Financial planners often work with averages. But the reality is that each bear market will be different from the norm. At the time that I write this, the depth of this particular drawdown does not even rank with the worst in history. Sure, it may still get worse, but that’s where we are today.
We may not want to hear about how things will get better, because the situation with the Covid-19 pandemic and its resulting prescription of social isolation and market downdrafts is scary. But, eventually, things will get better.
Keep in mind that things may get worse before they get better. The count of people with the virus will almost certainly increase. If you don’t have a source yet, you can keep up with it over here. But eventually, the Coronavirus epidemic will run out of steam. We will get back to our places of work. Kids will go back to school. Financial markets will right themselves out. We will revert to standard toilet paper buying habits. We will start going out to eat again. Life will become normal again.
Financially, the question is not just how bad will things get, but how long it will take for our nest eggs to rebuild, so we can put our lives back on tr
Hence, it could take us a while before we make it back to the previous market peak. However, we may want to look at the data differently. This graph shows that, historically, we have needed to achieve a return of 46.9% to recover from a bear market . According to Franklin Templeton calculations, these numbers can look daunting. However, they have been achieved and exceeded after every past downturn. While there is no guarantee, these numbers suggest that there will be strong returns once we have reached the bottom of the market. I like to think of this as an opportunity.
With the time that it takes for investments to grow and get your money back, there is time to take advantage of higher expected returns. For those who have resources available, this means that there is time to deploy your money at lower prices than has been possible in recent months.
Those of us who have diversified portfolios and are not in a position to make new investments, the opportunity is to rebalance to benefit from a faster upswing.
We know from history that every US stock market downturn was followed by new peaks at some point following.
Could this time be different?
Of course, that too is possible.
I like to think that the future will be better. We will still wake up in the morning looking to improve ourselves, make our lives better, and achieve our goals. We are still going to invent new technologies, fight global warming, and struggle for a more equitable society.
We are living through difficult times right now. Losses in our brokerage and retirement accounts are not helping. But we will get through this. Please reach out to me if you have specific questions or concerns.
These individuals no longer have the luxury of a steady paycheck, and unless they are one of the lucky ones with a defined benefit plan and/or a large portfolio of liquid investments, they will have to dip into their 401k’s and savings to fund their lifestyle.
Somebody in the de-accumulation phase will naturally worry about how long their money will last and whether they can maintain their lifestyles.
Let’s look at the data. According to the Social Security Actuarial Life Table (2014) estimates, life expectancy for a 65 male is 17.81 years and for a female 20.36 years. Somebody in above average health may live even longer – these are just median numbers. If you want to conduct your own calculations, you can refer to How Long Will You Live?
David Blanchett of Morningstar uses the 2012 Society of Actuaries annuity table to estimate the likelihood of living to a certain age using the methodology outlined in his 2013 FPA journal article. This cohort of individuals comes from a higher than average socio-economic group and tends to live longer than average.
Table 1 highlights the calculations from the perspective of a 65-year-old. There is a 50% chance that a male lives to age 89 with a female living to age 91.
Some people retire with very healthy nest eggs that, barring a cataclysmic event, will provide plenty of cash to fund their lifestyles. They need not worry much as long as assets vastly outstrip expenses. They have a high margin of safety.
For most retirees, however, the margin of safety provided by their financial assets in relation to their expenses is slimmer. They do need to worry about how much they are spending, how their investments are performing and how long they may need their portfolio assets to last. They may have other sources of income such as Social Security but still need to make their investment portfolios work hard to bridge the gap between lifestyle expenses and sources of income.
Most people in retirement face a balancing act
They can control their expenses to some extent (putting off non-essential expenses). They can plan and make sure that their investment portfolios are structured in accordance with their appetite and need for risk-taking (maybe requiring the help of a financial professional). But what they can’t control are capital market returns and how long they need to tap into their retirement accounts (how long they will live).
One way to identify the various trade-offs required to ensure the sustainability of an investment portfolio is to come up with a CHRIS, a Comprehensive Holistic Retirement Investment Strategy with the help of a financial professional. A good plan should clearly outline what actions you need to take and what type of minimum portfolio return you will need to achieve to ensure that the probability of running out of money before you or your partner/spouse die is within your comfort zone.
Another alternative is to forego a formal financial plan and utilize some sort of rule of thumb such as William Bengen’s 4% rule. According to this highly popular rule published in 1994, you can safely withdraw 4% of your capital every year in retirement. The research contains a number of key assumptions (such as a 50/50 stock/bond allocation) often ignored in the popular press, but the Bengen rule is not only well known but popular among many retirees.
Milevsky and Robinson provide a simple approach in their highly touted article “A Sustainable Spending Rate without Simulation” to calculating what they call the “probability of ruin.”
Milevsky and Robinson identify three important factors: your rate of consumption, the risk/reward structure of your portfolio, and how long you live. Visually, these concepts can be illustrated in a Retirement Finances Triangle as depicted in Figure 1.
Without going into the mathematics of the Milevsky and Robinson approach for calculating a “probability of ruin” lets us think a bit more deeply about what makes retirement planning complicated in the first place.
The first aspect that makes retirement planning difficult is the uncertainty surrounding how long you and your spouse/partner are going to live. People are living longer, on average, than in previous generations. But an average does not necessarily help you. Your physical and mental health could be dramatically different from the “average” individual.
The other variable that is highly uncertain and makes retirement planning more difficult relates to the variability of investment outcomes on your retirement portfolio. While history is a guide as to what to reasonably expect in terms of key asset class returns and risks over the long-term, in any given year returns could fall within a wide range.
As most people already know, stock returns exhibit more variability in outcomes than bonds. The “probability of ruin” calculation using the Milevsky and Robinson formula incorporates the ability of individuals to evaluate the implications of various forms of asset allocation with varying levels of expected risk and return.
As you have probably figured out by now, calculating the “probability of ruin” is extremely important in planning your retirement.
To make the situation more realistic let’s look through the eyes of George and Mandy, both aged 65 and about to retire from their corporate jobs. They have saved diligently over the years and now have a portfolio worth $1,000,000 that they will tap to fund their lifestyle in retirement.
George and Mandy estimate that they will need $90,000 a year to maintain their lifestyle. Their Certified Financial Planner has also told them that their Social Security income will be $50,000 a year. They face an annual gap of $40,000. They expect to tap into their retirement portfolio to fund this gap.
They are in reasonably good health and based on discussions with their financial planner they assume that they will live to age 90. To be safe, they assume a retirement horizon of 30 years.
Their starting portfolio value is $1,000,000 and they wish to withdraw $40,000 a year to fund their living expenses.
Capital Market Assumptions:
We assume that inflation will run 3% per year, on average. Currently, inflation is running a bit lower than 3% in the US but the historical average is only slightly north of 3%.
What sort of investment risk and return assumptions should people use to calculate the probability of running out of money under this scenario?
For illustrative purposes only, Insight Financial Strategists has aggregated all the asset class risk and return numbers into six multi-asset class strategy portfolios according to investment risk – Conservative, Moderate Conservative, Moderate, Moderate Aggressive, Aggressiveand the industry convention of a 60/40balanced strategy.
Source: Insight Financial Strategists
Let’s start out gently – the Case of No Uncertainty:
It always helps to start off with a hypothetical scenario where all decision elements are known with certainty up front. We assume that George and Mandy own a 60/40 portfolio returning 4.9% per year and an annual inflation rate of 3%.
If they were to withdraw the equivalent of $40,000 a year in inflation-adjusted terms what would the required distribution look like over their retirement years?
Source: Insight Financial Strategists
The red line in Figure 1 depicts what would happen to their expenses in retirement if inflation were to rise every year by 3%.
What started off as a withdrawal of $40,000 turns into a much larger number over time. For example, after ten years they would need to withdraw $52,000 each year to fund their lifestyle (assuming that their Social Security checks are adjusted annually for inflation as is the current practice).
After 20 years they would need to withdraw $70,000 from their portfolio each year and after 30 years (their last year in their calculations) the number would increase to $94,000 annually. Inflation can sure take a bite!
In terms of George and Mandy’s portfolio, the assumption is that it will yield 4.9% per year or in inflation-adjusted terms, 1.9% per year. After withdrawals are taken out of the portfolio by George and Mandy to fund their lifestyle net of portfolio returns (the assumed 4.9% nominal return per year) the assumed value of the portfolio is depicted in Figure 2.
Source: Insight Financial Strategists
At the end of the 30th year, the portfolio is expected to be worth $277K. As long as George and Mandy only live 30 years in retirement and the assumed inflation and portfolio returns prove spot on (accurate) then things should be ok. They will glide through retirement and even have some assets left over.
The problem occurs if either George and/or Mandy live past age 95. According to the actuarial data in Table 1, there is a 25% chance that George will live to age 99 and Mandy will live to age 101.
Now what? Their current $1,000,000 portfolio is now insufficient to fund their retirement expenses past the age of 97. They will run out of money and not be able to rely on portfolio income anymore.
What could they do to prevent such an unpleasant outcome?
For starters, they could spend less. For example, they could cut back their annual spending to $30,000.
They could also shoot for higher portfolio returns by taking on a bit more investment risk. George and Mandy understand that higher portfolio returns are not generated out of thin air. Higher prospective returns are tied to higher risks.
But does the real world work like this?
Is it just a matter of pulling some levers here and there and voila you have wished for the perfect outcome?
Unfortunately, referring to the Retirement Finances Triangle depicted in Figure 1 although there are some things that George and Mandy can control such as their expenses but when it comes to how long they will live and how their portfolio will actually perform over their retirement years there are lots of unknowns.
Let’s deal with the real world – Introducing Uncertainty:
What if George and/or Mandy live longer than the assumed 30-year lifespan? This is what professionals refer to as longevity risk. Living a high quality, long life is a very noble and common goal. Outliving your assets is a real fear.
What if portfolio returns do not measure up to our assumed returns? This is referred to as investment risk. What happens if investment returns are significantly below expectations and portfolio income proves insufficient to maintain your desired lifestyle? Most retirees seek some margin of safety in their investments for this exact reason.
The Milevsky and Robinson formula is designed to take these uncertainties into account by modeling the likely distribution of portfolio returns and longevity. The end output is a probability of running out of money at some point in time over the retirement horizon. They refer to this number as the “probability of ruin”.
Let’s start by looking at the implications of the various portfolios strategies presented in Table 1. The Conservative strategy is the least risky approach but also has the lowest prospective returns. This strategy is exclusively composed of bonds.
The Aggressive strategy is exclusively composed of equities and is expected to have the highest returns as well as the highest risk of all of our strategies.
The 60/40 strategy falls along the middle in terms of prospective portfolio returns and risk.
What do the different risk and return profiles of the strategies imply in terms of the probability of ruin of George and Mandy’s portfolio?
Figure 3 depicts graphically the output from the Milevsky and Robinson formula.
Source: Insight Financial Strategists
What immediately jumps out from the bar charts is that the probability of ruin for the various portfolios is quite high. No longer assuming that everything is perfect creates, not surprisingly, more difficult likely outcomes.
For example, if George and Mandy were to employ the Conservative strategy yielding an assumed 2.3% annual return there is an 80% probability of them running out of money at some point in retirement. Being conservative has its drawbacks!
What if they had the internal fortitude to employ the all-equity Aggressive strategy yielding a prospective return of 6.8% with a volatility of 17%? Their probability of ruin would drop to 37%.
Even if they employed the conventional 60/40 strategy, their probability of ruin would still exceed 45%.
What if the probability of running out of money is too high?
Well, for starters they could reduce their rate of consumption, i.e. spend less. Maybe not what they wanted to hear but possible.
Let’s assume that instead of taking out $40,000 a year from their investment accounts they withdraw only $30,000? Let’s also assume that they invest in the traditional 60/40 portfolio. The only thing that has changed from the previous scenario is that now George and Mandy are spending only 3% of their initial portfolio to fund their lifestyle.
By spending less and thus depleting their investment assets at a slower rate, they lower their probability of running out of money at some point over their remaining lives to 30%. George and Mandy start thinking that maybe searching for a more inexpensive vacation option makes sense and allow them to worry less about outliving their assets.
Source: Insight Financial Strategists
What else can they do to shift the odds in their favor?
Besides spending less, another option is to work a bit longer and postpone their retirement date. Let’s say they both work five years longer than originally planned. What would happen assuming that they still intend to withdraw $40,000 in portfolio income and they invest in the 60/40 strategy?
Source: Insight Financial Strategists
By delaying retirement for five years George and Mandy lower the probability of running out of money to below 38%. Not bad but maybe not quite to their satisfaction.
Could George and Mandy restructure their investment portfolio to improve their odds?
Yes, that is certainly a feasible approach as we already outlined in Figure 3. Higher return strategies carry higher risk but when held over the long-term tend to lower the probability of running out of money.
But not everybody is equally comfortable taking investment risk even if it is likely to result in higher ending portfolio values over the long-term.
Is there another approach to design a more suitable retirement portfolio?
While risk and return are inextricably intertwined, recent financial research has identified the “low volatility” anomaly where lower volatility stocks outperform their higher volatility cohorts on a risk-adjusted basis. See this note for an introduction to the low volatility anomaly.
Let’s say that instead of assuming a 10.4% volatility for the 60/40 portfolio we are able to utilize a mixture of similar investment vehicles designed to exhibit lower levels of volatility but equivalent returns. Say the volatility of this strategy is now 8.4% and uses a range of lower volatility fixed income and equity approaches plus possibly an allocation to a guaranteed annuity.
Figure 6 illustrates the implications of using the lower volatility investment strategy. The probability of ruin goes down marginally to below 42%. Good but not great in the eyes of George and Mandy.
Source: Insight Financial Strategists
What else can George and Mandy do?
After all, they have evaluated the impact of lowering their expenses, deferring their retirement date and structuring a more suitable investment portfolio and they still are uncomfortable with a probability of ruin in the 30% range.
The short answer as in many areas of life is to do a bunch of small things. They could elect to just lower their spending from 4% to 3% and the probability of running out of money would drop to about 30%.
But George and Mandy realize that they could do even better by doing all three things:
Working a bit longer
Structuring a more suitable investment portfolio
Figure 7 highlights the various alternative courses of action that they could take to increase the odds of not running out of money in retirement.
Source: Insight Financial Strategists
There are no guarantees in life, but spending less, delaying retirement and designing a more suitable portfolio lowers the probability of running out of money to about 20%.
While we all strive for control, George and Mandy are comfortable with this approach and the sacrifices required. To them leading a fulfilling life in retirement is more than just about money and sacrificing a bit in order to gain peace of mind is a worthwhile trade-off.
What does calculating the probability of running out of money in retirement teach us?
Is the trade-off that George and Mandy are making appropriate for you? Maybe, but maybe not. At the very least, understanding your own circumstances and your own probability of running out of money may lead to vastly different choices.
Your retirement could extend for 30+ years. Having enough resources to fund your retirement is important to maintain your lifestyle and achieve peace of mind.
While much of life is beyond our control, everybody can still exert some influence over their retirement planning. In this article we highlighted three general strategies:
Adjusting your spending
Delaying when you tap your retirement resources
Designing an investment portfolio that suitably balances risk and reward
As people enter retirement, they can’t eliminate either longevity or investment risk. What they can do is manage the risks and remain open to adapting their plan should things change.
At Insight Financial Strategists we don’t believe in shortcuts. A CHRIS, a Comprehensive Holistic Retirement Income Strategy, gives you the best chance of full understanding your circumstances and what needs to happen to fund your lifestyle in retirement.
Barring a full financial plan, at a minimum people should evaluate the likelihood of running out of money. Applying the Milevsky and Robinson formula represents a starting point for an in-depth conversation about your needs, goals and especially your attitude toward risk and capacity to absorb losses.
Interested in having the professionals at Insight Financial Strategists guide you? Please request a complimentary strategy session here.
Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.
This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including the risk of loss.
There’s been a lot of sideways action in this year’s capital markets. We have had a couple of mini-corrections already but equity markets have done a remarkable job of ignoring some clouds on the horizon.
What started back in February as aluminum and steel tariffs has delved into a war of words and escalation of tariffs between the world’s three largest economies of the US, China and Europe.
There is almost a sense of disbelief that this could be happening after decades of globalization. We are so used to the free flow of goods and services across borders that we hardly ever stop and think about where things are made.
Is a Toyota Camry Japanese or a “Made in the USA” car from a company that so happens to be domiciled in Japan? Is your iPhone an American product or a product made in Asia for a US-based company?
Global companies such as Apple or Toyota operate in highly inter-linked global supply chain and sales channels. A trade war will be highly disruptive to global trade and manufacturing.
Making Your Post-Divorce Portfolio Reflect the New You
Divorce is the final step of a long process. Whether the marriage was long or short, the end of marriage brings about the conclusion of an important phase of your life.
Divorce is an emotional event sometimes anticipated years in advance and at other times coming totally out the blue.
In all cases whether anticipated or not, divorce is a stressful event. According to the Holmes-Rahe Life Stress Inventory Scale divorce ranks as the second most stressful event that a person can experience in a lifetime.
For one, the dollar amounts are less than before and your current investment strategy reflects your goals as a couple rather than your own objectives going forward.
Moreover, most likely your confidence is a bit shot and your desire to take much investment risk is lower than before.
Ok, are you with me? You can control this aspect of your new life. What steps should you take to get the ball rolling?
We suggest an approach rooted in our P.R.O.A.C.T.I.V.E methodology.
The first step involves thoroughly examining your new situation from a non-financial standpoint. Where do you want to live? What type of lifestyle are you looking for? If you have children what type of issues do you need to account for?
The second step is to re-evaluate your comfort with taking investment risk. Now that you are solely in charge of your financial life how do you feel about taking on risk? Are you comfortable with the inevitable stock market swoons that occur periodically? Are you able to think as a long-term investor given your recent divorce?
The next step is really important. Your post-divorce portfolio needs to work for you. Establishing a hierarchy of financial objectives will drive the type of strategy that is most appropriate for you.
Is your primary objective to save for retirement? Do you have any major objectives besides retirement? Maybe you need to fund college tuition for your two kids. Maybe you plan on buying a new home in 2 years once your life has settled down?
Next you need to deal with the nitty gritty of figuring out exactly what you own and cash flow budgeting. What you own should not be difficult to figure out as you have just gone through the divorce process.
The second part of cash flow budgeting is often highly sensitive for people not used to budgeting during their marriage. If you have never had a budget or stuck to one this step seems like a major imposition. But unless money is so plentiful you have no choice.
At least for a period of time you will have to keep track of your expenses and gain an understanding of where the money is going. The reason this is important is that you may need to tap into portfolio gains to fund your living expenses. If that is the case, your portfolio should be structured to write you a monthly check with a minimal amount of risk and tax consequences.
The next step in the P.R.O.A.C.T.I.V.E process is to evaluate your tax situation. If you are in a high tax bracket you might want to favor tax-advantaged investments such as municipal bonds. If your income is going to be taking a hit post-divorce you probably will end up in a lower tax bracket increasing the attractiveness of a Roth conversion to your traditional individual retirement account.
The last three steps all involve figuring out how best to construct your investment portfolio. Going from your pre-divorce portfolio to something that fits your needs and goals will usually require some major re-adjustments in your strategy.
Going through our P.R.O.A.C.T.I.V.E process or a similar approach is probably the last thing you want to do on your own. Most likely you will need the help of an advisor to work through this.
Keep in mind that the reason you are doing this is to regain control over your financial life. You sought the help of a lawyer during your divorce. Now is the time to move forward and seek the help of financial professionals with an understanding of your situation and new set of needs.
What is the best way to implement a portfolio strategy for newly divorced people?
The most important aspect of post-divorce portfolio is that it fits you and your new circumstances and desires. Using our P.R.O.A.C.T.I.V.E methodology as a framework for evaluating your needs and desires we suggest implementing a portfolio structure that encompasses three “buckets”.
A “bucket” is simply a separate portfolio and strategy that has a very specific risk and return objective. Each bucket in our approach is designed to give you comfort and clarity about its role in your overall portfolio.
What is the role of these “buckets”?
Each “bucket” has a very specific role in the overall portfolio as well as very explicit risk and reward limits.
We label our three “buckets” as the Safe, the Purchasing Power and the Growth portfolios.
The role of the Safe Bucket is to provide liquidity and cash flow to you to meet your short-term lifestyle needs. How much you have invested in your Safe portfolio is a function of how much money you need to fund your lifestyle over the next few years.
The second bucket – the Purchasing Power portfolio – is designed to allow you to enhance your lifestyle in terms of real purchasing power. What this means is that every year your portfolio should have a return exceeding inflation.
Finally, the third bucket – the Growth portfolio – is designed to grow your portfolio in real terms. This portfolio is designed to maximize your returns from capital markets and will be almost exclusively invested in higher risk/higher reward equity securities.
Going through divorce is one of the most stressful situations anyone can face. Transitioning to a new beginning may take a short term for some but for most people the period of adjustment is fraught with uncertainty and doubt.
People often worry about their finances and whether they can maintain their lifestyle. A life event such as divorce also tends to shorten people’s horizon as their outlook in life often lacks clarity.
The implications from an investment standpoint are primarily a temporarily diminished desire to take on portfolio risk and a shortening of time horizons. In English this translates to searching for greater certainty and not looking too far out.
Our P.R.O.A.C.T.I.V.E approach is designed to make your money work for what you deem important. Divorce is difficult and transitioning to a new beginning takes time. As you adjust to your post-divorce life your financial assets will also need to be managed consistent with the new you.
At Insight Financial we are experts at guiding you through this difficult adjustment period and transition into a new beginning. To read our full report on our approach for managing your post-divorce investments please click here.
Our wealth management team at Insight Financial Strategists is ready to help you in your transition. To set up an initial consultation please book an appointment here.
Investment risk is an inevitable part of capital markets.
Markets do not just go up as much as we wish for that to be always the case.
Sometimes capital markets experience stress and the draw-downs can be extremely uncomfortable to investors.
How investors react to periods of capital market stress is incredibly important.
Become too aggressive and you could end up with major short-term losses and your financial survival may be at stake.
On the other hand, become too cautious and you may end up excluded from any future capital market appreciation.
So, if risk is inevitable, what can you do about it? Being either extremely aggressive or extremely risk-averse are probably the least desirable options especially if you wait to act until there is a market meltdown.
In the first case, you may not be able to stay invested as short-term losses cripple your psyche and your pocketbook. Even though you believe in your investments, your emotions will be tugging at you and second-guessing you. This is the curse of being too early.
In the case where people become too risk-averse, being too cautious prevents you from making up the losses experienced during periods of capital market stress by participating in the good times. Most likely you second guess yourself and by the time you take the plunge back in you have probably already missed out on some large gains. This is the curse of being too late.
Investing is not easy especially when things go against you in the short-term. It is best to understand what you are getting yourself in and have a plan for when things go awry. As Mike Tyson once said, “everybody has a plan until they get punched in the nose”.
Getting punched in the nose is not an uncommon experience for stock market investors. For bond market investors the experience is not as common but it still happens.
Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan. A great game plan is useless unless you have the ability to withstand the dark periods.
Investors are frequently confused by capital market behavior.Over the short-term asset classes can go almost anywhere as investment sentiment is usually a strong driver of returns. Market pundits attempt to provide some rationale for why things are moving in a certain direction, but in reality, most of what goes on from day to day in capital markets is usually nothing more than noise.
Markets are prone to bouts of over-confidence where all the bad news gets ignored and investors appear overly upbeat. Other times, markets will be laser-focused on negative short-term events of little economic significance and investors will become overly pessimistic. Even seasoned investment professionals feel sometimes that there is no rhyme or reason for what is happening to financial asset prices.
Over longer-term horizons, asset class fundamentals start being reflected in prices as investment sentiment becomes secondary. Profits, valuations, profitability, growth potential become the drivers of prices. Periods of stress are frequently forgotten and appear as mere blips on historical price charts.
One of the key tenets of long-term investing is that risk and return are inextricably tied together. Without any risk, you should not expect any incremental returns. Investing is inherently risky as outcomes – short or long-term – cannot be predicted with total certainty.
Most investors understand that, on average, stocks do better than bonds but that the price of these higher returns is a lot more risk. Investors also understand that longer-maturity bonds will do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.
But beyond this high-level understanding of capital market behavior, there is lots of confusion. Gaining a better understanding of key asset class risk and return relationships will help you become a better-informed consumer of investment strategies.
Understanding what you are getting yourself in when evaluating different investment strategies could significantly alter your wealth profile for the better and allow you to take advantage of market panics rather than simply react to crowd psychology like most people.
To become an informed consumer of investment strategies the first step is understanding key asset class risk and return tradeoffs. We use a dataset kindly provided online by Professor Aswath Damadoran at NYU to look at calendar year returns on US stock, bond and bill returns. Bond returns proxy for a 10-year constant maturity US Treasury Note and bills correspond to a 3 month US t-bill. US stocks are large capitalization stocks equivalent to the S&P 500. Figure 1 depicts the annual asset class returns since 1937.
The first thing that jumps out from the chart is the much higher level of return variability of stocks.
The second thing that jumps out is the incredible year over year smoothness of T-bill returns. Bonds are clearly somewhere in between with volatility characteristics much more similar to bills.
The third thing that jumps out are the rare but eye-popping large equity market meltdowns such as during 1937, 1974, 2002 and 2008. Lastly, of notice are the very large positive spikes in equity returns during years such as 1954, 1958, 1975, 1995 and 2013.
What is not entirely clear from looking at the yearly return chart is the huge cumulative out-performance of stocks relative to both bonds and bills. Table 1 provides summary statistics on calendar year returns for each asset class.
Over the 1928-2017 period, stocks have returned on average 12% per year with an annual standard deviation of 20% year. Bonds are next in line with an average return of 5% and a volatility of 8%. Bills have had the lowest rate of return at 3% with a volatility of 3%. These numbers correspond to the usual risk/reward relationships that investors know all about.
In 27% of the years between 1928 and 2017, stocks have had a negative return. The average return when the market has gone down is -14%. Nobody likes losses but even bond investors saw negative returns in 18% of the years and when they happened the average loss was -4%. The only way never to lose money in any given year is to invest in bills.
If one had invested $100 in December 1927 and held that investment the ending portfolio value would be $399,886 – a huge rate of growth despite the infrequent yet terrifying equity market meltdowns. Bonds don’t come even close with an ending portfolio balance of $7,310. Playing it safe with bills would have yielded a portfolio value of $2,016.
From a cumulative wealth perspective, stocks are clearly the superior asset class but only if the investor is able to stomach the rare but large equity drawdowns and seeing losses in over a quarter of the years.
If the investor is seeking stability with no chance of principal loss, T-bills are the preferred asset class. The rewards compared to stocks will be meager, but the ride will be smooth and predictable.
What happens when you extend the holding period out to, say 10 years? Does the spikiness of stock market returns disappear? What about the frequency of down years?
Using the same data set as before and forming rolling 10-year holding returns starting in 1927 we observe in Figure 2 that some of the volatility of stocks and bonds has dissipated. Instead of spikes we now have mountains and slopes.
The chart on rolling 10-year returns exposes the massive cumulative out-performance of stocks during most ten-year holding periods. There are instances of negative 10-year stock returns (6% as shown in Table 2) but they are swamped by the mountain of positive returns especially when viewed in relation to bond and bill returns.
We see only three periods when equity investors would have loved to play it safe and be either in bonds or bills – the early years post the Great Depression (1937-39), the Financial Crisis (2008-9), and economic stagnation and inflationary years starting in the mid-70s through the beginning of the equity bull market of 1982. In the first two instances, equity holders lost money. In the latter instance, equity investors enjoyed positive returns but below those of either bonds or bills.
Some observations are in order:
As one extends the holding period from 1 to 10 years some of the spikiness of one-year returns is smoothed out – not every year is fantastic and not every year is terrible, periods of stress are usually followed by periods of recovery and so on
Over a ten year holding period stocks do not look as scary – only in 6% of our observations do we see a negative return. When those losses occur the average loss is 10% on a cumulative basis.
Rolling 10-year maturity bonds every year over a decade yields no periods in our sample where the strategy exhibits a loss. The same holds true for bills.
Investors able to extend holding periods from short to longer maturities such as ten years significantly lower their odds of seeing negative returns as confirmed in the empirical data
What happens when we mix and match asset classes? Does that help lower our probability of loss? We look at some typical multi-asset class mixes over one-year holding periods:
The 60/0/40 portfolio composed of 60% stocks and 40% bonds – a traditional industry benchmark
The 40/0/60 portfolio composed of 40% stocks and 60% bonds – a moderately conservative mix
The 25/50/25 portfolio composed of 25% stocks, 50% bills and 25% bonds – a conservative mix for a very risk-averse investor
Mixing asset classes is usually referred to as multi-asset class investing. The premise for such an approach is based on the diversification benefits afforded by allocating in varying proportions to asset classes with their own unique risk and return characteristics.
It turns out that over the 1928-2017 period stocks were essentially uncorrelated to both bonds and bills. The correlation between bonds and bills was 0.3. Building portfolios with lowly correlated asset classes is hugely beneficial in terms of lowering the volatility of the multi-asset class mix.
What are the main conclusions that we can reach when mixing asset classes with widely different risk and return characteristics?
When combining stocks, bonds, and bills in varying proportions we arrive at portfolio results that fall between those of equities and bonds
The traditional 60/0/40 portfolio had a lower frequency of negative returns compared to an all-equity portfolio, significantly lower volatility and a cumulative ending portfolio value only about a 1/3 as large. What you gain in terms of lower risk, you lose in terms of compound returns.
The 40/0/60 portfolio which represents a lower risk alternative to the investor lowers volatility (to 9%) but at the expense of also lowering average returns (to 8%) and especially cumulative wealth (ending value of $58,090)
The lowest risk multi-asset class strategy that we looked at – the 25/50/25 portfolio – had the lowest average returns (6%), lowest volatility (6%) and lowest long-term growth.
A key implication of multi-asset investing is by combining asset classes with disparate risk and return characteristics you can build more attractive portfolios compared to single asset class portfolios
Comparing two traditionally low-risk portfolios – 100% bonds and the 25/50/25 portfolio – demonstrates the benefits of multi-asset class investing. The multi-asset class portfolio not only has higher average returns but lower risk. The frequency of calendar year loss is smaller (11% compared to 18%) and the long-term portfolio growth is over 2X that of the all-bond portfolio.
Three very significant lessons emerge from our study of asset class behavior that can vastly improve your financial health. The first relates to the holding period. Specifically, by having a longer holding period many of the daily and weekly blips that so scare equity investors tend to wash away.
Equity investments do not look as volatile or risky when judged over longer holding periods of say 10 years.
The second lesson relates to the power of compounding. Small differences in average returns can yield huge differences in long-term cumulative wealth. In terms of the multi-asset class portfolios – the 60/0/40 versus the 40/0/60 – yields only a 1% average return difference but a 2X difference over the 1928-2017 period.
Seemingly small differences in average calendar year returns can result in massive wealth differences over long holding periods.
The third lesson relates to diversification. By mixing together asset classes with varying risk and return characteristics we can significantly improve the overall attractiveness of a portfolio. Lower portfolio risk is achievable with proper diversification without a proportional sacrifice in terms of returns. Properly constructing multi-asset class portfolios can yield vastly superior outcomes for investors.
Every investor needs to come to terms with the risk to reward relationships of major asset classes such as stocks, bonds, and bills. Understanding the risk and return tradeoffs you are making is probably the most important investment decision affecting the long-term outcome of your portfolio.
Some investors can stomach the sometimes wild ride offered by stocks and choose to overwhelmingly use equity strategies in their portfolios. They don’t worry much about the daily vicissitudes of the stock market. They accept risk in return for higher expected returns.
Not everybody, however, can stomach the wild ride that sometimes comes from owning stocks despite understanding that over the long-term stocks tend to better than bonds and bills.
Some investors are willing to leave a bit of money (but not too much, please) on the table in return for a smoother ride. They may elect to hedge some of the risks. Or they may mix in varying proportions of risky and less risky asset classes and strategies.
Yet other investors are so petrified of losses and market volatility that they will forego any incremental return for the comfort and steadiness of a safe money market account. They choose to avoid risk at all costs.
Which is the better approach for you? Avoid all risks, save a lot and watch your investment account grow slowly but smoothly?
Or, take some risk, sweat like a nervous high schooler when capital markets go bust and grow your portfolio more rapidly but with some hiccups?
The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses to your wealth. If you already have a financial plan in place great. If you need help getting started or refining your plan, the team at Insight Financial is ready to share our expertise and bring peace of mind to your financial life. Book an appointment here.
Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan. In subsequent articles, we will be exploring different ways of managing risk and structuring portfolios.
Just two weeks ago the consensus was that we were going to experience a continuation of the bull market at least into the early part of this year. This is still our view. Although the stock market is a leading indicator, at this time this correction does not appear to be a recession driven correction.
The mental picture I use is that of flying. The six hour trip from Boston to LA is great when it is all smooth sailing. The plane seems to be flying itself and you pay more attention to the movie you are watching than thinking about the age of the aircraft or training of the pilot and crew.
But the first time there is a little air bump and maybe lighting strikes your plane you immediately tense up and fix your gaze on the crew. Are they calm? Do they seem competent? Is this their first rodeo?
You form a mental image of what you want your pilot to look like. Calm and collected for starters. But mainly experienced. We all want to see Captain Sully at the helm.
Clearly, we all would love smooth capital markets forever. But the close friend of return is always uncertainty. The two are inseparable even though they may not always be in direct contact. In times of turbulence you want experience at the helm and a solid understanding of how the two are intertwined.
How do we think of uncertainty in the capital markets? There are as many ways of defining uncertainty as there are opinions as to who the greatest quarterback in history is (we all know it is Tom Brady, right) but without hopefully appearing too cavalier we think that it is useful to think of uncertainty as a normal distribution of potential outcomes.
We fear the left tail where things go terribly wrong, we accept the middle of the distribution as textbook risk/return, and we think that our own brilliance (just joking) has led us to the right tail of the distribution.
In 2017 equities, in particular, had a monster year with the S&P 500 up over 25% and many international markets up even more. The year turned out much better than expected. What do we expect for this coming year?
Our baseline assessment is fairly benign as we discussed last month in our Capital Market Overview. A quick review is in order.
We expect equities to again do better than bonds. We also expect international assets to outperform domestic strategies. We expect robust global growth. Our most likely scenario for this year is for continued growth, subdued inflation and no major equity or bond market meltdown. In our judgement there is about an 80% probability that such a scenario plays out in 2018.
On the downside we expect the low volatility that has accompanied capital markets recently to once again revert back to risk on/off.
Our baseline assessment is fairly benign
We expect to see more large jumps in market prices caused by low probability events lurking in the left hand side of the distribution. The press calls these events Black Swans. Our best assessment is that there is about a 15% probability of seeing a Black Swan event in 2018.
On the other end of the uncertainty distribution you have what we call Green Swans – events, low in probability that when they happen are wildly positive for investors. We attach a 5% chance of experiencing such extreme positive events over the current calendar year
1. An inflation spike caused by a sustained rally in commodity prices
Inflation in the US is currently running a bit above 2% and market participants do not expect to see any major revisions over the next two decades (see the Philadelphia Federal Reserve estimate of inflationary expectations).
In our view, forecast complacency has set in and the risks are to the upside. Traders would describe the low inflation trade as over-crowded. Maybe it is time to re-think what happens if the consensus turns out to be wrong.
The immediate effect of an upward spike in inflation would be a rise in bond yields. Equities would probably take a short-term hit but the primary casualties would be found in the fixed income market.
What could cause a sustained surge in commodity prices? One, could be a supply disruption say in the oil market. Another could be related to the resurgence of global growth and continued demand for commodities such as iron ore and copper. Third, a depreciating US dollar leading to commodity price inflation.
2. A spike in capital market turmoil caused by a geo-political blowup
The blowup could be anywhere in the world but most political commentators point to North Korea and Iran as the most likely centers of conflict.
Another possibility is a cyberattack endangering public infrastructure facilities especially if it is sovereign sponsored. Third, Jihadi terrorism on a large scale and on high profile targets. And last, the outcome of the Special Counsel investigation into Russian meddling.
All of these events have blowup potential. While the probability of any of these events happening in 2018 is low, the magnitude of the capital market response is likely to be large and negative especially for equity markets. Global economic growth would also, no doubt, loose some of its momentum.
3. An avalanche of bond defaults in the apparel and retail industries in the US and/or a debt bomb crisis in China
It is no secret that the US apparel and retail sectors are going through massive consolidation driven in part by the shift to online shopping. It is widely acknowledged that the US retail market is over-built.
According to the Institute of International Finance global debt hit a record last year at $233 trillion. Debt levels as a percentage of global GDP are higher today compared to 2007. Figuring prominently in the debt discussion is China.
Global Debt Reaches a Record in Q3 2017 Source: IIF, IMF, BIS
The IMF recently issued a warning to the Chinese authorities about the rapid expansion of debt since the 2008 Financial Crisis. The rapid expansion in debt has funded lesser quality assets and poses stability risk for global growth according to the IMF.
Estimates by Professor Victor Shi at UC San Diego put Chinese total non-financial debt at 328 percent of GDP. Other estimates are even higher leading to an overall picture of rising liabilities and numerous de facto insolvencies. The robust GDP growth in China and the tacit understanding of the monetary authorities of the extent of the problem will hopefully keep the wolves at bay.
The implications of a debt scare for investors would be quite dire. Investors have had plenty of experience with debt crisis in recent years – Greece and Cyprus come to mind as Black Swan events that temporarily destabilized global capital markets. A Chinese debt scare would no doubt be of greater impact to global investors. Emerging market debt spreads would certainly blow up.
What about the right hand tail of the uncertainty distribution – the Green Swans?
These are wildly positive events for investors that carry a low probability of happening. What type of Green Swan events could we hope for that would lead capital markets to yet another year of phenomenal returns?
1. Positive global growth surprise possibly brought on by the recently enacted US tax reform
The US is the largest economy in the world and still remains a significant engine of global growth. Could we be surprised by a spurt in US economic growth this year?
According to the Conference Board US real GDP is expected to growth 2.8% in 2018. Could we see 4% growth? The President certainly hopes so. Not that likely. The last time that US GDP growth was above 4% was in 2000.
What could give us the upside scenario for growth? Maybe a jump in consumer spending (representing 2/3 of GDP) driven by real wage growth and lower taxes.
Another possibility is a surge in investment by US corporations driven by cash repatriations and recently enacted corporate incentives.
We view both scenarios as likely but providing only a marginal boost to growth. As they say we remain cautiously optimistic, but would not bet the farm on this.
2. A spurt in exuberant expectations driven by the cryptocurrency craze
Fear of missing out (FOMO) takes over repricing all investments remotely tied to the cryptocurrency craze along the way. We saw a similar scenario play out in 1999 in the final stages of the Technology, Media and Telecom (TMT) bubble.
In those days TMT stocks were no longer priced according to traditional fundamentals but instead on the idea that laggard investors would buy into the craze and drive prices even higher. Lots of investors succumbed to FOMO in the final stages of the bubble.
Photo by Ilya Pavlov on Unsplash
The recent price action of Bitcoin and most other cryptocurrencies has a similar feeling to the ending stages of the TMT bubble. It is almost as if Bitcoin and its cousins are being discussed along with the latest Powerball jackpot.
No doubt fortunes have been and will continue to be made in cryptocurrencies. Blockchain technology which underlies the crypto offerings is here to stay, but we worry about the lack of investor education and the speed of the price action in late 2017. Whatever happened to Peter Lynch’s “buy what you know” approach?
What would be our best estimate for capital markets should the cryptocurrency craze gain further momentum in 2018? First, technology stocks would continue out-performing. Chip suppliers such as Nvidia and AMD would continue to see massive growth.
Companies adopting blockchain technologies would see their valuations increase disproportionally. In general, animal spirits would be unleashed onto the capital markets making rampant speculation the order of the day. The primary beneficiary would be equity investors.
History tells us that it is almost certain that after 8 years of an economic expansion and stock market recovery we should see an outlier type of event in 2018. What shape and form it will take (or Swan color) we don’t know.
Preparing for tail risk events is very expensive and under most scenarios not worth bothering with.
Black Swans create great distress for investors, but the opportunity cost of playing it too safe is especially high today given prevailing interest rates that fail to keep up with inflation.
The fear of missing out (FOMO) during Green Swan events is also a powerful investor emotion. Again playing it too safe can result in many lost opportunities for capturing significant market up moves.
Investing in capital markets is all about weighting these probabilities and focusing on a small number of key research-driven fundamental drivers of risk and return.
How you structure your portfolio and navigate the uncertainties of capital markets is important to your long-term financial health. Putting a financial plan in place and having an experienced Captain Sully-type as your captain during times of turbulence should reassure investors in meeting their long-term goals.
Note:The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. Views expressed are the opinions of Insight Financial Strategists LLC as of the date indicated, based on the information available at that time, and may change based on market and other conditions. We make no representation as to the accuracy or completeness of the information presented. This communication should not be construed as a solicitation or recommendation to buy or sell any securities or investments. To determine investments that may be appropriate for you, consult with your financial planner before investing. Market conditions, tax laws and regulations are complex and subject to change, which can materially impact investment results.
Individual investor performance may vary depending on asset allocation, timing of investment, fees, rebalancing, and other circumstances. All investments are subject to risk, including the loss of principal.
Insight Financial Strategists LLC is a Registered Investment Adviser.
How to choose a financial planner is a question that vexes many people looking for one, even as a number of online resources address the topic. For instance, theFinancial Planning Association as well as a number of online resources in the financial and popular media offer advice on that.
I was prompted to think about this issue by a question I received recently
“Currently I am pulling about 4% on my trading accounts. These are probably below what is going on in the market, but that’s one of the reasons I am seriously looking at a financial adviser.
Do you have any empirical data (history) on what returns I could expect. I am a numbers type so that would definitely help me in my decision making process. “
It is a great question! Clients want results, and Financial Planners want results. The difficulty with using results to measure effectiveness, and as a benchmark on how to choose a financial planner, is that there are so many moving variables that using historical results to choose a financial planner is not effective. As the saying goes, there are lies, damn lies and then there are statistics.
Hence my answer:
Before answering the question “…we would need to work a little more on your objectives and your comfort with risk. An investment portfolio would have to reflect both. For instance, if you have a short term goal, you would want the money allocated to that goal to be in a lower risk investment allocation. If you have a long term goal, you would want the opposite. Then, could you compare the performance of the two? They would be like apples and oranges, so probably not.
Now if you and I had the same long term goal, should we be invested in the same way? Only if we have the same attitudes toward risk, ie how we feel when the market goes down. Depending on our respective comfort with risk, you and I would have different asset allocations. Could you compare the performance of our two asset allocations? It would be like comparing a red delicious with a granny apple. Sort of the same thing, but not quite.
With regard to your results, I assume that they are year to date. Compared to a S&P 500 return of 19.33% year to date on 9/23/2013, a 4% return year to date would be reflective of a fairly conservative asset allocation with relatively little risk. In a stock trading situation, your 4% probably came with taking substantial risk.
My job as a financial planner is to understand your goals and your comfort with risk. Then I can propose an investment allocation and investments that efficiently help you reach your goals with the appropriate amount of risk.
In summary, I could provide you with numbers, but they would not be meaningful without the underlying context of where they came from. Chances are they will be better than some other financial planners’, and worse than some others. In and of itself that would not be meaningful, and, in my opinion, you should not rely on those numbers to decide how to choose a financial planner.”
Chances are your retirement plan offers one or more stock funds to choose from. If it is consistent with your investment objectives and your investment risk tolerance, you may want to consider investing a portion of your plan in an aggressive growth fund.
Risks and Rewards
Aggressive growth funds, as the name indicates, are stock funds that are growth-oriented. Included in aggressive growth funds are several options like “small-cap” funds, “emerging market” funds, as well as various kinds of international funds. Aggressive growth funds tend to invest in smaller, fast-moving companies in developing sectors with the potential for rapid growth (hence the name), such as high-tech or biotechnology. They may also invest in equities that have fallen out of favor on Wall Street, but appear ready for a comeback.
Because they invest in companies that are often less known and not as established as the companies that make up the Dow Jones Industrial Average (DJIA), aggressive growth funds tend to exhibit volatile behavior. For instance, when the market goes down, an aggressive growth fund may go down more than the DJIA. Conversely, when the market goes up, aggressive growth funds often go up more. The goal of aggressive growth funds is to achieve higher returns than other stock funds.
Aggressive growth funds are best suited for long-term investors with the intestinal fortitude to bear the market’s worst downturns while seeking the strongest returns. For example, an investor may want to allocate some of his or her portfolio to aggressive growth funds to potentially accumulate as much as possible over a long time horizon. These funds may be especially suitable for younger investors with 25, 30, or 35 years until retirement.
Don’t Forget Diversification
Regardless of how aggressively you would like to invest, keep in mind the crucial benefits of allocating your money across investments that behave differently.
If you invest in an aggressive growth fund, you may want to balance its inherent risk with investments that have different risk characteristics such as growth and income funds, bond funds, and money market funds.
A financial planner can help you determine the investment allocation that’s best suited for you and your goals.