Is Your Investment Advisor Doing the Hokey Pokey?

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Over the last few months I have had numerous conversations with people regarding their investment advisor’s dance moves. It seems that over the past year there has been a lot of “dancing” going on in some people’s portfolios. Something along the lines of you put your money in the market, you pull your money out of the market, you put your money in the market and move your investment strategy all about. If that has been your investment advisor’s tune or you self-manage your investments and that’s your typical jam, I have one word for you: stop.

A strategy largely based on putting your money in and out of the market is essentially a market timing strategy, and imperfect timing is a very common cause of poor investment performance. The truth is, no one is smart enough or consistent enough to successfully invest with a money in and money out approach over a long period of time. Sure, you can be lucky and look brilliant over a short period of time, but, even so, the transaction fees and short term capital gains taxes generated by jumping in and out of the market time and time again will also diminish your investment returns.

Most people know they need to have a large portion of their assets invested to have a good shot at hitting their retirement goals and to protect their hard-earned assets against inflation. Investors need an overall investment strategy that is historically appropriate for their age and stage in life, withdrawal needs, and risk tolerance. Beyond that, it’s my professional opinion that relatively small tactical adjustments are appropriate when there are specific opportunities or risks in the market or world that you’re trying to navigate, but drastic investment strategy changes should be the exception - not the rule. Sometimes taking action and making a lot of changes in your portfolio can feel good, but “surgery by chainsaw” rarely works out best. Instead, considering things like the amount of U.S. versus international stocks, large cap versus small cap stocks, growth versus value stocks, corporate versus municipal bonds, and long-term versus short-term bonds can be a good idea. 

Consider this year for example. Who knew 2016 would get off to one of the worst starts for a calendar year in market history? What if you’d completely jumped out of the market in February because you thought it was the beginning of the next cyclical pullback and you missed the bounce back of March, April, and May and endured transaction fees and realized capital gains? How many people actually thought Great Britain would vote to leave the European Union? What if you’d completely jumped out of the market in June due to the surprise result, media barrage, and overreaction of other investors and you missed the swift recovery and positive market performance since then?

When investing you shouldn’t make too many one-way, all-in bets. You should view investing as a mechanism to give you a high probability of achieving your financial and life goals. Investing is a marathon, not a sprint. It’s not sexy and it’s not news, but I do firmly believe investing in a prudently diversified portfolio with a long-term outlook really does give you the best chance to accumulate and preserve wealth.

After all, isn’t that what it’s all about?

-Tom

Compounding – The Good, The Bad, and The Ugly

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• If you were to invest $5,000 per year for 30 years in a portfolio that averaged 5% per year, you’d end up with around $332,000.
• If you were to invest $5,000 per year for 30 years in a portfolio that averaged 6% per year, you’d end up with around $395,000. 
• If you were to invest $6,000 per year for 30 years in a portfolio that averaged 5% per year, you’d end up with around $399,000. 
• If you were to invest $6,000 per year for 30 years in a portfolio that averaged 6% per year, you’d end up with around $474,000. 

That’s the “miracle” of compounding. Sure, investment returns matter a lot, but as you can see from the examples above, how much you save can matter even more! The good part about compounding savings and investment returns is that slow and steady really can win the asset accumulation race in a big way. You might not think you could ever save up $474,000, but do you think you could save $6,000 this year?

 

Recently my wife and I have been looking at houses, and nothing gives me more indigestion than looking at how much a house costs. I’m not talking about the sticker price; I’m talking about how much a house costs over the life of a mortgage. For those of you who have bought a house, this is usually the number that shows up in the top, right-hand corner of one of your loan documents indicating the total amount expected to be paid over the life of the loan. Once interest is baked in on a thirty-year loan, it’s horrifying to see the difference between the initial sales price and what you will actually end up paying. Interest payments alone could be in the hundreds of thousands of dollars! The bad part about compounding interest on a home loan, car loan, student loan, and certainly credit cards is that you keep trying to pay off principal, but you keep getting charged interest. It’s like you have a hole in your bucket. I’ve tried Pepcid, Pepto, and Tums, and the only thing that seems to work is paying off more debt at a faster pace.

 

The ugly part of compounding has to do with the relationship between money and purchasing power. If you have $100,000 in cash and you bury it in the backyard, when you dig it back up, what do you have? That’s right, $100,000. The problem is that while your money was safely hiding underground, there’s a pretty good chance that the cost of goods and services went up (inflation). Think groceries, health care, and education expenses. You might still have the same amount of money, but you are actually poorer than you were because you can no longer buy as many goods and services as you used to since they are now at a higher price. Said another way, your purchasing power has gone down. I don’t see a lot of people burying money in their backyards, but I do see people hold on to exorbitant amounts of cash or an alarming amount of low-interest CDs and bonds. I don’t ever want to take away someone’s “cash blanket,” and I firmly believe that bonds have a place in most people’s investment portfolios to help provide for short-term liquidity needs, reduce overall volatility, and act as an income-producing alternative to stocks. However, just like chocolate cake, too much can be a bad thing. If you have too much invested in cash, CDs, or bonds, your minimal investment returns can lag the rate of inflation, and, compounded over time, you can lose purchasing power even if your assets are slightly growing or staying about the same.

 

That’s the good, the bad, and the ugly truths about compounding.

 

-Tom

 

Two Recipes for Success

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My wife and I both enjoy cooking. She’s a much better baker than me, and I’m a little bit more of a grill master than her, but if you ever get the chance to eat at our table, I don’t think you’ll be too disappointed regardless which one of us is the head chef. One night last week I happened to be working on a grilled chicken Greek salad for our dinner and was thinking about my day at work. I had a simple yet profound realization: Achieving financial success is a lot like cooking. Financial success is like cooking in the sense that both take time, attention, skill, and most importantly, adding the right ingredients at the right time. What I mean is that:

• Owning a bunch of stocks and real estate without having enough cash on hand is like having a whole bunch of macaroni and not enough cheese. The first time you face some financially significant, unforeseen expenses or are forced to live through a downturn in the stock or real estate market, you will find it a lot less pleasant trying to make ends meet with potentially depreciated stocks or illiquid real estate than you would if you had adequate cash savings in place. It could just be me, but if I’m going to err on the ratio of macaroni and cheese, it’s going to have a little extra cheese.
• Having a bunch of cash, CDs, and bonds, but no stocks or “growthier” assets to keep up with inflation, is like serving oatmeal without raisins, butter, or brown sugar. Sure, the oatmeal may initially make you feel nice and warm, but it’s not going to be enough to tide you over against long-term inflation.
• Saving only in retirement accounts like 401(k)s and Traditional IRAs, but not saving any funds in taxable portfolios or brokerage accounts along the way, is like stockpiling nothing but hot salsa for your chips. It’s good that you’re saving up, but it’s going to burn from a tax perspective when you need assets to supplement your cash flow in retirement (withdrawals would be taxed at ordinary income tax rates). Wouldn’t the taste of a little milder salsa or maybe some queso from a taxable portfolio or brokerage account help break up the tax heat in retirement (withdrawals would be taxed at capital gain income tax rates)?
• Keeping a bunch of debt without purposefully striving to extinguish that debt is like resigning yourself to the fact that your salt shaker has a gaping hole in the bottom of it without doing something about it. Plug the hole in your salt shaker and your monthly cash flow by paying off debt and eliminating its nasty monthly strain on your finances!
• Having a great investment strategy without addressing your life insurance, disability insurance, property and casualty insurance, or estate plan is like painstakingly picking out all of the best strawberries for a nice fruit salad, but closing your eyes and randomly selecting all the other types of fruit required to complete the dish. It only takes one really bad banana to mess the whole fruit salad up. So remember that it is crucial to address all parts of your financial plan and examine all components of your overall financial security.
• Trying to plan for retirement in an afternoon or completely fix the path your finances are headed down in one quick swoop is like trying to make a Thanksgiving turkey five minutes before company arrives. Developing and implementing a successful plan that helps you achieve your financial and life goals is more like making that perfect turkey, a six layer cake, or a really delicious stew; it takes time and care.

I really do enjoy cooking, and most days, I really enjoy financial planning. Maybe that’s because in many ways they are not that different. In terms of being a chef or a wealth advisor, I know that I’m not yet Bobby Flay, but my recipe book and cooking techniques are growing every day. As always, please don’t hesitate to let me know if you or someone you know needs “a cup of sugar” and think I might be able to help.

 

Finally, you might have noticed I titled this post “Two Recipes for Success.” If you’ve read this far, you’re in luck! Here’s a second recipe, and it’s one of my family and friends' favorite meals I make:

Tom’s “Barcelona Chicken”

Requires:
Chicken Breasts
Sweet Baby Ray’s Original Barbecue Sauce
Cholula Hot Sauce, Tabasco, or Hot Wing Sauce
Grandma’s Molasses
Honey
Velveeta Cheese
Red Onion
Tomato
Salt and Pepper

 

Directions:
1) Preheat oven to 375 degrees.
2) Take chicken breasts and remove excess fat. Lightly season with salt and pepper on both sides and lay in a baking dish. Drizzle chicken breasts with Cholula (or Tabasco or hot wing sauce), Grandma’s Molasses, and honey. Generously smother with Sweet Baby Ray’s.
3) Place chicken in oven for 45 minutes.
4) Dice tomato into little cubes.
5) Slice onion and sauté in skillet with a little olive oil. If onions are very strong, throw in a little pinch of sugar. Sauté until slightly browned and then remove from heat.
6) After 45 minutes, remove chicken from oven and cut open one chicken breast to make sure it's almost done cooking. Then lay one slice of Velveeta cheese on each chicken breast. Toss back in the oven for 5 more minutes until the cheese is nice and melted.
7) Remove chicken from oven and serve on plates. Top each chicken breast with a few of the diced tomatoes and sautéed onions.

Bon appétit!

-Tom

The Risks of a Fixed-Income Portfolio

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You know how most beaches have those ocean flag warning systems? Well even if you don’t, let me summarize: a green flag flying usually means calm conditions (go ahead and jump in), a yellow flag usually means moderate waves (be careful), a red flag usually means The Perfect Storm-type waves (don’t even think about it), and a purple flag signifies that there is marine life of some type nearby (you might want to see what it is, but you don’t want to be lunch). Well if I personally were a flag warning system for a fixed-income portfolio, I’d be yellow. Chances are you, or someone you know, currently has an investment strategy in place that is heavy on fixed income, and today I want to tell you to be careful, and that moderate waves are probably coming!

First of all, what do I mean when I say "a fixed-income portfolio?" I mean money that is being invested specifically in money market funds, Certificate of Deposits (CDs), and bonds. I’m not talking about your day-to-day checking account or your emergency fund savings account because those accounts should be viewed separately, and should be part of your financial plan and investment strategy regardless of the current market situation or forecast.

Fixed-income investments can be a sound strategy, and in my opinion, should be a portion of any well-diversified investment portfolio. Fixed-income investments are great because they are much less volatile than stocks, and theoretically, they offer a probable positive return (as long as the bank, company, or municipality in which you are invested doesn’t fail). On the other hand, fixed-income investments are not so hot historically because they do not keep up with inflation, and more importantly, a bond’s value typically goes down when interest rates increase. It’s inflation and interest rates that have my flag yellow.

From 1914-2012, the inflation rate (increase in prices) in the U.S. has averaged just a bit lower than 3.5%. What interest rates are you currently getting on your money market funds and CDs? For many of you, I bet the answer is less than 3.5%. Now the question I raise is this: even if your fixed-income investments are fairly stable and will likely offer a positive investment return, do you really want to invest a lot in something that will not grow as fast as prices have historically increased? Sure, inflation has been lower than average in recent years, and bond returns have been pretty good too, but over the long term, I’m not sure fixed-income investments will allow you to keep up with the Joneses. Fixed-income investments should still be a part of your prudently diversified portfolio, but if you have a lot of your assets invested in fixed-income investments, be careful; you could be on a path that will slowly erode your purchasing power.

As I alluded to earlier, a bond’s price and interest rates have an inverse relationship. Let’s say you previously bought a 7% bond for $1,000: you would expect to receive a coupon payment of $70 (7% of $1,000). Well what if interest rates go up 1%? Then, people buying a new $1,000 bond would expect to receive a coupon payment of $80 (8% of $1,000). Would someone still be willing to buy your previously purchased 7% bond for the $1,000 you originally paid when they can now get 8%? I don’t think so! In recent years, people holding lots of bonds have typically fared pretty well because the value of their bonds has been steadily increasing as interest rates have continued to decline to almost zero. The immediate problem for bondholders is that interest rates can’t mathematically go down much more. The bigger problem for bondholders is that interest rates will eventually go back up, and that means the value of bonds will have to go down. This concerns me because it really isn’t a matter of if interest rates go back up; it’s a matter of when. Bonds should still be a part of your prudently diversified portfolio, but if you have a lot of your assets invested in bonds, “waves” of interest rate increases are eventually coming; the bond investment return you have enjoyed in recent years will be hard-pressed to continue.

Fixed-income investments can be very solid investment positions. The problem is that fixed-income investments are like many other things in life - too many of them might not be good for you. My fixed-income flag is yellow, but I should tell you that not everyone shares my opinion. There are a lot of people much smarter than me out there whose fixed-income flags are proudly flying green. Of course, there are also a lot of people much smarter than me out there whose fixed-income flags are proudly flying red...

Great Tom, what should I do? Well, it all depends on your stage in life and your risk tolerance, but (1) make sure you have an adequate emergency fund, (2) make sure you have a prudent amount of diversified fixed-income investments to protect against market volatility and provide a stream of income, and (3) make sure you also have a prudent amount of diversified stock investments to protect your purchasing power against inflation and interest rate changes. Please talk to your financial advisor about your specific situation if you have any questions or concerns.

Well sorry to be a bit of a “Debbie Downer,” but I think it’s always important to tell you my true thoughts and concerns. In happier news, even with a yellow flag, the beach sounds pretty nice right about now!

-Tom