Archives for August 2011

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You Call This an Efficient Market?

I’ve mentioned before that, if there’s one thing from the academic world of finance that I think more investors should know about, it’s the concept of market efficiency.

To provide some background information: In an efficient market, the current price of each investment would reflect all known information about that investment.

In other words, in an efficient market, all public information would already be reflected in a stock’s price, so there would be nothing to gain from looking at financial statements or from paying somebody (i.e., a fund manager) to do that for you. Similarly, there would be no benefit to trying to time the market by determining whether the market as a whole is underpriced or overpriced.

Volatility and Market Efficiency

Many investors look at periods of market volatility and ask how such things could happen if markets were efficient. That is, how could the price of the market have been correct a month ago, and be correct today even though it’s 10% lower?

As explained by Eugene Fama*:

“The market can only know what’s knowable. … When there’s a large amount of economic uncertainty out there, there’s going to be a large amount of volatility in prices.”

In other words, efficient markets only reflect currently-known information. When previously-unknown information becomes available, market prices change accordingly. If that new information is surprisingly bad or surprisingly good, market prices will change dramatically and suddenly.

That’s how an efficient market should work.

Is the Stock Market Perfectly Efficient?

For the record, I don’t believe the stock market is perfectly efficient all the time. There have been a handful of investors throughout history who appear to have successfully identified inefficiencies that they could reliably exploit for profit. (And there could certainly have been more who succeeded in keeping their identity and methods a secret.)

That said, for most investors, myself included, it’s not worth the time and money to try and seek out inefficiencies, because:

  1. They’re hard to find (and they may disappear soon after being found if other investors find out about them as well), and
  2. Even if you think you’ve found one, it may turn out to have been nothing other than randomness, and if you bet heavily on it, you could end up in a heap of trouble.

Similarly, it’s no easy task to find a fund manager who will reliably outperform the market. In order to do so, you’d have to identify an inefficiency in another mostly-efficient market: the market for fund management skill.

*Update: The video from which that quote came has since been taken offline.

Dealing with Stock Market Volatility

In the last week, the following questions (and several similar ones) have showed up in my inbox:

“With the recent downturn, I’m considering move my 401k to bonds until the market volatility stops.”

“I have a little cash to invest, but in light of the recent volatility, I can’t figure out where to put it.”

“When the news says the market is going nuts, I go in and check my portfolio. Then when I see a large loss I will get nervous. How does one overcome this scenario?”

Because I keep getting these types of questions, I suspect many of you have similar concerns as well. What follows are my four tips for dealing with the recent volatility.

First, give up on the idea that the volatility will stop. The stock market is always a bumpy ride. Sure, some months/years/decades are less bumpy than others. But even at times when the market has been marching steadily upward, there’s no way to know that a dip, a series of bumps, or even a cliff isn’t just around the bend.

As such, you only want to put money in the stock market if you’re OK with the fact that its value will bounce all over the place from day to day and from year to year. In other words, when designing your portfolio, choose an asset allocation that you can be comfortable with even during the most volatile periods.

Second, remember that underneath all this unpredictable, bumpy, noisy, random volatility is something valuable (and, for what it’s worth, much more predictable): A world economy that manages to continue growing despite setback after setback. If you’re in a position to be able to accept the accompanying volatility/randomness, you can have a share of that growth.

Third, remember that it’s all one portfolio. That is, even if one holding is doing poorly, there’s no need to worry as long as the overall portfolio is doing OK.

Fourth, try to keep a long-term focus. The value of your portfolio tomorrow is only important to the extent that you’ll be selling your holdings tomorrow. In other words, if you’re in the accumulation stage, it’s entirely irrelevant.

And for those in retirement, you’re (ideally) only liquidating a very small portion of your portfolio every year. What matters is the average price you’re able to get for your holdings over the entire duration of your retirement–not the price on any one particular day.

Updated to add: Taylor Larimore, one of the authors of The Bogleheads’ Guide to Investing shared a recent Barron’s article pointing out that, while we’ve had a volatile year so far, it hasn’t yet approached 2008 or 2009 in that regard.

  • In 2008, there were 42 days in which the S&P 500 moved more than 3%.
  • In 2009, there were 23 such days.
  • So far in 2011, there have been only 7 such days.

Withdrawal Rates and Early Retirement

Connie writes in to ask,

“I’m 58, and I just found out that I’m going to be laid off in less than a month. My previous plan had been to work until 62, then retire and start Social Security right away. Still, it looks like I might have enough money not to have to go back to work if I cut my expenses just a little.

I’ve decided that I’m comfortable with a 4% withdrawal rate. But how do I account for the fact that the amount I’ll need to spend from my investments will decrease in a few years once I start claiming Social Security?”

This type of situation is very common–people whose income will increase at some point during retirement (usually due to Social Security) or whose expenses will decrease at some point (due to a mortgage being paid off or due to qualifying for Medicare, for instance).

In general, the way I’d approach the analysis for such situations is to use some mental accounting. Mentally separate your portfolio into two parts:

  1. The part that will satisfy your ongoing expenses (using whatever long-term asset allocation and withdrawal rate you choose to use), and
  2. A lump sum that will be used to pay the additional expenses for the first several years.

So How Much Money Does Connie Need?

So that we can walk through an example, let’s make up a few numbers for Connie. Let’s assume that:

  • Her expenses are $35,000 per year (and, aside from inflation, she doesn’t expect that to change),
  • She has no pension or other sources of non-investment income, and
  • If she claims Social Security at her full retirement age (FRA) of 66, her benefits will amount to $17,000 per year.

Important note: I’m only using this claim-at-FRA scenario for the sake of our first-glance analysis here. It’s not a suggestion that claiming at FRA is necessarily the best approach for early retirees. In some cases it makes sense to take Social Security early, and in other cases it makes sense to delay all the way to age 70.

This means that, for eight years (from age 58 to 66), Connie needs her portfolio to fund $35,000 of expenses. Then, starting at age 66, it will only have to fund $18,000 of expenses ($35,000, minus $17,000 Social Security).

Or, said differently, her portfolio must fund $18,000 of expenses every year for the rest of her life, plus $17,000 of additional expenses for the eight years until she reaches age 66.

Given that Connie is comfortable with a 4% withdrawal rate for the rest of her life, she needs $450,000 ($18,000 ÷ 0.04) to fund the $18,000 of annual expenses.

To that, we add $136,000 (8 x $17,000) for her eight years of higher spending prior to claiming Social Security. (The assumption here is that Connie puts this short-term money in something low-risk like a CD/bond ladder and that it ends up earning a 0% real return.)

So, in total, Connie needs $586,000.

Complicating Factor: Taxes

As you’ve probably noticed, we’ve completely ignored taxes here. Given the numbers we’ve assumed, this isn’t too terrible of an oversimplification.

  • At these income levels, Connie’s Social Security benefits would be mostly tax-free,
  • At these income levels, long-term capital gains and qualified dividends from taxable accounts would be taxed at 0%,
  • Some of her holdings may be in a Roth IRA, which would be entirely tax-free, and
  • The first $9,500 ($10,950 once she’s age 65) of otherwise-taxable income would be free from tax due to Connie’s standard deduction and personal exemption.

In other words, given the assumptions we’ve made, Connie’s overall effective tax rate is likely to be less than 5% for most of her retirement. Naturally, your own situation could be quite different–thereby necessitating that you increase the amount of savings needed to fund a given level of retirement spending.

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Safe Withdrawal Rates and Life Expectancy

If you’ve read much about retirement planning, you’ve probably encountered the “4% rule,” which suggests that investors withdraw no more than 4% of their portfolio per year during the early stages of retirement.

The 4% rule is the result of various studies (most famously this one), which showed that using a withdrawal rate much higher than 4% leads to an undesirably-high probability of running out of money over a 30-year retirement — the underlying assumption being that 30 years is a conservative (on the high end) estimate of how long retirement might last.

But just how conservative is that 30-year assumption? For a 65-year-old or a 65-year-old couple, it turns out it’s quite conservative. According to a handy calculator from Vanguard (which uses data from the Society of Actuaries):

  • A male age 65 has just shy of a 6% chance of living another 30 years,
  • A female age 65 has a 13% chance of living another 30 years, and
  • A male/female couple age 65 has an 18% chance that one of the spouses will live another 30 years.

So, for example, for a spending strategy that has a 20% historical failure rate over 30-year periods, the historical chance that an actual 65-year-old married couple would have run out of money during retirement is actually significantly below 20%. To run out of money, they’d need to have a poor-returns outcome and a living-longer-than-average outcome.

Incorporating Life Expectancy Data

Fellow blogger Wade Pfau recently ran the numbers and put together some handy charts to show the historical probability of running out of money (given various asset allocations and withdrawal rates) for a 65 year-old couple using actual life expectancies rather than an assumption that they’ll automatically live for 30 more years.

Of course, as with any study based on historical data, it’s only useful as a predictor to the extent that future returns look like past returns. And many experts believe that stock returns going forward are unlikely to be as high as those of the previous century.

Still, I find the results at least a little encouraging.

For example, according to Pfau’s research, a married couple both age 65 using a 4% withdrawal rate has a less than 10% historical probability of running out of money at most asset allocations. (Interestingly, at a 4% withdrawal rate, the failure rate is barely affected by asset allocation. Portfolios of 30% stocks, 70% stocks, and everywhere in between have nearly identical failure rates.)

Even if you bump the withdrawal rate up to 5%, the probability of running out of money doesn’t exceed 20% for most moderate asset allocations.

Admittedly, the idea that we might not live as long as we’d planned isn’t exactly an overwhelmingly positive message. But at least we might not have to be as stingy with our money as we’re often told to be.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Does It Still Make Sense to Max Out Your 401k?

A reader wrote in this week to ask:

“Considering the current plight of the stock market, do you still recommend 20-somethings max-out contributions to their 401k’s, or should they invest in something safer like a high-interest savings account instead?”

Should You Contribute to Your 401(k)?

The question of whether or not to contribute to a 401(k) doesn’t have anything to do with the stock market. I’ve yet to see a 401(k) plan that didn’t offer a single bond fund, and most plans even offer a very low-risk option such as a money market fund or a stable value fund. In other words, you can contribute to a 401(k) without investing a dime in the stock market.

So the primary question is this: Is this money intended for retirement? If so, it’s probably a good idea to take advantage of the tax breaks that come with investing via retirement accounts.

That said, there are some circumstances in which it makes sense to contribute to a Roth IRA before maxing out your 401(k). Specifically (assuming you’re eligible to make them) Roth IRA contributions should be a higher priority than 401(k) contributions if:

  1. Your employer does not offer a matching contribution (or you’ve already contributed enough to get the maximum match), and
  2. You expect your tax bracket in retirement to be greater than or equal to your current tax bracket.

Update: As has been noted by a couple savvy readers, an additional advantage of Roth IRAs is that contributions can be withdrawn free from tax and penalty at any time.

Alternatively, contributions to a traditional IRA should be the highest priority if:

  1. Your income is such that you’re eligible for deductible contributions to a traditional IRA,
  2. Your employer does not offer a matching contribution (or you’ve already contributed enough to get the maximum match),
  3. You expect your tax bracket in retirement to be lower than your current tax bracket, and
  4. The investment options in your 401(k) aren’t as good as those you would have access to in an IRA.

Should You Be Investing in Stocks?

As to the implied question of whether or not it makes sense to invest in the stock market, I don’t think that’s changed at all in the last month. The stock market was high-risk, and it still is high-risk. At the same time, it still has higher expected long-term returns than other asset classes.

So, for most 20-something investors, yes, I still think it makes sense to have some of their assets allocated to stock funds. But how much should be allocated to stocks varies from person to person. Some investors are risk-tolerant. Some are risk-averse. There’s nothing wrong with either one–it’s just important to understand which of those two you are, so that you can invest accordingly.

In other words, if you’re feeling the need to use a more conservative asset allocation in the future, that may be a good idea. But, as we discussed last week, remember not to hike the risk level back up (by moving more back into stocks) when stocks start to rise again, otherwise you’ll be setting yourself up for another selling-during-a-downturn scenario.

Risk Tolerance in Action

Credit where credit is due: The inspiration for this article comes from a recent post on the Bogleheads forum: “A Time to Evaluate Your Jitters.” I strongly encourage you to read the post, as the author made his points more eloquently than I’ll be able to.

In the last week we’ve mentioned two productive things to do during a market downturn:

  1. Rebalance your portfolio, and
  2. Check for tax-loss harvesting opportunities.

Today let’s add a third: Get a first-hand evaluation of your risk tolerance.

Is Investing Supposed to Be This Difficult?

If my email inbox is any indication, many investors have found it difficult to stick to their investment plans this week. Their plans call for rebalancing (which in this case means selling bonds and buying more stocks), but they’re nervous about doing so.

Rebalancing isn’t supposed to be easy. Selling your better-performing assets to buy more of your worse-performing ones is difficult for most investors.

But it’s not supposed to give you an ulcer or heart attack either. If you’re experiencing that degree of hesitance to stick to your original plan, what you’re getting here is first-hand, concrete evidence that your risk tolerance is not as high as you thought it was.

If the only way you’re going to be able to sleep at night is to use a lower stock allocation than your original plan called for, then so be it. It’s a costly lesson, but it’s a valuable one too.

So don’t waste it.

Whatever stock/bond allocation you end up settling on, do not move to a more aggressive allocation in the future. Otherwise you’re likely to repeat the same mistake when the market takes its next downturn.

A lower-risk, lower-expected return allocation that you can stick with is much better than a higher-risk, higher-expected return allocation that has you panic-selling in every bear market.

But This is Unprecedented!

Several readers have told me that this week has been an exception. They’re normally risk-tolerant, but this decline has been particularly difficult to deal with because the events causing it are so unprecedented.

But that’s the point. It’s always unprecedented.

Think back to the end of 2008. The housing market was crashing. The biggest, most famous financial institutions were failing one by one, and experts were predicting that our entire financial system would literally collapse if the Federal government didn’t step in to hold the pieces together. It was unprecedented.

Or think back to 2001. The technology sector upon which we’d pinned our hopes of wealth and prosperity had started to come to pieces. Then, after about a year of the market declining, terrorists attacked us on our own soil, killing thousands of people. To say that that was unprecedented is an understatement.

Risk tolerance isn’t just about your ability to deal with abstract market declines. It’s about your ability to stay calm while your portfolio is tanking and you’re being inundated with news of frightening, sometimes genuinely catastrophic, I-never-thought-this-could-happen type events.

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