Portfolio Allocations Matter

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Portfolio Allocations Matter

If the events of 2022 and 2023 haven’t conveyed that portfolio allocations matter to investors, it’s challenging to imagine what kind of investment landscape would drive that message home. It’s incredible to think that we’re already entering the fourth quarter of 2023! Before we know it, hurricane season will be behind us, and snow will be on the horizon for our clients in the Northern and Western states. As we approach the cooler months of the year, we can’t help but reflect on the past two years and appreciate the progress we’ve made. In comparison to the turbulent investment climate of 2022, 2023 has provided a welcome break from market volatility.

Take a look at the stark differences in performance of some of the major indices as of Friday, September 22nd as compared to their 2022 returns:1

Index
YTD
2022
S&P 500 (Large Cap)
+13.87
-18.31
NASDAQ (Tech)
+35.23
-32.38
Russell 2000 (Small Cap)
+1.95
-20.46
U.S. Aggregate (US Bonds)
-0.43
-13.01
S&P 500 Growth-only
+18.54
-29.41
S&P 500 Value-only
+8.78
-5.25

We often describe investing as a journey with both high and low moments. The extent of these highs and lows largely hinges on the composition of one’s portfolio and the strategy adopted. Portfolio allocations matter. Unless an investor holds a passive strategy aiming to closely replicate an index, like the ones mentioned earlier, they are likely to experience wildly different results than those published.

During our review meetings, we maintain a consistent practice of evaluating clients’ actual performance against a composite benchmark. This benchmark is a blend of various underlying indices with specific weightings, designed to mirror the composition of real-world portfolios and tailored to each client’s specific requirements. For instance, when examining a 60/40 benchmark, its year-to-date return stands at a positive 5.62%, in contrast to the negative -16.47% loss experienced in 20222. This divergence in results is noteworthy when compared to the major indices mentioned earlier.

This shows that portfolio allocations matter in real-world investment portfolios. The choices made in terms of how to invest (security selection) and where to invest (such as in specific sectors, asset classes, or countries) can significantly influence the nature of one’s investment journey. Fortunately, our clients entrust us to navigate this journey and make crucial decisions about investment design and strategy. The construction of a real-world portfolio takes into account various factors, including investment costs, the economic landscape, client objectives, risk tolerance, risk capacity, time horizon, and personal preferences. Each portfolio can be as unique as the individual it’s tailored for, highlighting the beauty of personalized investing.

Because portfolio allocations matter, tailoring their design necessitates setting realistic expectations. While it may be tempting to invest in an S&P 500 ETF with the aim of replicating its historical annual returns, typically around 10%3, the real challenge lies in sticking to that strategy plus dealing with the human element of investing and our natural tendency to avoid losses and discomfort.

Can one “set it and forget it?”

Looking at the differences of the S&P 500 index above can help paint this picture. Assume an investor buys an S&P 500 ETF (ticker SPY) on Jan 1st, 2022. Also assume that no additional trading nor reinvesting of dividends occurs. As of Friday, September 22nd 2023, this investor is still experiencing a negative return since the initial investment, despite nearly two years having passed. This hypothetical situation can be quite challenging to digest and underscores the importance of managing expectations in the realm of investing, which is just as crucial as the decision to invest in the first place. If you were this hypothetical investor who “set-it,” are you currently “forgetting it?” The answer to that is likely different for each person.

In reality, most investors don’t own just one investment but a myriad of investments they acquired over time as new money was contributed to their accounts. Human behavior is shaped by countless events, ranging from wars and recessions to business and personal triumphs, none or all may occur in any given year. The real challenge for investors lies in sifting through the overwhelming amount of information and noise generated by these events. The key question becomes: What makes up that critical percentage of information that warrants their attention and consideration?

The answer? It depends. It depends on how you’re affected by the events and how likely they are to influence your financial decisions. There’s a common saying that “the best strategy is one you’ll stick with.” Unfortunately, it’s not that easy since portfolio design has many facets to it. We explore those nuances during our onboarding process with new clients by showing them why portfolio allocations matter. We strive to uncover what they want their portfolio to accomplish and then design a specific mix of investments to help them achieve their goals. Each client is different and that’s what we value the most.

As we approach the end of 2023 and the likely challenges and volatility that lie before us, we’d welcome the opportunity to meet with you. We’re fiduciaries first and pride ourselves on being the outsourced financial planners’ and investment advisors’ that families can turn to when life becomes complicated. We take pride in being the kind of company our clients rely on when they want to discuss ideas or seek advice on a wide range of financial matters. We’re enthusiastic about the opportunity to be a valuable partner on your investment journey. You don’t need to invest alone when we’re here to help. Here’s how you can get in touch with us.

1https://www.ftportfolios.com/Commentary/Insights/2023/9/25/week-of-september-25th
260/40 Benchmark is a composite (blended) benchmark comprised of 38% iShares Russell 3000 Index ETF, 5% Vanguard Real Estate ETF, 9% MSCI EAFE Index, 8% iShares MSCI Emerging Markets ETF, and 40% iShares Core US Aggregate Bond Index ETF. Return calculated as of close of trading on 9.22.23.
3https://www.dimensional.com/us-en/insights/let-the-compounding-commence

Should one Refinance their Mortgage

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As mortgage rates sit at decade record highs, it’s no surprise to see and hear countless ads on social media and the radio that one “should refinance their mortgage” before rates go higher. Even during periods of decreasing rates, one “should refinance their mortgage” to take advantage of lower rates. It’s obvious to us that mortgage companies want borrowers to consider refinancing their mortgages regardless of where rates are. We aren’t faulting them, but in our fiduciary opinion, one “should refinance their mortgage” only when it is in their best interests.

How to determine when one should refinance their mortgage

It’s important to understand how interest rates work within mortgages and their impact on the amortization schedule. With the help of an example, we can illustrate the effects of mortgaging your home. Let’s assume you are purchasing a $450,000 home, 20% down, at 4.75% annual interest over 30 years. This results in a $360,000 mortgage with a Principal and Interest payment of $1,877.93 per month.[1]

The amortization schedule shows that $1,425 of the payment will apply to interest while $452.93 towards the principal of the loan. Each successive monthly payment will decrease the interest portion and increase the principal portion. The interest is front-loaded to the earlier years of the mortgage. And then vice versa towards the later years. It’s important to understand this because it can help determine when one should refinance their mortgage. And here’s why. If you pay this mortgage as agreed, then you will have paid $316,054.95 in interest over the life of your loan. That’s a lot of money not going in your pocket!

Why is this so important? Because each time one refinances their mortgage, it resets the amortization schedule. This can be a good or bad thing depending on how the numbers play out.

Holding all else equal, either refinancing from a 30 to a 15 year, refinancing to a lower interest rate, and/or adding additional payments usually have the effect of reducing total interest paid over the life of the loan.

On the other hand, holding all else equal, resetting from a 30 year to a new 30 year, using home equity to pay off consumer debt, or allowing forbearance programs to continue, usually have the effect of increasing the total interest paid.

There are, of course, exceptions to the above

We hear ads consistently tout the benefits of refinancing to pay off credit cards, student loans, and car loans. Because mortgage companies don’t have a fiduciary responsibility, they rarely must determine if that is in your best interests. It’s up to you to determine if it makes the most sense in your specific situation. Using equity to refinance credit cards, for example, won’t allow the mortgage interest on that portion of the loan to be deductible. It will also increase your balance owed and spread your payments over the life of the loan.

“But it’s at a lower rate!” That may be true; but behavioral finance can cause further problems if you don’t address why the balance of the credit card grew over time. If this is left unresolved, one risks allowing the credit card balance to continue to grow.

All credit card debt isn’t bad debt. It’s a great way of building credit that allows one to borrow at the best rates when used responsibly. Our job as advisors is to provide advice that is sometimes hard to swallow. But, that allows clients to better position themselves towards accomplishing their most important financial goals. It’s not always easy, but tiny adjustments now can have immense changes years later.  

In the end, one must compare the total interest and costs paid over the current mortgage versus the new mortgage. This may include additional comparisons of consumer debt balances and total interest over the life of those loans plus the opportunity costs of these choices. You need to answer: does refinancing this debt put me in a better financial position when it’s paid back?

Navigating this challenging financial life is no casual walk in the park. The good news is that you don’t have to travel alone. We help clients of all backgrounds make challenging decisions like deciding when they should refinance their mortgage. If you’re tired of the confusion of doing it alone or if you have existing advisors that just aren’t cutting it, consider getting in touch today. We’re fiduciaries first, which means we’ll provide the advice that is in your best interests, not in the interests of us or the mortgage company’s bottom line.   

[1] Ignoring property taxes and homeowner’s insurance premiums

Striving for Better Performance

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Better Performance

In striving for better performance, I often like to take a step back from the daily headlines to get a macro view of where we are and how far we’ve come year-to-date. As we enter the month of May, let’s check the pulse of the broad market indices as of 4.29.22 (source):

Dow Jones Industrial Average: -8.73
S&P 500: -12.92%
NASDAQ: -21.06%
MSCI EAFE: -12.00%
MSCI Emerging Markets: -12.15%
US Aggregate Bond Index: -9.50%

As a quick and simple refresher, the Dow is comprised of 30, mainly value oriented stocks. The S&P 500 is 505 of large cap companies with an overweight towards growth stocks. The NASDAQ is mainly growth oriented stocks while the MSCI EAFE tracks international developed stocks and the MSCI Emerging Markets tracks emerging market stocks. Lastly, the US Aggregate Bond Index tracks the performance of the total US bond market.

Notice that the year-to-date performance is negative across the board, including fixed income. The only asset class that is positive in nominal terms is cash. However, due to inflation, the real return on cash is negative as well. By “real return,” I’m referring to the purchasing power of a $1, which no longer buys the same amount of goods and services it did at the beginning of the year and can be expressed as the nominal rate minus the inflation rate.

With signs of the year-over-year growth rate of inflation possibly peaking, a Federal Reserve on a continued path towards tightening economic conditions, persistent supply chain challenges, and what is turning into a prolonged war between Russia and the Ukraine, where is an investor to turn for better performance?

Before we answer that…

In my opinion, there’s two ways to look at the notion of better performance. The first is obvious: the return must have a plus sign in front of it. You essentially end with more money than you started with. The second way is less obvious. The return is better than a benchmark return even if it still has a negative sign in front of the number. Think of the latter way as a negative result but less negative than it would be had you invested differently. It goes without saying that we naturally prefer to have positive real returns. But in some short-term periods, that won’t be the case.

Here’s a current example of better performance in two negative returning asset classes (again, as of 4.29.22):

S&P 500 Growth Index: -20.00%
S&P 500 Value Index: -5.02%

In this example, the S&P 500 Value Index is outperforming its growth counterpart by +14.98% year-to-date. In the fourth pillar of our Investment Philosophy, we actively choose to structure evidence-based portfolios for our clients by overweighting certain asset classes. One component of this is choosing to hold higher weights in value stocks over growth stocks. This strategy is performing well in the current environment even if it’s still negative, albeit, less negative than it would be if we didn’t have conviction in our investment philosophy.

This takes us back to the question at hand, where does an investor turn for better performance during these times?

We believe there’s several ways to answer this question and it depends on your individual circumstances.

First, visit the strategy you’ve implemented and try not to sell for the sake of avoiding losses; analyze and understand why you own what you own first. We’re overweight value stocks while slightly underweight international and emerging market stocks. We also favor quality and cash-flow rich companies within the portfolio. It’s important to note that this doesn’t mean avoiding growth stocks altogether since there can be pockets of better performance within that asset class as well.

Second, as interest rates rise, bond durations should remain on the shorter end of the curve. This won’t prevent negative returns for bonds, but it should dampen the impact to bond prices as interest rates rise. Floating rate bonds can also be attractive depending on individual risk tolerance and capacity.

Third, defensive sectors like consumer staples, utilities, and commodities can be attractive tactical additions to a portfolio. In our opinion, these areas can complement an existing, well-diversified portfolio but shouldn’t be the largest weights in it.

Fourth, be methodical (purposeful) in allocating new cash to investments and during rebalancing periods. Just as we do each day for client portfolios, we look for long-term value and opportunities in where we allocate cash. This approach can also manifest itself through dollar cost averaging like participants do with each payroll deferral into their employer sponsored retirement plans.

There’s no doubt that economic challenges lay ahead. We cannot predict what tomorrow will bring but we also aren’t blind to the potential risks in front of us. We don’t believe anyone can accurately—and consistently—outguess the direction of markets. For this reason, we believe constructing evidence-based portfolios that align with your tolerance and capacity for risk, your financial goals, and preferences is a better means to a positive investment experience.

We aren’t the type of firm that markets on doom-n-gloom predictions. Rather, we work with clients to identify what doom-n-gloom may look like specific to their lifestyle. No two clients are alike. We then build and manage portfolios that we believe match certain characteristics so that our clients can tolerate what the world brings their way. If the past several months have been challenging for you, get in touch with us. We’d love to show you how we help clients to see if we’re the right fit for each other.

Image Credit: Marco Verch Professional Photographer

Are you a Trader or Investor?

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Investor

In a world with constant information overload, sometimes it’s best to take a step back from financial news feeds to focus on core topics that drive home the fundamental components and experiences of being a long-term investor. I don’t need to explain to anyone that it isn’t easy being an investor. However, I believe it’s much harder to be a trader.

Allow me to explain.

A trader tends to rely on short-term, one-off theme-based events to drive their portfolio allocation decisions. They rely on timing the market with the goal of outguessing, and thus outperforming, a benchmark.

An investor tends to view those same events as statistical data and routine (standard) deviations. I, and many others, simply call it noise. An investor typically doesn’t allow this short-term “noise” to drive portfolio allocation decisions. Naturally, I’m making some generalizations since not all traders and investors fall into these categories.

Trading requires constant attention with an ability to guess accurately and consistently over time. Volumes of academic research exist to counter the belief that someone can accomplish this profitably. Trading and market timing strategies must be correct more than just once. An example of this would be selling at the depths of the COVID slump during March of 2020 with the goal of preventing further losses. But when does one buy back in…weeks or months later when things seem better? The 2nd worst performing day of 2020, March 12th, was immediately followed by the 2nd best performing day of 2020 (source). Think about that for a moment…by the time the trades settled the next day, one would have missed the rebound. Missing just a few of the best performing days, days that typically occur shortly after the worst performing ones, can significantly impact portfolio performance and value (source).

Investing is an opposite strategy because it relies on the belief that current market prices reflect all available information and expectations of the future. By that definition, it means that it is impossible to outguess the direction of the markets. Our Investment Philosophy is based on these beliefs. As advisors to our clients, we strive to not let the daily noise of markets impact how we design, implement, and rebalance their portfolio(s). It is the reason why our clients remained invested during March of 2020 and the various market corrections we experienced before then and since (i.e. January 2022).

Because we believe there’s no accurate way to guess which way the markets are going to go, we rely on decades of academic evidence to guide portfolio design. This belief, combined with individual investment and financial goals, time horizon, and appetite for risk, make up the toolkit we use in our daily approach to managing our clients’ investments and the advice we give.

Does this mean we ignore current events? Absolutely not. There are fundamental shifts that occur over time that help guide certain parts of the portfolio. One example of this is how our expectation of future interest rates impact the types of fixed income securities we recommend. During periods when rates are expected to rise (the current view), we strive to stay on the shorter end of the yield curve to lessen the impact of declining bond values while seeking unique areas of the fixed income market with positive correlation to rising rates.

We know last month was challenging for investors. The S&P 500 lost -5.47% of its value during January alone. With that in mind, was it challenging being an investor during 2021 when the same index gained 28.68% (source)? Obviously, no. But as investors, we must take the good with the bad since we rely on our commitments to an investment philosophy to smooth out the short-term noise.

The future is always uncertain. Many potential events are currently shaping the investing landscape. Yesterday’s 7.5% CPI (inflation) reading was a negative surprise, but one that makes sense given the Omicron surge of late December and January. The markets are digesting this number to price in what they believe the reaction from the Federal Reserve will be in March and the remainder of the year. Will the Fed increase rates by 0.25% or 0.50% and how many times this year? Will quantitative easing turn into quantitative tightening? If so, when? Does Russia invade Ukraine? Is there another COVID variant lurking around the corner? These are some of the uncertainties we face right now.

While I don’t know the answers above, I do know that markets are resilient and always forward looking. I know that corporations have an unwavering ability to flex in response to current events with the goal of increasing shareholder value. And I know that the future remains bright, albeit, challenging at times. The one constant lesson that investors know is that conviction matters: “time in the markets is better than timing the markets.” – old adage.

If you’re the type of investor who is seeking a partner to help you through the next few chapters of your life, consider getting in touch with us today. We’d love to learn more about you and how we may be able to team up.

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