Monday, January 22, 2018

Benchmark Asset Class ETF Returns for 2017


Chemistry 101
Below you’ll see what people in the investment business refer to as the periodic table of (asset class)
returns—named in honor of the periodic table of elements that we all studied in our high school
chemistry class. Koch Capital updates this table annually with the one-year returns and standard
deviation (volatility) of 13 benchmark asset class Exchanged-Traded Funds (ETFs), which collectively
represent a broad, global swath of the investable universe.

The table lists the annual returns for each asset class, ranked from best to worst such that the asset
classes with the highest returns are listed above those with the lowest returns for the year. The
volatility column to the far right displays the annual standard deviation of each asset class to its
immediate left; the higher the value, the more volatile that asset class’ price fluctuations.


Click here to view the entire chart and remember that past performance is not indicative of future results
Source: Koch Capital, InvestSpy
Color Matters
The asset classes are organized by color to make the table presentation more interesting. For example,
all the equity (stock) categories are shown in the blues and purples; the S&P 500, a common
equity benchmark, stands out in its signature black. The fixed income (bond) categories are in red,
orange and tan, and bleed into the yellow colors, which represent alternative asset categories. For this
demonstration, the alternatives include just gold and commodities. In green, cash (and cash
equivalents), the thirteenth asset class category, is represented by short-term Treasury bonds that
mature in one year or less.

The 2017 rising global tide lifts all boats, and most notably for the foreign developed and emerging
markets. Domestic US stocks weren’t shabby either providing double digit returns in both the large cap
and small cap arenas. Even the benchmark bonds in this example eked out positive returns in face of
moderately increasing interest rates.   

In summary, it was NOT a normal year for the world’s broad asset classes. The 2017 synchronized
global growth story, favorable expected fiscal policy changes in the form of US corporate tax and
regulatory relief, and continuing low interest rates contributed to the strong tailwind that drove these
terrific annual returns across the globe.

Pattern Hunting
As humans our brains naturally try to find patterns in what we see. Do you see any predictable pattern
of asset class returns from one year to the next? The answer is no. The point here is that asset class
returns are random no matter how convincingly your brain tells you, “Hey, I see a repeating historical
pattern here and I’m sure it will repeat in the future.”

Source:InvestSpy 1yr ETF correlations to 12/31/2017

The more subtle piece of information in the table above is the relationship between risk and correlation.
Even though long-term Treasury bonds TLT (red highlight) are volatile (risky), this asset class is
uncorrelated with most stock-based asset classes. When the S&P 500 SPY (black highlight) has
good year (over 10% annual return), long-term Treasury bonds (black) tends to under-perform, and
vice versa. Thus, you get the classic zig-zag relationship between stocks and bonds/alternatives, a
return saver courtesy of real diversification that helps your portfolio survive in years like 2008 and 2011.

Occasionally there will be years where both stocks (S&P 500) and bonds (US Gov’t 20yr Treasury)
deliver negative returns, although I haven’t recorded this outcome since starting the periodic table in
2001. It’s not a question of if but when this double barrel nasty outcome will occur, especially given this
year’s possible end to the 35-year bull market run in bonds. And when it does, make sure you have a
strategy to control your emotions and a plan to stay the course.
   

About Jim Koch
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment
Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to
individuals, families, trusts and business entities so they are better able to achieve their goals. Jim sees himself
as an “implementer” of financial innovation, using state-of-the-art technology to provide practical investment
management and retirement planning solutions for clients.

General Disclosures
This information is provided for informational/educational purposes only. The opinions referenced are as of the date of publication and are subject
to change due to changes in the market or economic conditions and may not necessarily come to pass. Nothing presented herein is or is
intended to constitute investment advice, and no investment decision should be made based on any information provided herein. The information
contained herein, while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable. Past
performance is no guarantee of future results.

Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or
forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.Under no circumstances
does the information contained within represent a recommendation to buy or sell any particular security or pursue any investment strategy.
There is a risk of loss from an investment in securities.  Different types of investments involve varying degrees of risk, and there can be no
assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Asset allocation
and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Please refer to the
Site Disclosure page for additional information.

Third Party Information
While Koch Capital has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the
accuracy, reliability, timeliness, or completeness of third party information presented herein. Any third party trademarks appearing herein are the
property of their respective owners. At certain places on this website, live 'links' to other Internet addresses can be accessed. Koch Capital does
not endorse, approve, certify, or control the content of such websites, and does not guarantee or assume responsibility for the accuracy or
completeness of information located on such websites. Any links to other sites are not intended as referrals or endorsements, but are merely
provided for convenience and informational purposes. Use of any information obtained from such addresses is voluntary, and reliance on it should
only be undertaken after an independent review of its accuracy, completeness, efficacy, and timeliness.

Thursday, February 16, 2017

More On A Two-Dimensional Risk Assessment Process


Risk Tolerance vs. Risk Capacity
Kudos to Michael Kitces for another informative research article on the important differences between investment risk tolerance and financial risk capacity. In this blog post, I’ll add to risk assessment discussion by introducing an alternative method for measuring financial risk capacity.

In general terms, risk tolerance or risk preference is your emotional willingness to accept more investment risk for an expected higher return. Risk capacity, on the other hand, is essentially your ability to live with the outcome of depending on risky assets to build a sufficient retirement nest egg. The previous statement is my opinion of what risk capacity really is. The more classic definition is how much risk a client can afford to take without risking his/her objectives.  

In the Kitces article, Michael points out the importance of measuring both types of risk separately in order to prevent the averaging of the two measures leading to inaccurate client risk profiles. He further demonstrates how Monte Carlo financial scenario planning provides a good measure of risk capacity and can be helpful when combined with traditional risk preference analysis.

Source: Michael Kitces, www.kitces.com

Rather than depend on Monte Carlo probabilities of success, I’m suggesting that funded ratio, current household assets divided by future living expenses, is a better measure of risk capacity and should be favored in two-dimensional assessment of financial risk.

Risk Capacity Changes Over Time
Traditional risk tolerance tends remain relatively stable over an investor’s lifetime. That is until the investor experiences a huge portfolio drawdown like in 2008-09, then preferences always get more conservative much to the consternation of most advisors who recognize that the time to load up on stocks is when the public is terrified of the market.

Source:Koch Capital

Rick capacity can fluctuate considerably over an investor’s lifespan for the simple reason that it includes non-investment life events that affect a household’s financial capability to accept risk. Life happens. And even the best portfolio returns may not be enough to counter the negative financial effects of an unplanned medical emergency or personal crisis.

When using the funded ratio approach to measure household risk capacity, you’re not only accounting for both investment and non-investment assets, but also using a measurement system that can be updated daily to help you quickly adapt your investment plan before your lifestyle is impacted. At Koch Capital, we think of household funded ratio monitoring as a real-time compass to help guide you to and through retirement.

     
Source:Koch Capital

When using the funded ratio as your household’s risk capacity measure, you are essentially accounting for all the household asset resources at your disposal. These assets include your current financial accounts like IRAs and 401ks, your real property holdings, your future ability save money, and your future pension and social security benefits.

In academic parlance, these three reservoirs of savings are referred to as: Financial Capital, Human Capital, and Social Capital. Since risk tolerance (preference) tends to focus on just the Financial Capital side of the equation, you need a mechanism to map the investor’s risk tolerance back to the broader household’s financial risk capacity.

At Koch Capital, we use Riskalyze to measure client investment risk preference; specifically how much portfolio loss an investor can tolerant before he or she hits the eject button. On the risk capacity side, we use our own proprietary funded ratio tool to measure the household’s capacity to accept risk, right up to the dollar amount where the client’s lifestyle is impacted. The diagram below demonstrates how the two measures intersect in the two-dimensional risk assessment framework.

   
Source:Koch Capital

In this two-dimensional risk assessment framework, risk capacity (funded ratio) influences risk tolerance more than tolerance affects capacity. This is because an investor’s risk tolerance, for example, to be aggressively invested on the Financial Capital (portfolio) side is also influenced by the household’s other risk capacity resources—Human Capital and Social Capital.

For example, if your funded ratio (household assets dividend by future liabilities) is over 1.0 and your conservative Social Security benefits constituents the largest portion of your Financial, Human and Social Capital mix, then your retirement plan can probably withstand a more aggressive portfolio allocation on the smaller Financial Capital portion of your overall household asset base.

Stress Test Your Lifestyle Resilience Before Investing Capital
Let’s look at a numerical example of mapping your risk tolerance (Riskalyze) number into your risk capacity (funded ratio) using the two-dimensional risk assessment framework. First, you need to calculate your risk tolerance for all your household’s investment portfolios. I referred to this previously as your Financial Capital.

 
Source:Koch Capital, Riskalyze

Ideally, the retirement-aspiring investor should obtain a single, aggregated Riskalyze number for all portfolios associated with the household. One way to approximate this aggregated value is to (1) calculate/estimate a Riskalyze number for each investment account using the free Riskalyze risk assessment service, then (2) create a spreadsheet to calculate the weighted average Riskalyze number, or 57 in my educational example above.

Next, derive your potential portfolio loss number by using the following Riskalyze hack. Create a dummy Riskalyze client and enter your weighted average risk number and the total value of your investment accounts. In my example, the weighted average, target risk level is 57 and the aggregate account balance is $3,353,106.

Riskalyze provides both the potential downside loss and upside gain over the subsequent six months (see below). Unfortunately, either you or your advisor or your advisor friend will need to be registered Riskalyze user to gain access to this hack.

Source: Riskalyze.com

For this example, the -11% potential loss percent or -$384,870 potential loss number is what I’m looking for as a numerical expression of the client’s aversion to investment losses. Please remember that it’s just a downside estimate and by no means 100% accurate, but still a useful estimate to map against the investor’s risk capacity. The estimated downside loss number will tell us if the investor’s risk tolerance matches up with the reality of the household’s current financial capacity to accept this level of investment risk.

For the statistical inclined, the resulting downside loss number is a two standard deviation forecast over the next sixth months of how much this combination of portfolios could lose (or gain) without you hitting the panic button. But just know that a true black swan event, though rare, would result in a three or more standard deviation loss, and possible permanent loss of capital if the investor sells near the bottom and/or the subsequent market recovery doesn’t materialize. Hence, we are stress testing for the less severe, but more likely market correction scenario.   
 
Now let’s switch over to the risk capacity side using Koch Capital’s risk capacity tool.

Click here for balance sheet image field descriptions
Source: Koch Capital

The graphic above is an annotated screenshot example of Koch Capital’s dashboard app which calculates the household’s current funded ratio. It shows that 11% drop in this household’s portfolios translate to a reduction in its funded ratio from 1.21 (overfunded) to 1.13 (constrained). While this potential portfolio drop would be emotionally troubling, it’s not enough to change the retirement funding trajectory in this example since the funded ratio is still greater than one and the target retirement date is still many years away.

This example also demonstrates why shifting funds from your more risky investment assets to your safer income assets (government bond ladders, annuities, etc.) will limit the downward funded ratio pressure. The riskier investment side of household asset pie would become smaller, thus less of a potential negative influence on household’s funded ratio. This risk reduction strategy is referred to as the “safety-first” approach to retirement income planning.

Beans and Rice, Rice and Beans
As debt-free maven Dave Ramsey frequently points out, “you have to live like nobody else, to live like nobody else.” And if that takes an inexpensive diet of rice and beans for a while to help pay off an expensive credit card balance, then you control your personal finance destiny, even on a modest income.

I bring this up for the simple reason that I have devoted way too much attention to  Financial Capital, investment risk and growing your nest egg through stock market investing. In reality your Human Capital (ability to earn income and save) is usually your best wealth generation asset. And in most cases, it’s less risky than depending on stock market gains.   

As Dave points out, “change starts with you.” Even the best investment managers cannot predict what the stock market will do next. But you control your ability to save for specific financial goals.

The funded ratio planning approach helps you intelligently budget for the future known goals (home, college, retirement, legacy, etc.) and plan for future unknown costs (medical emergency, family crisis, etc.), then guides you down the path to the lifestyle you desire and can afford.

Your greatest household asset is your ability to earn income and save for the future.  And whether you are saving for a house or saving for retirement, you probably have more risk capacity than you think.  

Thank you for your interest and appreciate your feedback......Jim   


P.S. For anyone interested the funded ratio approach, please request your own demo here.


Household Balance Sheet and HHBS are a registered service marks of the Retirement Income Industry Association (RIIA)

Additional Resource Links

Michael Kitces - Adopting A Two-Dimensional Risk Tolerance Assessment Process:

Moshe Milevsky - It’s Time to Retire Ruin (Probabilities):

Riskalzye Blog - And the Average Risk Number is….

Jim Koch - Should You Be 100% Invested In Stocks?

Jim Koch - Retirement Funded Ratio: The One Number Every Retirement Seeking Investor Should Know And Manage:



About Jim Koch
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to individuals, families, trusts, business entities and other advisers so they are better able to achieve their goals. Jim sees himself as an “implementer” of financial innovation, using state-of-the-art technology to provide practical investment management and retirement planning solutions for clients.

General Disclosures
This information is provided for informational/educational purposes only. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. Nothing presented herein is or is intended to constitute advice to use or buy any of third-party applications presented here, and no purchase decision should be made based on any information provided herein. The information contained herein, while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable.
Third Party Information
While Koch Capital has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, timeliness, or completeness of third party information presented herein. Any third party trademarks appearing herein are the property of their respective owners. At certain places on this website, live 'links' to other Internet addresses can be accessed. Koch Capital does not endorse, approve, certify, or control the content of such websites, and does not guarantee or assume responsibility for the accuracy or completeness of information located on such websites. Any links to other sites are not intended as referrals or endorsements, but are merely provided for convenience and informational purposes. Use of any information obtained from such addresses is voluntary, and reliance on it should only be undertaken after an independent review of its accuracy, completeness, efficacy, and timeliness.

Friday, January 6, 2017

Benchmark Asset Class ETF Returns for 2016


Chemistry 101
Below you’ll see what people in the investment business refer to as the periodic table of (asset class) returns—named in honor of the periodic table of elements that we all studied in our high school chemistry class. Koch Capital updates this table annually with the one-year returns and standard deviation (volatility) of 13 benchmark asset class Exchanged-Traded Funds (ETFs), which collectively represent a broad, global swath of the investable universe.

The table lists the annual returns for each asset class, ranked from best to worst such that the asset classes with the highest returns are listed above those with the lowest returns for the year. The volatility column to the far right displays the annual standard deviation of each asset class to its immediate left; the higher the value, the more volatile that asset class’s price fluctuations.

Click here to view the entire chart and remember that past performance is not indicative of future results
Source: Koch Capital, Quantext Portfolio Planner
 
Color Matters
The asset classes are organized by color to make the table presentation more interesting. For example, all the equity (stock) categories are shown in the blues and purples; the S&P 500, a common equity benchmark, stands out in its signature black. The fixed income (bond) categories are in red, orange and tan, and bleed into the yellow colors, which represent alternative asset categories. For this demonstration, the alternatives include just gold and commodities. In green, cash (and cash equivalents), the thirteenth asset class category, is represented by short-term Treasury bonds that mature in one year or less.

Taking more risk by favoring small capitalization stocks over large capitalization stocks rewarded investors in 2016. Small cap stocks outperformed large cap stock both domestically and abroad. Gold and commodities woke up this year and reversed the past two years of negative returns. And the bonds of all durations eked out low but positive returns even as rates jumped near year end.  

In summary, it was a normal-ish return year for most global asset classes. However, it’s worth noting that US stocks are still exhibiting very low volatility again this year, which generally indicates investor complacency. Everything is awesome, right?

Pattern Hunting
As humans our brains naturally try to find patterns in what we see. Do you see any predictable pattern of asset class returns from one year to the next? The answer is no. The point here is that asset class returns are random no matter how convincingly your brain tells you, “Hey, I see a repeating historical pattern here and I’m sure it will repeat in the future.”

Source: Quantext Portfolio Planner 1yr ETF correlations to 12/31/2016

The more subtle piece of information in the table above is the relationship between risk and correlation. Even though long-term Treasury bonds (red) are volatile (risky), this asset class is uncorrelated with most stock-based asset classes. When the S&P 500 (black) has good year (over 10% annual return), long-term Treasury bonds (black) tends to underperform, and vice versa. Thus, you get the classic zig-zag relationship between stocks and bonds/alternatives, a return saver courtesy of real diversification that helps your portfolio survive in years like 2008 and 2011.

Occasionally there will be years where both stocks (S&P 500) and bonds (US Gov’t 20yr Treasury) deliver negative returns, although I haven’t recorded this outcome since starting the periodic table in 2001. It’s not a question of if but when this double barrel nasty outcome will occur. And when it does, make sure you have a strategy to control your emotions and a plan to stay course.
   

About Jim Koch
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to individuals, families, trusts, business entities and other advisors so they are better able to achieve their goals. Jim sees himself as an “implementer” of financial innovation, using state-of-the-art technology to provide practical investment management and retirement planning solutions for clients.

General Disclosures
This information is provided for informational/educational purposes only. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Nothing presented herein is or is intended to constitute investment advice, and no investment decision should be made based on any information provided herein. The information contained herein, while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable. Past performance is no guarantee of future results.

Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.Under no circumstances does the information contained within represent a recommendation to buy or sell any particular security or pursue any investment strategy. There is a risk of loss from an investment in securities.  Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Please refer to the Site Disclosure page for additional information.

Third Party Information
While Koch Capital has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, timeliness, or completeness of third party information presented herein. Any third party trademarks appearing herein are the property of their respective owners. At certain places on this website, live 'links' to other Internet addresses can be accessed. Koch Capital does not endorse, approve, certify, or control the content of such websites, and does not guarantee or assume responsibility for the accuracy or completeness of information located on such websites. Any links to other sites are not intended as referrals or endorsements, but are merely provided for convenience and informational purposes. Use of any information obtained from such addresses is voluntary, and reliance on it should only be undertaken after an independent review of its accuracy, completeness, efficacy, and timeliness.