Many aspects of life require careful consideration and balancing of the tradeoffs that arise from competing demands. For example, a common lifestyle tradeoff is working longer hours versus spending more time with your family. The competing demands within this decision are the income necessary to provide a suitable quality of life for your family versus the immeasurable benefits of quality time with your family. There is no right answer, but most people understand the tradeoff and attempt to find the balance that is right for them.
Successful investing and financial planning also require balancing tradeoffs. For example, a common investment tradeoff is that of risk and return. One of the competing demands is preservation of capital versus preservation of purchasing power. The former may allow for a better night's sleep during periods of heightened uncertainty and corresponding volatility, but the latter helps ensure you'll have a comfortable bed in the future when accounting for rising prices from inflation. Once again, there is no right answer, no "optimal" solution. Understanding the tradeoffs between preserving capital and preserving purchasing power will help investors find the balance that is right for them. This balance will depend on their definition of risk and attitude towards it.
Some investors may consider risk to be volatility. They have difficulty stomaching the daily ups and downs associated with investing in asset classes that experience significant price fluctuations, such as equities, because declining prices are often accompanied by predominantly negative headlines. Although information will be reflected in prices before one can react to it, this is little solace to investors who extrapolate the recent past into the future and see the bad news as an indicator of what's to come rather than a commentary on what has already happened. These investors yearn for short-term preservation of capital.
Other investors may define risk as a diminishing standard of living. They have long-term financial obligations, such as spending during their retirement years, and their primary goal is building wealth to meet those future expenses. They recognize that, while the cumulative effects of inflation are sometimes glacially slow or even undetectable in real time, inflation can be the silent killer of a financial plan. These investors desire long-term preservation of purchasing power.
Investing is relatively straightforward when the definition of risk and attitude toward it are so black and white. For example, you can virtually guarantee the preservation of capital by investing in the equivalent of Treasury bills as long as you accept the corresponding potential for the loss of purchasing power. On the other hand, you can preserve purchasing power by investing in asset classes with expected returns exceeding inflation, providing you accept price fluctuations that can temporarily impair your capital.
Unfortunately, in practice, investing isn't that simple. Individual investors rarely have black and white objectives or well-defined definitions of and attitudes towards risk. Some expect long-term preservation of purchasing power and short-term preservation of capital. Making matters worse is the tendency for the priority and relative importance of their competing demands to change through time, often in response to what's happened in the recent past.
Investors who succumb to the cycle of fear and greed end up chasing a moving target. Advisors can try to mitigate this destructive behavior by focusing investors on the tradeoffs that were made at the outset when determining their balance between assets that are expected to grow faster than inflation and those that stabilize the portfolio and reduce its fluctuations. So if an investor is now fearful and therefore more focused on capital preservation, it is time to reframe the tradeoffs by emphasizing why growth assets were in the portfolio to begin with and how the so-called "riskless" asset (i.e., bills) can actually be extremely risky in the long run.
For example, Table 1 contains annualized returns from Australia, Canada, the US, and the UK for more than a century. Bills only slightly beat inflation before tax, but this small return advantage can easily disappear on an after-tax basis.1 Nonetheless, the table clearly demonstrates that equities have delivered returns exceeding both bills and inflation by a wide margin, even when accounting for taxes.2
Table 1: Annualized Nominal Returns (1900–2010)
Country Inflation Bills Equities
Australia 3.9% 4.6% 11.6%
Canada 3.0% 4.7% 9.1%
US 3.0% 3.9% 9.4%
UK 3.9% 5.0% 9.5%
In local currency. Dimson Marsh Staunton (DMS) Global Returns Database. Past performance is no guarantee of future results.
However, the tradeoff for pursuing higher expected returns of equities is accepting the risk of substantial declines compared to the relative stability of bills. Table 2 shows that equity values in the four markets have dropped from 50–69% over a two- to six-year period, whereas bills have always been flat or better (if you consider minus 2 basis points a rounding error).
Table 2: Worst Performing Periods for Equities and Bills, Nominal Returns (1900–2010)
Equities Bills
Country Period Total Return Period Total Return
Australia 1970–1974 –50% 1950 0.75%
Canada 929–1934 –64% 1945 0.37%
US 1929–1932 –69% 1938 –0.02%
UK 1973–1974 –61% 1935 0.50%
In local currency. Dimson Marsh Staunton (DMS) Global Returns Database. Past performance is no guarantee of future results.
The risk and return relationship from a preservation of capital perspective is apparent in these nominal returns, but the picture is a bit different after considering the impact of inflation. In terms of preserving purchasing power, now the "riskless" asset looks far from risk free.
Table 3 contains the biggest peak-to-trough declines, in real terms, for equities in these four countries over the same time period. It likely comes as no surprise that the magnitude of the real declines is substantial, with stock prices dropping anywhere from 55–71% after inflation. However, the duration of the declines is still relatively short, ranging from two to five years, and it took equity investors in these countries anywhere from three to eleven years to break even.
Table 3: Worst Performing Periods for Equities, Real Returns (1900–2010)
Peak to Trough Decline Subsequent
Recovery
Country Period Total Return Years Years
Australia 1970–1974 –66% 5 11
Canada 1929–1932 –55% 4 3
US 1929–1931 –60% 4 4
UK 1973–1974 –71% 2 9
In local currency. Dimson Marsh Staunton (DMS) Global Returns Database. Past performance is no guarantee of future results.
In contrast, the data in Table 4 for bills, or the "riskless" asset, in these four countries is revealing. The biggest peak-to-trough declines after inflation now remarkably range from 44–61%, a similar order of magnitude to equities. Furthermore, the duration of the declines extends to a range of seven to forty-one years with investors in bills waiting an astounding seven to forty-eight years to recover!
Table 4: Worst Performing Periods for Bills, Real Returns (1900–2010)
Peak to Trough Decline Subsequent Recovery
Country Period Total Return Years Years
Australia 1937–1977 –61% 41 21
Canada 1934–1951 –44% 18 34
US 1933–1951 –47% 19 48
UK 1914–1920 –50% 7 7
In local currency. Dimson Marsh Staunton (DMS) Global Returns Database. Past performance is no guarantee of future results.
More than ever, comparisons like these are needed when discussing the tradeoff of preserving capital versus preserving purchasing power. Investors feel the risk of equities in real time. Volatility is immediate and apparent as their portfolio value shows up in the mail every month or on their computer screen every day. Conversely, the risk of investing in bills and other low-volatility assets is less discernible and may take time to detect as it shows up when investors open their wallet at the grocery store or gas station many years later.
Investors may still want to revisit the tradeoffs they made and alter course if appropriate. However, changes to a long-term plan should reflect an informed decision rather than an emotional one. Fear and greed are powerful forces, but we should resist letting them dictate the tradeoffs we make in our lives or in our portfolios.
As the Most Interesting Man in the World would say, "stay invested, my friends!"
Many thanks to Marlena Lee for compiling this data from the Dimson Marsh Staunton (DMS) Global Returns Database and Brad Steiman , Northern Exposure Director and Head of Canadian Financial Advisor Services and Vice President
________________________________________
1. Returns in this table are pre-tax, but actual consumption, as represented by inflation, requires after-tax dollars; therefore, if the marginal tax rate on interest income exceeds [1 – (Inflation/Bill Return)], the real return is negative. (e.g., Canada: [1 – (3.0/4.7)] = 36% but the highest marginal tax rate on income is roughly 45%.)
2. The difference in the real return of equities versus bills would increase after taxes in countries where the tax rate on income exceeds the tax rate on dividends and capital gains.
Friday, May 25, 2012
Thursday, October 20, 2011
Living with Volatility - Third Quarter 2011
The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.
At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets. It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.
As for what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.
Markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor's of the US government's credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.
Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the long-term investors.
Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive months of gains. A little over a year after the low, gains had totaled almost 80%. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.
Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. For example, the IMF noted in its April 2011 World Economic Outlook that while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving. A globally diversified portfolio takes account of these shifts.
Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.
The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.
Adapted from “Living with Volatility” by Jim Parker, Outside the Flags column on Dimensional’s website, August 9, 2011. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.
At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets. It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.
As for what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.
Markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor's of the US government's credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.
Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the long-term investors.
Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive months of gains. A little over a year after the low, gains had totaled almost 80%. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.
Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. For example, the IMF noted in its April 2011 World Economic Outlook that while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving. A globally diversified portfolio takes account of these shifts.
Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.
The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.
Adapted from “Living with Volatility” by Jim Parker, Outside the Flags column on Dimensional’s website, August 9, 2011. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.
Wednesday, July 27, 2011
The Debt Ceiling and the Road Ahead
After all the debate in recent weeks over issues related to raising the nation's debt limit, it's hard to know exactly what might happen after August 2. Borrowing represents more than 40% of the nation's expenses, and any default on the country's obligations would be unprecedented.
As a rule, panic generally doesn't help you make wise financial decisions. That's why now might be a good time to review your portfolio to see if you have more exposure to a particular asset class than you'd prefer, regardless of what happens in Washington. And as the situation evolves, here are some mileposts that bear watching:
Auctions of Treasury securitiesThe yield on the 10-year Treasury note can serve as a barometer of anxiety levels; the higher the yield goes, the more bond prices will fall, indicating increasing anxiety in the bond markets.
Regardless of whether the debt ceiling stays the same, several significant auctions of Treasury securities are scheduled shortly after the August 2 deadline. Bids for 3- and 10-year notes and 30-year bonds will begin on August 3, and auctions will take place August 9-11. More importantly, the nonprofit Bipartisan Policy Center (BPC) estimates that payment of roughly $90 billion on maturing Treasury securities is due on August 4.
The difficulty in producing an agreement to raise the limit has led two major credit rating agencies to announce they are officially reviewing the United States' historically impeccable credit rating. Even if the Treasury attempts to avoid defaulting on Treasury securities by prioritizing payment of its obligations, the rating agencies have warned that any such move would likely trigger a downgrade, especially if no consensus has been reached on how to tackle the deficit.
A lowered credit rating would mean the United States would have to pay more to borrow in the future, making the national debt problem even worse in the long term. That's because the greater uncertainty about the country's willingness and ability to pay its bills would likely lead both domestic and foreign investors to demand greater compensation for buying Treasuries.
Bonds and non-Treasury borrowingHigher interest rates for Treasury bonds might also result in higher interest rates on other, nongovernmental loans such as mortgages and consumer credit. Since many interest rates are based on Treasury rates, rates generally would likely be affected. And since bond prices fall when rates rise, you should keep an eye on your bond portfolio.
One indicator of investors' assessment of the risks of Treasury bonds compared to other debt is what's known as the Baa/Treasury spread, which measures the difference between the yields of corporate bonds rated Baa and 10-year Treasuries. Normally, investors demand a higher yield for corporates because of their greater risk of default. The narrower the gap between the two, the less risky investors feel corporate bonds are compared to Treasuries.
Higher rates also could mean reduced credit availability. Some observers worry that tighter credit on top of a weak housing market could hamper economic recovery. And even if there were technically no default, the mere absence of an agreement that addresses the issue before August 2 would likely raise the global anxiety level substantially.
EquitiesThe stock market hates uncertainty, and the greater the uncertainty, the greater the potential impact on stocks. If investors become concerned about the availability of credit, they could punish companies that rely heavily on it. Fortunately, in the wake of the 2008 financial crisis, many companies took advantage of low interest rates to issue new bonds and/or refinance older debt. Also, many companies, fearing a sequel to 2008, have been sitting on a larger amount of cash than usual, which could help cushion the impact of tighter credit.
Markets also will be assessing the impact of either severe budgetary cutbacks or prioritization of existing government bills on the already fragile economy as a whole. If either seems to pose a serious threat to consumer spending, equities could feel the fallout.
Payment of government benefits, contracts, and departmentsAccording to the BPC, the country will have roughly $172.4 billion coming in during the rest of August to pay $306.7 billion of scheduled expenditures. Without an increase in the borrowing limit, the Treasury will have to rely on those revenues and prioritize which of its existing bills to pay. Here are some of the major payments scheduled for shortly after the Treasury's August 2 deadline:
Social Security payments for beneficiaries who began receiving benefits before May 1997 or who receive both benefits and Supplemental Security Income (SSI) are scheduled for August 3. Benefits for recipients with birth dates between August 1-10 are scheduled for the following Wednesday, August 10. Those with birth dates between the 11th and the 20th are scheduled for August 17, and August 24 is the date for birthdays between the 21st and the 31st.
For military service members, August 15 is the date for the scheduled mid-month installment of active duty pay, with the associated "advice of pay" notice set for August 5. And as previously noted, an estimated $90 billion in Treasury debt payments are due August 4.
Medicare, Medicaid, Social Security benefits, defense vendor payments, interest on Treasury securities, and unemployment insurance represent some of the federal government's largest costs for the month. The BPC estimates that covering those costs completely would leave no funds for such obligations as the Departments of Education, Labor, Justice, and Energy; federal salaries and benefits; military active duty pay and veterans' affairs; the Federal Transit Administration, Federal Highway Administration, Small Business Administration, and the Environmental Protection Agency; Housing and Urban Development and federal food and nutrition services; and IRS refunds.
The outlook for an agreementPlans have been put forward to tie increases in the debt ceiling to a balanced budget constitutional amendment, to specific spending cuts, and to a combination of spending cuts and revenue increases. There also has been talk of a fail-safe plan that would give the president authority to increase the debt ceiling in stages before the 2012 election; Congress would be able to vote against those increases but would not be able to effectively prevent them.
One proposal that seems to have a chance of winning at least some bipartisan support is based on months of negotiations by the "Gang of Six" senators from both parties. The proposal is designed to cut an estimated $3.7 trillion from the deficit over 10 years through such measures as shrinking the current six tax brackets to three, eliminating the alternative minimum tax, revising how Social Security cost-of-living increases are calculated, and reducing tax deductions for such items as mortgage interest, charitable donations, and retirement savings.
All parties have agreed it's important not to jeopardize the country's financial health. As the road to a resolution unwinds, it can be helpful to keep calm and monitor the situation.
All investing involves risk, including the risk of loss of principal, and there can be no guarantee that any investment strategy will be successful.
As a rule, panic generally doesn't help you make wise financial decisions. That's why now might be a good time to review your portfolio to see if you have more exposure to a particular asset class than you'd prefer, regardless of what happens in Washington. And as the situation evolves, here are some mileposts that bear watching:
Auctions of Treasury securitiesThe yield on the 10-year Treasury note can serve as a barometer of anxiety levels; the higher the yield goes, the more bond prices will fall, indicating increasing anxiety in the bond markets.
Regardless of whether the debt ceiling stays the same, several significant auctions of Treasury securities are scheduled shortly after the August 2 deadline. Bids for 3- and 10-year notes and 30-year bonds will begin on August 3, and auctions will take place August 9-11. More importantly, the nonprofit Bipartisan Policy Center (BPC) estimates that payment of roughly $90 billion on maturing Treasury securities is due on August 4.
The difficulty in producing an agreement to raise the limit has led two major credit rating agencies to announce they are officially reviewing the United States' historically impeccable credit rating. Even if the Treasury attempts to avoid defaulting on Treasury securities by prioritizing payment of its obligations, the rating agencies have warned that any such move would likely trigger a downgrade, especially if no consensus has been reached on how to tackle the deficit.
A lowered credit rating would mean the United States would have to pay more to borrow in the future, making the national debt problem even worse in the long term. That's because the greater uncertainty about the country's willingness and ability to pay its bills would likely lead both domestic and foreign investors to demand greater compensation for buying Treasuries.
Bonds and non-Treasury borrowingHigher interest rates for Treasury bonds might also result in higher interest rates on other, nongovernmental loans such as mortgages and consumer credit. Since many interest rates are based on Treasury rates, rates generally would likely be affected. And since bond prices fall when rates rise, you should keep an eye on your bond portfolio.
One indicator of investors' assessment of the risks of Treasury bonds compared to other debt is what's known as the Baa/Treasury spread, which measures the difference between the yields of corporate bonds rated Baa and 10-year Treasuries. Normally, investors demand a higher yield for corporates because of their greater risk of default. The narrower the gap between the two, the less risky investors feel corporate bonds are compared to Treasuries.
Higher rates also could mean reduced credit availability. Some observers worry that tighter credit on top of a weak housing market could hamper economic recovery. And even if there were technically no default, the mere absence of an agreement that addresses the issue before August 2 would likely raise the global anxiety level substantially.
EquitiesThe stock market hates uncertainty, and the greater the uncertainty, the greater the potential impact on stocks. If investors become concerned about the availability of credit, they could punish companies that rely heavily on it. Fortunately, in the wake of the 2008 financial crisis, many companies took advantage of low interest rates to issue new bonds and/or refinance older debt. Also, many companies, fearing a sequel to 2008, have been sitting on a larger amount of cash than usual, which could help cushion the impact of tighter credit.
Markets also will be assessing the impact of either severe budgetary cutbacks or prioritization of existing government bills on the already fragile economy as a whole. If either seems to pose a serious threat to consumer spending, equities could feel the fallout.
Payment of government benefits, contracts, and departmentsAccording to the BPC, the country will have roughly $172.4 billion coming in during the rest of August to pay $306.7 billion of scheduled expenditures. Without an increase in the borrowing limit, the Treasury will have to rely on those revenues and prioritize which of its existing bills to pay. Here are some of the major payments scheduled for shortly after the Treasury's August 2 deadline:
Social Security payments for beneficiaries who began receiving benefits before May 1997 or who receive both benefits and Supplemental Security Income (SSI) are scheduled for August 3. Benefits for recipients with birth dates between August 1-10 are scheduled for the following Wednesday, August 10. Those with birth dates between the 11th and the 20th are scheduled for August 17, and August 24 is the date for birthdays between the 21st and the 31st.
For military service members, August 15 is the date for the scheduled mid-month installment of active duty pay, with the associated "advice of pay" notice set for August 5. And as previously noted, an estimated $90 billion in Treasury debt payments are due August 4.
Medicare, Medicaid, Social Security benefits, defense vendor payments, interest on Treasury securities, and unemployment insurance represent some of the federal government's largest costs for the month. The BPC estimates that covering those costs completely would leave no funds for such obligations as the Departments of Education, Labor, Justice, and Energy; federal salaries and benefits; military active duty pay and veterans' affairs; the Federal Transit Administration, Federal Highway Administration, Small Business Administration, and the Environmental Protection Agency; Housing and Urban Development and federal food and nutrition services; and IRS refunds.
The outlook for an agreementPlans have been put forward to tie increases in the debt ceiling to a balanced budget constitutional amendment, to specific spending cuts, and to a combination of spending cuts and revenue increases. There also has been talk of a fail-safe plan that would give the president authority to increase the debt ceiling in stages before the 2012 election; Congress would be able to vote against those increases but would not be able to effectively prevent them.
One proposal that seems to have a chance of winning at least some bipartisan support is based on months of negotiations by the "Gang of Six" senators from both parties. The proposal is designed to cut an estimated $3.7 trillion from the deficit over 10 years through such measures as shrinking the current six tax brackets to three, eliminating the alternative minimum tax, revising how Social Security cost-of-living increases are calculated, and reducing tax deductions for such items as mortgage interest, charitable donations, and retirement savings.
All parties have agreed it's important not to jeopardize the country's financial health. As the road to a resolution unwinds, it can be helpful to keep calm and monitor the situation.
All investing involves risk, including the risk of loss of principal, and there can be no guarantee that any investment strategy will be successful.
Wednesday, July 13, 2011
Discipline: Your Secret Weapon
Working with markets, understanding risk and return, diversifying and portfolio structure—we've heard the lessons of sound investing over and over. But so often the most important factor between success and failure is ourselves.
The recent rocky period in financial markets has brought to the surface some familiar emotions for many, including a strong urge to try to time the market. The temptation, as always, is to sell into falling markets and buy into rising ones.
What's more, the most seemingly "well-informed" people—the kind who religiously read the financial press and watch business television—are the ones who feel most compelled to try and finesse their exit and entry points.
This suspicion that "sophisticated" investors are the most prone to try and outwit the market was given validity recently by a study, carried out by London-based Ledbury Research, of more than 2,000 affluent people around the world.(1)
The survey found 40 per cent of those questioned admitted to practising market timing rather than pursuing a buy-and-hold strategy. Yet the market timers were more than three times more likely to believe they traded too much.
"On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves," the authors said. "But that seems not to be the case—trading becomes addictive."
This perspective has been reinforced recently by one of the world's most respected policymakers and astute observers of markets—Ian Macfarlane, the former governor of the Reserve Bank of Australia and now a director of ANZ Banking Group.
In a speech in Sydney(2), Macfarlane made the point that the worst investors tend to be those who follow markets and the financial media fanatically, extrapolating from short-term movements big picture narratives that fit their predispositions.
"Most people experience loss aversion," he said. "They experience more unhappiness from losing $100 than they gain in happiness from acquiring $100. So the more often they are made aware of a loss, the unhappier they become."
Because of this combination of hyper-activity, lack of self-control and loss-aversion, investors end up making bad investment decisions, Macfarlane noted.
These behavioural issues and how they impact on investors are well documented by financial theorists. Commonly cited traits include lack of diversification, excessive trading, an obstinate reluctance to sell losers and buying on past performance.(3)
Mostly, these traits stem from over-confidence. Just as we all tend to think we are above-average in terms of driving ability, we also tend to over-rate our capacity for beating the market. What's more, this ego-driven behaviour has been shown to be more prevalent in men than in women.
A study quoted in The Wall Street Journal(4) showed women are less afflicted than men by over-confidence and are more likely to attribute success in investment to factors outside themselves – like luck or fate. As a result, they are more inclined to exercise self-discipline and to avoid trying to time the market.
The virtues of investment discipline and the folly of 'alpha'-chasing are highlighted year after year in the survey of investor behaviour by research group Dalbar. The latest edition showed in the 20 years to the end of December 2010, the average US stock investor received annualised returns of just 3.8 per cent, well below the 9.1 per cent delivered by the market index, the S&P 500.(5)
What often stops investors getting returns that are there for the taking are their very own actions—lack of diversification, compulsive trading, buying high, selling low, going by hunches and responding to media and market noise.
So how do we get our egos and emotions out of the investment process? One answer is to distance ourselves from the daily noise by appointing a financial advisor to help stop us doing things against our own long-term interests.
An advisor begins with the understanding that there are things we can't control (like the ups and downs in the markets) and things we can. Some of the things we can control including ensuring our investments are properly diversified—both within and across asset classes—ensuring our portfolios are regularly rebalanced to meet our long-term requirements, keeping costs to a minimum and being mindful of taxes.
Most of all, an advisor helps us all by encouraging the exercise of discipline—the secret weapon in building long-term wealth.
1. 'Risk and Rules: The Role of Control in Financial Decision Making', Barclays Wealth, June 2011
2. 'Far Too Much Economic News for Our Own Good', Ross Gittins, Sydney Morning Herald, June 13, 2011
3. Barberis, Nicholas and Thaler, Richard, 'A Survey of Behavioral Finance', University of Chicago
4. 'For Mother's Day, Give Her the Reins to the Portfolio', Wall Street Journal, May 9, 2009
5. '2011 QAIB', Dalbar Inc, March 2011
The recent rocky period in financial markets has brought to the surface some familiar emotions for many, including a strong urge to try to time the market. The temptation, as always, is to sell into falling markets and buy into rising ones.
What's more, the most seemingly "well-informed" people—the kind who religiously read the financial press and watch business television—are the ones who feel most compelled to try and finesse their exit and entry points.
This suspicion that "sophisticated" investors are the most prone to try and outwit the market was given validity recently by a study, carried out by London-based Ledbury Research, of more than 2,000 affluent people around the world.(1)
The survey found 40 per cent of those questioned admitted to practising market timing rather than pursuing a buy-and-hold strategy. Yet the market timers were more than three times more likely to believe they traded too much.
"On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves," the authors said. "But that seems not to be the case—trading becomes addictive."
This perspective has been reinforced recently by one of the world's most respected policymakers and astute observers of markets—Ian Macfarlane, the former governor of the Reserve Bank of Australia and now a director of ANZ Banking Group.
In a speech in Sydney(2), Macfarlane made the point that the worst investors tend to be those who follow markets and the financial media fanatically, extrapolating from short-term movements big picture narratives that fit their predispositions.
"Most people experience loss aversion," he said. "They experience more unhappiness from losing $100 than they gain in happiness from acquiring $100. So the more often they are made aware of a loss, the unhappier they become."
Because of this combination of hyper-activity, lack of self-control and loss-aversion, investors end up making bad investment decisions, Macfarlane noted.
These behavioural issues and how they impact on investors are well documented by financial theorists. Commonly cited traits include lack of diversification, excessive trading, an obstinate reluctance to sell losers and buying on past performance.(3)
Mostly, these traits stem from over-confidence. Just as we all tend to think we are above-average in terms of driving ability, we also tend to over-rate our capacity for beating the market. What's more, this ego-driven behaviour has been shown to be more prevalent in men than in women.
A study quoted in The Wall Street Journal(4) showed women are less afflicted than men by over-confidence and are more likely to attribute success in investment to factors outside themselves – like luck or fate. As a result, they are more inclined to exercise self-discipline and to avoid trying to time the market.
The virtues of investment discipline and the folly of 'alpha'-chasing are highlighted year after year in the survey of investor behaviour by research group Dalbar. The latest edition showed in the 20 years to the end of December 2010, the average US stock investor received annualised returns of just 3.8 per cent, well below the 9.1 per cent delivered by the market index, the S&P 500.(5)
What often stops investors getting returns that are there for the taking are their very own actions—lack of diversification, compulsive trading, buying high, selling low, going by hunches and responding to media and market noise.
So how do we get our egos and emotions out of the investment process? One answer is to distance ourselves from the daily noise by appointing a financial advisor to help stop us doing things against our own long-term interests.
An advisor begins with the understanding that there are things we can't control (like the ups and downs in the markets) and things we can. Some of the things we can control including ensuring our investments are properly diversified—both within and across asset classes—ensuring our portfolios are regularly rebalanced to meet our long-term requirements, keeping costs to a minimum and being mindful of taxes.
Most of all, an advisor helps us all by encouraging the exercise of discipline—the secret weapon in building long-term wealth.
1. 'Risk and Rules: The Role of Control in Financial Decision Making', Barclays Wealth, June 2011
2. 'Far Too Much Economic News for Our Own Good', Ross Gittins, Sydney Morning Herald, June 13, 2011
3. Barberis, Nicholas and Thaler, Richard, 'A Survey of Behavioral Finance', University of Chicago
4. 'For Mother's Day, Give Her the Reins to the Portfolio', Wall Street Journal, May 9, 2009
5. '2011 QAIB', Dalbar Inc, March 2011
Wednesday, July 6, 2011
Stars or Straws?
Investors frequently seek external validation to ease the anxiety of putting their money at risk. Problem is there is no guarantee that a "five-star" rating on a chosen fund will lead to a "five-star" investment experience.
It is human nature for consumers to seek comfort in the idea that the products they are buying are proven in the marketplace. That need is met by ratings agencies that play a legitimate and vital role in providing independent assessments of various investment products.
Those assessments are made in professionally compiled and detailed reports that can be a useful yardstick for investors and their advisors in comparing funds so that they can make a fully informed decision.
But despite diligent cautions from the agencies about chasing returns, problems arise when consumers blindly extrapolate star rating systems for various funds into imagined future performance.
The risks of this approach were highlighted in a survey by US private wealth management business Burns Advisory Group, which went back to 1999 to study the subsequent 10-year performance of Morningstar's five-star funds.(1)
Burns found that of the 248 funds rated five-star by Morningstar on December 31, 1999, only four were still receiving that rating a decade later. Of the original sample, 87 had ceased to exist. Of those still existing, all had been downgraded to an average of just under three stars. Even worse, in all categories except international stocks, the average performance for five-star funds over this 10-year period was worse than the average for all funds.
"These findings imply the star ranking methodology leaves long-term investors in the lurch," Burns concluded. "If nothing else, it demonstrates clearly why investors should not rely on one measure as their sole research tool."
But it is not just unsophisticated investors that are chasing performance. Another recent report suggests that even wealthy individuals and institutional investors can be blind-sided by past returns.
The study by researchers at the European School of Management and Technology, quoted in The Economist magazine, looked at how investors allocated money to hedge funds over 10 years from 1994.(2)
The researchers found that the funds that had performed well in the previous three quarters attracted significantly more money than their competitors. In other words, the supposedly "smart money" was chasing past returns.
Bear in mind, also, that indiscriminately chasing returns can be even more costly with hedge funds, which typically charge management fees of 2% or more, plus 20% of the returns they generate for clients.
Given the large body of academic evidence that it is extremely difficult to predict market returns with any confidence, it should be evident that past returns should not be the foundation for choosing one fund over another.
Leading academics Gene Fama and Ken French, in a recent study of mutual fund performance, showed how hard it is for investors to distinguish skill from pure chance in analysing the returns of individual funds.(3)
So what should an investor and his or her advisor weigh up in making a decision? The key here is to focus on items within their control, such as:
•Are the risks being taken related to return?
•Are those risks targeted in a reliable, consistent way?
•How diversified is the fund?
•Does it make promises it can't keep?
•What is more important - individual judgement or clear processes?
•Are the underlying strategies driven by forecasts?
•Does the fund take account of costs and taxes in its decisions?
•Does the fund manager communicate in a clear and consistent way?
While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. Anyone who makes those sorts of promises risks disillusioning those who put their faith in them.
But the above characteristics can give investors comfort that their money is being invested in a consistent, transparent way and that ensures that when the targeted premiums kick in, they are positioned to receive them.
This is a grounded, completely defensible approach. The alternative is that by reaching for the stars, investors are left clutching at straws.
1. McGuigan, Tom and Courtenay, Tim, Star Gazing: Five Star Funds Revisited, Burns Advisory Group, April 2010
2. Buttonwood, Who's the Patsy?, The Economist, May 29, 2010
3. Fama, Eugene F., and Kenneth R. French. 2009. Luck Versus Skill in the Cross Section of Mutual Fund Returns, SSRN
It is human nature for consumers to seek comfort in the idea that the products they are buying are proven in the marketplace. That need is met by ratings agencies that play a legitimate and vital role in providing independent assessments of various investment products.
Those assessments are made in professionally compiled and detailed reports that can be a useful yardstick for investors and their advisors in comparing funds so that they can make a fully informed decision.
But despite diligent cautions from the agencies about chasing returns, problems arise when consumers blindly extrapolate star rating systems for various funds into imagined future performance.
The risks of this approach were highlighted in a survey by US private wealth management business Burns Advisory Group, which went back to 1999 to study the subsequent 10-year performance of Morningstar's five-star funds.(1)
Burns found that of the 248 funds rated five-star by Morningstar on December 31, 1999, only four were still receiving that rating a decade later. Of the original sample, 87 had ceased to exist. Of those still existing, all had been downgraded to an average of just under three stars. Even worse, in all categories except international stocks, the average performance for five-star funds over this 10-year period was worse than the average for all funds.
"These findings imply the star ranking methodology leaves long-term investors in the lurch," Burns concluded. "If nothing else, it demonstrates clearly why investors should not rely on one measure as their sole research tool."
But it is not just unsophisticated investors that are chasing performance. Another recent report suggests that even wealthy individuals and institutional investors can be blind-sided by past returns.
The study by researchers at the European School of Management and Technology, quoted in The Economist magazine, looked at how investors allocated money to hedge funds over 10 years from 1994.(2)
The researchers found that the funds that had performed well in the previous three quarters attracted significantly more money than their competitors. In other words, the supposedly "smart money" was chasing past returns.
Bear in mind, also, that indiscriminately chasing returns can be even more costly with hedge funds, which typically charge management fees of 2% or more, plus 20% of the returns they generate for clients.
Given the large body of academic evidence that it is extremely difficult to predict market returns with any confidence, it should be evident that past returns should not be the foundation for choosing one fund over another.
Leading academics Gene Fama and Ken French, in a recent study of mutual fund performance, showed how hard it is for investors to distinguish skill from pure chance in analysing the returns of individual funds.(3)
So what should an investor and his or her advisor weigh up in making a decision? The key here is to focus on items within their control, such as:
•Are the risks being taken related to return?
•Are those risks targeted in a reliable, consistent way?
•How diversified is the fund?
•Does it make promises it can't keep?
•What is more important - individual judgement or clear processes?
•Are the underlying strategies driven by forecasts?
•Does the fund take account of costs and taxes in its decisions?
•Does the fund manager communicate in a clear and consistent way?
While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. Anyone who makes those sorts of promises risks disillusioning those who put their faith in them.
But the above characteristics can give investors comfort that their money is being invested in a consistent, transparent way and that ensures that when the targeted premiums kick in, they are positioned to receive them.
This is a grounded, completely defensible approach. The alternative is that by reaching for the stars, investors are left clutching at straws.
1. McGuigan, Tom and Courtenay, Tim, Star Gazing: Five Star Funds Revisited, Burns Advisory Group, April 2010
2. Buttonwood, Who's the Patsy?, The Economist, May 29, 2010
3. Fama, Eugene F., and Kenneth R. French. 2009. Luck Versus Skill in the Cross Section of Mutual Fund Returns, SSRN
Thursday, April 21, 2011
Municipal Bond Worries
In 2010, prominent industry analysts warned of a looming fiscal crisis among state and local governments. Some experts even predicted widespread municipal bond defaults in the US.1 Investor fears intensified in late 2010 when the municipal bond market experienced one of its largest selloffs in decades, which drove down prices and raised yields.2 While factors unrelated to credit concerns may have contributed to the selloff, some investors were motivated by a perception of rising credit risk among municipal bond issues.3
So, is the municipal bond market at risk of massive default? No one knows—and we are not in the prediction business. But your view probably depends on your economic expectations and familiarity with the municipal bond market. With this in mind, consider these principles:
• The municipal bond market is large and diverse. The media often report on municipal bond problems as though the market is a single, uniform sector. In reality, the market comprises an estimated $3 trillion in debt, with over 50,000 state and local issuers and about two million outstanding issues. These bonds are rated across a broad spectrum of credit categories and have different characteristics and structures for paying their obligations. Such complexity does not afford simple observations about the market.
• Historical default rates are low. Muni bonds have a strong track record of repayment. One reason is that state and local governments are motivated to avoid default since failure to pay affects their ability to raise capital in the future. Another reason is that most issues repay investors from either project revenues or from a general fund backed by the taxing power of the issuer. Chart 1 shows bond default rates in the US from 1970 to 2008. There have been no defaults in the top-rated investment grade tier (Aaa/AAA). Most defaults are limited to the non-investment grade universe.
Chart 1: Bond Default Rates—Cumulative Percent (1970-2008)
• Most fiscal problems are concentrated in a few large states. An estimated 58% of the recent budget shortfalls have occurred in five states: Arizona, California, Illinois, New York, and Texas.4 However, operating budgets deal with short-term revenues and costs, while municipal bond debt represents long-term borrowing to fund infrastructure projects (e.g., roads, bridges, schools, water systems, and hospitals). Moreover, current levels of state and local government debt, as well as interest payments on that debt, remain well within the historical range.5 Of course, many states are also wrestling with unfunded pension liabilities that may ultimately impact their budgets, but these tend to be longer term obligations as well.
• Municipal bonds are assessed according to actual financials, not models or projections. Some reports have compared the municipal bond market to the subprime mortgage securities market prior to the financial crisis. The circumstances are different. For one, state and local issuers are subject to financial disclosure rules, and the information they provide affects the market prices and credit ratings of their bonds. Also, municipal bonds are not exotic instruments with complex structures that obscure the underlying credit rating and market value of the assets.6 While municipal bond reporting is not as timely or thorough as reporting on corporate debt, investors hold an instrument that is more transparent than the mortgage derivatives that helped spark the financial crisis.
• Current market conditions do not imply unusually high risk. The market incorporates information and expectations into prices, including perceived risk, as illustrated by rising bond yields during the financial crisis and in the recent municipal market selloff. However, since the start of the recession in November 2007, average yields for the AAA-, AA-, and BBB-rated municipal securities have fallen.7 Also, total market volume as measured by total number of trades has been generally flat over the last three-year period.8
Risk Management Issues
Investors should always consider ways to manage risk in their fixed income portfolios. Here are a few guiding principles:
• Hold shorter-term issues. This approach may help reduce volatility and credit risk while enhancing liquidity. Also, fixed income investors who hold investment grade bonds must also consider their exposure to changes in interest rates. Bond prices move in the opposite direction of interest rate changes—and the longer a bond’s maturity, the greater its price change.
• Stay broadly diversified. Holding many municipal bond issues and avoiding concentration in a particular state, sector, or issue type can help reduce the impact of a few non-performing bonds. If default rates were to rise, investors with a well-diversified municipal portfolio should be less exposed.
• Focus on quality and use market pricing to confirm credit ratings. The most creditworthy bonds are those rated AAA or AA, and most of the current problems involve lower-rated bonds. Although ratings are useful, recent history in the mortgage-backed securities market has shown that a bond may not be rated accurately. A bond that is rated AAA should trade in a similar price range to other bonds with similar characteristics and a comparable rating.
Portfolio Decisions
Investors can either hold a portfolio of individual municipal bonds or buy shares in a fund. Building a portfolio of individual bonds offers more direct control over maturity, face value, bond type, credit range, and other issue characteristics. This approach may be useful for matching future liabilities and pursuing other investment objectives. But achieving broad diversification with a custom portfolio may prove a challenge, and the portfolio may be illiquid and expensive to trade, and require more attention and oversight than is feasible for an individual.
Investors often favor professional fund management for many reasons, including those specific to the way the bond market operates. Since bonds are traded through a network of dealers and not a centralized exchange, price discovery may not be easy. Muni bonds also tend to be illiquid since only about 0.7% of the market is traded daily (i.e., only 14,000 out of 2 million issues). These market realities result in high transaction costs. In fact, research shows that municipal bond trades are significantly more expensive than equity trades of equal size.9
Professional managers should have better access to multiple dealers and have the capacity for large- volume trades, which renders a cost advantage over smaller investors. Funds also offer better liquidity and broader diversification across issue type, maturity, credit quality, and geography. A shareholder can access daily share price and know the average credit rating within the portfolio. Equally important, managers should monitor average yields at different maturities, qualities, and regions to gauge the relative riskiness of different issues.
On the downside, managed funds can lose value and shareholders do not control the selection of bonds in the portfolio.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Municipal securities are subject to the risks of adverse economic and regulatory changes in their issuing states.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
End Notes:
1. Shawn Tully, “Meredith Whitney’s New Target: The states,” CNNMoney.com, Sept. 28, 2010.
2. Dan Seymour, “Default Uneasiness Chases Investors from Muni Funds,” American Banker, Jan. 25, 2011.
3. Ben Levisohn, Jane J. Kim, and Eleanor Liaise, “Munis: What to Do Now,” The Wall Street Journal, Jan. 15, 2011.
Other factors that possibly contributed to the selling pressure are: (1) a major Treasury selloff in late 2010, (2) Standard & Poor’s downgrade of “tobacco bonds” to junk status, (3) expiration of the Build America Bonds program in 2010, and (4) extension of the Bush-era tax cuts.
4. Randall Forsyth, “The Sky Isn’t Falling on the Muni Market,” Barrons.com, January 7, 2011.
5. Iris J. Lav and Elizabeth McNichol, “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm,” Center on Budget and Policy Priorities, Jan. 20, 2011.
6. Agnes T. Crane, “States’ Troubles Are Not the Real Risk for Muni Bonds,” The New York Times, Jan. 30, 2011. Also see Randall W. Forsyth, “Man Bites Dog in the Muni Market,” Barrons.com, Feb. 1, 2011.
7. Bank of America Merrill Lynch 1-10 Years AAA-BBB US Municipal Bond Index.
8. Municipal Securities Rulemaking Board (MRSB) 2010 Fact Book.
9. Lawrence E. Harris and Michael S. Piwowar, “Secondary Trading Costs in the Municipal Bond Market,” Journal of Finance, June 2006, Volume 61, Issue 3, pp 1361-1397.
So, is the municipal bond market at risk of massive default? No one knows—and we are not in the prediction business. But your view probably depends on your economic expectations and familiarity with the municipal bond market. With this in mind, consider these principles:
• The municipal bond market is large and diverse. The media often report on municipal bond problems as though the market is a single, uniform sector. In reality, the market comprises an estimated $3 trillion in debt, with over 50,000 state and local issuers and about two million outstanding issues. These bonds are rated across a broad spectrum of credit categories and have different characteristics and structures for paying their obligations. Such complexity does not afford simple observations about the market.
• Historical default rates are low. Muni bonds have a strong track record of repayment. One reason is that state and local governments are motivated to avoid default since failure to pay affects their ability to raise capital in the future. Another reason is that most issues repay investors from either project revenues or from a general fund backed by the taxing power of the issuer. Chart 1 shows bond default rates in the US from 1970 to 2008. There have been no defaults in the top-rated investment grade tier (Aaa/AAA). Most defaults are limited to the non-investment grade universe.
Chart 1: Bond Default Rates—Cumulative Percent (1970-2008)
• Most fiscal problems are concentrated in a few large states. An estimated 58% of the recent budget shortfalls have occurred in five states: Arizona, California, Illinois, New York, and Texas.4 However, operating budgets deal with short-term revenues and costs, while municipal bond debt represents long-term borrowing to fund infrastructure projects (e.g., roads, bridges, schools, water systems, and hospitals). Moreover, current levels of state and local government debt, as well as interest payments on that debt, remain well within the historical range.5 Of course, many states are also wrestling with unfunded pension liabilities that may ultimately impact their budgets, but these tend to be longer term obligations as well.
• Municipal bonds are assessed according to actual financials, not models or projections. Some reports have compared the municipal bond market to the subprime mortgage securities market prior to the financial crisis. The circumstances are different. For one, state and local issuers are subject to financial disclosure rules, and the information they provide affects the market prices and credit ratings of their bonds. Also, municipal bonds are not exotic instruments with complex structures that obscure the underlying credit rating and market value of the assets.6 While municipal bond reporting is not as timely or thorough as reporting on corporate debt, investors hold an instrument that is more transparent than the mortgage derivatives that helped spark the financial crisis.
• Current market conditions do not imply unusually high risk. The market incorporates information and expectations into prices, including perceived risk, as illustrated by rising bond yields during the financial crisis and in the recent municipal market selloff. However, since the start of the recession in November 2007, average yields for the AAA-, AA-, and BBB-rated municipal securities have fallen.7 Also, total market volume as measured by total number of trades has been generally flat over the last three-year period.8
Risk Management Issues
Investors should always consider ways to manage risk in their fixed income portfolios. Here are a few guiding principles:
• Hold shorter-term issues. This approach may help reduce volatility and credit risk while enhancing liquidity. Also, fixed income investors who hold investment grade bonds must also consider their exposure to changes in interest rates. Bond prices move in the opposite direction of interest rate changes—and the longer a bond’s maturity, the greater its price change.
• Stay broadly diversified. Holding many municipal bond issues and avoiding concentration in a particular state, sector, or issue type can help reduce the impact of a few non-performing bonds. If default rates were to rise, investors with a well-diversified municipal portfolio should be less exposed.
• Focus on quality and use market pricing to confirm credit ratings. The most creditworthy bonds are those rated AAA or AA, and most of the current problems involve lower-rated bonds. Although ratings are useful, recent history in the mortgage-backed securities market has shown that a bond may not be rated accurately. A bond that is rated AAA should trade in a similar price range to other bonds with similar characteristics and a comparable rating.
Portfolio Decisions
Investors can either hold a portfolio of individual municipal bonds or buy shares in a fund. Building a portfolio of individual bonds offers more direct control over maturity, face value, bond type, credit range, and other issue characteristics. This approach may be useful for matching future liabilities and pursuing other investment objectives. But achieving broad diversification with a custom portfolio may prove a challenge, and the portfolio may be illiquid and expensive to trade, and require more attention and oversight than is feasible for an individual.
Investors often favor professional fund management for many reasons, including those specific to the way the bond market operates. Since bonds are traded through a network of dealers and not a centralized exchange, price discovery may not be easy. Muni bonds also tend to be illiquid since only about 0.7% of the market is traded daily (i.e., only 14,000 out of 2 million issues). These market realities result in high transaction costs. In fact, research shows that municipal bond trades are significantly more expensive than equity trades of equal size.9
Professional managers should have better access to multiple dealers and have the capacity for large- volume trades, which renders a cost advantage over smaller investors. Funds also offer better liquidity and broader diversification across issue type, maturity, credit quality, and geography. A shareholder can access daily share price and know the average credit rating within the portfolio. Equally important, managers should monitor average yields at different maturities, qualities, and regions to gauge the relative riskiness of different issues.
On the downside, managed funds can lose value and shareholders do not control the selection of bonds in the portfolio.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Municipal securities are subject to the risks of adverse economic and regulatory changes in their issuing states.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
End Notes:
1. Shawn Tully, “Meredith Whitney’s New Target: The states,” CNNMoney.com, Sept. 28, 2010.
2. Dan Seymour, “Default Uneasiness Chases Investors from Muni Funds,” American Banker, Jan. 25, 2011.
3. Ben Levisohn, Jane J. Kim, and Eleanor Liaise, “Munis: What to Do Now,” The Wall Street Journal, Jan. 15, 2011.
Other factors that possibly contributed to the selling pressure are: (1) a major Treasury selloff in late 2010, (2) Standard & Poor’s downgrade of “tobacco bonds” to junk status, (3) expiration of the Build America Bonds program in 2010, and (4) extension of the Bush-era tax cuts.
4. Randall Forsyth, “The Sky Isn’t Falling on the Muni Market,” Barrons.com, January 7, 2011.
5. Iris J. Lav and Elizabeth McNichol, “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm,” Center on Budget and Policy Priorities, Jan. 20, 2011.
6. Agnes T. Crane, “States’ Troubles Are Not the Real Risk for Muni Bonds,” The New York Times, Jan. 30, 2011. Also see Randall W. Forsyth, “Man Bites Dog in the Muni Market,” Barrons.com, Feb. 1, 2011.
7. Bank of America Merrill Lynch 1-10 Years AAA-BBB US Municipal Bond Index.
8. Municipal Securities Rulemaking Board (MRSB) 2010 Fact Book.
9. Lawrence E. Harris and Michael S. Piwowar, “Secondary Trading Costs in the Municipal Bond Market,” Journal of Finance, June 2006, Volume 61, Issue 3, pp 1361-1397.
Thursday, March 10, 2011
Risks Worth Taking
A wise man once said that to profit without risk and to experience life without danger is as impossible as it is to live without being born. That all may be true, but which risks are worth taking and which are not?
The fact is even the most self-declared risk-averse people take risks every day. There are routine risks to our safety in crossing the road, in riding public transport, in exercising at the gym, in choosing lunch and in using electrical equipment.
Then there are the "big decisions" like selecting a degree course, choosing a career, finding a spouse, buying a house and having children. These are all risky decisions, all uncertain, all involving an element of fate.
In making these decisions, we seek to ameliorate risk by carefully weighing up alternatives, researching the market, judging possible consequences and balancing what feels right emotionally and intellectually, both in the short term and in the long.
Sometimes, we ask an independent outsider to guide us in making our decision. They do this by providing an objective assessment of the potential risks and rewards of various alternatives, by taking a holistic view of our circumstances and by keeping us free of distraction and focused on our original goals.
In investment, this is the value that a good financial advisor can bring—not only in understanding risk and return and how to build a portfolio but in knowing the specific needs, circumstances and aspirations of his or her individual client.
Quite simply, many people who invest without the help of an advisor take risks they do not need to take. They gamble on individual stocks, they rely on forecasts, they chase past returns, they fail to rebalance their portfolios to take account of changing risks and they run up unnecessary costs and tax liabilities.
To use an analogy, this is like trying to cross an eight-lane highway in the face of heavy traffic when there is a pedestrian bridge a little way down the road. You may well get to your destination safely through the traffic, but it will be despite your actions rather than because of them. Understanding risk in investment begins with accepting that the market itself has already done a lot of the worrying for you. Markets are highly competitive, which means that new information is quickly built into prices. Instead of trying to second guess the market, you work with it and take the rewards that are on offer.
Your biggest investment is in spending time with an advisor building a diversified portfolio designed to meet your long-term requirements, then meeting them periodically as your needs change and to ensure you are still on course.
In considering all of this, it is important to understand that risk can never be totally eliminated. If there were no risk, there would be no return. But your chances of a good outcome are far greater if you use the accumulated knowledge of financial science and the guiding hand of an advisor who knows you.
To sum up, risk and return are related. But not all risks are worth taking. The process of working this out starts with not trying to do it all alone.
The fact is even the most self-declared risk-averse people take risks every day. There are routine risks to our safety in crossing the road, in riding public transport, in exercising at the gym, in choosing lunch and in using electrical equipment.
Then there are the "big decisions" like selecting a degree course, choosing a career, finding a spouse, buying a house and having children. These are all risky decisions, all uncertain, all involving an element of fate.
In making these decisions, we seek to ameliorate risk by carefully weighing up alternatives, researching the market, judging possible consequences and balancing what feels right emotionally and intellectually, both in the short term and in the long.
Sometimes, we ask an independent outsider to guide us in making our decision. They do this by providing an objective assessment of the potential risks and rewards of various alternatives, by taking a holistic view of our circumstances and by keeping us free of distraction and focused on our original goals.
In investment, this is the value that a good financial advisor can bring—not only in understanding risk and return and how to build a portfolio but in knowing the specific needs, circumstances and aspirations of his or her individual client.
Quite simply, many people who invest without the help of an advisor take risks they do not need to take. They gamble on individual stocks, they rely on forecasts, they chase past returns, they fail to rebalance their portfolios to take account of changing risks and they run up unnecessary costs and tax liabilities.
To use an analogy, this is like trying to cross an eight-lane highway in the face of heavy traffic when there is a pedestrian bridge a little way down the road. You may well get to your destination safely through the traffic, but it will be despite your actions rather than because of them. Understanding risk in investment begins with accepting that the market itself has already done a lot of the worrying for you. Markets are highly competitive, which means that new information is quickly built into prices. Instead of trying to second guess the market, you work with it and take the rewards that are on offer.
Your biggest investment is in spending time with an advisor building a diversified portfolio designed to meet your long-term requirements, then meeting them periodically as your needs change and to ensure you are still on course.
In considering all of this, it is important to understand that risk can never be totally eliminated. If there were no risk, there would be no return. But your chances of a good outcome are far greater if you use the accumulated knowledge of financial science and the guiding hand of an advisor who knows you.
To sum up, risk and return are related. But not all risks are worth taking. The process of working this out starts with not trying to do it all alone.
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