Predicting the Future Archives

Staying Invested

February 11, 2019 by Justin M. Follmer, MBA, CFP®, AIF®

If we could choose a near-perfect example of why we harp on staying invested and remaining committed to an investment strategy that’s rooted in academic science, it would be the returns that equities experienced during January 2019. After a terrible 4th Quarter in 2018, most global equity benchmarks roared back from their holiday blues.

Here’s where we stand so far (from 1.1.19 through 2.1.19)¹:

S&P 500 Growth	+7.51%
S&P 500 Value	+8.80%
S&P Mid-Cap 400 Growth	+9.73%
S&P Mid-Cap 400 Value	+12.02%
S&P Small-Cap 600 Growth	+8.81%
S&P Small-Cap 600 Value	+12.46%

A keen eye will notice a couple of points with the data above that coincide with our Investment Philosophy and why staying invested was far better than selling out at the end of December. First, Small and Mid-Caps outperformed Large Caps. Second, Value in each market cap outperformed Growth. And while this is great news, it doesn’t mean that we’re now in the clear. In fact, I wouldn’t let any single month of data, either good or bad, persuade you to make any portfolio strategy changes nor would I let it convince you of any strategy other than staying invested.

I highlight the points above merely to show that in any given month, the premiums we target for our clients will either be positive or negative and it’s impossible to predict one way or the other. By staying invested, the goal is to constantly pursue the premiums regardless of our personal outlook. I touched on this topic back in November of 2018 in a newsletter titled “Chasing Premiums;” contact us to be included on future newsletter mailings.

As mentioned above, Value outperformed Growth across market capitalization. Using the Small-Cap results as an example, historically speaking, the amount of outperformance in any given month is expected² to be 0.27% (statistical mean) . In simpler terms, we should expect to have Small Cap Value outperform Small Cap Growth by 0.27%. Holding all else equal, if Small Cap Growth returns 1.00% for a hypothetical month, we should expect Small Cap Value to return 1.27% in that same month. Make sense?

In January 2019, Small Cap Value outperformed growth by 3.65%, well above the expected 0.27%. How can this be? Let’s travel all the way back to statistics class…you know, the class most people hated! Whenever there’s a mathematical mean or average, there’s also a measurement of results spread around that mean; what we call a standard deviation. Using historical data, the standard deviation of Small Cap Value is 2.82%. This signifies that performance of this premium in any given month has shown to be anywhere from -5.37% to 5.91% calculated as 2 standard deviations from the mean. This represents 95% of the results within a normal distribution.

To take this one step further and bring us back full circle as to why we care about this data and why staying invested is preferred to not, think about the following question for a minute. If we expect the premium of Small Cap Value in a given month to be positive (0.27% is a positive number) what percent of observations over the last, say, 10 years, were not? The answer: 4.53% of the observations were negative. Let’s ask the same question for other time periods:

Any given month:	42.68% negative.
1 Year:	29.59% negative.
3 Years:	18.00% negative.
5 Years:	11.68% negative.
10 Years:	4.53% negative.
20 Years:	0.82% negative.
30 Years:	0.17% negative.

Notice a trend? The longer you pursue the premiums by staying invested, the greater your chance of realizing positive premium results.

I’ll reiterate the following point: do not let a single month of data, or even six single months of data, change your outlook and, thus, investment strategy nor let it cause you to do anything other than staying invested. Your investment strategy should be based on your time horizon, financial goals, and tolerance for volatility (risk) and should change only when one of those change. We help guide, manage, and make minor adjustments along the way for our clients and we’d love to help you and your family too. Get in touch today to begin your journey.

Image Credit: MCLB Albany – navigating by use of compass and data – not by gut feelings and emotion.

https://www.ftportfolios.com/Commentary/MarketCommentary/2019/2/4/week-of-february-4th
I italicize the word “expect” on purpose – we expect these results because of past statistically significant observations, they are not guaranteed results. Very little is guaranteed in the investor world.
French, K. (2018) Volatility Lessons: What do past returns say about future performance. Tuck School of Business, Dartmouth College.

What are Alternative Investments?

August 24, 2018 by Justin M. Follmer, MBA, CFP®, AIF®

Diversification has been called the only free lunch in investing, so what’s the alternative?

This idea is based on research showing that diversification, through a combination of assets like stocks and bonds, could reduce volatility without reducing expected return or increase expected return without increasing volatility compared to those individual assets alone. Many investors have taken notice, and today, highly diversified portfolios of global stocks and bonds are readily available to investors at a comparatively low cost. A global stock portfolio can hold thousands of stocks from over 40 countries around the world, and a global bond portfolio can be diversified across bonds issued by many different governments and companies and in many different currencies.

Some investors, in search of additional potential volatility reduction or return enhancement opportunities, may even try to extend the opportunity set beyond stocks and bonds to other assets, many of which are commonly referred to as “alternative investments.” The types of offerings labeled as alternative investments today are wide and varied. Depending on who you talk with, this category can include, but is not limited to, different types of hedge fund strategies, private equity, commodities, and so on. These alternative investments are often marketed as having greater return potential than traditional stocks or bonds or low correlations with other asset classes.

In recent years, “liquid alternative investments” have increased in popularity considerably. This sub-category of alternative investments consists of mutual funds that may start from the same building blocks as the global stock and bond market but then select, weight, and even short securities¹ in an attempt to deliver positive returns that differ from the stock and bond markets. Exhibit 1 shows how the growth in several popular classifications of liquid alternative investments mutual funds in the US has ballooned over the past several years.

The growth in this category of funds is somewhat remarkable given their poor historical performance over the preceding decade. Exhibit 2 illustrates that the annualized return for such strategies over the last decade has tended to be underwhelming when compared to less complicated approaches such as a simple stock or bond index. The return of this category has even failed to keep pace with the most conservative of investments. For example, the average annualized return for these products over the period measured was less than the return of T-bills but with significantly more volatility.

While expected returns from such strategies are unknown, the costs and turnover associated with them are easily observable. The average expense ratio of such products tends to be significantly higher than a long-only stock or bond approach. These high costs by themselves may pose a significant barrier to such strategies delivering their intended results to investors. Combine this with the high turnover many of these strategies may generate and it is not challenging to understand possible reasons for their poor performance compared to more traditional stock and bond indices.

This data by itself, though, does not warrant a wholesale condemnation of evaluating assets beyond stocks or bonds for inclusion in a portfolio. The conclusion here is simply that, given the ready availability of low cost and transparent stock and bond portfolios, the intended benefits of some alternative investments strategies may not be worth the added complexity and costs.

CONCLUSION

When confronted with choices about whether to add additional types of assets or strategies to a portfolio for diversification beyond stocks, bonds, and cash it may help to ask three simple questions.

What is this alternative getting me that is not already in my portfolio?
If it is not in my portfolio, can I reasonably expect that including it will increase expected returns or reduce expected volatility?
Is there an efficient and cost-effective way to get exposure to this alternative investments asset class or strategy?

If investors are left with doubts about any of these three questions it may be wise to use caution before proceeding. Our financial advisors can help investors answer these questions and ultimately decide if a given strategy is right for them. Have questions or want to find out if alternative investments are right for your portfolio and financial goals? Get in touch today.

ALTERNATIVE INVESTMENTS STRATEGY DEFINITIONS

Absolute Return: Funds that aim for positive return in all market conditions. The funds are not benchmarked against a traditional long-only market index but rather have the aim of outperforming a cash or risk-free benchmark.

Equity Market Neutral: Funds that employ portfolio strategies that generate consistent returns in both up and down markets by selecting positions with a total net market exposure of zero.

Long/Short Equity: Funds that employ portfolio strategies that combine long holdings of equities with short sales of equity, equity options, or equity index options. The fund may be either net long or net short depending on the portfolio manager’s view of the market.

Managed Futures: Funds that invest primarily in a basket of futures contracts with the aim of reduced volatility and positive returns in any market environment. Investment strategies are based on proprietary trading strategies that include the ability to go long and/or short.

Category descriptions are based on Lipper Class Codes provided in the CRSP Survivorship bias-free Mutual Fund Database.

A short position is the sale of a borrowed security. Short positions benefit if the borrowed security falls in value.
Written by Dimensional Fund Advisors, LP with edits by Coastal Wealth Advisors, LLC.
Top image credit: InvestmentZen

Recent Market Volatility

February 13, 2018 by Justin M. Follmer, MBA, CFP®, AIF®

After a period of relative calm in the markets, recent market volatility in the stock market has resulted in renewed anxiety for many investors. From February 1–5, the US market (as measured by the Russell 3000 Index) fell almost 6%, resulting in many investors wondering what the future holds and if they should make changes to their portfolios.¹While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a normal part of investing. Additionally, for long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the drawdown itself.

Intra-year declines

Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 32 years out of the 37 examined. This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.

Recent Market Volatility — Exhibit 1: US Market Intra-Year Gains and Declines vs. Calendar Year Returns, 1979–2017. ²

Reacting Impacts Performance

If one was to try and time the market in order to avoid the potential losses associated with periods of increased volatility, would this help or hinder long-term performance? If current market prices aggregate the information and expectations of market participants, stock mispricing cannot be systematically exploited through market timing. In other words, it is unlikely that investors can successfully time the market, and if they do manage it, it may be a result of luck rather than skill. Further complicating the prospect of market timing being additive to portfolio performance is the fact that a substantial proportion of the total return of stocks over long periods comes from just a handful of days. Since investors are unlikely to be able to identify in advance which days will have strong returns and which will not, the prudent course is likely to remain invested during periods of volatility rather than jump in and out of stocks. Otherwise, an investor runs the risk of being on the sidelines on days when returns happen to be strongly positive.

Exhibit 2 helps illustrate this point. It shows the annualized compound return of the S&P 500 Index going back to 1990 and illustrates the impact of missing out on just a few days of strong returns. The bars represent the hypothetical growth of $1,000 over the period and show what happened if you missed the best single day during the period and what happened if you missed a handful of the best single days. The data shows that being on the sidelines for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer.

Conclusion

While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term declines could prove more harmful than helpful. By adhering to a well-thought-out investment plan, ideally agreed upon in advance of periods of volatility, investors may be better able to remain calm during periods of short-term uncertainty. If you find that you aren’t completely confident in your long-term investment strategy, give us a call

1. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

2.In US dollars. US Market is measured by the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

3. In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. One-Month US T- Bills is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values.

4. Source: Dimensional Fund Advisors, LP with edits by Coastal Wealth Advisors, LLC.

Bitcoin: A Prudent Investment?

January 5, 2018 by Justin M. Follmer, MBA, CFP®, AIF®

To Bitcoin or Not to Bitcoin: What Should Investors Make of Bitcoin Mania?

Bitcoin and other cryptocurrencies are receiving intense media coverage, prompting many investors to wonder whether these new types of electronic money deserve a place in their portfolios.

Cryptocurrencies such as bitcoin emerged only in the past decade. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and no regulator or nation state stands behind it. Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet. In the case of bitcoin, there is a finite supply of 21 million¹, of which more than 16 million are in circulation². Transactions are recorded on a public ledger called blockchain.

People can earn bitcoins in several ways, including buying them using traditional fiat currencies³ or by “mining” them—receiving newly created bitcoins for the service of using powerful computers to compile recent transactions into new blocks of the transaction chain through solving a highly complex mathematical puzzle.

For much of the past decade, cryptocurrencies were the preserve of digital enthusiasts and people who believe the age of fiat currencies is coming to an end. This niche appeal is reflected in their market value. For example, at a market value of $16,000 per bitcoin⁴, the total value of bitcoin in circulation is less than one tenth of 1% of the aggregate value of global stocks and bonds. Despite this, the sharp rise in the market value of bitcoins over the past weeks and months have contributed to intense media attention.

What are investors to make of all this bitcoin media attention? What place, if any, should bitcoin play in a diversified portfolio? Recently, the value of bitcoin has risen sharply, but that is the past. What about its future value?

You can approach these questions in several ways. A good place to begin is by examining the roles that stocks, bonds, and cash play in your portfolio.

EXPECTED RETURNS

Companies often seek external sources of capital to finance projects they believe will generate profits in the future. When a company issues stock, it offers investors a residual claim on its future profits. When a company issues a bond, it offers investors a promised stream of future cash flows, including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain but greater amount of expected cash in the future. One important role these securities play in a portfolio is to provide positive expected returns by allowing investors to share in the future profits earned by corporations globally. By investing in stocks and bonds today, you expect to grow your wealth and enable greater consumption tomorrow.

Government bonds often provide a more certain repayment of promised cash flows than corporate bonds. Thus, besides the potential for providing positive expected returns, another reason to hold government bonds is to reduce the uncertainty of future wealth. And inflation-linked government bonds reduce the uncertainty of future inflation-adjusted wealth.

Holding cash does not provide an expected stream of future cash flow. One US dollar in your wallet today does not entitle you to more dollars in the future. The same logic applies to holding other fiat currencies — and holding bitcoins in a digital wallet. So we should not expect a positive return from holding cash in one or more currencies unless we can predict when one currency will appreciate or depreciate relative to others.

The academic literature overwhelmingly suggests that short-term currency movements are unpredictable, implying there is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency. So why should investors hold cash in one or more currencies? One reason is because it provides a store of value that can be used to manage near-term known expenditures in those currencies as well as portfolio volatility dampening reasons.

With this framework in mind, it might be argued that holding bitcoins is like holding cash; it can be used to pay for some goods and services. However, most goods and services are not priced in bitcoins.

A lot of volatility has occurred in the exchange rates between bitcoins and traditional currencies. That volatility implies uncertainty, even in the near term, in the amount of future goods and services your bitcoins can purchase. This uncertainty, combined with possibly high transaction costs to convert bitcoins into usable currency, suggests that the cryptocurrency currently falls short as a store of value to manage near-term known expenses. Of course, that may change in the future if it becomes common practice to pay for all goods and services using bitcoins.

If bitcoin is not currently practical as a substitute for cash, should we expect its value to appreciate?

SUPPLY AND DEMAND

The price of a bitcoin is tied to supply and demand. Although the supply of bitcoins is slowly rising, it may reach an upper limit, which might imply limited future supply. The future supply of cryptocurrencies, however, may be very flexible as new types are developed and innovation in technology makes many cryptocurrencies close substitutes for one another, implying the quantity of future supply might be unlimited.

Regarding future demand for bitcoins, there is a non‑zero probability⁵ that nothing will come of it (no future demand) and a non-zero probability that it will be widely adopted (high future demand).

Future regulation adds to this uncertainty. While recent media attention has ensured bitcoin is more widely discussed today than in years past, it is still largely unused by most financial institutions. It has also been the subject of scrutiny by regulators. For example, in a note to investors in 2014, the US Securities and Exchange Commission warned that any new investment appearing to be exciting and cutting-edge has the potential to give rise to fraud and false “guarantees” of high investment returns⁶. Other entities around the world have issued similar warnings. It is unclear what impact future laws and regulations may have on bitcoin’s future supply and demand (or even its existence). This uncertainty is common with young investments.

All of these factors suggest that future supply and demand are highly uncertain. But the probabilities of high or low future supply or demand are an input in the price of bitcoins today. That price is fair, in that investors willingly transact at that price. One investor does not have an unfair advantage over another in determining if the true probability of future demand will be different from what is reflected in bitcoin’s price today.

WHAT TO EXPECT

So, should we expect the value of bitcoins to appreciate? Maybe. But just as with traditional currencies, there is no reliable way to predict by how much and when that appreciation will occur. We know, however, that we should not expect to receive more bitcoins in the future just by holding one bitcoin today. They don’t entitle holders to an expected stream of future bitcoins, and they don’t entitle the holder to a residual claim on the future profits of global corporations.

None of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of bitcoins. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries, although these effects may take some years to emerge.

When it comes to designing a portfolio, a good place to begin is with one’s goals. This approach, combined with an understanding of the characteristics of each eligible security type, provides a good framework to decide which securities deserve a place in a portfolio. For the securities that make the cut, their weight in the total market of all investable securities provides a baseline for deciding how much of a portfolio should be allocated to that security.

Unlike stocks or corporate bonds, it is not clear that bitcoins offer investors positive expected returns. Unlike government bonds, they don’t provide clarity about future wealth. And, unlike holding cash in fiat currencies, they don’t provide the means to plan for a wide range of near-term known expenditures. Because bitcoin does not help achieve these investment goals, we believe that it does not warrant a place in a portfolio designed to meet one or more of such goals.

If, however, one has a goal not contemplated herein, and you believe bitcoin is well suited to meet that goal, keep in mind the final piece of our asset allocation framework: What percentage of all eligible investments do the value of all bitcoins represent? When compared to global stocks, bonds, and traditional currency, their market value is tiny. So, if for some reason an investor decides bitcoins are a good investment, we believe their weight in a well-diversified portfolio should generally be tiny⁷.

Because bitcoin is being sold in some quarters as a paradigm shift in financial markets, this does not mean investors should rush to include it in their portfolios. It is possible, although uncertain, that much of the recent rise in the value of one bitcoin could be contributed to FOMO: the fear of missing out. When digesting the latest article on bitcoin, keep in mind that a goals-based approach based on stocks, bonds, and traditional currencies, as well as sensible and robust dimensions of expected returns, has been helping investors effectively pursue their goals for decades.

Article written by Dimensional Fund Advisors LP with edits by Coastal Wealth Advisors, LLC.
Source: Bitcoin.org
As of December 14, 2017. Source: Coinmarketcap.com
A currency declared by a government to be legal tender.
Per Bloomberg, the end-of-day market value of a bitcoin exceeded $16,000 USD for the first time on December 7, 2017.
Describes an outcome that is possible (or not impossible) to occur.Because bitcoin is being sold in some quarters as a paradigm shift in financial markets, this does not mean investors should rush to include it in their portfolios. When digesting the latest article on bitcoin, keep in mind that a goals-based approach based on stocks, bonds, and traditional currencies, as well as sensible and robust dimensions of expected returns, has been helping investors effectively pursue their goals for decades.
“Investor Alert: Bitcoin and Other Virtual Currency-Related Investments,” SEC, 7 May 2014.
Investors should discuss the risks and other attributes of any security or currency with their advisor prior to making any investment.

Average Annual Return

October 31, 2017 by Justin M. Follmer, MBA, CFP®, AIF®

“I have found that the importance of having an investment philosophy—one that is robust and that you can stick with— cannot be overstated.” —David Booth

The US stock market has delivered an average annual return of around 10% since 1926.¹ But short-term results may vary, and in any given period stock returns can be positive, negative, or flat. When setting expectations, it’s helpful to see the range of outcomes experienced by investors historically. For example, how often have the stock market’s annual returns actually aligned with its long-term average?

Exhibit 1 shows calendar year returns for the S&P 500 Index since 1926. The shaded band marks the historical average annual return of 10%, plus or minus 2 percentage points. The S&P 500 had a return within this range in only six of the past 91 calendar years. In most years the index’s return was outside of the range, often above or below by a wide margin, with no obvious pattern. For investors, this data highlights the importance of looking beyond average annual returns and being aware of the range of potential outcomes.

TUNING IN TO DIFFERENT FREQUENCIES

Despite the year-to-year uncertainty, investors can potentially increase their chances of having a positive average annual return outcome by maintaining a long-term focus. Exhibit 2 documents the historical frequency of positive returns over rolling periods of one, five, 10, and 15 years in the US market. The data shows that, while positive performance is never assured, investors’ odds improve over longer time horizons.

Conclusion

While some investors might find it easy to stay the course in years with above average annual returns, periods of disappointing results may test an investor’s faith in equity markets. Being aware of the range of potential outcomes can help investors remain disciplined, which in the long term can increase the odds of a successful investment experience. What can help investors endure the ups and downs? While there is no silver bullet, having an understanding of how markets work and trusting market prices are good starting points. An asset allocation that aligns with personal risk tolerances and investment goals is also valuable. In addition, we believe that a Johns Island Financial Advisor can play a critical role in helping investors sort through these and other issues as well as keeping them focused on their long‑term goals. We’d love to get to know you; give us a call to see how we can become your trusted financial partner.

^1. As measured by the S&P 500 Index from 1926–2016.

^2. In US dollars. The S&P data are provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Index returns and average annual return do not reflect the cost associated with an actual investment.

^3. From January 1926–December 2016 there are 913 overlapping 15-year periods, 973 overlapping 10-year periods, 1,033 overlapping 5-year periods, and 1,081 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. In US dollars. The S&P data are provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not an indication of future results.

^4. Source: Dimensional Fund Advisors with edits by Coastal Wealth Advisors, LLC