Merry Christmas!

I didn't get around to writing much this week but thankfully DFA's Weston Wellington did. In A Vote for Small Cap Stocks? he discusses how recent stock market behavior illustrates the difficulty of trying to get in or out at the most opportune times.

Have a safe and Merry Christmas!

Back to School

In addition to my day job as an investment advisor, I serve as Treasurer on a couple of non-profit boards, and coach a youth softball team. Those responsibilities, along with a couple of technical problems, resulted in this week's Accountable Update not being ready by press time.

Don't panic, though. My friends at DFA just came out with an Issue Brief about preparing for children's future college expenses. It has some similar themes to a couple of other recent Accountable Updates, Money For Nothing and College For Free and PSAT and an O$#!+ Moment, but it's a good read none the less. Next week, I hope to be back with all original content. For now, "Back to School".

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Back to School

September 2016

With school back in session in most of the country, many parents are likely thinking about how best to prepare for their children’s future college expenses.

Now is a good time to sharpen one’s pencil for a few important lessons before heading back into the investing classroom to tackle the issue.

THE CALCULUS OF PLANNING FOR FUTURE COLLEGE EXPENSES

According to recent data published by The College Board, the annual cost of attending college in 2015–2016 averaged $19,548 at public schools, plus an additional $14,483 if one is attending from out of state. At private schools, tuition and fees averaged $43,921.

It is important to note that these figures are averages, meaning actual costs will be higher at certain schools and lower at others. Additionally, these figures do not include the separate cost of books and supplies or the potential benefit of scholarships and other types of financial aid. As a result, actual education costs can vary considerably from family to family.

Exhibit 1.       Published Cost of Attending College

Source: The College Board, “Trends in College Pricing 2015.”

To complicate matters further, the amount of goods and services $1 can purchase tends to decline over time. This is called inflation. One measure of inflation looks at changes in the price level of a basket of goods and services purchased by households, known as the Consumer Price Index (CPI). Tuition, fees, books, food, and rent are among the goods and services included in the CPI basket. In the US over the past 50 years, inflation measured by this index has averaged 4.1% per year. With 4% inflation over 18 years, the purchasing power of $1 would decline by about 50%. If inflation were lower, say 3%, the purchasing power of $1 would decline by about 40%. If it were higher, say 5%, it would decline by around 60%.

While we do not know what inflation will be in the future, we should expect that the amount of goods and services $1 can purchase will decline over time. Going forward, we also do not know what the cost of attending college will be. But again, we should expect that education costs will likely be higher in the future than they are today. So what can parents do to prepare for the costs of a college education? How can they plan for and make progress toward affording those costs?

DOING YOUR HOMEWORK ON INVESTING

To help reduce the expected costs of funding future college expenses, parents can invest in assets that are expected to grow their savings at a rate of return that outpaces inflation. By doing this, college expenses may ultimately be funded with fewer dollars saved. Because these higher rates of return come with the risk of capital loss, this approach should make use of a robust risk management framework. Additionally, by using a tax-deferred savings vehicle, such as a 529 plan, parents may not pay taxes on the growth of their savings, which can help lower the cost of funding future college expenses.

While inflation has averaged about 4% annually over the past 50 years, stocks (as measured by the S&P 500) have returned over 9% annually during the same period. Therefore, the “real” (inflation-adjusted) growth rate for stocks has been around 5% per annum. Looked at another way, $10,000 of purchasing power invested at this rate for 18 years would result in around $24,000 of purchasing power later on. We can expect the real rate of return on stocks to grow the purchasing power of an investor’s savings over time. We can also expect that the longer the horizon, the greater the expected growth. By investing in stocks, and by starting to save many years before children are college age, parents can expect to afford more college expenses with fewer savings.

It is important to recognize, however, that investing in stocks also comes with investment risks. Like teenage students, investing can be volatile, full of surprises, and, if one is not careful, expensive. While sometimes easy to forget during periods of increased uncertainty in capital markets, volatility is a normal part of investing. Tuning out short-term noise is often difficult to do, but historically, investors who have maintained a disciplined approach over time have been rewarded for doing so.

RISK MANAGEMENT & DIVERSIFICATION: THE FRIENDS YOU SHOULD ALWAYS SIT WITH AT LUNCH

Working with a trusted advisor who has a transparent approach based on sound investment principles, consistency, and trust can help investors identify an appropriate risk management strategy. Such an approach can limit unpleasant (and often costly) surprises and ultimately contribute to better investment outcomes.

A key part of maintaining this discipline throughout the investing process is starting with a well-defined investment goal. This allows for investment instruments to be selected that can reduce uncertainty with respect to that goal. When saving for college, risk management assets (e.g., bonds) can help reduce the uncertainty of the level of college expenses a portfolio can support by enrollment time. These types of investments can help one tune out short‑term noise and bring more clarity to the overall investment process. As kids get closer to college age, the right balance of assets is likely to shift from high expected return growth assets to risk management assets.

Diversification is also a key part of an overall risk management strategy for education planning. Nobel laureate Merton Miller used to say, “Diversification is your buddy.” Combined with a long-term approach, broad diversification is essential for risk management. By diversifying an investment portfolio, investors can help reduce the impact of any one company or market segment negatively impacting their wealth. Additionally, diversification helps take the guesswork out of investing. Trying to pick the best performing investment every year is a guessing game. We believe that by holding a broadly diversified portfolio, investors are better positioned to capture returns wherever those returns occur.

CONCLUSION

Higher education may come with a high and increasing price tag, so it makes sense to plan well in advance. There are many unknowns involved in education planning, and there is no “one size fits all” approach to solving the problem. By having a disciplined approach toward saving and investing, however, parents can remove some of the uncertainty from the process. A trusted advisor can help parents craft a plan to address their family’s higher education goals.

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Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Diversification does not eliminate the risk of market loss. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful.

Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services Group.

Negative Real Returns

"Every single human being" should short treasuries.

So said Nassim Nicholas Taleb, speaking at a conference in Moscow on February 4, 2010. Taleb, you may recall, rose to fame with his 2007 book, "The Black Swan". In the book , he discusses the impact of unpredictable, low probability events and our tendency to oversimplify explanations for them after the fact. The timing of the publication, just before the mortgage crisis and stock market meltdown, resulted in Taleb being a frequent commentator in the financial press. His views most often represented cynical spins on markets and the economy.

He also recommended buying gold in that same speech.

To his credit, in a recent commencement address at American University of Beirut, he also said, 

"I hesitate to give advice because every major single piece of advice I was given turned out to be wrong and I am glad I didn’t follow them....

...If you give advice, you need to be exposed to losses from it."

While hindsight is 20/20, history teaches us that making these kind of prognostications are just as likely to make you infamous as they are to make you famous. Let's look at how Taleb's thoughts on US Treasury Bonds worked out.

I used Kwanti Portfolio Labs portfolio analytics software to compare three hypothetical investments results made on the day of his Moscow presentation through yesterday, 9/1/16. The investments were DFA Intermediate Government Fixed Income Portfolio (DFIGX), the Barclays US Treasury Long Index, and the Gold Spot price. As you can see from the chart below, gold was the worst performer of the bunch. Had you been short treasuries, those returns would have been essentially THE INVERSE (plus borrowing costs) of what you see reflected.

All of this is not to pick on Mr. Taleb. He is one of a handful of reliable pessimists that any "half empty glass" world view TV show, magazine writer, or forum will put in front of microphone when that perspective is desired. There are just as many "sunshine pumpers" alternately offered for opposing views.   

The criticism I offer is that much less exciting, yet evidenced based, approaches have shown that the main factors influencing the price of bonds are the length of maturity (term) and the underlying credit quality (credit). Pursuing strategies that seek to take advantage of these premiums have been effective, especially when real returns (after inflation) have been negative in many countries for the past few years.

The following "Issue Brief" from DFA delves into this a little further.

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Negative Real Returns

September 2016

Nominal interest rates are currently below zero in many countries, including Germany, Denmark, Switzerland, Sweden, and Japan.

These levels have turned the common belief that zero is the lower bound for such rates on its head. While negative nominal rates are a relatively new phenomenon, periods of widespread negative real returns across countries have been quite common.

WHY CARE ABOUT REAL RATES OF RETURN?

In 1970, a loaf of bread cost 25 cents. A gallon of gas cost 36 cents. Today, an average loaf of bread and a gallon of gas each cost around two dollars.[1] When the prices of goods and services increase, consumers can buy fewer of them with every dollar they have saved. This is called inflation, and it eats into investors’ returns.

Real rates of return are adjusted for inflation, so they account for changes in the purchasing power of a dollar over the life of an investment. Because inflation affects the cost of living, investors must consider the inflation-adjusted—or real—return of their investments. When inflation outpaces the nominal returns on an investment, investors experience negative real returns and actually lose purchasing power.

BRIEF HISTORY: TREASURY BILL RETURNS

Exhibit 1 shows the annual real returns on one-month US Treasury bills. From 2009 to 2015, the annual real return was negative. This circumstance is not unprecedented. Since 1900, the US has had negative real returns in over a third of those years. And negative real returns on government bills are not exclusive to the US. All countries listed in Exhibit 2 have had negative real returns on their respective government bills in at least one out of every five years from 1900 to 2015.

Exhibit 1.       Annual Real Returns of One-Month US Treasury Bills
Source: Dimson, Marsh, and Staunton (DMS); Morningstar.

Exhibit 2.       Percent of Years with Negative Real Returns on Government Bills, 1900–2015
Source: Dimson, Marsh, and Staunton (DMS); Morningstar.

BOND INVESTORS MAY GET MORE THAN THE BILL RETURN

In the current low-yield environment, rolling over short-term bills may not seem appealing to investors keen on protecting their purchasing power. Exhibit 3 shows that the return of one-month US Treasury bills has not kept pace with inflation[3] over the past 10 years. But even when the real return on bills is negative, a relatively common occurrence, bond investors may still achieve positive expected real returns by broadening their investment universe. The bond market is composed of thousands of global bonds with different characteristics. Many of those bonds allow investors to target global term and credit premiums, which in turn may provide positive real returns even in low interest rate environments. Exhibit 3 also shows that the Barclays Global Aggregate Bond Index has outpaced inflation while maintaining low real return volatility of 3.4% annualized over the past 10 years.

Exhibit 3.       Trailing Annualized Returns
Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Trailing returns are as of June 2016. The Barclays Global Aggregate Bond Index is hedged to USD. Real Return = [(1 + Nominal Return)/(1 + Inflation)] − 1. Sources: Barclays, Morningstar. Barclays indices copyright Barclays 2016.

Global diversification is often thought of as a tool for reducing risk. However, when it comes to fixed income, global portfolios can also play an important role in the pursuit of increased expected returns. Even if the expected real returns of bonds in one country are negative, another yield curve may provide positive expected real returns. The flexibility to pursue higher expected returns by investing in bonds around the world can be an important defense against low, and even negative, yields.

SUMMARY

The goal of many investors is to grow some (or all) of their savings in real terms. Even in a low interest rate environment, there may be bond investments that can still achieve this goal. In particular, investors who target global term and credit premiums should be better positioned to pursue higher expected returns.

[1]. Source: Bureau of Labor Statistics.

[2]. Measured as changes in the Consumer Price Index (CPI), which is defined by the US Department of Labor, Bureau of Labor and Statistics.

[3]. Measured as changes in the Consumer Price Index (CPI), which is defined by the US Department of Labor, Bureau of Labor and Statistics.    

Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Past performance is no guarantee of future results. There is no guarantee an investing strategy will be successful. Diversification does not eliminate the risk of market loss.