The Demise of an Investment Portfolio – Emotions and Market Timing

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Jane M. Young, CFP, EA

Forecasting the short-term movement of the stock market and trying to time the market is fruitless. As in all areas of our lives, we can’t control what life throws at us but we can establish a defensive position to best deal with a variety of outcomes. When it comes to our investments, we accomplish this through diversification, dollar cost averaging, maintaining an emergency fund and staying the course. We need to fight the natural inclination to make financial decisions based on emotions. Don’t forget that the stock market is counter-intuitive. Generally, the best time to buy is when things seem really bad and the best time to sell is when things seem the brightest. But then again, we just never know. It is easy to get caught up in the fear or euphoria of the moment. But, keep in mind that emotional reactions to the market can have a devastating impact on your portfolio. The stock market is a long- term investment and we need to avoid reacting to short-term events.

Proof of this can be seen in a Dalbar study conducted in March of 2010 for the time period of 1/1/90 – 12/31/09. During this time the average return in the equity market was 8.8% but the average return for the individual investor was only 3.2%. This discrepancy is a result of investors trying to time the market or reacting emotionally to financial news and events. Below are two quotes that sum this up very well.

“Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
-Peter Lynch, author and former mutual fund manager with Fidelity Investments

“The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it (time the market) successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently”
– John Bogle, founder of Vanguard Investments

Don’t Be Alarmed by the Financial Scaremongers

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Jane M. Young, CFP, EA

About once a week a client asks me about the latest prognostication from some famous so called “financial expert/alarmist.” They are either predicting the demise of the world as we know it or predicting a triple digit increase in the stock market. Maybe I am exaggerating, just a little, but we’ve all experienced those who think they can forecast the future and lead us to “Financial Paradise.” I remind my clients of two things with regard to these “miraculous forecasters.” The first is that most of the TV hosts, radio shows, magazines, and financial authors are in the business of making money by selling magazines, books, and ad space. They are not in the business of providing the consumer with the best possible advice. They want to entertain, tantalize, and terrorize you. This is what gets and keeps our attention. Let’s face it! Good solid investment advice is really boring. It doesn’t change much and doesn’t sell magazines! Secondly, they cannot predict what the market is going to do tomorrow much less six months from now. Historically, no one has ever been able to consistently predict the future of the financial markets. Sure, when you have thousands of people making forecasts a few are bound to get lucky. As a good friend often says, even a blind man eventually hits the bull’s eye.

Develop a solid plan to meet your unique situation and stick with it. Don’t let the financial hype throw you off course. Below are a few quotes that help emphasize the fallacy of placing too much faith in financial forecasts.

“We’ve long felt that the only value of stock forecasts is to make fortune tellers look good. Short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children” (Warren Buffett).

“Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window” (Peter Drucker).

” We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know” (J.K. Galbraith, US Economist and diplomat).

10 Investment Principles that Never Go Out of Style

Jane M. Young CFP, EA

Frequently people talk about how everything is different and we should change the way we invest. Yes, we have just experienced a very difficult year with some major changes in our economic situation. However, every time we go through a major market adjustment if feels like “this time is different”. We could take numerous comments made at the end of the last bear market and insert them into today’s headlines without missing a beat. I call this the “recency effect”; bad times always feel more desperate while we are experiencing them. We need to step back and look at the big picture; don’t throw the baby out with the bathwater. Good, sound investment fundamentals are still valid. Some people may reassess their tolerance for risk, start saving more money or cut back on their discretionary spending – but the following investment principals are good, time tested guidelines that everyone should follow in any market.

1. Don’t time the market – The stock market is counter-intuitive. Generally, it may be better to invest when things seem most dire and sell when everything is rosy. It is impossible to predict the movement of the stock market and history shows that those who do frequently miss out on big upswings.

2. Dollar Cost Average – This enables you to invest a set dollar amount every month or every quarter regardless of what the market does. As a result you buy more shares when the price is low and fewer when the market is high. Dollar cost averaging helps you mitigate risk because we don’t know what the stock market is going to do tomorrow.

3. Maintain at least 3 to 6 months of expenses in an emergency fund – This is especially important in difficult financial times when stock market values are low and unemployment is high. Unless you have a very secure job I currently recommend a 6 month emergency fund.

4. Don’t invest in anything you don’t understand – If you just can’t get your head around something after it’s been explained or you have done a reasonable amount of research don’t invest in it. If an investment opportunity is overly complicated something may be rotten in Denmark.

5. Don’t Chase Hot Asset Classes – Today international funds may be skyrocketing and tomorrow it may be small cap domestic stock funds. Don’t forget what happened to the stock market after the dot.com bubble burst.

6. Diversify, Diversify, Diversify – Everyone needs to diversify with a mix of fixed income and equity investments that is consistent with their own unique investment goals and objectives. Although most stocks dropped in unison over the last year, I still think there is value in diversifying between different types of stock mutual funds. I believe we will see some categories of stocks outpace others as the market rebounds. Depending on your risk tolerance, a small allocation in commodities and real estate may be advisable.

7. Don’t Make Emotional Decisions – Many investment decisions are triggered by fear and greed and they are equally damaging. Don’t make rash decisions based on emotion. Remember the stock market is counter-intuitive.

8. Don’t put more than 5% of your assets in one security – Any given company can go bankrupt as we have seen with many financial and automobile firms over the last year. I encourage the use of mutual funds over individual stocks to help mitigate this type of risk. If you do invest in individual stocks don’t put too much faith in any one company. If you are investing in your own company and you have a strong understanding of the firm’s performance you could go up to 10%.

9. Be tax smart – Take advantage of tax advantaged retirement plans such as Roth IRAs and 401k plans. Consider tax consequences when re-balancing your portfolio. Use a bear market to harvest some tax losses and off-load some bad or inappropriate investments.

10. Be aware of fees and surrender charges – When selecting investments be aware of high fees and commissions. Tread cautiously with anything that contains a contingent deferred sales charge. Many clients have come to me with a desire to sell or transfer previously purchased investments, usually annuities, only to find they have a 5-10% surrender charge if they sell within ten years of purchase. A surrender charge can have a big impact on your flexibility. If you really want a variable annuity buy one with low fees and no surrender charges.

What You Should Be Doing Now!

Jane M. Young CFP, EA

1. Start by re-evaluating your monthly expenses to determine how much money you need for necessary expenses. Then determine how much you have remaining after you cover these expenses.

2. During difficult economic times, like the present, most people should maintain an emergency fund of at least 6 months of expenses. If you have an exceptionally secure job you may be able to drop it down to 3 months. Always be sure to sure to maintain an adequate emergency fund.

3. Once your emergency fund is established pay off any high interest credit cards.

4. Put aside money for special one time expenses such as a new roof, a new car or a down payment on a house. If you don’t own your own home give some serious consideration to saving up to buy one. Decide how much you want to save on a monthly basis and start a systematic savings plan.

5. Now you can start investing! Determine how much you can afford to invest on a monthly basis. Most people should start by investing in their company retirement plan up to the level that the company will match. If you can afford to invest beyond the level of your company match, invest up to the maximum allowed in a Roth IRA. This should be done on a monthly basis to take advantage of dollar cost averaging – investing the same amount every month. The 2009 contribution limit for a Roth IRA is $5,000 if you are under 50 and $6000 if you are over 50. There is an income limit on your eligibility to contribute to a Roth IRA based on your adjusted gross income. For 2009, your eligibility to contribute begins to phase-out at $166,000, if you are married filing jointly and $105,000 if you are single.

If you still have money to invest after maximizing your Roth IRA, resume contributing to your company retirement plan up to the maximum amount. The maximum contribution limit for a 401k in 2009 is $16,500 if you are under 50 and $22,000 if you are over 50.

Invest your money in a diversified set of mutual funds. Establish an asset allocation consistent with your timeframe and risk tolerance. For most individuals this will vary from 50% to 80% in stock mutual funds, with the balance in fixed income investments. The market is still priced very low and it is a great time to buy stock mutual funds. However, the market will be very volatile over the next 6 – 9 months. Dollar cost averaging into your retirement plans will help you take advantage of this volatility.

This is very general advice and everyone’s situation is unique. Treat this advice as a general guideline and adapt it to your own situation or consult a Certified Financial Planner for guidance.

Does the Stimulus Make Gold Shine? (part II) – How to Buy Gold

If you decide to buy gold as a hedge against inflation there are several options. One can invest in gold through mutual funds, exchange traded funds (ETF), gold bullion, gold coins, gold mining stock and gold futures. In selecting an investment vehicle keep in mind your reason for purchasing gold – it’s a doomsday investment. If the entire financial world is crumbling around you, your gold needs to be secure. If you buy gold, consider investment in gold coins. Some options include the American Eagle, the Vienna Philharmonic or the Canadian Maple Leaf. With gold coins you have possession, they come in commonly accepted denominations and they are portable.

An exchange traded fund (ETF) may seem like a convenient way to buy gold. However, when you purchase an ETF, you own shares in the ETF, you don’t have physical possession of the gold. If you decide to purchase a gold ETF make sure the company has gold reserves to cover 100% of the investor deposits. Some of the largest ETFs have recently come under scrutiny for this issue. Finally, be cautious with investments in gold mutual funds, gold mining shares and ETFs that may become inaccessible in times of extreme market distress or collapse.

Does the Stimulus Make Gold Shine? (Part I)

Jane M. Young CFP, EA, CDFA

I have frequently been asked about the wisdom of investing in gold to hedge against inflation. Generally gold is not a great investment, it is commonly thought of as a doomsday investment. Gold is very risky and exceptionally volatile. The value of gold is based on what people are willing to pay. The market value of gold can be highly dependent on irrational emotions. Over long periods of time the return on gold has mirrored that of inflation resulting in a real return close to zero. The current price of gold is exceptionally high; it increased almost 60% over the three years ending in 2008. Additionally, the cost to acquire and sell gold can be prohibitive.

Recent increases in government spending make inflation a greater threat. A threat of inflation makes gold more appealing. Gold usually holds its value at times when other assets are losing their value. The demand for gold generally spikes in times of economic instability and inflation. If the government becomes unable to sell treasuries to cover significant increases in government spending it will resort to printing money. This will result in inflation. Historically, inflation has lead to higher gold prices.

If you decide to reinforce your portfolio with gold to guard against inflation or economic instability it should only represent a small percentage of your portfolio – generally 5% and no more than 15%.

Finding Peace of Mind in Turbulent Times

 Jane M. Young, CFP, EA

 

                                         

1. Don’t lose sight of your investment timeframe.  You’ve heard it time and time again but stock is a long term investment.  So, don’t let the current drop in the stock market cause you to make drastic changes to money you won’t need for 10, 15 or 20 years.   If you don’t need your money for 5 to 10 years stop worrying about it, the market will recover.   If you are in or approaching retirement, you should have put aside the money you will need in the short term.   Use this for your immediate needs.   Down the road in 5 or 10 years when you need to tap into your stock mutual funds they should be back to reasonable levels.   Don’t lose sleep about the level of your investments 10 years from now.

 

2. Every financial crisis feels like the end of the world while we are in it.  If you were to look at the headlines during any one of the past financial downturns you couldn’t differentiate them from today.   Every time we go through a financial crisis whether it’s the savings and loan crisis in the 80’s or the dot.com crisis the message is the same.  This time it’s different, things will never be the same, the sky is falling and so forth.   Everything isn’t rosy, but we will recover from this.  We need to avoid making decisions based on emotion and fear.  The media is in the business to sell papers or increase viewers.  They are going to sensationalize our economic situation.  Good news does not provide high ratings.    Take a deep breath, hug your kids, walk your dog, live your life and stay the course with your portfolio – this too shall pass.

 

3. Don’t pass up a once in a lifetime opportunity to invest in stock at exceptionally low values.  Sure it has been exceptionally painful to watch the stock portion of our portfolios drop by 40% but what a great opportunity we have.   If you have a long time horizon now is a great time to invest in the stock market.  I encourage you to invest a set amount of money into a diversified set of stock mutual funds every month (dollar cost averaging).   Investing in your company 401k or a Roth IRA is a great way to make systematic investments.   Now is the time to invest, not to sit on the sidelines.  It is always darkest before the dawn.  Remember, the stock market is counterintuitive – you feel like selling when you should be buying and you feel like buying when you should be selling.  Therefore, right now we should be buying!!!   When you feel it is safe to buy again it will be too late.

 

4.  Choose your battles and focus on what you can control.  You can’t control the fluctuations in the stock market or where the market is headed.  However, you can better prepare yourself for a weak economy.  Maybe now is the time to cut your personal spending and build up your emergency fund.  Evaluate how to reduce your expenses and pay off debt. Make sure your skills are current and relevant.  Build and strengthen your network now before you really need it.  If you are approaching retirement, and the market has set you back, evaluate alternatives and contingency plans.   Take advantage of opportunities available to you – buy stock mutual funds at low values,  re-finance your home at a low interest rate, convert your traditional IRA to a Roth and sell those especially weak stocks to harvest tax losses.

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