Download - Wealth Destruction
Wealth ManagementAn Unbiased Approach to Managing Your Investments Designed for the Affluent Investor
Adam Harding, CFP® InstructorPhone: 480.306.8705
Email: [email protected]
Fax: 480.505.4034
Contact Information
Course Introduction
Six Weeks
Course Material: Online Slides, Discussion Boards, Email Correspondence
Wealth Management Process – Six StepsStep 1
• Understanding Investor Behavior and Setting Goals
Step 2
• Defining Asset Classes and Measuring Different Types of Risk
Step 3
• Understanding Asset Allocation, Diversification, and Volatility
Step 4
• Tax and Estate Planning Considerations
Step 5
• Selecting Investment Managers, Evaluating Advisors, and Preparing Heirs for the Responsibility of Wealth
Step 6
• Collaborating Knowledge and Implementation
Notes of CautionParticipants are strongly urged not to alter their investment structure based on the early classes.
Wealth Management does not provide specific investment or tax advice.
This course covers many subjects relating to investments and certain portions may not coincide with the participant’s perception or experience. Participants are urged to ask questions at any time.
Participants may have questions about subjects not covered in the course material. Instructors are available during breaks and after class to answer questions.
Beta
Academics
Investment SeminarsMutual Fund Companies
NASDAQ
Brokerage Firms
College Costs
AlphaPerformance Reports
Standard Deviation
Correlation
CPAsInvestment Advisors
Books
Real Estate
Diversification
Print Media
Attorneys
Insurance
Pension
Defined Benefit
TelevisionRisk
Relatives
Retirement
S & P 500
CNBC
Discount Brokers
Mortgage Brokers
Money Managers
Liquidity
Internet
Bankers
Friends
Neighbors
Line of Credit
Confusion
?
Example: Calling the bottom is impossible
Boston Globe, Aug 12, 2000 – “…at these undervalued prices…we’re not selling any stock at these prices”. (on Monday, Aug 14, the S&P 500 closed at 1491. Four years later on Aug 12, 2004, the S&P fell a further 29% to close at 1063.)
Wired Magazine, Dec 4 2000 – “Fred Siegel, president of investment management firm Siegel Group, believes that it is unlikely that the Nasdaq will drop more than another 200 points.” (The Nasdaq fell over 1,000 points shortly after Siegel made his prediction.)
Market guru and former hedge fund manager Jim Cramer TheStreet.com said it best in Jan 2001: “I get paid to call bottoms. I don’t see one yet, but in my 18 years of trading I’ve never called one exactly right yet. I don’t see why this time will be any different.”
Wealth Management is More than Investing…
Source: DCA: It Gets You In At the Bottom, Cory JanssenDCA does not assure a profit and does not protect against loss in declining markets.
Cycle of Human Emotions
Point of maximum financial opportunity
Optimism
Excitement
Thrill
EuphoriaAnxiety
Denial
Fear
Desperation
Panic
Capitulation
Despondency Depression
Hope
Relief
Optimism
Point of maximum financial risk
“Wow, I feel great about this
investment.”
“Maybe the markets just aren’t for me.”
“Temporary setback. I’m a long-term investor.”
Source: Westcore Funds/Denver Investment Advisers LLC, 1998
Black Swan Event
We rarely see Black Swans coming, but when they do arrive, they shape our world profoundly.
- World Wars I & II - September 11, 2001 - The Rise of the Internet - The Great Recession
Sourec: http://online.wsj.com/article/SB10001424127887324735104578120953311383448.html
An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict.
The “Guess Right Ratio”
This Chart shows fund inflows and outflows to determine how often investors correctly time the market. Investors make money when the ratio exceeds 50%.
How have institutional portfolios compared to retail portfolios?
*Barclays Aggregate Bond Index“2011 Quantitative Analysis of Investor Behavior” from Dalbar, Inc. 2012
The Institutional Process
S&P
Averag
e Equity
Inve
stor
Averag
e Fixe
d Inco
me Inve
stor
Fixed
Inco
me Ben
chmark
*
Minimum
Mean
Median
Maxim
um
7.81%
3.49%0.95%
6.5%
-4.6%
7.9% 8.0%
41.0%
“Institutional”“Retail”
Many retail investors do not use a disciplined approach.
Result
Investor Behavior tends to be the cause of underperformance
Source: Bemanaged.com
The Institutional Process
Behavioral FinanceWhat is it?
– It is the “study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets.”
Why is it important?– It helps explain “why and how markets might be
inefficient.”
Psychological forces motivating the people and institutions that move the stock market daily, weekly and so on.
Traditional vs. Behavioral Finance
Traditional Finance Humans react rationally in the marketplaceDecisions based in fact and exclusive of sentimentDoes not explain the anomaliesBehavioral FinanceBorrows from Cognitive PsychologyExplains those events that are unexplainable by rational means
Behavioral Finance is not an arm of Traditional Finance, it’s a replacement.
Behavioral Finance implies that when greed prevails, markets tend to overshoot their true values, and when fear prevails, markets tend to undershoot their true values.
Tulip Mania• Tulip mania – a period in the Dutch Golden Age
during which contract prices for bulbs of tulips reached extraordinarily high levels
• At the peak, in February 1637, tulip contracts sold for more than 10 times the annual income of a skilled craftsman.
• Some bulbs were traded for as much as 2400 lbs of wheat, or 2 tons of butter.
Tulip Mania is generally considered the first recorded speculative bubble.
Signs of Modern Day Tulip Mania
Biases and Investments• We are biased.• Types:
• Overconfidence• Escalation Bias• Mental Accounting• Anchoring• Confirmation & Hindsight Bias• Regression to the Mean• Herd Behavior• Gambler’s Fallacy• Prospect Theory
Biases lead to misevaluations
Escalation Bias
• Overconfidence can lead to escalation bias• Hedge-funds that took leveraged bets against dot-
com companies in the late 90s• Long-Term Capital Management Hedge Fund
“The market can stay irrational longer than you can stay solvent. “ – John Maynard Keynes
Anchoring
• During normal decision making, individuals anchor, or overly rely, on specific information or a specific value and then adjust to that value to account for other elements of the circumstance.
• Usually once the anchor is set, there is a bias toward that value.
• EG- the status quo for the price of an engagement ring is supposedly 2 months salary. This figure is irrelevant and placed into society by profit maximizing jewelry companies; yet many men compare what they earn in 2 months to the amount they should spend.
The Fiduciary Process
Needs and Goals
Example
In 1953, a study of Yale students was conducted.
3% had written goals and 97% did not.
In the 1973 follow-up, the 3% who had goals had accomplished more than the 97% who had not.
Putting together a plan and setting attainable goals is important to achieve success. Writing out a plan and setting goals forces individuals to think about potential hurdles and how to get past those hurdles.
Performance Goals
• Specific
• Measurable
• Action Oriented
• Realistic
• Time Specific
Goals must be specific, measurable, action oriented, realistic, and time specific. For example, simply setting a goal that you want to 20lbs by the end of the year has little value unless you plan actions that will help you reach that goal.
Financial Life Cycle
Trends In Retirement People are living longer and spending more time in retirement
2012 2025 2050
Men
25
20
15
10
5
0
TIM
E IN
YEA
RS
LIFE EXPECTANCY AFTER AGE 65
10
16
13
19
16
22
Women
Lifestyle InflationLifestyle inflation is the phenomena of expenses actually increasing during retirement. It is not due to inflation or taxation, but to the increase in leisurely pastimes; golf, travel, dining out, attending performances, etc.
How will your retirement spending change?
TRAVEL
66%
DINING OUT
37%
GIFTS
33%
Monetary Needs: Maslow Meets Retirement
IMCA
Dream
Gift
Freedom
Security
Survival
Dream
Gift
Freedom
Security
Survival
Things to own, places to go, goals to accomplish
Charities, church, children, special interests
Hobbies, travel, personal growth, and education
Housing, Food, Clothing, Transportation
Health issues, aging parents, emergency repairs
$
$
$
$
$
Monetary Needs: Maslow Meets Retirement
Total $IMCA
Dream
Gift
Freedom
Security
Survival
Things to own, places to go, goals to accomplish
Charities, church, children, special interests
Hobbies, travel, personal growth, and education
Housing, Food, Clothing, Transportation
Health issues, aging parents, emergency repairs
$
$
$
$
$
Monetary Needs: Maslow Meets Retirement
Total $
1,000/mo
1,500
2,000
2,500
3,000
10,000/monthIMCA
Reaching Your Goals
Financial independence is when you can maintain your desired lifestyle for the remainder of your life
without the worry of money.
LIFESPAN
INCO
ME
PRO
DU
CTIO
N C
APAC
ITY
DESIRED LIFESTYLEFINANCIAL INDEPENDENCE
FINANCIAL DEPENDENCE
Learn To Ask The Question:
“How can I build multiple,
sustainable income streams?”
Bonds (Fixed Income)
Bond Basics
What is a bond?
• A bond, quite simply, is an instrument of debt. I’m sure you are all quite familiar with the general features of bonds, but I‘ll do my best to be thorough so that you feel more comfortable with them as we go forward.
Bond Basics
What is the difference between a stock and a bond?
• Owners of bonds have often have some kind of underlying collateral that secures their interest. Example: if a company goes bankrupt, after selling it’s assets it will pay bondholders and creditors before paying stockholders.
Bond Basics
Who issues bonds?
National Governments
Government Agencies
Supranational Agencies
States and Municipalities
Corporations
Asset Securitization
Bond Basics
Source: Dimensional Fund Advisors
Key Risks of Bond Investing• Interest Rate Risk
–Reinvestment Risk
– Inflation Risk
–Yield Curve Risk
• Credit Risk
• Liquidity Risk
• Currency Risk
Key Risks of Bond Investing
InterestRates
BondPrices
% $
Interest Rate Risk– Reinvestment Risk
Reinvestment Risk – The risk related to what the interest rate will be when income and/or principal from investments is reinvested. If interest rates fall, the investors will be worse off when reinvestment occurs. If they rise, they will be better off.
Two Factors have an effect on the degree of reinvestment rate risk:
Maturity of the Bond – The longer the maturity, the higher likelihood that interest rates will be lower than they were at the time of the bond purchase.
Interest Rate of the Bond – The higher the interest rate, the bigger the coupon payments that have to be reinvested, and consequently, the bigger the reinvestment rate risk.
Interest Rates – Last 30 Years
Source: https://www.google.com/url?sa=i&rct=j&q=&esrc=s&source=images&cd=&cad=rja&docid=3Q5TY1WELBT2_M&tbnid=6gsn2z4I1P4mJM:&ved=0CAMQjhw&url=http%3A%2F%2Ffinance.fortune.cnn.com%2F2012%2F11%2F28%2Fhigh-yield-debt%2F&ei=-e1BUqW3L6aRiAKt9oBw&bvm=bv.53077864,d.cGE&psig=AFQjCNEcybrE27qZ5C_vgVKmTXzn1z5Vgw&ust=1380138855843339
Key Risks of Bond InvestingInterest Rate Risk
– Inflation Risk
Cash flows from future investments won’t be worth as much in the future in real terms.
Nominal & Real Income from Bond in Year 1 = $1,000
Yearly Inflation = 3%
Nominal Income in Year 2 = $1,000
Real Income in Year 2 = $970
Real Income in Year 10 = $744.09
Key Risks of Bond InvestingInterest Rate Risk
– Yield Curve RiskShifting yield curves cause the price of a bond to change.
Interest rates cause the yield curve to shift.
When the yield curve shifts, the price of the bond, which was initially priced based on the initial yield curve, will change in price. If the yield curve flattens, then the yield spread between long- and short-term interest rates narrows, and the price of the bond will change accordingly. If the bond is a short-term bond maturing in three years and the three-year yield decreases, the price of this bond will increase.
If the yield curve steepens, this means that the spread between long- and short-term interest rates increases. Therefore, long-term bond prices will decrease relative to short-term bonds. Changes in the yield curve are based on bond risk premiums and expectations of future interest rates.
Key Risks of Bond InvestingS&P/Fitch Description
AAA Extremely High QualityAA+AAAA-A+AA-
BBB+BBB BBB-BB+BBBB-B+BB-
CCC+CCC CCC-CCCD Default
Very High Quality
Speculative
Very Speculative/Near Default
High Quality
Credit Risk
Higher perceived risk means that the lender will demand
a higher rate of interest for their capital.
InvestmentGrade
SpeculativeGrade
(“Junk”)
Key Risks of Bond InvestingLiquidity Risk
The ability to easily sell your bonds. The market for bonds is typically “thinner” than the market for stocks; meaning that there are fewer
buyers and sellers.
US Treasuries, historically, have had no liquidity risk. Small market bonds, “callable” bonds, and small face value bonds tend to have higher liquidity risk.
Key Risks of Bond InvestingCurrency Risk
Money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original
currency.
Fixed Income TypeAverage Annualized
Return
Lowest Annual 12 Month Rolling
Return
Highest Annual 12 Month Rolling
Return
Standard Deviation
Ending Value of $10,000
Investment
Treasury Bills 1.90% 0.10% 5.50% 0.39% 12,075.00$
Intermediate Treasury Bonds 4.09% -1.40% 12.00% 3.50% 14,932.00$
Long Treasury Notes 7.64% -12.90% 32.70% 13.50% 20,897.00$
Government Agency Bonds 4.24% -1.60% 10.20% 2.90% 15,147.00$
Treasury Inflation Protected Securities (TIPS) 6.65% -7.50% 19.50% 7.30% 19,042.00$
Mortgage Backed Securities 4.13% -0.10% 10.60% 2.30% 14,997.00$
Asset Backed Securities 5.45% -16.80% 26.30% 8.10% 17,003.00$
Municipal Bonds 5.10% -3.60% 14.80% 5.40% 16,448.00$
Investment Grade Corporate Bonds 8.10% -22.50% 46.60% 12.80% 21,796.00$
High Yield Corporate Bonds 10.61% -31.20% 64.90% 10.61% 27,434.00$
Foreign Bonds 8.03% -9.80% 23.70% 9.40% 21,661.00$
Preferred Stock 4.70% -59.73% 124.00% 23.70% 15,834.00$
Convertible Bonds 7.24% -33.20% 46.20% 14.30% 20,124.00$
Investment ComparisonCharacteristics and Returns – 1/31/2003 to 12/31/2012
Source: Morningstar Advisor Workstation, Hypothetical Illustration. Past performance not indicative of future results.
Suitability
Four general uses for bonds
• Capital preservation
• Equity hedge
• Income generation
• Total return
Short maturity Treasuries High quality short
maturity municipals
Suitability
Long maturity Treasuries High quality long
maturity municipals
Four General Uses for Bonds
• Capital Preservation
• Equity Hedge
• Income Generation
• Total Return
Suitability
May require taking on credit risk
Achieve yield target while minimizing risk of loss
Four General Uses for Bonds
• Capital Preservation
• Equity Hedge
• Income Generation
• Total Return
Suitability
Combine sectors with low correlation
Overweight cheap sectors, avoid rich sectors
Four General Uses for Bonds
• Capital Preservation
• Equity Hedge
• Income Generation
• Total Return
Equities
Principal Features of Stocks
• Limited Liability
• Liquidation Rights
• Voting Rights
• Potential for Dividends
• Potential Appreciation
Major Equity Indices• S&P 500 – Market-weighted index of 500 actively traded large cap US companies
• Dow Jones Composite – Price-weighted average of 30 significant US stocks
• NASDAQ Composite – An index of the stocks traded on the NASDAQ stock exchange
• Russell 3000 – An index that measures the performance of the largest 3000 US stocks
• Russell 1000 – An index that measures the performance of the largest 1000 US stocks.
• Russell 2000 – An index that measures the smallest 2000 stocks of the largest 3000 US stocks.
• MSCI EAFE – An index that measures equity performance outside of the US and Canada.
• Dow Jones US Real Estate– This index measures the performance of US REITs.
Stock Classification
Domestic / International
LargeCap / MidCap / SmallCap / MicroCap / NanoCap
Core (Blend) / Value / Growth
Stock Classification
• Domestic Stocks—issued by a corporation or company headquartered in the United States
• International Stocks—issued by a corporation or company headquartered outside of the United States
Stock Classification• Large Cap Stocks ($10 billion and above)
• Mid Cap Stocks ($2 billion - $10 billion)
• Small Cap Stocks ($300 million - $2 billion)
• Micro Cap Stocks ($50 million – $300 million)
• Nano Cap Stocks (Less than $50 million)
Market Capitalization is the number of shares outstanding times the stock price. In other words, the current market value of the company
Stock Classification
• Growth—companies with higher price-to-book ratios and higher forecasted growth values. In general, earnings chase price
• Value—Companies with lower price-to-book ratios and lower forecasted growth values. In general, price chases earnings.
• Core – When neither Value nor Core is dominant. When referring to equity mutual funds, this is often referred to as “Blend”.
The Power of Compounding
Source: seekingalpha
Dividend Reinvestment is the heart of compounding. You can see on this chart how the effects of investing none, half, or 100% of dividends can have a significant steepening-effect to your income curve. However, reinvesting dividends can end up leading to significant concentration-risk; meaning that your portfolio may be over-exposed to one particular security.
The Power of CompoundingS&P 500 Historical Return
Source: Hays Advisory
Market Cycles and Crisis Events
The following slide shows major events over the last several decades. You can see the effect of these events and how the market has rebounded.
A Chronicle of CrisesS&P 500 Historical Return
Source: Dalbar, Inc. Quantitative Analysis of Investor Behavior
Great Depression
Tech Wreck
Suez Canal Crisis
Black Monday
Nixon Resignation
Great Recession
S&P 500 Cycles Since 1928
Stock ValuationS&P 500 Historical P/E10 Ratio
P/E1
0 Ra
tio
Source: www.multipl.com
Mean: 16.49 Median: 15.89 Min: 4.78 (Dec 1920) Max: 44.20 (Dec 1999)
Stock ValuationS&P 500 Historical Dividend Yield
Yiel
d %
Mean: 4.43% Median: 4.37% Min: 1.11% (Aug 2000) Max: 13.84 (June 1932)
Source: www.multipl.com
Stock ValuationS&P 500 Real Price
Pric
e
Source: www.multipl.com
Annual Stock Market Returns 1926 through 2011
Source: Source: cbsnew.com
Annual Stock Market Returns
Source: Source: Siegel, Jeremy, Stocks for the Long Run (2007). Update 2012
January 1802 – June 2012 Real Returns
Long-Term 1802-2012 6.6%
Major Sub-Periods
I 1802-1870 6.7%
II 1871-1925 6.6%
III 1926-2012 6.4%
Post-War Periods
1946-2012 6.4%
1946-1965 10.0%
1966-1981 -0.4%
1982-1999 13.6%
2000-2012 -0.1%
Annualized Returns From 1/1926 to 12/2011Re
turn
%
Source: Ibbotson and Asociates
Historical Asset Class Returns
US Inflati
on
US 30-D
ay Treasu
ry Bills
US Long T
erm Gove
rnment B
onds
S&P 500
US Small
Cap St
ocks
2.99% 3.59%5.72%
9.77%11.88%