To Live off of, and Die from, the Equity Premium and Alpha

I’m working on my taxes. ?I’m not in a good mood. ?Okay, writing that made me chuckle, because I am usually in a good mood.

Let me divide my working life into four segments:

  • 1986-1998: Actuary — reasonably well paid, and significantly underpaid compared to the value I delivered.
  • 1998-2007 — Investment risk manager, Mortgage bond manager, Corporate bond manager, and Senior Analyst at a long/short hedge fund. ?Paid well for my efforts, and the ?rewards to clients were far more than what I was paid.
  • 2007-2010 — Almost no pay, as I deal with home issues, provide research to a small minority broker-dealer, and try to gain institutional asset management clients. ?Living off of assets from earlier days.
  • 2010-2014 — Living off of asset income as I slowly build a retail and small institutional client base for my value investing.

The last two periods are the most interesting in a way, because I was drawing more income from investments than I was from any other source. ?Even during my time at the hedge fund, I made more money from my own investing every year than I was paid, and I was paid well. ?That said the mid-2000s were a hot time, particularly if you made the right calls on a growing global economy.

My net worth today is roughly where it was at the peak of the markets in 2007, despite my low wage income. ?I have been bailed out by the returns of the equity market and my alpha.

This is not a comfortable place to be, because general equity returns are not predictable, and alpha, though I have had it for years, is not predictable either. ?That said, my client base has been growing, and in another year or so, my practice should support my family even if the markets don’t do well.

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Though I just told a story about me, the real story isn’t about me. ?Think of all of the people who are trying to manage their lump sum in retirement. ?They are relying on strong equity markets; they are hoping for alpha. ?They are not ready for setbacks.

Unless you are seriously wealthy, when you are not receiving reliable income from a wage-like source, you can feel like you are in a weak position. I have felt that on occasion, but in general ?I have not worried.

I write this because equity outperformance over bonds will likely be limited over the next ten years. ?I peg equities at about a 5%/year average nominal return, with a diversified portfolio of bonds at around 2-3%/year. ?Also the ability to add alpha is limited, because alpha is zero in total, and are you smart enough to find the managers that can do it?

In desperate times desperate men do desperate things. ?Low interest rates are leading many to speculate more than they ordinarily would. ?Equity allocations go higher. ?Allocations to “alternatives” go higher. ?People start using nonguaranteed income vehicles as if they had the structural protections of bonds.

As I always say, be careful. ?Those trying to manage a lump sum for income in retirement are playing a dangerous game where if you try to draw more than 3.5%/year with regularity will prove challenging, because that is playing at the boundary of what the assets can deliver, and leaves little room for an adverse scenario. ?Be careful.