Have we entered a Deflationary Spiral?

As of January 12, 2015, the S&P 500 Index is down over 3% YTD and it is the worst start to the year for the S&P 500 Index since 2009. The major news that came from overseas was the Euro zone slipped into deflation as prices in the euro zone fell 0.2% percent year-over-year in December. The plunge in energy prices is causing concerns that we might be entering a deflationary spiral. Investors are clearly unnerved by the precipitous drop in energy prices and other commodities which have historically been a reliable leading indicator of future economic growth. These indicators could be foretelling a period of slower global growth. We believe that energy prices may need to stabilize before markets become less volatile and begin to move much higher. We believe that if energy prices fall even more from these levels, corporates profits could be negatively impacted. The Federal Reserves ‘beige book’ reported this week that oil prices are causing a slowdown in areas of the country sensitive to oil prices.

As energy companies cut back on production we will sadly see layoffs as well as huge cuts in capital expenditures. Schlumberger, which is of the largest oil services company said that it will be firing 9,000 workers due to the plunging oil prices. We believe that this is just the beginning of massive layoffs in energy companies if energy prices do not rise. We believe that many energy companies will also start to announce one-time charges related to the fall in prices. On the other hand, well-run energy companies should be in a better position to gain market share and pick up assets on the cheap.

Why have markets suddenly become so volatile?

Global markets are clearly out of sync and market turbulence is now flashing in red, “fasten seatbelts”. Volatility has returned with a vengeance. The  investopedia definition of a volatile market is, “an unpredictable and vigorous changes in the prices of stocks.” Our definition of volatile markets is quite different. We believe that markets become volatile when the equilibrium of the stock market gets thrown out of balance as investors become uncertain of the future. Analysts fear that consumers will hold off on purchases if they believe prices will continue to fall. Interest rates around the globe have fallen to nearly zero in many overseas countries. For example, in Germany, the 5-year bond rate actually turned negative. Deflation is the real fear. Would you place your money in the bank if they paid you less than what you put in? Your reaction would be to find the bank that would pay you the most for your money and had the best reputation for security. For an overseas investor that bank is called the US Treasury. These foreign investors who buy US Treasuries first need to sell their home currency to convert into US dollars. Hence, the result is the US dollar is now stronger than the Euro when it was first launched back on Jan 4th 1999 at 1.1789. The Euro has continued to weaken and US Treasury rates have dropped. A weak Euro is not welcome news to a US multinational company that relies on a large proportion of its sales from outside the U.S.. We believe that earnings estimates may fall for many of these multinational US companies. However, many of these same companies may see a boost in profit margins due to the lower cost of energy. We believe this quandary is confusing many investors who are trying to determine the net effects of these changes on future cash flows. This uncertainty will be a major reason why stocks may remain volatile in the near term.

Why did we anticipate a drop in energy stocks last month?

We believed the cash flows for many energy companies tied to the energy markets would drop substantially. In our last few investment updates back in November and December of last year, we warned our clients to beware the “Black Swan” in oil. We recognized major downside risks within certain industries that rely on high oil prices. We cited our favorite quote from Warren Buffett, “Risk comes from not knowing what you’re doing.” Our article a few weeks ago warned about the falling future earnings estimates of energy companies and that these companies represented a classic “value trap”. In the last week, many of these companies have fallen over 8%. Sentiment has suddenly turned extreme as investors are now focused on the short-term and they now could be missing compelling future buying opportunities. We stand ready to buy the panic. We will carefully be watching the cash flows of these companies. We believe that the managements of these companies may not be too forthcoming on their future plans but accurately reported cash flow statements may tell the true story.  There is a high stakes game of poker occurring at the boards of many energy companies. Do you cut production or do you hold out and wait for your competitor to cut production. Drillers are hardwired to believe that energy prices will always go higher. Our belief is that future cash flows will be what ultimately drive these stock prices higher or lower.

Our current portfolio positioning

In our portfolios, we remain zero weight in energy companies. We are very close to buying select energy companies; however, we aren’t necessarily there yet. We hope to use volatility in our favor if these companies become even more oversold. We believe low interest rates are an enormous positive for stable US companies with above average dividends and stable cash flows. Most of our investments are in companies not tied to a falling commodity but could be beneficiaries of lower oil prices. Low oil prices we think should be a huge positive for families who have constrained budgets. We envision many families thinking of hitting the road for the first time in a long time to go on long distance vacations. Companies along this road may see a bump in future cash flows. We are also starting to invest in Europe and are focused on companies whose cash flows may increase from this new this new market environment – low energy prices, weak Euro, and a strong U.S consumer. A weak Euro should be a positive for companies that sell to the U.S. We are also willing to pay a premium for companies that are showing strong future cash flow growth. Many active fund managers that we follow are actually outperforming the markets this year. We have nearly eliminated our ETF/index exposure. Our major market call this year is that a well-diversified active portfolio may be in a better position to take advantage of this extreme market imbalance and volatility than an index fund. We will continue avoid large market index positions because our investment thesis has been that many energy related companies are unsuitable investments for investors who do not want to speculate on the future price of oil.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

 

Energy Stock Dividends and Falling Oil Prices – Something Has to Give

Energy Stock Dividends and Falling Oil Prices – Something Has to Give

The 60% decline in oil prices, which accelerated during the fourth quarter of 2014, has continued into 2015. This unexpected swift decline has left many investors flat-footed and utterly confused. Kenneth Rogoff, a Harvard University economics professor, believes oil prices are the big story for 2015 and this once-in-a-generation shock will have huge reverberations. We would add that this drop in energy prices could have serious implications on your investment portfolio. Thus far the exploration and drilling energy companies have dropped significantly in price but the stock prices of the large integrated energy companies have fallen more modestly. Many investors have considered the following reasons why energy prices have crashed.

  • Organization of Petroleum Exporting Countries’ (OPEC’s) decision to maintain production levels and market share vs. the US
  • Slowing growth overseas in China and Europe
  • Relatively warm weather
  • Too much supply from US producers
  • A geopolitical squeeze on Putin

The question that we are now examining is whether or not equity investors are still holding out for a quick rebound in energy prices. The last time oil prices was below $50 a barrel many of the integrated energy companies were trading almost 30% lower. It is possible that some investors are attracted to the high dividend yields of these companies as well as the low P/E’s. At this point, we believe that dividend cuts are at serious risk and P/E’s could rise. The future earnings estimates for the large integrated energy companies have already been cut by analysts and their valuations are not as cheap as they first appear. The table below shows the potential worst case scenario if dividends are cut back to 2009 levels based when oil was trading below $50 a barrel.

2009 P/E

2014 P/E

Forward P/E (Year)

Today’s Dividend Yield

Hypothetical Dividend Yield based on 2009 annual dividend and 1/6/15 stock price

Chevron Corp

6x

9x

15x

4.10%

2.50%

ConocoPhillips

5x

10x

18x

4.60%

2.90%

Exxon Mobil

7x

11x

17x

2.90%

1.80%

Source: Constant Guidance Financial and Morningstar. This is a hypothetical example that is demonstrating a mathematical principle. It does not illustrate any investment products and does not show past or future results.

We believe that the hypothetical dividend yield based on the 2009 annual dividend could be a possibility if energy prices remain low for an extended period of time. According to data complied by Bloomberg News, the tumble in crude prices has prompted energy-stock analysts to slash estimates for capital expenditure for the next year, cutting them as much as 9.1 percent since July. Typically, when capital expenditures drop so will the profits of many of these companies which could ultimately impact dividends. Another way we analyzed this question on the potential for dividend cuts was by illustrating the yearly dividend of the Energy Select XLE dividend since 2009 and comparing it to the change of oil prices and the price vs. the Energy Select XLE ETF. The last time oil traded at $50 a barrel dividends for the energy sector was over 50% lower. In 2009, the Energy Select XLE dividend was $1.03 and rose year over year until hitting $1.96 in 2014. We conclude that one of two things need to happen, either dividends could be cut or the price of oil will need to rebound significantly.

energyetf2

Source: Constant Guidance Financial and bigcharts.com – This is a hypothetical example that is demonstrating a mathematical principle. It does not illustrate any investment products and does not show past or future results.

In our opinion, the table and chart show that there could be downside risk remaining for these stocks if energy prices do not rise. We believe these companies may represent a classic “value trap”. The following quote from legendary investor Benjamin Graham applies well to today’s energy sector,

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Many investors are voting that energy prices will rise and these large integrated energy companies will continue to pay their dividends. The weighing machine will be the ability for these companies to actually pay their future dividends. We believe that either those stock prices will need to adjust or energy prices will need to rally significantly.

Over the past few months, we have recommended a zero weighting in energy companies and we continue to believe that there are more attractive sectors within the U.S. stock market to invest. We are advising that our risk-averse clients continue to underweight much of the energy sector but remain invested in other industries that are benefiting from the drop in energy prices. Given the huge volatility in the energy sector, there could be more interesting buying opportunities sooner then we originally thought from just a few weeks ago.

We are closely following comments made by the managements of major energy companies on the stability of their dividends. If energy companies cut their dividends many investors may be forced to sell their positions. This could create a potential buying opportunity. There is a chance that many energy producers suffer the same fate that gold miners have experienced in the past few years. Many of these gold stocks have seen huge rallies followed by ensuing reversals. We believe that active traders might target many E&P companies in the Permian Basin, Bakken, and Eagle Ford shale areas as very good tradable opportunities.

Overall, we believe risks remain and it is prudent to remain overly cautious. We will gladly sacrifice any potential upside off the bottom in exchange for not risking the permanent impairment of capital. We believe dividend cuts and potential bankruptcies could be around the corner for highly leveraged explorers with higher marginal costs if oil remains at these levels.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

 

Not Planning to Retire Soon – Hope for Less Rosier Headlines

The Dow Jones Industrial Average recently climbed to a record high of 18,000 for the first time on December 23rd.  Investors cheered this news and the media proclaimed that the bull market was heading even higher. There was no cheering from us at Constant Guidance Financial (CGF). We reflect back on Warren Buffett’s quote from his 1997 Berkshire Hathaway shareholder letter, “Disinvestors Lose as Market Falls—But Investors Gain.” Buffett’s point was that savers are able to deploy funds more advantageously at lower prices.  The stock market is the only market where people don’t like to buy “on sale”. If you are contributing to a 401(k) or other retirement vehicle and do not plan to retire in the near future, you should be hoping for less rosier headlines.

The Dow Jones Average is up nearly 175% since the low reached in November 2009. It is hard to believe that the index was at 6,547 such a short time ago.  While we prefer not to experience a significant market correction, we do prefer lower prices. We follow Buffett’s advice, “… smile when you read a headline that says, “Investors lose as market falls. Edit it in your mind to “Disinvestors lose as market falls — but investors gain.” As fundamental investors, we tell all of our clients who invest with as that we prefer lower markets. It is much easier to find better values when prices are lower.

In our view, there are not many bargains in equity markets these days. Investor confidence is at near all time highs, international investors are piling into the U.S. markets, companies are buying back record amounts of stock, and oil prices collapsed over 40%. Moreover, companies are flush with cash, jobs are plentiful, wages are on the rise, inflation is nonexistent, consumers are in a spending mood, and investors continue to buy every dip in the market. According to Barron’s Magazine, EVERY Wall Street strategist is bullish in 2015. They all expect to see a stronger U.S. economy next year.

At CGF, we do not make future market predictions because if we could accurately predict the market like the brokerage firms attempt, we would leverage our bet multiple times and plan to retire in 2016. We believe the best way to accumulate wealth over time is to find undervalued businesses and slowly compound returns over time.  We are constantly reevaluating our clients’ portfolios and looking for new investment opportunities. In the past, we were evaluating companies with earnings yield over 6%-8%. In this current market environment, the highest quality companies are now yielding between 4%-6%. Earnings yield is the quotient of earnings per share divided by the share price. We use earnings yield because we can compare the earnings of stocks to bonds. Earnings yield is the reciprocal of the P/E.  Today’s earnings yield is low relative to historic valuations; however, it is actually high when compared with bonds, CDs, and other assets. In this deflationary environment, many investors are satisfied with an average 4%-5% earnings yield versus an investment grade corporate bond with a 2% yield that has a 5-year duration. Earnings yield continues to favor equities. If interest rates begin to rise next year, then we would assume that equity markets would become more volatile. In the meantime, we will continue to hope for lower markets for our long-term clients and are willing to hold a small cash position for our clients nearing retirement as equity valuations remain slightly elevated.

The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded “blue chip” stocks, primarily industrials, but includes financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Invest More Like a Shark

Those of us who watch the hit TV show Shark Tank are very familiar with the panel of potential investors who consider offers from aspiring entrepreneurs seeking capital for their ideas. As investors, we are actually all “sharks” who make capital decisions on where to invest our money. Some investors hire wealth managers to make decisions for them and others prefer to make the decisions themselves. We believe the ultimate sharks are famed investors Warren Buffett and Charles Munger but the current panel of “sharks” are all well connected and great capital allocators. The sharks are never afraid of losing money as long as they believe the odds are tipped in their favor. We believe that thinking with the same mindset as the “sharks” will help you take some of the emotions out of these volatile markets.

We are all fortunate enough to live in country that offers some of the best investment opportunities in the world. However, some investors continuously monitor the markets for economic signs that might indirectly impact their investments. These questions usually apply to current events or headlines that capture readers attention. A few questions below seem to be the ones currently being debated.

  • After the enormous relief rally, has the current correction ended?
  • How low will the price of energy fall?
  • How will falling energy prices impact the economy in 2015?
  • Will the global contagion from the slowdown occurring in the rest of the world spillover into the US?
  • Is it possible that Russia will default on its debt and will Putin lose power?
  • Can the deflation/recession in Europe move to the US?
  • If the Federal Reserve starts to raise rates at some point, will my investments lose value?

We can state with a large degree of confidence that very few investors can accurately predict the answers to these questions. However, most of the responses you hear will make for entertaining commentary on TV. As value investors, we think it’s best to have a mindset of a “shark”. The successful investors on the Shark Tank have an entirely different set of questions they try to answer before taking ownership in the business.

  • How long will it take me to get my cash back and how much can this investment return?
  • What is my potential downside risk in this investment?
  • How much money can I possibly lose vs. the potential for upside?
  • Do I understand how this investment works and what are the potential risks?
  • Is this a scalable opportunity that can be leveraged?
  • Are there high recurring capital expenditures to fund this investment?
  • Can competitors easily replicate this idea and take market share?
  • Will I be able to work with this management team/entrepreneur seeking capital?

We believe that the second set of questions is how you should be evaluating your investments. The first set of questions are all irrelevant to long-term investors who are properly diversified to their risk tolerances and goals. The second set of questions are much more relevant to making ongoing capital allocation decisions. If you think of yourself as a “shark”, your investment process will be much more decisive and your long-term investment results may improve.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

 

 

2015 Portfolio Positioning: Beware the “Black Swan” in Oil

As we prepare for our year-end reviews with our clients, we are highlighting how the rout in energy prices has impacted their portfolios as they save for retirement or other financial goals. In our view, we continue to see major downside risks within certain industries and countries that rely on high oil prices. We believe that prudent sector rotation, where some industries do better than others, will be critical to adding some downside protection to your portfolio. One of my favorite quotes from Warren Buffett applies well to today’s market environment, “Risk comes from not knowing what you’re doing.” As we head into 2015, the market environment has become unpredictable as investors struggle with the uncertainty created from the drop in energy prices. With stocks falling off all-time highs and bond yields at all-time lows, we believe wary investors should seek a second opinion on their investments if they are uncertain of the likely outcomes from this difficult market environment. If your advisor is not providing you with timely market updates, they might be struggling with how to reposition your portfolio from this “Black Swan” event in oil prices, which has caused such capital loss in the energy sector.

Over the past few months, we have recommended a zero weighting in energy companies and we continue to believe that there are more attractive sectors within the U.S. stock market to invest. We are advising that our risk-averse clients continue to underweight much of the energy sector but remain invested in other industries that are benefiting from the drop in energy prices. Lower unemployment and lower energy bills should underpin the economy as we begin 2015. Economic data has shown that the drop in energy is positively impacting the consumer and many consumer discretionary and industrial companies stand to benefit. However, we now becoming more cautious on many of these companies as they have seen substantial gains in their stock prices. As we read press coverage about how consumers should benefit from lower fuel costs, we believe that investors have already priced in much the future cash flow gains from the drop in energy.

The greatest opportunity now might be uncovering potential opportunities in the energy sector but we remain cautious. We believe that low oil prices may continue to make markets volatile and this could create many interesting opportunities for investors as we head into 2015. Below are a few things that we are watching closely.

  • After the substantial drop in many Energy stocks the sector looks relatively cheap based on price-to-earnings (P/E) and price-to-free-cash flow (P/FCF) relative to the S&P 500 Index but this could be a classic “value trap” if the price per barrel of oil does not rebound.
  • If oil prices do not rebound there could be a number of bankruptcies and this time the government will not step in bail out the over-leveraged oil producers much like they did the banks in 2008. We expect continued volatility in the high yield credit markets, where energy issues makes up a significant portion of the overall asset class.
  • The bottoming process for oil companies will be marked by extreme volatility. A number of U.S. exploration and production (E&P) companies that have key strategic advantages might be acquisition targets for larger oil producers who have cash to spend and are not leveraged themselves. These companies we believe are becoming very attractive buying opportunities and we hope they become even cheaper.
  • We anticipate dividend cuts and/or capital write-downs if prices do not rebound. We are closely following comments made by the managements of major energy companies on the stability of their dividends. If energy companies cut their dividends many investors may be forced to sell their positions. This could create a potential buying opportunity.
  • There is a chance that many energy producers suffer the same fate that gold miners have experienced in the past few years. Many of these gold stocks have seen huge rallies followed by ensuing reversals. We believe that active traders might target many E&P companies in the Permian Basin, Bakken, and Eagle Ford shale areas as very good tradable opportunities.
  • A recent blue print that was created from the market crisis of 2008 might play-out for energy companies in 2015. The companies that were the most leveraged and experienced the closest near death experience were actually some of the best investments to make when the crisis ended.
  • If oil remains low, we believe that many U.S producers might be forced out of the market, but this could cause the price of oil to rise as fast as it has fallen when supply tightens.
  • As the tide goes out on many of the managements in the energy sector, we could be in store for a few more major surprises.
  • If prices continue to drop, we believe that larger investors such as Warren Buffett might step in and buy infrastructure companies that transport energy. These companies offer very good long-term investment opportunities when the dust settles.
  • Foreign governments that depend on high oil prices to sustain their government may experience political upheaval.
  • The falling price of oil might help many struggling European countries at the expense of Emerging Market countries that rely on higher oil to fund their governments.
  • The result from substantially lower deflation may result in a further drop in U.S. interest rates. A subsequent drop in mortgage rates could result in another refinancing boom, as young investors might look to this market as an opportunity to lock-in low fixed rates and take advantage of a stable housing market.
  • We are very wary of margin calls due to the highly leveraged market. The drop in oil prices might cause an unwinding of entire positions, which may result in a full market correction. Many tax sensitive investors might sell their 2015 winners to offset losses in their energy positions. This tax harvesting might add to market volatility as we close out 2015.

Untitled

Source: nyxdata.com; This is a hypothetical example that is demonstrating a mathematical principle. It does not illustrate any investment products and does not show past or future results.

Overall, we believe risks remain and it is prudent to remain overly cautious. We will gladly sacrifice any potential upside off the bottom in exchange for not risking the permanent impairment of capital. We believe dividend cuts and potential bankruptcies could be around the corner for highly leveraged explorers with higher marginal costs if oil remains at these levels.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

 

Falling Price of Oil – What Does It Mean For Your Portfolio?

Institutional Thinking for Individual Investors™

By Mitch Zides, CFA, CFP®, AIF®, NSSA® November 28, 2014

“Rule No.1 is never lose money. Rule No.2 is never forget rule number one.” – Warren Buffett.

As the price of oil has fallen sharply from nearly $110+ a barrel back in June 2014, to approximately $70 a barrel today, we reflect on Buffett’s famous quote. We all know that entails investing through uncertainty with the possibility of loss but keeping Buffett’s rule in mind can potentially keep you from avoiding major catastrophic losses. One of these losses is actually taking place in the energy sector.  This nasty reversal of over 38% is most likely having negative implications on your investments if you haven’t been correctly positioned for this this swift and unexpected drop in energy prices. Investors who have been properly diversified probably haven’t even noticed this complete meltdown in oil prices as markets have reached all time highs. However, if these unfavorable conditions persist for energy companies there could be unforeseen consequences that have yet to be played out.

In particular, the chain reaction will have major ramifications on many foreign countries that are dependent on high oil prices to fund their government budgets. As these countries fall into deficit, they might actually be forced to pump more oil out of the ground to increase revenues rather than cut prices to decrease supply. The most important assumption that investors must now make is how prolonged oil will remain at these levels. If OPEC members are trying to protect market share against the shale boom occurring in the US, we could be in for a protracted period of lower oil prices. If oil prices remain at these levels, we believe that many US shale energy companies will be forced out of business. Similar to the tech boom in the early 2000’s, the US has experienced a shale boom in recent years. There has been a substantial build up of capital in the energy sector and we could be more in a period of capital destruction in the next few years.

Another major implication will be that energy companies maybe forced to cut their dividends or even worse raise debt to sustain their dividends.  We have analyzed the cash flow statements of all the major energy producers and conclude that if these companies do not cut back on capital expenditures they will not have enough cash flow to fund dividends or buyback their company shares.

The margin of safety for investing in the energy sector is no longer in place. In our view, the true intrinsic value for energy companies is too difficult to estimate at these levels. We have completely avoided the energy sector and will continue to do so. We believe that the larger more diversified energy companies remain vulnerable at these levels. In our opinion, the time to buy the major energy producers will be when they announce dividends cuts. Many large institutional managers who are overweight energy will be forced to sell into a falling market as these cuts take place. We witnessed a similar meltdown of banking shares during the great recession as those companies were forced to cut their dividends. In hindsight, the time to buy was when banks cut their dividends. It is impossible to predict the direction of oil and we prefer not to make predictions; however, we will protect our clients’ capital from this vicious cycle. In addition, we will also not invest in any renewable energy technologies, which have seen their stocks drop 30% over the past month. Alway’s keeping Buffett’s rule at heart, we prefer to not risk investors capital during periods of unprecedented market stress.

Our recommendations are not suitable for all investors but, our clientele have trusted us to make tactical decisions on their portfolios. Our major criteria for selecting investments is that companies must actually have the financial capacity to pay their dividends from free cash flow and not from debt.  Investors with long-term investment horizons could potentially gain from buying these energy companies at lower levels, but we would rather wait for a better entry point.  Against this backdrop of falling energy prices, low interest rates, a strong US dollar, low inflation, strong corporate earnings, and falling unemployment, there are just better areas to make investments.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

 

 

 

Keeping Score: A Secret to Retiring Comfortably

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Institutional Thinking for Individual Investors™

By Mitch Zides, CFA, CFP®, AIF®, NSSA® November 21, 2014

Over the course of my investment career, I have been fortunate enough to work alongside many of the smartest investors in the world. A few of these managers posted annual 20%+ returns over their entire careers and managed upwards of $30 billion. Intellectually, the best investors shared similar investment approaches and took long-term views. Textbooks have been written on unlocking the secrets of how these investors beat the market year-over-year.

The importance of keeping score

In this article, I would like to share with you important insights from the best investors that you can apply that will help make you more money and it has nothing do to with selecting investments.  What all the best investors have in common is that they keep score.  They all know exactly how their investment results materialized. These investors have set a bar and are trying to beat it on a daily basis. They understand the tremendous power of compounding and how exceeding this bar will make more money over time.

To illustrate the importance of benchmarking and compounding, the chart below shows the annual returns of a $100,000 investment over a 30-year period using incremental returns of 1%.

Growth of $100,000

 

 

 

 

 

 

Source: Constant Guidance Financial – This is a hypothetical example that is demonstrating a mathematical principle. It does not illustrate any investment products and does not show past or future results.

A 4% change in return from 6% to 10% can be the difference between you retiring comfortably or having to scale down your lifestyle in retirement. However, many of us are playing this game without ever looking at the scoreboard. Most investors are typically too busy to calculate these numbers or don’t know how to make sense of these numbers.

Selecting a Proper Benchmark

If you currently work with a broker, they might be calculating these numbers, but from my experience this is not the case. I have evaluated the investment statements from hundreds of these brokers and I have only seen a few who have set a benchmark for the portfolio that they manage. Each year you should receive a report card of your performance to evaluate whether your portfolio has generated the highest possible returns to meet your goals.  Brokers tend to focus on relationship building rather than investing because they just don’t know how or don’t have the tools to create a proper allocation1.  The advisors that I have seen that excel in creating portfolios tend to come from an investment background and recognize the importance of portfolio management. Others are not educated in asset allocation or do not have the knowledge to properly evaluate a portfolio.

As the chart above showed, each 1% increase of early return can be the difference in over $100,000 over the course of your life. The next step that you should take would be to a select the proper benchmark that will allow you to evaluate what went wrong or how you can improve the risk/return profile of your asset allocation. By no means should you ever fire an advisor who has underperformed the benchmark over a short time period.  Markets go in and out of favor and you really need to evaluate someone over a full market cycle. On the other hand, if your broker can’t produce these numbers or can’t thoroughly articulate their investment philosophy you might start thinking about making a change.

Learning from the Best

One of the most popular investment letters that comes out each year is Warren Buffett’s yearly letter to shareholders – http://www.berkshirehathaway.com/letters/letters.html. Each of his letters begins with a table that shows how he increased book-value per share versus the S&P 5002. With this statistic it is easy to see how much value he created during that year. At the other end of the spectrum, is an investor like Jim Cramer who on average recommends 5-10 new investments a night which total hundreds over the course of a year which make it virtually impossible to determine his investment results.

If you work with an advisor, you should ask them to determine your average yearly return and how that performance stacks up against a benchmark.  It is also important for them to select the correct benchmark. Similar to your fingerprint, everyone has a different risk profile and attitude towards their money. If your advisor can’t come up with these numbers, I would recommend working with someone who can calculate the risk/return versus a benchmark that is most suitable to you.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

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