Everything You Need to Know About the Yield Curve

Everything You Need to Know About the Yield Curve

 

LUTZ BUSINESS INSIGHTS

 

everything you need to know about the yield curve

josh jenkins, cfa, senior portfolio manager & head of research

 

In recent weeks the financial markets have displayed a traditional warning sign that has garnered significant attention. Widely viewed as one of the most reliable and accurate predictors of an economic slowdown, this signal has intensified the debate on where we are at in the economy. I am referring to, of course, the inversion of the yield curve. If you follow the financial media, you have most likely been exposed to some of these deliberations. What follows is a primer on what the yield curve is, some perspective on what an inversion has meant in the past, and whether investors should care.

 

Yield Curve 101

The yield curve is a graphical representation of yields for bonds with varying maturities ranging from short to long-term. The curve is typically associated with Treasury bonds, and it provides investors with a visualization of risk (time to maturity) and reward (yield) in the market. As the long-term average line in the chart below illustrates, yield has historically increased with time to maturity. This is generally because an investor will require more reward for bearing extra risk. The longer the period you have your money tied up, the larger the chance something could go awry. When the yield curve slopes upward, it is considered “normal”, and signifies the presence of the risk (term) premium.

 

Yield Curve 1

 Source: Treasury.gov. Long-term average calculated using daily yields from 1/2/1990 – 3/29/2019

Investors monitor the slope over time by comparing long-term yields with short-term yields. An inversion occurs when the long-term yield falls below that of the short. The spread between the 10-year Treasury bond and 3-month Treasury bill is among the most followed, and in late March it inverted for a couple of days.

Short-term interest rates are generally driven by monetary policy established by the Federal Reserve, while long-term rates are arguably driven by market expectations for economic growth and inflation. When the curve inverts, it can be interpreted as the market’s expectation for weaker growth in the future. The blue line above reflects the yield curve as of the end of March, with an apparent slight downward slope.

 

A Crystal Ball?

People pay close attention to the yield curve, because of its track record as an accurate forecaster of upcoming recessions. The yield curve has inverted ahead of all seven recessions endured by the U.S. economy going back over 50 years, while flashing a false positive just once. You would be hard pressed to find another indicator with that much success.

The chart below illustrates the historical experience. The blue line represents the monthly spread between the 10-year Treasury bond and 3-month Treasury bill yields going back to the early 1960’s. You can see that ahead of every recession (highlighted by the grey bars), the curve has inverted. The lone false positive occurred in the mid-1960’s.

As accurate as the signal has been historically, acting on it presents significant challenges. One of the primary drawbacks has been the considerable variability in the timing between the inversion and the onset of the recession. Going back to the 1960’s the time lag has ranged anywhere from 6 to 23 months (Average: 13 months).

 

Yield Curve 2

 Source: Fred.stlouisFed.org. Data as of 1/31/1962 – 3/29/2019. The 10-year yield is represented by the 10-Year Treasury Constant Maturity Rate. The 3-month bill is represented by the 3-Month Treasury Bill Secondary Market Rate until 1/4/1982, and the 3-month Treasury constant maturity rate thereafter. The spread was calculated on the last trading day of each month. Recessions represented by the NBER monthly peak through trough index.

Another issue relates to equity market performance following the inversion. You would generally expect stocks to decline if you had a strong reason to believe the economy was on a path to recession, but this hasn’t been the case historically. Following the last 8 inversions, U.S. stocks were positive on average 3 to 12 months later. Any investor that sold out immediately following the signal would have missed out on those gains. Additionally, the overall range of return outcomes (displayed in the table below as the Max-Min Spread) is extremely wide. For example, while the average 12-month return following an inversion was a pedestrian 5.10%, past returns were as high as +30.59% and as low as -14.49%. A market timing signal that keeps you within a 45% range is not particularly useful.

 

Yield Curve 3

Source: Morningstar Direct. Data as of 1/31/1962 – 3/29/2019. Equity Returns are based on monthly IA SBBI Large Cap Stock Index data, and begin the first day of the month following the initial inversion. Returns for periods in excess of 12 months are annualized.

Despite the impressive accuracy inversions have displayed in predicting recessions, many market participants are not buying it. There are a variety of explanations for why an inverted curve may have lost its predictive power. Among the most frequently cited is that quantitative easing, an unconventional policy tool used by the Federal Reserve in the wake of the financial crisis, has artificially suppressed long-term rates. Others point to the fact that the curve, defined as the spread between 10-year bonds and 3-month bills, only remained inverted for a couple of days. Finally, the relative value in U.S. yields may be increasing demand from foreign investors, as interest rates in many major economies are near zero or even negative. While one must be careful in assuming “this time is different”, the factors above appear credible and shouldn’t be discounted.

 

Implication for Investors

For investors with a long-term financial plan, much of this discussion amounts to noise. Market developments may be fascinating for those who are interested, but the news flow of the day should not tempt investors into increased portfolio activity.  If a perfect and actionable indicator existed, everyone would use it, and everyone would be rich. Alas, this is simply not the case. Despite being one of the best precursors of trouble, there remains significant uncertainty following an inversion. A false positive is always a possibility, and there are some credible guesses as to why that could be the case now. Furthermore, even if a recession is coming, there is a massive range of outcomes in terms of time till recession and stock market performance that can result.

Maintaining a balanced and diversified portfolio frees the investor from trying to see into the future. If your portfolio remains appropriate relative to your financial plan, an inversion (or any other market development) should not be the catalyst for change. Diversified portfolios are designed with the knowledge that the market is cyclical, and that recessions are inevitable. What investors SHOULD do, however, is use the inversion as a sign to recalibrate expectations. Prepare yourself mentally for the possibility the road ahead will be bumpier. Those that stick to their plan in the face of fear and uncertainty have historically been rewarded.

 

 

IMPORTANT DISCLOSURE INFORMATION
PLEASE REMEMBER THAT PAST PERFORMANCE MAY NOT BE INDICATIVE OF FUTURE RESULTS.  DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ASSURANCE THAT THE FUTURE PERFORMANCE OF ANY SPECIFIC INVESTMENT, INVESTMENT STRATEGY, OR PRODUCT (INCLUDING THE INVESTMENTS AND/OR INVESTMENT STRATEGIES RECOMMENDED OR UNDERTAKEN BY LUTZ FINANCIAL), OR ANY NON-INVESTMENT RELATED CONTENT, MADE REFERENCE TO DIRECTLY OR INDIRECTLY IN THIS BLOG WILL BE PROFITABLE, EQUAL ANY CORRESPONDING INDICATED HISTORICAL PERFORMANCE LEVEL(S), BE SUITABLE FOR YOUR PORTFOLIO OR INDIVIDUAL SITUATION, OR PROVE SUCCESSFUL.  DUE TO VARIOUS FACTORS, INCLUDING CHANGING MARKET CONDITIONS AND/OR APPLICABLE LAWS, THE CONTENT MAY NO LONGER BE REFLECTIVE OF CURRENT OPINIONS OR POSITIONS.  MOREOVER, YOU SHOULD NOT ASSUME THAT ANY DISCUSSION OR INFORMATION CONTAINED IN THIS BLOG SERVES AS THE RECEIPT OF, OR AS A SUBSTITUTE FOR, PERSONALIZED INVESTMENT ADVICE FROM LUTZ FINANCIAL.  TO THE EXTENT THAT A READER HAS ANY QUESTIONS REGARDING THE APPLICABILITY OF ANY SPECIFIC ISSUE DISCUSSED ABOVE TO HIS/HER INDIVIDUAL SITUATION, HE/SHE IS ENCOURAGED TO CONSULT WITH THE PROFESSIONAL ADVISOR OF HIS/HER CHOOSING.  LUTZ FINANCIAL IS NEITHER A LAW FIRM NOR A CERTIFIED PUBLIC ACCOUNTING FIRM AND NO PORTION OF THE BLOG CONTENT SHOULD BE CONSTRUED AS LEGAL OR ACCOUNTING ADVICE.  A COPY OF THE LUTZ FINANCIAL’S CURRENT WRITTEN DISCLOSURE STATEMENT DISCUSSING OUR ADVISORY SERVICES AND FEES IS AVAILABLE UPON REQUEST.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over eight years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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Why Investors Should Own International Stocks

Why Investors Should Own International Stocks

 

LUTZ BUSINESS INSIGHTS

 

WHY INVESTORS SHOULD OWN INTERNATIONAL STOCKS

JOSH JENKINS, CFA, SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

 

There is a tendency for investors to focus their attention and investment dollars on assets located within the United States. This tendency is well documented and is referred to as Home Country Bias. People are generally more comfortable with the familiar and there is a certain sense of safety that comes with investing in what you recognize. The fact that the U.S. market has performed much better than its international counterpart in recent years further reinforces investor preference for domestic assets. Is this lack of international exposure wise? Or are these investors missing out on a significant opportunity by not allocating (more) internationally?

A strong argument can be made for maintaining a sizable allocation to international stocks. The benefit can generally be boiled down to a reduction in portfolio risk, while maintaining or even improving the expected return.

The reduction in portfolio risk is primarily a function of diversification. The behavior of the various stock markets across the globe will differ based on their own set of circumstances, each with unique growth prospects, fiscal and monetary policies, regulatory framework, and tax structures.  Globalization has increased the tendency for different markets to behave in similar fashion, but they remain far from perfectly correlated. In normal market conditions certain countries will often zig, while others zag.

The chart below demonstrates the impact on portfolio risk of adding international exposure to an all U.S. stock allocation. The X axis represents the portion of the portfolio allocated internationally, and the Y axis reflects the degree of risk reduction(1). As you can see, even a small allocation to non-U.S. stocks has historically reduced portfolio risk. This benefit increases as the allocation expands, with the maximum benefit generally achieved by allocating 25-40% of the stock exposure to non-U.S. companies. Beyond this level the benefit begins to erode as the portfolio becomes overly concentrated in non-U.S. stocks, which are more volatile on a standalone basis.

 

Risk Reduction From Adding International Stocks to a U.S. Stock Portfolio

Source: Morningstar Direct and DFA. U.S. stocks represented by the Russell 3000 TR index. International stocks represented by the MSCI EAFE NR Index from 1/1979 through 12/1998, and the MSCI ACWI ex US from 1/ 1999 through 1/ 2019. Returns based on monthly data, and the blended portfolios were rebalanced monthly. Risk was represented by standard deviation (annualized).

U.S. stocks have outperformed international stocks for much of the period following the 2008 financial crisis. The scale of the recent outperformance in terms of time and degree can easily lead investors to believe that this is the norm, but is this belief justified? To answer this question, we looked at the relative performance between U.S. and international stocks on a rolling five-year basis going back as far as we have data. The chart below reflects the results of this analysis, and clearly illustrates the relative performance between the two are cyclical. There have been several extended periods over the last 40 years where international stocks handily outperformed the U.S. market.

 

Cyclicality of U.S. vs. International Stock Returns

Source: Morningstar Direct and DFA. U.S. stocks represented by the Russell 3000 TR index. International stocks represented by the MSCI EAFE NR Index from 1/1979 through 12/1998, and the MSCI ACWI ex US from 1/ 1999 through 1/ 2019. Returns based on monthly data.

If we know international markets have outperformed in the past, do we have reason to believe they could again outperform in the future? The key to this question could lie in the relative valuation between the two.

Valuation is a measure of how cheap or expensive a stock (or entire market) is and is one of the best predictors of return over the long run. It is generally quoted in terms of the price paid for a unit of some fundamental figure, such as earnings. In simple terms: the lower the price you pay for an asset, the better the chance it is going to deliver an attractive return. Finally, relative valuation simply compares how cheap or expensive one investment is relative to another.

The chart below applies the relative valuation technique to the comparison of U.S. vs. international stocks(2). The middle grey bar indicates the level where the two alternatives are equally valued. When the green line is above the top grey line, international stocks are considered expensive. They are considered cheap when the green line is below the bottom grey line. As you can see, international stocks are currently near the cheapest levels relative to U.S. stocks in 18 years (as far back as we have data). This provides a sound basis to expect higher returns from international stocks over U.S. stocks moving forward.

 

Relative Valuation: U.S. vs. International Stocks

Source: Morningstar Direct. Valuations are based on an equally weighted composite of price/book value, price/earnings, price/sales, and price/cash flow. The chart illustrates the ratio of the international composite over the domestic composite. U.S. stocks were represented by the Russell 3000 index, international stocks were represented by the MSCI EAFE index. Data from 1/2001 to 12/2018. Gaps in the green relative valuation line are due to missing/inconsistent data.

While valuation is arguably the best predictor of long-term returns, it unfortunately does not tell us much about what is going to happen in the coming days, months, or even years. Markets can and will stay out of balance for extended periods of time. A second look at the cyclicality of returns chart, and you can see the outperformance of one market vs. the other is highly variable in terms of both duration and intensity. Like gravity, valuation should ultimately pull the market back toward balance, even if it takes a long time to do so.

Though many U.S. based investors exhibit Home Country Bias, there are compelling reasons to consider and/or maintain a meaningful allocation to international stocks. Through the benefit of diversification, adding international stocks can reduce fluctuations in portfolio value. While investors exhibiting Home Country Bias have been rewarded with strong performance in the U.S. recently, this relative performance has historically been cyclical. The attractive relative value provides us with a reason to expect international stocks to outperform in the future.

  • Risk in this instance is defined as the standard deviation of returns. The reduction in risk is measured by the spread between the standard deviation of the various blended portfolios and the Russell 3000.
  • The Y axis of the relative valuation chart can be interpreted as the discount on buying international stocks vs U.S. stocks. Over the measurement period the price paid for international stocks has average 74% of the price paid for U.S. stocks (based on the equally weighted composites of the four price multiples: P/E, P/B, P/S, P/CF). As of year-end 2018 the price paid for international was 65% of the U.S. price, meaning you can buy international stocks much more cheaply then you have been able to historically.

 

 

IMPORTANT DISCLOSURE INFORMATION
PLEASE REMEMBER THAT PAST PERFORMANCE MAY NOT BE INDICATIVE OF FUTURE RESULTS.  DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ASSURANCE THAT THE FUTURE PERFORMANCE OF ANY SPECIFIC INVESTMENT, INVESTMENT STRATEGY, OR PRODUCT (INCLUDING THE INVESTMENTS AND/OR INVESTMENT STRATEGIES RECOMMENDED OR UNDERTAKEN BY LUTZ FINANCIAL), OR ANY NON-INVESTMENT RELATED CONTENT, MADE REFERENCE TO DIRECTLY OR INDIRECTLY IN THIS BLOG WILL BE PROFITABLE, EQUAL ANY CORRESPONDING INDICATED HISTORICAL PERFORMANCE LEVEL(S), BE SUITABLE FOR YOUR PORTFOLIO OR INDIVIDUAL SITUATION, OR PROVE SUCCESSFUL.  DUE TO VARIOUS FACTORS, INCLUDING CHANGING MARKET CONDITIONS AND/OR APPLICABLE LAWS, THE CONTENT MAY NO LONGER BE REFLECTIVE OF CURRENT OPINIONS OR POSITIONS.  MOREOVER, YOU SHOULD NOT ASSUME THAT ANY DISCUSSION OR INFORMATION CONTAINED IN THIS BLOG SERVES AS THE RECEIPT OF, OR AS A SUBSTITUTE FOR, PERSONALIZED INVESTMENT ADVICE FROM LUTZ FINANCIAL.  TO THE EXTENT THAT A READER HAS ANY QUESTIONS REGARDING THE APPLICABILITY OF ANY SPECIFIC ISSUE DISCUSSED ABOVE TO HIS/HER INDIVIDUAL SITUATION, HE/SHE IS ENCOURAGED TO CONSULT WITH THE PROFESSIONAL ADVISOR OF HIS/HER CHOOSING.  LUTZ FINANCIAL IS NEITHER A LAW FIRM NOR A CERTIFIED PUBLIC ACCOUNTING FIRM AND NO PORTION OF THE BLOG CONTENT SHOULD BE CONSTRUED AS LEGAL OR ACCOUNTING ADVICE.  A COPY OF THE LUTZ FINANCIAL’S CURRENT WRITTEN DISCLOSURE STATEMENT DISCUSSING OUR ADVISORY SERVICES AND FEES IS AVAILABLE UPON REQUEST.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over eight years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

SIGN UP FOR OUR NEWSLETTERS!

We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

VIEW MODIFIED SUMMER HOURS HERE

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

601 P Street, Suite 103

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

3 Things All Investors Should Know

3 Things All Investors Should Know

 

LUTZ BUSINESS INSIGHTS

 

3 Things All Investors Should Know

JOSH JENKINS, CFA, SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

 

Market sentiment has been as volatile as stock prices in 2018 and there is an abundance of storylines impacting each. Investors spend a significant amount of time fretting over things like trade tensions, interest rates and inflation, but these macro variables are massively complex and impossible to correctly forecast consistently. To complicate matters further, even if you do make a correct forecast it doesn’t mean the market will respond in the way you expect. Instead of getting swept up by the narrative of the day, it’s better for investors to focus on what they can control. With this in mind, here are three things all investors should know. 

 

Investors are Rewarded Over Time

While an investor’s time horizon is not the only factor in determining their ability to take risk, the chart below demonstrates why it is an important one. We can see below the range of returns experienced for stocks, bonds, and a balanced portfolio, defined as a portfolio of 60% stocks and 40% bonds, across various time intervals going back to 1950. A few takeaways include:

  • The range of returns is very wide for the one-year window, but shrinks as you expand the measurement period.
  • The chances of generating a positive return increase as you expand the measurement period.

Total return range by asset class 

Investors with a long investment horizon need not care about the day-to-day or even year-to-year gyrations in the market. Looking back on nearly seventy years of history, there has never been a twenty-year period where stocks, bonds, or a balanced portfolio have posted a negative return. I’d add a generic disclaimer: anything is possible in the future and there is a first time for everything. Even so, this is very impressive, considering the first twenty-year period in the analysis (the twenty years ending January 1950) included the majority of the Great Depression and World War II.

You don’t have to have a twenty-year horizon to participate in the market. Even the intermediate five and ten-year periods have an excellent track record of both bonds and balanced portfolios batting a thousand. While stocks did not perform perfectly, they still delivered a gain 93% and 97% of the time for the five and ten-year periods respectively. Interestingly, all of the ten-year losses for stocks were associated with the infamous “lost decade”—the period sandwiched between two extreme and unusual market events: the height of the technology bubble in the late 1990’s and the trough of the great recession in the late 2000’s.

Though stocks were positive nearly 80% of the time over a one-year window, the wide range of outcomes highlights the importance of liquidity. The portion of the portfolio that needs to be quickly converted into purchasing power should consist of cash and bonds. When this is not the case, an investor risks becoming a forced seller. Volatility alone does not lead to a permanent impairment of capital, being forced to sell stocks after a downturn does.

 

Missing Out on a Few “Up” Days Can Devastate Your Returns

When volatility picks up in the market, many investors begin to think about selling out of risky assets and waiting in cash for the opportunity to reinvest when things have settled. While this strategy has intuitive appeal, there is a catch: It is virtually impossible to do it profitably.   

There are many factors that contribute to the futility in trying to time short-term market movements. Consider the initial sell decision: The desire to migrate to safety is generally associated with recent, and often dramatic, downward market movements. This desire for safety often equates to selling at or around a near-term low… not a good start. 

Frequently, these volatile periods do not involve steady price declines that occur in a linear fashion. Rather they are punctuated by violent moves both higher and lower. By way of example, consider October 2008, the worst month for U.S. stocks over the last thirty years. While many people carry visceral memories of that period, few probably recall that on two different occasions that month the market returned over 10% in a single day!

The chart below looks at the average calendar year returns for the S&P 500 from 1990 to 2017, as well as how your investment outcome would change if you missed a few of the largest returning days each year. A buy and hold investor would have received an average yearly return of 11.3%, not bad considering this period contains two of the most dramatic market drawdowns in U.S. history. Had you missed the single best day each year, your return would be reduced by a third to 7.6%. Miss four days, your average return becomes negative. Miss ten and stocks would have declined each year an average of -11.0%.

What would market returns look like if you missed a few of the best days each year?

Of course, this is a simple way of looking at things. Presumably, if you sell when prices are declining and that volatility happens to continue, though it often does not, then you may avoid some bad days in addition to the good. A major issue with this method is you still need a trigger to get back into the market, which for many people equates to seeing a recovery in prices. Now you have sold after losses and bought after gains.

On average, the market delivers a gain over just four days during the year and trades sideways the rest of the time. This realization is shocking to many. When viewed from this perspective, the pressure to not miss one of these days is high. Bottom line, don’t try to time the market and voluntarily become a forced seller.

 

Missing Out On a Few Big Winners Will Also Hurt Returns

A similar analysis as the one used above for market timing can be applied to diversification. The idea is straightforward. Investors that choose a concentrated approach to investing face a high degree of pressure to pick the right stocks. Look no further than the explosive growth in index funds to see that picking the winners is no easy task, even for the professionals.

In the absence of decades of index constituent data, I borrowed from a recent Morningstar article(1) and an academic paper(2) focused on the topic. The paper, published by Arizona State University, concluded that concentrated portfolios are likely to underperform the broad market over time. The cause? A small subset of stocks account for the majority of the gains. Sound familiar? The author analyzed returns going back to 1926 and found that roughly 4% of the best performing stocks accounted for all the wealth generated by the market over time. The other 96% of stocks essentially broke even.

To not own one of these star stocks risks missing out on tremendous gain. In many ways, diversification within your stock allocation is not about limiting the downside risk of any one company. Instead, it’s about maximizing the number of companies where you can participate in the upside. 

At the end of the day, your financial success or failure is not going to depend on forecasting macro events. The keys to your success will depend on devising and adhering to a sound financial plan. A good plan will balance near-term spending needs with long-term capital growth or preservation. It will keep you invested, even when doing so is uncomfortable. Finally, it will be diversified, ensuring that you participate in the wealth generated by the next crop of top performing businesses.

 

 

[1] Bryan, B. (2018, November 28). “Why Diversification Beats Conviction” Retrieved from Morningstar.com
[2] Bessembinder, H. (2017). “Do Stocks Outperform Treasury Bills?” Department of Finance, Arizona State University.
 
Important Disclosure Information
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over eight years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

SIGN UP FOR OUR NEWSLETTERS!

We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

VIEW MODIFIED SUMMER HOURS HERE

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

601 P Street, Suite 103

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Lutz Financial: Market Update

Lutz Financial: Market Update

 

LUTZ BUSINESS INSIGHTS

 

Lutz Financial: Market Update

JOSH JENKINS, CFA, SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

After recently hitting an all-time high, the U.S. stock market has experienced a return to volatility. While it’s perfectly natural to be uncomfortable watching the prices trend lower the way they have, it’s important to remember gyrations in a given week, month, or even year are generally not going to impact your financial plan and long-term goals. Still, we felt this was a good opportunity to reach out and let you all know what we are thinking.

Market Declines are Normal and Healthy

Last year was smooth sailing for investors as the market steadily marched higher with virtually no volatility. That experience was highly unusual, however, as the table below illustrates. Based on a study from the Capital Group, the stock market experiences a decline of -5% or more three times a year on average, and a -10% decline once a year. What we are experiencing today is normal, the uninterrupted gains of 2017 were not.

A History of Market Declines

After an extended period without a meaningful pullback, it’s easy to become complacent. When the market finally does retreat, it can feel like a shock to the system. The financial media certainly does not help the situation. Their business is predicated on attracting viewers, and perpetuating fear is extremely effective at doing that.

The truth of the matter is the market can sometimes rise too far too fast. When this happens, prices need to correct and reset for future gains. The beginning of this year offers a great example of this. Stocks went gangbusters in January, dipped in February and March, then rebounded and steadily moved to new highs.

While we know declines are an inevitable part of the market cycle, we don’t know how long they will last, or how far prices will fall. It is okay not to know these things, because nobody else knows either. The important thing is having a plan in place for when they arise.

The market is the most efficient mechanism anywhere in the world for transferring wealth from impatient people to patient people.” – Warren Buffett

Emotional Investing Leads to Bad Outcomes

When it comes to building and maintaining wealth, investors are often their own worst enemy. Rather than execute decisions based on thorough analysis, they have knee jerk reactions based on fear and greed. Everyone is susceptible to this pitfall – it’s the result of thousands of years of evolution. Our ancestors living in caves would not have survived long enough to procreate if they stopped to do a S.W.O.T. analysis each time they sensed danger. The fight or flight response kept them alive. While these emotions can keep us from physical danger, they often lead to poor decisions when it comes to investing.

The chart below from J.P. Morgan illustrates the conclusion of the prominent DALBAR study, which measured investor returns over a 20-year period. The result is not pretty. The average investor (orange column) earned just 2.6%, much lower than the funds they were investing in! The underperformance is largely the result of poor timing decisions, such as chasing recent winners and dumping recent losers. It may seem obvious that buying high and selling low is a poor strategy, but our raw desire to have more money than our neighbor, or to protect our life savings from decline can trump rational thought. A disciplined investor that was able to buy and hold a balanced portfolio like the 60/40 or 40/60 on the chart would have more than doubled the return of the average investor. Compounding a reasonable return over the next 20 years is how you build wealth, not trying to pick the next Amazon.

20-year annualized returns by asset class (19998-2017)

What Should Investors Do?

The best thing for investors to do is tune out the noise from the day to day gyrations in the market. Understand there will be bumps (sometimes large ones) in the road from time to time. Remember this is normal, healthy, and often offers a good opportunity to buy at a discount or harvest some losses. Keep emotions under control. Don’t become too excited when things are going well, or to down when things look dire. The best advice anyone can give, is to build a sound plan and then stick to it.

 

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over eight years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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Tuning Out the Noise

Tuning Out the Noise

 

LUTZ BUSINESS INSIGHTS

 

Tuning Out the Noise

If you are feeling uneasy about your investment performance during these periods of volatile market activity, download this video, “Tuning Out the Noise” to help remind you of the importance of remaining disciplined during uncertain times.

 

 

 

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

SOURCE: RPAG
COPYRIGHT 2018 RPAG. ALL RIGHTS RESERVED.
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VIEW MODIFIED SUMMER HOURS HERE

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Lessons for the Next Crisis

Lessons for the Next Crisis

 

LUTZ BUSINESS INSIGHTS

 

Lessons for the Next Crisis

September 2017

It will soon be the 10-year anniversary of when, in early October 2007, the S&P 500 Index hit what was its highest point before losing more than half its value over the next year and a half during the global financial crisis.

Over the coming weeks and months, as other anniversaries of major crisis-related events pass (for example, 10 years since the bank run on Northern Rock or 10 years since the collapse of Lehman Brothers), there will likely be a steady stream of retrospectives on what happened as well as opinions on how the environment today may be similar or different from the period leading up to the crisis. It is difficult to draw useful conclusions based on such observations; financial markets have a habit of behaving unpredictably in the short run. There are, however, important lessons that investors might be well-served to remember: Capital markets have rewarded investors over the long term, and having an investment approach you can stick with—especially during tough times—may better prepare you for the next crisis and its aftermath.

 

BENEFITS OF HINDSIGHT

In 2008, the stock market dropped in value by almost half. Being a decade removed from the crisis may make it easier to take the past in stride. The eventual rebound and subsequent years of double-digit gains have also likely helped in this regard. While the events of the crisis were unfolding, however, a future of this sort looked anything but certain. Headlines such as “Worst Crisis Since ’30s, With No End Yet in Sight,”[1] “Markets in Disarray as Lending Locks Up,”[2] and “For Stocks, Worst Single-Day Drop in Two Decades”[3] were common front page news. Reading the news, opening up quarterly statements, or going online to check an account balance were, for many, stomach-churning experiences.

While being an investor today (or during any period, for that matter), is by no means a worry-free experience, the feelings of panic and dread felt by many during the financial crisis were distinctly acute. Many investors reacted emotionally to these developments. In the heat of the moment, some decided it was more than they could stomach, so they sold out of stocks. On the other hand, many who were able to stay the course and stick to their approach recovered from the crisis and benefited from the subsequent rebound in markets.

It is important to remember that this crisis and the subsequent recovery in financial markets was not the first time in history that periods of substantial volatility have occurred. Exhibit 1 helps illustrate this point. The exhibit shows the performance of a balanced investment strategy following several crises, including the bankruptcy of Lehman Brothers in September of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year that it occurred or peaked.

 

Performance of a Balanced Strategy: 60% Stocks, 40% Bonds (Cumulative Total Return)

 

In US dollars. Represents cumulative total returns of a balanced strategy invested on the first day of the following calendar month of the event noted. Balanced Strategy: 12% S&P 500 Index,12% Dimensional US Large Cap Value Index, 6% Dow Jones US Select REIT Index, 6% Dimensional International Marketwide Value Index, 6% Dimensional US Small Cap Index, 6% Dimensional US Small Cap Value Index, 3% Dimensional International Small Cap Index, 3% Dimensional International Small Cap Value Index, 2.4% Dimensional Emerging Markets Small Index, 1.8% Dimensional Emerging Markets Value Index, 1.8% Dimensional Emerging Markets Index, 10% Bloomberg Barclays Treasury Bond Index 1-5 Years, 10% Citigroup World Government Bond Index 1-5 Years (hedged), 10% Citigroup World Government Bond Index 1-3 Years (hedged), 10% BofA Merrill Lynch 1-Year US Treasury Note Index. The S&P data are provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2017 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Citigroup Indices used with permission, © 2017 by Citigroup. Bloomberg Barclays data provided by Bloomberg. For illustrative purposes only. Dimensional indices use CRSP and Compustat data. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Not to be construed as investment advice. Rebalanced monthly. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance. See Appendix for additional information.

 

Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses immediately following most of these events, financial markets did recover, as can be seen by the three- and five-year cumulative returns shown in the exhibit. In advance of such periods of discomfort, having a long-term perspective, appropriate diversification, and an asset allocation that aligns with their risk tolerance and goals can help investors remain disciplined enough to ride out the storm. A financial advisor can play a critical role in helping to work through these issues and in counseling investors when things look their darkest.

 

Conclusion

In the mind of some investors, there is always a “crisis of the day” or potential major event looming that could mean the beginning of the next drop in markets. As we know, predicting future events correctly, or how the market will react to future events, is a difficult exercise. It is important to understand, however, that market volatility is a part of investing. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times. A well‑thought‑out, transparent investment approach can help people be better prepared to face uncertainty and may improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets.

 

Appendix

Balanced Strategy 60/40

The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor’s decision making if the advisor were actually managing client money. The balanced strategies are not recommendations for an actual allocation.

International Value represented by Fama/French International Value Index for 1975–1993. Emerging Markets represented by MSCI Emerging Markets Index (gross dividends) for 1988–1993. Emerging Markets weighting allocated evenly between International Small Cap and International Value prior to January 1988 data inception. Emerging Markets Small Cap represented by Fama/French Emerging Markets Small Cap Index for 1989–1993. Emerging Markets Value and Small Cap weighting allocated evenly between International Small Cap and International Value prior to January 1989 data inception. Two-Year Global weighting allocated to One‑Year prior to January 1990 data inception. Five-Year Global weighting allocated to Five-Year Government prior to January 1990 data inception. For illustrative purposes only.

The Dimensional Indices used have been retrospectively calculated by Dimensional Fund Advisors LP and did not exist prior to their index inceptions dates. Accordingly, results shown during the periods prior to each Index’s index inception date do not represent actual returns of the Index. Other periods selected may have different results, including losses.

Index Descriptions

Dimensional US Large Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th‑largest company whose relative price is in the bottom 30% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Large Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th‑largest company whose relative price is in the bottom 20% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.

Dimensional US Small Cap Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market‑capitalization‑weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the Eligible Market. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

Dimensional US Small Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 35% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 25% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.

Dimensional International Marketwide Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Marketwide Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index.

Dimensional International Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. July 1981–December 1993: It Includes non-US developed securities in the bottom 10% of market capitalization in each eligible country. All securities are market capitalization weighted. Each country is capped at 50%. Rebalanced semiannually. January 1994–Present: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Prior to July 1981, the index is 50% UK and 50% Japan. The calculation methodology for the Dimensional International Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

Dimensional International Small Cap Value Index is defined as companies whose relative price is in the bottom 35% of their country’s respective constituents in the Dimensional International Small Cap Index after the exclusion of utilities and companies with either negative or missing relative price data. The index also excludes those companies with the lowest profitability within their country’s small value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Created by Dimensional; includes securities of MSCI EAFE countries in the top 30% of book-to-market by market capitalization conditional on the securities being in the bottom 10% of market capitalization, excluding the bottom 1%. All securities are market-capitalization weighted. Each country is capped at 50%; rebalanced semiannually.

Dimensional Emerging Markets Index is compiled by Dimensional from Bloomberg securities data. Market capitalization-weighted index of all securities in the eligible markets. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008.

Dimensional Emerging Markets Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional Emerging Markets Value Index was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Fama/French Emerging Markets Value Index.

Dimensional Emerging Markets Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. January 1989–December 1993: Fama/French Emerging Markets Small Cap Index. January 1994–Present: Dimensional Emerging Markets Small Index Composition: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Source: Bloomberg. The calculation methodology for the Dimensional Emerging Markets Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

 

Source: Dimensional Fund Advisors LP.There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Diversification does not eliminate the risk of market loss.

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

 

[1]wsj.com/articles/SB122169431617549947.

[2]washingtonpost.com/wp-dyn/content/article/2008/09/17/AR2008091700707.html.

[3]nytimes.com/2008/09/30/business/30markets.html.

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