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Posts from the ‘Behavioral Finance’ Category

9
Dec

Prioritizing Savings for College and/or Retirement

The November 2018 AAII Journal, American Association of Individual Investors, included an interview with Harold Pollack. The discussion was about “The Index Card: Why Personal Finance Doesn’t Have to Be Complicated” (Portfolio, 2016). He wrote it with Helaine Olen.

The following passage is from a response to a question about prioritizing where to direct money.

There are different ways that people can do this. You should match your method with what gives you the mojo to actually do it.” … “Suppose I’m a young parent and I’m choosing between prioritizing my retirement and savings for my kid’s college. Mathematically, retirement tends to be the answer for most people, but your kid’s college gives you mojo in a different way. If you’re walking with your seven-year-old daughter in a store and you see a sweet $500 camera lens, you can point to it, and tell your daughter: “I really want that lens, I’m going to put that $500 toward paying for your college. Maybe some day you’ll do that for your daughter.’ That’s powerful and motivating.”  

2018 Nov.Beyond-the-Index-Card-Implement

 

1
Mar

Correction Time: The Market Takes a Hit

After reaching all-time highs on January 26, 2018, the Dow Jones Industrial Average and the S&P 500 went into a two-week slide that saw both stock indexes drop by more than 10%, a decline that is typically considered a market correction.1

Analysts have been saying for several years that the long, booming bull market was overvalued and due for a correction, so the drop was not a surprise in the big picture.2 And even after the 10% plunge, the Dow was up 19% over the previous 12 months, and the S&P 500 was up 12.5%.3

It’s natural to be concerned about this kind of shift, but more important to maintain perspective and focus on your long-term goals. It may be helpful to consider some of the reasons behind the surge of market volatility.

Too Much of a Good Thing?

The initial trigger for the downturn was a better-than-expected jobs report on February 2, that helped drive the Dow down more than 2.5%, a significant decline considering the unusually low volatility in 2017 and the beginning of 2018. The economy added 200,000 jobs in January, marking the 88th straight month of job creation, the longest such run in U.S. history. Wages rose by 2.9% over the previous January, the highest year-over-year increase since the end of the recession in June 2009. And the unemployment rate held steady at 4.1% for the fourth straight month, the lowest level in 17 years.4

Although the report was great news for U.S. workers, on Wall Street the rosy jobs picture generated fears of higher inflation that might drive the Federal Reserve to raise interest rates more quickly than anticipated. At its December 2017 meeting, the Federal Open Market Committee signaled its intention to raise the benchmark federal funds rate three times in 2018, bringing it up to a range of 2.0% to 2.25%. Theoretically, these changes have been priced into the market, but the strong jobs report made it more likely that the Fed will follow through on its projection and possibly execute further increases if inflation heats up.5

Stocks, Bonds, and U.S. Debt

Higher interest rates rattle the stock market because investors are more likely to move assets out of risky stocks and into more stable bonds as fixed-income yields become more attractive. Higher rates not only mean increased yields on new bonds but also on existing bonds, as prices are pushed downward to make yields competitive. In addition, the prospect of inflation tends to push bond prices lower and yields higher, because inflation erodes the purchasing power of fixed-income payments.

One reason for the initial reaction to the January jobs report expanding into a full-blown correction is that bond yields were already rising due to other factors. The yield on the 10-year Treasury note — a bedrock of global financial markets — has been rising since tax legislation was proposed in the fall of 2017, and the yield reached a four-year high of 2.85% the day the jobs report was released.6-7 Although the Tax Cuts and Jobs Act was generally welcomed on Wall Street, bond traders have been concerned that increased Treasury sales to pay for the $1.5 trillion tax cuts will erode bond prices. This concern was exacerbated by the bipartisan budget deal that further increased deficit spending.8

The Treasury is working to finance higher debt at the same time the Federal Reserve is unwinding its recession-era bond-buying program. With the Fed reducing its bond portfolio, the Treasury must sell more bonds to the public to cover growing deficits. The Treasury recently announced the first increase in bond sales since 2009.9

The question is who will buy these bonds and what are they willing to pay for them? A weak dollar has made Treasuries less appealing to foreign governments, which hold more than 44% of U.S. government debt. With the Treasury market depending more on U.S. investors, supply may be outpacing demand — illustrated by a tepid Treasury auction on February 7.10

The Long View

Although mounting government debt is a serious concern, the stock and bond markets are both driven in the long term by the economy, and the United States looks to be hitting its stride after a long, slow recovery. The global economy, which has been even slower to recover, is coming back as well.

A correction may be disturbing, but it can strengthen the market in the long term by returning equity values to levels that are more in line with corporate earnings and less dependent on investor exuberance. A corrected market may also be less vulnerable to overreaction. On February 14, the Dow and the S&P 500 closed up more than 1.2%, despite a consumer report that showed higher-than-expected inflation. Even with higher prices in January, core inflation (which excludes food and energy prices) is running at only 1.8%, still below the Fed’s 2% target rate.11

Of course, no one can predict the future, and you might see volatility for some time. The wisest course may be to remain patient and avoid making portfolio decisions based on emotion.

The return and principal value of stocks and bonds fluctuate with changes in market conditions. Shares, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest.

The S&P 500 is an unmanaged group of securities that is considered representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results. Actual results will vary.

1, 3) Yahoo! Finance, 2018, Dow Jones Industrial Average and S&P 500 index for the period 2/8/2017 to 2/8/2018

2) Bloomberg, February 6, 2018

4-5) The Wall Street Journal, February 2, 2018

6) CNBC, January 11, 2018

7) CNNMoney, February 2, 2018

8) MarketWatch, February 12, 2018

9) Bloomberg, January 31, 2018

10) Bloomberg, February 7, 2018

11) MarketWatch, February 14, 2018

5
Feb

Perspective on February 5, 2018 Market Events

It looks like the U.S. stock market will finally get something that happens, on average, about once a year: a 10+% percent drop—the definition of a market correction. The last time this happened was a whopper—the Great Recession drop that caused U.S. stocks to drop more than 50%–so most people today probably think corrections are catastrophic. They aren’t. More typically, they last anywhere from 20 trading days (the 1997 correction, down 10.8%) to 104 days (the 2002-2003 correction, down 14.7%). Corrections are unnerving, but they’re a healthy part of the economy—for a couple of reasons.

Reason #1: Because corrections happen so frequently and are so unnerving to the average investor, they “force” the stock market to be more generous than alternative investments. People buy stocks at earnings multiples which are designed to generate average future returns considerably higher than, say, cash or municipal bonds—and investors require that “risk premium” (which is what economists call it) to get on that ride. If you’re going to take more risk, you should expect at least the opportunity to get considerably more reward.

Reason #2: The stock market roller coaster is too unsettling for some investors, who sell when they experience a market lurch. This gives long-term investors a valuable—and frequent—opportunity to buy stocks on sale. That, in turn, lowers the average cost of the stocks in your portfolio, which can be a boost to your long-term returns.

The current market downturn relates directly to the first reason, where you can see that bonds and stocks are always competing with each other. Monday’s 4.1% decline in the S&P 500 coincided with an equally-remarkable rise in the yields on U.S. Treasury bonds. Treasuries with a 10-year maturity are now providing yields of 2.85%–hardly generous, but well above the record lows that investors were getting just 18 months ago. People who believe they can get a decent, relatively risk-free return from bond investments are tempted to abandon the bumpy ride provided by stocks for a smoother course that involves clipping coupons. Bond rates go up and the very delicate supply/demand balance shifts, at least temporarily, in their direction, and you have the recipe for a stock market correction.

This provides us all with the opportunity to do an interesting exercise. It’s possible that the markets will drop further—perhaps even, as we saw during the Great Recession, much further. Or, as is more often the case, they may rebound after giving us a correction that stops short of a 20% downturn. The rebound could happen as early as tomorrow or some weeks or months from now as the correction plays out.

Once it’s over, no matter how long or hard the fall, you will hear people say that they predicted the extent of the drop. So now is a good time to ask yourself: do I know what’s going to happen tomorrow? Or next week? Or next month? Is this a good time to buy or sell? Does anybody seem to have a handle on what’s going to happen in the future?

Record your prediction, and any predictions you happen to run across, and pull them out a month or two from now.

Chances are, you’re like the rest of us. Whatever happens will come as a surprise, and then look blindingly obvious in hindsight. All we know is what has happened in the past. Today’s market drop is nothing more than a data point on a chart that doesn’t, alas, extend into the future.

 

Sources:

https://www.fool.com/knowledge-center/6-things-you-should-know-about-a-stock-market-corr.aspx

https://www.yardeni.com/pub/sp500corrbear.pdf

https://finance.yahoo.com/news/stocks-getting-smashed-143950261.html

Bob Veres

19
Mar

When investing should you follow your gut?

Jason Zweig’s Wall Street Journal March 18, 2016 article, “The Three Worst Words of Stock-Market Advice: Trust Your Gut” is insightful.  The substance of the article is stated in a quote from Benjamin Graham’s book, “…The investor’s chief problem-and even his worst enemy-is likely to be himself.”

The article references research by “…finance professors William Goetzmann and Robert Shiller of Yale, along with Dasol Kim of Case Western Reserve University, have analyzed the Yale surveys and found that investors’ forecasts regularly look more like aftercasts—simple projections of the recent past into the future.”

“Prof. Shiller… has been surveying investors about their expectations since 1989.” One question is…What are the odds of a one-day crash of at least 12% in the U.S. stock market over the next six months? The probable answer was about 10 times the probability. “Remarkably, professional investors exaggerate the odds almost as badly as individual investors do.” “What’s more, the new study suggests, you probably should have put higher odds on an imminent crash back in January than you would now or would have six months or a year ago. That is partly because a sharp recent drop makes future declines seem more probable, and partly because the news media uses words like “crash” much more often after the market falls sharply.” “Naturally, investors tend to be complacent when they should be worried and afraid when they should be optimistic.”

“Words charged with negative emotion not only darken your view of the future, but they may make you feel that riskier investments have a lower—rather than a higher—potential return.”

“Dates like Oct. 28, 1929, and Oct. 19, 1987, when the Dow Jones Industrial Average fell 13% and 23% respectively, can “evoke a sense of doom,” says Prof. Goetzmann of Yale. ‘Crashes have a remarkably long life in the public imagination. Their echoes can last for decades’.”

Having a plan with a target allocation can help restrain reacting to your gut.  This provides a map to achieve your financial goals.  Your plan should be reviewed when your goals, priorities or circumstance change.  You should review your investments periodically to see if they still fit the reason you chose the investment.   There is not a consensus of how frequently you should review your plan and investments. Making changes too frequently is trading rather than investing.  Very few are consistently successful at trading.  There are costs and possible tax consequences when trading. Your plan should identify when the investment should be adjusted to meet your target (rebalancing). Set a percent or dollar amount of change that would justify rebalancing.

Generally rebalancing will increase the long-term performance.  Waiting too long can reduce your returns.

22
Feb

Highlights from various articles of note

Target Date Funds:
An article by John Sullivan in the inaugural issue of “401k Specialist” discussed Target Date Funds (TDF).  The article is based on a panel discussion at the 2015 Morningstar Investment Conference.   Initially these funds were disappointing.  One area of concern related to asset-class diversification. The question was not just about the ratio of stocks to bonds.  The portion in domestic, foreign and alternative investments was also a concern.  Another area requiring improvement was how the mix of assets changed over time and during retirement.

TDFs have improved since their introduction. Three companies account for 70% of the assets in these funds.  At one point they accounted for 80%.  Only one firm had funds (3) in the highest 10 performing funds.  The other top performing TDF’s were from 2 other firms.

The greatest benefits of TDFs from my viewpoint is the improvement in investor behavior.   “Investors are using them well.  They don’t exhibit the typical behaviors of fear and greed with target date funds, and as a result stay the course and remain invested longer.”

Not all TDFs are the same.  You want one that is consistent with your situation and your plan.

Retirement Planning Calculators:
This is the subject of a Wall Street Journal article, “New Study Questions Retirement Planning Calculators’ Accuracy.” This article was update online Feb. 22, 2016.

The article discusses an academic study of 36 retirement planning calculators.  “… ‘in most cases, the available offerings are extremely misleading ‘ and generally not helpful to consumers trying to figure out if they will have enough money to cover their expenses for the rest of their lives.”

The study was based on “… a hypothetical couple in their late 50s earning $50,000 each and aiming to retire at ages 65 and 63.”  The calculators were described as “…free and low-cost…” The cause of the misleading results was the limited amount of information used by the calculators.

“…the researchers identified a list of more than 20 factors they believe should be included…”

Do not use the simplest calculator available.  Pick one that has many questions.  Also review the assumptions they are using.  All calculators are use assumptions.  Some assumptions to all calculators are: life expectancy, health, inflation rates, investment returns.  Other questions would include the amount of your current investments and amounts you are currently savings.

6
Mar

The lessons learned from “the old Enron story” still apply.

The following is from Edward Mendlowitz’s Feb. 24, 2015 Blog.
“in his book Money: Master the Game, Tony Robbins dredges up the old Enron story, which I agree with, and want to call to your attention now.  Here is a brief listing copied from Tony’s book of the lauds, Enron received right up until their bankruptcy filing.

Mar 21, 2001 Merrill Lynch recommends
Mar 29, 2001 Goldman Sacks recommends
June 8, 2001 J.P. Morgan recommends
Aug 15, 2001 Bank of America recommends
Oct 4, 2001 A G Edwards recommends
Oct 24, 2001 Lehman Brothers recommends
Nov 12, 2001 Prudential recommends
Nov 21, 2001 Goldman Sacks recommends (again)
Nov 29, 2011 Credit Suisse First Boston recommends
Dec 2, 2001 Enron files Bankruptcy

Millions of Investors trusted these venerable firms and followed their recommendations.  A question I had at the time was, “How much work did they do before they made their recommendations?”  I could not have been too much since every recommendation was wrong.  Another observation is that many of the largest mutual funds has significant positions in Enron.

Now, lets fast forward to today.  Has anything changed?  Were lessons learned?  Are more intensive analysis being done now?  I suggest that nothing has changed.  Examples are in the many recommendations to buy oil stocks a few months ago before a subsequent additional 35% drop.  …Next, as Robbins points out, most actively managed mutual funds do not outperform the index they are trying to beat….

The principles in the book are easy to understand, digest and act on…. I have condensed them [his seven steps] and … restate as follows:

1. Commit to regular savings program
2. Know and understand why you are investing in
3. Develop a plan and, while at it, reduce spending, keep investment costs low and shed debt
4. Allocate your assets carefully and rebalance periodically
5. Create a lifetime income plan
6. Invest like the .001%, i.e. don’t be stupid and re-look at step 2
7. Be happy by growing and giving

All good advice you can start following today.

 

 

 

20
Oct

Market movements are often not based on fact.

Robert J. Shiller’s October 18th New York Times article, “When a Stock Market Theory Is Contagious” discusses the recent stock market fluctuation.  In addition to being a professor of economics at Yale University, he has authored many books, writes columns, co-created the “S&P/Case-Shiller Home Price Indices” and was 1 of 3 recipients of the 2013 Nobel Prize in Economic Sciences.

The topic of the  article ties into my comments about risk and volatility in my October newsletter.

“The problem is that short-term market movements are extremely hard to forecast.  But we live in the present and must try to understand what’s driving the market now, even if it’s much easier to predict their behavior in the long run.”  That is to say we do not know the future, but we can explain what happened in the past.

“…stock markets are driven by popular narratives, which don’t need basis in solid fact.”  The article compares the narratives with the “Ebola virus: they spread by contagion.”  The narratives causes investors “…to take action that propels prices…in the same direction.”  That is, we do not know why the market fell but people and companies may respond by cutting spending resulting in the market falling further.

Recent stories attribute the current drop in the stock market to a “global slowdown”.  The narrative can cause people and companies to spend less continuing the fall in the stock market.   He concludes with the following. “The question may be whether the virus mutates into a more psychologically powerful version, one with enough narrative force to create a major bear market.”

 

 

 

5
Sep

Financial markets fluctuate

Discussions in articles, books, studies and commentaries from different sources have some common elements about investing.  Investing is discussed in different contexts.  Examples of the different discussions include: performance, risk, retirement, budgeting, goals and government policies.

An example is an August 15th New York Times article:”Fears of Renewed Instability as Fed Ends Stimulus”.  The article reflects a conversation with Jeremy Stein, who left the Fed’s Board of Governors at the end of May to return to Harvard’s economics department.

Many investors are getting nervous because of the length of good stock and bond performance.  Recent fluctuations are a reminder that markets go down as well as up.  Maybe the recent gyrations are signs of impending instability.

Referring to the Federal Reserve (Fed) actions the article discusses the possible unintended consequences of the Fed policies that have guided us through the recent financial crisis.  The low rates have resulted in investors reaching for yield.  The consequence of reaching for higher yield is increased risk.  Some investors may not realize the increased chance of losses.  The result could be further strain on our economy.

The author of the article, James B. Stewart, included the following:

The Princeton economist Markus K. Brunnermeier, an expert on asset bubbles and crashes, has identified what he calls “synchronization risk,” a phenomenon in which investors ride a wave of price increases even if they realize the assets are overpriced.  “It’s what economists call a lack of common knowledge,” he said.  “We may all know an asset price is too high, but we don’t know the others know it, too.  Timing is everything.  The danger is if you move too early and the market doesn’t follow up.  So everyone waits on the sidelines watching and listening,”  as long as asset prices keep rising.  The danger comes when they all try to get out at the same time.”

“No one wants another crash, but a garden-variety correction may be just what’s needed to avoid one in the future.”

The discussion recognizes that the market fluctuates.  Frequent and/or large fluctuations indicate concern about the future direction of the markets.  No one thinks they know what direction the market will go when it fluctuates.  Investors are cautious when the market gyrate.  They become optimistic when the market continues to rally.  This is when investors become confident and make mistakes.

Economists, journalists, regulators and politicians are all poor forecasters of the future movement of the markets.

 

16
Jul

Reaching Your Goals

Gregory Karp, in his “Spending Smart” column “Money maxims: What dads can tell grads”, June 1, 2014 Chicago Tribune is the incentive for this blog.
Money can be saved or spent. How you handle money will have a significant impact on happiness and future financial well being. Studies relating to finances have increased in the last 15 years. Each year there seem to be more studies. Studies on happiness conclude that people are happier when they spend money on experiences rather than things. Other studies find that most people’s happiness increase as their income increases, up to about $70,000. Studies about retirement have found that the most important thing that anyone can do to reach their retirement living expenses is to save.
Saving is hard to do. Spending must be limited to available income. For most people, living within their income does not mean complete denial. It does require selectivity in the timing and amount of splurges.

Good daily spending habits are important. We have more control over daily spending habits than large items. Minimizing unnecessary and/or unwise expenditures will reduce many items that reduce the amount that can be saved on a regular basis. Most people give larger expenditures, such as homes and cars, significant thought and deliberation. They should also do the same for daily expenditures.

There are also studies that show that we should imagine ourselves in retirement. Aging Booth is an app that will show what you might look like when you age. You may have more incentive to save for that person. Contributing to a 401(k) plans and capturing any employer match may seem more important. Having part of your pay direct deposited to an investment account may also seem like a good way to be kind to the older you.
Necessities and a reserve fund come first. The reserve fund provides a cushion for the frequent unexpected expenditures. Preretirement six months of living expenses is generally recommended. After retirement, a minimum of living expenses after reoccurring income (like social security) for a year is recommended.

The sooner a saving program is started the less required on a periodic basis. To determine how much to save, you need to set financial goals. Your progress should be monitored, at least monthly; more frequently is better. Without knowing the future, your circumstance will change from what you originally projected.

3
Jul

“Studies show how to be a better consumer”

Gregory Karp’s article in the June 30th Chicago Tribune discusses some of the many studies about consumer behavior.

“There’s a whole area of academic study about consumer behavior that examines not what we buy, but why.”  Most of us can learn how to make better decision from some of these studies.  He discusses how some of our actions impact our choices.

“…participating in online social networks can raise your self-esteem. “ Heightened feelings of self-worth “…can lead to impulsive and indulgent behavior, poor traits.”    “…greater social network use was associated with a higher body mass index, increased binge eating, lower credit scores and higher levels of credit card debt…”   “The self-esteem and self-control effects did not seem to affect those with weak ties to their network.

“…for people trying to spend less and save more” they should consolidated their accounts rather than have multiple accounts for different purposes.  Some examples of multiple accounts include: vacation, new car, special celebrations and vacation homes.  “Individuals will save more and spend less when they have a single account. “  “Multiple accounts create vagueness about how much money you really have, making it easier to justify expenditures you shouldn’t make.…”  Mr Karp suggests that if you must use multiple accounts, use financial software.  This will provide a consolidated view of all your accounts.

“Physical acts of completion can provide consumers with a sense of closure that makes them happier with their purchases…”  “That’s as opposed to revisiting the decision and continually reassessing the options.”  “Consumers are less likely to be satisfied with a purchase when they compare it to other options.”  “Physical acts of closure enable consumers to perceive a difficult decision as complete and limit their tendency to compare their selection with the options they have rejected.”

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