Understand risk behind the wheel of a racecar

It took me quite some time in my professional career to grow comfortable and confident speaking with clients about risk and risk tolerance. Mostly because “risk” is very poorly defined by most financial professionals, I can understand how this comes to be.  You are the new guy/gal at a venerable firm with many hard-working, intelligent, successful colleagues, and you are looking to avoid asking elementary or profoundly philosophical questions, ie, you don’t want to be the new weirdo in the office. Risk tolerance is supposedly both how you feel now and your feelings about hypothetical situations, which has always made me suspicious.

I’ve grown to understand the problem is that both professional and amateur may not fully understand what they mean by risk. I’ve made the cardinal sin of saying risk is volatility to sound smart, not fully grasping that is a profoundly dumb and half-baked way to talk about risk.  First, nobody in the normal world talks like that, saying risk equals volatility.  Second, it is more likely that that person is trying to say something smart and noble, but it can be counterproductive and/or mildly offensive if you are speaking over the head of your intended audience.  Through this thought experiment, I’ve come to borrow my new definition of risk from others.  Risk should be understood as something turning out other than you had planned.  

As a simple example, I’m sure the purchasers of Ark Innovation ETF in February 2021 did not plan to watch their capital incinerate over the following twelve months.  This tongue-in-cheek example highlights the point that risk, by definition, must be an unknown.  As an aside, I’d like to totally ban the term “upside risk” from conversations with regular investors about their investment portfolios. This term is too often used by professional investors trying to in vain to predict the future. 

Many in the financial planning business build a risk tolerance questionnaire as part of initial relationship start-up. I must underline before I proceed further, that I am not against the questionnaire, my contention is with the presentation of risk. A risk tolerance questionnaire will generally use a series of questions about hypothetical scenarios to judge how you feel and would react to the riskiness of investments. Absent from these usually well-intentioned questions is a true emotional response that comes with markets “turning out other than you planned.”  Generally if the stock market is down 20-30-50%, other things are going badly in the world outside of the stock market.  

Consider the onset of Covid-19 in March of 2020.  The market had violent downside moves coinciding with incredibly anxiety-filled macro events. There was nothing wrong with a person who filled out a questionnaire stating they were “aggressive” considering selling and not increasing their investment holdings as they claimed they would when filling out the questionnaire. In fact, they are simply human beings who act rationally.  From a narrow market perspective, we can all discuss those rough weeks we went through in March in sanguine terms now, but to not understand how close we were to the precipices would be ignorant at best. I shudder to think of what would have happened without the Fed increasing its purchases of treasury bonds from a set number to unlimited. 

A more practical way to look at risk

I might brag that I would really enjoy driving a 1989 Ferrari F40 at full speed around a race track, but sadly this would be a lie.  During the only track day I have participated in, putting the accelerator down to the floor was not the issue as much as bravery on the brake pedal.  To improve your lap time, you must achieve the highest average speed possible around the track (no $&(%!).  To do this, you both need to go fast AND brake as late and smoothly as possible to hustle the car around corners in the most efficient way possible.  I found it easy to claim, I wasn’t driving a Ferrari by the way, that I would brake late and be solely focused on the racing line. The first time the car truly warmed up and the brake pedal traveled further than I expected before engaging the hot, ironically grippier, brakes I was no longer that brave.  I was especially considerate as one of the hardest braking zones of the track had you face-to-face with oncoming guardrails.  As a father of two, I was looking to win no awards for bravery at that turn.  My lap performance improved when I was able to get feedback from a more seasoned driver in the passenger seat.  The advice was that “smooth is fast and fast is smooth” as I was very jerky on both the accelerator and brake pedal.  My lap times improved with this feedback, more laps behind the wheel, and a greater understanding of the limits of the car I was driving.

I use a racing analogy for two reasons; first, I love talking about cars and racing.  Second, and more importantly, a colorful analogy helps hammer home more esoteric ideas. We can all imagine our financial plans as a race we need to win.  We all have different races and cars to drive in this race analogy.  We could all benefit from expert advice and feedback as to where we need to be more judicious on the brakes and, at times, hit the gas harder. Saying what we would do behind the wheel versus actually doing it can help the mind begin to plan but could serve little purpose when careening towards a guardrail, trusting the middle pedal.  Mike Tyson is quoted as saying, “Everyone has plans until they get punched in the mouth”.  

A good financial professional should help you understand what lap times you need to hit your goals (your financial plan).  What vehicle and features are best for your race (your portfolio of investments).  How and when should you speed up or slow down (the risks you need to take). And whether you should even drive or be the passenger (discretionary versus non-discretionary).  Risk in this scenario is not the consistency of one lap to another (remember the term volatility); risk is more likely when you press down on the brake pedal, and something unexpected happens. This is the risk I believe most of my clients are focused on and not some stuffy saying like “downside volatility.” I’ll end with one of my favorite quotes about going fast that could also be translated to market wipeouts.  “Speed has rarely ever killed someone. Coming to a sudden, unexpected stop is what has done most folks in.”  

Why did I take you on this roundabout journey (no pun intended) to discuss risk? In the spirit of continuous improvement on my craft and process, clearly communicating new-found thinking on a topic ensures a greater ability to understand and implement improvements fully. I am working to ban myself and those I can influence from using the interchanging words volatility and risk. Further, a core belief I hold when making investment decisions is that simple is always better; thus, we can simplify a conversation around risk and use risk to our advantage. Finally, I have a passion for my craft of investment management and believe it has many crossovers in life.  For example, I have noticed my ability to become more patient with investment decisions since becoming a father. I am sure all the parents reading this can understand this lesson without saying more. 

In the coming months, I will lead the firm's efforts to build a formalized investment management program. This entails the construction of portfolios for other advisors at our growing firm, many of whom do not enjoy and would prefer the expertise of a more seasoned investment professional constructing the portfolio.  In this capacity, I will also assume the title of Chief Investment Officer of Fiduciary Financial Advisors. While I would be the first person to admit that title inflation often occurs in the financial industry, I am taking this role extraordinarily seriously.  I do not foresee any changes to working with my existing clients, but will become very selective about the new clients I take into my practice. That said, I feel emboldened that I can work to serve more individuals and families via money management done the right, fiduciary way.  

“I write so that I can think” is a quote attributed to John Adams that I fully understand. Risk and return are to each other what light is to dark.  Simplifying an understanding of risk to manage it better can only benefit our investment return potential. 

I appreciate your time reading my views on this topic and hope they are thought-provoking. As always, I am happy to hear from you with any questions, comments, or just to say hello.  

Be well and invest for the long run, 

rob

Robert A Barcelona

Senior Financial Advisor

Fiduciary Financial Advisors

President HB Wealth Management, LLC

A few thoughts around dealing with market FOMO

The following is a note from “Hindsight Wealth Management”:

In our latest call we urge clients to go back in time to the start of the year, assemble a three-asset portfolio of Nvidia, Tesla, and Meta, to enjoy over 100% gains to start the year.  This is not dis-similar to our call in December of 2022 to have gone back in time and shorted the Nasdaq 100 at the beginning of that year. (If only jokes like this were true!)

Back to reality…

As of this writing, the Nasdaq 100 has risen nearly 40% to start the year.  While this sounds impressive, the index is yet to re-touch its early 2021 high, although it is not far off.  Two extreme thoughts prevail when viewed in hindsight; “I knew this would happen!” and “How did I not see this opportunity?”.   Most of us would find ourselves somewhere in between these two extremes, gravitating towards one end or the other based on actions we took in the past.  But, without having any idea of the future how can we assess the driving forces of the actions we took in the past?  Were they luck, skill, or an amalgam of both?

Through training and experiences (usually painfully stupid decision of a younger self!) my focus on viewing these types of events has moved from outcome to process.  What does this fully mean?  It is more insightful to focus energy, especially if you have FOMO (Fear of Missing Out), around what your decision-making process was in the past and if you could have reasonably achieved a desired outcome in the present.  As an example, if you didn’t win the lottery today because you didn’t buy a ticket yesterday, then you must consider changing your process going forward to purchasing a lottery ticket.  Obviously, this does not guarantee you will be a winner, but it will move you much closer to that outcome than your previous process provided. 

What does this mean for successful investing and how do we incorporate this thinking when building our portfolios?  Generally, you must find a way to own asset classes that have a high probability of outstanding outcomes.  Back in 2022, it was really ugly and sucky to own the Nasdaq 100.  I looked really dumb to a lot of clients especially those whom I had a very short track record of managing their money. However, come 2023, this holding or marginal buying looks brilliant in hindsight. Strangely, when you have adopted this mindset, you begin to view dramatic moves in the market less with FOMO and more with astonishment. 

A keen observer might note that I have just wasted a whole lot of time and energy explaining a “buy and hold” strategy.  True, but I see two counterpoints as to why it’s a bit more complicated. First, how did that do in 1965-1982?  My guess is that a purist advisor advocating a purely buy-hold strategy would have found themselves without many clients sticking with them through that malaise.  Second, buy and hold is extraordinarily challenging mostly because of societal influence, luck, and our natural desire to avoid pain.  Buy and hold, while difficult, is easier as an advisor because many of the influences above stated have a less potent effect when you are making fiduciary decisions over someone else’s money.  But that isn’t enough to declare victory, enter tactical rebalancing. 

“Buy low, sell high” are the most important words in the investment world.  Easier said than done, especially over long periods of time, but made more doable with a tactical rebalancing approach.  Consider a portfolio with two assets divided equally: the S&P 500 and a 10-year treasury bond. One would assume that, over a 10-year period, the treasury would receive its stated interest rate return compounded with the S&P 500 delivering an uncertain return. We would assume, as has been true a majority of years in market history, that the S&P 500 would outperform over the 10-year period while having a much wider swings in value.  Assuming these conditions, could your return be enhanced? 

Of course, in several ways.  First, you could know the absolute low or high in each of these assets and do the “buy low, sell high” thing with ease.  For the rest of us non-oracles, you could sell some of the S&P 500 if it rises above the 10-year treasury.  Great, easy to do except for the critical variables of how much and when?  Daily, monthly, yearly?  Imagine you choose yearly, the S&P outperforms the 10-year by 5%; however, during the year the performance difference drifted to 25% at one point.  Yes, more than likely you will be better off with the annual rebalance but try to convince me that you won’t feel like you missed out, see above. The solution becomes a tactical approach based on market conditions not on calendar periods.

What is the best way to implement this strategy?  I have found it to be more art than science. A ratchetted approach makes logical sense but the belief that you can follow some standard deviation or correlation should be approached with caution.  While these numbers seem like logical anchors, they require assumptions that can make them no better than a guess. This is where, I’m biased but probably correct, an experienced money manager can make the decisive choice. The more important point is consistently employing this strategy through all market conditions (you probably want more than a two-asset portfolio!). 

If you want to remove all FOMO from investing, build a time machine. Another more accessible strategy would be to work with an advisor that employs them.  Process always trumps luck in the long-run.  Regardless of outcome, investment success comes from a continuous refinement of process and leaves no room for FOMO. 

As always, reach out with questions, commentary, or just to say hello!

Robert A Barcelona

Senior Financial Advisor

Fiduciary Financial Advisors

President HB Wealth Management, LLC

A second bite at the apple

A second bite at the apple -Originally written January 8th, 2023
 

"I know now, after fifty years, that the finding/losing, forgetting/remembering, leaving/returning, never stops. The whole of life is about another chance, and while we are alive, till the very end, there is always another chance."

-Jeanette Winterson

 
2022 In numbers
 
During the past year we experienced violent tumult in financial markets not seen since the financial crisis of 2008-09.  Here are a few of the most important markets and indicators that impacted clients.
 
Bonds:  The iShares Core U.S. Aggregate Bond ETF: AGG faced a price decline of -14.38% in 2022 which was eclipsed in downside magnitude by the Vanguard Long-Term Bond Index Fund ETF: BLV with its -28.37% decline. I believe that the indices these funds represent have an unparalleled influence on all other risk assets.  Given these historic declines, the interesting change entering 2023 will be the four-plus and nearly five percent yield of each fund respectively. 
 
Money now having a price above zero, editorializing, will have continued impact on all global financial markets.  Does this price of money increase or decrease will be one of the most important catalysts for the general stock market to answer in the year ahead. 

All data sourced from Schwab Advisor Center, Research.  Charles Schwab and Co., Inc.

 
Inflation: According to the BLS survey data, November 2022 being the last reading as of this writing, inflation ended the year at a 7.1% YoY increase.  While 0.3% higher than the November 2021 reading, this reading represents a 2% decline from CPI’s zenith in June of 2022 at 9.1%.  Furthermore, if you were to annualize the last three months average inflation, you would find the current rate of inflation is annualizing at 3.6%.  
 
The Fed erred in calling inflation “transitory”.  While the word implies short-term that “short-term” isn’t defined to delineate three months from three years.  Close watchers of the sources of inflation could make the argument that certain drivers of inflation have been transitory; however, the drivers of inflation have moved from goods to services keeping overall numbers high.  The continued decline or stagnation of inflation will be another factor driving risk markets in the year ahead as it looks like inflation could cool rapidly.  
All data sourced from CPI Home : U.S. Bureau of Labor Statistics (bls.gov)
 
Equity markets: The S&P 500 suffered it’s fourth worst calendar performance since the 1957 inception of the index at -19.4% with the Nasdaq declining a painful -33.1%.  Stocks did not suffer equally as equites in the Vanguard High Dividend Yield Index ETF: VYM decline only   -3.48% which was nearly mitigated by it’s almost three percent dividend yield.  Emerging markets fell just around -29% depending on the index you choose. 
 
A rebound or lack thereof within the equity markets will dominate the coming year.  According to Twain “Prediction is difficult particularly when it involves the future” thus you will not find me gazing into my crystal ball to make predictions.  An important point to remember is that bear markets can and have persisted for more than one calendar year.  Diversification in asset class and equity type can help mitigate this potential continued bear market. This could be the year that international markets finally outperform given their previous streak of multi-year under performance.  

  
 
“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them.”

-Warren Buffett
 

The most interesting story in risk assets
 
Since I started investing in 2007-08 until the beginning of 2022 interest rates have generally moved in one direction, down.  In 2022 the long-term downward trend in rates, which you could easily argue began in the early 80’s, reversed its course.  The Fed raised rates at each meeting in 2022 including several, aggressive 0.75% rate increases later in the year.  This decisive rate-raising regime led to carnage in the bond market especially on the long-end of the yield curve (see BLV above!).  I especially like the Austrian 100-year bond offering maturing in 2117 that lost roughly 54% of its value in 2022. But, where there is carnage so is there opportunity… 
 
While my favorite ETF for long-term bonds, BLV, declined nearly 30% in 2022, it bottomed in late October and has since rallying nearly 9%.  In fact, not to be pedantic, BLV rallied nearly 17% off the lows of October into early December before retreating to end the year; thus, giving us a second bite at the apple. 
 
This rally was powered by the expectation, still yet to be fulfilled, that the Fed will end its tightening spree.  Perhaps, and a theory I find most plausible, entails the anticipation that Fed over tightening leads to a Fed induced slowdown.  The slowdown then is the tail that wags the dog by forcing the Fed to lower rates in response to recessionary pressures. In this scenario you would not expect downside price pressure on long-term bonds. The question becomes, can long-bonds rally higher in 2023? 
 
What makes long-term bonds (municipal, investment grade corporates, and treasuries, excluding high yield) most interesting is the balance of the risks in differing scenarios.  Let’s examine three of the many such scenarios that could unfold.
 
First, if the economy experiences a “soft landing”, that is no recession with an end to Fed rate raises, the price of long-bonds will be difficult to anticipate.  I would very much doubt the bonds fall in price as in this scenario, the Fed would have “vanquished” inflation which, quite clearly, is their stated goal.  More than likely this would leave us with the current yield of these bonds intact. This representing a relatively decent, diversifying return for the average portfolio at higher yields not seen in many years.  
 
Two other scenarios result in yield of these securities plus a duration trade.  That “duration trade” is the increase in price of these bonds because interest rates decline which adds to an already generous yield.  These two scenarios involve either inflation refusing to subdue easily thus forcing the Fed to continue tightening the economy into a recession or a recession that has already taken root due to the lag in the already steep interest rate increases. 
 
In either scenario we could assume that the long bonds would give the opportunity, while not guarantee, to outperform stocks that might struggle during recessionary pressure or continued inflation. While unknown, this seems most likely as investors would seek to move up the capital structure in times of recession. Moving up the capital structure means increasing the likelihood of recovering your investments if the company you invested in experienced insolvency.  Often this simply means becoming a bond holder versus equity holder especially in a year that equities may struggle. The overriding point is that return may be possible outside of the equity market given our current conditions.  
 
This circles all the way back to the earlier point that bear markets can exist for multiple years and require outside the box thinking to overcome.  Utilizing differing asset classes and imagining a multitude of outcomes while pursuing the highest probability opportunities remains our stance at Fiduciary Financial Advisors especially, when you have previewed the upside scenario. Never hesitate to take that second bite at the apple!
 
As always reach out with questions, commentary, or just to say hello!
 
Be well and invest for the long-term,
rob
 
Disclosure: The opinions expressed above are my own and do not constitute investment advice.  When investing in securities, there is always a potential for loss including principal loss. 

A Few Logical Questions During a Time of Malaise

A few logical questions during a time of malaise

Bear markets are defined as a 20% decline from a high-water mark in a security or index. I believe that a bear market is better defined by feelings of pessimism and fear. I would sum these feelings up with one word: malaise. By the ladder definition we have been feeling malaise since roughly February in financial markets. This feeling begs a few natural questions that I will offer opinion around.

• When does the malaise end?

Many will guess and some will get lucky, appearing to be seers of future events (you can always test their accuracy by asking for past predictive accuracy). The point remains that no serious market participant knows for certain when this will end. We could be days, weeks, or months away from this point. I believe the key variable to break this market pessimism is the Fed (Federal Reserve). It won’t occur the day the Fed says or signals that they are done raising rates, the turn will occur before that in anticipation of said occurrence. Keep in mind, I believe the Fed is the key variable but not the only variable. There are a litany of additional variables that could change the market’s course thus making clean predictions around the course of a future market a risky endeavor. We will entirely avoid said endeavor.

• What will it look like when the market turns?

Again, no serious market participant knows. We could have a rapid move higher if the Fed is able to pivot from increasing rates to holding or cutting rates while peace pervades in Ukraine and the US/world avoids damaging recessions. Consequently, we had a dry run of what the market would look like if there was a swift recovery. From a low on June 16th, we watch the S&P 500 rally back north of 17% in roughly a two-month period. This could be called a “V” shaped recovery given the shape created on a graph of a quick drop and quick recovery. This is one probable outcome while another, readers of my early piece “Fear of Flatness” know this outcome, is a choppy, directionless market. This outcome could already be showing as the afore mentioned rally has largely dissipated (as of this 9/22/22 writing) to leave us sitting near the mid-June lows. We must prepare for different potential recoveries from the lows in the market.

• What should be done in these markets?

An absence of action can constitute a purposeful choice. Simply put, making huge changes in volatile times can often substitute short-term relief for slow, long-term pain. Not making moves is a decision in and of itself.

Having the confidence to believe we or anyone we follow can confidently call the bottom and subsequent invest accordingly is not the course we choose. Helping our clients maintain the best asset allocation for their given situation based on financial planning and the ability to absorb various market outcomes is the chosen path. There is a saying that “you are rewarded for time in the market not timing the market”.

We favor small, incremental changes based on high probability outcomes. For example, increasing portfolio exposure last year and the beginning of this year to dividend paying stocks can help ride through a down or choppy market because of the organic portfolio cash-flow created by these dividends. The investment saying here is “a bird in the hand is worth two in the bush”. In times of stress, you want to know what you are holding not what you are fantasying about holding.

• Fine, I understand all of this, but is there any silver lining?

Yes, yes, a thousand times yes. Money now has a cost and that is, very probably, good for long-term economic health. Simply, if you or a company borrows funds to fuel a purchase or capital project, the project must now produce larger or more certain returns than it would have a year prior. This leads the market to cull weak capital investment ideas in favor of strong, sustainable projects.

Furthermore, savers are now rewarded exponentially more on a nominal basis than they were just twelve months ago. For example, if you had bought a 1-year treasury bond last September it would have yielded under 0.10%. Today a new 1-year treasury yields over 4.00% (as of 9/22/22). Over a 40x increase in yield. While this punishes borrowers and slows economic activity in the short-run, we are of the opinion that a more balanced cost of borrowing/reward for savings can act as a catalyst for the next, multi-year economic and equity market expansion.

To enjoy the wealth creating benefits of our free-market, capitalist system we must have periods of reset where weak, over leveraged borrowers are punished in the short-run and the strong, prudent capital allocators are rewarded in the long-run.

Final thoughts

Risk assets are on sale. If you accept the thesis about the in-ability to peg the bottom of the market, you can still rest assured that mathematically the average stock is anywhere from 10-30% lower than it started the year. If you look at the index level like the S&P 500, you are buying at a roughly 20% lower price than the start of the year. This doesn’t guarantee huge returns; however, historic precedence would indicate you have a higher probability of better future returns than had you purchased at the beginning of the year.

This year has not been fun nor rewarding in almost any asset market. Keep in mind that the decisions of today determine the returns of tomorrow. We keep today’s decisions, with high conviction, focused on the long-run, resisting short-term needs for catharsis, and take advantage of small, tactical moves for long-run success. This malaise too shall pass.

As always, I am available for questions, feedback, commentary, or just to chat by cell 248.982.8190 or email rob@ffadvisor.com. Be well and focus on the long-term!