Abnormal Volatility?

August 22, 2011

Is the market volatility over the past decade higher than that seen historically?  Apparently, not so:

Brightman said the annualized standard deviation of monthly stock-market returns was 15% for the past decade, up from about 10% in the 1990s and 1960s. Still, he said, “the average recent volatility of 14% to 15% is only slightly higher than the 13% to 14% level during the 1970s and 1980s.” Since 1831, the average is 14.5%.

–MarketWatch, Aug. 16, 2011

It always feels like the present must be so much different than the past, but in terms of volatility, it’s just not the case.  Markets are always full of both opportunity and peril.  There’s no need to wait for the stars to align before getting serious about your investment plan.  Of course you should allocate a sufficient percentage of your earnings to liquid investments to be able to weather the inevitable economic storms, but in order to preserve purchasing power throughout your potentially long life, you must realize that the biggest long-term threats to your financial health are inadequate savings and inflation, not volatility.

Source: Druta Soutions

Leave a Comment » | Markets, Retirement/Saving | Permalink
Posted by Andy Hyer

Good Advice on Retirement Calculators

August 22, 2011

Figuring out what you need to retire is not as simple as it seems.  Calculating your “number” is as straightforward as punching a few numbers into a calculator, but understanding the context of the inputs and the output is more complicated.  This article from Advisor Perspectives, by way of dshort.com, is the best discussion of retirement calculators I have seen.

After covering some of the issues with assumptions, Todd Tresidder summarizes with six rules for using retirement calculators:

Below are 6 rules for getting the most value of retirement calculators and not being deceived:

  1. The Map Is Not The Territory: Never delude yourself into believing your retirement estimate is accurate. It is simply a calculated projection of the assumptions used. If any assumptions are incorrect the estimate will be similarly wrong.
  2. Walk-forward Process: Don’t perform the retirement savings goal exercise once, put it on a shelf and forget it. Instead, check back every few years and see what assumptions proved valid and which ones did not. Adjust the assumptions, recalculate, and shift your plans accordingly. Rinse and repeat every few years. This way you will hit your retirement target like a rocket ship that constantly course corrects toward its target.
  3. Errors Multiply: Small errors in estimates compound into large errors in results. Retirement savings are built and spent over multiple decades. A 2% error in inflation or investment return that is manageable over 5-10 years is a complete disaster when compounded over 30-40 years. Small details make big differences so pay close attention to the details.

In short, retirement calculators should not be used as commonly practiced. You should never take a guess at the required assumptions, create a fictitious number, and plan your financial future based on it. That is a dangerous mistake even though it’s exactly what most people do.

After years of working with clients as a retirement planning coach, certain techniques have emerged that are extremely valuable in providing viable workaround solutions to the impossible-to-make assumptions. You can plan your finances into the future with confidence and security when retirement calculators are used as follows:

  1. Scenario Analysis: Use retirement calculators to test various retirement scenarios. For example, should you try to save your way to retirement with a traditional portfolio or pursue income-producing real estate as an alternative? Test both scenarios and see what the numbers indicate. How would a part-time hobby-business affect your retirement savings needs? What happens if you work 7 more years or convert your career into consulting for a phased retirement? Retirement calculators are fantastic tools for comparing the impact of various retirement planning scenarios. As you get creative applying various scenarios it usually becomes readily apparent what will work for your situation.
  2. Teach Principles: Retirement calculators are invaluable for teaching essential retirement planning principles. Users quickly grasp how real return net of inflation is the only number that matters after just a few quick scenario tests. They also see the importance of time in compounding their way to wealth versus trying to save their way to wealth. They understand how much they must save to support $1,000 per month in spending. Without a calculator these concepts are difficult to grasp, but with a calculator they become obvious for even a layman. Each lesson learned will affect how you plan your retirement.
  3. Confidence Interval: Since you can’t possibly estimate all the assumptions with accuracy, the next best thing is to use a range of plausible assumptions. Simulate one extreme by using all pessimistic assumptions like high inflation, low investment returns, and a very long life with prolonged medical expenses (just don’t have any razor blades nearby when you see the result). Then simulate the optimistic extreme with high investment returns, low inflation and a prompt, peaceful death without medical complications. You will be amazed. The pessimistic scenario can easily require 2-4 times the nest egg of the optimistic scenario. This can be a very instructive exercise for understanding the range of possibilities so you can plan accordingly.

Really, really good advice all around.  You can’t just calculate your number once and then forget about it.  It’s important to keep updating things as conditions evolve.  Give yourself a margin of safety.

 

 

2 Comments | Retirement/Saving | Permalink
Posted by Mike Moody

Adjusting Retirement Withdrawals for Inflation

August 16, 2011

Trying to figure out withdrawal strategies is quite tricky—and there are different schools of thought on how to set withdrawal rates.  Here is a link to a useful article by Morningstar (through Yahoo! Finance) on the simple mathematics involved in adjusting retirement withdrawals for inflation.

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Posted by Mike Moody

Congress Is Not Alone

July 27, 2011

Apparently Congress is not alone in its profligate ways.  According to US News:

More than 75 percent of advisers surveyed indicated that not saving enough was the major roadblock to their clients’ success. This is important because the amount saved is something that people can control, while investment performance or economic conditions are largely beyond our control.

Close behind, 73 percent of the advisers surveyed indicated that a client living beyond their means was the biggest obstacle to financial success. Again, an area that is within an investor’s control.

This is from a survey of more than 600 advisors done by Principal Financial.  The two biggest barriers to client success were not saving enough and living beyond their means, two factors which are obviously closely related.  If you are living beyond your means, clearly you are not going to be able to save enough.  Americans’ compulsive overspending seems to be mirrored by America’s compulsive overspending.

I guess the good news is that overspending is a behavioral issue under our control.  Willpower is hard.  An automatic investment plan is probably the way to go, especially to get started.  There are lots of good balanced funds around that can serve as a complete investment program.  Of course, I am biased in favor of the Arrow DWA Balanced Fund (DWAFX).

To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX) or the Arrow DWA Balanced Fund (DWAFX), click here.

Click here for disclosures.  Past performance is no guarantee of future results.

Living Beyond Their Means

Source: wikimedia.org

4 Comments | Retirement/Saving | Permalink
Posted by Mike Moody

Simple. Boring. Solid Savings Advice.

July 25, 2011

Simple. Boring. Solid savings advice from Carl Richards in What to Do If You Haven’t Saved Anything Yet.

(Even if you are actively saving and investing, the article is good motivation to keep it up.)

Source: Carl Richards

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Posted by Andy Hyer

The Silence of the Lambs

July 20, 2011

Vanguard‘s recent piece discusses the thumping that savers are getting at the hands of the Fed, otherwise known as financial repression:

…today’s near-zero interest rates are no laughing matter for many American savers—not just my kids. They are my parents, my friend saving for a down payment on a home, and my retired neighbors down the street. You may be one of the many Americans trying to live off of your well-earned savings, whether those funds are in money market or checking accounts. In my mind, savers—as opposed to investors—are the proverbial “sacrificial lambs” of monetary policy.

The Federal Reserve has held its interest rate target between 0% and 0.25% since late 2008. Adjusted for inflation, the yield on 3-month Treasury bills is actually negative, as illustrated in the chart below. Quite frankly, yields on such savings vehicles are likely to remain that way for some time, with the Fed expected to keep its target rate near 0% at least for another year—and possibly longer.

Since December 2007, personal interest income has declined by close to $100 billion. The modest economic growth the nation has experienced since 2008 has come, to some extent, at the price of a negative real rate of return for savers.

Vanguard includes a nice chart of real rates as well.  You can see that the green line—the real rate of return—is below zero.

The Silence of the Lambs

(click to enlarge)                 Source: Vanguard

Most savers probably do not remember volunteering to be the sacrificial lambs of monetary policy, as Vanguard terms it.  As an investor, you do not have to allow yourself to be shanghaied into a bad situation.  If you want to sit still and be sheared, fine.  But you have a choice in the matter, a choice to do something that might better your situation.

If the old axiom “money goes where it is treated best” is at all true, then tactical asset allocation driven by relative strength should be an efficient way to take advantage of that fact.  Relative strength does nothing but push the portfolio holdings toward those areas that are rewarding investors with good returns.  If the returns start to lag, the position is replaced with something more promising.  There’s going to be more volatility involved, but you might have a chance to stay away from the shears.

Leave a Comment » | Investor Behavior, Markets, Retirement/Saving, Thought Process | Permalink
Posted by Mike Moody

Never Underestimate Inertia!

July 8, 2011

The law of unintended consequences strikes again.  A few years ago, in 2006 to be exact, legislation enabling automatic employee enrollment in 401ks was passed in order to boost retirement savings.  An article in the Wall Street Journal suggests that automatic enrollment might be having the opposite effect.

Under the law, companies are allowed to automatically enroll workers in their 401(k) plans, rather than require employees to sign up on their own. The measure was intended to encourage more people to bulk up their retirement nest eggs—a key goal in a country where millions of people aren’t saving enough.

But an analysis done for The Wall Street Journal shows about 40% of new hires at companies with automatic enrollments are socking away less money than they would if left to enroll voluntarily, the Employee Benefit Research Institute found.

More people were getting enrolled in the plan, but the initial contribution rates were set at lower levels than new enrollees typically selected on their own!

More than two-thirds of companies set contribution rates at 3% of salary or less, unless an employee chooses otherwise. That’s far below the 5% to 10% rates participants typically elect when left to their own devices, the researchers said.

Some of the plans have automatic escalation, but even these plans did not seem to go far enough.

An October study by EBRI and the Defined Contribution Institutional Investment Association found that, depending on their incomes, 54% to 73% of employees would fall short of amassing enough money to retire if they enrolled in their companies’ 401(k) plans at the default-contribution rate and were auto-escalated by 1% a year to a maximum of 6%.

The net result has been a mixed bag.  Enrollment rates have climbed from 67% to 85%, but contribution rates have dropped!

Among plans Aon Hewitt administers, the average contribution rate declined to 7.3% in 2010, from 7.9% in 2006. The Vanguard Group Inc. says average contribution rates at its plans fell to 6.8% in 2010, from 7.3% in 2006. Over the same period, the average for Fidelity Investments’ defined contribution plans decreased to 8.2%, from 8.9%.

Vanguard estimates about half the decline “was attributable to increased adoption of auto-enrollment.”

Obviously, it’s not the auto-enrollment itself that’s the problem.  It’s simply that most of the plans have the automatic enrollment savings rate or the top escalation rate set way, way too low—and Big Brother underestimated inertia.

The study found that if people were auto-enrolled at 3%, they were just too lazy to proactively change it to 10%, or whatever.  If you are in charge of auto-enrollment at your firm, the obvious fix is to start it at 6% or so, and escalate it 1% annually, up to 15% or so.  A few more people might opt out due to the higher initial rate, but—again, due to inertia—most people would leave it alone and thus have a chance at a decent retirement.

Don't let inertia get the best of you

Source: www.ebaumsworld.com

Financial advisors, on the other hand, know all about inertia.  Advisors have to fight client inertia all the time.  Inertia is closely related to the behavioral finance construct of fear of regret.  Clients don’t want to make a mistake that they will regret, so they take no action at all.  Philosophically, of course, taking no action is also taking an action, but clients tend not to see it that way, despite the fact that in the long run, opportunity cost usually dwarfs capital loss.

Markets offer infinite opportunities for error and regret (much of which is unfortunately actualized by the typical retail investor) but you can’t let a little thing like that dissuade you.   That’s why one of the most important functions of a financial advisor is to get clients to do the right thing at the right time.  Disciplined use of relative strength can often be a big help in that regard.

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Posted by Mike Moody

Our National Pastime: Tinkering With CPI

July 7, 2011

The WSJ reports on the most recent sign that retirement planning is increasingly up to the individual:

One proposal under serious consideration would slow the way tax, spending and entitlement programs shift with inflation each year. The switch to using a different measure of inflation, known as a “chained” consumer-price index, is endorsed by many conservative and liberal groups who believe that inflation estimates in the government’s budget are overstated and lead the government to expand spending programs and adjust tax brackets too quickly, resulting in more spending and less revenue.

The Moment of Truth Project, a group established to help push into law last year’s White House deficit-reduction-panel proposal, projected that establishing a chained CPI measure would save roughly $300 billion over 10 years.

The biggest savings—an estimated $112 billion—would be from slowing the growth in the cost-of-living adjustments for Social Security beneficiaries. Another $33 billion would be saved by reducing cost-of-living adjustments for other federal programs. The Moment of Truth Project estimated that a chained CPI “would cause tax-bracket thresholds and other parameters to grow more slowly and raise an extra $87 billion” in revenue over 10 years. (my emphasis)

Tinkering with the CPI calculation has become a national pastime.  Let’s just hope that Americans adjust their savings rates accordingly…

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Posted by Andy Hyer

The Three Biggest Drivers of Retirement Savings Success

July 7, 2011

Smart Money has an excellent article laying it all out.  The data comes from a study of 3,000 workers by Putnam Investments.  What they found is that behaviors matter more than anything else.  To get right down to it, here are the three behaviors that brought the greatest success:

1. Employing a consistent, long-term savings and investing strategy.

2. Working with a financial adviser.

3. Saving money in your workplace retirement plan.

Having a consistent savings strategy was critical.  And it truly was the behavior that was most important.  From Smart Money:

The people who seemed most able to replace their current income in retirement – those who were on track to replace 100% or more of their current t income — and the people who seemed least able – those who were on track to replace less than 45% — had the same annual mean household income, $93,000. “A clear difference-maker appears to be behavior around savings,” not income, the survey concludes.

Having a good investing strategy like relative strength is important, but no investing strategy will get you to retirement successfully if you have no savings to invest.  Successful savers were likely to have an automated savings plan, were likely to contribute heavily to their 401ks, and got help from a financial advisor to make sure they were on track. 

I think one of the big values that a financial advisor can provide—besides helping clients select a reasonable investment strategy and discouraging them from emotional asset allocation—is to remind clients to save.  And guess what?  These behaviors are critical whether you are talking about retirement capital, or any other kind of  capital.  Savings is foundational for investment success.

Leave a Comment » | Investor Behavior, Retirement/Saving | Permalink
Posted by Mike Moody

The Woeful State of the American Saver

June 27, 2011

One of the biggest financial changes over the last generation has been the assumption of retirement savings risk by individuals.  A generation ago, many workers in both the private and public sectors had defined benefit plans that were quite generous.  (As we are finding out, the public pension plans were so generous that they are now bankrupting states, counties, and municipalities.)  Even the private corporate pension plans had great benefits—often nice payouts along with retiree healthcare.

As automation and productivity increased, fewer workers were needed to reach the same production level and corporations found themselves with fewer current employees trying to support a large base of retirees.  This is the same demographic situation that plans like Social Security find themselves in, by the way.  The cost pressures became unbearable, especially if the corporations intended to survive in an increasingly competitive global economy.

Corporations looked for ways to shift the retirement cost burden and over the past generation have moved to defined contribution plans, most often 401k and profit-sharing plans.  With a 401k plan, much of the onus of saving is shifted to the employee, although many of the best employers have excellent matching programs.

Alicia Munnell, the director of the Center for Retirement Research, recently penned an article in Smart Money that lays bare how Americans are doing on the path to retirement.  She writes:

In theory, a typical worker who ends up at retirement with earnings of slightly more than $50,000 and who contributed 6 percent steadily with an employer match of 3 percent should have about $320,000.

In fact, the typical individual approaching retirement had only $78,000, far short of the simulated amount.

She pulls data from a number of other sources to support the $78,000 number as realistic, but whatever the actual number, it is clearly far short of $320,000.  The amounts Americans have saved will produce a very meager retirement.

Using the SCF [Federal Reserve Survey of Consumer Finances] figure of $78,000, 401(k) balances will produce about $400 per month of income in retirement if the participant buys a joint-and-survivor annuity; $260 per month if the participant applies the “4-percent” rule.

$400 per month, even with some kind of Social Security benefit, is still going to put a lot of retirees squarely into the Alpo zone.  And you’ve got to hope that the Social Security benefits will still be intact.

Not recommended for retirees

source: www.easyfoodandlaundry.com

This is not an outcome that is good for anybody.  It’s not good for the retiree who is trying to eke out an existence on an insufficient level of income.  And it’s not good for responsible savers who do have adequate assets—that’s the first place the government will look for money to redistribute.

What can you do to help your clients avoid this problem?  As with most simple problems, the solution is fairly simple too.

1) Save more. 6%, as in the example, is probably not enough.  Most experts recommend a minimum of 10% of your income be saved.  I’d go for 15%.  It would not be tragic if I had too much money saved for retirement and had to work down my balance by taking Mediterranean cruises, for example.

2) Invest for growth. You might have to embrace a little risk, but the ultimate payoff may be well worth it.  Higher investment returns compounded over a long period of time can make a huge difference.  (Hint: relative strength is an excellent return factor for growth.)

3) As you near the withdrawal phase, transition to a less volatile portfolio mix. Studies show that less volatile mixes provide steady income for a longer period of time.

None of this is new—the same policy prescription was advocated in Andy’s Short Course in Financial Planning way back in 2007, before the financial crisis was a gleam in Ben Bernanke’s eye.  And eternal truths don’t change.  Get your clients on the right track, and push to keep them there.

1 Comment | Retirement/Saving, Thought Process | Permalink
Posted by Mike Moody

The Real Wealth of Nations

June 21, 2011

This article is about history that is still being written, and about a simple way to create a powerful, sustainable economy.  It is about Lee Kuan Yew and the Singapore Central Provident Fund.  Never heard of it?  Neither had I, until I happened upon a story about it in the book Animal Spirits by George Akerlof and Robert Schiller.  I was fascinated and dug in to do a little further research.  The best thing about this story is that it is true—and therefore it is repeatable.  It has critical lessons for the United States, if we want to remain a world power.  And it is something we can easily do, if we make the choice to do it.

Most debates about the sluggish economy are conducted along Keynesian lines and argue that spending needs to be stimulated.  If people would just spend more, the economy would grow.  After all, the reasoning goes, consumer spending is 2/3 of the economy.  This line of thinking led to citizens actually being sent spending money—stimulus checks—in the mail!  The effect was pretty much what you would expect if you thought about it for more than fifteen minutes: minimal and temporary.  Giving someone money does not create prosperity—note the effects of sudden money on lottery winners.

What we have is not a spending problem, but a savings problem. Savings is what creates dynamic economic growth. Exhibit 1 in my case for the power of savings is Singapore.  Singapore became quasi-independent in 1955, after being a British possession since the 1820s (although it was occupied by the Japanese during World War II).  For a period of time, it was also part of Malaysia, but become fully independent in 1965.  Lee Kuan Yew had some training at the London School of Economics and took classical economists like Adam Smith seriously.  Adam Smith emphasized the capital accumulation that comes from savings.  With no natural resources whatsoever, except its people and their work ethic, Singapore resolved to save its way out of poverty.

Singapore Skyline

Source: www.commons.wikimedia.org

Lee Kuan Yew started the Singapore Central Provident Fund in 1955 as a way for citizens to save for retirement.  It has since been extended to include savings programs for housing and healthcare.  According to Akerlof and Schiller:

Initially it required employees and employers each to contribute 5% of employees wage income to the fund, but then contribution rates were rapidly increased.  They were steadily raised until 1983, when employer and employee were required to give 25% each (a total of 50%!).  The contribution rates follow a complicated schedule, but even today high-wage employees age 25-50 pay 34.5% and their employers pay 20%.  The system has not been “pay-as-you-go,” and the sums collected have really been invested. Largely because of the CPF, the gross national savings rate of Singapore has been in the vicinity of 50% for decades.

I put the important part in bold.  This is completely unlike our Social Security system, where the employee and employer payroll contributions are deducted, but then spent immediately.  As a result, in the US there is no actual surplus capital, only net debt which is an IOU on future generations.  Singapore already has essentially privatized their Social Security system.  Far from leading to fiscal disaster as some claim, the huge pool of enforced savings has not only secured the retirements of Singaporeans, it has allowed an enormous amount of capital investment. 

Disciplined savings as a nation over a 50-year period literally transformed Singapore from a poor trading outpost that was kicked out of the Malaysian union to one of the wealthiest nations in the world.  According to the Credit Suisse Global Wealth Report:

Household wealth in Singapore grew steadily and vigorously during the past decade, rising from USD 105,000 at the outset to more than USD 250,000 at the end. Most was due to domestic growth and asset price increases rather than favorable exchange rate movements. As a consequence, Singapore now ranks fourth in the world in terms of average personal wealth.

Wealth in Singapore is double the average wealth level in Taiwan and 20 times higher than in a neighbor like Indonesia—not to mention higher than in the US.  Now, I suppose it is not entirely surprising that a high savings rate leads to wealth.  What is more interesting, I think, is what it did to the Singaporean economy.  What grew out of the immense savings was a capital investment boom unlike anything ever seen.  And, the capital investment was not made with borrowed money, robbed from Peter today to pay Paul tomorrow, but was based on actual savings.  Thus, the growth was sustainable.  Coupled with the power of compounding, the results have been astonishing.

The able J.P. Lee did a little digging around for me and put together this graphic on the comparative GDP growth rates of the US and Singapore over the last 50 years.  Shocking isn’t it?

Click to enlarge.  Source: St. Louis Fed; Dept of Statistics, Government of Singapore

The graph on the top is a logarithmic scale which shows how much more rapid the economic growth in Singapore has been.  The magnitude of the compounded difference, though, isn’t really apparent until you take a look at the arithmetic chart below it!  GDP growth in the US over the last fifty years has been a robust 6.8%, but it has been dwarfed by the growth rate in Singapore, which has averaged a stunning 12.2%!  (If we could get even a fraction of this additional growth by privatizing Social Security, sign me up.)

Can you imagine what a national savings program could accomplish in the US?  We have many economic advantages already, ranging from an excellent university system, a diversified economy, and abundant natural resources to an outstanding record of technological innovation.  What we lack is savings.  Intelligent incentives to save and invest, coupled with Social Security payroll deductions that are actually invested in accounts for the participants could have a mind-boggling impact down the road.

Personal savings is something quite different from government savings or spending.  The US government seems addicted to deficit spending, but as a citizen you can’t do anything about that directly.  On the other hand, your level of personal savings in entirely under your control.  Like Singapore, most individuals have the ability to compound their savings for fifty years.  Even if the US never adopts an intelligent enforced savings plan, there is nothing to stop you from doing it yourself.

Leave a Comment » | From the MM, Markets, Non-partisan op-ed, Retirement/Saving | Permalink
Posted by Mike Moody

Retirement Planning In The New Normal

June 17, 2011

Today’s WSJ reports another signal that retirement planning is increasingly up to the individual.

AARP, the powerful lobbying group for older Americans, is dropping its longstanding opposition to cutting Social Security benefits, a move that could rock Washington’s debate over how to revamp the nation’s entitlement programs.

Why the change?  Apparently, reality is finally beginning to sink in.

Social Security, which was created in 1935, is facing a demographic challenge as the baby-boom generation retires with fewer younger workers to support it. The program’s actuaries say that by 2036, the program will have exhausted its reserves and will only be able to pay 77% of promised benefits. Between now and 2036, the government, which has spent the money held in reserve, will have to borrow to meet those obligations.

I had to re-read to statement above to make sure that I understood (i.e.  the program will have exhausted its reserves by 2036, yet there are no reserves now…).  At any rate, the fact that even the AARP is coming around to the fact that Social Security cuts are on the way is significant.

Couple this development with the several decade-long trend away from defined benefit plans (where the employer is responsible for the saving and investing decisions) to defined contribution plans (where the employee is responsible for the saving and investing decisions) and we have a situation where it should becoming increasingly apparent that building and managing sufficient wealth to provide a comfortable retirement is up to the individual and nobody else.

(Click to Enlarge)

(Click to Enlarge)

These trends underscore the critical role of a financial advisor today and in the years ahead.  Without competent guidance from an advisor, I highly doubt most individuals, including highly-paid individuals, will embrace a savings and investment discipline that will get the job done.

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Posted by Andy Hyer

Not the Greatest Generation

June 1, 2011

It’s no secret that savings rates have been declining.  The low savings rate also appears to have an element of self-deception—or maybe it is just an outgrowth of the self-esteem movement.  (Or was it just my kids that got a trophy every sports season for merely participating?)  According to Financial Planning:

The survey found that 49% of respondents said they believe they’re doing a better job of saving money than their parents did even though the Bureau of Economic Analysis’ latest personal savings data found that Americans’ personal savings rate averaged a meager 3.48% of total income over the past decade — way, way down from the 9.63% recorded in 1981.

In short, they are saving 60% less than their parents, but many of them think they are doing great!  With many fewer individuals covered by defined benefit plans and retiree health coverage, it’s probable that future retirees will need to save much more than their parents did.

An advisor can play a big role in getting clients to understand the importance of saving and investing—and it appears that there is a lot of work to do.

Leave a Comment » | Investor Behavior, Retirement/Saving | Permalink
Posted by Mike Moody

Your Personal Inflation Rate

May 31, 2011

I was just made aware of an incredibly cool website called the Khan Academy, which offers short educational videos on a variety of topics from Calculus to Biology to Quantitative Easing.  I just watched this discussion of inflation and the construction of the CPI index.  The video does a great job of explaining some of the nuts and bolts of the CPI index’s construction.  Above all, you will walk away realizing that YOUR inflation rate could be wildly different than that reflected by CPI. For example, if healthcare costs make up more than 6.39% of your disposable income, then CPI may be understating your inflation rate.  Furthermore, for those of us who will be sending multiple children to college our inflation rate is likely significantly higher than CPI (education costs are only a 3% weight in CPI).

This is a crucial topic to have a handle on when devising an asset allocation since maintaining purchasing power for YOU may mean needing to earn much more than the 3.2% currently reflected by CPI.  This is useful information because it should inform the types of investments you choose as well as the amount of money that you will need to save.

Image source: Anyiko

2 Comments | Retirement/Saving | Permalink
Posted by Andy Hyer

Strategic Asset Allocation Bites

May 31, 2011

For the record, I love Christine Benz at Morningstar.  She writes great articles that are accessible and informative, and often with a non-traditional take on things.  That’s why I’m so disappointed with her recent article on asset allocation for retirement.  In fact, articles like this make me crazy.

Selecting a stock and bond mix is just a way to try to target volatility.  (Even asset class volatilities can vary over time, so it’s not a perfect solution.  But volatilities tend to be reasonably stable, so I can buy into the idea of volatility buckets.)  But traditional asset allocationists often make much broader claims.  Here are all of the things that typical strategic asset allocation cannot do:

1) It can’t help you predict what your returns will be. It can tell you what your returns would have been in the past, but that has no effect on what returns will look like in the future.  Most asset allocations simply assume that equity returns will always be positive and somewhere around the historical norm.  That’s a crucial problem because most asset allocations count on the equity returns to drive overall growth.

2) It can’t help you predict your risk level. Volatility might be somewhat predictable, but risk is a different animal.  You can’t eat low volatility if it turns out you did not invest in assets with good returns.

3) It cannot make the investing process predictable. Everyone wants certainty.  As long as historical norms continue, it seems like the process is fairly predictable.  If there is a paradigm shift, you will quickly realize it was not.  Markets are not predictable.  The primary function of strategic asset allocation seems to be to generate really nice-looking pie charts.

Yet many, many articles contain these sorts of homilies about asset allocation:

Most experts agree that your retirement portfolio’s asset allocation–its mixture of stocks, bonds, and cash–will have the biggest impact on how much it grows, as well as its risk level.  Unfortunately, retirement savers seeking guidance on what an appropriate asset allocation may have a hard time knowing where to look. Sure, you could certainly do worse than adopting Jack Bogle’s simple formula: 100 minus your age equals how much you should hold in stocks. But what if you want to come at the problem with a greater sense of precision?

Morningstar’s Asset Allocator tool provides another, goal-based view of asset allocation, harnessing your own portfolio information if you’ve saved one on Morningstar.com. The tool calculates how likely you are to meet financial goals based on your current portfolio value, monthly investments, time horizon, and asset mix, and is useful for fine-tuning your allocation.

I’m not trying to pick on Morningstar.  Their strategic asset allocation tool, I’m sure, is as good as anyone else’s.  The point is that all of the tools are flawed because their fundamental premise is flawed: they rely completely on historic return streams being repeated in one fashion or another.  If you were a Japanese investor in 1990 working with 40 years of data (1950 – 1990) to construct a strategic asset allocation for your retirement, it would no doubt include a large equity component because historic equity returns had been both large and positive for a long period of time.  Asset allocation steered you directly into a disaster.  Since we know this has already happened in other markets, why do we continue to court disaster here?  Do you really believe that other markets can go down, but not the US?  Why would you continue to use a tool that you know will eventually fail?

After all, it’s not as if alternatives do not exist.  There are various kinds of dynamic asset allocation to choose from.  Tactical asset allocation using relative strength is just one form; other analysts try to forecast returns based on asset valuation or to rebalance across asset classes when sentiment gets too one-sided.  How well something works is often a function of how well it is implemented, but no one can make a failed process work regardless of how cleverly it is implemented.  I urge you to rethink your asset allocation methodology before it bites you in the ass.  If your asset allocation is not responsive to actual price changes, it is pretty much useless.

A Regretful Strategic Asset Allocator

1 Comment | Markets, Retirement/Saving, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Building Financial Wealth: A Primer

April 19, 2011

Many of our clients refer to themselves as “wealth managers.”  For that reason alone, it’s important to define what financial wealth really is and how it is obtained.  Fortunately, there is a very relevant article on MarketWatch today by Jennifer Waters that is a good basic discussion.  First up, a basic definition of wealth:

“Wealth is what you accumulate, not what you spend,” according to Thomas Stanley and William Danko, the authors of the seminal tome on America’s wealthy “The Millionaire Next Door,” first published in 1996.

The emphasis is mine.  I think this part is so often overlooked—not by the truly wealthy, but by the general public.  The big spender is usually not actually wealthy, but merely has a high current income.  In fact, people are often wealthy precisely because they don’t overspend:

…most of those with big bucks live well under their means — think about Warren Buffet still living in that modest Omaha home — and they put their money instead toward investments that help them stockpile more wealth.

“It is seldom luck or inheritance or advanced degrees or even intelligence that enables people to amass fortunes,” the authors wrote. “Wealth is more often the result of a lifestyle of hard work, perseverance, planning, and, most of all, self discipline.”

www.cashadvocate.com

Is this shocking to anyone?  No—but it’s a good reminder.  You might get lucky with an inheritance, but wealth is rarely gained by winning the lottery.  Wealth is achieved by working hard, living under your means so that you can save, and then putting the money toward investments that help you stockpile more wealth.

Having a high income can obviously help you save, but a high income alone is no guarantee of eventual wealth, as the article points out:

People with high incomes who spend all that money are not rich; they’re just stupid.

A wise advisor once pointed out to me that, “Making the first million is difficult.  Making the second million is inevitable.”  What he was getting at, I think, is the point that the first million requires discipline, patience, and investing acumen, especially when you’re starting with nothing.  It takes quite a while for the snowball to accumulate as it rolls downhill.  If you are fortunate enough to acquire the first million, your saving and investing habits are well-established and ingrained, so the next million is relatively easy.  The second million is typically a lot faster than the first—that’s the way compounding works.

Once earned, wealth needs to be protected.  Intelligent portfolio construction is one way that advisors can add a lot of value to clients:

“The wealthiest clients have very, very diversified portfolios that go way beyond just stocks and bonds into hedge funds, currencies, commodities and emerging markets,” said Leslie Lassiter, managing director of the JPMorgan Private Wealth Management.

Flexible exposure to good asset classes at appropriate times can go a long way toward enhancing client wealth.  Whether you use something like our Global Macro strategy, or mix-and-match separate accounts or mutual funds is not so important.  The critical idea is making those investments work together toward the client’s end result.

The biggest objection of most clients boils down to this: they are very concerned that they won’t have fun if they live below their means.  I think this reflects a fundamental misunderstanding of what makes us feel good about our lives.  In the long run, spending more on a nicer car or another pair of shoes isn’t going to help.  In study after study, what gives meaning and enjoyment to our lives is the number and quality of our personal relationships.  That’s where real wealth is found.

1 Comment | Non-partisan op-ed, Retirement/Saving, Thought Process | Permalink
Posted by Mike Moody

The Death of Another Investment Adage

April 8, 2011

James Stewart of SmartMoney has a must-read article, Why Age Alone Shouldn’t Drive Asset Allocation, refuting one of the mostly widely accepted (and wrong in his opinion and mine) investment adages.

A time-honored investment adage is that your asset allocation should mirror your age: 60/40 stocks and bonds at age 40; 50/50 at fifty; 40/60 at sixty and so on. An entire industry of so-called target-date funds has grown in recent years to help investors implement this simple strategy. Many of these funds, which are a popular option in 401(k) plans, target an investor’s expected retirement date and then allocate and re-balance accordingly.

On the face of it, the logic of increasing an allocation to less-risky and volatile bonds as one gets older seems unassailable. As investors approach and enter retirement, their ability to earn their way out of a stock-market plunge evaporates. So does their ability to outlive a market decline.

So what’s wrong with the allocation adage and the many funds based on it?

Plenty. Like many adages, this one strikes me as grossly simplistic at best, and dangerous at worst.

I don’t know when the age/allocation rule originated, but it must have been a time when bonds were yielding considerably more than the near-zero investors are facing today. The Wall Street Journal ran a front-page article this week illustrating the hardships the Federal Reserve has inflicted on retirees trying to eke out a living from their savings. The 10-year Treasury is yielding a paltry 3.46%, which could easily be eaten away by loss to principal should yields go up, as they surely will someday.

As Stewart points out, interest-rate risk is something that must be considered before blindly increasing fixed income exposure as you age. One of the great advantages that relative strength-driven tactical asset allocation strategies have over target date funds is the ability to keep the portfolio fresh with those asset classes that are performing well and to underweight or eliminate exposure to weak asset classes. Just because fixed income has had a great run over the past three decades doesn’t mean that it will work out so well going forward.  In fact, investors should be aware that there have been plenty of periods where fixed income has performed abysmally.

Leave a Comment » | Retirement/Saving, Tactical Asset Alloc | Permalink
Posted by Andy Hyer

The Mathematics of Finance: Cruel and Unforgiving

April 6, 2011

Reporting on the Illinois pension dysfunction, an op-ed in the Chicago Tribune states the following:

The mathematics of finance is cruel and unforgiving: a million-dollar obligation 20 years in the future, assuming an 8 percent rate of return, could be met with a $21,852 annual contribution. Ignore the first 10 years, halving your savings period, and your required contribution does not merely double, but more than triples to $69,029, and if you wait until you have only one quarter the time, your annual contribution must go nearly eightfold, to $170,456.

The longer the state delays funding its obligations, the greater the burden of correcting the situation.

Of course, this principle equally applies to individuals saving for retirement.  The best practice is to save early and to save often.

Leave a Comment » | Retirement/Saving | Permalink
Posted by Andy Hyer

5 Biggest Retirement Myths

March 17, 2011

That’s the title of an article in Smart Money that really encapsulates the reality that retirees are facing.  The article makes a ton of good points about how traditional financial planning and portfolio theory have left retirees down. 

If you are a financial advisor, you should read this article. 

It discusses the inadequacy of typical retirement calculators, the often false belief that retirement will be less expensive than working, the rule of thumb that you should own more bonds as you age, the idea that moving to a low-cost area for retirement will save you money, and the dangerous idea that your entitlements from Uncle Sam are safe.  There are serious unintended consequences to each of these beliefs that are discussed by some of the retirees interviewed for the article. 

There is no magic bullet for retirement.  The only way you can really protect yourself is to save with a margin of safety and to use multi-asset portfolios (broad diversification!) as part of your retirement allocation.

Leave a Comment » | Retirement/Saving, Thought Process | Permalink
Posted by JP Lee

Nest Egg Survival

March 16, 2011

Craig Israelson has a nice article on Nest Egg Survival in the March issue of Financial Planning.  The overarching point he makes is that multi-asset portfolios tend to preserve assets better than all-bond portfolios when in distribution mode.  This is a crucial insight since financial advisors are going to see more and more clients in distribution mode.  This year, in fact, is the year the front end of the baby boom turns age 65 (1946  + 65 = 2011).  The whole article is well worth reading.

Interestingly, the 60/40 portfolio and the multi-asset portfolio dominated the all-bond portfolio in every rolling 25-year time frame. Moreover, this was during a time from (1970-2010) when bond returns were at all-time highs.

Clients who are nearing retirement often have a tendency to want to pile into bonds to “preserve capital.”  This instinct is probably wrong. Mr. Israelson shows rather convincingly that, although a balanced account or multi-asset portfolio has greater variability of outcomes than a pure bond portfolio, a mixed asset portfolio is probably the way to go even when in distribution mode.  Over the 17 overlapping 25-year periods studied, the mixed asset portfolios had average ending balances more than twice as high as the bond portfolio—and in no 25-year period were they worse.  (Lest you think 25 years is extreme, the Social Security Administration will tell you that if you are age 65 today, your life expectancy is another 19.72 years—which means that 50% of the 65-year-olds will live longer than that.  And most of us aspire to be in that second group.)

Source: Financial Planning magazine

Broadly diversified multi-asset portfolios like the Arrow DWA Balanced Fund (DWAFX) might be just the ticket for clients that are going to need distributions for an extended period of time.

To obtain a fact sheet and prospectus for the Arrow DWA Balanced Fund (DWAFX), click here.

Click here for disclosures.  Past performance is no guarantee of future results.

Leave a Comment » | Markets, Retirement/Saving, Tactical Asset Alloc, Thought Process | Permalink
Posted by JP Lee

Inflation: 0.8% or 9.1%?

March 10, 2011

From Anthony Mirhaydari’s 5 lies the economists are feeding us comes the following commentary on inflation:

Of course, there is also the question of whether economists are even properly accounting for inflation. Right now, the Fed’s preferred measure — the core personal consumption expenditure price index — is rising at just a 0.8% annual rate.

You probably feel like inflation is much higher than that piddling number. That’s because the core rate excludes rises in food and energy prices. Don’t you wish you could just exclude those price hikes from your household budget?

The reasoning behind the exclusion is that these volatile necessities won’t keep going up over the long term. Economists assume food and fuel inflation will be “contained” — just as rising mortgage defaults and foreclosures were “contained” to subprime borrowers back in 2007.

The latest Beige Book report of economic conditions, produced by Fed researchers, suggests otherwise. The report noted that nonwage input costs are increasing and that “(m)anufacturers in a number of districts reported having greater ability to pass though higher input costs to customers. Retailers in some districts mentioned that they had implemented price increases or were anticipating such action in the next few months.”

There’s more. The ISM manufacturing and nonmanufacturing prices-paid indexes have surged to levels not seen in three years. Crude material prices are up a massive 52% over the past three months, even if you exclude food and fuel. Inflation is spreading and becoming entrenched in the supply chain for all goods, despite assurances to the contrary.

To get a clearer picture of what’s really going on, we turn to John Williams of ShadowStats.com. He holds the official data in low regard and earns his living ironing out wrinkles in the government’s economic statistics. By reverse-engineering changes to how metrics like unemployment and inflation are calculated, Williams believes investors can get a truer picture of what’s going on. It’s not pretty: His inflation measure is riding at a 9.1% annual rate.

I guess everyone will have to decide for themselves whether they think their personal experience with inflation is closer to the Fed’s preferred measure of 0.8% or whether it is closer to John William’s measure of 9.1%.  If you are buying gas, food, health insurance, or paying for a child’s college tuition I suspect your answer will be closer to the latter.  Preserving purchasing power should be part of every discussion that financial advisors have with their clients. Clearly, sitting in cash or cash equivalents is not risk-free.

Leave a Comment » | Markets, Retirement/Saving, Thought Process | Permalink
Posted by Andy Hyer

Inflationary Risk – What Are Your Options?

March 1, 2011

Today I came across an article on SmartMoney entitled Fighting Inflation with Mutual Funds.  The gist of the article is that inflation is here (or on its way), so it’s time for investors to protect their purchasing power!  The article runs through three mutual fund categories as options for investors looking for that protection:

  1. Real Return Funds.  Consider these to be inflation-protected bond funds, invested in TIPS, floating rate notes, mortgages, or hard asset bonds like real estate.
  2. Global Bond Funds. Invest in the bonds from countries that benefit from inflation and commodity pressures, i.e., countries with lots of natural resources.
  3. Bank Loan Funds.  These funds allow investors to own chunks of corporate loans, which typically have floating interest rates.

The main problem I have with these options is that they are relatively inflexible.  In each case, the fund is designed to only invest in one specific asset class, while completely ignoring the rest of the field.  Let’s be honest with ourselves and admit that no one can predict what’s going to happen in the market going forward…unfortunately, it’s also impossible to predict which asset class or bond fund is going to outrun inflationary pressures.  In my opinion, these types of articles frame the question poorly, as the reader is presented with only three options, all of which I’d consider to be “locked-in” to one particular fund style.

Is it really wise to commit to just one asset class or bond-style, without leaving any room for adaptation and flexibility?

Our solution to this problem is the Global Macro portfolio (also available as the Arrow DWA Tactical Fund), which can invest across a broad range of asset classes that may provide inflation protection.  Because it’s a tactical strategy, the portfolio allocation across the asset classes can change, depending on which asset class is performing the best.  We built the portfolio to solve this very problem – if something is not performing relatively well, it gets kicked out and replaced with an asset class that is.

So, when considering which of the trillion different mutual funds on the market to buy, ask yourself, “Does this portfolio have the ability to adapt to a changing market environment going forward?”

To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX), click here.

Click here for disclosures.  Past performance is no guarantee of future results.

Leave a Comment » | Markets, Retirement/Saving, Tactical Asset Alloc | Permalink
Posted by JP Lee

From the Archives: Andy’s Short Course in Financial Planning

February 28, 2011

Andy and I were talking about the problems with the concept of “financial planning” in the office the other day. Most of what passes for financial planning is a waste of time. Financial anything is bogus if you have no money. Clients want financial planning to give them a road map to retirement, but in many cases the road is washed out because the client has not built up enough capital to get to their destination in the first place. Real financial planning gives the client guidance on how to build up the capital that is required to retire. Here’s the short course in financial planning, which is my restatement and interpretation of the advice Andy received as a young man. I think it’s pretty darn good advice.

1. Save 15% of each paycheck you get, starting with your first job. That’s pretty simple. If you do it, you’re already halfway to your goal. It’s also a pretty sure path to your goal, as opposed to saving erratically or waiting until you are 55 and then panicking because you haven’t saved enough money. Sure, you might have to live like a college student for a little while after college, but those cinder block and board bookcases are actually kind of charming, don’t you think?

2. Invest for growth. Forget about getting rich rolling CDs or Treasury bills. It’s not going to happen. Don’t bother with bonds either. Bonds have two good uses: for income and to reduce volatility. If you don’t need income, skip them. If you really can’t live with the volatility of a growth portfolio, then use only enough bonds to settle it down to where you can sleep. The best strategy is just to ignore the volatility. It’s not the same thing as risk. Distract yourself by reading the sports pages. How ‘bout those Golden State Warriors!

3. Transition to a balanced account as you near the withdrawal phase. Notice that I didn’t say retirement! Many retirees don’t actually need to draw down their accounts. The habits of saving and growth investing become so ingrained over time that they have much more capital than they need. Studies do show, however, that in the withdrawal phase, accounts survive longer when the volatility is lower. This is your chance to add bonds to the portfolio. Pick a timeframe and transition. For example, you could move 15% of your equity holdings to bonds each year for five years. After the five-year period, your allocation might be closer to 44% equities and 56% bonds. The lowest-risk spots on the efficient frontier for a two-asset portfolio tend to be around 20-40% equities and 60-80% bonds.

I should modestly point out here that our Systematic Relative Strength accounts are ideal growth vehicles for purposes of item #2! But really, any growth portfolio that you continue to contribute to will get you on your way. If you’re a young person just reading this, you have no idea how much more financially secure your life will be if you handle your finances this way. You’ll have a lot of options later, at a time when many of your peers will have none. If you’re an older person, realize it’s never too late to start. If you’re on the wrong path, get off it, and get on to the right one. The sooner you do it, the quicker you will see results.

– Originally published on 5/7/2007.

Leave a Comment » | Retirement/Saving | Permalink
Posted by Andy Hyer

Margin of Safety

February 22, 2011

I’ve been re-reading a few investment classics lately.  A concept that struck me recently was the “margin of safety” discussed in The Intelligent Investor.  (The Intelligent Investor was Benjamin Graham’s slightly simplified version of his approach to securities analysis for individuals.)  In fact, Graham claimed that the margin of safety was the essential message of his entire approach to investing:

Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

For Graham, the margin of safety might be in the interest coverage ratio for a bond, or in the projected earnings growth rate for a common stock.  The idea is that even if the investment does not meet your projection, you have ample room for error and are still likely to come out okay.  Hence, you have a margin of safety.

Margin of safety was the first thing that occurred to me when I read a Wall Street Journal article over the weekend entitled Retiring Boomers Find 401(k) Plans Fall Short.  (This morning the article also ran on MarketWatch.)  As the article points out, 401(k) plans first came into wide use in the 1980s, so the leading edge of the baby boomers now retiring are the first group to have the accounts form the backbone of their retirement savings.  The situation is not encouraging:

The median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed in that account to maintain its standard of living in retirement, according to data compiled by the Federal Reserve and analyzed by the Center for Retirement Research at Boston College for The Wall Street Journal.

How in the heck do you end up 75% short of the savings needed to maintain your standard of living?  Answer: no margin of safety.

Think about it—if you are doing things prudently, you should have a margin of safety.  You need to over-save in case something goes wrong.  Which, inevitably, it will.  Trust me on this: unexpected expenses are way, way more common than unexpected windfalls!  If you have a margin of safety in your savings, the worst case scenario is that you will have too much money saved for your retirement.  Is that really a problem?  Have you heard more retirees complaining that 1) they can’t get a first-class cabin on a last-minute Caribbean cruise, or 2) they were planning to travel in retirement but now they can’t afford to? 

401(k) providers are slowly catching on.  According to the article, Vanguard recently suggested saving 12-15% of their income, versus the 9-12% recommendation earlier.  In Andy’s short course in financial planning, we recommended that a minimum of 15% of income should be saved.

I think it is worthwhile to show clients the article.  It is a litany of undersaving and/or things going wrong, sometimes at the worst possible time.  (When else do things ever go wrong?)  In each case cited in the article, the retirees were up against it because they had no margin of safety.  Frankly, many clients are worse off than some of the retirees mentioned in the article.  As an advisor, it’s your job to help people make intelligent financial decisions, especially those they will find difficult to make on their own.  Convincing them to save with a margin of safety might just be the most important thing you will ever do for them.

Leave a Comment » | Markets, Retirement/Saving | Permalink
Posted by Mike Moody

The Devil You Know May Be the Biggest Problem

January 19, 2011

Although I don’t agree with his suggested solution to the problem, James Jessee, writing in Registered Rep, has some insightful comments on how poorly investors handle risk.  In general, they are very aware of tangible risk and almost oblivious to opportunity cost:

When it comes to assessing risk in one’s investment portfolio, most people tend to think in only one dimension. Ask them what risk concerns them most, and the answer is likely to be: losing money in the stock market. Far fewer would answer: outliving my retirement savings.

This is a problem because, over a long time horizon, opportunity cost typically dwarfs the immediate danger of losing money today.  This is grounded in a well-known finding in behavioral finance:

Behavioral studies show that our regret over losing money in a market decline is roughly twice as great as our euphoria over gains when the markets rise.

Losing money that was already reflected on a statement is very tangible, and investors are very distressed when markets decline.  They mentally take ownership of their highest market value and tend to benchmark everything from that.  When markets rise, it’s nice, but it doesn’t seem tangible unless the profits are grabbed in a sale.  (This is part of the reason that investors are twice as likely to sell winners as losers.) 

The long-run problem with excessive loss aversion is big opportunity cost.  Risk aversion can come in different flavors.  Avoiding the stock market is probably the most common foible.  Other attempts to avoid risk, like buying bonds, may also backfire by exposing the investor to far more risk than they bargained for.  It’s important to have a healthy respect for risk, but you can’t avoid it if you hope to preserve your purchasing power.  To the extent that investors irrationally avoid risk, they are more likely to fall short of their savings and retirement goals.

Leave a Comment » | Investor Behavior, Retirement/Saving | Permalink
Posted by Mike Moody

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