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Is the Past Prologue?

by Dan Tolomay, CFA

With the Standard & Poor’s 500 trading near all-time highs and bond yields remaining low, a natural question is, “what is the implication for future returns?”. Let’s take a look at: what has occurred in the past, what’s happening in markets now, and what we should expect and why.

From 1926-2017 U.S. bonds returned 5.35%, and U.S. stocks delivered 10.27% on average. During the same period, inflation averaged 2.91%. As a result, an investor in these assets would have earned between 5.35% and 10.27% in nominal (pre-inflation) terms or 2.44% to 7.36% on a real (inflation-adjusted) basis. A “balanced” portfolio of 60% stocks and 40% bonds (common among investors trying to fund a spending need and maintain purchasing power) would have provided 8.30% and 5.39% in pre- and post-inflation scenarios, respectively. The 5.39% real return would have allowed for withdrawals and covered all related costs.

None of us know the future, but we can use data to see what may play out over the next decade. While not a perfect predictor, looking at how expensive stocks are can be a good indicator of future long-term returns. Using historical data, U.S. equities are trading at a valuation level that implied a roughly 5.52% annual pre-inflation return over the next decade. Bonds, too, have a useful rule of thumb for estimating forward returns. There has historically been a close relationship between the ten-year Treasury note yield and the subsequent ten year return of the broad bond market. The 10-year yielded 2.51% at the end of April. The last piece of the puzzle is inflation. Breakeven inflation, which is the inflation rate that is priced in by the market where Treasury and Inflation-Protected Treasury notes provide the same real return, is 1.95%.

Looking ahead, then, an all bond portfolio might provide 2.51% pre-inflation return and an all stock portfolio could produce 5.52% of pre-inflation return. After inflation, the numbers drop to 0.56% and 3.57%, respectively. A 60/40 portfolio delivers 4.32% before inflation and 2.37% after inflation. Obviously, these implied returns provide less for portfolio draws and cost coverage.

What’s an investor to do?

Confirm asset allocation. A comparison of an account’s present value to its desired future value combined with a time horizon allows for a return goal to be defined. By comparing the required return to the expected return, tweaks may be necessary to a portfolio’s asset mix to reconcile the two. It is critical that risk is considered as well as return. Higher returns come with more volatility. If the portfolio is unable to tolerate the swings or if volatility causes the investor to deviate from plan, then risk is too high.

Focus on controllable factors. The account’s asset allocation will determine its return. And, while the current value cannot be changed, other levers can be pulled. The future value is one. The original goal may be too lofty and may require revision. A review of future spending plans is a healthy exercise. Alternatively, the goal may be left as is and the time horizon extended. Allowing funds more time to grow before use can offset lower potential returns. Lastly, the account can be funded at higher levels. More money growing at a lower rate can achieve the same goal as less money grown at a higher percentage.

Think bigger. The analysis thus far has focused on the U.S. only. However, nearly half of the global stock market lies beyond the borders. Those markets are trading at lower valuations and have higher expected returns than American shares. Diversifying globally increases the expected return on stocks. Similarly, the majority of the taxable bond market exists internationally. By not exposing all fixed income exposure to the United States’ yield curve and inflation environment, volatility can be lowered and returns can be potentially enhanced.

Think smaller. Looking at valuations and implied returns across the globe is helpful, and so is looking within markets. In the United States and developed international markets, the better buys (and, thus, higher implied results) lie in smaller companies and value stocks. Both have greater expected returns than their broad market measures.

Eliminate unfavorable odds. Harry Markowitz (Nobel Laureate) called diversification “the only free lunch in finance”. Holding a portfolio of only one or just a few stocks yields higher risk than potential reward.  This type of concentration risk is easily diversified away. Further, research shows that the vast majority of conventional active managers fail to outperform their benchmarks after cost. Trying to outsmart the collective market tilts the odds away from your favor. Lastly, there is a clear relationship between costs and returns. The more you pay, the less you keep.  Thus, keep costs low.

We cannot know what the future holds. What we can do is look at what’s happened historically and at what might occur based on current market fundamentals. Setting and sticking to a plan based on portfolio-specific circumstances and adapting as necessary is a key first step. Diversifying across and within markets, targeting higher expected returns is next. And, lastly, by avoiding unnecessary risks and minimizing costs, more return – whatever it ends up being – accrues to your bottom line.

Why Should You Diversify Globally?

by Chase Reid, CFA, CFP

With US stocks outperforming non-US stocks in recent years, some investors have again turned their attention towards the role that global diversification plays in their portfolios.

For the five-year period ending March 31, 2019, the S&P 500 Index had an annualized return of 10.91% while the MSCI World ex USA Index returned 2.20%, and the MSCI Emerging Markets Index returned 3.68%. As US stocks have outperformed international and emerging markets stocks over the last several years, some investors might be reconsidering the benefits of investing outside the US. While there are many reasons why a US-based investor may prefer a degree of home bias in their equity allocation, using return differences over a relatively short period as the sole input into this decision may result in missing opportunities that global markets offer.

Although international and emerging markets stocks have delivered disappointing returns relative to the US over the last five years, we will show that historical data support global diversification and that the human brain may be playing tricks on domestic investors all over the world.

The global equity market is large and represents a world of investment opportunities. As shown in Exhibit 1 below, nearly half of the investment opportunities in global equity markets lie outside the US. Non-US stocks, including developed and emerging markets, account for 48% of world market capitalization and represent thousands of companies in countries all over the world. A portfolio investing solely within the US would not be exposed to the performance of those markets.

Exhibit 1: World Equity Market Capitalization

At Trust Company, we retain a slight home bias. Our neutral US to International equity mix is 65% US and 35% International. This positioning largely stems from a thorough study performed by Vanguard. The analysis looked at the minimum variance (i.e. greatest risk reduction) point between US and international stocks for an investor based in the US. The researchers at Vanguard found that a range between 30% and 40% invested internationally saw the most benefit. This study was updated in February 2019 with similar findings.

We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the period in global markets from 2000–2009. During this period, often called the “lost decade” by US investors, the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of –9.1%. However, looking beyond US large cap equities, conditions were more favorable for global equity investors as most equity asset classes outside the US generated positive returns over the course of the decade (See Exhibit 2 below). Expanding beyond this period and looking at performance for each of the 11 decades starting in 1900 and ending in 2010, the US market outperformed the world market in five decades and underperformed in the other six. This further reinforces why an investor pursuing the equity premium should consider a global allocation.  By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur.

Exhibit 2: Global Index Returns, January 2000 – December 2009

Over long periods of time, investors may benefit from consistent exposure in their portfolios to both US and non US equities. While both asset classes offer the potential to earn positive expected returns in the long run, they may perform quite differently over short periods. While the performance of different countries and asset classes will vary over time, there is no reliable evidence that this performance can be predicted in advance. An approach to equity investing that uses the global opportunity set available to investors can provide diversification benefits as well as potentially higher expected returns.

Our partners at Dimensional Fund Advisors (DFA) provided a study of a globally balanced portfolio compared to the S&P 500 which goes back to 1970. The globally balanced portfolio is a 70/30 split between US stocks and international stocks with tilts to value and small companies. Exhibits 3 and 4 below compare the long-term success of the globally balanced portfolio (Exhibit 3) relative to the S&P 500 with the recent short-term outperformance of the S&P 500 (Exhibit 4).

Exhibit 3: Long-term (January 1970 – December 2017)

Exhibit 4:  Short-term (January 2010 – December 2017)

One of the most common investment conversations we have had with clients over the past decade has been our US to International weighting. Even with our underweight position to International equities, many clients have questioned the benefits of having International equity exposure at all. The data found in this piece provide a clear answer. Still, the questions continue and, in fact, are quite natural.

The field of behavior finance has exploded in recent years with many insights into humanity’s inherently flawed brains. The human brain is remarkably complex and able to perform great feats. Little children learn to speak and understand language within months of being born. We have built upon knowledge over centuries to spur new technologies such as the printing press, the automobile, computers, and today’s smart phones. The extents of our brains’ potential is still not fully known. Yet, we regularly call our kids by the wrong name, lose our keys, and struggle to remember what day it is. Maybe this is just this writer’s experience, but all of us can likely point to something quite simple that we simply cannot get right.

In his seminal work Thinking Fast and Slow, Daniel Kahneman describes two systems in our brain: system 1, which governs about 90% of what our body does every day and system 2, which does all our strong computing and analysis. Our system 2 is quite good and is responsible for humanity’s great triumphs. Our system 1 is quite bad, and in many cases, it is worse than animal brains. Our system 1 is quick to form error prone thinking habits without our even realizing it. Outlined below are a handful of common system 1 flaws that have very likely influenced investors in the debate regarding the optimal US to International equity mix.

If you are wondering if you have flawed thinking about your US to International equity mix, then reflect upon the arguments presented in this research piece. If the facts discussed herein leave you unconvinced about the necessity of diversification to international equities, then maybe one of the below biases is at work in your mind.

Recency Bias: Easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.

  • Example: Say you live in upstate New York. During the last two winters, this part of the country has received less than a foot of snowfall each year. Despite a long-term average of snowfall of 80 inches per year, you focus on recent winters and decide to forgo the all-wheel drive in your new car purchase.
  • Application: The S&P 500 has outperformed recently. Despite data showing global diversification as a superior strategy over a long time period, your brain incorrectly thinks that international equity does not warrant a place in your portfolio.

Familiarity Bias: Preference for familiar or well-known investments despite the seemingly obvious gains from diversification.

  • Example: Say you are a banker. Working as a banker for decades, you develop an expertise in what drives success and creates value for banks. Using this expertise, you invest all your assets in bank stocks in an effort to outperform the market. Little did you know, interest rates were about to move in a way that was extremely harmful for banks. This event was unknowable and completely outside of your area of expertise, so this unexpected interest rate movement created massive losses in your portfolio, even if you owned the best bank stocks.
  • Application: Investors across the globe show a strong home bias. In 2018, Charles Schwab performed a study on the UK’s home bias. The study revealed that 74% of UK investors hold a majority of their equity exposure in UK stocks. The UK is less than 5% of the global market. On top of that, 71% of UK investors believed that their country would be the top performer in 2019 despite Brexit and numerous unknowns surrounding this impending event. This same phenomenon takes place all over the world, not just in the US and UK. As a starting point, it’s far more likely that any investor is below the optimal allocation to international stocks rather than above it.

Confirmation Bias: Tendency to seek out and interpret any new evidence as confirmation of one’s existing beliefs or theories.

  • Example: Consider a Presidential election cycle. A majority of Americans will make up their minds about candidates in advance then reinforce these views through their interpretation of facts. Moreover, many media outlets disseminating these facts are biased themselves.
  • Application: Financial media in the US focus almost entirely on the US. This is not surprising. This is where their viewers reside. Financial media outlets are not in the business of financial advice; they are in the business of financial entertainment. Consider 2017, when the S&P 500 was up 22%. International stocks were up 27% with the emerging markets subset up 37%. This divergence in performance made little news and caused even less concern among US investors. Why did this go unnoticed? It was not widely reported, and when it was, the information was automatically minimized in the brain of a US investor. Since this fact does not support a naturally occurring home bias, it is quickly dismissed by the brain.

As the field of behavior finance continues to expand, many lessons will be learned. It is still not entirely clear what happens inside our brains that causes these flaws in our thinking, and it very well may be different for each individual.

To offer an amateur theory, we would point to a desire for control or certainty which are both fueled by fear. Most clients we work with have seized control of their careers, companies, and lives in general to meet goals. Generally, this proactive approach has led to much success. Unfortunately, markets do not work this way. You cannot manufacture returns in the way you can manufacture widgets. You cannot try harder to make the market go up. We have zero control over the market. We can only control our positioning relative to it, since we do control portfolio allocation, portfolio costs, and our reactions to portfolio volatility.

Thus, investing requires a release of control, a view of the long-term, and (of course) a globally diversified portfolio with an optimal mix of US to international stocks.

Building for the Next Generation

by Matthew Hornaday, Chief Operating Officer

Trust Company’s purpose is to enrich the lives of those we serve.  Our team of 28 employees strives each day to carry out this mission by providing comprehensive financial solutions to high net worth families and institutions.  We were founded in 1992 in response to eroding service by the large banks.  Now in our 26th year of operation as an independently owned North Carolina trust company, we remain dedicated to providing exemplary client service and establishing life-long relationships, and committed to building upon our solid foundation so that we will not only be in business to serve our clients for the next five years, but for the next generation and many generations to come.

As Trust Company continues to grow, improve, and evolve, we must make strategic modifications and enhancements to the firm.  Over the last two years, we have created four new roles in order to effectively serve our clients and to position ourselves for the future:

  • Client Services Manager: To manage our client services team across our Greensboro, Raleigh, and Charlotte offices, and maintain continuity in our client administration processes.
  • Compliance Officer: To manage the firm’s internal and external compliance responsibilities, and interaction with the NC Banking Commission and Internal Auditors.
  • Tax Director: To manage our tax practice.
  • Chief Operating Officer: To oversee the day-to-day operational and administrative aspects of the firm.

In addition, we continue to make enhancements to our processes and software platform including:

  • Transfer Forms: In an effort to increase client asset security, in 2018 we began requiring clients to complete a form including a directive in order to transfer funds to or from accounts on a one-time or recurring basis.
  • Customer Relationship Management (“CRM”) System: In March 2019, Trust Company launched a new CRM system, which will enable the firm to more effectively manage our client relationships and business processes.
  • ShareFile Vault: Trust Company utilizes ShareFile to securely send files to and from clients and third parties.  In 2019, we will more fully utilize the vault functionality within ShareFile to securely and seamlessly provide documents to clients and service providers.

We are excited about the future of Trust Company, the strength of our team, and the enhancements we have made and will continue to make.  We look forward to serving you for many years to come.


Charitable Giving in 2019

by Jonathan Henry, CFP®, CPA

As individual taxpayers begin to plan their charitable gifts in 2019, below are some planning points for your consideration that could help you maximize the tax deductibility of your gifts.

Taxpayers should consider “bunching” multiple years of desired annual charitable gifts into one year.  Recall that the Tax Cuts and Jobs Act (TCJA) increased the basic standard deduction to $24,000 for married couples ($12,000 for single filers) and capped the deduction for state and local taxes at $10,000.  This means that many taxpayers who have previously itemized deductions may now take the standard deduction.  Essentially, joint taxpayers will only be itemizing if their $10,000 of state and local taxes, mortgage interest, and charitable deductions collectively exceed $24,000.  For example, a married couple that typically makes $12,000 of annual charitable gifts and will hit the $10,000 cap for state and local taxes could bunch together two years for gifts for a total of $24,000 in year 1.  Their total deductions in year 1 would be $34,000 and in year 2 they would simply take the $24,000 standard deduction.  The bunching strategy would allow the couple to total $58,000 of deductions over the two year period compared to $48,000 if they simply continued with $12,000 of annual gifts.

Alternatively a donor advised fund could be utilized by “front-loading” charitable gifts now.  A donor advised fund is an investment account held for charitable purposes.  Donors receive a charitable tax deduction when the account is funded and then are able to make gifts from the account over time.  Continuing the example from above, the married couple could make their $24,000 of gifts in year 1 to a donor advised fund rather than to charitable organizations directly.  They would benefit from the deduction in year 1 but could wait until future years to decide which charities will ultimately benefit from their fund.

Taxpayers who withdraw funds from their IRA account simply because they are subject to the required minimum distribution (RMD) rules could create significant tax savings by making a qualified charitable distribution (QCD) from their IRA.  All or a portion of a taxpayer’s  RMD (up to $100,000) can be sent directly to a charitable organization thereby excluding that amount from the taxpayer’s gross income but counting it against the RMD requirement.  A QCD could be a particularly useful strategy for taxpayers who will not receive a tax deduction for their charitable gifts because of the current increased standard deduction.  This strategy could fulfil a taxpayers desire to be charitable and receive a tax benefit for their donations.  The lower adjusted gross income resulting from a QCD may also lessen the effects of phase-outs and limitations on other tax deductions.

Rather than giving a charity a cash gift, taxpayers should consider making an in-kind gift of appreciated securities.  Suppose you own a mutual fund with a basis of $20,000 and a current value $100,000.  If you sold the fund and gifted the cash to a charity, after paying taxes, the net gift would be approximately $77,000.   If the mutual fund was instead gifted directly to the charity, which the charity can sell tax-free as a tax exempt entity, the value of your gift would be $100,000.  This strategy is especially useful for securities with a very low, or perhaps unknown, basis.

As a reminder, the TCJA states that no charitable deduction is allowed for any payment to an institution of higher learning in exchange for which the taxpayer receives the right to purchase tickets or seating at an athletic event.

If you would like to discuss tax planning specific to you and your family in greater detail, please contact your Wealth Advisor.

Seeking Wisdom

by Chris Sutherland, CPA

Where do you turn for intellectual stimulation? For me, it starts with books and podcasts, but is cemented with relationships. What is the equation for good relationships? It’s hard to have strong relationships without experiences that bond and lead to stories. So, experience + story = relationship. I’m very fortunate to belong to two book clubs. Without those relationships, the books and podcasts have much less value. Below you will find some of both that piqued my curiosity this year.

Tribalism was a buzzword in 2018. It basically means being overly loyal to your own group. In its worst sense, tribalism is a lack of relationship. In her book, Strangers in Their Own Land, Arlie Russell Hochschild attempts to build an “empathy wall” with folks in Lake Charles, Louisiana by immersing herself in their culture. As a California Berkeley professor, she is much different than the folks she befriended in Louisiana. Her background as a sociologist is valuable, but it’s nearly impossible to remove all bias.

I’ve mentioned Just Mercy, by Bryan Stevenson, in prior blogs. I read it again recently. It was a game changer in how I viewed our justice system. The Innocent Man, by John Grisham, had a similar impact. I’m a Grisham fan, but this book is a little different. I believe it is his only foray into non-fiction. It tells the story of Ron Williamson, a former minor league baseball player from Ada, Oklahoma who was wrongly convicted of murder. If you are more into watching than reading, Netflix recently released a documentary adaptation by the same name. I watched all of the first season on two plane flights.

I subscribe to many podcasts. One of my favorites is On Being, by Krista Tippett. The On Being Project started with a radio show about faith and spirituality. While staying true to its roots, it has morphed into a pursuit of “deep thinking and social courage, moral imagination and joy, to renew inner life, outer life, and life together.” One of my favorite episodes of 2018 was Rachel Naomi Remen. Rachel is a physician and author. In this episode she discusses how healing is different than curing and how “science defines life in its own way, but life is larger than science. Life is filled with mystery, courage, heroism, and love. All these things we can witness but not measure or even understand, but they make our lives valuable anyway.”

After listening to Dr. Remen, I was compelled to pick up her book, Kitchen Table Wisdom. The book was a New York Times best seller after its release in 1996. The 10th anniversary edition digs deeper into healing stories. The forward by Dr. Dean Ornish introduces the book well – “Great artists in any field have the rare ability to see our world and our lives anew, to experience life directly without it being filtered through beliefs, expectations, and preconceptions. They can capture a lost sense of wonder and experience the full richness of life.” This book is a collection of stories about savoring and celebrating life, not about fixing wrongs.

As I reflect back on the past year and hope for less tribalism and more relationship, here are a few other books and a podcast that made an impact: Tattoos on the Heart, by Gregory Boyle, Breathing Under Water, by Richard Rohr, The Road to Character, by David Brooks, and Conversations with Tyler: Ross Douthat. At Trust Company of the South, we are very fortunate. Our vocation is all about relationships. Thank you for being a part. We all look forward to more experiences and stories in 2019!

Markets in 2018: A Preliminary Review

by Dan Tolomay, CFA and Chase Reid, CFA, CFP

Given recent investor behavior, we wanted to provide a commentary on diversification, particularly relative to the often highlighted S&P 500 index.  Our piece is broken into two sections.  The first portion looks at the investor psyche during periods when the S&P 500 appears to be king and diversification seems to be better identified as di-worse-sification.  The second portion of our commentary analyzes portfolio construction step-by-step to illustrate why performance of a diversified 60% /40% portfolio has deviated from the S&P 500 this year.  We hope you enjoy.

Investor Psyche About The S&P 500: You Were Always On My Mind

Global equity markets have seen resurgent volatility after an uncharacteristically quiet year for stocks in 2017.  This year, US stock investors had to wait almost nine months to break previous all-time market highs set back in January 2018, only to see markets fall back below all-time highs this October.

2017, on the other hand, saw new all-time S&P 500 highs reached on 67 trading days.  This is just over 25% of all trading days in US markets for a calendar year.  Another way to think about it is the S&P 500 averaged a new all-time high about once a week or five times per month.  With no significant drawdowns, 2017 proved to be a delightful year for investors, both US and international.

The quilt chart below is no doubt familiar.  It illustrates various global stock market categories.  You will notice common themes.  No portion of the equity market clearly outperforms over time, and no portion of the equity market clearly underperforms over time.  Finally, the gray global equity box is often in the middle experiencing a smoother average ride.

Simply put, diversification works.

In fact, most investors agree that diversification works.  This is not a controversial statement in investing.  It’s quite the opposite.

So, why do investors consistently measure their diversified portfolio against the S&P 500’s performance?

A well-diversified portfolio, like those we manage at Trust Company, is a globally allocated mix of stocks and bonds.  Referring back to the quilt chart, it is clear that US stocks, particularly large cap stocks as measured by the S&P 500 (green boxes), have performed better in recent years.  Further, US financial media and news outlets reinforce this information by rarely quoting any index outside of the big three US indices: S&P 500 Index, Dow Jones Industrial Average, and Nasdaq Composite.

This creates a well-researched phenomenon of how we instinctively view things in our brain.  It is called the availability bias.  This bias is simply defined as the human tendency to think that examples of things that readily come to mind are more representative than is actually the case.

In truth, this bias is hardly avoidable.  What do you imagine the ratings of financial media programs would be if pundits only discussed how a diversified portfolio performed?

When the S&P 500 is up some level more than a US investor’s diversified portfolio, the question naturally arises: why am I underperforming?  Unsurprisingly, it does not work the other way.  In 2017, few – if any – US investors were likely to ask the question: why was I not up 37% like emerging markets?

2017 saw global diversification work in a big way with both developed and emerging international stocks beating the S&P 500.  But based on what we know of the availability bias and financial media, this largely went unnoticed.  It is critical to fight our natural urges to only see what is right in front of us.  Instead, we must dig deeper into the complete story of global markets before making observations about portfolio performance.

One key takeaway from this discussion is that diversification works.  It has often been said that diversification does not work every time, instead it works over time.  The other key message is that we must always fight our biases.  As the great investor Benjamin Graham once said, “The investor’s chief problem – even his worst enemy – is likely to be himself”.

In the next section, we walk through an example 60% stock/40% bond portfolio to illustrate how its performance has differed from the S&P 500 in 2018 and why.

Diversified 60/40 Versus S&P 500 in 2018

To properly consider a globally diversified 60/40 portfolio, we will show in a number of steps how we arrive at the ultimate allocation.  Along the way, you will notice how a diversified portfolio differs from the S&P 500 and the reasons why it should.

Let’s start with a look at the S&P 500 versus a portfolio consisting of 60% global equities and 40% global fixed income.  In each step we will use well recognized market benchmarks for performance representation.

Right away, we see a major disparity in how our example global portfolio has performed year-to-date versus the S&P 500.  The other aspect to note is that we are comparing the S&P 500 which is 100% equity to a portfolio that has 40% of its allocation in bonds.  This is like comparing a basket of apples to a basket of apples and oranges.  This is a common error when investors analyze performance differences.

We will now add further allocation details similar to how Trust Company allocates its global stock and bond portfolios.  This will provide a window into how different parts of the market have performed this year.

Trust Company retains a slight home bias in its equity allocation relative to global markets which is roughly 50% US and 50% international.  This thinking is principled in a study performed by Vanguard which looked back over decades of data to determine the optimal mix of US and International stocks.  The range of preference was determined to be 30%-40% of a US investor’s equity exposure invested abroad.  Trust Company settled at the midpoint of 35%.

Within fixed income, the US is a much smaller component of global markets, around one-third of global fixed income.  In this asset category, there are a variety of reasons to retain a larger home bias, such as: costs associated with currency hedging, lower exposure to US Treasuries which are a safe haven in times of crisis, and lower transparency in some international bond markets. Thus Trust Company’s fixed income is divided 70% US/30% International across our bond portfolios.

Finally, let’s consider how Trust Company invests in equities relative to market weights.  Rigorous research illustrates that a tilt toward value stocks and smaller firms generates excess return over time.  Below are these two risk premiums over time in different markets.

The data show that these risk premiums do not go unrewarded over time.  That being said, they do not show themselves every day or every year.  In 2018, US Value stocks have underperformed the S&P 500 by 4.71% and smaller firms have underperformed the S&P 500 by 3.4%, as measured by the Russell 1000 value index and the Russell 2000 index respectively.

These measurements are taken at the index level, but investors cannot invest directly into an index.  So, it is worth considering how these numbers may differ at the fund level.

At the fund level, research shows that most active managers underperform over time.  Indexed funds may track more closely to their benchmark but will still underperform by their expense ratio over time.  Our core fund manager, Dimensional Fund Advisors (DFA), has proven to add value over most benchmarks in the long run.  This is partially due to DFA’s low cost structure but also due to their superior techniques for tilting to value and size premiums.

Taking all aspects into account, a diversified 60/40 portfolio has underperformed the S&P 500 in 2018 for three main reasons.

  • The S&P 500 is an all equity index while a diversified 60/40 has a large amount in fixed income.
  • International equities have performed worse in 2018 than US stocks.
  • Value and small stocks have underperformed.

As disheartening as all this information may appear for 2018, remember that diversification works over time.  Below is a look at the same comparison, but instead of looking only at 2018, we broaden the timeframe to 15 years.  As long-term investors, this is a much more appropriate time period to use when determining a proper long-term allocation.

The final, and most often overlooked, key in this analysis is the amount of risk required to earn these returns.  Money does not grow for free.  It requires payment in the form of risk.  Risk is a necessity in order to receive returns like those listed above.  It cannot be avoided, but it can – and by all means should be – minimized through diversification.

To that point, the S&P 500 returned 9.65% over the past 15 years by taking on 13.19% in risk, as measured by standard deviation.  Said another way, for every 1 unit of risk taken the S&P 500 earned .73% in return.  The Diversified 60/40 portfolio returned 7.49% over the past 15 years.  Its risk, as measured by standard deviation, was 8.94% over the same time.  Thus, the diversified portfolio earned .84% in return for every 1 unit of risk taken.  These calculations show that diversification helps investors use risk more efficiently to smooth their ride and target their goals with a greater degree of confidence.

2018 is a year where the diversified portfolio will likely be marginalized by financial pundits and US investors.  It will be questioned, criticized, and thrown out by some.  How quickly we forget why we diversify.  It was not that long ago that the S&P 500 returned 0% for a 10 year period.  Referred to as “The Lost Decade” for the S&P 500, those who diversified globally over the same time period saw a positive outcome.


If It Was Easy, Everyone Would Do It

by Dan Tolomay, CFA

Wouldn’t it be great if we were all in perfect shape and successful? I would argue no. At least we wouldn’t think it was great. The reason, I believe, that we value these attributes is scarcity. If everyone had a perfect body and was accomplished, it would be no big deal. It would be common and, as a result, its value would disappear.

While these end results are desirable, the effort to achieve these goals also commands respect. A good physique is the outcome, but it requires hours of effort and discipline to attain. Similarly, success – be it professional or personal – comes only after pouring time and energy into an effort. The same can be said of investing in the equity markets. Why do some investors stand out? The end result (higher returns) and effort (discipline) sets them apart. Higher returns can be sought through active management (stock picking and market timing); but, studies show that the higher costs that come along with this approach lead to sub-par results. Holding a concentrated portfolio of a few stocks may lead to outsized gains, but it may also leave you penniless.

Based on the above, one could argue for an indexing approach. Indexing avoids the losing bet of active management and diversifies a portfolio. Additionally, it keeps costs low. However, it has flaws. The return achieved will closely track the gain/loss on a benchmark. This benchmark, which is maintained by a third-party, defines the investment strategy. The strategy is not necessarily based on fundamentals, but on index rules. The focus of replicating the benchmark can lead to forced transactions and costs. Lastly, the changes that the index must make can distort prices of securities being added or removed.

Dimensional Fund Advisors (DFA) engages in asset class investing. This approach retains the benefits of indexing (low turnover, diversification, low costs). But, unlike indexing, the return sought is that of the asset class, not a commercial benchmark, and investment decisions are based on the return dimensions of stocks, not index rules. This technique means increased flexibility on transaction timing and better management of trading costs. Also, by avoiding securities that are part of an index change, mispriced securities can be evaded.

On top of these operational efficiencies, DFA targets factors (low valuation, small company size, and higher profitability) that have historically provided higher returns. But, these higher returns are not free. Return and risk are directly related – to achieve higher returns, higher risk must be borne. And, like fitness and success, if it was easy to achieve higher returns, everyone would follow the approach and achieve the better result.

Just as there are days that you may not want to go to the gym or spend another hour working on a task, there will be times in asset class investing where you’ll want to throw in the towel. Higher risk leads to the possibility of short-term underperformance. But, those who have the discipline to persevere and focus on the long-term goal will be rewarded with an outcome that is rare and desirable.

Dan is responsible for developing investment strategy and managing client portfolios for Trust Company. Prior to joining the firm in 2008, Dan was a vice president at Smith Breeden Associates in Chapel Hill. His focus was on performance measurement and, earlier, he performed analyses for the firm’s Financial Institutions Consulting Group. His career began as a financial analyst in the Business Process Outsourcing (BPO) unit of PriceWaterhouseCoopers.

Lasting Happiness

by Wallace Williams, CPA

A slew of studies released in the past few years have shown that counter to prevailing logic, the purchase of experiences – such as a family trip – make us happier than the purchase of things – such as a new house or a new car. On the surface it seems a better investment to spend a significant sum on a new car, which we will use and enjoy for years, rather than a family trip to Hawaii, which will be over and done in two weeks. But apparently not, for a number of reasons…

First, studies have shown that anticipating an experience elicits more happiness and excitement than waiting on a material good; waiting for a possession tends to be tinged with frustration rather than gleeful anticipation. Think about looking forward to that beach trip as opposed to waiting in line for a new iPhone. Some have hypothesized that anticipating an experience opens a world of possibilities and imagination – we’ll swim in the ocean, and walk on the beach, and eat at our favorite restaurant – while anticipating the possession of a material good is more limited – my new iPhone will have a bigger screen.

Secondly, with experiences we are less likely to fall victim to “keeping up with the Joneses”. People are less likely to measure the value of their experiences by comparing them to those of others – which is not always the case when it comes to our material possessions, such as our homes and cars and gadgets. So therefore experiences bring us more happiness, as they tend to remain untainted by the stain of envy and covetousness.

Most counterintuitively, studies have shown that in the long run, experiential purchases make us happier than material purchases, even though the material purchase is physically present for far longer. This is because as human beings, we have a remarkable capacity for what’s known as “hedonistic adaptation” – we stop appreciating things to which we are constantly exposed. The thrill of the new iPhone wears off after just a few days, but the trip to Hawaii – we’ll remember that with fondness for years to come.

And here’s another thing: our material possessions deteriorate and become obsolete over time. The new car gets a few dings in it. Our cool new iPhone is usurped by a later and greater version. But our memories of experiences actually get sweeter with the passage of time. Even a difficult and unpleasant experience – say that camping trip when the dog threw up all over the inside of the tent – becomes a great story.

Most important of all, purchased experiences are usually not solitary endeavors; we tend to share them with others. These shared experiences bond us more closely to those we love, and the act of remembering those experiences, over and over in the years to come, solidifies and strengthens those bonds. The latest iPhone, in all its technological glory, doesn’t come close to that kind of return on investment.

So if you’re thinking about investing your time and money in either an experience or an object – pick the experience. It will bring you far greater returns over the long run.

Wallace serves as Chief Financial Officer of Trust Company, as well as overseeing the Human Resources function.  She is a Certified Public Accountant, and joined Trust Company in 2004 after an eight year career in public accounting with Arthur Andersen, and several years as a controller in a not-for-profit organization. 

The Need for an Estate Plan

by Westray Veasey, J.D.

Years ago, the exemption against estate tax was only $600,000, and that forced many people to address their estate plans for tax reasons. With the exemption currently at $11,180,000, very few people have taxable estates, but really all of us have estate planning needs. Just because the IRS may have little to no claim to your estate, there are still many issues to address as part of an estate plan.
For example, do you know what happens to your assets if you die without a will? Assets that are titled jointly or have a beneficiary designation such as life insurance pass by operation of law to the joint owner or beneficiary. But the laws of the state in which you reside decide who inherits your individually-owned assets and personal belongings. For example, without a will, not all of your assets pass to your spouse, but, instead, some portion of your estate could pass to children. Here are ten things to consider when creating or updating an estate plan:

  • A comprehensive estate plan not only includes your will and/or trusts but health and financial powers of attorney to designate agents who can make financial and health care decisions for you if you become incapacitated.
  • Who should serve as your fiduciaries? The executor of your estate and your trustee will manage and distribute assets to your surviving spouse and/or children.
  • You can decide who should inherit your assets by having an estate plan. Without a will, the state statutes decide for you, and it is possible that without a will you could disinherit someone you believed would receive your estate.
  • Are there specific bequests you would like to make? Who would you like to have Grandmother’s china, Dad’s watch, or your wedding ring? You can outline such bequests in an estate plan.
  • North Carolina law allows you to appoint a guardian for your minor children in a will. Otherwise, the courts will make that determination.
  • Assets directly inherited by minors must be held in a court-supervised guardianship. Application must be made to the court for distributions, and when your child turns age 18, he or she will receive the remaining assets outright. An estate plan can include a trust for your minor children, where you can spell out who can control and distribute assets for them until they reach an age determined to be appropriate by you.
  • Do you need to consider special circumstances? Comprehensive estate planning will include contingencies for a child with special needs, a blended family with children from prior marriages, or liabilities to a former spouse.
  • You can protect your heirs from spendthrift behavior, spouses, and creditors through trusts.
  • You can consider the proper disposition of your life insurance and retirement accounts by revisiting the ownership and/or beneficiary designations of those accounts.
  • You can protect your business interests. Do the co-owners have an agreement that provides buyouts upon certain events and do you understand those provisions? Will the buyout be unfunded or backed up with disability or life insurance, and what are the income and estate tax implications of the buyout?

These are a few of the initial considerations you should discuss with your estate planning attorney. Of course, when you have a taxable estate, there are even more reasons to develop a thorough estate plan, not only to address the issues above, but also to mitigate your estate tax burden. Estate planning is not simply for the very wealthy; everyone should have an estate plan.

Westray serves as Fiduciary Counsel for Trust Company of the South, overseeing the firm’s legal matters, including its trust activities.  Westray also serves as a resource to the firm’s individual clients with regard to their estate planning matters and to our nonprofit clients with regard to compliance issues.  Prior to joining Trust Company of the South, Westray practiced law with Poyner Spruill LLP in their trusts and estates group. She has over fifteen years of experience advising clients in the areas of estate, generation-skipping transfer and gift tax planning, business succession planning, asset protection and estate and trust administration. Westray has been recognized in Business North Carolina Magazine’s “Legal Elite” for Tax and Estate Planning.

A Lasting Legacy

by Chris Sutherland, CPA

At a Berkshire Hathaway annual meeting a few years ago, Warren Buffet was asked, “In light of the record amount of wealth that is about to pass from the Baby Boomer generation, how much is enough to leave your children without ruining them?” As is often the case, Mr. Buffet’s response is worth repeating…

“I think that more of our kids are ruined by the behavior of their parents than by amount of the inheritance. Your children are learning about the world through you and more through your actions than they are through your words. From the moment they’re born, you’re their natural teacher. And it is a very important and serious job, and I don’t actually think that the amount of money that a rich person leaves to their children is the determining factor at all. In terms of how children turn out, I think that the atmosphere and what they see about how their parents behave are more important. I’ll say this. I’ve loosened up a little bit. Every time I rewrite my will, my kids are happy, because they know I am not reducing the amount.”

Teaching your children how to manage money and wealth is very important and as with most parental responsibilities, it can be very difficult. You must take advantage of the opportunities presented… the “teachable moments” in everyday life. And more important, you must be willing to let your children fail; don’t rescue them every time they make a poor choice.

The Early Years

It is important that your children learn the basics of cash management… counting, purchasing, saving money. They need to learn the value of a dollar. Many children have trouble holding on to money and consequently tend to spend all they have very quickly. The younger they learn that the money supply is not endless, the better. Let them “waste” a few dollars on trivial purchases or spend too much for an item. Inevitably (probably sooner rather than later!) they will come across a must-have trinket, but their pockets will be empty. Don’t give in to the “all my friends have one” plea! Let them go without.

The Teenage Years

By the time your children reach the teenage years, hopefully you’ve had some success instilling money management skills. It certainly doesn’t get easier as they grow older! The teachable moments don’t present as often and when they do, there is competition for advice from other forces, most notably other teens.

The teen years offer an opportunity to teach about work ethic and earning power as well as risk. It is very hard to succeed without hard work and risk. Take the opportunity to discuss your family business or career with your children. I’m sure there were many tough decisions over the years.

At this stage in life, your children are likely interested in more expensive purchases (i.e. a new car). They should help with the cost. This will not only give them some ownership and responsibility, it should also foster decision making. Hopefully they can determine on their own that a used Honda is just as good as a new BMW at getting them from point A to point B.

Young Adulthood

As your children transition out of school and into to the work force, their financial well-being becomes primarily their responsibility. Setting aside funds for an emergency, saving for retirement and budgeting are all important. We have been fortunate over the years to work with the young adult children of many clients. It’s very rewarding to play a role in their major life decisions, whether buying their first home, deciding on graduate school, or making a career transition.

Back to Mr. Buffet to finish where we started. His frugality has been widely reported over the years. He still lives in the same modest Omaha home where he raised his family. All three of his children are independently successful. He has helped them over the years, but not without a cost. His eldest son, Howard, is a farmer in Illinois. Mr. Buffet purchased Howard’s first farm for $300,000, but he didn’t give it to him. He kept ownership and charged Howard rent.

Those with good character will do well without much money, but massive wealth left to someone with no character is sure to do no good.

Chris is a Certified Public Accountant. He joined Trust Company of the South in 2008 after more than fourteen years with PricewaterhouseCoopers, LLP where he was a Director in their Personal Financial Services group. He is a Wealth Advisor in Charlotte, responsible for working directly with our clients to provide integrated wealth management solutions.

What Is Comprehensive Financial Planning?

by Matthew E. Hornaday, CPA

In most of our client and prospective client meetings, we reference the term “comprehensive financial planning” as a process that distinguishes us from many of our competitors. Our comprehensive planning approach, the cornerstone of our client relationships, is an ongoing process; it evolves and changes over time as our clients’ goals and needs change over time.

“Comprehensive financial planning” encompasses a review and analysis of financial and non-financial aspects of a client’s affairs including investment/asset management, insurance and risk management, income tax, retirement, and estate planning. While our initial client conversations generally focus on investment/asset management topics, our goal is to understand other areas of the client’s life as well, in an effort to add maximum value to the client relationship. Our discussions with clients, therefore, cover a broad range of topics including:

  • Investment/asset management planning discussions include understanding a client’s risk profile and cash needs, which facilitates establishing an investment objective and asset allocation strategy for underlying assets by account and on a consolidated basis.
  • Insurance and risk management planning discussions include reviewing current life, disability, long-term care, health, and property & casualty insurance policies as well as discerning and analyzing client needs.
  • Income tax planning discussions include reviewing income tax returns, how to best utilize loss carryforwards, and tax planning strategies based on specific client needs.
  • Retirement planning discussions include reviewing the client’s income sources and cash flow, future cash flow scenarios via Monte Carlo simulations, and IRAs including Roth conversions, and the most efficient way to distribute (monthly, annually, or other) based on the client’s unique needs.
  • Estate planning discussions include reviewing estate planning basics, the client’s estate balance sheet, the client’s current estate planning documents including family goals and an estate flowchart, and considerations based on our review of current documents.

The key benefits of comprehensive financial planning are peace of mind, focus to achieve clearly defined financial and non-financial goals, and increased trust between client and advisor. Some individuals, however, may choose not to provide the information necessary for comprehensive financial planning services because either they perceive the information gathering process to be too time consuming or difficult, or they may not want to focus on uncomfortable topics such as death or disability. While these reasons are certainly understandable, we believe the benefits of comprehensive financial planning far outweigh the costs.

At Trust Company of the South, we truly believe the philosophy: wealth management is more than managing money. Providing comprehensive financial planning services is one way we live out this mission on a daily basis.

Matthew is Chief Operating Officer and a Principal in Trust Company’s Greensboro office.  In addition to managing client family relationships and several nonprofit client relationships, Matthew is also responsible for establishing and enhancing Trust Company’s operational controls, procedures and people systems, ensuring the continued financial strength and efficiency of the company.

Helping Families Organize Financial Affairs

by Jay D. Eich, CFP®, CPA

One of our favorite compliments is when clients tell us we have helped the family finally get their affairs in order. No matter your age, organizing financial affairs is a tedious and difficult process. Trust Company can assist by pointing out some of the most important steps to take and guide you along the path of successfully completing this process.

The crucial first step in organizing financial affairs is not only sharing the details of the family’s assets, but also sharing the location of all financial records. This may require sifting through file cabinets, safe deposit boxes, storage units, and email accounts. Sometimes a parent has opened a bank account online and paper statements are not being mailed. Identifying all assets, their location, and their value is paramount in the organization process.

Next, identify the exact location of all original estate planning documents and insurance policies. We, along with your estate planning attorney and insurance professional, can help review these documents to ensure they reflect your parents’ current wishes and minimize their estate tax. If your parents’ goal is to have you assist with their financial affairs, be sure to work with an experienced estate planning attorney who can draft a Durable Financial Power of Attorney. This document will give the designated attorney(s)-in-fact the legal authority to engage in financial transactions on behalf of the parent. It is a good idea to have several copies of the executed Power of Attorney made as each bank, financial institution, insurance company, or medical facility may require a copy. Some institutions require their own in-house form. During this process it is a good idea to talk with each institution and determine exactly which form each institution requires before the need to use a Power of Attorney arises.

Remember, getting your parents’ financial affairs in order requires both patience and perseverance as you and your parents work with their banks, credit card companies, and other institutions. Many issues are difficult to tackle, and some will require discussions with siblings or other family members. For example, have your parents thought about who will pay the bills if Mom is suddenly incapacitated? Will housing need to change if health issues impair Dad’s mobility? What happens if one or both of your parents can no longer drive? We know these are scary questions as many of us have already gone through this with our own families. Having these discussions early on, becoming prepared, and having a clear understanding of your parents’ wishes will help eliminate some of the stress and tension that can arise as parents age and family dynamics change.

Once all the assets have been identified and the original documents have been located, it is important to verify that all bank, investment, retirement, and insurance accounts are properly titled so that they reflect your parents’ current wishes and minimize their estate tax. It is important to review all forms of insurance, particularly health and long-term care policies, at least every few years. Don’t forget that digital logins and passwords are just as important as health and financial information and should be kept in a secure, confidential location and the record updated at least annually.

While the above touched on some of the major tasks to tackle when beginning to organize your family’s financial affairs, there are a plethora of issues to still be considered. For some this article may have generated more questions than answers, but we hope it will encourage a healthy dialogue within your family. Think of this as a starting point. It’s important for adult children to be familiar with their parents’ financial affairs and their advisor team. That team could include an accountant, insurance professional, estate planning attorney, and wealth advisor. Engaging with your parents in discussions about their financial affairs benefits the entire family. Getting to know and spending time with their advisor team enables you to understand exactly what your parents want and how the team can assist your family in the years to come.

For more detailed information, please be sure to ask us about our “Guidebook for Your Family” and other resources we use to help you through this process.

Jay is a Certified Public Accountant and a CERTIFIED FINANCIAL PLANNER™. He joined Trust Company in 2008 after more than eleven years with PricewaterhouseCoopers, LLP where he was a Director in the Personal Financial Group. He is a Wealth Advisor in Charlotte, responsible for working directly with our clients to provide integrated wealth management solutions.