Barriers to Financial Security: Important Lessons / Chapter 6

Hard and Fast Solutions

We will discuss solutions more extensively in a future volume of articles, but they are worth summarizing here as well.

Investor Behavior & the Buy-Sell Cycle: Investors frequently engage in a buy-sell cycle that can be destructive to their portfolios as long as they are not aware of their behavior or able to modify it. Quite simply, this cycle begins with the purchase of stock that an investor believes will be particularly lucrative. Greed kicks in and all is well until the stock begins to lose value. As soon as this happens, the investor experiences fear, regret, and, eventually, panic if the stock’s value continues to decline. The investor sells the stock just before new information comes out that will send its value soaring. Recognizing and understanding this potential behavior will help investors avoid it.

Cash Flow Models: As investors assess where they are financially and where they would like to be, they will find cash flow models to be incredibly helpful tools. Whether trying to focus on the immediate future or trying to plan for retirement, investors who utilize cash flow models can avoid making rash, costly mistakes. An informed investment advisor, and even online tools, can help you develop an accurate cash flow model.

Managing Investment Costs: A valued advisor can manage clients’ investments objectively and can assist clients in making research-based decisions, which is important since investors can only control those factors of which they are aware. Similarly, such an advisor can also help clients limit the cost of investing, which in turn increases the amount of the investment return that clients keep in their pockets.

Managing Risk and Reducing Volatility: Investors will manage risk and reduce volatility more effectively if they have an efficiently designed portfolio. For every level of risk, the portfolio should take into account the optimal combination of investments that will give the highest rate of return. To do so, investors can utilize a variety of resources to stay informed and may also benefit from working with a valued advisor.

Conclusion: Now that you have some historical context, consider where we are today. During the first quarter of 2009, investors moved 285 billion in new net capital into money market funds and withdrew a net 31 billion out of equity funds. Do these changes suggest herd behavior? Perhaps. However, what long-term investors need to recognize is that if they radically alter their well-diversified portfolios, they also need to be prepared to assume a higher tolerance for risk. For example, investors who may have significantly lightened their exposure to risk by selling stocks in late 2008 and early 2009 might not have moved back into the market to participate in the 38% rally that took place between mid-March and mid-June of 2009. (On March 9, the S&P 500 was at 676.53, and by June 8 it was up to 939.14.) Though it begins to sound like a broken record, maintaining a diversified portfolio with exposure to multiple asset classes throughout a variety of market cycles really is the strategy that has provided investors with the least volatility in their returns. And these returns also end up being the most consistent with investors’ expectations.

Investors face a number of challenges if they plan to have successful investment experiences over the years. Of primary concern are the psychological impediments that make it difficult for us to make good decisions consistently. Investors also face the certainty of market volatility, as evidenced by historical trends. Therefore, they should utilize the resources necessary to manage investment costs and to process current academic research on corporate stock pricing, portfolio construction and management.

Additionally, take the time to remember the impact your emotions can have on your decision-making abilities when you are making financial decisions. Consider carefully not only the decisions you are facing, but also why you are contemplating them in the first place. Just being aware of the emotional complexities of making financial decisions will help you achieve financial security.

- James E Wilson, CFP®

This is the fifth chapter to a seven part series on the Barriers to Financial Security. To download a full copy of the whitepaper, click here

Barriers to Financial Security: Important Lessons / Chapter 5

Diversification

Most people understand the basic concept behind diversification: do not put all of your eggs into one basket. However, even people who are sophisticated investors can fall into investment traps. For example, many people have suffered losses because they placed a large percentage of their investment capital in their employers’ stock only to lose much of it during the recent downturn. Even though the employees may have understood that they were taking too much of a risk in doing so, they did not do anything to change their situations. Instead, they justified holding the position they had established because of the large capital gains tax they would have to pay upon selling the stock, or they imagined that the stock was just on the verge of taking off. In such instances, investors are too close to a particular stock, and they develop a false sense of comfort and overconfidence. They may rationalize that everyone with whom they work has invested in the company, and how could so many people be wrong? Similarly, they rationalize the importance of their investment in the company’s stock because they are professionally invested in the company and feel a certain sense of loyalty. Over the past year alone, many of these investors have felt the pain of such imprudent investment practices.

In much the same way, other investors believe they have diversified their portfolios effectively because they own a number of different stocks. What they may not realize, however, is that they are in for an emotional rollercoaster ride if these investments all belong to the same industry group or asset class and therefore share similar risk factors. For instance, investors in the late 1990s and early years of this decade learned that diversification among a variety of high tech stock companies was really not diversification at all. When a number of prominent technology stocks, including Cisco, Dell, and IBM, experienced billion dollar sell-offs between Friday, March 10 and Monday, March 13, 2000, the resulting chain reaction hit the entire tech industry.

Included with this article are charts (click here to view the full version of the whitepaper with attached charts) that will help investors understand how diversification dramatically impacts a portfolio. (It is important to remember, however, that one cannot directly invest in the S&P 500. This chart uses it as an index for illustration purposes only). So, imagine someone whose hypothetical portfolio consisted of a 100% investment in the S&P 500 (Portfolio 1). Between 1998 and 2007, he would have achieved a 4.38% annualized compound return and for every $1.00 invested, he would have ended up with $1.47. However, if he had merely invested 40% in a 2-Year Global Fixed Income Fund with the remaining 60% still in the S&P 500 (Portfolio 2), his annualized compound return increases to 4.72% and each dollar is now worth $1.51. Portfolio 5 shows additional diversification including investments in U.S. small and large value companies as well as in real estate. The annualized compound return of Portfolio 5 jumps to 8.9% while the growth of $1 reaches $2.15. Adding international stocks to Portfolio 10 even better demonstrates the potential of diversification because it achieves more than double the annualized compound return of Portfolio 1 (10.08%), and our investor’s $1 has now reached a value of $2.37. Explained this way, the benefits of diversifying are obvious; however, many people fail to take advantage of the potential of diversification.


- James E Wilson, CFP®

This is the fifth chapter to a seven part series on the Barriers to Financial Security. To download a full copy of the whitepaper, click here