What is Survivorship Bias?

Posted On August 15, 2024 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Survivorship bias is the problem that the track record of today’s stocks reflects only the ones that survived. The stocks and funds which failed are no longer part of the performance history of today’s stocks or mutual fund databases. And as we will see, over the years, there have been a lot of stocks that have had bad returns and disappeared. We will also discuss how to invest wisely given the reality of survivorship bias.

Growing up in Rochester NY, my neighbor on the left worked for Eastman Kodak. Our neighbor on the right worked for Kodak. And all three neighbors across the street worked for Kodak. Kodak Park was the largest industrial site in the world, stretching for miles along Ridge Road. Rochester was a company town and there was tremendous pride in Kodak. The stock had done well for employees and residents, the company contributed a lot to the community, and the pension plan provided security to tens of thousands of retirees.

Kodak, the stock, was part of the S&P 500 Index and was one of 30 components of the Dow Jones Industrial Average from 1930 until April 2004. The company actually invented the digital camera in 1975, but thought it would be too impractical to ever have value. The rest, as they say, is history. The company had a long decline into obsolescence and filed for bankruptcy in 2012. The once mighty stock went to zero.

Stock Market 1926 through 2023

A new research paper by Hendrik Bessembinder looks at US stocks from 1926 through 2023, a 98-year period. During this period, there were a total of 29,078 US-listed stocks. Today, there are around 5,000. He looked at the performance of these stocks and it is a remarkable picture of Survivorship Bias.

Only 31 stocks have been in existence for the entire 98 years. The average stock existed only for 11.6 years. Approximately 24,000 companies have disappeared: either bankrupt, merged, acquired, or taken private.
51 percent of the stocks had negative returns over their entire life, with a median compound cumulative return of -7.41%. Most stocks lost money!
Thankfully, the compounding effect of the winning stocks greatly offset the stocks which lost money. The mean performance is much better than the median performance of the 29,078 stocks.
If you randomly select 10 stocks from history, your chance of outperforming the S&P 500 is very small. That is because most of the wealth creation in the market comes from a small percentage of top-performing companies. The majority of stocks under-perform the index.

Idiosyncratic Risk

Eastman Kodak, Lehman Brothers, Enron, and General Motors all went bankrupt and their stocks went to zero. Even though the stock market has done well over the long-term, there are still many individual stocks that get destroyed. We call this Idiosyncratic Risk, or “company specific” risk. Unfortunately, even if you do your homework, investors risk being caught in the next Bear Stearns or Washington Mutual.

What can you do to address Survivorship Bias and reduce the Idiosyncratic Risk of individual stocks?

Diversify extensively with index funds. While single companies do go bankrupt, we have never seen all 500 companies of the S&P 500 index go bankrupt at once. An index fund can greatly spread out your risk. Recognize the difference between speculating on an individual company versus investing in the market as a whole.
Note that index funds are not static. Every year, the S&P 500 Index adds growing companies and drops other companies which are on their way down. Sure, there are still surprises where an S&P 500 company disappears suddenly (like Silicon Valley Bank last year), but you still have 499 other holdings.

Fund Shenanigans

It’s not just individual stocks that exhibit survivorship bias. Mutual Fund companies do the same thing, deliberately getting rid of their worst funds. A fund with a poor track record eventually gets so small that it is unprofitable, and the fund company shuts it down. Even more nefarious, companies create dozens of stock funds and then take the ones with a poor track record and roll them into their funds with better ratings. The crappy fund disappears and now it looks like all their funds are 4-star and 5-star funds!

You might think the solution is to avoid the mutual funds with a poor track record and go with a top ranked actively managed fund. Unfortunately, we know that performance is rarely consistent with actively managed mutual funds. Is that my opinion? No, this is what decades of data shows from the Standard and Poors Persistence Scorecard. For example, there were more than 2000 US stock mutual funds in December 2019. The top quartile (the top 25%) included 529 funds in 2019, but not a single one of those funds remained in the top quartile over the next four years, through December 2023. Past performance (you should know this by heart by now) is no guarantee of future results.

One of the consistent findings of the S&P Persistence Scorecard is that the worst performing funds are the most likely to merge or be shut down. And then you can’t find those one-star funds on Morningstar because they no longer exist. That’s survivorship bias. Our approach: use low-cost index funds from Vanguard, SPDRs, and others. Then we are not chasing performance, looking for the hot fund, sector, or country. And we have been saying for a long time: the vast majority of active managers under-perform their benchmark over time.

Keeping It Simple

The stocks which exist today are different from the ones from 98 years ago. Companies come and go. Survivorship Bias masks the poor track record of the many stocks and funds which have disappeared. When we only see the ones which survived and thrived, investing success looks easier and more inevitable than it really is. Unfortunately, there are stocks and funds out there today which will someday suffer the same fate as Eastman Kodak and thousands of other past stocks. Understanding this history will help you be a better investor in the decades ahead.

How can we reduce Idiosyncratic Risk or Survivorship Bias? Fortunately for investors, this complex question has a simple answer. We can diversify and reduce the importance of any one stock in our portfolio. With index funds, we get broad diversification, with hundreds or thousands of holdings, in a low-cost, tax-efficient vehicle. No doubt an index fund will own some stocks that fail, but one stock out of 500 may only move the index by 0.2% for one day. It often is hardly even noticed. And using index funds also helps keep us out of the worst actively managed funds, which sometimes were the best funds from five years ago. These are time tested strategies and the data keeps proving that this approach remains a wise choice for investors.

Bubble, Bubble Toil and Trouble

Posted On July 27, 2024 By Scott Stratton, CFP(R), CFA In Portfolio Management /

A bubble is brewing. The price of US Tech stocks has grown much faster than their earnings, fueled by the hype of AI transforming productivity and life as we know it. The comparison with 1999 is uncanny, but it’s not that investors have forgotten about the Tech Bubble. I think many are just hoping to make additional gains while momentum is leading these stocks higher.

We are going to look at valuations to put current prices in perspective. Today’s tech stocks have massive profits, unlike the cash-burning dot-com’s that went bankrupt in 2000. It’s great that these tech companies are doing so well, but that doesn’t mean that the price of their stock can never be too high. While the prices have not yet reached absurd levels, they are elevated enough to raise concerns about their sustainability.

Too Big?

Just how big have tech stocks gotten? The three largest stocks in the world are Nvidia, Apple, and Microsoft, all recently with values over $3 trillion, each. Let’s compare these three stocks to countries. Nvidia is worth more than all the stocks in Germany. All 489 German companies put together are worth less than Nvidia. Apple is worth more than all the stocks in the UK. Microsoft is worth more than all the stocks in France. Is each of these companies really worth more than the entire stock market of a major European economy? Apparently the market thinks so, but it is a remarkable disparity.

Nvidia added $1 trillion in market cap, going from $2 trillion to $3 trillion, in just 30 days. Compare this to Warren Buffet at Berkshire Hathaway. He is considered by many to be the greatest investor ever, and it took him 60 years to grow his company to a value of $875 billion. Nvidia grew that much in value in 30 days. Did they do something in 30 days that is worth more than the company Warren Buffet has built over 60 years? We will have to wait and see, but I’m a skeptic.

Value Matters

Today, Nvidia is trading for a Price/Earnings ratio of 65 times earnings, and 43 times the expected earnings of the year ahead. That is double the PE of the S&P 500 Index at 22 times earnings. And today’s S&P 500 is in the top 10% most expensive, historically. These companies will have to really maintain investor excitement, if the stocks are priced at double the market PE. The growth of these tech stocks has come from expanding the multiple – the P part of the PE ratio. The earnings, the E part of the PE ratio, needs to catch up. That could take years. I pick on Nvidia, but the story is similar for Microsoft, Meta, Amazon, Apple, Alphabet, and Tesla. All these are richly valued even though they are incredibly profitable.

After the 2000 tech bubble, many of the survivors took a decade to get back to their value at the peak. You may recall, this was called “the lost decade” in the stock market. I certainly hope this doesn’t happen again. But, today’s most expensive stocks could risk having disappointing returns for years to come. In the past, a PE of 23 often was a bull market peak valuation.

There are other categories which are not as overvalued as Tech. Consider the comparison of Growth Stocks (NASDAQ) versus Value Stocks (Small Cap Russell 2000), with this chart from DoubleLine. Today, the growth/value divide has actually exceeded the levels of 1999. To me this suggests there could be a reversion to the mean in the next couple of years, where growth lags and value finally does well.

Looking Ahead

Investors spend too much time looking at the rear view mirror rather than forward through the windshield. Past performance is not indicative of future returns. And when a bubble occurs, it can take years to deflate. The stocks with the best past returns can do poorly, while the stocks with the worst recent returns may do better going forward. Consider the projected annual returns, for the next 10 years, from the Vanguard Capital Markets Model:

US Growth Stocks: 0.4% – 2.4%
US Value Stocks: 4.1% – 6.1%
US Small Cap: 4.3% – 6.3%
Foreign Developed Stocks: 6.7% – 8.7%
Emerging Markets: 6.0% – 8.0%

According to their calculation, you would be better off buying a 10-year US Treasury Bond (at 4.25% today), rather than owning US growth stocks over the next decade. Investors have been enjoying Tech growing at 20% a year, and now we are looking at an expected return of 1.4%. This is why we own value stocks, small cap, foreign stocks, and emerging markets in our portfolios. We are looking forward, not backward at past returns, when creating our models. We are diversifying into what we believe might be tomorrow’s winners rather than looking to concentrate into what has worked most recently.

Evidence Based Investing

We will see if today’s tech stocks have become an unsustainable bubble. These are really good companies which have enormous profits and are still growing at attractive rates. Even if there is not an abrupt bursting of the tech bubble, it is possible that growth segments will under-perform other categories over the years ahead. There is a strong rationale to be cautious about investing in stocks which have become very expensive.

Over the next month or year, growth stocks could continue to go up. Still, tech stocks could prove to be in a bubble which we see correct later. There might be an outside catalyst (think COVID, geopolitical event, debt crisis, recession, or something which no one had even considered), which causes a drop in the market. If this occurs, the most expensive stocks often sell off the most.

Tech stocks have become very large, quite expensive, and have a lower expected return than other stocks and many bonds. Our diversification allows us to both play defense today and also to own the categories with the highest expected return going forward. Don’t give up on Diversification!

Stocks, Bonds, and Risk

Posted On May 27, 2024 By Scott Stratton, CFP(R), CFA In Portfolio Management /

I enjoy watching history documentaries, especially about the WWII era. One film shared this quote from a US Army manual:

“…commanders need to balance the tension between protecting the force, and accepting and managing risks that must be taken to accomplish their mission…”

While I am neither soldier nor general, as a portfolio manager, my challenge is to protect client’s assets while accepting and managing the risks that must be taken to achieve their goals, such as retirement. Stocks have been doing very well. In the past week, the S&P 500, NASDAQ, and the Dow have all made new highs. The S&P is up 11 percent, year to date, a fantastic run on top of last year’s great performance. Where are the risks today, and how can we manage the risks to accomplish our mission?

Performance Chasing

Some investors are frustrated that their diversified portfolio is not up as much as the S&P. There is an increasing feeling that stocks are invincible right now and everyone wants to ride the gravy train for as long as they can. Caution is being thrown to the wind as investors seem to be willing to pay any price for certain tech stocks – even if the company is trading for 100 times what they will make this year. The Bull Market appears to be alive and well and so is investors’ performance chasing.

It’s remarkable that we’ve had such high interest rates, and an inverted yield curve, and the economy continues to grow. Maybe the Fed will finally engineer the soft landing that they have been unable to achieve in the past. I hope that happens, but hope is not a good investment rationale.

We remain invested in the stock market, but I hardly think this is the time to become more aggressive. At some point, the high valuations will matter. In the past, when the S&P has traded for 21 times forward earnings (like now), the subsequent years of returns were below average. That should make sense to everyone, just as when the market is cheap, the subsequent returns are usually above average. Both reflect a reversion to the mean.

Bonds Can Get The Job Done

What do today’s stock valuations suggest about forward returns? As of May 15, 2024, the Vanguard Capital Markets Model suggests a 10-year return of US stocks of 4.3%, plus or minus one percent. That is less than half of historical returns, and would be quite a disappointing performance.

And where are bond yields today? The 10-year US Treasury has a yield of 4.5% and we can find 10-year Agency bonds near 6%. Remarkably, the expected return from bonds is now higher than stocks for the next decade. Investors are having a hard time getting their head around this new reality because over the past decade, the S&P 500 (SPY) is up 12% annually, while the Aggregate bond index (AGG) is up only 1.25% a year.

At no point in the last 15 years have bonds looked this good compared to stocks, on a forward looking basis. To investors, bonds look boring and stocks are exciting. However, if you are focused on how to achieve your goals over the next decade, while minimizing the risk of losses to your portfolio, you may benefit from adding more bonds.

What Is Your Mission?

Many of my clients are within five years of retirement or have already retired. For many, our mission is to provide steady growth, spin off some income, and not blow up the portfolio. We are concerned about sequence of returns risk and longevity risk. For clients needing income and withdrawals, bonds and fixed annuities are an excellent choice.

For investors who are in growth mode, there is still a good case for bonds. We should focus on the long-term returns available, with the least amount of volatility. In portfolio management terms, we aim to provide a strong risk-adjusted return, measured by a higher Sharpe Ratio. And for these growth investors, bonds still play a role. Bonds can improve our risk profile and also provide an opportunity for flexibility in the future.

With bonds, you can consolidate your gains while you wait for the stock market to have a correction at some point in the years ahead. With stocks, we may have some years of growth and then the next Bear Market could bring us right back to today’s levels (or maybe even lower). The investor who has bonds (growing by 5%), has a future opportunity to rebalance. We can trim the bonds and buy back stocks when they trade at a lower Price to Earnings ratio (PE). We can be defensive today, while waiting for a better opportunity to be more aggressive.

Don’t Be A Hero

You don’t have to be fully invested in stocks. If you have done a financial plan, you should have an idea of what required return is necessary to accomplish your goals. In many cases, today, bonds can provide the return needed to achieve your objectives. And that reduces the uncertainty of stocks not performing as hoped or as they have historically.

Ideally, investing should be boring. We don’t want to have exciting investments. Our Wealth Management process is focused on protecting your wealth and accepting and managing the risks that must be taken to accomplish your goals. If we can take a path with less risk and more certainty, that is often what we should choose. We look at future expected returns as our guide, rather than recent past performance.

Stocks have had a strong performance and we will continue to invest in a diversified portfolio. We should also point out that while the expected return of US stocks is only 4.3%, Ex-US stocks have an expected return of 7.7%. Opportunities still exist. But for now, bonds offer a compelling return versus an expensive US stock market.

What is a MYGA Annuity?

Posted On March 7, 2024 By Scott Stratton, CFP(R), CFA In Portfolio Management, Retirement Planning /

A MYGA is a Multi-Year Guarantee Annuity. It is also called a Fixed-Rate Annuity and behaves somewhat like a CD. There is a fixed rate of return for a set term, typically 3-10 years. At the end of the term, you can walk away with your money or reinvest it into another annuity or something else. Today’s MYGA rates are in the mid-5% range, the best they have been in a decade.

Annuities are one of the most confusing insurance products for consumers because there are so many varieties. In addition to MYGAs, there are Variable Annuities, Fixed Index Annuities, and Single Premium Immediate Annuities (SPIAs). Some of these are expensive, illiquid, and have quite a poor reputation. That’s because the Variable and Index annuities can pay a high commission, and have been sold by unscrupulous insurance agents to clients who didn’t understand what they were buying. States have been cracking down on bad agents, but even now, some of these products are highly complex and difficult to understand how they actually work. They are a tool for a very specific job and investors have to make sure that it is right for them. Unfortunately, with some agents, their only tool is a hammer, so every problem looks like a nail.

Why I like MYGAs

I do like MYGAs and think they are a good fit for some of my clients. Unlike the other annuities, MYGAs are simple and easy to understand. I have some of my own money in a MYGA and will probably add more over time. We consider a MYGA to be part of our fixed income allocation. For example, we may have a target portfolio of 60/40 – 60% stocks and 40% fixed income – and a MYGA can be part of the 40%.

Here are some of the benefits of a MYGA:

Fixed rate of return, set for the duration of the term. Non-callable (more about this below).
Your principal is guaranteed. MYGAs are very safe.
Tax-deferral. You pay no income taxes on your MYGA until it is withdrawn. This can be beneficial if you are in a high tax bracket now, and want to delay withdrawals until you are in a lower tax bracket in retirement.
You can continue the tax deferral at the end of the term with a 1035 exchange to another annuity or insurance product. This is a tax-free rollover.
Creditor protection. As an insurance product, a MYGA offers asset protection.

Lock in Today’s Rates

Interest Rates have risen a lot over the last two years as the Federal Reserve has increased rates to fight inflation. As a result, the rates on MYGAs are the best they have been in over a decade, over 5% today. The expectation on Wall Street is that the Fed will begin cutting interest rates sometime this year as inflation is better under control.

Now appears to be a good time to lock-in today’s high interest rates with a MYGA. This is one of their big advantages over most bonds. Today’s bonds often are callable. This means that the issuer can redeem the bonds ahead of schedule. So, when we buy an 5-year Agency or Corporate bond with a yield of 5.5%, there’s no guarantee that we will actually get to keep the bond for the full five years. In fact, if interest rates drop (as expected), there will be a wave of calls, as issuers will be able to refinance their debt to lower interest rates.

We are already seeing quite a few Agency bonds getting called in the past month.

We don’t have this problem with a MYGA, they are not callable. The rate is guaranteed for the full duration. Given the choice of a 5.5% callable bond or a 5.5% MYGA, I would prefer the annuity given the possibility of lower rates ahead. The MYGA will lock-in today’s rates whereas the callable bond might be just temporary. If rates fall to 4%, the 5.5% bond gets called and then our only option is to buy a 4% bond.

Some bonds are not callable, most notably US Treasuries. However, the rates on MYGAs are about 1% higher than Treasuries today. If you are planning to hold to maturity, I would prefer a MYGA over a lower-yielding, non-callable bond.

The Fine Print

What are the downsides to a MYGA? The main one is that they are not liquid and there are steep surrender charges if you want your money back before the term is complete. Some will allow you to withdraw your annual interest or 10% a year. Other MYGAs do not allow any withdrawals without a penalty. Generally, the higher the yield, the more restrictions.

One way we can address the lack of liquidity is to “ladder” annuities. Instead of putting all the money into one duration, we spread the money out over different years. For example, instead of having $50,000 in one annuity that matures in five years, we have $10,000 in five annuities that mature in 1, 2, 3, 4, and 5 years. This way we will have access to some money each and every year.

Like a 401(k) or IRA, withdrawals from an annuity prior to age 59 1/2 will carry a 10% penalty for pre-mature distributions from the IRS. The penalty only applies to the earnings portion. Think of a MYGA as another type of retirement account.

Lastly, I do get paid a commission on the sale of the annuity from the insurance company. This does not come out of your principal – if you invest $10,000, all $10,000 is invested and growing. And I do not charge an investment management fee on a MYGA, unlike a bond. A 5% MYGA will net you 5%, whereas a 5% bond will net you 4% after fees. So in this case, I think the commission structure is actually preferable for investors.

Is a MYGA right for you?

Most of my MYGA buyers are in their 50s and older and have a lot of fixed income holdings already. They don’t need this money until after 59 1/2 and are okay with tying it up, in exchange for the guarantees and tax-deferral benefits. They have other sources of liquidity and a solid emergency fund. When we compare the pros and cons of a MYGA to a high-quality bond, for some the MYGA is a good choice. If you are not a current client, but are interested in just a MYGA, we can help you with no additional obligation. I am an independent agent and can compare the rates and features of MYGAs from different insurers.

Many investors have been wishing for a safe investment where they can just make 5% and not lose any money. That used to be readily available 20 years ago, but disappeared after 2009 when central banks took interest rates down to zero. Today 5% is back and we can lock it in for 3-10 years with a MYGA. You can’t get that in a 10-year Treasury. Other bonds and CDs with comparable rates are probably callable. If you want a safe, non-callable, guaranteed 5%+, a MYGA may be for you.

Performance Chasing Versus Diversification

Posted On January 25, 2024 By Admin In Behavioral Finance, Portfolio Management /

The chart below highlights the perils of performance chasing versus the benefits of diversification. This chart from JP Morgan shows the annual performance of major investment categories from 2008 through 2023. It includes US Stocks (large and small), Developed Markets, Emerging Markets, Fixed Income, Cash, Real Estate, and even Commodities.

The results are all over the place. What is often the best investment in one year turns out to be the worst investment the next year. Consider:

Commodities were the best category in 2022 and the worst in 2023.
Real Estate Investment Trusts (REITs) went from worst in 2020 to best in 2021, and back to worst in 2022.
Cash was the worst investment in 2016 and 2017, then the best in 2018, and back to the worst in 2019. It was however, positive, in each of these years!
Emerging Markets Stocks were the worst category in 2008 then the best in 2009. EM was the best in 2017 and then the worst in 2018.

Past Performance Is…

Today a lot of investors are experiencing FOMO because they didn’t own enough Tech stocks in 2023. A small number of stocks (seven, in fact) crushed the rest of the US stock market as well as the other categories. There is a palpable frustration to have a diversified portfolio and lag funds which are concentrated in a few growth names.

This January, investors are looking at their 401(k) or IRA statements and wondering if they should make a change. They see that the XYZ Growth fund was up 40% last year, and it is tempting to drop their diversified portfolio in favor of a fund that performed better last year.

This is performance chasing. It is abandoning the benefits of diversification in favor of betting on what has been hot recently. And it is hazardous to your wealth. Often, what is at the top one year will under-perform in the following years. If you chase performance, you will often buy a hot sector just as it is about to go cold. And then you find that you are switching funds every year because there is always a “better” fund. Just remember, past performance is no guarantee of future results!

Valuations Matter (Eventually)

Today’s market has some similarities with the Tech Bubble in 1999. People got very excited about a relatively small number of Tech companies and bid them up to expensive valuations. Those stocks became quite bloated and drove up the multiple of the entire US stock market. In the frenzy, there were a lot of people who bought tech funds at or near the top. They were late to the party and missed the big gains in 98 and 99, but were invested very aggressively when the bubble burst in 2000.

Stocks were so overvalued that we had three years of subsequent losses in the S&P 500: 2000, 2001, and 2002. That had never happened before. The amount of wealth that was wiped out in the Tech Bubble was truly staggering. The bubble seems pretty obvious in hindsight, but human nature has not improved since 1999. We are prone to make the same mistakes.

I don’t know that we are in a new Tech Bubble, but the lesson remains the same. We don’t chase performance, we invest based on valuation. Our portfolios are diversified across many categories, and rebalanced annually. We use index funds and focus on keeping costs and taxes low.

Our tilts towards areas of greater expected return actually means that we do the opposite of performance chasing. We prefer to buy what is on sale, cheap, and out of favor. We are looking for the categories in the lower half of the chart to return to being in favor. This is a disciplined, long-term process which has worked over time. (See: Our Investment Themes for 2024.)

Reversion To The Mean

In the short run, expensive stocks can still go up in price if there are enough buyers. That’s where we are today, but the party won’t last forever. US Growth stocks are expensive and have a lower expected return going forward. The expensive valuations are expected to gradually revert down towards historical levels. And the inexpensive categories have room to return to more normal valuations. The chart below shows Vanguard’s projected returns over the next 10 years.

Over the next decade, Vanguard forecasts US Equities to have an annualized return of 5.2%, versus 8.1% for International Equities. With performance chasing is investors are looking backwards. They project recent returns into the future (Google “recency bias“), rather than recognizing that returns average out over time. Instead of piling into the hot stocks, sectors, or categories, investors should stay diversified and also own the categories which have under-performed.

Performance Chasing is a constant temptation because a diversified portfolio will (by definition) always lag some small subset of the market. There is always a hot category. Unfortunately, no one has a crystal ball to predict what will be the next hot investment and jumping around is more likely to harm than help returns. Thankfully, investors are well-served by ignoring the noise and staying on course with a diversified portfolio designed for their needs and long-term goals.

Investment Themes for 2024

Posted On January 1, 2024 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Each year, I rethink our portfolio allocations and today I am sharing our Investment Themes for 2024. We don’t time the market, nor do we try to predict how the market will perform. I think this is not only impossible, but also likely to cause more harm than good. We remain globally diversified, use index funds, and maintain a buy and hold philosophy. We have a target asset allocation for each investor and rebalance positions when they drift from our targets.

But that doesn’t mean we are completely passive. No, each year we slightly adjust our portfolio models in two ways. First, we look at current valuations and expected long-term returns (typically 10 years). With this information we add weight to the Core categories which have better valuations and expected returns. And we reduce categories which might be overvalued and have lower expected returns. This is forward looking, rather than looking back at past performance.

The second adjustment we make to portfolios is to annually evaluate Alternative holdings for inclusion in our models. Alternative, or satellite, positions are smaller, more niche investments, which I don’t think merit permanent inclusion as a Core position, but may be appropriate at certain times. We will describe our alternative positions more below.

2023, Better Than Expected

2023 ended up being a great year in the stock market, with the S&P 500 up 24%. This was a shocker. A year ago, 85% of economists were predicting a recession in 2023. But it never happened and the consensus was wrong. A year ago, I wrote that in spite of the calls for recession, the bad news may have already been priced into stocks and that we would remain invested. You can read my Investment Themes for 2023 here. And here are links for my 2022 Themes and 2021 Themes.

Although the S&P 500 and NASDAQ had a great year in 2023, it was aften a frustrating year for investors. Market breadth was poor and performance was concentrated in a fairly small number of Growth and Technology stocks. 2/3 of stocks did worse than the S&P 500 average. And other categories, such as International, Small Cap, or Value, lagged the Mega-Cap names.

It was also a strange year for bond investors. Rising interest rates pushed down the prices of bonds, and detracted from their performance. So, unfortunately, bonds did not add much to the bottom line in 2023. But the flip side of rising rates is that we have purchased very attractive yields which we will hold and profit from for years to come.

Economic Expectations and Stocks

Markets had a great 2023 and the US avoided a recession. But I am afraid this is no guarantee that the economy is in the clear now. The Federal Reserve raised interest rates and has managed to bring inflation down to 3% without damaging the economy or causing higher unemployment – yet. In the past, such aggressive tightening by the Fed has led to a recession. Will they finally be able to engineer a “soft landing” and not cause a recession? The strength and resilience of the US economy in 2023 is truly the envy of the world.

Unfortunately, I think we need to remain cautious and recognize that it is possible that 2023 only postponed a slowdown rather than avoided one altogether. Today the consensus is that the Fed is done raising rates and will start cutting interest rates later in 2024 once inflation is closer to their 2% target. But none of this is a guarantee that a recession is off the table. 2024 could be another volatile year.

And where are we in terms of valuations? US stock earnings grew by 3% in 2023, but stock prices went up 24%. That means that now US stocks are even more overpriced and the expected returns going forward are lower. The returns of 2023 are surprising because they are unwarranted. US growth stocks have become more expensive, not better.

Looking at our core stock categories today, we have the same themes, but only more so. US Value is cheaper than Growth and has a higher expected return. International has a higher expected return than US. Small Cap is attractive relative to large cap. Emerging Markets have strong growth potential. We were already tilted towards Value and International at the start of the year, and this was early. US Growth outperformed in 2023, but the case for Value and International has only grown stronger and more compelling. Our outlook is for more than one year at a time, and sometimes that means we have to remain patient to see a reversion to the mean.

For 2024, we will make a small addition to our International funds, from our US Midcap funds. We use Index exchange traded funds (ETFs) for our Core positions.

Source: Vanguard Economic and Market Outlook for 2024, published December 2023

Interest Rates and Bonds

Interest rates rose steadily through October of 2023. We continued to buy individual Investment Grade bonds. Our core bond holdings are laddered from 1-5 years and we generally hold to maturity and reinvest. 2023 offered the best yields available in the past 15 years. We wanted to lock in some of these yields for longer, and so we had extended duration in 2023, adding some longer term 10-15 year bonds.

Interest rates peaked in October with the 10-year Treasury briefly touching 5%. Since then, the 10-year has fallen to 3.9%, a massive move in a very short period of time. (This high demand for bonds, and inverted yield curve, is a red flag for stocks and the economy.) We’ve seen a lot of Agency bonds getting called and refinanced to lower rates. And so it is possible we have seen the peak interest rates for this cycle already.

I am glad we were buying when we did and that we extended duration. Today, it is less attractive to buy longer bonds, and our purchases in 2024 will return to being on the shorter end of the yield curve. We will not be adding to bond holdings in 2024, just aiming to maintain our 1-5 year ladder as bonds mature or are called. But there is a good rationale for holding bonds. Real yields (after inflation) are attractive. We have purchased yields which are comparable to the expected 10-year return of US stocks. And so, the 60/40 portfolio at the start of 2024 looks better than it has in years. And if we have a Bear Market in stocks in the next couple of years, the bonds will be defensive and give us the opportunity to rebalance and buy stocks when (not if) they drop.

Alternatives

Bond yields have been so good in 2023 that the appeal of alternatives is less. Why take on a volatile, complex investment if T-Bills are yielding over 5%? We will not be adding to any alternative or satellite categories in our 2024 models. We have several existing positions, which we will continue to hold.

TIPS (Treasury Inflation Protected Securities) were added in 2022 and they have given us a good inflation hedge. Our largest TIPS holding will mature in 2027 and at this point the plan is to hold to maturity. Inflation is less of a concern now, but our TIPS are still paying a decent yield.

Last year, we trimmed our holdings in Preferred Stocks, which sold off as interest rates rose. Today, they have started to bounce back and offer yields over 6% while often trading at a 30% discount to their Par value. The current 6-8% cash dividends we receive from Preferreds is above the expected return of common stocks. I’m happy to have that cash flow for retirees or to have cash to reinvest throughout the year. There is some potential for price appreciation in the next rate cutting cycle, but I am happy to hold these for the dividends and ignore any price volatility.

Our third satellite holding is a small position in Emerging Markets bonds. We use a Vanguard fund and ETF, which offer low cost diversified access to this high yield sector. I’ve seen that this category often bounces back well after a difficult year. And after being down in 2022, our fund was up nearly 14% in 2023. The fund begins 2024 with a 7% yield.

Staying On Course

We look each year to make some minor changes in our allocations, and communicate these ideas in our “Themes” letter. But, I think the real key for investors is to think long-term and be willing and able to stick with the process. There will inevitably be ups and downs and the markets often surprise us and don’t do what we expect. We have done well to stick to the basics: Don’t try to outsmart the market. Buy and Hold index funds. Keeps costs and taxes to a minimum.

If you have questions about our Investment Themes for 2024, please reach out. Even with these themes, we still have different investment models for our clients’ individual needs, risk tolerance, and time horizon. 2023 was a year full of surprises, and we will have to see what is in store for 2024!

Should I Add More Bonds?

Posted On November 3, 2023 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Yields have risen on bonds this year and for many investors it may now make sense to increase their bond exposure. Eleven months ago, I wrote how bond yields had actually crossed above the expected return for stocks. At that time, we could find A-rated bonds with a 6 percent yield. And that compared favorably to the 5.7% expected return of stocks, as projected by Vanguard over the subsequent 10-years ahead.

This past month, we bought some new 10-year government agency bonds with a 7% yield. Now it looks even better to be adding bonds and maybe even reducing some of your stock market exposure. Last November, the Vanguard Capital Markets Model suggested a 5.7% expected return for US stocks over the next 10 years. As of mid-year 2023, they have reduced that to 4.7%.

Even though stock predictions are usually very inaccurate, I do think it is worthwhile to look at these projections. While the historical returns of US stocks may have been 9-10% over the long haul, returns can be above or below average for an extended period. There have been many 10 year periods which have done better or worse than the “average”. There are many factors which can help us estimate returns, including starting equity valuations (such as the Price/Earnings ratio), corporate earnings growth, or productivity gains. It should not come as a surprise that when stocks are expensive (like in 2000), the following 10 years are below average. Or when stocks are beaten down and cheap (like in 2009), the next 10 years are often above average in return.

Portfolio Models

We manage a series of investment portfolios for our clients with an approximate benchmark blend of stocks and bonds. Our Premiere Wealth Management Portfolio Models include:

Ultra Equity (100% stocks / 0% bonds)
Aggressive (85/15)
Growth (70/30)
Moderate (60/40)
Balanced (50/50)
Conservative (35/65)

In the 4th quarter of each year, we analyze our portfolio models and make tactical adjustments based on where we perceive relative value. We overweight the segments or categories which have better expected returns and we reduce the categories which have a lower expected return. In addition to our Core holdings of Index Funds and investment grade bonds, we consider satellite investments in alternative categories.

But this year is different. We are now looking at bond yields that are above the expected return of US stocks. I think it may make sense for a lot of my clients to consider a healthy increase in their bond holdings. For the last 15 years, since the 2008 global financial crisis, bond yields have been absurdly low. Today, we have a chance to lock-in longer yields at a time when the stock market looks potentially mediocre for the next several years of returns.

I have thought for a long time about how to increase bond holdings. If we move a 60/40 portfolio from 40% to 50% bonds, we probably shouldn’t still call it a 60/40 model. So, instead of making large changes on the model level, I will be discussing with each client if we now want to consider reallocating from the 60/40 to the 50/50 model, for example.

Pro / Con of Adding Bonds

The hope, by adding more bonds, is to reduce volatility and have a smoother, more consistent return each year. If the 4.7% expected return of stocks is correct, bonds could out-perform stocks and improve the return of the overall portfolio. For investors close to retirement, adding bonds could reduce the impact of a large drop in stocks, right before income was needed. And for retirees taking distributions, the now high income from bonds means we can better meet your need for cash flow versus selling shares of stocks.

Of course, there is no guarantee stocks will under-perform as projected. The 10 year projection from Vanguard is an annualized average – the stock market will undoubtedly have years with very different performance than the annual average. Investors with FOMO may be unhappy in bonds, even 7% coupons, if stocks are up 20% in one year. Young investors who are making monthly deposits may prefer dollar cost averaging and not worry as much about stock market fluctuations.

Understand Callable Bonds

Many of the Agency, Corporate, and Municipal bonds available today are “callable” bonds. That means that the issuer has the right to pay off the debt early. “Calls” happens when interest rates fall and the issuer can replace their 7% debt with a lower yield bond. It’s just like refinancing a mortgage to a lower rate.

We don’t necessarily have to hold a 10-year bond to maturity. Here is how past economic cycles worked: Eventually, the economy will slow and fall into recession. At some point, the Federal Reserve cuts interest rates and we often see both short and longer term interest rates drop. At that point, the issuer of the 7% bond may be able to refinance down to 6% or 5%. So, they will call their bonds early and redeem them at full value.

If we are in a recession, it’s also possible that the stock market could be down 20% or more in that period. And that may be a good time to rebalance – to take the proceeds from the called bond and invest it back into a stock market that is beaten up. That certainly worked well in March and April of 2020. If interest rates drop, we are likely to get called and might not be able to find another 7% bond. But that may be okay, if we are willing to rebalance the overall portfolio and buy other investments when they are on sale. And of course, regardless of when a bond is redeemed, we made 7% a year, since we bought these bonds at Par.

Reducing Call Risk

Why not just buy non-callable bonds? I would if they were more available and at the same yields. Most bonds today are callable, with the main exception being US Treasury bonds. But the yield on the 10-year Treasury is 4.7%, not 7%. So, I am willing to take some call risk for the extra 2% in return. Still, there are some things we are doing:

Buying discount bonds. Older bonds with a lower coupon often trade at a similar yield to maturity as new issue (and high coupon) bonds. These are less likely to be called. And if we buy a bond at 90 and they call it at 100, that is great.
Preferred Stocks are also now trading at sizable discounts, often 60-70 cents on the dollar. If we are comparing a bond from Wells Fargo versus their Preferred Stock, there may be advantages of the Preferred. While they may have similar current yields, the preferred has upside to its $25 price. The bonds, trading near Par, have no price appreciation potential.
Fixed annuities (multi-year guaranteed annuities or MYGAs) generally are not callable. And since there is no 1% management fee on the annuity, a 5.5% 5-year annuity may net the same return as a 6.5% 5-year corporate bond. Except the annuity is guaranteed, unlike a corporate bond. So, if you aren’t needing flexible liquidity, MYGAs can reduce your call risk and lock in today’s interest rates.

Your Bond Strategy

We’ve waited 15 years to have bonds with these juicy yields. I think now is not a time to be too defensive with a money market or short-term T-Bills. Those are fine for your immediate needs. But at some point in the future, rates could drop. The risk is that when today’s 5.5% T-Bills mature, the new T-Bills might only yield 3% or 2%. Then we will regret not locking in the longer duration yields available to us now at the end of 2023.

These last four years have been quite a roller coaster for investors. A huge crash in March of 2020, followed the fastest recovery of stocks ever. Then unprecedented inflation. A Bear Market in 2022 brought a 20% drop. A recovery in 2023 that was limited only to a handful of tech stocks. A lot of stock funds have little or almost no gains to show for all this commotion. Stocks have been disappointing.

Bonds today offer a higher yield than the 4.7% expected return of US stocks over the next decade. That’s quite a shift and investors should pay attention – yields will not stay at these levels forever! We are always cautious in making large changes, but would generally prefer bonds over stocks if they had the same return.

Stocks are supposed to have an Equity Risk Premium to compensate you for their added risk and volatility. Not today. Bonds offer lower volatility, a more predictable return of “yield to maturity”, and current income. For retirement planning, these are very desirable qualities that can improve the outcomes of our planning simulations both before and during retirement years. These are the reasons will are looking to add more bonds today.

Index Funds vs Mutual Funds

Posted On September 21, 2023 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Twice a year, Standard and Poors updates their comparison of Index Funds vs Mutual Funds, called SPIVA (S&P Index versus Active report). I have written about SPIVA a number of times, and it is worth repeating, because the data is remarkably consistent.

The majority of actively managed funds do worse than a benchmark or index. The newest report was published today, covering all US Funds through June 30, 2023. When we look at long-term returns, here are the percentage of active mutual funds that performed worse than their benchmark:

Category	5-yr	10-yr	15-yr	20-yr
All Domestic Stock Funds	89.08%	90.19%	93.15%	93.12%
International Stock	81.84%	84.78%	85.33%	92.50%
Emerging Markets	70.70%	87.56%	89.58%	92.42%

Source: SPIVA US Mid Year 2023

The evidence comparing index funds versus mutual funds is clear: Index funds are the hands down winner. While past performance is no guarantee of future results, there continues to be overwhelming evidence that index funds do better than the vast majority of active funds over the long-term. And this finding is remarkably consistent, regardless of whether we are in a Bull or Bear market.

Equal Weight Index

2023 has been a strange year in the market, with narrow breadth of performance. Looking at the S&P 500, performance has been concentrated in a small handful of names, with five large stocks up more than 100% in the first half of the year. So for strategies which didn’t own these high flyers, it was tough to keep up. Value, Small Cap, and other strategies have lagged the Large Caps this year.

But that is likely to reverse, as it has been quite extreme. I’ve written previously about Equal Weight funds, specifically the S&P 500 Equal Weight. It owns the same 500 or so stocks as the S&P 500, but in equal proportion. The standard S&P 500 which weights each stock on its size (“market capitalization”).

Over the very long-term, the Equal Weight strategy (EW) has outperformed. From 1991 through 6/30/2023, the EW S&P 500 index has a return of 11.82% a year, versus 10.55% for the regular S&P 500. That is a noteworthy, long-term improvement in performance, and is typically attributed to the idea that EW has less of the “over-valued” stocks and more of the “under-valued” stocks.

While EW has outperformed over 30+ years, it has not done so consistently or every year. But what is interesting is that when EW has underperformed to an extreme level, it has historically snapped back. And that is where we are today: EW lagged by 9.9% for the first half of 2023. In the chart below from S&P, previous 6-month periods of EW underperformance were followed by periods of strong EW outperformance. The returns have been mean reverting, with EW providing long-term returns in excess of the cap-weighted index

Mean Reversion Ahead?

This would suggest that the outperformance by the Mega-Cap names of the S&P 500 is unlikely to continue. We own some Value and Mid Cap funds which have not kept up with the S&P 500 this year. That can be frustrating and make investors want to pile into those high flying stocks. But the reality is that the outperformance of the biggest stocks versus EW may be overdone. In fact, it is in the 2nd percentile for the first half of the year, more extreme than 98% of previous 6-month periods. Generally, I believe mean reversion is more likely than an extreme trend continuing indefinitely.

We diversify our portfolios broadly and tilt towards areas of better relative value. This has us owning Value funds, multi-factor strategies, small and mid-cap, and Emerging Markets. Why? Our belief in the two topics we discussed today:

Passive, index strategies are better than active management over the long-term
We count on mean reversion rather than performance chasing

Both of these approaches are well-grounded in research, but require patience and discipline to stay the course. That’s where we are today. And the data reminds us that this still makes sense. The question of Index funds vs mutual funds is just the beginning. There will be ups and downs, which no one can predict or time, so our focus is on having a good investment process and understanding the fundamentals.

Growth, The Big Picture

Posted On September 18, 2023 By Scott Stratton, CFP(R), CFA In Financial Planning, Portfolio Management /

With all the noise in today’s markets, it is easy to miss the big picture about growth. 2022 and 2023 have been two of the strangest years in a generation for investors. As a result, it is easy to feel uncertain about investing right now. And that uncertainty often leads investors to make bad choices. So, we are going to step back and look at the 30,000 foot view of what really matters for investors.

In 2022, we saw inflation rise to 9% and the Federal Reserve start the process of slowing the economy. As the Fed raised interest rates, stocks dropped 20%, briefly entering Bear Market territory. In the bond market, rising interest rates snipped the price of bonds, sending the US Aggregate bond index down double digits. For diversified investors, 2022 was a perfect storm where diversification failed and both stocks and bonds were down an uncomfortable level.

Now in 2023, we have seen the Federal Reserve continue to raise rates up to the present moment. At the start of the year, I saw one report that said the probability of a recession in the next 12 months was 100%. 100%, a certainty! And while the full 12 months are not up yet, we have not had a recession. In fact, the S&P 500 Index is up 15.83% this year. While the yield curve remains inverted, a favorite predictor of recessions, it now appears that the likelihood of a 2023 recession is diminished and might not happen at all.

Don’t Time The Market

Comparing 2022 and 2023 doesn’t make sense. The market “should” not be up 15% this year. And yet here we are, with a very welcome gift of an amazing performance in the first seven and a half months of the year. The consensus economic forecasts at the start of 2023 were lousy. If we had listened to them, we would have sold our stocks and hid out in cash. We would have missed out on the gains that we have had for 2023!

There are often compelling historical precedents to entice investors to think we can predict what is going to happen over the next 12 months. Making changes to your investments feels obvious, a smart choice, and low-risk. Unfortunately, history shows us that it is hubris to try to time the market and more often detrimental than beneficial.

It is a challenge to actually stay the course and maintain your discipline. It is difficult to ignore the forecasters and not think that there is an opportunity for you to either protect your principal or rotate into a better performing investment.

Timing the market continues to be a bad idea. I didn’t hear any forecasters in January predict that stocks would be up 15% by August. If we had listened to their predictions, although well-intentioned, we would have made a mistake. Thankfully, we didn’t try to time the market this year. Here is how we manage a portfolio:

Establish a target asset allocation for each client’s individual needs and risk tolerance.
Rebalance portfolios when they drift from the targets.
Adjust our portfolio models annually based on the valuation and expected returns of each category.
Use Index Funds and manage each client’s portfolio to keep costs down and minimize taxes.

Rebalancing

The funny thing about rebalancing is that it often means doing the opposite of what you might expect. When stocks were down 20% last year or in 2020, we were buying stocks. Now, when stocks are up 15-20% and there is a lot of optimism for a soft landing, we are trimming stocks and buying bonds. In hindsight, this looks pretty logical. However, in real time, rebalancing often feels like not such a good idea. And sometimes it isn’t – there’s no guarantee that rebalancing will improve returns. But, what it does offer is a disciplined process to managing an investment portfolio, versus the behavioral traps of trying to time the market. The bizarre markets of 2022-2023 certainly reinforce the potential benefits of rebalancing.

Average Versus Median

Do you remember from high school algebra the difference between Average and Median? Average is the total sum divided by the number of items. Median is the data point in the middle. And there can be a big difference between Average and Median. Stock markets are cap weighted, so the larger stocks move the index more than the smaller stocks. Still, let’s consider how the “average” return of an index can be quite different from the median returns of its component stocks.

The year to date return of the S&P 500 Index ETF (SPY) is 15.83% as of August 16. But that is not the median return of the stocks. Of 504 components of the S&P 500, only 135 have done better than 15.83% YTD and 369 have done worse than the overall index. If you had picked a random stock from the S&P, there was a 73% chance that you would have done worse than “average” this year.

And what is the Median performance of the S&P 500 this year? Only 3.36%, an under-performance of more than 12% than the overall index. Even worse, 212 stocks in the S&P 500 are down, negative for the year.

What is the big picture of growth in stocks? Trying to pick individual stocks is extremely difficult. Don’t think that using an index fund means “settling for average”, the reality is that over time, the index return has done much better than the median stock.

This year has been such a frustrating year for investors because stocks are all over the place. If you don’t own a few of the top performers, you are likely lagging the benchmark by a wide margin. What is a way to make sure you own the winners today and tomorrow? Own the whole market with an Index Fund. Realize that if you pick a stock from the S&P 500, it is not a 50/50 coin toss that you will beat the market average. The chance is lower than 50% because the market average typically does better than the median stock. The stocks which do outperform will move the index disproportionately and they will be fewer in number.

There is a lot of noise and confusion in the markets today, and that’s okay. We are in uncharted waters and seem to be going from one “unprecedented” event to another. Thankfully, I don’t think we need to have a crystal ball to be successful as long-term investors. What I believe can help is stepping back to remember the big picture: don’t time the market, stick to an allocation and rebalance, and use index funds. That’s our roadmap. When in doubt, we can recheck our directions and keep going.

What You Can Control

In the short-term, stock markets can be very volatile. As a result, I believe a lot of inexperienced investors mistakenly think that their success depends on their ability to game the markets. They think that growth is achieved through trading or superior returns.

Unfortunately, trying to outsmart the market often makes your performance worse, rather than better. Active management doesn’t work, at least not consistently over 10 or more years. We stick to passive, low-cost index funds or ETFs for our stock market exposure. And we remain invested in a long-term asset allocation.

Once that investment decision is out of the way, the main determinant of success is your savings rate. How much are you investing each month? That is what you can control. If you want to be more successful in accumulating your wealth, you don’t need to worry about the Jobs Report this week, or what was in the Federal Reserve meeting notes. You need to focus on how can you can save an extra $100, $500, or $1000 a month and make that a habit.

Instead of worrying about your YTD performance, calculate how much wealth you will have in 10 or 20 years, with an average rate of return. Because in the long-run, an average rate of return is excellent. And then what you can control – your savings – is what actually matters more. Growing your wealth is largely a factor of savings and time. Chasing investment performance is a distraction.

Develop Your Saving Habits

Make savings automatic. Put your investing on autopilot with monthly contributions to your 401K, IRA, and investment accounts.
Save More. Don’t just do the 401(k) match, try to put in the maximum to each account. And then ask where else can you invest? Do the math of how much money you want to accumulate. (I can help with that.)
Keep the big expenses down. Living beneath your means is easy if you are smart about your housing costs and your cars. Many Americans who are not frugal in those areas do not have anything leftover to invest.
Develop your career. If you can expand your income without increasing your expenditures, your savings can increase dramatically. If you ever have a chance to work for a company with stock options, go there. I have seen over the years, tremendous wealth accumulated from stock options.
Be an Entrepreneur. This can be high risk, but when they are successful, entrepreneurs earn and save much more than employees. Besides a salary, an entrepreneur is growing a business that has value.

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