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May 26, 2015

Questions about the market

by Josh Clavell

As the market moves around, I thought I would take this time to address some common questions.

questions about the market

When you know the market is going down, why don’t you get us out of stocks?

The truth is that nobody knows what the market will do. Sure, the media “talking heads” all profess to know, but they only get attention for sensationalism, entertainment or being right the last time! What if we took you out of the market and it shot up right after? Market increases tend to happen in spurts. If you miss only a few of the best days a year, your returns will likely not even keep up with inflation.

Why are we in bonds when interest rates can only go up?

Bonds produce ongoing income no matter what the stock market does. Many investors fear that when interest rates rise, their bonds will be worth less. This is only true if you sell the bonds before maturity. Let’s say you buy a 10-year bond for $10,000 paying 4%. You will collect $400 per year and, at the end of ten years, you will get your $10,000 back. If, after two years, the interest rates rise to 5%, you won’t be able to sell your bond for $10,000. An investor would pay you less to get 4% when other bonds are paying 5%. As long as you hold onto the bond, you will still get interest payments and $10,000 at maturity. When interest rates rise, as your bonds mature, the next bonds you buy will pay more! So, an increase in interest rates is good for your portfolio – as long as you can handle the temporary paper losses.

Why do we hold “ABC” fund when it hasn’t performed well in the last several years?

Your portfolio is diversified, with various types of investments held in specific percentages. Your particular asset allocation was specifically designed for you to get the largest long-term return for the amount of downside you’re willing to tolerate. Diversification means that some pieces will perform better while other pieces perform worse. The key is looking at your portfolio’s overall return, not the individual pieces. A fund that hasn’t done well for several years might be the very fund that saves your portfolio when the other funds drop.

When the market goes up, why doesn’t my portfolio increase by as much?

With higher ups, comes lower lows. Think back to 2008, how would you feel about your portfolio losing 40% or more? To get returns like the Dow or the S&P 500, you’d have to be fully invested in just that one part of the market. And, you’d have to be willing to ride out the extreme falls.

For example, Jack holds an aggressive portfolio with a long-term expected return of 10%, while Jill holds a moderate portfolio with an expected return of 8%. Here is a possible scenario:

                          Jack              Jill

Investment          $100,000        $100,000

Year 1 Loss         ($20,000)        ($8,000)

Year 1 Balance.      $80,000        $92,000

Year 2 Gain          $32,000         $22,000

Year 2 Balance.     $112,000.       $114,000

In this case, Jill came out ahead even though her average 8% return was less than Jack’s average 10% return. In year 1, Jill was okay losing only 8% when her friend Jack lost 20%. In year 2, she wasn’t pleased when her portfolio only increased by 24% while Jack gained 40%. However, considering the overall return for the two years, Jill came out ahead.

What do you do with my portfolio when the market goes down?

We harvest tax losses and rebalance. Harvesting tax losses makes lemonade out of lemons: We sell loss positions to recognize tax losses and immediately replace them with something similar (so you stay fully invested). The losses can offset gains in the current or future years – so you can keep more of your earnings and give less to Uncle Sam. We also rebalance your portfolio when a position’s value declines materially from its target percentage. This keeps your risk/return strategy intact and gives us the opportunity to buy bargains. This ongoing process ensures that your long-term goals will continue to be achievable.

We are always available to answer your questions about your financial plan or investments!

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