Why Most Retirement Investment Plans Are Wrong—Part II

 

Traditional investment strategies do not work for most retirement investment plans. Those who are in or saving for retirement often fail to meet their goals by following these strategies. There are better ways to manage a portfolio for retirement that will not incur as much damage from inflation, long-term bear markets, and fundamental changes in the economy and markets. To implement such strategies, the investor must think like a fox. That is, the investor must be flexible and adapt to changes rather than latching on to “one big thing” and following that idea indefinitely.

To develop an effective investment strategy, the retirement-minded investor should return to the original Modern Portfolio Theory, published in the 1950s. This theory has several principles that largely were forgotten in recent decades. These principles are key to investing successfully over the long-term in changing markets. Be sure to consider each of these principles when considering investments and constructing your portfolio.

Risk is as important as return, and risk is not volatility. Most investors focus on return. They want to know how much they can earn from an investment. That is the wrong focus. The long-term trend of the economy and markets is positive, and most asset classes will earn positive returns over the long term.

Long-term successful investors look at the other side of a potential investment at least as intently as at the potential return. They ask what could go wrong with the investment not only in the long-term but over shorter periods. They want to identify the potential risks, assess how likely they are to be realized, and decide if they can be reduced, hedged, or avoided. The investor also is willing to decide the risks are not worth taking regardless of the potential rewards.

Successful investors also know that risk is not volatility. The real risks to investors are that they will fail to meet their goals or that they will suffer a permanent loss of capital from the investment. Modern investment theory teaches that volatility is risk. Investors should spend more time considering those issues than the potential return.

True diversification is needed to reduce risk. Most investors believe they have diversified portfolios. They usually own a collection of mutual funds. They might own large company U.S. stocks, small company U.S. stocks, developed country international stocks, emerging market stocks, some bonds, and perhaps some real estate stocks. These asset classes are used to develop most portfolios, because the assets are readily available for purchase and there is enough historic data to use the capital asset pricing model we discussed in the last posting.

The problem is that these assets really are not diversified. Most of them are just different types of equities and are highly correlated with each other. The correlation is less than 100%, but generally they move in the same direction in response to the same economic events. Most importantly, they usually are in bear markets at the same time.

The result is the investor is not really diversified. In an overall bull market, the returns are fine. But in bear markets, especially extended bear markets, the portfolio fails to meet its goals. All or most of the portfolio declines. This is especially apparent to anyone who held such a traditional portfolio the last 10 years. The excess returns of the 1990s have been followed by returns below the long-term average. At times, the 10-year returns have been negative or less than the return from treasury bills.

True diversification is when the assets in the long-term portfolio have low correlations or negative correlations with each other. Owning different types of stocks is not true diversification. An example of better diversification is to match stocks with commodities. Occasionally these two assets move in the same direction, but they generally have low or negative correlations. Another example is to have a fund that shorts stocks all the time or selectively. Fortunately, innovations in mutual funds and exchange-traded funds made true diversification accessible to more investors. Small investors now can own funds that sell short or have inverse returns with major asset class indexes.

The risk of the portfolio as a whole is more important than the risk of individual assets. Often investors will avoid an investment because they consider it risky. What they do not realize is that a portfolio of risky assets can be less risky than any of the assets individually if there is true diversification. One risky asset might be in a bear market while another is in a bull market. When a portfolio is properly diversified with different risky assets, the overall portfolio can move steadily upward over time though the assets within it are quite volatile.

There are times when true diversification does not work. These periods generally are when there is a credit crunch, severe recession, or depression. We saw this phenomenon in recent months as all assets declined other than U.S. treasury bills and, to a lesser extent gold. Most of the price declines were sharp. But except for those periods a portfolio of risky assets with true diversification is less risky than a “safe portfolio” of risky assets that have high correlations with each other.

Forecasting is essential to risk reduction and efficiency. The mantra for the last few decades has been that investors should think long-term. They should look at historic returns and risk and build a portfolio that over the long-term has had the risk and return profile they desire. They should ignore any changes over shorter periods than the long-term and simply buy and hold the portfolio.

That approach makes the false assumption that the historic returns and relationships will repeat. It also assumes the patterns will be repeated not only for the long term but also for the individual investor’s shorter time frame. While 20 years is the long-term for an investor, it is a short period in market history. Assets with high long-term returns have 20 year periods of low returns and even negative returns. That is why it is essential that an investor start with the long-term historic returns but make a forecast of whether or not those returns will be earned in the near future before committing to a portfolio allocation. We will discuss forecasting again shortly.

Markets are not always efficient and rational. Can there be any doubt about this principle now? Markets are people acting together, and people are not always efficient and rational. The argument in the past was that while individuals can be inefficient and irrational, when their actions are grouped together in a market the result is efficient and rational. There are few better cases against the efficient market hypothesis than the last 10 years, and especially the last few months.

Markets are not rational because investors make mistakes. At times investors collectively make mistakes or act emotionally. They can become extremely optimistic or extremely pessimistic and drive markets to extremely high or low valuations. A long-term buy-and-hold portfolio does not recognize these possibilities.

Risks outside the market are significant to an investor. One reason for long-term bull and bear markets and for investor mistakes is investors and markets are influenced by factors other than strict market fundamentals. Inflation, monetary and fiscal policy, politics, government actions, wars, and other forces impose risks on the markets. The recent crisis is again a good example. Home prices and the performance of subprime loans in a few areas of the country triggered a credit crunch that led to a financial panic and destabilization of the entire system. Because of the influence of outside forces on markets, an investor must focus on risk when considering an investment. One never knows when potential risks will become real and what forces will trigger those risks.

Those are the basic principles. Those principles can be used to build better portfolios. Here are two processes for using the principles to develop a portfolio.

One way is to develop a long-term buy-and-hold portfolio but be sure that it has true diversification. There must be assets that have low or negative correlations with each other. If you have portfolio simulation software that can backtest the portfolio, it should show that the portfolio as a whole has a low correlation with major market indexes such as the S&P 500 and that the long-term returns are acceptable.

A buy-and-hold portfolio that meets these tests can be created using hedge funds. There has been a lot of criticism of hedge funds lately, because many people rushed into hedge funds in the last few years without understanding them. There are many different investment styles among hedge funds. A diversified portfolio of hedge funds can have true diversification and provide steady returns over time though the individual funds will have a great deal of volatility. I prefer a portfolio of no-load mutual funds that employ investment strategies similar to those used by traditional hedge funds. I have composed such a portfolio using funds including Hussman Strategic Growth, Berwyn Income, FPA Crescent, Wintergreen, and other funds.

If you choose a long-term fixed portfolio, be sure to rebalance it back to the original allocation at least annually. The markets will move the portfolio from its original allocation. To retain the same risk profile, the allocation should be restored.

Another approach is for investors who do not want a buy-and-hold portfolio. They need a starting portfolio, then they need to take additional steps.

The first step is to make forecasts about the performance of different asset classes. Once the long-term allocation is established, it has to be adjusted to reflect current market conditions. These forecasts are not short-term. You are not attempting to time the market, respond to the latest market noise, or follow the headlines. Institutional investors generally do a forecast of the next 10 years. Some others do a shorter period of three to five years. The process generally involves at least annually reviewing the returns for the most frequent period and checking valuations. Then, they consider if the return is likely to equal, exceed, or fall below that level for the next period. The portfolio is adjusted based on the study. Assets that have turned in above average returns and seem at risk for not continuing that are reduced or eliminated. Assets that have done poorly will be added or increased if there is reason to believe their bear markets might end. The process is done at least annually.

One way to do the forecast is to compare recent three year returns with the long-term average for an asset. If the recent performance is below the long-term average, the asset might be undervalued and due for a higher allocation in the portfolio. A recent above-average return might be a reason to be cautious about an investment and decrease its allocation.

Another way to do the forecast is to consider valuation measures. These must be used with caution, as we discussed in the last post, because data points do not work mechanically. An asset can be overvalued or undervalued for a considerable time by a valuation measure before the market turns. Or a valuation measure that used to work might stop working.

In the forecast you might want to consider assets that are not in the original long-term portfolio. Some assets are attractive only when they are selling at very low valuations. For example, a conservative investor might not want to own emerging market stocks all the time. But after those stocks have a bear market and are selling at low prices, the risk-reward trade off could look attractive. The stocks could be added to the portfolio for one to three years.

The point of the forecast is to consider which risks are in the portfolio and how you want to handle them. Some risks can be balanced with uncorrelated assets. Other risks might be acceptable. At times an investor will reduce or eliminate the portfolio’s exposure to an asset when the risk is too high.

I recommend doing a forecast using a one to three year outlook. Consider the valuations of assets, their recent price history, and the economic cycle.

This strategy also must have contingency plans. After making forecasts, the investor should ask, “What if I am wrong?” Markets can surprise people, because markets change and are influenced by outside forces. The investor can be wrong and must consider the probability of being wrong. One contingency plan is to eliminate risks you do not want to take.

Another contingency plan is to establish sell signals or stop-loss orders. If an asset declines by a fixed percentage or if there is a change in an economic indicator to which the asset is sensitive, reduce the allocation to the investment. These changes should be determined in advance and followed when triggered. Too often, investors are not able to objectively evaluate a portfolio position while markets are changing. The analysis should be done in advance, and the contingency plan followed if the markets turn in the wrong direction. After the investment is sold or reduced, new forecasts can be made and the situation considered more dispassionately.

A portfolio based on forecasts requires regular monitoring and adjusting. Markets change, and forecasts can be wrong.

Managing a retirement investment portfolio is an exercise in risk management. Investors cannot rely on the notion that only long-term returns matter. They might not be around for the long-term, and the short- and intermediate-term can be painful. The retirement investor needs to recognize that there are cycles, and the level of risk for an asset varies during the cycle. To meet goals, the investor needs to identify the risks in the portfolio and decide how to deal with them. There are several ways to deal with investment risk. The investor needs to select a method and follow it.





Posted 10-31-2008 12:38 PM by Bob Carlson