Tag Archives: Retirement planning

Zoom Out

Time brings perspective, and now might be a good time to reflect on that. This month has been exhausting for investors. The damage is relative. If you invested last month and need to sell now, you might have a problem. But if you are a prudent investor with a 3 to 5-year time horizon, I think you’ll be just fine. This is normal volatility. For perspective, consider the following views of the S&P 500.

First, consider how you feel. The chart below shows a 5-day view. Pretty lousy, huh?

Next, we’ll zoom out to a 3-month view. Not much better.

Now let’s see how the index has done over the past 12 months.

As the above chart shows, it has been like a roller coaster, but it is still positive. Now let’s zoom out to the 2-year view. I think most investors would be pleased with the 29% gain they would have received from the SPY, an ETF that tracks the total return of the S&P 500 including dividends. These charts show just the index, excluding dividends.

Finally, here’s the 5-year view that shows the accumulation of retained earnings created by millions of people going to work every day. This is more like it. Now our scary stock market looks more like a not so uncommon speed bump along the way to greater prosperity.

Exhale and have a nice day!

Charts from Yahoo Finance. Past results are not guaranteed. Investing involves risk, including loss of principal.

Recession Strategy

I am seeing a lot of ink about how to prepare for the next recession. Clients want to know what we’re doing to prepare. Investment companies are asking me which funds I think are best for the next downturn.

The real issue is not how deep the correction will be. The real concern is the duration of the decline. How long will it take to get back to even? The problem is not that the stock market will go down. The real problem is if you need to sell stock when valuations are low to fund current living expenses. That converts a temporary loss of capital into a permanent loss of capital.

I’ve been investing since the 1970’s. My education and career have focused on economics and finance. What have I learned? In my view, valuation risk is easy to observe, but timing a correction is still difficult. I recognized that the S&P 500 was overvalued in 1998, but it doubled again before getting cut in half in 2000. I observed in 1999 that the market would either go down by 50% or trade sideways for 10 years while earnings caught up. I had no idea I would be right on both counts. Despite that, a diversified portfolio including small cap, international and bonds fared much better.

Systemic risk is harder to recognize. I didn’t see the 2008 crisis coming. But it really wasn’t a stretch to see what asset class was overvalued, i.e. real estate. But then you needed to understand that banks and credit agencies were operating in a corrupt system underwritten by government agencies, that mortgage defaults would create a downward spiral as underwater homeowners defaulted, forcing prices ever lower.

We accept the unpredictable nature of corrections, and that unique circumstances precipitate them. Today, credit seems to be the most mispriced asset class, driven by government intervention. But bonds are math, and the effects of normalization should be more moderate than a speculative equity correction unless there are forces involving leverage that are not on my radar – like the mortgage security market. Still, the recovery of the past 10 years made staying invested worthwhile. We just needed to hedge for liquidity needs over the next 3 to 5 years to emerge unscathed.

What does all this mean? I believe that a heightened level of concern about the next recession or correction is healthy. As investors de-risk portfolios, valuations will be earnings driven, and that’s a good thing for fundamental investors. Certainly war, policy mistakes, and scandal can impact markets, but these events have nothing to do with the duration of a market expansion. They can happen at any time, so why should the risk seem greater now?

My favored strategy continues to be the bucket approach. One of the key benefits of a financial plan is that it identifies anticipated liquidity needs. Given that most market downturns are resolved in less than 3 to 5 years, it is prudent to establish reserves equal to your liquidity needs in something with less risk than the stock market. Accepting risk in the short-term is gambling, and gambling with what you can’t afford to lose is a bad idea. Investors have time on their side as companies continue building wealth even while the market doesn’t always correlate with that. Be prepared, be vigilant, and stay the course until fundamentals indicate otherwise.

“WE’RE BUYING STOCKS THIS MORNING, AND I’D RATHER BUY THEM CHEAPER, BUT I’VE BEEN BUYING STOCKS SINCE MARCH 11th, 1942, AND I REALLY, I BOUGHT THEM UNDER EVERY PRESIDENT, SEVEN REPUBLICANS, SEVEN DEMOCRATS I’VE BOUGHT THEM QUARTER AFTER QUARTER. SOME OF THE BUYS WERE TERRIFIC, SOME OF THEM WEREN’T AT SUCH GOOD TIMES AND I DON’T KNOW WHEN TO BUY STOCKS, BUT I KNOW WHETHER TO BUY STOCKS, AND ASSUMING YOU’RE GOING TO HOLD THEM, WOULDN’T YOU RATHER OWN AN INTEREST IN A VARIETY OF GREAT BUSINESSES THAN HAVE A PIECE OF PAPER THAT’S GOING TO PAY YOU 3% IN 30 YEARS OR SHORT TERM DEPOSIT THAT PAYS YOU 2% OF THE SORT.” WARREN BUFFETT, August 30, 2018

Investing involves risk, including loss of principal. Past results do not guarantee future results.

How High is too High?

What difference 3 quarters makes! The S&P 500 is up 14.2% year-to-date, and 4.5% in the 3rd quarter. After the initial Trump rally, nearly everyone, myself included, expected some type of correction. The market continues to brush-off geopolitical concerns. While North Korea might make for scary headlines, the markets are voting that it is unlikely to have a real adverse impact on corporate earnings.

Stocks sell at a multiple of current earnings. The multiple depends on how the market views future earnings. The question of how high the market can go is to ask how much the businesses in the index are worth.

The good news is that there really is not a limit. If a working man puts $5 in a jar every day and does not die, how much is the jar worth? I can calculate how much you should pay for this man’s savings today, but over time, the answer is unlimited.

This is not to suggest the market can’t be overvalued because it can be. Rather, there is no number that represents an absolute limit. I believe the market is moving higher because we have an administration that is pro-business and focused on tax reform. Fiscal spending is also becoming a factor.

There is room for further gains, but corrections will happen. Volatility is the price of equity returns, and that’s been missing for the most part. Stay the course but plan for liquidity.

Managing Volatility in Growth Portfolios

In normal times you might own bonds for either of two reasons.  You might enjoy the regular income from interest payments, or you might own them for the stability they add to an equity portfolio.

Neither of those reasons carry the usual appeal with today’s ultra-low interest rates.  If you’re counting on bonds for income, you are going to need to own a lot more bonds.  While bonds add stability, the total return will be reduced when interest rates eventually move to higher, normal levels.  Neither reason is particularly compelling these days, although the stability factor is more compelling given stability in a quick equity correction.

The bond market is not uniform.  Some parts of the bond market have less exposure to interest rate risk.  Additionally, the proliferation of alternative strategies offers investors a wide array of tools for managing risk in today’s macro driven investment climate.

Much has been written about various types of risk, and that is not the focus of this essay.  My purpose is to explain an approach to managing equity market risk in the current low-interest rate environment.

Liquidity is important.  Let’s take the case of the Brexit induced market decline that began last Friday.  Over two days the Dow lost about 900 points as stunned markets went into “sell first, ask questions later” mode.  If you believed, as I did, that the world economy was not poised for mass suicide, and that cooler heads would prevail as hysteria faded, you might have been inclined to sell some of those bond positions to buy equities at distressed prices.

If those bond or alternative positions were in mutual funds, the cash would not be available for trading until the next day.  Using margin is not a bad strategy, since you can execute a purchase locking the price before the bond fund sale is complete.  If you wait until the next day, the price could be higher.  It could have gone lower too, but that’s speculation.  If you want to control the trade, you want to make timely buy and sell decisions.

Using hedge positions in ETF format eliminates the liquidity problem.  Unfortunately, many of the better bond funds and hedge strategies are based on active management, and hence not available in ETF format.  There is no perfect solution.  If the main objective is performance relative to a benchmark, for a fixed/alternative portfolio component, then the mutual fund liquidity problem can be overcome with judicious use of margin.  If the objective is to hedge a richly valued market in a world fraught with macro risk, then bond sector ETF’s can fit the bill.

Then again, in a rich market, cash is an attractive asset class.  To paraphrase Charlie Munger, a good way to get rich is to put $5 million in a checking account and wait for a good crisis.

Random Thoughts on Investing and Politics

Which way is the market going?  If you listen to the news, you will be a pessimist, since most news is negative.  But if you pay attention to quarterly earnings reports and long-term earnings trends, you will be an optimist.

Businesses are organizations of people who get up every day to create value for customers, with profits flowing to the owners of the company as the reward for their ingenuity and placing capital at risk.  If and when profits decline, the owners and management take corrective action.  In the extreme, they might liquidate the business to avoid further loss of capital, freeing capital and labor resources for redeployment in more productive enterprise.

In 1776, Adam Smith coined the term “Invisible Hand” in a book “An Inquiry into the Nature and Causes of the Wealth of Nations”.  In it he wrote, “Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it … He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”

Government intervention often impairs the efficient deployment of resources and the creative destruction of inefficient enterprise.  Subsidies and taxes distort economic incentives and reduce the efficient allocation of resources.  The invisible hand is not an outdated classical concept.  It is the natural phenomenon that guides free markets.  Capitalism drives scarce resources to their most productive use.

Socialism short circuits the resource allocation process of capitalism, removing the invisible hand from sectors of the economy.  Without a profit motive, inefficiencies tend to grow unchecked.  While segments of society may be protected, you end up with a smaller pie.

The political pendulum swings between the left and the right.

On Raising the Fed Funds Rate

When you’re drinking beer, the goal can be to drink more.  That’s a problem for some people.  They do not recognize their disequilibrium.  Putting the glass down might not bring immediate gratification, but it is simply the right thing to do with any normal, long-term perspective.fredgraph Fed Funds Rate

The Fed needs to get off the sauce.  Current interest rates compromise reasonable capital allocation, and encourages uneconomic decisions.  The longer the distortion persists, the greater the risk.  Any investment decision that gets squeezed out because of a .25% interest rate increase, at current rates, was a bad idea anyway.  That represents net positive for the economy by discouraging inferior projects and speculation.

Interest rates are the cost of money.  It shouldn’t be virtually free.

Social Security: Take or Defer?

I crunched the numbers on the question of deferring Social Security for a year to increase the payment by 8%, for each year it is deferred to age 70.  Most advice seems to favor deferral, unless health is an issue.

My numbers do not necessarily support that conclusion.  While the 8% increase can be viewed as a compelling guaranteed return, it also comes with a long payback.  The breakeven of deferring, if the safe investment rate is 3%, is about 17 years.  This may be the best case for waiting.

On the other hand, recipients with other sources of income might be able to invest their social security payments at a rate competitive with the 8% Social Security escalator.  In this case, there is little benefit for deferring.

In summary, if the first year’s SS payment is invested and earns 8%, then it is equal to the first payment if deferral is elected.  This process repeats for all payments, so the payment streams are equal.  When we consider a safe money reinvestment rate, there is a small benefit to deferral, but the payback period is long.  The decision is not as clear as I’d assumed.

My spreadsheet (in PDF format, so no formulas) is here, https://www.daltonfin.com/wp-content/uploads/2015/06/Take-or-Defer-Spreadsheet-Analysis.pdf.

Observations on Variable Annuities

A 64-year-old woman asked her financial advisor, “Why is the annuity a good idea?”  He replied that it gives her what she wants, a guaranteed income.  That is the key.  His approach solves problems by giving people what they want.  Wants are emotionally based.  Needs are comparatively fact-based.

Rather than pander to emotional desires, I try to convince clients to do what I would do if I were in their situation.  A fiduciary does not begin with the emotional component as the objective.

As interest rates increase over the next few years, it will be easier to generate income from a diversified portfolio.  While interest income will be taxed as ordinary income, capital gains and qualified dividends are currently taxed at lower rates.  Lower expenses, the step-up in basis for non-qualified (not in a retirement plan) assets, and access to a much wider investment universe are benefits of regular investing versus an annuity.

She is concerned about negative media. She believes everyone is expecting a market correction.  I responded that if most people are bearish, then that would be baked into prices already, reducing the risk of a correction.  Negative sentiment is healthy.  Exuberance is dangerous.  Markets are counter-intuitive, which explains why emotional investing is a bad idea.A Balanced Fund vs S&P 500

As reference, the above chart illustrates a popular, low-cost balanced fund (the blue, top line).  The 2000 – 2002 correction barely registers as a dip with the balanced fund.  The blue line shows that a 3 to 5-year reserve fund would have been sufficient to avoid selling at a loss during the 2008-2009 crisis.  The fund’s performance suggests that concerns referencing the last 2 major bear markets are more about the unknown than they are grounded in fact.  This is not unlike children being afraid of the monster under the bed.

The orange line below the blue line represents the S&P 500.  Investing in only the S&P 500 is not a good idea, but that seems to be the straw man argument many insurance companies use to sell annuities.

Finally, consider the commission.  How much is it and where does it come from?  This is not alchemy.

Past performance is not a guarantee of future results. Investing involves the risk of principal.  The chart illustrates the performance of a popular balanced fund from January, 1999 to April 27, 2015.  The fund may hold up to a 75% equity allocation.  The chart is intended to illustrate the performance of a diversified portfolio relative to the S&P 500 during the 2000 – 2002 and 2008 – 2009 bear markets.  Diversification does not guarantee against loss.  The balanced fund is the Dodge and Cox Balanced Fund, and the data is from Morningstar.

How to Prepare for the Next Crash

First let’s define “Crash”.  To most, the term implies a decline of severe magnitude. A key question is the duration of the impairment, or how long might it take to recover?  Another consideration is stock market valuation.

By my observation, there hasn’t been a stock market crash in the US in the last hundred years that began with stocks at historically reasonable valuations that persisted more than 5 years.  The risk of a crash depends on valuation.  The average PE ratio in 1929 was about 60 times earnings. Fifteen or sixteen is widely considered average, and implies a 6.25% to 6.67% earnings yield.  That’s reasonable.  Today, the PE for the S&P 500 is was 18.94 on 9/26/2014 according to the Wall Street Journal, and that’s a little above normal.  It implies expectations that the economy and growth will continue to accelerate from the anemic post mortgage crisis recovery.

So how do you prepare, just in case?  The conventional approach to hedging the stock market is to incorporate bonds to a portfolio.  You own bonds for either of two reasons; either you need income, or you want to reduce the volatility of a portfolio.  Currently the ability of bonds to generate income is diminished by Fed policy.  While bonds may still provide some stability in the event of a crash, it is widely recognized that interest rates are likely to rise and that will reduce the value of outstanding bonds with fixed coupons.  Choose your poison.

An alternative strategy is to focus on the likely duration of a downturn in the stock market, and plan for expected liquidity needs for that amount of time.  A key benefit of financial planning is that it identifies liquidity needs.  During a period of low interest rates, one can substitute a reserve strategy, often called the Bucket Approach, to provide for anticipated liquidity needs for as long as a crash/correction might be likely to persist.  This frees the remainder of the portfolio for management with a longer time horizon, and with focus of fundamental metrics like valuation and macroeconomic factors.

A Better Financial Planning and Investment Process

When you meet with a financial planner, you might expect to answer a series of questions designed to measure your risk tolerance.  If you are a moderate risk investor, you’ll get a portfolio constructed to accept moderate volatility.  If you are conservative, you’ll get a safe portfolio with limited growth potential.  In other words, your emotional state dictates your investment strategy.

Emotional investing does not often lead to good outcomes.  As an investor, I believe emotions can be your worst enemy.  Evolution wired us as herd creatures based on the safety of numbers.  Straying from the herd is dangerous.  We seek affirmation, which leads to the tendency to buy high and sell low.  According to research from Morningstar Inc., investors routinely underperform the funds they invest in. It is hard to make money doing what everyone else is doing, but we like to buy things after they’ve already demonstrated good performance.

Investing based on an assessment of emotional condition puts disposition at the forefront of investing strategy.  This seems to be the way the financial planning profession approaches investment advice.

I believe that the most important aspect of financial planning is identification of goals and the liquidity required to fund those goals at the right time.  Rather than build the portfolio around an emotionally based risk number, I suggest starting with a rational assessment of liquidity needs.  The greatest risk is having to sell a security when the price is temporarily depressed, converting a temporary loss into a permanent loss.  Let’s address that risk by planning for liquidity events.  The remaining balance can be invested to maximize returns rather than pander to your emotional state.

Emphasize fundamentals like Warren Buffett.  Make tactical adjustments based on fundamentals, and try to keep emotions out of the equation.