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Fires in California Remind Us to Use Our Hearts and Heads

Fires in California Remind Us to Use Our Hearts and Heads

By: Joe Delaney

At times like these, when record-breaking fire is again ravaging parts of California, we remember that our financial portfolios are not just numbers on paper. They are about protection for ourselves and our loved ones. They are also about our human desire to be good custodians of the world and empathic neighbors.

Here in the San Francisco area, we at Lifeguard Wealth are having a lot of conversations with people about what they can do to help. We share our thoughts below. First, let’s summarize what’s happening in this state.

Wildfire Update

At the time of this writing, the Camp Fire in Butte County, northern California has become the most destructive and deadliest in California history, eclipsing last year’s Tubbs fire in Santa Rosa. CBS News reported on November 13th that it had burned through 130,000 acres and taken 48 lives.

Meanwhile, the Woolsey and Hill Fires are burning to our south, northwest of Los Angeles. These have claimed over 100,000 acres and 2 lives.

As always, high winds, high temperature and dry air are fueling this latest outbreak. Firefighters are doing their best to channel the blaze away from population centers, but many people have already lost their homes and business. There will be more destruction before this is over.

How You Can Help (and Be Smart About It)

There are many organizations you can support that are claiming to help. It is important to use both your heart and your head when the need is so great. If you do not have a personal relationship with a charity’s leadership, you must do your research to be sure it is utilizing your donations effectively.

A good resource to consult is charitynavigator.org. When you plug in an applicable key phrase such as “California fire,” you will see a list of organizations and their classifications. This makes it easy to identify whether their mission includes providing immediate assistance. You can then select a charity to review details including its Form 990, which includes service accomplishments from the previous tax year.

This is a good way to check up on a charity someone has recommended to you. You can type in the name of a specific organization to see its details. We recommend the American Red Cross and Salvation Army, two strong charities that had a big presence in the communities struck by last year’s fires.

Another Reminder to Be Prepared

As I shared in an article last year, we should do more than donate to worthy causes when disaster strikes and move on with life. This is an opportunity to prepare ourselves for the next one.

Go here to review my recommendations to

1) Get an emergency kit,

2) Make a family plan,

3) Be informed, and

4) Review your personal lines of insurance coverage annually.

To the last point, I will add a tip to minimize the financial impact of a loss of home and property: Video your home. This is simple, easy and could save you a lot of time and money when working with your insurance company after a disaster. Take 10 minutes to walk around your home, garage and outside on the property and capture all that you own.

Today’s technology makes this easier than ever. If you take the video with your smartphone, you need only upload it to your cloud service of choice. Google Drive, Apple’s iCloud and Dropbox are a few of the most popular.

It doesn’t hurt to load it onto your computer and copy it to a flash drive that you keep in a fireproof box as well. While unlikely, the structures housing the servers where your backed up files are stored (the “cloud”) are susceptible to natural disaster and failure as well.

Be Smart About Helping Others and Yourself

In summary, keep these two takeaways in mind:

  • There’s nothing wrong with acting from the heart in the midst of a disaster like these wildfires, as long as your head is also at work. There’s no sense giving money to an organization that may squander it.
  • Also, put yourself in the place of the families affected by tragedy and consider what you can do now to be better prepared if and when it happens to you.

Lifeguard Wealth is eager to help you with both. Philanthropy and wealth protection are two important legs on a four-legged stool of wealth management (along with wealth accumulation and wealth transfer to the next generation).

Let’s put our hearts and heads together to guard what matters most.

Riding The Elephant: Mastering Decision-Making In Money And Life

Riding The Elephant: Mastering Decision-Making In Money And Life

By Tim Maurer

The most compelling findings regarding financial decision-making are found not in spreadsheets, but in science. A blend of psychology, biology and economics, much of the research on this topic has been around for years. Its application in mainstream personal finance, however, is barely evident. Perhaps a simple analogy will help you begin employing this wisdom in money and life: The Rider and the Elephant.

First, a little background.

Systems 1 and 2

Daniel Kahneman’s tour de force, Thinking, Fast and Slow, leveraged his decades of research with Amos Tversky into practical insight. Most notably, it introduced the broader world to “System 1” and “System 2,” two processors within our brains that send and receive information quite differently.

System 1 is “fast, intuitive, and emotional” while System 2 is “slower, more deliberative, and more logical.” The big punch line is that even though we’d prefer to make important financial decisions with the more rational System 2, System 1 is more often the proverbial decider.

Many other authors have built compelling insights on this scientific foundation. They offer alternative angles and analogies, but I believe the most comprehendible comes from Jonathan Haidt.

The Rider and the Elephant

The author of The Happiness Hypothesis and a professor at New York University’s Stern School of Business, Haidt describes the two systems in a helpfully visual way:

The mind is divided in many ways, but the division that really matters is between conscious/reasoned processes and automatic/implicit processes. These two parts are like a rider on the back of an elephant. The rider’s inability to control the elephant by force explains many puzzles about our mental life, particularly why we have such trouble with weakness of will. Learning how to train the elephant is the secret of self-improvement.”

Do you see the connection? System 1, in this case, is the Elephant. It’s instinctive, powerful and predictably emotional. System 2 is the Rider. It’s the rational thinker, capable of deconstructing complex problems but incapable of overpowering the Elephant.

How, then, do we, as Haidt suggests, train the Elephant?

Elephant Training

First, recognize that the Elephant—emotion—is not the problem. Indeed, it may be part of the solution. Too many in the realm of personal finance have labeled emotion as the enemy.  They tell consumers that investing, in particular, is best practiced by ignoring or suppressing emotions. But this is shortsighted.

Let’s say an investor is coached that the market goes up and down, but ultimately, a willingness to stay invested in stocks will net the best long-term returns. Therefore, one’s portfolio would be optimally invested wholly (or mostly) in equities. Well, suppressing one’s emotions regarding the fear of deep market losses might help an investor stick with their financial plan in a mild correction, but in the early 2000s and again in 2008, many an Elephant reared up and sent the rider on a precipitous fall of his or her own.

No, optimal portfolio construction involves inviting the Elephant into the boardroom to have a say. Emotions should not be ignored, but rather acknowledged and accounted for in the creation of an ideal investment portfolio. Practically speaking, this means that many people with equity-heavy investements—at any age—should listen to the Elephant and seriously consider increasing their exposure to a portfolio’s stabilizing force: conservative fixed income. It’s also important to recognize at this point that most households have two Riders and two Elephants, each of which needs to be heard.

The Rider and Elephant work best as a team. While this is readily apparent in most areas of investing, it becomes especially clear in decisions involving the prospect of death or disability. Statistically speaking, when it comes to writing estate planning documents and planning for death or disability with insurance, the collective Elephant has simply run for the hills, ignoring this possibility altogether. But the Rider can coach the Elephant very effectively:

Rider: “We need to talk about our will.”

Elephant: “Death? Ooh, no. I’m not going there.”

Rider: “I understand. It’s not exactly fun to consider, but what scares me even more is what could happen if we don’t consider it at all.”

Elephant: “Yeah, I guess I hadn’t thought about it that way.”

Rider: “Like, wouldn’t we rather decide who would take over our role as parent if we were gone, rather than entrust that important decision to the state?”

Elephant: “Yep, let’s schedule that appointment.”

Every great team has to practice in order to work together effectively, so try imagining the implications of your neuro-duo in any number of circumstances, from budgeting, insurance and allocating your 401(k) plan to even more important stuff, such as career, marriage and child-rearing. Through persistent practice, it’s even possible to transfer the once-complex tasks undertaken by the Rider to newly instinctive responses by the Elephant.

And if you’re interested in further training, consider choosing anything from the following reading list:

This commentary originally appeared July 24 on Forbes.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by myself and other featured authors are their own and may not accurately reflect those of Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2018, Lifeguard Wealth
As always, if you have any questions please contact Lifeguard Wealth.
Be Prepared for Losses

Be Prepared for Losses

By Larry Swedroe

The stock premium—the annual average return of stocks minus the annual average return of one-month Treasury bills—has been high, attracting investors to the stock market. For the period 1927–2017, it averaged 8.5%. There have also been size (return of small stocks minus return of large stocks) and value (return of value stocks minus return of growth stocks) premiums of 3.24% and 4.82%, respectively.

However, the excess returns are generally referred to as risk premiums—they aren’t free lunches. We see evidence of that in the volatility of the premiums. The stock, size and value premiums have come with annual standard deviations of 20.41% (2.4 times the stock premium), 13.78% (4.3 times the size premium) and 14.20% (2.9 times the value premium), respectively.

Let’s take a closer look at some of the data that illustrate the riskiness of the premiums. For the period:

  • The stock premium was negative in 27 of the 91 years (30% of the years). There were 17 years (19% of the years) when the premium was worse than -10%, 12 years (13% of the years) when it was worse than -15% and seven years (8% of the years) when it was worse than -20%. As another indicator of the volatility of the stock premium, we see that the gap between the best and worst years was 102.2%, more than 12 times the size of the premium itself. The worst year was 1931, when the premium was -45.11%. Given a premium of 8.5% and a standard deviation of 20.41%, this was more than a 2.5 standard deviation event. The best year was 1933, when the premium was 57.05%, also more than two standard deviations from the mean. In fact, we had six such two-standard-deviation events. We would have had just four if the returns had been normally distributed.
  • The size premium was negative in 42 of the years (46% of the years). There were 10 years (11% of the years) when it was worse than -10%, three years (3% of the years) when it was worse than -15%, and three years (3% of the years) when it was worse than -20%. The worst year was 1929, when the premium was -30.8%, a 2.5-standard-deviation event. The best year was 1967, when the premium was 50.69%, more than a three-standard-deviation event. The gap between the best and worst years was 81.49%, more than 25 times the size of the premium itself. In five of the years, returns were more than two standard deviations from the mean.
  • The value premium was negative in 35 of the years (38% of the years). There were 11 years (12% of the years) when it was worse than -10%, four years (4% of the years) when it was worse than -15%, and three years (3% of the years) when it was worse than -20%. The worst year was 1999, when the premium was -31.7%, more than a 2.5-standard-deviation event. The best year was 2000, when the premium was 39.69%, a 2.5-standard-deviation event. The gap between the two was 71.39%, 14.8 times the size of the premium itself. In six of the years, returns were more than two standard deviations from the mean. Even if we extend our time frame to five years, we see that there is still risk in the premiums. Using non-overlapping data, we have 18 five-year periods.
  • In four periods (22% of the periods), the stock premium was negative. The worst period was 1927–31, when the stock premium was -46.76%.
  • In nine periods (50% of the periods), the size premium was negative. The worst period was also 1927–31, when it was -30.92%.
  • In five periods (28% of the periods), the value premium was negative. The worst period was 2007–11, when it was -32.27%. If we extend our time frame to 10 years, we have nine non-overlapping periods. There were no periods when the stock premium was negative, one period when the value premium was negative (2007–16, when it was -17.59%) and two periods when the size premium was negative (1947–56, when it was -29.95% and 1987–96, when it was -19.21%).

Further Evidence

Eugene Fama and Ken French examined the volatility of the three equity premiums we have been discussing in their December 2017 study “Volatility Lessons,” which covered the period July 1963 through December 2016. In addition to finding high volatility of stock returns, they also found:

  • Skewness of returns is -0.53 for monthly equity premiums, so the distribution of monthly premiums is skewed to the left. (If a distribution is symmetric about its mean, Skew (the third moment about the mean, divided by the cubed standard deviation) is zero.) However, Skew is positive (0.25) for annual premiums and increases a lot for longer return horizons, to 3.78 for 30-year premiums. Increasing right skew means more of the dispersion is toward good outcomes (good news).
  • Monthly equity premiums are “leptokurtic,” which means there are more extreme returns than we would expect with a normal distribution (the tails are fat). Kurtosis (the fourth moment about the mean, divided by the standard deviation to the fourth power) is 3.0 for a normal distribution, and 4.97 for monthly equity premiums. Kurtosis falls to 3.19 for annual premiums but then rises strongly for longer return horizons, to 32.37 for 30‑year returns. The combination of right skew and kurtosis means that outliers are primarily in the right (good) tail.
  • The standard deviation of equity premiums increases with the return horizon, from 17% for annual premiums to 2551% for 30-year premiums.
  • In general, the distribution of premiums moves to the right faster than its dispersion increases. For example, the median increases 231-fold, from 6% for annual premiums to 1390% for 30-year premiums. Together, increasing kurtosis and right skew for longer horizons spreads out the good outcomes in the right tail more than the bad outcomes in the left.

Fama and French noted that while most of the news about equity premium distributions for longer return horizons is good, there is bad news. They used the realized monthly returns from the period their study covered to construct long-horizon simulation returns, and found that for the three- and five-year periods that are often the focus of professional investors, negative equity premiums occur in 29% of three-year periods and 23% of five-years periods of simulation runs. Even for 10- and 20-year periods, negative premiums occur in 16% and 8% of simulation runs, respectively.

Fama and French found similar results for the size and value premiums, and concluded that this is simply the nature of risk—if you want to earn the expected (the mean of the distribution of potential outcomes) premiums, you must accept the fact that you will experience losses, no matter how long your horizon. Said another way, if you can’t stand the heat, get out of the kitchen.

They concluded: “The high volatility of stock returns is common knowledge, but many professional investors seem unaware of its implications. Negative equity premiums and negative premiums of value and small stock returns relative to Market are commonplace for three- to five-year periods, and they are far from rare for ten-year periods. Given this uncertainty, investors who will abandon equities or tilts toward value or small stocks in the face of three, five, or even ten years of disappointing returns may be wise to avoid these strategies in the first place.”

Myopic Behavior Kills Returns

In my more than 20 years of providing investment advice, I’ve concluded that most investors —both individual and institutional—believe that when it comes to evaluating investment returns, three years is a long time, five years is a very long time and 10 years is an eternity. However, financial economists know that the historical evidence demonstrates that 10 years can be nothing more than noise and thus should be treated as such.

Most investors lack the discipline required to do so. Thus, they end up being subject to recency, which results in buying after periods of strong performance (when valuations are high and expected returns are low) and selling after periods of weak performance (when valuations are low and expected returns are high). That’s not a prescription for investment success. It is also why Warren Buffett says his favorite investment horizon is forever.

Before concluding, it’s important you understand we cannot be certain of the investment risks (the odds of negative premiums) we have been discussing. That should make us less confident about earning premiums, meaning the odds of not earning the premiums may be higher than our estimates.

In other words, at best we can only estimate the odds of experiencing negative premiums—we cannot know them. That helps explain why the premiums have been so large. Investors don’t like uncertainty and demand large ex-ante premiums as compensation. They dislike even more owning assets that tend to do poorly during bad times, when their labor capital is put at risk. And that’s exactly when the three premiums tend to turn negative. Together, these two issues provide the explanation for the large size of the three risk premiums.

Two more important points we need to cover both relate to the diversification of risk. First, the odds of earning the premiums are based on portfolios that are highly diversified. For more concentrated portfolios (like those of the typical actively managed fund or the typical individual investor buying individual stocks), uncertainty about outcomes is higher. That is another reason why active investing is called the loser’s game.

Second, there is very low correlation of the three risk premiums. From 1964 through 2017, the annual correlation of the size and value premiums to the stock premium has been just 0.26 and -0.25, respectively, and the annual correlation of the size and value premiums is close to 0 (0.02). That makes them effective diversifiers of portfolio risk, a type of diversification not achieved by investors whose portfolios are limited to total market portfolios.

This is an issue that many find difficult to understand. Here is a brief, and hopefully helpful, explanation. It’s true that total market portfolios own small and value stocks, providing positive exposure to the premiums. However, they have no net exposure to the size and value premiums because their holdings of large and growth stocks provide negative exposure to the premiums—exactly offsetting the positive exposure provided by the small and value stocks.

Summary

The bottom line is that when developing your investment policy statement, you must be sure that your portfolio doesn’t take more risk than you have the ability, willingness and need to take. You must also be sure that you understand and accept the nature of the risks you are going to have to live with over time. The appropriate warning is that most battles are won in the preparation stage, not on the battlefield.

If you don’t understand the nature of the risks, when they do show up, you will be unable to keep your head while all about you are losing theirs, and it’s far more likely your stomach will take over. And I’ve yet to meet a stomach that makes good decisions. The result will likely be that your well-developed plan will end up in the trash heap of emotions. Forewarned is forearmed.

Next, we’ll take look at the two premiums related to bonds: term and default.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by myself and other featured authors are their own and may not accurately reflect those of Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2018, Lifeguard Wealth
As always, if you have any questions please contact Lifeguard Wealth.
Credit Premium: Fact(or) Fiction

Credit Premium: Fact(or) Fiction

By Jared Kizer

The above title may well end up being my most significant marketing achievement. Yet, it is a good descriptor of a research topic I’ve tackled, and I continue to be surprised by how little attention has been paid to whether there’s any historical justification that the credit premium — the difference in return between corporate bonds and comparable maturity government bonds — is additive to portfolios that already own stocks and government bonds. Based upon work I’ve previously done and the working paper I posted in March, I’m convinced that it isn’t, at least in the form it takes in most investment-grade corporate bond indexes and many investment-grade corporate bond funds. Here, in the spirit of AQR’s pieces on various premia, I’ll detail what I believe are some facts and fiction related to the investment-grade credit premium that investors should understand.

Fiction: Early 20th century data on the credit premium is reliable and good quality.

I’m as much of a fan as anyone of using the longest-run data possible for research purposes. However, a close inspection of the primary series typically used for long-run analysis of the credit premium — Ibbotson and Sinquefield’s default premium series — reveals that its early history is highly suspect. In the piece I first linked to above, I find that the series had a Sharpe Ratio in excess of 1.30 (!?!?!?) during the 1930s and that the credit premium’s annual returns exhibited positive correlation with Moody’s annual measure of corporate bond defaults. This directional correlation relationship, of course, makes no sense since one would expect to see years with larger numbers of corporate bond defaults to correspond with below average, and commonly negative, returns for the credit premium. This expected relationship is indeed what you do see when examining more recent historical measures of the credit premium (e.g., Barclay’s measure of the credit premium that it began calculating in 1988). In my mind, the fact pattern of impossibly high risk-adjusted returns within the context of the 1930s and a nonsensical relationship with measures of corporate bond defaults renders the early history of the Ibbotson and Sinquefield data useless.

Fact: After controlling for equity market risk, the credit premium hasn’t been statistically significant.

Once you focus on the reliable history of the credit premium, you find that the credit premium has been meager in absolute terms and not statistically significant either before or after adjusting for embedded equity market risk. Using Barclay’s data, the credit premium was just 54 basis points (bps) per year with a volatility of 351 bps over the period of 12/1974–10/2017 (the period used in the research paper linked to above). Even before adjusting for equity market risk, this is not statistically reliable.

After adjusting for equity market risk via regression, the series has alpha that is no different from zero. Practically, this indicates that corporate bonds have not been additive to portfolios that include equities. In other words, corporate bonds provide exposure to two risks — interest rate risk and equity market risk — that are already present in most all investment portfolios.

Fact: The credit premium isn’t really a credit premium.

If you’re familiar with how most investment-grade corporate bond indexes and many corporate bond funds are managed, it’s interesting to note they aren’t generally exposing investors to credit risk in the true sense of the word. When I think about credit risk, I think of it as the risk that an asset I own won’t be able to pay back some portion of principal and interest while I own it. Since most investment-grade strategies own bonds rated Baa or higher and sell securities if they are downgraded to Ba or lower, it’s rare that bonds actually default while still in the index or fund. Instead, the risk an investor is exposed to is more adequately characterized as downgrade risk or repricing of credit risk risk (J).

The perhaps more insightful way to think about this is that when an investor purchases an investment-grade corporate bond fund, the portfolio management approach is similar to buying a portfolio of investment-grade corporate bonds and simultaneously buying puts on each of the holdings that will be in the money if the bond is downgraded to Ba or lower. Thought about in this way, it’s not surprising that what is characterized as the credit premium has been extremely weak historically because investors are effectively buying protection against the dominant risk of holding the bond (i.e., the risk of it actually defaulting).

Fact: Investment-grade corporate bond funds would be better served by continuing to hold bonds that are downgraded to junk.

In the Financial Analysts Journal paper “Capturing Credit Spread Premium,” Bruce Phelps and Kwok-Yuen Ng’s document that reconstructing Barclay’s investment-grade corporate index to allow bonds that get downgraded to remain in the index improved the realized annual credit premium from 48 to 80 bps over the period of 1990–2009. This result was statistically significant, meaning the improvement in return doesn’t appear to be a random result, and indicates a substantial portion of the true credit premium is lost as a result of the sell-when-downgraded to junk methodology. That said, my guess is this change in methodology doesn’t change the result that the premium is not significant after accounting for equity market risk, but investors who still want to own corporate bonds (or must own them due to regulatory constraints) would be well-served by looking for solutions that adopt the methodological changes outlined by Phelps and Ng.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by myself and other featured authors are their own and may not accurately reflect those of Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2018, Lifeguard Wealth
As always, if you have any questions please contact Lifeguard Wealth.
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