Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best.  First, I don’t like infographics or video.  I want to learn things quickly.  Give me well-written text to read.  A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem.  Do you want to reduce the volatility of your asset portfolio?  I have the solution for you.  Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard.  Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?”  In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments.  Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

  • Growth stocks
  • Midcap stocks (value & growth)
  • Small cap stocks (value & growth)
  • REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
  • Developed International stocks (of all kinds)
  • Emerging Market stocks
  • Frontier Market stocks
  • And more…

And initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Not much.  The diversification from investor behavior is largely gone (the liability side of correlation).  Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets?  Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

  • Timberland
  • Real Estate
  • Private Equity
  • Collateralized debt obligations of many flavors
  • Junk bonds
  • Distressed Debt
  • Merger Arbitrage
  • Convertible Arbitrage
  • Other types of arbitrage
  • Commodities
  • Off-the-beaten track bonds and derivatives, both long and short
  • And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what?  Much the same thing happened here as happened with non-“blue chip” stocks.  Initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Some, but less.  Not everyone was willing to do all of these.  The diversification from investor behavior was reduced (the liability side of correlation).  These don’t move in perfect lockstep, so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are some that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short.  Many of those blew up last time.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again?  Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point.  Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder.  Think of cash, which doesn’t earn much or lose much.  Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time.  Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%).  This isn’t a call to go nuts and sell all of your risky asset positions.  That requires more knowledge than I will ever have.  But it does mean having some dry powder.  The amount is up to you as you evaluate your time horizon and your opportunities.  Choose wisely.  As for me, about 20-30% of my total assets are safe, but I have been a risk-taker most of my life.  Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification.  You will have to wait for those ideas to be forgotten.  Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

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This book is not what I expected; it’s still very good. Let me explain, and it will give you a better flavor of the book.

The author, Jason Zweig, is one of the top columnists writing about the markets for The Wall Street Journal.  He is very knowledgeable, properly cautious, and wise.  The title of the book Ambrose Bierce’s book that is commonly called The Devil’s Dictionary.

There are three differences in style between Zweig and Bierce:

  • Bierce is more cynical and satiric.
  • Bierce is usually shorter in his definitions, but occasionally threw in whole poems.
  • Zweig spends more time explaining the history of concepts and practices, and how words evolved to mean what they do today in financial matters.

If you read this book, will you learn a lot about the markets?  Yes.  Will it be fun?  Also yes.  Is it enough to read this and be well-educated?  No, and truly, you need some knowledge of the markets to appreciate the book.  It’s not a book for novices, but someone of intermediate or higher levels of knowledge will get some chuckles out of it, and will nod as he agrees along with the author that the markets are a treacherous place disguised as an easy place to make money.

As one person once said, “Whoever called them securities had a wicked sense of humor.”  Enjoy the book; it doesn’t take long to read, and it can be put down and picked up with no loss of continuity.

Quibbles

None

Summary / Who Would Benefit from this Book

If you have some knowledge of the markets, and you want to have a good time seeing the wholesome image of the markets skewered, you will enjoy this book.  if you want to buy it, you can buy it here: The Devil’s Financial Dictionary.

Full disclosure: The author sent a free copy to me via his publisher.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I intended on writing this at some point, but Dr. Wesley Gray (an acquaintance of mine, and whom I respect) beat me to the punch.  As he said in his blog post at The Wall Street Journal’s The Experts blog:

WESLEY GRAY: Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance.  “No problem,” you might think—buy and hold and ignore the short-term noise.

Easier said than done.

Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009. The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period.

What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.”

The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially.

In other words, fund managers can deliver a great long-term strategy, but investors can still lose.

CGMFX Dollar Weighted_1552_image002That’s why I wanted to write this post.  Ken Heebner is a really bright guy, and has the strength of his convictions, but his investors don’t in general have similar strength of convictions.  As such, his investors buy high and sell low with his funds.  The graph at the left is from the CGM Focus Fund, as far back as I could get the data at the SEC’s EDGAR database.  The fund goes all the way back to late 1997, and had a tremendous start for which I can’t find the cash flow data.

The column marked flows corresponds to a figure called “Change in net assets derived from capital share transactions” from the Statement of Changes in Net Assets in the annual and semi-annual reports.  This is all public data, but somewhat difficult to aggregate.  I do it by hand.

I use annual cashflows for most of the calculation.  For the buy and hold return, i got the data from Yahoo Finance, which got it from Morningstar.

Note the pattern of cashflows is positive until the financial crisis, and negative thereafter.  Also note that more has gone into the fund than has come out, and thus the average investor has lost money.  The buy-and-hold investor has made money, what precious few were able to do that, much less rebalance.

This would be an ideal fund to rebalance.  Talented manager, will do well over time.  Add money when he does badly, take money out when he does well.  Would make a ton of sense.  Why doesn’t it happen?  Why doesn’t at least buy-and-hold happen?

It doesn’t happen because there is a Asset-Liability mismatch.  It doesn’t matter what the retail investors say their time horizon is, the truth is it is very short.  If you underperform for less than a few years, they yank funds.  The poetic justice is that they yank the funds just as the performance is about to turn.

Practically, the time horizon of an average investor in mutual funds is inversely proportional to the volatility of the funds they invest in.  It takes a certain amount of outperformance (whether relative or absolute) to get them in, and a certain amount of underperformance to get them out.  The more volatile the fund, the more rapidly that happens.  And Ken Heebner is so volatile that the only thing faster than his clients coming and going, is how rapidly he turns the portfolio over, which is once every 4-5 months.

Pretty astounding I think.  This highlights two main facts about retail investing that can’t be denied.

  1. Asset prices move a lot more than fundamentals, and
  2. Most investors chase performance

These two factors lie behind most of the losses that retail investors suffer over the long run, not active management fees.  remember as well that passive investing does not protect retail investors from themselves.  I have done the same analyses with passive portfolios — the results are the same, proportionate to volatility.

I know buy-and-hold gets a bad rap, and it is not deserved.  Take a few of my pieces from the past:

If you are a retail investor, the best thing you can do is set an asset allocation between risky and safe assets.  If you want a spit-in-the-wind estimate use 120 minus your age for the percentage in risky assets, and the rest in safe assets.  Rebalance to those percentages yearly.  If you do that, you will not get caught in the cycle of greed and panic, and you will benefit from the madness of strangers who get greedy and panic with abandon.  (Why 120?  End of the mortality table. 😉 Take it from an investment actuary. 😉 We’re the best-kept secret in the financial markets. 😀 )

Okay, gotta close this off.  This is not the last of this series.  I will do more dollar-weighted returns.  As far as retail investing goes, it is the most important issue.  Period.

I was asked to participate with 57 other bloggers in a post that was entitled 101 ETF Investing Tips.  It’s a pretty good article, and I felt the tips numbered 2, 15, 18, 23, 29, 35, 44, 48, 53, 68, 85, 96, and 98 were particularly good, while 10, 39, 40, 45, 65, 67, 74, 77, 80, and 88 should have been omitted.  The rest were okay.

One consensus finding was that Abnormal Returns was a “go to” site on the internet for finance.  I think so too.

Below were the answers that I gave to the questions.  I hope you enjoy them.

1) What is the one piece of advice you’d give to an investor just starting to build a long-term portfolio?

You need to have reasonable goals.  You also have to have enough investing knowledge to know whether advice that you receive is reasonable.  Finally, when you have a reasonable overall plan, you need to stick with it.

2) What is one mistake you see investors make over and over?

They think investment markets are magic. They don’t save/invest anywhere near enough, and they think that somehow magically the markets will bail out their woeful lack of planning.  They also panic and get greedy at the wrong times.

3) In 20 years, _____. (this can be a prediction about anything — investing-related or otherwise)

In 20 years, most long-term public entitlement and private employee benefit schemes that promised fixed payments/reimbursement will be scaled back dramatically, and most retirees will be very disappointed.  The investment math doesn’t work here – if anything, the politicians were more prone to magical thinking than naïve investors.

4) Buy-and-hold investing is _____.

Buy-and-hold investing is the second-best strategy that average people can apply to markets, if done with sufficient diversification. It is a simple strategy, available to everyone, and it generally beats the performance of average investors who buy and sell out of greed and panic.

5) One book I wish every investor would read is _____. (note that non-investing books are OK!)

One book I wish every investor would read is the Bible. The Bible eliminates magical thinking, commends hard work and saving, and tells people that their treasure should be in Heaven, and not on Earth.  If you are placing your future hope in a worry-free, well-off retirement, the odds are high that you will be disappointed.  But if you trust in Jesus, He will never leave you nor forsake you.

6) The one site / Twitter account / newsletter that I can’t do without is _____.

Abnormal Returns provides the best summary of the top writing on finance and investing every day.  There is no better place to get your information each day, and it comes from a wide array of sources that you could not find on your own.  Credit Tadas Viskanta for his excellent work.

7) The biggest misconception about investing via ETFs is_____.

The biggest misconception about investing via ETFs is that they are all created equal.  They have different expenses and structures, some of which harm their investors.  Simplicity is best – read my article, “The Good ETF” for more.

8 ) Over a 20-year time horizon, I’m bullish on _____. (this can be an asset class, fund, technology, person — anything really!)

Over 20 years, I am bullish on stocks, America, and emerging markets.  Of the developed nations, America has the best combination of attributes to thrive.  The emerging markets offer the best possibility of significant growth.  Stocks may have a rough time in the next five years, but in an environment where demographic and technological change is favoring corporate profits, stocks will do better than other asset classes over 20 years.

9) The one site / Twitter account / newsletter that I can’t do without is _____.

Since you asked twice, the Aleph Blog is one of the best investing blogs on the internet, together with its Twitter feed.  It has written about most of the hard questions on investing in a relatively simple way, and is not generally marketing services to readers.  For the simple stuff, go to the personal finance category at the blog.

10) Any other ETF-related investing tips or advice?

For a fuller view of my ETF-related advice, go to Aleph Blog, and read here.  Briefly, be careful with any ETF that is esoteric, or that you can’t draw a simple diagram to explain how it works.  Also realize that traders of ETFs tend to do worse than those that buy and hold.

 

Photo Credit: Teresa Robinson || Your plans, your needs, your dreams, your risks...

Photo Credit: Teresa Robinson || Your plans, your needs, your dreams, your risks…

What I am going to write here is half of my summary of how Asset Allocation is done.  Most of this will be done in the context of personal finance, because it is the most complex case, though this paradigm is sufficiently general that it can be applied to any entity.

Good asset allocation, and financial planning generally, focuses on two main questions:

  • When will the cash be needed for expenses?
  • What are the likely returns being offered by asset classes over the planning horizon at every period in which cash will be needed?  Also, how likely are those returns?

Tonight I am writing about the first question.  For institutions, there are typically two solutions — there is a spending rule for endowments, whereas for defined benefit pension plans and other types of employee benefit plans, the actuaries will sit down and estimate future cash needs, and when the needs will take place.  (The same applies to financial institutions, though for institutions with short-term funding profiles, you won’t typically use actuaries, not that you couldn’t.)

For individuals and families, the issues come down to needs, wants, dreams, and risks.  As for risks, you can look at the earliest series at my blog, [summary here] which was on personal finance.  (I never intended to write much on personal finance, and so that was a summary set to get my main ideas out.)

Then comes the hierarchy of expense: needs, wants, and dreams.  Aim to satisfy each one successively.  Some people can only afford needs, others can get to wants, and a few others can get to dreams.  Now, that’s an oversimplification, because many people will reshape their wants and dreams to fit their cost structure.  Happiness is frequently a choice, rather than an abundance of goods and experiences.

Regardless, once you have a spending goal, and your main risks are covered, then you have something to shoot for, and asset allocation can begin.  In the process you might come up with a return target to shoot for, which I call Your Personal Required Investment Earnings Rate.  The basic idea is this:

Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.  Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.  Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.  Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

For more, you can read the article, which has a decent amount on whether return needs are reasonable or not.  More on this topic when I try to describe setting asset earnings assumptions, which is decidedly more complex.  Till then.

Photo Credit: Ian Sane || Many ways to supplement retirement income...

Photo Credit: Ian Sane || One of many ways to supplement retirement income…

Investing is difficult. That said, it can be harder still. Let 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. They get there late, and then their emotions trick them into action. A rational investor would say, “Okay, I missed that move. Where are opportunities now, if there are any at all?”

Investing can be made even more difficult.  Investing reaches its most challenging level when one relies on his investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will say that 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.

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 a retirement portfolio is a particularly hard version of this problem.  Let me point out some of the areas where it will be hard:

1) The retiree doesn’t know how long he, his spouse, and anyone else relying on him will live.  Averages can be calculated, but particularly with two people, the odds are that at least one will outlive an average life expectancy.  Can they be conservative enough in their withdrawals that they won’t outlive their assets?

It’s tempting to overspend, 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.

2) One conservative 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 near the end of a bull market.

That said, 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 income needs are greater than that, the odds of obtaining those yields over the long haul go down dramatically.

3) How does a retiree deal with bear markets, particularly ones that occur early in retirement?  Can he and will he reduce his expenses to reflect the losses?  On the other side, during bull markets, will he 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 similarly bad idea.

Academic risk models typically used by financial planners typically don’t do path-dependent analyses.  The odds of a ruinous situation is far higher than most models estimate because of the need for withdrawals and the autocorrelated nature of returns – good returns begets good, and bad returns beget bad in the intermediate term.  The odds of at least one large bad streak of returns on risky assets during retirement is high, and few retirees will build up a buffer of slack assets to prepare for that.

4) Retirees should 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 capital gains if bought at the right time, when they are out of favor, and reducing exposure when everyone is buying them.  Negatively, all junior debt tends to return worse on average than senior debts.  It is the same for equity-like investments used for income investing.

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 many 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.

5) Leaving retirement behind for a moment, consider the asset accumulation process.  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, there is no benefit much from a general rise in values from the stock or bond markets.  The value of a 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.

Retirees should be aware that the actions taken by one member of a large cohort of retirees will be taken by many of them.  This makes risk control more difficult, because many of the assets and services that one would like to buy get bid up because they are scarce.  Often it may be that those that act earliest will do best, and those arriving last will do worst, but that is common to investing in many circumstances.  As Buffett has said, “What a wise man does in the beginning a fool does in the end.”

6) Retirement investors should 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 a person can do that successfully, he is rare.

What is achievable by many is to maintain a constant risk posture.  Don’t panic; don’t get greedy — stick to a moderate asset allocation through the cycles of the markets.

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

Another way retirees can succeed would be investing in growth at a reasonable price – stocks that offer capital growth opportunities at an 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.

Yet another way to enhance returns is 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.  After the companies do well, reinvest in new possibilities that have better appreciation potential.

 

8 ) Many say that the first rule of markets is to avoid losses.  Here are some methods to remember:

  • Always seek a margin of safety.  Look for valuable assets well in excess of debts, governed by the rule of law, and purchased at a bargain price.
  • For assets that have fallen in price, don’t try to time the bottom — buy the asset when it rises above its 200-day moving average. This can limit risk, potentially buying when the worst is truly past.
  • Conservative investors avoid the areas where the hot money is buying and own assets being acquired by patient investors.

9) As assets shrink, what should be liquidated?  Asset allocation is more difficult than it is described in the textbooks, or in the syllabuses for the CFA Institute or for CFPs.  It is a blend of two things — when does the investor need the money, and what asset classes offer decent risk adjusted returns looking forward?  The best strategy is forward-looking, and liquidates what has the lowest risk-adjusted future return.  What is easy is selling assets off from everything proportionally, taking account of tax issues where needed.

Here’s another strategy that’s gotten a little attention lately: stocks are longer assets than bonds, so use bonds to pay for your spending in the early years of your retirement, and initially don’t sell the stocks.  Once the bonds run out, then start selling stocks if the dividend income isn’t enough to live on.

This idea is weak.  If a person followed this in 1997 with a 10-year horizon, their stocks would be worth less in 2008-9, even if they rocket back out to 2014.

Remember again:

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.

Deciding what to sell is an exercise in asset-liability management.  Keep the assets that offer the best return over the period that they are there to fund future expenses.

10) Will Social Security take a hit out around 2026?  One interpretation of the law says that once the trust fund gets down to one year’s worth of payments, future payments may get reduced to the level sustainable by expected future contributions, which is 73% of expected levels.  Expect a political firestorm if 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.

Even if benefits last at projected levels longer than 2026, the risk remains that there will be some compromise in the future that might reduce benefits because taxes will not be raised.  This is not as secure as a government bond.

11) 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.

Also consider other risks, and how assets may fare.  Retirees should analyze what exposure they have to:

  • Deflation and a credit crisis
  • Expropriation
  • Regulatory change
  • Trade wars
  • Changes in taxes
  • Asset illiquidity
  • Reductions in reimbursement from government programs like Medicare, Medicaid, etc.
  • And more…

12) Retirees need a defender of two against slick guys who will try to cheat them when they are older.  Those who have assets are a prime target for scams.  Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make assets stretch further.  But there are other scams as well — retirees should run everything significant past a smart younger person who is skeptical, and knows how to say no when it is necessary.

Conclusion

Some will think this is unduly dour, but 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, retirees need to be ready for the hard choices that will come up. They should think through them earlier rather than later, and take some actions that will lower future risks.

The basic idea of retirement investing is 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.

Retirees should aim for the best future investment opportunities with a margin of safety, and let the retirement income take care of itself.  After all, they can’t rely on the markets or the policymakers to make income opportunities easy.

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I am generally not a fan of formulaic books on investing, and this is particularly true of books that take unusual approaches to investing. This book is an exception because it does nothing unusual, and follows what all good quantitative investors know have worked in the past.  The past is not a guarantee of the future, but if the theories derived from past data make sense from what we know about human nature, that’s about as good as we can get.

The book begins with a critique of the abilities of financial advisors — their fees, asset allocation, and security selection.  It then shows how models of financial markets outperform most financial advisors.

Then, to live up to its title , the book gives simple versions of models that can be applied by individuals that would have outperformed the markets in the past.  You can beat the markets, lower risk, and “Do It Yourself [DIY].”  It provides models for asset allocation, stock selection, and risk control, simple enough that a motivated person with math skills equal to the first half of Algebra 1 could apply them in a moderate amount of time per month.  It also provides a simpler version of the full model that omits the security selection for stocks.

The book closes by offering three reasons why people won’t follow the book and do it themselves: fear of failure, inertia, and not wanting to give up an advisor who is a friend.  It also offers three risks for the DIY investor — overconfidence, the desire to be a hero (seems to overlap with overconfidence), and that the theories may be insufficient for future market behavior.

This is where I have the greatest disagreement with the book.  I interact with a lot of people.  Most of them have no interest in learning the slightest bit about investing.  Some have some inclination to learn about investing, but even the simple models of the book would make their heads spin, or they just wouldn’t want to take the time to do it.  Some of it is similar to seeing a Youtube video on draining and refilling your automatic transmission fluid.  You might watch it, and say “I think I get it,” but the costs of making a mistake are sufficiently severe that you might not want to do it without an expert by your side.  Most will take it to the repair garage and pay up.

I put a knife to my own throat as I write this, as I am an investment advisor, but there is more specialized knowledge in the hands of an auto mechanic than in an investment advisor, and the risk of loss is lower to manage your own money than to fix your own brakes.  That said, enough people after reading the book will say to themselves, “This is just one author, and I barely understand the performance tables in the book — if right, am I capable of doing this?  Or, could it be wrong?  I can’t verify it myself.”

The book isn’t wrong.  If you are willing to put in the time to follow the instructions of the authors, I think you will do better than most.  My sense is that the grand majority people are not willing to do that.  They don’t have the time or inclination.

 

Quibbles

The book could have been clearer on the ROBUST method for risk control.  It took me a bit of effort to figure out that the two submodels share half of the weight, so that when submodels A & B flash green — 100% weight, one green and one red — 50% weight, both red — 0% weight.

Also, the book is enhanced by the security selection model for stocks, but how many people would have the assets to assemble and maintain a portfolio with sufficient diversification?  The book might have been cleaner and simpler to leave that out.  The last models of the book don’t use it anyway.

Summary / Who Would Benefit from this Book

I liked this book, and I recommend it for those who are willing to put in the time to implement its ideas.  This is not a book for beginners, and you have to be comfortable with the small amount of math and the tables of financial statistics, unless you are willing to trust them blindly.  (Or trust me when I say that they are likely accurate.)

But with the caveats listed above, it is a good book for people who are motivated to do better with their investments.  If you want to buy it, you can buy it here: DIY Financial Advisor.

Full disclosure: I received a copy from one of the authors, a guy for whom I have respect.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

An investor can and should learn from the past.  He should never react to the recent past.  Why?  The past can’t be changed, but it can be known.  Reacting to the recent past leads investors into the valleys of greed and regret — good investments missed, bad investments incurred.

We’ve been in a relatively volatile environment for the last two weeks or so.  Markets are down, with a lot of noise over China, and slowing global growth.  Boo!

The markets were too complacent for too long, and valuations were/are higher than they should be, given current earnings, growth prospects and corporate bond yields.  It’s not the best environment for stocks given those longer-term valuation factors, but guess what?  The market often ignores those until a crisis hits.

The FOMC is going to tighten monetary policy soon.  Boo!

The things that people are taking on as worries rarely produce large crises.  They could mark stocks down 20-30% from the peak, producing a bear market, but they are unlikely of themselves to produce something similar to 2000-2 or 2008-9.

Let’s think about a few things supporting valuations and suppressing yields at present.  The overarching demographic trend in the market leads to a fairly consistent bid for risky assets.  It would take a lot to derail that bid, though that has happened twice in the last 15 years.  Ask yourself, do we face some significant imbalance where the banks could be impaired? I don’t see it at present.  Is a major sector like information technology or healthcare dramatically overvalued?  Maybe a little overvalued, but not a lot in relative terms.

There are major elections coming up next year, and a group of politicians harmful to the market will be elected.  This is a bad part of the Presidential Cycle.  Boo!

Take a step back, and ask how you would want your portfolio positioned for a moderate pullback, where you can’t predict how long it will take or last.  Also ask how you would like to be positioned for the market to return to its recent highs over the next year.  Come up with your own estimates of likelihood for these scenarios, and others that you might imagine.

We work in a fog.  We don’t know the future at all, but we can take actions to affect it, and our investing results.  The trouble is, we can adjust our risk profile, but our ability to know when it is wise to take more or less risk is poor, except perhaps at market extremes.  Even then, we don’t act, because we drink the Kool-aid in those ebullient or depressed environments.  We often know what we should do at the extremes, but we don’t listen.  There is a failure of the will.

This is a bad season of the year.  September and October are particularly bad months.  Boo!

I often say that there is always enough time to panic.  Well, let me modify that: there’s also always enough time to plan.  But what will you take as inputs to your plan?  Look at your time horizon, and ask what investment factors will persistently change over that horizon.  There are factors that will change, but can you see any that are significant enough for you to notice, and obscure enough that much of the rest of the market has missed it?

Yeah, that’s tough to do.  So perhaps be modest in your risk positioning, and invest with a margin of safety for the intermediate-to-long-term, recognizing that in most cases, the worst case scenario does not persist.  The Great Depression ended.  So did the ’70s.  Valuations are higher now than in 2007.  (Tsst… Boo!)  The crisis in 2008-9 did not persist.

That doesn’t mean a crisis could not persist, just that it is unlikely.  Capitalist systems are very good at dealing with economic volatility, even amid moderate socialism.  Go ahead and ask, “Will we become like Greece?  Argentina?  Venezuela?  Russia?  Spain?  Etc?”  Boo!

It would take a lot to get us to the economic conditions of any of those places.  Thus I would say it is reasonable to take moderate risk in this environment if your time horizon and stomach/sleep allow for it.  That doesn’t mean you won’t go through a bear market in the future, but it will be unlikely for that bear market to last beyond two years, and even less likely a decade.

Photo Credit: Dr. Wendy Longo || This horizon is distant...

Photo Credit: Dr. Wendy Longo || This horizon is distant…

I ran across two interesting articles today:

Both articles are exercises in understanding the time horizon over which you invest.  If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets.

Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell.  Some people don’t have much choice in the matter.  They have retired, and they have a lump sum of money that they are managing for long-term income.  No more money is going in, money is only going out.  What can you do?

You have to plan before volatility strikes.  My equity only clients had 14% cash before the recent volatility hit.  Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened.  That flexibility was built into my management.  (If the market recovers enough, I will rebuild the buffer.  Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.)

If an older investor would be hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term.  With a higher level of bonds in the portfolio, he could more than proportionately draw down on bonds during a crisis, which would rebalance his portfolio.  If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then.  That also would rebalance the portfolio.

Again, plans like that need to be made in advance.  If you have no plans for defense, you will lose most wars.

One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time.  When the time for converting assets to cash is far distant, using a single point may be a decent approximation.  When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi) Monte Carlo simulations, and sensitivity analyses are done must reflect that.

Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement.  The same would apply to an early spike in inflation rates followed by deflation.

The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes.  If it doesn’t include the Great Depression, it is not realistic enough.  Run them forwards, backwards, upside-down forwards, and upside-down backwards.  (For the upside-down scenarios normalize the return levels to the right side up levels.)  The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions.  History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner.

You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time.  Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there.

One more note: and I know how to model this, but most won’t — in the Great Depression, the returns after 1931 weren’t bad.  Trouble is, few were able to take advantage of them because they had already drawn down on their investments.  The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns.  They had to be lower, because many people could not hold their investments for the eventual recovery.  Part of that was margin loans, part of it was liquidating assets to help tide over unemployment.

It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low.  That’s not all that much different than some had to do in the recent financial crisis.  Now, who is willing to throw *that* into financial planning models?

The simple answer is to be more conservative.  Expect less from your investments, and maybe you will get positive surprises.  Better that than being negatively surprised when older, when flexibility is limited.

Photo Credit: edkohler || Buy Now and smile!

Photo Credit: edkohler || Buy Now and smile!

 

One of my clients asked me what I think is a hard question: When should I deploy capital?  I’ll try to answer that here.

There are three main things to consider in using cash to buy or sell assets:

  • What is your time horizon?  When will you likely need the money for spending purposes?
  • How promising is the asset in question?  What do you think it might return vs alternatives, including holding cash?
  • How safe is the asset in question?  Will it survive to the end of your time horizon under almost all circumstances and at least preserve value while you wait?

Other questions like “Should I dollar cost average, or invest the lump?” are lesser questions, because what will make the most difference in ultimate returns comes from  the above three questions.  Putting it another way, the results of dollar cost averaging depend on returns after you put in the last dollar of the lump, as does investing the lump sum all at once.

Thinking about price momentum and mean-reversion are also lesser matters, because if your time horizon is a long one, the initial results will have a modest effect on the ultimate results.

Now, if you care about price momentum, you may as well ignore the rest of the piece, and start trading in and out with the waves of the market, assuming you can do it.  If you care about mean reversion, you can wait in cash until we get “the mother of all selloffs” and then invest.  That has its problems as well: what’s a big enough selloff?  There are a lot of bears waiting for rock bottom valuations, but the promised bargain valuations don’t materialize because others invest at higher prices than you would, and the prices never get as low as you would like.  Ask John Hussman.

Investing has to be done on a “good enough” basis.  The optimal return in hindsight is never achieved.  Thus, at least for value investors like me, we focus on what we can figure out:

  • How long can I set aside this capital?
  • Is this a promising investment at a relatively attractive price?
  • Do I have a margin of safety buying this?

Those are the same questions as the first three, just phrased differently.

Now, I’m not saying that there is never a time to sit on cash, but decisions like that are typically limited to times where valuations are utterly nuts, like 1964-5, 1968, 1972, 1999-2000 — basically parts of the go-go years and the dot-com bubble.  Those situations don’t last more than a decade, and are typically much shorter.

Beyond that, if you have the capital to spare, and the opportunity is safe and cheap, then deploy the capital.  You’ll never get it perfect.  The price may fall after you buy.  Those are the breaks.  If that really bothers you, then maybe do half of what you would ultimately do, but set a time limit for investment of the other half.  Remember, the opposite can happen, and the price could run away from you.

A better idea might show up later.  If there is enough liquidity, trade into the new idea.

Since perfection is not achievable, if you have something good enough, I recommend that you execute and deploy the capital.  Over the long haul, given relative peace, the advantage belongs to the one who is invested.

If you still wonder about this question you can read the following two articles:

In the end, there is no perfect answer, so if the situation is good enough, give it your best shot.