Category Archives for "Sustainable Investing"

What’s After The Bear Market?

By Chris Chen CFP | Financial Planning , Investment Planning , Portfolio Construction , Retirement Planning , Sustainable Investing

What's After The Bear Market?

For the month ending 3/20/2020, the S&P 500 has been down almost 32%. Maybe it is because it’s happening right in front of us, but, somehow, the drawdown feels worse compared to history’s other bear markets.

According to Franklin Templeton, there have been 18 bear markets since 1960 which is about one every 3.1 years . The average decrease has been 26.3%, taking a little less than a year from top to bottom.  

Financial planners often work with averages. But the reality is that each bear market will be different from the norm. At the time that I write this, the depth of this particular drawdown does not even rank with the worst in history. Sure, it may still get worse, but that’s where we are today. 

We may not want to hear about how things will get better, because the situation with the Covid-19 pandemic and its resulting prescription of social isolation and market downdrafts is scary. But, eventually, things will get better. 

Keep in mind that things may get worse before they get better. The count of people with the virus will almost certainly increase. If you don’t have a source yet, you can keep up with it over here. But eventually, the Coronavirus epidemic will run out of steam. We will get back to our places of work. Kids will go back to school. Financial markets will right themselves out. We will revert to standard toilet paper buying habits. We will start going out to eat again. Life will become normal again. 

Financially, the question is not just how bad will things get, but how long it will take for our nest eggs to rebuild, so we can put our lives back on tr

Historically, since WWII, it has taken an average of 17 months for the S&P 500 to get back to its peak before a bear market .

The longest recovery since we have had reliable stock market records has been the Great Depression. The longest recovery post-WWII was in the wake of the dot-com crash at the beginning of this century. That took four years. The stock market recovery following the Great Recession of 2008 and 2009 took only 3.1 years . 

Hence, it could take us a while before we make it back to the previous market peak. However, we may want to look at the data differently. This graph shows that, historically, we have needed to achieve a return of 46.9% to recover from a bear market .  According to Franklin Templeton calculations, these numbers can look daunting. However, they have been achieved and exceeded after every past downturn. While there is no guarantee, these numbers suggest that there will be strong returns once we have reached the bottom of the market. I like to think of this as an opportunity.  

With the time that it takes for investments to grow and get your money back, there is time to take advantage of higher expected returns. For those who have resources available, this means that there is time to deploy your money at lower prices than has been possible in recent months.

Those of us who have diversified portfolios and are not in a position to make new investments, the opportunity is to rebalance to benefit from a faster upswing. 

We know from history that every US stock market downturn was followed by new peaks at some point following.

Could this time be different? 

Of course, that too is possible.

I like to think that the future will be better. We will still wake up in the morning looking to improve ourselves, make our lives better, and achieve our goals. We are still going to invent new technologies, fight global warming, and struggle for a more equitable society. 

We are living through difficult times right now. Losses in our brokerage and retirement accounts are not helping. But we will get through this. Please reach out to me if you have specific questions or concerns.

3 Simple Ways to Avoid Ruining Your Retirement

By Eric Weigel | Investment Planning , Retirement Planning , Sustainable Investing

 

What’s your “Probability of Ruin”?

Many people considering retirement or in the early phases of this new stage in life worry about outliving their assets.  

These individuals no longer have the luxury of a steady paycheck, and unless they are one of the lucky ones with a defined benefit plan and/or a large portfolio of liquid investments, they will have to dip into their 401k’s and savings to fund their lifestyle.

Somebody in the de-accumulation phase will naturally worry about how long their money will last and whether they can maintain their lifestyles.

People are living longer these days and it is not unheard of for a newly minted retiree to live another 30 years.  

Let’s look at the data. According to the Social Security Actuarial Life Table (2014) estimates, life expectancy for a 65 male is 17.81 years and for a female 20.36 years.  Somebody in above average health may live even longer – these are just median numbers. If you want to conduct your own calculations, you can refer to How Long Will You Live?

David Blanchett of Morningstar uses the 2012 Society of Actuaries annuity table to estimate the likelihood of living to a certain age using the methodology outlined in his 2013 FPA journal article. This cohort of individuals comes from a higher than average socio-economic group and tends to live longer than average.

Table 1 highlights the calculations from the perspective of a 65-year-old. There is a 50% chance that a male lives to age 89 with a female living to age 91.

Table 1

 

Source: David Blanchett, Morningstar

The point of these projections is that most people should plan for a long period in retirement. The good news is that we are living longer today but the bad news is that we need to make our retirement savings last longer if we are to maintain a certain lifestyle.

Some people retire with very healthy nest eggs that, barring a cataclysmic event, will provide plenty of cash to fund their lifestyles.  They need not worry much as long as assets vastly outstrip expenses.  They have a high margin of safety.

For most retirees, however, the margin of safety provided by their financial assets in relation to their expenses is slimmer.  They do need to worry about how much they are spending, how their investments are performing and how long they may need their portfolio assets to last.  They may have other sources of income such as Social Security but still need to make their investment portfolios work hard to bridge the gap between lifestyle expenses and sources of income.

Most people in retirement face a balancing act

They can control their expenses to some extent (putting off non-essential expenses).  They can plan and make sure that their investment portfolios are structured in accordance with their appetite and need for risk-taking (maybe requiring the help of a financial professional). But what they can’t control are capital market returns and how long they need to tap into their retirement accounts (how long they will live).

One way to identify the various trade-offs required to ensure the sustainability of an investment portfolio is to come up with a CHRIS, a Comprehensive Holistic Retirement Investment Strategy with the help of a financial professional.  A good plan should clearly outline what actions you need to take and what type of minimum portfolio return you will need to achieve to ensure that the probability of running out of money before you or your partner/spouse die is within your comfort zone.

Another alternative is to forego a formal financial plan and utilize some sort of rule of thumb such as William Bengen’s 4% rule. According to this highly popular rule published in 1994, you can safely withdraw 4% of your capital every year in retirement.  The research contains a number of key assumptions (such as a 50/50 stock/bond allocation) often ignored in the popular press, but the Bengen rule is not only well known but popular among many retirees.

Should one just jump ahead in and rely on the Bengen 4% rule? Our view is that before you do so, you really should understand the probability of running out of money.

Milevsky and Robinson provide a simple approach in their highly touted article “A Sustainable Spending Rate without Simulation” to calculating what they call the “probability of ruin.”

Milevsky and Robinson identify three important factors: your rate of consumption, the risk/reward structure of your portfolio, and how long you live. Visually, these concepts can be illustrated in a Retirement Finances Triangle as depicted in Figure 1.

Without going into the mathematics of the Milevsky and Robinson approach for calculating a “probability of ruin” lets us think a bit more deeply about what makes retirement planning complicated in the first place.

 Figure 1

The first aspect that makes retirement planning difficult is the uncertainty surrounding how long you and your spouse/partner are going to live. People are living longer, on average, than in previous generations. But an average does not necessarily help you.  Your physical and mental health could be dramatically different from the “average” individual.

The other variable that is highly uncertain and makes retirement planning more difficult relates to the variability of investment outcomes on your retirement portfolio.  While history is a guide as to what to reasonably expect in terms of key asset class returns and risks over the long-term, in any given year returns could fall within a wide range.

As most people already know, stock returns exhibit more variability in outcomes than bonds.  The “probability of ruin” calculation using the Milevsky and Robinson formula incorporates the ability of individuals to evaluate the implications of various forms of asset allocation with varying levels of expected risk and return.

As you have probably figured out by now, calculating the “probability of ruin” is extremely important in planning your retirement.

The Setting:

To make the situation more realistic let’s look through the eyes of George and Mandy, both aged 65 and about to retire from their corporate jobs.  They have saved diligently over the years and now have a portfolio worth $1,000,000 that they will tap to fund their lifestyle in retirement.

The Problem:

George and Mandy estimate that they will need $90,000 a year to maintain their lifestyle.  Their Certified Financial Planner has also told them that their Social Security income will be $50,000 a year.  They face an annual gap of $40,000. They expect to tap into their retirement portfolio to fund this gap.

They are in reasonably good health and based on discussions with their financial planner they assume that they will live to age 90. To be safe, they assume a retirement horizon of 30 years.

Their starting portfolio value is $1,000,000 and they wish to withdraw $40,000 a year to fund their living expenses.

Capital Market Assumptions:

We assume that inflation will run 3% per year, on average.  Currently, inflation is running a bit lower than 3% in the US but the historical average is only slightly north of 3%.

What sort of investment risk and return assumptions should people use to calculate the probability of running out of money under this scenario?

Past returns are often a poor guide in forecasting returns and George and Mandy decide as a starting point to use the current Insight Financial Strategists long-term capital market assumed risk and return numbers as outlined in Table 2. These numbers are derived from expected long-term growth, profitability and starting valuation relationships.  They should be viewed as purely hypothetical and subject to great variation.

For illustrative purposes only, Insight Financial Strategists has aggregated all the asset class risk and return numbers into six multi-asset class strategy portfolios according to investment risk – Conservative, Moderate Conservative, Moderate, Moderate Aggressive, Aggressive and the industry convention of a 60/40 balanced strategy.

Table 2

Source: Insight Financial Strategists

Let’s start out gently – the Case of No Uncertainty:

It always helps to start off with a hypothetical scenario where all decision elements are known with certainty up front. We assume that George and Mandy own a 60/40 portfolio returning 4.9% per year and an annual inflation rate of 3%.

If they were to withdraw the equivalent of $40,000 a year in inflation-adjusted terms what would the required distribution look like over their retirement years?

Figure 1

Source: Insight Financial Strategists

The red line in Figure 1 depicts what would happen to their expenses in retirement if inflation were to rise every year by 3%.

What started off as a withdrawal of $40,000 turns into a much larger number over time. For example, after ten years they would need to withdraw $52,000 each year to fund their lifestyle (assuming that their Social Security checks are adjusted annually for inflation as is the current practice).

After 20 years they would need to withdraw $70,000 from their portfolio each year and after 30 years (their last year in their calculations) the number would increase to $94,000 annually. Inflation can sure take a bite!

In terms of George and Mandy’s portfolio, the assumption is that it will yield 4.9% per year or in inflation-adjusted terms, 1.9% per year. After withdrawals are taken out of the portfolio by George and Mandy to fund their lifestyle net of portfolio returns (the assumed 4.9% nominal return per year) the assumed value of the portfolio is depicted in Figure 2.

 Figure 2

Source: Insight Financial Strategists

At the end of the 30th year, the portfolio is expected to be worth $277K.  As long as George and Mandy only live 30 years in retirement and the assumed inflation and portfolio returns prove spot on (accurate) then things should be ok.  They will glide through retirement and even have some assets left over.

The problem occurs if either George and/or Mandy live past age 95. According to the actuarial data in Table 1, there is a 25% chance that George will live to age 99 and Mandy will live to age 101.

Now what? Their current $1,000,000 portfolio is now insufficient to fund their retirement expenses past the age of 97.  They will run out of money and not be able to rely on portfolio income anymore.

What could they do to prevent such an unpleasant outcome?

For starters, they could spend less. For example, they could cut back their annual spending to $30,000.

They could also shoot for higher portfolio returns by taking on a bit more investment risk.  George and Mandy understand that higher portfolio returns are not generated out of thin air.  Higher prospective returns are tied to higher risks.

But does the real world work like this?

Is it just a matter of pulling some levers here and there and voila you have wished for the perfect outcome?

Unfortunately, referring to the Retirement Finances Triangle depicted in Figure 1 although there are some things that George and Mandy can control such as their expenses but when it comes to how long they will live and how their portfolio will actually perform over their retirement years there are lots of unknowns.

Let’s deal with the real world – Introducing Uncertainty:

What if George and/or Mandy live longer than the assumed 30-year lifespan? This is what professionals refer to as longevity risk.  Living a high quality, long life is a very noble and common goal. Outliving your assets is a real fear.

What if portfolio returns do not measure up to our assumed returns? This is referred to as investment risk. What happens if investment returns are significantly below expectations and portfolio income proves insufficient to maintain your desired lifestyle?  Most retirees seek some margin of safety in their investments for this exact reason.

The Milevsky and Robinson formula is designed to take these uncertainties into account by modeling the likely distribution of portfolio returns and longevity.  The end output is a probability of running out of money at some point in time over the retirement horizon.  They refer to this number as the “probability of ruin”.

Let’s start by looking at the implications of the various portfolios strategies presented in Table 1. The Conservative strategy is the least risky approach but also has the lowest prospective returns. This strategy is exclusively composed of bonds.

The Aggressive strategy is exclusively composed of equities and is expected to have the highest returns as well as the highest risk of all of our strategies.

The 60/40 strategy falls along the middle in terms of prospective portfolio returns and risk.

What do the different risk and return profiles of the strategies imply in terms of the probability of ruin of George and Mandy’s portfolio?

Figure 3 depicts graphically the output from the Milevsky and Robinson formula.

Figure 3

Source: Insight Financial Strategists

What immediately jumps out from the bar charts is that the probability of ruin for the various portfolios is quite high. No longer assuming that everything is perfect creates, not surprisingly, more difficult likely outcomes.

For example, if George and Mandy were to employ the Conservative strategy yielding an assumed 2.3% annual return there is an 80% probability of them running out of money at some point in retirement.  Being conservative has its drawbacks!

What if they had the internal fortitude to employ the all-equity Aggressive strategy yielding a prospective return of 6.8% with a volatility of 17%? Their probability of ruin would drop to 37%.

Even if they employed the conventional 60/40 strategy, their probability of ruin would still exceed 45%.

What if the probability of running out of money is too high? 

Well, for starters they could reduce their rate of consumption, i.e. spend less. Maybe not what they wanted to hear but possible.

Let’s assume that instead of taking out $40,000 a year from their investment accounts they withdraw only $30,000? Let’s also assume that they invest in the traditional 60/40 portfolio. The only thing that has changed from the previous scenario is that now George and Mandy are spending only 3% of their initial portfolio to fund their lifestyle.

By spending less and thus depleting their investment assets at a slower rate, they lower their probability of running out of money at some point over their remaining lives to 30%. George and Mandy start thinking that maybe searching for a more inexpensive vacation option makes sense and allow them to worry less about outliving their assets.

 Figure 4

Source: Insight Financial Strategists

 

What else can they do to shift the odds in their favor?

Besides spending less, another option is to work a bit longer and postpone their retirement date. Let’s say they both work five years longer than originally planned.   What would happen assuming that they still intend to withdraw $40,000 in portfolio income and they invest in the 60/40 strategy?

Figure 5

Source: Insight Financial Strategists

By delaying retirement for five years George and Mandy lower the probability of running out of money to below 38%. Not bad but maybe not quite to their satisfaction.

Could George and Mandy restructure their investment portfolio to improve their odds?

Yes, that is certainly a feasible approach as we already outlined in Figure 3.  Higher return strategies carry higher risk but when held over the long-term tend to lower the probability of running out of money.

But not everybody is equally comfortable taking investment risk even if it is likely to result in higher ending portfolio values over the long-term.

Is there another approach to design a more suitable retirement portfolio?

While risk and return are inextricably intertwined, recent financial research has identified the “low volatility” anomaly where lower volatility stocks outperform their higher volatility cohorts on a risk-adjusted basis.  See this note for an introduction to the low volatility anomaly.

Let’s say that instead of assuming a 10.4% volatility for the 60/40 portfolio we are able to utilize a mixture of similar investment vehicles designed to exhibit lower levels of volatility but equivalent returns. Say the volatility of this strategy is now 8.4% and uses a range of lower volatility fixed income and equity approaches plus possibly an allocation to a guaranteed annuity.

Figure 6 illustrates the implications of using the lower volatility investment strategy.  The probability of ruin goes down marginally to below 42%.  Good but not great in the eyes of George and Mandy.

Figure 6

Source: Insight Financial Strategists

What else can George and Mandy do? 

After all, they have evaluated the impact of lowering their expenses, deferring their retirement date and structuring a more suitable investment portfolio and they still are uncomfortable with a probability of ruin in the 30% range.

The short answer as in many areas of life is to do a bunch of small things.  They could elect to just lower their spending from 4% to 3% and the probability of running out of money would drop to about 30%.

But George and Mandy realize that they could do even better by doing all three things:

• Spending less
• Working a bit longer
• Structuring a more suitable investment portfolio

Figure 7 highlights the various alternative courses of action that they could take to increase the odds of not running out of money in retirement.

Figure 7

Source: Insight Financial Strategists

There are no guarantees in life, but spending less, delaying retirement and designing a more suitable portfolio lowers the probability of running out of money to about 20%.

While we all strive for control, George and Mandy are comfortable with this approach and the sacrifices required. To them leading a fulfilling life in retirement is more than just about money and sacrificing a bit in order to gain peace of mind is a worthwhile trade-off.

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What does calculating the probability of running out of money in retirement teach us?

Is the trade-off that George and Mandy are making appropriate for you? Maybe, but maybe not. At the very least, understanding your own circumstances and your own probability of running out of money may lead to vastly different choices.

Your retirement could extend for 30+ years. Having enough resources to fund your retirement is important to maintain your lifestyle and achieve peace of mind.

While much of life is beyond our control, everybody can still exert some influence over their retirement planning.  In this article we highlighted three general strategies:

• Adjusting your spending
• Delaying when you tap your retirement resources
• Designing an investment portfolio that suitably balances risk and reward

As people enter retirement, they can’t eliminate either longevity or investment risk. What they can do is manage the risks and remain open to adapting their plan should things change.

At Insight Financial Strategists we don’t believe in shortcuts. A CHRIS, a Comprehensive Holistic Retirement Income Strategy, gives you the best chance of full understanding your circumstances and what needs to happen to fund your lifestyle in retirement.

Barring a full financial plan, at a minimum people should evaluate the likelihood of running out of money. Applying the Milevsky and Robinson formula represents a starting point for an in-depth conversation about your needs, goals and especially your attitude toward risk and capacity to absorb losses.

Interested in having the professionals at Insight Financial Strategists guide you? Please request a complimentary strategy session here.

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Disclaimer:

Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including the risk of loss.

 

Is Your Caution Today Hurting Your Tomorrow?

By Eric Weigel | Financial Planning , Investment Planning , Retirement Planning , Sustainable Investing

How our brain works:

We all think that we are fully rational all the time but in reality the way our brains operate that is not always the case.

One of the key functions of the brain is self-defense. When the brain perceives danger it makes automatic adjustments to protect itself.  When it perceives discomfort it seeks to engage in an action that removes the stress.

In his book “Thinking Fast and Slow” Nobel Prize Winner Daniel Kahneman explains how we all have a two way system of thinking that we use to make decisions.  He labels the two components as System 1 (Thinking Fast) and System 2 (Thinking Slow).

System 1 is automatic, fast responding and emotional. System 2 is slower, reflective and analytical.

Think of your System 1 as your gut reaction and your System 2 as your conscious, logical thought.

While we all like to think that our key life decisions are governed by our logical thought (System 2) research has shown that even major decisions are often driven by our gut feel.

Which System do we use to make a decision? That depends on the problem. If we have seen the problem many times before such as what to do when see a red light we default to our automatic System 1 thinking.

When we face a challenge or issue that we have not seen before or maybe infrequently we tend to use System 2, our more reflective and analytical capabilities.

Kahneman’s research shows that we spend most of our time in System 1. While most people think of themselves as being rational and deliberate in their decision making, the reality is that we often employ “short-cuts” or heuristics to make decisions.

Most of the time, these “short-cuts” work just fine but occasionally for more difficult or complex problems the impressions arrived from System 1 thinking can lead us astray.

Why? Above all else, System 1 thinking seeks to create quick and coherent stories based on first impressions.  These impressions are a function of what our brain is sensing at that moment in time.

According to Kahneman, conclusions are easily reached despite often contradictory information as System 1 has little knowledge of logic and statistics. He calls this phenomenon – WYSIATI – for “what you see is all there is”.

The main implication from WYSIATI is that people often over-emphasize evidence that they are familiar with and ignore evidence that may be much more relevant to the problem at hand but that they are not fully aware of.

System 1 conclusions therefore may be biased and lead to decision “short-cuts” or heuristics that seriously impair the quality of a decision.

What makes making “money” decisions so hard?

When it comes to investing people often rely too much on System 1 or automatic thinking. The research shows that we are not infallible and we in fact often make behavioral mistakes. Sometimes we over-rely on our gut feel without properly evaluating the consequences of our actions.

Often our brain perceives of the dangers first and sends us a warning signal to be careful.  Losing money puts us on red alert.

Behavioral finance research (for example in the book Nudge) has shown that losing money makes you twice as miserable as gaining the same amount makes you happy. People are loss averse.

Loss aversion makes people overvalue what they have due to a reluctance to incur any losses should they make a change. What they give up, sometimes unknowingly, is potential upside.

Loss aversion creates inertia. Inertia often works against investors that overvalue the attractiveness of their current holdings.

There are different degrees of loss aversion.  According to Prospect Theory, all investors value gains less than losses but some exhibit an extreme dislike for potential losses that significantly hinders their long-term wealth creation potential.

Nobody likes to lose money, but taking on risk in order to compound your hard earned savings is an integral feature of how capital markets work.  You don’t get a higher reward unless you take additional risk.

Most investors know that stocks do better than bonds over the long-term but that the price of these higher returns is more risk.  Investors also understand that bonds do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.

But knowledge stored in your logical and analytical System 2 thinking does not always make it through in the face of stress or uncertainty.

People can become too risk averse for a couple of reasons:

• Case A: They let their fears and emotions guide their investment decision making and give disproportionate importance to avoiding any losses
• Case B: They fail to calibrate their expectations to the likely frequency of outcomes.

In Case A, investors seek the perceived safety of bonds often not realizing that as interest rates go up bonds can lose money.  Or they simply pile into CD’s not realizing that their returns most often fail to keep up with inflation. Stocks are frowned upon because you can lose money.

Investors in Case A let their decisions be driven by emotion and fear and will over-value the importance of safety and under-value the importance of future portfolio growth.  Their account balances will not go down much when capital markets experience distress, but neither will they go up much during equity bull markets.

In Case B investors mis-calibrate their expectations for various investment outcomes and the consequences can be as dire as in the first situation.  Behavioral finance research has shown that investors frequently over-estimate the likelihood and magnitude of extreme events such as stock market corrections.

Investors often become fixated on what could happen should an equity market correction occur, but they fail to properly evaluate the likelihood and magnitude of such a correction in relation to historical precedents.  They also importantly fail to properly calibrate the probability of observing a recovery after going through such a correction.

What are the implications for investors playing it too safe?

Let’s consider the case of investors currently working and saving a portion of their income to fund a long-term goal such as retirement. These individuals are in the accumulation phase of their financial lives.

Somebody in the accumulation phase will naturally worry more about how fast they can grow their portfolio over time and whether they will reach their “number”.  People in the accumulation phase care primarily about their balances going up year after year. They are in “growth” mode.

The Hypothetical Setting:

To better illustrate this situation let’s look through the eyes of a recent college grad called Pablo earning $40,000 a year. Pablo is aware of the need to save part of his salary and invest for the long-term.  He just turned 22 and expects to work for 40 years.

Pablo will also be receiving annual 2.5% merit salary increases which will allow him to save a greater amount each year in the future.

The Problem:

Pablo faces two key decisions – what percentage of his salary to save each year and the aggressiveness of his portfolio which in turn will determine its most likely return.

He is conflicted. He has never made this much money before and worries about losing money. He also understands that he alone is responsible for his long-term financial success.

Pablo knows that there is a trade off between risk and return but he wants to make a smart decision. His System 1 thinking is saying play it safe and don’t expose yourself to potential loses.

At the same time his rational and informed System 2 thinking is influenced by a couple of finance and economics classes he recently took while in college.

Pablo can succumb to automatic System 1 thinking and invest in a very conservative portfolio. Or he can rely on his System 2 thinking and invest in a higher risk and commensurately higher return portfolio.

One Alternative – Save 10% of his Income and play it safe investing

For simplicity sake assume that Pablo decides to put 10% of his salary into an investment fund. The fund consists primarily of high grade bonds such as those contained in the AGG exchange traded fund.

From the knowledge gained in his econ and finance classes Pablo estimates that this portfolio should return about 4% per year – a bit below the historical norm for bonds but consistent with market interest rates as of August 2018.

Pablo also understands that such a portfolio will have a bit of variability from year to year. He estimates that the volatility of this portfolio is likely to be about 6% per year. Again, this estimate is in line with current bond market behavior as of August of 2018.

He knows that this is a low risk, low return portfolio but the chances of this portfolio suffering a catastrophic loss are negligible. He is petrified of losing money so this portfolio might fit the bill.

How large could his portfolio be expected grow to over 40 years of saving and investing in this conservative manner?  We built a spreadsheet to figure this out. We assumed a 4% portfolio return on principal, 2.5% annual salary increases and a half year of investment returns on annual contributions also at 4%.  Remember that this is a hypothetical example with no guarantee of returns.

At the end of 40 years Pablo’s salary is assumed to have grown to $107,403 and his portfolio, invested in this conservative manner, would have a balance of $575,540.  The growth of this portfolio (identified as 10_4) is shown in Figure 1. The naming convention for the portfolios corresponds to the savings rate followed by the assumed hypothetical rate of return on the strategy.

Figure 1

Source: Insight Financial Strategists, Hypothetical Example

Pablo knows that his portfolio will not exactly return 4% every year. Some years will be better, other years much worse but over the next 40 years the returns are likely to average close to 4%.

But Pablo does not feel comfortable just dealing in averages.  If things go bad, how bad could it be?

Given the volatility of this conservative portfolio there is a 10% chance of losing 3.6% in any given year. These numbers are calculated by Insight Financial Strategists based on an approximation of a log-normal simulation and are available upon request. Not catastrophic but nobody likes losing money.

Figure 2 shows the 90^th and 10^th probability bands for this conservative portfolio. These bands are estimated based on the expected average return of the portfolio and its volatility.

The actual portfolio return would be expected to lie about 2/3 of the time within these bands. In the short-term, say 1 to 2 years out, the portfolio returns are more unpredictable.  Over longer horizons, the average return to this conservative portfolio should fall within much tighter bands given the assumed risk and return numbers in the log-normal simulation.

Based on the calculations, the average returns over ten years should range between 6.3% and 1.4% per annum. Clearly, even this conservative portfolio has some risk especially in the short-term, but over longer holding periods returns should smooth out.

Figure 2

Source: Insight Financial Strategists

Another Alternative – Save 20% of his Income and continue investing in a conservative portfolio

Assuming the same 2.5% annual salary increases, the final salary would have been the same but his nest egg would have grown to $1,151,080. Pablo keeps looking at Figure 1 (the 20_4 line representing a 20% savings rate invested at an assumed 4%) and starts thinking that maybe a bit of extra saving would be a very good thing.

He still has a 10% probability of being down 3.6% in any given year, but if his budget allows, he feels that he can forego some frills until later.

Now, Pablo is starting to get excited and wonders what would happen if he invested more aggressively, say in a variety of equity funds?

Yet Another Alternative – Keep saving the same amount but invest more aggressively

The likely returns would go up but so would his risk. He estimates that based on current market conditions and the history of stock market returns (obtained from Professor Damodaran of NYU) that this more aggressive portfolio should have about an 8% annual rate of return with a volatility of around 14% per year. These estimates are both a bit lower than the 1926-2017 average reflecting higher current (as of August 2018) valuations and lower levels of overall market volatility.

He is thinking that maybe by taking more risk in his portfolio during his working years he will be able to build a nest egg that may even allow him for some luxuries down the road.

He also knows that things do not always work out every year as expected. Pablo is pretty confident that 8% is a reasonable expectation averaged over many years, but how bad could it be in any given year?

A log-normal simulation was conducted using the assumed risk and return numbers – same approach as before.

Figure 3 shows the 90^th and 10^th percentile bands for this portfolio.

Figure 3

Source: Insight Financial Strategists

Given the volatility of this equity-oriented portfolio, there is a 10% chance of losing 9.2% in any given year (based on the simulations). Ouch, the reality of equity investing is starting to sink in for Pablo.

But Pablo is also encouraged to see that his returns in any given year are equally likely to be about 26% or higher. That would be nice!

Especially when it comes to equities there is a wide range of potential returns but over time these year by year fluctuations should average out to a much narrower range of outcomes. While our best estimate is that this portfolio will return on average 8% per year over a ten-year window the range of expected outcomes should be between a high of 12.9% and a low of 1.6%.

Pablo decides to research the history of stock, bond, and cash returns by reading our April Blog on Understanding Asset Class Risk and Return and looking at a chart of long-term returns from Morningstar (Figure 4).

Figure 4

Source: Morningstar

He is surprised to find that over the long-term equities do not seem as risky as he previously thought. He is also quite surprised by the wide gap in wealth created by stocks versus bonds and cash.

The research makes Pablo re-calibrate his expectations and he starts wondering whether the short-term discomfort of owning equities is worth it in the long run.

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The “Aha!” Moment:

Pablo’s System 1 thinking is on high alert and his first thought after seeing how much he could lose investing in equities is to run back to the safety of the bond portfolio.

But something tells him to slow down a bit and think harder. This is a big decision for him and his System 2 thinking is kicking in. Before he throws the towel in on the equity-oriented portfolio he glances again at Figure 1 to see what might happen if he invests more aggressively.

What he sees astounds him. It is one thing to see compounding in capital market charts and yet another to see it in action on your behalf. Small differences over the short term amount to very large numbers over long periods of time.

If Pablo were to invest in the more aggressive portfolio there would be more hiccups over the years but his ending account balance should be $1,440,075 if he consistently put aside 10% of his salary every year.

If he saved 20% the ending portfolio balance would double in size.

Decision Time – Picking among the alternatives

Pablo is now faced with a tough decision.  Does he play it safe and go with the conservative portfolio? Or, does he go for more risk hoping to end up with a much larger nest egg but knowing that the ride may be rough at times?

Beyond the numbers, he realizes that he needs to look within to make the best possible decision.  His System 1 thinking is telling him to flee, but his System 2 thinking is asking him to think more logically about his choices.  He also needs to deal with how much he is planning to save from his salary.

Fear versus Greed:

He needs to come to terms with how much risk he is willing to take and whether he can stomach the dips in account balance when investing in riskier assets.  As Mike Tyson used to say, “Everybody has a plan until they get hit in the face”.

In structuring his investment portfolio Pablo needs to balance fear with greed.  Paying attention to risk is absolutely necessary but always in moderation and in the context of historical precedents.  If Pablo lets his fears run amuck he may have to accept much lower returns.

With the benefit of hindsight, he may come to regret his caution. On the other hand, the blind pursuit of greed and a disregard for risk may also in hindsight come back to bite him.  Pablo needs to find that happy medium but only he can decide what is right for him. Risk questionnaires can help in this regard. Try ours if you like!

Consumption Today versus Tomorrow:

Pablo also needs to come to grips with how much current consumption he is willing to forego in order to save and invest.  We live in an impulse oriented society. Spending is easy, saving is hard.

Saving is hard especially when you are starting out.  On the other hand, over time the saving habit becomes an ingrained behavior.  The saving habit goes a long way toward ensuring financial health and the sooner people start the better.

Will Pablo be able to save 10% of his salary? Or, even better will he be able to squeeze out some additional expenditures and raise his saving to 20%?

If possible Pablo should consider putting as much money in tax-deferred investment vehicles such as a 401(k). He should also have these contributions and any other savings automatically deducted from his paycheck. That way he won’t get used to spending that money. Pablo may come to see these deductions from his paycheck as a “bonus” funding future consumption.

“The greatest mistake you can make in life is to continually be afraid you will make one”

— ELBERT HUBBARD

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Lessons Learned:

This has been an eye-opening experience for our hypothetical friend Pablo.  He was not expecting such a difference in potential performance.  He now realizes the importance of maximizing saving for tomorrow as well as not succumbing to fear when investing for the long-term.

He has learned several invaluable lessons that also apply to individuals in the accumulation phase of their financial lives

Lesson 1: The Importance of Saving

• Delaying consumption today allows you fund your lifestyle in the future
• Saving even small amounts makes a big difference over the long-term

Lesson 2: The value of patience and a long-term perspective

• In the early years you may not notice much of a difference in portfolio values
• Keep saving and investing – disregard short-term market noise and stick to a plan

Lesson 3: Small differences in returns can amount to huge differences in portfolio values

• Seemingly tiny differences in returns can result in large differences in portfolio values
• Compounding is magic – take advantage of it when you can

Lesson 4: The importance of dealing with your fear of losing money

• Letting your first instinct to avoid risky investments dictate what you own will work against you
• Investing involves risk – best to manage rather than avoid risk
• The pain and agony of losing money in any given year is alleviated over the long term by the higher returns typically accruing to higher risk investments

Lesson 5: Investing in your financial education pays off

• Gaining a proper understanding of capital market relationships is an invaluable skill to possess
• Leaning on financial experts to expedite your learning is no different than when athletes hire a coach

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Now what should you do?

Avoid all risks, save a lot and watch your investment account grow slowly but smoothly? Or, take some risk and grow your portfolio more rapidly but with some hiccups?

Are a couple of restless night’s worth the higher potential returns in your portfolio? On

Also, are you willing to delay some current consumption in order to invest for the future?

The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses.

Interested in having the professionals at IFS identify your risk tolerance, time horizon, and financial needs? Please schedule a complimentary consultation here.

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Disclaimer:

Much of the data used in these illustrations comes courtesy of Professor Aswath Domodaran from NYU and covers US annual asset returns from 1928 to 2017. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including risk of loss.

Doing Good While Also Doing Well

By Eric Weigel | Investment Planning , Sustainable Investing

Incorporating Sustainable Investing Principles Into Your Portfolio

 

The term “sustainable investing” is often used interchangeably with “socially responsible investing”. In general, these terms describe an approach to investing that combines traditional financial methods to portfolio construction with the desire to simultaneously create positive societal outcomes.

What might these societal outcomes be? The industry has gravitated to three broad areas of impact – Environmental, Social and Governance (ESG).

We are all exposed to these various areas in our daily lives and many of us care deeply about some of these issues.  For the most part, we have channeled our beliefs into action through charitable giving and volunteering efforts.

But a new way of “doing good while also doing well” has emerged in the last few years .  Investment strategies have been designed to deliver competitive financial returns while also impacting society in a positive manner.

Sounds too good to be true? Large institutional investors have been able to achieve both financial and societal returns for a long time, but only in recent times have investment strategies been designed to enable individual investors to achieve the same objective.

 

How did sustainable investing get started? In its early days socially responsible or what we now call sustainable investing took an exclusionary view to investing . For example, tobacco companies were often excluded from portfolio mandates. Another, probably more extreme example involved the divestment of South African investments during the apartheid era.  Companies selected under this form of exclusionary screening had to meet a minimum threshold of “do no harm” but that was about it.

How has sustainable investing changed in the last few years? More recently, investors have looked at ways to create positive social outcomes within their financial portfolios.  The focus has shifted toward emphasizing investments with the dual objective of superior risk adjusted financial returns along with demonstrably positive environmental, societal and/or governance outcomes.

Doing well while doing good

“Doing good while doing well” is the basic rationale why investors are increasingly interested in enhancing how they manage their portfolios by including non-financial metrics such as environmental, societal and governance factors.

Besides ethical and moral motivations, why have investors suddenly become so interested in sustainable approaches to investment management?   Simple – self-interest combined with the realization that currently disclosed financial metrics are insufficient to properly account for the long-term sustainability and valuation of companies.

Large and small investors have woken to the fact that environmental issues such as climate change and carbon emissions have significant implications for our global well-being as well as for the long-term financial health of companies. This is the E in ESG.

Investors are also becoming very interested in the societal impacts of corporate behavior. Issues such as workers’ rights, gender and diversity policies and human rights in general. This represents the S in ESG.  For example, recent sexual harassment scandals at various media companies highlight the impact of non-financial events on corporate valuation.

Probably the oldest way of using non-financial criteria to evaluate companies involves the area of corporate governance.  This is the G in ESG.  Board composition, executive compensation practices and sustainability disclosure criteria are just three areas of increasing investor attention.

Is it possible to achieve competitive returns and also deliver a significant impact? Research indicates that “doing good while doing well” is achievable if properly implemented.

One of the concerns of early investors in SRI approaches was that excluding companies deemed to be “bad actors” would significantly restrict one’s investment opportunities and returns would commensurately suffer.

Recent empirical studies show that returns need not suffer especially when risk-adjusted.

Research from Morningstar depicted below highlights a segment of socially responsible funds compared to the broad universe of US equity mutual funds. The general conclusion is that socially conscious funds tend to have a higher representation among 3 and 4 star funds and lower proportions in the tails.

While not a ringing endorsement, the Morningstar research at least points out that there is no empirical reason to suspect that socially conscious funds underperform the general universe of US mutual funds.

 

Research generally shows that sustainable investing strategies do no harm, but can you do better? Yes, when the issues examined have a clear link to financial performance.  This relates to the issue of materiality.

Certain ESG issues are important from a societal standpoint but have a tenuous relationship to financial metrics such as company profitability or asset valuation.  For example, preserving the Costa Rican Toucan is a worthwhile societal goal, but few publicly traded companies have a direct financial link to such an effort.

On the other hand, global warming has a direct effect on the severity of hurricanes and directly impact the financial performance of companies in the insurance and construction industries among others.  Such an effect would be deemed material and of great consequence to individual investors with allocations to sustainable investing strategies.

Recent research by Harvard professors Khan, Sarafeim and Yoon identified a large variation in long-term measures of company financial success when evaluating companies on material ESG metrics.   Their conclusion is that companies with superior sustainability practices outperform companies with poor practices. *

How can individual investors incorporate sustainable investing strategies into their overall portfolios?  Our take is that properly constructed portfolios incorporating financial as well as non-financial ESG criteria are competitive on a risk-adjusted basis over short holding periods while providing significant positive upside over the long-term.

Our belief is that investors will benefit long-term from lower levels of business risk in their holdings as well as potentially higher stock returns.

Companies with superior ESG practices tend to provide greater transparency in their disclosures, be better prepared to deal with adverse events when they happen, and be more open to adapting their business models around environmental, social and governance issues likely to be material over the long-term.

Are sustainable investing strategies different from traditional approaches? The same risk-return balancing issues that apply to any investment portfolio apply to an approach using sustainability criteria. The biggest difference at the moment occurs at the implementation stage.

Implementing ESG portfolios requires additional research and caution.  While a growing universe of investment vehicles exist in the form of mutual and exchange traded funds there are wide differences in liquidity, composition and cost.  Properly conducting due diligence on the various sustainable investing offerings requires an above-average experience and know-how of financial materiality issues.

At Insight Financial Strategists we have done significant research on sustainable investing and believe that these strategies are here to stay and will deliver on the goal of “doing good while doing well”.

Please schedule a time to discuss with us your financial planning and investment needs and how a sustainable investing approach might fit your requirements.

 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. Views expressed are the opinions of Insight Financial Strategists LLC as of the date indicated, based on the information available at that time, and may change based on market and other conditions.  We make no representation as to the accuracy or completeness of the information presented.  This communication should not be construed as a solicitation or recommendation to buy or sell any securities or investments. To determine investments that may be appropriate for you, consult with your financial planner before investing. Market conditions, tax laws and regulations are complex and subject to change, which can materially impact investment results.

*  “Corporate Sustainability: First Evidence on Materiality” by Mozaffar Khan, George Serafeim, and Aaron Yoon, Harvard Business School Working Paper No. 15-073, March 2015.

Individual investor performance may vary depending on asset allocation, timing of investment, fees, rebalancing, and other circumstances.  All investments are subject to risk, including the loss of principal.

Insight Financial Strategists LLC is a Registered Investment Adviser.