But If Not

November 30, 2010

I believe equities will likely do very well over the next 20 years, but if not, I take comfort in knowing that it doesn’t necessarily mean that my portfolio needs to remain stuck in neutral.

DShort has produced a series of charts showing the 5, 10, 20, and 30-year total real returns of the S&P Composite (U.S. equity returns) that could be a great resource for a financial advisor who is talking to their clients about the advantages of an adaptive multi-asset class strategy.

(Click to Enlarge)

Unfortunately, a 20-year time horizon is no guarantee that a cap-weighted indexing approach will result in meaningful portfolio gains. Let me first say, that this is not an argument not to have equity exposure! Of course, most investors should have equity exposure. However, this reality should make you think about the flexibility that will be needed as part of your asset allocation.

There have been 20-year periods where the real annualized returns of equities have been over 13% and others where they have been slightly negative. The advantage of a “global macro” approach is that we don’t have to fret about whether or not the next 20 years are going to be rewarding for equity investors. If equities ultimately do well over the next couple of decades, global tactical asset allocation strategies are likely to have significant exposure to this asset class. However, I believe today’s investors will appreciate knowing that they have some other options (like commodities, real estate, fixed income, currencies, or even inverse equities) if equities don’t do well.

Click here to watch a video presentation on our approach to multi-asset class investing.

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

Leave a Comment » | Tactical Asset Alloc | Permalink
Posted by Andy Hyer

Will Inflation Wipe You Out?

September 28, 2010

Although a number of economists are still concerned about deflation, there is a growing concern on the part of other economists about inflation. Irwin Kellner, the economist at MarketWatch, had an article with his take on the topic recently. One thing that is clear is that inflation is partly a child of globalization. A recent Yahoo! Finance article on Starbuck’s planned price increase makes that clear:

The upcoming agony of Starbucks devotees offers three fundamental truths that should be apparent to all who pay attention to economic news:

(1) global growth is strong;

(2) U.S. growth is weak compared to global growth;

(3) the world’s national economies and markets have never been more connected or interconnected.

The global economy continues to recover from the plague year of 2009 — the first since 1944 in which the world’s economic output shrunk. The International Monetary Fund pegs growth at 4.5 percent for 2010.

In nearly every corner of the world, more people are building and eating more stuff. That has pushed up prices for a range of commodities — steel, copper, cotton, soybeans, wheat, and cotton. Many commodities (notably oil and gold) are priced in dollars. Slow U.S. growth, which weakens the dollar, can also have the effect of making commodities more expensive.

But it’s the third factor — the rising tide of globalization — that is making venti-size waves at Starbucks and elsewhere. In an era where production of key staples and finished goods can happen anywhere, so too can problems. Coffee is expensive in part because of poor harvests in Vietnam and Colombia. Bloomberg reported on Monday, that “raw sugar rose to a seven-month high in New York on concern that suppliers will struggle to meet demand.” A big part of the problem: “Drought in Brazil, the world’s biggest producer of coffee and oranges as well as sugar, is harming crops and drying the Amazon River to its lowest in 47 years.” For farmers in Brazil, Antonio Carlos Jobim’s Waters of March can’t come soon enough.

In other areas, the problem is too much water. Bloomberg notes that “sugar-cane yields in Uttar Pradesh, India’s biggest cane producer” could be harmed by recent flooding. The price of a pound of sugar for delivery in October has soared 67 percent in the past few months (For current prices on agricultural commodities, check out the CME Group’s website.)

Since inflation is a global phenomenon, it’s not going to be possible to counteract it with a new government policy. Inflation is bigger than any one government, so we’re just going to have to deal with it. Here’s the big problem: most investors do not have the resources to deal with inflation.

Rob Arnott has an outstanding article on the inflation problem for 401k investors. (You really need to read this article all the way through. Important stuff.) The problem with most 401k plans is that investors do not have sufficient flexibility to deal with inflation if it crops up:

The evidence supports this: investors hold between 55–75% in stocks and 25–45% in short-term fixed-income and bonds. Most 401(k) plans have a money market or stable value option, and one or two bond funds providing fixed-income exposure. But, on average, only 5 of the typical 18 investment choices are non-stock funds! With stock funds comprising 70% of our available choices, it’s no coincidence that the average 401(k) investor has roughly 70% of their 401(k) in stocks.

I’d generalize things even further: even outside a 401k plan, most investors do not have the expertise to use an alternative toolset to deal with investment problems that they have not been seen in their investing career. Inflation requires that alternative toolset. Mr. Arnott thinks there are four critical components:

An effective real return strategy should have four key components:

1. Inflation-fighting assets such as TIPS, REITs, and commodities should be blended into the portfolio in a meaningful way.

2. Non-dollar assets should be used on a scale large enough to protect against any government choices that may debase the dollar. Of course, Japan and Europe face the same “3-D Hurricane” that we face here, only more so. So, these non-dollar investments should be in the emerging markets, in the local currencies. It bears mention that the emerging markets largely shrugged off the “global financial crisis” and the “great recession.” Why? Most did not have massive debt. Most did not respond to the crisis with massive deficit spending and new debt. And most chose to let failing enterprises fail instead of propping them up.

3. There should be investments in inflation “stealth fighters” such as high-yield bonds, bank loans, convertibles, and local currency emerging markets debt. Inflation stealth fighters work in a subtle way. Inflation reduces the real value of the debts, improving debt coverage ratios. As the coverage ratios improve, the credit spread can narrow creating capital gains on top of the original rich yields. This leads to startlingly high correlations between their returns and the rate of inflation.

4. Tactical allocations among the asset class choices. Higher inflation breeds volatility which, in turn, breeds opportunities to be tactical in response to price dislocations. This includes the ability to invest in absolute return, low beta, alpha-oriented strategies for times when both traditional and real return funds offer meager risk-adjusted returns.

That is a handful. Excuse me for believing that Mom and Pop are not prepared to deal in TIPs, REITs, commodities, high-yield bonds, bank loans, convertibles, and emerging markets debt and equity, let alone make knowledgeable tactical asset allocations among them! Most investors have enough trouble making money in boring stocks and bonds.

Our Global Macro portfolio (and the Arrow DWA Tactical Fund, DWTFX) is designed to deal with this very problem. It allows an investor to rotate toward strong asset classes, whether in domestic equities, international equities, emerging market debt and equity, REITs, commodities, inverse funds, currencies, inflation-protected securities, and more traditional fixed income. Both exposure and timing are addressed so that Mom and Pop-who have no expertise-don’t have to try to figure out what to buy and when. Best of all, the portfolio adapts as strength in various asset classes waxes and wanes. Market regimes change, and while Mr. Arnott is concerned about inflation now, it is possible that an entirely different concern will be on the horizon a few years from now. Global Macro is designed to roll with the changes.

To receive the brochure for our Global Macro strategy, click here. For information about the Arrow DWA Tactical Fund (DWTFX), click here.

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

Leave a Comment » | From the MM, Markets | Permalink
Posted by Mike Moody

Bonds: Upon Further Review

June 16, 2010

One of the effects of PBSS (Post-Bear Stress Syndrome) has been the flood of money into fixed income over the last couple of years. According to the Investment Company Institute, from October of 2007 through May 2010 there have been net inflows into bond funds of $230 billion while there have been net redemptions from equity funds of $553 billion. After going through two major bear markets in 10 years, investors want less risk. It is only understandable that investors have reacted this way. Over the last ten years, investor’s focus has steadily moved from investing in order to achieve long-term financial goals, like providing for a comfortable retirement, to a focus on avoiding short-term portfolio losses. However, the further that we get from the last bear market the more investors are going to remember the whole reason for investing in the first place. Once again, they will start looking at their current assets and deciding whether or not they will have enough money to maintain their lifestyle throughout their lives. When those shifts in focus start to take place, more and more investors are going to take a closer look at their current asset allocation and wonder if their giant bond portfolio is going to get the job done.

For many investors today, their view of bonds has been colored by the performance of this asset class over the last thirty years. Over this period of time, the wind has been at the back of bond investors as the yields have steadily declined from their peak in 1981 (bond yields and prices move inversely).

(Click to Enlarge)

Data courtesy of The Leuthold Group.

However, the experience of fixed income investors was something entirely different prior to 1981. As seen in the chart above, from 1957 until 1981 bond yields trended higher (and bond prices declined.)

The chart below shows the real (net of inflation as defined by CPI) return of the 10 year Treasury Note Total Return Bond Index from 1969 to April 2010.

(Click to Enlarge)

Data courtesy of The Leuthold Group.

A lot of investors may be surprised by this chart. All of a sudden bonds don’t seem quite so safe when considered in the context of real (after inflation) returns. I have real return data for the 10-year Treasury Note Total Return Index from December of 1969 through April 2010. From December 1969 through December of 1981, when yields were rising, the average 12 month real return of bonds was -3.16%. From January 1982 through April 2010, when yields were declining, the average 12 month real return of bonds was 7.18%. The question now is what comes next for bonds. They have been excellent for 30 years, but we have also seen periods where they were dreadful.

Harold Parker, one of our senior portfolio managers, entered this business in the late 1970s and offers some perspective on investor sentiment towards bonds both then and now:

One of the problems with getting older is that you start to lose some of your old friends. I have been experiencing that in my life. The friends who are being called back to their maker were born in the early 1980′s and one by one they are disappearing. These friends, these remnants of a bygone era, are not people; they are Treasury bonds. They are some of the last survivors of a time when double digit yields on long term Treasurys were there for the taking. Locking in a “risk free” double digit yield for decades seems so attractive now, yet investors could hardly be persuaded to take long term bonds by anything short of a gun.

It was a different world when these old friends were born. Bonds had been in a decades-long bear market. Inflation was running at double digits. The conventional wisdom was that nobody in their right mind would buy a long-term bond. Real estate and gold were booming and it took yields of over 13% to entice buyers.

But alas, our old friends are leaving us. As they leave, we find ourselves in a very different world. We have enjoyed a decades-long bull market in bonds as interest rates have declined to levels not seen since our grandparent’s days. Inflation rates are low and and most non-bond asset classes look volatile and risky.

Nobody in their right mind would buy anything but a bond now.

With interest rates and inflation at rock bottom levels, every investor should be asking the question of what comes next for bonds. In order to achieve long-term financial goals, and with risk management still a priority, I would suggest that there are much better investment options than bonds right now. One such option would be our Global Macro strategy (available as a separately managed account and as the Arrow DWA Tactical Fund - DWTFX). This strategy can invest in bonds, but only does so when the relative strength of bonds is strong. The strategy can also invest in U.S. equities, international equities, currencies, commodities, real estate, and inverse equities.

The chart below shows the allocation of our Global Macro strategy to fixed income over the period of its testing and live performance. You will notice that the exposure to fixed income tends to pick up during major bear markets, but is reduced or eliminated when there is better relative strength in other asset classes.

(Click to Enlarge)

Investors have no desire to jump from the frying pan and into the fire in their search for safety. Yet, that may be exactly what they are doing by piling into fixed income right now. I would suggest that a global tactical asset allocation strategy would give them the comfort of knowing that it can be allocated very conservatively at times, but it will systematically move to other asset classes when needed.

To receive the brochure for our Global Macro strategy, click here. For information about the Arrow DWA Tactical Fund (DWTFX), click here.

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

2 Comments | Markets, Tactical Asset Alloc | Permalink
Posted by Andy Hyer

Retirees “Consumed by Fear”

June 14, 2010

So says a recent Bloomberg story about the retirement finances of Americans, and, indeed, there is ample reason to worry. According to the article, nearly half of those nearing retirement are predicted to run out of money.

Source: airanwright.com

Although we all worry about the government having a fiscal crisis, perhaps we should pay more attention to our onrushing collective personal fiscal crisis. How did everything become so dire? Part of it may have to do with the fact that traditional pension plans have been supplanted in the main by 401k plans:

In 1983, 62 percent of workers had only company-funded pensions, while 12 percent had 401(k)s, the center said. In 2007, those numbers were 17 percent and 63 percent, respectively.

Part of it may have to do with the relatively low level of Social Security benefits available to the average worker:

The average monthly Social Security benefit as of April was $1,067.

On the other hand, the biggest part of it may have to do with pre-retirees not saving enough:

The average 401(k) account balance as of March 31 was $66,900, according to Boston-based Fidelity Investments, which has 11 million participants.

A couple of solutions were mentioned in the article. One possibility is to include an annuity option to generate the highest possible income payout in retirement. However, with the savings levels cited, that’s probably not going to get it done. Another promising possibility is to indicate on the employee statements exactly how much monthly income can be expected from the portfolio. Although it might be a shock for employees on the cusp of retirement, that option might also serve as a wakeup call for workers who are not saving enough and still have enough time to do something about it.

Now that retirement is largely left up to the individual, investing decisions and disciplined saving are more important than ever. If you are not already taking a systematic approach to saving and investing, now would be a good time to start.

1 Comment | Retirement/Saving | Permalink
Posted by Mike Moody

Before There was David Swensen, There was Harry Browne

May 20, 2010

Kudos to Mark Hulbert for his interesting historical article on MarketWatch entitled “A Portfolio for All Seasons.” It was a nice discussion of what I think was one of the intellectual precursors of the Yale endowment portfolio. Harry Browne was a newsletter writer in the 1970s and 1980s. He proposed a permanent portfolio that would never need to be changed, except maybe for periodic rebalancing.

Browne’s idea was to invest in a basket of asset classes, each one of which has a low correlation with the others. As a result, when any one of the asset classes is performing poorly, there is a good chance that the others will at least be holding their own — if not actually appreciating in value.

Hmmm…investing in a basket of uncorrelated asset classes. This sounds familiar from both modern portfolio theory and David Swensen’s work at Yale. Browne had a particular portfolio mix in mind:

The basket that Browne recommended was equally divided between stocks, long-term Treasury bonds, gold and Treasury bills. In his 1987 book, he reported that, over the prior 17 years, back to 1970, this portfolio had produced as 12.0% annualized return. This was better than a buy-and-hold in either stocks or bonds, though behind gold.

Essentially, Browne proposed a mix of stocks, bonds, cash, and alternative investments. In 1987, this was pretty unusual. Most newsletter writers recommending gold were either gold bugs (buy gold and live in a bunker) or strategic asset allocationists (have a 5-10% portfolio allocation to gold as a concession to inflation or global catastrophe). The end-of-the-world crowd would never want to own stocks of corrupt corporations or bonds of currency-debasing governments. The 60/40 policy mix group would blanch at having such a large allocation to alternatives. Yale’s endowment model today is an interesting modification because it is equity-oriented, but also willing to hold significant allocations to unusual asset classes. One of the unique things I learned from the article is that Browne’s approach actually spawned a mutual fund. Hulbert writes:

Browne’s approach in the decades since has continued to perform as advertised. Consider the Permanent Portfolio fund /quotes/comstock/10r!prpfx (PRPFX 39.88, -0.38, -0.94%) , which was created in large part out of Browne’s work. Its current target allocations are 25% in gold and silver, 35% in U.S. Treasurys, 15% in aggressive growth stocks, 15% in real-estate and natural resource stocks, and 10% in Swiss-franc denominated assets.

…You might therefore want to remember Browne’s investment approach as you suffer through yet more of the markets’ frightening volatility. His permanent portfolio serves as a reminder that we don’t have to be constantly betting on the markets’ short-term gyrations, nor suffer from huge losses along the way, in order to produce decent long-term returns.

It sounds like the mutual fund hasn’t quite stuck to Browne’s original guidelines, but it’s clearly in the same spirit. The real point is that an endowment-type portfolio, while perhaps not very sexy, can generate nice long-term returns-and it might be able to keep clients from jumping out of the window. The endowment-type portfolio that we manage, the Arrow DWA Balanced Fund (DWAFX), is built in the same spirit. There are sleeves for domestic and international equities, fixed income, and alternative assets. Unlike Mr. Browne’s approach which called for equal-weighting, the size of our sleeves varies by relative strength-within boundaries-so that the portfolio can adapt to different environments. The fixed income position tends to act as a volatility buffer, with growth typically coming from the equity portion of the account. The alternative assets often provide an uncorrelated growth component. The approach was sound when Mr. Browne proposed it, sound when Mr. Swensen modified it, and seems to be working today-and there aren’t very many investment approaches that can make that claim.

Leave a Comment » | Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Morningstar: What NOT to Do When Investing for Income

April 23, 2010

Maybe Christine Benz, the personal finance specialist at Morningstar, is a regular reader of our blog. Or maybe she just gets it. She wrote a great piece on what income investors should avoid. Here’s a section of it:

Is it even healthy to focus on generating income, particularly if doing so comes at the expense of total return? Is generating a livable yield from a portfolio a vestige of a bygone era? No and yes, I’d say.

It’s easy to see the intuitive appeal of being able to live on the income you earn from clipping bond coupons, yet being too income-focused carries its own set of pitfalls. A key one in today’s low-yield environment is that you have to venture into very risky stuff to generate a livable yield, and that could erode your principal in the process. And by focusing unduly on investments that kick off income, you also risk starving your portfolio of the capital-appreciation potential that comes with stocks. True, stock returns have been no great shakes over the past decade, but bonds may well fight their own uphill battle over the next one.

The bottom line is that most people will have to tap their principal to fund living expenses in retirement, so the key aim for most retirees and pre-retirees should be to grow those retirement kitties as large as they can. If they have to tap their principal, they’ll be tapping a larger base than if they had focused on income without regard to total return. Investments that generate current income aren’t bad, but total return is your real bottom line.

[The emphasis is mine.] This is exactly what we wrote about on 4/16 in a post on investing for income. We made the added point that capital gains can be spent just as easily as income, so there is no reason not to focus on total return. We also had a suggestion for how an income-oriented investor might be persuaded to incorporate growth into the portfolio. I don’t always agree with Morningstar’s orientation on investing-they tend to think that value is the only way to go-but I think their take on investing for income and the dangers of only paying attention to the current yield are right on the money.

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

Investing for Income

April 16, 2010

As the front end of the baby boomers hit retirement age, investing for income has become their mantra. Retirees are often sold terrible investments because of their known propensity to lunge at income the way a starving fish attacks a baited hook. But is investing for income desirable, or even possible? Let’s take a look at the income possibilities from bonds, stocks, and alternatives.

Bonds are boring and safe, and are usually the first place investors go for income-except that with current interest rates, there isn’t much income available. Most retirees can’t live on 2-year Treasury yields of 1.04%, and moving out to the 30-year Treasury at 4.72% brings with it a significant chance of getting hurt by inflation. Yields on junk bonds (euphemistically known as high-yield bonds) are higher, but that crosses over from investing for income to its less glamorous cousin, “reaching for yield.” Junk bonds might work for a while, as long as the economy is in recovery mode, but are probably not a long-term solution for a retiree. As the saying goes, “More money has been lost reaching for yield than at the point of a gun.”

Many investors have looked to the stock market for dividend yield. Doug Short has a nice piece on the disappearing yields in stocks on his excellent site. The chart below is taken from his article. Stock prices have been rising, but dividend yields have been going the other direction.

Click to enlarge. Source: dshort.com

The traditional high-dividend sectors for investors were always banks, oil stocks, utilities, and REITs. When stock prices plunged in 2008, many banks eliminated or severely slashed their dividends. Some REITs had the same problem. Oil stocks and utilities don’t have nearly the dividend yields they used to. All of the dividend cuts and reductions caused the high-yielding equities to do worse than the general market. (See the chart below for a comparison of the S&P 500 to the Dow Jones Select Dividend Index ETF.)

Source: Yahoo! Finance

Alternatives range from MLPs (typically finite lives and unstable income streams) to all sorts of structured products. This morning someone sent me an offering flyer for a 12-year 8% CD, where the quarterly rate is based on the slope of the yield curve. 8% was the cap rate, but it could drop to 0% if the yield curve flattened out. I’m not sure Mrs. Jones is ready to speculate with derivatives.

All in all, it appears that the income investor has hit a rough patch and there seems to be no easy way out. I’m going to let you in on a secret that very few investors know: capital gains can be spent just as easily as dividends. Ok, that’s not really a secret at all, but many investors act like it is. They chase yield so they can spend the income, but really, total return is all that matters.

Segmentation, like the distinction investors often impose between income and principal, is a natural function of the mind. Many retirement planners have been using this human tendency to segment things by presenting a retirement income solution that consists of a number of buckets, a solution that is generally well-received by clients.

The first bucket is the liquidity bucket, where spending will be drawn from. The second bucket is the income bucket, which is typically put into some kind of fixed-income investment. The third bucket is the growth bucket. By segmenting the growth portion, the investor might be more willing to leave it alone as it gyrates with the market.

When there is a particularly good quarter or good year, the growth bucket can be trimmed back and the proceeds “deposited” into the liquidity bucket. Obviously, you could use any number of buckets depending on how finely you choose to segment the investment universe. The relative size and specific composition of each bucket would be determined by the client’s situation. Most often, all of this can be done within one account. The buckets are mental, but they help separate the investments and their specific purpose in the client’s mind.

When viewed in the context of buckets within a single account, it becomes quite apparent that total return is what counts. Investing for income may be a misnomer; investing for total return is the real deal.

Leave a Comment » | Investor Behavior, Markets, Non-partisan op-ed, Retirement/Saving, Thought Process | Permalink
Posted by Mike Moody

Delayed Gratification

April 5, 2010

Stanford University psychology researcher Walter Mischel famously demonstrated the importance of self-discipline (the ability to delay immediate gratifiction in exchange for long-term goal achievement) in achieving lifelong success in his well-known “Marshmallow Study.” In the study which began in the 1960s, he offered hungry 4-year-olds a marshmallow, but told them that if they could wait for the experimenter to return after running an errand, they could have two marshmallows. Those who could wait the fifteen or twenty minutes for the experimenter to return would be demonstrating the ability to delay gratification and control impulse.

About one-third of of the children grabbed the single marshmallow right away while some waited a little longer, and about one-third were able to wait 15 or 20 minutes for the researcher to return.

Years later when the children graduated from high school, the differences between the two groups were dramatic: the resisters were more positive, self-motivating, persistent in the face of difficulties, and able to delay gratification in pursuit of their goals. They had the habits of successful people which resulted in more successful marriages, higher incomes, greater career satisfaction, better health, and more fulfilling lives than most of the population.

Those having grabbed the marshmallow were more troubled, stubborn and indecisive, mistrustful, less self-confident, and still could not put off gratification. They had trouble subordinating immediate impulses to achieve long-range goals. When it was time to study for the big test, they tended to get distracted into doing activities that brought instant gratifciation This impulse followed them throughout their lives and resulted in unsucessful marriages, low job satisfaction and income, bad health, and frustrating lives.

I recently came across an in-depth article about Walter Mischel in The New Yorker, which discusses the Marshmallow Study in the context of his long career. It gives a fascinating look into the events and studies that led Mischel to the Marshmallow Study and his subsequent research on the subject of delayed gratification. He is a big believer that people can actually develop the ability to delay gratification through hard work and training.

One particularly relevant passage of the article is as follow:

At the time, psychologists assumed that children’s ability to wait depended on how badly they wanted the marshmallow. But it soon became obvious that every child craved the extra treat. What, then, determined self-control? Mischel’s conclusion, based on hundreds of hours of observation, was that the crucial skill was the “strategic allocation of attention.” Instead of getting obsessed with the marshmallow—the “hot stimulus”—the patient children distracted themselves by covering their eyes, pretending to play hide-and-seek underneath the desk, or singing songs from “Sesame Street.” Their desire wasn’t defeated—it was merely forgotten. “If you’re thinking about the marshmallow and how delicious it is, then you’re going to eat it,” Mischel says. “The key is to avoid thinking about it in the first place.

In adults, this skill is often referred to as metacognition, or thinking about thinking, and it’s what allows people to outsmart their shortcomings. (When Odysseus had himself tied to the ship’s mast, he was using some of the skills of metacognition: knowing he wouldn’t be able to resist the Sirens’ song, he made it impossible to give in.) Mischel’s large data set from various studies allowed him to see that children with a more accurate understanding of the workings of self-control were better able to delay gratification. “What’s interesting about four-year-olds is that they’re just figuring out the rules of thinking,” Mischel says. “The kids who couldn’t delay would often have the rules backwards. They would think that the best way to resist the marshmallow is to stare right at it, to keep a close eye on the goal. But that’s a terrible idea. If you do that, you’re going to ring the bell before I leave the room.”

As discussed in the article, researchers have concluded that although intelligence is very important to long-term individual performance, self-control is even more important. Furthermore, self-control can be developed over time, even if it may come more easily to some than to others.

Delayed gratification is, of course, the rationale for investing. It is what motivates people to save for tomorrow what they could spend today. Delayed gratification is what allows people to accept short-term volatility in exchange for the expectation of more plentiful long-term rewards. I would strongly suggest that investors are best served by doing very thorough research about about investing early on in their lives so that they can adhere to an overriding investment philosophy for a long period of time. Such research might lead a person to determine a disciplined long-term savings plan. It might also lead a person to a deep commitment to a given number of investment strategies like relative strength, value, and/or indexing. Finally, the key to long-term success is to focus on other things while adhering to those saving and investment principles for the long run.

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

Getting Off the Sidelines

February 17, 2010

We’re at a strange place in the market cycle. Depending on the day, investors are either fearful of a further decline or fearful of missing the recovery. No one can tell if we are in the eye of the storm and about to head into the dreaded double dip or if the nascent economic recovery has legs and is about to surprise on the upside. Despite the best year of the decade in 2009, it’s safe to say that investor confidence is still very fragile.

Amid that backdrop, investors have responded by clinging to cash. According to a recent article in Investment News, more than $9 trillion is on the sidelines. Investors need to figure out some way to get back in the game.

Of course, investor angst is understandable. Most investors diversified and tried to be patient, the very behavior they had been counseled to follow. Then 2008 came along and they got whacked when almost every asset class dropped. In other words, they did what they were told and it turned out disastrously for them. Now investors don’t know what to do or who to believe.

It’s not that investors are living in a cave. They can see the current environment and they understand that there are multiple risks they need coverage against: inflation, deflation, currency depreciation, and so on. With the yield on cash at essentially zero, they also know they can’t sit in money market funds forever and reach their investment goals.

Investors recognize that a potentially broader approach to asset classes would be helpful, but they are paralyzed with fear and have no idea how to implement that kind of investment policy. It’s not so much that they are afraid of the market as they are afraid of jumping in (or out) and getting it wrong.

Our Global Macro portfolio offers a possible solution for some of that $9 trillion sitting on the sidelines. Investors, I believe, after being beaten half to death by the proponents of sit-and-take-it investing, are now open to a tactical approach that offers great flexibility of exposure to different asset classes. They can see with their own eyes that the world has changed. They are just confused about how to handle the timing of multiple asset class exposures and reluctant to attempt it on their own.

Their problems can be addressed with something like the Global Macro portfolio because the timing and market exposure is handled for them. If conditions are harsh, the portfolio could be held in fixed income, inverse funds, and cash. If risk is being rewarded, aggressive assets such as domestic equities, emerging markets, and real estate might be held. In an inflationary environment, there might be more exposure to basic materials and commodities. If the dollar depreciates, the portfolio might be heavily laden with international equities and foreign currencies. The other significant benefit is that the systematic relative strength process used to run the accounts continues to adapt to new conditions as markets change. I think investors breathe a little easier when they recognize that there is a specific strategy that is being followed-it won’t be optimal in every environment, but it won’t be driven by fear and greed.

It’s up to each client and each advisor to figure out how to get off the bench and back into the game, but for many clients a global allocation product might smooth the transition back onto the field of play.

Leave a Comment » | Investor Behavior, Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

A Wakeup Call for Investors

January 19, 2010

If you have money left over after paying your bills, you fall into the category of “investor.” You could invest your surplus money in having a good time in Vegas, a mattress, a bank savings account, or any manner of financial instruments. Some investments have a financial return; others only a psychic return if you are lucky.

Most people invest for a simple reason: to provide income when they are no longer able to work. Some people might actually want to retire, so they invest to provide income for the time after they voluntarily choose to stop working. To get from “investor” status to actual retirement status, a few difficult things have to happen correctly.

1. You actually need to save money. And you have to save a lot. In today’s America, this means becoming a cultural outlaw and foregoing some current consumption. Welcome to the radical underground.

2. You need to save the money in assets that produce income or capital gains. (Income-producing assets are nice, but capital gains can be spent just as effectively.) These assets are often volatile, leveraged like real estate, or intangible like stocks and bonds. Scary stuff, in other words. Investing your surplus funds in Budweiser, while it may confer certain social benefits, will not provide a retirement income.

3. You need to manage not to muck up your returns. The DALBAR numbers don’t lie. To earn decent real returns, you need to select quality money managers and/or funds and then leave them to do their work.

4. You need to be able to do realistic math. For example, most people think their home is a great investment—but they never subtract from the returns all of the property taxes and maintenance that are required, or remove the effects of leverage. Every study that does shows that homes are not a good financial investment. In addition, in order to make a projection of how much money you will require to retire, you need to be able to make a reasonable estimate of your real net-net-net returns (after inflation, taxes, and expenses) over your compounding period. Investors, imbued with overconfidence, almost always make assumptions that are far too bullish.

Jason Zweig has an excellent article in the Wall Street Journal discussing realistic assumptions for net-net-net rates of return.

Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%.

All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.

Mr. Zweig points out that many investors, even some institutional investors, are assuming net-net-net returns of 7% or more. When he asked truly sophisticated investors what return they thought was reasonable, he got very different answers.

I asked several investing experts what guaranteed net-net-net return they would accept to swap out their own assets. William Bernstein of Efficient Frontier Advisors would take 4%. Laurence Siegel, a consultant and former head of investment research at the Ford Foundation: 3%. John C. Bogle, founder of the Vanguard Group of mutual funds: 2.5%. Elroy Dimson of London Business School, an expert on the history of market returns: 0.5%.

The reality is pretty shocking, isn’t it? This is why the investor has an uphill battle. And the consequences of messing any of the four steps up along the way can be pretty steep. In Mr. Zweig’s eloquent words,

The faith in fancifully high returns isn’t just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that cannot last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.

Saving too little can become a big problem. I would add that ruining your returns by thrashing about impulsively will only add to the amount you will need to save. Almost everyone has a number in mind for the amount of assets they will need in retirement. Try redoing the math with realistic numbers and see if you are really saving enough.

Leave a Comment » | Investor Behavior, Markets | Permalink
Posted by Mike Moody

More on Target Date Funds

December 16, 2009

Ah, target date funds were such a simple concept. Buy the fund for your projected retirement date and let the glide path guide you to a rosy retirement. It was the ultimate set-it-and-forget-it investment product. Who wouldn’t want that?

In practice, target date funds have run into all sorts of complicated hurdles.

1) Consumers didn’t know how to use the funds and so bought multiple target date funds in the same account, combined target date funds with a bunch of other active funds, or traded in and out of target date funds on a short-term basis.

2) The glide path turned out not to be fixed. Some investment committees tinkered with the asset allocations of the funds from time to time, so consumers were never completely sure what they were getting. The allocations also varied widely from provider to provider, based on different assumptions for returns, risk, and appropriate allocations for retirees.

3) When even 2010 target date funds took a beating in 2008, consumers discovered that the strategic asset allocation process embedded in the funds hadn’t done very much to protect their retirement assets. Almost universally, consumers expected the funds to be much more conservative when only two years from their retirement date.

4) The logic of allocating more and more to fixed income as the fund holder nears retirement is questionable. Yes, bonds are typically less volatile, but there’s no guarantee that will be the case. And piling more assets into bonds at today’s near-zero interest rates doesn’t necessarily seem like a clever idea.

And now this: it turns out that a substantial part of the fixed income allocation in some of the target date funds—and keep in mind that the fixed income allocation expands as retirement nears—is composed of low-rated, high-yield bonds. Probably not what the soon-to-be-retiree was expecting.

Frankly, some of these items are not the fault of the target date fund at all. There’s nothing wrong with high-yield debt as an asset class, for example. Consumers should do some due diligence and know what they are buying and how to use it properly. On the other hand, the marketing of the products sometimes gave the impression that everything would be handled for you.

Here’s a way to avoid most of these problems entirely: tactical asset allocation. Instead of assuming that it’s always good to own more bonds as you get older, how about investing on the merits of the individual asset? To me, the tactical approach just makes much more sense. Own stocks and other risky and higher-potential assets in environments when risk is being rewarded and switch to fixed income and other lower-risk assets in environments when risk is not being rewarded. Tactical asset allocation does require constant monitoring and adjustment, but it could turn out to be well worth it.

Leave a Comment » | Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody