Tag Archives: wealth management

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.

Rearview Mirror

In December, 2008, a client transferred his account to my practice.  He was in cash.  I advised that he had a special opportunity to, in all likelihood, double his account in about 5 years by buying cheap stocks during a market panic.  I couldn’t convince him.  He was nervous.  Just when I thought I’d saved him from himself, he ordered me to sell everything I’d implemented, on March 6, 2009.  Perfectly bad timing.  C’est la vie.

Since the U.S. stock market hit bottom on March 9, 2009, the S&P 500 Index had risen 248% as of the first quarter of this year. In little more than six years, the present bull market achieved third-place rank among the top 10 bull markets.

Bull Market Chart

 

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, since you cannot invest directly in an index.

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.

The Benefits of Rebalancing

If stocks historically have higher returns than bonds, then selling stocks to buy bonds reduces portfolio returns over the long-term.  Conversely, for those with the fortitude to sell bonds and buy stocks when there’s blood in the streets, the process reverses.  The effect is more likely reduced volatility than increased returns.

I’d rather build a portfolio by planning for liquidity needs rather than putting the client’s emotional IQ in control of his asset mix by managing to control volatility.  Warren Buffett doesn’t rebalance.  I prefer to manage risk in the context of valuation.  That, I can control.

Great Ideas, Bad Timing

The stock market is setting new highs, but fundamental economic data remains subpar. For the past several years, we have expected “next year” to finally break out to a GDP growth rate of at least 3%, representing an escape velocity to grow our way out of the credit crisis doldrums.

The zero interest rate policy sustains the slow growth scenario, but there is only so much Fed monetary policy can do. The fundamental problems are fiscal in nature, and until Washington decides business and rich people are not the cause of the problem, we’ll continue to trudge along. Policies to stimulate business and job creation would be a nice start. Can you name one pro-business policy? Requiring businesses to offer health-care helps some people with medical issues, but does it stimulate job creation? Raising the minimum wage has noble intent, but if you are running a business, you’ll sharpen your pencil again before expanding.

No one can say how long the divergence between disappointing GDP growth and a rising stock market will last. Either the economy’s pent up demand overcomes Washington’s bureaucracy and grows faster, or we’re in for a correction. Let’s ignore the possibility of change in Washington for the meantime.

The key takeaway is, plan for liquidity, lean toward equity with the balance, and hope Washington will get out of the way. Lyndon Johnson pushed his Great Society programs at the same time as he funded the Vietnam War. We had a miserable decade in the stock market. Obama is pushing social reforms at the same time we try to recover from a credit crisis. Great ideas, bad timing.

Boutique vs Enterprise Wealth Management

I run a boutique wealth management practice.  There is a trend toward bigger firms using a team approach with relationship managers, investment specialists, financial planners, attorney’s and tax professionals on staff. They bring vast resources to the table.  More expertise and experience must be better, right?  Maybe not.  These large advisory firms are not built to enhance the relationship between client and advisor.  Rather, they are designed as scalable models of efficiency to build and manage ever-growing piles of assets.  An advisor’s ego is directly correlated with the amount of assets his firm manages.  It is the measure of success in the industry.

I believe a firm of specialists compartmentalizes the firm’s view of the client. 

The challenge for the client is finding a financial advisor competent in the areas they need.  Investment management and financial planning are my specialties.  If tax or legal assistance is required, I have seasoned relationships that may serve clients better than restricting the choice to whoever a large firm brings on staff. If the investment advisor and the financial 

planner are not in the same body, something will get lost in their communication.  Maybe not in the quantified financial planning report, but in the emotional tone or body language the client showed in the planning interview.

Who’s really calling the shots and who answers the phone when you call?