In last month’s blog, “Factors That Figure in Your Evidence-Based Portfolio,” we discussed key factors that are used in constructing evidence-based investment portfolios. Now let’s look at a few additional ones—and why incorporating them into a portfolio can be tricky.
First, a quick reminder that the three well-established stock market factors are equity, value and small-cap. For bonds, the key factors are term and credit. These factors have formed the backbone of evidence-based portfolio construction, helping investors strike the most effective balance between return and risk.
Continued research has found additional market factors that provide the potential for additional premiums. As with the earlier factors, these premiums seem to result from accepting added market risk, avoiding ill-advised investor behaviors or both. In academic circles, the most prominent among these are considered to be profitability and momentum.
Over the past several months, our blog series on evidence-based investing has explored the ways we can use stock and bond market factors to help drive an effective investment strategy.
We turn now to what is arguably the most significant factor in evidence-based investing: the human factor.
Despite everything we know about efficient capital markets and all the solid evidence available to guide our rational decisions, we’re still human. We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions—a brew of instincts and emotions that spur us to leap before looking.
In last month’s blog, we discussed the deep-seated “fight or flight” instincts that that trick us into making significant money-management mistakes. Now let’s take a look at a half-dozen of the behavioral biases that arise from our wiring, and how they can sabotage even the best-laid investment plans.
Behavioral Bias #1: Herd Mentality
Herd mentality is what happens to you when you see a market movement afoot and rush to join the stampede. The herd may be hurtling toward what seems like a hot buying opportunity, such as a “next big thing” stock. Or it may be fleeing a perceived risk, such as a country in economic turmoil. Either way, as we covered in “Ignoring the Siren Song of Daily Market Pricing,” following the herd puts you on a dangerous path toward buying high, selling low and incurring unnecessary expenses.
Behavioral Bias #2: Recency
Your long-term plans are also at risk when you succumb to the tendency to give undue weight to recent information. In “What Drives Market Returns?” we learned that stocks have historically delivered premium returns over bonds. Whenever stock markets dip downward, though, we typically see recency bias at play, as droves of investors sell their stocks to seek “safe harbors.” In a roaring bull market, they reverse course and buy.
The stock market has taken investors on a rollercoaster ride over the past few weeks, jangling plenty of nerves in the process.
In times like these, looking at some historical perspective can go a long way toward easing investors’ minds. Specifically, let’s look at market corrections, which are said to occur when the market falls 10% from a recent high point.
Market declines of 10% occur, on average, once per year, according to research by JP Morgan Asset Management. And drawdowns of 20% take place once per market cycle.
The bottom line is that corrections are completely normal. They’re part of the process that, over time, keeps the prices of stocks in line with their fundamental value based on earnings and other factors. You might think of corrections as a pressure valve, keeping the market from expanding into a dangerous bubble.
Welcome to the final installment in our Evidence-Based Investment Insights: Bringing the Evidence Home. We hope you’ve enjoyed reading our series as much as we’ve enjoyed sharing it with you. Here are the key take-home messages from each installment:
- You, the Market and the Prices You Pay. Understanding group intelligence and its effect on efficient market pricing is a first step toward more consistently buying low and selling high in free capital markets.
- Ignoring the Siren Song of Daily Market Pricing. Rather than trying to react to ever-changing conditions and cutthroat competition, invest your life savings according to factors over which you can expect to have some control.
- Financial Gurus and Other Unicorns. Avoid paying costly, speculative “experts” to pinch-hit your market moves for you. The evidence indicates that their ability to consistently beat the market is rarer than rare.
If you’re planning for retirement, you should be aware of Congress’ recently enacted budget deal. Why? Because it eliminates a popular Social Security claiming strategy known as “file and suspend.”
File and suspend is essentially a way for married couples to squeeze the maximum amount of benefit dollars from Social Security over their lifetimes. In some cases, file and suspend is projected to add hundreds of thousands of dollars to a couple’s lifetime retirement income.
Before we go any further, it’s important to clarify that couples who already have the file-and-suspend strategy in place will not be affected by the new legislation. In fact, there is still a six-month window for couples who meet certain age requirements to use file and suspend before the law’s provisions take effect.
Even in a bull market, certain investments within a diversified portfolio are likely to post losses. The good news, though, is that these losses can be put to good use through a process known as tax-loss harvesting.
In a nutshell, tax-loss harvesting enables you to offset the capital gains taxes that you’ve incurred on your successful investments. It’s a service that we at Align Wealth Management provide automatically for our clients’ taxable investment accounts.
Here’s an illustration of how tax-loss harvesting works. Suppose Investment A has a realized gain of $1,000, while Investment B has a loss of $1,000. By selling Investment B, we realize a loss that will neutralize the $1,000 capital gain for tax purposes.
The beginning of a new year wouldn’t be complete without a chorus of financial experts making predictions about the stock market.
But unless 2016 is very different from years past, the experts will be terribly wrong. The record shows that even the brightest minds on Wall Street get their predictions wrong most of the time.
Consider the research of Motley Fool columnist Morgan Housel. Housel studied forecasts that 22 of Wall Street’s top strategists made for the Standard & Poor’s 500 index from 2000 to 2014. He found that their predictions differed from the S&P’s actual performance by an average of about 15 percentage points annually.
The stock market hasn’t been a happy place so far in 2016. But for long-term investors, the real risk right now is losing sight of the big picture and making counter-productive short-term decisions.
So we’d like to provide some perspective on why a properly designed, long-term portfolio is still a good place to be. First, it’s worth pointing out that the market correction that we’ve seen in the past couple of months isn’t unusual. In fact, it’s pretty routine: Historically, market declines of at least 10% have occurred once a year.
Temporary declines are the market’s self-correcting mechanism, its way of “repricing” stocks, bonds and other investments that have become expensive relative to their fundamentals.