Active v. Passive - The Secret to Winning the Loser's Game

This is the final post on active v. passive investing but before moving on let me briefly summarize.

• Academic evidence points overwhelmingly to indexing being the best way for the vast majority of people to invest. Index funds should form the biggest part of every portfolio.
• Mathematically, after costs, the average returns of a passive investor have to exceed the average returns of an active investor.
• The market cap-weighted index reflects the consensus view of the market and therefore is the ideal starting point for a passive investor.

But the cap-weighted index isn’t perfect and, depending on how much risk you’re prepared to take, you may want to tilt the portfolio towards other types of risk, or beta, such as small company or value stocks.

Again beta is a measure of overall market risk. But what about alpha? That’s the name given to any return provided by an investment over and above the benchmark index.

First and foremost you should be indexing. Alternatively you could tilt your portfolio towards different types of risk.

But is there ever a case for chasing alpha - either by choosing stocks yourself or by employing an active fund manager?

Professor Ken French from Tuck School of Business says: “That’s a great question. Does it make sense for the average investor to invest in an active fund? What I know is that the active investor who does invest in an active fund has to expect to lose relative to a passive strategy.”

Professor John Cochrane from the University of Chicago says: “I take a dim view of active management. For any investor to invest, you have to understand why the person you’re giving your money to is in the half that’s going to make money, and not the half that’s going to lose money. What’s special about him? What’s special about you that you know how to evaluate him?”

Much evidence is stacked against active fund management. But, say for example, in spite of everything academia has said, you still want to take a gamble with part of your portfolio, how do you choose an active fund from the thousands of funds available?

Daniel Godfrey from the Investment Management Association says: “Well certainly not just by looking at past performance. A consumer would need to do a number of things. Firstly they can just offset the decision-making altogether and go to an independent financial adviser, and many do. And they will select funds for them, and that may be a mix of active and passive funds, and that’s a perfectly sensible thing to do.”

Value investing is particularly worth investigating - as are the writings of the man usually credited with founding it - the British-born American academic and professional investor Benjamin Graham.

Like Sharpe and Fama, Graham’s aim was to take the guesswork out of picking stocks. He famously inspired one of his pupils, Warren Buffett. And Buffett’s subsequent success is testimony to the validity of Graham’s approach.

Buffett has described Graham’s book The Intelligent Investor as by far the best book about investing ever written. In it Graham wrote that investment is most intelligent when it is most businesslike.

In his preface to the fourth edition of the book, Buffett said: The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.

Whichever route you go down - passive, active or somewhere in between - your behavior is absolutely critical - particularly at times when emotions are running high. Everyone knows the idea is to buy low and sell high, but time and again we do the precise opposite.

Many investors pile in just as the market reaches a top. Then, even worse, they bail out just as prices reach the bottom and are bound to rise again. That kind of behavior is sadly all too typical, and even the professionals are prone to it. The effect on the long-term value of our investments can be catastrophic.

So, how do we as investors curb that sort of self-destructive behavior? Well, one way is to have an automated approach to investing. So, once you’ve chosen a strategy and the level of risk you’re prepared to take, you leave your investments exactly as they are. Either once or no more than twice a year you should rebalance your portfolio to realign it with your risk tolerance. But again, this can be done automatically.

Merryn Somerset Webb from MoneyWeek says, “There are lots of styles that work over the long term. Value works, dividend investing works, momentum investing works if you get it right. All sorts of things work. But they only work if you stick with them."

It also helps to have a financial adviser to keep you on track. Charles Ellis says: “There are two main roles for an adviser. One is to help individuals understand themselves and what their real financial purposes are, and what their anxieties would be. And the second is to hold the client’s hand and encourage them to stay in it for the long term.”

Vanguard founder Jack Bogle says: “Why in the name of peace do we pay any attention to the stock market? It's a giant distraction to the business of investing.”

Of course it doesn’t help that we’re constantly hearing about the markets. There are specialist magazines. Almost every major newspaper has a money section. There are radio shows and, of course, entire television channels devoted to the latest on the markets and where the so-called experts think they’re heading.

And that, in a nutshell, is the secret to winning the loser’s game. First, choose a strategy that’s based on evidence - ideally one designed to capture the returns of the whole market - and then tailor it to your attitude to risk. Secondly, stick to your strategy through thick and thin. Rebalance your portfolio, yes, but most important of all, stay the course.

CBlakely CFP®, CTFA        02/2015

Sources: Winning the Loser’s Game – Charles D. Ellis;  Robin Powell: How to Win the Losers Game – SensibleInvesting.tv Link to the video

Revisiting the 4 Percent Spending Rule

A well-known approach to addressing prudent retirement spending is known as the “4% spending rule.” This guideline states that retirees with a diversified portfolio balanced between stocks and bonds can safely withdraw 4 percent of their initial balance at retirement, then adjusting the dollar amount for inflation each year thereafter.An inflation-adjusted withdrawal rate is intended to provide a predictable stream of withdrawals that keep up with inflation.

 

Conversely, using a percentage-of-portfolio withdrawal method, the retiree withdraws the same percentage annually from the prior year-end portfolio balance. The dollar amount will fluctuate with market performance, and while the portfolio balance and withdrawals may shrink, the portfolio is unlikely to ever be fully depleted.

In practice, retirees are likely to incorporate a hybrid spending method—spending moderately in years when the market is up and spending less when the market experiences prolonged downturns.

The factor that has the biggest impact on withdrawal rates is the retirement planning time horizon. For most people, an estimate of how long the retirement portfolio will be needed can be based on the investor’s current health and anticipated longevity, as determined by statistics, and history. An estimate of age 90 is a reasonable default given today’s longer life expectancies. For a 65-year-old married couple today, for example, there is a 72 percent chance that at least one spouse will live to age 85, a 45 percent chance that one will live to age 90, and an 18 percent chance that one will reach age 95!

With today's yields near historic lows retirees, whose dividends and interest combined are less than 4 percent are often reluctant to spend from principal to make up for the deficiency. And many are wondering whether 4 percent is still a reasonable spending goal.I feel it is a reasonable starting point for investors who follow a total-return spending approach. A total-return approach is one in which investors remain appropriately balanced between stocks and bonds, and diversified across varied asset classes so that portfolios may potentially benefit from both dividends and interest and appreciation of capital (i.e. stocks moving up in price).

Instead of changing the portfolio to chase income, by reducing equity exposure and adding bonds it may be wise to consider the total-return approach to allow for spending both from portfolio cash flow and from the potential increase in the portfolio value.This empirically decreases the odds of  outliving your portfolio.

CBlakely CFP®, CTFA                   October 2012 

 

Source: Society of Actuaries Retired Participants 2000 Mortality Table., Fiancial Planning Journal

The Financial Problem of Living Too Long - Solved!

If you are one of the 10,000 baby boomers retiring today (or in the next several years) then this post may be of some interest to you because for many, traditional asset allocation is inadequate at confronting retirement risk. Let me explain.

Trying to rebuild a retirement portfolio in a low return investment landscape has many challenges. Importantly there are two risks that really have taken center stage, investment-performance risk and longevity risk. Equity market returns have been lousy for about a decade, prompting new phrases into our vernacular such as, “the new normal” and “stocks suck.” Over the last generation life spans have increased to the point that the fastest growing segment of Americans is the over 100 age group – aka the Willard Scott gang. The odds of at least one spouse reaching the age of 86 is 25 percent.

Since the great recession of 2008 income losses for those nearing retirement, specifically households led by people between the ages of 55 and 64 have taken the biggest hit, a decline of 9.7 percent. During retirement, the income flowing from a portfolio made up of stocks and bonds is sensitive to market fluctuations.  This can significantly increase an investor’s longevity risk, or outliving one’s assets.

Creating a portfolio that confronts and diminishes these risks requires adding longevity insurance into the mix. Yep, you guessed it, I’m talking about annuities.  But wait, Ibbotson Associates research shows that investors can mitigate both longevity and investment performance risks with a carefully constructed combination of a guaranteed income stream and traditional assets such as mutual funds and ETF’s.

Annuities can be expensive (guarantees normally cost more) and hard to understand. Determining how and when to use them can be confusing too which is why few investments are as polarizing, but it is wise to set aside preconceived notions in response to this current challenging environment.  Many retirees should consider ways to turn a portion of their portfolio into pension- like income streams.

A fairly recent innovation in deferred variable annuity (VA) products is the guaranteed minimum withdrawal benefit (GMWB) rider. The GMWB rider for life gives you the ability to protect your retirement investments against downside market risk by allowing you the right to withdraw a fixed percentage of the benefit base each year until death. The benefit base can step up and resets to the high-water mark of the contract value on the rider anniversary date when the market has performed well. The remaining contract value at death will be paid to your beneficiaries, which removes concern about giving up liquidity to your heirs (i.e. if I die early, my family loses).

After deciding whether longevity insurance has a place in your retirement portfolio the next challenge is how much to allocate to this product versus traditional assets. The easiest way is for your advisor to follow up the strategic asset-allocation decision with a secondary “product-type” optimization.  Barring that, a recent Ibbotson study using  Monte Carlo simulation based optimization to find an optimal product-type mix of traditional products and a VA+GMWB by maximizing a utility function at the life expectancy  offers helpful guidelines to product allocation. See the major findings (below):

Ø  The higher the risk tolerance, the lower the VA+GMWB allocation;

Ø  The longer the life expectancy (subjective), the higher the VA+GMWB allocation;

Ø  The higher the age, the lower the VA+GMWB allocation;

Ø  The higher the ratio between wealth and income gap, the lower the VA+GMWB allocation; and

Ø  The preference for bequest has almost no impact on the VA+GMWB allocation.

By adding products that offer guaranteed income for life to your portfolio (if appropriate) you can avoid an extreme outcome (i.e. outliving your assets) and better enjoy your retirement. But, as case studies show investors and advisors must be careful when determining which products and allocation percentages.

CBlakely CFP®, CTFA          Auggie 2012

Sources: The New York Times; Allocation to Deferred Variable Annuities with GMWB for Life, Xiong, Idzorek, Chen (Ibbotson); The Impact of Skewness and Fat Tails on the Asset Allocation Decision, Xiong, Idzorek (Financial Analysts Journal, Vol. 67 #2)