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What You Should Know About Financial Markets
Let time work in your favor. Let the market worry about itself.
What You Should Know About Financial Markets Let time work in your favor. Let the market worry about itself. Financial markets are unpredictable. No matter how much research you do and how closely you follow the news, trying to “time the market” usually means withdrawing too early and investing too late. Most investors see better performance by focusing on the long game. With a diversified portfolio and a patient and disciplined approach, the more time you give your investments in the market, the better your portfolio performs. When you try to time the market, you also risk short-term capital gains taxes. Even if you make a profit with constant buying and selling, these taxes quickly eat into your gains. Hold your assets for over a year, and you’ll avoid these short-term taxes. If you do need to make adjustments, try to keep them to a minimum. The best way to adjust your asset allocation is to look at how much time you have to reach your goal. The closer it gets, the less risk you’ll want to take. Got more time? There’s more to unpack about financial markets. In 5 minutes In this guide, we’ll explain: Why a long-term strategy is often the best approach The problems with trying to time the market How to accurately evaluate portfolio performance How to make adjustments when you need to Why a long-term strategy is often the best approach Watch the market closely, and you’ll see it constantly fluctuate. The markets can be sky high one day, then come crashing down the next. Zoom in close enough on any ten-year period, and you’ll see countless short-term gains and losses that can be large in magnitude. Zoom out far enough, and you’ll see a gradual upward trend. It’s easy to get sucked into market speculation. Those short-term wins feel good, and look highly appealing. But you’re not trying to win the lottery here—you’re investing. You’re trying to reach financial goals. At Betterment, we believe the smartest way to do that is by diversifying your portfolio, making regular deposits, and holding your assets for longer. Accurately predicting where the market is going in the short-term is extremely difficult, but investing regularly over the long-term is an activity you can control that can lead to far more reliable performance over time. The power of compounding is real. By regularly investing in a well-diversified portfolio, you’re probably not going to suddenly win big. But you’re unlikely to lose it all, either. And by the time you’re ready to start withdrawing funds, you’ll have a lot more to work with. The basics of diversification Diversification is all about reducing risk. Every financial asset, industry, and market is influenced by different factors that change its performance. Invest too heavily in one area, and your portfolio becomes more vulnerable to its specific risks. Put all your money in an oil company, and a single oil spill, regulation, lawsuit, or change in demand could devastate your portfolio. There’s no failsafe. The less you lean on any one asset, economic sector, or geographical region, the more stable your portfolio will likely be. Diversification sets your portfolio up for long-term success with steadier, more stable performance. The problems with trying to time the market There are two big reasons not to try and time the market: It’s extremely difficult to consistently beat a well-diversified portfolio Taxes Many investors miss more in gains than they avoid in losses by trying to time a dip. Even the best active investors frequently make “the wrong call.” They withdraw too early or go all-in too late. There are too many factors outside of your control. Too much information you don’t have. To beat a well-diversified portfolio, you have to buy and sell at the perfect time. Again. And again. And again. No matter how much market research you do, you’re simply very unlikely to win that battle in the long run. Especially when you consider short-term capital gains taxes. Any time you sell an asset you’ve held for less than a year and make a profit, you have to pay short-term capital gains taxes. Just like that, you might have to shave up to 37% off of your profits. With a passive approach that focuses on the long game, you hold onto assets for much longer, so you’re far less likely to have short-term capital gains (and the taxes that come with them). You don’t just have to consistently beat a well-diversified, buy and hold portfolio. In order to outperform it, you have to blow it out of the water. And that’s why you may want to rethink the way you evaluate portfolio performance. How to evaluate portfolio performance Want to know how well your portfolio is doing? You need to use the right benchmarks and consider after-tax adjustments. US investors often compare their portfolio performance to the S&P 500 or the Dow Jones Industrial Average. But that’s helpful if you’re only invested in the US stock market. If you’re holding a well-diversified portfolio holding stocks and bonds across geographical regions, the Vanguard LifeStrategy Funds or iShares Core Allocation ETFs may be a better comparison. Just make sure you compare apples to apples. If you have a portfolio that’s 80% stocks, don’t compare it to a portfolio with 100% stocks. The other key to evaluating your performance is tax adjustments. How much actually goes in your pocket? If you’re going to lose 30% or more of your profits to short-term capital gains taxes, that’s a large drain on your overall return that may impact how soon you can achieve your financial goals. How to adjust your investments during highs and lows At Betterment, we believe investors get better results when they don’t react to market changes. On a long enough timeline, market highs and lows won’t matter as much. But sometimes, you really do need to make adjustments. The best way to change your portfolio? Start small. Huge, sweeping changes are much more likely to hurt your performance. If stock investments feel too risky, you can even start putting your deposits into US Short-Term Treasuries instead, which are extremely low risk, highly liquid, and mature in about six months. This is called a “dry powder” fund. Make sure your adjustments fit your goal. If your goal is still years or decades away, your investments should probably be weighted more heavily toward diversified stocks. As you get closer to the end date, you can shift to bonds and other low-risk assets. Since it’s extremely hard to time the market, we believe it’s best to ride out the market highs and lows. We also make it easy to adjust your portfolio to fit your level of risk tolerance. It’s like turning a dial up or down, shifting your investments more toward stocks or bonds. You’re in control. And if “don’t worry” doesn’t put you at ease, you can make sure your risk reflects your comfort level. -
Deriving an Assumption on Inflation
While our assumption on inflation comes down to a judgment call in the end, we take a ...
Deriving an Assumption on Inflation While our assumption on inflation comes down to a judgment call in the end, we take a thoughtful approach to balancing the information coming from what we believe to be the best sources of data. Expected annual inflation is a key assumption used by our retirement savings and withdrawal advice, which help you plan for the future. To make these calculations, we must assume a specific growth rate for investments, but the rate of return that really matters is the “real” rate of return—i.e. the return adjusted for inflation. This is because the prices of everything that you buy tend to increase over time, so if you want to maintain the same ability to spend, your plans must take into account the fact that goods and services will cost more in the future. An example from Investopedia (that we have revised a bit) helps to illustrate this concept. Say you have $20,000 and want to buy a car that costs this same amount. Instead of purchasing the car now, you could decide to wait and invest the money for 1 year so as to have a cash cushion after buying the car. Assuming that you can earn 5% interest over a 12-month period, you will have $21,000 in one year. So it seems as if you can generate $1000 in savings by delaying your purchase for one year. But say inflation on car prices over the same one-year period is 2%. That same car will cost $20,400 in one year. The actual amount of money that remains after you purchase the car will be $600, i.e., 3% of your initial investment of $20,000. Your purchasing power due to investing only increases by $600 instead of $1000. 3% is indeed your real rate of return as it accounts for the effects of inflation. Multiple factors can drive the inflation rate including economic growth, public policy, and monetary policy. As a result, no one knows with certainty how the prices of the broad set of goods and services that you purchase will increase in the future. There are many different, credible sources of data for developing views on how inflation will evolve over time. No one source is necessarily going to give you the “right” answer so it is important that you use the multiple sources of information that will help you filter signal from noise. While our assumption on inflation comes down to a judgment call in the end, we take a thoughtful approach to balancing the information coming from what we believe to be the best sources of data. These sources include: Forward guidance from the Federal Reserve Market expectations derived from the pricing of US Treasuries and Treasury Inflation Protected Securities (TIPS). Customers with differing views on inflation can also override our assumption via the Edit Assumptions panel, which can be found on the Plan tab of a Retirement goal. We discuss each of these sources as well as our overall thought process in more detail below, but our broad conclusions based on the present state of the data are as follows: The Federal Reserve explicitly aims for an annual inflation rate of 2% over time and has demonstrated effectiveness in keeping inflation anchored to this level. Macroeconomic projections from the Fed also indicate that long-term inflation forecasts remain near 2% if not below this level. As of May 2, 2017, almost all inflation expectation measures derived from market prices suggest that the market expects inflation to be below 2% across multiple short- and long-term horizons. Since these measures are volatile, we will be keeping a close eye on how market expectations evolve going forward, but inflation expectations seem to be well- contained at the moment. Based on all of these sources, we assume a 2% rate of inflation in our financial planning calculations. The Target Inflation Rate The Federal Reserve explicitly states that an inflation rate of 2 percent is most consistent with their mandate for price stability and maximum employment over the long-run.1 But what data are Fed officials using to evaluate ongoing inflation trends? While they monitor multiple measures of inflation, it is widely recognized that the Fed prefers to use the core Personal Consumption Expenditures (PCE) index.2 This core measure strips out volatile components such as food and energy, allowing the Fed to better gauge long-term trends. Note that the monthly, year-over-year percent change in core PCE, a commonly used measure of inflation, has been strongly anchored to 2% since the early 1990s. Through its implementation of monetary policy—the process of raising or lowering the costs of borrowing through the U.S. federal funds rate—the Fed has demonstrated effectiveness in anchoring the long-term inflation rate to 2%.3 Accordingly, at Betterment we account for this trend and model inflation to remain stable for the foreseeable future. PCE Core Inflation Source: Federal Bank of St. Louis FRED, author's calculations However, we recognize that inflation target changes are possible as a result of macroeconomic conditions, political climate, public policy and Fed policy. Indeed, the 2% explicit inflation target itself is relatively new (introduced by Ben Bernanke in January of 2012).4 To address this possibility and help ensure our inflation expectations remain as accurate as possible, we monitor both forward inflation projections and implied inflation rates from the fixed income securities markets. Forward Fed Projections The Fed distributes their macroeconomic projections to the public on each FOMC meeting date (just hours after). These reports include information about the distribution of projections across all 17 Federal Open Market Committee (FOMC) participants for real GDP growth, the overall inflation rate, overall PCE inflation, core PCE inflation and the Fed Funds rate. The median and central tendency5 forecasts for one, two, and three years ahead as well as longer-term are provided. The ranges on the forecasts one, two, and three years ahead are also provided. An example of the Fed report from the March 2017 FOMC meeting is shown below. We monitor these reports closely and focus on any significant changes in projections for PCE and core PCE inflation in particular for any indication that we need to be adjusting our views accordingly. At present, inflation projections are tame with the relevant inflation statistics all near 2% and below this level in many cases. Forward Fed Projection Table Source: Federal Reserve Board Inflation Breakeven Rates Given pricing in the TIPS and US Treasury markets, we can derive the market's expectation for inflation at different horizons. This expectation is often referred to as the breakeven inflation rate. For a given maturity, the breakeven inflation rate is the difference between the yield on a US Treasury note (bond) and the yield on an inflation-protected US Treasury security (also known as TIPS) with the same maturity. If we perform this calculation for a 5-year maturity, for example, we get the market's expectation for inflation over the next five years. How does this make sense as an expectation for inflation? The cash flows on TIPS are tied to the Consumer Price Index (CPI), another common gauge for inflation. The principal on TIPS rises with CPI while the coupon rate represents a real return (i.e., return above inflation). To the extent that the semi-annual coupon payments and the final redemption value of TIPS track increases and decreases in CPI, investing in TIPS serves as a perfect hedge against inflation. In contrast, US Treasury bonds are fully exposed to inflation risk. Thus, the yield spread of a US Treasury bond over TIPS with the same maturity—often referred to as the TIPS spread—represents the premium an investor demands for being subjected to the risk of inflation in the future. The markets, in fact, give us a term structure of inflation expectations as shown below. Term Structure of Expected Inflation Rates Source: US Treasury; author's calculations This gives us the market's expectation for future inflation over 5-year, 7-year, 10-year, 20-year, and 30-year horizons. We see that only the breakeven inflation rate for the 30-year horizon is just north of 2% as of 2017-05-02. Since breakeven inflation rates are based on a pricing measure that changes regularly, they can provide an early indicator of meaningful increases in inflation. But as appealing as these market-based measures might be, they are not without their drawbacks and therefore cannot serve as the sole basis for formulating our inflation assumptions. For one, breakeven inflation rates reflect factors that may have nothing to do with long-term inflation expectations. For example, TIPS are not as liquid as plain vanilla US Treasuries and their yields may, therefore, have an embedded liquidity premium. Changes in risk appetite which cause nominal Treasury yields to rise and fall can also influence the TIPS spread. Additionally, regardless of maturity, whether 5-year, 7-year, 10-year, 20-year or 30-year, inflation expectations based on the TIPS spread are volatile as clearly shown below. Our goal is to forecast long-term inflation and we do not want to get whipped around by transitory changes in market expectations. We would need to see sustained and persistent increases in breakeven inflation rates above 2% across the term-structure before we would consider an increase in our long-term expected inflation assumption. Expected Inflation Rates Across All Available Maturities Source: US Treasury 5-year, 5-year Forward Inflation Expectations Rate Another long-term measure of the market's expectations for inflation expectations is the 5-year, 5-year forward inflation expectations rate. This is a measure of what the market expects inflation to be over a 5-year period five years from now. In other words, it is an inflation breakeven rate that, as shown in the figure below, applies to the five-year period starting five years from the respective dates in the x-axis. This market-based measure of long-term inflation expectations is preferred by the Fed as it is less sensitive to cyclical factors like energy prices. It, therefore, gives a better indication of whether the market thinks that the Fed is meeting its goal of long-term price stability. Currently, this measure suggests an expected inflation rate of under 2%. This market-based measure is also volatile and is just one additional source of information about inflation rates that we watch. 5-year, 5-year Forward Inflation Expectations Rate Source: Federal Bank of St. Louis FRED Conclusions Long-term historical trends suggest that the Fed has been very effective at keeping the long-term inflation rate anchored at 2%. Current Fed projections show that policymakers are not anticipating that this will change anytime soon. Furthermore, almost all market-based measures currently indicate that inflation expectations fall below the Fed’s 2% target and we would need to see more sustained deviations above this target level before changing our expected inflation assumption. For all these reasons, we assume a 2% inflation rate in our financial planning models and research. 1 See https://www.federalreserve.gov/faqs/economy_14400.htm 2 See https://www.federalreserve.gov/faqs/economy14419.htm and https://en.wikipedia.org/wiki/Coreinflation for more on this preference. 3 See https://research.stlouisfed.org/publications/review/12/01/65-82Thornton.pdf for a historical perspective on this. 4 https://en.wikipedia.org/wiki/Inflation_targeting 5 The sample mean, excluding the three highest and three lowest projections. -
The Economy’s Performance vs. the Stock Market’s Outcomes
What the economy is doing today tells you very little about what the stock market might do ...
The Economy’s Performance vs. the Stock Market’s Outcomes What the economy is doing today tells you very little about what the stock market might do tomorrow. Today’s the 30th anniversary of the Crash of 1987. A common time for people to look at the stock market and wonder what comes next. Here’s one of the strangest and most frustrating things about investing: What the economy is doing today tells you very little about what the stock market might do tomorrow. Go back to January, 2010. President Obama summed up the state of the economy in his State of the Union Address: One in 10 Americans still cannot find work. Many businesses have shuttered. Home values have declined. Small towns and rural communities have been hit especially hard. And for those who'd already known poverty, life's become that much harder. This wasn’t hyperbole. The economy was about as bad as it had been in 30 years. Investors witnessing the pain inflicted on businesses and consumers at this time could say, “The economy is a mess, so I don’t want to invest in the stock market.” I wouldn’t blame them. That makes rational, logical sense. But the S&P 500 is up more than 200% since that speech. The market’s average annual return since 2010, at nearly than 13% per year, is about 40% higher than the long-term historic average. It was one of the best times to invest in modern history. Now go back to January, 2000. President Clinton summed up the state of the economy in his State of the Union Address: We begin the new century with over 20 million new jobs; the fastest economic growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest poverty rates in 20 years; the lowest African-American and Hispanic unemployment rates on record; the first back-to-back surpluses in 42 years; and next month, America will achieve the longest period of economic growth in our entire history ... My fellow Americans, the state of our Union is the strongest it has ever been. This wasn’t hyperbole either. The economy was about the strongest it had ever been. Investors witnessing the strength of businesses and consumers at this time could say, “Everything's going right. Now is the perfect time to invest.” I wouldn’t blame them. That makes rational, logical sense. But three months after this speech the market peaked, and began one of the worst three-year periods in history. The S&P 500 fell nearly 40% by the end of 2002. It was one of the worst times to invest in modern history. Researchers at the Vanguard Group once crunched historical numbers to show how economic numbers like GDP growth, interest rates, government debt, corporate profit margins, and earnings growth correlated with stock market returns over the following year and 10 years. The answer for virtually every metric was: They tell you almost nothing. There is a huge disconnect between economic performance and stock market outcomes. There is a huge disconnect between economic performance and stock market outcomes. “Many commonly cited signals have had very weak and erratic correlations with actual subsequent returns, even at long investment horizons,” the researcher wrote. Things like GDP growth and interest rates in one year had literally zero correlation to what the stock market might do over the following year. One Vanguard researcher with a sense of humor tested the correlation between nationwide rainfall and subsequent stock market returns. It was actually a better predictor of what the stock market will do next year than things like GDP growth, earnings growth, and analysts’ estimates of future economic growth. The stock market is driven by a combination of companies earning profits and changes in investors’ moods about those profits. The latter is the most important driver, especially in the short run. When investors get optimistic they pay more for $1 of corporate earnings than they do when they’re pessimistic. And those mood changes often have no connection to what the economy is doing at the moment, for two reasons: One, moods are driven by hormones rather than data, persuaded by things like herd mentality and the fear of missing out. Two, moods look ahead to the future, anticipating what might happen next year with little care about what’s happening now. That’s likely why stocks performed so well in 2010 when the economy was doing so poorly. Investors were looking ahead at what might happen to company profits in 2011 and beyond. And the apparently felt pretty good about it. The point isn’t that investors should pay no attention to what the economy’s doing. But be careful when letting the view of what’s going on around you today guide what you do with your investments today. Instead, try to let two questions steer your thoughts about the market: Your individual goals. How long can you stay invested for before needing this money? Your tolerance for the market’s ups and downs. Are you able to handle the psychological sting of normal market volatility, particularly in the context of how long you can stay invested for? Those won’t tell you what the market might do next. But they’ll help you, as an investor, form a rational plan in a world where the economy’s influence on the stock market often seems to make no sense.
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