Investments, Tax Reform and New Year

Investment returns in 2017 for different financial sectors have broken previous records. Pundits, as they usually do, offer polemic diatribe on where the markets are going and what an investor should do to capture the upside and avoid the downside. The only sure bet in knowing how an investment or market segment performed is after the fact by looking at real results once computed. There is truth to the adage hindsight is 20/20. In other words, "It's easy to know the right thing to do after something has happened, but it's hard to predict the future."

The chart below clearly shows annual returns for different asset classes. It is highly unlikely to realistically guess what an asset class will do, but reviewing research and statistical analysis can accurately determine how a market segment did after the fact. The numbers reflect what the returns were if you were 100% invested in a specific asset in that year. What is clearly and definitively illustrated is that no one class consistently returned results that could be replicated repeatedly in consecutive years (exception small cap 2003 and 2004).

Illustration Courtesy of Dimensional Fund Advisors

Annual returns (%): 2002—2016

In US dollars. Diversification does not eliminate the risk of market loss. Past performance is not a guarantee of future results. Indices are not available for direct investment. Their performance does not reflect expenses associated with the management of an actual portfolio. Source: S&P data provided by Standard & Poor's Index Services Group. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Dow Jones data provided by Dow Jones indices. Dimensional Index data compiled by Dimensional. MSCI data © 2017, all rights reserved. The BofA Merrill Lynch Indices are used with permission; copyright 2017 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Merrill Lynch, Pierce, Fenner & Smith Incorporated is a wholly owned subsidiary of Bank of America Corporation. Bloomberg Barclays data provided by Bloomberg. Citi fixed income indices copyright 2017 by Citigroup.

Analysts in the financial market arena have commented on the (high) price of stock vs its real underlying value. Investors buying and selling financial securities determine the price. However, adding the element of expectation doesn’t necessarily translate to prices being an accurate picture of true value. Ken Little recently stated, “People get excited about what they read and they want a part of the action. They jump into a stock that's already trading at a premium. In other words, they buy high."

It has been reported that 2017 market returns have been kind to many retirement plans in addition to personal non-retirement holdings. The questions that seem to always appear when things have been doing well, is it time to sell and take profits, add to a portfolio, stay the course or rebalance existing holdings and allocations? Complicating the mix of decisions is tax reform and the unknown of things to come down the legislative pike.

Having a Roadmap

Investors who consult and plan with a financial professional often begin the investment participation with an in depth discussion of goals and timelines. Careful attention is given to income, expenses, determining net worth with current and anticipated cash flow at different life cycle phases. Additional conversations include review of other important issues, i.e. budgeting, insurance, estate and legacy planning needs, trusts, family dynamics, business strategies, etc.

An Investment Policy Statement (IPS) is developed to outline acceptable risk and percentage of allocation to various financial products. The goal is to obtain a desired rate of return incorporating inflation and potential tax consequences. The IPS becomes an important guiding and reference source for both the investor and advisor as short-, mid- and long term needs are addressed.

Financial Index

A financial index exists for a specific market segment and consists of all companies within that specific index, either equity or bond. An index, i.e. S&P 500 or US High Yield Corporate Bond is considered the benchmark for a market segment that any of the individual companies can be compared to when determining returns within a segment. As an investor cannot buy an index, investment companies will mirror all the like corporations or bond issuers within the respective index and make shares available for purchase using a mutual fund or other like investment.

Financial Sectors

According to Bloomberg, there are 10 financial sectors. Each sector has multiple companies that have a direct relationship to that sector.

An investor can purchase a chosen sector by buying a stock, mutual fund or Exchange Traded Fund (ETF) of the entire sector, sub-sector, or company within a sector. As an example the Utilities Sector can have sub-sectors consisting of electric, gas, water or renewable utilities and companies specifically related to them.

The stock market and its related sectors are not the only investment opportunities available. According to Kevin Johnston, “The top 5 alternative investments to the stock market are: peer-to-peer lending, real estate, gold [commodities], owning your own business and equity crowd funding."

Other Investment Choices

There are choices to invest in markets other than stocks and bonds. “Real estate investment trusts (“REITs”) allow individuals to invest in large-scale, income-producing real estate." For investors who do not directly own commercial real estate, REIT’s offer the opportunity to include this investment as part of a portfolio. Publicly traded REITs can be bought and sold on an exchange. This differs from non-traded REITs which are not sold on an exchange but through a broker or agent. There are upfront costs associated with this purchase and obtaining information may not be as readily available vs a public REIT. As with any investment, investors should be aware of the differences of each and mindful of the inherent risks and benefits when investing in either type of REIT.

Commodities are traded by a broker and only after you have been granted acceptance to place orders. “Commodities are hard assets ranging from wheat to gold to oil. Since there are so many, they are grouped in three major categories: agriculture, energy, and metals.” After you deposit an initial amount (often thousands of dollars) into your opened margin account, an order may be placed. Commodities are highly leveraged and should be traded with care and great diligence of understanding the inherent risks associated with participating with this market. “There is always a chance that one can lose more money than initially invested.”

Although not considered an alternate investment, socially responsible investors have been clamoring to have the ability to invest in companies with similar philosophies. Environmental, Social, and Governance (ESG) stocks have become more mainstream and accepted since first introduced decades ago. According to Christopher Skroups, “When we talk about ESG, we are primarily referring to identifying and reducing risks relating to environment, social issues and corporate governance.” Similar to any investment made, there are never any guarantees. However, over time these types of investments have shown that adding to a portfolio may benefit your cause and also allow for a positive return.

Decisions

There are many financial investments to consider and research. The ability to invest in a wide swath of financial products is good for the investor. The challenge is to decide which financial products to participate in, and determine how much risk to undertake and the expected rate of return. Do you purchase a concentrated position increasing your potential return but also become exposed to an equally or possibly greater loss? Do you approach investing with a diversified approach spreading risk amongst a portfolio of different financial products? Does active or passive investing matter or use a blended approach? There are always questions to be asked but not always answered. Staying informed of market movements, reviewing key investment data and having a plan with goals to be achieved may help limit negative exposure to known factors and help mitigate the unknown.

Kevin Johnston stated, “Your investment portfolio should be diversified. This means you should consider a variety of stocks, but it also means you can invest in non-stock market investment vehicles. Consider where your money would grow best, based on your tolerance for risk."

The myriad of competing opinions, available information and choices, complicates decisions when deciding the best methods to use when selecting investments. Applying investment diversification and allocation can help balance risk and return in accordance with your desired results. Consulting with a Certified Financial Planner™ professional can help navigate the way.