Investing Fundamentals

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Investing in Opportunities – The Key to Identifying Ideal Outcomes

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Working with so many individual business owners, it’s easy to gain a respect for their ability to have a vision and execute on opportunities. At Capstone, what we aim to do is help these business owners and entrepreneurs carry over their knowledge and acumen into investing in other areas.

In a recent article titled Investing Versus Flipping, author Chris Brightman of Research Affiliates does a great job of bridging the knowledge and experience that business owners have and applying it to investing in stocks and bonds. Additionally, he identifies the key to investing in any opportunity, whether it be companies, real estate or stocks and bonds, with the premise being “short-term price volatility as opportunity; high price as risk.”

Specifically, the example provided describes the difference between investing in real estate in Orange Country, California versus Atlanta, Georgia. Brightman exclaims:

“I am buying cheap houses in Atlanta with long-term expected after-tax returns of 5%. These home investments seem safe to me. Comparable houses in the OC are far more expensive. I estimate long-term after-tax returns of only 1% for investing in houses in Orange County. I judge these high housing prices as creating risk to achieving my return goal for retirement.”

Aim High, Buy Low – The Advantage of Investing in Emerging Markets

This same example can be applied to different opportunities in stocks as well. Today’s high-priced U.S. stock market provides quite a bit of risk. However, emerging markets like Brazil, Malaysia and China sell at lower prices and are harbingers of higher returns.

Take some time to enjoy Brightman’s article, and transpose your skills as a business owners to investing opportunities for maximum growth.

Lived, Accumulated and Retired – A Wise Approach to Preserving Your Wealth

As an individual investing in a 401k, there are many things you can do to ensure that you get to a healthy retirement: saving more, working longer, and certainly using a Dynamic portfolio that relates more to wealth rather than last year’s hot investment.

For those who are lucky enough to have lived, accumulated and retired at the right age, it does not matter what allocations you have. However, for those who entered retirement around 1965, or in the past 10 years, the risk of running out of money is much greater.

Wealth and Returns

In Investing for Retirement: The Defined Contribution Challenge, Ben Inker and Martin Tarlie, both from GMO, suggest  — and I reiterate in The 401k Retirement Challenge and Static and Target Date Funds – a Curse on the Industry – that individuals focus more on wealth than they do returns. This is no small feat. Between CNBC and the press blaring what current returns are, it is hard for individuals to turn the other way. More specifically, Inker and Tarlie state:

“We believe that the right way to build portfolios for retirement is to focus on how much wealth is needed and when it is needed, with a focus not on maximizing expected wealth, but on minimizing the expected shortfall of wealth from what is needed in retirement.”

This suggests that 401k investors take a different approach. The premise of this course is to focus on the wealth that is necessary in order to get to the desired goal (note that this approach does not discuss returns or benchmarks).

  1. Determine how much you want/need (i.e. an investor thinks she needs $50,000 a year in retirement).
  2. Determine what value you will need in your portfolio to achieve that income (ex: $800,000 at a 5% constant withdrawal rate).
  3. Decide how much you will need to save and contribute to the portfolio to reach this goal.
  4. Design a Dynamic portfolio to accomplish the expected goal.
  5. Review the portfolio annually. Look at where you currently are versus the progression to the goal. Draw a line and a glide path to get to that goal with reasonable expectations. Ask yourself why you may be above or below that line and what might you need to do in order to stay at — or rise above — that line.

The industry — and especially 401k providers — seem to think investing more aggressively at a young age and reducing stock exposure is the way to go. Many of these investors are under the belief that once an individual enters retirement, any and all short-term losses are simply not recoverable.

Forecasting for more than one year out is difficult for most people. Regrettably, valuations do not tell us much about what will happen in the coming week, month, quarter or even the next few years. However, valuations can tell us the expected investment returns over the course of a 10, 15, and even 20-year period of time.

Individuals have come to believe that they should expect 10% in returns. Why shouldn’t they, given the recent strong returns over the last 5 years? Nonetheless, it’s important to remember that investment returns of the stock or bond market are anything but constant.

What Did You Do in the Last Stock Market Downturn?

Were you one of the many individuals who sold stock when the market began to sink in 2008?  How much had the market fallen before you sold?

These are two good questions to ask yourself, as the best way to predict your willingness to take future risks is to analyze how you reacted in the last go-around.

If you did sell when the market was down, perhaps now is the time to do something different with your portfolio. For example, Craig L. Israelsen suggests diversifying across seven asset classes dispersed into 12 different mutual funds, in what he calls the 7Twelve portfolio.

This is very similar to the Yale endowment that looks to gain a higher investment return by allocating share between several investment strategies and classes.

Some investors who are diversified across multiple assets groan when the S&P 500 is on a tear, as they believe they could be earning more if they were in an index fund that tracked the S&P 500.

The S&P 500 is an index of 500 of the largest companies in the United States. The weighting of each stock is based on its market cap. Apple has the largest market cap assuming the greatest position within the index, with a weighting of 4.03%, while the smallest holding, Diamond Offshore Drilling represents just 0.01%. Consequently, if the top 10 companies are doing well in the S&P 500 index, the overall index usually performs well. However, the index excludes small companies in either the mid-cap 400 index or the small-cap 600 index. These are companies that are even smaller than Diamond Offshore drilling.

Additionally, the S&P 500 leaves out other investments, such as real estate, commodities, infrastructure, international stocks and bonds. There are times that having these additional investments help in doing two things: smoothing out returns to avoid significant losses, and producing stronger returns by not losing as much as the S&P 500. However, when the S&P 500 is the strongest, investors grumble about not having all their investments in one place, often forgetting they can lose all the gains they have experienced recently.

However, these investors are the same individuals who sell quickly when the stock market declines.

Celebrate the Little Things

There are two additional strategies that behavioral finance has taught us. One is to rejoice over the small wins. The second is to pay less attention to your investments.

Weber’s law states that we prefer to experience small, continual wins rather than one sizeable gain. Rather than looking for a single grand lottery payday, we should be searching for the things that benefit us day in and day out.

Divert Your Attention

Second, we all know of people who look at their investment statements weekly. If you find yourself concerned about whether your account has gone up or down on a weekly basis, you should think about tucking those reports away and create a schedule to view them on a monthly, quarterly, or even annual basis.

It’s also important to avoid selling out when there is a decline in the market. Refraining from this can significantly benefit your returns over time. Recent research conducted by Vanguard indicated that average annual returns can increase by almost 2% per annum if individuals continue to hold their investments as the stock market corrects.

Hang On To Your Investments Longer

The pain associated with loss is often greater than what is felt with gains. As a result, people tend to avoid monetary losses at all costs. When individuals have loss aversions, they tend to sell all of their investments during periods of market disruption. While freeing themselves from low-value investments may be comforting at the time, this decision often results in stocks being sold at the worst possible moment.

The reactions that individuals have to market fluctuations are often reoccurring; therefore, if you sold out in 2008, it is highly likely you will do the same the next time the market takes a turn for the worse. Consequently, you should look to diversify your investments.

No matter what your approach to buying and selling may be, it is always helpful to remove your focus on the day-to-day gyrations of the stock market and look for ways to enjoy the small wins throughout your investment process.

Plan Now, Savor Late – How Preparing For Retirement Early Can Help You Achieve Your Goals

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Helping people fulfill their goals and accomplish their dreams is a wonderful profession to be in. In my career, one of the primary areas of focus is retirement. Clients are continually asking if and when they can retire and how long they can go before they will run out of money in retirement.

I am here to tell you … you can do it. Will it require a fair amount of work? Yes. Will it take some sacrifice? Yes. But you can do it.

Determining Your Financial Goals in Preparation for Retirement

In a recent Forbes article titled, “Can You Retire With $2 Million?”, author Jeff Rose discusses the hurdles many hopeful retirees face when it comes to creating an investment strategy that fits their needs, desires and most importantly, their budgets.

The article focuses primarily on portfolio allocation. While asset allocation strategies are undoubtedly important, I would personally prefer to help clients figure out what their goals are and the best methods we can apply to get them there.

In conversations with clients and prospects, we often hear that personal goals have not been established and many of these clients are still unsure of what they would love to do on a daily basis upon entering retirement.

At Capstone, we do the heavily lifting in terms of looking at the numbers. We want to hear from you, our client on your passions and what you would like to do throughout your retirement. What makes you happy? What gives you the freedom and allows you the lifestyle you enjoy?

In the Forbes article, four important questions were asked:

• What will a typical day look like for you in retirement?
• What hobbies or activities do you think will keep you the busiest?

• What will you be doing in retirement that you are not able to do now?
• What are the challenges, opportunities, and strengths that will either help or hinder you from achieving these goals?

One client we have enjoys nothing more than going out in the yard and raking leaves on a beautiful Colorado day. Another individual is looking forward to helping underprivileged kids attend college. One particular client is anticipating the ability to spend more time on the tennis court and the golf course. Many others are trading in their desk job so that they can spend time with their grandkids.

Developing a plan is unique to all. Thinking about the plan is fun and exciting. It is amazing what you can do when you take the time to strategize and dream. To help begin outlining your plan for retirement, contact us today.

Cash – The Donald Trump of Retirement Investing

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There have been numerous times in this presidential cycle where Donald Trump has said something and I’ve cringed. A political analyst that I was listening to recently said it best — Donald Trump is an astute business operative, but with the remarks he makes, do we really want him as the leader of our country?

Trump has struck a nerve with many people. He speaks freely and is blatant about the ills that plague our nation.

The amount of cash in one’s portfolio evokes a similar adverse response in investors. As Donald Trump is to voters, cash is burdened with low returns, lack of space for other investments and a shortage of cash flow. All of these combined garner cringes from investors.

Keeping Cash at Hand to Secure Swift Investments

Yet cash has its place, just as Trump has demonstrated his ability to be business-savvy. Cash provides the opportunity to move quickly and pounce on an investment. In the recent downturn, we took advantage of two quality stocks with decent dividends, and one closed-end fund with favorable cash flow. If we were fully invested, this would not have been possible. But with cash at hand, we were able to purchase Johnson Controls (JCI), Symantec (SYMC) and Aberdeen Global Income (FCO).

Johnson Controls manufactures building management systems for heating ventilation and air conditioning. Symantec provides security software for computers, and Aberdeen Global Income invests in foreign government bonds predominantly in Canada, New Zealand and Australia as of recently. Each of these stocks have received quite a scare in the downturn, all in great excess of 20% or more.

All three of these companies have valuable products and initiatives in place for sustained operations. Consequently, having cash on hand to purchase these opportunities was an advantage for our company.

While cash does not provide a return, and people typically do not want to pay a fee for holding onto it, cash does serve a purpose: to take advantage of the opportunities that arise in an ever-changing market.

So, the next time you see cash in your account and automatically produce a gag reflex, take a second look at the opportunities cash may provide for your account to promote and stabilize your current and future financial well-being.

How Smart People Lose Money… Understanding Risk Management to Save Your Investments

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Financial risk is associated with the permanent loss of money. In order to measure the amount of risk a client is dealing with, advisors use maximum drawdown to measure the largest single drop from peak to bottom in the value of a portfolio. It also helps to offer financial advisors a worst-case scenario so they can prepare portfolios based on potential risks that are assessed.

To adequately prepare for maximum drawdowns and elevated risk, financial advisors spend a great deal of time educating clients on loss aversion and how it can affect client behavior. Loss aversion, first demonstrated by Amos Tversky and Daniel Kahneman, refers to a client’s tendency to strongly prefer avoiding losses versus their desire to acquire gains.

Most studies suggest that losses are twice as psychologically powerful as gains. There are four primary benefits of understanding loss aversion when helping clients cope with risk:

  • Investments and stock shares can be sold quickly in times of decline
  • Documenting past losses can help prepare individuals for future risks
  • Remedies, including diversification, focusing on the big picture, paying less attention to accounts and the stock market can be applied to help save high-risk investments

Applying Mental Accounting to Regulate Investments

To avoid losses from occurring due to an investor panicking and selling at an inopportune time, certain strategies should be practiced by the advisor and client alike. Mental accounting helps individuals to organize, evaluate, and keep track of financial activities, including the source of the money and purpose for each account.

Because clients often value various amounts of money in different ways, mental accounting can help assign different functions to each asset group, which affects consumption decisions and other behaviors pertaining to investment strategies.

Unfortunately, bad things do happen to good people. When it comes to managing risk, we see many of these instances occur as a result of poor research and a constant desire to believe only half of the facts. Quite often, clients choose to ignore the base rate, also known as the base rate fallacy. This occurs when individuals are uncertain of the probability that something detrimental may occur and therefore follow historical probabilities from the past year in order to keep a low insurance deductible. Advisors will frequently encourage clients to ignore the basic, nonexclusive data and only focus on specific information that pertains to a certain investment decision unique to their particular portfolio.

Another way that clients often find themselves actually welcoming risk into their investments is through heavily practicing confirmation bias, which is the act of seeking out things that support your viewpoint, while ignoring data that disputes their belief. This bias may result in unforeseen risks and loss of principal.

Overconfidence in the investment process can also lead to serious declines and an elevated level of risk as it gives clients the assumption that their investments will be protected, despite the actual unpredictability of the stock market. This prompts frequent decisions being made without sound research and potential losses being overlooked.

You Win Some, You Lose Some – Why Risk is Needed

While playing it safe can seem like a good idea in the investment world, taking too little risk can actually cause problems to your portfolio. Taking a minimal approach to risk can result in investment loss when inflation is low, much like it is now, as no money can be made when it is sitting idle in a bank account. As an investor, keeping up with inflation is crucial, as the value of the dollar continues to drop. For example, 20 years ago, a Big Mac sandwich from McDonalds could be purchased for $1. Fast forward to today, where the same sandwich now is averaging $4.64. By applying an appropriate amount of risk to your investments, each dollar is able to stretch further as you continue to keep pace with the rate of inflation.

Regardless of the amount of risk you are willing to take, it’s important to diversify your investments. Rather than concentrating all of your risk in one particular investment, seek to hold multiple investments that all pose a different risk profile. By owning a series of investments, you can reduce the overall risk found in each individual investment. One may zig while the other zags, working together to reduce your risk.

For more information on risk management and how to accurately balance your portfolio, contact us today.

The Quest for a Favorable 401k – Understanding Your Options for Smarter Investments

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When you aren’t accustomed to doing it regularly, choosing what to invest in can be difficult. Heck, try investing routinely and you will see that it is never an easy boat to row.

If you don’t have a substantial idea of what to invest in your 401k, how can you evaluate whether your 401k options are any good?

Healthcare professionals, including nurses, counselors, and practitioners come to us with all sorts of opportunities for investment. In an ideal world, we would get to choose what our clients select from in their 401k. Unfortunately, this is often not the case.

Identifying Applicable Asset Groups

This past week, we began working with a client in the finance industry. His company offers investment platforms to individuals and institutions. Based on his profession, you would think this client would have a great spread of options. The reality could not be further from the truth.

Before we dive into his limited options, let’s begin by looking at what we believe to be a good selection of investment opportunities, which include the following 12 assets groups:

  • Large-cap US (the largest of the large companies — typically over $10 billion in value)
  • Mid-cap US (companies worth between $2 and $10 billion)
  • Small-cap US (companies worth less than $2 billion)
  • Developed countries (France, Japan, etc.)
  • Emerging markets (Brazil, Thailand, etc.)
  • US bonds
  • International bonds
  • Treasury inflation protected bonds (TIPs) – bonds that provide compensation for rising inflation
  • Real estate
  • Natural resources (gold, oil, and agriculture)
  • Absolute return- funds that select investments known to increase in value even when the stock market is declining
  • Cash

The idea behind incorporating such a diverse selection is that when one or more of these investments are doing well, the others may not be performing as great. Over time; however, the poorly performing investments increase in value and the diversity helps smooth out returns. Within each option, you may have one index fund that is low-cost, and another that is actively managed, whereby the additional returns offset the higher expenses.

All in all, you may be looking at 12 to 24 investment choices.

With the in-house knowledge to choose, you would think our client’s financial advising company would provide employees with the best options to choose from. We unfortunately discovered that such options were not offered for 401k investments within the business.

What we did find was that this company had five large-cap funds, three mid-cap funds, three small-cap funds, a fund that blends stocks and bonds, two foreign stock funds, two bond funds and two cash funds. To its credit, the funds were low-cost; however, this is where the kudos ends. From our list above, we can see that we are missing five crucial categories of funds: real estate, natural resources, absolute return, emerging markets, and TIPs.

Why Additional Opportunities Matter

Let’s take a look at when having these other investments would have been beneficial to our client’s 401k. From 2002 to 2006, emerging markets led the way in producing steep returns. Then from 2006 to 2007, natural resources did exceedingly well. From 2007 to 2009, TIPS — as well as other bonds — outperformed other investment options.

As for all the professionals figuring out whether or not your company offers valuable investment options, we advise you to compare your investment selection to the list we provided above. From there, we suggest contacting your benefits administrator to request a copy of the investments offered in the program to better understand what options may provide you with the greatest returns in the future.

photo credit: hyena reality via freedigitalphotos

Do Investors Understand Risks and Rewards?

By Ted Schwartz

I am a long term believer that good investing is a balancing act of evaluating how much you expect to make from an investment and how much risk is involved in trying to make that return. I believe this is a dynamic and changing calculation. When investments are expensive, your risk will increase and your expected return will drop. Not a good idea!

So, I was shocked to see the money flows for 2012 in mutual funds. About a hundred billion dollars went out of Equity Funds and into Intermediate Term Bond Funds. The expected returns for these bond funds are near an all-time low at this point. Their coupons (the amount paid to you in interest) are often about the same as the expected rate of inflation. So, in real terms you get nothing from that component. The only way you could make any money on the valuation side would be for interest rates to decline even further. This is not impossible, but there is not much room for further rate decline. History says rates will rise, the only question is when. That means the potential returns on these investments are very, very small indeed.

The risks? Due to rates being so low, relatively small increases in rates would likely cause relatively large declines in bond prices. A one percent increase in interest rates (still leaving us well below normal) would likely cause a loss of 5% or more in bond values. A two percent change would likely elevate this to double digits.

Why take the risk of these losses to potentially have such a small return on your investment? That is the question for which I cannot find a good answer. Anyone?

A Fine Whine


By Ted Schwartz

This week I met with two very bright individuals who parroted the CEO cry that we “need certainty” before the economy will improve and companies will hire people. At the same time, I am reading Taleb’s, Antifragile. His whole point would be that things in life are not predictable and actual results often do not even approximate the outcomes we think are possible. Taleb would argue that certainty is a bad thing, making us more fragile to the problems that will inevitably crop up in the future.

For me, the whole notion of certainty being a necessity goes against the grain of everything I know. The rationale for why entrepreneurs can earn more than employees is that they are taking a risk. The reason equity investors make more than fixed income investors is referred to as the risk premium. You expect to earn more due to the increased risks you take. Now, the cry is that we have to be assured of future results and of what taxes we will owe on our profits. We now refer to things like “making the tax cuts permanent.” The chart below shows the changes in the maximum marginal rates since 1913. Does this look like we offered “certainty” and low taxes up until President Obama arrived on the scene?


Let’s not forget that we experienced a huge amount of growth during the period since 1913. During this time frame we also experienced almost 20 recessions. Yet, we did not have entrepreneurs constantly saying they would not hire or invest unless they were given certainty of results. It is the cry of the 21st century entitled, “the successful class must be assured results before taking any risks.” It really can’t work that way.