Institutional investors always ask what time it is.

Not (only) because they have an expensive lunch with a pension manager to go to, but also because there is an investment clock that reflects the business cycle.

The pretty clock shown here was created by Merrill Lynch.

Merrill went bust shortly afterwards, so you might wonder if the clock is faulty.

But in fact the idea of an investment clock has been around for decades.

The investment clock captures two important truths:

• Capitalist economies follow a business cycle

• No sector of the economy, or asset or company exists in isolation.

Boom and bust is nothing new, despite what bear market doomsters will have you believe.

It’s inherent in the cyclical expansion and contraction of the economy that it overheats and is cooled off, either intentionally through interest rate rises, or else through asset price crashes or similar market medicine.

(Source: WelkersWikinomics)

The following image shows how the different sectors or assets do well at different points in the business cycle:

You can clearly see where the investment clock idea comes from.

It’s 7pm on the investment clock! I’m going to be rich!

It would be nice if telling the time on the investment clock was as simple as seeing when it’s time to leave the office.

In fact, telling the time is extremely hard, and the difference between a couple of hours on the clock can have huge ramifications.

Cyclical shares, for instance, can easily fall 80% or more in the event of a recession. Later they rally almost as hard ahead of a recovery.

False starts also complicate matters. The hands on the investment clock can go backwards as well as forwards.

Several times in an expansion or contraction it will seem like a new phase has begun, only for the economy to step back in the other direction.

If market timing was easy, we’d all be doing it. And then it would no longer work, because we’d be bidding up the prices in advance.)

The uncertainty about the business cycle and what impact it will have on asset prices is one reason why investor sentiment also tends to cycle from despair to euphoria and back again every few years.

Using the investment clock

I think the investment clock concept is useful in understanding how economies relate to asset classes.

And I agree it’s potentially useful – if you’re an active investor – when you’re deciding where next to direct new money, particularly if you’re rebalancing your asset allocation.

You might decide to direct new funds towards a sector that you judge is coming up on the clock, for instance. It could look cheap, unless others agree with your time-keeping and have already started buying…

But as always, drip feeding money into the market long-term will be a better course for most people than attempting any market timing.

Remember too that regular rebalancing can automatically take advantage of the cycles in the market without you having to make judgement calls, by naturally selling some of your winners in the good times and topping up on what’s down in the bad.

Tending to your asset allocation rules like this will be more beneficial for most investors, even those who find investment clocks helpful in making sense of the economy.

The fact is simple methods of market forecasting don’t work – at best you’ll have to make a a series of correct judgement calls, which very few have proven consistently able to do.

Do you feel lucky, punter?

Other investment clocks

For fun I’ve collected a few more investment clocks from around the web, and included them with a few comments below.

Source: Fidelity

Please note: Unless stated, no original source was cited when these images were found. If one of these clocks is yours and you can prove it, please do drop me a line and I’ll either credit you or remove the image as you see fit.

Good reads from around the Web.

A US researcher called Wade Pfau has been wading through the weeds of retirement investing for the past several years. I’ve featured his work here many times.

An article in Financial Planning this week is perhaps the most accessible summary yet of his findings.

I’d say Wade’s biggest contribution has been to unmask the 4% withdrawal rate “rule” as an accident of history that was never meant to carry the hopes of every last wrinkly American on its shoulders.

And if the 4%-rule was adopted unthinkingly in the US, its importation into the UK was even more anomalous.

After all, the initial data that alighted on 4% as being a safe withdrawal rate was always US-derived.

Yet many UK writers and bulletin board pundits have put forward the 4% rule as if it’s a third Law of Finance.

Wade looks almost exclusively at the US market, but the article does include some international statistics – including a grim one for UK investors.

The half-as-lucky generation

All told, the article’s thrust is pretty hard reading:

New research shows that Americans retiring in 2015 need to be far more conservative in their withdrawal rates during retirement.

The historic 4% annual withdrawal rate is over two times the level that Americans can safely withdraw without expecting to outlive their assets.

The real safe withdrawal rate, accounting for fees and today’s stock and bond market levels, is under 2% per year.

Bleak!

Now, I will say I’ve long been more optimistic about future returns than today’s low rates would imply – at least when it comes to equities.

I also think the US valuation situation is more extreme than the UK one, and that UK investors will see higher returns than US investors from here.

The US stock market looks expensive to me. The UK market? Not so much.

Still, what do I know that the world’s collective investing dollars does not?

The more important takeaway is that there was never any such thing as a Safe Withdrawal Rate. It was always going to depend on starting valuations, an unknowable future, and personal circumstances.

So any such target withdrawal rate – high or low – is at best a rule of thumb.

A Southern gentleman never spends his capital

I tend to leave discussions about all this to my passive minded co-blogger, The Accumulator.

That’s not just because he finds it much more fascinating than I do – and I have a low boredom threshold.

It’s also because I am a clear oddity, whereas his path towards early retirement is a much more middle of the road affair.

True, he’s ultra-frugal. More so than me.

But I am a monomaniacal active investor who suggests other people invest passively for their own good. I don’t even really notice I’m saving 50% or more of my earnings, it’s just what I do. It just happens. It’s probably genetic, if not mildly aspergic.

In addition, I plan to someday live off investment income and never spend my capital, which in some respects makes the Safe Withdrawal Rate irrelevant for me (or at least changes the frame of the problem).

But very few people will be able to do this – at least not unless they’re born wealthy to start with. The maths and human psychology just doesn’t work for most.

If they earn enough to make saving enough to eventually live off their capital a realistic possibility, then in most cases they’ll get used to a far higher standard of living well before then than their portfolio will throw off in income alone

And if they don’t earn enough? Well, they don’t earn enough.

Sorry. Life isn’t all ha ha ha, hee hee hee.

Do it his way

In contrast, The Accumulator earns fairly well but hardly bulge bracket, lives simple but saves hard, fully intends to run down his capital, and bridles at talk of investing specifically for dividends and the like as specious active investing nonsense.

And that world view is a much more sensible one for most people, because planning to spend your capital means you’ll need much less of it in the first place.

Living off your capital implies an inefficient use of that capital, because your plan is basically to die with it still invested.

If instead you spend your capital, you can retire earlier or you can have more slap-up dinners at Nandos once you do.

Those extra chicken wings and curly fries are the pay-off in a bet that you’re making that your heart will run out before your cash does…

Get a new plan

If I were however planning to spend my capital, I’d do a few things.

Firstly, I’d almost certainly plan to at some point buy an annuity with a portion of my pot.

Creating a minimum income floor like this gives you some of the benefits of living off your capital, in exchange for effectively spending it and betting you’ll outlive your actuary’s best guess.

The inflation-linking would be expensive, but I’d do it anyway.

And yes, annuities look poor value right now. But I wouldn’t do this unless I had a fairly sizable pot to play with – that’s what I expect to have, and this is about what I’d do.

(I can’t really tell you how I’d retire early without much money, because I wouldn’t.)

Secondly, I’d investigate the various dynamic withdrawal strategies that have been put forward, including by Wade Pfau himself.

Essentially these boil down to “spend less when your investments do poorly”. Seems like common sense to me, but perhaps it is best codified.

Finally, I wouldn’t under-estimate the difficulty of actually spending your capital when you do pull the ripcord.

I know myself well enough to understand I could probably never do this (or at least not until very late in the game), which is why it isn’t in my plan.

But even pragmatic financial freedom seekers might be surprised how difficult spending money is.

Would you like to make a withdrawal?

It’s one thing to spend your money as a 65-year old who has simply flopped over the line at the end of the traditional 40-year rat race.

But if you’re someone who has saved extra-hard all your life and retired early (or even, and better, if you’ve transitioned to an opt-in-and-out lifestyle where you make money when you want to, doing what you want to), then it’s going to be tough to start splashing the cash.

If you don’t believe me, ask a real early retiree like Jim at SexHealthDeathMoney.

Jim warns that:

The pain of cashing in investments just to live from month to month is almost physical.

[continue reading…]

Good reads from around the Web.

There are many reasons to be a passive investor, but guaranteed returns is not one of them.

Is passive investing most people’s best chance of capturing the expected returns?

Definitely.

But you can’t bank on expected returns.

This was illustrated nicely by Motley Fool columnist Morgan Housel in an article this week on how long it takes to prove yourself as an active investor.

Morgan was discussing how some lauded active investors might just have been born at the start of a good run for their asset class – and wondering how long you’d have to invest for in order to know your returns weren’t simply down to luck.

But the graph that illustrates his piece might interest passive investors, too.

It shows how US stocks did over various 20-year periods, which Morgan suggests would reflect the key years in an investor’s life (35-55, he says):

Source: Motley Fool

From eyeballing the graph we can see that, for instance, the 20 years following 1910 were an awful lot easier to find gains in than the 20 years from 1930.

Lies and statistics

Now before anyone in any particular camp starts having a go in the comments, this is just one way of looking at a particular slice of data and it’s designed to make a particular point.

So yes, plenty of caveats.

For a start we nearly all invest regularly over many years, not just in a one-off lump sum.

Also, sensible passive portfolios are diversified – rather than just being all-in US stocks or any other asset class.

Indeed, rather than being pessimistic or misleading, Housel’s graph of US stock market returns reminds us why geographical diversification is important.

The evidence is that a wide variety of very simple well-diversified and rebalanced passive portfolios will deliver solid positive returns over the long-term (though nothing is ever certain!)

Finally, active investing is always a zero sum game. So to extend on Morgan’s comments, this means that an active investor in a good market may find it easier to put up impressive sounding numbers, but on average they will still lag tracker funds that follow the same benchmark.

Careful what lessons you learn

I suspect we will all take what we want to find from such graphs.

Passive investing skeptics will ignore my points about geographic diversification and regularly investing over a lifetime – and Morgan’s point about lucky fund managers – and say this is why you can’t rely on trackers for your returns.

And before I scoff at them too loudly, I must admit I did think to myself that this data shouldn’t really scare me, because as an active investor – for my sins – I flit about territories and individual stocks like a butterfly on a buddleia bush.

But it would be wrong (and ironic) to take away the message that passive investing is a flawed strategy from an article that is trying to show how the perception of an active manager’s success could just be down to when their parents happened to get jiggy with it.

(Again, read my zero sum game article if you don’t understand why.)

The active fund industry will always use the fact that shares go up and down and markets sometimes disappoint to play on people’s feeling that passive investing feels wrong.

But those feelings are not a good guide to the reality.

Certainly we need to be alert to the potential pitfalls, such as not being diversified or falling prey to sequence of returns risk.

And I do still hear too many new-ish passive investors saying things like “I can expect to get 5% from shares over the next few years”.

No you can’t, not over five-years.

You can hope to – but remember that average returns are not normal.

You know what you’ve got to do

I know these warnings and caveats are all a bit relentless, particularly if you’re new to investing.

I’m tempted to write that investing is like an onion, and that every time you peel away a layer you find a new layer and another complication.

But really it’s more like a childhood cut that turns into a scab.

You know what is happening and what you need to do – which is leave it alone – but you can’t resist picking and poking at it.

And if you do it may just start to bleed again!

The principles of investing – regular savings, compound interest, diversification, rebalancing, time horizons – were all worked out long ago.

Investors will experience very different markets depending on when they were born, but the principles don’t change.

[continue reading…]