What Drives Market Returns?

By Brian Puckett, JD, CPA/PFS, CFP®

Align Wealth Management

In last month’s blog, “Get Along, Little Market,” we discussed the benefits of diversifying your investments to minimize avoidable risks, manage those that are unavoidable when we’re seeking market gains, and better tolerate market volatility along the way.

Our next topic: understanding how to build your diversified portfolio to effectively capture market returns. To do that, we must understand where those returns actually come from.

Market returns represent something deeper than the ups and downs of stocks and bonds. They are our compensation for providing the financial capital that feeds the human enterprise going on all around us.

When you buy a stock or a bond, your capital is ultimately put to work by businesses or agencies that expect to succeed at whatever it is they are doing, whether it’s growing oranges, running a hospital or selling virtual cloud storage. You, in turn, are not giving your money away: You mean to receive your capital back, and then some.

A company hopes to generate profits. A government agency hopes to fund its work with money to spare. Investors hope to earn generous returns. Now,

even if a business is booming, you cannot necessarily expect to reap the rewards simply by buying its stock. By the time good or bad news is apparent, it’s already reflected in share prices.

So what does drive expected returns? One factor is the acceptance of market risk. Stocks, as you may know, are often riskier than bonds. When you buy a bond:

• You are lending money to a business or government agency, with no ownership stake.

• Your returns come from interest paid on your loan.

• If a business or agency defaults on its bond, you are closer to the front of the line of creditors to be repaid with any remaining capital.

On the other hand, when you buy a stock:

• You become a co-owner in the business, with voting rights at shareholder meetings.

• Your returns come from increased share prices and/or dividends.

• If a company goes bankrupt, you are closer to the end of the line of creditors to be repaid.

In short, stock owners generally face higher odds of not receiving an expected return and of losing their money. While stocks are considered riskier than bonds, they have also tended to deliver higher returns over time. This outperformance of stocks is called the equity premium. The precise amount of the equity premium, and how long it takes to be realized, is never certain.

As the chart below shows, stock have handily outperformed bonds over time. However, they also have exhibited a bumpier ride along the way:

Exposure to market risk is among the most important factors contributing to premium returns. But it’s not the only factor. Next month, we’ll continue to explore market factors and expected returns, and discuss why our evidence-based approach is so critical to that exploration.

Get Along, Little Market

By Brian Puckett, CFP®, CPA/PFS, Attorney at Law

As we discussed in our previous blog, “Managing the Market’s Risky Business,” properly diversifying your investment portfolio helps to minimize unnecessary risks and better manage those that remain. But diversification provides us with an additional benefit: It helps to create a smoother ride toward our goals.

Like a bucking bronco, near-term market returns are characterized by periods of wild volatility. Diversification helps you “break” the horse. That’s important because, as any rider knows, if you fall out of the saddle, you’re going to get left in the dust.

When you crunch the numbers, we see that diversification helps to minimize volatility along the way to your expected returns. Imagine several jagged, upward trending lines on a chart; they represent several kinds of holdings. Individually, each holding has a bumpy ride. Bundled together, however, the upward trend remains, but the jaggedness along the way can be dampened (albeit never completely eliminated).

www.cbsnews.com/news/how-to-diversify-your-investments/

A key reason diversification works is related to how different market components respond to price-changing events. When one type of investment zigs due to a particular news story, another may zag. Instead of trying to move in and out of investments as they zig and zag, wise investors remain broadly diversified. This increases the odds that, when some of your holdings underperform, others will outperform, or at least hold their own.

The results of diversification aren’t perfectly predictable. But it is a coherent, cost-effective strategy for capturing market returns where and when they occur, and it’s far better than guesswork.

The Crazy Quilt Chart is a classic illustration of this concept. It shows that there is no discernible pattern of how different asset classes have performed.

If you can predict how each column of best and worst performers will stack up in years to come, your psychic powers are greater than ours.

Diversification provides not only more manageable exposure to the market’s long-term expected returns, but also a smoother expected ride along the way. Perhaps most important, it eliminates the need to try to forecast future market movements—and that helps to reduce those nagging self doubts that throw so many investors off course.

In our next blog, we will pop open the hood and begin to take a closer look at some of the mechanics of solid portfolio construction.

Managing the Market’s Risky Business Part I

By Brian Puckett, CFP®, CPA/PFS, Attorney at Law

In last month’s blog post, “The Full-Meal Deal of Diversification,” we described how effective diversification means more than just holding a large number of accounts or securities. It means having efficient, low-cost exposure to a variety of capital markets around the globe. Today, we’ll expand on the benefits of diversification, beginning with its ability to help you better manage investment risks.

Most of us learn about risk even before we have the words to describe it. Our lessons start when we, say, tumble into the coffee table, or reach for that pretty cat’s tail. Investment risks, alas, are a little more complex. They come in two broadly different varieties: avoidable, concentrated risks and unavoidable market risks.

First let’s look at concentrated risks. They are the ones that wreak havoc on particular stocks, bonds or sectors. Even in a bull market, one company can experience an industrial accident (Exxon Valdez), causing its stock to plummet. A municipality can default on a bond (Detroit, LA) even when the wider economy is thriving. A natural disaster (Japan’s Tsunami) can strike an industry or region while the rest of the world thrives.

In the science of investing, concentrated risks are considered avoidable. Bad luck still happens, but you can dramatically minimize its impact on your investments by diversifying your holdings widely and globally, as we described in our last post. In a well-diversified portfolio, some of your holdings may indeed be affected by a concentrated risk. But it’s likely that you’ll have plenty of unaffected holdings.

Financial Gurus and Other Unicorns Part II

By Brian Puckett

Across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking. Among the earliest such studies is Michael Jensens 1967 paper, The Performance of Mutual Funds in the Period 1945–1964. He concluded that there was very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.

A more recent landmark study is Eugene Famas and Kenneth Frenchs Luck Versus Skill in the Cross Section of Mutual Fund Returns, from 2009. Fama and French demonstrated that the high costs of active management show up intact as lower returns to investors.

In the decades between those two studies, as 100 similar studies, published by a whos-who of academic luminaries, have echoed the findings of Jensen, Fama and French. In 2011, the Netherlands Authority for the Financial Markets (AFM) scrutinized this body of research and concluded: Selecting active funds in advance that will achieve outperformance after deduction of costs is exceptionally difficult.

Can hedge fund managers and similar experts fare better than mutual fund managers? The evidence suggests not. For example, a March 2014 Barrons column took a look at hedge fund survivorship. The author reported that nearly 10% of hedge funds existing at the beginning of 2013 had closed by year-end, and nearly half of the hedge funds available five years prior were no longer available (presumably due to poor performance).

So far, weve been assessing some of the reasons its hard to beat the market. The good news is that there is a simple way to let the market do what it does best on your behalf. In our next few blogs, well begin to explain how.

Financial Gurus and Other Unicorns Part I, By Brian Puckett

In our last blog, Ignoring the Siren Song of Daily Market Pricing, we examined how price- setting occurs in capital markets, and why investors should avoid reacting to breaking news. Now lets look at why using a professional pinch hitter to try to beat the market is also ill-advised. In the words of Morningstar strategist Samuel Lee, managers who have persistently outperformed their benchmarks are rarer than rare.

As we explained in Jelly Beans and Investing Wisdom, independently thinking groups (such as capital markets) are better at arriving at accurate answers than even the smartest individuals in the group. Thus, even experts in analyzing business, economic, geopolitical or any other market-related information face the same challenges you do in predicting market behavior. For these experts, beating the collective group intelligence remains a prohibitively tall hurdle, especially when their fees are factored in.

But maybe you know of an extraordinary stockbroker, fund manager or TV personality who strikes you as being among the elite few who can make the leap. Maybe they have a stellar track record, impeccable credentials, a secret sauce or brand-name recognition. Should you turn to them for the latest market tips or should you pursue a strategy of capturing market returns with the least amount of risk, cost and tax?

Unfortunately, there is little credible evidence that hiring a stock picker/market timer is a good idea. In fact, the evidence to the contrary is overwhelming. Star fund managers often fail to survive, let alone persistently beat appropriate benchmarks. A 2013 Vanguard Group analysis found that only about half of some 1,500 actively managed funds available in 1998 still existed by the end of 2012, and only 18% of the survivors outperformed their benchmarks. Dimensional Fund Advisors found similar results in its independent analysis of 10-year mutual fund performance through year-end 2013.

Ignoring the Siren Song of Daily Market Pricing Part II

Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law

The second reason to consider breaking news irrelevant to your investing is what we’ll call “The Barn Door Principle.” By the time you hear the news, the market already has incorporated it into existing prices, well ahead of your ability to do anything about it. The proverbial horses have already galloped past your open trading door.

This is especially so in today’s micro-second electronic trading world. In his article, “The Impact of News Events on Market Prices,” CBS MoneyWatch columnist Larry Swedroe explored how fast global markets respond to breaking news. Pointing to evidence from a number of studies among several developed markets, he found that the universal response was nearly instantaneous price-setting during the first handful of post-announcement trades. In the U.S. markets, it was even faster than that.

In other words, unless you happen be among the very first to respond to breaking news (competing, mind you, against automated traders who often respond in fractions of milliseconds), you’re setting yourself up to buy higher or sell lower than those who already have set new prices based on the news. And that, of course, is exactly the opposite of your goal.

It makes little sense, then, to play an expensive game based on ever-changing information and cutthroat competition over which you have no control. A better way to invest is by paying heed to a number of market factors that you can better expect to manage in your favor. We’ll introduce these factors to you in a future blog.

But first, you may be wondering: Even if you aren’t personally up to the challenge of competing against the market, perhaps there’s a pinch-hitting expert out there who can do it for you. In our next blog, we’ll explore whether that’s the case.

In Uncertain Markets, Beware of the Herd Part 2

Market risk is a fact of life, and the market’s periodic ups and downs are something we can’t control. But market risk is deliberately built into your portfolio because with it comes the potential for reward. This is why, as tempting as it may be to follow the herd by trading on bad (or good) news, we must stay the course. Consider that:

1. By the time you’re aware of good or bad news, the rest of the market knows it too, and already has incorporated it into existing prices.

2. It’s unexpected news that alters future pricing, and by definition, the unexpected is impossible to predict.

3. Any trades, whether they work or not, cost real money.

Rather than try to play an expensive game based on information over which we have little control, we continue to recommend that you focus on what can be controlled:

1. Minimizing costs.

2. Forming an investment plan to guide you to your goals—and sticking with that plan.

3. Positioning your investments to participate in long-term market growth.

4. Maintaining diversified holdings to dampen market risks.

Our clients have heard this message before, but it bears repeating whenever the market is roiled by emotion: Stick with your long-range investment approach—or, if your personal goals have changed, work with us to thoughtfully adjust your approach. As always, if you’d like to review your investments, please don’t hesitate to contact us.