August 2013 Volume 3
“The superior man is distressed by the limitations of his ability; he is not distressed by the fact that men do not recognize the ability he has.” -Confucius
One of the biggest challenges we face as investors is to define our goals and then map out a course for achieving them. Part of this is knowing our own risk appetites and constructing a portfolio that will allow us to remain largely invested even when times are difficult. For those less adventuresome, that may mean a much more conservative approach than, say, someone with few obligations and a sizeable penchant for risk. Either way, it is important to properly construct a portfolio with your own profile as a guide and then select an appropriate benchmark that will allow an objective review of your performance over time relative to both the benchmark and your goals. Selecting an appropriate benchmark is a topic many professionals in the investment community have shown great passion about. For our purposes (and since we are not generally dealing with institutions where these issues have broader implications) a benchmark should at least come close to tracking the broad asset classes represented in your portfolio. That is to say if your portfolio is 40% in bonds and 60% in stocks, the benchmark should have similar weightings. Also, if the stock portion is 50% domestic and 50% foreign, then so should your benchmark. We could do a more thorough treatment of appropriate benchmarks in a whole letter, but for now this description should suffice.
Up to this point most readers will probably feel that all of this sounds reasonable and logical. It is, however, a good leaping off point for a study in human behavior. Often times the logical and pragmatic get replaced by human emotion. This is particularly acute in the capital markets where a myriad of financial assets trade every day, giving an investor an up to the minute reading on the status of their financial well being. There is the always human tendency to alter a set of well defined goals in favor of the vogue. Missing out is a truly human emotion. It is this emotion that is the bane to most successful investment plans. One of the big errors that investors make in the hurricane of emotion is proper perspective. For example, in today’s news you may very well find articles of how well the general stock market is doing and how far it has gone up in the last four years(150%!). What you will not likely find is the peak to peak returns over a full market cycle. This is important because the peak to peak returns (or trough to trough returns) represent the real returns investors can likely achieve by assembling a portfolio similar to the benchmark without trading in and out of the assets in question at all the right times (a feat few, if any, professionals have perfected). In the graph below we examine the S&P500 Index’s price performance over more than a decade. The return from August 2000 through October 2007 (red arrow) was 0.29% per year. With dividends the compounded annual rate was close to 2.46%. From August 2000 through July 2013 (green arrow) the price return was 0.81% per year and with dividends was close to 2.92%. These numbers are a far cry from the historical returns from stocks over the last century (closer to 9+% with dividends).
The historical long term returns may not rejoin us until the excessive debt burdens the world has accumulated over the last two decades show signs of being resolved to something much more sustainable and manageable. A big reason for this lies in the observed historical record that suggests that large debt burdens are deflationary precisely because more and more productive output goes to service the debt rather than for productive purposes. This brings us back to full cycle returns and their measurement. Since we have completed roughly 2 full peak to peak market cycles since the 2000 market peak, the question becomes, “what will the full 2-cycle trough to trough returns look like?”. Without having significantly reduced our overall debt burdens since the 2008 financial crisis, my suspicion is that the 2.50 to 3.00% peak to peak total return is still valid and likely for the trough to trough returns. This is also validated by long-term explanatory variables like S&P500 revenues and Shiller 10-year smoothed earnings. If this proves to be the case a price correction of 45% is not out of the question. To punctuate this possibility consider that we’ve had two similar episodes (each with over 45% declines) since 2000. Why point this out in a piece about performance measurement? The simple fact is that human nature forces us to change our perspective based on the most recent past rather than on accumulated facts. By nature we have a great capacity to forget those things that caused us the most pain in our past. By doing this, it is tempting to judge the performance of our own portfolios against those that have performed best in the recent past, ignoring important facts like 1) Is it the appropriate benchmark? 2) Does it comport with my personal goals? and 3) Are the risks similar to those I am comfortable with?, etc..
Strategy vs. Tragedy
By setting appropriate benchmarks, outlining goals and properly accounting for risks, investors can find comfort in the product of those endeavors … namely a strategy. Well defined, a strategy is the hallmark of successful investing where everyday we are bombarded with calls to action that suggest our current portfolio is somehow misaligned. By having a strategy, we can largely ignore the day to day machinations of the media or market movements in favor of a more pragmatic approach that allows us to evaluate, research, measure and adjust according to our goals. Conversely, those unfortunate enough to abandon the aforementioned rigor in designing their investment posture and goals will likely be persuaded to take more risk at the wrong times, less risk when it is appropriate to increase it and, most likely, measure their performance against the wrong benchmarks.
This all leads to a failure to meet even their most modest goals, leaving them in with a sense of despair … a tragedy. The importance of having a well defined strategy cannot be understated. It keeps undue risks from creeping into your portfolio at all the wrong times and forces unemotional risk taking as markets sell at discounted prices. This balance will likely temper portfolio returns at market tops and reduce volatility on market sell-offs, but produce long term consistency that the effect of compounding will highlight. In addition, and as a word of caution, a good strategy will likely give an investor a sense of comfort in what is likely to be a messy exit of central bank intervention. If you’re not sure what this means, it is the unprecedented monetary injections by the European Central Bank (ECB), the Bank of Japan (BoJ), the Peoples Bank of China (PBC) and our own Federal Reserve Bank. These have served to create a buffer in world economies since the 2008 financial crises, but are experimental in nature and expected to end at some future date leaving who knows what in their wake. The uncertainty of how the (un)anticipated exit will affect all assets will undoubtedly be more challenging for market participants that do not have a disciplined strategy in place.
In conclusion, have a well thought-out strategy that not only uses the appropriate benchmarks for comparison, but also has your goals and risk tolerance solidly as a centerpiece. The risks inherent in your portfolio should be a close match to what you can likely tolerate when things are not going so well and, remember, those same constraints reduce potential returns when euphoria abounds in the markets. Keep a guided path and you will achieve your ultimate goals!
Raymond M. Lombardo, CIMA
July 2013 Volume 3
“We should not look back unless it is to derive useful lessons from past errors, and for the
purpose of profiting by dearly bought experience.” –George Washington
Building Wealth Over the Long Term
Make Key Strategic Decisions
Wealth building comes generally over time and by making key life decisions along the way. Sure, there is the twenty-something who wrote a technology changing code or the gifted musical prodigy that makes millions before their 25th birthday; but, for the majority of us, its about plotting out a strategic course that may at times be less thoughtful than others. One way or another, to build enduring wealth, a rough plan and encouragement to pursue our passions goes a long way to set-ting us on the right course. Landing a job that speaks to our passions may be one of the more im-portant strategic moves we make because our income tends to be one of our biggest assets. So it follows that educational decisions are one of the first big key decisions we make. It could be that the education an individual pursues is not necessarily an academic one, it may be vocational, but just know it is an important key decision.
Investing is another key decision we make along the way. Often investing is couched in terms of savings, as we are often told it is virtuous to save some of our earnings for a “rainy day”. But, really, investing is a key decision that should not be just relegated to a passbook savings account. By way of illustration consider the table. Here, investor A starts investing at age 18 by putting $2,000 each year away earning 8% per year. At age 26 he stops. Investor B starts putting $2,000 each year into an investment earning 8% per year at age 26 and continues to do so until he is 65. At age 65 investor A still has a mi-nor advantage over investor B even though he invested only $16,000 in contrast to investor B’s $78,000 investment. Oh, and if investor A had kept contributing the $2,000 per year until he/she reached age 65, he/she would have $1,050,000. The moral is to invest early and often,that is an important key decision.
Given that over time assets tend to appreciate, ownership is another key strategic decision. Whether you own a business and its equipment, own the building you do business out of, or the home you live in, ownership often means that you are paying yourself in one way or another. The cumulative effects of doing this over a long period of time have similar results as investing. An important note on key strategic decisions is to make them on your timetable and comfort level, seek professional advice where appropriate and ignore what the masses are doing as their objectives, circumstances and emotions often differ from your own. That leads us to the next topic in building wealth … mistakes!
Avoid Making Big Mistakes
We all make mistakes. As humans this is often how we learn and improve outcomes. Some would call it per-spiration (Einstein), others desperation (Ray Ramano) and still others exasperation (Lucille Ball). In any case we can-not avoid making them from time to time and we wouldn’t want to. Mistakes allow us to make systems that are more robust and a few small errors can keep us from making much bigger ones down the road. I once got very good ad-vice about when we make mistakes and it goes like this, ’When you’ve recognized you’ve made a mistake, immedi-ately accept responsibility for it and take measures to cor-rect it’. By following this simple principle, we add integrity to our actions and, quite frankly, sleep better.
When I talk about making big mistakes, I’m talking about the life altering, wealth altering kind. One example of a mistake in investing would be to commit an unusually large portion of one’s in-vestable assets to a single investment. This is often done when there is a high degree of emotion involved (i.e. ‘I will get rich if I do this’ or ‘I’m missing the boat because everyone else is doing it’). Sometimes this works out (no doubt some readers may have examples of such times), though most times this ends in a severely impaired portfolio or just plain disaster.
Another example, though maybe not so conventional for a financial newsletter, is where af-fairs of the heart are concerned. I’m sure no one goes into a marriage thinking about divorce, but divorce is very often a significant financial setback. Giving as much serious thought to financial matters in a relationship, as well as the emotional status of ourselves and our partner, may allow us to establish a sound foundation for building wealth together or separating amicably if the relationship doesn’t work out.
A final example is the reckless use of leverage. It is very hard in today’s world to operate completely debt free and in many cases it is not advisable. Being young with a new and promising job and a stable stream of income affords that person the ability to use debt judiciously to purchase a home or pursue a unique business opportunity. In this position even a small amount of borrowing for investment may be warranted. It is the use of debt to finance a lifestyle or to buy non-productive items that has the ability to sink an individual’s wealth accumulating ability. Here, think in terms of accumulating a large amount of credit card debt, buying more house than you likely can afford, purchasing a car that exceeds your needs and pocketbook, etc.. These moves tend to have a cumulative negative effect on wealth.
Living With Failure
Almost without exception, those people that have experienced any success in their lives will tell you they have often failed along the way. The difference in successful people is in their attitude toward failure. They often view failure not as a setback, but rather, as a learning experience that allows them to hone their skill set for success. I’m sure that doesn’t mean they are not discouraged, but that dejected feeling is fleeting and leads to an even more focused determination to succeed.
Another very important observa-tion to make is what lessons we learn from our failures. Not all failures are created equal. What I mean by that is that sometimes it’s not our execution or idea that is responsible for the failure. It can merely be the circumstances surrounding it, like timing, market acceptance, etc.. It is critical that we take the right lessons from our failures so that we don’t abandon key elements of our strategy for the wrong reasons. A good example of this in investing is a person who is new to investing in stocks and buys a stock that immediately goes down and then swears off all stock investing for life.
A final reflection regarding failure is that the failures need not be ours for us to learn some-thing from them. Success sometimes comes in learning from other’s mistakes. We often see this in business where being the first to market with a product or service does not necessarily lead to suc-cess. The emergent company is trounced by a second or third entrant into the market because the latter enters the market with knowledge the originating company could not have had. This is a use-ful examination because it translates beyond business and into many aspects of our lives.
The key take-away is that we need to scrub our (and other’s) failures for the right clues that will lead us to a successful future. Maybe even more importantly, we need to maintain an optimistic attitude even in the face of failure. To do otherwise will most certainly mean that we will struggle to meet our long-term goals and aspirations.
Raymond Lombardo, CIMA
March 2013 Volume 3
“I am for doing good to the poor, but…I think the best way of doing good to the poor, is not making them easy in poverty, but leading or driving them out of it. I observed…that the more public provisions were made for the poor, the less they provided for themselves, and of course became poorer. And, on the contrary, the less was done for them, the more they did for themselves, and became richer.” – Benjamin Franklin
What Is Money?
You may know where your money is, but do you know what it is? Whether you are an engineer, salesperson, teacher or coffee house barista, you likely go to work most days and at the end of a week or two you receive a form of payment that represents compensation for the goods or services you’ve provided. We generally regard this payment as money. It is a medium by which we can conduct our daily affairs. Now, in a building somewhere in Washington D.C. or N.Y the authority is given to push a computer button and create $1 trillion; no work, no services, no goods. Is this money? Is this moral? Do you know what money is? It’s the math that matters. Now before you cringe at that four letter word, understand that without it there would be no computers or cell phones, no movies, flight, or even widely distributed food for that matter. But the math I’m talking about is the math of excess. Specifically the excess of money being thrown at our problems without regard to the destructive side effects, never mind that they are destined to fail in time. Now, I don’t claim to know the right size for government, but I’m pretty sure size is not the issue, efficiency is (put simply, would you rather have a small car that gets 10 m.p.g. or a midsized car that gets 28 m.p.g.?). With regard to market dynamics, the new math seems to work as described in figure 1 above, where a is printing money and b is higher stock prices. Seems pretty simple, and it is. The question then arises, why haven’t we done this before? And the answer is that there can be no sustainable wealth created by just running a printing press. There is no value creation, and hence no wealth creation. True wealth is created when we invest in new ideas or make old ideas more productive. It is created when, through hard work and determination, a new business thrives by providing a useful service or eliminates an unpleasant task long burdening the populace. So the wealth that seems so easily conjured up by massive amounts of money printing and deficit spending is fleeting. The math is flawed. The reason we know this is because these type of experiments have been tried before and have proven to have very spotty,if not downright horrible, track records. Minor devaluations (devaluation of currency or purchasing power comes from the decline in value of money as money becomes more abundant than goods and services) seem to occur frequently throughout history and create some trading advantages, but the type and size of money creation we’ve witnessed globally in recent years is only accelerating and has a formidable record of disaster.
(see: Sovereign Defaults).
The math that makes us much more comfortable with future returns and is rooted in base fundamentals is shown in figure 2 . Without going into all the gory details it simply takes into account the long-term growth of the economy (g), normalized long-term earnings trends and price to earnings (PE) trends, time values and dividends (dy). Things that really matter in a sound running economy. Implicit in these factors are investments in infrastructure and buildings, machines, workforce training, intellectual property and a myriad of other things that we seem to be doing too little of right now. These observations are critical because they shape how we invest our clients’ capital. If we were to assume that the recent 3-year returns in stocks will continue unimpeded while the Federal Reserve continues to pump money in the system, what are we to think the markets will do once they reverse course? Many investors have been conditioned to buy only with the Federal Reserve in easing mode, who will buy when they tighten? Already risk premiums (the excess returns expected from stocks over treasury bonds) are at the some of the lowest levels I’ve seen in my career spanning 25 years. This is at a time when the risks to the system are more elevated than at any time during that period. If we take the long-run nominal growth in the economy of 6%, a PE of 16 on normalized earnings (vs. 22 currently) and dividends of roughly 2%, the math shows us to expect roughly 4.1% annually from stocks over the next 10 years. Could we see a better outcome than that? Sure, but it most likely won’t come in a straight line. For stocks to offer more normalized long term returns in the 8% range the S&P500 would have to decline to about 1000, or a 33% decline from today’s price. Another option would be if the S&P500 stayed at it’s current level over the next 5 years while the economy continued to grow at its long run average. Because we believe it is highly unlikely for the stock market to just ‘level out’, our justifiable concern is for a correction that can cause plenty of pain for the unannointed. It’s this reason we continue to patiently hold slightly elevated cash balances for our clients’ accounts.
To understand the difficulty of modern day wealth advisory, consider the graph in figure 3. Historically, a client would outline their goals and ambitions and set out a timeline
in which they wanted to try and achieve them. After careful consideration of their risk tolerances and other factors a strategy could be implemented to set the target for saving and investing toward those goals. The likely outcomes and framework looked
a lot like the parallel green lines Figure 3 in our graph. The risks we knew were there could be managed, although not entirely eliminated. The red lines in our graph represent the likely outcomes of uncertain events. They’ve always existed, however, their range was more narrow and their occurrence more unlikely. Today we have a situation where the uncertain
events have become more probable and the range of outcomes more widely distributed. Of the more probable uncertain events we include inflation, hyperinflation, deflation and war. Why? Principally because of global over indebtedness, central bank interventions, currency debasement, trade wars and fiscal mismanagement. The outcome of each will affect a portfolio of assets very differently. In the event we experience one or several of these over the next decade, standard portfolio construction returns may seem like just a rounding error. It is wise (although not entirely painless) to have a plan where highly liquid assets can be deployed quickly when an opportunity arises because of illiquidity and fear in the markets. For the time being none of these uncertain events or fears are present in the marketplace (in fact, maybe just the opposite; one of euphoria). Subsequently, the opportunity set is limited. That has not stopped the Federal Reserve from having a policy that leads to gross misallocation of capital, so long as they feel that the side effects will be overwhelmed by genuine growth in the economy. There is a dangerous set of assumptions in this prescription, however, I will point out that the powers that be have very few options at this point. Whether we agree with current policy or not,one of the observations we’ve made with respect to further increases in asset prices relates to continued Federal Reserve easing. We are now seeing the effects in the real estate market where prices in the Case-Shiller 20-city composite index have increased approximately 6.5% year-over-year. If the strength in home prices continues, it adds another level of underpinning to the languid recovery. Selectively, we’ve also identified the biotech arena as an area of interest because it rests on a sound foundation of continued research and discovery particularly as it relates to DNA and the human genome.
Raymond M. Lombardo, CIMA
See how long your money will last with our new tool.
In planning for retirement our first objective should be to “get real”. Many of us are just not all that prepared to replace our working income in a comfortable retirement. It’s kind of like losing weight, we know what we need to do to get there, and we just don’t have the discipline and focus to achieve our goal. According the Employee Benefit Research Institute:
“…. Workers who say they are very confident about having enough money for a comfortable retirement this year hit the lowest level in 2009 (13 percent) since the Retirement Confidence Survey started asking the question in 1993, continuing a two year decline. Retirees also posted a new low in confidence about having a financially secure retirement, with only 20 percent now saying they are very confident (down from 41 percent in 2007).”
We welcome Rhondi E. Sandblom to our team here at Clearview. Rhondi comes to us with a wealth of experience in operations management working in prior capacities in finacial services and the construction industry. This solid addition to our team will continue to help us build on the service excellence we strive to provide to all of our clients.
We are adding to our suite of robust technologies to advance our reporting and analytical capabilities by implementing Morningstar Office. We are also improving our conferencing abilities with online meeting software that will make engaging clients easier from their home or office computing devices. Stay tuned for further updates.
The stock market has posted the second year of annual advances since reaching a low in March of 2009. The S & P 500 and Dow Industrials have gained nearly 100% from those recessionary lows. The coming year may see challenges to these heady advances and post more modest gains.