Taking Advantage of Fear

Investor Fear Itself Can Help Diversify a Portfolio

It makes sense. When markets fall, measures of investor fear increase.  The most commonly accepted way to measure investor fear is using the price investors are willing to pay to buy put options, which offer investors downside risk protection.  The price of such options is measured in the market using the VIX index, often referred to as the “Fear Index”.

When we diversify our client portfolios, we naturally use traditional asset classes such as bonds, which tend to increase when stocks fall in value.  We also use investments in assets like real estate investment trusts, preferred stocks, etc.  When markets fall, these investment classes may help offset stock losses – but sometimes traditional methods of diversification do not work so well.  (real estate didn’t fare too well during the financial crisis, for instance).

Knowing that investor fear often increases when stock prices fall, it would seem ideal to be able to invest in fear itself.  Well, you can.  And we do, by using option strategies to profit from investor fear.

In fact, with bond investments paying such low interest rates, and real estate and other assets near record highs, we are relying more than ever on option based strategies (and the fear index) to offset stock market risk.  The primary vehicle we are using at the moment is the Catalyst Hedged Futures Strategy Fund.

What should an investor expect from this strategy?  In an up market, the fund makes money (through buying and selling call options) in the traditional manner as the price of the S&P 500 goes up.  At the same time, the fund uses put options which allow it to make money when investor fear measurements move higher (typically when the market falls).  The fund needs the VIX to remain elevated (above 20 is good) for a period of time (several weeks) before it can reap profits from investor fear.

In August of 2015, the VIX shot up to almost 40, but quickly retreated before the fund could start making money.  In 2016, the fear index has been strangely reluctant to increase (although it is up 14% as I write this today, with the S&P down sharply).  We have now seen the VIX hanging above 20 for several weeks, almost since the 1st of January, which should allow Catalyst to start reaping profits from its downside options strategy.

We can look to the past for some indication of how well the strategy can work to offset market losses.  In 2011, the S&P 500 fell by 19%.  The VIX went above 20 in June and stayed above 20 (indicating high level of fear) until late in December.  The Catalyst fund earned nearly 10% during those 6 months.

During the financial crisis, the VIX soared to record highs and remained elevated for over 18 months.  While this was a terrible period for stocks, this long period of elevated volatility was an ideal environment for the Catalyst Fund strategy – it was up nearly 75% from Jan 2008 to June 2009.  (click here to view performance of Catalyst fund vs. diversified stock and bond funds)

Our clients know we take risk management seriously.  Minimizing losses in poor markets is almost as important to long term investor success as maximizing gains when the market soars.  Using fear to our investors’ advantage is just one tool we use to limit losses during these uncertain times.

We are a little disappointed that, due to the lackluster response of the VIX to the current market correction, the fund has not already started to produce even stronger results.  We remain highly confident however that if the fear index remains at current levels, or moves higher, the fund will deliver strong positive returns which will provide much needed support for client portfolios.

Note:  Past performance does not predict future results.  Diversification does not eliminate risk of loss.  Investments described involve risks which need to be fully understood before investing – this is not a recommendation for any investor to buy any fund mentioned.  Call our office to learn more about how Financial Pathways manages risk in our client portfolios.   

Financial Pathways Has a New “Ask An Advisor Page!”

A quick update on our presence on the internet: Financial Pathways has a new profile on Investopedia’s “Ask an Advisor” website!  You can visit the site to ask us any questions you might have about finances, retirement and any other topic you might need a quick answer for.  Here’s the link: “ask an advisor

Diversification Still Works in a Wild Market

Stocks are down sharply – but other portfolio assets are holding their own.

I think they say that for stocks, this has been one of the most awful starts to a new year – almost EVER!  Worries over China, slowing global growth, and an almost unbelievable fall in oil prices all worry the markets.  On top of the worries is the fact that the market has been going up pretty much since 2011 without a break – an unprecedented period of time without a correction.  This makes a correction overdue.  The speed and swiftness of this correction, just like the brief dip last August, is a bit disconcerting.  In the summer of 2011 it took a few months for the market to lose 19% – we are down about 8% in just 2 weeks!

The good news is that diversification is working – to some extent.  Not as well as we would like, but it IS working.  Some of our positions are up, others are down only slightly.  Here is a list of our top 10 most widely held positions across all client portfolios.  You can see how some investment classes (bonds, managed futures) are doing well, and others (real estate, preferred stocks, hedged equity) are down – but not nearly as much as the stock market.  Remember as you look at these numbers – they are returns for TWO WEEKS – yet they look like a (bad) annual return!!!

Fund Name Class YTD Performance
Catalyst Hedged Futures Fund Managed Futures 0.37%
Dimensional International Core Equity International Stock -9.48%
Dimensional US Core Equity 1 US Stock -8.79%
Metropolitan West Total Return Bond Multisector Bond 0.69%
Pimco Income Fund Multisector Bond -0.68%
Dimensional US Core Equity 2 US Stock -9.17%
DFA Global Five Year Income Global Bonds 0.92%
Gateway Fund Hedged US Equity -4.54%
Ishares Residential Real Estate Real Estate -3.31%
Principal Preferred Securities Preferred Stocks -0.49%

This is fairly predictable.  Bonds do tend to rise when stocks fall (except the high yield “junk bond” variety which is another story).  Managed futures funds can also do well in a downturn, but because this is a trend following strategy, these funds tend to do their best work as a bear market deepens and lengthens in duration.  We are relying on this asset class to do very well if this downturn drags on into next week and beyond.  Preferred stocks act more like bonds than stocks, so it is no surprise they are holding up well.

What do investors need to do?  Well, nothing we haven’t already done.  We had already positioned most of our portfolios in a fairly defensive posture since late last year.  We believe our current asset allocation provides a very healthy level of diversification.  We have learned the lesson over and over again – don’t change horses in midstream.  Waiting out these difficult markets has been the best approach to take over and over again.  This has been true of short sharp corrections like 2011, as well as the deep prolonged bear markets of 2008 or 2000/2001.

In fact, maybe the best thing we can do is to stop focusing on the media hype and try to keep recent moves in perspective.  Stocks are down 7-9% on the year – and maybe down about 11% since their peak in May of 2015.  This downturn isn’t even significant enough to earn the title of bear market.   The US economy keeps chugging along.  And while China has its issues and challenges – but it is still a vibrant economy growing over  6% per year (if we can believe their numbers, that is???).

It might also be helpful to consider that while many are biting their nails and worrying, I have a few clients who have cash on the side who say they are itching to get back into the markets as prices fall.  One man’s debacle is another man’s opportunity.  It all depends on your perspective!   A client asked me yesterday if I thought this was a good time to put cash back into the markets.  My reply was that I can’t say for sure it is the BEST time to get back in – but I knew for darn sure that with the market down 10% it was a 10% better time to get back in than last month was!

Hang in there, hopefully the second half of January provides a bit of a respite from the bad news.

Uplifting Consumer Views On the Economy

It is so predictable.  The stock market falls, and the media starts to bring forth all the doomsayers.  How is it that – while very little in the economy and in the world actually changed between Dec. 31 and Jan 13, the media seems to suddenly be taken over by agents of gloom?   We know why – because fear sells media.

So in a week where the stock market has been busy trying to find its legs again, it is refreshing to see some good news come out.  Despite the stock market rout, US consumers are apparently quite optimistic about the economy.  For more, see the Bloomberg article. 

As the article points out, this is not the only economic good news of late.  Last weeks employment report was stunningly strong.  The economy produced almost 300,000 new jobs in December, and a high percentage of those jobs were in higher paying fields.  So the market has its own reasons for needing to sell off – but two key indicators of economic health, consumer confidence and jobs = seem to be on firm footing.



A Creative, If Risky, Way to Supplement Retirement Income

I shared a similar story a couple of years ago about the growing number of crimes being committed by the elderly, particularly in Europe.  Here is a BBC story about a particularly audacious burglary attempt by a group of, shale we say “experienced” crooks in their 70s and 80s.  These guys should have stuck with working on the golf game!

Seems as if saving more money wouldn’t have been enough to steer them from a life of crime however.  The quoted interviews indicate they were motivated more by the thrill than a need for money.

Is the American Retirement Crisis Real?

Discussion of a looming retirement crisis is driving public policy discussions in the U.S., but is it real?  Offering a different look at the facts and figures, this Washington Post article suggests that the “crisis” might not be so much of a crisis at all.

Fees, Asset Allocation, and Consistency Drive Returns

Fees are Important – But Asset Allocation and Consistency Remain the Primary Determinants of Long Term Returns

Our Take on Fees:  What is it you are paying for, and do you actually get it?

Popular investment media for the past couple of years has been all over the issue of fees.  Statements are made (and not questioned) claiming that the single best thing an investor can do to improve returns is lower fees – usually by throwing out their actively managed mutual funds and replacing them with index funds.

We agree that reducing fees is important – to a point.  But as with many things in life, our advice is to consider what you are paying for.  What is the value added you receive?  For instance, research conclusively demonstrates that paying fees for an asset manager (or investment advisor) to choose stocks for a portfolio does not add value in excess of the fees paid.  Few stock picking managers beat their benchmark index in any given year, so why pay good money in a Quixotic quest to “beat the market” when you can “match the market” with low cost index funds?   We agree.

However, there are some cases where fees seem justified based on the evidence.  Take emerging market stocks as an example.  The emerging market world is dominated by the biggest player – China.  The Chinese stock market is a mess.  Most active managers have shied away from Chinese stocks, and with good reason.  But by owning an index fund, you may inadvertently be overexposing yourself to additional risk.

We are also willing to pay for active management when it comes to controlling risk.  We find considerable value in certain funds which use put and call options to create returns which are not tied to the stock market, which reduces the risk in our portfolios when markets behave badly.  It costs money to execute these strategies, but the impact on portfolio risk and returns makes some of these funds worthy of consideration despite the cost.

Actually that raises an interesting point.  Some investors seem to misunderstand mutual fund fees.  When a fund posts a 10% return, and has a 1% fee – the 10% return is the return AFTER the fees have been paid.  In other words, reported returns are NET of all fees. You do not pay the fees yourself, the fund company does.  Some investors we speak to miss this distinction.

Ignore Asset Allocation at Your Own Peril!

With all the focus on fees, I worry that some investors may conclude that all they need to do is buy Vanguard Total Stock Market Index fund, and their investment work is done.  After all, the fees are as low as they come, right?  Lost in the discussion of fees is that the primary determinant of investment risk and return over time remains the same as it has always been:  Asset Allocation.

Asset Allocation is Wall Street-ese for how your portfolio is divided between types of investments.  U.S. and foreign stocks and bonds.  Large companies and small.  Real estate, commodities, and alternative investment strategies such as managed futures.  A diversified portfolio may produce higher returns for a given level of risk than a portfolio which is not diversified.  So while an investor can get excellent low cost exposure to all sectors of the US stock market with the Vanguard fund – the more important decision is how he will choose to diversify those stock holdings with other types of investments.

While mutual fund fees are important, I would rather see a client in an appropriate asset allocation using higher cost funds than in a wildly inappropriate allocation using low cost index funds.

Consistency of Strategy is Critical as Well.

You can use the cheapest index funds available in the market, but if your investment strategy swings with the tides of the market and daily news flow, your returns will suffer.  Investors are typically their own worst enemy – selling when market conditions get scary, and buying when the bulls are running free.  Again, an investor who uses more expensive funds but stays the course as markets change will likely post stronger long term returns than the investor who is constantly trying to outguess the markets by shifting and changing his investment portfolio.

One Social Security Claiming Strategy Remains – For a Few

If you turned 62 by January 1 of this year, you may still have one Social Security claiming trick up your sleeve.  As many are aware, Congress recently closed some of the popular loopholes which permitted retirees to maximize Social Security using strategies such as “file and suspend”.  These strategies permitted some retirees to increase their lifetime Social Security benefits by tens of thousands of dollars, but Congress took the punch bowl away through passage of the budget bill late last year.  This was a gift to the Obama administration, who had long opposed the strategies as a giveaway to “wealthy” Social Security recipients.

There is one strategy that remains in place for seniors – providing you turned 62 years of age by Jan 1, 2016.  You will still have the ability to file a “restricted claim for spousal benefits only” once you reach your own full retirement age.  This permits a recipient to collect their spousal benefit at age 66 or 67 (equal to 1/2 of their spouses benefit) while they let their own benefit (based on their own earnings) to grow until age 70.

One catch:  The other spouse must already be COLLECTING social security benefits.  In the past, recipients could file for benefits at Full Retirement Age, which made the spousal benefit available to their partner, then immediately suspend payments, which would then allow THEIR benefit to keep growing until age 70.

Under the new regime, the system favors couples with an age difference of several years, since one can wait until 70 to collect, then the other can file a spousal benefits claim at Full Retirement Age, then their own benefit at age 70.

If you haven’t turned 62 yet – someone will have to discover some new loopholes in the law for you.

Five Financial New Years Resoutions

We work with many people each year on personal finances.  Based on our experience, here are some suggestions regarding possible New Years resolutions to help address what are frequently neglected but important aspects of your personal financial situation.

Resolution One:  Get the estate plan in order

Will.  If you don’t have a will, draft one.  If you do have one, pull it out and look it over.  If it is more than 5 or 10 years old, it may need updating to keep up with changes in your life and family situation. Everyone who owns assets should have a will, but it is especially important for those who have children, are or have ever been divorced, or want to leave assets to someone other than direct family descendants.

Power of Attorney and Health Care Powers.  These are usually part of an estate plan most attorneys will put together for you.  It names a person you trust to perform financial transactions or make health care decisions in the event you are incapacitated.

Review Beneficiaries and Asset Titling.  How assets are titled, including named beneficiaries on accounts, is just as important – sometimes more important – than the language in your will.  This can be very important for those whose wills contain detailed provisions to deal with children from mixed marriages, trusts, charitable bequests, etc.  Asset titling is often forgotten, and source of much misunderstanding during settlement of estates.

Resolution Two:  Review Your Insurance Coverage.

Life insurance.  For most people, the reason for life insurance is quite simple.  It provides protection for those who rely on you being alive for their financial security.  For instance, if you have minor children or a non working spouse who rely on your ability to earn a living, then you need insurance.  In retirement, when many people are living off savings and assets, life insurance may become unnecessary.

Disability.  Review your employer policy.  Does it provide sufficient benefit that your family could survive if you were unable to work?  If not – or if you don’t have insurance coverage at all – consider a private disability policy.

Long Term Care Insurance.  No one likes to think about it, but end of life medical costs can be devastating.  Whether or not you buy insurance, you owe your loved ones a serious effort to plan for potential costs of long term care, whether in a nursing facility or at home.

Resolution Three:  Consolidate Investment Accounts.

Many investors seem to assemble over the years a rather haphazard collection of investments, with multiple IRA’s, Roth IRAs, 401k plans not only from their current employer, but from several past employers as well, as well as multiple savings accounts and CDs.  The resulting complexity can make it difficult to implement or maintain any kind of cohesive investment plan.  Consolidate 401k’s and IRA’s where possible, consolidate cash and investments into a) checking for immediate needs b) emergency reserve of 3-6 months worth of expenses in savings or money market accounts and c) a taxable investment account.

Resolution Four:  Create a Plan / Update Your Plan.

I am always amazed how many people go through their entire working career before doing a financial plan six months before they plan to retire.  OK, maybe later is better than never, but sooner is always better than later.  Without a plan, you may not be saving enough to maintain your lifestyle in retirement.  But you may also be saving MORE than you need as well, which may be preventing you from achieving some of your life goals as well.  If you do have a plan, take it out and look it over.  Are you making the desired progress toward your goals?  Have you followed through on the recommendations made in the plan?  If circumstances or goals have changed, maybe it is time to update the plan.  We like to update our client plans annually to maintain focus and momentum.

Resolution Five: Track your Spending / Create a Budget 

Where does all the money go?  Most people really have no idea.  “I make good money, but it seems we spend every time we make – and I have no idea where it all goes!”  We hear this from clients all the time.  The solution is obvious – pay closer attention to how you spend and proactively control it.  We like the new budget apps like and, which not only track spending, but provide real time feedback via smart phone apps so users always know how they are doing vs. their planned spending budget.  It takes work and sometimes a bit of creativity to use these apps and maintain them over time, but with practice and an hour a week, you can be the master of your money rather than the other way around!



Is 2016 Sell Off a Bubble Bursting or Sign of a Healthy Market?

Trump uses stock market correction to create new bogyman

I don’t normally post on politics, but I feel strongly on this one.  I realize that Trump’s political success is based on stoking fear and hate, but now the Donald has gone too far.  I need to respond once he tries to instill needless and senseless fear in the minds of investors, some of whom happen to be my clients.  Read Yahoo Finance for more…

Trump is now using a run of the mill and not-so-severe stock market correction to create a new bogeyman.  First he wants us to believe that the Mexican gardener in your backyard is a mass murderer and rapist.  Then he wants you to think the taxi driver who drove you from the airport to your hotel is wearing a suicide vest under his coat.  Now he wants you to believe that the stock market is “a bubble” created by “Wall Street paper pushers” and he can solve it (and make the market only ever go up?) by taxing the evildoers who are behind the conspiracy.   As evidence, he tells supporters to trust him because “I know this stuff”.  (I have a rule against voting for any candidate who uses words like “stuff”).

Politicians like Trump want you to believe that when stocks go up, that is the market reflecting their genius.  When stocks go down, that is a conspiracy by the fat cats on Wall Street.  When oil markets are in the news, the logic works the other way.  Politicians take credit for falling prices while rising prices are the result of shadowy back room manipulations by another bogyman called “Big Oil” which needs to be punished with special taxes for their alleged misdeeds.  Rather than use their position to educate the public, politicians prefer to exploit people’s lack of understanding regarding the way in which markets actually work.

Now on the question of taxing Wall St., I will say that I would support a tiny transaction tax to limit the economically pointless and potentially destabilizing practice of computerized high speed trading, and I also favor tax reform which would prevent a few on Wall Street to pay much lower tax rates than all the rest of us, but that is another issue.  Lets instead focus on Trumps premise.  Is the stock market “a bubble”?  And if so, is either his alleged “bubble” or the recent sell off created” by “Wall Street paper pushers”?

The answer is No.  You would be hard pressed to find any economist who will agree with Trump’s premise that world stock markets are experiencing a bubble.  The S&P 500 index today is valued at only slightly more than historical averages.  Given that interest rates are at an all time low,  giving investors few alternative investment choices, a slight premium for stock prices seems reasonable.  A bubble would imply prices which have been driven sky high through speculation and debt fueled investing (as in 1999 internet stocks, or 2006 real estate prices).  This is simply NOT the case in any of today’s global stock markets (with the exception of China, which is another story).

Is the stock market correction itself even worth getting excited about?  Hardly!  In fact, it is the past 4 or 5 years of extreme calm in the markets that is abnormal.  We normally expect to see a “correction” or downward move of 10% in the market every two years or so.  Going into summer of 2015 we hadn’t seen such a move in about 4 years.  Right now the S&P 500 is down just barely 10% from its peak on May 19, 2015.  Ok, the last week has been a bit disconcerting with a fall of almost 6% in 5 days – but this is not all that unusual, except the fact that this happened to fall on the first 5 days of the year which some may feel is some kind of omen.  (I don’t believe in omens, I believe in markets).

Market prices continue to be set the way they are always set – based on market participants estimations of how much money the companies which comprise “the market” will be able to make in the future.  Nothing else.  So why the sell off this year?  Quite simply, market participants are questioning their assumptions about the business environment, and ability of companies to make money, in the future.  The market sees threats from low oil prices destabilizing certain markets, a slowing of China’s economy, aging populations around the world perhaps reducing demand for goods and services.  These are not new threats really – its just that after focusing on the rosy side of the picture for the past few years, the market appears to have determined that it is prudent to also price certain threats and risks back into the market.  These fears seem to me to be fears of “growth may be slower than expected” – rather than “OMG the economy is going to collapse!”

A market which sells off occasionally like this is not in a bubble.  It is actually the sign of a very healthy market, which is trying to price in potentially negative outcomes.  In fact, this market is now perhaps hyper focused on the negative.  So much so that last week it moved lower even on news of an extremely strong employment report from the Labor Dept.  If Trumps business executive peers shared his apparent belief in an economy on the brink – they are not showing it by their decisions to hire so many new workers!

Lastly, an occasional market sell off provide opportunities.  Cheaper stock prices give investors who were not entirely in stocks the opportunity to invest more at lower prices.  Rebalancing a portfolio after a 10-15% sell off can increase future potential returns when markets recover.  Fear and volatility itself actually provides an opportunity to make money in markets for investors familiar with option strategies.

So the world is NOT collapsing.  Strong employment trends indicate the economy is healthy and strong.  The market is not in a bubble, and is showing a healthy skepticism in its current doldrums.  Your 401k is not being manipulated by Wall Street paper pushers.   There is plenty of malfeasance and misbehavior on Wall Street to talk about – but this has little to do with the price of stocks from day to day.