If you’ve invested long enough, it’s almost certain that you’ve been made to feel less than knowledgeable, either by your advisor (unwittingly, of course) or by ‘Mr. Market.’ People invest for as many reasons as there are people. Today’s Brief addresses the purpose of the vast majority of investors; that of saving to replace the paycheck. Some call it retirement, some call it freedom from salary, others refer to it as their second half, and still others call it doing what you really want to do, or were meant to do all along. Whatever you call it, it happens when you begin depending on your investments to see you through life, no longer relying on what is commonly referred to as ‘your day job.’
There are two primary markets comprising the capital markets; stock and bond or equity and fixed. Stock markets and the individual stocks that comprise them captivate our attention and our money as they seem to climb effortlessly to new heights. We become enthralled as we watch our portfolio miraculously grow day by day. But then, almost without notice, the beast can turn and rend our hopes and our portfolios to pieces.
The fixed income market attracts the more conservative investor. Many who invest in this market, primarily or exclusively, were driven to it by terrible experiences suffered in the stock market. They load up on CDs, bonds, and annuities, to avoid the risks they suffered at the hands of the stock market. Yet, this investor may face a more devastating threat to his ultimate welfare than his more overtly risky counterpart. Inflation is not always terribly obvious, but it is almost always with us. The saver may not even notice it while he is saving, because his salary is likely keeping pace with rising prices. Not so for the retiree dependent on the income from CDs, bonds, or annuities.
There are at least five major components of investing; time, return, risk, inflation, and planning. Without good planning, the most significant is time. It cannot be overstated that the sooner you begin an efficient and disciplined investment program the better off you will be. The investor who starts early can save less, for a shorter period of time and accept a lower return (and risk) than the late starter. Consider this: A wise saver who starts immediately investing $5,000 a year for ten years at 9% will have $1 million in 40 years. The procrastinator who waits for 11 years to start saving for a goal of $1 million in 40 years will have a much tougher time of it. For starters he will have to earn 11%, not 9% on his investments, save $150,000 of his earnings, not $50,000 as our wise saver, and save for 30 years, not ten as our wise investor who started ten years earlier.
As much as time is a good thing in investing, returns, or the chasing of them, can be a bad thing, taking the investor further from his goal. Returns on your investments are vital to meeting your goals, and the more the better, right? The problem in the real world is that returns are not predictable, they are uncertain and the direction of markets is unknowable. Anyone who tells you otherwise is misleading you.
For the last 10 years only 38% of active managers beat the S&P 500, according to a study done by Blackrock. That number falls to 25% when taxes and fees are considered. That means the average investors saving for retirement under the misconception that he must out-perform the market to succeed has only a 1 in 4 chance of actually doing so over a meaningful period of time. Stated alternatively, he has a 75% chance of under-performing it! At least with indexes, you are assured of not materially under-performing the markets 100% of the time, not just 25% of the time. And if you are still thinking you are good enough to stay with the 25% of managers who do outperform, consider this: a recent study entitled “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas” of actively managed domestic equity mutual funds from the beginning of 1975 through 2006 demonstrated that only .6% (after expenses) showed genuine market-beating ability (NYT July 13, 2008).
Professional investors, like insurance companies and pension fund managers understand risk and measure it using probabilities to determine the amount of confidence they can have in achieving or exceeding their goals. For an example, when an insurance company sells an annuity they have somewhere beyond a 90% confidence of making a profit, a 50%-89% confidence of making a huge profit and 5-49% confidence of making an obscene profit, depending on the returns they can generate investing in the same capital markets that you and I invest in.
Insurance companies and Wall Street use powerful probabilistic tools to ensure winning more often than they lose, not unlike casinos. Now consider this; if they win more than they lose, reaping huge profits in the process, where do you think these profits come from? Is your house made of marble, like theirs is?
Capital market returns over the past 85 years have averaged between 7.6% (30% stocks/70% Treasuries) and 11.5% (100% stocks). But there is a real problem with averages as 2008 (and the last decade) has painfully reminded us. RETURNS ARE UNCERTAIN. To demonstrate we’ll look at a 37-year period, typical for either saving or spending during a lifetime. We have monthly data for the capital markets allocated by stocks and Treasuries going back for 85 years; so there are 576 37-year intervals in the data. In other words we calculate the average return for the years 12/1926 – 12/1963, then 1/1927 – 1-1964, then 2/1927 – 2/1964 and so on for 576 times. We calculate the actual capital markets for a 60% stock and 40% Treasury portfolio. Fascinatingly, this exercise reveals a very wide range in returns indeed. The worst 37-year average return was 5.81% for the period 9/29 – 8/66, and the best was 11.86% from 6/32 – 5/69.
So how do you deal with all this uncertainty? Remember our earlier example of the insurance company profitably selling annuities while working in the same capital markets? The same powerful probabilistic tools are available to you, but you have to seek them out. We use a patented process not unlike those earlier mentioned, but built for the benefit of individual investors, helping them to navigate and uncertain future of returns, confidently meeting or exceeding their important goals and priorities. We turn the tables in their favor.
Unfortunately, the vast majority of investors buy what Wall Street is selling – you have to take greater risk to get the returns necessary to meet your retirement needs. In the most basic of terms, the brokerage, mutual fund, and managed money industries exists to generate better returns than an investor could get simply by buying index funds. If returns were the constant 11.5% average of the stock market for the past 85 years, they would have a tough sale. But recall the huge range in returns demonstrated two paragraphs earlier as they ranged from 5.8% to 11.9% over various 37-year periods. The investment industry uses uncertainty and complication to their marketing advantage. They coax you into believing that you must achieve extra-market returns in order to meet your goals. The guaranteed results are that you will spend more in management expenses, taxes, and risk under-market performance. In fact, the extra risk increases uncertainty in your plan and this translates directly into loss of lifestyle. In order to compensate for the increased uncertainty (remember the probabilities) you will have to save more, invest and work longer, reduce your retirement spending, or take even more risk to maintain them.
Many people who invest primarily in CDs, bonds, and annuities were driven there by losses they sustained or witnessed of those taking too much risk in stocks. As a result they shun stocks at all costs. Unfortunately the investing knife cuts two ways; risk on the one and inflation on the other. Inflation is a fundamental part of our economy. We have learned to live with it and indeed don’t pay much attention during our earning years, because our salaries and wages generally rise with cost of living adjustments, advancement and growth in the case of the self-employed. But retired investors in CDs, bonds, or annuities who no longer have a substantial rising income find their quality of life measurably eroding because of inflation. Except during rare periods, prices for consumer goods generally rise by 2-4% a year. Medical, food and energy prices can rise even faster than consumer products for extended periods. Returns on CDs and short-term bonds are generally equal to the rate of inflation, before taxes. After taxes our retiree is backing up. It may well be too late when he realizes that his ‘safe’ investments aren’t really safe at all.
Stocks, for all their volatility provide significant benefits to both the saver and the retiree. Their values and dividends generally rise in value as the underlying companies they represent grow, and their growth is typically faster than the rate of inflation. So, stocks generally represent a vital component of almost any investment portfolio. The key is balancing the risk they represent against the necessary benefit they provide. Again, that’s where probabilities come in.
The final and most fundamental to an efficient and effective investment program is planning. Dave Kohl, a Professor at Virginia Tech says that people who regularly write their goals down earn nine times as much over their lifetimes as people who do not. His research indicates that 80% of Americans say they don’t have goals, while 16% say they do have goals but don’t write them down. Less than 4% right them down and only 1% actually record them and review them on an ongoing basis. In business school the mantra was fail to plan – plan to fail.
Everyone has goals, they just may not have thought much about them. We find that our new clients have almost as much difficulty with this aspect of the process as they do letting go of the need to beat markets. Goals vary by importance and priority and they have degrees from simply acceptable to ideal. ‘Ideally I’d like to retire this past Monday, but if required to meet other important goals, I’d be comfortable working until age 75.’
Goals change and so do asset values. As they do, opportunities and risks develop that would go unnoticed without professional sophisticated oversight. This is where the individual investor really can’t go it alone. He can buy indexes like those suggested by John Bogle in his popular book entitled “Gone Fishing Portfolio” making modest adjustments to re-balance, but he will miss the many, sometimes subtle, opportunities and risks along the way that might allow him to improve his odds of meeting important goals or to reduce lifestyle sacrifices required to reach them. The value of these opportunities and the difficulty of detecting them cannot be overstated.
Of opportunities Peter Drucker said “most of the time opportunity comes in over the transom. And opportunity doesn’t stay long. If you don’t respond to an opportunity, it moves on.” Our planning ensures that our clients recognize and respond to every opportunity that comes their way when asset values and goals change, as they will surely do.
In future Briefs we’ll consider more advanced topics, such as tax location management and a more in-depth look at the many faces of risk.
Have a nice weekend.