Some years ago, my wife, Kate, and I were at dinner with a group of my work colleagues and our company’s CEO.

Our boss tried an experiment with the table. He drew two hypothetical stock charts on a napkin and asked us what we saw. A Rorschach test for stock nerds, you might say.

My fellow analysts and I, eager to impress our boss, searched for clever technical explanations.

“Oh, I see a ‘cup and handle’ pattern,” we might have said – or some such nonsense. We all missed the point of the exercise.

Kate, who teaches science, took a different approach. She looked at a horizontal zig-zagging chart and said, “That looks like a predator/prey diagram.”

On the second chart, Kate took a second to consider it, and said, “That looks like…faith.”

The graph looked something like this:

The table was impressed by both answers, but particularly by the second one.

The more I’ve thought about Kate’s observation, the more I believe she captured – unintentionally yet brilliantly – the essence of patient investing.

Faith?

With hindsight, it’s easy to determine which markets, companies, funds, and ETFs were great and worth holding onto through turbulence.

Historical returns, however, don’t capture the emotional roller coasters along the way.

Consider this. Had you bought shares of Wal-Mart on the 1st of September 1987 and held through the 1st of September 2017, you’d be up over 2,330% (including dividends, not reinvested). That’s an 11.22% compounded annual growth rate.

Those data points alone make it sound like it was nothing but rainbows and kittens for Wal-Mart investors over 30 years.

On the contrary!

During that period, there were 16 calendar months where the stock dropped by more than 10% and 97 weeks with 5%-plus losses. And this doesn’t include extended periods of market under-performance.

Equally important, during that three-decade period, Wal-Mart posted 26 calendar months of 10%-plus gains and 121 weeks of 5%-plus gains. A lot is made of investors selling after price drops, but my guess is most of us – certainly myself – have sold at least one good performer in order to ‘take a profit’, only to watch the stock multiply after that.

There were plenty of opportunities along the way for Wal-Mart investors to sell on panic or euphoria. It’s precisely these moments of emotional trading decisions that can derail a well-constructed investment strategy.

What it takes to stay invested

Though the impact of investment fees have on performance have been in the spotlight (and justifiably so), our poor behaviors can play an even greater role in under-performance.

This isn’t to say that a stock price plunge or a huge run-up in a stock or fund shouldn’t make us reevaluate our position. That absolutely should happen. Burying your head in the sand is not a realistic solution.

Skepticism is a healthy trait for investors. As the saying goes, the opposite of faith isn’t doubt, but certainty. Without some modicum of faith, emotion can run wild after reading a positive or negative news story, or after a substantial gain or loss in your stock or portfolio.

So, in what might we place our faith to stick with an investment – in good and bad times?

Your investment philosophy: Being comfortable in your investment approach, setting out an appropriate financial plan, and properly allocating your portfolio to various asset classes can help you weather market turbulence. Presumably you’ve created your plan with adverse market scenarios in mind. Put some faith in that strategy.

A company: If you’re a stockpicker, you might ask whether you believe a particular company you own is doing something special. Do they continue to execute on their business plan? If so, then to the extent possible diminish the stock market’s influence on your opinion of the company. Don’t check stock prices every day. Turn off real-time quotes on your broker’s homepage. Imagine you invested in a privately-run business where there was no daily price telling you its value. What would you use to measure a private company’s progress? You’d look at business fundamentals – dividends and book value per share growth, returns on equity, and so on. Use those factors to measure confidence in the company, not the stock price.

Optimism: Having invested through the financial crisis, I recall the allure of pessimistic arguments and admittedly I fell victim to some of it. A costly mistake. Bearish opinion always sounds much more refined and intelligent than the optimist saying things will turn around – even if the optimist don’t know quite how. But looking at a long-term chart of the US and UK stock markets, the pessimists haven’t seemed very smart for very long.

Historical evidence: While past performance is no guarantee of future results, there is compelling research that shows the benefits of being a patient investor. In 2013, for example, Morgan Housel dug through Robert Shiller’s U.S. market data going back to 1871. He found that your odds of generating positive after-inflation returns were as good as a coin flip in a one-year period. But over greater than 20-year periods, you would have always come out ahead in real terms. It’s not guaranteed these returns will repeat themselves, but it’s as compelling evidence as I’ve found for being a patient investor.

Source: Morgan Housel using data from Robert Shiller. 1-day returns since 1930, via S&P Capital IQ.

I’m not endorsing blind faith, but rather a healthy faith – a faith that comes with a dose of skepticism and introspection.

Being ‘actively patient’ is not simple. It’s hard to stay calm during both bull and bear markets.

With time and experience though, we can learn to filter financial results and market news to investigate the facts and discard the noise.

Bottom line

Faith seems too simple and perhaps a little naive when there are so many complicated explanations for investment performance. But the ability to keep your cool and stay focused whether times are good or bad is rare in investing.

The market is full of driven and intelligent people trying to outguess each other in the short run. Don’t play that game. Placing faith in the evidence, whether in your passive or active investing strategy, in a business or group of businesses, or in optimism alone can differentiate you from the crowd and help you achieve your long-term goals.

Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.

What caught my eye this week.

Josh Brown at The Reformed Broker wrote this week about the rise of the robots – and of artificial intelligence (AI) – from an investing perspective.

The perceived danger of advances in AI is a common theme these days. (I just saw Blade Runner 2049, and very good it is, too.)

But Josh struck a novel note when he suggested fears about AI and automation mean some investors are no longer putting money to work to replace their income when they retire in their 60s – but rather to have a life-raft if AI kills their job long before then:

There is a sense of desperation underlying the way in which we’re investing. […]

A 45 year old married father of two with a mortgage and a pair of college educations to fund. The remote yet persistent threat of a nuclear war is not what keeps him up at night.

In fact, he might almost see it as a relief should it come. He is a bundle of raw nerves, and each day brings even more dread and foreboding than the day before.

What’s frying his nerves and impinging on his amygdala all day long is something far scarier, after all. He, like everyone else, is afraid that he doesn’t have a future.

He is petrified by the idea that the skills he’s managed to build throughout the course of his life are already obsolete.

“Just own the damn robots!” concludes Josh, and I agree you should have a few horses in the race.

Hopefully there aren’t many Monevator readers who only own the UK stock market or companies listed on it. But if you’re one of them, know that you are getting very short-changed in the robot department. When chip designer ARM was acquired by SoftBank we lost our last great listed tech titan. You have to look overseas.

Personally I own technology investment trusts and individual tech shares. If you are a passive investor with solid exposure to the US market (perhaps through a global tracker) you’ll be getting a lot of technology through that, too.

Fun and games

I wrote an unfinished post (actually a chapter of a very unfinished investing book) along the same lines as Josh a few years ago. I agree it’s worth some thought.

But actually, I am not at all sure that all the riches will go to the robot owners.

For starters, it’s very unclear whether robots and AI really will take all our jobs. I’ll grant you things do feel different right now, but historically technology creates far more work than it destroys. Also, my friends working in the field say progress is very over-hyped.

But even if robots do take all today’s jobs, that doesn’t mean they’ll necessarily take all the wealth.

When industrialization replaced 98% of the jobs in farming, farmers didn’t become rich, nor did the manufacturers of farm equipment inherit the world. You’d have done better to invest in companies benefiting from the resultant urbanization boom, and the changes to leisure and consumption.

What will we do if robots do all the work but fail to get all the pay?

Perhaps we’ll play more computer games. Maybe instead of shares in robot makers – or even companies that make use of robots – we should own game creators like Electronic Arts.

Think that’s a depressing future for humanity? Then alternatively you could buy shares in Diageo, the UK whiskey behemoth. Perhaps we’ll all drink ourselves into oblivion…

[continue reading…]

How should you manage your money when you retire? Should your portfolio change when you finally sign your F.U. letter to the boss?

Is the famous 4% rule really safe or is there a better way?

While the passive path to accumulating your pension pot is well lit by blogs, books, and preachers of the gospel, the more difficult question of how to safely ration your retirement savings has no simple answer.

Attempts to supply a silver bullet to retirement spending often flounder. Proposed solutions may be unrealistic, mistranslated, too narrow, or grossly oversimplified on their journey from academic journal to custom and practice.

Michael McClung’s achievement is to survey that landscape with the rigorous eye of an engineer who wants to build a house that won’t fall down.

He’s poured his findings into Living Off Your Money. It’s a practical, safety-conscious, and evidence-based manual that DIY investors can use to avoid the retirement quicksands.

Hazards ahead

One big thing lifelong savers need to grasp as they contemplate retirement is that we become more vulnerable as we rundown our stockpile.

An unfortunate sequence of returns can put us on a crash course early on. Inflation and even the blessing of a long life can put us on prison rations in our twilight years.

The situation is worsened because traditional retirement rules-of-thumb like the ‘4% rule’ are about as reliable as ‘red sky at night’.

The 4% rule is prone to failure, numerous caveats that don’t fit into 140-characters or fewer (or even 280), and it’s barely applicable outside the US. And where the 4% rule can leave some retirees on the brink of poverty, it can leave others departing the stage with most of their hard-earned loot unspent.

The system offered by Michael McClung takes a data-forged sword to those twin-headed terrors. His design relies upon two important techniques that many retirees may struggle with:

• Dynamic asset allocation
• Dynamic withdrawal rate

Dynamic asset allocation means that your yin and yang of equities and bonds is no longer fixed by some permanent cosmic ratio. Instead, your percentages can pitch up and down depending on the motions of the market.

A 50:50 portfolio could, with McClung’s system, average between 30%-70% equities over the course of a retirement.

In extreme conditions you could end up with 100% of your portfolio in equities. Conversely when equities are storming ahead you’ll convert them into high-quality bonds, ensuring there’s fodder in the barn for when winter comes. And when equities are blown away like dandelions in a category five hurricane you’ll live on bonds until they’re gone. There’s no automatic annual rebalancing here.

With a dynamic withdrawal rate, your income rate can also vary every year.

A tempestuous retirement could see withdrawal rates swing between 2.5% and 6%. Benign conditions might bless you with an average withdrawal rate of 7.7%. When your portfolio swells, a dynamic withdrawal rate lets you spend more. When conditions worsen you batten down the hatches.

All this may make the system sound random, but it’s rather that the plan flexes in response to market feedback. It gives you a brake and an accelerator to apply rather than putting you on rails until your retirement train terminates.

If that sounds like market-timing, it isn’t.

Trial by data

Living Off Your Money builds on the work of other retirement researchers. (These guys have lower profiles than North Korean late-night comedians, and are probably only familiar to you if you’re into obscure financial planning journals.)

All have sought to improve upon the cult of 4% inflation-adjusted withdrawals plus annual rebalancing.

For his part McClung reverse-engineers their systems, tests them to within an inch of their algorithms, and then bolts together the best parts to come up with his recommendations.

The major difference between McClung and most other retirement researchers is that McClung has subjected these formulas to more tests than a talking ape.

Standard practice is to pit your proposals against the historical performance of US equities and bonds and leave it at that.

The danger is that a system that worked well when US assets outgrew those of most other nations may not look so clever when planted in poorer home soils. Even US investors may not enjoy such sunny days again. Non-US residents have no reason to expect to.

McClung guards against this by testing his contestants against the UK and Japanese datasets. Neither has enjoyed the same hot-hand as the US.

No retirement strategy trumps all others, everywhere, every time. Optimisers are missing the point – you might as well try to optimise a baby. What works in one situation won’t always work in another. McClung acknowledges this and recommends a plan that:

• Works well during historically difficult retirement periods
• Is robust across geographies
• Maximises withdrawals
• Avoids catastrophic failure like a zombie plague
• Leaves a large margin for error

He doesn’t stop there. McClung also checks his system versus the chilling effects of a low-growth world. His recommendations assume a globally diversified portfolio and performance. McClung’s mindset is world-first, not America-first, which makes his work directly applicable to UK investors in a way that most retirement research isn’t.

The Living Off Your Money strategy can also be calibrated for shorter and longer retirements. That is especially handy if financial independence is on your ‘to do’ list.

Don’t misunderstand me – McClung isn’t claiming his method is fail-safe. Very few retirement strategies would look good after a dose of German-style hyperinflation and being on the wrong side of two World Wars.

There are no guarantees, only probabilities.

The downside

There’s always a downside in investing and the trade-off demanded of you by the Living Off Your Money approach to retirement spending is that you can tolerate a volatile income and asset allocation.

Yes, you’ll probably be able to spend more over the course of your retirement. But there will be times when you’ll need to spend less. (The reality is that many retirees do naturally vary their income anyway outside of the confines of the retirement researcher’s lab.)

Sticking to the plan may also mean going all-in on equities in extreme conditions. Many retirees couldn’t cope with those strains.

To help alleviate some of these issues, McClung explains ways to take the edge off his purest prescriptions.

Floors and ceilings can be used to contain your equity allocation. There’s also an extensive section on creating guaranteed income to cover the bills when your withdrawal rate dips alarmingly low.

You may need to work longer to be able to afford such optionality. That’s the price of sleeping well at night.

Easy doesn’t do it

While McClung is a master of retirement theory, he doesn’t wallow in it. He never loses sight of his goal of creating a book that can genuinely help people.

The explanations are clear, and McClung carefully ropes off step-by-step practical sections that can be chewed on separately if you’d rather skip the methodology hors d’oeuvres.

Yet his work is steeped in integrity. McClung goes to great pains to explain his guiding principles and assumptions and – unlike some financial writers – all of his recommendations can be fulfilled in real life. There’s even a spreadsheet on his website to support anyone who wants to implement his strategy.

None of this changes the fact that reading this book and managing your portfolio by its light requires a fair degree of investment literacy.

The truth is, nobody should manage their retirement investments without a strong financial education and Living Off Your Money can help school anyone, regardless of whether you ultimately apply its teachings.

Long-term Monevator readers will be in their element. But if you just want to get by with a couple of blog posts and a few simple rules that could be printed on a tea towel then this isn’t the plan for you. Your best bet would be to accumulate so many assets that you are left with plenty of room for error.

On the other hand if you have a strong risk tolerance, genuinely enjoy engaging with investing, and want to do more with less then McClung might just change the course of your retirement.

If you’re not sure which camp you fall into then McClung has made three sample chapters available for free.

Alternatively, check Living Off Your Money out on Amazon and let us know in the comments below what you think of it.

Take it steady,

The Accumulator