Oil, innovation and your financial future

Innovation is having a tremendous impact on capping the future price of oil and gas, which is very positive for the economy and your financial future.

The national average of gas is around $2.40 per gallon. A large increase in the price of gas would have a significant negative financial and psychological effect on US consumers and the US economy.

However, due to technological innovations, we do not think there will be permanent or long term significant increase in the price of gas.

Throughout the economy and world, we continue to stress the importance of innovation, and the resilience and abilities of companies and industries to adapt and change. We are rational optimists. What has occurred within the oil industry is another positive example of this.

The recent range of around $45-55 per barrel of oil is likely to remain or be capped on the upside. There may be temporary periods above this range, but technological innovation and cost cutting in hydraulic fracking, horizontal drilling and other techniques continue to make US producers more profitable, even at lower oil prices. If the price of oil increases suddenly, then US producers will increase their production and prices would fall.

What does this mean to you and your financial future?

  • If the price of oil and gas are not likely to increase significantly, that limits a major potential factor of future inflation. Gasoline is a major cost for most individuals. Oil and related products are key raw materials for many industrial and consumer products.
    • This is all positive for your financial future in the long and short term.
  • When we invest in stocks, we recommend broad diversification. We do not recommend placing major bets on specific industries or sectors.
    • The significant innovations in the oil industry and the resulting reduction in oil prices increase the risk, or limit the relative upside, of many oil and gas-related stocks and master limited partnerships.
    • While oil and gas companies may be profitable, stocks in other industries may outperform oil related stocks over the long term, as other industries may have greater pricing power or growth potential.

The background

In past decades, OPEC countries could dictate and control the price of oil, and thus the price of gasoline. This caused major inflation and very negative economic impacts in the 1970s. This may no longer be feasible, as US producers are part of a free market economy.

The price of oil has been in a range around $50 per barrel since August, 2015, almost 2 years. OPEC countries want to gradually raise oil prices. They have been trying to cut back production to raise oil prices in recent months, but their efforts have been mitigated by US producers.

US technological innovation in fracking and shale production are offsetting the OPEC countries efforts to increase the price of oil. The major benefit of this to the economy and you is a “cap” on oil and gasoline prices has developed. If correct, this limits future inflation, as oil and gas are key components of inflation.

US oil production has been increasing in recent years and has surged to a record of almost 10 million barrels per day. If OPEC tries to cut their production to cause oil prices to rise, then US producers will pump more oil, as it becomes more profitable for them to do so. As oil prices are based on supply and demand, if OPEC cuts and the US producers pump more, then oil prices are likely to stay within a range or even go down.

From an investment perspective, rapid technological innovation has drastically changed the nature of the energy sector and investing in this area. Rapid change and innovation are impacting so many other industries. Trying to predict these changes and which companies will succeed or face challenges is difficult or many times impossible, especially over the longer term.

The rapid pace of change makes our investment philosophy of asset class investing and broad, global diversification all the more applicable and appropriate.

Change and innovation will continue. Our investment style is consistent with your goal of having a successful investment experience and meeting your financial priorities.

We want to wish each of you a happy and peaceful Memorial Day weekend. We hope that you take time to consider the sacrifices of current and past service members, who enable us to have so many of the freedoms that the United States uniquely enjoys. 

For further reading on this topic, I highly recommend the following articles (paywall may be in place):

 “OPEC, Fighting Market Forces, Extends Productions Cuts” The New York Times, May 25, 2017 Stanley Reed

“How American Shale Drillers Flipped OPEC’s Script” The Wall Street Journal, May 24, 2017

Lynn Cook and Benoit Faucon

Why You Should Have A Written Investment Plan

This could be a financial recipe for long term investment success.

  • Have a written Investment Plan.
  • Understand it.
  • Make sure it is adequately diversified
  • Stick to it, in both up and down stock markets.
  • Rebalance and review as needed.
  • Repeat.

All our clients have a written investment plan, which they have signed and agreed upon.

A written investment plan does not need to be extremely long, but they serve many purposes. We call ours an Investment Policy Statement (IPS).

All investors should have a written investment plan because they provide clear direction, guidance and discipline for all of your investable assets, including assets in a 401(k) plan.

Having a written investment plan may help you be more confident and have a greater sense of peace of mind. Our clients can understand why we are structuring their portfolio as we do, as we have already discussed it with them. We do not make major moves because some analyst in NY thinks now is the time to get into energy stocks or invest more Europe. We have a plan. We have talked about it. And we adhere to it.

Rather than accumulate a bunch of overlapping mutual funds or a collection of individual stocks over the years, buying this hot one and that sector the next year, having a written plan allows you to have a comprehensive, well diversified portfolio for the long term that is aligned with your financial goals.

As a traveler going to a new city, you would use your phone’s mapping app or car’s GPS to guide your way from point A to point B. For an investment portfolio, an investment plan provides similar benefits.

The IPS that we develop provides an agreed upon asset allocation of how much to invest in stocks, fixed income and cash, based on each client’s specific personal needs.

The investment plan describes how the portfolio will be very diversified by asset classes, both within the US and globally. We set limits for each asset class, to minimize the risk of over exposure to certain sectors or asset classes. For example, through the investment plan and the underlying mutual funds we utilize, a client would not incur the unnecessary risk of too much exposure to a certain industry, market sector or geographic region.

A written investment plan provides discipline for buying and selling decisions. We “rebalance” a portfolio after a certain asset class performs very well, such as US small value in 2016. If that asset class exceeds it target allocation, we consider selling a portion. We would then evaluate the overall portfolio to reallocate those dollars into fixed income or a stock asset class which is below its target weighting. This discipline of rebalancing, which we have adhered to since we started our financial advisory firm, strives to buy low and sell high, without the guessing.

We revise Investment Policy Statements over time as events occur in your life or as you progress towards your financial goals. As you get older, you may become more conservative or accumulate adequate assets so that less stock exposure is prudent. These are valid reasons to change your overall investment policy.

We do not recommend changing one’s investment plan because of market conditions or predictions about the future of the stock market. All too often, this is emotionally driven and not in your best interest. These may be reasons to have discussions with us, but not necessarily to make major changes to your long term financial plan.

Some investment concepts are fads. Having a written Investment Policy is not a fad, it is an important, evolving document for your entire financial life.

Like a great recipe, if an Investment Policy Statement is prepared well and followed, it should provide a good outcome.

 

Being Adequately Prepared

Boaters prepare and practice for emergencies. The Boy Scouts motto is: be prepared.

As investors, we all need to be prepared.

As we discussed last week, the long-term average annual return of US large company stocks is 10%

However, each year’s return generally varies from this 10% average. One year may be up, the next may be down. There are years of small gains and others with large losses. Stocks can go down for month after painful month, with seemingly no end in sight.

This is the inherent risk in owning stocks. This is the fear factor. The reality is that broad stock markets can lose 20%-30%-40% or more in a year or two. Individual stock losses can be even worse.

This is why we work with you to develop an appropriate asset allocation to stocks, so that you can emotionally and financially handle the temporary losses (stock market declines) that will be incurred over time.

Let’s focus on two key points:

  • Temporary losses (declines)
  • Declines will occur at various times.

To be a successful long term investor, you need to be prepared for the extent of the declines which will likely occur in the future, just as they have in the past. The timing of the declines are not predictable, just as it is not possible to accurately predict when the gains will occur.

         We do not recommend doing this.

The declines will only be temporary, even though it does not feel this way in the midst of a significant market downturn…unless you panic and sell all of your stocks and go to cash.

Despite periods of temporary losses, the long-term trend of broad stock market averages is clearly positive. To get to that 10% average annual return I cited earlier, the down years are included.

Historically, there are far more positive years than down years. This is why it is rewarding to remain invested in stocks.

However, at some point during most years, there are intra-year declines of (10-14%), on average. This happens even in years which turn out to be very good ones. For example, last year was a good year for stocks and there were two periods of significant declines. You need to be prepared to handle these types of declines every year.

But wait. There’s more. And it’s worse. On average, there have been major declines of greater than 20% every 5-6 years since World War II.

So why are we reminding you of this vital historical information?

We are providing you with this information so you will be better able to handle the future temporary declines when they occur, as they can’t be predicted. But we know they will occur. We know there will be some kind of crisis. It may be caused by a political or economic event. It may be a “correction,” which is just a natural decline in stocks, on the stock markets’ long-term climb to higher and higher new highs.

We want you to be emotionally prepared for these temporary declines, so you can follow our advice and remain invested according to your investment plan. Remember, US stock markets, as well as International and emerging country stock markets, are made up of individual companies. These companies have real worth, assets, earnings and the ability to adapt.

When the markets declined in 2007-2009, some companies did go out of business. But in a broadly-based globally diversified portfolio such as we recommend, the broad decline was temporary. The vast majority of public companies and their stocks recovered and rebounded to much higher levels than before the crisis. The rebound began much before most people were confident in the economic recovery.

When the next downturn or crisis occurs, we must remember these lessons and facts.

And when the downturns do occur, and they will, we will be here to discuss and reinforce these concepts. We will provide you with the confidence to stay invested. That is exactly what we did for our clients during 2007-2009.

This is our role. This is our value. We are here to be truthful and realistic with you. We want you to be prepared.

We hope this is truly helpful to you and your family, today and in the future.

A better way to invest in stocks

Our goal as a financial advisory firm is to provide you with a positive investment experience so you and your family can meet your unique financial and life goals.

To assist you as a successful investor, our firm has a set of investment philosophies and beliefs which we adhere to. These principles are based on evidence and historical data, not on forecasts or crystal balls.

It is important that you understand that the structure of your stock investments is based on the following evidence, which guides our advice:

  • Large US company stocks have averaged approximately 10% annual returns over many decades.
  • Small US company stocks have averaged approximately 12% annual returns over many decades.
    • Thus, as small company stocks return more than large company stocks, we allocate or tilt towards small stocks, to provide you with greater expected returns over the long run.
  • Value stocks outperform growth stocks over the long term.
    • Thus, we allocate more towards value stocks than most others, as this should provide you with greater expected returns over the long run.
    • Further, we recommend small value stocks and allocate away from US large company stocks based on this data of greater expected returns.
  • International stocks (companies based outside of the US in developed countries) outperform US large company stocks over the long term.
  • Emerging market stocks, which are companies based in lesser-developed countries of the world, outperform US and developed company stocks over the long term.
    • As International diversification provides greater expected returns as well as smooths out the volatility of just owning large US company stocks, we recommend a healthy allocation of non-US based stocks.
      • See blog post dated April 13, 2017 on the benefits of global diversification.
  • We implement our stock investment strategy primarily using asset class mutual funds because the type of funds we use give you the best chance to perform better over the long term. In an uncertain world, these type of stock funds provide you a greater chance of better returns than “actively” managed mutual funds, hedge funds or a set of stocks that most people hold.
    • See blog post dated April 6, 2017 for recent data on the underperformance of active money managers.

This does not mean that small stocks will always outperform large stocks. This does not mean that value stocks will always outperform growth stocks. We know and expect that these expected return premiums will not occur every year.

But we do know that these asset class return premiums have existed over many decades of historical data, some dating back to the 1930s.

For example, small and value stocks vastly underperformed large company stocks in the late 1990s. Then small company and value stocks far outperformed large growth stocks for years after.

Last year, US small value stocks far outperformed large US company stocks. This year, International and emerging markets are outperforming all US asset classes.

We cannot predict which asset classes will do the best over a year or even over a number of years. No one can.

We will monitor and follow the historical data and academic evidence which should provide you with the greater expected investment returns over the long term. We will remain disciplined and regularly rebalance your portfolio, so that your exposure to these asset classes remains in line with the investment plan we develop for you.