AAII Investor Update: 5 Strategies for Avoiding Unnecessary Risks

Thursday, December 8, 2011
Charles Rotblut, CFA
AAII Journal Editor

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Outflows from domestic equity funds totaled $6.67 billion last week. This was the largest estimated amount of weekly withdrawals since August 10, 2011, according to the Investment Company Institute.

Our monthly Asset Allocation Survey also signaled an increased aversion to equities, with stock/stock fund allocations falling to 53.1% last month. Many investors, both individual and institutional, are frustrated by the market’s headline-driven volatility, and some are just plain scared by it.

One option is to simply move to all cash and wait for an “all clear” signal, but by doing so, you run the risk of waiting too long to reenter the market. Mr. Market never gives you the “all clear” signal until after you have already missed out on big gains. So, the secret is to keep investing in stocks (if your financial goals call for it), while not taking unnecessary risks. Here are few specific things to focus on.

Allocation – In a difficult environment, your financial tolerance for risk can be higher than your emotional tolerance. Yet, it is your financial tolerance that should govern your allocations, especially if you have a long investing time horizon. Simply put, the longer the time period before you need the money, the bigger the threat inflation becomes and greater the need to include stocks in your portfolio. If you are really nervous, cut back on your allocation to stocks a little and rebalance your portfolio when your allocations drift off target by five percentage points or more.

Valuation – There were 84 S&P 500 member companies trading with a price-earnings ratio below 12 AND a price-to-book ratio below 2 at the end of last week. With so many cheaply valued stocks, why chase after a stock with a high valuation? Granted, some stocks are cheap for a reason, but there are enough with both low valuations and good fundamentals to qualify as bargains.

Cash Flow – Is the company generating cash or is it spending more cash than it brings in? Cash can be spent on salaries, marketing, new projects, and dividends, while earnings, which is an accounting figure, cannot. Look at the cash flow statement and see if cash from operations (CFO) is positive.

Fund Performance and Expenses – If you invest in mutual funds or exchange-traded funds (ETFs), compare the fund’s performance and expenses to those of its peers. If you own actively managed funds, ensure that the returns have historically been in the top quartile for the fund’s category. Both mutual funds and ETFs should have low comparative expenses and good tax efficiency. (Our mutual fund and ETF guides have this information.)

Regulatory – Numbers often do not tell the full story, which is why you need to read a security’s regulatory filings or a fund’s prospectus. In fact, you might be surprised by what you find. For example, the prospectus for this week’s Green Bay Packers stock offering includes a conduct clause. Packers shareholders can be fined up to $500,000 for “conduct detrimental to the welfare of the NFL.” This is an unusual example, but it is not uncommon to find conflicts of interest, practices that are not shareholder friendly and other things that give may give you second thoughts.

Finally, realize that the market’s volatility and slow economic growth could continue for a while. It may not be pleasant, but sometimes the best strategy is to grin and bear the short term, while investing for the long term.

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The Week Ahead

Seven S&P 500 member companies will report earnings next week: Best Buy (BBY) on Tuesday; Joy Global (JOY) on Wednesday; Accenture (ACN), Adobe Systems (ADBE), Discover Financial Services (DFS) and FedEx (FDX) on Thursday; and Darden Restaurants (DRI) on Friday.

The Federal Open Market Committee will hold its final meeting of the year on Tuesday. This will be a one-day meeting. Also on Tuesday will be the release of November retail sales. November import and export prices will be published on Wednesday. Thursday will feature the November Producer Price Index (PPI), the December Empire State index, the December Philadelphia Fed survey, and November industrial production and capacity utilization. The November Consumer Price Index (CPI) will be published on Friday.

Friday will also be a quadruple witching day, meaning both options and futures contracts expire.

The Treasury Department will auction $32 billion of three-year notes on Monday, $21 billion of 10-year notes on Tuesday and $13 billion of 30-year notes on Wednesday.

No Federal Reserve officials are currently scheduled to speak.

AAII Sentiment Survey

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 38.6%, up 5.5 points
  Neutral: 26.7%, down 0.9 points
  Bearish: 34.8%, down 4.7 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Bullish sentiment rebounded in the latest AAII Sentiment Survey, but bearish sentiment stayed above average for the fourth consecutive week.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded 5.5 percentage points to 38.6%. Even with the improvement, optimism remained below its historical average of 39% for the third consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 0.9 percentage points to 26.7%. This is an eight-week low for neutral sentiment. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 4.7 percentage points to 34.8%. Even with the decrease, this is the fourth consecutive week, and the 36th out of 42, that bearish sentiment has been above its historical average of 30%.

The ongoing market volatility, combined with slow economic growth, the European sovereign debt crisis and Washington politics, continues to leave many AAII members frustrated and cautious. Improvements in optimism this year have proven to be fragile in part due to the headline-driven nature of the current market climate. It should also be noted that many individual investors have responded by becoming more conservative with their portfolio allocations, as was evident in our November Asset Allocation Survey.

This week’s special question asked about last week’s coordinated central bank move to provide liquidity support to Europe. Specifically, we asked AAII members if the announcement made them more or less optimistic that the events in Europe won’t negatively impact the U.S. economy. Responses were split with the largest number of respondents saying they were less optimistic.

Here is sampling of the responses:

  • “Less optimistic. I have seen no evidence to date that the European leaders know what to do to reduce the effects of a debt de-leveraging cycle.”
  • “I’m less optimistic because such a move implies that the credit markets were very close to freezing up.”
  • “Neither. I think the underlying problem of too much debt remains unaddressed.”
  • “I’m a little more optimistic.”

AAII Asset Allocation Survey

October Asset Allocation Survey results:
Stocks/Stock Funds:
    53.1%, down 3.4 points
Bonds/Bond Funds:
    21.2%, up 2.3 points
    25.7%, up 1.1 points

Asset Allocation details:
    26.3%, down 2.6 points
Stock Funds:
    26.8%, down 0.8 points
    4.6%, down 0.2 points
Bond Funds:
    16.7%. up 2.6 points

Take the survey »

Individual investors responded to last month’s market’s volatility by increasing their cash and bond allocations according to the November AAII Asset Allocation survey. Allocations to cash reached a two-year high.

Stock and stock fund allocations fell by 3.4 percentage points last month to 53.1%. This was the smallest percentage allocated to equities since July 2010. November was also the fourth consecutive month that equity allocations were below their historical average of 60%.

Bond and bond fund allocations rose by 2.3 percentage points to 21.2%, a three-month high. November was the 30th consecutive month that fixed-income allocations were above or at their historical average of 15%.

Cash allocations increased 1.1% to 25.7% last month. The last time cash allocations were higher was November 2009, when investors kept 27.1% of their portfolios in cash. The historical average is 25%.

November’s volatility, combined with slow economic growth, the European sovereign debt crisis and Washington politics, caused AAII members to take a more conservative stance. Individual investors became more pessimistic about the short-term outlook for stocks, with bearish sentiment rising throughout the second half of November. Many individual investors are also frustrated with the inability of the stock market to sustain an upward trend and the historically low yields offered by bonds.

This month’s special question asked AAII members why they were allocating to cash in their portfolios. The majority of members said they are looking or waiting for future investment opportunities. Several expressed a belief that stock prices could be cheaper next year. Short-term savings was the second most common response, followed by money set aside for retirement withdrawals. Many respondents said they are holding cash to protect against ongoing market volatility.

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor