What Is The Impact of Social Security on Divorced Retirement Income

By Chris Chen CFP | Financial Planning , Investment Planning , Portfolio Construction , Retirement Planning , Risk Management

When mediating a divorce settlement, a 50-50 split of assets isn’t always equitable when Social Security benefits are taken into account . Let’s explore some examples.

The complexities of Social Security retirement benefits make it a difficult topic for divorce settlement negotiations. It is an exceedingly important source of income for retirees, especially divorced and even affluent retirees. Therefore, Social Security’s place in a person’s retirement income plan is a critical item for mediators, divorce financial planners, lawyers and their clients to understand to achieve the elusive goal of a fair and equitable settlement.

The maximum benefit in 2023 is $54,660 a year. Of course, most people don’t get the maximum. Still, as the benefit decreases, I find that it constitutes a greater percentage of income. And, because state courts do not have jurisdiction over SS allocation, its impact tends to be overlooked in settlement negotiations .

How does it work in practice? Take Jack and Jill, who are retired and are both 66. Each has a house of equal value (to simplify), $1.7 million in their IRAs and $300,000 in other liquid assets for a total of $2 million. For Jack and Jill, a 50-50 division leaving each party with $1 million should be a fair division, right?

Maybe. But let’s first go over some Social Security background.

A Short History

The Social Security Act, passed in 1935, included benefits for workers but not their spouses . At the time, women who did not work outside of the home could not qualify for Social Security retirement benefits. A sweeping series of amendments enacted in 1939 extended Social Security to spouses and minor children. Wives who had not earned a Social Security retirement benefit or whose retirement benefit was less than 50% of their husband’s qualified for the first time.

Catching up with a changing society, another reform extended Social Security retirement benefits to divorced wives in cases when the divorce happened after a marriage of longer than 20 years. The word “spouse” replaced the word “wife” in the 1970s, allowing husbands to collect retirement benefits on their ex-wives’ records .

Later, the length of marriage required to qualify for benefits after a divorce was reduced to 10 years. When SCOTUS legalized same-sex marriage in 2015, survivor and divorce benefits extended to same-sex couples .

This short history of Social Security shows how it has evolved. Ex-wives and ex-husbands can now all receive retirement benefits based on an ex’s work record .

However, qualifying conditions must be met. The rules can be confusing and challenging to keep track of, especially for those who have had more than one marriage and divorce or those whose ex-spouse has died.

Benefits for Divorced People

When a divorced spouse claims their benefit at full retirement age or later, they will qualify to receive 50% of their ex-spouse’s primary insurance amount (PIA), so long as they have not remarried before 60 years of age and their own benefit is less than 50% of their ex-spouse’s.

In Jack’s and Jill’s case, Jack’s PIA is $3,000 per month, and Jill does not qualify for a retirement benefit on her own record. She can file for her divorced-spouse benefit at her full retirement age of 66. She will qualify for 50% of Jack’s PIA, $1,500.

However, divorced people who claim on their ex-spouse’s record will not get more if they delay their benefits past full retirement age, 66 to 67, depending on the birth year .

Note that if Jill had her own Social Security retirement benefit and it was more than 50% of Jack’s, she would receive only her own benefit. She would not also receive her divorced benefit!

Sometimes people wonder how the age difference with their ex-spouse can affect their benefits. The good news is that the ex-spouse’s age when they claim it is irrelevant. As long as Jill claims at full retirement age, she will receive her maximum divorce benefit independently of the timing of Jack’s claim.

Who Qualifies?

A person who claims benefits based on a former spouse’s record must be single at the time . So unfair, you say? If Jill has remarried, generally, she could get 50% of her new husband’s benefit, or her own, if her own is greater than 50% of her new husband’s. So let’s continue with a single Jill.

Jack may be married or unmarried. It makes no difference. If Jack is (re)married, Jill and the current wife could both qualify for the 50% benefit from Jack’s record.

Suppose Jill, who receives the 50% benefit, remarries. In that case, her 50% benefit from Jack’s record stops unless Jill’s new spouse also gets a divorced-spouse benefit. That’s except if the remarriage occurs after age 60.

Jill’s marriage must have lasted 10 years or longer to claim Social Security retirement benefits on Jack’s record . Because of that requirement, sometimes people who think of divorce will delay until 10 years of marriage are achieved. For example, if you’ve been married for 9.5 years, it may be worth waiting another six months. And with the slow speed of divorce proceedings, that is entirely possible without trying too hard!

Sometimes people are not sure when they got divorced. People often mark their court appearance date as the divorce date. In most states, however, the actual divorce date is later than the court appearance . For example, in Massachusetts, it is 90 or 120 days after the court appearance depending on the filing type.

More Marriages and Divorces

People sometimes ask: What if you had two or more 10-year marriages?

Then it can become complicated. Those who have divorced more than once after marriages of 10 years or longer get the higher of the two divorced-spouse benefits, so long as they are currently unmarried .

For example, suppose that Sheryl was married to Patrick for 20 years and then to John for 12 years. Sheryl has now divorced for the second time and has remained single for more than two years since her last divorce, from John.

Patrick’s PIA is $3,200, and John’s PIA is $2,800. So let’s suppose that Sheryl’s retirement benefit, based on her own record, is $1,200. However, she is at full retirement age (66 or 67, depending on her birth year).

When Sheryl files, she can receive $1,600, half of Patrick’s PIA, because it is higher than John’s $1,400 and her own benefit of $1,200. And, no, she cannot get both Patrick’s and John’s retirement benefits!

If Sheryl divorced less than two years before, she must wait until her last ex, John  in this case, has filed for his benefit. In addition, the worker on whose record the retirement benefit is claimed, Patrick, must have reached 62 years of age.

Patrick’s filing status is irrelevant to Sheryl’s claim if they divorced more than two years before. So unless Sheryl tells him, Patrick will never know if his ex-spouse has claimed. In either Patrick’s or John’s case, their own benefits will not decrease based on Sheryl’s claim.

It should be clear by now that Social Security rules can be complex. Next, I will be covering issues that can occur when your ex passes away and when the retiree also gets a pension benefit. Finally, I will be bringing it together by looking at an example where the application of the rules results in Jill getting 35% less retirement income than Jack, even though their assets are divided 50-50.

When Your Ex dies

Mike and Marie are 66 and have been married for more than 10 years and divorced for more than two. Because Marie is single and not remarried, she qualifies for a divorced-spouse retirement benefit based on Mike’s record, whether or not Mike has filed.

If Mike has passed away, Marie receives a divorced-spouse survivor benefit based on Mike’s record if she is currently unmarried or if she remarried after age 60. In addition, Marie’s benefit will be 100% of Mike’s PIA, the amount that Mike would have received at full retirement age. In the case of Mike dying, Marie’s retirement benefits are capped to full retirement age.

What if the same two people have married, divorced, remarried each other and divorced again? In that case, the length of the two marriages can be added together (including the time in between) to reach the qualifying minimum of 10 years. That is, if the remarriage happens before the end of the calendar year following the divorce!

Say Mike and Marie were married for seven years, from May 2002 to August 2009. They remarried in December 2010 and divorced again in November 2013 for three years. The total for the two marriages is 10 years. Mike and Marie meet the 10-year requirement because their second marriage happened before the end of the calendar year after the first divorce.

If, instead, Mike and Marie had remarried in January 2011, the 10-year clock would have been reset to zero.

Pension Repercussions

In my previous article, Jill and Jack divorced, and she had no Social Security record of her own and met the requirements to receive half of Jack’s PIA of $3,000. But let’s consider what would happen if Jill had a record of her own.

When Jill applies for her divorced spouse’s retirement benefit, what if she also worked for an employer not participating in the Social Security system? For example, many state and municipal government employees are exempt from paying into the Social Security system . For instance, if Jill was a teacher for her town’s school system, in many states (but not all) she could qualify for a state pension. But then her divorced-spouse Social Security benefit would be reduced by two-thirds of the amount of her pension because of the Government Pension Offset (GPO) rule . As a result, Jill’s Social Security benefit may be zero, depending on the size of her pension.

How would that work? Jill currently receives a $3,000 monthly teacher pension in Texas. She has divorced Jack after more than 10 years of marriage. Jack’s PIA is $3,000. Jill’s divorced-spouse benefit of $1,500 would be reduced by $2,000 (two-thirds of $3,000), which reduces the benefit amount to zero. She doesn’t get any Social Security.

If Jack dies, Jill becomes eligible for a divorced-spouse survivor benefit. After the GPO reduction, she will receive $800 ($3,000 – $2,000 = $800).

Suppose the spouse with the benefit also qualifies for a pension from an entity that doesn’t pay into Social Security. In that case, the Windfall Elimination Program (WEP) kicks in . That reduces the spouse’s benefit payments, and the ex-spouse’s benefit adjusts downward as well.

Note that if Jill benefits from a pension but always paid into Social Security, she would not be subject to the GPO and WEP rules. She may have other challenges that require the help of a professional to sort out, but she would benefit fully from both her Social Security and her pension.

What Does It All Mean?

As a reminder, Jack and Jill are retired and decided to divide their assets 50-50. Jack also benefits from a $3,000 Social Security PIA retirement benefit, and Jill has a divorced-spouse benefit of $1,500. Jack opts to delay his Social Security until 70 when his benefit would increase to $4,081. Jill has no such option.

A common (but potentially dangerous) rule of thumb in retirement planning is that if a retiree begins retirement by taking a 4% distribution from assets and increases it annually with inflation, the retiree will not run out of assets in their lifetime. (1)

As detailed in the table below, Jack and Jill’s 50-50 division of assets may look fair. However, Jill’s income will be 35% less than Jack’s.

For couples that have fewer assets to divide, the difference is larger. For example, if Jack and Jill had $500,000 each and the other assumptions were the same, the difference would be 45%.

On the other hand, couples that have more assets have a smaller difference. For example, if Jack and Jill had $5,000,000 each and all the other assumptions remained the same, the difference in income would be $12%.

Last Words

In the example, the difference between Jill’s and Jack’s total incomes comes to slightly more than $2,500 a month. Over a 20-year lifetime, it can easily add up to more than $600,000. When you add Social Security cost-of-living adjustments (COLA), the difference could be more than $875,000.

The difference in Social Security income is not a challenge that can be dealt with directly in litigation, because the courts have no jurisdiction over Social Security . However, a couple mediating could potentially address the issue to achieve a more balanced retirement income for both and a more equitable settlement. Most likely, that would require the assistance of a divorce financial planner.

The example of Jack and Jill is simplified from cases we might run across. There may be other assets, such as a pension, a vacation home and rental real estate. There may be child support and alimony. Maybe Jill qualifies for her own Social Security benefit. There may be an inheritance looming. Jack and Jill may be further away from retirement. Their investment styles may differ.

Diverse circumstances will complicate the analysis, often beyond what can be easily handled by a lawyer or a mediator. However, it is crucial for a couple and their mediator and lawyers to understand the consequences of their decisions. That is so especially for women because they will need to stretch their assets to meet their longer statistical life expectancy .

I have a series of handy flow charts that can help guide mediators and clients through the decision complexities. Please ask for it at info@insightfinancialstrategists.com.

Note:(1) The 4% rule is widely used as a rule of thumb to estimate retirement income from assets . It was initiated in a 1994 study by Bill Bengen published in the Journal of Financial Planning. More recent revisions of the study imply that the safe withdrawal rule could be less than 4%. Other methods to plan retirement income may be more appropriate depending on the case.

Secure 2.0

By Chris Chen CFP | Financial Planning , Investment Planning , Portfolio Construction , Retirement Planning , Risk Management

Congress passed SECURE 2.0 on December 23, 2022, and it was signed into law by President Biden on December 29, 2022, leading us to several significant changes in retirement planning . As the numeral indicates, SECURE 2.0 follows SECURE 1.0, which passed in 2021. SECURE 2.0 was long rumored but took a long time to become law. SECURE 2.0 was first proposed in Congress in May 2021. The following describes some of the major provisions of the law. If you are looking at retirement, there may well be something in there for you.

Required Minimum Distributions (RMDs):

One of the most consequential items for people approaching retirement is the postponement of RMDs from the current 72 years of age to 75, depending on the birth year.

SECURE 2.0 resets RMDs to:

• 73 if you turn 72 from 2022‐2027 
• 74 if you turn 72 in 2028‐2029 
• 75 if you turn 72 in 2030 or later

This will allow retirees to alter their retirement plan by continuing their Roth conversions for a few years past the former limit of 72 or even to have some for those who have to start late.

The key benefit, of course, is that a Roth conversion allows a retiree with a relatively low tax bracket to make the conversions at a relatively cheap cost . Unfortunately, when we have to take the RMDs, our tax brackets typically jump up, and Roth conversions can become uneconomical . 

Why would a retiree want to do a Roth conversion? For one, a Roth conversion can allow retirees to manage their taxes better . They may need to take more money out of their IRA in future years and thus pay a larger tax. If they have a Roth, they could take a distribution if they qualify, thus avoiding jumping tax brackets. The Roth conversion could allow them to arbitrage their taxes and reduce their lifetime tax bill. 

Another intriguing opportunity is legacy planning. An inherited IRA must be fully disbursed within ten years of inheritance . That can be quite inconvenient for heirs as they will be responsible for paying income taxes they would incur upon distributions. Depending on the age and situation of the heir, the inheritance could come in their peak earning years and thus end up being smaller after taxes than anticipated. More time for the parents to work with Roth distributions can help alleviate the issue. 

These are just a few possibilities that a later RMD requirement can allow. Check-in with me to see how it may affect your situation. 

IRA RMD penalties

Previously, there was no statute of limitations to IRA penalties. Even though IRS penalties and interests on most tax issues have a 3-year statute of limitation, there is no such thing for IRA penalties . The IRS could assess penalties and interest for missed RMD years after the event.

Unfortunately, missing an RMD is common. However, most people do that as a mistake.

It seems unfair to apply penalties and interest forever. Our government has decided to agree: SECURE 2.0 fixes that issue by applying the same statute of limitation to the IRA RMDs as it does to other tax issues .

Secure 2.0 Checklist

Catch-up contributions

SECURE 2.0 finally indexes IRA catch-up contributions for inflation . 

Before this year, IRA contributions, including plan salary deferral, plan catch-up contribution, and plan overall limits, were indexed for inflation. However, until the end of 2022, the IRA catch-up contribution limit was not. It had to be increased by legislation, which only happened once… in 2006!

The law also creates new plan catch-up contribution limits in years a participant turns 62, 63, and 64.

Such participants (62- to 64-year-old) have the following catch-up contribution limits beginning in 2023:

• 401(k)s and similar plans: $10k ($6.5k today)
• SIMPLE: $5k ($3k today)

At first glance, this is nice, but I can’t help but notice that Congress seems very interested in helping 62- to 64-year-olds save for retirement, but not 65, 66, and 67-year-olds. They go out of their way to ensure you that at 65 or later, you are out of luck. It would seem logical to increase the limit up to 67, especially since Full Retirement Age for Social Security can go that late. 

Catch-up contributions to Roth

One of the peculiar points of the new law is that it requires savers to make all catch-up contributions to Roth accounts! 

It’s interesting because not all plans, such as the SEP and SIMPLE IRAs, have Roth options. Many regulations will have to change to accommodate that new legal provision!

The only reason I can think of for that provision is that it allows the IRS to collect taxes now and not let them defer. However, people love their Roth accounts, so it’s all good, even though it is likely to increase taxes during working years for some.

SEP and SIMPLE Roth accounts

Continuing on this Roth trend, the law allows the creation of SEP and SIMPLE Roth accounts. For some reason, SEP and SIMPLE have not had a Roth option until now. 

Further, individual employees will be able to direct the employer matching contributions to the Roth side.  

This is great news for employees of smaller companies as it gives them more planning flexibility.

QCD rules

The Qualified Charitable Distribution (QCD) allows taxpayers to make charitable contributions directly from an IRA to a non-profit . This allows the taxpayer to decrease their balances and their RMDs and associated income taxes. It’s a convenient provision that presents interesting planning opportunities for charitably and tax-minded individuals.

Currently, the QCD is limited to $100,000 a year. SECURE 2.0 indexes that amount to inflation . 

The law also allows a one-time QCD, up to $50,000, to a split-interest entity such as a Charitable Remainder Trust (CRUT), a Charitable Remainder Annuity Trust (CRAT), or a charitable gift annuity. However, it’s not clear that it is cost-effective to establish a CRUT or a CRAT for this relatively small amount.

RMD penalties

Many know there is a 50% penalty for missing an RMD. The new law reduces it to 25% . The penalty is further reduced to 10% for timely and appropriately corrected errors within the “correction window,” which could be as long as three years. Sounds great, but right now, if you realize you missed an RMD but take corrective action and properly request relief, you’ll likely get a waiver of the 50% penalty.

It is still a 10% or 25% penalty, and you will be just as annoyed if you have to pay it, so plan accordingly.

Qualified student loan payments

Student loan borrowers who make payments towards their loan can have a “matching contribution” to their 401(k), 403(b), or SIMPLE IRA . 

This is great for borrowers who can now better pay their loans and save for retirement. It is also great for employers who can now provide an additional benefit for employees they want to retain.

529 Rollovers

Beginning in 2024, 529 beneficiaries will be able to roll over their account directly to a Roth IRA with no tax and no penalty ! This is great for people who have overfunded their 529 accounts.

There are a number of limitations, including the amount and the length of time that the account must have been held. It is one of the more complicated benefits of SECURE 2.0, so consult with your Certified Financial Planner.

In a scenario by industry pundit Michael Kitces, a child with an overfunded 529 could rollover over time the maximum of $35,000 to a Roth account and could end up with more than $1M at retirement. The power of compounding still amazes me!

These significant features of SECURE 2.0 change the retirement landscape significantly for many in pre-retirement or retirement. However, there are many more obscure and technical provisions of that new law. It will pay to consult with a specialist. What is obscure and technical to me could be quite interesting to you!  

To learn more about how this can impact your financial outlook, visit Insight Financial Strategists,  or schedule a complimentary call, 

 

(1): I should note that it is impossible to guarantee future returns.  

Investment Bucket Strategy for Retirement

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Risk Management

Retirement Bucket Strategy 

What is the retirement bucket strategy? How does it work, and is this strategy right for you?

A key question for people retiring even with a healthy amount of assets is: is that going to last all the way?

So many elements go into answering that question. Still, on top of most people’s minds, one usually keeps them up at night: their investments.

And it makes sense: you can control your spending, social security is more or less a given, and Medicare and Medigap take care of most healthcare expenses. The biggest unknowns of our retirement are our lifespan and whether our investments will last all the way .

An effective retirement investment strategy is using the bucket investment strategy.

What Are The Three Buckets of Investing?

With the the retirement bucket strategy, retirees segment their spending needs into “buckets” depending on the time horizon of their spending . Of course, retirees can use as many buckets as they would like. However, for this discussion, let’s assume a 3 bucket investment strategy where the buckets can be arranged according to time horizon: near-term, medium-term, and long-term.

Retirees can use the immediate bucket to cover current living expenses and fund their lifestyle. Then they can use the intermediate bucket to refill the immediate bucket and the long-term bucket to refill the intermediate bucket. With a bucket retirement plan, each bucket pours into the next, creating multiple buckets or lines of defense between a retiree and adverse market events . 

The immediate bucket

The near-term or immediate bucket covers near-term living and lifestyle expenses. That could be defined as 1-5 years. In the case of Insight Financial Strategists, we tend to use five years.

To cover current living and lifestyle effectively, the risk of investments in the immediate bucket needs to be kept low. Hence the immediate bucket is invested in low-risk instruments, even cash, to ensure that market events such as a sudden drop in values don’t affect the investment and the spending they are associated with.

In market downturns, a low-risk immediate bucket allows the investor to leave their other buckets invested and not have to sell their investments at a loss.

Every year that passes reduces the money in the immediate bucket. With a five-year immediate bucket, there are only four years of expenses left after one year has passed. At that time, the immediate bucket is replenished from the intermediate bucket.

The long-term bucket is invested in assets that are expected to bring higher returns

The intermediate bucket

The role of the intermediate bucket is to get a better balance between risks and returns. While the immediate bucket is useful to tamp down short-term risk, too much in the immediate bucket would leave the retiree open to other risks, such as inflation, if the intermediate and long-term buckets did not complement it.

The amount budgeted in the intermediate bucket reflects spending and lifestyle needs after year 5 to another milestone. Our firm’s intermediate bucket covers expenses between the sixth and tenth year.

In addition to the time horizon, the risk embedded in the intermediate bucket reflects the investor’s risk tolerance. Typically this would result in a mix of stocks and bonds.

The allocation provides more growth potential than the low-risk immediate bucket and lower volatility than the long-term bucket. Because of that latter point, the intermediate bucket is expected to recover faster from a market downturn than the long-term bucket. 

Assets from this intermediate bucket are typically used to replenish the immediate bucket as it dwindles. 

The long-term bucket

Lastly, the long-term bucket aims to provide the portfolio with growth for assets expected to be used ten years or more in the future. In a retirement horizon of 20 years, 30 years, or longer, that is necessary to fight inflation and ensure that there will be enough in a retiree’s later years. 

In a retirement bucket strategy, the long-term bucket is invested in assets such as stocks that are expected to bring higher returns , although with higher volatility. The volatility is acceptable in this bucket because the immediate bucket covers short-term needs, and long-term bucket funds are not needed for another 10+ years. Downturns caused by the increased volatility have historically recovered (1). 

Graph 1: S&P 500 Performance 

Graph 1 represents the performance of the S&P500 from 2005 to 2021. Clearly, downturns occur, notably from the end of 2007 to the beginning of 2009. However, in the long term, the market is positively biased (1). 

How does it Work?

In years when the market is up, rebalancing happens normally. We replenish the immediate bucket from the intermediate bucket and the intermediate bucket from the long-term bucket. So if the market is up substantially, we might harvest more of the gains in case future years are less giving. 

Graph 2: A Hypothetical Bucket Plan

Exact bucket sizing will depend on the retirees’ needs and lifestyles. Most retirees will have a steady source of income, such as Social Security. In 2023, the maximum Social Security benefit is $4,459 per month, equivalent to $53,508 per year. If that is the retiree’s only steady income source, we expect the immediate bucket to cover expenses above that amount. For example, the retiree’s immediate bucket in Graph 2 represents spending for the plan’s first five years including potential mortgage payments. When netting steady income, such as Social Security, the plan generates an income need that investments can cover.

Graph 3: Power of Compounding

A key reason to remain invested in the intermediate and long-term buckets is the power of compounding . This property allows money invested over a more extended period of time to grow substantially. For example, Graph 3 shows the difference in the value changes between a hypothetical investment and cash. 

What are the benefits of a retirement bucket strategy?

There are a few distinct benefits of the retirement bucket strategy.

First, the financial planning needed to size retirement buckets properly can give retirees a great visual of how they can ride through retiremen t, living the life they prefer, yet without running out of funds. If the plan shows that it will be difficult, retirees can adjust their spending accordingly. Most people are surprised how even small changes in the parameters of a plan can result in outsized long-term effects.

Second, the bucket approach to investing can give retirees the peace of mind of knowing that their short-term needs will be taken care of regardless of market events . It will not stop people from worrying about what happens in the long-term bucket. After all, that’s where a lot of their resources are. 

Third, financial planning gives the investor a stronger ability to plan taxes optimally. It allows a deliberate use of various accounts such as brokerage, Traditional retirement, and Roth accounts.  

Fourth, it allows retirees to plan their legacy better. With the retirement bucket strategy, planning expenses and the resources needed to fund them enable the retiree to identify a legacy surplus if any. The excess funds can become an additional bucket focused on legacy planning. That allows the retiree to better think through how to help their children or their favorite causes. It enables them to plan the distribution of a legacy in a way that helps the children when they need it, which may be before the retirees’ death. 

What are the drawbacks of a retirement bucket strategy?

Some critics claim that the retirement bucket strategy results in an investment strategy that is too conservative and overweighted in bonds. However, as we size the buckets according to a retiree’s spending needs, there is no overweighting or underweighting, just right-sizing. That perhaps is the best feature of the retirement bucket strategy: removing the uncertainty of arbitrary allocation and distribution strategies.

Other critics find the retirement bucket strategy challenging to maintain. 

Working optimally, the retirement bucket strategy requires retirees to update their financial plans periodically . It also requires regular adjustments in investments. All of that can be complicated. However, the right software and skills help simplify the process.

Is the investing bucket strategy right for you? 

If you need a retirement plan that allows you to 

1. Balance your short-term and long-term needs
2. visualize your income and expenses, and visualize whether you will have enough for your lifetime. 
3. If you need to plan for a legacy without guessing how much you can spend, the bucket investing approach should be an option.  

To learn more about the retirement bucket strategy, visit Insight Financial Strategists,  or schedule a complimentary call, 

 

Check out our blog post on Carrying a Mortgage in Retirement!

 

 

(1): I should note that it is impossible to guarantee future returns.  

Should you cancel your LTC insurance?

By Chris Chen CFP | Financial Planning , Retirement Planning , Risk Management

Long Term Care (LTC)

LTC can be a stressful subject to discuss, especially when costs are addressed. The reality is that Long Term Care is expensive. According to Genworth, a prominent provider of Long Term Care insurance, the median national cost of a stay at an assisted living facility is $48,000 annually in 2018. The total long term care costs, over someone’s lifetime, ends up being much larger depending on where and how long a person will be needing it.

For example, the median cost of assisted living in New Jersey in 2018 was $72,780, according to Genworth. If someone were to stay at an assisted living facility for three years, the cost would be in excess of $200,000. Nursing home care could be even more expensive.

Aside from overall unpleasantness, a key issue with planning for LTC is the uncertainty. 70% of Americans will need it. But how much, and for how long? LTC is often the most unpredictable expense of retirement, and the least planned for.

Even insurance companies have difficulty ascertaining the cost. Large long term care insurance companies such as John Hancock have left the field and no longer offer LTC policies to the general public. Others, including Genworth and Mass Mutual, have been struggling with State Insurance Commissions to increase premiums. Recently, Genworth was approved to increase premiums by 58% in 22 States.

According to the Federal Government, Long Term Care is the range of services and support you will need to meet health and personal care needs over a long period of time when you are unable to provide it for yourself. LTC is not medical care, but rather assistance with the basic personal tasks of everyday life.

The fact is that most of us will require some form of long term care usually toward the latter part of our lives . Given the high probability, and the high level of expense, it is something that needs to be addressed in our financial and retirement plans.

We have plenty of statistics on how LTC affects us as a whole, but very few on how it will affect us individually. Are we going to be part of the 70%, or can we avoid it and be part of the 30%. We just don’t have a very good way to predict how much long term care we will need, when we will need it, and how much it will cost. This is precisely why long term care planning is necessary as part of normal financial or retirement planning.

Who Pays for Long Term Care?

People often assume that Medicare or Medigap (the supplemental coverage for Medicare), or even regular health insurance will cover the cost of their Long Term Care facilities.

Unfortunately, that is incorrect. Medicare is set up to cover only direct medical expenses, such as doctor and hospital visits, tests, and medicine. When it comes to issues of old age care, Medicare is not involved.

In general, most people without a plan who need Long Term Care will pay for it out of their own assets. Once there is no money left, Medicaid will usually take over. This approach works best for people who have enough assets to cover the other foreseeable circumstances in their future.

It is good to know that Medicaid is there, should we need it. However, planning for Medicaid to take over is a backup plan at best.

How do I protect my assets from nursing homes?

A close alternative to spending your own money and then letting Medicaid take over is actually to plan for Medicaid to take over. That involves creating a trust in which to put your assets so they can be protected in the event that long term care is needed. When that happens, the assets remain safely in the trust, and Medicaid pays for your long term care. You should keep in mind that Medicaid is taxpayer-funded, and as with other government programs, it is periodically under stress for funding. In other words, it is not easy to predict with certainty that such a plan would work, especially if it is much in the future.

Long Term Care Insurance

For others, purchasing a long term care insurance policy may be a better alternative. In exchange for the premiums, the insurance company commits to pay the amount contracted for. Effectively, the policy covers a significant percentage of the uncertainty generated by long term care. That amount can vary to take into account your own circumstances.

Who needs Long Term Care Insurance?

Long Term Care Insurance can help to preserve assets for other goals, including for legacy . It can also help you determine the level of care that you would like when you have a need for long term care.

From a tax viewpoint, it is worth noting that some of the premiums for most standard LTC policies available today may be deductible from taxable income within the limits specified by the IRS, especially for business owners. Also, up to certain limits, benefits are not taxed as income. Take this favorable tax treatment as a sign that Uncle Sam would like to encourage you to be covered (and not use Medicaid)!

The challenge with LTC insurance is that insurance companies have miscalculated the premiums required to cover their costs. As a result, premium increases, including the one mentioned earlier from Genworth, have shocked pre-retirees and retirees alike, resulting in a considerable debate about whether to drop LTC insurance policies altogether.

The financial impact of premium increases is real. It is a painful hit on a sore subject. And as with any price increase like that, the impulse is just to cancel.

However, canceling would be a mistake for many people. The cost of LTC must be covered somehow, and if not through insurance, it is usually through your own assets. However, it does provide an opportunity to reconsider the issue with your financial planner. Most people affected by price increases bought their policy many years ago. It would be beneficial to re-analyze the LTC need and the benefits of the policy. You may find out that you are over-insured, or underinsured. And then you can figure out a way forward on how to right-size your coverage.

According to Tara Bernard at the New York Times analyzing your LTC coverage can even lead to a renegotiation of the policy, especially if you are reducing the benefits.

Long Term Care insurance helps pay for long term care expenses, helps preserve your assets and your legacy. Also, a portion of the premium is potentially tax-deductible. So why are so many people resistant to traditional Long Term Care insurance?

First, as we mentioned before, it is expensive. Although, it is worth noting that the cumulative cost of LTC insurance premiums is often less than the cost of Long Term Care itself!
Second, the possibility that the insurance policy may not be used, as in the case of death happening suddenly, is enough to stop many people from acquiring Long Term Care insurance. In this paradigm, the thought of paying premiums for years, and not collecting a benefit would make the insurance a waste.

Don’t Waste the Premiums

To counter this objection, the insurance industry has created products that allow you to “not waste the premiums.” These products allow you to purchase an annuity or a life insurance policy with a special “rider” that allows their conversion to an LTC policy should the need arise.

These products allow you to get Long Term Care coverage if needed, and allow repurposing the funds in case the Long Term Care benefit is not used. The details of these products are beyond the scope 0of this post. Suffice it to say, that these alternatives can provide a lot of flexibility, at a cost, in a financial plan. For people who have significant assets that are not needed for their retirement plan, these alternatives may be worth considering.

Should I cancel my LTC insurance?

Because of the increases in premiums that are sweeping the LTC insurance industry, many people are wondering if long term care insurance is worth it and if they should cancel their policies . There is no easy answer to that question. The increased cost can be burdensome. But the other side to this question is if you cancel your insurance because of the premium increase, how are you going to pay for your Long Term Care expenses when they occur?

The answer is different for everyone. Being a financial planner and number geek, I believe that the answer for many resides in comparing the costs and the benefits. For most people that will result in keeping your insurance. If you are not sure, schedule a call with me, and we can review.

LTC can be a significant expense. As such, it needs to be factored into your overall retirement plan. The four approaches discussed (pay out of assets, Medicaid planning, traditional long term care insurance, and “not waste the premium” alternatives) all offer different benefits and should be matched to the right circumstance and individual preference.

In my experience, most people find it liberating to include LTC in a retirement plan formally, and know what is planned and how much is planned for. It then leaves greater flexibility to focus on the fun aspects of life!

If you need to figure out which option works best for you, schedule a conversation with me today!

 

Check our other posts on Long Term Care:

Planning For Long Term Care

Long Term Care Considerations for Retirement Planning

How Jill Can Plan To Pay for Long Term Care

 

Don’t Ignore the Chatter – a Trade War represents a Major Risk

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

Quarterly Capital Market Perspectives

There’s been a lot of sideways action in this year’s capital markets. We have had a couple of mini-corrections already but equity markets have done a remarkable job of ignoring some clouds on the horizon.

The big elephant in the room that investors have chosen for the most part to ignore is the possibility of an all-out global trade war.

What started back in February as aluminum and steel tariffs has delved into a war of words and escalation of tariffs between the world’s three largest economies of the US, China and Europe.

There is almost a sense of disbelief that this could be happening after decades of globalization.  We are so used to the free flow of goods and services across borders that we hardly ever stop and think about where things are made.

Is a Toyota Camry Japanese or a “Made in the USA” car from a company that so happens to be domiciled in Japan? Is your iPhone an American product or a product made in Asia for a US-based company?

Global companies such as Apple or Toyota operate in highly inter-linked global supply chain and sales channels. A trade war will be highly disruptive to global trade and manufacturing.

Ultimately, an all-out trade war creates massive uncertainty and significantly lowers global economic growth going forward. According to Oxford Economics a trade war could cost the global economy $800 Billion.

To read more about our views on key risk factors facing investors for the rest of 2018 and our intermediate-term outlook for major asset classes please read our Quarterly Capital Market Perspectives.

Post-Divorce Investments – What do I need to plan for now?

By Eric Weigel | Divorce Planning , Investment Planning , Portfolio Construction , Risk Management

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.

Typically when you divorce you end up with an investment portfolio that is ½ of your old couple’s portfolios. Invariably, your new portfolio will not be suitable anymore.  If you haven’t been the “financial” person in your marriage you may not even know what you own.

Most likely you will need to make changes to your portfolio to suit your new situation. You are now also solely responsible for your financial health.

Your post-divorce portfolio should reflect your updated needs, objectives and comfort level with investment risk.  This may not be what you bargained for or you may feel ill-prepared to handle this on your own.  You may feel that your life is out of your sync, but aligning your financial assets to your new situation is entirely under your control.

Why do you need a new portfolio once you divorce?

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.

As wealth managers our first goal is to first understand the client’s circumstances and needs once the divorce is finalized. Our P.R.O.AC.T.I.V.E process serves as the framework for initiating and exploring client concerns and issues.

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.

 

Other posts you may find interesting

Pension Division in Divorce

4 Risks of Pension Plans in Divorce

Post-Divorce Investments 

 

 

3 Mistakes DIY Investors Are Prone to Making in a Crisis

By Eric Weigel | Investment Planning , Portfolio Construction , Risk Management

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.

My contention is that when the rubber hits the road, many DIY investors are ill-equipped to deal with extreme capital market uncertainty. 

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.

Many DIY investors have not seen a real crisis in their investment lifetimes.  While everybody can read about stock market crashes unless you live through such a period it is hard to truly assimilate their impact both on your pocketbook but more importantly on your psyche.

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!

Oftentimes when an investor sells in a panic the most troubling decision is when to buy in again. Even worse if the decision to sell turns out to be wrong, the investor will endlessly question themselves and lose confidence in their ability to navigate on their own.

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.

 

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.

During a period of crisis, the tendency of DIY investors is to focus almost exclusively on sentiment. When sellers want out now and buyers are scarce the price will automatically come down.

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.

DIY investors often lack an understanding of context and an assessment of prospective fundamentals in the face of wildly fluctuating capital market conditions. The tendency by many is to stand pat, but what if changing market fundamentals require a change in portfolio positioning?  Intentional investing often requires action.

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”.

As capital markets change over time so will the risk characteristics of a portfolio even if rebalanced periodically to static weights. 

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

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

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.

For DIY investors, changing levels of volatility and correlations can cause significant changes to the risk/returns characteristics of their portfolios. For example, volatility tends to spike up during periods of capital market stress and remain low when markets are trending up.

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.

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Conclusion:

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.

DIY investors tend to make three types of mistakes during a crisis – they chuck it all in a panic, they freeze up and do nothing, and, lastly, they ignore changing levels of portfolio volatility.

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.

 

5 Symptoms of “Fake” Portfolio Diversification

By Eric Weigel | Investment Planning , Portfolio Construction , Risk Management

What You Need To Do Immediately Diversification is one of the core concepts of investment management yet it is also one of the least understood .

In many ways diversification is like apple pie and motherhood – good for you and always taken at face value without any real introspection.

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?

Understanding the portfolio diversification concept is not an academic nicety. Proper diversification is crucial for growing your wealth and managing through the inevitable ups and downs of financial markets .

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.

With portfolio diversification there is no such contract and especially there is no set deductible capping your losses.  When somebody says “my portfolio is diversified” it can mean a million things .  But does it mean what you think it does?

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?

Or maybe you read a mutual fund advertisement stating that the fund you own has investments in a large number of industries.  Sometimes people think sprinkling their money across a large number of funds with different names means that they are diversified .

Why the confusion? Without getting too technical, diversification can mean a whole lot of different things depending on the context.

Properly understanding the context and what diversification means is difficult for non-financial people to wrap their hands around.  And that is a big problem and why investors often fail to capitalize on what Nobel Prize winner Harry Markowitz once called the only free lunch in financial markets .

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?

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Should you just assume that you are diversified?

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.

You don’t need a PhD from MIT or Chicago to understand the concept of diversification but pay attention as the details are important.

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.

Most people already know that when economic times are good, stocks will typically go up more than bonds but when there is a crisis the reverse will often occur.

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?

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Symptom 1: Your portfolio is nothing more than a collection of funds you have accumulated over time  

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.

Symptom 2: The more funds and strategies the more diversified my portfolio  

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.

Owning a large number of investments does not mean that you are diversified.  It probably means that you or your advisor are confused about how to construct a portfolio. You can actually be much more diversified with a small number of uncorrelated investments – the number of investments is immaterial.

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.

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.

We have had more biotech booms and busts than probably for any other sector over the last 30 years .  Many of the biotech stars of old unfortunately were sold for cents on the dollar despite promising early findings.

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.

Diversification within an asset class such as stocks or bonds is not nearly as powerful as diversification across divergent asset classes

What do you mean?

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.

A diversified mix of stocks, bonds and real estate is usually a great starting point for building your long-term financial wealth while allowing you to sleep well at night. Don’t overthink it.

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.

For most people it is far wiser to leave a bit of money on the table by diversifying across asset classes than go head first into a market crash.

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.

 

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Conclusion:

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.

Capital Market Perspectives – April 2018

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

 

The last couple of months have tested investors.  In a sense, we all got lulled by the wonderful returns of last year and any hiccup was bound to create some stress.

The talk at the end of 2017 was all about tax cuts and the short-term boost that lower tax rates would provide to consumer spending and the bottom-line of US corporations.

For the first month of the year, things couldn’t have been going better for equity investors. Bond investors while not exactly sitting in the catbird’s seat were slowly adapting to the inevitable rise in yields.

Emerging market equities, in particular, jumped ahead and the mood among global investors was one of optimism.  Market commentators were even talking about a stock market melt-up!

Two months later the mood has changed drastically. Investors are nervous and we have already witnessed two small corrections in the equity markets.

Figure 1

Source: FRED (Federal Reserve Economic Data), Insight Financial Strategists, April 2018

The first mini-correction attributed to rising inflationary expectations took the S&P 500 from a peak of 2873 on January 26 to a low of 2581 on February 8. The 11% drop while not unprecedented was keenly felt by investors accustomed to the record low levels of volatility seen in the last year. It felt like going from a newly paved highway to a dirt road without any warning signs!
 

Were rising inflationary expectations to blame for the early February stock market fall?  Our research did not support this story.  We had been seeing a slow rise in inflationary expectations for about a year but US Inflation Protected Note prices containing the market’s consensus forecast of inflation over the next 5 and 10 years did not exhibit any significant upward pressure.

Inflation in the US seems to be fairly range bound with the latest year over year reading of 2.3% (February). Inflationary expectations as of April 6 for the next 5 years stand at 2.0% and for 10 years out at 2.1%.

The market implied forecast may turn out to be too benign, but for now, our own view of economic conditions in the US is closely aligned with these market-based expectations.

A number of events could have caused the early February correction, but in the context of long-term capital market history, we think that this episode will appear as a mere blip on price charts. Rising inflationary expectations do not seem a likely culprit for this episode of equity market stress.

Figure 2

Source: Quandl, FRED, Insight Financial Strategists, April 2018

What about the most recent late March equity market drawdown? US equity market markets staged a strong recovery from the February lows with the S&P 500 having recovered all but 3% of the losses from the January 26 peak. Since early March the global markets have, however, been on a roller coaster ride.  Up one day, down big the next. As of April 6, the S&P 500 has lost over 6% since March 9.

The second mini-correction of the year has re-tested the resolve of equity investors. Volatility levels have jumped up and have risen significantly from the lows of 2017. The intraday movement of markets (the difference between the high and low of the day) has been about 2X that of normal periods and 4X that experienced last year.

Figure 3

Source: Quandl, FRED, Insight Financial Strategists, April 2018

Market volatility has been historically low over the last few years but the large intraday swings we have been seeing this year are distressing to even seasoned investors.  John Bogle in a recent interview for Marketwatch commented that he had not seen such a volatile market in his lifetime. He was referring specifically to the huge intra-day moves seen over the last two weeks.

 What has caused this recent bout of stock market volatility? As always there are many possible reasons, but this time around we see a more direct link to the uncertainty surrounding a possible global trade war.

Markets do not react well to uncertainty especially to events that are both hard to quantify in terms of the probability of occurrence and the magnitude of consequences.

Trade wars are not everyday events.  The last time wholesale tariffs were imposed in the US happened in 1930 when the Smoot-Hawley Tariff Act was passed.  While economists will debate whether the Act exacerbated the Great Depression, in general, it is acknowledged that tariffs limit economic growth.

Free-trade has been a goal of most nations for the last 50 years. Gains from free trade provide a win-win outcome enabling producers to focus on goods and services where they enjoy a comparative advantage and consumers to reap the benefits through lower costs is one of the strongest held beliefs of modern economics.

Global trade of goods and services currently accounts for 27% of worldwide output (according to the OECD). Disrupting global trade by imposing tariffs on a large number of items seems reckless.  It is especially reckless when considering that we picked a fight with the world’s largest economy – China.  China also owns 19% of the outstanding supply of US Treasuries.

No doubt Chinese trade practices are unfair to US companies. Forcing US companies to transfer technical know-how to Chinese firms seems especially egregious given the state of China’s economic development.  China is the largest global economy and many of its technology companies are already global powerhouses.

Another bone of contention for some is the under-valuation of the yuan.  An undervalued currency is a huge weapon for increasing the attractiveness of a country’s exports.  However, it is not clear that the yuan is under-valued. According to an IMF report in July of 2017, the fair value of the yuan was roughly in line with market prices and fundamentals.

At first, the tariffs proposed by the Trump administration seemed fairly innocuous – washing machines and solar panels. Then on March 1, the US proposed tariffs on steel and aluminum.  Not good especially since many traditional allies of the US (mainly Canada and South Korea) would be the primary targets. Gary Cohn, the administration’s top economic advisor, resigned in protest sending shockwaves through the financial community. The S&P 500 reacted with a 1.34% loss for the day

However what really got the capital markets in a tissy was the announcement on March 22 of tariffs on $50 billion worth of Chinese imports.  The fight was on and it did not take very long for Chinese authorities to retaliate with in-kind tariffs on US goods.

The S&P 500 dropped 2.55% on March 22 and 2.12% on the next day.  Likewise, Chinese equity markets reacted quite negatively to the possibility of an all-out trade war with the US with the iShares China Large-Cap ETF (FXI) dropping 3.8% and 2.4% respectively on those days.

 

Where is this all going to end up? In an all-out trade war like after the passage of the Smoot-Hawley Act? Or, in serious bilateral negotiations between the US and China?

Our guess is that there are enough rational agents in both the US and Chinese administrations to avert an all-out trade war, but getting the negotiations going will not be easy and will take time.  China has already requested negotiations through the WTO Dispute Settlement Mechanism. Luckily there is at least a 60 day comment period separating talk and action.

The US is not likely to be a winner in a global trade war.  Nobody is really.  The most likely outcome is lower overall global growth and increased uncertainty – not a good recipe for capital markets especially in light of current above-average valuation levels.

 

The main problem for the US is that as a nation we are not saving enough.  The current net savings rate as a function of GDP currently stands at 1.3%. This number has been steadily trending down – the average since 1947 when numbers were first compiled is 6.6%.

The US balance of payments and trade deficits are a function of the imbalance between domestic savings and our thirst to grow and consume.  In 2017, the US had merchandise trade deficits with 102 countries. China is not our only problem!

Let’s hope that cooler heads prevail and that the disruption to global trade proves minimal.  Some of the damage has already been done as uncertainty has engulfed global capital markets.

The real economic damage of a global trade war is likely to be substantial.  Both equity and bond markets would come under significant stress.  Equities would likely take the most immediate hit as earnings growth, especially for multi-nationals, would drop significantly.

Bonds are also likely to take a hit as a likely reaction by the Chinese authorities would be to decrease their investments in the US Treasury market. Interest rates in the US would likely jump up causing pain to fixed income investors as well as worsening the federal budget deficit.

 

What do we expect in the intermediate-term from capital markets? While all this talk about trade wars and inflation scares may fill our daily news capture, it is worthwhile to remember that fundamentals drive long-term asset class performance.

In the short-term, capital markets can be heavily influenced by changing investor sentiment, but over the horizons that truly matter to most investors most periods of capital market stress tend to wash out.

Our current capital market perspectives assume that a trade war will not materialize.  Our views are informed by a number of proprietary asset class models updated as of the end of March.

Our current intermediate-term views reflect:

• A preference for stocks over bonds despite their higher levels of risk
• A desire for international over US equity based on valuation differentials and a depreciating US dollar – we especially like emerging market stocks
• Within the fixed income market, we favor corporate bonds as we believe that economic conditions will remain robust and default risk will be contained
• Small allocations to commodities as this asset class gradually recovers from the bear market it’s been in since the 2008 Financial Crisis
• A reduction in our exposure to real estate as the asset class is being heavily penalized in the markets for its interest rate sensitivity
• Minimal allocations to cash – the opportunity cost of holding large sums of low yielding cash is high especially for investors with a multi-year horizon
• A return of risk on/off equity market volatility– this will surely stress investors without a solid plan for navigating market turbulence

 

 What should individual investors do while politicians flex their muscles? For starters evaluate your goals, risk attitude, spending patterns and investment strategy.  Make sure that the shoe still fits.  Capital markets are not static and neither are personal situations.

A long-term orientation and tactical flexibility will be a necessity for investors as they navigate what we think will be difficult market conditions over the next decade.

Such an approach will be especially important for individuals near or already in retirement. The sequence-of-returns-risk is especially important to manage in the years surrounding retirement when the individual will start drawing down savings.

Our approach at Insight Financial Strategists explicitly deals with this type of sequence-of-returns-risk by building the individual’s portfolio around the concept of goal-oriented buckets. Each bucket has a distinct goal and risk profile.

The short-term bucket, for example, while customized for each individual, has the overriding goal of providing a steady stream of cash flow to the individual.  This is the safe money designed to exhibit minimal volatility.

The goal of the intermediate-term bucket is different – this part of the portfolio is designed to grow the purchasing power of the individual in a risk-controlled manner. A sometimes bumpier ride is the price of growth for this bucket but the rewards should be more than commensurate with the additional risk taken.

Finally, the long-term bucket is designed to maximize the long-term appreciation of this portion of the portfolio.  This bucket will be the most volatile over the short term and is suitable for individuals with time horizons exceeding ten years and able and willing to withstand the inevitable periods of capital market stress.

Understanding Asset Class Risk and Return – Your Pocketbook and Psyche Will Thank You

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

 

Markets do not just go up as much as we wish for that to be always the case.

Sometimes capital markets experience stress and the draw-downs can be extremely uncomfortable to investors.

How investors react to periods of capital market stress is incredibly important.

Become too aggressive and you could end up with major short-term losses and your financial survival may be at stake.

On the other hand, become too cautious and you may end up excluded from any future capital market appreciation.

 

So, if risk is inevitable, what can you do about it? Being either extremely aggressive or extremely risk-averse are probably the least desirable options especially if you wait to act until there is a market meltdown.

In the first case, you may not be able to stay invested as short-term losses cripple your psyche and your pocketbook.  Even though you believe in your investments, your emotions will be tugging at you and second-guessing you.  This is the curse of being too early.

In the case where people become too risk-averse, being too cautious prevents you from making up the losses experienced during periods of capital market stress by participating in the good times. Most likely you second guess yourself and by the time you take the plunge back in you have probably already missed out on some large gains.  This is the curse of being too late.

 Investing is not easy especially when things go against you in the short-term. It is best to understand what you are getting yourself in and have a plan for when things go awry. As Mike Tyson once said, “everybody has a plan until they get punched in the nose”.

Getting punched in the nose is not an uncommon experience for stock market investors.  For bond market investors the experience is not as common but it still happens.

Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan. A great game plan is useless unless you have the ability to withstand the dark periods.

Investors are frequently confused by capital market behavior.  Over the short-term asset classes can go almost anywhere as investment sentiment is usually a strong driver of returns.  Market pundits attempt to provide some rationale for why things are moving in a certain direction, but in reality, most of what goes on from day to day in capital markets is usually nothing more than noise.

Markets are prone to bouts of over-confidence where all the bad news gets ignored and investors appear overly upbeat.  Other times, markets will be laser-focused on negative short-term events of little economic significance and investors will become overly pessimistic.  Even seasoned investment professionals feel sometimes that there is no rhyme or reason for what is happening to financial asset prices.

Over longer-term horizons, asset class fundamentals start being reflected in prices as investment sentiment becomes secondary.  Profits, valuations, profitability, growth potential become the drivers of prices.  Periods of stress are frequently forgotten and appear as mere blips on historical price charts.

One of the key tenets of long-term investing is that risk and return are inextricably tied together.   Without any risk, you should not expect any incremental returns. Investing is inherently risky as outcomes – short or long-term – cannot be predicted with total certainty.

Most investors understand that, on average, stocks do better than bonds but that the price of these higher returns is a lot more risk.  Investors also understand that longer-maturity bonds will do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.

But beyond this high-level understanding of capital market behavior, there is lots of confusion. Gaining a better understanding of key asset class risk and return relationships will help you become a better-informed consumer of investment strategies.

Understanding what you are getting yourself in when evaluating different investment strategies could significantly alter your wealth profile for the better and allow you to take advantage of market panics rather than simply react to crowd psychology like most people.

To become an informed consumer of investment strategies the first step is understanding key asset class risk and return tradeoffs.  We use a dataset kindly provided online by Professor Aswath Damadoran at NYU to look at calendar year returns on US stock, bond and bill returns.  Bond returns proxy for a 10-year constant maturity US Treasury Note and bills correspond to a 3 month US t-bill.  US stocks are large capitalization stocks equivalent to the S&P 500. Figure 1 depicts the annual asset class returns since 1937.

The first thing that jumps out from the chart is the much higher level of return variability of stocks.

The second thing that jumps out is the incredible year over year smoothness of T-bill returns.  Bonds are clearly somewhere in between with volatility characteristics much more similar to bills.

The third thing that jumps out are the rare but eye-popping large equity market meltdowns such as during 1937, 1974, 2002 and 2008.  Lastly, of notice are the very large positive spikes in equity returns during years such as 1954, 1958, 1975, 1995 and 2013.

 Figure 1

What is not entirely clear from looking at the yearly return chart is the huge cumulative out-performance of stocks relative to both bonds and bills. Table 1 provides summary statistics on calendar year returns for each asset class.

Table 1

Key highlights:

• Over the 1928-2017 period, stocks have returned on average 12% per year with an annual standard deviation of 20% year. Bonds are next in line with an average return of 5% and a volatility of 8%. Bills have had the lowest rate of return at 3% with a volatility of 3%. These numbers correspond to the usual risk/reward relationships that investors know all about.
• In 27% of the years between 1928 and 2017, stocks have had a negative return. The average return when the market has gone down is -14%. Nobody likes losses but even bond investors saw negative returns in 18% of the years and when they happened the average loss was -4%. The only way never to lose money in any given year is to invest in bills.
• If one had invested $100 in December 1927 and held that investment the ending portfolio value would be $399,886 – a huge rate of growth despite the infrequent yet terrifying equity market meltdowns. Bonds don’t come even close with an ending portfolio balance of $7,310. Playing it safe with bills would have yielded a portfolio value of $2,016.
• From a cumulative wealth perspective, stocks are clearly the superior asset class but only if the investor is able to stomach the rare but large equity drawdowns and seeing losses in over a quarter of the years.
• If the investor is seeking stability with no chance of principal loss, T-bills are the preferred asset class. The rewards compared to stocks will be meager, but the ride will be smooth and predictable.

 

What happens when you extend the holding period out to, say 10 years? Does the spikiness of stock market returns disappear? What about the frequency of down years?

Using the same data set as before and forming rolling 10-year holding returns starting in 1927 we observe in Figure 2 that some of the volatility of stocks and bonds has dissipated. Instead of spikes we now have mountains and slopes.

Figure 2

 

The chart on rolling 10-year returns exposes the massive cumulative out-performance of stocks during most ten-year holding periods.  There are instances of negative 10-year stock returns (6% as shown in Table 2) but they are swamped by the mountain of positive returns especially when viewed in relation to bond and bill returns.

We see only three periods when equity investors would have loved to play it safe and be either in bonds or bills – the early years post the Great Depression (1937-39), the Financial Crisis (2008-9), and economic stagnation and inflationary years starting in the mid-70s through the beginning of the equity bull market of 1982.  In the first two instances, equity holders lost money.  In the latter instance, equity investors enjoyed positive returns but below those of either bonds or bills.

Table 2

Some observations are in order:

• As one extends the holding period from 1 to 10 years some of the spikiness of one-year returns is smoothed out – not every year is fantastic and not every year is terrible, periods of stress are usually followed by periods of recovery and so on
• Over a ten year holding period stocks do not look as scary – only in 6% of our observations do we see a negative return. When those losses occur the average loss is 10% on a cumulative basis.
• Rolling 10-year maturity bonds every year over a decade yields no periods in our sample where the strategy exhibits a loss. The same holds true for bills.
• Investors able to extend holding periods from short to longer maturities such as ten years significantly lower their odds of seeing negative returns as confirmed in the empirical data

 

What happens when we mix and match asset classes? Does that help lower our probability of loss? We look at some typical multi-asset class mixes over one-year holding periods:

• The 60/0/40 portfolio composed of 60% stocks and 40% bonds – a traditional industry benchmark
• The 40/0/60 portfolio composed of 40% stocks and 60% bonds – a moderately conservative mix
• The 25/50/25 portfolio composed of 25% stocks, 50% bills and 25% bonds – a conservative mix for a very risk-averse investor

Mixing asset classes is usually referred to as multi-asset class investing.  The premise for such an approach is based on the diversification benefits afforded by allocating in varying proportions to asset classes with their own unique risk and return characteristics.

It turns out that over the 1928-2017 period stocks were essentially uncorrelated to both bonds and bills.  The correlation between bonds and bills was 0.3.  Building portfolios with lowly correlated asset classes is hugely beneficial in terms of lowering the volatility of the multi-asset class mix.

Table 3

 

What are the main conclusions that we can reach when mixing asset classes with widely different risk and return characteristics?

• When combining stocks, bonds, and bills in varying proportions we arrive at portfolio results that fall between those of equities and bonds
• The traditional 60/0/40 portfolio had a lower frequency of negative returns compared to an all-equity portfolio, significantly lower volatility and a cumulative ending portfolio value only about a 1/3 as large. What you gain in terms of lower risk, you lose in terms of compound returns.
• The 40/0/60 portfolio which represents a lower risk alternative to the investor lowers volatility (to 9%) but at the expense of also lowering average returns (to 8%) and especially cumulative wealth (ending value of $58,090)
• The lowest risk multi-asset class strategy that we looked at – the 25/50/25 portfolio – had the lowest average returns (6%), lowest volatility (6%) and lowest long-term growth.
• A key implication of multi-asset investing is by combining asset classes with disparate risk and return characteristics you can build more attractive portfolios compared to single asset class portfolios
• Comparing two traditionally low-risk portfolios – 100% bonds and the 25/50/25 portfolio – demonstrates the benefits of multi-asset class investing. The multi-asset class portfolio not only has higher average returns but lower risk. The frequency of calendar year loss is smaller (11% compared to 18%) and the long-term portfolio growth is over 2X that of the all-bond portfolio.

 

Three very significant lessons emerge from our study of asset class behavior that can vastly improve your financial health.  The first relates to the holding period.  Specifically, by having a longer holding period many of the daily and weekly blips that so scare equity investors tend to wash away.

Equity investments do not look as volatile or risky when judged over longer holding periods of say 10 years.

The second lesson relates to the power of compounding. Small differences in average returns can yield huge differences in long-term cumulative wealth.  In terms of the multi-asset class portfolios – the 60/0/40 versus the 40/0/60 – yields only a 1% average return difference but a 2X difference over the 1928-2017 period.

Seemingly small differences in average calendar year returns can result in massive wealth differences over long holding periods.

The third lesson relates to diversification. By mixing together asset classes with varying risk and return characteristics we can significantly improve the overall attractiveness of a portfolio. Lower portfolio risk is achievable with proper diversification without a proportional sacrifice in terms of returns.   Properly constructing multi-asset class portfolios can yield vastly superior outcomes for investors.

 

Every investor needs to come to terms with the risk to reward relationships of major asset classes such as stocks, bonds, and bills.  Understanding the risk and return tradeoffs you are making is probably the most important investment decision affecting the long-term outcome of your portfolio.

Some investors can stomach the sometimes wild ride offered by stocks and choose to overwhelmingly use equity strategies in their portfolios. They don’t worry much about the daily vicissitudes of the stock market.  They accept risk in return for higher expected returns.

Not everybody, however, can stomach the wild ride that sometimes comes from owning stocks despite understanding that over the long-term stocks tend to better than bonds and bills.

Some investors are willing to leave a bit of money (but not too much, please) on the table in return for a smoother ride. They may elect to hedge some of the risks.  Or they may mix in varying proportions of risky and less risky asset classes and strategies.

Yet other investors are so petrified of losses and market volatility that they will forego any incremental return for the comfort and steadiness of a safe money market account. They choose to avoid risk at all costs.

 

Which is the better approach for you? Avoid all risks, save a lot and watch your investment account grow slowly but smoothly?

Or, take some risk, sweat like a nervous high schooler when capital markets go bust and grow your portfolio more rapidly but with some hiccups?

The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses to your wealth.  If you already have a financial plan in place great. If you need help getting started or refining your plan, the team at Insight Financial is ready to share our expertise and bring peace of mind to your financial life. Book an appointment here.

Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan.  In subsequent articles, we will be exploring different ways of managing risk and structuring portfolios.