The S&P 500 added to gains in August, surpassing its high reached in January while international stocks, mainly those in emerging markets, continued to feel pressure.
After gaining over 37% in 2017, the MSCI index of emerging market stocks is down 7.2% for 2018. What started as isolated pockets of stress in Turkey and Argentina has spilled over to other vulnerable countries. Higher interest rates and a stronger US dollar served as a catalyst for a fairly boiler plate emerging market swoon. Trade uncertainty has only thrown gasoline on the flames.
The US Federal Reserve, as usual, is accepting most of the blame but shows no signs of blinking. Despite unusual criticism from non-US central bankers and President Trump, the Fed remains on track to further increase short-term rates, pointing to a steady US economy and modest inflation pressures.
There are likely more challenges ahead for emerging markets. With currency declines placing upward pressure on inflation, governments are faced with tough choices to either stem the pressure on the currencies and contain inflation or support economic growth. While investment opportunities are in the making, it will take time before the ramifications will be fully understood.
Common Retirement Misconceptions
Over the years and through many discussions, we see various approaches from individuals and families when it comes to preparing for retirement. We all use certain rules of thumb – without them it would be too hard to get through life. But in financial planning, these rules can often oversimplify, leading to problems down the road. Here we address some common rules and discuss how they may lead you astray.
“I need X percent return to retire successfully”
When an investor targets a rate of return, he or she often over looks the uncertainty and the impact variability of returns can have on wealth.
Financial markets fluctuate. Targeting a return based on market averages may result in missing the goal about half the time. We often take comfort in the fact that financial markets will deliver a certain positive return over the long-term, but sometimes the long-run is just too long.
Target returns also gloss over a subtle but important detail: the order of the returns can impact the trajectory of your wealth. An investment may deliver 6% per year on average but won’t do so every year. In years of poor returns, the money spent doesn’t have the oppurtunitiy to catch performance rebounds. The result is less wealth despite earning the same return. Not accounting for the impact of withdrawals during market declines could also lead to missed goals.
A robust financial plan should incorporate uncertainty into the mix because the return on your money can only be estimated with a wide degree of precision. Instead of targeting a 7% or 8% annual return, perhaps a better approach is to work up a strategy based on a return of at least 5%. Of course this may place the burden somewhere else by either increasing saving today or lower spending in the future. While these can be difficult choices to make, it is better to address such deficiences now than hold on to a risky financial plan.
“Allocate 100 minus your age to stocks”
Deciding the right mix of stocks, bonds and other assets is a key part of retirement planning. One adage is that 100-minus your age should represent the allocation to equities. So a 60-year old investor would be 40% stocks and 60% bonds. This results in a declining equity glide path for aging investors. While reasonable, is this the best strategy given your circumstances?
Take an investor with $10 million in investable assets and spends $100,000 per year in retirement. On the conservative end of the spectrum, he or she could safely protect the entire pot from inflation by investing in a portfolio of low-risk Treasury Inflation Protected Securities (TIPS). On the other end, the investor could also place everything in stocks and spend the same amount without significant risk of running out of money. If the investor can stomach the market swings (after all they don’t really affect his or her living standard), then he or she can endow the next generation, or perhaps a charitable endeavor with the extra return.
So, the “right” asset allocation is somewhere in between, and may be totally independent of the investor’s age. For most folks, own too many bonds and risk not earning a high enough return. Own too many equities and we can’t stick to our plan during the downturns. Finding the right mix depends on the size of the nest egg and it’s ultimate use. One size rarely fits all.
“Spend the income, save the principal”
In retirement, investors often want to generate income without dipping into capital. With interest rates historically low, this often results in “reaching for yield” – searching for bonds offering outsized income. But what is often shrouded as a conservative investment may actually increase risk.
Higher yielding bonds carry greater credit risk – the risk you don’t get all your money back. This higher risk tends to make these bonds behave more like stocks. Historically, the highest yielding bonds have exhibited a higher chance of default and loss severity relative to lower yielding, safer bonds. These bonds are often associated with large drawdowns, high volatility, and low liquidity.
For stocks paying an above average dividend, it is important to understand why the company is enticing investors with such yield. Much like bonds, this could be an indication of financial distress.
Sometimes there is a mismatch between the income need of a retiree and what can be found in the market with a reasonable amount of risk. Often, this leads to tough questions. But taking some risk in stocks may be a better solution than risking permanent capital loss in high-yield/high-risk income opportunities.
What It All Means
Rules of thumb can be helpful in financial planning but taken without regard to your personal situation, they can result in unintended problems. General rules are rarely substitutes for more in depth analysis based on personal needs, and a balanced approach can help deal with the fact the future is unknowable and flexibility in any plan is important. Financial plans should not be overly complex, but over simplification may sweep important weak points under the rug. Better to find them now than when it may be hard to change course.
The real challenge of diversification is psychological. Holding assets that you may not favor at the moment, while committing to a long-haul strategy requires an investor to hold competing thoughts in their head. Being right and investing successfully rarely fully align. This is another way of saying diversification is about protecting one’s self from the worst irrational exuberance and knee-jerk fears. We continue to trim emerging market assets from portfolios, while committing to stay invested internationally.
Please contact us if you would like to discuss your financial plan or your investment strategy.
Contact us at 865-584-1850 or firstname.lastname@example.org
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index is a reflection of the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.