Perspectives on Brexit: Remember the Forest

Perspectives on Brexit: Remember the Forest

There’s really no nice way of putting it. Friday was not a fun day for the majority of investors after the Brexit vote.

Following Britain’s decision to leave the European Union after a more than 30-year marriage, the S&P 500 index fell 3.59%, while European markets collectively suffered declines in excess of 11%.

The fallout from Brexit simultaneously illustrates two realities of investing:

  1. The interconnected nature of modern global stock markets
  2. The importance of genuine and broad diversification

While the majority of investors experienced losses on Friday, very few who were properly diversified suffered anything close to a double digit decline. Only those making narrow, concentrated bets felt that kind of pain.

More importantly, for an investor whose risk profile dictates owning a portfolio with less than 100% stocks (which is the case for the majority of investors), several asset classes they likely own went up on Friday. This list included US treasury bonds, TIPS, and international bonds.

Bad Benchmarking

For investors with an appropriate asset allocation and a broadly diversified portfolio, Friday was a perfect example of why it’s a bad idea to judge your investments against the commonly reported stock benchmarks (such as the Dow Jones Industrial Average, the S&P 500, or the FTSE).

If you do this, when markets go down you’re going to think your portfolio lost far more than it actually did. On the other hand, when markets go up you’re going to expect returns for risks you didn’t take.

Neither is good for your psyche.

Don’t Miss the Forest for the Trees

With all of that said, on days like Friday the single most important word for us to lean on as investors is perspective.

It’s rarely ever as bad (or as good) as it seems in the heat of the moment.

Getting to the heart of this post, we also need to avoid the risk of missing the forest for the trees. While the financial news media would have us think that the world is coming to an end following Brexit, Friday was simply one day in an incredibly long investment history.

In other words, it was simply one tree within a gigantic forest.

Zooming Out for Perspective

To help illustrate this, let’s take a look at the history of the S&P 500. The first chart below shows the performance of the index for the five trading days last week:

S&P 500 Index – 5-Day

5 Day Performance S&P 500

Not surprisingly the decline on Friday is both obvious and, apparently, quite significant.

The same is true for the last month:

S&P 500 Index – 1-Month

1 Month Performance S&P 500

However, when we look at the year-to-date chart, we start to see that while Friday’s losses weren’t fun, the declines essentially just rolled back the clock to the middle of May:

S&P 500 Index – YTD

YTD Performance S&P 500

Zooming out to a one year chart, it’s now pretty clear that just in the last 12 months we’ve experienced several ups and downs of equal or greater magnitude than what we witnessed on Friday:

S&P 500 Index – 1-Year

1-Year Performance S&P 500

However, even one year of returns represents just a handful of trees within what is a really large forest. Let’s zoom out further by taking a look at the five year and 10 year charts below:

S&P 500 Index – 5-Year

5-Year Performance S&P 500

S&P 500 Index – 10-Year

10-Year Performance S&P 500

While we can see Friday’s decline in the chart, you’d be hard-pressed to describe it as anything different than many other short periods of time since 2006.

Finally, if we really want to see just how tiny of a blip Friday was on the radar, let’s look at the logarithmic charts dating back to 1990 and then even further back to 1950:

S&P 500 Index (Log) – Since 1990

Since 1990 Performance_S&P 500

S&P 500 Index (Log) – Since 1950

Since 1950 Performance S&P 500

As the charts help us to see, the reliable wealth building power that comes from diversified investing means that short-term declines are outweighed handily by long-term returns.

On the Temptation to Respond

Over the coming days, weeks, and months, we’re going to hear an almost endless barrage of “what to do now” and “how to protect yourself after Brexit” on TV and in print media.

It can be tempting to want to “do something” in response.

However, shooting from the hip in following market events is never a good idea. Instead, we need to ask ourselves a few simple questions:

  1. Have I properly evaluated my willingness, ability, and need to take risk as an investor?
  2. Does my portfolio align with my risk profile? Is my asset allocation appropriate for my risk tolerance?
  3. Do I have a written investment policy statement that outlines these things and illustrates why my portfolio is appropriate for me?

If the above is true, then the best approach is the same as it has always been: Remain disciplined with your asset allocation, monitor regularly and rebalance when appropriate, and make changes to your portfolio only in response to your own path towards your goals.

On the other hand, if the above is not true, there’s no better time than now to review your risk profile and properly align your portfolio accordingly.

Whether markets go up or down from here is anyone’s guess. However, with the wrong asset allocation it’s a virtual certainty that you’ll be unhappy with the outcome.

Either because your portfolio is more risky than you’re comfortable with or because you’re invested too conservatively and won’t benefit enough from the growth of stocks to reach your goals.

New Fiduciary Ruling Creates More Confusion for Investors

new fiduciary law

Last week, the Department of Labor (DOL) issued a new ruling which expands the definition of the term “fiduciary” under the Employee Retirement Income Security Act of 1974 (ERISA).

If you’re not familiar with the word fiduciary and how it fits into the world of financial advice, the shorthand definition is that a fiduciary is someone who is required to act in someone else’s best interest.

Although on the surface, it would seem obvious that more consumers receiving more advice that is actually in their best interest would be a good thing, I have some significant concerns with the new ruling.

More Laws, More Confusion

At the top of my list is that I believe the law is likely to create more confusion, not less, among investors who are seeking professional advice. Likewise, I think that many investors will presume that this new fiduciary ruling will put an end to poor or conflicted advice, when in fact that is far from the truth.

Potentially worst of all is that the ruling comes at a time when I see real progress already being made towards educating consumers about the power of things like index funds, low cost investing, and action-oriented financial planning.

Although the DOL may believe that the expanded fiduciary requirements will accelerate this trend, there is little to nothing in the new law that suggests it actually will.

A Commitment to Doing What is Right

To be clear, as a Registered Investment Advisor (RIA), my firm has consistently adhered to a fiduciary standard since the company’s inception. This commitment is defined in the Wealth Engineers Code of Ethics, in each client’s written services agreement, and in the disclosure brochure that is filed with the regulatory authorities and provided to every client.

More importantly, however, putting clients first is simply the right thing to do. I don’t need a fancy word like “fiduciary” to tell me that. I know that my clients have placed great trust in me to provide them with honest advice and to serve as a steward for their finances. That responsibility is something I take very seriously. No law or compliance requirement will change that.

Unfortunately, the new law takes a word that should have a simple and universal meaning and further muddies the water with a series of “ifs, ands, or buts.”

Part-Time Fiduciaries

For example, under the DOL’s new requirements, an advisor who is a registered representative of a broker dealer will now be required to act as a fiduciary when providing advice or recommendations for an investor’s individual retirement account (IRA). So far, so good (at least it would seem).

However, that very same advisor has no fiduciary obligation to that very same client for any of their non-retirement accounts.

This effectively turns thousands of broker-dealer reps into “part-time fiduciaries” who will now split their time between commissioned sales person and fiduciary advisor, often to the same client.

Even worse, the definition of fiduciary in the ruling still allows broker-dealer rep to sell proprietary products and expensive annuities to the client in their IRA. In what world that meets the definition of fiduciary I’m not sure.

My Advisor is a Fiduciary (Except When He’s Not)

Unfortunately, this is just the most recent instance of broker-dealer reps being granted the authority to confuse clients by wearing multiple hats.

The other recent example is broker-dealer reps who are also CFP® Professionals.

While the CFP Board of Standards states affirmatively that “CFP® professionals are held to strict ethical standards to ensure financial planning recommendations are in your best interest,” that doesn’t tell the whole story.

That’s because the CFP Board only requires broker-dealer reps to act in the client’s best interest specifically when delivering financial planning advice. At all other times, a representative has no such obligation.

Confused yet?

Potentially the most frustrating part for a consumer is not knowing when a broker representative is acting in their best interest and when they are not.

Does the advisor sound an alarm and flash some lights to let the client know?

Does the advisor swap their green tie for a red one?

How to Find a Full-Time Fiduciary

Thankfully, what hasn’t changed as a result of the new “fiduciary standard” is that there is still a clear way for consumers to obtain professional advice that puts their interests first all of the time: When selecting a financial professional, choose a fee-only Registered Investment Advisor (RIA).

Even better, ask them to show you in writing that they specifically adhere to a fiduciary standard when delivering investment and financial planning advice.

While nothing can guarantee a successful relationship, working with a fee-only RIA puts you on much firmer ground.

If You Don’t Like the Weather, Wait Five Minutes

weather volatile markets

“If you don’t like the weather, wait five minutes.”

That’s one of the first things you hear when the subject of weather comes up in Denver. While that’s a slight exaggeration, it’s not terribly far off.

Case in point: Last Tuesday afternoon. The high temperature was a beautiful 72 degrees. My wife and I went out on a walk with our son early that evening and the weather was bordering on perfect.

Standing outside, you’d have no idea that the scenery was going to change so drastically in less than 12 hours. With the sun beaming down on your head, the prediction for a few of inches of snow the following day might have seemed like an April Fool’s joke come early to an out of town visitor.

However, if you’ve ever spent any time in Colorado, you know that the weather can turn on a dime. In this case, a few inches of snow quickly became nearly a foot and a half, as we saw blizzard-like conditions nearly all day on Wednesday. Denver International Airport shut down for the first time in almost a decade and the freeways turned into parking lots.

The Futility of Forecasts

From what I can gather, none of the meteorologist’s weather models even came close to predicting the magnitude of the storm. Instead, the news channels were scrambling that morning to provide reports on road closures and how many flights had been canceled.

While clearing my driveway for the second time on Wednesday, I couldn’t help but find parallels between the crazy weather we sometimes have here in Colorado and the challenging markets that we often face as investors.

Although weather forecasters in Denver have notoriously poor track records, my experience has been that at least they are directionally correct most of the time. In other words, while they were way off with the volume of snow we got last Tuesday, at least they predicted snow.

Unfortunately, the same cannot be said for our investment forecasting friends. Their predictions are often so bad that the weather equivalent would be like calling for buckets of rain on a day that turns out to be 80 degrees without a cloud in the sky. Needless to say, such forecasts aren’t even worth the paper they are written on.

Putting that aside, instead of diving into the quantitative aspects investing today I thought I would share a few quick tips for managing through weather in Denver that apply equally as well to successful investing. If you keep these tips in mind, you’ll be in good position to stand firm through both volatile weather and volatile markets.

Tip #1: Be Prepared in Advance

Most people that live in climates that can experience sudden changes in weather know that it’s a good idea to take some basic steps of precaution. During the winter months, that means stashing some extra non-perishable food in the house, storing a warm blanket in your car, and keeping your gas tank at least a quarter full at all times. Of course, these things should be done before you actually need them because you’ll be hard pressed to track them down in the middle of a snow storm. Undoubtedly, however, every time you watch the news after severe weather you realize just how many people fail to prepare in advance.

The same type of basic preparation applies to your investments. Since we don’t know where markets are going in the near-term or when they will shift directions, we simply can’t follow a “just-in-time” approach to investing. Instead, we need to determine the proper level of risk for our portfolio at the outset so that when the unexpected inevitably happens, we’re well positioned to successfully manage through it.

This type of preparation is critically important when we’re talking about growth as well. For example, while international and emerging market stocks had a rough third quarter last year, they responded with very strong returns in October. Without continued allocations to a wide range of asset classes, we run the risk of missing out on positive returns.

Tip #2: Dress in Layers

A timeless principle of living in Denver is to always be prepared for a wide range of temperatures by dressing in layers. After seeing a few days with 30 or 40 degree swings, you understand just how good this advice is. So when you reach into your closet before heading out the door, you learn pretty quickly that it’s a bad idea simply to “grab a heavy jacket” because it’s January. While that would probably be good to have at 7am, you might find yourself sweating through it by the afternoon.

The same principle of dressing in layers applies to your portfolio as well. We call it diversification. While a diversified portfolio doesn’t guarantee any specific return or eliminate risk, it does ensure that you aren’t going to experience the extreme swings that are so common with a single stock or even a single asset class. Most importantly, when you invest in a wide range of global asset classes, you not only have the ability to reduce risk, but you can also increase your expected returns. That’s a win-win.

Tip #3. If You Don’t Like the Weather, Wait Five Minutes

Having discussed weather quite a bit already, this tip doesn’t need much of an introduction. However, in my view, it’s probably the most important one for us as investors. The reason is because in the heat of the moment, it can seem like the world is falling apart when stocks are in decline. Every news headline is negative and the tone of every pundit is dire. It truly seems like an economic catastrophe in the same way that the Denver storm was a weather catastrophe last week.

However, in the same way that things improved in short order weather-wise (most of the snow was melted in a few days and it was 66 degrees yesterday), the same can also be said for a bear market. While it may not happen in five minutes, in the grand scheme of things, stock market declines are a handful of fallen trees in an otherwise beautiful forest. For that reason, the next time it seems like the financial world is coming to an end, just pause and remember that brighter days are right around the corner.