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Market Commentary – July 2017

Stock Markets

The chart at right shows stocks performing well in the past quarter and six-month periods.  Year to date, domestic large-cap stocks were up about 9% while small-cap stocks were up 5%.  Stocks traded in international developed markets and emerging markets were up 14% and about 19%, respectively.

Over three, five and ten years, domestic markets (both large-cap and small-cap) were especially strong.  These results are starting to give rise to concerns of “irrational exuberance” and over-valuation in these markets.  Keep in mind, however, we could be observing a bounce off the sharp decline of 2008, one of the worst periods in stock market history.  So, what do we have now – “over-valuation” or “regression to the mean”?  Not so much exuberance in other markets.

The usual proxy for the domestic large-cap stock market is the S&P 500, a well-worn index that many consider representative of the total stock market.  Today the S&P 500 is skewed by well-known technology companies – Apple, Microsoft, Alphabet (Google) and Amazon make up the top four stocks, with Facebook coming in at number six.  Thus, the S&P 500 is more indicative of how the largest technology stocks fared versus stocks in general.

The chart shows the extent that markets fall in and out of favor through time, which provides an incentive to try and predict.  However, this is not something we recommend.  Instead, maintain commitments to each asset class and reap the benefits of diversification.  In any event, recent periods have been generally good for stocks.

Bond Markets

The Yield Curves chart at the right yields of U.S. Treasury securities across various maturities as of June 2017, June 2016 and December 2016.  Today’s curve is more pronounced and shown in green.  Notice how it has “flattened” – long rates are down and short rates are up.  Yields have increased over the past year resulting in a negative impact on bond returns over that period.

The rise in short-term rates is consistent with recent Fed activity.  Yields on bonds of longer maturities are market determined.  It has been, and continues to be, widely anticipated that the Fed will continue to increase interest rates.  Yet, longer-term bond yields have not increased.  This flattening of the Yield Curve can be a harbinger of difficult times ahead as the market may be telling us they don’t expect the Fed will be able to increase rates.  We’ll see.

Stock values have been climbing almost uninterruptedly over the recent past.  Bonds have not.  This record is consistent with the long-held maxim that if you can stand the heat, stocks will eventually outperform bonds.  The recent track record, along with this widely held belief, has some wondering why hold bonds at all.

While stocks look good, there are still reasons to hold bonds.  First, bonds reduce volatility, which can make it easier to remain committed to a given risk strategy over the long term.  Failing to do so means not realizing the positive long-term returns of stocks.  In some periods, maintaining an allocation to bonds provides a better outcome.  (A portfolio with a 30% allocation to bonds did better than an all stock portfolio in 27% of the ten-year periods since 1926.)  Prudence means not taking unnecessary risks and matching a portfolio’s profile to established long-term goals – bonds help do that.

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Why Perspective Matters

I often say that one of our primary roles as an advisor is to provide context and perspective for clients, allowing us to collaboratively make better decisions.

Behavioral economists have identified narrow framing as the tendency for investors to make decisions without considering the big picture or long-term effect on their portfolio.  This behavior can be harmful when it leads to bad decisions, like falling in love with a stock or a market sector that has done particularly well recently.  If we observe a particular sector doing well, and conclude we should buy more, the overweight can reduce diversification, and hurt portfolio performance when an inevitable market correction occurs.  Similarly, a narrow focus on a single, very risky asset may lead us to reject it from the portfolio, when a small percentage could add valuable diversification over the long term.  The benefits of portfolio theory are enormous, but require that we consider the big picture – the whole portfolio.

A recent post on the Rockbridge website includes a link to a Wall Street Journal article discussing some of the pitfalls of narrow framing (https://rockbridgeinvest.com/do-you-suffer-from-narrow-framing/), but this is not a new subject.  The author of this article, Shlomo Benartzi, was cited for his previous work by some other famous behavioral economists in a research paper from the late 1990’s.  The authors of that paper included Amos Tversky and Daniel Kahneman, the subjects of Michael Lewis’ recent best seller The Undoing Project.

That paper discusses myopic loss aversion, which is the combination of a greater sensitivity to losses than to gains, and a tendency to evaluate outcomes frequently.  The authors did an experiment that supported their theory that long-term investors would make better decisions if they looked at their portfolio performance less frequently, like yearly instead of monthly.  Looking at short-term results is like narrow framing; it is easy to ignore the big picture and focus on a small piece of data. (If you still think looking at your 401(k) balance every day is a good idea, I can send you a copy of the paper!)

It turns out that being short-sighted and attaching outsized negative emotions to losses (another way to say myopic loss aversion), is not good for long-term investment results.

Behavioral economists have devised several experiments to illustrate how loss aversion affects decisions.  One of my favorites is the following two questions:

  • Scenario One:  You have accumulated $9,000 and face a choice: take $9,500 for sure OR flip a coin, heads you get $10,000 and tails you keep the $9,000 you start with.
  • Scenario Two:  You have accumulated $10,000 but cannot just keep it.  Your choices are:  flip a coin, heads you keep $10,000 and tails you keep only $9,000 OR take $9,500 for sure.

Research shows that most people in Scenario One will take the sure gain.  The chance for additional gain is not worth the risk of the coin toss.  On the other hand, when faced with Scenario Two, most people choose to gamble, because the pain of loss is significant, and therefore we tend to justify taking more risk to avoid a loss.  Now step back and compare the two scenarios – they are exactly the same, but framed differently.  It is irrational, from an economic perspective, to choose a different answer based on how the options are framed, but most of us do.

Behavioral economists depart from traditional economists by acknowledging that humans do not always appear rational.  Real people often make decisions that differ from a rational person trying to maximize their economic well-being.

Our role as advisors is to recognize that humans allow emotions to affect decision making.  We can then help reframe decisions in ways that lead to better long-term outcomes.  Pitfalls we can help investors avoid include:

  • Falling in love with the short-term    performance of a particular asset or sector and taking too much risk.
  • Being frightened by negative performance and taking too little risk.
  • Buying winners and selling losers without considering overall portfolio diversification.
  • Focusing on an isolated account without considering its role in the context of your total portfolio.  Sometimes this can be minimized by consolidating accounts; for instance, all your old 401(k) accounts can be consolidated in one rollover IRA account at the same custodian that holds your taxable brokerage account.  This makes it easier to track overall performance and optimize placement of tax-efficient and inefficient asset.

If we acknowledge the impact of our emotions, and constantly force ourselves to step back far enough to see the big picture, we can expect better long-term investment results.

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History of the Fee-Only Advisor Movement

I recently returned from a fee-only advisor industry conference.  In addition to educational opportunities, it was a rewarding experience to spend time with other like-minded professionals. Rockbridge advisors have been attending these conferences for almost 10 years, so I thought it would be interesting to share a bit of the history behind the fee-only movement.

More than 40 years ago, consumers had very few choices when seeking out investment advice.  Large companies that paid representatives to sell individual securities and other financial products dominated the industry.  In 1982, a group of independent advisors got together in Atlanta, Georgia to brainstorm ways to deliver investment advice to their clients that didn’t require them to accept commissions from sales of financial products.  This small band of advisors sent out hundreds of invitations to other advisors around the country to see if there were others who felt the same way.  In February 1983, The National Association of Personal Financial Advisors (NAPFA) was born.  The first meeting brought together 125 advisors who were committed to expanding the use of fee-only financial planning by individual consumers.

NAPFA established a set of professional standards for fee-only financial advisors. They set their members apart from the crowd by committing to a fiduciary standard of care and rejecting commission compensation.  NAPFA advisors are different from other financial professionals in many ways.  They must adhere to a strict fee-only business model and provide comprehensive planning to their clients.  In fact, NAPFA requires members to submit a financial plan for peer review before being accepted into the Association.  Members are also required to complete 60 hours of continuing education every 24 months.

Today NAPFA membership exceeds 2,400 advisors nationwide.  The Association hosts two national conferences per year where members get together in formal study groups around the country to help each other and exchange ideas.

Rockbridge Investment Management is proud to be a member of NAPFA since 2008.  The advisors of Rockbridge have attended numerous NAPFA conferences while also taking a leadership role by volunteering on national and regional boards of the organization.  Many of our clients first learned about our firm by visiting the NAPFA website in search of a fee-only fiduciary advisor.

Today, the government and the media have been spreading the word about this band of fee-only fiduciary advisors that stands ready to provide objective, unbiased financial advice to consumers who are ready for a change.  At Rockbridge, we are ready for the growth opportunities that will come as consumers learn about the benefits of working with a fee-only advisor.

If you would like to learn more about NAPFA, please visit their website at www.napfa.org.

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