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The Patient Investor

Written by Eric Hutchens on .

"No matter how great the talent or efforts, some things take time. You can't produce a baby in one month by getting nine women pregnant."  — Warren Buffett

Topic #3 –You, Your Financial Well-Being and the Federal Reserve

Beginning in December 2016, the U.S. Federal Reserve (the Fed) had been gradually ratcheting-up the federal funds rate, until it reached its December 2018 level of 2.25–2.50%. Effective August 1, 2019, that changed: The Fed lowered the federal funds rate by a quarter point, to 2.20–2.25%. Even though the announcement was not a huge surprise, it was the first rate decrease since the thick of the 2008 Economic Crisis. As such, the move is receiving wide media coverage accompanied by the usual outpour of opinions on whether it will help or hurt us.

What does the rate change mean to your financial well-being? Is there anything you should “do” to your investment portfolio in response? We typically recommend you remain informedbut you act only on factors you can expect to manage within your personal investing. This is nearly always the case for economic events and other breaking news over which we have no control.

In that context, let’s take a moment to share some insights about the Federal Reserve funds rate.

What Is the Federal Reserve?

As described on its consumer education site, the Federal Reserve is the central bank of the U.S. It was created by Congress as an independent government agency in 1913 “to provide the nation with a safer, more flexible, and more stable monetary and financial system.”

Jerome Powell is its current board of governors’ chair. He and his board are based in Washington, DC. They also oversee 12 regional reserve branches across the country and are tasked with three main roles:

  1.  Monetary Policy: Promoting “maximum employment, stable prices and moderate long-term interest rates”
  2.  Supervision and Regulation: Overseeing U.S. banks and gathering information to understand financial industry trends
  3.  Financial Services: Serving as a bank for U.S. banks as well as for the country’s monetary operations―issuing currency, managing the government’s bank accounts, borrowing money in the form of U.S. Savings bonds and more

What Is Going On?

While you wouldn’t want to run a country without all three of these roles in place, monetary policy is where much of the headline-grabbing action is found. The Fed continuously grapples with when, by how much, and how often it should change the federal funds rate.

The Federal Reserve sets monetary policy through its Federal Open Market Committee (FOMC), which includes the Fed’s board members and a rotating representation of Reserve Bank presidents.

The FOMC holds eight regularly scheduled annual meetings to consider what actions to takeif any. In the days before those meetings, the financial press often reports on expected outcomes as if they were nearly a done deal. Markets often respond accordingly, pricing in whatever is most expected to happen before it actually does. In reality, nobody knows for sure what the outcomes will really be until those meetings have taken place. If the outcome is a surprise, market volatility may result, as prices adjust to the latest expectations.

While the FOMC has a number of ways to seek balance among the competing demands of the economy, raising or lowering the federal funds rate has long been one of its more powerful management tools. So, it’s no wonder the question can grab everyone’s attention whenever the FOMC is set to meet. It’s also no wonder that investors are bombarded with the usual volume of conflicting coverage on what is and is not at stake, and what may or may not come to pass. Depending on who you heed, lower or higher federal funds rates can be anything from a panacea, to a global scourge, to a non-event in the markets.

What Does All This Mean to You and Your Money?

First, it helps to understand that there is an intricate interplay between nations’ monetary policies, global interest rates and the markets in general. Anyone who claims to know exactly what will happen in one arena when we pull a lever in another had best be able to present a functioning crystal ball to be believed.

To cite one example, consider this March 2018 column by Wall Street Journal columnist Jason Zweig, in which he chastises various brokers for their still-anemic sweep account yields despite then-rising interest rates. At the time, he observed: “The Federal Reserve has driven short-term interest rates up a full percentage point since late 2016; one-month Treasury bills were yielding 1.6% this week. But you’d never know any of that from looking at the returns on the cash in your brokerage account.”

The same came happen in reverse. When the Fed lowers rates, you may or may not see similar declines in the loan rates you pay on your mortgage, credit cards, and other consumer debt. That’s because the only interest rate the Fed has direct control over is the U.S. federal funds rate, which is the rate at which depository institutions (mostly banks), lend and borrow overnight funds with one another.

Why is there often a disconnect? It’s partly the result of those multiple global factors at play, with the Fed’s actions representing only one among many others. A post by “The Grumpy Economist” John Cochrane even suggests that the Fed’s actions may be one of the less-significant factors involved: “Lots of deposits (saving) and a dearth of demand for investment (borrowing) drives (real) interest rates down, and there is not a whole lot the Fed can do about that. Except to see the parade going by, grab a flag, jump in front and pretend to be in charge.”

What Should You Do?

Whenever you’re wondering how best to respond to a shifting landscape such as that wrought by falling (or rising) interest rates, begin by asking yourself: What can I do about it?

Unless you are Fed chair Jerome Powell, there is probably nothing you can do to personally influence what the Fed’s decisions will be, or how the global markets are going to respond to them. But there is plenty you can do to help or harm your own wealth interests.

First, if you already have a solid financial plan in place, we do not recommend abandoning it in rash reaction to unfolding news. If, on the other hand, you do not yet have a well-built plan and portfolio to guide the way, what are you waiting for? Personalized financial planning is a good idea in all environments.

Next, recognize that rising or falling interest rates can impact many facets of your wealth: saving, investing, spending and debt. A conversation with a wealth manager is one way you can position yourself to make the most of multi-factored influences in unfolding economic news.

Together and through varied interest rate climates, we can help put these and many other worldwide events into the context they deserve, so you can make informed judgments about what they mean to your own interests. The goal is to establish practical ways to manage your debt; wise ways to save and invest; and sensible ways to spend, before and in retirement.

These are the factors that matter the most in your life, and over which you can exercise the most controlfor better or for worse. Give us a call today if we can help make things better for you.

Stay patient, my friends.

 

The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.

 

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The Patient Investor

Written by Eric Hutchens on .

"No matter how great the talent or efforts, some things take time. You can't produce a baby in one month by getting nine women pregnant."  — Warren Buffett

Topic #2 – Would You Have Fired Warren Buffett?

One of the most interesting trends in the stock market in recent years has been the strong outperformance of “growth” stocks versus “value” stocks.

Growth stocks have been outperforming value stocks for much of the last decade, and the discrepancy has accelerated over the last 18 months. To provide some historical perspective, at the start of October the difference between growth and value had reached the third highest level since 1990.1

Some of you may remember the two previous times that the difference was this large. The first time was the peak of the “tech bubble” in 2000 and the second time was the market peak before the Great Recession in 2007.

Now, we’re not calling for a market meltdown. However, we do think it’s important to understand what is happening because it is a relatively rare occurrence, and it has had an impact for investors.

Why is this important? As you may know, we use “evidence-based” investment strategies. These strategies use “factors” to seek higher performance levels over time. Eugene Fama famously won a Nobel Prize in 2013 for his work in identifying some of these factors. One of the most well-known was the “value” factor.

In a nutshell, Eugene Fama and Ken French found that value stocks have tended to outperform growth stocks over time. Not just by a little—but by an impactful amount of about 3.5% per year between 1928-2017 in the U.S. (see Chart 1). This has also been a similar case for international and emerging market stocks.2

 

Dimensions of Expected returns 

 

Over rolling ten-year periods, value has been shown to beat growth 84% of the time.3

 

historical perf of premiums

 

Even though the data shows that value was generally more successful, it still means that growth has beaten value in 16% of the 10-year periods. That is exactly where we find ourselves today.

Two well-known institutional investment managers, Dimensional Fund Advisors (DFA) and AQR, both utilize evidence-based approaches with multiple factors in their funds. Many of the factors have been performing relatively well over the last 18 months. However, the value factor has been so out of favor that it’s overwhelmed all of the other factors. The impact has resulted in some relative underperformance this year for some of DFA’s funds and negative returns for some of AQR’s funds.

We believe that the evidence supports these strategies working over time. Nothing is broken—value is simply out of favor at the moment, as we would expect periodically. We can’t predict what’s going to happen in the markets. The best thing we can do is be thoughtful and consistent in making decisions about things we can control, like diversification.

Warren Buffett is the world’s most famous value investor and he has been known to seek out attractively priced companies. You may remember that during the tech bubble, he didn’t do so well as growth stocks kept going higher and his investors felt like they were missing out. Warren Buffett stuck to his beliefs in buying underpriced stocks, while many people wondered if he was too old fashioned. Some went so far as to fire him as their manager.

After the tech bubble burst, Buffett went on to become one of the most successful investors in history. In retrospect, those individuals who fired him may now regret that decision.

Just like Warren Buffett, we still see the benefit of investing in value as a thoughtful and evidence-based approach. It just isn’t working optimally at the moment.  

It’s also interesting to note that the stock market decline during the week of October 8th was driven mainly by losses in tech and growth stocks. Was this a short-term move that will pass quickly or did it signal the start of value outperformance over growth? Only time will tell.

Stay patient, my friends.

Additional resources:

Two great pieces that explore evidence-based investing in light of the current market environment:

 

1AQR, AQR Global Stock Selection 2018 Mid-Year Update

2Dimensional Fund Advisors, Performance of the Premiums in Equity Markets. 2018. In US dollars. US relative price premium: Fama/French US Value Research Index minus Fama/French US Growth Research Index.

3 Dimensional Fund Advisors, Where’s the Value. July, 2018. In US dollars. Based on rolling annualized returns using monthly data. Rolling multiyear periods overlap and are not independent. Fama/French indices provided by Ken French. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.

 

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The Patient Investor

Written by Eric Hutchens on .

"No matter how great the talent or efforts, some things take time. You can't produce a baby in one month by getting nine women pregnant."  — Warren Buffett

Topic #1 – Decision-making and Diversification

Welcome to my blog and thank you for checking it out! My vision is to periodically share ideas that our investment committee has been discussing. No set schedule—I’ll wait until there’s something timely.

I wanted to set the stage with thinking about how we approach stock market events and in a larger sense, our lives. It starts with focusing on what we can control (our decisions and temperament) and what we can’t control (most everything else).

Follow the Serenity Prayer, “Grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference.”

Knowing the difference between what you can and can’t control is important in how you measure results. When you boil down why an event turned out the way it did, it is typically not productive to waste time and energy focusing on things outside of your control. We can’t control whether the market went up or down, if interest rates rose or fell, or which way our home’s value went. In investing, what we can control and manage is the quality of our decisions. How do we make decisions? Is our decision making process objective or based on our emotions? Are there behavioral biases that may be skewing our view? Is there historical evidence that supports our decisions?

Investing involves MANY decisions. How much risk should I take? In which assets should I invest? How should I diversify to reduce risk? Which managers should I use?

One thing we do know is that nothing works all of the time. In the short run, even the best decisions can look unwise.

For example, hypothetically, we might take on a new client and invest their portfolio only to have a particular asset class drop substantially shortly afterward. Was that investment decision a mistake? Probably not. Is the timeframe we are looking at much too short? Probably yes.

From 1950 to the present, the U.S. stock market has gone up 53.7% of days, 56.9% of weeks, and 60.2% of months. Looking at larger intervals, it’s gone up 78.8% of years, 92.2% of each five year period and 96.6% of each ten year period.1  Viewed on a day-to-day basis, those odds aren’t much better than a coin flip, but over longer periods of time, the odds get stronger. That being said, there is still a chance for a negative return, even over long stretches of time.

All of this relates to the question of diversification. Right now, much of the coverage by the media is about U.S stocks reaching new all-time highs, led mainly by the tech sector. However, the media seems to be missing the fact that year-to-date, many other asset classes have been treading water or have been negative. Taking it a step further, most asset classes, relative to US equities over the last five years, have had a negative effect on overall portfolio performance.

In light of these recent circumstances, it is natural to wonder, “Should I just buy an S&P 500 index fund and be done with it?” Does diversification actually help?

In our quarterly newsletters, we have been running a series on common “behavioral” biases. One of the most challenging is called “recency bias,” when people tend to gravitate towards what has worked in the recent past. Another bias is the “hot hand fallacy” when people believe that random success will be repeated. In the last several years, U.S. equities have done well and have been favored investments to own. Our minds can trick us into overestimating the odds that this successful trend will continue. Because markets are naturally volatile and unpredictable, this type of thinking could potentially lead to buying high and selling low if investors chase whatever has done well recently.

To illustrate the risk of owning a single asset class like U.S. stocks, let’s go back for a moment to 2009. If you had all of your money in the S&P 500 for the previous ten years (2000-2009)—also known as the “lost decade”—you would have averaged a -1 % return per year for 10 years!2  You would have also needed to stomach two historical market declines without throwing in the towel on your investment strategy.

Over that same decade, broad diversification by asset class worked very well. Many of the same asset classes that are out of favor today such as emerging markets, commodities, bonds, etc., did perform well during that time period. In addition, since a diversified portfolio generally will not drop to the extent that the U.S. equity market did, you may have had a much better chance of sticking to your plan and staying invested rather than reacting to natural emotions and biases.

Harry Markowitz has famously said that the only free lunch in investing is diversification—and we agree. We know we are not smart enough to predict which asset class will do the best next week or next year, nor do we think anyone else can on a consistent basis. What we do know is that diversification gives you stronger odds to achieve your financial goals over the long run.

Some things just take time. Stay patient, my friends!

 

1 Dimensional Fund Advisors, Returns 2.0. S&P 500 data from 1/3/1950-9/25/2018
2 Dimensional Fund Advisors, Matrix Book 2018

The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.

 

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