Author Archives: Geoff Considine

About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for Aquila Energy. Leaving Aquila in 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002. Geoff has published commentary and analysis in a range of publications, including Advisor Perspectives, Financial-Planning.com, and Horsesmouth.com. Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com (http://www.foliofn.com)). Neither Quantext nor Geoff Considine is an investment advisor.

Am I Saving Enough to Reach My Goals?

This is the second installment in our series on how individual investors can assess their financial health.

Am I saving enough to reach my goals?The starting point for any discussion of a household’s financial health is to evaluate current savings and savings rates in the context of financial goals.  The three largest expenses that most families will face are buying a home, paying for college, and providing income in retirement. Setting specific savings targets and timelines is a key step in increasing your ability to meet these goals.

To determine whether you are saving enough to pay for one or more of these goals, consider the following factors:

  • Expected total cost of goal
  • When the money is needed
  • Current amount saved for the goal
  • Expected annual rate of saving towards the goal
  • How much risk to take in investing to meet the goal

Retirement

A good first step for estimating how much you’ll need for retirement—and how you’re doing so far—is to try Morningstar’s Retirement Savings Calculator.  This tool uses a range of sensible assumptions (which you can read about in the study from which it was developed) to estimate whether you are saving enough to retire.  The study accounts for the fact that Social Security represents a different fraction of retirement income for households at different income levels and assumes that investments are consistent with those of target date mutual funds.  The calculator scales income from your current age forward, based on historical average rates of wage growth.

Are you saving enough for retirement?

The calculations assume that you will need 80% of your pre-retirement income after subtracting retirement contributions, and that you will retire at age 65.  The estimated future returns for the asset allocations are provided by Ibbotson, a well-regarded research firm (and wholly owned subsidiary of Morningstar).

The final output of this model is a projected savings rate that is required for you to meet the target amounts of income.  If this is less than you currently save, you are ahead of the game.

College

There are enormous variations in what a college education costs, depending on whether your child goes to a public or private institution and whether those who choose public schools stay in-state.  There is also a trend towards spending two years at a community college before transferring to a larger comprehensive university.    estimates that the average annual all-in cost of attending a public four-year university is $23,000 per year, while the cost of attending a private four-year university averages $45,000 per year.  This includes tuition, room, board, books and other incidentals.  It is worth noting, however, that the all-in cost of private universities are often far above $45,000 per year.  The University of Chicago has an all-in cost of $64,000 per year.  Yale comes in at $58,500.

Every college and university has information on current costs to attend, as well as a calculator that estimates how much financial aid you can expect to be given, based on your income and assets.  There are a variety of ways to reduce the out-of-pocket cost of college including work-study, cooperative education programs, and ROTC.  There are also scholarships, of course.

College tuition and fees have been rising at about 4% per year beyond inflation for the past three decades.  With inflation currently at about 2%, the expected annual increase in college costs is 6%.

To be conservative, assume that money invested today in a moderate mix of stocks and bonds will just keep up with inflation in college costs.  Vanguard’s Moderate Growth 529 plan investment option has returned an average of 6.9% per year since inception in 2002 and 6.4% per year over the past ten years.  In other words, $23,000 invested today will probably pay for a year at a public four-year university in the future.  You can invest more aggressively to achieve higher returns, but taking more risk also introduces an increased exposure to market declines.

Using the simple assumption that money invested today in a moderately risky 529 plan or other account is likely to just keep pace with cost inflation makes it easy to figure out how you are doing in terms of saving.  If you plan to pay the cost of your child’s four-year in-state education and you have $46,000 invested towards this goal, you are halfway there.

Buying a Home

A house is a major financial commitment—one of the most significant that most people make.  Unlike retirement or education, there is an alternative that provides the same key benefits: renting.

For people who decide to buy, a key issue is how much to save for a down payment.  The amount that a lender will require depends on your income, credit score, and other debts.  Zillow.com provides a nice overview, along with an interactive calculator of down payment requirements. This tool can help estimate how all of the factors associated with obtaining a mortgage can vary with the down payment.

In general, the goal is to have a down payment ranging from 5% to 20% of what you plan to spend on a home.  By experimenting with the calculator at Zillow, you can determine how much house you can afford and how much you will need to put down.  A down payment of 20% or more is the most cost-effective route because smaller down payments require that you buy mortgage insurance, which adds to the monthly payment.

There are several alternatives for investing a down payment fund.  The primary consideration, however, is whether you are willing to adjust your timeframe based on how the market performs.  If you are committed to buying a house within one to three years, you really cannot afford to take on much risk.  If you are looking at a timeframe of five years or more—or if you hope to buy in one to three years but you are comfortable delaying if market returns are poor—you can afford to take more risk.  There is no single answer for everyone.

If you are investing only in low-risk assets, however, estimating how much you need to save each month for a required down payment is straightforward enough, because the current expected rate of return on safe assets is close to zero.

 

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How Am I Doing? An 8-Point Financial Checklist

How am I doing?A question that nags at many people is whether they are on track financially.  Even an average financial life can seem remarkably complex.  How does anyone know whether he or she is doing the right things?  A range of studies on how people manage their money suggests that many, if not the majority, are making choices that look decidedly sub-optimal.  Americans don’t save enough money and when they do save and invest, they often make basic mistakes that substantially reduce their returns.  More than 60% of self-directed investors have portfolios with inappropriate risk levels.  Almost three quarters of Americans have little or no emergency savings.  The solution to these problems starts with an assessment of where you are and where you need to be.

The key, as Einstein once said, is to make things as simple as possible but no simpler.  In an attempt to provide a checklist that’s in line with this edict, I offer the following questions that each person or family needs to be able to answer.

The first three questions focus on consumption and saving:

  1. Am I saving enough for to meet personal goals such as retirement, college education, and home ownership?
  2. Am I saving enough for contingencies such as a job loss or an emergency?
  3. Am I investing when I should be paying down debt instead, or vice-versa?

The next five questions deal with how you invest the money that you save:

  1. Is my portfolio at the right risk level?
  2. Am I effectively diversified?
  3. Am I aware of how much am I paying in expenses?
  4. Are my financial decisions tax efficient?
  5. Should I hire an investment advisor?

Anyone who can answer all eight of these questions satisfactorily has a strong basis for assessing whether he or she is on track. Odds are there are more than a few questions here that most of us either don’t have the answer to or know that we are not addressing very well.

Part of what makes answering these questions challenging is that the experiences of previous generations are often of limited relevance, especially when it comes to life’s three biggest expenditures: retirement, college, and housing.

For example, older people who have traditional pensions that guarantee a lifetime of income in retirement simply didn’t need to worry about choosing how much they had to save to support themselves during retirement.

The cost of educating children has also changed, increasing much faster than inflation or, more crucially, household income.  For many in the older generation, college was simply not a consideration. It has become the norm, however, and borrowing to pay for college is now the second largest form of debt in America, surpassed only by home mortgages.  Children and, more often their parents, must grapple with the question of how much they can or should pay for a college education, along with the related question of whether a higher-ranked college is worth the premium cost.

The third of the big three expenses that most families face is housing costs. Following the Second World War, home buyers benefitted from an historic housing boom.  Their children, the Baby Boomers, have also seen home prices increase substantially over most of their working careers.  Even with the huge decline in the housing crash, many Boomer home owners have done quite well with real estate.    Younger generations (X, Y, and Millenials), by contrast, have experienced enormous volatility in housing prices and must also plan for more uncertainty in their earnings.  And of course, what you decide you can afford to spend on a home has implications for every other aspect of your financial life.

In addition to facing major expenses without a roadmap provided by previous generations, we also need to plan for the major known expenses of everyday life. It’s critically important to determine how much to keep in liquid emergency savings and how to choose whether to use any additional available funds to pay down debts or to invest.  There are general guidelines to answering these questions and we will explore these in a number of future posts.

The second set of questions is easier to answer than the first.  These are all questions about how to effectively invest savings to meet future needs.  Risk, diversification, expenses, and tax exposure can be benchmarked against professional standards of practice.

What can become troubling, however, is that experts disagree about the best approach to addressing a number of these factors.  When in doubt, simplicity and low cost are typically the best choices.  Investors could do far worse than investing in a small number of low-cost index funds and choosing the percentages to stocks and bonds based on their age using something like the ‘age in bonds’ rule.  There are many ways to try for better returns at a given risk level, and some make far more sense than others.  Even Warren Buffett, arguably the most successful investor in the world, endorses a simple low-cost index fund strategy.  Upcoming posts will provide a number of straightforward standards for addressing these questions.

Investors who find these questions  too burdensome or time consuming to deal with may wish to spend some time on the eighth and final question: whether they should hire an investment advisor to guide them.  Investors may ultimately choose to manage their own finances, search out a human advisor, or use an online computer-driven advisory service.

While financial planning can seem complex and intimidating, our series of blog posts on the key issues, as outlined in the eight questions above, will provide a framework by which individuals can effectively take control and manage their financial affairs.

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The Future of Retail Banking

Future of Retail BanksUSA Today ran a story in March on the changing nature of retail banking in America.  This sounds kind of boring, perhaps, but it has broad implications both for bank clients and, potentially, for investors.  The gist of the story is that banks are closing retail branches in small towns.  A lack of traditional banking services is not a rural phenomenon, however, with substantial populations of people in urban areas who do not use traditional banks.  For an informative interactive tool that allows you to explore the populations of people lacking key financial services, see here.  There is a substantial population of people who have little or no access to traditional bank services (the under-banked or the un-banked), and it would seem that this population is likely to continue to grow if banks close their smaller retail branches.  The solution, I believe, is that online banking services will serve the under-banked and un-banked, just as they have in the developing world.

In general, poorer households hold little if any assets in savings accounts and primarily use banks to cash checks.  Banks don’t make money from check cashing, so they have a hard time profitably serving these customers.  With interest rates at or near record lows, even bank clients with meaningful levels of savings provide little in the way of income to banks.  And banks, not surprisingly, are focusing on wealthier clients as the way to boost revenues.  The goal is to sell more profitable investing and financial planning services to wealthier clients.  As the large banks try to move up-market in terms of products and services that they offer, it seems likely that an increasing number of less-wealthy Americans are quite likely to have less access to traditional bank services.

What does the future of retail banking look like?  First, it seems inevitable that serving less-wealthy clients in physical branches will continue to be a relatively unattractive business.  Second, check cashing and payday lending businesses—alternatives to traditional banks–will probably continue to grow.  Lisa Servon, a professor of Urban Policy, argues that payday lenders provide a valuable service and that the industry is unfairly demonized.  If people need to borrow money and don’t have access to a traditional bank, a payday loan may be worth the cost.  Third, the increasing role of online banking and bill payment among the middle class reduces the time that customers spend in physical branches.  There are a range of perspectives on the future of retail banking (see here and here).

My belief is that physical retail bank branches will largely disappear.  If you really want or need to go to a physical branch – to access your safety deposit box, for example – you probably don’t mind driving.  Otherwise, what does the retail bank really provide that you cannot get online?  Bank analyst Dick Bove actually makes the case that quality customer service at branch locations is not necessarily even a good sign for investors.  He posits that bank employees generate more revenue for the bank by spending their time “selling products”, rather than by trying to solve problems for customers.

As the systems for mobile banking expand, this could dramatically help the un-banked and under-banked as well as displacing retail banking services for the more affluent.  In the developing world, for example, mobile banking (banking services provided via mobile phone) is already a dominant force.  Businesses can pay their employees via mobile banking, entirely removing the need to cash a physical check.  The M-Pesa mobile payment business now serves seventeen million people in Kenya alone.  Mobile payments were the fastest growing form of payments in China in 2013, totaling $1.6 Trillion.  There are also a host of non-banking firms that are providing services that look like banking. There is no obvious reason that some or all of these types of services cannot expand into the U.S. to serve the un-banked and then move up-market to replace some or all retail banking services to more affluent customers.  The current situation reminds me of a number of cases of technological innovation discussed in The Innovator’s Dilemma, the ground-breaking book by Clayton Christensen.  The book argues that new technologies first succeed not by displacing entrenched providers, but rather by first meeting the needs of an un-served population.  After the new technology has proven its worth, it then moves up-market to disrupt the traditional business model.  The current state of mobile banking is in serving the developing world, where people often have little or no access to traditional banks at all.  The enormous growth in these businesses suggests that the future is to move up the food chain.  Mobile payment technology and usage is growing in the U.S., albeit slower than expected.  Accenture projects that as much of 35% of retail banks’ revenues could be lost to a range of online services providers by 2020.  Given that retail banks in the U.S. are seeing their traditional businesses struggle along with  less use of their branch offices, coupled with a growing population of potential clients who the retail banks do not serve at all, mobile banking looks to me like the future of retail banking.

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Goldman Sachs Predicts 4.5% 10-year Treasury Yields

Treasury BondGoldman Sachs just came out with a prediction that 10-year Treasury bond yields will rise to 4.5% by 2018 and the S&P 500 will provide 6% annualized returns over that same period.  The driver for this prediction is simply that the Fed is expected to raise the federal funds rate.

Because rising yields correspond to falling prices for bonds, Goldman’s forecast is that equities will substantially outperform bonds over the next several years.  If you are holding a bond yielding 2.5% (the current 10-year Treasury yield) and the Fed raises rates, investors will sell off their holdings of lower-yielding bonds in order to purchase newly-issued higher-yielding bonds.  If Goldman’s forecast plays out, bondholders will suffer over the next several years, while equity investors will enjoy modest gains.

Historical Perspective

This very long-term history of bond yield vs. the dividend yield on the S&P 500 is worth considering in parsing Goldman’s predictions.

Bond Yield vs. Dividend Yield

Source: The Big Picture blog

Prior to the mid 1950’s, the conventional wisdom (according to market guru Peter Bernstein) was that equities should have a dividend yield higher than the yield from bonds because equities were riskier.  From 1958 to 2008, however, the 10-year bond yield was higher than the S&P 500 dividend yield by an average of 3.7%.

Then in 2008, the 10-year Treasury bond yield fell below the S&P 500 dividend yield for the first time in 50 years.  Today, the yield from the S&P 500 is 1.8% and the 10-year Treasury bond yields 2.5%, so we have returned to the conditions that have prevailed for the last half a century. But the spread between bond yield and dividend yields remains very low by historical standards.  If the 10-year Treasury yield increases to 4.5% (as Goldman predicts), we will have a spread that is more consistent with recent decades.

Investors are likely to compare bond yields and dividend yields, with the understanding that bond prices are extremely negatively impacted by inflation (with the result that yields rise with inflation because yield increases as bond prices fall), while dividends can increase with inflation.  During the 1970’s, Treasury bond yields shot up in response to inflation. Companies can increase the prices that they charge for their products in response to inflation, which allows the dividends to increase in response to higher prices across the economy.  The huge spread between dividend yield and bond yield in the late 70’s and early 80’s reflects investors’ rational preference for dividends in a high-inflation environment.

What Has to Happen for Goldman’s Outlook to Play Out?

To end up with a 4.5% 10-year Treasury yield with something like a 2% S&P 500 dividend yield, the U.S. will need to see a sustained economic recovery and evidence of higher prices (inflation) driven by higher employment and wage growth.  In such an environment, investors will be willing to accept the lower dividend yield from equities because dividends grow over time and tend to rise with inflation.  This has been the prevailing state of the U.S. economy over the last fifty years.  Most recently, we had 10-year Treasury yields in the 4%-5% range in the mid 2000’s.  If, however, we continue to see low inflation and stagnant wages in the U.S. economy, bond yields are likely to remain low for longer.

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Investing Implications of Trends in Household Wealth

Shifting Wealth

A new study released by the Russell Sage Foundation analyzes trends in household wealth over the last twenty years, with a focus on the years surrounding the ‘great recession’ of 2008.  The study examines changes in household net worth for the median household, as well as for the 95th percentile of households by wealth (the richest 5%), the poorest 25% of households (the 25th percentile) and tiers in between.

7-30-2014

Source: Russell Sage Foundation

The results, adjusted for inflation (values are shown in 2013 dollars), show that the median U.S. household remains substantially poorer in terms of total net worth than it was before the recession and is actually now poorer than it was in the mid 1980’s.  What’s more, median household net worth has not recovered at all since the great recession.  The same trends are evident even for the wealthiest quarter of households (the 75th percentile), although the gains in wealth by this tier of households in the 80’s, 90’s, and early 00’s were sufficiently great that the top quarter of households by wealth is more than 25% wealthier today than in the mid 80’s.

The most striking feature of this chart is the spread in wealth levels.  While the median and 25th percentiles of households by wealth are substantially poorer today than they were twenty years ago, the wealthiest 10% (the 90th percentile) and the wealthiest 5%, in particular, are substantially richer today.  The increasing spread between the percentiles through time is evidence of growing inequality.  The study concludes that much of the divergence between wealthier and poorer households reflects the proportion of their wealth held in homes vs. stocks and bonds.  Housing prices remain well below their previous peaks in 2007, while the equity markets have regained their previous levels.  For poorer households, homes represents the vast majority of their net worth.  This is not the case for wealthier households.  The results of this study are consistent with other analysis—this is confirmation rather than being surprising.  Nonetheless, each new set of results that are consistent adds weight.

Implications for Investors

The implications of the trends in the table above are substantial.  If the median household is seeing declining or stagnant wealth levels—with more extreme declines for poorer households—this will ultimately reduce their capacity to buy and consume goods and services.  Indeed, the Russell Sage study concludes that declining household wealth shows that poorer households, unable to support their current consumption with income, are gradually depleting their assets.  At the other end of the spectrum, the wealthiest 10% of households has seen a substantial decline in net worth as well, even though this tier enjoyed huge gains in the past twenty years.

Aside from the fact that declining household wealth reduces the ability to spend, there is also the problem of the wealth effect.  Households that have disposable income are less likely to spend it if they feel less wealthy and even the 95th percentile of households by wealth is less wealthy than it was just five years ago.

The simplest interpretation of these data are that mid-market retail products and retailers are going to suffer, while the budget products and retailers and the luxury markets will perform relatively better.  So, for example, Family Dollar stores (FDO), WalMart (WMT), Costco (COST) and other discount retailers should do well.  More broadly, however, the declining disposable incomes for the middle tier of investors suggests that the companies that provide the basic products and services that people depend upon are good bets.  Utilities (IDU), oil companies (IGE), and pharmaceutical companies (JNJ, BMY, GSK, PFE) are fairly well insulated from changes in wealth distribution.

The more challenging questions involve discretionary goods and services that are higher-priced and easier to do without or that can be displaced by lower-cost competitors.  Companies like Bed, Bath, and Beyond (BBBY), Whole Foods (WFM), Abercrombie and Fitch (ANF), and Express (EXPR) sell products for which there are cheaper and largely indistinguishable alternatives.  The winners in this mid-market business are those companies that provide fairly low-cost products while retaining brand appeal to wealthier customers (SBUX, CMG, NKE).

Another theme that looks promising is consumer products that are expensive relative to peers but that represent a low-cost substitution as compared to other types of conspicuous consumption.  Apple (AAPL) has successfully capitalized on this trend.  The new iPhone may be expensive compared to other phones, but it is fairly cheap as a prestige object.   Smart phones also provide low-cost entertainment via product offerings such as Facebook (FB).  People who spend their time surfing Facebook or watching Netflix (NFLX) are likely to see cable TV as expensive.  This realization is already expressed in the high prices of these firms relative to their earnings, however.

The Take-Away

The latest data on growing wealth inequality add support to the conclusion that the middle tier of American families is getting squeezed.  The long-term implications for how people spend their money are worth considering.  The ultimate losers will be companies that sell fairly high-cost goods or services to the middle class for which there are low-cost alternatives and for which there are up-market competitors that appeal to wealthier families.  One class of winners will be low-cost ‘prestige’ brands such as smart phones and Starbucks coffee.  It is hard to imagine the average urban millennial substituting his iPhone for generic pay-as-you-go hardware or rushing to the office with a cup of gas station coffee rather than the iconic Starbucks cup.  As discretionary wealth gets tighter for the middle tier, low-cost mobile entertainment looks like a winner at the expense of cable and satellite TV.

The discount retailers and providers of basic goods such as fuels and pharmaceuticals are likely to hold up well simply because changing wealth distributions will have little impact on their businesses.

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Low Beta Market Sectors

With U.S. equity markets near their record highs and a bull market run that is starting its sixth year, the potential for a correction is a growing concern.  In addition, U.S. equity prices look fairly high when viewed in terms of the PE10 ratio.  Another factor that concerns some market watchers is that volatility (as measured by VIX) is at very low levels, reminiscent of 2007.  This type of complacency has historically been followed by increasing volatility, as levels return to their historical average, accompanied by a sell-off in higher-risk assets as investors adjust their portfolios to mitigate the effects of higher volatility.

Investors seeking to remain invested in equities at a target level but who want to reduce their exposure to market swings and to mitigate the impact of a rise in market volatility have historically been well-served by increasing their allocations to low-beta market sectors.  In this article, I will review the defensive value of low-beta allocations as well as examining the consistency of beta over time.

Beta measures the degree to which a security or a portfolio responds to a move in a benchmark index such as the S&P500.  A portfolio with beta equal to 80% (also written as 0.8) tends to go up 0.8% when the market rises 1.0% and vice versa.  Beta may be thought of as showing whether a security amplifies the moves in the benchmark (beta greater than 100%) or damps the moves in the benchmark (beta less than 100%).

How Beta Varies by Sector

The SPDR Select Sector ETFs provide a convenient way to break out the sectors of the U.S. equity markets by dividing the S&P500 into nine sectors.  These sectors illustrate how much beta varies.

Low Beta Market Sectors - 1

Betas and 10-year average annual returns for major sectors and indexes

The S&P500 has a beta of 100%, by definition.  Some readers may be surprised that emerging market stocks have beta of almost 140%, which means that emerging market equities tend to go up (down) 1.4% for every 1% gain (drop) in the S&P500.  Even before the market crash of 2008, emerging market stocks were high beta—this is not a new phenomenon.

There are three U.S. equity sectors with betas well below 100%: consumer staples (XLP), healthcare (XLV), and utilities (XLU).  It is often believed that low-beta equities have very low average returns.  In fact, a well-known but now widely-discounted model of equity returns (the Capital Asset Pricing Model, CAPM) assumes that beta of an equity or asset class corresponds directly to expected return.  High-beta asset classes have high expected return and vice versa.  Low-beta equities have historically substantially out-performed what would be expected on the basis of CAPM, however, and the past ten years is no exception.  These three sectors have all out-performed the S&P500 over the past ten years.  The return numbers shown here are the arithmetic averages, including reinvested dividends.

Low Beta Asset Classes in 2007-2008

The first question that is worth asking about beta is the degree to which beta corresponds to losses in really bad market conditions.  In the table below, I have tabulated beta calculated using three years of data through 2007 for each of the funds above, as well as the returns for each of these in 2008.

Low Beta Market Sectors - 2

Beta calculated through 2007 vs. 2008 returns

The three sectors with the lowest betas going into 2008 (consumer staples, healthcare, and utilities) had an average return of -22.3% in 2008, as compared to -36.8% for the S&P500.  An equity tilt towards these lower beta sectors could have reduced losses in that year.

Consistency of Beta through Time

The astute reader may notice that the betas calculated using ten years of data through May of 2014 (shown in the first table) are, in some cases, quite different from the betas calculated using three years of data through December of 2007 (shown in the second table).  Beta varies through time.  The betas calculated using three years of data through May 2014 provide an interesting contrast to the three-year betas through the end of 2007.

Low Beta Market Sectors - 3

Comparing betas for two 3-year periods

We are looking at two distinct 3-year periods, separated by almost six and a half years and, in general, low-beta sectors at the end of 2007 remain low-beta today and high-beta sectors back then are still high-beta.  The two most notable exceptions are international equities (EFA) and the technology sectors (XLK).  These changes notwithstanding, the three sectors with the lower betas in 2007 also have the lowest betas in 2014.

There are a number of factors that will determine whether any sector will weather a broad market decline better than others.  Beta is one important factor, but there are others.  In 2008, the financial sector suffered disproportionately large losses—well beyond what would have been expected on the basis of beta alone.  The underlying drivers of the 2008 market crash were most severe in the financial sector.  Small-cap stocks, by contrast, fell considerably less than the beta value of this sector would have suggested.

Low-Beta and Asset Allocation

Low-beta asset classes have historically provided some protection from market declines and increasing volatility.  There are a range of other considerations that potential investors should consider, however when creating a portfolio.  The selection of individual asset classes should be made with consideration of the characteristics of the total portfolio, including desired risk level, interest rate exposure, and income generation.  The target for total portfolio beta is primarily determined by an investor’s total risk tolerance.  A target beta level can be achieved both by choosing how to allocate the equity portion of a portfolio among sectors and by varying the balance between equity (stocks) and fixed income (bonds) investments.  Fixed income asset classes tend to have very low—even negative—values of beta.  In my next blog entry, I will explore these two approaches to managing beta at the portfolio level.

History suggests that low-beta sectors can provide some protection from market downturns.  The length of the current equity rally, and the substantial increases in equity valuations in recent years, are motivating some investors to consider their best defensive alternatives to protect against the inevitable reversal.  The question for investors to ask themselves is whether they are best-served by reducing portfolio beta by reducing their exposure to equities, by shifting some portion of assets from high-beta to low-beta sector, or both.

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