Good reads from around the Web.
Most of us know that investing works best when it’s a long-term project.
But too many people don’t appreciate that a long-term view doesn’t mean you’re guaranteed to do well, especially with an equity-heavy portfolio.
I’ve written before about sequence of returns risk, which is the danger that you’ll be unlucky and see your share portfolio plunge just before you’re set to stop contributing and to start living the high life.
What’s so hateful about this risk is that you can spend your life being the smuggest sensible investor on the block – admirably tuning out the market noise and boasting about your puny fees at parties, if you’re lucky enough to go to those sort of parties – and then wham…
…the market crashes. Overnight that annoying cousin who pumped all his money into buy-t0-let gets the All You Can Eat Deal at the retirement cafe, and you’re left hunting for bargains at Aldi.1
The incomparably consistent Morgan Housel expanded on this risk for the Motley Fool US, with the following striking graph:
US data from Robert Shiller and Morgan Housel (Click to enlarge)
Housel writes:
What amazes me is that these hypothetical investors would be considered some of the smartest around, investing steadily every month no matter what the market was doing, for decades on end.
Doing this is emotionally taxing, and few investors can keep it up over time.
In the real world, investors are more likely to buy after stocks have boomed, and to sell after a crash — which devastates returns.
Yet even with hypothetically perfect behavior, the difference in results between investors born in different generations can be the difference between no retirement and a lavish retirement.
And it’s mostly a factor of luck.
It is indeed striking to see the big differences in outcome, and it demonstrates exactly why different generations talk so variously about a particular asset class.
For instance, most people who invested through the 1980s and 1990s know little of the 1920s or 1930s – the UK market went up roughly sevenfold over the former period, and bonds did well too. Anyone who retired in the mid-to-late 1990s is likely to be an evangelist for long-term investing, but if you retired in 2008 you might have a different view.
Similarly, London property has been a winner for so long that people have forgotten it once fell in value. And people forgot in the 1990s that gold sometimes shines, to the extent that few people cared less when the UK government started flogging it off for a pittance.
Don’t be a loser
The only way to avoid being at the mercy of this rollercoaster ride is diversification across asset classes.
In particular, to avoid a catastrophic outcome you need to temper down any full-on enthusiasm for equities at least a couple of decades before you stop contributing money and start to make withdrawals.
That doesn’t mean abandoning equities or market timing, or anything like that. It means that a 100% equity portfolio should be at most a 50-80% equity portfolio say 20 years before your ‘date’, and you should rebalance from there as required.
I think rough bands are fine, incidentally– it’s better to be approximately right with this stuff then precisely wrong. And as far as I’m concerned the rest of the money can be in cash, given the weird situation at the moment, provided you’re prepared to chase higher rates. But of course classically it should be in bonds, and that’s the way to head if and when rates normalise.
Either way, you’re protecting yourself from the risk of a stock market that crashes and takes 15-20 years to get back to where it was.
If that seems fanciful, look at a graph of the FTSE 100 or Japan’s Nikkei 225.
Aim for a good result, not the best result
Sometimes diversification and rebalancing actually increases your returns, as an article from A Wealth of Common Sense this week showed:
But more often you’ll do slightly worse because you diversified. That’s the price of ensuring that you don’t do really, really badly.
Rebalancing is key, as Common Sense author Ben Carlson concludes:
In almost half of all annual periods you had a loser in the group. Each of these losses created opportunities to rebalance to boost future returns. And even though there were plenty of down years for each fund, the portfolio as a whole was still positive over 70% of the time.
The biggest risks in investing are like icebergs – they’re hidden in the long-term, beneath the chop of short-term movements.
Don’t hit an iceberg!
From the blogs
Making good use of the things that we find…
Passive investing
- The “Larry Portfolio” [Small cap tracker and government bonds!] – Mint
- An inside look at the financial media – Canadian Couch Potato
- Do you really know your risk tolerance? – Canadian Couch Potato
- Confessions of an index investor – Rick Ferri
- Beware squirrely risk assessment – Think Advisers
Active investing
- 6 signs of a good investing process – Clear Eyes Investing
- The US oil sector: An introduction and history – Millenial Invest
- A high-yield portfolio works [Yep!] – Total Return Investor
- Emerging markets have room to run – Ben Carlson @ Yahoo
Both/other stuff
- Tuning your mister or missus for financial freedom – Mr Money Mustache
- Squeeze the cheese, reduce the fees – Under the Money Tree
- Exploring changes to the UK pension system – Retirement Investing Today
- A tribute to Milton Friedman – Calafia Beach Pundit
Product of the week: Most lenders are hiking mortgage rates, but Yorkshire Building Society has just cut its two-year fixed rates to 1.74% (with a 40% deposit) and 1.99% (25%), both with a £975 fee. ThisIsMoney says that compares well to the competition.
Mainstream media money
Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.2
Passive investing
- Warren Buffett’s love/hate affair with index funds – Motley Fool US
- Fund fees are falling, but there’s a catch – Roth/CBS
- Buy and hold is impossible [Really?] – Marketwatch
Active investing
- When entertainment passes for investment advice – Bloomberg View
- 5 lessons learned eating lunch with Tom Gayner – Motley Fool US
- Why you stink at market timing – Consumer Reports
Other stuff worth reading
- John Bogle: The future of investing [Search result] – Wall Street Journal
- When competition obscures financial goals – New York Times
- Beware of buying a buy-to-let in Detroit – The Guardian
- Taxman returns £4m [Only £4m? I say good work HMRC ] – Telegraph
- Council tax: How does your bill compare? – Telegraph
- How to earn cashback from all sorts of purchases – ThisIsMoney
Book of the week: I think most active investors should read less about share price moves and more about business. If that sounds boring, try the inspiring Creativity, Inc.
Like these links? Subscribe to get them every week!
- Okay, so I already hunt for bargains at the supermarket. But it’s fun because it’s a choice! [↩]
- Reader Ken notes that: “FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.” [↩]
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> The only way to avoid being at the mercy of this rollercoaster ride is diversification across asset classes.
I disagree that it’s the only way. Your proposed solution indeed shows the other way. Diversification across time. You got into the market over decades. It doesn’t seem hopelessly unreasonable, assuming you are crystallising your equity savings to buy an annuity which is passe these days, to take yourself out of the market over the preceding 5/10 years, moving the assets to less risky/differently risky classes. You are using bonds as a proxy for the notional ‘risk-free asset’ though hyperinflation would give the lie to that, but in current conditions the approximation is okay-ish.
This is usually seen as diversifying in asset classes, but it’s also diversifying your risk profile across time into what’s considered a less risky and less voltaile asset class. Stock market falls are usually temporally steeper that market rises, and this temporal asymmetry makes sense to smooth it across the time axis as well as the asset class axis.
Of course another way open to people now is to use drawdown and intelligent management of your discretionary spend. Draw down more and to the round the world trip at market highs and spend less in lows. But that does demand more intestinal fortitude; I’m not sure the annuity is dead yet.
Another way to get that temporal diversification is to annuitise in five-year stages post-retirement, though costs of annuities mean doing that in lumps of < 50k is cost-prohibitive
@Ermine — Did you look at the graph above? 🙂 Time doesn’t save you from the extremes. If you’re saying “take money out” over time then you are actually diversifying across asset classes — the “in the stock market” asset class, and the “whatever it is that isn’t the stock market” asset class.
Quite a bearish post so a change of opinion perhaps?
As I’ve been lucky (oh sorry, a shrewd investor) over the past 25 years I’ve been inclined to take some risk off the table myself these last few years while still keeping some money in the game
To me the premium for taking risk (high yield bonds, long term gilts, peer to peer lending, buy to let or whatever) just doesn’t seem to be worth the downside
@Neverland — Not at all, we’ve been writing about diversification for six years, and sequence of return risk for at least four.
I’ve been known to go *over* 100% allocated to equities, but it was with my eyes absolutely wide open and aware I was taking a big risk, and with my active investing hat on (and I haven’t been positioned like that for at least a couple of years!)
That said when I began investing over a decade ago, I really had no concept how bad truly bad spells could be. Few people probably suffer that illusion now, but as the bull market (essentially) rolls on for the next 5-10 years (most likely) then that obliviousness will build again.
Good work on “winning the game” as one of the US writers say (I forget which one!)
I thought this might interest you.
http://ftalphaville.ft.com/2014/08/01/1914342/the-hare-gets-rich-while-you-dont-back-the-passive-tortoise/
How does one diversify one’s way around this?
http://www.marketwatch.com/story/the-biggest-retirement-risk-no-one-talks-about-2014-05-08
Annuities?
I came across these two posts this week and I thought that they were a worthy addition to some of your excellent posts on sequence of returns risk.
http://mobile.nytimes.com/2014/07/26/upshot/why-a-soaring-stock-market-is-wasted-on-the-young.html?referrer=
http://mobile.nytimes.com/2014/07/26/upshot/in-investing-when-matters-just-as-much-as-what.html?_r=0&referrer=
@TI but does not the graph above predicate coming out of the market all of a sudden? The original article doesn’t explicitly say that, but it seems to be implied in the ended up bit
as well as
You get in gradually. And you dive out at 65 all of a sudden, snapshot, bingo however the cards fall. Particularly with that asymmetric steepness of bear markets it’s barmy. If you could get in all at once and exit over a working lifetime that would suit the stats more, but life ain’t like that. I still think there’s the case to be made to get in slowly and get out slowly. At least over a period covering more than a business cycle of about 10 years. That will be easier with the longer working lives of the more longer-lived generations to come.
@ermine — It does I think, yes. But as I say above, what you’re saying is “chance it early perhaps but diversify later”.
“Getting out of the market gradually” as you’re suggesting is equivalent to a rule like ‘120 minus your age’ in equities and the rest in bonds. 🙂
I’m not disagreeing with your proposed solution, I’m just arguing it’s the same solution. 🙂
I like your point about aiming for a good result, not the best result. I use this method to make a lot of my choices. Going for something I think is highly likely to turn out well, rather than a risky thing which could be the best of the best has worked out well for me so far!
depressing but realistic article .
when a the stock market crashes[ unhappy face] do you still take an income from your stock portfolio say 4% of what the balance is at that time or not ? or leave it alone and instead live off your cash and bond investments ?
you also say the bull market may continue for the next 10- 15 years? [hope so] but a crash is coming at some point.
with this I keep thinking a HYP of income paying blue chips may be a better option as it wont matter if the underlying value of the shares drops to half but your getting an income! . with about 10 years to go for me and only part my money invested at the moment I keep considering HYP. as trackers will just half in value in a crash .
@Dawn — I said 5-10 years. 🙂 And there will definitely be corrections along the way. It’s obviously just a hunch, and could easily be wrong. I just feel after the past 15 years we’re likely due a good run.
Yes, I like income strategies for the reason you state. Downside is you need a lot more capital. Search for One Number To Beat in search box top right.
thankyou for responding.
I suppose the figures we are looking at is £200,000 capital invested in blue chips with about 5% dividened would bring in £10,000 pa income.
I like a tracker fund for emerging markets and one for US & Europe because buying individual shares from these regions would be difficult and exposure to them I think is good but im leaning towards the rest of my portfolio as HYP . this would exclude exposure to UK small and mid caps unless I got ftse 250 tracker at some point but as your recent post suggests this group has had a very good run recently and might be about to hit a downturn.
@The Investor
‘I just feel after the past 15 years we’re likely due a good run.’
OK so the UK market has oscillated sideways for 13+ years.
But starting from an All Share Yield of ~2% in Dec 99 we now see a yield ~3.3%.
Would you go so far as to say at that ~3.3% level the UK market now offers attractive valuations?
Just to add, very much concur with the main thrust :-
‘Don’t be a loser
The only way to avoid being at the mercy of this rollercoaster ride is diversification across asset classes.’
@magneto — ‘Meh’ valuation, rather than actively attractive. You need to adjust for buy backs and to some extent rates, too, as the yield is better by those lights than it looks (one can debate how much better, but certainly different to 1999 when you could get 5-6% on risk free cash as an alternative!) Plus 1999/2000 was 5-6 years into economic expansion, so less upside likely to come from growing earnings.
This stuff is all guesswork though, and is best ignored by most investors. 🙂
Thought provoking, although is think worth bearing in mind that these are the extremes in the chart, ie when you either got really lucky or really unlucky. In life sometimes you just have to hope that ‘ok you probably won’t get the former but fingers crossed you won’t get the latter either’.
At least of you do everything right and fate deals you a bad hand, you will know that you tried and it wasn’t your fault.
I think this is a very important bit in Housel’s original post.
‘In all the red scenarios above, holding stocks for just a few years longer would have dramatically improved returns. Without the ability to hold out a few years for a recovery, your experience as an investor relies on luck. And good luck with that.’
That ability to realise now is a bad time to cash I’m the chips and hold on for five years or so longer is an important insurance to keep,up your sleeve.
Which is probably another way of saying the asset diversification bit.
Apologies for those typos above, damned predictive iPad.
Thanks for the sobering post to burst our bubbles and give us all a reality check!
Ok, so I’ve got to ask.. Is there anything that looking at CAPE10 could had done to help the worst scenarios?