Archives for March 2010

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Tactical Asset Allocation: Adjusting Based on Valuations

The most common method for determining your stock/bond allocation is to base the decision primarily upon your age, then make an adjustment based on your personal tolerance for volatility.

The idea is that, over extended periods of time, stocks are likely to outperform bonds. So the longer your investment time horizon, the more you should have invested in stocks.

But one could (quite reasonably) make the case that the likelihood of stocks outperforming bonds over a given period also depends upon:

  • Market valuation levels at the beginning of the period, and
  • Available interest rates at the beginning of the period.

So wouldn’t it make sense to take those factors into account when determining your asset allocation?

Estimating Future Returns

Tactical asset allocation strategies seek to estimate the future return of the stock market over your investment time horizon. Then, you compare that estimated return to the return offered by other investments–most notably TIPS due to their predictable returns–and determine your allocation accordingly.

For example, if the expected return that you calculate for the stock market is no higher than the current rate available on TIPS, it wouldn’t make sense to hold very much in stocks. (Why take on the additional risk if there’s no additional expected return?)

To date, the best method I’ve seen for estimating future market returns is the Gordon Equation, which states that inflation-adjusted market returns must equal:

  1. Dividend yield, plus
  2. Inflation-adjusted earnings growth, plus (or minus)
  3. The effect of changes in the market’s P/E ratio.

Because of the compounding nature of dividends and earnings growth, as we look at longer and longer periods, the first two factors become the primary determinants of return. Over shorter periods, however, changes in P/E play the biggest role in determining return.

Implementation of Tactical Asset Allocation

So how, exactly, should a tactical asset allocation strategy be implemented within the context of an investor’s lifetime? For example, how should you incorporate your age into the equation (if at all)?

My suggestion would be this: The longer your time horizon, the smaller the risk premium you demand. (That is, the younger you are, the smaller the necessary spread between the expected return of stocks and the available return on TIPS.)

Why? Because the longer the period in question, the more confident you can be in the Gordon Equation’s estimate of future market returns. (Reason being that the first two factors–dividend yield and earnings growth–are the more predictable ones. And the longer the period in question, the greater the portion of returns they comprise.)

Causes for Concern with Tactical Asset Allocation

As much sense as it might make to consider market price levels and market interest rates when determining your allocation, there are a few reasons I’ve been hesitant to implement such a strategy with my own portfolio.

First, regarding the Gordon-Equation-based strategy, there’s always that third factor–changes in the market’s P/E ratio–which simply can’t be predicted with certainty. Even if you can say with a fair degree of confidence that the market is undervalued (or overvalued) there’s really no telling when it will correct itself.

Second, no matter what strategy you come up with, it’s going to have a built-in historical bias. That is, it’s going to be optimized to work in conditions that resulted from the chain of events that occurred over the last 85 years or so (the period for which we have market data). How well it will work over the next 85 years is unknown.

Third, there are numerous funds that implement tactical asset allocation strategies. Yet they don’t appear to make up a noticeably disproportionate amount of top-performing funds. Why is that?

Why I Don’t Pick Stocks

You’re a weekend poker player. You like to play, and you’re actually pretty good. While visiting a friend, he describes an online poker site he’s been using:

  • There’s a $5 fee to play,
  • You get to pick the game,
  • You get to choose the maximum and minimum bets, and
  • You don’t get to know the identity of your opponent.

Are you interested in playing? If so, how much would you be willing to stake on a game?

And, do your answers change if you know that, more likely than not, your opponent is a professional poker player?

Backtesting Investment Strategies

I just finished reading Jim Otar’s Unveiling the Retirement Myth (mini review: packed with important insights and bizarre hypothetical examples).

Otar explains his approach to investment planning this way:

“Instead of presenting a ‘forecast’ of a client’s future financial picture based on assumptions, [I present] an ‘aftcast’ of client’s potential outcomes based on actual market history.”

In other words, Otar argues that, rather than making potentially faulty assumptions about the future, we should stick to the only real data we have: market history. Otar’s methodology is similar to that of the famous Trinity Study: to determine the viability of an investment strategy, check to see how frequently it would have worked in the past.

I’m in agreement that the fewer assumptions you make, the more well-founded your conclusions will be. But there’s one assumption I’m comfortable making: The future won’t look exactly like the past. And as I wrote last week, there’s a big difference between:

  • “Historically, Strategy X has worked 90% of the time,” and
  • “Strategy X works 90% of the time.”

Conclusions from Hindsight

The fact that an investment strategy (a market timing method, for instance) has notworked historically may be a sufficient reason not to count on it to work in the future. But the fact that a strategy has worked in the past isn’t sufficient evidence that it will work in the future.

When you have the benefit of hindsight (and the computing power and data to back-test any strategy you can come up with), there are an infinite number of investment strategies that will have succeeded based on nothing other than randomness. (Investing based on last year’s butter production in Bangladesh comes to mind.)

Rather than investing based upon back-tested observations like these two provided by Otar:

  • Rebalancing on presidential election years has historically provided the best returns, or
  • If the last year’s market performance was worse than the average of the last six years, next year is likely to be better than average

…I prefer to base my investment strategies on simple concepts. Concepts like the following:

  • Diversifying across many asset classes and many companies helps to reduce risk,
  • Reducing investment costs helps to increase investment return, and
  • Given enough time, most economies will create wealth.

Saving for College with a Savings Account

I recently ran across a post on ING’s We the Savers blog in which the author explains his plans to save for his kids’ education:

“What do I do for my kids? Play Russian Roulette with the market and pray there’s enough for them to pay for books?

I’ve got a better idea. I figured that if I start saving $50 a paycheck for them in an Orange Savings account, they’ll have almost $50,000 to do whatever they want to with when they turn 18. Not too shabby.”

He’s saving for his kids’ education, and he’s getting started while they’re young (they’re 3 and almost 1). So thumbs up to him for that. But his specific saving plan leaves something to be desired:

  1. It neglects to take advantage of any of the types of tax-advantaged accounts that would provide better tax treatment than a taxable savings account.
  2. It uses a short-term investment (cash) for long-term needs (college 15 or 17 years from now).

Tax-Advantaged College Savings Accounts

There are 3 primary types of accounts that could be used to save for college in a tax-advantaged way:  529 plans, Coverdell accounts, and Roth IRAs. They each have their pros and cons (discussed more thoroughly in the article I just linked to), but any of the three is likely to come out ahead of a taxable account.

Everything in a Savings Account?

In the quote above, the author clearly indicates that he’s uncomfortable taking on stock market risk. Fortunately, there are ways to earn higher returns than a savings account without having to take on such risk. In fact, if college is 15 years away, there’s a way to earn returns that are both higher and more predictable.

Specifically: Buy Treasury Inflation-Protected Securities (TIPS).

Because they’re not as liquid and because they experience short-term fluctuations in price, TIPS generally offer higher returns than savings accounts. For instance:

  • If you were to purchase a TIPS maturing in January of 2025 (i.e., shortly before a child who is currently 3 would be going to college), you would get a 1.968% after-inflation yield.
  • In contrast, an ING savings account is currently only paying 1.1%, and that’s before accounting for inflation.

Not only can TIPS offer a higher return, but their returns are more predictable. Savings account returns are not predictable over long periods because:

  1. Savings yields can change at any time, and
  2. Inflation isn’t predictable (that is, even if you did know you’d get an X% yield over the period, there’s no way to know what the real, inflation-adjusted return would be).

In contrast, if you purchase TIPS with the appropriate maturity, you can achieve a (mostly) predictable inflation-adjusted return.

Living off the Income

I recently had a conversation with a family member who’s nearing retirement. When I asked what withdrawal rate he was planning to use, he explained that his plan was to “live off the income” of his portfolio so that he doesn’t have to worry about running out.

People say that a lot, and it certainly can be a good plan. But the plan’s probability of success depends a lot upon how it’s implemented. Specifically, it makes a big difference whether you plan to:

  1. literally live off the income (that is, only spend the dividends and interest earned each year),
  2. live off an estimate of the average income (e.g., each year, withdraw 3% of what your portfolio was worth on the day you retired–based on the assumption that the portfolio should generate an average income of 3% per year), or
  3. live off an estimate of the total expected return for the portfolio (e.g., withdraw 6% each year on the assumption that the portfolio’s total return will average out to 6% per year).

Plan #1: Spend only the Income

If you spend only the dividends and interest from your holdings, you obviously won’t run out of money. Unfortunately, this plan isn’t feasible for most investors because:

  1. It can involve significant fluctuations in income from year to year,
  2. It requires you to have a very large portfolio, and
  3. The income might not keep up with inflation.

Plan #2: Spend Based on Expected Portfolio Income

If you base your spending upon an estimate of the income you expect your portfolio to generate, you eliminate the difficulties caused by having an unsteady income. The catch, of course, is that you expose yourself to the possibility of running out of money should your portfolio’s earnings end up below your estimate.

And you’ll still need a very large portfolio.

Plan #3: Spend Based on Expected Total Return

If your plan is to withdraw money based on the total return you expect your portfolio to earn, then you’re likely in trouble.

First, as with plan #2, the portfolio might not earn what you expect.

Second, volatility will be a problem. For example, if the funds in which you’re invested earn an effective annual return of 8% over the 30 years of your retirement, and each year you withdraw 8% of your portfolio’s at-retirement value, you’re taking a serious risk of running out of money.

Why? Because the funds didn’t earn 8% each year. If the bad years come first, you’re up a creek.

Adjusting for Inflation

Since plans #2 and #3 are just guesses anyway, you can always build an inflation adjustment into the guess. (Something along the lines of “withdraw 3% of the portfolio value in the first year, then adjust the withdrawal amount upward each year based on inflation.”)

Of course, such adjustments don’t actually increase your probability of success. All they do is increase the rate at which you draw down your portfolio, effectively obtaining a higher standard of living now in exchange for a greater risk of running out of money later.

Said differently, building an inflation adjustment into your withdrawal plan makes sure your standard of living doesn’t decline…right up until the (possible) point where it does.

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Know anybody 50 or older?

For as long as I can remember, my mom has been saying that she wants to live to be 100.

And she’s not kidding around. She might have the healthiest diet of anyone I know (not surprising–she’s a dietitian), and she’s passionate about fitness–swimming, running, yoga, you name it.

But she made one mistake: She waited until age 53 to get a colonoscopy. She didn’t wait until 60. She didn’t wait until 55. She waited to 53.

…and it almost killed her.

The colonoscopy and ensuing tests showed that Mom had Stage IV colon cancer. (Stage IV is the most advanced stage of cancer–it means that the cancer has spread to other organs. Statistical survival rates for stage IV colon cancer aren’t exactly promising: 8-15% chance of surviving 5 years beyond diagnosis.)

That was in August. Since then, she’s had 10 inches of her large intestine removed, 5 months of chemotherapy with a whole list of terrible side effects, and–just this last week–20% of her liver removed.

Based on the information we have at the moment, she’s now cancer-free. (Woohoo! 😀)

It’s worth noting, however, that:

  1. If Mom had waited until 54 instead of 53…Well, according to her doctors, she wouldn’t have made it to 54.
  2. If Mom hadn’t been in super shape (cancer notwithstanding), this would have gone far worse than it has.

What does this have to do with personal finance?

A few things, I guess:

  • Cancer treatment is expensive,
  • Health insurance is essential, and
  • Missing 5 months of work isn’t great for one’s finances.

But that’s not really why I’m bringing this up. I’m bringing this up because my Mom almost died–completely unnecessarily. This whole thing was entirely avoidable. From the Center for Disease Control and Prevention:

“Colorectal cancer almost always develops from precancerous polyps (abnormal growths) in the colon or rectum. Screening tests can find precancerous polyps, so that they can be removed before they turn into cancer.”

Please don’t wait until you’re 53 to get a colonoscopy.

And tell your loved ones, too.

I know it’s not an easy thing to slip into a conversation. Conveniently, March happens to be Colon Cancer Awareness Month, so perhaps you could use that as an opener. 🙂

A Note on Risk Factors

Aside from her age, my mom had precisely none of the risk factors involved with colon cancer. But she got it anyway. Please don’t put off getting tested just because you don’t fit the mold of somebody at high risk for colon cancer.

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