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Assessing The Utility Of Wall Street’s Annual Forecasts

It’s that time of year when everyone starts preparing for the New Year and Wall Street makes its 2016 predictions. I’ll get right to the point here – these annual predictions are largely useless. But it’s still helpful to put these predictions in perspective, because it highlights a good deal of behavioral bias and some of the mistakes investors make when analyzing their portfolios. The 2016 annual stock market predictions are reliably bullish. Of the analysts that Barrons surveyed, they found no bears and an expected average return of 10%. This is pretty much what we should expect. After all, predicting a negative return is a fool’s errand given that the S&P 500 is positive about 80% of the time on an annual basis. And the S&P 500 has averaged about a 12.74% return in the post-war era. So, that 10% expected return isn’t far off from what a smart analyst might guess, if they’re at all familiar with probabilities. There is a chorus of boos (and some cheers) every year when this is done. No analyst will get the exact figure right, and there will tend to be many pundits who ridicule these predictions despite the fact that expecting a positive return of about 10% is the smart probabilistic prediction. In fact, if most investors actually listened to these analysts and their permabullish views, they’d have been far better off buying and holding stocks based on these predictions than most investors who constantly flip their portfolios in and out of stocks and bonds. But that’s the reason why these predictions exist in the first place. Because every year, investors perform their annual check-ups and evaluate the last 12 months’ performance before deciding to make changes. And of course, Wall Street encourages you to do exactly that, because turning over your portfolio means increasing the fees paid to the people who promote these annual predictions. But when we put this analysis in the right perspective, it becomes clear that this mentality is misleading at best and highly destructive at worst. Stocks and bonds are relatively long-term instruments. The average lifespan of a public company in the USA is about 15 years.¹ And the average effective maturity of the aggregate bond index is about 8 years.² This means an investor who holds a portfolio of balanced stocks and bonds holds instruments with a lifespan of about 11.5 years. When viewed through this lens, it becomes clear that evaluating a portfolio of long-term instruments on a 12-month basis makes very little sense. What we do on an annual basis with these portfolios is a lot like owning a 12-month CD that pays a one-time 1% coupon at maturity and getting mad that the CD hasn’t generated a return every month. But this annual perspective makes even less sense from a probabilistic perspective. As I’ve described previously , great investors think in terms of probabilities. When we look at the returns of the S&P 500, we know that returns tend to become more predictable as we extend time frames. And the probability of being able to predict the market’s returns increases as you increase the duration of the holding period. While the probability of positive returns becomes increasingly skewed as you extend the time frame, there is still far too much randomness inside of a 1-year return for us to place any faith in these predictions. The number of negative data points is only a bit lower than the number of positive data points, even though the average return is positively skewed: (click to enlarge) So, at what point do returns become reliably positive? If we look at the historical data, we don’t have reliably positive returns from the stock market until we look about 5 years into the future, when the average 5-year returns become positively skewed. A 50/50 stock/bond portfolio has a purely positive skew, with an average rolling return of 3 years. Interestingly, this stock market data is just as random even though it’s positively skewed. So, trying to pinpoint what the 5-year average returns will be is probably a fool’s errand (even though stocks will be reliably positive, on average, over a 5-year period). (click to enlarge) All of this provides us with some good insights into the relevancy of making forecasts about future returns. When it comes to stocks and bonds, we really shouldn’t bother listening to or analyzing predictions made inside of a 12-month period. The data is simply too random. As we extend our time horizons, the data becomes increasingly reliable with a positive skew. But it still remains a very imprecise science. The bottom line – If you’re going to hold stocks and bonds, it’s almost certainly best to plan on having at least a 3-5 year+ time horizon. Any analysis and prediction inside of this time horizon is likely to resemble gambling. As Blaise Pascal once said, “All of human unhappiness comes from a single thing: not knowing how to remain at rest in a room”. The urge to be excessively “active” in the financial markets is strong; however, the investor who can take a reasonable temporal perspective will very likely increase their odds of making smarter decisions, leading to higher odds of a happy ending. Sources: ¹ – Can a company live forever? ² – Vanguard Total Bond Market ETF, Morningstar

Vanguard’s Total Bond Market ETF Is A Great Fund For Investors Seeking Higher Quality

Summary BND offers a very low expense ratio that allows the interest to reach shareholders. The biggest risk factor for the fund is the diverging interest rate policies in the U.S. and Europe leading to potentially higher levels of volatility in rates. The exposure to MBS is unfortunate given the options investors have for using mREITs to acquire MBS at a discount to book value. Vanguard Total Bond Market ETF (NYSEARCA: BND ) is a solid bond fund. As I’ve been searching for appealing bond funds, I’ve found some of my favorites are from Vanguard. Given my distaste for high expense ratios, it should be no surprise that the Vanguard products would be appealing. Some funds are able to offer low expense ratios and mitigate their risks by strictly dealing in the most liquid bonds where pricing is most likely to be efficient and relying on the market to ensure that the risk/return profile is appropriate. Generally I favor ETFs that have low expense ratios and strictly deal in highly liquid bonds where the pricing will be more efficient. The expense ratio for BND is a .07%. This is one of the funds that falls into my desired strategy of using highly liquid securities and a very low expense ratio to rely on the efficient market to assist in creating fair values for the bonds. Yield The yield is 2.45%. The desire for a higher yield should be fairly easy for investors to understand. Bond funds that offer a higher yield are offering more income to the investor. Unfortunately, returns are generally compensating for risk so higher yield funds will usually require an investor either take on duration risk or credit risk. In many situations, an investor will take on a mix of the two. Junk bond funds generally carry a high degree of credit risk but low duration risk while longer duration AAA corporate funds have only slight to moderate credit risk combined with a significant amount of duration risk. Theoretically treasuries have zero credit risk and long duration treasuries would have their risk solely based on the interest rate risk. The yield for BND is coming primarily from the interest rate risk on the fund. The average duration is 5.8 years and the average effective maturity is 8 years. Fluctuations in the interest rate environment will be a major source of changes in the fair value of the fund. Duration The following chart demonstrates the sector exposure for this bond fund: At the present time I’m concerned about taking on duration risk in early December because of the pending FOMC (Federal Open Market Committee) meeting. I believe it is more likely than not that we will see the first rate hike in December. I think a substantial portion of that probability has already been priced into bonds, so investors willing to take the risk prior to the meeting could see significant gains if the Federal Reserve does not act. The very interesting thing we are seeing in the interest rate environment today is a divergence in policy between the domestic interest rates and the interest rates in Europe established by the ECB (European Central Bank). The ECB has announced another decrease in their short term rates to negative .30% while the Federal Reserve is planning to increase short term rates. That disconnect is going to make bond markets very interesting over the next few years. Credit Risk The following chart demonstrates the credit exposure for this bond fund: High quality corporate debt may often show significant correlation to treasuries but it offers higher yields. The biggest weakness for a high quality corporate debt fund is the fact that some bonds may still fall into lower credit quality and eventually default. Even if the fund sells the bonds before they default, they will receive a much lower fair value for those bonds when the market assess that the bond is riskier. I find high credit quality corporate debt to be a fairly attractive space for bond investing because it offers higher yields than treasuries but is unlikely to suffer from high default levels. By combining high credit quality corporate debt with treasury positions BND is able to create a higher yield than the fund would otherwise have while maintaining exceptionally high credit quality overall. The one notable concern I have in this regard is that over 20% of their “U.S. Government” debt is coming through the form of mortgages, and investors have access to mREITs that are trading at enormous discounts to book value. Conclusion I’m not a fan of holding the MBS at book value, but other than that I find the fund to be a solid choice for bond investors. It offers a reasonable yield for the very low credit risk on the fund and a very low expense ratio so the interest from the securities is actually reaching the shareholders. The biggest risk here, in my opinion, is the challenges we may see in the interest rate environment as the United States and Europe intentionally move in the opposite directions.

Support The Environment And Profit With Fossil Fuel Free ETFs

The ongoing Paris climate talks have brought green investing back into focus. As concerns about the harmful impact of fossil fuels on the environment continue to grow, many investors are looking to eliminate fossil fuels related exposure from their portfolios and invest in cleaner alternatives. A growing number of institutional investors like pension funds, charities and endowments are increasingly divesting from fossil fuel companies. Recently, New York’s comptroller announced plans to invest the state retirement fund assets in companies with lower carbon emissions via an index designed by Goldman Sachs. Many retail investors are also interested in getting oil, gas and coal companies out of their portfolios, and fossil fuel free or low carbon ETFs are a great investment option for them. They help investors to exclude companies that are not aligned with their values and yet earn market-like returns. In the current market scenario, apart from moral and ethical concerns, financial concerns also should deter investments in fossil fuels. Looking at the shorter term, with oil price expected to stay low, fossil fuel investments look bad and even in the longer term, there is a case for avoiding these investments as governments all over the world work together to limit carbon emissions. To learn more about a couple fossil fuel free/low carbon ETFs – SPDR S&P 500 Fossil Fuel Free ETF ( SPYX ) and iShares MSCI ACWI Low Carbon Target ETF (NYSEARCA: CRBN ), please watch the short video below: Original Post