Understanding Tail Risk and how to protect your investments

Understanding tail risk

What is Tail Risk?

Tail Risk is the possibility of suffering large investment losses due to sudden and unforeseen events. The name tail risk comes from the shape of the bell curve. Under normal circumstances, your most likely investment returns will gravitate in the middle of the curve. For long term investors, this will represent your average expected return. The more extreme returns have a lower probability of occurring and will taper away toward the end of the curve.

Understanding tail risk
Source: Pimco

The tail on the far-left side represents the probability of unexpected losses. The far-right represents the most extreme outcomes of substantial investment gains. For long-term investors, the ideal portfolio strategy will seek to minimize left tail risk without restricting the right tail growth potential.

Why is tail risk important?

Intuitively, we all want to be on the ride side of the bell curve. We want to achieve above-average returns and occasionally “hit the jackpot” with sizeable gains.

In real life, abrupt economic, social, and geopolitical events appear a lot more frequently than a rational human mind would predict. Furthermore, significant market shocks have been occurring about every three to five years resulting in “fatter” tails.

Also known as “Black Swans, they are rare and unique. These “one-off” events impose adverse pressure on your investment portfolio and create risk for outsized losses. Tail risk events bring a massive amount of financial and economic uncertainty and often lead to extreme turbulence on the stock market.

The Covid outbreak, Brexit, the European credit crisis, the collapse of Lehman Brothers, the Enron scandal, the US housing market downfall, and the 9/11 terrorist attacks are examples of idiosyncratic stock market shocks. Very few experts could have predicted them. More notably, they caused dramatic changes to our society and our economy, our consumer habits, and the way we conduct business.

Assessing your tail risk exposure

Retirees and those close to retirement, people who need immediate liquidity, executives, and employees holding a large amount of corporate stock are more susceptible to tail risk events. If you fall into one of these categories, you need to review your level of risk tolerance.

Investing is risky. There are no truly risk-free investments. There are only investments with different levels of risk. It is impossible to avoid risk altogether. The challenge for you is to have a reasonably balanced approach to all the risks you face. Ignoring one risk to help you prevent another risk does not mean you are in the clear.

Winners and losers

It is important to remember that every shock to the system leads to winners and losers. For example, the covid outbreak disproportionately hurt leisure, travel, retail, energy, and entertainment businesses. But it also benefited many tech companies as it accelerated the digital transformation. As bad as it was, the global financial crisis damaged many big and small regional banks. But it also opened the door for many successful fintech companies such as Visa, Mastercard, PayPal, and Square and exchange-traded fund managers like BlackRock and Vanguard. The aftermath of 9/11 drove the stock market down, but it led to a boost in defense and cybersecurity stocks.

Know your investments

The first step in managing your tail risk is knowing your investments. That is especially important if you have concentrated positions in a specific industry, a cluster of companies, or a single stock. Black Swan events could impact different stocks, sectors, and countries differently. For instance, the Brexit decision mostly hurt the performance of the UK and European companies and had no long-term effect on the US economy.

Know your investment horizon

Investors with a long-term investment horizon are more likely to withstand sudden losses. The stock market is forward-looking. It will absorb the new information, take a hit, and move on.

I always give this as an example. If you invested $1,000 in the S&P 500 index on January 1, 2008, just before the financial crisis, you would have doubled your money in 10 years. Unfortunately, if you needed your investment in one or two years, you would have been in big trouble. It took more than three years to recover your losses entirely.

Diversify

Never put all your eggs in one basket. The most effective way to protect yourself from unexpected losses is diversification. Diversification is the only free lunch you will ever get in investing. It allows you to spread your risk between different companies, sectors, asset classes, and even countries will allow your investment portfolio to avoid choppy swings in various market conditions. One prominent downside of diversification is that while you protect yourself from the left tail risk, you also limit the right tail potential for outsized returns.

Hold cash

Keeping cash reserves is another way to protect yourself from tail risk. You need to have enough liquidity to meet your immediate and near-term spending needs. I regularly advise my clients to maintain an emergency fund equal to six to twelve months of your budget. Put it in a safe place, but make sure that you still earn some interest.

Remember what we said earlier. There is no risk-free investment – even cash. Cash is sensitive to inflation. For instance, $100,000 in 2000 is worth only $66,800 in 2020. So, having a boatload of cash will not guarantee your long-term financial security. You must make it earn a higher return than inflation.

Furthermore, cash has a huge opportunity cost tag. In other words, by holding a large amount of money, you face the risk of missing out on potential gain from choosing other alternatives.

US Treasuries

US Government bonds have historically been a safe haven for investors during turbulent times. We have seen the demand for treasuries spiking during periods of extreme uncertainty and volatility. And inversely, investors tend to drop them when they feel confident about the stock market. Depending on their maturity, US treasuries may give you a slightly higher interest than holding cash in a savings account.

While offering some return potential, treasuries are still exposed to high inflation and opportunity cost risk. Also, government bonds are very sensitive to changes in interest rates. If interest rates go up, the value of your bonds will go down. On the other hand, when interest rates go down, the value of your bonds will decrease.

Gold

Gold is another popular option for conservative investors. Similar to treasuries, the demand for gold tends to go up during uncertain times. The faith for gold stems from its historical role as a currency and store of value. It has been a part of our economic and social life in many cultures for thousands of years.

As we moved away from the Gold standard, the Gold’s role in the economy has diminished over time. Nowadays, the price of gold is purely based on price and demand. One notable fact is that gold tends to perform well during periods of high inflation and political uncertainty.

In his 2011 letter to shareholders of Berkshire Hathaway, Warren Buffet described gold as an “asset that will never produce anything, but that is purchased in the buyer’s hope that someone else … will pay more for them in the future…..If you own one ounce of gold for an eternity, you will still own one ounce at its end.”

Buying Put Options to hedge tail risk

Buying put options om major stock indices is an advanced strategy for tail risk hedging. In essence, an investor will enter into an option agreement for the right to sell a financial instrument at a specified price on a specific day in the future. Typically, this fixed price known as a strike price is lower than the current levels where the instrument is trading. For instance, the stock of XYZ is currently trading at $100. I can buy a put option to sell that stock at $80 three months from now. The option agreement will cost me $2. If the stock price of XYZ goes to $70, I can buy it at $70 and exercise my option to sell it at $80. By doing that, I will have an immediate gain of $10. This is just an illustration. In real life, things can get more complicated.

The real value of buying put options comes during times of extreme overvaluation in the stock market. For the average investor, purchasing put options to tail risk hedging can be expensive, time-consuming, and quite complicated. Most long-term investors will just weather the storm and reap benefits from being patient.

Final words

Managing your tail risk is not a one-size-fits-all strategy. Black Swam events are distinctive in nature, lengh, and magnitude. Because every investor has specific personal and financial circumstances, the left tail risk can affect them differently depending on a variety of factors. For most long-term investors, the left tail and right tail events will offset each other in the long run. However, specific groups of investors need to pay close attention to their unique risk exposure and try to mitigate it when possible.

Benefits and drawbacks to buying Indexed Universal Life Insurance

Indexed Universal Life Insurance IUL

Today, I am going off the beaten path for me and will discuss the pros and cons of buying Indexed Universal Life Insurance. As a fee-only advisor, I do not sell any insurance or commission-based products. However, on numerous occasions, I have received requests from clients to review their existing insurance coverage. I certainly do not know every IUL product out there. And I might be missing some of the nuances and differences between them. My observation is that IUL is not suitable for the average person due to its complexity and high cost. And yet, the IUL might be the right product for you if you can take advantage of the benefits that it offers. 

Retirement Calculator

What is an Indexed Universal Life Insurance (IUL)?

Indexed Universal Life is a popular insurance product that promises protection coverage with stock market-like performance and a zero-downside risk. Like other universal life insurance, IUL offers a death benefit and a cash value. Your cash value account can earn interest based on the performance of a specific stock market index such as the S&P 500, Dow Jones Industrial Average, the Nasdaq 100, and Russell 2000.

IUL Illustration rate

IUL policies use an illustration rate for advertising and hypothetically projecting the policy values in their sales materials. The Illustration rate is the fixed rate derived from historical performance. Usually, the illustration rate ranges between 5% and 10%.

Is IUL right for me?

On the surface, Indexed Universal Life Insurance sounds like a great deal. You receive a stock market upside with zero risks for losses. Nevertheless, IUL comes with some severe caveats.

Let’s break down the main benefits and drawbacks of IUL.

 Benefits of Indexed Universal Life Insurance

Tax-Deferred Accumulation

Index Universal Life Insurance allows you to grow your policy cash value and death benefit on a tax-deferred basis. Typically, you will not owe income taxes on the interest credited to your cash value and death benefit.

Tax-Free Distribution

Life Insurance, in general, is a lucrative tool for legacy planning. With IUL, your policy beneficiaries will receive the death benefit tax-free. As long as you maintain your insurance premiums and don’t take outsized loans, you can pass tax-free wealth to the next generation.

Access to a cash value

You can always withdraw your policy basis (original premiums paid) tax-free. In most cases, you can also access your cash value through tax-favorable policy loans or withdrawals. In case of emergency, you may borrow from your indexed universal life insurance policy. You can access your cash value without any penalty regardless of your age.

Supplemental Retirement Income

You can use the cash value from your policy as a source of supplemental retirement income.  You can also use it to cover future medical expenses.

Limited downside risk

IUL offers protection against stock market volatility. An IUL delivers stock market-linked gains without the risks of losing principal due to the stock market declines. With the IUL’s principal-protection guarantee, your annual gains are locked in. Your principal cash value remains the same, even if the stock market goes down.

A guaranteed minimum rate

Many IUL policies come with a guaranteed minimum annual interest rate. This rate is a floor of how much you can earn every year. The guaranteed allows you to receive a certain percentage regardless of how the market performs. This floor rate depends on the specific insurance, and it could vary between 0% and 2%.

Drawbacks of Indexed Universal Life Insurance

IUL is complex

IUL is an extremely complex insurance product. There are many moving parts in your UIL policy, making it confusing and hard to understand. Most sales illustration packages portray an ideal scenario with non-guaranteed average market performance figures. In reality, between your annual premiums, cap rates, floors, fees, market returns, cash value accumulation, riders, and so on, it is tough to predict the outcome of your insurance benefits.

Upfront Commissions

The people who sell IUL are highly trained sales professionals who may not be qualified to provide fiduciary financial advice. The IUL comes with a hefty upfront commission, which is often buried in the fine print and gets subtracted from your first premium payment.

IUL has high fees

The policy fees will shock you and eat your lunch literally. I have personally seen charges in the neighborhood of 11% to 13% annually. These fees will always reduce the benefits of your annual premium and earned interest.

Limited earnings potential

IUL policies will typically limit your stock market returns and will exclude all dividends. Most IULs offer some combination of participation rate and capped rate in comparison to the illustration rate used in their marketing materials.

Participation Rate is the percentage of positive index movement credited to the policy. For example, if the S&P 500 increased 10% and the IUL has an annual participation rate of 50%, your policy would receive 5% interest on the anniversary date.

Cap Rate is the maximum rate that you can earn annually. The cap rate can vary significantly from policy to policy and from insurance provider to the next.

 Why capped upside is an issue?

The problem with cap rates and participation rates is they limit your gains during, especially good years. Historically, the stock market returns are not linear and sequential, as the policy illustration rates suggest. In the 40 years between 1980 and 2019, the stock market earned an average of 11.27% per year. During this period, there were only eight years when the stock market had negative returns or 20% of that period. There were only seven years when the stock market posted returns between 0% and 10%. And there were 25 years when the stock market earned more than 10% per year. In 17 of those 25 periods, the stock market investors gained more than 20% or 42% of the time.

In other words, historically, the odds of outsized gains have been a lot higher than the odds of losses.

However, as humans, the pain of losing money is a lot stronger than the joy of gaining.

In effect, long-term IUL policyholders will give up the potential of earning these outsized profits to reduce their anxiety and stress of losing money.

Surrender charges

IULs have hefty surrender charges. If you change your mind in a couple of years and decide to cancel your policy, you may not be able to receive the full cash value. Before you get into a contract, please find out the surrender charges and when they expire.

Expensive Riders

Indexed Universal Life Insurance typically offers riders. The policy riders are contract add-ons that provide particular benefits in exchange for an additional fee. These provisions can include long-term care services, disability waivers, enhanced performance, children’s’ term insurance, no-lapse guarantee, and many more. The extra fee for each rider will reduce your cash value, similar to the regular policy fees. You need to assess each rider individually as the cumulative cost may outweigh your benefit and vice versa,

Cash value withdrawals reduce your death benefit

In most cases, you might be able to make a tax-free withdrawal from the cash value of your IUL policy. These withdrawals are often treated as loans. However, legacy-minded policyholders need to remember that withdrawing your cash value reduces your beneficiaries’ death benefit when you pass away.

Potential taxable income

There is still a chance to pay taxes on your IUL policy. If you let your policy lapse or decide to surrender it, the money you have withdrawn previously could be taxable. Withdrawals are treated as taxable when they exceed your original cost basis or paid premiums.

15 Costly retirement mistakes

15 Costly retirement mistakes

15 Costly retirement mistakes… Retirement is a major milestone for many Americans. Retiring marks the end of your working life and the beginning of a new chapter. As a financial advisor, my job is to help my clients avoid mistakes and retire with confidence and peace of mind.  Together we build a solid roadmap to retirement and a gameplan to achieve your financial goals. My role as a financial advisor is to provide an objective and comprehensive view of my clients’ finances.  As part of my process, I look for any blind spots that can put my clients’ plans at risk.  Here is a list of the major retirement mistakes and how to avoid them.

1. Not planning ahead for retirement

Not planning ahead for retirement can cost you a lot in the long run. Delaying to make key decisions is a huge retirement mistake that can jeopardize your financial security during retirement. Comprehensive financial planners are more likely to save for retirement and feel more confident about achieving their financial goals.  Studies have shown that only 32% of non-planners are likely to have enough saved for retirement versus 91% of comprehensive planners.

Reviewing your retirement plan periodically will help you address any warning signs in your retirement plan. Recent life changes, economic and market downturns or change in the tax law could all have a material impact on your retirement plans. Be proactive and will never get caught off guard.

2. Not asking the right questions

Another big retirement mistake is the fear of asking the right question. Avoiding these

Here are some of the questions that my clients are asking –

  • “Do I have enough savings to retire?”
  •  “Am I on the right track?”.
  • “Can I achieve my financial goals?”
  • “Can I retire if the stock market crashes?”.
  • “Are you fiduciary advisor working in my best interest?” (Yes, I am fiduciary)

Asking those tough questions will prepare you for a successful retirement journey. Addressing your concerns proactively will take you on the right track of meeting your priorities and achieving your personal goals

3. Not paying off debt

Paying off debt can be an enormous burden during retirement. High-interest rate loans can put a heavy toll on your finances and financial freedom. As your wages get replaced by pension and social security benefits, your expenses will remain the same. If you are still paying off loans, come up with a plan on how to lower your debt and interest cost. Being debt-free will reduce the stress out of losing viable income.

4. Not setting goals

Having goals is a way to visualize your ideal future. Not having goals is a retirement mistake that can jeopardize your financial independence during retirement. Without specific goals, your retirement planning could be much harder and painful. With specific goals, you have clarity of what you want and what you want to achieve. You can make financial decisions and choose investment products and services that align with your objectives and priorities. Setting goals will put you on a successful track to enjoy what matters most to you.

5. Not saving enough

An alarming 22% of Americans have less than $5,000 in retirement savings. The average 401k balance according to Fidelity is $103,700. These figures are scary. It means that most Americans are not financially ready for retirement. With ultra-low interest rates combined with constantly rising costs of health care,  future retirees will find it difficult to replace their working-age income once they retire. Fortunately, many employers now offer some type of workplace retirement savings plans such as 401k, 403b, 457, TSP or SEP IRA. If your employer doesn’t offer any of those, you can still save in Traditional IRA, Roth IRA, investment account or the old fashioned savings account.

6. Relying on one source for retirement income

Many future retirees are entirely dependent on a single source for their retirement income such as social security or pension.  Unfortunately. with social security running out of money and many pension plans shutting down or running a huge deficit, the burden will be on ourselves to provide reliable income during our retirement years.  If you want to be financially independent, make sure that your retirement income comes from multiple sources.

7. Lack of diversification

Diversification is the only free lunch you can get in investing and will help decrease the overall risk of your portfolio. Adding uncorrelated asset classes such as small-cap, international and emerging market stocks, bonds, and commodities will reduce the volatility of your investments without sacrificing much of the expected return in the long run.

A common mistake among retirees is the lack of diversification. Many of their investment portfolios are heavily invested in stocks, a target retirement fund or a single index fund.

Furthermore, owning too much of one stock or a fund can cause significant issues to your retirement savings. Just ask the folks who worked for Enron or Lehman Brothers who had their employer’s stocks in their retirement plans. Their lifetime savings were wiped out overnight when these companies filed for bankruptcy.

8. Not rebalancing your investment portfolio

Regular rebalancing ensures that your portfolio stays within your desired risk level. While tempting to keep a stock or an asset class that has been on the rise, not rebalancing to your original target allocation can significantly increase the risk of your investments.

9. Paying high fees

Paying high fees for mutual funds and high commission insurance products can eat up a lot of your return. It is crucial to invest in low-cost investment managers that can produce superior returns over time. If you own a fund that has consistently underperformed its benchmark,  maybe it’s time to revisit your options.

Many insurance products like annuities and life insurance while good on paper, come with high upfront commissions, high annual fees, and surrender charges and restrictions.  Before signing a contract or buying a product, make sure you are comfortable with what you are going to pay.

10. No budgeting

Adhering to a budget before and during retirement is critical for your confidence and financial success. When balancing your budget, you can live within your means and make well-informed and timed decisions. Having a budget will ensure that you can reach your financial goals.

11. No tax planning

Not planning your taxes can be a costly retirement mistake. Your pension and social security are taxable. So are your distributions from 401k and IRAs. Long-term investing will produce gains, and many of these gains will be taxable. As you grow our retirement saving the complexity of assets will increase. And therefore the tax impact of using your investment portfolio for retirement income can be substantial. Building a long-term strategy with a focus on taxes can optimize your after-tax returns when you manage your investments.

12. No estate planning

Many people want to leave some legacy behind them. Building a robust estate plan will make that happen. Whether you want to leave something to your children or grandchildren or make a large contribution to your favorite foundation, estate, and financial planning is important to secure your best interests and maximize the benefits for yourself and your beneficiaries.

13. Not having an exit planning

Sound exit planning is crucial for business owners. Often times entrepreneurs rely on selling their business to fund their retirement. Unlike liquid investments in stocks and bonds, corporations and real estate are a lot harder to divest.  Seling your business may have serious tax and legal consequences. Having a solid exit plan will ensure the smooth transition of ownership, business continuity, and optimized tax impact.

14. Not seeing the big picture

Between our family life, friends, personal interests, causes, job, real estate properties, retirement portfolio, insurance and so on, our lives become a web of interconnected relationships. Above all is you as the primary driver of your fortune. Any change of this structure can positively or adversely impact the other pieces. Putting all elements together and building a comprehensive picture of your financial life will help you manage these relationships in the best possible way.

15. Not getting help

Some people are very self-driven and do very well by planning for their own retirement. Others who are occupied with their career or family may not have the time or ability to deal with the complexities of financial planning. Seeking help from a fiduciary financial planner can help you avoid retirement mistakes. A fiduciary advisor will watch for your blind spots and help you find clarity when making crucial financial decisions.

The recent market volatility – the tale of the perfect storm

The recent market volatility – the tale of the perfect storm

The recent market volatility – the tale of the perfect storm

October is traditionally a rough month for stocks. And October 2018 proved it.

S&P 500 went down -6.9% in October after gaining as much as 10.37% in the first nine months of the year. Despite recouping some of its losses in early November, the market continues to be volatile, with large daily swings in both directions. On top of that, Small Cap stocks, which were leading the way till late September, went down almost 10% in the span of a few weeks.

So, what led to this rout?

The market outlook in September was very positive. Consumer sentiment and business optimism were at a record high. Unemployment hit a record low. And the market didn’t really worry about tariffs.

I compiled a list of factors that had a meaningful impact on the recent market volatility. As the headline suggested, I don’t believe there was a single catalyst that drove the market down but a sequence of events creating a perfect storm for the equities to go down.

Index Q1 2018 Q2 2018 Q3 2018 Q3 YTD 2018 Oct – Nov 2018 Nov 2018 YTD
S&P 500 Large-Cap (SPY) -1.00% 3.55% 7.65% 10.37% -4.91% 5.45%
S&P 600 Small-Cap (IJR) 0.57% 8.69% 4.87% 14.64% -9.54% 5.09%
MSCI EAFE (VEA) -0.90% -1.96% 1.23% -1.62% -7.06% -8.68%
Barclays US Aggregate Bond (AGG) -1.47% -0.18% -0.08% -1.73% -0.81% -2.54%
Gold (GLD) 1.73% -5.68% -4.96% -8.81% 1.39% -7.42%
Source: Morningstar

1. Share buybacks

The month of October is earnings season. Companies are not allowed to buy back shares as they announce their earnings. The rationale is that they possess significant insider information that could influence the market in each direction. As it turned out, 2018 was a big year for share buybacks. Earlier in the year, S&P estimated $1 trillion worth of share buybacks to be returned to shareholders. So, in October, the market lost a big buyer – the companies who were buying their own shares. And no one stepped in to take their place.

The explosion of share buyback was prompted by the TCJA law last year which lowered the tax rate of US companies from 35% to 21%. Additionally, the new law imposed a one-time tax on pre-2018 profits of foreign affiliates at rates of 15.5% for cash and 8% for non-cash assets. Within a few months, many US mega-cap corporations brought billions of cash from overseas and became buyers of their stock.

2. High valuations

With the bull market is going on its ninth year, equity valuations remain high even after the October market selloff.

Currently, the S&P 500 is trading at 22.2, above the average level of 15.7. Its dividend yield is 1.9%, well below the historical average of 4.34%.

Furthermore, the current Shiller PE Ratio stands at 30.73, one of the highest levels in history. While the traditional Price to Earnings ratio is calculated based on current or estimated earning levels, the Schiller ratio calculates average inflation-adjusted earnings from the previous ten years. The ratio is also known as the Cyclically Adjusted PE Ratio (CAPE Ratio) or PE10.

While a coordinated global growth and low-interest rate environment had previously supported the thesis that high valuation ratios were justified, this may not be the case for much longer.

3. The divergence between US and international stocks

The performance of International Developed and Emerging Market remains disappointing. While the US markets are still in positive territory, International Developed and EM stocks have plunged by -8% and -15% respectively so far in 2018.  Higher tariffs imposed by the US, negative Brexit news, growing domestic debt in China, and slower GDP growth in both the Eurozone and China have spurred fears of an upcoming recession. Despite attractive valuations, international markets remain in correction territory, The dividend yield of MSCI EAFE is 3.34%, while MSCI EM is paying 2.5%, both higher than 1.9% for S&P 500.

4. The gap between growth and value stocks

The performance gap between growth and value stocks is still huge. Growths stocks like Apple, Amazon, Google, Visa, MasterCard, UnitedHealth, Boeing, Nvidia, Adobe, Salesforce, and Netflix have delivered 10% return so far this year. At the same time value strategies dominated by Financials, Consumer Staples and Energy companies are barely breaking even.

Index Q1 2018 Q2 2018 Q3 2018 Q3 YTD 2018 Oct – Nov 2018 Nov 2018 YTD  P/E Ratio
S&P 500 Large Cap Growth (IVW) 1.81% 5.17% 9.25% 16.97% -6.95% 10.01% 29.90
S&P 500 Large Cap Value (IVE) -3.53% 1.38% 5.80% 3.26% -2.59% 0.67% 19.44

 

5. Tempering earnings growth

So far in Q3 2018, 90% of the companies have announced earnings. 78% of them have reported better than expected actual earnings with an average earnings growth rate of 25.2%. 61% of the companies have reported a positive sales surprise. However, 58 companies in the S&P 500 (12%) have issued negative earnings guidance for Q4 2018. And the list of stocks that tumbled due to cautious outlook keeps growing – JP Morgan, Facebook, Home Depot, Sysco, DR Horton, United Rentals, Texas Instruments, Carvana, Zillow, Shake Shack, Skyworks Solutions, Michael Kors, Oracle, GE, Cerner, Activision, etc.

Despite the high consumer optimism and growing earnings, most companies’ CFOs are taking a defensive approach. Business investment grew at a 0.8% annual rate in the third quarter, down from 8.7% in the second quarter. This was the slowest pace since the fourth quarter of 2016.

The investment bank Nomura also came out with the forecast expecting global growth to slow down. Their economists predicted that global growth in 2019 would hit 3.7% and temper to 3.5% in 2020 from 3.9% in 2018. According to Nomura, the drivers for the slowdown include waning fiscal stimulus in the U.S., tighter monetary policy from the Federal Reserve, increased supply constraints and elevated risk of a partial government shutdown.

 

6. Inflation is creeping up

Almost a decade since the Credit Crisis in 2008-2009, inflation has been hovering below 2%. However, in 2018, the inflation has finally made a comeback. In September 2018, monthly inflation was 2.3% down from 2.9% in July and 2.7% in August.

One winner of the higher prices is the consumer staples like Procter & Gamble, Unilever, and Kimberly-Clark. Most of these companies took advantage of higher consumer confidence and rising wages to pass the cost of higher commodity prices to their customers.

7. Higher interests are starting to bite

After years of near-zero levels, interest rates are starting to go higher. 10-year treasury rate reached 3.2%, while the 2-year rate is slowly approaching the 3% level. While savers are finally beginning to receive a decent interest on their cash, CDs and saving accounts, higher interest rates will hurt other areas of the economy.

 

With household debt approaching $13.4 trillion, borrowers will pay higher interest for home, auto and student loans and credit card debt. At the same time, US government debt is approaching $1.4 trillion. Soon, the US government will pay more for interest than it is spending on the military.  The total annual interest payment will hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office.

The higher interest rates are hurting the Financial sectors. Most big banks have enjoyed a long period of paying almost nothing on their client deposits and savings accounts. The rising interest rates though have increased the competition from smaller banks and online competitors offering attractive rates to their customers.

We are also monitoring the spread between 2 and 10-year treasury note, which is coming very close together. The scenario when two-year interest rates go above ten-year rates causes an inverted yield curve, which has often signaled an upcoming recession.

8. The housing market is slowing down

Both existing and new home sales have come down this year.  Rising interest rates, higher cost of materials, labor shortage and high real estate prices in major urban areas have led to a housing market slow down.  Existing home sales dropped 3.4% in September coming down for six months in a row this year. New building permits are down 5.5% over 2017.

Markets have taken a negative view on the housing market. As a result, most homebuilders are trading at a 52-week low.

9. Fear of trade war

Some 33% of the public companies have mentioned tariffs in their earnings announcements in Q3.  9% of them have negatively mentioned tariffs. According to the chart below, Industrials, Information Technology, Consumer Dictionary, and Materials are the leading sectors showing some level of concern about tariffs.

10. Strong dollar

Fed’s hiking of interest rates in the US has not been matched by its counterparts in the Eurozone, the UK, and Japan. The German 10-year bund now yields 0.4%, while Japanese 10-year government bond pays 0.11%. Combining the higher rates with negative Brexit talks, Italian budget crisis and trade war fears have led to a strong US dollar reaching a 17-month high versus other major currencies.

Given that 40% of S&P 500 companies’ revenue comes from foreign countries, the strong dollar is making Americans goods and services more expensive and less competitive abroad. Furthermore, US companies generating earnings in foreign currency will report lower US-dollar denominated numbers.

11. Consumer debt is at a record high

The US consumer debt is reaching 4 trillion dollars. Consumer debt includes non-mortgage debts such as credit cards, personal loans, auto loans, and student loans. Student loans are equal to $1.5 trillion while auto debt is $1.1 trillion and credit card debt is close to $1.05 trillion. Furthermore, the US housing dent also hit a record high. In June, the combined mortgage and home equity debt were equal to $9.43 trillion, according to the NY Fed.

The rising debt has been supported by low delinquencies, high property values, rising wages, and low unemployment. However, a slowdown in the economy and the increasing inflation and interest rates can hurt US consumer spending.

12. High Yield and BBB-rated debt is growing

The size of the US corporate debt market has reached $7.5 trillion. The size of the BBB rated debt now exceeds 50% of the entire investment grade market. The BBB-rated debt is just one notch above junk status. Bloomberg explains that, in 2000, when BBB bonds were a mere third of the market, net leverage (total debt minus cash and short-term investments divided by earnings before interest, taxes, depreciation, and amortization) was 1.7 times. By the end of last year, the ratio had ballooned to 2.9 times.

Further on, the bond powerhouse PIMCO commented: “This suggests a greater tolerance from the credit rating agencies for higher leverage, which in turn warrants extra caution when investing in lower-rated IG names, especially in sectors where earnings are more closely tied to the business cycle.”

13. Oil remains volatile

After reaching $74.15 per barrel in October, US crude oil tumbled to $55, a 24% drop. While lower crude prices are pushing down on inflation, they are hurting energy companies, which are already trading in value territory.

According to WSJ, the oil’s rapid decline is fueling fears for global oversupply and slowing economic growth. Furthermore, the outlook for supply and demand shifted last month as top oil producers, began ramping up output to offset the expected drop in Iranian exports. However, earlier this month Washington decided to soften its sanctions on Iran and grant waivers to some buyers of Iranian crude—driving oil prices down. Another factor pushing down on oil was the strong dollar.

14. Global political uncertainty

The Brexit negotiations, Italian budget crisis, Trump’s threats to pull out of WTO, the EU immigrant crisis, higher tariffs, new elections in Brazil, Malaysian corruption scandal and alleged Saudi Arabia killing of a journalist have kept the global markets on their toes. Foreign markets have underperformed the US since the beginning of the year with no sign of hope coming soon.

15. The US Election results

A lot has been said about the US elections results, so I will not dig in further. In the next two year, we will have a divided Congress. The Democrats will control the house, while the Republicans will control the Senate and the executive branch. The initial market reaction was positive. Most investors are predicting a gridlock with no major legislature until 2020. Furthermore, we could have intense budget negotiations and even another government shutdown. Few potential areas where parties could try to work together are infrastructure and healthcare. However, any bi-partisan efforts might be clouded by the upcoming presidential elections and Mueller investigation results.

In Conclusion

There is never a right time to get in the market, start investing and saving for retirement. While market volatility will continue to prevail the news, there is also an opportunity for diligent investors to capitalize on their long-term view and patience. For these investors, it is essential to diversify and rebalance your portfolio.

In the near term, consumer confidence in the economy remains strong. Rising wages and low unemployment will drive consumer spending. My prediction is that we will see a record high shopping season. Many of these fifteen headwinds will remain. Some will soften while others will stay in the headlines.

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at [email protected] or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation, and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

Market Outlook October 2018

Overview

The US stock market was on an absolute tear this summer. S&P 500 went up by 7.65% and completed its best 3rd quarter since 2013. Despite the February correction, the US stocks managed to recover from the 10% drop. All major indices reached a series of record highs at the end of August and September.

Index Q1 2018 Q2 2018 Q3 2018 YTD 2018
S&P 500 Large-Cap (SPY) -1.00% 3.55% 7.65% 10.37%
S&P 600 Small-Cap (IJR) 0.57% 8.69% 4.87% 14.64%
MSCI EAFE (VEA) -0.90% -1.96% 1.23% -1.62%
Barclays US Aggregate Bond (AGG) -1.47% -0.18% -0.08% -1.73%
Gold (GLD) 1.73% -5.68% -4.96% -8.81%
Source: Morningstar

 

The US Economy remains strong

Markets have largely shrugged off the trade war fears benefiting from a strong economy and high corporate earnings.

US Unemployment remains low at 3.9% in July and August, levels not seen since the late 1960s and 2000.

Consumer sentiment is at a multi-year high. The University of Michigan Consumer Sentiment Index hit 100.1 in September, passing 100 for the third time since the January of 2004.

Business optimism hit another record high in August.  The National Federation of Independent Business’ small business optimism index reached the highest level in the survey’s 45-year history. According to NFIB, small business owners are planning to hire more workers, raise compensation for current employees, add inventory, and spend more on capital investments.

A hypothetical 60/40 portfolio

A hypothetical 60/40 index portfolio consisting of 30% US Large Cap Stocks, 10% US Small Cap Stocks, 20% International Stocks, 33% US Fixed Income and 7% Gold would have returned 3.06% by the end of September.

Index Allocation Return
S&P 500 30% 3.11%
S&P 600 10% 1.46%
MSCI EAFE 20% -0.32%
Barclays USAgg Bond 33% -0.57%
Gold 7% -0.62%
Hypothetical Performance 3.06%

 

US Equity

I expect a strong Q4 of 2018 with a record high holiday consumer and business spending. While stock valuations remain elevated, robust revenue and consumer demand will continue to drive economic growth.

After lagging large-cap stocks in 2017, small-cap stocks are having a comeback in 2018. Many domestically focused publicly traded businesses benefited massively from the recent corporate tax cuts, higher taxes on imported goods and healthy domestic demand.

This year’s rally was primarily driven by Technology, Healthcare and Consumer Discretionary stocks, up 20.8%, 16.7%, and 13.7% respectively. However, other sectors like Materials, Real Estate, Consumer Staples, Financials and Utilities are either flat or negative for the year. Keep in mind of the recent reshuffle in the sector classification where Google, Facebook, Netflix and Twitter along with the old telecommunication stocks were added to a new sector called Communication services.

Sector performance

Sector Performance Price per Price to Dividend
YTD Earnings Sales Yield
as of 10/3/2018 (TTM)  (TTM) (%)
Communication Services -1.91% 22.6x 1.3x 4.83%
Consumer Discretionary 13.72% 16.5x 1.0x 1.27%
Consumer Staples -5.50% 15.1x 1.0x 2.86%
Energy 8.67% 14.0x 1.2x 1.74%
Financials 0.29% 15.2x 2.1x 1.91%
Health Care 16.71% 18.2x 1.2x 1.86%
Industrials 4.73% 15.7x 1.1x 1.85%
Information Technology 20.86% 14.8x 2.1x 0.90%
Materials -3.56% 13.2x 1.1x 1.79%
Utilities 0.77% 17.1x 1.3x 3.70%
Source: Bloomberg

 

I believe that we are in the last few innings of the longest bull market. However, a wide range of sectors and companies that have largely remained on the sidelines. Some of them could potentially benefit from the continued economic growth and low tax rates.

International Equity

The performance gap between US and foreign stocks continues to grow. After a negative Q1 and Q2, foreign stocks recouped some of the losses in Q3. Furthermore, emerging market stocks are down close to -9% for the year.

Bad economic data coming from Turkey, Italy, Argentina, Brazil, Indonesia, South Africa, and China along with trade war fears put downward pressure on foreign equity markets. Additionally, rising right-wing sentiments in Italy, Austria, Sweden, Hungary, and even Germany puts doubts on the stability of the European Union and its pro-immigration policies.

In my view, the risk that the financial crisis in Turkey, Argentina, and Italy will spread to other countries is somewhat limited. However, the short-term headwinds remain, and we will continue to monitor these markets.

Brexit

Another major headline for European stocks is the progress of the Brexit negotiation. While soft Brexit would benefit both sides, a hard exit could have a higher negative impact on the UK.

I remain cautiously positive on international stocks. According to WSJ, foreign stocks are trading at a 12% discount over US equity on price to earnings basis. This year created value opportunities in several counters. However, the issue with European and Japanese stocks is not so much in valuations but the search for growth catalysts in conservative economies with an aging population.

Fixed Income

Rising Fed rates and higher inflation have driven bond prices lower so far this year. With inflation rate hovering at 2%, strong employment figures, rising commodity cost, and robust GDP growth, the Fed will continue to hike interest rates. I am expecting one more rate hike in December and three additional hikes in 2019.

I will also continue to monitor the spread between 2-year and 10-year treasury. This spread is currently at 0.23%, the lowest level since 2005.  Normally, a negative spread, i..e 2-year treasury rare higher than 10-year is a sign of a troubled economy.

While modest, individual pockets of the fixed-income market are generating positive performance this year. For instance, short duration fixed income products are now yielding in the range of 1.5% to 2%. The higher interest is now a compelling reason for many investors to keep some of their holdings in cash, CDs or short-term instruments.

With 10-year treasury closing above 3% and moving higher, fixed income investors will continue to see soft returns on their portfolio.

Gold

Gold is one of the big market losers this year. The strong dollar and robust US economy have led to the precious metal sell-off.  While the rise cryptocurrency might have reduced some of the popularity of Gold, I still believe that a small position in Gold can offer a buffer and reduce the overall long-term portfolio volatility. The investors tend to shift to Gold during times of uncertainty.

Navigating market highs

With S&P 500, NASDAQ and Dow Jones hitting all-time highs, how should investors manage their portfolio?

Rebalance

End of the year is an excellent opportunity for reconciliation and rebalancing to your target asset allocation. S&P 500 has returned 16.65% in the past five years, and the chance that equities are taking a big chunk of your portfolio is very high. Realizing some long-term gains and reinvesting your proceeds into other asset classes will ensure that your portfolio is reset to your desired risk tolerance level as well as adequately diversified.

Think long-term

In late January and early February, we experienced a market sell-offs while S&P 500 dropped more than 10%. Investors in the index who did not panic and sold at the bottom recouped their losses and ended up with 10% return as of September 30, 2018. Taking a long-term view will help you avoid the stress during market downturns and allow you to have a durable long-term strategy

 

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at [email protected] or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

Market Outlook April 2018

Market Outlook April 2018

Market Outlook April 2018

After a record high 2017, the volatility has finally returned. Last year the market experienced one of the highest risk-adjusted performances in recent history. In 2017 there were only 10 trading where the S&P 500 moved by more than 1% in either direction, with not a single trading day when it moved by more than 2%. In contrast, in the 61 trading days of Q1 of 2018, we had 26 days when the S&P 500 moved by more than 1% and 8 days where it changed by more than 2%.

Learn more about our Private Wealth Management services

 

VIX Index Q1 2018

Market Outlook April 2018
VIX index Q1 2018. Source Yahoo Finance

The VIX Index, which measures the volatility of the S&P 500 started the year ar 9.77. It peaked at 37.33 and ended the quarter at 19.97.

Markets do not like uncertainty, and so far, Q1 had plenty of that. In the first 3 months of the year market landscape was dominated by news about rising inflation and higher interest rates, the Toys R Us bankruptcy, trade war talks and tariffs against China, and scandals related to Facebook user data privacy.

Except for Gold, all major market indices finished in the negative territory.

Index Q1 2018
S&P 500 -1.00%
Russell 2000 -0.18%
MSCI EAFE -0.90%
Barclays US Aggregate Bond Index -1.47%
Gold +1.73%

 

Fixed Income

Traditionally bonds have served as an anchor for equity markets. Over time stocks and US Treasury bond have shown a negative correlation. Usually, bonds would rise when stocks prices are falling as investors are moving to safer investments. However, in 2018 we observed a weakening of this relationship. There were numerous trading days when stocks and bonds were moving in the same direction.

On the other hand, despite rising interest rates, we see the lowest 10-year/2-year treasury spread since the October of 2007. The spread between the two treasury maturities was 0.47 as of March 29, 2018. While not definite, historically negative or flat spreads have preceded an economic recession.

Momentum

Momentum remained one of the most successful strategies of 2018 and reported +2.97%. Currently, this strategy is dominated by Technology, Financials, Industrials, and Consumer Cyclical stocks. Some of the big names include Microsoft, JP Morgan, Amazon, Intel, Bank of America, Boeing, CISCO, and Mastercard.

Value

Value stocks continued to disappoint and reported -3.73% return in the Q1 of 2018. Some of the biggest names in this strategy like Exxon Mobile, Wells Fargo, AT&T, Chevron, Verizon, Citigroup, Johnson & Johnson, DowDuPont and Wall-Mart fell close to or more than -10%. As many of these companies are high dividend payers, rising interest rates have decreased the interest of income-seeking investors in this segment of the market.

Small Cap

As small-cap stocks stayed on the sideline of the last year’s market rally, they were mostly unaffected by the recent market volatility.  Given that most small-cap stocks derive their revenue domestically, we expect them to benefit significantly from the lower tax rates and intensified trade war concerns.

Gold

Gold remained a solid investment choice in the Q1 of 2018. It was one of the few asset classes that reported modest gains. If the market continues to b volatile, we anticipate more upside potential for Gold.

 

Outlook

  • We anticipate that the market volatility will continue in the second quarter until many of the above issues get some level of clarification or resolution.
  • We expect that small and large-cap stocks with a strong domestic focus to benefit from the trade tariffs tension with China and other international partners
  • The actual impact of lower taxes on corporate earnings will be revealed in the second half of 2018 as Q3 and Q4 earnings will provide a clear picture of earnings net of accounting and tax adjustments.
  • Strong corporate earnings and revenue growth have the ability to decrease the current market volatility. However, weaker than expected earnings can have a dramatically opposite effect and drive down the already unstable markets.
  • If the Fed continues to hike their short-term lending rates and inflation rises permanently above 2%, we could see a further decline in bond prices.
  • Our strategy is to remain diversified across asset classes and focus on long-term risk-adjusted performance

 

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at [email protected] or +925-448-9880.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

 

Biggest Risks for the Markets in 2018

Biggest Risks for the Markets in 2018

Biggest Risks for the Markets in 2018

Wall Street is gearing for another record year on the equity market. On January 2nd Nasdaq crossed 7,000. A day later S&P 500 reached 2,700. Dow Jones followed by passing over 25,000. Who can ask for a better start?

However, with S&P 500 earning +22% and Nasdaq gaining 32% in 2017, many are wondering if the equity market has any fuel left for another big run. With momentum on its side, the recent corporate tax cuts, and president’s promises for deregulation we have the foundation for another record high year. But not everything is perfect. In times of market euphoria, investors tend to ignore warning signals.

Surely, there is no shortage of potential threats that can trigger another significant market correction or an economic recession. In my view, here are the biggest risks for the market in 2018 and beyond.

Learn more about our Private Wealth Management services

Government shutdown

With the start of the year, both Republicans and Democrats are gearing for a battle as the current government funding bill expires on January 19.

Republicans are invigorated after winning their most important battle of 2017. The GOP voted for the most extensive tax overhaul in 30 years which promises to cut taxes for corporations and middle class but also introduces additional $1.5 trillion to the budget deficit in 10 years without counting for growth. Their 2018 agenda includes cutting entitlements, building a border wall, financing a new infrastructure plan, increasing the military budget and maybe repealing Obamacare.

On the opposite end, after their win in the Alabama senate race, Democrats are slowly recovering from their knockdown phase after the US 2016 Presidential election.  Democrats will try to push their agenda on the Dreamers Act and save the government healthcare subsidies.

With a slim Senate majority and traitorous rifts inside the party, the GOP will have a hard time passing any significant legislation. The Senate leadership already expressed their desire to work with Democrats on the next bill on avoiding a government shutdown. While the public may appreciate a bi-partisan agreement, both parties have shown an enormous resistance to compromise on any level.

Geopolitical crisis

There is a growing number of geopolitical threats that can compromise the global growth. The world is becoming a treacherous place where one miscalculation can lead to a human disaster. From cyber-war with Russia to nuclear tension with North Korea, ongoing unrest in the Middle East, shutting down NAFTA, populist governments taking over Europe, and hard Brexit negotiations.

China is looking to fill the vacuum left by the US after scrapping the Trans-Pacific Trade Agreement.  Russia and President Putin want to play a bigger role in the world affairs. The remnants of ISIS are spread around the world and planning the next terrorist attack. The 16-year war in Afghanistan is still going with no resolution in sight. The tension between Iran and Saudi Arabia is on its highest level for years. The president must maneuver carefully in the dangerous waters of world politics where governments are becoming more and more protectionist and populist.

Health Care Chaos

The GOP was unsuccessful in repealing the Affordable Care Act. However, they were able to remove the individual mandate as part of the recent tax cut bill.

With the penalty going away in 2019, there will be no incentive for healthier individuals to sign up for health insurance.  Furthermore, this will lead to a lower number of insured participants and drive higher their cost of health care.

US has already the most expensive health care among all OECD counties. The average cost per individual in the USA is $10,000 versus $6,700 for Switzerland and $5,100k for Germany. The Congress and Senate must find a solution to address the climbing health care cost. The alternative will lead to more healthy people dropping from the system, skyrocketing medical bills, social unrest,  and even economic slowdown.

Retail meltdown

US retail is in danger. In 2017, 19 retailers including Toys R US, Aerosoles, Perfumania, True Religions and Gymboree filed for bankruptcy protection. Many others like Teavana, Bebe, and Kenneth Cole closed all their physical locations to focus on online expansion. Despite rising consumer confidence and record-high holiday shopping spree, traditional brick-and-mortar retailers are struggling to stay afloat.

Apart from a few big names, US retailers are loaded with debt. According to Bloomberg, $100 million of high-yield retail debt was set to mature in 2017. Furthermore, this figure will rise to $1.9 billion in 2018 and will average $5 billion between 2019 to 2025. With rising interest rates and permanent drift towards online shopping, many retailers will continue to close down unprofitable locations. Local economies relying heavily on retail jobs will suffer high unemployment rates in the coming years.

Consumer debt crunch

The US household debt has reached $13 trillion in the third quarter of 2017, according to the New York Fed. Driven by low-interest rates, the mortgage debt increased to $8.7 trillion. Student debt has reached $1.36 trillion. Auto loan debt is $1.2 trillion. While mortgage delinquencies are stable at 1.2%, bad auto loans have risen to 2.4%, and student debt delinquencies have reached 9.6%.  The rising interest rates can lead to more people failing on their loans, which can potentially trigger another crisis similar to 2008.

Interest hikes and hyperinflation

The US fed is planning for three rate hikes in 2018. Oil has slowly passed $60 a barrel. And US dollar reached 1.20 against the euro. Moreover, U.S. manufacturing expanded in 2017, as gains in orders and production capped the strongest year for factories since 2004.  While around the world factories have warned they are finding it increasingly hard to keep up with demand, potentially forcing them to raise prices.

While CPI hovers around 1.7%, global markets have not priced in the prospects for higher inflation. Therefore, unexpected spike in prices can lead to more Fed rate hikes.

Additionally, the lost corporate tax revenue can jeopardize the ability of the US Treasury to issue debt at lower rates, which can drive the budget deficit even further. Historically, uncontrolled inflation combined with growing budget deficit has led to periods of hyperinflation, higher credit cost and loss of purchasing power.

Retirement savings going down

Only half of US families have a retirement account. The 401k plan patriation is only 43%. Of those with retirement savings, the average balance is just $60,000. Social Security ran $39 billion deficit in 2014 and will be entirely depleted by 2035.

With rising interest rates and GOP plans to cut entitlements, many Americans will face enormous retirement risk and suffer substantial income loss during their non-working years. Without an urgent reform, the US social security system is a time-ticking bomb that can hurt both businesses and families.

Mueller investigation

The former FBI chief investigation is at full speed as more revelations about the Trump campaign appear almost on a daily basis. You might need a crystal ball to predict what will be the exact outcome. However, it is virtually certain that there were people in the Trump circle who were pursuing their own personal interests. The initial theory of collusion and obstruction of justice is leading to allegations about money laundering. If the Mueller investigation proves those accusations, we could experience a political crisis not seen since Watergate.

 

About the author: Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm. Babylon Wealth Management offers highly customized Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans and other institutional clients. To learn more visit our OCIO page here.

Market Outlook December 2017

Market Outlook December 2017

Market Outlook December 2017

As we approach 2018, it‘s time to reconcile the past 365 days of 2017. We are sending off a very exciting and tempestuous year. The stock market is at an all-time high. Volatility is at a record low. Consumer spending and confidence have passed pre-recession levels.

I would like to wish all my readers and friends a happy and prosperous 2018. I guarantee you that the coming year will be as electrifying and eventful as the previous one.

 

The new tax plan

The new tax plan is finally here. After heated debates and speculations, president Trump and the GOP achieved their biggest win of 2017. In late December, they introduced the largest tax overhaul in 30 years. The new plan will reduce the corporate tax rate to 21% and add significant deductions to pass-through entities. It is also estimated to add $1.5 trillion to the budget deficit in 10 years before accounting for economic growth.

The impact on the individual taxes, however, remains to be seen. The new law reduces the State and Local Tax (SALT) deductions to $10,000. Also, it limits the deductible mortgage interest for loans up to $750,000 (from $1m). The plan introduces new tax brackets and softens the marriage penalty for couples making less than $500k a year. The exact scale of changes will depend on a blend of factors including marital status, the number of dependents, state of residency, homeownership, employment versus self-employment status. While most people are expected to receive a tax-break, certain families and individuals from high tax states such as New York, New Jersey, Massachusetts, and California may see their taxes higher.

 

Affordable Care Act

The future of Obamacare remains uncertain. The new GOP tax bill removes the individual mandate, which is at the core of the Affordable Care Act. We hope to see a bi-partisan agreement that will address the flaws of ACA and the ever-rising cost of healthcare. However, political battles between republicans and democrats and various fractions can lead to another year of chaos in the healthcare system.

 

Equity Markets

The euphoria around the new corporate tax cuts will continue to drive the markets in 2018. Many US-based firms with domestic revenue will see a boost in their earnings per share due to lower taxes.

We expect the impact of the new tax law to unfold fully in the next two years. However, in the long run, the primary driver for returns will continue to be a robust business model, revenue growth, and a strong balance sheet.

Momentum

Momentum was the king of the markets in 2017. The strategy brought +38% gain in one of its best years ever. While we still believe in the merits of momentum investing, we are expecting more modest returns in 2018.

Value

Value stocks were the big laggard in 2017 with a return of 15%. While their gain is still above average historical rates, it’s substantially lower than other equity strategies.  Value investing tends to come back with a big bang. In the light of the new tax bill, we believe that many value stocks will benefit from the lower corporate rate of 21%. And as S&P 500 P/E continues to hover above historical levels, we could see investors’ attention shifting to stocks with more attractive valuations.

Small Cap

With a return of 14%, small-cap stocks trailed the large and mega-cap stocks by a substantial margin. We think that their performance was negatively impacted by the instability in Washington. As most small-cap stocks derive their revenue domestically, many of them will see a boost in earnings from the lower corporate tax rate and the higher consumer income.

International Stocks

It was the first time since 2012 when International stocks (+25%) outperformed US stocks. After years of sluggish growth, bank crisis, Grexit (which did not happen), Brexit (which will probably happen), quantitative easing, and negative interest rates, the EU region and Japan are finally reporting healthy GDP growth.

It is also the first time in more than a decade that we experienced a coordinated global growth and synchronization between central banks. We hope to continue to see this trend and remain bullish on foreign markets.

Emerging Markets

If you had invested in Emerging Markets 10-years ago, you would have essentially earned zero return on your investments. Unfortunately, the last ten years were a lost decade for EM stocks. We believe that the tide is finally turning. This year emerging markets stocks brought a hefty 30% return and passed the zero mark. With their massive population under 30, growing middle class, and almost 5% annual GDP growth, EM will be the main driver of global consumption.

 

Fixed Income

It was a turbulent year for fixed income markets. The Fed increased its short-term interest rate three times in 2017 and promised to hike it three more times in 2018. The markets, however, did not respond positively to the higher rates. The yield curve continued to flatten in 2017. And inflation remained under the Fed target of 2%.

After a decade of low interest, the consumer and corporate indebtedness has reached record levels. While the Dodd-Frank Act imposed strict regulations on the mortgage market, there are many areas such as student and auto loans that have hit alarming levels. Our concern is that high-interest rates can trigger high default rates in those areas which can subsequently drive down the market.

 

Gold

2017 was the best year for gold since 2010. Gold reported 11% return and reached its lowest volatility in 10 years.  The shiny metal lost its momentum in Q4 as investors and speculators shifted their attention to Bitcoin and other cryptocurrencies. In our view gold continues to be a solid long-term investment with its low correlation to equities and fixed income assets.

 

Real Estate

It was a tough year for REITs and real estate in general. While demand for residential housing continues to climb at a modest pace, the retail-linked real estate is suffering permanent losses due to the bankruptcies of several major retailers. This trend is driven on one side by the growing digital economy and another side by the rising interest rates and the struggle of highly-leveraged retailers to refinance their debt. Many small and mid-size retail chains were acquired by Private Equity firms in the aftermath of the 2008-2009 credit crisis. Those acquisitions were financed with low-interest rate debt, which will gradually start to mature in 2019 and peak in 2023 as the credit market continues to tighten.

Market Outlook December 2017

In the long-run, we expect that most public retail REITs will expand and reposition themselves into the experiential economy by replacing poor performing retailers with restaurants and other forms of entertainment.

On a positive note, we believe that the new tax bill will boost the performance of many US-based real estate and pass-through entities.  Under the new law, investors in pass-through entities will benefit from a further 20% deduction and a shortened depreciation schedule.

 

What to expect in 2018

  • After passing the new tax bill, the Congress will turn its attention to other topics of its agenda – improving infrastructure, and amending entitlements. Further, we will continue to see more congressional budget deficit battles.
  • Talk to your CPA and find out how the new bill will impact your taxes.
  • With markets at a record high, we recommend that you take in some of your capital gains and look into diversifying your portfolio between major asset classes.
  • We might see a rotation into value and small-cap. However, the market is always unpredictable and can remain such for extended periods.
  • We will monitor the Treasury Yield curve. In December 2017 the spread between 10-year and 2-year treasury bonds reached a decade low at 50 bps. While not always a flattening yield has often predicted an upcoming recession.
  • Index and passive investing will continue to dominate as investment talent is evermore scarce. Mega large investment managers like iShares and Vanguard will continue to drop their fees.

 

Happy New Year!

 

Final words

If you have any questions about your existing investment portfolio, reach out to me at [email protected] or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

 

The Rise of Momentum Investing

The Rise of Momentum Investing

The Rise of Momentum Investing

While the momentum theory has been around for two decades, we had to wait until 2017 to see the rise of momentum investing. The largest momentum ETF (MTUM) is up 35% YTD. And unless something dramatic happens in the remaining few weeks, momentum will crush all major market-cap weighted indices and ETFs.

About this time last year, I posted my first article about momentum investing in Seeking Alpha. You can see my article here. At that time MTUM had only $1.8 billion of AUM and trailed the S&P 500 2016 returns in the range of 5% versus 12%. Eleven months later, MTUM is up 35% versus 16.5%. I can’t take any credit for calling this wide margin in performance, but it certainly grabbed the attention of investors. MTUM is currently at $4.8b AUM and possibly growing even more down the road.

Learn more about our Private Wealth Management services

What is momentum investing

So what is momentum and why do we keep hearing about it a lot more lately?

The momentum investing is a pure behavioral play. Not surprisingly the rise of momentum investing coincided with Richard Thaler’s Nobel award for his work on how human behavior and finance play out together.

Momentum investing exploits the theory that recent stock winners will continue to rise in the near-term. The strategy is based on the 1993 Journal of Finance research “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” by Narasimhan Jegadeesh and Sheridan Titman

Their research discovers a pattern that buying stocks that have performed well in the past and selling stocks that have performed poorly generate significant positive returns over 3- to 12-month holding periods. Furthermore, the research discusses that the success of this strategy is due to behavioral finance factors.

Investors commonly overact on the news and therefore overbuy the winners and oversell the losers.

Many investors consider the momentum strategy as a substitute for growth investing. However, the momentum theory embraces both value and growth stocks as long as they have risen in the past 6 to 12 months.

While the momentum theory has been around for over 20 years, the strategy has not received a wide acceptance amongst investors. Despite its academic fundamentals, momentum strategy has experienced contradictory practical interpretations amongst fund managers, which has reported a massive variability of returns.

Fortunately, the growing popularity of market-cap and smart beta ETFs made the momentum strategy widely available to retail investors. Further down, I will discuss how to take advantage of the momentum theory by using MTUM – iShares Edge MSCI USA Momentum Factor ETF. This ETF has been around since April 2013. It has a dividend yield of 1.12% and an expense ratio of 0.15%.

MTUM replicates the MSCI USA Momentum Index. MSCI USA Momentum Index uses a multi-step process to filter for stocks that fit the momentum criteria. The composition process starts with selecting companies with the highest 6- and 12- month performance. The performance is later weighted by their 3-year standard deviation and given a momentum score. The final weight in the momentum index is given by multiplying the momentum score by the market capitalization weight in the parent index. In this case, the parent index is MSCI USA Index, which has 616 constituents and covers about 85% of the US market cap. Company weights for MSCI USA Momentum Index are capped at 5%. The index is rebalanced semiannually. However, spikes in market volatility can trigger ad-hoc rebalancing.

 

Performance and risk

MSCI USA Momentum Index has consistently outperformed MSCI USA and S&P 500 since its inception. The index has achieved a cumulative return of 531% versus 400% for MSCI USA and 423% for S&P 500 since October 2002.

In annualized terms, MSCI USA Momentum Index posted 9.07% 10-year return and 13.65% return since its inception in 1994.

The index beat its parent in 9 out of the past 15 years and underperformed in six – 2003, 2006, 2008, 2009, 2012 and 2016.

It is an interesting observation that the Momentum strategy underperformed in the years following a significant market pullback or sluggish return (02-03, 05-06, 08-09 and 11-12). It takes a two-year cycle for the Momentum Index to start outperforming again after experiencing a negative period. The composition of the index is somewhat reactive, which naturally doesn’t allow it to take advantage of market rallies in specific sectors.

MSCI USA Momentum Index Performance

Source: MSCI

 

Counterintuitively to what some may think, the MSCI Momentum Index has reported lower standard deviation (risk) than its parent index for the past 3-year and slightly higher standard deviation for the 5- and 10-year period. The risk-weighted methodology described earlier helps the index cap its volatility despite high turnover.

Higher returns and capped volatility has allowed the momentum index to report consistently high risk-adjusted returns. Its 10-year Sharpe ratio is 0.59 versus 0.51 for MSCI USA and 0.53 for S&P 500. Since inception, the Momentum Index posted the impressive 0.72 versus 0.54 MSCI USA and S&P 500.

MSCI USA Momentum Index Risk Adjusted Returns

Source: MSCI

 

MTUM ETF

Going back to the iShares Edge MSCI USA Momentum Factor ETF, it has been around since April 2013. Since inception, its performance has been consistent with the index. MTUM posted 17.3% return versus 13.4% for S&P 500 and 15.32% for IWF, Russell 1000 growth ETF.

MTUM Performance Since inception

MTUM has reported a Sharpe ratio of 1.61 vs. 1.33 for S&P 500 and 1.41 for IWF.

Few other interesting facts for investors looking to diversify. The US market correlation is equal to 0.87. Beta is 0.90. Alpha is 4.7%, and R2 is 73.7%. In other words, the momentum strategy achieved its return not only with less risk but a lot lower correlation to the total market, which is critical for portfolio diversification.

MTUM Holdings

Momentum investing is a dynamic strategy with quarterly rebalancing. Due to its 114% turnover, it is extremely cost ineffective for the average retail investor to replicate it

Currently, MTUM overweights Financials, Technology, and Industrials which have primarily driven the market since the beginning of 2017. Simultaneously, the ETF underweights Consumer Cyclical, Utilities, and Energy. Its main holdings include Microsoft, Bank of America, JP Morgan, Apple, United Health Group, NVIDIA, Home Depot, Comcast, and Boeing. Just to illustrate the dynamic nature of this strategy, a year ago its top holdings were in Technology and Utilities with leading names such as Facebook, Amazon, Google, and Nextera.

 

Final thoughts

  1. The momentum strategy has outperformed the broad market in the past 22 years.
  2. While being in the public eye for over two decades and posting impressive long-term absolute and risk-adjusted returns, the momentum strategy is still not a highly popular trade and has mostly been a theoretical exercise with conflicting practical results.
  3. Only lately, the rise of ETFs had made the strategy available to regular investors.
  4. The momentum strategy tends to lean towards sectors with a recent high
  5. Like any factor strategy, the momentum can underperform the broad market for extended periods

 

 

About the author: Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm. Babylon Wealth Management offers highly customized Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans and other institutional clients. To learn more visit our OCIO page here.

Holdings disclaimer: I own MTUM and we regularly invest MTUM for our clients

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

 

6 Saving & Investment Practices All Business Owners Should Follow

6 Saving & Investment Practices All Business Owners Should Follow

In my practice, I often meet with small business owners who have the entire life savings and family fortune tied up to their company. For many of them, their business is the only way out to retirement. With this post, I would like to offer 6 saving & investment practices all business owners should follow.

Having all your eggs in one basket, however, may not be the best way to manage your finances and family fortune. Think about bookstores. If you owned one 20-30 years ago, you probably earned a decent living. Now, bookstores are luxuries even in major cities like New York and San Francisco. Technology, markets, consumer sentiments, and laws change all the time. And that is why it is vital that you build healthy saving and investment routines to grow your wealth, protect your loved ones, and prepare yourself for the years during retirement.

Start Early

I always advise my clients to start saving early and make it a habit. Saving 10-20 percent of your monthly income will help you build and grow your wealth. For instance, by starting with $20,000 today, with an average stock market return of 6 percent, your investments can potentially accumulate to $115,000 in 30 years or even $205,000 in 40 years.

Saving and investing early in your career can build a buffer to correct for any sidesteps or slip-ups. Starting to build your wealth early will provide the necessary protection against market drops and economic recessions and prepare you for large purchases like a new home, college tuition, a new car or even expanding your business.

Build a Safety Net

Life can often be unpredictable in good and bad ways. Having an emergency fund is the best way to guard your wealth and maintain liquidity for your business. I typically recommend keeping 6 to 12 months of basic living expenses in your savings account.

Even though my firm does not offer insurance, I often advise my clients especially those who are sole bread earners or work in industries prone to accidents to consider getting life and disability insurance. Good insurance will guarantee protection and supplemental income for yourself and your loved ones in case of unexpected work or life events.

Manage Your Debt

The last eight years of a friendly interest environment has brought record levels of debt in almost every single category. Americans now owe more than $8.26 trillion in mortgages, $1.14 trillion in auto loans, and $747 billion in credit cards debt. If you are like me, you probably don’t like owing money to anyone.

That’s great, however, taking loans is an essential part of any enterprise. Expanding your business, building a new facility or buying a competitor will often require external financing. Keeping track of your loans and prioritizing on paying off your high-interest debt can save you and your business a lot of money. It may also boost your credit score.

Set-up a Company Retirement Plan

The US Government provides a variety of options for businesses to create retirement plans for both employees and owners. Some of the most popular ones are employer-sponsored 401k, self-employed 401k, profit-sharing, SIMPLE IRA, and SEP IRA.

Having a company retirement plan is an excellent way to save money in the long run. Plan contributions could reduce current taxes and boost your employees’ loyalty and morale.

Of the many alternatives, I am a big supporter of 401(k) plans. Although they are a little more expensive to establish and run, they provide the highest contribution allowance over all other options.

The maximum employee contribution to 401(k) plans for 2017 is $18,000. The employer can match up to $36,000 for a total of $54,000. Individuals over 50 can add a catch-up contribution of $6,000. Also, 401k and other ERISA Plans offer an added benefit. They have the highest protection to creditors.

Even if you already have an up-and-running 401k plan, your job is not done. Have your plan administrator or an independent advisor regularly review your investment options.

I frequently see old 401k plans that have been ignored and forgotten since they were first established. Some of these plans often contain high-fee mutual funds that have consistently underperformed their benchmarks for many consecutive years. I typically recommend replacing some of these funds with low-fee alternatives like index funds and ETFs. Paying low fees will keep more money in your pocket.

Diversify

Many business owners hold a substantial amount of their wealth locked in their business. By doing so, they expose themselves to what we call a concentrated risk. Any economic, legal and market developments that can adversely impact your industry can also hurt your personal wealth.

The best way to protect yourself is by diversification. Investing in uncorrelated assets can decrease the overall risk of your portfolio. A typical diversified portfolio may include large-, mid-, small-cap, and international stocks, real estate, gold, government, and corporate fixed income.

Plan Your Exit

Whether you are planning to transfer your business to the next generation in your family or cash it in, this can have serious tax and legal consequences. Sometimes it pays off to speak to a pro.

Partnering with someone who understands your industry and your particular needs and circumstances, can offer substantial value to your business and build a robust plan to execute your future financial strategy.

 

The article was previously published in HVACR Business Magazine on March 1, 2017

End of Summer Market Review

End of Summer Market Review

Happy Labor Day!

Our hearts are with the people of Texas! I wish them to remain strong and resilient against the catastrophic damages of Hurricane Harvey. As someone who experienced Sandy, I can emphasize with their struggles and hope for a swift recovery.

 

I know that this newsletter has been long past due. However, as wise people say, it is better late than never.

It has been a wild year so far. Both Main and Wall Street kept us occupied in an electrifying thriller of election meddling scandals, health reforms, political battles, tax cuts, interest rate hikes and debt ceiling fights (that one still to unfold).

Between all that, the stock market is at an all-time high. S&P 500 is up 11.7% year-to-date. Dow Jones is up 12.8%, and NASDAQ is up to the whopping 24%. GDP growth went up by 3% in the second quarter of 2017. Unemployment is at a 10-year low. 4.3%.

Moreover, despite record levels, very few Americans are feeling the joy of the market gains and feel optimistic about the future. US families are steadily sitting on the sideline and continuing to pile cash. As of June 2007, the amount of money in cash and time deposits (M2) was 70.1% of the GDP, an upward trend that has continued since the credit crisis in 2008.

End of Summer Market Review

Source: US Fed, https://fred.stlouisfed.org/graph/?g=dZn

Given that the same ratio of M2 as % of GDP is 251% in Japan, 193% in China, 91% in Germany, and 89% in the UK, US is still on the low end of the developed world. However, this is a persistent trend that can reshape the US economy for the years to come.

 

The Winners

This year’s rally was all about mega-cap and tech stocks. Among the biggest winners so far this year we have Apple (AAPL), up 42%, Amazon (AMZN), 27%, NVIDIA (NVDA), 54%, Adobe, 48%, PayPal, 55%. Netflix, 36%, and Visa (V), 33%,

Probably the biggest story out there is Amazon and its quest to disrupt the way Americans buy things. Despite years of fluctuating earnings, Amazon is still getting full support from its shareholders who believe in its long-term strategy. The recent acquisition of Whole Foods and announcement of price drops, only shows that Amazon is here to stay, and all the key retail players from Costco, Wall-Mart, Target, and Walgreens to Kroger’s, Home Depot, Blue Apron and AutoZone will have to adjust to the new reality and learn how to compete with Amazon.

The Laggards

Costco, Walgreens, and Target are bleeding from the Amazon effect as they reported- 0.49%, -0.74% and -21% year-to-date respectively. Their investors are become increasingly unresponsive to earnings surprises and massively punishing to earnings disappointments.

Starbucks, -0.74%, is still reviving itself after the departure of its long-time CEO, Howard Shultz, and will have to discover new revenue channels and jump-start its growth.

The energy giants, Chevron, -5%, Exxon, -12%, and Occidental Petroleum, -14.5% are still suffering from the low oil prices. With OPEC maintaining current production levels and surge in renewable energy, there is no light at the end of the tunnel. If these low levels continue, I will expect to see a wave of mergers and acquisitions in the sector. Those with a higher risk and yield appetite may want to look at some of the companies as they are paying a juicy dividend – Chevron, 4%, Exxon, 4%, and Occidental Petroleum, 5.4%

AT&T, -7% and Verizon, -5%, are coming out of big acquisitions, which down-the-road can potentially create new revenue channels and diversify away from the otherwise slow growing telecom business. In the near-term, they will continue to struggle in their effort to impress their investors. Currently, both companies are paying above average dividends, 5.15%, and 4.76%, respectively.

And finally, Wells Fargo, -4%. The bank is suffering from the account opening scandals last year and the departure of its CEO.  The stock has lagged its peers, which reported on average, 8% gains this year. While the long-term outlook remains positive, the short-term prospect remains uncertain.

 

Small Caps

Small Cap stocks as an asset class have not participated in this year’s market rally. Despite spectacular 2016 returns, small cap stocks have remained in the shadow of the uncertainty of the expected tax cuts and infrastructure program expansion. While I believe the Congress will come out with some tax reductions in the near term, the exact magnitude is still unclear. My long-term view of US small caps remains bullish with some near-term headwinds.

 

International Stocks

After several years of lagging behind US equity markets, international stocks are finally starting to catch up. The Eurozone reported 2% growth in GDP. MSCI EAFE is up 17.5% YTD, and MSCI Emerging Markets is up 28% YTD.

Despite the recent growth, International Developed and Emerging Market stocks remain cheap on a relative basis compared to US Stocks.  I maintain a long-term bullish view on international and EM stocks with some caution in the short-term.

Even though European Central Bank has kept the interest rates unchanged, I believe that its quantitative easing program will slow down towards the end of 2017 and beginning of 2018. The German bund rates will gradually rise above the negative levels. The EUR / USD will breach and remain above 1.20, a level not seen since 2014.

Interest Rates

I am expecting maximum one or may be even zero additional rate hikes this year. Under Janet Yellen, the Fed will continue to make extremely cautious and well-measured steps in raising short term rates and slowing down of its Quantitative Easing program. Bear in mind that the Fed has not achieved its 2% inflation target and any sharp rate hikes can ruin the already fragile balance in the fixed income space.

Real Estate

After eight years of undisrupted growth, US Real Estate has finally shown some signs of slow down. While demand for Real Estate in the primary markets like California and New York is still high, I expect to see some cooling off and normalization of year-over-year price growth

US REITs have reported 3.5% total return year-to-date, which is roughly the equivalent of -0.5% in price return and 4% in dividend yield.

Some retail REITs will continue to struggle in the near-term due to store closures and pressure from online retailers. I encourage investors to maintain a diversified REIT portfolio with a focus on strong management, sustainability of dividends and long-term growth prospects.

Gold

After several years of underperformance, Gold is making a quiet comeback. Gold was up 8% in 2016 and 14% year-to-date. Increasing market and political uncertainty and fear of inflation are driving many investors to safe havens such as gold. Traditionally, as an asset class, Gold has a minimal correlation to equities and fixed income. As such, I support a 1% to 5% exposure to Gold in a broadly diversified portfolio as a way to reduce long-term risk.

 

About the author: Stoyan Panayotov, CFA is a fee-only investment advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

 

6 Essential steps to diversify your portfolio

6 Essential steps to diversify your portfolio

Diversification is often considered the only free lunch in investing. In one of my earlier blog posts, I talked about the practical benefits of diversification. I explained the concept of investing in uncorrelated asset classes and how it reduces the overall risk of the investments.  In this article, I will walk you through 6 essential steps to diversify your portfolio.

1. Know your risk tolerance

Risk tolerance is a measure of your emotional appetite to take on risk. It is the ability to endure volatility in the marketplace without making any emotional and spur of the moment investment decisions. Individual risk tolerance is often influenced by factors like age, investment experience, and various life circumstances.

Undoubtedly, your risk tolerance can change over time. Certain life events can affect your ability to bear market volatility. You should promptly reflect these changes in your portfolio risk profile as they happen.

2. Understand your risk capacity

Often your willingness and actual capacity to take on risk can be in conflict with each other. You may want to take more risk than you can afford. And inversely, you could be away too conservative while you need to be a bit more aggressive.

Factors like the size of savings and investment assets, investment horizon, and financial goals will determine the individual risk capacity.

3. Set a target asset allocation

Achieving the right balance between your financial goals and risk tolerance will determine the target investment mix of your portfolio. Typically, investors with higher risk tolerance will invest in assets with a higher risk-return profile.

These asset classes often include small-cap, deep value, and emerging market stocks, high-yield bonds, REITs, commodities and various hedge fund and private equity strategies. Investors will lower risk tolerance will look for safer investments like government and corporate bonds, dividends and low volatility stocks.

In order to achieve the highest benefit from diversification, investors must allocate a portion of their portfolio to uncorrelated asset classes. These investments have a historical low dependence on each other’s returns.

The US Large Cap stocks and US Treasury Bonds are the classic examples of uncorrelated assets. Historically, they have a negative correlation of -0.21. Therefore, the pairs tend to move in opposite direction over time. US Treasuries are considered a safe haven during bear markets, while large cap stocks are the investors’ favorite during strong bull markets.

See the table below for correlation examples between various asset classes.

Asset Correlation Chart
Source: Portfoliovisualizer.com

4. Reduce your concentrated positions

There is a high chance that you already have an established investment portfolio, either in an employer-sponsored retirement plan, self-directed IRA or a brokerage account.

If you own a security that represents more than 5% of your entire portfolio, then you have a concentrated position. Regularly, individuals and families may acquire these positions through employer 401k plan matching, stock awards, stock options, inheritance, gifts or just personal investing.

The risk of having a concentrated position is that it can drag your portfolio down significantly if the investment has a bad year or the company has a broken business model. Consequently, you can lose a substantial portion of your investments and retirement savings.

Managing concentrated positions can be complicated. Often, they have restrictions on insider trading. And other times, they sit on significant capital gains that can trigger large tax dues to IRS if sold.

5. Rebalance regularly

Portfolio rebalancing is the process of bringing your portfolio back to the original target allocation. As your investments grow at a different rate, they will start to deviate from their original target allocation. This is very normal. Sometimes certain investments can have a long run until they become significantly overweight in your portfolio. Other times an asset class might have a bad year, lose a lot of its value and become underweight.

Adjusting to your target mix will ensure that your portfolio fits your risk tolerance, investment horizon, and financial goals. Not adjusting it may lead to increasing the overall investment risk and exposure to certain asset classes.

6. Focus on your long-term goals

When managing a client portfolio, I apply a balanced, disciplined, long-term approach that focuses on the client’s long-term financial goals.

Sometimes we all get tempted to invest in the newest “hot” stock or the “best” investment strategy ignoring the fact that they may not fit with our financial goals and risk tolerance.

If you are about to retire, you probably don’t want to put all your investments in a new biotech company or tech startup. While these stocks offer great potential returns, they come with an extra level of volatility that your portfolio may not bear. And so regularly, taking a risk outside of your comfort zone is a recipe for disaster. Even if you are right the first time, there is no guarantee you will be right the second time.

Keeping your portfolio well diversified will let you endure through turbulent times and help your investments grow over time by reducing the overall risk of your investments.

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing, Copyright: www.123rf.com

Top 5 Strategies to Protect Your Portfolio from Inflation

Top 5 Strategies to Protect Your Portfolio from Inflation

Protecting Your Portfolio from Inflation

The 2016 election revived the hopes of some market participants for higher interest rates and higher inflation. Indeed, the 10-year Treasury rate went from 1.45% in July to 2.5% in December before settling at around 2.35-2.40% at the end of February 2017. Simultaneously, the Consumer Price Index, which is one of the leading inflation indicators, hit a five-year high level at 2.5% in January 2017. As many investors are becoming more concerned, we will discuss our top 5 strategies to protect your portfolio from inflation.

Higher interest and inflation rates can hurt the ability of fixed-income investors to finance their retirement. Bonds and other fixed-income instruments lose value when interest rates go up and gain value when interest rates come down.

There were numerous articles in popular media about the “great rotation” and how investors will switch from fixed to equity investments in the search for a higher return. None of that has happened yet, and the related news has seemed to disappear.

However, the prospects for higher inflation are still present. So, in this article, I would like to discuss several asset classes that are popular among individual investors. I will explain see how they perform in the environment of rising inflation.

Cash

Cash is by far one of the worst vehicles to offer protection against inflation. Money automatically loses purchasing power with the rise of inflation. Roughly speaking, if this year’s inflation is 3%, $100 worth of goods and services will be worth $103 in a year from now. Therefore, someone who kept cash in the checking account or at home will need extra $3 to buy the same goods and services he could buy for $100 a year ago.

A better way to protect from inflation, while not ideal, is using saving accounts and CDs. Some online banks and credit unions offer rates above 1%. This rate is still less than the CPI but at least preserves some of the purchasing power.

Equities

Stocks are often considered protection tools against inflation. They offer a tangible claim over company’s assets, which will rise in value with inflation. However, historical data has shown that equities perform better only when inflation rates are around 2-3%. To understand this relationship, we have to look at both Real and Nominal Inflation-Adjusted Returns. As you can see from the chart below, both real and nominal stock returns have suffered during periods of inflation that is over 5% annually. Moreover, stocks performed very well in real and nominal terms when inflation rates were between 0% and 3%.

High inflation deteriorates firms’ earnings by increasing the cost of goods and services, labor and overhead expenses. Elevated levels of inflation have the function to suppress demand as consumers are adjusting to the new price levels.

While it might look tempting to think that certain sectors can cope with inflation better than others, the success rate will come down to the individual companies’ business model. As such, firms with strong price power and inelastic product demand can pass the higher cost to their customers. Additionally, companies with strong balance sheets, low debt, high-profit margins, and steady cash flows tend to perform better in a high inflation environment.

Real estate

Real Estate very often comes up as a popular inflation protection vehicle. However, historical data and research performed the Nobel laureate Robert Shiller show otherwise.

According to Shiller “Housing traditionally is not viewed as a great investment. It takes maintenance, it depreciates, it goes out of style. All of those are problems. And there’s technical progress in housing. So, the new ones are better….So, why was it considered an investment? That was a fad. That was an idea that took hold in the early 2000s. And I don’t expect it to come back. Not with the same force. So people might just decide, ‘yeah, I’ll diversify my portfolio. I’ll live in a rental.’ That is a very sensible thing for many people to do”.

Shiller continues “…From 1890 to 1990 the appreciation in US housing was just about zero.  That amazes people, but it shouldn’t be so amazing because the cost of construction and labor has been going down.”  Rising inflation will lead to higher overhead and maintenance costs, potential renter delinquency, and high vacancy rates.

To continue Shiller’s argument, investors seeking an inflation protection with Real Estate must consider their liquidity needs. Real Estate is not a liquid asset class. It takes a longer time to sell it. “Every transaction involves paying fees to banks, lawyers, and real estate agents. There are also maintenance costs and property taxes. The price of a single house also can be quite volatile.”  Just ask the people who bought their homes in 2007, just before the housing bubble.

Commodities

Commodities and particularly gold tend to provide some short-term protection against inflation. However, this is a very volatile asset class. Gold’s volatility measured by its 42-year standard deviation is 33% higher than that of stocks and 3.5 times greater than the volatility of the 10-year treasury.  Short-term inflation protection benefits are often overshadowed by other market-related events and speculative trading.

Not to mention the fact that gold and other commodities are not easily available to retail investors outside the form of ETFs, ETNs, and futures. Buying actual commodities can incur significant transaction and storage cost which makes it almost prohibitive for individuals to physically own them.

Bonds

According to many industry “experts” bonds are a terrible tool to protect for inflation. The last several years after the great recession were very good to bonds since rates gradually went down and the 10-year treasury rate reached 1.47% in July 2017.  The low rates were supported by quantitative easing at home and abroad and higher demand from foreign entities due to near zero or negative rates in several developed economies. As the rates went up in the second half of 2016, bonds, bonds ETFs and mutual funds lost value. While bonds may have some short-term volatility with rising inflation, they have shown a strong long-term resilience. The 42-year annualized return of the 10-year Treasury is 7.21% versus 10.11% for large Cap Stocks. The Inflation adjusted rate of return narrows the gap between two asset groups, 3.07% for bonds and 5.85% for stocks.

For bond investors seeking inflation protection, there are several tools available in the arsenal. As seen in the first chart, corporate bonds due to their stronger correlation to the equities market have reported much higher real returns compared to treasuries. Moving to short-term duration bonds, inflation-protected bonds (TIPS), floating-rate bonds, are banks loan are some of the other sub-classes to consider

4 Steps to determine your target asset allocation

4 Steps to Determine your target asset allocation

One of the financial advisors’ primary responsibilities is to determine and document their clients’ target asset allocation. The target allocation serves as a starting point and guideline in diversifying the client portfolio and building future wealth. Clients’ unique financial goals, lifestyle, investment horizon, current and expected income, and emotional tolerance to market turbulence will impact their future asset allocation.

The target investment mix is not constant. It can shift from more aggressive to more conservative or vice versa with substantial changes in lifestyle, family status, personal wealth, employment, and age.

Assess your risk tolerance

Most advisors use questionnaires to evaluate their client’s risk tolerance. The length of these surveys varies from advisor to advisor. Furthermore, some assessments are available online for free. The idea behind all of them is to determine the investor’s tolerance to market volatility, and unpredictable macroeconomic and life events.

Individuals with high-risk tolerance have the emotional capacity to take on more risk. They can endure significant market swings in order to achieve a higher future return.

On the opposite side, investors with low-risk tolerance are willing to sacrifice higher returns for safer, low volatility assets which will have smaller swings during turbulent markets.

A free risk tolerance test is available here:

https://www.calcxml.com/calculators/inv01?skn=#top

Regardless of which test you take, if you answer all questions consistently, you should expect to get similar results.

Advisors, of course, should not rely solely on test results. They need to know and understand their clients. Advisors must have a holistic view of all aspects of client’s life and investment portfolio.

 

Set your financial goals

Your financial goals are another critical input to determine your target investment mix. Your goals can stretch anywhere from a couple of months to several decades. They can be anything from paying off your debt, buying a house, planning for a college fund, saving for a wedding, a trip or retirement, making a large charitable donation, and so on.

Each one of your goals will require a different amount of money for completion.

Having your goals in place will define how much money you need to save in order to reach them. The range of your goals versus your current wealth and saving habits will determine your target asset allocation.

More aggressive goals will require more aggressive investment mix.

More balanced goals will call for more balanced investment portfolio.

Sometimes, investors can have a conflict between their financial goals and risk tolerance. An investor may have low to moderate risk tolerance but very aggressive financial goals. Such conflict will ultimately require certain sacrifices – either revising down the investor’s financial goals or adjusting his or her willingness to take on more risk.

Define your investment horizon

Your investment horizon and the time remaining to your next milestone will significantly impact your investment mix.

529 college fund plan is an excellent example of how the investment horizon changes the future asset mix. Traditional 529 plans offer age-based investment allocation. The fund is initially invested in a higher percentage of equity securities. This original investment relies on the equities’ higher expected return, which can potentially bring higher growth to the portfolio. Over time, as the primary beneficiary (the future student), approaches the first year in college, the money in the 529 plan will gradually be re-allocated to a broadly diversified portfolio with a large allocation to fixed income investments. The new target mix can provide more safety and predictable returns as the completion of the goal approaches.

The same example can apply for retirement and home purchase savings or any other time-sensitive goal. The further away in time is your goal; the stronger will be your ability to take on more risk. You will also have enough time to recover your losses in case of market turmoil. In that case, your portfolio will focus on capital growth.

As the completion time of your goal approaches, your affinity to risk will decrease substantially. You also won’t have enough time to recover your losses if the market goes down considerably. In this situation, you will need a broadly diversified portfolio with refocusing on capital preservation.

 

 Know your tax bracket

The investors’ tax bracket is sometimes a secondary but often crucial factor in determining asset allocation. The US Federal tax rate ranges from 10% to 39.6% depending on income level and filing status. In addition to Federal taxes, individuals may have to pay state and city taxes.

Investors can aim to build a tax-efficient asset allocation.  They can take advantage of the preferential tax treatment of different financial securities among various investment account types – taxable, tax-deferred, and tax-exempt accounts. 

For instance, they may want to allocate tax-efficient investments like Municipal bonds, MLPs, ETFs and Index funds to taxable accounts and higher tax bearing investments like Gold, Bonds, and REITs into tax-advantaged accounts.

In any case, investors should attempt to achieve the highest possible return on an after-tax basis. Building a tax-efficient investment portfolio can add up to 1% or more in performance over an extended period.

Introduction to portfolio diversification

Introduction

Portfolio diversification is one of the main pillars of retirement planning. The old proverb “Never put all your eggs in one basket” applies in full strength to investing.

Even the Bible talks about diversification. Ecclesiastes 11:2 says “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.”

Wealth and asset managers use diversification as a tool to reduce overall portfolio risk. Diversification of investments with little correlation to one another allows the portfolio to grow at various stages of the economic cycle as the performance of the assets moves in different directions.

What is portfolio diversification?

According to the Securities and Exchange Commission (SEC): “The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.” – https://www.sec.gov/investor/pubs/assetallocation.htm

By combining low correlated and uncorrelated assets in a portfolio and being disciplined over an extended period, you aim to achieve the highest return per certain level of risk.

Diversification reduces your exposure to a single company or an asset class. As assets move up and down each year, a diversified portfolio will allow you to build a cushion for losses and avoid being dependent on one security in case it loses its value or has a rocky year.

The financial history remembers many examples of fallen stocks, such as Enron and Lehman Brothers. The employees of these companies who invested heavily in their employer’s stock without diversifying lost a significant amount of their retirement savings.

Correlated Investments

Correlated investments move in similar fashion driven by related factors. Owning two or more securities from the same industry or with similar risk profile does not contribute to your portfolio diversification. Hence, these securities will concentrate your exposure to the same market factors. 

These three pairs are an example for correlated stocks – Coca-Cola and Pepsi, Target and Costco, Verizon and AT&T. While there are some differences in their business model and historical performance, the pairs are exposed to the same economic factors, industry drivers, and consumer sentiments.

Uncorrelated Investments

The combination of uncorrelated investments decreases the overall portfolio risk

The classic example of uncorrelated investments is stocks, bonds, and gold. Historically these large asset categories have moved independently from each other.  Their returns were influenced by different events and economic drivers.

Even within the equity space alone, investors can significantly improve their portfolio diversification by looking at companies in various industries and exposure to regional and international markets.

The pair – Amazon and PG&E is a model for uncorrelated companies. Amazon is a global online marketplace that sells discretionary consumer items. Amazon business is dependent on the economic cycle and consumer spending sentiments. PG&E is a California-based utility company that provides electricity and gas to its customers. PG&E customers (being one of them) have a limited choice for service providers. Amazon competes with many large and small-size, local and foreign companies. PG&E has virtually no competition apart from renewable sources. Amazon has expansive market potential. PG&E growth is constrained to its local market. Therefore the difference between their core business models reflects on their historical price performance and risk profile. Their shares’ price depends on different factors and hence fluctuates independently.

Sharpe Ratio

Before we continue, I want to introduce a key performance metric in asset management called Sharpe Ratio. The ratio got its name from its creator the Nobel laureate William F. Sharpe.

The Sharpe ratio measures the excess return per unit of risk of an investment asset or a portfolio.  It is also known as the risk-adjusted return.

This is the formula:

Sharpe Ratio

 

 

 

Where:

Rp is the Return of your security or portfolio.

Rf is the risk-free return of a US Treasury bond

σp is the standard deviation of your portfolio. Standard deviation measures the volatility of your portfolio returns.

 

The Sharpe ratio allows performance comparison between separate portfolios and asset classes with different return and risk. As a rule of thumb, the Sharp metric penalizes portfolios with higher volatility.

Take a very simplified example; portfolio ‘A’ has 5% return and standard deviation of 10%. Portfolio ‘B’ has 6% return and standard deviation of 15%. The risk-free rate is 1%

‘A’ portfolio: Sharpe Ratio is equal to (5% – 1%)/10% = 0.4

‘B’ portfolio: Sharpe Ratio is equal to (6% – 1%)/15% = 0.33

Portfolio ‘A’ has the higher Sharpe ratio and therefore the higher risk-adjusted return. Despite its lower return, it benefited from its lower volatility.

Even though ‘B’ had a higher return, it was penalized for having a higher risk.

 

Test 1

We will continue the explanation of the benefits of diversification with an example with real securities.

We will use two ETFs – SPY which tracks the US Large Cap S&P 500 Index and IEF, which follows the performance of the 10-year US Government bond. Let’s create three portfolios – one invested 100% in SPY,  second invested 100% in IEF and third with 50%/50% split between both funds. Each portfolio starts with hypothetical $1 million. We track the performance for ten years (January 1, 2006, to December 31. 2015).

 

One key assumption is that at the end of each year we will rebalance the 50/50 portfolio back to the original target. We will sell off the excess amount over 50% for the overweight ETF, and we will buy enough shares from the underweight ETF so we can bring it back to 50%.

Results

Ticker Initial Balance Final Balance Average Return Standard Deviation Best Year Worst Year Max. Drawdown Sharpe Ratio US Market Correlation
IEF $1,000,000 $1,698,866 5.44% 6.46% 17.91% -6.59% -7.60% 0.68 -0.30
50/50 $1,000,000 $2,002,079 7.19% 7.11% 13.11% -9.45% -20.14% 0.86 0.87
SPY $1,000,000 $2,010,149 7.23% 15.23% 32.31% -36.81% -50.80% 0.47 1.00

Diversification2_1

 

The 100% SPY portfolio has the highest return of 7.23% and best overall final balance ($2.01m). The SPY portfolio has the largest gain in a single year, 32.3% but also the biggest yearly loss of -36.8%. It also has the highest measure of risk. Its standard deviation is 15.2%.  Its risk-adjusted return (Sharpe ratio) has the lowest value of 0.47.

IEF has the lowest return of the three portfolios, 5.44% but also has the “best” worst year, -6.6% and the lowest risk, 6.5%. Sharpe ratio is 0.68, higher than that of SPY.

The  50/50 portfolio has an average return of 7.19%, only 0.03% less than SPY alone. It has a standard deviation of 7.1%, only 0.65% higher than that of the 100% EIF. its market correlation is 0.87. Most importantly, the 50/50 portfolio has the highest risk-adjusted return, equal to 0.86.

The 50/50 portfolio illustrates the benefits of diversification. It provides almost the same return as the 100% large-cap portfolio with much lower risk and better returns consistency.

Test 2

In the second example, we will introduce two more portfolios.

Portfolio #4 holds 100% GLD. GLD is the largest and most liquid  ETF in the gold market.

In portfolio #5, we will split SPY and IEF into 45% each and will add 10% in Gold ETF. Same rules apply. Once a year we rebalance the portfolio to the original target allocation 45/45/10.

Results

Ticker Initial Balance Final Balance Average Return Standard Deviation Best Year Worst Year Max. Drawdown Sharpe Ratio US Market Correlation
IEF $1,000,000 $1,698,866 5.44% 6.46% 17.91% -6.59% -7.60% 0.68 -0.30
50/50 $1,000,000 $2,002,079 7.19% 7.11% 13.11% -9.45% -20.14% 0.86 0.87
SPY $1,000,000 $2,010,149 7.23% 15.23% 32.31% -36.81% -50.80% 0.47 1.00
GLD $1,000,000 $1,967,041 7.00% 19.20% 30.45% -28.33% -42.91% 0.39 0.07
45/45/10 $1,000,000 $2,028,238 7.33% 7.05% 13.92% -8.01% -16.75% 0.88 0.81

 Diversification4

 

The GLD portfolio has the highest volatility. Its standard deviation is 19.20%. It has the lowest risk-adjusted return of 0.39 and a second-lowest return of 7%.

Let’s look at our fifth portfolio – 45% SPY, 45% IEF and 10% GLD. The new portfolio has the highest return of 7.33%, the highest final balance of $2.28m, second lowest standard deviation of 7.05% and the highest risk-adjusted return of 0.88. It also has a lower correlation to the US market, 0.81.

Recap

Portfolio #5 is the clear winner of this contest. Why? We build a portfolio of uncorrelated assets, in this case, gold, 10-year Treasury, and large-cap stocks. Subsequently, we not only received an above average annual return, but we also achieved it by decreasing the risk and minimizing the volatility of our portfolio.

These hypothetical examples illustrate the benefits of diversification. Among them are portfolio risk mitigation, reduced volatility, higher risk-adjusted return, and more efficient capital preservation.

 

Asset correlation

So how do you determine the relationship between assets? Any financial software can provide you with this data.

If you are good at math and statistics, you can do parallel performance series for your securities and find the correlation between them.

There are a couple of free online tools, which you can use as well.

Beta

One easy way to get a sense of the correlation of your securities to the general stock market is Beta. Most financial websites like Google Finance and Yahoo Finance will give you this metric. Beta shows you the stock volatility compared to S&P 500. That said, the beta of S&P 500 is always 1. So for instance, if the beta of your stock is 2, you should expect twice as much volatility of your stock as compared to S&P 500. If the beta is 0.5, you would expect half of the volatility. If the beta is -0.5, then your stock and S&P will be negatively correlated. When one goes up, the other one will go down.

A quick search in Good Finance brought me these results for the securities we discussed earlier.

Beta for IEF is -0.20, SPY is 1, GLD is 0.07, Coca Cola, 0.51, Pepsi, 0.44, Target, 0.63, Costco, 0.55, Verizon, 0.22, AT&T, 0.29, Amazon, 1.1 and PG&E, 0.17,

Few other companies and ETFs of interest are: TLT, 20-year T-bond Index, -0.59, VNQ, REIT Index, 0.81, VYM, Vanguard High Dividend ETF, 0.81, USMV, iShares Low Volatility ETF, 0.68,  Google, 1.03, Facebook, 0.76, Wal-Mart, 0.19, Starbucks, 0.80, McDonalds, 0.51. Walt Disney, 1.32, Bank of America, 1.74.

The beta of the stocks can vary depending on market conditions, economic and business cycles. I recommend using in combination with other metrics like standard deviation, R-square, and Sharpe Ratio. This approach will help you gauge the expected volatility of your stock.

How many assets should you ideally keep in your portfolio?

Some theories call for 7-10 broad asset classes. This method is ideal for smaller-size portfolios. It will help control trading and rebalancing costs.

Other theories call for 20-25 asset classes. This approach is best suitable for large-size portfolios with more complex structure.

A regular portfolio should include these three groups with their subclasses.

Equity includes Large Cap, Mid Cap, Small Cap, Micro Cap, International Developed and Emerging Markets. In addition to that, you can add growth, value, dividend, low volatility, and momentum strategies.

Fixed Income includes US Treasuries, Municipal Bonds,  Investment Grade Corporate Bonds, High Yield, Preferred Stock, International, and Emerging Market Bonds

Alternative Investments include Real Estate, Precious Metals, Commodities, Infrastructure, Private Equity, Hedge Funds.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation, and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions.  Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com