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Economy, Personal Finance, Retirement, Stock Market, Wealth Management

Enjoy the Market Rally, But Prepare for the Retreat!

Investors may be lulled into a false sense of security by this market.

Will the current bull market run for another year? How about another two or three years? Some investors will confidently say “yes” to both questions. Optimism abounds on Wall Street: the major indices climb more than they retreat, and they have attained new peaks. On average, the S&P 500 has gained nearly 15% a year for the past eight years.

Stocks will correct at some point. A bear market could even emerge. Is your investment portfolio ready for either kind of event?

It may not be. Your portfolio could be over weighed in stocks and stock mutual funds – that is, a higher percentage of your invested assets may be held in equities than what your investment strategy outlines. As your stock market exposure grows greater and greater, the less diversified your bull market and bear marketportfolio becomes, and the more stock market risk you assume.

You know diversification is important, especially when one investment sector that has done well for you suddenly turns sideways or plummets. When a bull market becomes as celebratory as this one, that lesson risks being lost.

How do bear markets begin?

They seldom arrive abruptly, but some telltale signs may hint that one is ahead. Notable declines or disappointments in corporate profits and quickly rising interest rates are but two potential indicators. If the pace of raising rates speeds up at the Federal Reserve, borrowing costs will climb not only for households, but also for big businesses. A pervasive bullishness – irrational exuberance, by some definitions – that helps to send the CBOE VIX down to unusual lows and can be seen as another indicator of a bear market or stock correction.

How long could the next bear market last?

It is impossible to say, but we do know that the longest bear market on record lasted 929 days (calendar days, not trading days). That was the 2000-02 bear. A typical bear market lasts 9-14 months.

Enjoy this record-setting Wall Street run, but be pragmatic.

Equities do have bad years, and bears do come out of hibernation from time to time. Patience and adequate diversification may make a downturn more tolerable for you. You certainly do not want the value of your portfolio to fall drastically in the years preceding your retirement.  If this happens, you will have a narrow window of time to try and recoup that loss. Remember, the market does not always advance. It may be time to lock in these gains or re balance your portfolio.

Be careful listening to the media.

So while 15% gains sound great, way over 200% gains without a significant correction; the average annual return since the 2000 bear market has been only 4.11% (without dividends). Adjust for inflation and the return goes down to 1.90%. Minus out taxes, management fees, brokers fees and expenses and it seems like those that have been in the market since 2000 are still losing money.

The coming correction is right around the corner. Be Proactive, Not Reactive. Our clients didn’t lose a dime in 2000 or 2008. How low can it go? That’s anyone’s guess but this guy thinks it will be the Worst Stock Market Crash Ever… and that would be pretty bad.

Personal Finance, Retirement, Wealth Management

Saving for Retirement

Overcoming Retirement Challenges

In a 2013 survey of people aged 50 to 70 with $100,000 or more in investable assets, 90% reported that they had experienced at least one setback in saving for retirement. In fact, the average respondent had experienced four setbacks with an average loss or missed opportunity of $117,000.1

The future is always uncertain, and as the saying goes, “Life happens.” It would be wise to prepare for the unexpected and react logically rather than emotionally when faced with retirement challenges. Here are some obstacles you might need to overcome.

Surviving market downturns. More than half of those surveyed said their assets had been reduced by market losses during the Great Recession.2 Yet another survey suggested that about 50% of workers who were 32 to 51 when the recession started actually showed gains in their retirement accounts during the 2007 to 2009 period.3 This group may have had lower balances when the recession began, and it’s likely that they continued saving throughout the downturn, which might have helped them benefit when the market started to improve. Remember that all investments are subject to market fluctuation and the potential for loss.

saving for retirement and challenges-to-retirement-savings

Saving too little or too late. To accumulate sufficient assets to retire at age 65, one rule of thumb suggests saving 15% of income starting at age 25. Someone starting at age 35 might need to save about 30% each year, and the savings percentage would increase to about 64% annually for someone starting to save at age 45!4 If these percentages seem unrealistic, consider that any savings increase is better than none. In addition to maximizing your retirement contributions, you may also need to adjust your lifestyle and control your spending. Once you reach age 50, you are eligible to make additional “catch-up” contributions.

Experiencing a traumatic event. A job loss, unexpected medical expense, death of a loved one, or divorce might make it difficult to save for retirement. Having an emergency savings account that could help cover at least three to six months of living expenses would put you in a stronger position. If possible, avoid tapping your retirement savings, especially tax-deferred IRAs and 401(k)s, because withdrawals are taxed as ordinary income and may be subject to a 10% federal income tax penalty if taken prior to age 59½. When your life returns to normal, try to save as much as possible at the highest contribution rate you can afford.

Balancing college and retirement. When these two priorities compete, many people — 15%, according to one survey — stop saving for retirement to pay for their children’s educational costs.5 A wide variety of college funding options are available, but there is no “scholarship” for retirement. The key is to balance your children’s needs with your own retirement goals and find an appropriate strategy.

The road to retirement is long, winding, and seldom smooth. But with patience and a steady commitment, you could reach your destination regardless of how many obstacles you encounter along the way.

For more information on this topic please contact Ben Borden Richmond, Va Financial Advisor, (804) 282-8820.

1–2), May 14, 2013
 3) The Pew Charitable Trusts, 2013
 4), September 24, 2012
 5), March 4, 2013
Personal Finance, Wealth Management

Investment Risk Tolerance

Understanding Your Investment Brain

A recent academic study confirmed that willingness to take investment risk is affected not only by an investor’s age but by the current economic climate.1 The more conservative risk tolerance associated with age might be considered rational behavior, because older investors may have less time to recover from potential losses and generally need to tap their savings sooner than younger investors.

Changing one’s risk tolerance based on current economic conditions, however, may be less rational. Assuming more risk when the market is up and less risk when the market is down might encourage you to buy when prices are high and sell when prices are low.

Because no one can predict the market’s ups and downs, a wiser approach might be to adopt an investment strategy appropriate for your personal situation and to maintain it regardless of market volatility. Doing so could help you become a more rational investor.

investment risk tolerance

Reference Points and Mental Accounts

The field of behavioral finance seeks to understand how and why investors react to different events and outcomes. It’s been widely accepted for some time that investors tend to react more negatively to losses than they react positively to gains. Recent research suggests that people have a subjective reference point for considering whether an investment is a success or a failure, and they may have different reference points for different investments. Investors also use mental accounts to organize investments for specific goals.2

Understanding your own reference points and mental accounts may help you determine an appropriate asset allocation based on your risk tolerance. Although asset allocation is a method to help manage investment risk, it does not guarantee against investment loss.

Hard-Wired Responses

Neuroscientists are discovering that many emotions and behaviors are “hard-wired” in the brain. In an experiment where investing was rewarded more highly than not investing, people with damage to areas of the brain related to emotions and risk — including the amygdala, orbitofrontal cortex, and insula regions — were not constrained by investment losses and achieved higher returns than those with healthy brains. In other studies, however, people with damage to these areas have gone “bankrupt” due to poor judgment and taking on too much risk.3

Another experiment, which looked at how people use past rewards to predict future payoffs, found that most subjects were unduly influenced by the two most recent results, perceiving a pattern where there was none. However, people with damage to a region of the brain called the frontopolar cortex made decisions primarily on cumulative reward history rather than on the most recent outcomes.4

The brain may also have a “motivation center” that drives efforts to achieve a goal based on the perceived value of success. In a series of tests, an increase in the dollar value of a potential reward created increased activity in a region of the brain called the ventral striatum, which led to increased efforts to achieve the reward.5

These findings suggest that investors may have to control natural responses that could lead to their becoming too risk averse, reacting too quickly, or pursuing potential gains without appropriate caution. If you become overly emotional when it comes to your investments, it may help to take a step back and consider the situation rationally based on your overall financial strategy.

1) University of Missouri, 2012
2), February 23, 2012
3), October 16, 2012
4) The Wall Street Journal, July 21, 2012
5), February 22, 2012

Personal Finance, Wealth Management

Long Term Investing Practices

Nobel Prize Winners Offer Investing Lessons

A trio of American scholars were recently awarded the 2013 Nobel Memorial Prize in Economic Sciences. Eugene Fama and Lars Peter Hansen, professors at the University of Chicago, and Robert Shiller, a professor at Yale University, will share the honor and the $1.2 million award.1

The three economists made far-reaching discoveries related to the workings of financial markets, asset prices, and behavioral finance. Here’s a closer look at how their research contributed to the formation and refinement of fundamental concepts in portfolio management and long-term investing practices.

Father of Modern Finance

Eugene Fama introduced the efficient markets hypothesis in the 1960s. It is based on the premise that asset prices adjust quickly and are an accurate reflection of all relevant information. His research found that movements in stock prices are unpredictable, following a “random walk” that makes it extremely difficult for investors to choose outperforming individual stocks on a consistent basis or to predict the right time to buy or sell financial assets (market timing).2
The realization that trying to “beat the market” is often fruitless eventually led to the introduction of index funds designed to track the holdings of broader market indexes such as the S&P 500. At the end of 2012, 373 index funds managed more than $1.3 trillion in total net assets. About one-third of U.S. households with mutual funds owned shares in at least one index fund.3

In later research, Fama determined that market capitalization and valuation can affect the risk and return potential of equity investments.4

The return and principal value of stocks and mutual funds fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments seeking to achieve higher returns also involve greater risk.


Accounting for Human Nature

In 1981, Robert Shiller published a ground-breaking study that seemed to contradict Fama’s theory that markets are always efficient. If they were, stock prices would generally mirror the growth in earnings and dividends.
Shiller’s research showed that stock (and bond) prices fluctuate more often than changes in companies’ intrinsic valuations (such as dividend yield) would suggest.5 He concluded that asset prices sometimes move erratically in the short term simply because investor behavior can be influenced by emotions such as greed and fear.

Shiller believed that human psychology could cause “bubbles” to form in asset markets. Investor enthusiasm (“irrational exuberance”) and a herd mentality can create excessive demand for “hot” investments, driving up prices until they become very expensive relative to long-term values.

In fact, Shiller became well known in the 1990s for warning that rapidly rising stock prices during the Internet boom could lead to a bubble that would eventually burst, causing values to collapse. He had similar warnings in the last decade about the run-up in housing prices, and he helped develop one of the most closely watched indexes of home values.6

A Scientific Approach

Lars Peter Hansen developed a statistical method that is widely used to test theories of asset pricing, including those advanced by Fama and Shiller. The Generalized Method of Moments is an econometric tool that helps estimate the relationships between important variables that are hidden inside large amounts of financial and economic data.

Hansen’s work improved on older methods for “formulating, analyzing, and testing dynamic economic models in environments with uncertainty.” His techniques have been adopted by social scientists in many other fields.7

The work of all three economists supports the notion that asset prices can be difficult to predict in the short run, but markets tend to weigh their prospects more accurately over longer periods of time.

This reinforces the importance of committing to a long-term investing strategy that fits your financial goals and risk tolerance, which may help you avoid costly, emotion-driven mistakes.

Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1) The Wall Street Journal, October 14, 2013
2, 4–5) InvestmentNews, October 14, 2013
3) USA Today, October 15, 2013
6) CNNMoney, October 14, 2013
7) The University of Chicago, 2013
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