Fall 2015 Newsletter

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Market Volatility and Investor Behavior

The significant downside volatility in world stock markets during the third quarter of this year reminds us of one simple fact:

No one knows what the market is going to do next.

Investors need to prepare ahead of time, in both their portfolios and their mindsets, for likely market behavior. Preparation necessitates the identification of the type of investments available, the risk and reward characteristics of those investments, and the risk preferences of the investor.

The best preparation involves having an objective investment plan and sticking with that plan. This way, decisions are called for by the plan and not in response to strong emotional reactions to outside events. Of course, creating and implementing a plan calls for a level of expertise beyond the reach of most retirement investors, which is precisely why the preparation and yearly update of an Investment Policy Statement (IPS) by a qualified adviser is so critical.

Keep in mind, retirement accounts have a longer horizon and, therefore, warrant a different perspective than a brokerage account, for example. Short-term performance in a retirement account is much less important than long term, and, therefore, long term investing principles are to be used. Strategic asset allocations need to be established. Portfolio diversification is critical. Shorter term techniques such as large market timing bets must be minimized in retirement investing.

We thought we would share some of the behavioral biases that impact investment portfolios and often lead to poor choices1:

Loss Aversion

Loss aversion occurs because human beings place a higher value on avoiding a potential loss than winning a potential gain. Empirical estimates find that losses are felt between two and two-and-a-half times as strongly as gains. Unfortunately, the loss is not felt until it has occurred, and selling the investment at this time can have severe negative consequences on long-term portfolio performance, especially if this behavior is repeated over the lifetime of the portfolio.

Recency Bias

Humans tend to extrapolate recent events into the future indefinitely. We see this often in communications with investors who want to own more of Asset A and less of Asset B because the returns of Asset A have been better over the last three months, or year, etc. This is not a bias unique to the individual investor; market strategists often recommend the most aggressive of allocations near a market peak and the most conservative strategies near market bottoms.

Herding

We all tend to run in herds. The tendency to follow the investment decisions and strategies of others is even more prevalent in the institutional marketplace than with individual investors. If “everyone” is selling bond funds because “everyone” knows that interest rates have to rise, it seems to make sense to sell your bond funds too. A similar behavior is referred to as the “Prudence Trap”, it is the desire to not stray too far away from what the rest of the world thinks or does.

These are just three of the many behavioral biases that can lead to investment decisions that can lower long-term portfolio growth. The point is to be skeptical and cautious when you begin to feel an emotional reaction to your portfolio performance or allocation. Investment decisions should be made in the bright light of objective reason and fact, without the least allowance given to emotion. Emotion, even in the most capable investor, can be corrosive to a retirement portfolio and jeopardize a lifetime of disciplined saving.

1For a more detailed analysis of investor behavior, see “Above the Market”, RPSeawright.wordpress.com, July 16,2012.

Perspective on the Recent Stock Market Decline

The U.S. stock market, as measured by the S&P 500, fell by 6.4% in the three-month period ending September 30, 2015. History shows us that such declines are not unusual, however.

Looking back to 1970, we find twenty quarters where the losses have exceeded 10%, the latest occurring in September, 2011. Seven of those 10% plus losses occurred in the third quarter of the year, interestingly.

In the 45-year period since 1970, we find only one year, 2002, where the market experienced double digit quarterly declines back to back.

Health Care Sector Could be Affected by New Billing Codes

Healthcare stocks and mutual funds have enjoyed outsized returns since the Affordable Care Act was passed in March, 2010. The majority of healthcare mutual funds have generated compound annual rates of return in excess of 20% over the last five years, well ahead of the 13.7% compound return for the S&P 500.

Industry analysts in general point to the probability that medical costs for uninsured patients will decline, as more citizens comply with the mandatory health insurance provisions of the Act. Detractors point to the significant higher out of pocket costs most insured patients are experience as a roadblock to pursuing insured healthcare services.

Starting October 1st, providers will face a brand new set of procedure/billing codes that could cause some market turmoil. According to a recent Wall Street Journal1 article, the number of diagnostic codes doctors must use to get paid will grow to 70,000 from the current 14,000. Hospital procedure codes expand from 4,000 to 72,000.

Among the most bizarre (and entertaining) ICD-10 codes2:

  • 07 – “Burn Due to Water-Skis on Fire”
  • 1 – “Problems in Relationship with In-Laws”
  • 22 – “Struck by Orca, Initial Encounter”
  • 810 – “Civilian Watercraft Involved in Water Transport Accident With Military Watercraft”
  • X52 – “Prolonged Stay in Weightless Environment”

170,000 Ways to Classify Ailments, Melinda Beck, Wall Street Journal, September 27, 2015”

2”20 bizarre new ICD-10 codes”, Keith L. Martin, Medical Economics, June 16,2015”

Returns by Investor Type

(Periods Ending September, 2015)

Aggressive Index

Three Months........ -10.08%

Year to Date.......... -6.79%

One Year................ -4.25%

Moderately Aggressive Index

Three Months........ -7.74%

Year to Date.......... -5.24%

One Year................ -3.10%

Moderate Index

Three Months........ -5.10%

Year to Date.......... -3.54%

One Year................ -1.83%

Moderately Conservative Index

Three Months........ -2.72%

Year to Date.......... -2.30%

One Year................ -1.03%

Conservative Index

Three Months........ -0.84%

Year to Date.......... -0.98%

One Year................ -0.16%

Key Market Returns

(Periods Ending September, 2015)

S&P 500 Index

Three Months........ -6.44%

Year to Date.......... -5.29%

One Year................ -0.61%

Foreign Stocks

Three Months........ -10.23%

Year to Date.......... -5.28%

One Year................ -8.66%

Aggressive Index

Three Months........ 1.23%

Year to Date.......... 1.13%

One Year................ 2.94%

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