Quality Asset Management

How can you Plan in a World of Uncertainty?

January 30, 2014August 1, 2011 by Gil Hanoch

After experiencing the 2008 recession, many feel it is difficult to plan for the future. The recent stock decline scared them, and now they are torn between preparing for (1) a similar decline in the future, and (2) the erosion of assets due to lifelong withdrawals that increase with inflation. This article provides principles that can help you prepare for an uncertain future.

A common instinct, after a severe decline, is to put substantial assets in cash and bonds, to be prepared for a repeat decline. This leaves the investor vulnerable to both longevity and inflation risks. While the psychological impact of a recent severe decline is far greater than all preceding gains, you should consider the likelihood and risk of each case. A rule I use is:

Plan for the most expected, and be prepared for the worst.

Most people live a long life, and the life expectancy keeps growing very rapidly. The investment that best supports income that grows with inflation is globally diversified stocks. By focusing your investments in stocks, you are prepared for the most expected, but may not be prepared for the worst.

A globally diversified stock portfolio can decline for a number of years. Here are ways to address this risk:

A zero-cost solution is to limit the withdrawal rate from the stock portfolio. If you can limit your withdrawals to 3%-4%, depending on the portfolio, you are likely to fully recover from the worst of the declines. This is thanks to the limited negative impact of the declines to money you actually take out during the decline.
If your withdrawals are larger than 3%-4%, you can defer retirement if possible. If you can defer to the point of limiting the withdrawals to 3%-4%, you go back to having a zero-cost solution.
Alternatively, a limited allocation to cash and bonds can support the excess withdrawals during declines. Such allocation should be strictly limited to supporting withdrawals during severe declines. Otherwise, it compromises your preparation for the most expected – many years of withdrawals that grow with inflation. Determining the size of this allocation requires a very careful analysis by an experienced professional.
In addition to the discussion above, you are subject to the risk of panic during declines. While you may survive a decline in stocks if you limit the sales to covering immediate expenses, most people (including professionals) panic during the worst of declines and sell stocks excessively. The solution is to find an investment advisor with proven iron discipline.

To Summarize

Individual investors face two main financial risks: (1) severe market declines; (2) lifelong withdrawals that increase with inflation. Given how painful severe declines are, some people focus on the risk of declines on the account of the risk of lifelong-withdrawals. A better solution is to plan for the most expected (longevity), and be prepared for the worst (severe decline). This can be done by an allocation to a globally diversified stock portfolio, managed by a disciplined investment advisor, with an optional allocation to cash & bonds that depends on the withdrawal rate.

Disclosures Including Backtested Performance Data

Can Money buy Happiness?

April 5, 2021June 1, 2011 by Gil Hanoch

Many people believe that if they had plenty of money, they would be happy in life. Yet, so many wealthy people are no happier than when they had only modest means. This article provides a potential explanation, followed by ideas for using money to increase happiness.

When does Money not buy Happiness?

Despite the benefits of money, people often do not become much happier thanks to money. I believe that it is the result of their narrow focus on the most known benefit of money: material pleasures. Examples include buying nice cars, clothes, eating in nice restaurants, and owning a home, yacht or a private jet. When you use your money mostly for material pleasures, the following happens:

The excitement fades. Compare your first ride in a nice car you bought to your daily commute to work a year after you bought it. Your mood that day is much more likely to affect your happiness during the ride than the nice car.
The expense stays. While you are likely to be only modestly happier thanks to the repeated material pleasure, the upkeep never goes away. Furthermore, when it is time to replace your car (to continue the example above), you are not likely to feel comfortable downgrading. This is because the pain of downgrading is greater than the pleasure of upgrading.
Your financial risk grows. Now that your ongoing expenses grew for the long run, your financial risk is higher. Since you did not use your money to substantially increase your savings, if you lose your source of income, you are in trouble. Replacing a $1M/year job is far more difficult than replacing a minimum-wage job.
Your freedom declines. The need for high income to sustain the material pleasures you got used to, reduces your freedom. Now you are wedded to your job, even if you are unhappy with it.
You have no extra free time. At best, you are stuck working the same amount in the long run. At worst, after the excitement from a material purchase fades, you seek other purchases. The need for further purchases can become an addiction – a very expensive one – that requires working harder and longer, leaving you with less free time.

How to Use Money for Happiness

If you can follow a number of principles, you can significantly increase your odds of becoming happier as you accumulate more money:

Set an ultimate goal of sustained happiness, rather than simply making more money. Keep looking for what makes you happy in life in a sustainable way and pursue that. Make sure that money is not specified as the goal -it is only a means to goals. This will allow you to go against the statistics, and be much happier thanks to the extra money.
Live below your financial means, and keep growing your investments compared to spending. When your income grows, don’t increase your spending until after saving from your higher income. Spend according to your increased savings, not increased income. This ensures that you are no more dependent on income from work than before the raise, and allows for growing happiness in all areas listed below.
Continue growing your spending very slowly, until it can be sustained from your investments alone. Your investment advisor should be able to provide you with a withdrawal rate that is likely to allow the portfolio to keep growing despite extreme market declines (often in the range of 3%-4%). If you spend $100k per year and the sustainable withdrawal rate is 4%, keep the spending from growing much until your portfolio crosses $2.5M (or a higher amount if you increased your spending).
Once your investments can sustain your spending, you can increase your spending in proportion with the growth of your investments. At this point, you can enjoy the increased happiness through spending on material pleasures, without sacrificing free time, financial security, family connections, and all other ways in which money can provide happiness.

Money can make life nicer in many non-material ways

Here are some ways to make life very nice using money, beyond material pleasures.

Get protection from the unexpected. Cash reserves can be a lifesaver between jobs or when your business is hurt due to economic declines. They also help in case of an expensive repair or healthcare expense.
Free up time for retirement. If you are able to save and invest your money responsibly, you can grow it at a high rate over the years, getting an unbelievable reward for delaying your gratification. For a hypothetical example, if you manage to save $200,000 by age 35, and keep that amount for retirement at age 75 in a globally diversified stock investment generating 9% per year (a rate that was surpassed using investments of globally diversified stock portfolios), you get rewarded with growth to $6.3M, or $2.1M after discounting the amount by annual inflation of 3%. This amount, along with social security, and can provide income to cover all of your expenses forever. At that point, you can use your time for whatever makes you happiest.
Free up time gradually during life. Retirement doesn’t have to be a transition from working full time to not working at all. Once you accumulate substantial savings, you can work less and start depending on small & sustainable withdrawals from your investments. For example, if your portfolio allows for sustainable 4% withdrawals, you can start living off of, say 2%-3%, leaving some cushion for unexpected expenses + allowing the money to keep growing for the day you would want or need to work even less or stop working completely.
Choose the job you enjoy most. The more money you have, the less you depend on work to cover your ongoing expenses, and the more freedom you have to choose the job you like, even if it provides a lower pay.
Strengthen family connections. If you work less, or at a job you like more, you can become a more pleasant and balanced person that has more tolerance and time for family life. This can lead to an improved marriage, and a better connection with your children, parents and friends.
Show appreciation. When you pay someone for a product or a service, you can feel good about showing appreciation for what they do.
Do less of what you don’t like to do. Many chores in life can be outsourced for a fee. The more money you have, the more of these chores you can pay others to do. Examples include: cleaning, gardening, cooking, doing laundry, preparing taxes, and doing simple home repairs.
Simplify shopping. The more money you have, the nicer you can make your shopping experience. You can seek the exact products you want, as opposed to focusing on the cheapest ones, making the decision process quicker and more enjoyable. In addition, you can hire professionals you appreciate most, as opposed to the cheapest ones.

Summary

Money makes life easier, and provides security, flexibility and freedom. By deferring most material purchases until after security, flexibility and freedom are achieved, you can turn your wealth into enormous happiness.

Disclosures Including Backtested Performance Data

The “Income for Life” Conundrum

January 30, 2014April 1, 2011 by Gil Hanoch

You can achieve financial freedom using an investment that provides income for as long as you live. A globally diversified stock portfolio with limited withdrawals addresses this need well, and has the side effect of likely leaving your heirs with a large pot of money. While you may be happy to help them out, you may prefer to enjoy more of your money during your lifetime. The article explains why this is impossible, and why it should not bother you.

If you can save a large enough amount, to allow you to make very limited withdrawals from your investments (typically 3%-4% per year) and cover your expenses, a globally diversified stock portfolio may be your best solution for income for life. It provides a unique combination of benefits:

Income for life . If you choose a low enough withdrawal rate, and keep the diversified portfolio with no individual stock selection or market timing, the portfolio may provide you with income forever, which, by definition, includes the rest of your life.
Automatic inflation adjustments . Since inflation is the increase of the cost of goods and services, and you own the companies that provide these goods and services, their income and value ultimately grows with inflation. This allows for the portfolio to withstand growing withdrawals that are adjusted for inflation.
Availability for unusual expenses . The entire investment is available to you at all times, and can support some level of unusual expenses, beyond the typical withdrawal rate. This flexibility can be very valuable if you want to move to a more expensive house, or face a large medical bill or any other extraordinary expense. (This applies to infrequent excess withdrawals – withdrawing a higher percentage for many years in a row will put you at risk of running out of money during your lifetime.)
Growing income, beyond inflation . The investment is expected to grow over time, despite the ongoing withdrawals. During declines you can keep the income constant (with inflation adjustments). In all other times, as the portfolio reaches new peaks, withdrawing the same percentage of the peak value provides growing income.
Money left for heirs or charities . A side effect of the money growth is that you get to leave a large pot of money to your heirs or charities of choice.

The problem : While most people are happy to take care of others through the money they leave, some may prefer to enjoy more of their money during their lifetime, while leaving behind a smaller amount.

No solution : Since you cannot know your lifespan in advance, you cannot plan to use up most of your money during your lifetime. Say you increase your withdrawal rate, with an aim to use up most of your money by age 95 (or pick any other specific age). There are problems with this approach:

You may live to be 100 or longer, and end up bankrupt. Lifespans have grown at a rapid rate in the past century, and it is impossible to know whether you will live to be 80, 100, or 120.
A major stock market crash early in your retirement can result in depletion of your money at a younger age.
Instead of seeing your portfolio grow throughout life, you are planning to see it decline over time. This means that instead of having greater means to deal with unplanned expenses, your means decline.
The difference between seeing your financial security increase over time and seeing it decline over time, is remarkable. Your choice will affect your feeling of financial security every day for the rest of your life.

Why it doesn’t matter : When comparing this lifelong income generating investment to the alternatives, even when ignoring the leftover money, this solution seems superior and pleasing. Let’s review two common alternatives:

Annuity : This product is designed specifically to address the need for income for life. While it can work very well, it has several flaws: (1) no flexibility for large withdrawals; (2) income grows with inflation at best – you lose all the excess income growth obtained through stocks; (3) the income depends on the solvency of a single insurance company (compared to thousands of stocks around the world).
Real Estate : Owning several properties can provide income for life, but does not allow easy access to the principal. In addition, it has no flexibility for large withdrawals. On the contrary – you may incur shortfalls in income through repairs and vacancies. There are some ways around these limitations, including selling a property to cover a large expense, or borrowing temporarily from a home equity line of credit, but they tend to be more difficult to implement and limited than the easy accessibility to a stock portfolio. Despite the limitations, this solution is legitimate, and many people swear by it.

Summary

Using a globally diversified stock portfolio for generating lifelong income has many benefits, and one of them may be seen as a downside by some people – a substantial pot of money left for your heirs. There is no way around this outcome, but when comparing this solution to common alternatives, the benefits clearly outweigh this negative (for those who see it as a negative).

Disclosures Including Backtested Performance Data

Great Wealth: Step by Step

January 30, 2014February 1, 2011 by Gil Hanoch

When you hear about a very wealthy person, you might try to learn what steps were taken to achieve the wealth, so you can repeat them to become wealthy. In most cases, you will fail, because you have different circumstances or because luck played a big role. This article presents a systematic way for maximizing your wealth, regardless of your circumstances.

The article does not mention ideas that depend on luck, tough predictions or that may be difficult to follow, including:

Work for the next Google, start it, or invest in it.
Buy real estate in a location that will boom in the next 10 years.
Become a famous actor, artist, musician, or writer.

It also avoids ideas that are useful, but depend on your individual abilities, and some luck, including:

Become the CEO of a large company.
Become a highly paid professional.

As you may pursue some of the approaches above, this article focuses on things that you can control better. Given the limited space, it is not a comprehensive guide for maximum wealth, but it should steer you in the right direction.

Step 1: Live below your means. The first ingredient for systematic wealth generation is to save as much as possible from your income. It is easiest to be frugal if you are happy, because unhappy people are at risk of using spending to make up for the missing happiness. More importantly, if you are not happy, what is the point of becoming wealthy? Here are a few ideas for maximizing your happiness with minimal spending:

Find a job/business/activity where you are appreciated. Start by finding your strengths and passions. If you can find work that you are both passionate about and is in demand, you are set. Otherwise you may have to find a compromise, or split your time between two occupations: one that makes you happy and a less ideal one to pay the bills.
Surround yourself with people that you can connect with, whether family, friends, or people with a common interest. Prefer people that build up your energy.
Help others. While official volunteer work is a clear example, you can find ways to help people around you at all times, whether it is a family member, friend, co-worker, client or a complete stranger.
Fill up your time with cheap fun activities, for example:
- Walk, hike or ride a bike
- Watch the ocean
- Read books from the library
- Play games, do puzzles, socialize
- Listen to music
- Garden
Don’t overwork for extended periods. While the extra work can increase your savings, you might get burned out, or simply overspend to compensate for the work stress.

Do whatever it takes to live within your means and save some amount regularly. Knowing that life is financially sustainable is critical for staying peaceful and relaxed. Since we tend to focus on changes in life and not the absolute position, knowing that you are growing your savings is relaxing.

For many people, this may be the toughest step, and may require creative actions, including:

Obtaining new skills through a degree or some form of training.
Making changes to the circle of friends or even moving to a different place, where there is less pressure to live at a certain material standard.
Selling assets and belongings that are expensive to maintain, including houses, cars or boats.

Once you established expenses that are below your income, be very strong at keeping the expenses from growing much. For any increase in your income, use most of it for increased savings.

Step 2: Build cash reserves. Save several months of living expenses in a low risk place, such as cash in a checking or savings account. This may not be easy, because this money does not grow much. A big motivation is the thought about how helpful this money would be if there is an unexpected emergency expense or you lose your job.

Step 3: Save into a globally diversified stock portfolio, with no market timing and no individual stock selection. If done right, this step can be really fun. You have to educate yourself about the extreme volatility of stock investments, as well as the high long-term rewards and the reasons for them. Whether you invest on your own or with the help of a professional investment advisor, it is critical for the person managing the money to have iron discipline.

Step 4: Use money to make money. Once you started building an investment portfolio, there are several ways in which you can use your money to reduce your expenses or increase your savings growth:

Count a small withdrawal rate from your portfolio as a part of your reserves for emergencies. While stocks are very volatile in the short run, they can tolerate a low withdrawal rate at all times. This depends on the portfolio, and can be in the range of 2%-4%.
Increase the deductibles on various insurance policies, such as car, home and health. When doing so, make sure you are prepared financially and mentally to spend the money out of your own savings, and don’t do so if you are at a much higher risk than the average insured.
Increase the mortgage on your home, as long as you can sustain the payments through low withdrawals from your investments, and you have iron discipline!
Switch from a fixed mortgage to a variable rate, unless your fixed rate is very low. Fixed mortgages cost more to compensate the lender for interest rate risk.

The last two points require very careful analysis – I do not recommend doing them without the help of an experienced professional.

Step 5: Keep a watch on expenses. As you grow your savings and/or income, it can become increasingly difficult to keep the material standard of living from growing. A few ways of dealing with it are:

Raise your standard of living with the growth of your income, but do so minimally and choose things that maximize the growth of your happiness.
Instead of thinking about your low (and declining) standard of living relative to your income and/or assets, think about your growing standard of living.
Remember that more money (beyond a pretty basic amount) typically does not make people happier. That is where a focus on happiness first can help.

Step 6: Financial freedom . Once your investments grow to the point where your annual living expenses amount to no more than 2%-4% of your investments (depending on the portfolio), you will achieve financial freedom! Now you can choose to spend your time in any way that will make you happy. As a huge added bonus, you can keep growing your spending whenever your investments grow to new peaks, without reducing your financial security.

Example : If you can save 10% of your income per year and put it into a stock portfolio with real long-term growth of 12% per year (nominal growth 15% minus 3% inflation), you can reach financial freedom (at a 4% withdrawal rate) within 31 years. Note: I assume that the growing income allows for an increased saving rate. This is a reasonable assumption because wages have historically grown about 1% faster than inflation in the long run.

For income of $100,000, and $10,000 saved per year, you may reach $2.5M in 31 years.

If you stop working at that point, and withdraw 4% of your portfolio per year, you may see your assets and available income double every 9 years, reaching $10M, 24 years into your full retirement.

Notes about the steps above:

They are pretty simple. You don’t have to be very talented, lucky or smart to follow them. You do have to be strong and consistent. This requirement is what fails most people.
They are not guaranteed to make you wealthy or happy. They are general guidelines. Stock growth can vary from its average for extended periods, and the average may change over time.
They are not appropriate for everyone. Some people place greater emphasis on the present, and are willing to accept higher financial risk and lower future wealth. There is no right or wrong – it is a clear tradeoff.

Disclosures Including Backtested Performance Data

Do you have Financial Freedom?

January 30, 2014December 1, 2010 by Gil Hanoch

Financial success is often measured in terms of high income or high net worth. This article offers an alternative measure that focuses on the freedom to choose what to do with your time, and is stated as a low withdrawal rate from a diversified stock portfolio.

High Income is a powerful tool for covering expenses. An individual making $1M per year is considered financially successful. While high income can allow you to live comfortably as well as prepare for substantial surprise expenses, it does not capture financial freedom:

It ignores expenses. If you make $1M per year, and spend $1M in a normal year, you will be in trouble as soon as a surprise expense comes up. Considerably more modest income of $60k with expenses of $30k would leave you with a greater cushion for surprise expenses.
It depends on willingness to work. Whether the income is from employment or self-employment, it depends on your willingness to work. A portion of your time has to be spent on work, and you are not free to do as you wish with your time.
It depends on ability to work. Even if you love your job and cannot think of any other way to spend your working hours, you may not be able to work forever. Risks include disability, aging, business failure, and layoffs.

Note that guaranteed income that does not depend on work or on a company’s solvency can count as a contributor to financial freedom, but is still subject to your spending relative to the income amount.

Net Worth can be calculated by adding the value of your bank accounts, brokerage accounts, retirement accounts, real estate including your own home, art collection and anything else of monetary value (assets), and deducting all mortgages, business loans, student loans, car loans, and any other financial obligation (liabilities).

High net worth means you have plenty of money that you can potentially spend as you may choose, and may seem like a good measure of financial freedom. Anyone with $10M or even less can buy a private jet, but may not have financial freedom. The problems with net worth as a measure of financial freedom are:

It ignores expenses. A person with a new worth of $10M would typically be considered wealthy, and would be expected to have financial freedom. If $5M is invested in a nice home, and supporting staff, maintenance and all other living expenses total $500k per year, the person is not financially free, given the spending of 10% ($500k of $5M) of the investable assets per year. This withdrawal rate cannot be sustained reliably at all times, no matter which investment you choose.
It ignores the investment approach . Continuing the example above, say that expenses were cut down to $200k per year, limiting the withdrawal rate to 4%. This withdrawal rate could be sustained given the right portfolio. But if the entire portfolio is put into bonds or into a concentrated stock portfolio, the withdrawal rate cannot be sustained.

An alternative measure: very low withdrawal rate from a diversified stock portfolio . Limiting the withdrawal rate from a globally diversified stock portfolio provides a high probability of financial freedom – the ability to sustain life for as long as needed with no need to worry about work. With the right portfolio, a withdrawal rate of 2%-4% can be sustained through major declines. At 2%-3%, there isn’t much that can affect your financial stability and freedom. Specifically:

A prolonged and deep decline in your portfolio is not likely to be a problem. At 2%-3% you should have been able to sustain the 2008 recession as well as the Great Depression without any problems. This still holds true if you never reduce your withdrawals (the withdrawal rate is measured from the peak value of the portfolio), and adjust them for inflation.
Unexpected expenses can be supported to a large degree given that the entire investment is liquid, ready to be sold at any time with no notice.
Inflation is not a problem given that companies’ earnings grow with inflation. It may not happen instantaneously, but over time stock prices grow well beyond inflation.
Growing income beyond inflation is an extra bonus, given the high long-term growth of stocks. Whenever there is a growth spurt, you get a nice increase in your income, while maintaining the withdrawal rate.

Great news! Now you have two ways to achieve financial freedom – build up your savings, or reduce your spending.

Focus on the positive. You may feel constrained by limiting your spending, in the face of advertising and seeing others living more lavishly. The comfort of not being stuck in the rat-race and not depending on work can give you the strength to keep your expenses at a low percentage of your assets.

In addition, while most people spend most of their lives trying to keep up with their expenses, you can get handsome ‘raises’ to your income once you reach the low withdrawal rate for the first time. This is thanks to the growth of stock investments, combined with the fixed percent withdrawal.

A practical progression: While most 20-year-olds don’t have the assets to generate lifelong income, they can establish a certain standard of living, and raise it more slowly than their income. With every raise, they can save a greater portion of their pay. If they ever get to earn a substantial income, they can stop raising their standard of living until they reach financial freedom. This is in line with the idea that living off of $40,000 can make you much happier than $30,000, but going from $200,000 to $210,000 will not have nearly as much of an impact, and may not make you happier at all in the long run.

Assumption about investing: The financial security of a low withdrawal can be obtained only if the stock portfolio is highly diversified, and held with iron discipline through all declines, however deep or long, with no market timing or individual stock selection.

Summary

High income and high net worth do not guarantee financial freedom. Financial freedom can be obtained by maintaining a low spending rate (2%-4% annually) compared to your assets, if they are invested with discipline in a diversified stock portfolio, with no market timing or individual stock selection.

Disclosures Including Backtested Performance Data

Optimal Retirement Income in the face of Financial Disasters

January 30, 2014October 1, 2010 by Gil Hanoch

After living through the Great Recession of 2008, you might ask: “What is the best way to provide myself with retirement income that can sustain through future catastrophes?” This article answers this question, when considering extreme cases, including severe and prolonged declines, far worse than 2008.

Imagine that you are a retiree and are fully dependent on your investments to provide you with income for as long as you live. The amount can be your total estimated expenses minus any social security income and pension plans. You would like to receive a certain amount of income each year, with adjustments for inflation in subsequent years.

The ideal investment would survive all of the following:

Withdrawals during a prolonged decline.
Withdrawals growing with inflation, as well as hyperinflation.
Withdrawals lasting for as long as you live.
All local damages including natural disasters, theft, confiscation during a war, and legal changes.
Change in supply and demand.

The risk of a short life: While longevity introduces the financial risk of running out of money, the risk of a short life is not a financial risk. By definition, if your money can support you for 30 years, it can support you for 29 years, 3 years or 3 days. Therefore, we limit the discussion of need #3: “Withdrawals lasting for as long as you live”, to the case of a long life. While this may sound trivial, some retirees confuse the health risk of a short life with a financial risk. To be clear – a short life, by definition, cannot be riskier than a long life, financially speaking.

When testing various investments, we can weed-out the ones that cannot survive any of the above:

Cash, Checking, Savings, Money Market, High-Grade Bonds: These all have very low growth rates (#2, #3). Some even have negative real growth. Putting substantial portions of your money in any of these may help you temporarily during stock declines, but they all share longevity risk – running out of money. For a high enough allocation you are actually guaranteed to run out of money.
Fixed annuities: A fixed annuity with inflation-adjusted income is exactly the product that should provide you with income for as long as you live. The problem is that it is backed by an insurance company. Bankruptcy of the company could hurt your annuity income. Given that your income depends on the solvency of a single company, the risk is too big to bear, no matter how stable the company seems. Additional problems are:
1. Annuities with inflation protection tend to provide a very low payment.
2. Nothing is left for your heirs, unless you accept an even lower payment.
3. If you have a surprise expense at some point, there is no way to make a bigger withdrawal at one point, and make up for it later.
Work: While not an investment, it is a way to provide retirement income. It is nice to work for as long as you enjoy it and are able to, but you cannot count on this for life. You may lose your job during an economic contraction (#1), or at any other time. Most people are not able to or do not want to work for as long as they live (#3).
Tangible assets: Anything you can touch (tangible) is subject to local damages (#4). It can be stolen or lost, and therefore cannot be useful. The one exception is a limited amount of cash to keep you going, in case of no access to an ATM.
Gold and other commodities: These do not generate any value (#3). Any change in real-price reflects changes in supply and demand (#5), making these speculative investments with zero expected real returns. In fact, after a 28% tax on long-term holding of gold (taxed as a collectible), storage costs and high transaction costs, you should expect negative real returns. None of these assets appreciate in value reliably during declines. Gold has been especially risky with a nearly 30-year decline to recovery period in recent history. Commodities tend to be highly volatile, and may decline in value irreversibly whenever replacements are found.
Real Estate – Individual Properties: Any individual property is subject to local damages (#4). It can be destroyed in a natural disaster or war. Insurance may not cover all types of damages, and the insurance company may not stay solvent and able to repay all homeowners, in case of a large scale disaster. Even if all damages are covered, no rental income is available during the rebuilding of the property. Vacancies can occur also during economic downturns. Another risk is a drop in property values and rental income due to local changes, including irreparable structural problems, and change in demographics or job opportunities.
Real Estate – Dispersed Individual Properties: Geographic dispersion can alleviate most of the problems described above, if the number of properties is large enough. To account for country-wide problems (including confiscation during wars), international dispersion is necessary. Structured correctly this may be a viable solution, but it is impractical for most individuals. If ownership is leveraged with mortgages, the risk of dropped income gets magnified. To own tens of properties with no leverage, you may need substantial resources, and still need an array of professionals to help with management, repairs and taxation. The result is not too appealing, because income after all expenses tends to be limited, and the growth of property values is not spectacular. In the very long run you can expect real estate to grow only in line with wage increases. In the past 100+ years, this was about 1% higher than inflation, providing minimal real growth.
Real Estate – Pooled (REITs = Real Estate Investment Trusts): These investments are similar to stocks in terms of their volatility and returns. They can be held as a part of a diversified stock portfolio.
Real Estate – Own Home: Owning your home has value beyond investment considerations. It can be a good idea, as long as you have large enough investments to supply you with ongoing income as well as money for maintaining your home.
Stocks, concentrated portfolios: Concentrated stock portfolios may decline for many years, and may never recover.
Stocks with a high withdrawal rate: Globally diversified portfolios have recovered from all declines, but with a high enough withdrawal rate, you may not live to enjoy the recovery period.

One investment that can survive all of the above: Globally diversified stocks with a low withdrawal rate, no market timing and representing entire markets . Below is a description of how it can survive the different risks:

Withdrawals during a prolonged decline: Globally diversified portfolios have recovered from all declines, and it is reasonable to expect this trend to continue as long as people will want to get things in the cheapest and easiest way possible. With a low enough withdrawal rate, you can weather extreme declines.
Withdrawals growing with inflation, even in the face of hyperinflation: Inflation represents the rise in cost of goods. By owning the companies that provide these goods, your investments grow with inflation over time.
Withdrawals lasting for as long as you live: Given that company ownership provides the highest growth rate in the long run, diversified stocks provide the highest chance of lifelong income.
All local damages including natural disasters, theft, confiscation during a war, and legal changes: Thanks to the global diversification, no local damage can decimate your entire portfolio.
Change in supply and demand: A global stock portfolio holding companies in all industries, does not depend on demand for any specific product or service. If there is weaker demand for a specific product or service, this demand gets replaced by demand for an alternative that other companies in your portfolio provide. As long as people keep looking to get things done cheaply and simply, they will use the products and services of companies in your globally diversified portfolio.

Psychological Risks: Given the volatility of stocks, investing large portions of your money in them requires iron discipline. Many individuals lost substantial parts of their life’s savings during major market crashes due to fear. The best way to minimize this risk is to get the help of a professional that demonstrated iron discipline during stock declines, and kept his clients’ money as well as his/her own fully invested during those times.

Withdrawal Rate : The acceptable withdrawal rate from the stock portfolio depends on the portfolio. Some portfolios can withstand withdrawal rates of up to 4%, and survive substantial declines. To be prepared for very extreme and rare declines, that may occur less than once in a lifetime, you may want to go down as low as about 3%. The exact percentage depends on the portfolio.

Low Withdrawal Rate: If you can limit yourself to a very low withdraw rate from your globally diversified stock portfolio (with inflation adjustments), you may have the best plan for your retirement income, even at hypothetical times when people on the streets are begging for food.

With a very low withdrawal rate, putting a portion in more stable investments like cash or bonds will not help your already high short-term security (very low withdrawal rate), but will hurt your long-term security in the face of longevity and inflation.

Making up for a Higher Withdrawal Rate : For higher withdrawal rates, a limited allocation to bonds may provide you with income during severe declines and improve your security. Once you withdraw much more than 4%, there is nothing that can save you from extreme catastrophes.

What if this Solution is not Good Enough? You may feel that no matter how low you bring the withdrawal rate, there could always be a case that will result in a depletion of your assets. This is true, and it would be nice to get a perfect guarantee. Unfortunately, all alternatives fail under certain conditions. While no solution is perfect, the diversified stock solution is likely to withstand the most extreme scenarios.

When comparing the different risks, the odds for the global stock portfolio are much higher than the alternatives, thanks to the combination of high diversification and high average growth rate. Most other solutions fail in the face of inflation combined with longevity and/or concentration risks.

Summary

During substantial stock market declines, you may be concerned with the security of a diversified stock portfolio, and look for more stable alternatives. There are investments that suffer less extreme declines, but they suffer from other risks including inflation, longevity and various localized risks. When considering the entire bag of financial risks, diversified stocks provide the highest likelihood of success in providing lifelong retirement income. This is all subject to you or your advisor having iron discipline in staying invested at all times.

Disclosures Including Backtested Performance Data

Forecasting Yesterday

September 19, 2024August 1, 2010 by Gil Hanoch

Does the stock market affect your mood? Do you feel happy when the stock market is up and upset when it goes down? This is natural, and it affects many of us. A problem occurs when people act on these feelings. This article analyzes the drivers of change in stock prices, with some practical consequences.

Stock prices change every day. Some of the changes are due to company-specific information, and some are related to the whole economy. Changes related to the economy may occur in the following sequence:

Economic data is released, resulting in change of expectations for the future of the economy. The change is assessed relative to the prior expectations.
This new economic data gets reflected quickly in the stock market. For example, an expectation for a slower economy than previously expected will cause the stock market to decline soon after this information becomes public.
When the stock market declines, some individuals and professionals become negative about the future of the stock market, and expect it to keep going down.

This last step is where the logical sequence breaks:

You can expect the future of the economy to affect today’s stock prices.
The future of the economy should not affect tomorrow’s stock prices. Once the data is released, it gets reflected in stock prices quickly (typically within seconds to minutes). There is no economic reason for stock prices to repeat their adjustment to the same data the next day.
You cannot expect today’s stock prices to affect tomorrow’s stock prices, since prices are related to expected economic value, not prior prices.

Furthermore, stock prices do not change according to the expectation for the economy, but according to the changed expectation for the economy. The results may be counterintuitive, for example:

If investors expect the economy to boom in upcoming quarters, data indicating a slower expected expansion would be a reason for stocks to decline.
The same works in the other direction: if investors expect the economy to slow down in upcoming quarters, new data indicating a more moderated slowdown would be a reason for gains in stocks.

Once you digest the ideas above, there is another factor to consider: Stock valuations ultimately gravitate towards neutral values:

The higher the valuation (e.g. Price/Book Value) of stocks, the more the price will sink given a less positive prediction for the economy.
Similarly, the lower the valuation of stocks, the more the price will jump given a less negative prediction for the economy.
For example, in March 2009 stock valuations hit extremely low values. When bad news came, but just slightly less bad than before, stock prices went up. Given the extremely low valuations, instead of a moderate increase, stocks shot up very high very fast.

One more phenomenon plays into the mix: Given that investors (including some of the biggest institutional ones) are not perfectly rational, they sometimes tend to keep buying stocks that are already expensive or sell stocks that are already cheap. This is what I referred to as “the herd effect” in prior articles, and what is called “momentum” by the investment profession. The results:

You can make money by buying expensive stocks (or selling short cheap stocks) for some stretches of time. Given that valuations do not change indefinitely in one direction in the long run, these upward and downward runs get broken by huge upward and downward corrections. As a result, stock valuations cannot be used to predict the near-term changes in stock prices in a systematic way.
In general, high valuations cannot be used to predict declines even for long time horizons, since book values of companies tend to grow over time. By the time a bubble gets popped, book values can keep up with prices, resulting in the next bottom being higher than current prices. For example, Extended-Term Component by QAM was more expensive than usual in the end of 2004. Despite that, it had gains all the way to the end of 2008 (around the recent bottom of the worst recession in nearly a century).
Low valuations can be used to predict gains in the long-term. Global stock markets always grow in the long run (at least as evidenced in the past few hundreds of years, and as logically expected). The chances of gains, and specifically abnormally high gains, go up the lower the current valuations are.

One way to benefit from this last point is to buy stocks with low valuations (Price/Book Value), and hold them for the long run.

Summary

Not much can help us predict the future of the stock market. The best you can do is hold stocks with low valuations for the long run, to enjoy high average returns.

New economic data affects stock prices today, but neither this data or current stock prices can do a lot to help you predict future stock prices. Understanding this can help individuals as well as professionals avoid ‘forecasting yesterday’.

“Valuation” is a term for how expensive a stock is. Two common measures are Price/Earnings and Price/Book Value.

Disclosures Including Backtested Performance Data

Why do Investors Love Large U.S. Stocks?

January 30, 2014June 1, 2010 by Gil Hanoch

Investors in the U.S. typically have a strong bias towards buying Large U.S. Stocks. This article discusses some reasons for this bias, with their benefits and costs.

Here are some reasons for buying Large U.S. Growth (high price to book value) stocks:

Low Risk . This group of companies is the most stable in the world. They are located in the most developed country in the world, and have very large markets to their products and services. If you were to pick a single stock to invest in, a Large U.S. stock would be a conservative choice, relative to other stocks.
Home Bias . Investors feel comfortable investing in companies geographically closer to them.
Familiarity Bias . Investors feel comfortable investing in names they hear often. Historically this made more sense, when information traveled slowly, and for people who analyzed individual stocks.
Costs . It is cheapest to buy these stocks, in terms of bid-ask spread. This trading cost can reach several percent of the stock price, and historically was even higher, making it a big factor to consider when trading frequently.
Tradition Bias . Investors are afraid of change. Some of the reasons listed above were good reasons for people to buy these stocks in the past. People feel comfortable sticking to approaches that worked in the past, even if they are no longer the correct ones.

As explained above, Large U.S. stocks made sense at times when trades were very expensive, and there were no options to cheaply invest in highly diversified portfolios, with very low turnover . Today, assuming you are not a speculator that happened to believe in a certain Large U.S. stock, there is only one reason to invest in such stocks: diversification.

The group of Large U.S. stocks is the least volatile, and has less than perfect correlation with other groups of stocks. These characteristics make it a good addition to a portfolio to reduce its volatility. Given that the returns of this group are the worst of all groups of stocks, in some cases by a wide margin, it makes sense to limit the allocation to this group. Greater allocations should be made to small stocks, international stocks and emerging markets stocks. It may feel riskier to limit the allocation to the safest stock class, but it is not. A highly diversified portfolio of large and small stocks around the world is a lot less volatile than a portfolio concentrated in Large U.S. stocks. See “Can the S&P 500 be dangerous?” (Hanoch, Apr. 2005) for a demonstration of this concept.

Summary

There are many reasons for investors to love Large U.S. stocks, and almost none of them makes financial sense for a conservative investor. The one good reason to hold such stocks is to diversify a global stock portfolio.

Turnover = the percent of the portfolio that is being sold each year. Low turnover means low trading costs. Mutual funds that represent a wide asset class with no market timing or individual stock selection tend to have very low turnover.

Disclosures Including Backtested Performance Data

Has Stock Diversification Failed?

April 9, 2014April 1, 2010 by Gil Hanoch

During 2008 and 2009, some claimed that diversification of stock investments is no longer beneficial, and, consequently, that we should look elsewhere to reduce our investment risks. This article assesses these claims, and demonstrates, through analysis, the benefits of diversification, even in the face of the 2008 decline. More specifically, it will discuss the potential benefit of adding small, international and emerging markets stocks, to help diversify the typical US centric portfolio.

What seemed wrong with Stock Diversification in 2008? During the market decline of 2008 all stock classes declined substantially. Adding small, international and emerging markets stocks, not only did not help a U.S. centric portfolio, but even aggravated the decline, leading to a lower bottom. This can be seen in the graph below, comparing the globally diversified portfolio Long-Term Component with the S&P 500 in 2008-2009.

This result may lead you to believe that stock diversification failed.

If you redeemed your entire investment after these two years, stock diversification would not have helped you. However, a two-year investment should not be put into any stock portfolio.

Appropriate usages of stock investments include:

Long-Term Growth
Immediate retirement income, as long as withdrawals are limited to a small percentage every year¹.

Contrary to Some Claims, Global Diversification of Stocks was Successful . If we expand the period of comparison by two additional years, starting in 2006, we get improved results, thanks to higher returns surrounding the decline. Diversification provided substantially improved security, flipping the total returns to positive, with a total difference of 24%.

If we further expand the comparison to the 10 years 2001-2010, we get a striking difference greater than 200%.

While the correlation between the portfolios seems relatively high, the diversified portfolio provided substantially better results. Two factors helped, as can be seen in the graph above:

In early 2002 there were several months in which the diversified portfolio gained, while S&P 500 declined. These few months were enough to have the diversified portfolio recover from the early 2000’s recession very quickly and have a lasting impact until today.
In 2003-2007 the diversified portfolio had faster overall growth, providing a result 3 times larger (200% higher) than the S&P 500. So, while the S&P 500 stayed at levels below the level of 10 years ago for a long period, the diversified portfolio maintained nice gains throughout the entire 2008 decline.

To judge whether diversification is beneficial, we should do two things:

Compare the length of declines, in addition to the depth. In the middle graph (4 years), you can see that, thanks to the higher 2009 returns, the recovery above the 2006 level occurred many months earlier.
Expect diversification to provide some moderation or shortening of declines, but not eliminate severe declines altogether. Given that diversifying a U.S. Large centric stock portfolio does not hurt the long-term returns (it actually increases them), it would make sense to diversify even without any risk-reduction benefit. Not only is there a risk reduction benefit, it occurs in most declines and tends to be substantial.

To further demonstrate the benefits of stock diversification, a table is provided, comparing the diversified stock portfolio to the S&P 500 over different horizons, all relevant for a retiree looking for current income:

Annual Returns: S&P 500 vs. Diversified Stock Portfolio (Long-Term Component)
Calendar	Years	S&P 500	Long-Term Component	Annual Benefit
2007-2009	3	-5.6%	-2.2%	+3.4%
2005-2009	5	0.4%	7.7%	+7.3%
2001-2010	10	1.4%	14.3%	+12.4%

Summary

Despite claims to the contrary, stock diversification still holds, and is beneficial through declines, including the great 2008 decline. Diversification may help shorten tough declines and/or make them shallower. In some cases, the benefit appears before and/or after the decline, still providing a great benefit to the long-term investor as well as the retiree that depends on current income.

¹ 3%-4% is a common range, depending on the portfolio

Disclosures Including Backtested Performance Data

What is a Retiree’s Time Horizon?

April 6, 2021February 1, 2010 by Gil Hanoch

Have you ever heard about the principle of shifting the portfolio allocation from stocks to bonds as you approach retirement? This article presents an alternative to the principle above that may be more in line with a retiree’s needs.

Before continuing, you are encouraged to read the article “What is your Time Horizon?” (Hanoch, Apr. 2006). It demonstrates several cases in which the principle above does not work.

When was the principle above appropriate? The idea of having most of your portfolio in bonds as you near retirement worked in the days when people retired at age 65 and typically lived for another 5 to 10 years. Under those conditions, and assuming limited resources, it was very important to protect the income for the upcoming few years, even at the expense of long-term depletion of assets.

Can you do better? The article mentioned above presents a more accurate approach to evaluating the time horizon of any person regardless of their age:

Your time horizon is the time until you will need to use your money. Each person may have several time horizons for different parts of their savings.

If you are about to retire, and have a very short life expectancy and limited resources (the case described above), your time horizon is short, and most of your money should be invested in bonds, as suggested before.

In any other case the principle above fails, and the more accurate definition of time horizon, provides a better guideline for investment. Let’s review several cases:

Case 1: Your income needs are very small compared to your portfolio size . If you withdraw a small enough percentage of your portfolio every year, even a high (as high as 100%) allocation to diversified stocks can be the most conservative plan. Depending on the portfolio, once the withdrawal rate becomes as low as 2%-4%, the stock portfolio can handle severe declines without depleting over time. In such a case, given your high short-term security in retirement, it is better to keep a very high allocation to stocks, to retain and increase your financial security over time, for as long as you live.

Case 2: Your income needs are fairly high compared to the portfolio size. If you expect to need, say 10% of your portfolio each year, you cannot afford having all of your money in stocks, because a big decline early in your retirement can deplete your whole portfolio in the first decade of your retirement. In such a case, the rule above should be applied as follows: leave enough money in bonds and cash to cover a number of years of living expenses, depending on how diversified your stock portfolio is. To maximize your financial security, the bond allocation should be used whenever the portfolio experiences a severe decline, and at no other time. As your portfolio grows, resulting in a lower annual withdrawal rate, you can reduce your allocation to bonds and shift into stocks, despite (actually, regardless of) your growing age. This is because your short-term security increases with your portfolio size, and you better address the now bigger risk – outliving your money.

Case 3: Guaranteed income that covers all expenses. If you are expecting guaranteed retirement income to provide for all your needs, your portfolio time horizon is infinite. You will not depend on any of the money while you are alive, and your heirs cannot depend on your money at any specific point, since they don’t know how long you will live. In this case a high allocation to stocks (up to 100%) may be the most appropriate, providing the highest potential future extra cash for any desire or unexpected need.

Lifelong Security in Retirement

When people talk about retirement, the immediate thought is that the time horizon is short and emphasis should be given to providing money for short-term needs. Given the growing longevity of humans, this proposition has become incorrect and even dangerous. The average life expectancy of an individual retiring at age 65 is currently around 20 years, and this number keeps growing over time.

Say you spend 8% of your money per year, and you put most of it in bonds at age 65, with a growing allocation to bonds over time, you have a risk of going broke. Based on my analysis above, an allocation of more than 50% to stocks is likely to be appropriate, and should provide short-term security throughout extreme declines, as well as much higher security for as long as you may live.

Just as you don’t count on your portfolio to grow every year by its average growth rate, you shouldn’t plan on dying according to your life expectancy. The portfolio Long-Term Component has average returns greater than 10%, yet any conservative plan should not count on withdrawals much greater than 4%. Similarly, I would not recommend on planning to die (or alternatively go broke) anytime before age 100. As explained in the article “Preparing for a Long Life” (Hanoch, Dec. 2006), the difference between the withdrawal rate that will deplete your money in 30-40 years and the withdrawal rate that will never deplete your money, is relatively small. This leads me to construct retiree investment portfolios to last forever, in nearly all cases.

If this seems extreme to you, think about the hundreds of thousands of 100+ year-old people alive today, and imagine the millions that could reach this age group in upcoming decades, if you project the historic longevity growth. Preparing for life at this age, is no less important than preparing for a big crash in your stock portfolio starting precisely as you retire.

Assumptions

The ideas in this article depend on several important assumptions:

Your stock portfolio is globally diversified, and you do not individually select stocks or try to time the market.
You are highly disciplined, with nerves of steel, or your Investment Advisor has such nerves and you listen to him/her at all times. Specifically, you use stocks for living expenses when the stock portfolio is growing, and bonds when the stock portfolio is at a decline. Only if you depleted all your bonds at an extended decline, and there is no other source of money, you go back to selling stocks, and replenish your bond reserves when, and only when, the portfolio is recovered.

If these two are not true for you, please disregard this article.

Disclosures Including Backtested Performance Data