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In This Issue: Take The Path Of Least Regret, Avoid Sinking Luck May Be No Lady To Retirees That Gamble A Portfolio Mix For All Seasons
Take The Path Of Least Regret, Avoid Sinking The new movie, “A Perfect Storm,” offers a horrific reminder of nature’s awesome power when several random climactic conditions occur simultaneously. The real-life heroine of the original story, Linda Greenlaw, is a neighbor of mine in Maine, where I spend summer vacations. When she returns from fishing expeditions, the world price of tuna drops by a few fractions. She makes her living on a sea that once sent a 95-foot wave crashing against the ocean liner Queen Mary. It broke the windows in the pilot house and tipped the giant ship to within a few degrees of capsizing. So where am I going with this? I’m reminded of the vast economic forces that sweep through society. As mere mortals, we like to think that the president, or Congress, or Alan Greenspan, or somebody can control these forces. Remember the days of Jimmy Carter and “stagflation” (a stagnant economy and inflation?) Or Gerald Ford’s “WIN” buttons (“Whip Inflation Now?”). The economy suffers or benefits periodically from its own version of the perfect storm — when cyclical events compound to trigger dramatic results on the upside or the downside. Good or bad, they are out of our control. This “perfect storm” analogy presents a good visual image of what happens with different types of assets in a retirement account. Investment types have different “wave actions.” The starting point for minimizing risk and generating higher returns is understanding how different types of investments are inversely correlated. For example, you can expect different results from a fund investing in small companies than from a large-company, value-oriented mutual fund. Investing half of your money in each fund — the small-cap and the large-cap value — will generate average results that are more like a straight line. I call this the “Path of Minimum Regret.” A more common experience is if investors have a combination of funds that were all about the same. This is by far the most common experience of most investors. Many of us own a dozen or more of the largest, most popular funds — with portfolios that look pretty much alike. In the end, they all wind up with similar results. Graphing a combination of 4 types of funds can illustrate how the results compare. Take, for instance, a bond fund, an S&P 500 fund, a small company fund, and a foreign stock fund. Calculating the average return of all four funds each year and expressing this average as a fifth line will show this line to be the straightest and most predictable. A straight line of results offers a better prediction of what will happen in the future. In other words, it represents less volatility — and less risk. The actual annual returns generated by the combination of four different investments assumes that the investments, in real life, were balanced at the end of each year. In other words, if you started with one quarter of the money in each fund at the beginning of the year, you would sell at year’s end a portion of the winners and buy the losers to bring the percentages back to 25 percent in each investment. In effect, this is a form of dollar-cost averaging. (Remember, we are talking about investing within a tax-deferred retirement account, such as an IRA, so that capital gains taxes are not a factor.) Many people have adopted a more “set it and forget it” approach, which, for the late ’90s, has served them better than rebalancing. That’s because the S&P 500 funds or their clones have done so well. “Letting the winners ride,” as they say in the gambling world, has paid off more handsomely than selling some of the winners at the end of each year. Of course, the last few years of the bull market have yielded unprecedented results. In theory, the practice of systematically bringing fund types back to even percentages of total holdings will be worth the effort during more normal time periods. The greatest barrier to a year-end adjustment is the “status quo bias.” In fact, a $500,000 MacArthur “genius” fellowship was just granted to a Berkeley economics professor who studied procrastination and its role in poor money management. (The professor, incidentally, admits to keeping too much money in a low-interest bank account, due to his own procrastination!) Creating (and maintaining) a path of minimum regret reduces investment variables and keeps things simple. Simplicity leads to constructive change. By comparison, trying to pick the “best” investments for your 401(k) selection often leaves us in a catatonic, do-nothing state. The message: Develop a simple strategy. And remember, even perfect storms have survivors, and these fortunate folks, like my neighbor Linda, live to sail another day.
Luck May Be No Lady To Retirees That Gamble Is
the national obsession with gambling driving the stock market?
If so, that’s disturbing news for serious retirement investors,
even if their gambling is limited to the office betting pool. Like other vices, tolerance of gambling in American culture is cyclical. It was popular during Revolutionary times, then banned for about 100 years when we decided that there were better ways to allocate resources. In the last 20 years, gambling has been revitalized as both a legitimate industry and a lucrative source of state revenues. In my view, a society that encourages gambling reinforces the misguided notion that you can get something for nothing. Call me a Calvinist, but I don’t see how we as a people benefit in any fundamental way from gambling’s proliferation. I enjoy gambling for entertainment and social interaction, but I don’t believe these factors alone explain its explosive growth. Instead, I believe the “something-for-nothing” notion is the seed for other social problems. Recently, in Southern California, a business associate took me to lunch at a card room restaurant. The parking lot was full and the gaming tables were packed with people playing cards at noon. Who were these people, and why weren’t they back at their offices, eating a sandwich at their desks? In another instance, I was driving into Connecticut and saw a billboard for off-track betting that proclaimed, “Like the Stock Market. Only Faster.” If only it were that simple. The trouble
with gambling is the mindset that we can win big if only we
get lucky. Sadly, I’ve seen this attitude drift into retirement
plan decision-making — with tragic results. Even non-gamblers
are prone to this influence. The gaming industry spends billions
in marketing to persuade us that Lady Luck will smile down on
each of us sooner or later. It’s a craps-table version
of Joe Camel. In my view, “a high degree of certainty” means that savings will compound at a rate of only 5 percent to 7 percent, instead of the 10 percent to 15 percent scenario commonly applied. What this lower rate of return means is that we have to force ourselves to save more. In short, we have to tell ourselves something that we don’t want to hear. Let’s face it, saving money is tough. Many household budgets are stretched, even in prosperous times. It’s much easier to assume a higher rate of return than it is to pry out another $5,000 for a retirement plan. The pervasiveness of gambling, and its something-for-nothing message, influences many people to avoid the pain and take the easier path. Yale’s
Robert Shiller, in his book “Irrational Exuberance,”
identifies America’s gambling obsession as one of 12 factors
contributing to the steep rise in stock prices. We are bombarded
daily with stories about the instant millionaire with the winning
lottery ticket, or the lucky neighbor who’s getting rich
from an IPO. Maybe the cycle is turning. A county in South Carolina recently voted to shut down video poker casinos. Wall Street analysts are worried that Las Vegas casinos have overbuilt. We could be approaching what New Yorker writer Malcolm Gladwell calls “the tipping point” a subtle but decisive shift in values. The lesson is to be an informed pessimist in your retirement planning. Assume the most conservative estimates of returns — and save accordingly. Don’t be overly influenced by outsized and unsustainable gains in the past three years. Most of all, don’t let relentless marketing from the gambling industry brainwash you into a casino player’s mentality. Investing for a comfortable retirement requires discipline, brains and skill. You won’t get there depending on luck.
A Portfolio Mix For All Seasons Call me old-fashioned, but I still associate sports with particular times of the year. Baseball is spring, golf and tennis are summer, football is fall, and basketball and hockey are winter. To every sport there is a season. Watching the NBA finals in June’s 100-degree heat seems like a violation of the natural order of the universe. Of course, television programmers tore up the traditional sports calendar long ago. The world of investing, however, still maintains a healthy respect and appreciation for the ebb and flow of the seasons. In putting together a mix of asset types for your 401(k) rollover, the key is to build a portfolio that will work for you during various economic times — the stormy months as well as the balmy ones. In my previous columns on 401(k) rollovers, we have chosen a financial institution, won the battle with the application process, and identified superior-performing mutual funds. Now the challenge is to find the mix for all seasons. Doing this well depends upon your personal circumstances and level of risk aversion. First, let’s look at personal circumstances. You are probably in one of three groups: 1) Relatively far from retirement with at least 10 working years left; 2) within a few years of retirement, or 3) Actually retired. Let’s look at the third group, because retired folks have fewer options. The stock market can drop in value by as much as 35-50 percent, if we remember the lessons of ’29 and ’74. If you are retired and remain committed to stocks, could you afford to meet your living expenses if your account dropped to half its current value? The chart below illustrates how different combinations of bonds and stocks performed during the downdraft of ’74: (Note: We ended the comparison with 1993, because it represents a more typical 20-year period than the 25-year period ending in 1998.)
Two fundamentals are important. First, we don’t spend our entire retirement nest egg the day we retire. That’s just common sense. Yet, financial advisers who argue that retirees should have all their investments moved into bonds by retirement are effectively assuming that retired people die before inflation starts chewing into their retirement plan’s value. Too often, retirees agonize over investment arithmetic when they should be looking at something more fundamental. Namely, what are the chances of a prolonged retirement period? Are we in good health today, and have we inherited good genes that spell “longevity?” If the answer is “yes” for at least one spouse (if married), then keeping some money in stocks will be an important strategy for staying ahead of inflation. Next, assume that the income from retirement assets will come almost entirely from the interest on bonds or the sale of some stocks periodically, and that this will be about 8 percent. Will that level of income support your estimated retirement income needs, when combined with Social Security and other resources? If a 35 percent decline in your portfolio would put you underwater or force you to move, you should not remain fully exposed to stocks. On the other hand, if income from stocks would be more than enough to support your lifestyle, even after a substantial market correction, then it hardly makes sense to retreat to a more conservative mix. If the numbers from the ’74 market drop makes you worry, it may be time to move some portion of assets into bond mutual funds. In previous articles (available at pensiondynamics.com) I have written about the advantages of short-term bond funds and the possible advantages of putting a high-yield bond fund in the mix. This combination should perform better over time than the revolving door of bank CD’s. Next, for those of us who are still making contributions to retirement plans, we should consider a “divide and conquer” strategy. Separate assets into two groups — existing money and future new contributions. Then, if we feel a need to hedge our bets for practical or psychological reasons, we can consider moving a portion of our existing accounts into assets that will be more resilient during a market downturn. This means shifting existing assets into a combination of bond mutual funds or value-oriented stock funds. Then, consider allocating new inbound contributions into the most aggressive investments available. Why? Because for new inbound money we actually benefit from a downturn, thanks to dollar-cost averaging. That’s an aspect of retirement investing that many people don’t understand. When it comes to fresh, inbound money deposited regularly into retirement accounts, we should hope for a market decline, because inbound deposits will be buying mutual fund shares at bargain prices. Sooner or later, when the market rises, we will own valuable shares bought at low prices. When does “new money” become “old money” for the purpose of this discussion? Probably about once every five to ten years. The further you are from retirement, the greater the proportion of “new money.” The fundamental message is that nonfinancial events having little to do with the stock and bond markets, such as your health and lifestyle, are the most influential for a sensible retirement plan. It is easy to lose focus and get caught up in the math and hysteria of today’s markets while completely overlooking the most important number. The purpose of retirement planning, remember, is to look out for “No. 1.” Accurately assessing the nonfinancial facts and circumstances of our lives will contribute more than a strenuous, and ultimately futile, attempt to pick tomorrow’s top-performing mutual fund.
• There was a British philosopher named Sir William of Occam who lived in the 14th Century. To him is credited the observation that the simpler the explanation for something, the more likely it is to be correct. Over the centuries this insight has become known as “Occam’s Razor”. Such a notion has an inherent appeal, all the more because it generally works. When applied to finances and particularly to long-term investing, it certainly works, as the record of the financial markets in the 20th Century—especially the last 50 years—amply demonstrates. • Anyone who follows the stock market even tangentially is well aware of the immense amount of effort invested in attempting to predict short-term variations in the market as a whole and of individual stocks in particular. Many people earn a living analyzing market trends using ever more sophisticated techniques and technologies. Many others risk great amounts of capital in prodigious efforts to “beat the market” by out-predicting it. As history amply demonstrates, most of these people are doomed to failure—or at least to do no better than if they had simply bought and held the market. In the short run, the market has a nasty habit of zigging just when you predict that it will zag. • Remember Occam’s Razor: simple works. In the world of long-term investing, simple means index funds. Index funds are the preferred choice for reasons of simplicity, low cost and performance. Small differences in return are magnified over time by the effect of compounding. Even a 1 percent difference in annual return translates into a 14% difference in capital accumulation over 25 years. • Don’t complicate your investing style by giving in to short-term influences like fear, greed, exuberance or hope. Annually assess your funds’ performance. Watch for major changes of direction brought about by management changes or investment style that could signal time for a change. Be cautious. Be patient.In time your portfolio will certainly flourish.
Over the last 200 years or so since the stock market came into existence, records show that the market as a whole averages a return of around 7% after inflation. At the same time, an examination of annual returns reveals a massive variation from a high of 67% to a low of –39%, or 106 percentage points. This variation narrows sharply as the examination period increases from one year to 25 years, approaching the 7% average. It is not difficult to make sense of all of the statistics. First, in the short run, the market is powerfully influenced by speculative pressures. Second, as the time frame increases to as much as 25 years, the primary fundamentals of earnings growth and dividend yield take hold and drive results. In fact, in the successive 10-year periods between 1930 and 1990, the combined earnings growth and dividend yields of U.S. corporations varied less than 1% from the overall market return during those periods. This being the case, the simplest and most effective approach is to find groups of investments that will be the most likely to match the performance of the total market and to make our selection from those groups based on perhaps the most powerful single investing principle: minimize investment expense. Investing in individual stocks or bonds is costly. Transaction fees undercut returns while the expense of assembling a portfolio that emulates the market is completely unsupportable for the individual investor. In the mutual fund industry, equity fund expense ratios average 1.5% annually and range from 0.2% for unmanaged funds to 2.2% and more for actively managed funds. Such expense ratios in combination with transaction costs strongly influence long-term results and are responsible for actively managed funds under-performing the market as a group by about 8%. This leaves us with unmanaged funds that seek to match market performance at a very low cost. These are index funds. For the long-term investor, these are by far the best and most productive choice.
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