Stress Testing vs. Market Timing
I’ve gotten feedback on the Portfolio Stress Testing that I offer to my financial advising customers. Much of it is good, but some wonder if I’m being true to all of my principles. “John?” my clients tell me, “you recommend against market timing, yet your Portfolio Stress Testing approach is going to shape my portfolio to guard against certain problems that may be coming down the road. Isn’t that another way of doing market timing?”
No – and here’s the simple reason. Most of my clients, if you peel back the covers, are closet market timers. Lots of clients and potential clients of mine admit to wondering what would have happened if they got out of the market just before the crash. Others wonder what would have happened if they got into a certain investment just before its big run-up. This is a very natural thing for people to wonder – I see it a lot.
Most of my clients are hoping to beat the market with their portfolios. And how do you beat the market? It’s easy – you just need to know in advance what the market is going to do, and position your portfolio to benefit from the coming change. You see the fallacy already – nobody knows what the market is going to do in advance. But that kind of guessing is the heart of market timing. Stress testing is very different. When stress testing portfolios, we build portfolios that have a general direction to them – something that satisfies my clients’ desires to drive their investments toward a goal, while still guarding against the most likely problems that can attack their portfolios.
Inflation is a great example. A few years ago, only a few of my customers were worried about the impact of inflation on their portfolios. But what a difference a few years has made! Low interest rates, large quantities of government spending, high deficits, and other factors have spooked investors about inflation so badly that some are considering buying gold to hedge against the inflation! (Crazy, if you ask me, but that’s a subject for another article.) So is it sensible to build a stress-tested portfolio that still has good income performance, but is better safeguarded against inflation risk? Of course it is. Is that market timing? Nope – that’s smart investing.
Portfolio Stress Test
I’ve recently debuted a new tool in my financial planning business. I call it the Portfolio Stress Test. You’re probably familiar with the idea of stress tests in the health arena. Maybe your doctor has put you on a treadmill to see how your body reacts to a variety of exercise activities. Tests like these show us where we need to improve our health to avoid trouble down the road. That’s exactly my goal with the Portfolio Stress Test.
What the Portfolio Stress Test does is checks to see if a portfolio is prepared for the next ‘big thing’. Our economy is big and complex, and from time to time, big unexpected changes come our way. (Kind of like finding out the arteries in your heart are getting clogged). Take inflation, for example. Surprisingly high amounts of inflation can throw people’s investments into chaos, as they suddenly aren’t earning enough to keep up with inflation. Would you want to know if your portfolio is too vulnerable to inflation? Of course you would – the same way you’d want to know if your heart wasn’t strong enough to run a marathon.
My Portfolio Stress Test actually measures seven different kinds of stress that can give a portfolio a stroke: strong economic expansion; tough recession; high inflation; unprecedented deflation; a strong dollar; a weak dollar; and Black Swans.
What’s a Black Swan? A Black Swan event is a completely unexpected, high impact event that pulls the whole financial world down with it. In short, do you remember 2008? 2008 was nothing but one big Black Swan event, as far as I’m concerned. But there’s good news: Black Swans in the financial world, like their counterparts in the natural world, are few and far between.
The important question to ask yourself about your portfolio is not whether one of these problems will ever hit your portfolio. The important question is which one is going to hit next – and when. An even better question is this: is your portfolio ready to handle what’s coming next, regardless of what it is? Is it ready to handle all seven of the big things that could be coming next? Would you rather have a portfolio that’s been stress tested against all the things you think could happen to it, or tested against all the things I think could happen to it? Get your portfolio stress tested today.
Turning the Lights On
Our culture is very safety-conscious. We buckle up for safety. Food packages let us know whether the product was made in a factory that also processes nuts. Our hot cups of coffee carry large warnings to let us know that the hot coffee is, in fact, hot. I guess my point is sometimes we can get a little overzealous with our safety checks.
I don’t understand all the moving parts of my car. I don’t understand all the moving parts of my chair. But I trust both of those machines – both with my weight, and at least one with my life. Financial planning can be a lot like that. I don’t want my customers to feel like they need to understand the financial markets perfectly in order to rebalance their portfolio in a way that serves their goals. Now, I do want my customers to ask smart questions. I don’t want people investing with Bernie Madoff, for example. But some people can take question-asking too far.
Let me give you an analogy. In some ways, pulling the trigger on certain portfolio changes is as simple for me as turning on a light switch. And most people appreciate that I know what I’m doing, and that the changes I put into play make their financial picture better. But some people watch me getting ready to flip the switch to improve their portfolio, and they get panicky. “Wait, John”, their attitude says, “tell me more about how this light switch works.”
Some people are content to know that at the other end of the wire is some kind of power generator, and that some kind of transmission equipment carries the power to the building, and that the switch connects a couple of wires that lets the light come on. Other people are harder to reassure. They would wonder exactly how that power was being generated: coal, nuclear, hydro-electric? They’d be uneasy not knowing exactly what kinds of cable carried the electricity to the building, and what kind of insulation protected it from the elements. Still others are going to want a seminar on electricity and magnetism before they feel comfortable making a move to throw the switch.
In a field where you aren’t an expert, there comes a point where learning more about that field costs you more in time than you gain in benefits. I don’t want people making dumb decisions with their portfolios. So here’s two important ways to improve your investment performance. First, find trustworthy individuals to help you shape your portfolio. And second? Trust them.
Cramer Isn’t a Lousy Stock Picker?
“While Cramer may be entertaining and mesmerizing to many of his viewers, his aggregate or average stock recommendations are neither extraordinarily good nor extraordinarily bad.”
Really? Says who?! This quote appears in an article I just read, which claims to have proof that Jim Cramer, of the popular Mad Money TV show, is not a lousy stock picker. Now, this kind of thing always aggravates me. I hate stock picking. If you’ve watched any of my video blogs at JohnPollock.tv, you know I consistently urge my customers to stop trying to pick stocks. So imagine my surprise to read an article that says Cramer isn’t a lousy stock picker. My attitude? Every stock picker is a lousy stock picker – it’s just the nature of stock picking.
I have to credit Jim Cramer with at least this much – he is a great showman. He can be fun to watch (at least in small doses), and I won’t rule out the possibility that people can learn interesting things about the market by watching his show. But did you know that his show is produced by the same people who produce the Jerry Springer show? Think about it.
But still, let’s be analytical about this. If you read further into the article, you learn that two researchers from Northeastern University analyzed all of Cramer’s trade recommendations and found that Cramer’s picks would have shown a gain of 12.1% over the last few years, during a time where the Standard and Poor’s index only gained 7.4%. That’s not bad, right? But check out the fine print.
Cramer tends to pick small-cap stocks, and guess what – small-caps tend to grow quickly! That’s just how they work. Knowing that, let me tell you how you beat Cramer’s portfolio. Stop picking individual stocks, and buy a broadly-based structured fund that focuses on small-cap stocks. You’ll cut out the trading costs (consider that each trade that Cramer recommends would probably cost you ten bucks in trading costs), you’ll cut out the taxes, and you’ll have better returns.
And here’s another nice benefit; you won’t have to waste an hour of your life every day watching Cramer’s show!
Gold is Not Always an Inflation Hedge
I listen to a lot of talk radio on my commute to work. I’ve been hearing lots of commercials urging me to add gold to my portfolio because it “can be a hedge against inflation”. I’m awfully glad to have caught a segment on Fox Business with Mark Matson, who addresses that idea and provides some welcome clarity.
Mark founded and is the CEO of his own financial advice company called MatsonMoney. His main point on gold is that it’s only grown at a rate of 2% since 1850, during a time where inflation has been at 3%. That’s a terrible investment, even if you’re just trying to hold on to the value that’s already in a portfolio. In the same time range, stocks gained 9%, says Mark. If your goal is to just keep up with inflation, Mark suggests, short term fixed-income investments are a good move, but to beat inflation, Mark stresses the vital need to be in equities. Gold, he says, is great for jewelry, but bad for your portfolio.
He points out the comparison between the gold market and other commodities markets like oil and gas. Each of these markets has seen big short-run price spikes, but like technology stocks in the nineties, these markets have a few years of spectacular growth, but then burn out. By the time most people learn about the run-up, Mark says, it’s already time to start getting out of that market to avoid the inevitable crash. Investing in those markets when everybody is throwing money at it isn’t prudent investing; it’s gambling.
Mark Matson recommends having some portion of just about any portfolio in equities, expecting that those stocks should be held for ten, twenty, maybe even thirty years or more. Large stocks, from established companies are okay, he points out, but micro-cap stocks (small companies) historically have an expected premium over large stocks by about 3%. Value stocks (companies with a net worth that is much higher than the total value of its stock) have another 3 to 4 percent premium above micro-cap stocks over the long term.
So Mark emphasizes the importance of avoiding short-term fads like gold investing in favor of investments that have proven growth over a long term, focusing on stocks for growth, and short-term fixed income investments (like bonds on government debt) to hedge against inflation. He also warns his audience to rebalance their portfolios quarterly to compensate for big swings in either the equity or bond markets, while also keeping an eye on the diversification benefits that come from international investing.
In the late 90’s, I watched a totally clueless co-worker trading technology stocks before the crash. More recently, I watched a somewhat less clueless coworker pondering the house flipping business before the sub-prime market imploded. It’s nice to hear a professional like Mark Matson confirming that the current run-up in gold is just another reenactment of the Holland tulip mania. Don’t be clueless – gold is not an inflation hedge.
I Hate Life Insurance
I am a financial consultant and I have a confession to make – I hate life insurance. Personally, I do not like paying for it or talking to people about it. It seems like I am paying for something that I will never really benefit from. I know it is necessary. But the fact is that just because I do not like it, it does not mean I do not to have it. And it definitely does not mean that my clients do not need to have life insurance.
Most people hate life insurance because they had a bad experience when they bought a whole life insurance policy maybe in their early 20’s through someone known to them or their family. If someone even mentions the term life insurance to them, they develop an instant aversion. Understandable, but they must realize that all life insurance is not bad. Life insurance is a financial tool and if it is correctly applied, it can do a world of good to their financial planning.
You need to ensure that it is not being sold to you. What I mean is do not buy it for the reasons the life insurance salesman offers like — it is an investment, a retirement tool, and it gives you so many benefits. Buy it only when it satisfies your needs and your financial objectives.
In reality, life insurance is only good for a handful of things – making sure that the family is taken care of when you pass away and that they are able to retain the lifestyle they are accustomed to. It is more a stewardship issue, a responsibility, or a peace-of-mind issue. Another important benefit from life insurance is in estate planning. It is better to pay 10 cents to a dollar to a life insurance company then pay 50 cents to a dollar to the federal government. So if you do not need your 401(K) to pay for your retirement, then cash it out, pay the relevant taxes and invest the leftover amount in a life insurance policy (purchased and maintained by an Irrevocable Life Insurance Trust), then the money could just go to the loved one’s estate tax-free. With the help of life insurance, you are able to save a good amount in taxes. Simple and beneficial math!
You need a financial coach who can offer you a comprehensive financial analysis, thereby guiding you about whether you need life insurance or not. Thus, it is probably better to get that advice from someone who does not like life insurance in the first place — A person like me!
Just like you, I feel that I am overpaying for insurance. I pay thousands of dollars every month towards insurance for everything that I am not going to get any benefit from. It is just a fall back plan. I feel like there is no tangible benefit to be derived from the insurance I keep paying for. And, I am actually aiming not to get any benefit from these. For example: I have a homeowner’s insurance, but I am not going to burn down my house just to take advantage of it. Life insurance is similar. I am not going to die or try to reach my death faster just so that my family could benefit from it. Despite knowing this, I am aware that life insurance is still an essential part of financial planning.
Life insurance is not inherently evil, but it is a necessary tool for planning and a product like many others. It must be set right by maximizing the return on investment, which is the death benefit, and minimizing the cost. Most life insurance is sold in such a way so as to maximize the cost and minimize the death benefit, as the salesman can then maximize his commission.
We don’t work this way. We are your financial coaches and our financial advice strictly caters to your objectives, whether it is estate planning or helping your family. We always recommend the best tools available to us to help you achieve your financial goals. Life insurance is sometimes a very handy tool towards that.
Sell The Blades
Today, I am going to talk about a very interesting concept – sell the blades. I remember that Gillette pioneered this concept of “Give the razor free and sell the blades”. So the strategy employed by them was to give the handle free or really cheap and then once the person owns it, sell the blades to him. This interesting strategy was very effective in boosting their sales and increasing their market penetration.
The same concept of “sell the blades” was utilized in the printer industry. The printer would be sold for a fraction of the actual cost and then the cartridges were sold at a high price. Sell the blades was also used very effectively by the cell phone companies who gave away the phone or actual instrument at very low rates or at great discounts and then made all the money on the minutes sold for it.
Thus “sell the blades” is an excellent marketing and business strategy. Getting a free razor or a printer provides value to the consumer in the market place and then selling the blades increase the profitability of the seller.
I am going to link this “sell the blades” strategy to my business model which is very unique. I am a financial advisor or a financial coach and I had a client who needed some advice. I recommended to him a financial product, which he really liked, which generated income for him, provided him double-digit dividend month in and month out, and was inflation protected. While advising him, I also told him that I get nothing to promote this product – no commissions and no fees. And he was quite baffled as to why I would promote something that I had no monetary gains from. And that is the exact point of “sell the blades” strategy.
I promote this product because it is a very good product and would help the client immensely. I am a financial coach and a coach only advises what is good for the player and not what is good for himself. Of course, a coach in turn gets paid for his services and gets a player who has a better chance of winning. So a coach would obviously base his recommendations keeping the player’s strengths and weaknesses in mind just like selling the blades.
Similarly, as a financial coach, I do not get paid for every product that I recommend but overall I get paid and benefit when the client does well. Obviously, I am in the business to make a living but I am also here to serve my client’s needs and if I am a good coach, then I will benefit monetarily too.
So, like the “sell the blades” example, there are cases when the products I recommend give me no money, for example: paying off mortgages. When I advise a client to pay off his mortgage, that takes money away from the table and I do not earn anything on it. But then that is the soundest financial advice and so I advocate that course of action so I am selling the blades. The same applied to the product I had advised, on which I earned nothing.
The point is that in all businesses, there is some part of business where everyone gives away a razor free and then sells the blades. I also sell the blades!