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.

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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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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.

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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.

inflation 300x217 Your Personal Inflation Rate

Image source: Anyiko

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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

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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.”

Building Financial Wealth: A Primer

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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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The Bucket List

December 10, 2010

A really nice how-to article from Morningstar on how to implement the bucket approach for retirees. I think they get most of this right in terms of implementation, and agree with them that the approach resonates with actual retirees. Here’s an excerpt on implementation:

1. Determine the Paycheck You Need From Your Portfolio
If you’re attempting to create the equivalent of a paycheck from your portfolio, the first step is to gauge your income needs during retirement, either on an annual or a monthly basis. Start by tallying your total expenditures, then subtract steady sources of income that you can rely on, including Social Security and pension income. What’s left over is the amount that you’ll need to extract from your portfolio each month or each year.

2. Make Sure Your Withdrawal Rate Is Sustainable
The next step is to evaluate whether your desired portfolio withdrawal amount is too large or just about right. Most financial planners consider a 4% annual withdrawal rate, combined with annual upward adjustments to accommodate inflation, a safe withdrawal amount. For another check, premIcon The Bucket List Morningstar’s Asset Allocator tool can help you determine whether your current portfolio puts you on track to meet your retirement-income needs. (Just bear in mind that it’s using fairly rosy return expectations for stocks.)

3. Put in Place a Short-Term Bucket Holding of at Least Two Years’ Worth of Living Expenses
Assuming your desired withdrawal rate is sustainable, set up a short-term bucket consisting of at least two years’ worth of living expenses set aside in highly liquid (that is, checking, savings, money market, and certificate of deposit) investments.

Where you hold these assets depends on where you are in retirement as well as where you’re holding the bulk of your retirement savings. Being strategic about where you take withdrawals from can help you stretch out the tax-savings benefits from your tax-sheltered accounts. This article provides more detail on sequencing withdrawals to maximize your long-term tax savings, but here’s a quick overview:

  • If you’re older than 70 1/2 and taking required minimum distributions from your IRA or the retirement plan of your former employer, some or all of your near-term paycheck should come from those accounts. (Bear in mind that the amount of your RMD will vary from year to year, based on your account balances as well as your age.)
  • If you’re not 70 1/2 or your RMDs won’t cover your cash needs, turn to your taxable accounts to see if they will cover your cash needs during the next two years.
  • If your RMDs and taxable accounts won’t cover at least two years’ worth of living expenses, carve out any additional amount of living expenses from your IRA or company retirement plan assets using the sequence outlined above. Save Roth accounts for last because they offer the most flexibility and long-term tax-savings benefits.

4. Put It on Autopilot
Once you’ve identified where your cash will be coming from during the next few years, contact your financial-service provider to see if it can help automate your withdrawals, sending you the equivalent of a paycheck at preset intervals. (Better yet, your firm should be able to deposit the paycheck directly into your account.) The larger your fund company or brokerage firm, the more likely it is to offer such an option.

5. Other Important Tasks
In addition to getting your paycheck plan up and running, it’s important to periodically replenish your cash assets as they become depleted. Once you’ve set aside your cash position, put in place a plan to periodically refill your cash stake so that it always will cover at least two years’ worth of living expenses. Plan to incorporate this step into your rebalancing process. Ideally, you’d fill up your most liquid bucket with proceeds from rebalancing-related sales or with money from your next most liquid pool of assets (for example, intermediate-term bonds).

Bravo, Morningstar! I think there is some wiggle room about how many buckets to use, and what assets go into what buckets, but the general approach is sound. From my point of view, the psychological advantage of using buckets is that you might have a better shot at getting retirees to leave the capital growth portion of the account alone. I think it’s also important to make sure that the buckets cover the entire risk spectrum. If you use three buckets, but they are all fairly conservative, your client is not going to end up with enough growth over time. Mentally, you might want to think of the buckets as 1) generally stable, 2) somewhat balanced, and 3)growth-y. That gives you a lot of latitude to customize the buckets for individual clients. For example, a client who has an existing pension and a healthy retirement account balance might be able to use short-term bonds for the first bucket, something like the Arrow DWA Balanced Fund for the second bucket, and a 50/50 blend of a value manager and the Systematic RS Aggressive portfolio for the growth segment. You can change the volatility of the overall account by dialing the volatility level of the individual buckets up and down. And, keep in mind that there is no functional difference between a total return approach and the bucket approach if the overall allocation is the same. The only difference is in the mind of the client—but if a bucket approach helps the client to behave better, it’s a big plus.

3 Comments | Investor Behavior, Retirement/Saving | Permalink

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Inflation’s Impact On The Concept Of “Safe” and “Risky”

November 17, 2010

Admit it-at times over the last couple of years your commitment to allocating a large portion of your portfolio to risky securities has been shaken to the core. Perhaps, you might have thought that you could get along just fine over the long run without exposing your portfolio to risk.

Via Mebane Faber’s World Beta and Ned Davis Research, comes a nice reminder of one of the primary reasons to invest: preservation of purchasing power.

Due to the impact of inflation, the purchasing power of the U.S. dollar has declined by 94% over the last 76 years!

Alternatively, you could have invested in stocks or bonds and have preserved and increased your purchasing power.

It is funny how the concept of “safe” and “risky” change when the effects of inflation are taken into account.

4 Comments | Retirement/Saving, Thought Process | Permalink

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Warning: Retirement Disaster Ahead

October 29, 2010

That’s the catchy title of an article in Smart Money that details the problems facing long-term investors at the present time. It draws upon calculations of long-term expected returns made by Rob Arnott of Research Affiliates. (There’s a link to the paper in the Smart Money article.) Those expected returns, in his estimation, are low, only about 2.1% per year after inflation for a 60/40 balanced portfolio. That’s too low for most pensions and individual investors to reach their goals. Arnott and his co-author, John West, point out that returns:

can only come from four things: Dividends, earnings growth, inflation and changes in valuation.

This all sounds very bleak. You can argue with their assessment of inflation, long-term earnings growth, or valuation, but that really isn’t the point. They are mathematically correct about the sources of return. However, they have slipped in another assumption without mentioning it. It is assumed that the investor will be passive.

If low returns are all that is available to a passive investor, maybe a change in approach is in order. An individual investor has no control over inflation, so that return component will be the same for everyone. Shooting for higher earnings growth makes sense-Arnott and West suggest emerging markets-but there are also dozens of excellent growth stocks in the U.S. market. Any company that is rapidly growing revenues and earnings, either on a cyclical or a secular basis, is worth a look. High relative strength, by the way, tends to identify those companies quite effectively. Another thing that may work well is a more tactical approach that rotates across global asset classes. With a strategic asset allocation, returns are always capped at the level of the best performing asset. With a relative strength-driven tactical approach, it is quite possible to perform better than the best-performing asset over time, as the investor is holding assets only during periods of strength.

There is no good reason to passively accept low returns when other approaches may be much more effective.

2 Comments | Markets, Retirement/Saving, Tactical Asset Alloc, Thought Process | Permalink

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Advice From Retirees: Learn From Their Mistakes

September 22, 2010

The market drop in 2008 was a very unpleasant events for retirees, or near retirees. The strong market in 2009 was perhaps equally unexpected. Merrill Lynch Wealth Management did a survey of affluent retirees in early 2010 to find out how they were coping. The insights are important.

Surprisingly, given the opportunity to do it all again, roughly half (51%) of retired respondents indicated that they would have focused more on their “life goals” and less on “the numbers” and on hitting a specific nest egg dollar amount when planning for retirement, while the remaining respondents (49%) indicated that they would have focused more on “the numbers.”Retirees who wished they had focused more on their “life goals” indicated that they would have spent more time determining how they wanted to live in their retirement years (38%) and based their retirement income needs not just on a number that would sustain them but on one that would help them live their ideal lifestyle during these years (13%). Additionally, 8 percent would have created a plan to better support their philanthropic missions. Among those who indicated that they would have focused more on “the numbers,” 23 percent wished they had started working with a financial advisor earlier in life and 18 percent would have given up more luxuries in order to reach their retirement goals. Among all retired respondents, three out of 10 (31%) worked with a financial advisor when planning for retirement, though, in hindsight, more than half (55%) wished they had started doing so sooner.

I find it quite enlightening that among the group most focused on life goals, they really wished they had spent more time figuring out what they wanted to do in retirement and then saved enough to live their ideal lifestyle and not just enough to get by. Among the group focused on the numbers, a significant chunk wished they had started working with a financial advisor earlier-and for those already working with a financial advisor, a majority wished they had started working with an advisor sooner.

In short, most of the retirees wish they had saved more and started working with an advisor earlier. For advisors, the implications are clear: push clients to save more and to focus on retirement much earlier.

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What’s Your Retirement Number?

September 17, 2010

Once in a while, I think it is important to revisit our touchstone in the financial advisory business-what is the point of investment management in the first place? I’ve always looked at it as a way to make our clients’ dreams come true, not necessarily in the fantasy sense, but in terms of being financially comfortable and having the freedom not to worry about money constantly. Surveys indicate that the main reason investors save is to meet their retirement goals. Of course, there are often other goals along the way, like buying a house or getting the kids through college, but retirement is the Big Kahuna.

How paradoxical is it, then, that Americans do such a lousy job saving for retirement? According to a recent article on MarketWatch, the current gap between what Americans will need to retire and what they have actually saved is a staggering $6.6 trillion dollars. Yes, trillion with a T. Suddenly saving and getting good investment advice seems a lot more important!

Part of the reason the gap is so big is that most investors never bother to calculate how much money they might actually need to retire! According to Retirement Investigator:

…if you are like 58% of active workers, you haven’t. That’s right, 58% of workers have NEVER tried to calculate what they need to save for a comfortable retirement…

And “only 42% of active workers have ever tried to calculate how much they need… and 8% of those admitted they arrived at their answer by guessing,” reported National Underwriter on April 24, 2006.

For whatever reason, trying to figure out a retirement number must be either baffling or terrifying to investors. (Or maybe they just find it amusing. ING has developed an entire advertising campaign around “the number,” with individuals walking around with bright orange numerical plaques.)

Source: Adrant

I will de-mystify the process and show a couple of simple calculations to arrive at your retirement number, depending on whether you want to be conservative or minimalist in your estimate. First, let’s define our terms. When I am talking about a conservative approach to a retirement number, I am talking about the pool of capital that would be required to support your required spending on a sustainable basis, while attempting to leave the original capital intact. A minimalist approach simply assumes, as the study in the MarketWatch article did, that you convert all of your savings to an immediate annuity.

Sustainable spending is a tricky concept. Dozens of studies have been performed on historical data that suggest that the proper spending rate is 3 to 5%. A lot of endowments use 4%, for example. In reality, I think the sustainable spending level depends quite heavily on financial conditions at the time. A stock market with a 6% dividend yield is going to support more spending than a market yielding 3%. In other words, I tilt toward a relative calculation first developed by James Garland. He shows that you can generally spend more than just your dividend and interest income, but far less than your total earnings yield. His rule of thumb is that sustainable spending is about 130% of the yield on the major stock indexes. (You can use this link to find the current dividend yield on the major stock indexes.) The current yield on the S&P 500, for example, is now 2.02%, so 130% of that number would be 2.626% (2.02 x 1.3 = 2.626). Garland’s sustainable spending rule will form the basis for our conservative estimate.

The basis of every retirement number is income. The easiest way to calculate a retirement number is to determine what income you need in retirement and work backward from there. Let’s say that you would like to have an income of $50,000 in retirement, in today’s dollars. The calculation of the conservative retirement number is straightforward. First, find your multiplier by dividing your sustainable spending level into 100. At the current time, that would be about 38 (100 / 2.626 = 38.080731). Your retirement number is simply your desired income times the multiplier, which in the example would amount to $1.9 million ($50,000 x 38). This calculation gives you the amount in today’s dollars. You can either adjust it upward for inflation to get a future dollar number, or you can use real returns (nominal returns minus inflation) to determine if you are on track on not. Morningstar’s savings calculator is easy to use. There are literally hundreds of others on the web.

The minimalist approach is a little different. It assumes that you will take all of your savings and convert it to an immediate annuity. In this approach, you aren’t worried about dipping into principal-in fact, you’re liquidating it. On the plus side, it allows you generate more income with the same amount of capital. Again, the easiest way to do this is to back into the number. I used one of the popular annuity websites to do this calculation, assuming a 62-year-old couple in Richmond, Virginia. The desired monthly income would be $4,167 , which is equivalent to our earlier annual income of $50,000. The day I ran it, annuity rates were such that I got a quote for a single-life annuity with no payments to beneficiaries for $707,351 at the low end, all the way up to a joint life annuity with a minimum 20-year payment period for $888,741 at the top end. (Every annuity company will have different rates and some have different income options, including income that grows with inflation.)

What did we learn from this little exercise?

1) Retirement requires a lot of money! We determined that supporting $50,000 of spending requires a capital pool of $700,000 to $1.9 million. If you fiddle around with one of the many retirement calculators for a while, you will quickly realize that…

2) You need a high savings rate to get to your retirement number. Putting a 3% contribution into your 401k isn’t going to do it. Think about 15% as a starting number. Without savings to work with, no amount of investment management can help you.

3) Compounding makes a big difference too. The earlier you start, the more years you have to compound. And your assets will compound much faster when your investment return is high. As you play around with a retirement calculator, it becomes clear that you have to…

4) Invest for growth. Here, we finally get back around to why investment management is important. Low rates of return that barely offset inflation, sustained over long periods of time, will not allow you to reach your retirement number. Nope-you’re going to have to figure out how to intelligently expose your portfolio to return factors (and risk) that will allow you to compound at rates far above inflation, at least for an accumulation portfolio. (Perhaps your risk exposure will need to be reduced when you transition to a distribution portfolio, but that’s another discussion.)

Any proven return factor, rigorously executed, will give you a decent chance of reaching your goals, but we tilt toward a relative strength approach. It has been shown to work within markets-and also across markets and asset classes. That flexibility may prove to be critical in a world where many of the best investment opportunities may not be in the U.S., or maybe not even in equities at all. Relative strength is possibly the most adaptable tool in the investment toolkit.

4 Comments | From the MM, Retirement/Saving | Permalink

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It’s Later Than You Think

July 29, 2010

A good bit of the practice of most financial advisors is helping clients accumulate enough assets for retirement. I was reading through a MetLife survey on retirement readiness, much of it do with the emotional side of readiness, and was struck by a couple of responses. MetLife surveyed a diverse group, starting with pre-retirees as young as age 45, up through actual retirees, who composed about 20% of the sample.

Here’s what really struck me: they asked the pre-retirees “Do you plan to retire…?” and these are the responses they got.

Earlier than you planned/expected 6%

About the same time as you planned/expected 47%

Later than you planned/expected 46%

Most people, in other words, expect to retire on their own schedule, while a big chunk also figure they will have to work longer than they thought.

But when they asked the actual retirees, who have already gone through the transition, “Did you retire…?” there was a completely different outcome.

Earlier than you planned/expected 64%

About the same time as you planned/expected 33%

Later than you planned/expected 3%

Almost two-thirds ended up retiring earlier than they thought they would, and almost no one retired later than they expected. Since the survey is current, I’m going to assume that the 64% didn’t retire early because they made an enormous amount of money shorting the market in 2008. I’m guessing they retired earlier than they expected because they had health issues, got laid off due to lower productivity relative to younger workers, or simply got sick of working and decided not to deal with it anymore. And, really, the reason for early retirement doesn’t matter.

The message is simply this: Your clients are expecting to retire on their schedule, but 2/3 of them may well have their retirement accelerated. To be prudent, they will need to have their capital accumulation completed earlier than they think. You may be planning to save for another ten years; you might only have five.

It’s almost impossible to overstate the importance of savings and a patient investment policy in preparing for retirement. Save early and often. And search out proven return factors, like relative strength, and stick with them over the long term.

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Maybe This is Why Warren Buffett is Always So Jovial

July 7, 2010

It turns out that money can buy happiness. Well, maybe not directly-but researchers were surprised when they examined data from a Gallup survey. According to a Wall Street Journal synopsis of the results:

A new analysis of Gallup World Poll data, surveying 136,000 people across 132 nations from 2005 to 2006, suggests that income is much more highly correlated to happiness (or at least a form of it) than previously thought.

Even some experts in behavioral finance were surprised:

What was interesting about the study was how universal the desire for financial success was across the world. “People in Togo and Denmark have the same idea of what a good life is, and a lot of that has to do with money and material prosperity,” Daniel Kahneman, professor emeritus of psychology and public affairs at Princeton University, told the Washington Post. “That was unexpected.”

To me, it’s not so surprising. If you work in the financial services field, you see firsthand how hard people strive to achieve financial success for themselves and their families. When they fail, they are miserable.

Warren Buffett, on the other hand, has a lot to be happy about. He has lifelong buddies (Charlie Munger), new friends (Bill Gates), influence, and financial security. Although he might be less happy if his friends and influence went away, he probably wouldn’t be miserable because he would still have financial security, Cherry Coke, and the t-bones at Gorat’s.

Maybe This is Why Warren Buffett is Always So Jovial

Source: Yahoo! News

Financial security is a much more important financial good than people give it credit for. Like most quantities, it seems to be relative. A retired executive might feel pinched or deprived at a different level of retirement income than a retired janitor, for example. This psychological insight led some clever financial service professional in the hazy past to popularize the “70% of income in retirement” rule of thumb, which is completely relative. There’s probably a paper waiting to be written on the S-curve of satisfaction with relative retirement income levels-above (and below) certain thresholds, satisfaction is probably reliably high (or low). In between, there may be a steep incline, where rising assets equate with rising happiness. At this point in the curve-where most of us are-the impact of good or bad financial advice can be huge.

Perhaps financial advisors can’t do much about the current worldwide financial malaise, but they certainly have the ability to influence and improve their clients’ finances through the encouragement of savings and the pursuit of sensible investment policies.

1 Comment | Just for Fun, Non-partisan op-ed, Retirement/Saving | Permalink

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Investing: Is It Worth the Drama?

July 5, 2010

You are 55 years old and retirement is no longer a thing of the distant future. In fact, you and your spouse seem to find yourselves discussing your retirement goals more and more frequently. You have considered your desire to travel the world, your desire to have the financial flexibility to be able to visit children and future grandchildren who are spread across the country. You consider the quality of healthcare you would like to be able to afford, the type of home you want, the type of cars… Yes, you are very aware that the way that you handle your finances over the next 15 years is going to largely determine the quality of retirement that you enjoy.

When the stock market rises, you feel increasingly optimistic about your financial future. However, when it falls you start to get nervous and have even had knots in your stomach at times. Perhaps, you have even considered leaving the stock market for good in order to just invest your money in certificates of deposit where at least you know that you will get your money back with some modest return.

Some variation of the thought process described above is commonplace among those who see retirement on the horizon. Any time the financial markets experience turmoil, it is natural for investors to ask themselves why they voluntarily signed up for this! During such periods of introspection, it is a must to ponder the reasons for investing in the first place. Despite the ever-present risk of loss that exists in the financial markets, the financial markets also present one of the best available means of accumulating wealth. It is also at times of market turmoil that the consequences of “dialing down the risk” must be considered.

The table below highlights the differences in annual distributions for 6 different investors who each arrive at age 55 with $1 million in savings. It makes many simplifications and does not consider inflation, additional savings, alternative methods of distribution, and other factors. However, its purpose is to highlight the impact that the rate of return earned on the $1 million over the 15 years from age 55 to 70 of the hypothetical investor have on the annual distributions from age 70 through 95. It assumes that the entire value of the portfolio is removed from the markets when the investor turns 70 years old and then simply divides the value of the portfolio by 25 in order to get the annual distribution amount.

(Click to Enlarge)

Molly Mattress decides that she doesn’t need the stress of investing. She is simply going to hide her money under her mattress and enjoy her life without having to worry if her money will be there in the future or not. While it is true that the risk of short-term loss is no longer an issue for Molly, she also is left with only $40,000 per year from age 70 until age 95. Cindy CD at least earns interest on her money (2.78% is the current average interest rate on 5-year certificates of deposits, according to www.bankrate.com.) By taking this action, Cindy is able to bump up her annual distribution to $60,352 per year. On the other end of the spectrum is Venturesome Vic who earns an annualized return of 10% on his money for 15 years and is then able to enjoy distributions of $167,090. Cautious Kate, Average Alex, and Optimistic Oscar fall in between those extremes.

Does this focus on the amount of the annual distributions change anything? It should. After all, it is easy to focus on the here and now and focus on avoiding short-term losses. However, permanent reductions in risk tolerance when an investor is still potentially decades away from “pushing up daisies” may result in a very modest and potentially unpleasant standard of living during the retirement years.

Source: www.calwatchdog.com


3 Comments | Retirement/Saving, Thought Process | Permalink

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Your Money or Your Life

June 23, 2010

This used to be just a cliche that muggers would use when relieving you of your wallet. Apparently Americans headed toward retirement feel like they are being mugged as well. According to an Allianz Life Insurance study cited in Financial Planning magazine,

…more respondents between the ages of 44 and 49 say they fear outliving their assets more than they fear death (77% versus 23%).

In other words, an overwhelming majority consider running out of money a fate worse than death. Saving and investing must be far worse than death because Americans really don’t want to do that.

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Volatility Is Not The Same Thing as Risk!

June 16, 2010

We repeat this to our investors often, so often I probably mumble it in my sleep. You can imagine, then, how excited I was to read this great article on risk and volatility by Christine Benz, the personal finance writer at Morningstar. The article makes so many outstanding points it’s hard to know where to start. I highly recommend that you read the whole thing more than once.

Ms. Benz starts with the “risk tolerance” section of the typical consulting group questionnaire. They generally ask at what level of loss an investor would become concerned and pull the plug. (In my experience, many clients are not very insightful; every advisor has seen at least one questionnaire of a self-reported aggressive investor with a 5% loss tolerance!) In truth, these questionnaires are next to worthless, and she points out why:

Unfortunately, many risk questionnaires aren’t all that productive. For starters, most investors are poor judges of their own risk tolerance, feeling more risk-resilient when the market is sailing along and becoming more risk-averse after periods of sustained market losses.

Moreover, such questionnaires send the incorrect message that it’s OK to inject your own emotion into the investment process, thereby upending what might have been a carefully laid investment plan.

But perhaps most important, focusing on an investor’s response to short-term losses inappropriately confuses risk and volatility. Understanding the difference between the two-and focusing on the former and not the latter-is a key way to make sure your reach your financial goals.

There are three different issues she addresses here, so let’s look at each of them in turn.

1) You’re a crummy judge of your own risk tolerance. We all are. That’s because our money is personal to us. One of my psychologist clients once exclaimed, “Money is my most neurotic asset!” It’s much easier to take an outside view and look at it with some psychological distance. An experienced advisor is more likely to be able to gauge your risk tolerance correctly than you are. There are also good resources like Finametrica for learning more about psychologically appropriate levels of portfolio risk. But Ms. Benz really gets to the heart of things: your risk tolerance will change depending on your emotions! That’s something no advisor can calibrate exactly, nor are you likely to guess how powerfully the swell of fear will hit you after a particularly heinous quarterly statement.

2) It’s not okay to panic. As Ms. Benz points out, discussing loss tolerance in this fashion implies that it is ok to bail out emotionally at some point. If you have losses that are uncomfortable, perhaps you need to revisit your overall plan, but it’s unlikely that major modifications are needed if you were thoughtful when you put it together in the first place. Markets, and strategies, go through tough periods and it’s important to be able to persevere.

3) At the height of emotion, volatility and risk get confused. Volatility is just a measurement of how much your investments are whipping around at the moment. Risk isn’t the same thing. Ms. Benz clarifies the difference:

…volatility usually refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period-a day, a month, a year. Such fluctuations are inevitable once you venture beyond certificates of deposit, money market funds, or your passbook savings account. If you’re not selling anytime soon, volatility isn’t a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.

The most intuitive definition of risk, by contrast, is the chance that you won’t be able to meet your financial goals and obligations or that you’ll have to recalibrate your goals because your investment kitty come up short.

Through that lens, risk should be the real worry for investors; volatility, not so much. A real risk? Having to move in with your kids because you don’t have enough money to live on your own. Volatility? Noise on the evening news, and maybe a frosty cocktail on the night the market drops 300 points.

This is one of the best descriptions of risk I’ve ever read, one that puts opportunity cost front and center. Risk isn’t your portfolio moving around; that’s just volatility—noise, really. Risk is eating Alpo in retirement, or as she mentions, being forced to move in with your kids.

Source: Purina

Risk is the very real possibility of having a severe investment shortfall if you avoid volatility like the plague. Low volatility investments earn low returns (or worse if they are Ponzi achemes).

The challenge of every individual investor, hopefully with help from a qualified financial advisor, is how to balance volatility and return-while keeping risk from sneaking up and biting you you-know-where. Ms. Benz has some thoughts on this as well:

So how can investors focus on risk while putting volatility in its place? The first step is to know that volatility is inevitable, and if you have a long enough time horizon, you’ll be able to harness it for your own benefit. Using a dollar-cost averaging program-buying shares at regular intervals, as in a 401(k) plan-can help ensure that you’re buying securities in a variety of market environments, whether it feels good or not.

Diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis. That can make your portfolio less volatile and easier to live with.

Again, she makes several very cogent points, so let’s deal with them one by one.

1) Volatility is inevitable. Deal with it. Preferably by constructing your portfolio thoughtfully in the first place.

2) Better yet, volatility can be your ally. Buy on dips. (Easy to say, harder to do.) In truth, high-return, high-volatility strategies can be tremendous wealth builders because the long-term returns are good and you get plenty of opportunities to add money during the dips. Toward that end, we publish a High RS Diffusion Index each week to help identify those dips in our particular strategy.

3) Diversify appropriately. We believe it’s often more fruitful to mix strategies as opposed to asset classes. For example, relative strength strategies tend to work very well when blended with deep value strategies.

Ms. Benz lays out the real definition of risk: failing to accomplish your goals.

It also helps to articulate your real risks: your financial goals and the possibility of falling short of them. For most of us, a comfortable retirement is a key goal; the corresponding risk is that we’ll come up short and not have enough money to live the lifestyle we’d like to live.

Clearly, the biggest risk for most investors is their own behavior. They avoid volatility rather than embracing it. Instead of buying on dips and being patient with proven strategies, they sell during pullbacks and buy only after an extended period of good performance. When you start to conceptualize risk as shortfall risk, you can also see that another of your big risks is not saving enough in the first place. At the risk of sounding like my mom, if you don’t have any money, no investment advisor is going to be able to help you retire. Savings, too, is behavior that can be modified.

What can be done to help clients embrace volatility, or at least deal constructively with it? Are there any ”nudges” that can be applied in order to increase their patience and their overall good investment behavior? Ms. Benz makes a suggestion in this regard:

Many financial advisors have begun to embrace the concept of creating separate “buckets” of a portfolio-and in particular, a bucket for any cash the investor expects to need within the next couple of years. By carving out a piece of your portfolio that’s sacrosanct and not subject to volatility or risk, you can more readily tolerate fluctuations in the long-term component of your portfolio.

Sure, it’s a cheap psychological trick that plays to the mind’s natural tendency to segment things-but if it helps, why not? We’ve discussed in the past that a portfolio carved into buckets is functionally equivalent to a balanced or diversified portfolio with the same asset allocation, but if it helps clients behave better then it’s worth trying.

Whether you are an advisor or an individual investor, educating yourself about key concepts like the difference between volatility and risk will pay large dividends down the road.

2 Comments | From the MM, Investor Behavior, Markets, Retirement/Saving, Thought Process | Permalink

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Are You a Stock or a Bond?

June 14, 2010

If you’re a financial advisor, you’re probably a stock. Your neighbor, the fireman, is probably a bond. In this interesting article from the Wall Street Journal, Moshe Milevsky discusses personal risk management and asset allocation from a different perspective.

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