Nassim Taleb popularized the idea of Black Swan events in his best selling books, "Fooled By Randomness" and "The Black Swan". These events are unpredictable and have significant effects on financial markets. Market participants are adept at constructing narratives in hind sight that make the events seem obvious. The 2008 housing crisis which produced the worst economic downturn since the Great Depression of the 1930s along with a market crash is an excellent recent example.
The key is that the event be totally unexpected. It can be either good or bad.
One candidate I believe that is out there at present is that the actions followed by Central Banks and the U.S. Federal Reserve will actually produce a well functioning global and U.S. economy. This is based on my watching the markets, reading about the markets and talking to investors. I have to say that I don't know of anyone who thinks that there aren't some serious bumps and bruises if not much worse in the near to intermediate future coming from following a zero interest rate and negative interest rate policy. I have to add that I believe this is so even for the Fed governors in their heart of hearts. Uncharted waters are scary
But, what if the economy ratchets up its growth rate to 3%, the unemployment rate drifts a bit lower in the U.S., tax collections reduce the deficit and the Federal Reserve has the Fed Funds rate at a more normal 3% rate say in 4 years? Wouldn't this qualify as a "Black Swan"?
And surely all those now predicting a sharp downturn immediately ahead would have no problem creating a narrative explaining how we got on the road to nirvana.
To be absolutely clear I don't expect this to happen. This is merely an academic exercise to keep us on our toes. To be sure, I'm in the camp of those who believe that manipulating the price of money or practically the price of anything is bad policy and distorts the system (i.e. creates bubbles) and eventually ends badly.
Sunday, September 25, 2016
Sunday, September 18, 2016
Recent Data on Passive Versus Active
One of the most important decisions an investor can make is whether to go passive or active. Passive accepts the market return, active seeks to beat the market return.
I am in the camp that says most investors investing for retirement should go passive (see previous post of "Proposal"). This rests on the belief that capital markets are mostly efficient. This means that stock and bond prices rapidly reflect publicly available information.
Believing in efficient markets practically comes with the territory of being an economist. Economists are drilled in the idea that when you have low barriers to entry, abnormal (i.e. greater than market ) profits won't persist. Take this idea to the capital markets where billions of dollars are on the line and it is pretty straightforward.
But this isn't an intuitive notion for most people. They hear their friend made a killing selling beanie babies and they run out and garner an inventory only to watch them gather dust later in their basement.
So what does recent data on passive versus active show? One of the most anticipated reports of the year produced by Standard & Poor's is called the SPIVA report. This year, through 6/30/2016, 84.6% of large cap active managers underperformed the S&P 500 Index.
This means that if you bought SPY, the low cost index ETF, you outperformed 85 out of 100 managers for the year. For what it's worth, yearly performance is pretty much useless. Anything can happen in a year.
What is important is longer term performance because that is where costs that arise from active trading, management fees etc. come into play. The data shows that over the 5 years ended 6/30/2016 only 8% of active large cap managers performed better than the index. To break this down consider that if you had given 100 active large cap managers $1 million 5 years ago only 8 would have come back with better than index returns.
These results, along with the results of other market sectors, including "fixed income" are reported by Ryan Vlastelica in "How passive funds extended their dominance over actively managed rivals" /MarketWatch 9/15/2016.
There are various ways to try to beat the market. Some try to time the market, i.e. jump in when they think it is going up, jump out when then think it's going down. I call this the "hokey - pokey" approach to investing. And actually it amuses me. For example I was recently entertained by the mass exit called for after the Brexit vote. As we saw the market didn't fall off a cliff, instead it reached new records.
Another was to beat the market is to try and pick the best stocks. In this category I find especially interesting the so-called long/short Funds. If you think you can pick stocks then surely this proposition would interest you: study the stocks in the S&P 500 and short the 50 you dislike the most and with the proceeds buy equally weighted positions in the 50 you like the best.
Clearly, if you have any stock picking ability you would provide a superior return. Not only that but you should do well in any kind of market. This was, in fact, the pitch Funds following this approach presented. I know because I spent the first 20 years of my career investing for pension funds, endowments and other institutional investors. I heard the pitches.
How have they done you ask? William Baldwin, "Scary Results At Long-Short Equity Funds", 8/23/2016 Forbes provides some data. He says that Morningstar puts 133 publicly offered Funds in this category and that they returned 2%, average annualized return for 3 years ended 6/30/2016. The average stock index Fund returned 11.7%/year.
Is it really any wonder active funds are seeing huge outflows and index funds are seeing huge inflows. You don't need to be an economist to grasp that money flows from poorly performing high cost products to better performing low cost products.
I am in the camp that says most investors investing for retirement should go passive (see previous post of "Proposal"). This rests on the belief that capital markets are mostly efficient. This means that stock and bond prices rapidly reflect publicly available information.
Believing in efficient markets practically comes with the territory of being an economist. Economists are drilled in the idea that when you have low barriers to entry, abnormal (i.e. greater than market ) profits won't persist. Take this idea to the capital markets where billions of dollars are on the line and it is pretty straightforward.
But this isn't an intuitive notion for most people. They hear their friend made a killing selling beanie babies and they run out and garner an inventory only to watch them gather dust later in their basement.
So what does recent data on passive versus active show? One of the most anticipated reports of the year produced by Standard & Poor's is called the SPIVA report. This year, through 6/30/2016, 84.6% of large cap active managers underperformed the S&P 500 Index.
This means that if you bought SPY, the low cost index ETF, you outperformed 85 out of 100 managers for the year. For what it's worth, yearly performance is pretty much useless. Anything can happen in a year.
What is important is longer term performance because that is where costs that arise from active trading, management fees etc. come into play. The data shows that over the 5 years ended 6/30/2016 only 8% of active large cap managers performed better than the index. To break this down consider that if you had given 100 active large cap managers $1 million 5 years ago only 8 would have come back with better than index returns.
These results, along with the results of other market sectors, including "fixed income" are reported by Ryan Vlastelica in "How passive funds extended their dominance over actively managed rivals" /MarketWatch 9/15/2016.
There are various ways to try to beat the market. Some try to time the market, i.e. jump in when they think it is going up, jump out when then think it's going down. I call this the "hokey - pokey" approach to investing. And actually it amuses me. For example I was recently entertained by the mass exit called for after the Brexit vote. As we saw the market didn't fall off a cliff, instead it reached new records.
Another was to beat the market is to try and pick the best stocks. In this category I find especially interesting the so-called long/short Funds. If you think you can pick stocks then surely this proposition would interest you: study the stocks in the S&P 500 and short the 50 you dislike the most and with the proceeds buy equally weighted positions in the 50 you like the best.
Clearly, if you have any stock picking ability you would provide a superior return. Not only that but you should do well in any kind of market. This was, in fact, the pitch Funds following this approach presented. I know because I spent the first 20 years of my career investing for pension funds, endowments and other institutional investors. I heard the pitches.
How have they done you ask? William Baldwin, "Scary Results At Long-Short Equity Funds", 8/23/2016 Forbes provides some data. He says that Morningstar puts 133 publicly offered Funds in this category and that they returned 2%, average annualized return for 3 years ended 6/30/2016. The average stock index Fund returned 11.7%/year.
Is it really any wonder active funds are seeing huge outflows and index funds are seeing huge inflows. You don't need to be an economist to grasp that money flows from poorly performing high cost products to better performing low cost products.
Monday, September 12, 2016
A Proposal - Summary
This proposal's purpose is to give everyone at least a framework of how to go about building a nest egg for retirement, as presented in the previous 4 posts. Like many areas we have gone 90% of the way to handling a problem but then stop just short of wrapping it up.
The 401(k) and similar qualified plans are excellent for getting people to a successful retirement. The problem is many don't know how to use it. The purpose of the proposal is to fix that. As mentioned in previous posts if you know how to invest or have a different approach then go for it. Again, a caveat, if you are hell bent on beating the market by picking stocks or active Funds or timing the market all I can say is "good luck". The odds are against you.
Begin by emphasizing the importance of starting early and putting away at least 10% of every paycheck.
So, the proposal: start with an appropriate target date/life cycle/retirement date Fund . How to do this will be presented in a 15 minute video when you take your job. Secondly, once you reach $60,000 or so in your 401(k) switch to low cost index Funds with an appropriate asset allocation. Typically this would be somewhere around 70% stocks/30% bonds. Finally, when you reach the point where you are thinking of generating an income off of your portfolio consider creating a dividend stream by using bonds Funds and Dividend Funds and even individual dividend stocks.
The first two steps require very little time. The third is a bit more time consuming.
As explained in the previous 4 posts there is no need to switch at various points. If you have no interest and just want to stick with the life cycle approach you can do that. Or you can stay with the low cost, index Funds. The only reason to switch at various times is to lower the costs a bit. It is worth noting that directly investing in the dividend stocks can potentially be the most rewarding because you have opportunities for tax loss harvesting, judicially increasing yields oner time etc.
The bottom line is that this proposal provides a way to emphasize to workers that by following some very basic steps they can end up enjoying a nice retirement.
The 401(k) and similar qualified plans are excellent for getting people to a successful retirement. The problem is many don't know how to use it. The purpose of the proposal is to fix that. As mentioned in previous posts if you know how to invest or have a different approach then go for it. Again, a caveat, if you are hell bent on beating the market by picking stocks or active Funds or timing the market all I can say is "good luck". The odds are against you.
Begin by emphasizing the importance of starting early and putting away at least 10% of every paycheck.
So, the proposal: start with an appropriate target date/life cycle/retirement date Fund . How to do this will be presented in a 15 minute video when you take your job. Secondly, once you reach $60,000 or so in your 401(k) switch to low cost index Funds with an appropriate asset allocation. Typically this would be somewhere around 70% stocks/30% bonds. Finally, when you reach the point where you are thinking of generating an income off of your portfolio consider creating a dividend stream by using bonds Funds and Dividend Funds and even individual dividend stocks.
The first two steps require very little time. The third is a bit more time consuming.
As explained in the previous 4 posts there is no need to switch at various points. If you have no interest and just want to stick with the life cycle approach you can do that. Or you can stay with the low cost, index Funds. The only reason to switch at various times is to lower the costs a bit. It is worth noting that directly investing in the dividend stocks can potentially be the most rewarding because you have opportunities for tax loss harvesting, judicially increasing yields oner time etc.
The bottom line is that this proposal provides a way to emphasize to workers that by following some very basic steps they can end up enjoying a nice retirement.
Monday, September 5, 2016
A Proposal - Step 4
Ok...so to rehash what we have so far to get most people on track for a nice retirement: for your first job, assuming the company has a decent 401(k) just elect to put at least 10% away out of each paycheck and pick the Fund corresponding to the retirement date or life cycle or target date Fund. Forget about it, go to work and when it reaches $60,000 or so say switch to a well defined asset allocation using low cost index Funds.
How to do this can be presented by Human Resources on the first day of employment by using a short online video. Why can't Fund providers do this? Well, they can but they won't because they get far greater fees by getting Plan participants to use higher cost actively traded Funds that they switch around frequently.
The beauty of going target date Fund and then low cost Funds is that it gets over some formidable hurdles. First, many would be participants back off because there are so many choices. Economic theory has found that too many choices is actually not a good thing in many instances. Secondly, many would be participants just don't understand the process and that they are responsible for building their own nest egg. They think it takes time and expertise to do this. In fact, it runs itself once it is set up.
Now we come to the third and final phase. This is when you have reached the point where you need to generate an income off your nest egg. Note that at this point your goal has changed significantly from growing your nest egg to generating an income off of your nest egg.
There are some choices here. Today for example you can get approximately 5.5% off your nest egg by buying a single premium immediate pay annuity. This is an insurance product that pays a monthly income (or at whatever interval you pretty much request) and has the clear advantages of ensuring you never run out of money and not being subject to a possible sharp drop in the market. The big disadvantage is that you lose control of the money both for emergency needs and for leaving assets to heirs.
Another choice is to invest in Treasury Notes. At the present time the 10 year Treasury Note yields 1.6%, about in line with the rate of inflation. A big disadvantage in addition to the low yield is that the interest payment stays constant over the life of the Note. This means that the interest payment you receive over the next 10 years would stay the same. Assuming inflation rises this means you would be losing ground.
The third alternative is to create, in effect, your own annuity by using dividend stocks. For the retiree willing to spend some time at it there are numerous solid stocks that offer yields of 3% and higher. Furthermore, they have a history of increasing their yields. To get an idea of the stocks in this category just Google "dividend stocks" and you'll come up with all kinds of listings. Finance magazines such as Barron's, Kiplingers. Money etc. constantly provide lists of attractive dividend payers as well.
But what about the possibility of the market dropping? After all, at this point we are in retirement and as commenters like to say "retirees don't have much time for the market to recover after a downturn". This actually isn't too great an issue in my view if you frame the process appropriately.
Think about the first two alternatives: an annuity and a Treasury Note. In each instance we did the investment and then whatever happened to the market didn't matter. Think also about your Social Security. Does a market downturn have any impact on Social Security?
The point here is that once you have invested the main concern is with your income stream not with the market value of the portfolio. Odds are that with some basic principles your income stream should increase as your stocks increase their dividends. If over time your portfolio rises in value it's basically gravy. If it drops it is no big deal, again as long as your income stream holds up.
What are the basic principles? First, limit the size of specific company holdings to 5% of total assets. This limits the impact of a negative event. Secondly, be careful about industry diversification. For example, choose Verizon or AT&T but not both. They are in the same industry. Choose one or two energy companies, utility companies, banks etc. If you extend to riskier companies invest 2.5% of total assets. You'll find business development companies that offer, for example, double digit yields. Always remember that extra yield means extra risk.
A negative for this approach is that it takes time. The first two approaches ran themselves. Not the dividend portfolio. But some retirees find that creating a dividend portfolio and managing it is a great "hobby" in retirement. As you get into it you find numerous opportunities, on an ongoing basis, to increase yield and improve the portfolio. The bottom line is that it can pay off nicely for the retiree willing to put in the effort.
How to do this can be presented by Human Resources on the first day of employment by using a short online video. Why can't Fund providers do this? Well, they can but they won't because they get far greater fees by getting Plan participants to use higher cost actively traded Funds that they switch around frequently.
The beauty of going target date Fund and then low cost Funds is that it gets over some formidable hurdles. First, many would be participants back off because there are so many choices. Economic theory has found that too many choices is actually not a good thing in many instances. Secondly, many would be participants just don't understand the process and that they are responsible for building their own nest egg. They think it takes time and expertise to do this. In fact, it runs itself once it is set up.
Now we come to the third and final phase. This is when you have reached the point where you need to generate an income off your nest egg. Note that at this point your goal has changed significantly from growing your nest egg to generating an income off of your nest egg.
There are some choices here. Today for example you can get approximately 5.5% off your nest egg by buying a single premium immediate pay annuity. This is an insurance product that pays a monthly income (or at whatever interval you pretty much request) and has the clear advantages of ensuring you never run out of money and not being subject to a possible sharp drop in the market. The big disadvantage is that you lose control of the money both for emergency needs and for leaving assets to heirs.
Another choice is to invest in Treasury Notes. At the present time the 10 year Treasury Note yields 1.6%, about in line with the rate of inflation. A big disadvantage in addition to the low yield is that the interest payment stays constant over the life of the Note. This means that the interest payment you receive over the next 10 years would stay the same. Assuming inflation rises this means you would be losing ground.
The third alternative is to create, in effect, your own annuity by using dividend stocks. For the retiree willing to spend some time at it there are numerous solid stocks that offer yields of 3% and higher. Furthermore, they have a history of increasing their yields. To get an idea of the stocks in this category just Google "dividend stocks" and you'll come up with all kinds of listings. Finance magazines such as Barron's, Kiplingers. Money etc. constantly provide lists of attractive dividend payers as well.
But what about the possibility of the market dropping? After all, at this point we are in retirement and as commenters like to say "retirees don't have much time for the market to recover after a downturn". This actually isn't too great an issue in my view if you frame the process appropriately.
Think about the first two alternatives: an annuity and a Treasury Note. In each instance we did the investment and then whatever happened to the market didn't matter. Think also about your Social Security. Does a market downturn have any impact on Social Security?
The point here is that once you have invested the main concern is with your income stream not with the market value of the portfolio. Odds are that with some basic principles your income stream should increase as your stocks increase their dividends. If over time your portfolio rises in value it's basically gravy. If it drops it is no big deal, again as long as your income stream holds up.
What are the basic principles? First, limit the size of specific company holdings to 5% of total assets. This limits the impact of a negative event. Secondly, be careful about industry diversification. For example, choose Verizon or AT&T but not both. They are in the same industry. Choose one or two energy companies, utility companies, banks etc. If you extend to riskier companies invest 2.5% of total assets. You'll find business development companies that offer, for example, double digit yields. Always remember that extra yield means extra risk.
A negative for this approach is that it takes time. The first two approaches ran themselves. Not the dividend portfolio. But some retirees find that creating a dividend portfolio and managing it is a great "hobby" in retirement. As you get into it you find numerous opportunities, on an ongoing basis, to increase yield and improve the portfolio. The bottom line is that it can pay off nicely for the retiree willing to put in the effort.
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