What is an Index (and why should you care)?

Recently I was on vacation with a friend, and while enjoying the sunshine she received a CNN alert…

Breaking News: Dow Jones Industrial Average soars to an all time high.

She then asked me what the Dow Jones was exactly … “Should I know what this means?” My response was, “it’s a stock market index, of course.” Seeing the perplexed look on her face, I realized that she had no idea what I was talking about. After having this conversation, I wanted to share with you what I shared with my friend.

  1. What is a market index? – A stock market index is simply a measurement of the value of the market or a section of the market. Let’s break it down into a simple example. Assume ABC index is made up of 6 companies. At the end of trading on Monday the index is at 5,000 points. On Tuesday, three of the companies go up in value, two of the companies go down and the sixth company stays the same. The total value of the stocks change by 3% on Tuesday, so now the index is at 5,150 points. This tells you that this section of the market went up in value from Monday to Tuesday.
  2. Why are market indexes important? Choosing appropriate investments is only the beginning. One of the biggest challenges of an investor is to determine how well your portfolio is performing. Are you lagging behind the market or beating it? You can only know the answer to these questions if you have something to compare your investments to. Indexes allow you to measure the performances of your investments against an appropriate benchmark.
  3. How do you choose the right benchmark? In general, when you are tracking the performance of an investment, you look at a benchmark that is most similar to your investment. For example: If your portfolio is all U.S. large cap stocks you would likely use the S&P 500 as your benchmark. If your portfolio is all fixed income then you would most likely benchmark against the Barclays Aggregate Bond index. If your portfolio is a combination of both large-cap stock and fixed income you would want to use a blended benchmark of the two indexes.
  4. All of this is for naught if you don’t know what indexes track which stocks. Here are some of the most common market indexes and the companies they are comprised of.
  • Dow Jones Industrial Average (DJIA) – This is one of the most popular measures of the market. A.K.A. “The Dow” or “Dow 30” is a price-weighted measure of 30 US blue-chip companies. The index covers all industries with the exception of transportation and utilities, which are covered by other Dow Jones indexes.
  • S&P 500 Index - This index is based on 500 U.S. large cap companies that have common stock listed on the NYSE or NASDAQ. These companies are representative of the industries in the U.S. economy.
  • Russell 2000 – This index tracks 2,000 small-company stocks. It serves as benchmark for the small-cap component of the overall market.
  • Dow Jones Wilshire 5000 – This index covers over 5,000 US companies listed on major stock exchanges. This includes US companies of all sizes across all industries.
  • Barclays Capital Aggregate Bond Index – This is a broad-based benchmark that measures the investment grade, US dollar-denominated fixed-rate taxable bond market.
  • MSCI EAFE Index – This index is designed to measure the equity market performance of developed markets outside of the U.S. and Canada. EAFE is an acronym that stands for Europe, Australasia and Far East. (Check out Sarah DerGarabedian’s blog post from last week to read why it’s important to have an international allocation – http://wp.me/plOKq-oE 
  1. It’s important to remember when comparing your investment returns to compare your results to the long-term market, not just the past year. Typically analysts look at 3, 5 and 10 year returns. Short-term results can often be misleading due to short-term volatility. A quick Google search should provide you with the long-term returns of any of the major indexes.

After explaining all of this information to my friend, I think she had a better grasp on market indexes and hopefully this information is helpful to you too. One realization that came from our conversation is that sometimes financial advisors (nerds) forget that things that seem so common to us aren’t as familiar to those not in the industry. We never want a client to leave a meeting or conversation feeling confused or uncertain. If you have questions, please ask! We may just write a blog post about it.

Ashley Woodring, CFP®

Financial Advisor

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Kit Kats, Blow Pops, and the Benefits of Diversification

“But international stocks are underperforming the S&P 500! Why are you buying international mutual funds in my account?”

We hear this question a lot. People often wonder why we include various sectors and asset classes in our portfolios, but the one that tends to get the most scrutiny is international equity. Many investors exhibit what is known as “home bias,” or the tendency to invest primarily in domestic securities, whether it stems from a nationalistic desire to “buy local” or simply the belief that international investing carries additional costs and complexities. Often, investors eschew international diversification to their detriment, as many studies have shown that the inclusion of international equities lowers portfolio volatility while increasing risk-adjusted return. However, these metrics are not what investors see – they see performance. They see that the return on their international fund is lower than the return on the S&P 500 and fear that it will be a drag on their returns forever. So why don’t we sell it?

Quite simply, we keep it for the diversification benefits. With Halloween just around the corner, perhaps an analogy will help. When you’re trick-or-treating, you knock on the door of every lighted house and collect as much candy as you can carry home. Then you dump it out on the floor and sort through it to revel in the spoils. Hopefully you’ll come home with lots of chocolate candy bars, M&Ms, Milk Duds, Junior Mints, and Reese’s cups. Then there might be a smattering of Smarties, Starburst, and Skittles, which are fine. Invariably there will be a few of those orange and black-wrapped peanut butter taffies, some chalky Dubble Bubble and a handful of Dum Dums – but that’s OK. A few crummy candies won’t ruin the night, since you have so much more of the good stuff. And you never know which houses are going to hand out what candy, so you have to hit them all. (And to the person handing out raisins, just stop. Don’t be that guy.)

Now imagine that your portfolio is a bag of Halloween candy. Even if you love Snickers, it would be pretty disappointing if your entire haul was nothing but Snickers – that would defeat the purpose of trick-or-treating, because you could simply go to the store and buy a bag. No, you want a wide variety from which to choose, based on changing moods and cravings! In a similar way, you need to diversify your investments so that the mood of the day doesn’t destroy your savings in one fell swoop. If your entire portfolio consists of the stock of one bank and the bank goes under, you lose all of your money. If you buy the stock of 5 different banks, but the entire banking industry hits a rough patch, your portfolio plummets…so you buy the stock of 40 different companies in different sectors and industries to spread the risk. But what if they’re all domestic companies and the domestic economy tanks? I think you see where this is going. Different investments zig and zag, moving in opposite directions simultaneously, which dampens the overall volatility of the portfolio.

You may not be a huge fan of Blow-Pops, but what happens if you fill your bag with Kit Kats and you’re suddenly in the mood for Sour Apple? What if you leave your bag in the sun and all the Kit Kats melt? It’s true that if particular sector (such as international equity) underperforms and you have it in your portfolio, you might get a lower return on your portfolio for that period. But when that sector rallies, you’ll be happy you had a couple of Blow-Pops in your bag.

Sarah DerGarabedian, CFA

Portfolio Manager

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Why not Short the Market?

A “short sale” refers to selling stock that you do not own with the hope of repurchasing it at a lower price later. It is a way for an investor to try and profit from their view that a particular investment is overvalued and likely to fall in price. This technique can be used on individual stocks, or on Exchange Traded Funds (“ETFs”) that represent anything from individual sectors to the overall market. While there are many successful investors who have done well on the short side, for most people this strategy doesn’t make a lot of sense due to the risks involved.

The mechanics of a short sale are as follows: An investor goes to their broker, borrows shares of a stock and sells them. The short sale proceeds are credited to the short seller’s account, less a fee for borrowing the stock. You must have a margin account in order to short stock. If the price of the shorted stock rises, the short seller will need eventually to borrow on margin to keep the position open.

The short seller receives interest on the short sale proceeds, although this is minimal currently since interest rates are low. In practice, this interest is often split with the buyer of the shares or the brokerage firm that is facilitating the short sale. The short seller must pay any dividends on the borrowed stock to the purchaser of the shares.

Risks of Short Selling:

Swimming Against the Tide –Since 1926, about 7 out of 10 years have been positive for the overall market. If you are short the overall market, chances are you will be in a losing position after a year.

Timing is Critical—Stocks can move quickly in either direction, and it is difficult to predict the future. If the event that you are betting on fails to materialize, or if the opposite happens, your losses can mount quickly. For this reason, short selling is more common among professional and institutional investors.

It can be Expensive to Maintain a Short Position— With today’s low interest rates, the combination of the borrowing cost and the dividends the short must pay to the long far outweighs the interest on the short sale proceeds that the seller is earning. For example, say you short 100 shares on Johnson and Johnson at $108 because you think Band-Aid sales are going to decline sharply. You receive proceeds of $10,800 and earn money market interest at 0.01%, or $10.80 per year. Your annual cost to carry the position is the 2.8% dividend, or $302.40 plus any borrowing costs charged by your broker. These additional costs can be quite high for stocks that are hard to borrow.

Limited Profits but Potentially Unlimited Losses–At most, any stock can go down 100% in value. However, there is no limit to how far a stock or the overall market can go up. If it goes up by enough to wipe out the equity in your margin account, the brokerage firm will buy-in the security at a loss and close the trade. Say you short a stock at $8/share. The most you can make is $8 if the company goes out of business and you are able to buy back the borrowed shares at $0. But what if good news comes out and the stock goes from $8 to $18? You just lost $10/share when your maximum theoretical profit was $8. In reality, few companies go out of business so your maximum profit is even more limited.

We believe that, rather than trying to profit on short-term price movements, our clients should place the equity portion of their investments in a diversified portfolio of quality companies with the potential for rising earnings and rising dividend income.

Bill Hansen, CFA

Managing Partner

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Market Update Through 3Q 2014

as of Sept 30, 2014
                                                     Total Return
Index 12 months YTD QTD Sept
Stocks
Russell 3000 17.76% 6.95% 0.01% -2.08%
S&P 500 19.73% 8.34% 1.13% -1.40%
DJ Industrial Average 15.29% 4.60% 1.87% -0.23%
Nasdaq Composite 20.61% 8.56% 2.24% -1.82%
Russell 2000 3.93% -4.41% -7.36% -6.05%
MSCI EAFE Index 4.25% -1.38% -5.88% -3.84%
MSCI Emerging Markets 4.30% 2.43% -3.50% -7.41%
Bonds
Barclays US Aggregate 3.96% 4.10% 0.17% -0.68%
Barclays Intermediate US Gov/Credit 2.20% 2.22% -0.03% -0.51%
Barclays Municipal 7.93% 7.58% 1.49% 0.10%
Current Prior
Commodity/Currency Level Level
Crude Oil  $91.16  $105.37
Natural Gas  $4.12  $4.46
Gold  $1,211.60  $1,322.00
Euro  $1.26  $1.36

Mark A. Lewis

Director of Operations

A Real World Retirement Story

My father was ready for retirement. We had several discussions about picking the right time. Choosing when to retire is always a big decision. Conventional wisdom suggests the longer you wait, the better. You have more time to save and eliminate debt. Your Social Security benefit could be higher. On the other hand, how many people do you know who died before they could retire? There is something to be said for “getting out of the game” and enjoying your life.

We discussed a myriad of items. In the interest of brevity, let’s talk about two of them: finding the right insurance coverage and managing your time.

Health care is a big ticket item. No matter how well we take care of ourselves, our bodies will need more attention as we get older. Finding the right coverage is vital. Individuals over age 65 have Medicare Part A. Most people obtain supplemental insurance coverage since Part A does not pay for everything. Some plans are very expensive. Some plans provide minimal coverage at a reduced cost. Penalties can be incurred if one does not sign up for Medicare when required. And, if someone retires before age 65, coverage must be found to bridge the gap between the retirement date and Medicare eligibility.

I was overwhelmed. I arranged for my parents to meet with an insurance agent who specializes in Medicare plans.

Thanks to the draft, my dad spent a few years in the Army. His service gave him a permanent distaste for peeling potatoes. More importantly, it provided him with access to health care benefits. His previous employer’s insurance plan was awful, so he used the VA coverage as a supplement for years. He said the prescription drug discounts are good.

The agent found appropriate policies for both of my parents. My father’s supplemental policy needs were reduced by the VA coverage, whereas my mother needed increased coverage. It helped to have someone with Medicare knowledge guide them through the process. I highly recommend seeking help instead of trying to research it on your own.

She could not help us with the other problem: occupying my dad’s time. He is not a “lounge around the house” kind of guy. He must stay busy. He made a plan for the first year of retirement. He wanted to remodel the kitchen – build cabinets, replace the countertop himself, install new flooring, et cetera. He planned to tackle some home improvement projects at my house (yeah!). He wanted to get a dog which would give him a buddy and an excuse to get outdoors. Then, in about a year, he hoped to get a part-time job at a nearby home improvement store. He would be perfect for the job, and the store employs a lot of older workers.

He knew he could not be happy unless he was busy doing something. When considering retirement, it is very important to think about how one will occupy time previously spent working. We all have fantasies about what we would do. When faced with the reality of filling those hours, though, it can be a daunting task.

In the end, my father did retire. I saw an immediate “lightness.” He smiles and laughs easily. Plagued with ulcers and wicked reflux most of his life, his gastro issues have greatly improved. Retirement definitely agrees with him.

Someday, you may have the same conversations with your parents. My advice is to get help from people who know more than you – financial advisors, insurance experts, estate planning attorneys – whenever you encounter unfamiliar issues.

The same advice applies if you are considering retirement. There is more to the issue than whether or not you will have enough money. My parents and I spent almost a year talking about it. Just as you took time to find the right career or the right house, care should be taken with retirement planning too.

Of course, Parsec is here to guide you. Retirement matters are too complex to tackle alone.

Cristy Freeman, AAMS®
Senior Operations Associate

Fears of a “Summer Pause” Prove Ephemeral

Many analysts, pundits and prognosticators were sounding alarms about “cautious consumers” and “threats to continued economic growth” after the Census Bureau reported on August 13 that both retail sales and the broader category of retail and food services sales in July were almost exactly what they had been in June. In other words, both categories were flat from month to month. Even more depressing, June was confirmed to have only increased 0.2 percent from May.

Those of us with more experience and greater knowledge of the volatility of these series cautioned against making snap judgments. We recommended waiting for the next release before becoming concerned about consumer spending, which makes up by far the largest share of GDP (68.5 percent of nominal GDP in 2013). The retail and food services part is about half of total personal consumption expenditures.

As is nearly always the case, this advice proved sound when we read the Census Bureau release of September 12. As the chart shows, not only did retail and food services sales set a new record of $444.7 billion in August, seasonally adjusted, but also both June and July were revised to be much larger than previously reported.

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July sales are now $ 441.8 billion on a seasonally adjusted basis, up 0.3 percent from June, rather than the originally reported $439.8 billion or 0.0 percent. June is now reported up 0.4 percent rather than 0.2 percent to a total of $440.3 billion rather than $439.6 billion, seasonally adjusted.

For the first eight months of 2014, total retail and food services sales were $3.46 trillion, up 3.7 percent from the same period in 2013. The biggest gain was at auto and other motor vehicle dealers, where sales were 8.0 percent ahead of the first eight months of 2013.

There are several reasons for this. One is that the average age of the 253 million vehicles we own (the “fleet”) is the highest ever, about 11.4 years. Another is that consumers have record levels of income and near-record levels of employment. A third is that banks, car dealers and credit unions are all competing to finance vehicle purchases at very good terms, including low rates, relaxed credit standards and maturities as long as eight years to keep monthly payments down. A fourth reason is that some measures of consumer confidence, while far from record levels, are at the highest point since the recession ended in June 2009.

Nonstore retailers (think catalog and internet stales) are up 6.5 percent from the first eight months of 2013 to $300.9 billion. That amount is 71.3 percent of the total for general merchandise stores ($421.6 billion) and nearly triple the $101.9 billion at department stores, where sales are off 2.5 percent from the first eight months of 2013.

We should see a record holiday shopping season in 2014. That will keep retailers smiling and contribute to several more quarters of real GDP growth above 3.0 percent at a seasonally adjusted annual rate, which is now the consensus for the first time in this expansion. That will be very good news if the economy follows that forecast. We’ve all been waiting impatiently for the US economy to break out of the subpar 2.1 percent a year growth path it’s been stuck in for the five years since the recession ended.

Dr. James F. Smith

Chief Economist

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The Rational Investor… or Not?

This is the last post in a series of six blog entries focused on topics that might be of interest to the Millennial generation. If you would like to see our attempt at making these subject matters entertaining, visit our YouTube page to see a video version of this article.

 

So here’s the setup: you have two large pizzas. One is cut into four pieces, the other is cut into eight pieces. Would you rather have one piece from the former, or two pieces from the latter? If you asked a hungry four-year-old that question, he’d probably be totally confused because you used the words “former” and “latter.” But then he’d go for the 2 pieces because in his mind, two pieces are more than one. Of course, anyone with a basic knowledge of fractions knows this is a trick question, because it’s the same amount.

Let’s imagine now that the pizzas are companies, and the pieces are shares of stock in those companies. You have $1000 to invest. Company A’s stock price is $50, and company B’s stock price is $100. Assuming that there are no trading costs, you can purchase 20 shares of company A and 10 shares of company B. All else equal, which would you buy? Answer: it doesn’t matter – your investment in either company is the same. You’d be surprised at how many people would choose company A because you get “more” shares of stock or because they think the shares are a better “value” by virtue of having a lower price per share. The thing you have to realize is this – a company can issue any number of shares it wants to. If the price per share is $100 they can issue a 2-for-1 split, and now you’ll have 2 shares worth $50 each for every one you had before. Your total dollar investment in the company doesn’t change, though.

We all want to believe we are rational and that emotions are only something that affect other people, but it just isn’t true. We all have made mistakes like the investor in the example above and that’s why behavioral finance is one of the fastest-growing branches of psychology. This is just one example of common investor misconceptions but there are many more – click on the link above for a lighthearted look at a few that we see from time to time. Remember to always discuss your investment decisions with your advisor, so that he or she can lead you in the direction of the logical and unbiased choice.

Sarah DerGarabedian, CFA
Portfolio Manager

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