According to Daniel Kahneman, Princeton professor of psychology and the so-called father of behavioral economics, it is our “remembering self” that makes decisions rather than our “experiencing self.” Of course, we are not two selves, but thinking this way gives us a good metaphor for discussion. In other words, we construct stories out of memories and those inform our decisions to a much greater extent than what we are experiencing in the present moment. We see this happening routinely as people make investment decisions. The stories that make up memories of risk and reward, past gains and losses ring loud and true in the psyche of most investors. Such thinking has caused many to miss the 2013 rally or to remain invested right through the two recessions of this century. Modern portfolio theory, espoused by the vast majority of advisors, holds that the market has no memory. That simply does not hold up to scrutiny or common experience.
Nevertheless, the turning of the calendar presents a good time to remember and to evaluate where you have been and to look to where you might be headed into 2014. Unless you have been hiding under a rock for the past few months, you know that the stock market has been “melting up” and that we are in the midst of the longest bull market ever. Lately, I have been asking our clients which risk presents them with the greater concern: 1) missing market gains in good markets? or 2) losing principal when the market falls? Confronted with the question, if you only think about the past few years, you might be looking at your annual returns and feeling some regret or remorse that you missed the rally in the stock market—if in fact, like many investors, you did miss at least some of it. Ask yourself if you have chosen to accept the wrong kind of risk. Wrong for you that is; not wrong in a universal sense. Alternatively, it could be that you are focusing on too short a time frame.
According to Morningstar, the 10-year average of the S&P 500 index has been 7.34% a year through December 13, 2013. Even many who have adopted a wealth preservation or absolute return strategy have done as well with their diversified portfolio. Doug Short reported on the same day that the S&P 500 was up by a grand total of 22% since January 1, 2000. That, of course, works out to be about 1.6% a year and includes the current bull market but also includes two very sharp and deep declines. Hardly anybody would be satisfied with those returns over such a long period but many buy-and-hold investors got what they bargained for and have either long forgotten the outcome or never bothered to look.
Given such a roller coaster ride as we have seen in the past 14 years, it would seem then that one need to remain invested so long as the market is trending up and have an exit strategy for getting out as it turns down. Nearly everybody appears to eschew market timing, however they still must admit to a deep desire to avoid the downturns but participate in the up-market. One way to have a chance of doing that is a) to be invested and b) to employ some sort of risk control so as to avoid the serious downturn as it begins to unfold.
Once the strategy is matched to objective, where then does one go with their money in the marketplace of 2014? A good place to look is the growing universe of exchange traded funds (ETF’s). ETF’s come in a variety of sizes and types and there is surely one to address nearly every asset class today. In fact, there are ETF’s that move counter to the market. On days when the market is down, these instruments go up. Leverage can be served up in some ETF’s that have as their objective to double or even triple the daily movement of an index. Most ETF’s are extremely tax efficient and some have very low expense ratios. An added bonus is that they can be traded on the exchanges rather than having to be bought or sold at the closing net asset value as do more traditional openend mutual funds. Sector ETF’s can be an effective way to rotate between sectors. One downside to ETF’s is that one usually has to pay a commission to buy or sell the instrument. However, some discount brokerage firms offer a pretty wide array of ETF’s that can be bought and sold without incurring transaction costs. Another downside can sometimes be the lack of liquidity. Some are so thinly traded as to make them impractical for an investment of respectable size.
Generally, asset allocators recommend that the more conservative your risk tolerance the more you should be invested in bonds. Presently however, bonds could present as much or more downside risk as stocks. Recall that as interest rates rise, bond values fall. 2014 could be the year that the bond market says it has had enough of low interest and will start bidding up the rates. For that reason if bonds are to be included at all right now, only short term bonds would be indicated since the longer dated bonds will suffer more in a rising interest rate environment. High quality U.S. stocks seem to present the best place to put equity investments as the New Year unfolds. Even that should be done cautiously.
Once a vehicle is chosen, the proper sizing of the position becomes imperative. Decide going in how much downside risk you would be willing to accept should that investment not do what you expect it to do. Purchase only that number of shares that will keep you from reaching your point of ruin should the price drop to that predetermined level. Set that as a stop alert and monitor it for a potential sale should that price, and therefore that amount of loss, be reached. Resolve that a small loss will not ever become a big loss in your portfolio. Wishing you a very Happy and Prosperous New Year!
Scott Neal, CPA, CFP is President of D. Scott Neal, Inc., a fee-only financial planning and registered investment advisory firm that subscribes to the fiduciary oath. Offices are located in Louisville and Lexington. He can be reached by calling 800-344-9098 or via email: scott@dsneal.com