We believe two investment factors can offer prudent, effective approaches to thinking about and acting upon investments, trends and correlation.
We’re not talking about stock market trends. Instead, we favor using demographic and economic trends to help triangulate volatile and often conflicting information. These trends are not difficult to detect. Over the years, patient, thoughtful investors have capitalized on these trends, and we think they can now.
Correlations between Returns of Different Asset Classes
By “correlation,” we mean the covariance of investment returns in a portfolio. A well-constructed investment portfolio holds assets whose returns don’t always change in the same direction at the same time. Moreover, we believe a well-constructed portfolio should hold some assets that are more or less insulated from day-to-day stock market and interest rate volatility. Non-correlated returns can contribute to portfolio diversification.
By “asset class,” we mean a group of assets sharing important properties. Because they share properties, asset class member prices often change in tandem.
- Common stocks are an asset class partly because they represent ownership of issuing corporations and issuers offer no guarantees about stock or dividend value.
- Interest-bearing securities are an asset class partly because issuers guarantee lenders interest payments and the issue’s principal value upon maturity.
In our opinion, shares in real estate investment trusts (REITs) and mutual funds generally fail the asset class standard. Share ownership often represents a claim on assets that do not share important properties. For example, REIT shares can represent ownership in diverse commercial real estate properties as well as U.S. Treasury securities and mortgage-backed securities (derivatives). Twenty-five percent of a REIT’s assets and income can derive from assets unrelated to real estate, while non-real estate assets like cash and government bonds can be included in the remaining 75%.[i]Recent changes in REIT and private real estate prices reveal their differences: Whereas private real estate prices increased in 2018, many REIT shareholders lost value.[ii]
The World is Hard
REIT and mutual fund share ownership, besides potentially representing ownership in correlated assets, can impose a tax liability if shares are held outside of tax-deferred accounts. In 2018, domestic fixed-interest bond values generally declined because prevailing interest rates increased. Also, in 2018, stock values generally declined partly because of trade and geopolitical uncertainties. Yet, during the year many of those funds sold profitable holdings. In many cases, even though the funds lost value, share owners will pay tax on realized capital gains.[iii] This capital gains tax issue is characteristic of packaged investment products and not typically an issue with direct ownership of investment assets.[iv]
This example of paying taxes on an investment that loses value is just one of many challenges investors face. The case of an 80-year-old Walmart greeter exemplifies the real consequences of challenges to growing and preserving wealth. Laid off at age 56 one year before earning a full pension, Tom Coomer spent down his retirement savings just to stay afloat.[v]To make matters worse, some in the media and retail investment industry try to place blame on investors for their failures to adequately save for retirement.[vi]In retrospect, maybe Mr. Coomer could have avoided his situation; maybe not without the benefit of hindsight. But, as Nobel Laureate Richard Thaler[vii]said, “…we don’t think people are dumb. We think the world is hard.”[viii]It’s hard for Mr. Coomer, it’s hard for Dr. Thaler, it’s hard for all people.
There are no guarantees in this world, but some strategies can often work better than others. In our opinion, investors can benefit from trends and from using non-correlated assets to help manage risk.
- Recognizing a trend: In 2017, 35.1 million households owned traditional IRAs,[ix]and about 2.5 million Baby Boomers turn 70 each year,[x]the age at which they start taking required withdrawals from their traditional IRAs. How will these withdrawals affect investment values?
- Recognizing a trend: Demographers forecast persistence in the growth of seniors in the U.S. for decades.[xi]What opportunities and threats will this trend present?
- Using non-correlated assets: Opportunities exist to own real estate through direct participation (DPRE). How can direct participation aid portfolio diversification and capitalize on trends?
These questions seem more relevant than short-sighted questions about how the markets will perform in 2019. We believe these are worthy questions for all investors because the answers might help investors make good decisions.
[i]26 USC § 856 Retrieved from http://uscode.house.gov/view.xhtml?req=(title:26%20section:856%20edition:prelim).
[ii]Askola, J. (December 2018). Be greedy when others are fearful – real estate edition. Seeking Alpha. Retrieved from https://seekingalpha.com/article/4230180-greedy-others-fearful-real-estate-edition.
[iii]Marks, Ben. (December 2018). A down year for mutual funds, especially at tax time. Star Tribune. Retrieved from http://www.startribune.com/a-down-year-for-mutual-funds-especially-at-tax-time/503293572/.
[iv]We do not give tax advice. We encourage readers and listeners to consult a tax professional.
[v]Strassman, M. (December 2018). “I blame myself”: Retirement remains out of reach for millions of Americans. CBS News. Retrieved from https://www.cbsnews.com/news/i-blame-myself-retirement-remains-out-of-reach-for-millions-of-americans/.
[vi]Schafer, L. (December 2018). Stop blaming yourself for retirement savings shortfalls. Star Tribune. Retrieved from http://m.startribune.com/index.php/lee-schafer-stop-blaming-yourself-for-retirement-savings-shortfalls/503627202/.
[vii]Richard Thaler is a Nobel Laureate and an economist known for his work in behavioral economics.
[viii]Dubner, S. (December 2018). People aren’t dumb. The world is hard. Freakonomics. Retrieved from http://freakonomics.com/podcast/thaler-rebroadcast/
[ix]Investment Company Institute (ICI). (2018). Investment Company Fact Book. Retrieved from http://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2018/2018_factbook.pdf.
[x]Newcott, B. (January 2016). Boomers turn 70. AARP Bulletin. Retrieved from https://www.aarp.org/politics-society/history/info-2016/baby-boomers-turning-70.html.
[xi]Roberts, A.W., Ogunwole, S. U., Blakeslee, L. and Rabe, M.A. (October 2018). The population 65 years and older in the United States: 2016 (ACS-38). U.S. Census Bureau.Retrieved from https://www.census.gov/content/dam/Census/library/publications/2018/acs/ACS-38.pdf.
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