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.
It is health insurance plan signup season . Whether you subscribe to your employer’s health care insurance plan or you buy your own directly, it is the time of the year when you have to sign up all over again. Unless you have specific circumstances such as a change of employer, a divorce, or new baby, this is the one time in the year when you get to change your health care insurance plan.
If you have been keeping abreast of the popular financial media, you may have come across the Health Savings Account (HSA). According to AHIP (America’s Health Insurance Plans), 22 million people had HSA accounts in 2018. Financial Planners love HSA. It is potentially the most tax advantageous vehicle that exists. Contributions to HSAs are pre-tax, the money is invested tax-free, and distributions are tax-free if used for health purposes. Triple tax-free. HSAs are even better than Roth retirement accounts !
The reality is that we all have health care expenses, and they can be substantial . Having the ability to pay with tax-free money is a critical advantage. If you have to pay a $100 hospital invoice, you might have to earn $150 or more first, pay Federal income taxes, Social security taxes, state income taxes, before you can have $100 to pay your bill. With an HSA, there is no income tax, you pay with $100 of your earnings.
A Health Savings Account is effectively an alternative to the Flexible Spending Account (FSA) , the more traditional way to pay for health care expenses that are not covered by insurance. The FSA allows employees to save pre-tax from earnings, and then to spend it on health care expenses without paying taxes on the earnings. Money in FSAs, however, is not invested, and it must be spent by year-end or be forfeited. It has to be spent, or it will be lost. HSA funds, on the other hand, can be invested, and funds from HSA accounts can be carried over into the future. Thus, HSAs can be spent in a way that is similar to other retirement savings accounts such as the IRA or the Roth IRA.
IRA
Roth IRA
529
FSA
HSA
Contributions are pre-tax
Yes
No
No
Yes
Yes
Funds are invested tax-free
Yes
Yes
Yes
N/A
Yes
Distributions are tax-free (1)
No
Yes
Yes
Yes
Yes
Distributions can be taken in the future
Yes
Yes
Yes
No
Yes
If used as intended for retirement, education or health expenses respectively
What’s in it for the employer?
In order to contribute to an HSA, you must have chosen a High Deductible Health Plan with your employer.
According to the IRS, for 2019, a high deductible is defined as $1,350 ($1,400 in 2020) for an individual or $2,700 for a family ($2,800 in 2020.) On top of this high deductible, annual out of pocket expenses (including deductibles, copayments, and coinsurance) cannot exceed $6,750 for an individual or $13,500 for a family. Those numbers increase in 2020 to $6,900 for an individual and $13,800 for a family.
For employers, offering high deductible health insurance plans is more cost effective than other plans. Therefore, they will prefer that their employees sign up for high deductible plans. Many employers will contribute directly to HSA accounts to encourage their workforce to choose a high deductible health insurance plan.
Theoretically, if employees have to pay out of pocket or out of their HSA for their health care expenses, they will be more careful about their choices. While the funds in the HSA remain available to be used for health care expenses immediately if needed, the designers of the HSA believe that the ability to carry over HSA balances to future years will motivate employees to be better health care shoppers when choosing treatments or, indeed, when choosing to be treated in the first place. The net result is that high deductible health plans help employers contain health care expenses, and shift the burden on their employees.
And how do you maximize the value of the HSA? By contributing to the maximum, and investing it. A dollar contributed may be worth many times its value in the future when invested.
The Internal Revenue Service allows individuals in 2020 to contribute up to $3,550 to their HSAs. Families may contribute up to $7,100. Both individuals and families can benefit from a catch-up provision of $1,100 if they are over 55.
If you are choosing the high deductible plan to save money, but you are not able to contribute to your HSA, you are putting yourself at risk if you have an unforeseen health event. Not having enough saved to cover the cost of the health care you need means that you may have to go into debt until you have met your plan’s deductible.
So, if you have a tight budget, please think twice before trying to save money with a high deductible plan. It may just backfire on you.
Unintended Consequences
A question that is often minimized at enrollment time is what happens to the HSA if you have miscalculated, and you happen to have a significant health care expense in the year that you are contributing?
First, if it is a major event, you may consider using funds in your HSA account. However the health care insurance will eventually kick in and cover most of the cost. So as a subscriber to a high deductible plan, you are still protected from the catastrophic consequences of an unexpected health issue. While you may not harvest all the benefits of the HSA, and you will likely lose the cost savings of choosing a high deductible plan, you are protected from financial disaster.
What if it is not a reallymajor event, just a somewhat major event like, say, a trip to the emergency room for a temporary issue that you will easily recover from?
In that case, you also have the option to use your funds in the HSA to pay for those expenses. Your contributions will have been pre-tax as with an FSA. You will not have enjoyed much investment growth. Your distribution will still be tax-free. You are giving up the future benefits of the HSA, but you are dealing with your more immediate issues. Basically, your HSA will have functioned like an FSA. You will also lose the savings benefits of choosing a lower cost high deductible plan over a higher cost low deductible plan.
What if instead, you decide to pay for your trip to the emergency room out of pocket with post-tax savings and save your HSA for the future, as your wealth manager told you that you should? The real cost of your $5,000 trip depends on your income and tax bracket. If you happen to be in the 32% Federal tax bracket and you live in Massachusetts, the cost of the $5,000 emergency room trip will be around 58% higher.
HSAs provide some tremendous benefits that should be considered by everyone who is looking to enhance their health care and their retirement situation. However, the decision to choose a Health Savings Account should be based on more than just taxes and the cost of your health care insurance. It is important to consider the very real costs of unforeseen events and to be realistic about your health insurance needs.
Maybe because we are working against a deadline, many year-end planning opportunities seem to be tax related . Tax moves, however, should be made with your overall long-term financial and investment planning context in mind. Make sure to check in with your financial and tax advisors.
1) Harvest your Tax Losses in Your Taxable Accounts
As of[ October 26, the Dow Jones is up 1.65%, and the S&P500 is up just 0.98% ]for the year. Unfortunately, many stocks and mutual funds are down for the year. Therefore you are likely to have a number of items in your portfolio that show up in red when you check the “unrealized gains and losses” column on your brokerage statement.
However, you can also offset your losses against gains. For example, if you were to sell some losers and hypothetically accumulate $10,000 in losses, you could then also sell some winners. If the gains in your winners add to $10,000, you have offset your gains with losses, and you will not owe capital gain taxes on that joint trade!
This could be a great tool to help you rebalance your portfolio with a low tax impact. Beware though that you have to wait 30 days before buying back the positions that you have sold to stay clear of the wash sale rule.
2) Reassess your Investment Planning
Tax loss harvesting is a great tactic to use for short-term advantage. As an important side benefit, it allows you to focus on more fundamental issues. Why did you buy these securities that you just sold? Presumably, they played an important role in your investing strategy. And now that you have accumulated cash, it’s important to re-invest mindfully.
You may be tempted to stay on the sideline for a while and see how the market shakes out. Although we may have been spoiled into complacency after the Great Recession, the last month has reminded us that volatility happens.
Take the opportunity to review your goals, ensure that your portfolio risk matches your goals and that your asset allocation matches your risk target..
3) Check on your Retirement Planning
It is not too late to top out your retirement account! In 2018, you may contribute a maximum of $18,500 from your salary, including employer match to a 401(k), TSP, 403(b), or 457 retirement plan, subject to the terms of your plan. Those who are age 50 or over may contribute an additional $6,000 for the year.
If you have contributed less than the limit to your plan, there may still be time! You have until December 31 to maximize contributions for 2018, reduce your 2018 taxable income (if you contribute to a Traditional plan), and give a boost to your retirement planning.
Alternatively to deferring a portion of your salary to your employer’s Traditional plan on a pre-tax basis, you may be able to contribute to a Roth account if that is a plan option for your employer. As with a Roth IRA, contributions to the Roth 401(k) are made after tax, while distributions in retirement are tax-free.
Many employers have added the Roth feature to their employee retirement plans. If yours has not, have a chat with your HR department!
Although the media has popularized the Roth account as tax-free, bear in mind that it is not. Roth accounts are merely taxed differently . Check in with your Certified Financial Planner practitioner to determine whether electing to defer a portion of your salary to on a pre-tax basis or to a Roth account on a post-tax basis would suit your situation better.
It is health insurance re-enrollment season! The annual ritual of picking a health insurance plan is on to us. This could be one of your more significant financial decisions for the short term. Not only is health insurance expensive, it is only getting more so.
First, you need to decide whether to subscribe to a traditional plan that has a “low” deductible or to a high deductible option. The tradeoff is that the high deductible option has a less expensive premium. However, should you have a lot of health issues you might end up spending more. High deductible plans are paired with Health Savings Accounts (HSA).
The HSA is a unique instrument. It allows you to save money pre-tax and to pay for qualified healthcare expenses tax-free. Unlike Flexible Spending Accounts (FSAs), balances in HSAs may be carried over to future years and invested to allow for potential earnings growth. This last feature is really exciting to wealth managers: in the right situation clients could end up saving a lot of money.
If you pick a high deductible plan, make sure to fund your HSA to the maximum. Employers will often contribute also to encourage you to choose that option. If you select a low deductible plan, make sure to put the appropriate amount in your Flexible Spending Account. FSAs are used to pay for medical expenses on a pretax basis. Unlike with an HSA, you cannot rollover unspent amounts to future years.
6) If you are past 70, plan your RMDs
If you are past 70, make sure that you take your Required Minimum Distributions (RMDs) each year. The 50% penalty for not taking the RMD is steep. You must withdraw your first minimum distribution by April 1 of the year following the year in which you turn 70 ½, and then by December 31 for each year after.
Perhaps you don’t need the RMD? You may want to redirect the money to another cause. For instance, you may want to fund a grandchild’s 529 educational account. 529 accounts are tax-advantaged accounts for education. Although contributions are post-tax, growth and distributions are tax-free if they are used for educational purposes.
Or, you may want to plan for a Qualified Charitable Distribution from the IRA and take a tax deduction. The distribution must be directly from the IRA to the charity. It is excluded from taxable income and can count towards your RMD under certain conditions.
7) Plan your charitable donations
Speaking of charitable donations, they can also be used to reduce taxable income and provide financial planning benefits. However, as a result of the Tax Cut and Jobs Act of 2017 (TCJA), it may be more complicated than in previous years. One significant difference of the TCJA is that standard deductions went up to $12,000 for individuals and $24,000 for married filing jointly. Practically what that means is that you need to accumulate $12,000 or $24,000 of deductible items before you can feel the tax savings benefit.
In other words, if a married couple filing jointly has $8,000 in real estate taxes and $5,000 of state income taxes for a total of $13,000 of deductions, they are better off taking the standard $24,000 deduction. They would have to donate $7,000 before they could start to feel the tax benefit of their donation. One way to deal with that is to bundle your gifts in a given year instead of spreading them over many years.
For instance, if you plan to give in 2018 and also in 2019, consider bundling your donations and giving just in 2019. In this way, you are more likely to be able to exceed the standard deduction limit.
If your thinking wheels are running after reading this article, you may want to check in with your wealth manager or financial planner: there may be other things that you could or should do before the end of the year!
Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented. To determine investments that may be appropriate for you, consult with your financial planner before investing. Tax laws and regulations are complex and subject to change, which can materially impact investment results. 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.We make no representation as to the completeness or accuracy of information provided at the websites linked in this newsletter. When you access one of these websites, you assume total responsibility and risk for your use of the websites to which you are linking. We are not liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, websites, information, and programs made available through this website.
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.
Figure 1
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.
The Setting:
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.
The Problem:
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?
Past returns are often a poor guide in forecasting returns and George and Mandy decide as a starting point to use the current Insight Financial Strategists long-term capital market assumed risk and return numbers as outlined in Table 2. These numbers are derived from expected long-term growth, profitability and starting valuation relationships. They should be viewed as purely hypothetical and subject to great variation.
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.
Table 2
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?
Figure 1
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.
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.
Figure 3
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.
Figure 4
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?
Figure 5
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.
Figure 6
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:
Spending less
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.
Figure 7
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.
We all think that we are fully rational all the time but in reality the way our brains operate that is not always the case.
One of the key functions of the brain is self-defense. When the brain perceives danger it makes automatic adjustments to protect itself. When it perceives discomfort it seeks to engage in an action that removes the stress.
In his book “Thinking Fast and Slow” Nobel Prize Winner Daniel Kahneman explains how we all have a two way system of thinking that we use to make decisions. He labels the two components as System 1 (Thinking Fast) and System 2 (Thinking Slow).
System 1 is automatic, fast responding and emotional. System 2 is slower, reflective and analytical.
Think of your System 1 as your gut reaction and your System 2 as your conscious, logical thought.
While we all like to think that our key life decisions are governed by our logical thought (System 2) research has shown that even major decisions are often driven by our gut feel.
Which System do we use to make a decision? That depends on the problem. If we have seen the problem many times before such as what to do when see a red light we default to our automatic System 1 thinking.
When we face a challenge or issue that we have not seen before or maybe infrequently we tend to use System 2, our more reflective and analytical capabilities.
Kahneman’s research shows that we spend most of our time in System 1. While most people think of themselves as being rational and deliberate in their decision making, the reality is that we often employ “short-cuts” or heuristics to make decisions.
Most of the time, these “short-cuts” work just fine but occasionally for more difficult or complex problems the impressions arrived from System 1 thinking can lead us astray.
Why? Above all else, System 1 thinking seeks to create quick and coherent stories based on first impressions. These impressions are a function of what our brain is sensing at that moment in time.
According to Kahneman, conclusions are easily reached despite often contradictory information as System 1 has little knowledge of logic and statistics. He calls this phenomenon – WYSIATI – for “what you see is all there is”.
The main implication from WYSIATI is that people often over-emphasize evidence that they are familiar with and ignore evidence that may be much more relevant to the problem at hand but that they are not fully aware of.
System 1 conclusions therefore may be biased and lead to decision “short-cuts” or heuristics that seriously impair the quality of a decision.
Often our brain perceives of the dangers first and sends us a warning signal to be careful. Losing money puts us on red alert.
Behavioral finance research (for example in the book Nudge) has shown that losing money makes you twice as miserable as gaining the same amount makes you happy. People are loss averse.
Loss aversion creates inertia. Inertia often works against investors that overvalue the attractiveness of their current holdings.
There are different degrees of loss aversion. According to Prospect Theory, all investors value gains less than losses but some exhibit an extreme dislike for potential losses that significantly hinders their long-term wealth creation potential.
Nobody likes to lose money, but taking on risk in order to compound your hard earned savings is an integral feature of how capital markets work. You don’t get a higher reward unless you take additional risk.
Most investors know that stocks do better than bonds over the long-term but that the price of these higher returns is more risk. Investors also understand that bonds do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.
But knowledge stored in your logical and analytical System 2 thinking does not always make it through in the face of stress or uncertainty.
People can become too risk averse for a couple of reasons:
Case A: They let their fears and emotions guide their investment decision making and give disproportionate importance to avoiding any losses
Case B: They fail to calibrate their expectations to the likely frequency of outcomes.
In Case A, investors seek the perceived safety of bonds often not realizing that as interest rates go up bonds can lose money. Or they simply pile into CD’s not realizing that their returns most often fail to keep up with inflation. Stocks are frowned upon because you can lose money.
Investors in Case A let their decisions be driven by emotion and fear and will over-value the importance of safety and under-value the importance of future portfolio growth. Their account balances will not go down much when capital markets experience distress, but neither will they go up much during equity bull markets.
In Case B investors mis-calibrate their expectations for various investment outcomes and the consequences can be as dire as in the first situation. Behavioral finance research has shown that investors frequently over-estimate the likelihood and magnitude of extreme events such as stock market corrections.
What are the implications for investors playing it too safe?
Let’s consider the case of investors currently working and saving a portion of their income to fund a long-term goal such as retirement. These individuals are in the accumulation phase of their financial lives.
Somebody in the accumulation phase will naturally worry more about how fast they can grow their portfolio over time and whether they will reach their “number”. People in the accumulation phase care primarily about their balances going up year after year. They are in “growth” mode.
The Hypothetical Setting:
To better illustrate this situation let’s look through the eyes of a recent college grad called Pablo earning $40,000 a year. Pablo is aware of the need to save part of his salary and invest for the long-term. He just turned 22 and expects to work for 40 years.
Pablo will also be receiving annual 2.5% merit salary increases which will allow him to save a greater amount each year in the future.
The Problem:
Pablo faces two key decisions – what percentage of his salary to save each year and the aggressiveness of his portfolio which in turn will determine its most likely return.
He is conflicted. He has never made this much money before and worries about losing money. He also understands that he alone is responsible for his long-term financial success.
Pablo knows that there is a trade off between risk and return but he wants to make a smart decision. His System 1 thinking is saying play it safe and don’t expose yourself to potential loses.
At the same time his rational and informed System 2 thinking is influenced by a couple of finance and economics classes he recently took while in college.
Pablo can succumb to automatic System 1 thinking and invest in a very conservative portfolio. Or he can rely on his System 2 thinking and invest in a higher risk and commensurately higher return portfolio.
One Alternative – Save 10% of his Income and play it safe investing
For simplicity sake assume that Pablo decides to put 10% of his salary into an investment fund. The fund consists primarily of high grade bonds such as those contained in the AGG exchange traded fund.
From the knowledge gained in his econ and finance classes Pablo estimates that this portfolio should return about 4% per year – a bit below the historical norm for bonds but consistent with market interest rates as of August 2018.
Pablo also understands that such a portfolio will have a bit of variability from year to year. He estimates that the volatility of this portfolio is likely to be about 6% per year. Again, this estimate is in line with current bond market behavior as of August of 2018.
He knows that this is a low risk, low return portfolio but the chances of this portfolio suffering a catastrophic loss are negligible. He is petrified of losing money so this portfolio might fit the bill.
How large could his portfolio be expected grow to over 40 years of saving and investing in this conservative manner? We built a spreadsheet to figure this out. We assumed a 4% portfolio return on principal, 2.5% annual salary increases and a half year of investment returns on annual contributions also at 4%. Remember that this is a hypothetical example with no guarantee of returns.
At the end of 40 years Pablo’s salary is assumed to have grown to $107,403 and his portfolio, invested in this conservative manner, would have a balance of $575,540. The growth of this portfolio (identified as 10_4) is shown in Figure 1. The naming convention for the portfolios corresponds to the savings rate followed by the assumed hypothetical rate of return on the strategy.
Figure 1
Source: Insight Financial Strategists, Hypothetical Example
Pablo knows that his portfolio will not exactly return 4% every year. Some years will be better, other years much worse but over the next 40 years the returns are likely to average close to 4%.
But Pablo does not feel comfortable just dealing in averages. If things go bad, how bad could it be?
Given the volatility of this conservative portfolio there is a 10% chance of losing 3.6% in any given year. These numbers are calculated by Insight Financial Strategists based on an approximation of a log-normal simulation and are available upon request. Not catastrophic but nobody likes losing money.
Figure 2 shows the 90th and 10th probability bands for this conservative portfolio. These bands are estimated based on the expected average return of the portfolio and its volatility.
The actual portfolio return would be expected to lie about 2/3 of the time within these bands. In the short-term, say 1 to 2 years out, the portfolio returns are more unpredictable. Over longer horizons, the average return to this conservative portfolio should fall within much tighter bands given the assumed risk and return numbers in the log-normal simulation.
Based on the calculations, the average returns over ten years should range between 6.3% and 1.4% per annum. Clearly, even this conservative portfolio has some risk especially in the short-term, but over longer holding periods returns should smooth out.
Figure 2
Source: Insight Financial Strategists
Another Alternative – Save 20% of his Income and continue investing in a conservative portfolio
Assuming the same 2.5% annual salary increases, the final salary would have been the same but his nest egg would have grown to $1,151,080. Pablo keeps looking at Figure 1 (the 20_4 line representing a 20% savings rate invested at an assumed 4%) and starts thinking that maybe a bit of extra saving would be a very good thing.
He still has a 10% probability of being down 3.6% in any given year, but if his budget allows, he feels that he can forego some frills until later.
Now, Pablo is starting to get excited and wonders what would happen if he invested more aggressively, say in a variety of equity funds?
Yet Another Alternative – Keep saving the same amount but invest more aggressively
The likely returns would go up but so would his risk. He estimates that based on current market conditions and the history of stock market returns (obtained from Professor Damodaran of NYU) that this more aggressive portfolio should have about an 8% annual rate of return with a volatility of around 14% per year. These estimates are both a bit lower than the 1926-2017 average reflecting higher current (as of August 2018) valuations and lower levels of overall market volatility.
He is thinking that maybe by taking more risk in his portfolio during his working years he will be able to build a nest egg that may even allow him for some luxuries down the road.
He also knows that things do not always work out every year as expected. Pablo is pretty confident that 8% is a reasonable expectation averaged over many years, but how bad could it be in any given year?
A log-normal simulation was conducted using the assumed risk and return numbers – same approach as before.
Figure 3 shows the 90th and 10th percentile bands for this portfolio.
Figure 3
Source: Insight Financial Strategists
Given the volatility of this equity-oriented portfolio, there is a 10% chance of losing 9.2% in any given year (based on the simulations). Ouch, the reality of equity investing is starting to sink in for Pablo.
But Pablo is also encouraged to see that his returns in any given year are equally likely to be about 26% or higher. That would be nice!
Especially when it comes to equities there is a wide range of potential returns but over time these year by year fluctuations should average out to a much narrower range of outcomes. While our best estimate is that this portfolio will return on average 8% per year over a ten-year window the range of expected outcomes should be between a high of 12.9% and a low of 1.6%.
Pablo decides to research the history of stock, bond, and cash returns by reading our April Blog on Understanding Asset Class Risk and Return and looking at a chart of long-term returns from Morningstar (Figure 4).
Figure 4
Source: Morningstar
He is surprised to find that over the long-term equities do not seem as risky as he previously thought. He is also quite surprised by the wide gap in wealth created by stocks versus bonds and cash.
The research makes Pablo re-calibrate his expectations and he starts wondering whether the short-term discomfort of owning equities is worth it in the long run.
Pablo’s System 1 thinking is on high alert and his first thought after seeing how much he could lose investing in equities is to run back to the safety of the bond portfolio.
But something tells him to slow down a bit and think harder. This is a big decision for him and his System 2 thinking is kicking in. Before he throws the towel in on the equity-oriented portfolio he glances again at Figure 1 to see what might happen if he invests more aggressively.
What he sees astounds him. It is one thing to see compounding in capital market charts and yet another to see it in action on your behalf. Small differences over the short term amount to very large numbers over long periods of time.
If Pablo were to invest in the more aggressive portfolio there would be more hiccups over the years but his ending account balance should be $1,440,075 if he consistently put aside 10% of his salary every year.
If he saved 20% the ending portfolio balance would double in size.
Decision Time – Picking among the alternatives
Pablo is now faced with a tough decision. Does he play it safe and go with the conservative portfolio? Or, does he go for more risk hoping to end up with a much larger nest egg but knowing that the ride may be rough at times?
Beyond the numbers, he realizes that he needs to look within to make the best possible decision. His System 1 thinking is telling him to flee, but his System 2 thinking is asking him to think more logically about his choices. He also needs to deal with how much he is planning to save from his salary.
Fear versus Greed:
He needs to come to terms with how much risk he is willing to take and whether he can stomach the dips in account balance when investing in riskier assets. As Mike Tyson used to say, “Everybody has a plan until they get hit in the face”.
In structuring his investment portfolio Pablo needs to balance fear with greed. Paying attention to risk is absolutely necessary but always in moderation and in the context of historical precedents. If Pablo lets his fears run amuck he may have to accept much lower returns.
With the benefit of hindsight, he may come to regret his caution. On the other hand, the blind pursuit of greed and a disregard for risk may also in hindsight come back to bite him. Pablo needs to find that happy medium but only he can decide what is right for him. Risk questionnaires can help in this regard. Try ours if you like!
Consumption Today versus Tomorrow:
Pablo also needs to come to grips with how much current consumption he is willing to forego in order to save and invest. We live in an impulse oriented society. Spending is easy, saving is hard.
Saving is hard especially when you are starting out. On the other hand, over time the saving habit becomes an ingrained behavior. The saving habit goes a long way toward ensuring financial health and the sooner people start the better.
Will Pablo be able to save 10% of his salary? Or, even better will he be able to squeeze out some additional expenditures and raise his saving to 20%?
If possible Pablo should consider putting as much money in tax-deferred investment vehicles such as a 401(k). He should also have these contributions and any other savings automatically deducted from his paycheck. That way he won’t get used to spending that money. Pablo may come to see these deductions from his paycheck as a “bonus” funding future consumption.
“The greatest mistake you can make in life is to continually be afraid you will make one”
— ELBERT HUBBARD
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Lessons Learned:
This has been an eye-opening experience for our hypothetical friend Pablo. He was not expecting such a difference in potential performance. He now realizes the importance of maximizing saving for tomorrow as well as not succumbing to fear when investing for the long-term.
He has learned several invaluable lessons that also apply to individuals in the accumulation phase of their financial lives
Lesson 1: The Importance of Saving
Delaying consumption today allows you fund your lifestyle in the future
Saving even small amounts makes a big difference over the long-term
Lesson 2: The value of patience and a long-term perspective
In the early years you may not notice much of a difference in portfolio values
Keep saving and investing – disregard short-term market noise and stick to a plan
Lesson 3: Small differences in returns can amount to huge differences in portfolio values
Seemingly tiny differences in returns can result in large differences in portfolio values
Compounding is magic – take advantage of it when you can
Lesson 4: The importance of dealing with your fear of losing money
Letting your first instinct to avoid risky investments dictate what you own will work against you
Investing involves risk – best to manage rather than avoid risk
The pain and agony of losing money in any given year is alleviated over the long term by the higher returns typically accruing to higher risk investments
Lesson 5: Investing in your financial education pays off
Gaining a proper understanding of capital market relationships is an invaluable skill to possess
Leaning on financial experts to expedite your learning is no different than when athletes hire a coach
Avoid all risks, save a lot and watch your investment account grow slowly but smoothly? Or, take some risk and grow your portfolio more rapidly but with some hiccups?
Are a couple of restless night’s worth the higher potential returns in your portfolio? On
Also, are you willing to delay some current consumption in order to invest for the future?
The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses.
Interested in having the professionals at IFS identify your risk tolerance, time horizon, and financial needs? Please schedule a complimentary consultation here.
Much of the data used in these illustrations comes courtesy of Professor Aswath Domodaran from NYU and covers US annual asset returns from 1928 to 2017. 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.
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 risk of loss.
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.
Conclusion:
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.
Do-It-Yourself (DIY) Investors have been cropping up everywhere since the end of the 2008 Financial Crisis.
DIY investors tend to be well-educated professionals of reasonable means that prefer to build their own portfolios without the help of an investment professional.
They educate themselves about investing by reading a number of investment books (here is a popular one for Bogleheads) and subscription-based services espousing the benefits of the DIY approach.
A lot of DIY investors identify strongly with Jack Bogle, the founder of Vanguard for his dedicated approach to index investing.
One thing that distinguishes today’s crop of DIY investors from the original crop back in the 90’s is that today’s investors are much more focused on exchange-traded funds (ETF) as compared to individual stocks. A large number of inexpensive and liquid ETF’s have made this possible.
The primary appeal of DIY investing revolves around gaining control over your portfolio.
You are in charge and make all decisions. From selecting a specific ETF to all buy and sell decisions. A secondary appeal of DIY investing is cost – if you are the manager of your own portfolio you save yourself the fee that would have gone to your investment advisor. Typically this fee amounts to about 1% of the value of your portfolio.
DIY investors tend to do well when capital markets exhibit low volatility and the trend in price is well established. Everybody loves up-trending markets that don’t fluctuate much. But as Humphrey Neill, a famous contrarian investor used to say “Don’t confuse brains with a bull market”.
The analogy I like to use is that of a pilot. When everything is calm even a novice will look good. But when the friendly skies become turbulent, a novice pilot will likely tense up and the odds of making a mistake will increase significantly.
DIY investors face the same situation. During periods of calm, portfolio decisions will come easily. The cost of a poor decision is not likely to have major consequences in such a benign environment.
But when the capital markets get dicey, the implications of one’s actions increase dramatically. A poor decision could decimate the value of your portfolio and seriously harm your overall financial health.
Stock market corrections are not fun for anybody, but experienced investment managers have the real benefit of having seen a movie of the same genre before.
I have lived through the 1987, 2000-2002 and 2008 stock market meltdowns. None of these were fun but I learned valuable lessons in each of these crises. Mainly I learned not to panic but also ways to course correct once it became clear that action was required. A key insight is that changing fundamentals require changing portfolio compositions.
A crisis such as 2008 is extremely disorienting even for professional investors, but the advantage that experience and knowledge of capital market behavior afford you is a game plan honed by the school of hard knocks.
Without the benefit of having lived through previous periods of real capital market stress and the knowledge of how markets typically behave, DIY investors are at a significant disadvantage.
The potential for errors during a crisis goes up exponentially. Three common reactions or mistakes that we have seen from DIY investors involve:
1. Selling Everything in a Panic
No questions asked, just get rid of everything that is taking a hit before it gets even worse. Taking action by selling everything may give the DIY investor a sense of relief. But making decisions in a highly charged emotional state is asking for trouble.
If the decision to sell is based on solid research and is well thought out, fine. But if it is based on impulse and an immediate need to get rid of the stress then it is most likely that the portfolio was not appropriate for the individual in the first place. Investing comes with volatility, there is no way around this!
DIY investors tend to focus on the initial portfolio composition or asset allocation but often fail to plan ahead should market conditions change. And if there is one thing that holds true is that change is inevitable and an ongoing part of financial markets. Planning ahead for changing market conditions is an integral component of a well-designed investment plan.
Fortunately, most DIY investors know that impulsively selling everything in a panic is not a good wealth creation strategy. But don’t kid yourself – in a market meltdown you will want to sell everything and more!
You will have to control your emotions and have the stomach to weather the inevitable periods of market turbulence.
Photo by Goh Rhy Yan on Unsplash
2. Becoming extremely risk-averse and freezing up even if action is clearly needed
Most market corrections are short-lived and while painful in the short-term they barely register on the long-term map. For example, in 2018 we have already had a couple of equity market corrections but in each case, the market recovered its losses fairly quickly.
No harm, no foul! Doing nothing or standing pat works just fine when markets recover.
The bigger problem for investors is when corrections take on a bigger life and become outright market crashes. For example, the S&P 500 was down three straight years from 2000 to 2002. What do you do when the roof seems to be caving in?
Many DIY investors close their eyes and pretend that this is not happening to them. They get frozen and choose to ignore reality. This is not an abnormal reaction at all for us humans, but we also know that small problems many times lead to big problems if we do not address the underlying issue.
Wishing the problem away does not work. From the field of behavioral finance, we know that investors tend to hang on to their losing investments way too long. The flipside is that research has also shown investors to sell their winners way too soon. This effect is known as the disposition effect.
The price of financial assets such as stocks is a function of fundamentals (growth and profitability), the fair price of those fundamentals (investment multiples) and the sentiment of buyers and sellers.
You observe falling prices and you get more and more uncomfortable. But is there any real economic information in investor sentiment?
Experienced investors while not immune to the same feelings of fear will look at the underlying fundamentals and the value of those fundamentals. Experienced investors know that investor sentiment is fickle and lacks much predictive ability.
Has something changed recently to warrant this drop in market values? Are growth rates and profitability permanently impaired, or is the market overreacting? Are investors reacting to the perception of market over-valuation? These are all questions that require some real expertise and most importantly an understanding of context.
There is no cookie cutter way to analyze market action making the experience in similar conditions coupled with knowledge of historical market behavior all that much more valuable.
3. Failing to assess the changing risk levels of their portfolios
A frequent mistake made by DIY investors is to focus almost exclusively on returns and ignore the risk and correlation structure of their portfolios.
Much of the thought behind DIY investing hinges on ideas derived from Modern Portfolio Theory (MPT) but somehow you hardly ever hear DIY investors justify changing allocations based on the volatility structure and composition of their portfolios.
A related mistake is to often assume diversification benefits that often are not there when you need them most. A good read on “fake diversification” can be found here.
Ignoring changing asset volatility and correlation is a serious mistake made by many non-professional investors. In fact, one could say that by ignoring the volatility structure of portfolios DIY investors are ignoring some of the lowest hanging fruit available.
As Nobel Prize Winner Harry Markowitz once said: “diversification is the only free lunch provided by capital markets”.
In a study done a couple of years ago on portfolio rebalancing, I showed just how much stock and bond volatility and correlations can change over time.
Figure 1
Source: Global Focus Capital LLC
Stock volatility, in particular, can move quite a bit around. Bond volatility while still variable shows much lower variability. And, correlations between stocks and bonds can move between positive and negative values implying large changes in diversification potential for a portfolio.
Say, a DIY investor has a portfolio composed of 60% US stocks and 40% US Bonds. The DIY investor diligently rebalances this portfolio every month so that the weights stay in sync. What would this 60/40 portfolio look like in terms of volatility?
Using the above study over the 2000 to 2016 period, the average volatility of this 60/40 portfolio would average 8%. Assuming that the average volatility would not change much would be a mistake. The range of volatility goes from 4% to 15% as shown in Figure 2.
Even the old standby 60/40 portfolio exhibits wildly fluctuating levels of portfolio risk. A 4% volatility level implies a much lower level of potential downside risk compared to a portfolio with a volatility of 15%. Experienced investment professionals inherently understand this and often seek to target a narrower pre-defined range of portfolio volatility.
Figure 2
Source: Global Focus Capital LLC
DIY investors do not often construct portfolios targeting an explicit range of risk. Instead, the often hidden assumption is that over the long-term asset returns, volatilities and correlations will gravitate toward their “normal” levels. These assumptions are not supported by the empirical evidence.
Also, correlations among investments within the same asset class (broadly speaking equities, bonds and alternatives) tend to also jump up during periods of crisis leading many to question the benefits of asset diversification. What investors should be questioning instead is why they did not re-adjust their portfolios to reflect the changing conditions.
DIY investing is here to stay. Many non-investment professionals have educated themselves as to the virtues of retaining control over their portfolios. After all, DIY investors are saving themselves the fee that they would normally pay their advisor for managing their portfolio.
When markets trend up and volatility is low, DIY investors will typically fully participate in the gains.
But there is another “cost” that DIY may be incurring on their own that often rears its ugly head especially during periods of capital market turbulence.
We are all human and we suffer from the same biases and fears. The difference is that experienced professional investors have the advantage of having seen similar periods of capital market stress before and possess a more nuanced perspective of normal capital market behavior.
Professional investors while prone to the same fears as the DIY crowd are better positioned to focus their attention on the fundamentals of investment performance -growth, profitability & valuation – that ultimately drive portfolio values.
Experience and knowledge gained over many market cycles are at a premium when your portfolio most needs it. At Insight Financial Strategists we are experts in integrating your financial planning needs with your investments.
You do not have to go at it alone and compete against the pros. Our investment approach is rooted in the latest academic research and implemented using low-cost investment vehicles.
Interested in talking? Please schedule a complimentary consultation here.
Investors throw out lots of platitudes about their portfolios being diversified. Financial literature often contains allusions to diversification but do Main Street people really understand this important concept?
Think of portfolio diversification benefits in the same way you think about insurance on your house. When nothing bad happens you go on and maybe for a second you think about whether you really need this form of protection.
But when something bad happens like a stock market crash or a tree falls on your garage, you do not even think for a nano second as to what you paid for the protection. Whatever the price was, it was well worth it!
The portfolio diversification concept is, however, different from typical insurance in some important ways. When you buy insurance on your house you have a contract regarding the conditions under which the insurer will pay, how much, and importantly a maximum out of pocket deductible.
The devil is always in the details, right? You may think that your portfolio is diversified because nothing bad has happened yet. Or, you may think that your portfolio is diversified because your advisor said so. Who knows?
When typical investors hear the word diversification they think protection against portfolio losses. If you are diversified, your losses will be less than if you are not diversified, right? During a stock market meltdown such as 2008 your diversified portfolio should do ok, right?
Probably not. Remember the old saying – assume makes an a** out of you and me! Better be safe than sorry when it comes to your financial health.
Let’s start with some basics. Very simply put, diversification means that you are not exposed to any one investment type determining the bulk of your portfolio returns. One investment will neither kill nor make your whole portfolio.
A diversified portfolio contains investments that behave differently. While some investments zig, others zag. When one investment is up big, you might have another one that is down. Your portfolio ends up in the middle somewhere. Never as high as your best performing investment and never as low as your worst nightmare investment.
Asset classes such as bonds and stocks have very different behavior patterns. Sometimes these differences get lost in jargon such as risk and return or the efficient frontier concept.
Why do you own stocks in your portfolio? Why do you own bonds and, say, real estate? Why do you have some money stashed away in an emergency fund at the local bank?
I know these questions may seem a bit sophomoric but knowing the “why” for each of your investments is important to understanding how well prepared you are to withstand periods of financial market stress.
The whole point of owning stocks, bonds and potentially other major asset classes as a mix is to protect your portfolio from bad things happening.
Sure we would all love to get the upside of stocks without any downside but in reality nobody has the foresight to tell us in advance (please avoid subscribing to that doom and gloom publication that just popped up in Facebook) when stocks will collapse and when they will thrive. Anybody up to buying some snake oil?
Diversification is not necessary if you have a direct line to the capital market gods. If you are a mere mortal proper diversification is absolutely necessary to ensuring you remain financially healthy.
Spreading your bets around, mixing a variety of asset classes, hedging your bets, not putting all your eggs in one basket – whatever your favorite phrase is you also need to live it. Diversification is one of those good habits that you should practice consistently!
With that warning in mind, what are 5 telltale signs that your portfolio may let you down when you need it the most?
Accumulating investments over time is a very common practice. People sometimes get enamored with a certain investment type such as tech in the late 90’s and when things don’t pan out they are reluctant to sell the investment.
Not dissimilar to hanging on to that old dusty treadmill in the basement or that collection of Bennie Babies in the attic. Many individual investors are hoarders without admitting it.
Sometimes it is as simple as when people change jobs leaving behind a 401(K).
Solution: Research each one of your funds. For example if you own the Alger Large Cap Growth fund (ACAAX) use a free tool such as Morningstar to do some basic research.
But let me warn you – looking only at past returns will tell you much about the past but virtually nothing about the future. Ruthlessly eliminate funds that you don’t understand, have high fees or simply do not fit the style that you’re looking for. Don’t eliminate funds based solely on past performance.
Some people think that if you own a lot of different funds or investments you are automatically diversified. A bit of this and a bit of that. Some growth, some value, a sprinkling of emerging markets and a Lifestyle fund thrown in the mix. There is no rhyme or reason for any of this, but many people use this approach, right?
This is a very common mistake of investors. A lot of funds of the similar ilk does not make a diversified portfolio. It makes for keeping track of many more things, but not necessarily things that matter to your financial health.
Solution: Less is often better when it comes to your investments. Too many funds means extra confusion. Simplify to a small number of funds that will serve as your core portfolio holdings. Think of these funds as the pillars holding up your financial house.
Choose low cost funds that you will be comfortable holding for decades. Hint – focus on a small number of broad based index funds covering stocks and bonds.
Photo by Natalie Rhea Riggs on Unsplash
Symptom 3: Your portfolio contains lots of investments with the same “theme”
Sounds like you have a fun portfolio when things go well but a nightmare when they don’t. People fall in love with investment themes all the time. They ride the theme hard not properly understanding that market sentiment is often fickle and can change on a dime.
In the late 90’s it was all about the internet. Many people loaded up on the sector and lost their shirt soon after.
Starting in mid-2017 the buzz was all about cryptocurrencies. Many investors especially those too young to have experienced a stock market meltdown went head first into the craze and now probably are licking their wounds.
Solution: Theme investing is risky. Identifying the next emerging technology or the next Amazon or Google has a very low probability of success. Even the most seasoned venture capital firms thread lightly when it comes to the “new, new” thing. You should too!
If you really understand a theme think about how long it will take for the mainstream to adopt it in mass. Invest only a small percentage of your portfolio. For the rest of us, best to keep our greed in check and just say, no!
Symptom 4: All your investments are in the same asset class
This is a variation of the previous issue. Sometimes you hear people say, “I am just a bond guy”. Or, maybe they say “I am a stock jockey”. People come to identify with their investments as a badge of honor without realizing the consequences to their financial health. As my mother would say, “do things in moderation”. I still think that this is great advice whether it is about eating or investing.
The problem with just owning investments in one asset class is that you do not get the main course of the free lunch. You get the appetizer, but then you are shooed out of the room.
Let’s take the case of stocks. In any given day, most stocks tend to move up or down together. When the overall equity market (say the S&P 500) is up big for the day, you only find a very small percentage of stocks down for the day. Similarly, when the broad equity market experiences a meltdown you will unfortunately only find a handful of stocks that went up for the day.
Same applies to bonds but the herding effect is even stronger. Take the case of US bonds of a similar maturity, say 10 years. This cohort of bonds moves in a pack all taking their lead from the 10 Year US Treasury. If the 10 Year Treasury moves up, the vast majority of bonds move up in lockstep. Same on the downside. Just like sheep.
Sure, some stocks or bonds will do better than others. Overall, securities within an asset class tend to move up or down together. Call it a sister or brotherhood, while major asset classes relate to each other more as distant cousins.
Solution: For most people it makes sense to hold investments in all the key asset classes. The three main asset classes that you should own are stocks, bonds and real estate.
Don’t get too cute. If you own a home you probably already have enough real estate exposure.
Why should you own stocks? For growing your nest egg over the long-term. Sure stocks can be incredibly volatile, but if you plan to hold your stock investments for say longer than 10 years, history tells us that you can potentially maximize the growth of your portfolio. For a good review of the long-term power of stock investing read our recent blog.
Why own bonds? Historically, people held bonds for the yield and stability. In the current low interest rate environment, focus on stability but keep an eye out for a more normal interest rate environment. In the US we are already moving in that direction as the Federal Reserve hikes rates and Europe is not that far behind.
But, why is the stability of bonds useful? Mainly as an anchor to your stock investments. Bonds tend to do well during period of stock market stress so they tend to offset some of your losses.
Because bonds tend to be less than 1/3 as volatile as stocks holding a combination of bonds and stocks in your portfolio will dampen valuation changes in your accounts. The value of your holdings will still be heavily influenced by movements in your stock holdings. Your account values will, however, not fluctuate as much. Is this worth it to you?
For many people holding bonds allows them to sleep better at night especially when equity markets go through the inevitable corrections. A good night’s sleep is a prerequisite for a happy life.
Symptom 5: Your portfolio has never gone through a tough market environment
Given the low level of capital market volatility that we have had in the last few years, I would not be at all surprised to see people who dismiss the need for diversification. After all if you just pick your investments wisely why should you worry?
Somebody that has been riding the FANG (Facebook, Amazon, Netflix and Google) stocks for a number of years probably does not see any need for bonds in their portfolio. Maybe they got a hint that they should diversify a bit during the February 2018 mini-correction but all seems to be forgotten three months later.
Go back to the late 90’s. Investors were riding AOL, Cisco, Dell, and Microsoft. Very few individual investors saw the implosion that was about to hit and obliterate equity portfolios.
For example, investors in the Technology SPDR ETF (XLK) were riding high on the hog until March 1, 2000 when the XLK hit $60.56. By July 1, 2002 the price had dropped to $14.32 – a horrific 76% decline from the peak. It took until late 2017 for the XLK to hit its March 1, 2000 peak. That is a long time to wait to breakeven!
You don’t need diversification when things are going well. You only need it when the bottom is falling out from one of your investments. Every single investor in the world has gone through a rough performance patch and nobody is immune to the pain and agony of market crashes such as 1987, 2000-2002 and 2008-2009.
Solution: Stress test your portfolio or at a minimum ask yourself what would happen if certain events of the past repeated themselves.
Could you withstand a sudden 20% daily loss in the stock market? How about a couple of years of major losses such as over the 2000-2002 period? Would you have the stomach to weather these storms?
Many times the tension is between your rational side and your emotions. Behavioral research shows that most times the emotional side wins out. Most investors panic during corrections because they are not properly diversified.
Investing is fun when capital markets are going up and everybody is making money. Equity market corrections and, heaven forbid, crashes are extremely stressful for the vast majority of investors.
Having a little bit of a cushion can mean the difference between emotionally and financially staying with your investing plan and chucking it all at what may turn out the most painful time.
Recovering from painful events is especially difficult when your state of mind is poor and your pocket book is much lighter than before.
Making decisions under stress is never optimal. Self-improvement experts always talk about making decisions while in peak states, not when you are emotionally down.
Nobel Prize winner Harry Markowitz called portfolio diversification in finance its only free lunch. Most people agree with his statement and attempt to build diversification into their investment strategies.
But the devil is in the details. Many people remain confused by the term and its impact on their financial health.
But understanding portfolio diversification is not an academic nicety – it materially affects your financial health
For most investors the relevant context for diversification involves the key broad asset classes of stocks, bonds and real estate.
If you like smoother rather than bumpier rides, portfolio diversification is for you. You will sleep better at night especially when equity markets go haywire.
Investors can easily fall in the trap of thinking that their portfolios are diversified or that they do not need any diversification.
Making too many assumptions is not a good investment practice. Better to know in advance whether you have the mental fortitude and financial resources to weather the inevitable storms.
For technically oriented investors Portfolio Visualizer is a great free tool that allows you to estimate correlations among your list of funds.
For a more in-depth analysis of your portfolio’s true diversification consult a professional consultant experienced in portfolio construction issues. You will get a lot more than simple correlations among your funds. You will get a full picture of the risk profile of your investments but keep in mind that ultimately the portfolio you own must work for you.
Your ideal portfolio must be designed in relation to your goals and needs while allowing you to sleep at night. Only a comprehensive wealth management assessment can give you the level of detail required.
We are expert portfolio construction professionals and would glad help you assess the quality of your portfolio. Don’t assume that you are diversified. Contact the team at Insight Financial Strategists for a free initial consultation.
At Insight Financial Strategists we are your fiduciaries. Our advice is focused solely on our view of your best interests. As fee only practitioners, our interests are aligned with yours.
4 Counter-Intuitive Steps to Take Now to Make Your 401(k) Rock
With the demise of traditional defined benefit plans, 401(k)’s provide the most popular way for individuals to save for their retirement.
401(k)’s are also the second largest source of US household wealth right behind home equity.
According to the Investment Company Institute there were over 55 million active participants in 401(k) plans plus millions of former employees and retirees as of the end of last year. The amount of money is staggering at $5.3 trillion as of the end of 2017.
Given the importance of 401(k)’s to US household financial health you would think that plan participants would watch their balances like a hawk and actively manage their holdings.
Some people do, but the vast majority of people do not truly understand what they own or why. Most people know that the more they contribute to their 401(k) the higher their ending balances are going to be, but beyond that there is a lot of confusion.
Understanding how their 401(k) fits in with the rest of their financial picture
When given a choice, people usually start with the issue or problem that they perceive as the easiest to figure out, not necessarily the one of greatest importance.
Many people approach the problem of how to invest their 401(k) in a simplistic manner.
Many 401(k) participants start off by selecting funds. For most participants this is not an easy choice, but in comparison to the other issues this one appears manageable.
Picking funds before figuring out your goals and objectives is like picking furniture before you know the size and shape of your dining room. It might work out but it would involve a lot of luck. Do you want to count on luck when it comes to your financial future?
A different way of addressing the challenge is to start the other way around. Start with the end goal in mind.
Re-frame the problem to first figure out what you are trying to do. You want your 401(k) to work for you and your family, right? Sound like a better starting point?
Without knowing what you are trying to do and what really matters to you putting money into your 401(k) loses meaning.
What funds to select
First figure out for yourself why you are taking money out of your paycheck to put into your 401(K). What is your “why”?
The answer may be obvious to you, but when money gets tight due to some unforeseen life event you will be glad that you have a tangible picture for its ultimate use.
Visualize what you are going to do with that money. Is it for a retirement full of adventure? Is it for buying that dream sailboat that you’ll take around the world? Or, is it simply to preserve your lifestyle once you retire? Money has no intrinsic value if you don’t spend it on things that matter to you and your family.
“Money cannot buy peace of mind.
It cannot heal ruptured relationships, or build meaning into a life that has none.”
— Richard M. DeVos, Billionaire Co-founder of Amway, Owner of Orlando Magic
So, if starting with the end in mind makes sense to you, let’s take a look at the four counter-intuitive steps that you can take now to make your 401(k) work for you. Figure 1 lays it all out.
Figure 1
Step 1: Define what matters to you and inventory your resources
Visualize your goals and objectives for the type of life you and your family want to lead. Don’t just think about your retirement – think as broadly as possible.
Close your eyes, visualize, pour a nice glass of cabernet for you and your partner before you have the “talk”, write it down in your journal – whatever approach gets you out of your everyday busy persona and makes you focus on what you really want out of life.
How do you want to use your money to accomplish this lifestyle?
Maybe you and your spouse want to engage in missionary work in 10 years. Maybe you also need to fund college expenses for your children? Maybe you see a lakefront house in the near future? There is no cookie cutter approach when it comes to people’s dreams! It’s up to you to make them up.
Your house, your emergency fund, investments in mutual funds, possibly a little inheritance, company stock. Almost forgot, your spouse’s 401(k) and that condo that he/she bought before you met. Take a comprehensive inventory of your assets.
How much debt do you have? That is part of your financial picture as well. Do you anticipate paying your mortgage off in the next few years?
Wealth managers talk about a concept called the household balance sheet. It’s the same idea that financial analysts use when evaluating a company. In the corporate world you have assets, liabilities and the difference is net worth. In your own world you have assets, obligations and unfunded goals, and net worth is the difference.
Sounds a bit harsh when it involves you, right? Don’t take it personally. The key idea is taking an inventory of what you own, what you owe and then matching that up to your goals and aspirations.
Step 2. How aggressive do you need to be while being able to sleep at night
The whole idea of saving and investing is about making your goals and aspirations a reality. If you already have enough assets to fund your desired lifestyle into perpetuity then you don’t really have to worry too much about investing. Just preserve what you got!
If you are like most people, you need to make your investments work for you. You need a return on your assets.
It’s a good idea to be realistic about goals and objectives. Are your goals reachable? Is there only a tiny probability of reaching them?
Are your goals a stretch, reachable with some effort, or a slam dunk?
Your answer will dictate how aggressive you will need to be in your investment strategy.
If your goals are a stretch you need high return/high risk investments – be ready for a volatile ride and many highs and lows
If your goals are within reach using conservative asset class return assumptions you need a moderate return/moderate risk portfolio – you will still experience fluctuations in your portfolio that will leave you feeling anxious at times, but the periods of recovery will more than make up for the periods of stress
If your goals are a slam dunk, you are lucky and you will only need low return/safe investment strategies – your portfolio values will not fluctuate much in the short-term but your portfolio will also not grow much in size
To some extent this is the easy part. There is a link between risk and return in the capital markets. Higher risk usually translates over long periods of time into higher returns. Equities do better on average than bonds and bonds in turn do better than money market investments. So far so good.
Figuring out the required rate of return to fund your goals and objectives given your resources involves math but little emotional contribution.
But what about your emotions?
This is the tricky part. Many people are able to conceptualize risk in their heads, but are entirely unable to deal with their emotions when they start losing money.
They think of themselves as risk takers but can’t stand losing money. They panic every time the stock market takes a dip. It does not matter why the market is tanking – they do not like it and run for the exits.
Let’s examine a simple situation where we classify your need and comfort level with investment risk in three states: low, medium and high.
Figure 2 lays out all the possibilities. Ideally, your two dimensions of risk will match up directly. For example, if your need for risk is low and your comfort level with taking risk is low you are all set. Same if you need a high risk/high return strategy to meet your goals and objectives and you are comfortable experiencing significant fluctuations in your portfolio.
Figure 2
The real problem for you is, however, when the two dimensions of risk are not aligned. You’ll need to resolve these differences as soon as possible to regain any hope of financial health.
Let’s say you are really risk averse. You fear losing money. Your worst case scenarios (bag lady, eating cat food) keep popping up in your nightmares. If your goals and objectives are ambitious in relation to your resources (high need for risk) those nightmares will not go away and you will live in fear.
You can do one of two things – learn to live with fear or, scale back your goals and objectives. There is no right or wrong answer – it’s up to you but you must choose.
What if you are comfortable taking on lots of investment risk? Would you like a low risk/low return portfolio? Probably not. In fact, such a portfolio would probably drive you crazy even if you did not need any higher returns.
People comfortable with investment risk frequently suffer from fear of missing out (FOMO). They think that they should be doing better. They want to push the envelope whether they need to or not.
FOMO is as damaging of an emotion as living in fear. Both states spell trouble. You will need to align both dimensions of risk to truly get that balance in your financial life.
Step 3. Determine the asset allocation consistent with your goals and risk preferences
Sounds like a mouthful, right? Let’s put it in plain English. First of all, the term asset allocation simply refers to how much of your investment portfolio you are putting into the main asset classes of stocks, bonds and cash/bills.
Sure, we can get more complicated than that. In our own research we use ten asset classes, but in reality breaking up the global equity and bond markets into finer breakouts is important but not critical for the average individual investor.
Figuring out the right range of stocks, bonds and cash is much more important than figuring out whether growth will outperform value or whether to include an allocation to real estate trusts. Do the micro fine tuning later once you have figured out your big picture asset allocation.
All right, since we are keeping things simple let’s look at some possible stock/bond/cash allocations. We are going to use information from our IFS article on risk and return. As a reminder the data used in these illustrations comes courtesy of Professor Aswath Domodaran from NYU and covers US annual asset returns from 1928 to 2017.
Table 1
The top half of the table shows the performance and volatility of stocks, bonds and cash/bills by themselves. From year to year there is tremendous variability in returns but for the sake of simplicity you can use historical risk and returns statistics as a rough guide.
Here is what you should note:
If you need high risk/high portfolio returns and you can take the volatility go with a stock portfolio with average historical returns of 12%. On a cumulative basis nothing comes close to stocks in terms of wealth creation but you should expect a bumpy ride
If you only need low risk/low returns and you are extremely risk averse go with cash/bill type of portfolios returning, on average, 3%. This portfolio is probably just going to keep up with inflation
If you have a medium tolerance for risk and medium need for taking risk then you will likely gravitate toward a combination of stocks, bonds and cash
There is an infinite number of combinations of asset class weights – the three asset allocations in the bottom panel of Table 1 may very well apply to you depending on your risk tolerance, need for return and time horizon
What about the stock/bond/cash mixes?
The 60% stock/40% bond allocation has over this 1928-2017 period yielded a 9% return with a 12% volatility. Historically, you lost money in 21% of years but if you are a long-term investor the growth of this portfolio will vastly outstrip inflation
The 40% stock/60% bond portfolio is a bit less risky and also has lower average yields. When a loss occurs, the average percentage loss is 5%. This portfolio may appeal to a conservative investor that does not like roller coaster rides in his/her investment accounts and does not need the highest returns.
The 25% stock/50% bond/25% cash portfolio is the lowest risk/return asset class mix among our choices. Historically this portfolio yields an average return of 6% with a volatility also of 6%. This portfolio may appeal to you if you are naturally risk averse and have a low tolerance for portfolio losses, but you might want to also check whether these returns are sufficient to fund your desired goals and objectives
Step 4. It’s finally time to pick your funds
Yes, this is typically where people start. Many times people pick a bunch of funds based on a friend’s recommendation or simply based on the brand of the investment manager. Rarely do people dig deep and evaluate the track record of funds.
A lot of people pick their funds and declare victory. They are making a huge mistake. They are not framing the problem correctly.
The problem is all about how to make your 401(k) work for you in the context of your goals and objectives, your resources and your comfort with investment fluctuations.
Picking funds is the least important part. You still have to do it but first figure out what matters to you, your need and comfort with risk and your target stock, bond, cash mix.
Once you have your target asset allocation go to work and research your fund options. Easier said than done, right?
Here are some fund features that you should focus on:
Passive or Active Management – a passive fund holds securities in the same proportions as well-known indices such as the S&P 500 or Russell 2000. An active fund is deliberately structured to be different from an index in the hope of achieving typically higher returns
Fund Style – usual distinctions for equity funds are market capitalization, value, volatility, momentum and geographic focus (US, international, emerging markets). For bond funds the biggest style distinctions are maturity, credit and geographic focus
Risk Profile – loosely defined as how closely the fund tracks its primary asset class. Funds with high relative levels of risk will behave differently from their primary asset class. Accessing a free resource such as Morningstar to study the basic profile of your funds is a great starting point. For a sample of such a report click here
Fund expenses – these are the all in costs of your fund choices. Lower costs can translate into significant savings especially over long periods of time. In general, index funds tend to be lower cost than actively managed funds
Understanding what makes a good fund choice versus a sub-optimal one is beyond the financial literacy and attention span of most plan participants.
For most people a good rule of thumb to use is to allocate to at least two funds in each target asset class.
Let’s make this more concrete. Say your target asset allocation is 60% stocks and 40% bonds. Most 401(k) plans have a number of stock and bond funds available.
What should you do? A minimalist approach might entail choosing an S&P 500 index fund and an actively managed emerging market equity fund placing 30% in each. This maybe appear a bit risky to some so maybe you only put 10% in the emerging market fund and 20% in a US small capitalization fund.
Same on the bond side where you might allocate 20% to an active index fund tracking the Bloomberg US Aggregate index and 20% in a high yield actively managed option.
Let your fund research dictate your choice of funds. You should keep things simple.
Know what funds you own and why. Keep your fund holdings in line with your asset allocation. Spreading your money into a large number of fund options does not buy you much beyond unneeded complexity.
Picking funds that closely match the risk and return characteristics of your asset classes (say stocks and bonds) is good enough.
Trying to micro-manage the selection of funds will not likely lead to a huge difference in overall portfolio returns.
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Conclusion:
The task facing you in managing your 401(k) may seem daunting at times. You may feel out of your own depth.
You are not alone but if you reverse the usual way in which most participants manage their 401(k)’s you should gain greater control over your long-term financial health.
Start with the end in mind. What is this money for? Think about your life goals and objectives. Depending on your resources, you will need to figure what type of risk/return portfolio combination you will need as well as how comfortable you are dealing with the inevitable investment fluctuations.
Lastly, keep it simple when choosing your funds. You have figured out the important stuff already. Pick at least a couple of funds in each of your target asset classes by performing some high level research from sites such as Morningstar and MarketWatch.
Keep in mind that more funds do not translate into higher levels of diversification if they are all alike. Know what you own and why.
If this is all just too much for you, consider hiring Insight Financial Strategists to review your 401(k) investment allocations. We will perform a comprehensive analysis of your asset allocation and fund choices in relation to your stated goals and objectives while also keeping your expressed risk preferences in mind.
The analysis will set your mind at ease and make your 401(k) work for you in the most effective manner. We are a fee based fiduciary advisor, which means we are obligated to act solely in your best interest when making investment recommendations.
In general, when IRA aggregation is permissible for distribution purposes, all the Traditional IRAs, SEP IRAs, and SIMPLE IRAs of an individual are treated as one traditional IRA. Similarly, all of an individual’s Roth IRAs are treated as a single Roth IRA.
The following are seven key aggregation rules for IRAs that could save you time and money . The key learning is that it takes strong recordkeeping and awareness of the rules to avoid the pitfalls of aggregation. You should be aware of the requirements, observe them or get help from your Wealth Manager.
IRA Aggregation does not apply to the return of excess IRA contributions
The IRA contribution limit for individuals is based on earned income. Individuals under 50 years of age can contribute up to $5,500 a year of earned income. Those older than 50 years of age are allowed an additional catch up contribution of $1,000. The contribution limit is a joint limit that applies to the combination of Traditional and Roth IRAs.
When the IRA contribution happens to be in excess of the $5,500 or the $6,500 limit (for people over 50), the excess contributions, including net attributable income (NIA), ie the growth generated by the excess contribution, must be returned before the IRA owner’s tax filing due date, or extended tax filing due date. Those who file their returns before the due date receive an automatic six-month extension to correct the excess contributions.
Mandatory aggregation applies to the application of bases for Traditional IRAs
Contributions to Traditional IRAs are usually pre-tax. Thus, distributions from IRAs are taxable as income. In addition, distributions prior to 59.5 years of age are also subject to a 10% penalty.
After-tax contributions to an IRA, but not the earnings thereof, may be distributed prior to 59 ½ years of age without the customary 10% penalty. Distributions from an IRA that contains after-tax contributions are usually prorated to include a proportionate amount of after-tax basis (amount contributed) and pre-tax balance (pro rata rule).
Suppose that Janice has contributed $700 to a non-deductible Traditional IRA, and it has grown to $1,400. If Janice takes a distribution of $500, one half of the distribution is returnable on a non-taxable basis, and the other half is taxable and subject to the 10% penalty if Janice happens to be under 59½ years of age. You can see why Janice would want to keep accurate records of her transaction in order to document the taxable and non-taxable portions of her IRA.
Limited aggregation applies for inherited Traditional IRAs
In practice, it means that if Johnny inherited two IRAs from his Mom and another from his Dad, Johnny must take the Required Minimum Distributions for his Mom’s two IRAs separately from his Dad’s, and also separately from his own IRAs.
Furthermore, IRAs inherited from different people must also be kept separate from one another. They can only be aggregated if they are inherited from the same person. In addition, inheriting an IRA with basis must be reported to the IRS for each person.
Mandatory aggregation applies to qualified Roth IRA distributions
Qualified distributions from Roth IRAs are tax-free. In addition, the 10% early distribution penalty does not apply to qualified distributions from Roth IRAs.
Roth IRA distributions are qualified if:
– they are taken at least five years after the individual’s first Roth IRA is funded;
– no more than $10,000 is taken for a qualified first time home purchase;
– the IRA owner is disabled at the time of distribution;
– the distribution is made from an inherited Roth IRA; or
– the IRA owner is 59½ or older at the time of the distribution.
If Dawn has two Roth IRAs, she must consider both of them when she takes a distribution. For instance, if Dawn takes a distribution for a first time home purchase, she can only take a total $10,000 from her two Roth IRAs
Optional aggregation applies to required minimum distributions
The RMD for each IRA must be calculated separately; however, the owner can choose whether to take the aggregate distribution from one or more of his Traditional, SEP or SIMPLE IRAs.
So, if Mike has a Traditional, a SIMPLE and a SEP IRA, he would calculate the RMD for each of the accounts separately. He could then take the RMD from one, two or three accounts in the proportions that make sense for him.
As a reminder, Roth IRA owners are not subject to RMDs.
Limited aggregation applies to Inherited IRAs
Beneficiaries must take RMDs from the Traditional and Roth IRAs that they inherit with the exception of spouse beneficiaries that elect to treat an inherited IRA as their own.
With this latter exception, RMD rules apply as if the spouse was the original owner of the IRA.
When a beneficiary inherits multiple Traditional IRAs from one person, he or she can choose to aggregate the RMD for those inherited IRAs and take it from one or more of the inherited Traditional IRAs. The same aggregation rule applies to Roth IRAs that are inherited from the same person.
Suppose again that Johnny has inherited two IRAs from his Mom and one from his Dad. Johnny can calculate the RMDs for the two IRAs inherited from his Mom, and take it from just one. Johnny must calculate the RMD from the IRA inherited from his Dad separately, and take it from that IRA.
If in addition, Johnny has inherited an IRA from his wife, he may aggregate that IRA with his own.
If an IRA distribution is rolled over to the same type of IRA from which the distribution was made within 60 days, that distribution is excluded from income.
Such a rollover can be done only once during a 12-month period.
In this kind of situation, all IRAs regardless of types (Roth and non-Roth) must be aggregated. For instance, if an individual rolls over a Traditional IRA to another Traditional IRA, no other IRA to IRA (Roth or non-Roth) rollover is permitted for the next 12 months.
Conclusion: What you should keep in mind
These are some of the more common IRA aggregation rules. There are others including rules for substantially equal periodic payments programs (an exception to the 10% early distribution penalty), and those that apply to Roth IRAs when the owner is not eligible for a qualified distribution.
Lastly, many of the potential problems that people may face with IRA aggregation can be avoided with proper documentation. Recordkeeping is essential. Individuals can do it themselves or they can rely on their Wealth Managers. In the case where you have to change financial professionals, make sure that you have documented the history of your IRAs.
