Despite the large and seemingly meaty title, this will be a short piece.  I class these types of investors together because most of them have long investment horizons.  From an asset-liability management standpoint, that would mean they should invest similarly.  That may be have been true for Defined Benefit [DB] pension plans and Endowments, but that has shifted over time, and is increasingly not true.  In some ways, the DB plans are becoming more like life insurers in the way they invest, though not totally so.  So, why do they invest differently?  Two reasons: internal risk management goals, and the desires of insurance regulators to preserve industry solvency.

Let’s start with life insurers.  Regulators don’t want insolvent companies, so they constrain companies into safe assets using risk-based capital charges.  The riskier the investment, the more capital the insurer has to put up against it.  After that, there is cash-flow testing which tends to push life insurers to match assets and liabilities, or at least, not have a large mismatch.  Also, accounting rules may lead insurers to buy assets where the income will show up on their financial statements regularly.

The result of this is that life insurers don’t invest much in risk assets — maybe they invest in stocks, junk bonds, etc. up to the amount of their surplus, but not much more than that.

DB plans don’t have regulators that care about investment risks.  They do have plan sponsors that do care about investment risk, and that level of care has increased over the past 15 years.  Back in the late ’90s it was in vogue for DB plans to allocate more and more to risk assets, just in time for the market to correct.  (Note to retail investors: professionals may deride your abilities, but the abilities of many professionals are questionable also.)

Over that time, the rate used to discount DB plan liabilities became standardized and attached to long high quality bonds.  Together with a desire to minimize plan funding risks, and thus corporate risks for the plan sponsor, that led to more investments in bonds, and less in equities and other risk assets.  Some plans try to cash flow match expected future plan payments out to a horizon.

Finally, endowments have no regulator, and don’t have a plan sponsor that has to make future payments.  They are free to invest as they like, and probably have the highest degree of variation in their assets as a group.  There is some level of constraint from the spending rules employed by the endowments, particularly since 2008-9, when a number of famous endowments came to realize that there was a liability structure behind them when they ran low on liquidity amid the crisis. [Note: long article.]  You might think it would be smart to have the present value of 3-5 years of expenditures on hand in bonds, but that is not always the case.  In some ways, the quick recovery taught some endowment investors the wrong lesson — that they could wait out any crisis.

That’s my quick summary.  If you have thoughts on the matter, you can share them in the comments.

 

Photo Credit: wackystuff

Photo Credit: wackystuff

No one wants to be a forced seller in a panic. So how does anyone get into that situation?  Two things: bad planning and a bad scenario.

Let’s start with the obvious stuff: the moment you start using leverage, there is a positive probability of total failure, and more leverage increases the probability.  Other factors that raise the probability are lack of diversification of assets, a short term for repayment on the leverage, a run on the bank, or restrictive rules on what happens if your assets decline too much in value.

For the big guys, I think that covers most of it.  With little guys, there is one more painful way that it happens, with insult added to injury.

Assume the man in question has no formal leverage, except maybe a mortgage on his house.  He has a stock portfolio, and like many, has bought popular stocks that everyone thinks will do well.  Then a significant panic hits the market because enough corporate or banking debts are incapable of being repaid.

The value of his portfolio falls a lot, but he doesn’t sell or worry immediately, because he has a solid job and has a buffer of a few months expenses set aside.  Then the shock hits.  In the midst of the panic he faces one of the following:

  • The loss of his job (or severe trouble in his business)
  • Disability with no insurance
  • An uninsured casualty of some sort
  • Divorce
  • Health problems not covered by insurance
  • Death (and his wife has to pick up the pieces)
  • Etc.

Guess what?  Even though he planned ahead, the plan did not consider true disasters, where two things fail at the same time.  His buffer runs out, and in order to live, he has to sell stocks at a time when he thinks they are undervalued.

This happens to some degree in the depths of bear markets, because unemployment and credit panics are correlated.  Other contingencies may not be correlated, but a certain number of them happen all the time — the odds of them happening when the stock market is down is still positive.

What can be done?  Here are a few ideas:

  • Hold a bigger buffer.  Maybe toss in some high quality long bonds, as well as cash.
  • Reduce fixed commitments.
  • Insure most reasonably possible large insurable contingencies — death, disability, health, liability, etc.
  • Keep a rolling hedge of protective puts (costly)
  • Increase portfolio quality and diversification to lessen the hit.

The time plan for a flat tire is before you have one.  As an example, I keep wrenches that are better than what the automakers put in their tire changing kits in my cars.  The same is true for financial disasters.  The planning is best done in the good times, like now.  Consider your financial and personal risks, and adjust your positions accordingly, realizing that no one can survive every panic.  Eventually you have to trust in God, because no earthly security system is comprehensive.

Photo Credit: Mark Stevens

Photo Credit: Mark Stevens

There’s one thing that is a misunderstanding about retirement investing. It’s not something that is out-and-out wrong. It’s just not totally right.

Many think the objective is to acquire a huge pile of assets.

Really, that’s half of the battle.

The true battle is this: taking a stream of savings, derived from a stream of income, and turning it into a robust stream of income in retirement.

That takes three elements to achieve: saving, compounding, and distribution.

What’s that, you say?  That’s no great insight?

Okay, let me go a little deeper then.

Saving is the first skirmish.  Few people develop a habit of saving when they are relatively young.  Try to make it as automatic as possible.  Aim for at least 10% of income, and more if you are doing well, particularly if your income is not stable.

Don’t forget to fund a “buffer fund” of 3-6 months of expenses to be used for only the following:

  • Emergencies
  • Gaining discounts for advance payment (if you know you have future income to replenish it)

The savings and the “buffer fund” provide the ability to enter into the second phase, compounding.  The buffer fund allows the savings to not be invaded for current use so they can be invested and compound their value into a greater amount.

Now, compounding is trickier than it may seem.  Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years).  Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, you don’t benefit much from a general rise in values from the stock or bond markets.  The value of your portfolio may have risen, but at the cost of lower future opportunities.  This is more ironclad in the bond market, where the cash flow streams are fixed.  With stocks and other risky investments, there may be some ways to do better.

1) With asset allocation, overweight out-of-favor asset classes that offer above average cashflow yields.  Estimates on these can be found at GMO or Research Affiliates.  Rebalance into new asset classes when they become cheap.

2) Growth at a reasonable price investing: invest in stocks that offer capital growth opportunities at a inexpensive price and a margin of safety.  These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into.  This is harder to do than it looks.  More companies look promising and do not perform well than those that do perform well.

3) Value investing: Find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that.  As your companies do well, reinvest in new possibilities that have better appreciation potential.

4) Distressed investing: in some ways, this can be market timing, but be willing to take risk when things are at their worst.  That can mean investing during a credit crisis, or investing in countries where conditions are somewhat ugly at present.  This applies to risky debt as well as stocks and hybrid instruments.  The best returns come out of investing near the bottom of a panic.  Do your homework carefully here.

5) Avoid losses.  Remember:

  • Margin of safety.  Valuable asset well in excess of debts, rule of law, and a bargain price.
  • In dealing with distress, don’t try to time the bottom — maybe use a 200-day moving average rule to limit risk and invest when the worst is truly past.
  • Avoid the areas where the hot money is buying and own assets being acquired by patient investors.

Adjust your portfolio infrequently to harvest things that have achieved their potential and reinvest in promising new opportunities.

That brings me to the final skirmish, distribution.

Remember when I said:

You don’t benefit much from a general rise in values from the stock or bond markets.  The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income.  If interest rates are low, as they are now, safe income will be low.  The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don’t look at current income.  Look instead at the underlying economics of the business, and how it grows value.  It is far better to have a growing income stream than a high income stream with low growth potential.

Also consider the risks you may face, and how your assets may fare.  How are you exposed to risk from:

  • Inflation
  • Deflation and a credit crisis
  • Expropriation
  • Regulatory change
  • Trade wars
  • Etc.

And, as you need, liquidate some of the assets that offer the least future potential for your use.  In retirement, your buffer might need to be bigger because the lack of wage income takes away a hedge against unexpected expenses.

Conclusion

There are other issues, like taxes, illiquidity, and so forth to consider, but this is the basic idea on how to convert present excess income into a robust income stream in retirement.  Managing a pile of assets for income to live off of is a challenge, and one that most people are not geared up for, because poor planning and emotional decisions lead to subpar results.

Be wise and aim for the best future opportunities with a margin of safety, and let the retirement income take care of itself.  After all, you can’t rely on the markets or the policymakers to make income opportunities easy.  Choose wisely.

Photo Credit: Roscoe Ellis

Photo Credit: Roscoe Ellis

I was reading an occasional blast email from my friend Tom Brakke, when he mentioned a free publication from Redington, a UK asset management firm that employs actuaries, among others. I was very impressed with what I read in the 32-page publication, and highly recommend it to those who select investment managers or create asset allocations, subject to some caveats that I will list later in this article.

In the UK, actuaries are trained to a higher degree to deal with investments than they are in the US. The Society of Actuaries could learn a lot from the Institute of Actuaries in that regard. As a former Fellow in the Society of Actuaries, I was in the vanguard of those trying to apply actuarial principles to risk management, both when I managed risks for insurance companies, worked for non-insurance organizations, and manage money for upper middle class individuals and small institutions. Redington’s thoughts are very much like mine in most ways. As I see it, the best things about their investment reasoning are:

  • Risk management must be both quantitative and qualitative.
  • Risk is measured relative to client needs and thus the risk of an investment is different for clients with different needs.  Universal measures of risk like Sharpe ratios, beta and standard deviation of asset returns are generally inferior measures of risk.  (DM: But they allow the academics to publish!  That’s why they exist!  Please fire consultants that use them.)
  • Risk control methods must be implemented by clients, and not countermanded if they want the risk control to work.
  • Shorting requires greater certainty than going long (DM: or going levered long).
  • Margin of safety is paramount in investing.
  • Risk control is more important when things are going well.
  • It is better to think of alternatives in terms of the specific risks that they pose, and likely future compensation, rather than look at track records.
  • Illiquidity should be taken on with caution, and with more than enough compensation for the loss of flexibility in future asset allocation decisions and cash flow needs.
  • Don’t merely avoid risk, but take risks where there is more than fair compensation for the risks undertaken.
  • And more… read the 32-page publication from Redington if you are interested.  You will have to register for emails if you do so, but they seem to be a classy firm that would honor a future unsubscribe request.  Me?  I’m looking forward to the next missive.

Now, here are a few places where I differ with them:

Caveats

  • Aside from pacifying clients with lower volatility, selling puts and setting stop-losses will probably lower returns for investors with long liabilities to fund, who can bear the added volatility.  Better to try to educate the client that they are likely leaving money on the table.  (An aside: selling short-duration at-the-money puts makes money on average, and the opposite for buying them.  Investors with long funding needs could dedicate 1% of their assets to that when the payment to do so is high — it’s another way of profiting from offering insurance in of for a crisis.)
  • Risk parity strategies are overrated (my arguments against it here: one, two).
  • I think that reducing allocations to risky assets when volatility gets high is the wrong way to do it.  Once volatility is high, most of the time the disaster has already happened.  If risky asset valuations show that the market is offering you significant deals, take the deals, even if volatility is high.  If volatility is high and valuations indicate that your opportunities are average to poor at best, yeah, get out if you can.  But focus on valuations relative to the risk of significant loss.
  • In general, many of their asset class articles give you a good taste of the issues at hand, but I would have preferred more depth at the cost of a longer publication.

But aside from those caveats, the publication is highly recommended.  Enjoy!

Photo Credit: Alon

Photo Credit: Alon

There is always a reason to worry, and always enough time to panic.

Look over there, behind that bush: interest rates are rising. In Europe and China, deflation is threatening. The geopolitical situation is in many ways tense over Russia and Middle East issues. Japan is a mess. Emerging markets will get hit when the Fed starts to tighten.

I could go on, and talk about the longer term demographic problems that we face, and other aspects of lousy government policy, but it would get too long. The point is, there are things that you can worry about. But what should you do?

For many people, worry paralyzes. If there are significant potential problems, they won’t invest, or they will keep their investments very simple and safe. They may fall prey to those who scam by offering “safety” though gold, guns, food storage, life insurance products, etc. Is there a better way to avoid worry?

The first way to avoid worry is to realize that more things can go wrong than do go wrong. Many of the things you might worry about will not happen. Second, even when things do go wrong, the market prices often reflect those possibilities, so the markets may not react badly. Third, the markets have endured many crises in the past and have come back from those crises. Fourth, in the worst crises you can imagine, it will not matter what you do if those take place — you will lose a lot, but so will everyone else. If no strategy can work in the worst problems, you should spend your time praying rather than worrying.

Some might say to me, “But I don’t want to lose a lot of money! I’m relying on it for my retirement (or whatever).” If that is your problem, the answer is simple — invest less in risk assets. Give up some potential return so that you can sleep at night. That has been my advice to a bunch of pastors who generally don’t understand the markets at all. We offer them blended portfolios of risky and safe assets ranging from low volatility to the volatility level of the stock market. I tell them to look at what the blended portfolios have lost in 2008, and size the risk of their holdings to what they can live with in terms of risk if they had to liquidate at a bad time. If they are still squeamish, I tell them to take the risk level down another notch.

There is a risk to not taking enough risk, and that will be the point of part 2, but it is better for the squeamish to implement a sub-optimal plan than no plan. It is also better for the squeamish to implement a sub-optimal plan than a plan that they can’t maintain, because they get too scared.

Solutions have to be real-world to meet people where they are. After that, maybe we can try to teach people not to worry, but human nature is difficult to change.

PS — for any that might say that they are worried that they aren’t going to earn enough to be able to retire or stay comfortably retired, part 2 will have something to say there as well.

Photo Credit: PSParrot

Photo Credit: PSParrot

Happy New Year to all of my readers. May 2015 be an enriching year for you in all ways, not just money.

This is a series on learning about investing, using my past mistakes as grist for the mill.  I have had my share of mistakes, as you will see.  The real question is whether you learn from your mistakes, and I can say that I mostly learn from them, but never perfectly.

In the early 90s, I fell in with some newsletter writers that were fairly pessimistic.  As such, I did not do the one thing that from my past experience that I found I was good at: picking stocks.  Long before I had money to invest, I thought it was a lot of fun to curl up with Value Line and look for promising companies.  Usually, I did it well.

But I didn’t do that in that era.  Instead, I populated my portfolio with international stock and bond funds, commodity trading funds, etc., and almost nothing that was based in the USA.  I played around with closed-end funds trying to see if I could eke alpha out of the discounts to NAV.  (Answer: No.)  I also tried shorting badly run companies to make a profit.  (I succeeded minimally, but that was the era, not skill.)

I’ve been using my tax returns from that era to prompt my memory of what I did, and the kindest thing I can say is that I didn’t have a consistent strategy, and so my results were poor-to-moderate.  I made money, just not much money.  I even manged to buy the Japanese equity market on the day that it peaked, and after many months got out with a less-than-deserved 3% loss in dollar terms because of offsetting currency movements.

One thing I did benefit from was learning about a wide number of investing techniques and instruments, which benefited me professionally, because it taught me about the broader context of investing.  That said, it cost time, and some of what I learned was marginal.

But not having a good overall strategy largely means you are wasting your time in investing.  You may succeed for a while with what some call luck, but luck by its nature is not consistent.

Thus, I would encourage all of my readers to adopt an approach that fits their:

  • Knowledge
  • Personality
  • Available time

You have to do something that you truly understand, even if it is hiring an advisor, wealth manager, etc.  You must be able to understand the outer edges of what they do, or how will you evaluate whether they are serving you well or not?  Honesty, integrity, and reputation can go a long way here, but it really helps to know the basics.

Picking fund managers is challenging enough.  How much of their good performance was due to:

  • their style being in favor
  • new cash flows in pushing up the prices of the assets that they like to buy
  • a few good ideas that won’t be repeated
  • a clever aide that is about to leave to set up his/her own shop
  • temporary alignment with the macroeconomic environment
  • or skill?

Personality is another matter — some people don’t learn patience, which cuts off a number of strategies that require time to work out.  Few things also work right off the bat, so even a good strategy might get discarded by someone expecting immediate results.

Time is another factor which I will take up at a later point in this series.  The best investment methods out there are no good for you unless you can make them fit into the rest of your life which often contains the far more important things of family, recreation, faith, learning, etc.  It’s no good to be a wealthy old miser who never learned to appreciate life or the goodness of God’s providence in life.

And so to that end, I say choose wisely.  My eventual choice was value investing, which isn’t that hard to learn, but requires patience, but can scale to the time that you have.  For those that work in a business, it has the side-benefit that it is the most businesslike of all investment methods, and can make you more valuable to the firm that you work for, because you can learn to marry business sense with your technical expertise, potentially leading to greater profit.

For me, I can say that it broadened my abilities to think qualitatively, complementing my skills as a mathematician.  The firms I worked for definitely benefited.  Maybe it can do the same for you.

Till next time, where I tell you how value investing is *not* supposed to be done. 😉

PS — one more note: it is *very* difficult to make money off of macro insights in equities.  Maybe there are some guys that can do that well, but I am not one of them.  Limiting the effect of my insights there has been an aid to doing better in investing, because it forces me to be modest in an area where I know my likely success is less probable.

Photo Credit: Chris Piascik

Photo Credit: Chris Piascik

Most formal statements on financial risk are useless to their users. Why?

  • They are written in a language that average people and many regulators don’t speak.
  • They often don’t define what they are trying to avoid in any significant way.
  • They don’t give the time horizon(s) associated with their assessments.
  • They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
  • They don’t consider whether history might be a poor guide for their estimates.
  • They don’t consider the conflicting interests and incentives of the parties that direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
  • They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
  • Occasionally, approximations are used where better calculations could be used.  It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
  • Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
  • Where complex math is used, there is no simple language to explain the economic sense of it.
  • They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story.  I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did.  The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into.  It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them.  The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual.  You can’t believe how many people came to us saying, “I get it.”  Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known.  Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not.  It combined the best of both rules and principles, going well beyond the minimum of what was required.  Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

  • Investment prospectuses and reports, and all investment and insurance marketing literature
  • Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
  • Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
  • The reports that sell-side analysts write
  • The analyses that those that provide asset allocation advice put out
  • Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
  • Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Photo Credit: Hans and Carolyn || Do you have the right building blocks for your model?

Photo Credit: Hans and Carolyn || Do you have the right building blocks for your model?

Simulating hypothetical future investment returns can be important for investors trying to make decisions regarding the riskiness of various investing strategies.  The trouble is that it is difficult to do right, and I rarely see it done right.  Here are some of the trouble spots:

1) You need to get the correlations right across assets.  Equity returns need to move largely but not totally together, and the same for credit spreads and equity volatility.

2) You need to model bonds from a yield standpoint and turn the yield changes into price changes.  That keeps the markets realistic, avoiding series of price changes which would imply that yields would go too high or below zero. Yield curves also need ways of getting too steep or too inverted.

3) You need to add in some momentum and weak mean reversion for asset prices.  Streaks happen more frequently than pure randomness.  Also, over the long haul returns are somewhat predictable, which brings up:

4) Valuations.  The mean reversion component of the models needs to reflect valuations, such that risky assets rarely get “stupid cheap” or stratospheric.

5) Crises need to be modeled, with differing correlations during crisis and non-crisis times.

6) Risky asset markets need to rise much more frequently than they fall, and the rises should be slower than the falls.

7) Foreign currencies, if modeled, have to be consistent with each other, and consistent with the interest rate modeling.

Anyway, those are some of the ideas that realistic simulation models need to follow, and sadly, few if any follow them all.

Photo Credit: Jimmie

Photo Credit: Jimmie

Every now and then, a piece of good news gets announced, and then something puzzling happens.  Example: the GDP report comes out stronger than expected, and the stock market falls.  People scratch their heads and say, “Huh?”

A friend of mine who I haven’t heard from in a while, Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.”  This much is true, but why is it true?  How can the market go down on good economic news?

Some of us as investors use a concept called a discounted cash flow model.  The price of a given asset is equal to the expected cash flows it will generate in the future, with each future cash flow discounted to reflect to reflect the time value of money and the riskiness of that cash flow.

Think of it this way: if the GDP report comes out strong, we can likely expect corporate profits to be better, so the expected cash flows from equities in the future should be better.  But if the stock market prices fall, it means the discount rates have risen more than the expected cash flows have risen.

Here’s a conceptual problem, then: We have estimates of the expected cash flows, at least going a few years out but no one anywhere publishes the discount rates for the cash flows — how can this be a useful concept?

Refer back to a piece I wrote earlier this week.  Discount rates reflecting the cost of capital reflect the alternative sources and uses for free cash.  When the GDP report came out, not only did come get optimistic about corporate profits, but perhaps realized:

  • More firms are going to want to raise capital to invest for growth, or
  • The Fed is going to have to tighten policy sooner than we thought.  Look at bond prices falling and yields rising.

Even if things are looking better for profits for existing firms, opportunities away from existing firms may improve even more, and attract capital away from existing firms.  Remember how stock prices slumped for bricks-and-mortar companies during the tech bubble?  Don’t worry, most people don’t.  But as those prices slumped, value was building in those companies.  No one saw it then, because they were dazzled by the short-term performance of the tech and dot-com stocks.

The cost of capital was exceptionally low for the dot-com stocks 1998-early 2000, and relatively high for the fuddy-duddy companies.  The economy was doing well.  Why no lift for all stocks?  Because incremental dollars available for finance were flowing to the dot-com companies until it became obvious that little to no cash would ever flow back from them to investors.

Afterward, even as the market fell hard, many fuddy-duddy stocks didn’t do so badly.  2000-2002 was a good period for value investing as people recognized how well the companies generated profits and cash flow.  The cost of capital normalized, and many dot-coms could no longer get financing at any price.

Another Example

Sometimes people get puzzled or annoyed when in the midst of a recession, the stock market rises.  They might think: “Why should the stock market rise?  Doesn’t everyone know that business conditions are lousy?”

Well, yes, conditions may be lousy, but what’s the alternative for investors for stocks?  Bond yields may be falling, and inflation nonexistent, making money market fund yields microscopic… the relative advantage from a financing standpoint has swung to stocks, and the prices rise.

I can give more examples, and maybe this should be a series:

  • The Fed tightens policy and bonds rally. (Rare, but sometimes…)
  • The Fed loosens policy, and bonds fall. (also…)
  • The rating agencies downgrade the bonds, and they rally.
  • The earnings report comes out lower than last year, and the stock rallies.
  • Etc.

But perhaps the first important practical takeaway is this: there will always be seemingly anomalous behavior in the markets.  Why?  Markets are composed of people, that’s why.  We’re not always predictable, and we don’t predict better when you examine us as groups.

That doesn’t mean there is no reason for anomalies, but sometimes we have to take a step back and say something as simple as “good economic news means lower stock prices at present.”  Behind that is the implied increase in the cost of capital, but since there is nothing to signal that, you’re not going to hear it on the news that evening:

“In today’s financial news, stock prices fell when the GDP report came out stronger than expected, leading investors to pursue investments in newly-issued bonds, stocks, and private equity.”

So be aware of the tone of the market.  Today, bad news still seems to be good, because it means the Fed leaves interest rates low for high-quality short-term debt for a longer period than previously expected.  Good news may imply that there are other places to attract money away from stocks.

Ideas for this topic are welcome.  Please leave them in the comments.

Photo Credit: eric731 -- People can budget, but can they manage risk?

Photo Credit: eric731 — People can budget, but can they manage risk?

Investing is difficult.  That said, we can make it harder still.  We can encourage people with little to no training to try to do it for themselves.  Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell.  We get there late, and then our emotions trick us into action, when the rational investor says, “Okay, I missed that move.  Where are there opportunities now, if there are any at all?”

But investing can be made even more difficult.  Investing reaches its most challenging level when you are relying on your investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will tell you, portfolio decisions are almost always easier when there is more cash flowing in than flowing out.  It means that there is one dominant mode of thought: where to invest new money?  Some attention will be given to managing existing assets — pruning away assets with less potential, but the need won’t be as pressing.  (Note: at really high rates of cash inflow, investing gets really tough as well, but that’s another story, and one that I successfully lived though 1998-2003…)

What’s tough is trying to meet a cash withdrawal rate that is materially higher than what can safely be achieved over time, and earning enough consistently to do so.  Doing so as an amateur managing your own retirement portfolio will be a particularly hard version of this problem.  Let me point out some of the areas where it will be hard:

1) You don’t know how long you, your spouse, and anyone else relying on you will live.  Averages can be calculated, but particularly with two people, the odds are that one will outlive an average life expectancy.  Can you be conservative enough in your withdrawals that you won’t outlive your money?

2) My estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%.  That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero when you are near the end of a bull market.

Now, most people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets.  At present, if interest rates don’t go lower still, that will likely (60-80% likelihood) work.  But if your income needs are greater than that, your odds of yields over the long haul go down dramatically.

3) Will you be able to maintain an iron discipline, and not overspend your assets?  It’s tempting to do so, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs.  It is incredibly difficult to avoid paying for an immediate pressing need, when the soft cost is harming your future.  There is every incentive to say, “We’ll figure it out later.”  The odds on that being true will be low.

4) How will you deal with bear markets, particularly ones that occur early in retirement?  Can you and will you reduce your expenses to reflect the losses?  On the other side, during bull markets, will you build up a buffer, and not get incautious during seemingly good times?

This is an easy prediction to make, but after the next bear market, look for a scad of “Our retirement is ruined articles.”  Look for there to be hearings in Congress that don’t amount to much — and if they do amount to much, watch them make things worse by creating R Bonds, or some garbage like that.

5) Avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield — it is the oldest scam in the books.  This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc.  They have no guaranteed return of principal.  On the plus side, they may give you capital gains if you use them right, buying them when they are out of favor, and reducing exposure when everyone is buying them.

Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because a decent number of people are buying them as if they are magic.  The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.

6) Avoid taking too much or too little risk. It’s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree.  If you can do that successfully, you are rare.  What is achievable by many is to maintain a constant risk posture.  Don’t panic; don’t get greedy — just stick to your investment plan through the cycles of the markets.

7) As assets shrink, what will you liquidate?  The best thing would be being forward-looking, and liquidating what has the lowest risk-adjusted future return.  What is achievable is selling assets off from everything proportionally, taking account of tax issues where needed.

8 ) Are you ready for Social Security to take a hit out around 2026?  Once the trust fund gets down to one year’s worth of payments, future payments get reduced to the level sustainable by expected future contributions.  Expect a political firestorm when this becomes a live issue, say for the 2024 Presidential election.  There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.

9) Be wary of inflation, but don’t overdo it.  The retirement of so many people may be deflationary — after all, look at Japan and Europe so far.  Economies also work better when there is net growth in the number of workers.  It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.

10) You need a defender of two against slick guys who will try to cheat you when you are older.  If you have assets, you are a prime target for scams.  Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make your money stretch further.  But there are other scams as well — run everything significant past a smart younger person who is skeptical, and knows how to say no when needed.

Conclusion

If this all seems unduly dour (and I haven’t even talked about defined benefit plan issues), let me tell you that this is realistic.  There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.

Even with skilled advisers helping you, you need to be ready for the hard choices that will come up.  Better you should think through them earlier rather than later.  Who knows?  You might take some actions that will lower your future risks.  More on that in a future post, as well as the other retirement risk issues.