Archives for April 2009

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Financial Planners, Volatility, and Asset Allocation

Carl at Behavior Gap posted an article yesterday about the different variables involved in a financial plan. He made an excellent point: Rather than have a greater equity allocation than you’re comfortable with, you can adjust some of the other variables. You can save more, retire later, spend less in retirement, or leave less to your kids.

This is absolutely true, and I think we’d do well to discuss these other variables more frequently. (And if you’ve been around here for long, you know that I’m not a big fan of the typical stop-working-completely concept of retirement.)

Carl also said something that I want to focus on more precisely:

“Financial planning is NOT about trying to talk yourself into putting all your money into stocks and then dealing with the pain in down markets. It is about deciding which levers [i.e., other variables] to pull and when.”

As it stands, I agree with this statement.

I would like to add, however, that–in my opinion–an absolutely essential function of a financial planner is to help investors (specifically those with a long way to go until retirement) understand that:

  • Volatility and down markets do not, in fact, have to be painful, and
  • Reacting to down markets as if they’re painful will cause nothing but problems.

For example…

Imagine this scenario: A 30-year-old investor comes into a financial planner’s office for a meeting. During the meeting, the investor explains that he’s uncomfortable with almost any volatility, so at the moment his entire 401(k) and IRA are invested in fixed income investments.

Now, it seems to me that it’s the planner’s responsibility at this point to make it explicitly clear what a 100% fixed income allocation is likely to mean in terms of retirement possibilities.

In my experience, most investors tend to dramatically underestimate the amount of savings necessary for the retirements they’re envisioning. Similarly, I worry that many investors don’t fully understand what a low equity allocation will mean for them in terms of retirement options.

There’s no need to tell the investor that this is the wrong decision, but it’s important to at least make sure it’s an informed decision.

Teaching volatility tolerance

I’m absolutely convinced that increased knowledge about the cyclical nature of markets and the actual (as opposed to purely psychological) consequences of volatility leads to increased volatility tolerance.

Note: I’m not saying that it leads to any particular, extremely high level of volatility tolerance, just that I believe it increases it.

There’s no question that a greater tolerance for volatility is a good thing. It can allow an investor to:

  • (safely) invest a greater portion of his portfolio in equities, or
  • have a greater degree of comfort–and therefore a smaller chance of making a mistake–with whatever level of equity allocation he already has.

And I think that helping an investor develop his tolerance for volatility is one of the most valuable services a financial planner can provide.

Chaos Theory and Investing

I’m no mathematician or physicist, but I’ve always found the concept of chaos theory to be fascinating. The main idea of chaos theory (as I understand it anyway) is that:

  • Every event is the result of literally thousands of different variables interacting, and
  • Changing just one of those variables (even a seemingly insignificant one) can cause events to unfold in an entirely different way.

Real life example

For me, the idea hits home in that I can trace several major aspects of my life (including the city I live in and the woman I’m married to) directly back to a birthday present my best friend received more than a decade ago.

It sounds crazy to say, but if my friend Matt’s aunt (whose name I don’t know and whom I’ve never met) had given him a different gift for his twelfth birthday, my life would look completely different than it does today.*

I suspect that if you take a few moments to think about it, you’ll find that your life probably has at least one similar event–something seemingly small/insignificant that turned out to have astonishingly far-reaching consequences.

So what does this have to do with investing?

Chaos theory and picking stocks

The same small-events-with-unpredictably-large-consequences phenomenon that occurs in the lives of people occurs in the lives of businesses as well. The success or failure of a business can hinge entirely upon who the salespeople and executives of the business happen to know (or meet). As silly as it might sound, a business’s fate can be wildly influenced by a seemingly random conversation between two parents at a grade-school softball game.

The takeaway is that–if we’re to believe the ideas behind chaos theory–then there’s no sense in trying to pick stocks, as it would be literally impossible to account for the multitude of things that could determine a business’s success or failure.

Chaos theory and timing the market

Of course, if the number of factors that go into choosing one individual stock are too numerous to keep track of, keeping track of the factors affecting the stock market would be even more impossible. End result: Don’t even think about trying to time the market.

What do you think?

What are your thoughts on all this? Does this chaos theory idea–to which I’m sure I haven’t done justice–make sense? Or do you think it’s hogwash? Is it reasonable to believe that an investor can successfully predict the fate of a given company?

*For anybody who’s curious: The gift was a deck of Magic: The Gathering cards. Matt and I ended up getting really into the game, and from ages 14-17 we traveled across the country to play in tournaments. On one trip to Chicago, I fell in love with the city. I ended up attending Loyola University Chicago, where I met my wife.

Investment Results and Sample Size

I briefly touched on the idea of sample size a while back when discussing the likelihood that a fund manager’s performance could be the result of luck rather than skill. Today I’d like to discuss the idea in a bit more depth.

Generally speaking, the more observations made in any given study (i.e., the larger the sample size) the more confidence we can have in the study’s conclusion. And that makes perfect sense–the more consistently we see the same results occur, the more confident we can be that the results aren’t due to randomness (i.e., “noise”).

So here’s my question: In the world of investing, why do we often let this idea go completely out the window when making decisions?

Sample size and fund managers

Why, for example, would we look at a mutual fund that’s outperformed the market for 8 of the last 10 years and even begin to think that it’s due to skill? A 10-observation sample size is very small. (Example: How much faith would you put in a medical study that only included 10 patients?)

Further, a fund manager randomly picking stocks could be expected to beat the market in 5/10 years. (Well, probably 4 out of 10 after expenses.) Outperformance in 8 years out of a 10-year sample is almost meaningless statistically.

I’m not saying that this means that a fund manager who outperforms in 8/10 years isn’t skilled. I’m simply arguing that we don’t have (even close to) enough data to know for sure. And therefore betting one’s money on it seems rather imprudent.

Sample size and market forecasters

Or what about market forecasters who successfully predicted the big crash late last year? As with every big market move, the forecasters who accurately predicted it are now regarded as experts. And what’s the sample size here?

One! A person predicts one market movement correctly, and we call him an expert.

By way of comparison, imagine if last fall Gallup had telephoned precisely one person, asked him who he was planning on voting for, and then made an official prediction that that candidate would win the election.

Overestimating our knowledge

There are plenty of other examples of such behavior–got any favorites?–but I’m sure you get the point. We need to be careful not to overestimate our knowledge about something based on such small amounts of data.

Active vs. Passive Investing: The Results Are In.

Update: Since originally writing this article, the 2009 and 2010 scorecards have been released as well. It’s the same story: Actively managed funds lose.

The results are in: S&P has released their Indices Versus Active Funds Scorecard for year-end 2008.

And guess what? It’s ugly. Active funds got crushed. The passive index benchmark outperformed the majority of active funds in 9 out of 9 equity fund categories (i.e., large cap growth, large cap value, etc.) for the 5-year period ending 12/31/2008.

Now, I freely admit that a 5-year period is shorter than ideal for making comparisons of equity funds. But before we conclude that this is a crazy coincidence, let’s back up a few years and take a look at the scorecards from prior 5-year periods.

  • 2006? Active funds lost in 9/9 categories.
  • 2005? Active funds lost in 9/9 categories.
  • 2004? Active funds lost in 8/9 categories. (50.54% of actively-managed large cap value funds outperformed the index for that period! Go team go!)

I’ll spare you the rest of the years. But the short version is that it’s more of the same.

What about fixed income funds?

I’m glad you asked. A few figures regarding the 5-year period ending 12/31/2008:

  • The passive benchmarks outperformed greater than 90% of actively-managed government bond funds.
  • The passive benchmarks outperformed greater than 90% of actively-managed investment-grade corporate bond funds–with 100% (!) outperformance in both the long-term and short-term categories.
  • The passive benchmark outperformed greater than 95% of actively-managed municipal bond funds.

If that doesn’t make you wary about investing in an actively-managed fixed income fund, I don’t know what will.

Why do most actively-managed funds do so poorly?

Simple: They cost too much. Most active fund managers have to beat their benchmark index by 1-2% per year just to break even on an after-expense basis.

A performance improvement of 2% may sound small. But when we remember that the total stock market’s long-term return is only 8-10%, it starts to become clear why so few funds are able to perform such a feat over any extended period.

Is it possible to beat index funds?

Yes. It’s definitely possible–as evidenced by the fact that the passive benchmark didn’t outperform 100% of actively-managed funds. Of course, it’s also possible to go to a casino, play blackjack for 8 hours and come out ahead. Doesn’t mean we should bet on it.

Why own bonds?

Yesterday we talked about a poor reason to own bonds. Today I want to discuss a valid reason. Adding a bond component to a portfolio of stocks (or stock-based funds) serves one primary purpose: It reduces volatility.

Still in the buying stage?

If you’re young–or more specifically, if you’re dollar-cost-averaging into your investments–volatility actually increases your return. So it’s hard to classify it as entirely undesirable.

That said, as we’ve seen in the last year, the volatility that comes with a 100% stock portfolio can be downright terrifying for some people. If you think that a high degree of volatility is likely to either:

  1. Cause emotional/psychological problems (trouble sleeping for instance), or
  2. Cause you to panic and sell after a downturn

…then it’s probably a good idea to include a degree of fixed income when determining your asset allocation.

To put it differently: The bond component isn’t there to protect you from volatility per se. It’s there to protect you from yourself.

Planning on selling soon?

On the other hand, if you’re at the point in your life where you’re dollar-cost-averaging out of your investments, then volatility has the opposite effect: It decreases your returns.

Note the difference here. When you’re buying, volatility is a mixed bag–it has both positives and negatives. When you’re selling, however, volatility has no redeeming qualities at all. In short, that’s why it makes sense for investors to shift their asset allocation more toward fixed income as they get closer to retirement.

It’s all about balancing.

Regardless of which stage you’re in, including bonds in your portfolio involves a trade off. You’re exchanging expected returns for reduced volatility.

  • If you’re still buying, the purpose of reducing the volatility is to provide you with the psychological benefits mentioned above–to protect you from yourself.
  • If you’re selling (or will be in less than a decade or so), reducing volatility increases your expected returns as well as providing all the same psychological benefits.

Investing and the Worst-Case Scenario

As you probably know if you’ve been following this blog for very long, I tend to recommend rather high equity allocations for those of us who still have multiple decades to go until retirement.

My own retirement portfolio is 90% in stock index funds, and as I’ve discussed before, I don’t see anything wrong with being 100% in equities if you’re still quite young and have a particularly high tolerance for volatility.

The fear

You’ll often hear that being so heavily invested in equities is dangerous. People say things like, “What if stocks go to zero? You could lose all your money if you aren’t diversified.”

That’s true. And it’s an understandable fear. After all, we’ve seen several high-profile occasions on which (individual) stocks went to zero over the last decade.

However, the way I see it, there are two major problems with worrying about a similar thing happening to an internationally-diversified portfolio of stock index funds.

First, it’s extremely unlikely that all (or even most) of the businesses in the world economy will become valueless.

Second, if that were to happen, bonds would offer you absolutely no protection.

Bonds won’t save you.

For the entire world stock market to go to zero (or for that matter, to earn any substantial negative return) over, say, a 30 or 40-year period, the businesses that make up our global economy would have had to collectively become unprofitable. This, of course, would have several ramifications:

  • You would lose your job.
  • So would every other person living in a country with a developed economy.
  • The world economy as we know it would have completely collapsed. And we would each be reliant on our abilities to produce physical goods to sustain ourselves.

Note that in such a scenario, having had your IRA and 401k go to zero would be the least of your concerns. Of course, there are things you can do to prepare yourself for such a situation. For example:

  1. Learn to grow your own food, and
  2. Buy a gun.

As you may have guessed, I’ve done neither of the above–although I suppose my wife is currently looking into what edible plants can be grown indoors. The point, though, is that “own bonds” is not on the list.

In an environment in which business are no longer making any profits, corporate bonds would be just as worthless as common stocks. And government bonds would almost certainly be as well. (If nobody is making any money, how would the government have any tax revenue?)

So is there any reason to own bonds?

In short: Yes. There certainly are some valid reasons to include bonds in your portfolio. (More on this tomorrow.) [Update: See follow-up post here.] However, protecting yourself from a doomsday/economic collapse scenario is not one of those reasons.

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