A reader asks;
A consistent theme of your work is the desirability of accepting slightly less than market returns in return for reduced risk. But the market perform very well over rolling 10 yrs., and superbly over rolling 20 yrs. So, why settle for below-average returns, especially for well-diversified, long-term, do-it-yourself accounts, when volatility is actually working for you...The one answer I can come up with is the need to tailor the account to the investor's risk tolerance, but that's really a personality consideration, not an investment issue.
Actually the point of the posts that are long these lines are to get readers to explore the notion. This is not a topic explored elsewhere very often (I don't think, anyway). Not everyone needs 12% growth. Some folks only need, say, 7%. There is an argument to be made for not taking the risk to get more return than your financial plan calls for. Further there are people that simply cannot tolerate normal stock market volatility. We have clients that fit this description some of whom can afford a low tolerance and some who cannot.
The reader's thought in the context of 20 year time periods is correct. I have seen data that says the market is higher in 15 years rolling time periods something like 92% of the time. This all speaks to something I have touched on previously; there is a mathematical argument to be made for 100% equities all the time. As a practical matter I have only met a few people that can think of their stock market portfolio in terms of that many years.
I made a reference in passing the other day to behavioral finance and the pain of losses having more emotional impact than the joy of gains; supposedly it is twice the impact.
The bottom line, I think, for this question is that for the reader's comments to be 100% right 100% of the time would require completely emotionless robotic like approach to stock market investing for both do-it-yourselfers and clients of a money manager. I know from the correction in the spring, more specifically some of the comments left on the blog, zero emotion is far and few between.
My exploration of this topic has come at time when the market has been doing very well and emotions are generally running low. IMO, this is the time to think about this sort of low impact concept. During the decline of last spring I devoted more posts to how markets do correct and the notion that that time period was teaching people whether they had too much in certain parts of the market.
My own opinion is that if you sweat normal declines in such a way as to lose sleep you need to make changes. I can guarantee there will be a 20% decline in our lifetime again, probably a 30% decline for that matter, both are in the market's historical fat tail. At some point after that decline, regardless of whenever it comes, the market will go back up and make a new high.
Here I am being neither bullish nor bearish, I am just saying that markets, in the future, will be similar as they were in the past. Not exact but similar.
Rationally, there is no reason to fear a portfolio decline today if your time horizon is in fact 20 years from now yet people do. Some introspection now while things are peachy could spare grief the next time there is a bear market.
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23 comments:
Roger, I agree with everything you said in this post. I would only suggest that people shouldn't easily succumb to their inherit emotions, their natural risk tolerance without attempting some rehabilitation. I would also hope wealth managers such as yourself would attempt to re-program or rehabilitate clients who are either too risk adverse or too risk prone. Maybe that's asking you to play psychologist, but you admitted that investor emotion has huge consequences in regards to performance.
Before I accepted below average returns to reduce risk, I would blindly buy a total market index fund and live with what comes (equalling a rocky market).
obviously this is more about psychology than anything else. The 7:08 comment might be right for that person but wrong for someone else.
TomK yes there is an element of trying to point out what is too conservative, it is not winnable very often however.
One thing I would add that appears to have been glossed over. If over 15 years, the market is up 92% of the time, then that means there is an 8% possibility that you could put your money in stocks for 15 years and lose money. That, I believe would be as emotionally devastating, or more than any short term 10% swing. I'm more scared of that scenario than most. Give me some cash flow from Dividends at least....
In a market where it may take 20 years to go back the previous peak will make a lot of unhappy investors. Market like this will encourage people to gamble on the directions of the market and most likely result in a lot of broken dreams. I believe a steady return regardless of the market will be the theme of the future. Hedge funds are not the only ones taking advantage of this trend. I wish to hear your opinion.
I enjoy your posts and this one got me thinking. Is there a way to play a long term bear strategy on specific stocks? I.E., I think Netflix and Radio Shack are terrible long term plays.
It's even better to achieve market-level returns with less than market risk, which is pretty close to what Roger's 'model' portfolio has accomplished YTD, but the larger point may be that investor risk tolerance logically should change over time: Someone with a 30-40 year time horizon would probably do quite well just sticking to a few appropriately diversified index funds but a very high allocation to equities is unlikely to work for a retired person unless they have other sources of income and/or adequate capital resources outside financial markets.
In effect, most of us are typically not investors (in the sense of directly building a company via capital), we are more usually traders with different time horizons who delve the secondary (stocks and bonds) and tertiary (derivatives) financial asset markets for incremental value. The goal is to increase and then maintain purchasing power (wealth) and the ways we measure that as well as the ways we pursue that goal will be all over the map as they should be; alignment between the goal (as individually defined) and a strategy most likely to reach it is what matters IMO.
Anon 9:06 - you nailed it, great summary!
OG
Thanks OG, not sure why my handle didn't stick to that post but us old geezes know the game just the same. -RW
Here are some benchmarks and good examples of portfolio performance:
Type 10 yr SD(risk)
VBINX balanced 8% 4.8
SP 500 LB 9 6.6
TWEIX LV 13 4.6
PRWCX Bal 12 5.1
FPACX Bal 12 4.8
TEDIX Int V 15 8
I am not promoting these funds but how many portfolio managers would share these info?
So you want market return at lower risk? Yes it is possible! Personally I like to have a little more return than the balanced index(VBINX) but it is probably an excellent base to start a portfolio design before you get too diverified.
"It's even better to achieve market-level returns with less than market risk."
Why settle for market-level returns? If your going to "trade" vs. investing in index funds why settle for market level returns?
.."but a very high allocation to equities is unlikely to work for a retired person unless they have other sources of income and/or adequate capital resources outside financial markets"
In my own experience alot of "retirees" either have pension plans or othe forms of income. Why limit these retirees to a "very high allocation of equities"? With inflation, skyrocketing nursing home care, etc... shouldn't they always have some % of thier money in the derivatives market? Should not everyone who is seeking to increase and maintain thier purchasing power at least have some % of thier funds in the tertiary market?
to the 10:47 comment,
FWIW my experience with people says no.
Anon 10:47
The individual "settles" for what their plan requires, no one said anything about settling for anything otherwise; achieving market return for less than market risk is nominally 'better' than achieving less than market return, that's all.
As to buying an index fund, my point was that is still trading on a secondary price series and a decision to buy at a particular time or sell at a particular time, whether in a week, a year, or a decade, is still a timing decision. Conceptually there is no distinction even though all the difference in the world resides in the timing dictated by the alignment between goal, strategy and personal preference(s).
As to derivatives, that's a matter of plan and method as well. Personally I've written calls at a preferred sell price for an asset I already own and have sold puts to acquire an asset at a price where I wish to accumulate because my strategy requires I be paid for waiting but otherwise I usually don't deal in tertiary instruments; e.g., to strategically hedge a long market position I'm more likely to short than buy a put.
FWIW
"As to derivatives, that's a matter of plan and method as well"
I guess that's where my thought was. It seems that, in general, the "reduce risk with age" strategies are way to conservative. If you are retiring in your 60's, would it not be logical that you also need to protect against living into your upper 90's which is 40 years! Wouldn't any "retiree model portfolio" include some % of derivitives so that over the course of 40 years, the portfolio is making money in the good years and the bad?
Anon, no argument there, in fact I believe our host has written a number of posts concerning longevity and portfolio composition. There are ways to assure portfolio growth w/o using derivatives but your basic argument is sound IMO.
This has got to be one of the most active threads in a while. By derivative mkt, this would be the same as "write-buy" (is that right?) vehicles? This one is on the wish list for new etfs, I believe. Anyway, the road to steady returns is being postulated as how to make money in a down market. The small guy has more choices today. Until I understand them better, I will use cash as the flight to safety. Shorts, a different animal, can become like a double whip saw. Imagine getting an ultra short etf becasue the market looks overbought, then getting stopped out for a realized loss, and then watching the market go into a major correction with no proetection for another loss.Roger, you offered ytd performance data. Could you keep us abreast of max yearly draw downs? Eager to learn more. Seasoned commentary on this blog. Love it.
ON TOPIC, quoted from Rev. Shark today, if the rev don't mind:
At the risk of sounding redundant, the market has become quite extended and market players will be quick to protect their profits at the first signs of any cracks. Trying to predict when this market will turn is useless, but it is increasingly necessary to have a plan in place when its time to sell. As a little league coach would say, we should ask ourselves, If the ball comes to me, what do I do? Even if you are the athletically challenged kid they put in right field, sooner or later, somebody's gonna hit the ball your way and a plan of action is a must.
RevShark
Anon 9:00, short sell them if you are bearish long term. That is the way to do it.
So what are appropriate returns? 3% above inflation every year? 7% above inflation every year? In the 1980's inflations ran in the high teens and 20% return did not mean a thing. Yes, for the past couple of years the inflation was low but the dollar devaluated 30% against EURO. We never seem to really get ahead in real purchasing power.
Anon 5:42, if you live in the US then your liabilities are measured in $USD so the Euro is just another asset class (unless you travel there a lot perhaps). What matters most is your purchasing power at home and, for that, a suitable, annualized premium above inflation will do I think: I use 5% above a 13-week T-Bill index or a moving average of non-seasonally adjusted CPI (whichever is higher) as an ROI target myself. A bit arbitrary perhaps and in the 80's I missed it as often as not by a point or three but as a purchasing power benchmark it works well enough. Asset managers with clients have to worry about market oriented benchmarks such as the S&P500 but I don't think such indices need to be more than just another indicator for the individual personally. JMO
Can you suggest where to find moving average of CPI? Great stuff.
anon 6:11
You can get the data here:
http://research.stlouisfed.org/fred2/series/CPIAUCNS?&cid=9
Just dump it into Excel and run and moving average.
Anon 6:11, I constructed my own MA of CPI and a separate T-Bill index years ago because I couldn't find such benchmarks elsewhere. Historical data is not hard to come by and tom k's advice is spot on.
That said, over the past decade or so, I've probably come to rely more on the T-Bill rate simply because it is regulated as much by market forces as the Fed; a bit too much statistical adjustment (e.g., hedonics, equivalent rent, etc.) going on with the CPI these days to suit me.
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