Foreign Bond5.6%

International17.0%

Large Cap32.4%

Foreign Bond8.1%

Balanced6.6%

Small Cap18.4%

Foreign Bond10.9%

Balanced-25.4%

Small Cap27.2%

Large Cap15.1%

Large Cap2.1%

Small Cap16.4%

International21.8%

Balanced8.0%

Large Cap15.8%

Balanced8.7% -33.8%

Balanced24.6%

Balanced13.4%

Balanced0.4%

Large Cap16.0%

Balanced19.2%

Small Cap6.4%

Small Cap4.6%

Balanced14.8%

Aggregate Bond 7.0%

Large Cap-37.0%

Large Cap26.5%

Foreign Bond10.5%

Small Cap-4.2%

Balanced12.7%

Aggregate Bond -2.0%

Aggregate Bond 6.0%

Aggregate Bond 2.4%

Foreign Bond5.3%

Large Cap5.5%

International-43.2%

Aggregate Bond 5.9%

International9.4%

International-11.8%

Aggregate Bond 4.2%

Emerging Markets-2.3%


Foreign Bond-9.5%

Aggregate Bond 4.3%

Small Cap-1.6%


Foreign Bond2.3%

Aggregate Bond 6.5%


Foreign Bond3.3%

Foreign Bond-0.6%

International-3.6%

4.9%Large Cap Small Cap

600

800

1000

1200

1400

1600

1800

2000

2200

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2005-2010, 2012-2014 2011

1000

1050

1100

1150

1200

1250

1300

1350

1400


hig

hes

tlo

wes

t



the independent advisor - the fiduciary group€¦ · 2015, but global monetary conditions should...

Documents