Good reads from around the Web.

Two excellent pieces this week on the pointlessness of trying to predict where economies or markets are going – even if you’re engaged in active investing.

On the first point, Nick Kirrage of the Value Perspective served up a thought experiment:

[Imagine it’s January 2009 and…] I am prepared to answer any macro question you want to ask. Then you can decide on your investments and, rather than waiting five years, I will give you a lift in the time machine and we will see how you have done.

“Fair enough,” you say. “What happened to house prices?” “Well,” I reply. “We saw a really nasty step down and then they pretty much went sideways for five years so, in real terms, you lost maybe 15% or 20%. Things have been picking up a little bit recently but they are still not great.”

“All right,” you nod. “What happened to banks?”

“Well, it hasn’t been pretty,” I reply. “There was the personal protection insurance mis-selling and Libor scandals, the euro was on the brink of collapse for much of the period and we saw a double-dip in the UK economy that almost turned into a triple-dip. At the risk of repetition, things have been picking up a little bit recently but they are still not great.”

“OK, last question,” you say. “What about the consumer and the high street?” “Basically, it has been a series of insolvencies,” I reply. “Blacks, Comet, Peacocks – just one business after another. The consumer has been trying to pay down debt but has not really managed it and is still very much in the red. No two ways about it, it has been brutal.”

It’s very unlikely that you’d have bought shares – especially housebuilders, banks, and retailers – based on that hypothetically certain forecast.

Yet many companies in these sectors have delivered superb returns since then and the FTSE 100 is up 70% or so, with dividends. Only paying attention to the fear prevailing in the market and the consequently cheap valuations could have helped you from a timing perspective.

Morgan Housel makes a similar point for the US Motley Fool, urging investors to stop paying attention to useless numbers:

One of the most dangerous things you can do is pretend the economy, or the stock market, is simple and easy to understand. It causes you to see patterns that are really just random flukes, and wrongly assume that if one lever is pulled over here, something predictable will happen over there.

This is one reason clueless, passive investors often outperform professional ones. Clueless investors aren’t tempted by false-insight masquerading as brilliance.

For most people, passive investing via index funds is an easy way to avoid the traps of market timing, misreading the runes, or reading stupid permabear-ish blogs that will one day be right, only in the same way Cliff Richard gets a hit single every two decades.

[continue reading…]

Don’t hold your breath waiting for a perpetual motion machine. According to the first law of thermodynamics, energy cannot be created or destroyed, only transformed from one form to another.1

Many have claimed over the centuries they can beat the law of the conservation of energy.

But today’s physicists scoff. We’re wedded to the laws of thermodynamics and the principles of entropy.

A schoolchild could see the flaws in the first perpetual motion machines, but even modern theoretical ones have been debunked.

There are always energy inputs and outputs the inventor overlooked.

Risks, rewards, rows, and rip-offs

I see parallels with investing, and especially with risk.

Whenever a row flares up about the merits of some particular asset class, often someone is really just expressing a preference for one type of risk over another.

Often the most vocal are only revealing what they don’t know, or at least under-appreciate. But at their worst, they’re as misleading as a batty inventor hawking Newton’s cradle as the solution to clean energy.

Financial firms exploit the confusion, too, for example by peddling structured products. They’ll sell you a guaranteed equity bond – that isn’t a bond, and perhaps isn’t even guaranteed.

The most complicated ones mix several indices or stocks to produce something so opaque you might as well buy magic beans. They also introduce counterparty risk, since they’re based on derivatives backed by investment banks.

Even professionals struggle to evaluate the risks. What hope do we have?

I’ve explained how to construct a DIY version of such a bond if you’re curious2.

The point though is that structured products are risk transformation machines. They are marketed as reducing risk (“guaranteed!” “bond!”), but in reality they swap one risk for another – including the risk that a lot of your returns are going to end up in the provider’s back pocket!

The law of investing risk

For fun, we might write the first law for investing to state:

“Investing risk cannot be created or destroyed. It can only be transformed from one form of risk to another.”

Note I don’t mean this to be literally true. For a start, diversification provides a ‘free lunch’ that does reduce risk.

I’m also not saying some investments can’t be riskier then others.

True, we can’t really quantify risk (which is why academics turn it into volatility, which we can) so it’s hard to say whether, for example, swapping blue-chip shares for growth stocks is riskier for a particular individual. Especially as it’s impossible to divine the future, or even to value the market – let alone consider a parallel universe where things played out differently.

The chances you’ll do worse holding growth shares might be much higher than if you’d invested into an index fund, but the returns if they do well could be greater. Academic studies show value shares have usually beaten growth shares, but they might not for you.

And that’s critical. We never truly know the odds.

You might say, “Well, I’d rather have the surer returns from an index fund to the uncertain returns from a bunch of small cap stocks” and that’s sensible.

But understand you have given something up – the “risk” of doing better from the riskier offering.

Nobody knows

Another example: Try suggesting it’s okay for some people to hold a slug of government bonds.

Then duck.

Critics don’t like the idea of holding bonds, because they see them as priced for a certain fall3. Bonds have been through a 30-year bull market, and the yields are very low. It seems likely that yields will go up, depressing prices. That makes bonds riskier in their view.4

If you think a 0.25% real return on a ten-year bond is not worth the risk that inflation will be higher and your return negative, you may choose to sell your bonds.

But risk has not been eliminated. It has merely been transformed.

If you go 100% into shares, you swap the seemingly high risk of low returns from bonds for the possibility of doing much better, but also the chance that some years your share portfolio may fall 40%. That’s unlikely to happen with bonds.

Similarly, some people say “deflation is dead” and that you should only own hard assets, such as shares, property, or gold. No bonds or cash.

They might be right or wrong. We don’t know that they will or won’t be. We can’t invest in counterfactuals, only the reality that unfolds over time, and this uncertainty means most of us should spread our bets by spreading our risks.

A Japanese investor in 1989 might have thought deflation was dead. Yet that’s what she got for 20 years.

You think a low return from bonds is much likelier than deflation? So do I. But you’re taking on new risks if you swap all your bonds for equities.

Risk transformers: Dangers in disguise

I could go on – and if you were at the worst dinner party of your nightmares, perhaps I would.

So let’s end with a few more examples of the transformation of risk:

• You want excellent returns ASAP, so you put all your money into momentum stocks. For a while you outperform, then the market tanks.

• Dismayed, you switch to a diversified portfolio. Volatility is reduced, and sure enough your portfolio returns 6-10% a year. However after three years you calculate you would have doubled your money if you’d stuck with your beaten up growth shares.

• You decide you have zero risk tolerance, so you only save in cash. The cost of peace of mind is the risk of not having enough money to retire on because the returns from cash are so low.

• To boost your returns, you lock your cash away for five years at a slightly higher interest rate. But have you remembered the time value of money?

• You want an income in retirement so you buy dividend-paying stocks. You get a rising income. However you overpaid for your shares during a period of dividend mania, and your portfolio’s value lags the index. (You don’t mind? Great – it was the right transformation for you.)

• You’re a fund manager who will be fired if you fall behind your peers. So you mimic the index, swapping career risk for the risk of short-changing your clients.

• You hate the UK economy so put all your money in Japan. It does well, but you forgot about currency risk. Your returns are halved. (Or maybe doubled!)

• You don’t like owning property shares so you invest in a buy-to-let. You’ve swapped stock market volatility for concentration risk, as well as the risk of having less free time. (You’re hit in year two with a bill to replace the roof, or you take a tenant to court.)

• You think shares are too risky so you give your money to a manager who mysteriously returns 10% every year. Oops, he was Bernie Madoff!

• You and your Nobel Prize winning buddies make steady returns whatever the market through arbitrage. You’ve swapped short-term volatility for modest but positive returns, as well as the risk of catastrophic failure – but you don’t realise that, because it’s not in your model. Catastrophe occurs, and your fund, LTCM, goes bust.

The list is endless.

At your own risk

I’m not saying there’s no case for making judgments about what risks are right for you, or even that some kinds of risks aren’t better compensated than others – such as the return premiums that have stood the test of time.

Also, my First Law of Investing Risk is for fun, not meant as a genuine principle of finance. (My real first law is every investment can fail you.)

The takeaway is an old one: If something looks to good to be true, it probably is. Look for the hidden risk!

Now, where did I put my electromagnets? I’m bored of these soaring energy bills, and I have an incredible gadget in the cellar…

1. Note to the scientifically minded: This is a bird’s eye view for the purposes of an investing metaphor. Unlike a hypothetical ‘isolated system’, a blog article is not perfect or complete. [↩]
2. It’s harder now with low interest rates. [↩]
3. I happen to think bonds are likely to do poorly from here, too. But that’s not the whole picture. [↩]
4. Some have even called them riskier than equities, which in my opinion is misinformation of the ‘not knowing what you don’t know’ variety. [↩]

Remember the rules of thumb that advise shrinking your equity allocation as you age in retirement? Well, a radical paper from two US retirement research experts, Wade Pfau and Michael Kitces, threatens to turn that advice on its head.

Their research suggests that investors may actually be better off increasing equity exposure during retirement.

In the world of retirement planning that’s like walking into the medieval Vatican and claiming that the Earth is not flat, that it does indeed revolve around the sun and, by the way Popey, women would make very good priests.

Sequence of returns risk

The conventional approach of decreasing your equity allocation in retirement is meant to protect you from big bear markets. The idea is to cut the risk of your portfolio evaporating when you have fewer years left and can’t wait for a market recovery.

But the biggest threat to a successful retirement is a long run of bad returns in the early years, otherwise known as sequence of returns risk.

A combination of a lost decade and having to sell equities at low prices in order to live can diminish your portfolio – to the point where it won’t recover even when the salad days return.

U-turn if you want to

The contrary approach being advocated by Pfau and Kitces builds in sequence of return risk protection, according to their results.

In this analysis, your equity allocation is trimmed in the run up to retirement as normal. But then, instead of continuing to cut shares out of your life like so many Mars Bars, you gradually increase your intake – post-retirement – for so long as ye shall last.

The authors call this a rising equity glide path and envisage a lifetime allocation to equities that resembles a U shape.

The range of outcomes once retired for the rising glide path boil down to two main eventualities:

Scenario #1: A poor stock market followed by an upturn

Part one: Bad stock market returns early on: The majority of your portfolio is in fixed income assets i.e. bonds, cash and/or annuities. You don’t permanently damage your portfolio because your living expenses are mostly paid from the fixed income, so you don’t have to sell equities at low prices.

Part two: Stock market returns recover later: Equities should eventually bounce back due to mean reversion. Because your equity allocation is increasing, you benefit from pound-cost averaging – buying low and selling higher. These gains carry you to safety, making up for the ground lost in the early years. (By contrast, a strategy that requires you to sell equities at this time chokes off the upside, increasing the chances of you running out of money.)

Scenario #2: A good stock market followed by a bad one

Part one: Good stock market returns early on: Your portfolio grows well beyond the amount you need for a happy retirement. At this point you could decide to protect your winnings and move into less risky assets, knowing your retirement is secure (unless you marry a Kardashian).

Part two: Poor returns later: In most scenarios the portfolio swelled so much in the golden years that it’s still able to sustain your life style as your clock runs down, even if (/when) the market eventually turns lower.

Of course, other things could happen, too.

• The market could be great for decades: If the market smiles upon your entire retirement then who cares how rich you are when you die? (My postal address is available on request, and I currently accept bequests…)

• The market could be bad and stay bad: If your fate is nothing but lost decades then we’re all in trouble. At least your early (and traditional) heavy fixed income allocation starts you off on the right foot.

So what should I do?

You can find out how all the scenarios play out in detail by reading the research paper and Kitces’ excellent précis.

To give you a flavour, they researchers find that the chances of not running out of money at a 4% withdrawal rate are optimised when:

• Equity allocation at the start of retirement is 20 – 40%.

• Equity allocation at the end of 30 years is 60 – 80%.

The percentages change according to each scenario’s assumptions based on differing withdrawal rates, returns, retirement lengths and objectives. The historical returns scenario favours an initial equity allocation of 30% and a final figure of 70%.

The authors suggest that the rising equity glidepath can be managed using a rule like rebalancing 1% of your portfolio per year from fixed income to equity.

The more downbeat the return assumptions1, the less difference a rising equity glidepath makes in comparison to conventional strategies.

In certain low-return scenarios, the results require investors to think about what they fear most – missing their target income goal, or missing it by miles.

If you’re dead set on reaching an ideal income goal then you need a high equity start and end point. Essentially you’re gambling that equity returns turn out favourably, but you could suffer if they don’t.

If you choose a low equity start and end, then you limit the chances of a big shortfall but increase the probability that you will run out of money before the end of your retirement. (In other words, you’re not heavily exposed to a major fail scenario for equities that means you burn through your capital very quickly, but by the same token you’re not exposed to a major success scenario either).

Tricky.

Why can’t it be simple?

It seems the debate on the best retirement strategy is far from over.

When I first started investing, I clung on to rules of thumb as beacons of certainty that I could navigate by. But it’s obvious now that there is no single rule of thumb that everyone can abide by and expect to live happily after.

Certainly simpler strategies exist, and rules of thumb can help us manoeuvre into the right areas, but it is in our nature to want to optimise our approach.

Rising lifespans throw another Zimmer frame into the traditional machinery of pension planning, too.

Pfau and Kitces acknowledge there is plenty more work to be done refining their analysis. Other researchers may well counter or improve upon their findings.

But what makes this research so exciting is its potential to cave in the calcified assumptions of old while helping us achieve better results just when we need them – in the future.

Take it steady,

The Accumulator

1. The study uses historical returns as well as a more conservative set designed to mimic the possibility of the ‘new normal.’ [↩]