The Federal Reserve Open Market Committee just released the minutes from the December meeting, during which the committee decided to increase the fed funds rate by one quarter point to 1.5%. Key economic indicators reviewed by the members of the FOMC suggest that “real GDP will increase at a modestly faster pace than potential output through 2019”. Further, “the unemployment rate is projected to decline further over the next few years and to continue running below the staff’s slightly downward-revised estimate of the longer-run natural rate over this period”. Now, in my view, the Federal Reserve Open Market Committee has access to any economist and any economic forecast it chooses to listen to. Interestingly, all the participants at the December meeting felt that GDP, a measure of national economic output, would be higher in 2018 and most participants at the meeting indicated that proposed changes to tax policy, (which had not been implemented yet) were the main reason for increasing their estimate of future GDP growth.
Finally, one of my favorite economists, Richard Thaler, who won the Nobel Prize in Economics this year, wrote a paper in 1990 where he laid out his theory of the “house money effect”. Basically, Thaler and his co-author Eric Johnson found that investors often compartmentalize money into different buckets depending on the source of the funds. If you have ever gambled, or have friends who do, you know full well that most of us tend to treat “our money” and “the casinos’ money” as two different pools. What we should be doing is treating all of it as our money at all times. However, Thaler noted that people tend to increase their risk taking behavior when playing with house money. Also noted was the tendency of people to take smaller risks if they had just lost the previous wager.
The relative popularity of target date retirement funds, index funds and exchange traded funds, both passive and active, that seem to only generate positive returns for investors may play into the house money effect. I wonder how many investors are staying in the market even though they really aren’t convinced it will keep going higher. At the same time, members of the FOMC, a group that can exert considerable influence over the stock market, are saying that economic conditions remain favorable through 2018 and many have actually increased their forecast for economic growth. Nick Colas at DataTrek sums up his view of the stock market this way: “Absent a genuine and large scale geopolitical shock that dents consumer confidence (and sends stocks 10% lower over a week or less), we believe “house money” rules will hold in 2018 for U.S. stocks.”
We remain long-term investors and stress the importance of understanding your true tolerance for risk. An honest assessment of your financial needs and your ability to sleep at night determine your risk tolerance. The return of the stock market over the last twelve months, up or down, should have little to do with it. Long-term investors know that a well disciplined investment plan builds long-term wealth. Of course we are cognizant of the recent above average returns in the stock market and we have taken steps in our managed accounts to decrease risk though diversification and smaller bets relative to the benchmark index. It is our belief that the current and forecasted economic environment will support continued economic expansion and that in turn will support continued positive returns in the stock market.
Our best advice is to remain fully invested but be aware of the temptation to adjust your risk tolerance based on the House Money effect. We monitor our managed accounts to make sure they are allocated appropriately between stocks, bonds and cash. Check your 401(k) or other investment accounts to make sure your asset allocation is appropriate for your risk tolerance and don’t be afraid to rebalance back to your long-term targets if necessary.
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Managing money is more than simply trading stocks and bonds. It's planning of life's milestones, in your life and in the lives of those you care about most. At Old National Wealth Management, we invest the time to understand your goals and the discipline to manage your assets accordingly.
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