Gil Hanoch

How should you deal with the Real Estate Slow Down?

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Real estate markets throughout the U.S. are growing more slowly and in some cases are declining. This article provides some guidelines for dealing with this environment.

Statistics

First, let’s put the recent growth of real estate in long-term perspective. The following graph shows the inflation-adjusted annual growth of two high growth areas from 1977 to 2005: California as a whole and a high growth area within California :

2006-11 How should you deal with the Real Estate Slow Down_clip_image002
Source: Office of Federal Housing Enterprise Oversight (OFHEO)

The following table compares recent performance with the two recent cycles:

Annual Growth of Real Estate (adjusted for Inflation: CPI – Shelter)
Period California Riverside-San Bernardino- Ontario
Last 5 years 14.2% 16.4%
Recent cycle (1990-2005) 3.8% 3.4%
Previous cycle (1980-1989) 3.9% 2.0%

Based on this data:

  1. Growth since the beginning of the recent cycle was similar to the previous cycle. Therefore, there is no statistical reason to believe that long-term real estate values should adjust significantly downwards to make up for the recent excessive growth.
  2. Recent growth of real estate was approximately quadruple the cycle average. Statistically, you can expect the next 5 years to have lower and possibly negative inflation-adjusted growth.

Please note that there is no guarantee that the future will behave similar to the past. These are just statistics that give you an idea of where we stand historically.

What should you do next?

This section provides ideas for dealing with the slow down in real estate, depending on your goals.

Speculator . If your goal is to make fast money on real estate, with the intention of buying and selling quickly, you are dealing with risky business, no mater when you do that. The risk increases as you borrow more of the cost. Statistically, you may lose money in the next few years, especially when considering inflation and the large transaction costs. This makes speculation at this point even riskier than at other times. Therefore, you should be inclined to avoid buying for short-term speculation and consider selling short-term speculative investments, or be prepared to hold on to them for many years.

Long-Term Investor . If your goal is to buy a property as a long-term investment, you may see a decline in your investment in the next few years. If history is any indication for the future, it may even take 10 or more years to see any profit. But in the long run (20+ years), you are likely to make money, regardless of the upcoming years. Given the recent history, you should be especially careful not to buy overvalued properties, but you do not have to avoid purchases altogether, and you do not need to rush to sell your long-term investments.

Buyer of personal residence . If you are buying a place to live, there are many benefits, both financial and non-financial. As long as you expect to keep owning a home for many years, you should outlive any potential decline period and enjoy the long-term growth of real estate. Even if you expect to move within 5-10 years to a place with similar growth patterns and of similar or greater value, you should be immune to short-term declines, or even benefit from them. The one caveat is that the high transaction costs may be prohibitive, if you expect to move in very few years.

On the move . If you are thinking of moving you should not necessarily hold off. Since you are selling one property in exchange for another one, you are staying in the real estate market. You should be careful not to upgrade to a much more expensive place that requires stretching your means or that is located in a market that recently increased significantly more than the market you currently live in.

Disclaimers

The guidelines above are general. Every transaction should be evaluated individually. There are many factors affecting each transaction. These include the value of the local real estate market in question and the specific property. At all times there are both overvalued properties and bargains.

In all cases you should consider transaction and maintenance costs and the risk of declines, repairs, extended periods of a vacant rental property and increasing interest rates on variable loans.

Sounds familiar?

This advice above is similar to the advice I would have given to stock investors in 2000. Since you don’t know when the slowdown will end and how deep it will go, your best bet is to invest for the long run, or avoid the risk altogether.

One difference between real estate and diversified investments in the stock market is that real estate recessions tend to be significantly longer, transactions are much more expensive and the investment is less liquid (takes longer to sell). Globally diversified stock portfolios usually recover from recessions within less than 5 years, but real estate recessions may last 10 years or more. Therefore, think very carefully before speculating in real estate for short and even medium periods.

Disclosures Including Backtested Performance Data

Can you select Superior Mutual Funds?

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This article reviews an article published by the Journal of Financial Planning: The Difficulty of Selecting Superior Mutual Fund Performance * [February 2006]. This is one of many research projects that compare actively managed mutual funds with passively managed funds and past performance with future performance.

First, let’s explain the two types of mutual funds:

Actively managed mutual funds tend to select stocks individually and time the market with the hope of outperforming the average market.

Passively managed mutual funds try to replicate the returns of the market, or a certain asset class, and are usually called index funds.

Several important results are presented:

  1. 90% of Large Cap Active Managers underperformed Indexes, over a 20-year period .
  2. 97% of Mid Cap Active Managers underperformed Indexes, over a 20-year period .
  3. Past Winners became Losers . Actively managed funds that outperformed indexes over the first 10 years, underperformed the indexes in the following 10 years. Past winners became losers, hampering the chance of predicting outstanding fund managers.
  4. Higher Taxes . The results were magnified when considering taxes: active managers lost 0.89% more of the returns to taxes, when compared to index funds (1.51% loss compared to 0.62%).

What can we conclude from these results? If you are looking to get the highest returns on your investment, you would not want to settle for average. You would like to find a superior fund manager that can beat the market.

Unfortunately, most fund managers underperform the market. When going to smaller companies, it is nearly impossible to find a fund manager that is better than the average market (3% chance!)

Even if you managed to find the rare fund manager who beat the market for many years, s/he is likely to do worse than the market in the future.

You are at a dead-end. Ads focus on recent returns of mutual funds. Returns of indexes that have a consistent investment allocation and that are measured over periods of 25+ years may be more reliable. The ads tend to focus on periods no longer than 10 years. Even Morningstar gives significant weight to returns over the past 3, 5 and 10 years. The whole mutual fund industry focuses on ratings that do not provide you with helpful information.

The good news! It turns out that if you settle for “average”, you end up outperforming most investors. Once you are settled on average, you can focus on things you can control and measure very well: diversification, minimization of taxes and all other investment costs. You might think that you settled for average, but at this point, very few people, including most sophisticated money managers are doing better than you.

* Referenced with permission.

Disclosures Including Backtested Performance Data

Should you buy a Hot Stock?

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Did you ever get a stock tip? Do you know of a company that looks very promising? Before rushing to invest in the company, this article will point out a critical principle that many investors overlook.

First, a disclosure is needed: QAM does not buy individual stocks for its clients or for its members. Many academic studies show that most investors and professional money managers lose money when compared to market indexes. Therefore, QAM views individual stock selection as a speculative activity that may have entertainment and excitement benefits, but no expected financial benefits.

Note that this disclosure does not apply to stocks and stock options given by an employer. These may be held for a limited period, to reap the value of discounted pricing and tax benefits.

If you are considering buying a stock, whether for speculation or entertainment, you want to maximize your chances of making a profit beyond the market indices, to justify the risk taken. The following principle will help you avoid certain losses that many stock-pickers incur.

The value of a stock is negatively related to its price. Specifically:

  • The more expensive a stock is, the less attractive it is
  • The cheaper a stock is, the more attractive it is

Note the following implied and related points:

  1. The stock price compared to the company’s earnings (P/E ratio) gives one indication about whether a stock is expensive. This should be your first step in choosing a stock. A glaring warning signal about a dangerous stock is a high P/E ratio. If people would have used this single warning signal during the tech boom, they could have avoided most of their losses.
  2. The more the stock price increased recently, the less money you will get to make. This is by far the most important point to remember. Not understanding this is a big reason people underperform the general stock market. Buying a hot stock is like buying a car after a huge sale ended, or when there is huge demand and the dealer is asking for an excessive price.
  3. A poorly performing company may not be a bad investment. An important factor to consider is whether or not the company’s stock price is low compared to the actual future earnings of the company. This requires correctly predicting the future earnings of the company. For the price to be low, most smart and hard working analysts in the world should disagree with your opinion about the future earnings and be wrong, while you should be right.
  4. The earnings of a company may be distorted or stated based on different assumptions for different companies. A good analysis should include a detailed review of the footnotes of the company’s financial statements and other information that is not highly visible.

To Summarize

Because of all the difficulties in consistently finding good investments, you would be best putting your money in index funds and focusing on the best asset allocation, tax planning, estate planning, etc. If you cannot fight the urge to beat the market, please treat it as speculation or entertainment, and allocate to it a small amount (e.g., 5% of your money or less) accordingly.

Disclosures Including Backtested Performance Data

“This Time it’s Different!”

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Have you ever heard someone say, “This time it’s different! This time the stock market may not recover from the recent declines?”

Throughout recorded history the stock market never declined without a full recovery. How is that possible? In order to answer this question, we need to understand what a stock is. A stock represents ownership in a company. In order for a highly diversified portfolio to decline without recovery, the concept of companies should stop working. This requires people to prefer to build their own homes, manufacture their own cars and grow their own food.

By now it is probably clear to you that there is no real risk for an irreversible decline. But our basic instincts keep leading us to expect declines following declines. This is the result of a psychological bias that makes us put more weight on the recent history when trying to understand long-term trends.

This is a natural human instinct. We tend to prepare for earthquakes just after living through a big one. We prepare for floods after our home was flooded. Similarly, we expect declines to continue, possibly without recovery, just after a decline has started.

It is as illogical as it is natural to expect this. The stock market tends to go up and down in value in a cyclical way. These cycles vary in length and magnitude and have no predictable pattern, so you cannot predict the near-term future based on the recent past. If you want to make the most thoughtful bet on the future change, it would be a reversion to the long-term average. This principle worked during all past declines and is the one principle that agrees with the idea that people like using companies to make life easy.

Once you understand this idea you can live relaxed through all market declines. But in addition to peace of mind, there is a large financial benefit. When the stock market declines, many people are unable to fight their human instinct, and sell stocks after they declined in value. At the same time, investors that understand the cyclical nature of the stock market, make an extra effort to buy during the decline periods. This can be financially rewarding beyond any imagination; the bigger the recent decline the bigger the reward.

Note that the recovery tends to be most dramatic in its early phases. As a result, people who wait to identify the bottom before buying in, usually give up most of the gains compared to people who buy as soon as they have the extra long-term money in their hands.

Since we have never experienced an irreversible decline in the stock market, and having one in the future is against the human nature of wanting to get things done easily and cheaply, the risk for it is nearly nonexistent. If you have the urge to worry about something, you can focus on more likely risks: an earthquake, flood, fire, sudden death and plenty of other rare but possible catastrophes. Otherwise, you can just enjoy life, while seeing your money grow rapidly – not every day, but over the long run.

Caution:

  1. The discussion above is based on holding a highly diversified portfolio, while making no changes based on any type of analysis or predictions. Changes must be limited to rebalancing in order to bring the accounts in line with the intended portfolio allocation.
  2. You should keep money outside the stock market (in cash or low risk bonds), to provide for your living expenses during significant recessions. This amount should be planned in advance, specified in a written investment plan, and kept regardless of the market conditions. The recommendation to add money to the stock portfolio during declines refers only to money available beyond these reserves.

To Summarize

Our basic intuition and instincts are our biggest enemies in investing! By setting them aside and using cold logic, we can benefit from financial peace of mind at all times. In addition we can enjoy enormous financial rewards if we happen to come by some spare money that we can invest for the long run during declines.

Disclosures Including Backtested Performance Data

Is your Cash Dragging you Down?

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This article presents the effects of holding unplanned cash in an investment portfolio and the benefits of optimizing the cash level.

Let’s first discuss planned cash. Every investor needs cash in order to meet daily expenses during severe declines of the investment portfolio. This amount should be decided upon before putting any money in the stock market, because sharp declines can come at a surprise leaving no time for last minute planning.

Once you set aside the amount of planned cash, your goal should be to minimize the amount of extra cash in your investment portfolio. This excess cash is a well-known investment phenomenon. It can come from many different sources, but they all can be summarized by the following definition.

Cash Drag : the negative effect on a portfolio’s performance due to holding cash beyond the amount specified in the Investment Plan.

Each of the following is a reason to minimize your Cash Drag:

  1. You already defined the amount of cash needed for your short-term security and set aside this amount. Any extra cash is eating away at your long-term growth.
  2. If you don’t plan how much you will leave in cash and therefore don’t have a set amount that is consistently available, you cannot count on a set amount to be there when you need it most.

We shall identify a few categories of Cash Drag. For categories you can control, the impact will be presented. The cash will be assumed to earn 6% less than the stock portfolio (e.g. 3% vs. 9%). In addition the impact will be expressed in terms of loss for a retiree with a portfolio of $1,000,000.

Cash inside mutual funds: All mutual funds carry cash to meet potential daily redemptions. There is no way to avoid this amount altogether, but you can minimize this by choosing index funds that tend to have a low percentage of cash.

Cash for liquidity: Cash that brokers and investment advisors hold inside investment accounts for upcoming management fees and transactions. This can be completely eliminated, if the investment professional plans right. These amounts tend to be relatively small, but not insignificant. 2% excess cash for this purpose would reduce your total returns by 2%x6% = 0.12%, lowering the 9% growth to 8.88%, or costing the $1,000,000 retiree $1,200 per year.

Cash waiting for the right investment opportunity: Investment professionals and individuals that try to pick promising stocks have to leave cash available for the right moment. These amounts tend to be significant and can run as high as 30% or more. The impact of 30% in cash, would be 30%x6% = 1.8%, lowering the 9% total growth to 7.2%, and costing the retiree $18,000 per year.

Cash allocated to protect from an anticipated recession: This is the most dangerous category of Cash Drag, for two reasons: the size of the cash allocation and the attempt to time the market. Some people allocate large amounts of cash when a recession is anticipated. A not uncommon allocation of 50% costs the investor an average of 50%x9% = 4.5%, lowering the 9% annual growth to 4.5%, costing the retiree $45,000 per year!

The impact is magnified by the timing component. In nearly all cases, the allocation to cash happens after the beginning of a decline or well before it, and the allocation back to stocks usually happens after the surge in stock prices is over.

When making the allocation after the decline began, you immediately realize a loss. For example, many stock portfolios frequently decline by 10% from their recent peak. Anyone that gets nervous about the future of the portfolio, and allocates 50% to cash, would realize an immediate 50%x10% = 5% loss, or $50,000 for our retiree!

When reverting the allocation to stocks after the recovery began, you give up these gains. People that experienced a dramatic shock by the 2000-2002 recession, waited for a long time to put money back into stocks. A retiree that had 50% in cash and waited until the end of 2004 to put the cash into stocks would have given up more than 100% growth in a portfolio like Long-Term Component. If our retiree had $500,000 of the $1,000,000 portfolio in cash, this would amount to losing $250,000!

To Summarize

No matter how adventurous you feel, how strongly you believe in your predictions or how fearful you are of a recent decline turning into the worst recession you’ve ever seen, please be very careful with your money. This is not a $20 gamble in Las Vegas – you are gambling with your life’s savings. The most conservative approach to investing involves planning in advance for severe scenarios. Once your plan is ready, keep it in writing, and stick to it without gambling on stock increases or recessions.

Disclosures Including Backtested Performance Data

Could you withstand another Great Depression?

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If you accumulated a large amount of money, one of your biggest fears might be losing it during a severe stock market crash like the Great Depression.

This article analyzes several portfolios that could survive the Great Depression, ranking them by the security level that they provide. The table below presents the following information about these portfolios, based on data from 1927 to 2005:

  1. The highest amount of annual fixed income that a $1,000,000 portfolio can provide and still fully recover from the Great Depression. It accounts for taxes and inflation.
  2. The relative security level of the portfolio, when invested during the Great Depression. The portfolio allowing for the highest withdrawals is the safest. Viewed differently, for any required withdrawal rate, the safest portfolio is most likely to outlive the Great Depression.

Some simplifying assumptions, that should not affect the general conclusions, are made:

  1. The total tax rate is assumed to be 35%. In practice, there may also be state taxes, and long-term stock gains are currently taxed at 15% . This assumption presents the stock portfolios more negatively than they really are.
  2. There are no transaction costs. These should be minimal for large portfolios.
  3. There are no mutual fund fees. These are not negligible, but are small enough to not affect the security ranking of the portfolios.
Portfolio Annual fixed income per $1,000,000 portfolio Security level during Great Depression
Long-Term US Government Bonds $5,0001 Lowest
Long-Term US Corporate Bonds $7,4002 Low
Stocks +
Long-Term US Corporate Bonds3		 $0 bonds $15,6004 Medium
$200,000 bonds $27,3004 High
$500,000 bonds $40,0004 Highest

1 $5,000 = 0.5% x $1,000,000; 0.5% = 5.5% x (1-0.35) – 3.1 = average returns – taxes – inflation

2 $7,400 = 0.74% x $1,000,000; 0.74% = 5.9% x (1-0.35) – 3.1 = average returns – taxes – inflation

3 The bond component is used only during recessions, and is adjusted with inflation. The stock portion is invested using the following indexes: 1/3 US Large Value and 2/3 US Small Value.

4 The figures were calculated using a spreadsheet that tracked the annual values of the stock component, bond component and withdrawal rate, based on the annual returns of the different components and inflation. The withdrawal rates of 1.56%, 2.73% and 4% are the highest values that resulted in a portfolio that recovered and kept growing until 2005, as simulated. Detailed values are available upon request.

Note that there are many other investments that are considered very conservative. These include: CDs, insurance, fixed and variable annuities, municipal bonds and corporate bonds. A common trait to these investments is that they all depend on the solvency of a single company or entity. If the company issuing any of the above declares bankruptcy, your investment is at risk. During the Great Depression, this happened to many companies, so we avoid discussing these options. Only investments that can be significantly diversified (e.g., using index mutual funds) were considered. The two main categories are bonds and stocks.

Note several remarkable findings:

  1. The portfolio of government bonds was effectively the riskiest portfolio. This is remarkable since government bonds are considered virtually risk-free, given that the government can always raise taxes to repay its debt. Any withdrawals above $5,000 resulted in depletion of the portfolio.
  2. The portfolio that is usually considered riskiest: 100% stocks ($0 bonds), was much safer than all bond portfolios, allowing for a 2-3 times higher withdrawal rate.
  3. A stock portfolio that included a fixed amount of bonds to be used only during recessions was the safest, allowing for a remarkable $40,000 withdrawal rate after inflation and taxes.

A few notes that make the results above even more remarkable:

  1. We used a stock portfolio that is concentrated in a single country (US) while the country experienced a severe depression. A globally diversified portfolio would increase the stability of the stock portion, and would require more in stocks and less in bonds.
  2. The analysis assumes that we started investing at the same year the depression started (1929). This is the toughest assumption we could make and is necessary from the most conservative viewpoint. If you would use any other beginning year, the results should favor portfolios with a higher stock allocation.

Note: Any allocation to stocks assumes avoiding market timing or specific stock selection. These are strategies that made rich people poor during the depression, and are avoided altogether.

To Summarize

If you want your money to provide you with fixed income that grows with inflation despite severe economic disasters, the most secure solution may need to include a significant stock allocation. We don’t know what the future will bring us, but we do know that a large diversified stock allocation was necessary to outlive the greatest recorded economic disaster in recent history – the Great Depression.

This is great news, because you have to hold stocks to avoid losing your long-term investments and you have to hold stocks to grow your investments significantly. One decision promotes both goals at once.

Disclosures Including Backtested Performance Data

What is your Time Horizon?

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Your time horizon has a significant impact on how you can invest your money. You probably heard two general statements about time horizon:

  1. Young people in their twenties, with enough income to cover their expenses, have a very long time horizon for their savings, and therefore can take large amounts of risk.
  2. People near retirement have a very short time horizon, because soon they will not have earned income and they will be financially dependent on their savings.

This article presents an approach to evaluating the time horizon of any person regardless of their age.

Your time horizon is the time until you will need to use your money.
Each person may have several time horizons for different parts of their savings.

The first sentence is the basis for the claims in the two examples above. The second sentence states that you should not lump all of your savings into one time horizon. You can optimize your financial security by listing the expenses you might face in the future and specifying the time until each amount is needed.

A few cases might help exemplify this approach:

  1. A 22 year old person starting a new job may have a short time horizon for amounts he might need to live off of, in case he loses his job. The period considered should be a conservative time period needed to find a new job in case of a recession. Other amounts may have a long time horizon.
  2. A 65 year old man that is about to retire and has no guaranteed income other than social security, has a short time horizon for amounts he will need in the next few years to complement the social security income. Additional amounts that will not be needed for many more years have a long time horizon.
  3. A 65 year old woman, with a guaranteed retirement that should fully cover her expenses, has a long time horizon for all of her savings. Be cautioned that if there is any risk to the “guaranteed” retirement income, some savings should be kept for possible short-term needs.
  4. An 85 year old woman, with a need for $100,000 per year, $5,000,000 in the bank and no other sources of income, has a short time horizon for amounts that are needed for living expenses in the next few years and a long time horizon for the rest of the money, which is most of the $5,000,000.

The difference between these cases and the two cases presented above is the separation into several time horizons based on the different financial needs. Specifically, not all young people have a long time horizon and not all retired people have a short time horizon. In addition, stating a short or a long time horizon for the total individual’s savings creates injustice in most cases. Most people have a short time horizon for certain amounts and a long time horizon for other amounts.

Why is this important? Amounts that you may need in the next few years should be invested conservatively outside the stock market, since any stock portfolio can decline significantly for several years. The price you pay for conservative investments is lower expected returns than stock returns. The investments may even lose value compared to inflation, but it is a price that has to be paid.

Amounts that you can leave untouched for several years can be invested in a diversified stock portfolio. This is based on the assumptions that you will not sell the portfolio at a decline and you can wait enough years for a recovery from long declines. The reward for this patience is higher expected returns.

Because of the tradeoff between low volatility and high returns, you want to make sure that you minimize the risks of amounts you need in the short run, and maximize the returns of amounts you need in the long run. The best way to do this is to categorize the savings into individual amounts based on the future needs of the money.

Caution! The process above can help you determine the optimal investment approach for the disciplined and systematic investor. It assumes the following:

  1. You periodically review your savings to make sure you have correct allocations for short-term and long-term needs.
  2. You invest your long-term money in a way that is likely to grow in the long run. This means that you avoid trying to choose specific stocks, since any single stock can decline irrecoverably. It also means that you buy and hold onto the investments without trying to time the ups and downs of the market – another behavior that may lead to irrecoverable losses. If you have the urge to choose specific stocks or time the market, do so with amounts that you are willing to lose altogether (infinite time horizon).
  3. You are committed to hold onto your long-term investments through all declines. The reason you can afford to invest in the stock market is your ability to wait for recoveries. If you suspect that you might sell your stock portfolio after a decline because of a fear of no recovery, you would be better off avoiding the stock market altogether.

To Summarize

Time horizon is a critical element in investment decisions. By correctly identifying the time horizons of your savings, you can maximize your financial security in the short run and the long run, without any conflict between the two.

Disclosures Including Backtested Performance Data

Can Increased Risk be Conservative?

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[Updated Data February, 2011]

This article provides important guidance for conservative investors. It is especially important for retirees with limited or no sources of new income.

It is a common belief that as a conservative investor, you should put your money in some of the most stable companies in the world: the largest stocks in the US . Many people go one step further, diversify and hold 500 of these through an S&P 500 Index fund, in order to reduce the risks specific to any particular company. In addition, some hold onto them for the long run, and avoid the big risk of buying or selling at the wrong time.

Is this a conservative approach?

This approach reduces many of the risks investors face today, but you can do much better! You probably heard that if you can afford to take higher risks you may benefit from higher returns by holding stocks of small and international companies. These companies are indeed riskier than the companies in the S&P 500, but if you hold them together in one portfolio, you may reduce your total risks.

Can this work in real life?

Yes, the Long-Term Component by QAM is an example of a portfolio that holds thousands of companies, some very risky when observed individually, and is significantly more conservative than the S&P 500.

Let’s look at the 2000-2002 recession and recovery periods for the S&P 500 and Long-Term Component.

2006-03 Can Increased Risk be Conservative_clip_image002

The following table summarizes certain differences between the portfolios:

  S&P 500 Long-Term Component
Recession max decline -45% -20%
20% decline duration 39 months 1 month
Recession to recovery period 6 years 1 month 2 years 4 months
Returns from bottom to 12/2007 98% 321%

All measures are striking and especially notable is the recession to recovery period. It took 6 years for the S&P 500 to recover, compared to 2 years for the diversified portfolio.

Why does this work?

The change in value of a portfolio is a result of the combined changes of its components. During the recession period, many companies in both portfolios declined significantly. Some went bankrupt. The key to the Long-Term Component’s success was lower correlation between the prices of the stocks in it.

All companies in the S&P 500 are subject to the same risks common to large companies in the US . The decline in the US affected 100% of the portfolio. The long-Term Component is diversified in nearly 40 countries around the world, including large and small companies. Small companies tend to better diversify since they serve more local markets and are less affected by global events.

Even small differences in the timing of recessions around the world, reduces the duration and magnitude of declines in the portfolio. The following example demonstrates this principle:

Imagine two portfolios that each had the same returns with a 1 year offset between the two, a 2 year recession and a total decline of -14%. The following table shows the portfolio returns each year.

Year 1 2 3 4
Portfolio 1 12% -10% -4% 6%
Portfolio 2 -10% -4% 6% 12%
Combined (equally) 1% -7% 1% 9%

When the portfolios were combined they had half the decline (7%) for half the duration (1 year), compared to the declines of each of the individual portfolios. This demonstrates how two portfolios with the same risk characteristics, but some difference in the timing of recessions, had much shorter and shallower declines, when combined together.

Reduce risk or increase returns?

Both! As demonstrated above, diversification can result in higher returns despite the lower risk. These high returns are a very nice benefit, but remember that the first priority of a conservative investor should be to limit the risk to acceptable levels. Only within these constraints you should try to maximize your returns. Diversification should be practiced even if the returns where not higher. The higher returns are a benefit of the diversification, not a reason for it.

To Summarize

Constructing a diversified portfolio that limits the risks to an acceptable level are a must for every investor, and especially for people with limited current income.

Any portfolio considered should be judged as a whole and without letting emotions get in the way. Risky stocks, having low correlation with an existing portfolio, make the portfolio more conservative, while low-risk stocks having high correlation with the portfolio do not reduce the risks.

To stay most conservative, you should include thousands of companies and avoid individual stock selection or market timing altogether (e.g. using index funds).

Disclosures Including Backtested Performance Data

Currency Risks for the Long Run?

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You may know that diversifying your investments outside the US can significantly reduce your risks, while increasing the potential returns. This is true because the different stock markets don’t go up and down at the exact same time, allowing a globally diversified portfolio to have shorter and shallower declines than a portfolio that is concentrated in the US stock market.

Global diversification into thousands of stocks in many countries and continents limits to an acceptable level the various risks, including: country risk, political risk, regulation risk and liquidity risk.

There is one risk that should be addressed separately: currency risk. This article will offer a separate discussion for short-term and long-term currency risks.

What is the short-term currency risk of international investments?

It is the risk of a significant strengthening of the local currency (US Dollar for Americans) compared to other currencies, whether temporary or long-term.

Can this happen?

Currencies tend to be less volatile than stocks, and are not correlated with the price of stocks. As a result, they are not expected to increase the risks of a globally diversified portfolio.

In addition, by holding a portfolio that is denominated in different currencies, short-term fluctuations are diversified. Note that whenever people use more of one currency compared to another one, this currency increases in value while the other declines. By holding a globally diversified portfolio, when some of the currencies you hold go down, others should go up.

All historic measures of returns include the currency impact. Historically, the international diversification of stocks proved to be very valuable, even when considering the currency impact.

What is the long-term currency risk of international investments?

It is the risk of a significant and irreversible strengthening of the local currency (US Dollar for Americans) compared to most other currencies.

Can this happen?

Let’s try to imagine such a situation. As the dollar strengthens, goods become more expensive in the US relative to other countries. At that point, Americans and others would start buying goods in other countries. The influx of dollars into other countries would make them more widely available, weakening the dollar and breaking the long-term strengthening-streak of the dollar. Academically, this is called “Purchasing Power Parity”.

As mentioned in the section about the short-term currency risk, historic evidence shows the contained long-term risk of currencies when combined with stock investments.

To Summarize

All of the risks that are specific to any individual country, including currency risk, are reduced to acceptable levels within the context of a globally diversified portfolio. Diversifying a portfolio globally reduces the risks specific to the home country (e.g. US), without introducing other bigger risks. This is both logical and has withstood the test of time.

Disclosures Including Backtested Performance Data

Make Volatility Your Friend

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Volatility is known as an undesirable thing that you should strive to minimize. This is very logical – when you invest your money, you want it to grow. You want to be able to take it out whenever you want or need and make a profit.

Unfortunately, investments that grow steadily with no declines provide very low returns. After considering inflation and taxes, you are left with very little gains, if any. Good examples are money market accounts, CDs and short-term government bonds.

Can you get higher returns? Yes, you can get much higher returns! But it comes at a price: volatility. Stocks, on average, provide much higher returns in the long run, but they also may decline in value. You may even lose your whole investment!

How can you avoid losing your whole investment? Luckily stocks as a group tend to grow in the long run. Globally diversified stock portfolios have never declined without recovering. Our desire to get things done as simply and cheaply as possible is what keeps companies growing.

As long as you keep your money diversified over many companies in different industries and countries, you are not likely to see it disappear. In addition, you would have to avoid mutual funds that research companies and try to choose specific stocks or the timing of investments, since the wrong decisions may lead to irrecoverable losses.

Can you avoid losing any money? If history is any indication for the future, yes! If you can hold on to your diversified investments through decline periods and make sure you sell only after full recovery, you are not likely to ever lose money.

The catch! The catch is that you might need money before your investments recover. You cannot control the timing and the length of declines of your portfolio. During long recessions, you may lose faith in stocks before they recover.

Is there a solution? There is a very good solution: diversify and study the history of your portfolio. There is no guarantee that the future will not be worse than the past, but by knowing how your portfolio reacted to catastrophic events, you can get a sense of how long severe declines tend to last. With that information at hand you can achieve two things:

  1. You can plan for a catastrophe worse than anything you’ve seen in decades, and keep some money in stable investments to support you through these periods.
  2. Whenever your portfolio declines, look back at history, recall why companies have always existed, and get ready for a recovery. The longer and deeper the decline, the bigger the recovery.

Can volatility be good? Yes! So far, we treated volatility as something that can negatively affect our investments, and found ways to minimize the chances for these negative effects. But I would dare to go one step further and claim that we need volatility. The high returns we get on our stock investments are a compensation for the volatility. If stocks ever stopped being volatile, the returns on investing in them would decline significantly. Much lower returns would compensate for the lower volatility.

The ideal practical world. Considering that high returns are compensation for high volatility, the ideal world is the one in which we can choose investments offering high long-term returns, and prepare for the volatility so well that it does not put us at any significant risk or stress. Fortunately this solution exists and is simple. Let’s review it:

  1. Choose the most profitable investment: stocks.
  2. Diversify them significantly, while including the asset classes that tend to grow the most and ones that are least correlated: small stocks, cheap stocks (“value”), international stocks and emerging markets stocks.
  3. Avoid any attempts to choose individual stocks that do better than average – you will have no way of being truly confident that huge declines will be followed by rapid growth.
  4. Learn the portfolio’s long-term historic behavior. Make sure to choose a long enough period that smoothes out anomalies. This is normally at least 25-30 years. Find the length of the longest decline of the specific portfolio you constructed, and prepare for worse than that.
  5. Keep enough money outside the stock market, to provide for you during the period of decline you chose to be prepared for.
  6. Put the rest in your diversified stock portfolio.
  7. Make sure you never deviate from your plan! The only reason to update your plan is changes in your own circumstances, not moves in the portfolio.

Smile! Now you are ready to get excited and smile whenever your portfolio goes down, including occasional significant declines – this is what keeps your pay so amazingly high.

Disclosures Including Backtested Performance Data