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In a comment to June 19’s post, Anonymous asked what I mean by “pure” annuity. “Pure annuity” is not a term of art, I’m afraid. I made it up. Forgive me for not defining my terms.
What I meant by “pure” annuity is an annuity that pays an agreed annual payment, beginning at an agreed starting date, either for your life, or for the life of you and your spouse. It is “pure” in the sense that it does not contain the following features:
• Payment does not vary with the performance of some asset class, such as with the S&P 500 index; that’s called a “variable” annuity. In my mind, however, an annuity that varies with an inflation index is an acceptably pure annuity.
• Payment is not guaranteed for a minimum period, such as 10 years, should you not live that long. It’s purely for your life. In my mind, however, an annuity that continues for the life of your spouse, should he survive you, is pure enough. Most couples properly view themselves as a single economic unit.
I’m no expert on annuities. I know what I like about them in concept, but I don’t know enough about them to know when they’re a good deal or a rip-off. For a good informative website about annuities, go to AnnuityDigest.com.
Showing posts with label Investments. Show all posts
Showing posts with label Investments. Show all posts
Monday, June 29, 2009
Sunday, June 28, 2009
TIPS and Losses
In a comment to June 24’s post, Paul asks a good question: Can “investing in TIPS lead to zero possibility of losses over any and all time periods?”
I think the answer is “no,” but perhaps it depends on the way you look at it. Here are the dangers of TIPS.
Treasury Inflation Protected Securities, or TIPS, are issued by the U.S. government and backed by the full faith and credit of the United States. That means the likelihood of default is close to zero. Not zero, but close to zero. We think of default by the U.S. Treasury as inconceivable, but perhaps it’s more accurate to characterize it as inconceivably bad, rather than inconceivable.
Another obvious danger of TIPS derives from the manner in which it is adjusted for inflation. The Treasury increases the principal value each year to reflect changes in the Consumer Price Index. But the CPI is an imperfect measure of inflation. It’s made up of changes in the prices of a typical basket of goods and services. But a “typical” basket ain’t your basket. The goods and services in the CPI are not necessarily those that you need; nor are they necessarily measured in your part of the country. I don’t foresee the day when the Treasury starts publishing “CPI-Paul.”
Perhaps the most important point to recognize about TIPS and losses is this: Like other bonds, TIPS can gain or lose value in the marketplace. You likely won’t lose principal, but you can lose value. Those are two different things. TIPS are subject to the same laws of supply and demand as other securities. With the government backing of their principal, and their inflation protection, TIPS ought to be less volatile than stocks or other bonds. And I imagine they are, although I have not confirmed that. (Maybe someone reading this post has looked at this. Anyone?) Less volatile, perhaps, but somewhat volatile nonetheless. The market value of TIPS is determined by millions of purchasers and sellers, each acting based on his own financial needs, opinions, and prejudices. So if you have to sell some TIPS to meet your need for cash, you will find that their value has gone up or down, notwithstanding their rather conservative nature. So there is quite a distinct possibility of losses.
You could minimize that possibility by buying TIPS with staggered maturities, so you never have to sell them; just wait around to collect the proceeds as they mature. But your ability to do that is limited by both the impossibility of predicting your future spending needs, and the fact that you simply can’t get TIPS of any maturity in any denomination you wish. They’re not that fine-grained.
So the bottom line is there is no hiding from the possibility of real losses, even with TIPS.
Besides, you would pay a steep price for that low probability of losses in the form of measley returns.
I think the answer is “no,” but perhaps it depends on the way you look at it. Here are the dangers of TIPS.
Treasury Inflation Protected Securities, or TIPS, are issued by the U.S. government and backed by the full faith and credit of the United States. That means the likelihood of default is close to zero. Not zero, but close to zero. We think of default by the U.S. Treasury as inconceivable, but perhaps it’s more accurate to characterize it as inconceivably bad, rather than inconceivable.
Another obvious danger of TIPS derives from the manner in which it is adjusted for inflation. The Treasury increases the principal value each year to reflect changes in the Consumer Price Index. But the CPI is an imperfect measure of inflation. It’s made up of changes in the prices of a typical basket of goods and services. But a “typical” basket ain’t your basket. The goods and services in the CPI are not necessarily those that you need; nor are they necessarily measured in your part of the country. I don’t foresee the day when the Treasury starts publishing “CPI-Paul.”
Perhaps the most important point to recognize about TIPS and losses is this: Like other bonds, TIPS can gain or lose value in the marketplace. You likely won’t lose principal, but you can lose value. Those are two different things. TIPS are subject to the same laws of supply and demand as other securities. With the government backing of their principal, and their inflation protection, TIPS ought to be less volatile than stocks or other bonds. And I imagine they are, although I have not confirmed that. (Maybe someone reading this post has looked at this. Anyone?) Less volatile, perhaps, but somewhat volatile nonetheless. The market value of TIPS is determined by millions of purchasers and sellers, each acting based on his own financial needs, opinions, and prejudices. So if you have to sell some TIPS to meet your need for cash, you will find that their value has gone up or down, notwithstanding their rather conservative nature. So there is quite a distinct possibility of losses.
You could minimize that possibility by buying TIPS with staggered maturities, so you never have to sell them; just wait around to collect the proceeds as they mature. But your ability to do that is limited by both the impossibility of predicting your future spending needs, and the fact that you simply can’t get TIPS of any maturity in any denomination you wish. They’re not that fine-grained.
So the bottom line is there is no hiding from the possibility of real losses, even with TIPS.
Besides, you would pay a steep price for that low probability of losses in the form of measley returns.
Wednesday, June 24, 2009
Stock Market Losses
In a comment to May 7’s post, David asked for some clarification. May 7’s post was about the frequency with which stocks and bonds have exhibited real (i.e., inflation-adjusted) losses over different time periods. It was noted that since 1926, the longest period it has taken stocks to recover their purchasing power after a loss was 19 years. Yes, unfortunately, that was a 19-year stretch; not 19 months. And yes, that means, had you been investing then, you might not have lived long enough to see your investments recover.
Let’s put that observation in perspective (especially since we’ve just been through a major down market in late 2008 and early 2009).
• 19 years is the worst so far. The one we’ve just been through might be even worse yet. History is just history; not a predictor of the future.
• If you’re focusing on worst case, bonds have exhibited even worse results. We have gone through a period where it has taken bonds 52 years to recover their purchasing power. There is no shelter from the storm.
• Take heart! Both stocks and bonds have been winners more often than losers. How much more often? It depends on the length of time you’re looking at, as shown in the graph in May 7’s post. In investing, time is your best friend.
• That particular measure—frequency of a real loss—is just one small aspect of risk and reward. It says nothing about how bad your loss might be. Nor does it say anything about the reward side: How large might you expect your gain to be.
Investment risk and reward is too multi-dimensional to capture in a single measurement. Take a look at March 16’s post for a refresher.
Let’s put that observation in perspective (especially since we’ve just been through a major down market in late 2008 and early 2009).
• 19 years is the worst so far. The one we’ve just been through might be even worse yet. History is just history; not a predictor of the future.
• If you’re focusing on worst case, bonds have exhibited even worse results. We have gone through a period where it has taken bonds 52 years to recover their purchasing power. There is no shelter from the storm.
• Take heart! Both stocks and bonds have been winners more often than losers. How much more often? It depends on the length of time you’re looking at, as shown in the graph in May 7’s post. In investing, time is your best friend.
• That particular measure—frequency of a real loss—is just one small aspect of risk and reward. It says nothing about how bad your loss might be. Nor does it say anything about the reward side: How large might you expect your gain to be.
Investment risk and reward is too multi-dimensional to capture in a single measurement. Take a look at March 16’s post for a refresher.
Friday, June 19, 2009
401(k) Investment Options
My friend David asked what I think of adding more participant investment options to his company’s 401(k) plan. He’s on his company’s 401(k) committee, and their investment advisor has recommended adding more options to the current array of 15. Additional fixed income options are on the table.
The easy, short, and largely correct answer is: If that’s what your professional advisor recommends, then do it. That’s what you pay them for.
But maybe David was looking for more substance than that rather facile response.
Initially my reaction is how can more choices ever be bad? If your 401(k) plan is thin on fixed income options, why not add one or two more? It’s always better for participants to have more choices, right?
Not always. Behavioral finance research (which I’m too lazy to look up and cite) has shown that offering too many choices can actually paralyze some people. When faced with too many confusing choices they can react by not choosing at all. In the context of a 401(k) plan, that might mean that their account defaults to some “safe” option determined by the plan, which in the past has often meant a money market fund. In the long run that's a bad choice. (That’s changing, as more and more plans move to a life-cycle fund as the default option.)
For some employees, 401(k) paralysis might be worse. It might mean that they're put off from making an elective deferral at all, which is an awful result.
So the desire to improve the array of options for the group should be tempered by the desire to limit 401(k) paralysis. How many employees can benefit by adding more refined asset classes, compared to how many will now suffer 401(k) paralysis? That’s not an easy question. For one thing, the more fine-grained the asset classes you offer, the fewer employees who can appreciate the subtle distinctions among them. My speculation is that with 15 options you’re getting to the point where only those employees who are receiving professional advice can actually benefit from more options.
Now, having nibbled around the edges of the question, I may as well offer a couple of substantive observations.
One: As long as you’re increasing your plan’s fixed income options, it would be a shame if you fail to offer a TIPS (Treasury Inflation Protected Securities) option.
Two: If you really want to do your employees a favor, offer them a pure annuity option. Not a variable annuity, but a pure annuity that they can add to on a paycheck-by-paycheck basis. This will enable those employees who long for a traditional pension to create one of their own within the confines of your company’s 401(k) plan. (For why I think annuities are valuable for a portion of one's retirement assets, see March 9's post and March 15's post.)
Thank you, David, for giving me the opportunity to shoot my digital mouth off.
The easy, short, and largely correct answer is: If that’s what your professional advisor recommends, then do it. That’s what you pay them for.
But maybe David was looking for more substance than that rather facile response.
Initially my reaction is how can more choices ever be bad? If your 401(k) plan is thin on fixed income options, why not add one or two more? It’s always better for participants to have more choices, right?
Not always. Behavioral finance research (which I’m too lazy to look up and cite) has shown that offering too many choices can actually paralyze some people. When faced with too many confusing choices they can react by not choosing at all. In the context of a 401(k) plan, that might mean that their account defaults to some “safe” option determined by the plan, which in the past has often meant a money market fund. In the long run that's a bad choice. (That’s changing, as more and more plans move to a life-cycle fund as the default option.)
For some employees, 401(k) paralysis might be worse. It might mean that they're put off from making an elective deferral at all, which is an awful result.
So the desire to improve the array of options for the group should be tempered by the desire to limit 401(k) paralysis. How many employees can benefit by adding more refined asset classes, compared to how many will now suffer 401(k) paralysis? That’s not an easy question. For one thing, the more fine-grained the asset classes you offer, the fewer employees who can appreciate the subtle distinctions among them. My speculation is that with 15 options you’re getting to the point where only those employees who are receiving professional advice can actually benefit from more options.
Now, having nibbled around the edges of the question, I may as well offer a couple of substantive observations.
One: As long as you’re increasing your plan’s fixed income options, it would be a shame if you fail to offer a TIPS (Treasury Inflation Protected Securities) option.
Two: If you really want to do your employees a favor, offer them a pure annuity option. Not a variable annuity, but a pure annuity that they can add to on a paycheck-by-paycheck basis. This will enable those employees who long for a traditional pension to create one of their own within the confines of your company’s 401(k) plan. (For why I think annuities are valuable for a portion of one's retirement assets, see March 9's post and March 15's post.)
Thank you, David, for giving me the opportunity to shoot my digital mouth off.
Tuesday, May 12, 2009
Magnitude of 12-Month Real Gains
Yesterday’s post explored one facet of risk: The potential magnitude of real losses you would have experienced over different time frames in past years with your stock and bond investments. It pays to know the extremes of bad outcomes you might expect, as that can help you select an appropriate asset allocation; you can then eliminate asset allocations with potential outcomes you simply could not stand.
But why are you looking at just the worst outcomes? What are you, some kind of paranoid? What about the best outcomes? Take a look at the right hand extremes of the charts in yesterday’s post. These endpoints represent the best historical real returns of stocks, bonds, and a 50%-50% mixture over different time frames.
To summarize, here are the historically best aggregate real returns between 1926 and 2008:
Over 12 Months:
Stocks: 182%
Bonds: 26%
50%-50% mixture: 99%
Over 60 Months:
Stocks: 347%
Bonds: 105%
50%-50% mixture: 157%
Over 120 Months:
Stocks: 473%
Bonds: 146%
50%-50% mixture: 216%
Of course, you don’t plan your future by looking at the rosiest outcome. To the contrary. You plan by eliminating options that carry a meaningful likelihood of disastrous results. But it’s instructive to understand the other extreme as well.
Two important caveats: (1) Future outcomes can certainly be worse than any experienced in the past. (2) The growth and shrinkage of your pot of retirement assets is something of a red herring. The right yardstick is the growth and shrinkage of your future annual spending. While the size of your pot is an important key determinant, it’s just a step on the road to what really matters: Your standard of living as reflected in the allowance you allow yourself, given the size of the pot. More to come on this in future posts.
But why are you looking at just the worst outcomes? What are you, some kind of paranoid? What about the best outcomes? Take a look at the right hand extremes of the charts in yesterday’s post. These endpoints represent the best historical real returns of stocks, bonds, and a 50%-50% mixture over different time frames.
To summarize, here are the historically best aggregate real returns between 1926 and 2008:
Over 12 Months:
Stocks: 182%
Bonds: 26%
50%-50% mixture: 99%
Over 60 Months:
Stocks: 347%
Bonds: 105%
50%-50% mixture: 157%
Over 120 Months:
Stocks: 473%
Bonds: 146%
50%-50% mixture: 216%
Of course, you don’t plan your future by looking at the rosiest outcome. To the contrary. You plan by eliminating options that carry a meaningful likelihood of disastrous results. But it’s instructive to understand the other extreme as well.
Two important caveats: (1) Future outcomes can certainly be worse than any experienced in the past. (2) The growth and shrinkage of your pot of retirement assets is something of a red herring. The right yardstick is the growth and shrinkage of your future annual spending. While the size of your pot is an important key determinant, it’s just a step on the road to what really matters: Your standard of living as reflected in the allowance you allow yourself, given the size of the pot. More to come on this in future posts.
Monday, May 11, 2009
Magnitude of 12-Month Real Losses
May 7’s post explored how frequently your investments might be expected to experience real (i.e., inflation-adjusted) losses after different lengths of time. The graph in that post showed, historically, how frequently investments in stocks, bonds, and a 50%-50% mixture of stocks and bonds have exhibited real losses over periods ranging from 12 months to 52 years.
Pretty good information. It provides you with a gauge of how frequently you might get scared. But there’s another dimension to consider. Just how scared will you get? Are we talking “Ghostbusters” or “Alien”?
The charts below attempt to give an idea of the magnitude of the real losses (and gains) that the markets have historically provided. Rather than the frequency of bad results, it measures their size.
The bottom chart summarizes the results over short (12-month) periods. As might be expected, stocks have been very scary over the short run, exhibiting the worst potential losses over 12-month periods—as bad as a 64% loss in value. In contrast, bonds’ worst 12-month real loss has been only 16%. A 50%-50% mixture of stocks and bonds resulted in a 27% worst-historical-case loss. The range between worst cases and best cases are shown in 10-percentile increments. (As with May 7’s post, I looked at all 12-month periods between January 1, 1926 and December 31, 2008. There have been 977 of them. For stocks, I used total return on the S&P 500; for bonds, intermediate term Treasury bonds; and for inflation, changes in the Consumer Price Index. In other words, the usual suspects.)
If you lengthen the period between measurements, ignoring interim ups and downs, things start to change. The middle chart shows the same data for 60-month (5-year) periods. Stocks still exhibit the potentially worst result, with a worst-case real loss during 1926-2008 of up to 51%, with bonds’ worst real loss over a 60-month period of 28%. With time, stocks' worst performance gets better, and bonds' worst performance gets worse. And the 50%-50% mixture of stocks and bonds now exhibits the best worst case, with only a 21% loss.
And if you lengthen it further to 120 months (10 years), the pattern continues to hold: A 50%-50% mixture of stocks and bonds has provided the least bad worst case, as shown in the top chart below.
By the way, those of us who suffered through 2008 will not be surprised to learn that between 1926 and 2008, the worst 120-month period for stocks, in terms of inflation-adjusted losses, was the 120 months from December 1, 1998 to November 30, 2008. Just thought you might want to know.
Pretty good information. It provides you with a gauge of how frequently you might get scared. But there’s another dimension to consider. Just how scared will you get? Are we talking “Ghostbusters” or “Alien”?
The charts below attempt to give an idea of the magnitude of the real losses (and gains) that the markets have historically provided. Rather than the frequency of bad results, it measures their size.
The bottom chart summarizes the results over short (12-month) periods. As might be expected, stocks have been very scary over the short run, exhibiting the worst potential losses over 12-month periods—as bad as a 64% loss in value. In contrast, bonds’ worst 12-month real loss has been only 16%. A 50%-50% mixture of stocks and bonds resulted in a 27% worst-historical-case loss. The range between worst cases and best cases are shown in 10-percentile increments. (As with May 7’s post, I looked at all 12-month periods between January 1, 1926 and December 31, 2008. There have been 977 of them. For stocks, I used total return on the S&P 500; for bonds, intermediate term Treasury bonds; and for inflation, changes in the Consumer Price Index. In other words, the usual suspects.)
If you lengthen the period between measurements, ignoring interim ups and downs, things start to change. The middle chart shows the same data for 60-month (5-year) periods. Stocks still exhibit the potentially worst result, with a worst-case real loss during 1926-2008 of up to 51%, with bonds’ worst real loss over a 60-month period of 28%. With time, stocks' worst performance gets better, and bonds' worst performance gets worse. And the 50%-50% mixture of stocks and bonds now exhibits the best worst case, with only a 21% loss.
And if you lengthen it further to 120 months (10 years), the pattern continues to hold: A 50%-50% mixture of stocks and bonds has provided the least bad worst case, as shown in the top chart below.
By the way, those of us who suffered through 2008 will not be surprised to learn that between 1926 and 2008, the worst 120-month period for stocks, in terms of inflation-adjusted losses, was the 120 months from December 1, 1998 to November 30, 2008. Just thought you might want to know.
Sunday, May 10, 2009
Annuities I’d Like to See
Yesterday’s post discussed the three main functions of that pot of assets you’ve accumulated toward your retirement. Since the mainest of the main functions is to provide you with a stream of retirement income for the rest of your indeterminate life, the purchase of an annuity with some of those assets theoretically serves that function quite well. Emphasis on the word “theoretically.” If only the absolute right insurance product existed! If anyone out there knows of a product that meets all of the following criteria, please post a comment or send me an email. And pass this post on to your insurance agent to get some additional professional perspective.
Longevity Insurance. According to some academics, the most efficient use of your hard-earned assets would be to use a small portion of them (I’ve seen estimates of 10% to 15%) to purchase an annuity that doesn’t start to pay you unless and until you reach an advanced age. Say 85. So the annuity is really a form of insurance. Longevity insurance. Some insurance companies, but not too many, offer annuities of this sort.
Buying a pure annuity requires a trade-off. You lose emergency access to the funds, and you eliminate your children’s inheritance. But you get something valuable in exchange: Every dollar goes toward providing you a lifetime allowance. So using only 10%-15% of your assets for this purpose sounds like a pretty good trade-off .
Inflation Adjustment. The ideal annuity/longevity insurance would have inflation protection by increasing annual payments by changes in the Consumer Price Index. Such a product exists (one is offered by AIG) in the world of immediate annuities, but not in the world of longevity insurance where payout is deferred 20 years or so. That would be nice to have.
Low Creditor Risk. Speaking of AIG, you want to buy an annuity only from a company that is superbly solvency. You’ll be relying on that solvency for a long long time. All states offer a guaranty fund in case an insurer goes belly up, but only up to stated limits which differ from state to state, and which may not cover your entire annuity.
Rate Risk. The annuity you’re able to buy will vary, largely with current interest rates, depending on when you buy it. For example, an article by Chen and Malevsky point out that $100,000 would have purchased a $1,150/month annuity in the 1980’s, but only about $700/month in 2003. That’s a 36% drop, just depending on what year you bought the thing. An ideal annuity product would allow you to buy a little slice of your longevity insurance each year during your working years—and beyond—in order to hedge against this fluctuating market.
Transparency. It’s hard to know whether you’re getting a good deal from your insurer. It would be nice if there was some uniform basis on which to compare similar, but not identical, products from different insurers.
If there were products meeting these criteria, maybe that would solve the "annuity puzzle," as it's been called: The mystery of why more people don't buy these things.
Any annuity you purchase ought to then have an impact on how you invest and spend the balance of your assets. Indeed, the same statement applies to your Social Security benefit and any pension you’ve earned. The existence of these largely-guaranteed streams of income can free you up for greater spending and a higher percentage of riskier higher-yielding investments.
All credit for some of the good ideas expressed in this post goes to discussions with my friends Peter (of Stembrook Asset Management) and Jennifer. All of the bad ideas, of course, are mine.
Longevity Insurance. According to some academics, the most efficient use of your hard-earned assets would be to use a small portion of them (I’ve seen estimates of 10% to 15%) to purchase an annuity that doesn’t start to pay you unless and until you reach an advanced age. Say 85. So the annuity is really a form of insurance. Longevity insurance. Some insurance companies, but not too many, offer annuities of this sort.
Buying a pure annuity requires a trade-off. You lose emergency access to the funds, and you eliminate your children’s inheritance. But you get something valuable in exchange: Every dollar goes toward providing you a lifetime allowance. So using only 10%-15% of your assets for this purpose sounds like a pretty good trade-off .
Inflation Adjustment. The ideal annuity/longevity insurance would have inflation protection by increasing annual payments by changes in the Consumer Price Index. Such a product exists (one is offered by AIG) in the world of immediate annuities, but not in the world of longevity insurance where payout is deferred 20 years or so. That would be nice to have.
Low Creditor Risk. Speaking of AIG, you want to buy an annuity only from a company that is superbly solvency. You’ll be relying on that solvency for a long long time. All states offer a guaranty fund in case an insurer goes belly up, but only up to stated limits which differ from state to state, and which may not cover your entire annuity.
Rate Risk. The annuity you’re able to buy will vary, largely with current interest rates, depending on when you buy it. For example, an article by Chen and Malevsky point out that $100,000 would have purchased a $1,150/month annuity in the 1980’s, but only about $700/month in 2003. That’s a 36% drop, just depending on what year you bought the thing. An ideal annuity product would allow you to buy a little slice of your longevity insurance each year during your working years—and beyond—in order to hedge against this fluctuating market.
Transparency. It’s hard to know whether you’re getting a good deal from your insurer. It would be nice if there was some uniform basis on which to compare similar, but not identical, products from different insurers.
If there were products meeting these criteria, maybe that would solve the "annuity puzzle," as it's been called: The mystery of why more people don't buy these things.
Any annuity you purchase ought to then have an impact on how you invest and spend the balance of your assets. Indeed, the same statement applies to your Social Security benefit and any pension you’ve earned. The existence of these largely-guaranteed streams of income can free you up for greater spending and a higher percentage of riskier higher-yielding investments.
All credit for some of the good ideas expressed in this post goes to discussions with my friends Peter (of Stembrook Asset Management) and Jennifer. All of the bad ideas, of course, are mine.
Thursday, May 7, 2009
Frequency of 12-Month Real Losses
April 28’s post and yesterday’s post explored the frequency with which your investment accounts might be expected to show real, inflation-adjusted losses. Let’s look at that from just one more perspective.
April 28’s post looked at calendar year periods of different lengths. But we can get a more robust sense of how long it might take for different asset classes to recover from real losses by looking at 12-month periods of all sorts—not just calendar years. After all, there have only been 83 calendar years between 1926 and 2008—the period studied—but there have been 988 12-month periods to pore over if we look at all 12-calendar-month periods (e.g., April 1 2008 – March 31, 2009) between January 1, 1926 and March 31, 2009.
The pattern we saw in April 28’s post holds. Take a look at the graph below. Historically, both stocks and bonds have recovered from real (i.e., inflation-adjusted) losses given enough time. The longer the period between measurements, the less likely your investment will have experienced a real loss. Stocks (the blue line) have taken as long as 19 12-month periods, and bonds (the red line) have taken as long as 52 12-month periods. A 50%-50% mixture of stocks and bonds (the green line) has taken up to 20 12-month periods, but overall has tended to suffer fewer losing periods than either stocks or bonds standing alone.
As in prior posts, I measured stock performance by the total return on the S&P 500; bond returns by the total return on intermediate term Treasury bonds; and inflation by changes in the consumer price index.
As previously pointed out, this is just one aspect of investment risk, and a rather narrow one at that. Stay tuned for more and different ways to wallow around in risk.
April 28’s post looked at calendar year periods of different lengths. But we can get a more robust sense of how long it might take for different asset classes to recover from real losses by looking at 12-month periods of all sorts—not just calendar years. After all, there have only been 83 calendar years between 1926 and 2008—the period studied—but there have been 988 12-month periods to pore over if we look at all 12-calendar-month periods (e.g., April 1 2008 – March 31, 2009) between January 1, 1926 and March 31, 2009.
The pattern we saw in April 28’s post holds. Take a look at the graph below. Historically, both stocks and bonds have recovered from real (i.e., inflation-adjusted) losses given enough time. The longer the period between measurements, the less likely your investment will have experienced a real loss. Stocks (the blue line) have taken as long as 19 12-month periods, and bonds (the red line) have taken as long as 52 12-month periods. A 50%-50% mixture of stocks and bonds (the green line) has taken up to 20 12-month periods, but overall has tended to suffer fewer losing periods than either stocks or bonds standing alone.
As in prior posts, I measured stock performance by the total return on the S&P 500; bond returns by the total return on intermediate term Treasury bonds; and inflation by changes in the consumer price index.
As previously pointed out, this is just one aspect of investment risk, and a rather narrow one at that. Stay tuned for more and different ways to wallow around in risk.
Wednesday, May 6, 2009
Frequency of Monthly Real Losses
April 26’s post explored the frequency with which your investment accounts can be expected to show real, inflation-adjusted losses. And the clear pattern was this: Look at your account annually, and it’s scary; losses are depressingly frequent. Stretch out your interval between measurements, and losses tend to melt away. Time—if you’ve got it—heals all losses.
What if you go in the other direction? What if you measure the progress of your investment account more frequently, rather than less? After all, who can resist reviewing their accounts frequently? As indeed you should.
Not surprisingly, it turns out the pattern holds when you shorten the interval to a month. The frequency with which investments have incurred monthly real losses is a bit greater than the frequency of annual real losses. Here are the results for the 999 months between January 1926 and March 2009. Stocks have suffered a real loss in value 41% of the time (compared to 33% calendar year losses). Bonds have suffered a real loss 44% of the time (compared to 39% calendar year losses). And a 50%-50% mixture of stocks and bonds has suffered a real loss 41% of the time (compared to 31% calendar year losses).
As in April 26’s post, stock performance is measured by the total return on the S&P 500, including appreciation, depreciation and dividends. Bond performance is measured by the total return on intermediate term Treasury bonds. And inflation is measured by changes in the consumer price index.
So what’s the message? Quoting the great philosopher, Betty Davis in “All About Eve”: “Fasten your seatbelts. It’s going to be a bumpy ride.”
What if you go in the other direction? What if you measure the progress of your investment account more frequently, rather than less? After all, who can resist reviewing their accounts frequently? As indeed you should.
Not surprisingly, it turns out the pattern holds when you shorten the interval to a month. The frequency with which investments have incurred monthly real losses is a bit greater than the frequency of annual real losses. Here are the results for the 999 months between January 1926 and March 2009. Stocks have suffered a real loss in value 41% of the time (compared to 33% calendar year losses). Bonds have suffered a real loss 44% of the time (compared to 39% calendar year losses). And a 50%-50% mixture of stocks and bonds has suffered a real loss 41% of the time (compared to 31% calendar year losses).
As in April 26’s post, stock performance is measured by the total return on the S&P 500, including appreciation, depreciation and dividends. Bond performance is measured by the total return on intermediate term Treasury bonds. And inflation is measured by changes in the consumer price index.
So what’s the message? Quoting the great philosopher, Betty Davis in “All About Eve”: “Fasten your seatbelts. It’s going to be a bumpy ride.”
Thursday, April 30, 2009
The Tax Cost of Turnover
Yesterday’s post discussed the costs of turnover in your account—the selling and buying of stocks. I thought it would be instructive to quantify the tax costs of turnover to see just how much it’s worth worrying about. It turns out that over time, the tax cost can be meaningful. Remember, this discussion only applies to taxable investment accounts, since turnover inside tax-favored retirement accounts is tax-neutral; it carries no tax cost.
Let me describe two little experiments. The first applies to those who are not yet retired and are still accumulating assets and the second applies to those who are in retirement and spending down their assets.
The first experiment. Picture a hypothetical person just like you (but not as good looking). At age 30, he’s got $1,000,000 of cash to invest, which he intends to invest 75% in stocks and 25% in bonds. His goal is to accumulate a retirement fund at age 65. Assume all gains are long-term capital gains, and there are no commission costs. Applying reasonable assumptions, with very modest turnover (1% per year, which is about right for an index fund), he can expect to accumulate $4,512,913 in real (inflation-adjusted) dollars, after taxes.
Now change just the turnover assumption to 70% annual turnover (not unusual for an actively managed stock fund). Capital gains tax costs lower the after-tax accumulation at age 65 to $3,677,357. That’s a 19% drop in the retirement fund, which would likely translate into a 19% drop in available retirement spending. Small costs add up!
Now the second experiment. Picture someone age 65, with a $5,000,000 taxable account. She plans to spend an amount which will leave her children with half her wealth remaining if she were to die 30 years hence at age 95. She plans to invest her account 50% in stocks and 50% in bonds. Assume only a modest 1% turnover, and her after-tax allowance from this taxable account is $208,050. Change that turnover assumption to 70%, and her after-tax allowance drops to $190,225. That’s a 9% cut in lifestyle.
Again, turnover matters.
Let me describe two little experiments. The first applies to those who are not yet retired and are still accumulating assets and the second applies to those who are in retirement and spending down their assets.
The first experiment. Picture a hypothetical person just like you (but not as good looking). At age 30, he’s got $1,000,000 of cash to invest, which he intends to invest 75% in stocks and 25% in bonds. His goal is to accumulate a retirement fund at age 65. Assume all gains are long-term capital gains, and there are no commission costs. Applying reasonable assumptions, with very modest turnover (1% per year, which is about right for an index fund), he can expect to accumulate $4,512,913 in real (inflation-adjusted) dollars, after taxes.
Now change just the turnover assumption to 70% annual turnover (not unusual for an actively managed stock fund). Capital gains tax costs lower the after-tax accumulation at age 65 to $3,677,357. That’s a 19% drop in the retirement fund, which would likely translate into a 19% drop in available retirement spending. Small costs add up!
Now the second experiment. Picture someone age 65, with a $5,000,000 taxable account. She plans to spend an amount which will leave her children with half her wealth remaining if she were to die 30 years hence at age 95. She plans to invest her account 50% in stocks and 50% in bonds. Assume only a modest 1% turnover, and her after-tax allowance from this taxable account is $208,050. Change that turnover assumption to 70%, and her after-tax allowance drops to $190,225. That’s a 9% cut in lifestyle.
Again, turnover matters.
Wednesday, April 29, 2009
Turnover
Turnover carries costs. I’m not talking about those flaky fruit-filled pastries that Pillsbury sells. I’m talking about the selling and buying of stocks in your investment account.
First, there are the obvious transaction costs. When you sell one stock and buy another, you incur a commission cost. Commission costs have gone down in recent years, but they’re still not zero. Then there’s the spread between the stock’s bid and ask prices, the difference between what buyers are offering to pay and what sellers are willing to sell for. That’s another cost.
There’s also a tax cost if your securities are in a taxable investment account: the capital gains tax you incur if the stock has appreciated. (This tax discussion does not apply to sales inside tax-favored retirement accounts like traditional IRA’s and Roth IRA’s. Which is why those types of accounts can make you a better investor, as described in April 20’s post.) For as long as you hold a stock, its appreciation is tax-free to you. You get to determine when to pay the tax on that appreciation by choosing when to sell the stock. You can defer tax by deferring the sale. In fact, under current law, if you delay long enough and die holding an appreciated stock, your heirs get a new tax basis equal to the stock’s value at the date of your death, so nobody ever pays tax on the appreciation. What a deal! Makes you feel kind of foolish, doesn’t it, for having sold that Google stock the week before you got hit by a bus. (The rule about disappearing gains at death is scheduled to change next year, but there’s reason to believe Congress might act to keep the old rule. Watch this space for developments.)
Under the circumstances, why have any turnover? Well, there are plenty of good reasons for turnover. First, you may own a stock that did well for a while, but which you think is no longer a good investment. Second, you may need to sell an appreciated stock to generate cash to meet your spending needs. You can’t eat appreciation. Third, you may need to sell an appreciated stock to rebalance your portfolio back to your desired asset allocation mix.
But just because you have to have some turnover does not mean it has to be excessive. You can be astute about how you manage your stock sales. You can wait until short-term gain has ripened into long-term gain (generally, after one year and a day), since long-term gains enjoy significantly lower tax rates. You can offset gains by also selling some depreciated stocks. You can arrange your stock sales to serve triple duty: investment changes, cash generation, and asset class rebalancing, all at the same time.
One easy way to reduce excessive turnover is to invest in index funds rather than actively managed funds. By their nature, index funds tend to have low turnover, since not too many stocks enter or leave the index. Conversely, actively managed funds tend to have higher turnover, as fund managers make frequent sell and buy decisions. An in-between approach is to select a tax-efficient stock fund, where the fund managers take tax costs into account as they make their sell and buy decisions.
Okay. So there’s a tax cost to turnover. Just how significant is that cost? More on that tomorrow.
First, there are the obvious transaction costs. When you sell one stock and buy another, you incur a commission cost. Commission costs have gone down in recent years, but they’re still not zero. Then there’s the spread between the stock’s bid and ask prices, the difference between what buyers are offering to pay and what sellers are willing to sell for. That’s another cost.
There’s also a tax cost if your securities are in a taxable investment account: the capital gains tax you incur if the stock has appreciated. (This tax discussion does not apply to sales inside tax-favored retirement accounts like traditional IRA’s and Roth IRA’s. Which is why those types of accounts can make you a better investor, as described in April 20’s post.) For as long as you hold a stock, its appreciation is tax-free to you. You get to determine when to pay the tax on that appreciation by choosing when to sell the stock. You can defer tax by deferring the sale. In fact, under current law, if you delay long enough and die holding an appreciated stock, your heirs get a new tax basis equal to the stock’s value at the date of your death, so nobody ever pays tax on the appreciation. What a deal! Makes you feel kind of foolish, doesn’t it, for having sold that Google stock the week before you got hit by a bus. (The rule about disappearing gains at death is scheduled to change next year, but there’s reason to believe Congress might act to keep the old rule. Watch this space for developments.)
Under the circumstances, why have any turnover? Well, there are plenty of good reasons for turnover. First, you may own a stock that did well for a while, but which you think is no longer a good investment. Second, you may need to sell an appreciated stock to generate cash to meet your spending needs. You can’t eat appreciation. Third, you may need to sell an appreciated stock to rebalance your portfolio back to your desired asset allocation mix.
But just because you have to have some turnover does not mean it has to be excessive. You can be astute about how you manage your stock sales. You can wait until short-term gain has ripened into long-term gain (generally, after one year and a day), since long-term gains enjoy significantly lower tax rates. You can offset gains by also selling some depreciated stocks. You can arrange your stock sales to serve triple duty: investment changes, cash generation, and asset class rebalancing, all at the same time.
One easy way to reduce excessive turnover is to invest in index funds rather than actively managed funds. By their nature, index funds tend to have low turnover, since not too many stocks enter or leave the index. Conversely, actively managed funds tend to have higher turnover, as fund managers make frequent sell and buy decisions. An in-between approach is to select a tax-efficient stock fund, where the fund managers take tax costs into account as they make their sell and buy decisions.
Okay. So there’s a tax cost to turnover. Just how significant is that cost? More on that tomorrow.
Tuesday, April 28, 2009
Frequency of Losses—Asset Class Mixture
Sunday’s post looked at one aspect of risk—a very narrow aspect, at that—and compared the riskiness of stocks and bonds. But of course nobody ought to have all of their retirement investments solely in one asset class or another. How risky is investing if your assets are in a mixture of stocks and bonds?
I’m glad you asked. The green line in the graph below builds on the information shown in Sunday’s post. It answers the musical question, “In the past, how frequently would you have experienced a real (i.e., inflation-adjusted) loss if your assets were invested 50% in stocks and 50% in bonds?”
As in Sunday’s post, the answer depends on how frequently you choose to measure your investment progress. Historically, a 50%-50% mixture of stocks and bonds has been slightly less risky—at least as measured by this particular and narrow dimension of risk—than either stocks or bonds standing alone. If you had looked at your investments every calendar year, your mixture would have shown a real loss during 31% of the 83 years studied. That is slightly better than 33% for 100% stocks and 39% for 100% bonds.
And, as with stocks alone or bonds alone, the green line shows a generally decreasing frequency of real losses as you increase the length of time between measurements. With a 50%-50% mixture, in the past 83 years there has been no period of 18 years or longer during which such a mixture exhibited a real loss.
Important: Note that the green line is mostly lower than either the blue line (100% stocks) or the red line (100% bonds). Which means that a nice mixture of stocks and bonds has proven less risky than putting all your eggs in one basket. At least as measured by this particular (and limited) facet of risk.
But, like a Batman villain, risk has many faces. More to come.
I’m glad you asked. The green line in the graph below builds on the information shown in Sunday’s post. It answers the musical question, “In the past, how frequently would you have experienced a real (i.e., inflation-adjusted) loss if your assets were invested 50% in stocks and 50% in bonds?”
As in Sunday’s post, the answer depends on how frequently you choose to measure your investment progress. Historically, a 50%-50% mixture of stocks and bonds has been slightly less risky—at least as measured by this particular and narrow dimension of risk—than either stocks or bonds standing alone. If you had looked at your investments every calendar year, your mixture would have shown a real loss during 31% of the 83 years studied. That is slightly better than 33% for 100% stocks and 39% for 100% bonds.
And, as with stocks alone or bonds alone, the green line shows a generally decreasing frequency of real losses as you increase the length of time between measurements. With a 50%-50% mixture, in the past 83 years there has been no period of 18 years or longer during which such a mixture exhibited a real loss.
Important: Note that the green line is mostly lower than either the blue line (100% stocks) or the red line (100% bonds). Which means that a nice mixture of stocks and bonds has proven less risky than putting all your eggs in one basket. At least as measured by this particular (and limited) facet of risk.
But, like a Batman villain, risk has many faces. More to come.
Sunday, April 26, 2009
Frequency of Investment Losses
There are many, many facets of investment risk and uncertainty. I catalogued a bunch of them in March 16’s post. Today’s post focuses on just one aspect of investment risk: How frequently can you expect to experience a loss?
First, let me narrow the inquiry. How frequently might you expect to experience a real, i.e., inflation-adjusted, loss? If you just look at the nominal value of your account, your perceived losses will be much less frequent. But we’re much too wise to ignore the hidden loss engendered by inflation. So we’ll ask the question “How frequently can you expect the inflation-adjusted value of your account to decline when you invest in different asset classes—stocks and bonds?”
Not surprisingly, the answer depends on how frequently you look at your account statement. The shorter the interval, the more frequent the incidence of real loss. Time erases all losses. Time also erases outsized gains, but that’s an inquiry for another day; today we look at losses.
If you look at your investment results every calendar year you’ll find that a sickeningly high percentage of the time you will have realized an inflation-adjusted loss. 33% with stocks and 39% with bonds. Where did these percentages come from? I looked at the 83 years from 1926 through 2008 (yes, that horrible 2008). For stocks, I measured the total return on the S&P 500; for bonds, I measured the total return on intermediate term treasury bonds; for inflation, I measured the change in the Consumer Price Index.
But if you expand the interval between measurements—increasing the interval from one year to every two years, things improve a bit. The percentage of losing periods drops to 27% for stocks and 32% for bonds. And so the trend continues, as shown in the graph below. Although the trend is more pronounced for stocks than for bonds. By the time your time horizon increases to 18 years, you find that stocks have not shown a real loss for any period of 18 years or longer between 1926 and 2008. For bonds, the magic number is somewhat higher—the interval has to be 50 years before you can say bonds have never exhibited real losses during the 83 years studied.
So time heals all losses. But there’s four hairballs on this particular lollypop: (i) the future might be worse than the past; (ii) you might simply not have enough time to recoup your losses; (iii) the scariness of the ride along the way (think 2008) might cause you to change your asset allocation in ways you’ll later regret; and (iv) the graph says absolutely nothing about the magnitude of losses, just the frequency. Magnitude is for another day.
First, let me narrow the inquiry. How frequently might you expect to experience a real, i.e., inflation-adjusted, loss? If you just look at the nominal value of your account, your perceived losses will be much less frequent. But we’re much too wise to ignore the hidden loss engendered by inflation. So we’ll ask the question “How frequently can you expect the inflation-adjusted value of your account to decline when you invest in different asset classes—stocks and bonds?”
Not surprisingly, the answer depends on how frequently you look at your account statement. The shorter the interval, the more frequent the incidence of real loss. Time erases all losses. Time also erases outsized gains, but that’s an inquiry for another day; today we look at losses.
If you look at your investment results every calendar year you’ll find that a sickeningly high percentage of the time you will have realized an inflation-adjusted loss. 33% with stocks and 39% with bonds. Where did these percentages come from? I looked at the 83 years from 1926 through 2008 (yes, that horrible 2008). For stocks, I measured the total return on the S&P 500; for bonds, I measured the total return on intermediate term treasury bonds; for inflation, I measured the change in the Consumer Price Index.
But if you expand the interval between measurements—increasing the interval from one year to every two years, things improve a bit. The percentage of losing periods drops to 27% for stocks and 32% for bonds. And so the trend continues, as shown in the graph below. Although the trend is more pronounced for stocks than for bonds. By the time your time horizon increases to 18 years, you find that stocks have not shown a real loss for any period of 18 years or longer between 1926 and 2008. For bonds, the magic number is somewhat higher—the interval has to be 50 years before you can say bonds have never exhibited real losses during the 83 years studied.
So time heals all losses. But there’s four hairballs on this particular lollypop: (i) the future might be worse than the past; (ii) you might simply not have enough time to recoup your losses; (iii) the scariness of the ride along the way (think 2008) might cause you to change your asset allocation in ways you’ll later regret; and (iv) the graph says absolutely nothing about the magnitude of losses, just the frequency. Magnitude is for another day.
Monday, April 20, 2009
The Better Investor Savings Bucket
There are many nice tax savings features of tax-favored retirement accounts—Individual Retirement Accounts, Roth IRA’s, 401(k) Plans, etc. And I’ve written a large number of posts about them. One of the subtler benefits of tax-favored retirement accounts compared to taxable investment accounts is how they make you a better investor.
Think about it. When you have your savings in a taxable investment account, the income tax consequences taints every investment move you make (or neglect to make).
• You tend to prefer tax-exempt municipal bonds over treasury or corporate bonds—so you don’t have to pay federal income tax on the interest.
• You tend to prefer your own state’s municipal bonds over your neighboring state’s, so you don’t have to pay state income tax on the interest.
• You tend to prefer stocks over bonds so you can benefit from temporarily tax-free appreciation and lower-taxed capital gain instead of taxable interest.
• You tend to prefer growth stocks over dividend-paying stocks for the same reasons.
• You tend to hold onto stocks that have substantially appreciated to avoid triggering a whopping capital gain.
• For the same reason, you tend to avoid rebalancing your mix of stocks and bonds to get back to your desired asset allocation.
• You tend to hold onto recently purchased stocks for longer than you might otherwise wish so you can turn high-taxed short-term gain into low-taxed long-term gain.
• As you age, you tend to hold onto highly appreciated stocks so your family can benefit from the increase in tax basis that occurs at death. Which some days feels like it’s just around the corner, doesn't it?
• When your stocks lose value, you tend to sell them prematurely for no other reason than to benefit from the tax losses.
All of these distortions in your thinking and acting just melt away when your investments are in a tax-favored retirement account. The shelter of its tax-exemption allows you to make the right investment decisions untainted by extraneous tax consequences. Goodness knows it’s hard enough to do that without the Tax Code breathing down your neck.
Think about it. When you have your savings in a taxable investment account, the income tax consequences taints every investment move you make (or neglect to make).
• You tend to prefer tax-exempt municipal bonds over treasury or corporate bonds—so you don’t have to pay federal income tax on the interest.
• You tend to prefer your own state’s municipal bonds over your neighboring state’s, so you don’t have to pay state income tax on the interest.
• You tend to prefer stocks over bonds so you can benefit from temporarily tax-free appreciation and lower-taxed capital gain instead of taxable interest.
• You tend to prefer growth stocks over dividend-paying stocks for the same reasons.
• You tend to hold onto stocks that have substantially appreciated to avoid triggering a whopping capital gain.
• For the same reason, you tend to avoid rebalancing your mix of stocks and bonds to get back to your desired asset allocation.
• You tend to hold onto recently purchased stocks for longer than you might otherwise wish so you can turn high-taxed short-term gain into low-taxed long-term gain.
• As you age, you tend to hold onto highly appreciated stocks so your family can benefit from the increase in tax basis that occurs at death. Which some days feels like it’s just around the corner, doesn't it?
• When your stocks lose value, you tend to sell them prematurely for no other reason than to benefit from the tax losses.
All of these distortions in your thinking and acting just melt away when your investments are in a tax-favored retirement account. The shelter of its tax-exemption allows you to make the right investment decisions untainted by extraneous tax consequences. Goodness knows it’s hard enough to do that without the Tax Code breathing down your neck.
Monday, April 13, 2009
Investments and Diversification
Aesop said, “Don’t put all your eggs in one basket. “ Or maybe it was Benjamin Franklin. Anyway, it was one of those know-it-alls.
That homily applies to your investments as well. Once you have an asset allocation plan, you will have to fill up your stock percentage with various stocks, and your bond percentage with various fixed income investments. One rule that should guide that process is the principle of diversification. Do not have too large a percentage of your stocks in the stock of any single issuer, or in any single industry, or even in any single financial sector or country. Why? Because by concentrating your assets in one company (or industry or financial sector or country), you run the risk that a single adverse event, always unanticipated, can decimate your retirement fund. That’s an extra risk you do not need to take. By spreading your stocks among a number of companies (and industries and financial sectors and countries), you increase the likelihood that a downturn in one company (or industry, financial sector or country) will be offset by superior performance elsewhere. The risk of concentration is potentially enormous (think Enron).
Moreover, according professor and economist Burton Malkiel in his classic book A Random Walk Down Wall Street, many financial professionals believe that the markets do not even reward you with any extra return for taking that extra risk. What a lousy deal that is!
How much concentration is too much? Opinions differ, but a good rule of thumb is to avoid having more than 5% of your stocks in any single issuer. That’s 5% of your stocks, which is an even smaller percentage of your overall investments.
There is one particular type of concentration problem to be wary of: owning too much stock in the company you work for. That’s an easy trap to fall into. Companies often like to fill up their 401(k) plans with their own stock. They often make matching contributions in the form of company stock. Or they make company stock the default investment option. They sponsor ESOPs, which by design are intended to be invested primarily in company stock. They sponsor plans that enable employees to purchase company stock at a discount. They reward employees with bonuses in the form of shares of stock and stock options. Companies like to do this because it supposedly encourages employees to work toward profitability for their own benefit. But it adds extra uncompensated risk to your investments.
And, worse, looking at your bigger financial picture, if your company goes under, you lose your job at the same time your portfolio gets decimated. Again, think Enron. So it’s a good idea to keep an eye on how much company stock you own, directly and indirectly, and adjust it downward where you have the power to do so, if the percentage gets too high.
I understand that your company is different. It’s not Enron. It’s the beast of its industry. I don’t care! It’s good to be loyal and true to the home team, but at some point it’s prudent to put a cap on your loyalty.
That homily applies to your investments as well. Once you have an asset allocation plan, you will have to fill up your stock percentage with various stocks, and your bond percentage with various fixed income investments. One rule that should guide that process is the principle of diversification. Do not have too large a percentage of your stocks in the stock of any single issuer, or in any single industry, or even in any single financial sector or country. Why? Because by concentrating your assets in one company (or industry or financial sector or country), you run the risk that a single adverse event, always unanticipated, can decimate your retirement fund. That’s an extra risk you do not need to take. By spreading your stocks among a number of companies (and industries and financial sectors and countries), you increase the likelihood that a downturn in one company (or industry, financial sector or country) will be offset by superior performance elsewhere. The risk of concentration is potentially enormous (think Enron).
Moreover, according professor and economist Burton Malkiel in his classic book A Random Walk Down Wall Street, many financial professionals believe that the markets do not even reward you with any extra return for taking that extra risk. What a lousy deal that is!
How much concentration is too much? Opinions differ, but a good rule of thumb is to avoid having more than 5% of your stocks in any single issuer. That’s 5% of your stocks, which is an even smaller percentage of your overall investments.
There is one particular type of concentration problem to be wary of: owning too much stock in the company you work for. That’s an easy trap to fall into. Companies often like to fill up their 401(k) plans with their own stock. They often make matching contributions in the form of company stock. Or they make company stock the default investment option. They sponsor ESOPs, which by design are intended to be invested primarily in company stock. They sponsor plans that enable employees to purchase company stock at a discount. They reward employees with bonuses in the form of shares of stock and stock options. Companies like to do this because it supposedly encourages employees to work toward profitability for their own benefit. But it adds extra uncompensated risk to your investments.
And, worse, looking at your bigger financial picture, if your company goes under, you lose your job at the same time your portfolio gets decimated. Again, think Enron. So it’s a good idea to keep an eye on how much company stock you own, directly and indirectly, and adjust it downward where you have the power to do so, if the percentage gets too high.
I understand that your company is different. It’s not Enron. It’s the beast of its industry. I don’t care! It’s good to be loyal and true to the home team, but at some point it’s prudent to put a cap on your loyalty.
Sunday, April 12, 2009
Investment Returns and Market Timing
Given the extreme swings in stock prices, wouldn’t it be better just to get out of stocks before they go down, and reinvest in them before they go back up?
Forget about it! That’s called market timing and it can’t be done. Despite the tens of thousands of highly paid Wall Street professionals spending all their working hours studying the stock market, nobody has been able to consistently predict when the market will turn up or down. Successful market timing requires that you make two correct guesses—when to sell stocks and then when to buy back in. And it is critical that you make that second call correctly. For example, according to economist and mathematician Benoit Mandelbrot, in his book The (Mis)Behavior of Markets, during the 1980s, 40% of the gains in the S&P 500 occurred on just 10 trading days; miss those days and you miss a big chunk of stocks’ performance. The risks of being out of the market when it goes up actually exceed the risks of being in the market when it goes down.
Here’s a little fable as to why it is foolish to think you can guess right where all others have failed. I owe this to an example appearing in Roger Gibson’s brilliant investment book Asset Allocation.
Imagine that you begin January 1, 1926 with $10,000 to invest. Now imagine that you are successfully able to guess correctly whether the upcoming month is going to be good for stocks or bad. When you sense that stocks will outperform cash, you keep your assets in stocks, specifically in the stocks that make up the S&P 500. When you sense that cash will perform better than stocks in the upcoming month, you sell and move your assets into cash. By the end of 2007 your account would be worth over $400 trillion, more than thirty times the actual market value of the S&P 500, clearly an impossibility. If you could successfully predict the direction of the market, your wealth would grow so large that your trading would influence the market.
The moral of the story is to find your appropriate asset allocation and then stick to it, rather than to try outguessing Mr. Market.
Forget about it! That’s called market timing and it can’t be done. Despite the tens of thousands of highly paid Wall Street professionals spending all their working hours studying the stock market, nobody has been able to consistently predict when the market will turn up or down. Successful market timing requires that you make two correct guesses—when to sell stocks and then when to buy back in. And it is critical that you make that second call correctly. For example, according to economist and mathematician Benoit Mandelbrot, in his book The (Mis)Behavior of Markets, during the 1980s, 40% of the gains in the S&P 500 occurred on just 10 trading days; miss those days and you miss a big chunk of stocks’ performance. The risks of being out of the market when it goes up actually exceed the risks of being in the market when it goes down.
Here’s a little fable as to why it is foolish to think you can guess right where all others have failed. I owe this to an example appearing in Roger Gibson’s brilliant investment book Asset Allocation.
Imagine that you begin January 1, 1926 with $10,000 to invest. Now imagine that you are successfully able to guess correctly whether the upcoming month is going to be good for stocks or bad. When you sense that stocks will outperform cash, you keep your assets in stocks, specifically in the stocks that make up the S&P 500. When you sense that cash will perform better than stocks in the upcoming month, you sell and move your assets into cash. By the end of 2007 your account would be worth over $400 trillion, more than thirty times the actual market value of the S&P 500, clearly an impossibility. If you could successfully predict the direction of the market, your wealth would grow so large that your trading would influence the market.
The moral of the story is to find your appropriate asset allocation and then stick to it, rather than to try outguessing Mr. Market.
Saturday, April 11, 2009
Investment Returns and Asset Allocation
In yesterday’s post, I included a graph showing how stocks and bonds have performed over different time horizons. But of course, you will not invest all of your retirement assets in one asset class or the other. To find the right compromise between the higher return of stocks and the greater stability of bonds, you will want to arrive at the right mix of stocks and bonds—your asset allocation plan. More easily said than done.
The graph below shows quite clearly how mixing the two asset classes has historically resulted in gains and losses that are in between those of stocks and bonds. There are good reasons for mixing asset classes. Most of us want the higher returns offered by stocks, but we could not afford the potential losses if all our investments were in stocks.
And stocks and bonds will behave differently during different economic periods. To some extent poor performance of one asset class will be offset by better performance in the other. This will result in a reduction of volatility, a smoothing of the peaks and valleys of your investment returns. The graph below demonstrates this by showing how a portfolio of 50% stocks and 50% bonds would have performed during different periods in history (the same periods reviewed in yesterday's post), and comparing that mix to 100% stocks and 100% bonds.
Is 50-50 the right asset allocation? No; it’s just an example.
The graph below shows quite clearly how mixing the two asset classes has historically resulted in gains and losses that are in between those of stocks and bonds. There are good reasons for mixing asset classes. Most of us want the higher returns offered by stocks, but we could not afford the potential losses if all our investments were in stocks.
And stocks and bonds will behave differently during different economic periods. To some extent poor performance of one asset class will be offset by better performance in the other. This will result in a reduction of volatility, a smoothing of the peaks and valleys of your investment returns. The graph below demonstrates this by showing how a portfolio of 50% stocks and 50% bonds would have performed during different periods in history (the same periods reviewed in yesterday's post), and comparing that mix to 100% stocks and 100% bonds.
Is 50-50 the right asset allocation? No; it’s just an example.
Friday, April 10, 2009
Investment Returns over Multi-Year Periods
It’s all about your time horizon.
In the last few posts, I have quoted some statistical returns for stocks, bonds and inflation, but only looking at single-year periods. It turns out those figures are not very helpful, since we all invest our retirement assets for some longer-term period, our “time horizon” in investment industry jargon. How many years will it be before you will have to cash in your investment and spend the proceeds? The longer the time horizon, the more stocks have done better than bonds.
Over longer periods of time, inflation poses a greater risk than depreciation in stock value. Conversely, the shorter your time horizon, the less appropriate stocks are. The risk of a short run loss in value over one or two years is too great to make it worth trying to strive for their greater returns.
The following graph shows how stocks and bonds have fared historically over two, five, 10, 20, and 30 year periods. The blue bars show the range of annualized real (i.e., after-inflation) returns experienced by stocks (as represented by total return on the S&P 500 index) and bonds (as represented by total return on intermediate term Treasury bonds) during the period 1926-2008. Inflation is represented by changes in the Consumer Price Index. The black bar shows the median return for all periods during the 83 years studied.
This graph paints an important picture. Notice that stocks have performed well over longer periods of time. In fact, they have outperformed bonds in every 20-year and 30-year period from 1926 to 2008. According to author and finance professor Jeremy Siegel, in his book Stocks for the Long Run, not since 1831-1861 have fixed income investments outperformed stocks over a 30-year period. And that remains true for the 20- and 30-year periods punctuated by the positively horrible 2008.
Another important thing to notice from the graph is how the wild swings in returns, in both stocks and bonds, are increasingly muted as your time horizon expands. Time erases your losses! Unfortunately, time also erases your outsized gains. The longer the period, the smaller the range of annualized returns. For example, annualized real returns in stocks over short (2-year) periods ranged from a whopping gain of 43% to a sickening loss of 29%; a spread of 72%. But over 20-year periods, the range of annualized real returns in stocks shrank considerably—to a high of 13% and a low of 0.85% (a mere14% range).
A third thing to notice is how the median return stays roughly the same no matter how long or short the period. Moreover, as the range of returns shrinks with ever-longer time horizons, the median becomes much more useful as a tool for projecting the future, since your future is more likely to be closer to the median than with shorter periods.
After you have experienced a year like 2008, it is a bit comforting to remember that time can heal your outsize losses. But it is equally critical to remember that if you invest your retirement assets in stocks, you can always expect to experience many individual one-year periods of significant real losses (one out of three calendar years between 1926 and 2008, as seen in yesterday’s post). And often those one-year periods follow on each others’ heals, making for quite the sickening ride. It takes courage and conviction to get through the short-term downs in order to benefit from long-term gains.
Now here’s the ugly part. When it comes to retirement savings, defining your time horizon is particularly complex. That’s because you won’t be spending all your money at once. Rather, if for example you are ten years away from retirement, you have a ten-year time horizon on a small piece of your investments, an 11-year time horizon on another small piece of your investments, and so on and so on. Nothing’s easy, is it?
In the last few posts, I have quoted some statistical returns for stocks, bonds and inflation, but only looking at single-year periods. It turns out those figures are not very helpful, since we all invest our retirement assets for some longer-term period, our “time horizon” in investment industry jargon. How many years will it be before you will have to cash in your investment and spend the proceeds? The longer the time horizon, the more stocks have done better than bonds.
Over longer periods of time, inflation poses a greater risk than depreciation in stock value. Conversely, the shorter your time horizon, the less appropriate stocks are. The risk of a short run loss in value over one or two years is too great to make it worth trying to strive for their greater returns.
The following graph shows how stocks and bonds have fared historically over two, five, 10, 20, and 30 year periods. The blue bars show the range of annualized real (i.e., after-inflation) returns experienced by stocks (as represented by total return on the S&P 500 index) and bonds (as represented by total return on intermediate term Treasury bonds) during the period 1926-2008. Inflation is represented by changes in the Consumer Price Index. The black bar shows the median return for all periods during the 83 years studied.
This graph paints an important picture. Notice that stocks have performed well over longer periods of time. In fact, they have outperformed bonds in every 20-year and 30-year period from 1926 to 2008. According to author and finance professor Jeremy Siegel, in his book Stocks for the Long Run, not since 1831-1861 have fixed income investments outperformed stocks over a 30-year period. And that remains true for the 20- and 30-year periods punctuated by the positively horrible 2008.
Another important thing to notice from the graph is how the wild swings in returns, in both stocks and bonds, are increasingly muted as your time horizon expands. Time erases your losses! Unfortunately, time also erases your outsized gains. The longer the period, the smaller the range of annualized returns. For example, annualized real returns in stocks over short (2-year) periods ranged from a whopping gain of 43% to a sickening loss of 29%; a spread of 72%. But over 20-year periods, the range of annualized real returns in stocks shrank considerably—to a high of 13% and a low of 0.85% (a mere14% range).
A third thing to notice is how the median return stays roughly the same no matter how long or short the period. Moreover, as the range of returns shrinks with ever-longer time horizons, the median becomes much more useful as a tool for projecting the future, since your future is more likely to be closer to the median than with shorter periods.
After you have experienced a year like 2008, it is a bit comforting to remember that time can heal your outsize losses. But it is equally critical to remember that if you invest your retirement assets in stocks, you can always expect to experience many individual one-year periods of significant real losses (one out of three calendar years between 1926 and 2008, as seen in yesterday’s post). And often those one-year periods follow on each others’ heals, making for quite the sickening ride. It takes courage and conviction to get through the short-term downs in order to benefit from long-term gains.
Now here’s the ugly part. When it comes to retirement savings, defining your time horizon is particularly complex. That’s because you won’t be spending all your money at once. Rather, if for example you are ten years away from retirement, you have a ten-year time horizon on a small piece of your investments, an 11-year time horizon on another small piece of your investments, and so on and so on. Nothing’s easy, is it?
Thursday, April 9, 2009
Investments and Inflation Protection
As discussed in January 25’s post, inflation is just about inevitable. The nominal value of your investment may increase, but if it does not increase at a greater rate than inflation, its real value—its purchasing power—actually diminishes. So ideally you want your investments’ total return to exceed the rate of inflation.
How well do stocks and bonds achieve that goal? Historically stocks have done a better job of out-pacing inflation than bonds. Consider these statistics over the years 1926 through 2008. Stocks are represented by total return on the S&P 500; bonds are represented by total return on intermediate term Treasury bonds; inflation is represented by changes in the Consumer Price Index.
Geometric average annual nominal returns
Stocks: 9.62%
Bonds: 5.44%
Inflation: 3.01%
Geometric average annual real (inflation-adjusted) returns
Stocks: 6.42%
Bonds: 2.25%
Number of years (out of 83) experiencing a real (inflation-adjusted) loss:
Stocks: 27 (33%)
Bonds: 32 (39%)
The figures above look just at single-year periods. But that's short-sighted. Tomorrow’s post will take a more realistic look at how well stocks and bonds have increased purchasing power by analyzing longer periods.
How well do stocks and bonds achieve that goal? Historically stocks have done a better job of out-pacing inflation than bonds. Consider these statistics over the years 1926 through 2008. Stocks are represented by total return on the S&P 500; bonds are represented by total return on intermediate term Treasury bonds; inflation is represented by changes in the Consumer Price Index.
Geometric average annual nominal returns
Stocks: 9.62%
Bonds: 5.44%
Inflation: 3.01%
Geometric average annual real (inflation-adjusted) returns
Stocks: 6.42%
Bonds: 2.25%
Number of years (out of 83) experiencing a real (inflation-adjusted) loss:
Stocks: 27 (33%)
Bonds: 32 (39%)
The figures above look just at single-year periods. But that's short-sighted. Tomorrow’s post will take a more realistic look at how well stocks and bonds have increased purchasing power by analyzing longer periods.
Wednesday, April 8, 2009
Investments and Principal Protection
As you select the right mix of stocks and bonds for your retirement assets, consider this fundamental difference between them: When you own stocks, there is nobody guaranteeing that you will get back the amount you originally paid. With bonds, however, the issuer and its creditworthiness promise repayment. And when that issuer is the U.S. government, you can be sure your principal is protected.
But note that protection of principal is not the same as protection of value. A rise in interest rates or turbulent market forces can cause a bond to decrease in value even as the creditworthiness of its issuer remains unchanged.
And with both stocks and bonds, nobody is promising to repurchase the investment if you suddenly find you need to convert some of it to cash. For that, you are relying on the existence of an active and liquid marketplace—the stock or bond market—where buyers and sellers meet (anonymously) to set prices and make deals.
But note that protection of principal is not the same as protection of value. A rise in interest rates or turbulent market forces can cause a bond to decrease in value even as the creditworthiness of its issuer remains unchanged.
And with both stocks and bonds, nobody is promising to repurchase the investment if you suddenly find you need to convert some of it to cash. For that, you are relying on the existence of an active and liquid marketplace—the stock or bond market—where buyers and sellers meet (anonymously) to set prices and make deals.
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