Limit Stock Market Losses to Improve Long-term Returns

men putting out fireInvesting in stocks can be brutal. According to research, the S&P 500 lost at least 10% from a previous high every two-and-a-half years on average, and at least 20% every six. A 30% loss happened every 13. It has fallen 50% from a peak three times since 1954. None of these declines were, or could have been, anticipated with any kind of precision, and they certainly do not come at regular intervals. And, remarkably, losses of this magnitude contradict the models we use to describe market behavior.

For example, the largest S&P 500 one-day loss was 20.5% in October 19 1987. According to a widely used model of stock market returns (which assumes that they form a bell curve around an average) the likelihood of the 1987 loss is similar to picking the right card in a deck containing as many cards as there are atoms in the known universe. In other words, the chance that such drop could happen is essentially zero.

Clearly the problem is not that impossible events happen but that our models are inadequate. A lot of analysts have tried to come up with better ones, but so far this quest has proven fruitless. We still can’t predict markets with any meaningful accuracy. This is why markets are not so much like the weather, as they are often compared, but rather like earthquakes, which scientists now admit are unpredictable.

But here is the good news: we cannot predict earthquakes, but we know how to build earthquake-resistant structures. Likewise, we cannot predict markets but we have techniques that can help us limit losses when markets tank.

There are some very basic reasons why limiting losses is more important than producing strong returns.

A well-known example goes like this: If you lose 50% of $100 you need a 100% return on the remaining $50 to break even. This means that a large percentage loss requires a very large percentage gain for full recovery.

But a far more important example is this: If you only lose 20% of $100, you will need just 25% to bring the remaining $80 back to $100. So a small loss requires much less effort to come out from it.

This is even more important for retirees who use savings to pay for living expenses.
For example, taking $10 after a portfolio falls from $100 to $50 leaves the saver with only $40. A subsequent 100% return only takes the portfolio back to $80. That means that the $10 withdrawal turned into $20 because of its bad timing.

But when $100 only falls to $80 and $10 are taken, a subsequent 25% recovery on the remaining $70 brings the value up to $87.50. This means that the $10 withdrawal turned into $12.50—a much smaller penalty for taking money out at the worst possible time.

The moral is clear: limiting losses is an essential element in portfolio management.
Limiting losses requires some basic processes in place. The best known is diversification, or investing in a mix of assets that tend to move in different directions. But a mix that looks diversified today may not be diversified tomorrow, especially when markets take a turn for the worse. This is because in down markets investors sell everything and correlations go up sharply. Therefore, a mix that does not take into account how the market cycle changes is prone to go through periods where diversification goes away just when investors need it most.

Adapting portfolios to market conditions requires dedication, patience, and a well-designed set of rules. This is, or should be, the professional portfolio manager’s job. Some investors insist that the portfolio manager’s job is simply to beat the market by picking a high proportion of winning assets. Accordingly, they are willing to pay a premium for those managers who seem to have the hot hands. This is a bad approach, commonly known as “chasing past returns.”

Many studies show that virtually no active fund can consistently beat its benchmark, and not because of fees. According to Standard & Poor, which publishes a regular analysis of fund performance, most funds underperform their benchmarks both before and after fees.

The simple explanation is that poorly diversified funds can only outperform their benchmarks through superior forecasting. But, just like for earthquakes, forecasting the market accurately is impossible. As one academic put it:

Going back to basics, the idea “to invest successfully in the stock market, you need to know whether the market is going to go up or go down” is just wrong. (Professor David Aldous, UC Berkeley – The Kelly criterion for favorable games)

While limiting downside exposure is crucial in portfolio management, having this protection in place at all times can be frustrating. If the market keeps on rallying, the “insurance” against declines appears to be an unnecessary drag on returns, just as going through the expense of building a house that is earthquake-resistant may seem like a waste as long as there are no earthquakes.

We all have complained about paying for insurance that we don’t seem to need. This is understandable as long as disaster does not strike. But the temptation to cancel insurance can be dangerous. If you are not yet convinced this is so, please reread the first paragraph to see why having a systematic process to protect investments from losses is a good idea.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours.

We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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Path Financial Expands Investment Advisor Team

Oxana Saunders Vice President Path FinancialSarasota-based investment advisory firm Path Financial, founded by president and chief investment officer Raul Elizalde, has named Oxana Saunders as vice president. Ms. Saunders will focus on business development, client relations, and portfolio management; she holds a NASAA Series 66 Investment Advisor Representative license and joined Path in early January 2017. Together, the two senior executives provide clients with 47 years of investment expertise honed during their respective careers on Wall Street.

Ms. Saunders will work with new clients to provide investment advice based on their life goals and personal circumstances. She is available to speak to individuals and organizations on a variety of investment-related topics, including helping clients better understand family investments, and how individuals can protect assets in times of life transition. Initial consultations are complimentary; Oxana Saunders may be reached at 941.894.2571, and oxana@pathfinancial.net.

A graduate of Baruch College with a degree in Finance and Investments, Ms. Saunders enjoyed a successful career on Wall Street prior to relocating to Sarasota in 2016. She began her investment banking career at Lehman Brothers (later Barclays Capital), where she rose to the position of Senior Vice President and was responsible for distributing a full line of products to U.S. institutional investors. She was instrumental in propelling the bank to the top of industry surveys, and was later was hired by Deutsche Bank to expand its client base. Her clients included first-tier financial institutions such as Alliance Bernstein, Oppenheimer Funds, and T Rowe Price.

“Ms. Saunders is a consummate professional with tremendous experience and intimate knowledge of financial markets,” stated Mr. Elizalde. “Throughout her career, she has made it a priority to help her clients and put their interests first. I am delighted she has joined Path Financial.”

Path Financial is a Florida-registered investment firm, partnered with preferred account custodians such as Charles Schwab & Company and TD Ameritrade. Path is rated “A+” by the Better Business Bureau, and is located at 1990 Main St., in Sarasota, Florida.

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Beware the Mountain of Debt

mountain of debtBoth interest rates and stocks soared after the US election. This is because everyone seems to agree that the new US administration will spend a lot, collect less in taxes, and cut back regulations.

This is a mix that could fuel the economy and be good for stocks. Not so with bonds: It will likely lead to higher interest rates as inflation rises, the Fed fights it with higher policy rates, and firmer economic activity pushes market rates higher.

It could also backfire on stocks if high inflation and higher wages actually drag economic activity down. Furthermore, higher US rates relative to rates abroad are sure to push up the US dollar, hurting exporters and manufacturers. This could also weaken the economy, bring down corporate revenue, and dim prospects for stocks.

This would be a worst case scenario of higher nominal rates and a decelerating economy. It is known as stagflation, and it has a reserved spot next to deflation as a nightmare scenario for policymakers.

Also, the economic policies that the new administration has so far hinted at are radically different from what has been the norm in the past few decades. This guarantees that they will face strong headwinds before they can be implemented, including congressional opposition. There is a chance that the consensus scenario may never materialize, may be watered down, or may take far longer than the market is willing to wait. So the optimism about stocks can prove to be short-lived.

Regardless of whether stocks go up or down, it is quite likely that Interest rates will remain above the historically low levels of last year, or climb even higher. This could exacerbate vulnerabilities in the economy that have so far gone relatively unnoticed.

One such issue, and a well-known trigger of past crises, is a large accumulation of private debt.

Debt is a key factor in lubricating economic activity: Households use it to buy homes or cars that could not otherwise afford, businesses use it to finance investments or fulfill orders in advance of payment, municipalities use it to pave roads and lay out utilities, and so on. Without debt, growth would be slow, halting, and ultimately impossible.

Households, businesses and governments always carry debt on their balance sheets, and constantly take new debt to replace the one that comes due. When rates go up, the cost of rolling over debt goes up as well. That is why higher rates tend to dampen economic activity, which is a normal swing in the business cycle.

But when indebtedness becomes too large, the balancing act of renewing old debt with new one becomes more difficult to pull off for reasons other than cost. Lenders start questioning the sustainability of the process, especially if rates go up sharply, and sources of funding dry up. Large debt accumulation then leads to a liquidity crisis, just when access to financing is needed the most.

The last few years of ultra-low interest rates sparked a massive increase in US business debt. The opportunity to borrow at some of the lowest rates in recorded history was too good to pass up.

But the new debt has not been used primarily to invest in the economy: much went to build cash reserves, and some more to buy back stocks or increase dividends. In the last couple of years private domestic investment has gone down while the stock of private debt continued to grow.

The earnings-to-net-debt ratio for S&P 500 corporations – a key measure of borrowers’ ability to reduce their debt levels – is at its lowest level in at least a decade, according to the research firm Factset. And while some analysts find comfort in the fact that corporate cash is also very high at $1.75tn, the reality is that much of it is concentrated in just a few technology companies: Google, Apple, Microsoft, Cisco and Yahoo account for a third of all US corporate cash.

We showed the chart below in various newsletters in the past and we updated it with the latest numbers. The chart shows that there has never been a larger or faster 4-year accumulation of non-financial business debt. Not surprisingly, prior surges of indebtedness ended in tears.
graph

This is not solely a US problem. China, most pointedly, has seen an explosive ballooning of private, non-financial corporate debt that just reached an eye-popping 170% of GDP.
Some early signs of a brewing debt crisis would include an increase in corporate credit rating downgrades, Chapter 11 restructurings, liquidity problems in the bond market, and so on. So far, these symptoms are not evident, but conditions could turn optimal for a debt crisis if interest rates rise quickly, budget deficits get out of control, and economic activity does not pick up.

Even without a sudden crisis, it remains to be seen how the mountain of global corporate debt can be gracefully wound down without anyone getting hurt. History shows that large debt accumulations rarely end up well. Close attention to any early warnings will be crucial to navigate through the rest of 2017 and beyond.

What now?

We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Why bonds collapsed and what you can do about it

pathThe result of last week’s election made some Americans happy and others miserable. Given how high emotions are running, it is remarkable that voter participation was so low: Almost 47% of voters did not show up to choose the next president. Many people, it seems, were indifferent. Not so the bond market.

Take the US 10-year note, for example: in the week from 11/4 through 11/11 it climbed 44 basis points, from 1.78% to 2.22%. This is the largest move, both in absolute and relative terms, since the New York Fed started publishing data in 1962. Because prices and interest rates moved in opposite direction, bonds crashed.

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The size of this change is hard to overstate. It dragged bonds around the world: the German 10-year bond rate surged 45 basis points from -0.13% to 0.32%, for example. The UK’s 10-year bond rose by an astonishing 78 basis points, from 0.64% to 1.42%.

These moves wiped out trillions of dollars of savings allocated to fixed income. Wealth destruction is probably more brutal in Europe and Japan, where individual savers and institutional investors rely far more heavily than Americans on fixed-income products.

Why did bonds suffered this much?

President-in-waiting Trump has said during the campaign that, under certain circumstances, he would be willing to renegotiate the US debt, which would be a repudiation of the “full faith and credit of the United States.” This is exceedingly unlikely to happen, both because he would be unleashing a catastrophe and because the legal hurdles are too steep. But he said it, and it affects perception.
Many economists expect that the combination of large tax cuts and public infrastructure spending promised by Donald Trump would increase the size of the US debt by trillions of dollars, even after accounting for the potential growth generated by the stimulus. We don’t know yet whether this is in fact the plan of the new administration. If it is, and economists are right, it will also weaken the credit quality of US Treasuries.

Inflation expectations have gone up, partly because of the possible stimulus mentioned above. Ten-year expected inflation (calculated from TIPs) climbed 20 basis points, from 1.68% on 11/4 to 1.88% on 11/11. In part, this is a consequence of the possible stimulus discussed above.

Whatever the reasons, the market appears convinced that rates are heading higher, and Investors who are still exposed to long-duration Treasuries need to look at ways of transitioning out of them.
Unfortunately, the precipitous and historical magnitude of the recent move raises the question of whether to cut losses now or to wait for some kind of “relief rally” providing a better exit point.
The problem is that rates are universally expected to climb. Therefore, the majority of investors are likely to be waiting for the same exit point, which gets in the way of it happening at all.

Another problem is that when the Fed started raising or lowering rates in the past, it almost never stopped at one or two hikes. The higher-rate path that started last December is likely to be a multi-hike trail. This will push bond rates higher still.

Investors are exposed to bonds in two ways. One is by holding individual bonds, which is not the worse option because the scheduled payments take place independent of market conditions. Another is through mutual bond funds, which unlike individual bonds are at the mercy of rising rates and have no guaranteed schedule of payments. Unfortunately, individual investors are far more likely to hold bond funds than individual bonds.

The larger issue is that fixed income, up to now an integral part of investment portfolios, may no longer be the best asset class to diversify equity exposure.

The well-known “60/40” strategy that calls for a mix of 60% in stocks and 40% in bonds worked very well for the last 35 years of declining interest rates. But, if rates have bottomed out and start to climb in earnest, bond funds could be a significant drag on portfolio performance. This is especially so in the early stages of rate increases, when higher interest payments are not enough to offset losses of principal. To make matters worse, interest rate trends are measured in decades, not years. Once they start, it’s anybody’s guess when they will end.

Investors needing diversification may have to change their approach. One is through cash, which simply muffles equity returns. Another, which we advocate, is by abandoning the idea that a static diversification such as the “60/40” is appropriate for all market conditions. A better way, in our view, is to become considerably more active in asset allocation. We have developed specific processes to implement such active strategies.

In the last few years, investors were told many times that interest rates were heading higher only to see they go lower. It’s still early to say whether we have finally reached the turning point. But the new era that the United States is entering could finally get us there. If so, investors will need to change the way they diversify their portfolios going forward.

What now?
We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return. We implement this process for our clients and we tailor it for their specific circumstances. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Raul Elizalde in SRQ Magazine Article on Brexit

SRQ Magazine published this November 1st look at how Brexit might affect local investors. The author, Jacob Ogles, includes quotes from Path Financial president Raul Elizalde and shares his thoughts on what individuals could be doing right now to keep their investments safe. Click here to read the full article at SRQ Magazine.

srq-magazine

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Why trying to beat the market is a very bad idea

path-1The usual investor experience is a recurring cycle of euphoria and disappointment. Fortunately, there is a better alternative that can put an end to the emotional and financial rollercoaster that is all too common in traditional investing. This alternative requires a serious examination of what are the right priorities that should drive the portfolio management process.

One of the most dangerous goals individual investors have embraced is trying to “beat the market.” This objective can cause tremendous damage to their portfolios.
Here is why: Beating the market (i.e. “getting a better return than the index”) does not accomplish much when the market goes down in a big way. A portfolio that declines by 30% when the index goes down 40% beats the market handily, but it hardly qualifies as “success.” This issue became clear during the market crash of 2008-2009.

Another reason is that for a portfolio to beat the return of an average basket of stocks, it has to be more aggressive than the basket itself. If the market goes up, a portfolio heavy on conservative assets is unlikely to show higher returns than the market. That means that it needs to be over-exposed to aggressive stocks, which magnifies losses when the market sooner or later takes a turn for the worse. This is what happened to investors who loaded up on dot-com stocks during the late 90s, only to see them crash back to earth after the internet bubble burst.

Another issue is that “beating the market” is a pointless goal by itself. An elderly individual with many millions of dollars in the bank, modest expenses, and no legacy goals is much better off with hyper-conservative investments to protect his or her savings rather than with a stock portfolio. Equity exposure is inherently risky, and potential returns would offer no marginal benefit to a portfolio that has already achieved the investor’s goal of paying all living expenses many times over.

These three reasons – limiting the downside, determining the risk/return portfolio profile, aligning risk to goals – have a common thread: managing risk is more important than targeting returns. As a bonus, concentrating on risk rather than returns may actually lead to stronger portfolio performance.

Chasing returns often leads to this kind of unsatisfying experience:
path-2In the last twenty years alone, investors have been badly bruised by several legs of bull and bear markets that leave them disappointed with their investment results. This is one of the reasons why the current bull market, although one of the strongest ever, has been called “the most hated rally in history.” Many investors are still stuck on the “I should have bought earlier”/“I still don’t trust it” phase, or have finally entered in the last 18 months, only to witness a market largely trapped in a range.

Ironically, this dispiriting cycle reinforces the idea that beating the market is a do-or-die goal. As the thinking goes, eking a market-beating return while the market goes up may well be the only way to cushion the downside when the cycle inevitably turns. Compounding this mistake, most investors think they will be able to identify the early stages of a bear market and exit early enough to prevent a big loss.

A much better approach is to focus on managing risk using a systematic, disciplined approach. This can result in a much more satisfying pattern that may require investors to accept lower returns than the market during a bull run in exchange for a considerably gentler experience during times of crisis.

path-3At Path Financial we specialize in designing portfolios intended to provide such smoother experience. It requires a dynamic management of positions to ensure that the level of targeted protection is consistent with the market cycle. Most importantly, it focuses on risk management over return targeting as a source of investment performance.

As an example, we tested how a hypothetical portfolio of mutual funds would perform under some of our process rules. We chose mutual funds that have been around for a long time in order to cover many market cycles of boom and bust, and selected a group representing a broad array of domestic and foreign equity, bond, and commodity baskets.

path-4As the graph shows, this hypothetical portfolio managed according to our risk-based approach could provide a much smoother long-term ride than the stock market, or than a more typical 60% stocks/ 40% bonds mix. It captures a positive return when the market goes up, and drastically cuts the downside in times of crisis. The process focuses on controlling risk over producing high returns, and yet it delivers a comparable performance than a much riskier all-equity exposure over the long term.

To achieve these results investors must take a long-term view and turn their focus away from trying to find market-beating positions, which is a largely impossible task other than by luck. Once they embrace the idea that risk management alone can produce much more stable long-term returns, they will be in a far better position to leave behind the frustrating cycle of euphoria and disappointment they often experience.

What now?
We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return. We implement this process for our clients and we tailor it for their specific circumstances. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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Path Financial Adds TD Ameritrade as Account Custodian

With $736 Billion in Assets, TD Ameritrade Brings Enhanced Benefits to Clients

td-ameritradeSarasota-based investment advisory firm Path Financial, LLC, managed by president and chief investment officer Raul Elizalde, has added TD Ameritrade as one of its preferred account custodians. Partnering with TD Ameritrade, which has over $736 billion in assets, will provide enhanced benefits to Path’s clients, such as competitively priced transaction costs, the elimination of miscellaneous fees, TD Ameritrade’s asset protection guarantee, and broad investment choices including access to over 15,000 mutual funds.

Elizalde is a Contributing Author for the online publication Oxford World Financial Digest, and has built a national reputation for providing financial insights and analyses that are frequently published online by some of the most respected financial media in the country, including Morningstar, Motley Fool, the Street and Yahoo! Finance. As a speaker, advisor, and financial news commentator, he has been quoted by the nation’s leading newspapers—The Wall Street Journal, The Washington Post, the Financial Times and The New York Times — and has appeared as a guest commentator on Reuters and Bloomberg TV, and made presentations to the World Bank, the Council of the Americas, the Emerging Markets Trading Association, and other global organizations. His career as a Wall strategist for first-tier financial institutions included holding positions as Global Fixed Income and Quantitative Strategist for ING Barings; Head of Research at Santander Investment Securities; and Fixed Income Strategist for Banc of America Securities.

Elizalde is a current member and recent chair of the Asset Management Committee for the State College of Florida Foundation. Path Financial is a Florida-registered investment firm rated “A+” by the Better Business Bureau, and is located at 1990 Main St., in Sarasota, Florida. For more information, call 941-350-7904.

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You May Not Be As Diversified As You Think

onionsDiversification is the key element when managing a portfolio. If you want to smooth the ups and downs of individual assets, combine them in a basket. The less correlated those assets are, the steadier the basket’s performance.

Implementing this simple concept effectively, however, is not easy. One major reason is that asset correlations change over time, both in magnitude and direction. For example, when interest rates fall, bond prices go up but stocks can go up or down, depending on whether investors think that lower rates as a stimulus for the economy, or that they are a sign that the economy is slowing down. Because the relationship between stocks and bonds changes over time, the “optimal” proportion of both in a portfolio changes as well.

It is very difficult to forecast changes in correlations. That’s why a common approach is to assume that they will remain constant – which is where the advice that a portfolio must contain a 60% stocks/40% bonds comes from. The assumption is that such pre-set allocation will be good enough to smooth volatility and produce positive results, even if at times it is not the “best” mix for achieving the sometimes opposite goals of maximizing returns and minimizing volatility.

Is it possible to obtain better results by actively managing a mix of assets instead of fixing it at some arbitrary level?

This question is sometimes dismissed out of hand because it sounds like asking whether it is a good idea to “time the market”, an activity that is generally thought to reduce portfolio returns. Indeed, many studies show that portfolio results tend to decline when trading activity increases. The reason behind this is not clear. Some studies blame transaction costs associated with more frequent buying and selling, while others blame behavioral biases – chasing winners; holding on to losers far too long; fear and greed, etc. that are absent when a portfolio is left alone. Regardless, it is not difficult to show how simple active strategies can outperform a passive approach.

For example, it is possible to improve returns over a simple 70% stock/30% bond strategy with the following rebalancing rule: if stocks outperform bonds in any six-month period, change the mix to 90% stocks/10% bonds for the following six months. Otherwise, change it to 50%/50%. In other words, give an extra 20% to the asset class that did better in the prior six months. This “momentum” rule clearly outperforms the “passive” allocation for any base mix of stocks and bonds –70%/30%, 20%/80%, or any other.

image 1Notably, the rule only improves results starting in the early 1990s, making little difference over the “base” allocation before then. This is because there was a substantial change in the correlation between interest rates and stock returns that started around that time. This phenomenon became clear in hindsight, and many of the papers that describe it were published many years after the fact. An investor dedicated to building portfolios on the basis of responding dynamically to shorter-term correlation changes could have achieved higher returns much sooner.

It seems plausible that looking at diversification in more dynamic terms can yield better results, and in fact dynamic techniques have spread widely in the last few years. This approach has been at the center of our practice since we started managing clients’ portfolios, and we focus on developing, improving, and implementing these techniques for individual investors.

While simple strategies like the one described can be effective over the very long term, their benefits over much shorter periods may be less apparent. This is important, because the usual life of an individual’s investment portfolio is often measured in years, not decades. One consequence of this is that for retirement portfolios controlling volatility becomes more important than maximizing returns. This is because pursuing higher returns exposes a portfolio to more risk, which can get in the way of protecting a savings portfolio so it can fund future living expenses. While a static allocation designed to reduce risk must reduce its expected returns, a dynamic allocation tries to find a way to capture more of the upside while keeping risk low..

The main goal of managing diversification dynamically is to provide a better trade-off between higher returns (more risk) and lower volatility (less risk) than a static portfolio mix. This is best achieved over the long term, since fixed allocations can, and do, outperform dynamic management over shorter periods. The process used to improve this trade-off is often a differentiating factor among portfolio managers who pursue the same goal.

What now?

We believe that our portfolio management process, focused on measuring risk, can be very effective at managing the trade-off between risk and returns. We implement this process for our clients, tailored for their specific circumstances, and we can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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Are You Financially Literate?

classroomIn 2009, the Financial Industry Regulatory Authority, or FINRA, started a periodic survey of the financial capabilities of US adults, measuring the skills, judgment and resources needed to manage their financial well-being. Questions range from credit-card behavior (are you paying just the minimum due?) to home equity (do you owe more on your mortgage than your home is worth?).

The study was repeated in 2012 and 2015. Results are encouraging: resources and judgment show a steady improvement over six years. But when it comes to skills, results are disappointing. More and more adults fail to demonstrate a basic level of financial knowledge.

First, the good news. As labor conditions improve, fewer individuals spend more than they make: 20% in 2009, 19% in 2012, and 18% in 2015. The Affordable Care Act had a strong impact on reducing the number of people with overdue medical bills: 26% in 2012 versus 21% in 2015 (the question was not asked in 2009). Similarly, more people have rainy day funds (35% in 2009, 40% in 2012, and 46% in 2015) and fewer pay just the minimum on credit card balances (40% in 2009, 34% in 2012, 32% in 2015). And as home prices recovered, just 9% report having a home underwater in 2015 (i.e. with a mortgage balance higher than the value of the home) versus 14% in 2012.

The data paints a much improved picture. In fact, when asked directly if people are satisfied with their personal finances, the percentage saying “yes“ has gone up to 31% in 2015 from 24% in 2012 and 16% in 2009.

Unfortunately, the opposite is true of financial literacy. Study participants were asked five questions about basic aspects of economics and daily-life finances regarding inflation, interest rates, mortgage debt, and investment risk. In 2009 the percentage of respondents with 3 or less correct answers was 58%. This went up to 61% in 2012 and again to 63% in 2015.

This is a worrisome development because, as FINRA notes, “individuals need at least a fundamental level of financial knowledge” to make sound financial decisions.

Even more worrisome for us at Path Financial is that in 2015 Florida scored second-worst in the nation, at an average of 2.89 correct answers out of five (Texas was worst, at 2.81). You can take the five-question quiz here.

An even more worrisome fact is that, despite their poor performance in this quiz, Americans tend to see themselves as highly versed in financial matters. In 2015, 76% gave themselves a “high” assessment of their own financial knowledge. And while the proportion of “high” self-scoring went up in each of the study years, the public’s ability to answer basic questions correctly went down every time.

Furthermore, when asked to evaluate their math skills, less than two-thirds among the 79% of respondents who gave themselves a “high score” could estimate compound interest correctly in the context of debt.

The disconnect between people’s perceived and actual financial skills is alarming, because it is contributes to making bad decisions regarding savings, investments, and debt.

Understanding risk and avoiding fraud, specifically, are two key areas that are difficult to handle without basic financial knowledge. Even securing conflict-free advice can be challenging without some level of financial literacy: for example, many “seminars” aimed to the public, usually involving a free meal, are aimed more at selling products preying on financial illiteracy than on actually enlightening the public.

This does not mean that everyone who is not a financial expert is doomed to investment failure. But a basic set of skills is necessary to identify those “too good to be true” situations that we all encounter at some point.

A good place to start is an adult-education course offered by a community college, although you may not be able or willing to commit to classroom training. If you want to hire a financial advisor to help you instead, you can screen his or her record beforehand at the Investment Advisor Public Disclosure website. Watch for “disclosures,” which alert the public to client disputes or regulatory violations involving the advisor or firm you want to check out.

Another excellent resource is FINRA’s “protect your money” site. One of the links will take you to a “scam meter” that asks a few questions about investments you might be considering. See, for example, if you identify with these statements:

– I learned about an investment at a free investment seminar

– I cannot clearly articulate what the investment is

– I am not sure what license the person selling the investment has

– The investment is guaranteed

These four answers earn four red flags in the “scam meter”. This is a useful tool that will not analyze a specific investment but can alert you to potential dangers when considering one.

The bottom line is that it would be great for individuals to have better investment skills, but the numbers show little improvement on that front. Also, free tools that can help people avoid serious investment mistakes remain under-utilized. In the meantime, well-crafted investor protection regulations will have to fill the gaps.

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