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Are stocks indicating a slow down?

April 19, 2018

By Darren P. Wurz, MSFP

As April unfolds, financial markets are starting to rebound from their sell-off amidst trade tensions. Markets have been hit by a series of shocks over the past few months, trade being just one of them. Volatility still remains elevated as we move into April. For now, fear of a full blow trade war seems to be receding, as China and Trump soften their tone. Chinese President Xi promised to expand intellectual property protections and open up China's economy to more foreign investment. However, geopolitical tensions remain elevated with sanctions against Russia going into effect and military action in Syria taking place. As a result, commodities gold and oil have rallied recently.

Uncertainty could be affecting confidence in the markets and economy. Small business optimism fell slightly in March, but in February hit 35 year highs! Part of the recession in optimism could be to blame on the labor markets, which are tightening and producing labor shortages. This along with high employment turnover is driving up wages.

Rising wages and input costs are putting pressure on consumer prices. March consumer prices rose 2.4% year over year. Core inflation, excluding food and energy, was up to 2.1% from 1.8% from the previous month. Evidently, price pressures are building. This price pressure definitely makes a strong case for further rate hikes this year. It could even lead the Fed to adopt a faster rate hike path. However, consensus still seems to be for a total of three rate increases in 2018.

What will the rest of 2018 look like? The economy and the markets seem to be a bit divorced right now. First quarter earnings reports are starting to come out. The consensus estimate is for an increase in earnings of 16.3% for the S&P 500. This would be an impressive first quarter—the highest estimates since 2011. This may be due to the tax policy, which corporations started benefitting from in quarter 1.

Still, despite these expectations, the S&P declined 1.2% during the first quarter. However, the recent market volatility has not affected earnings expectations, which remain robust. Earnings reports have started coming out. Through April 11, 5% of the index has announced results with 64% beating top-line estimates.

Are earnings estimates going to be accurate? Or is the stock market signaling a slowdown in the economy? We'll see what lies ahead. We know that markets can become severely divorced from the underlying economic fundamentals. Even in booming economies, markets can decline as investors give in to headlines and souring sentiment. In any environment, we believe it is best to stick to a rules-based, pre-defined strategy and not let earnings estimates or analyst predictions set your course. Want to learn about our strategies? Give me a call today!

 

Sources:
TD Ameritrade Institutional
Wall Street Journal

CFRA

 

What to do if stocks have peaked

April 19, 2018

By: Darren P. Wurz, MSFP

As reported by CNN Money, 58% of global money managers surveyed by Bank of America Merrill Lynch believe that either the stock market has already peaked or that it will peak this year. Given the rough start to the year, it's not hard to see why they are feeling this way. So what happens next? A prolonged downturn? It's possible. Cracks are starting to form in the global economy. The U.S. economy may be slowing by some measures. GDP is being revised lower. China is bracing for a slowdown and easing monetary policy. Often the stock market is a leading indicator for the economy, meaning that it plunges just before the economy does.

Whether the peak is now or a year from now, it is coming. And investors need to have a plan in advance. Downturns can be severe and prolonged. Remember the start of the 2000s? The market declined for three years in a row, devastating portfolios of millions of investors. Remember 2008? The market lost nearly half its value and took years to recover.

Traditional wisdom would say that it is best to stay put. Whatever you do, don't sell! And stick to your long term strategy. Well if your long term strategy is to simply stay invested in the same funds forever, this doesn't sound like much of a strategy to me. In fact, I believe this is a view that has been promoted by the mutual fund industry solely for the sake of their own pocketbooks—in the interest of not losing assets.

Sometimes investors stay put simply because they are caught between two dilemmas:

  1. Oh man, I should have gotten out of the market
  2. But if I get out now, I could miss the upswing

If you're nodding your head right now, you know what I mean. These ideas arise from two very human emotions: regret and fear. These emotions cloud our judgment and prevent us from making good decisions. And both of these emotions come from too much attention on the past.

We believe the best thing investors can do is to be forward-thinking. The past is done. Could have, should have, would have doesn't work in the markets. The only thing that matters is what's next. You'll never time the market just right. So stop with the could-have's and the what-if's. The smart money knows there's always a bull market somewhere. For instance, in 2008 when the sky was falling, long term treasury bonds did exceptionally well. And while the S&P 500 declined by almost half, there were some sectors that did better than others. Evaluate the investment horizon for opportunities and invest in whatever you think is the best opportunity at the time. If there's another opportunity that is more attractive than your current holdings, go there.

Want to evaluate where you are and what attractive opportunities still exist in the markets? Call me today! I'll be happy to talk with you. 859-291-9879

Sources: CNN Money

 

 

How to forecast your expenses in retirement

April 19, 2018

By: Darren P. Wurz, MSFP

I've talked to a lot of retirees and people close to retirement. And I've run into some very smart people! Many retirees I talk to have done their own financial forecasting and modeling, trying to estimate what their expenses will be 5, 10, 15 years from now and if their portfolio will be able to sustain the spending.

So how exactly do you forecast your expenses in retirement? This is tricky. Even the most avid budgeter is going to be off because there are a lot of unknowns. But there are ways to improve your accuracy. Let's start with the worst method: cash flow.

The worst way to forecast your expenses is based on your current overall cash flow. The way this is done is like this: take your current take home pay, subtract taxes, subtract how much you are putting away in retirement accounts and other accounts and voila! There's how much you'll spend in retirement.

There are a few problems with this method. First, what you spend money on right now is not what you'll necessarily spend money on in retirement. Unless of course you want to buy work clothes and drive to an office every day in retirement. But if you're like me, you want to do different things—like travel, try new hobbies, maybe start a business just for fun, volunteer, dote on your grandkids, etc.

Secondly, your expenses will change over time. The amount you spend on healthcare will go up probably because you won't have a generous employer health plan. Medicare isn't free. And furthermore, healthcare costs will probably increase faster than other expenses like food and shelter. Other things change too. For example, at a certain point in time your home will be paid off and you'll spend less because you won't have a mortgage.

Okay, so what's the better method? Goals-based budgeting. Create a separate budget for different categories: basic living expenses, healthcare, mortgage, travel, a home remodel, a new sports car, etc. Start with the basics—the bills and spending on everyday things like food. These are your basic living expenses. Make sure you adjust your budget for inflation—I estimate about a 2.5% increase each year. Add in the mortgage and when it gets paid off, but make sure you keep the property taxes in your budget. Oh and these will inflate each year too. When it comes to healthcare expenses, I use a higher inflation rate: 6.5%. If you need help estimating these costs, AARP has a health care costs calculator on their website.

Sounding confusing and tricky? Maybe you need the help of someone who specializes in this stuff. With a Master's degree in Financial Planning, I've got the skills to help you. Give me a call today! 859-291-9879

 

 

Can Bonds have BEAR markets too?

March 15, 2018

By: Darren P. Wurz, MSFP

Bonds have long been used as a “safe-haven” for investors. For years, investors and portfolio managers have incorporated a percentage of bonds in their overall allocation to supposedly reduce volatility and hopefully defend against a market downturn. It's almost common knowledge that more aggressive investors should hold less bonds and more conservative investors should hold more bonds in their portfolios. This has served investors well for over 30 years. From a high of around 20% in the 1980s, interest rates have declined over time to near 0% during the Great Recession. There have been bumps along the way, but overall, the trend has been downward. When interest rates decline, bond prices rise. Bond investors have benefited tremendously from the price appreciation in bonds that has resulted from declining interest rates.

But don't for a second think that bonds are “safe” assets. Interest rates are poised to rise and have been rising over the past couple years as the economy finds its footing. Bonds have not fared well over the past few months. In January, the Barclays Aggregate Bond Index declined by 1.15%. More interestingly, in February, as the S&P 500 fell 3.89%, the bond index also declined by 0.95%, offering only relative shelter for investors.

The one year return for the index is a paltry 1.46% (all data is as of 3/15/2018). And I expect that bond returns will be muted if not negative if the rise in interest rates continues. Certain segments of the bond market will fare better than others. Some bond types are less sensitive to changes in interest rates. Investors should bear in mind the goal of their bond holdings. If the goal is capital preservation and buffering market volatility, investors should pay attention to these risks.

Are you looking to preserve your wealth by using bonds but feeling wary about interest rates? We should talk! Give us a call at 859-291-9879.

Sources
www.morningstar.com

 

Lessons from the Dow's "Biggest Point Drop Ever"

February 15, 2018

By Darren P. Wurz, MSFP

The market raced upward through January and cratered back to Earth in February. Volatility jumped through the roof and the sudden break in year-long calm caused investors' hands to sweat. Markets can be an emotional ride and the events of the past couple weeks remind me of some very important lessons for investors:

1. Don't read the headlines. The news is in the business of selling ads. They want to sensationalize everything to get more viewers and more advertiser dollars. I loved seeing “biggest point drop ever for the Dow Jones” in the headlines. This is ridiculous nonsense. Points DON'T matter. In the 1987 crash, the Dow dropped 95 points. That seems mild compared with the Dow's 1,175 point decline on February 5th, right? Well consider that today the Dow is around 25,000 and in 1987 it was around 2,400. What matters is percentages—not points. 

2. Don't listen to the gurus. The so-called “geniuses” on CNBC and other news outlets should not be your guide. I literally watched a news outlet show two completely different stories from two seemingly competent experts in the same day. One said the market was going to skyrocket back, the other said this was only the beginning of a huge downturn. Obviously, both can't be right. Further, I love watching the talking heads trying to explain why the market is doing different things. The market is RANDOM and often without explanation. In his book, The Beast on Wall Street, Robert Haugen documents the 100 largest stock market moves over the last century and shows that most had absolutely no correlation to global events or economic news. 

3. Ignore the short term volatility. Markets can fluctuate wildly in the short term. True--these short term fluctuations can sometimes be the start of longer term trends. But much of the short term fluctuations in the market are random noise. What really matters is what happens over the next 12 months and beyond. 

4. Summon your inner Spock. When the headlines are screaming panic, the talking heads are pounding their heads and markets do weird things, it's easy to let your emotions get the best of you. Human beings are prone to severe judgment errors in decision making that arise from our behavioral psychology. Instead of sitting there watching the news and wringing your hands over what to do, have a disciplined, rules-based plan prepared in advance and above all, stick to your plan!

References:
Haugen, R. A. (1999). The beast on wall street: How stock volatility devours our wealth. Upper Saddle River, NJ: Prentice Hall.

 

 

This Can't Go On Forever

January 22, 2018

By Darren P. Wurz, MSFP

The first couple weeks of 2017 have been absolutely stellar. If we keep up this pace, the S&P 500 could have an almost 200% year, according to Barron's magazine!

Of course, that's absolutely ludicrous. The further we go up, the greater the risk we face of going down. The risk of a major pullback is growing by the day. We're witnessing the best start to a year since 2003—which followed a bear market during the early 2000s and was followed by a subsequent 12% drop. Only this time, this stellar start to the year comes on the heels of a 9 year bull run. This has been the second most expensive rally since World War II, second only to the dot com bubble of the 90s.

Are we at the top of the market? The most expensive market top was in March 2000, with a P/E ratio of 31. Currently, the S&P is trading at a P/E ratio of over 25. The average market top has been at about 18.5. We're not yet in unfamiliar territory, but we're close.

Meanwhile, market data continues to be very good. There are high hopes for 4th quarter results which will are starting to come in. Analysts are expecting a gain of about 10%, which would be fantastic. Retail sales rose 0.4% month over month in December, which is very good. 4th quarter consumption growth is expected to come in around 3.3% year over year.

Small businesses are very optimistic, especially given that small businesses stand to benefit the most from the tax overhaul. Small business owners are showing historically high levels of optimism. They do, however, face a headwind in the labor markets, citing a difficulty in finding workers in this tight labor market.

How's inflation doing? The year over year pace for December is expected to be about 1.8%. Even though that number is just shy of the Federal Reserve's 2% goal, the economy is growing strongly. Given the increasing risk of economic overheating, TD Ameritrade is forecasting 3 rate hikes for 2018.

Where is there still some opportunity in the market? CFRA suggests small-caps and mid-caps may be the winners for 2018. With the S&P 500 as expensive as it is right now, CFRA is projecting only a 5% gain for the S&P 500. Meanwhile, CFRA sees more room for growth in small and mid size companies. They're projecting a 12% for the S&P 400 (mid-caps) and a 15% gain for small-caps. Of course, no one knows what the future may hold. In any market environment, we believe in staying diversified and sticking with a long term plan. If you'd like to talk about your investment plan and whether or not it is situated appropriately for the future, give me a call!

859-291-9879

Sources

The Weekly Bottom Line. TD Ameritrade. January 12, 2018.

Stovall, Sam. (2012). “Capping Expectations: Mid- and small-cap stocks boast greater price appreciation potential.” The Outlook by CFRA

Chang, Sue. (2018). “This epic stock-market rally will get a second wind from stellar earnings.” Retrieved from: https://www.marketwatch.com/story/this-epic-stock-market-rally-will-get-a-second-wind-from-stellar-earnings-2018-01-13

Levisohn, Ben. (2018). “Over! The! Top! Dow surgest 228 points as S&P has best start since 2003. Retrieved from: https://www.barrons.com/articles/over-the-top-dow-surges-228-points-as-s-p-has-best-start-since-2003-1515801547


This Economy Won't Let Hurricanes Blow it Off Course

October 16, 2017

By Darren P. Wurz, MSFP

Global stock markets have re-accelerated their march to new highs, despite tensions with North Korea, gradually rising interest rates, hurricanes and uncertainty with US government policy. While emerging markets and large cap growth stocks have been the main leaders this year, small caps finally rallied after a lackluster 2017 so far.

The recent hurricanes have had a mixed effect on the economy. While unemployment is up in hurricane hit regions, recovery efforts have given a boost in some areas. Retail sales were up 1.6% for the month of September, partly due to increased sales of cars and building and material supplies. Strong growth in other spending categories has certainly helped buoy any temporary hurricane effects as well. Rising incomes and strong job growth may lead to stronger consumer spending yet.

At the same time, the low-inflation saga continues. While headline inflation rose at a 2.2% year over year pace, much of this was caused by increases in gasoline prices following the hurricanes. Core inflation (which excludes food and energy prices), remains at 1.7% year over year. While the Fed seems intent on continuing its gradual increase in interest rates, inflation stubbornness may weigh on their decision making process. However, the consensus among analysts is still for a rate hike this coming December.

Altogether, economic growth in the US and other regions appears robust. This growth trend may be supporting stock prices. According to the IMF, though, there continue to be considerable risks to the global economy's slow recovery. We continue to monitor global economic events for our clients and will keep you informed. Call or email me if you have questions or concerns.

859-291-9879

dpw@fortunefinancialservices.com

Sources

TD Ameritrade

 

Retirement Birthday Milestones

The 5-10 years before retirement are often referred to as the “retirement red-zone” because they are so critical. Doing the right things at the right time can mean the difference between retirement success and disaster. As you get closer to retirement, here are some milestones to keep on your radar:

  • Age 50: Earliest age to make catch-up contributions to IRAs and employer-sponsored retirement plans
  • Age 55: Earliest age to make “catch-up” contributions to a health savings account
  • Age 55: Earliest age to take distributions from your 401(k) without penalty
  • Age 59-1/1: Earliest age to withdraw money from IRAs and most tax-deferred retirement plans without penalty
  • Age 62: Earliest eligibility to begin collecting Social Security benefits
  • Age 65: Eligible to enroll in Medicare     
  • Age 66: Eligible for full Social Security benefits for those born between 1943 and 1954
  • Age 67: Eligible for full Social Security benefits for those born in 1960 or later

the information above Does not constitute investment advice or a recommendation of any kind, financial or otherwise. 


 

Why Target Date Funds Fail Investors

October 6, 2017

By Darren P. Wurz, MSFP

One of the most popular investment strategies for investors is the “target-date fund.” Often part of 401k offerings, these funds offer an easy way to put your retirement savings on auto pilot. However, they have some important drawbacks to be aware of. Target date funds vary widely in their approach. They are only as good as the underlying investments they are made of. And they may expose investors to greater risk than they are aware of.

To start, what is a target date fund? Target date funds are mutual funds that are designed with a particular retirement year in mind. They adjust their portfolio over time as that date draws near, becoming gradually more conservative. For example, if you want to retire in 2040, you might buy a 2040 target date retirement fund. This fund will start off more aggressive (i.e. with a greater percentage in equities or stock) and slowly become more conservative, reducing exposure to equities and shifting to bonds over time. While this may seem like a prudent way to manage retirement funds, there are some important things to consider.

“It's not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.”—Robert Kiyosaki

 

First of all, target date retirement funds are not all created equal. Even though they have similar objectives, target date funds vary widely in their composition and strategy. For example, 2020 target date retirement funds exhibit extreme variation in their exposure to equities, with the most conservative having as little as 12% in US equities and the most aggressive having as much as 41% in US equities. They also vary widely in their approach to bonds, with bond allocations ranging from 29% to 77%! Clearly, there is little agreement in the field as to what approach is best and some are riskier than others.

This variety makes it difficult to compare and evaluate target date funds. Because of the differences in their portfolio composition and strategic approach, these funds may also vary widely in their performance from year to year. It is usually not best to select a fund based on it's performance alone and this is especially true for target date funds. Differences in performance between target date funds might be caused by differences in their composition and exposure to particular asset classes.

In addition to have such wide variety, target date funds do not know you personally. They do not know how much risk you are comfortable with. They do not know how much risk you are personally and financially capable of handling, if you have other assets to take into consideration or how risk may affect your long term retirement outlook. More importantly, they do not take into consideration your life expectancy or time horizon. A 50 year old retiring in 2020 has a different time horizon and different needs than a 70 year old retiring in 2020. But target date funds do not know this—they simply follow a prescribed formula as time marches on.

Many companies construct their target date funds using a mix of their own funds, making the target date fund a “fund of funds” This has two downsides. First, you may only get the funds that particular fund company has. If the fund company has less than desirable funds, so will your portfolio. If the fund company does not offer a fund in a particular asset class, you will not get exposure in that asset class.

There are other downsides to the structure of target date funds. As time marches on, target date funds maintain their desired percentages of stock and bonds and other investments through what is called rebalancing—selling assets that are larger than their targets and buying assets that are smaller than their targets. While this approach is consistent with the goal of target date funds, which is to provide diversification and an allocation appropriate for your age and time horizon, this prevents the fund from being able to react to market events to either take advantage of opportunities or mitigate risk when needed. 

And mitigating risk is what I am really getting at in this article. Even though target date funds may position themselves more conservatively over time, they fail to protect investors from market risk. In 2008, many target date funds declined more than their investors were expecting or were prepared for. For example, investment research company Morningstar found that the average 2010 target date fund, designed for people retiring in 2010 and which by 2008 should be fairly conservative, had a negative 23% year in 2008. Remember how we said target date funds vary widely in their composition? In 2008, 2010 target date funds ranged from as much as 65% in stocks to as little as 26% in stocks. More aggressive funds suffered much worse performance in 2008. The worst among them was down 41%. If you are approaching retirement in two years, can you afford for your portfolio to decline by this much?

To make matters worse, it took nearly 3 years for most funds to fully recover. On Dec. 31, 2009, the average target date retirement fund's 3 year annualized return was -0.97% according to a report by Morningstar.

Was 2008 an anomaly? Perhaps. But steep drops in the market are a lot more common than we would like to admit. And the markets are a lot more risky than investors are oftentimes aware. 2008 showed us that a traditional stocks and bonds portfolio may not be able to sufficiently mitigate risk for retirees. The markets will go through bad times. A bear market will probably return at some point. Target date retirement funds may not be able to provide adequate risk management for retirees.

Do target date funds have a place at all? Target date funds do have benefits and may be suitable for some investors. For smaller portfolios, they are an easy and inexpensive way to achieve diversification. However, for a large nest egg for someone near retirement, they may not be ideal. Want to review your portfolio to see if it is positioned appropriately to mitigate risk as you near retirement? Call me today! I'd be happy to talk with you.

Sources
Prestbo, John. “Opinion: Target-date retirement funds may miss the mark for investors.” Jan 11, 2016. Retrieved from www.marketwatch.com
Morningstar. “Target-date series research paper: 2010 industry survey.” 2010. Retrieved from Morningstar.com
Powell, Robert. “Target-date funds missed the target in 2008.” Feb 4, 2009. Retrieved from www.marketwatch.com

This article does not constitute investment advice or a recommendation of any kind. Past performance is not indicative of future results. Opinions given in this article are not necessarily those of Fortune Financial Services, Inc. or Prosperity Wealth Management, Inc.

 

Market Snapshot: August 2017

August 15, 2017

By: Darren P. Wurz, MSFP

So much for low volatility. The last few weeks have shown us how quickly the markets can change. Let's start with North Korea. The ramped up rhetoric between the US and North Korea was blamed for rattling the markets recently. The thing to remember here is that North Korea has threatened Gaum many times in the past and backed down. However, the media attention and new capabilities North Korea is boasting about has made some investors uneasy.

In other news, there's been chaos in Venezuela. The Constituent Assembly in Venezuela declared itself supreme. In response, the US sanctioned 8 individuals. Venezuela is the third largest exporter of crude to the US. There could be some effects in oil markets from this, which might put some much needed upward pressure on the price of crude.

In Europe, the UK is beginning its negotiations for leaving the EU. EU officials have suggested this would come at a price tag of 50 to 100 billion euros. Get ready for the fight over how much the UK ends up forking over. Was Brexit really a great idea?

In the US, earnings are growing. Earnings for the S&P are expected to rise 11.9% compared with the same quarter last year—9.2% if you exclude the energy industry. Earnings for the energy industry are expected to rise somewhat faster than the S&P overall. And energy companies are hitting rock bottom in terms of valuation right now.

Also, the Fed is talking about reducing the size of its balance sheet—or in other words allowing some of the trillions of dollars' worth of debt it acquired in the financial crisis to mature. They've said they expect to begin this process soon, possibly this year. However, at the same time—are you ready for this?—the government needs to raise the debt ceiling again. We could see some turmoil in the markets if a fight over the debt ceiling unfolds. The Fed may delay reducing its balance sheet if this doesn't happen to avoid upsetting the markets.

Inflation is still stubbornly low, running below the Fed's 2% goal. The consensus among analysts is only  50% chance of further rate hikes—potentially good news for bondholders. The Fed may also want to pause rate hikes while it reduces the balance sheet.

Interest rates remain historically low. The long term outlook for growth and inflation is weak, owing to several headwinds facing developed economies: global debt, aging populations and the disinflationary effects of globalization and technological advances.

We continue to monitor events in the global economy as they relate to our clients' portfolios and we'll alert you if any changes are needed. In any environment, we believe it is important to stay diversified and stick to a long term strategy. 

 

 

 

The Calm Before the Storm?

July 28, 2017

By: Darren P. Wurz, MSFP

The buzzword on Wall Street lately has been “volatility,” or more specifically the lack thereof. Volatility describes the ups and downs in the stock market over a period of time. Volatility can change. The markets can experience periods of high volatility and periods of low volatility. A period of high volatility would be characterized by extreme price swings—markets going up and down by large percentages from day to day. A period of low volatility would be characterized by just the opposite. Lately, traders have been complaining about how unusually low volatility has been. An eerie calm seems to have come over the market. Indeed, volatility is at lows not seen since at least 2007, just before the financial meltdown. That fact alone immediately puts people on edge. Is this the calm before the storm? Is this an omen of choppy waters to come?

"Fragility is the quality of things that are vulnerable to volatility." --Nassim Nicholas Taleb

The Chicago Board Options Exchange created the Volatility Index (VIX) in 1993 to measure and track stock market volatility. The VIX measures the market's expectations of volatility by averaging the weighted prices of options on the S&P 500. Options are instruments that traders use to speculate on price swings or to hedge their positions against price swings. Basically, the more expensive these options are, the more the “market” (i.e. traders) expect the market to swing. This index has become the standard for measuring market volatility and has become known as the “fear” index. The higher the VIX, the more fearful investors are thought to be and vice versa. To illustrate, the VIX reached an all time high on October 24, 2008, at 89.53—during the height of the financial crisis. The long term average for the VIX is around 18.  On the other hand, the all time low for the VIX was 9.31 on December 22, 1993. It hit the 9's in May.

This period of low volatility might suggest that investors are feeling pretty good right now. The US indices are at all-time highs, corporate earnings are strong, the economy continues to expand and there don't seem to be any imminent threats to our economic welfare.

But is investor emotion and behavior the root cause of volatility? While it is likely that volatility can be induced by investor behavior, as in the case of the financial meltdown, there are other possible causes.

First, volatility can be random. In Robert Haugen's book, Beast On Wall Street, he reports most of the largest one day price moves in the market cannot be linked to any significant world events, i.e. they are random. This isn't the kind of randomness you might expect though. Periods of elevated volatility tend to occur in random clusters instead of being scattered about. Famed mathematician and scientist Benoit Mandelbrot discovered this. This is not what we would expect if we are following modern portfolio theory—the theory that gave rise to passive or index investing. Modern portfolio theory would suggest that big market moves are rare and shouldn't occur in clusters.  But what we actually find is that big one-day moves are a lot more common than they should be.

Another cause of low volatility might be passive investing itself. More and more money is flowing out of actively managed funds into passively managed index funds and exchange-traded funds. An increasingly large amount of capital in our market is being invested in companies without any evaluation of the underlying risk. According to Bloomberg's Dean Curnutt, this could result in a dangerous circularity. This sounds similar to what happened with collateralized mortgage obligations during the financial crisis—mortgages being packaged up and sold as high quality debt investments without any consideration of the risk of the underlying mortgages.

So what is wrong with low volatility? The real risk of low volatility is how it affects investor behavior. During periods when stock markets are rising and volatility is low, investors become more willing to take risks. They make the mistake of assuming the markets are less risky than they actually are. They become less risk averse. They shift more money to stocks and away from bonds or cash. They fail to hedge against potential loss.

The graph below is TD Ameritrade's IMX index. When this index rises, it indicates that retail investors are increasing their exposure to stocks. The index has been around since 2013 and recently hit its all-time high. Clearly, investors are holding much more stock in their portfolios than in recent years.

This is dangerous for the markets as a whole, because it increases the likelihood of panic-selling caused by herd mentality during times of crisis. Dean Curnutt writes, “The result [of low volatility] is an inability to appreciate how quickly the market conditions can change, especially as trading strategies that capitalize on quiet markets become vulnerable to unwind, serving to amplify a risk-off event.”

Investors need to be careful. Higher volatility will likely be back at some point in the future. And those who have been careless in risk taking will pay the price. In the meantime, don't let this period of low volatility cause you to make the mistake of taking more risk than you should in your portfolio. If current market conditions are making you think you should make a change, be careful! Stick to your long-term investing strategy and an allocation that is appropriate for your risk tolerance and time frame.  If you would like to discuss how volatility affects your portfolio, I would be happy to talk with you.

Sources:
TD Ameritrade
Chicago Board Options Exchange
Curnutt, D. (2017, May 26). Low volatility is market's most significant danger. Retrieved from www.bloomberg.com