I have had clients over the years ask me if I could ever envision a scenario where I would change my tune. My tune, of course being that – over time – owning small pieces of all of the great companies of the world (aka owning stocks) gives folks a significantly greater chance of growing their wealth and also lessens the chance of them running out of money than lending to companies/governments (aka owning bonds). I cannot imagine ever changing this tune, as the evidence overwhelmingly points to this tune as being gospel.
That said, we have also stated in every client’s Investment Policy Statement something to the effect of, “as new asset classes make their way into the mainstream or as new evidence points to new investments providing greater diversity and/or lower expected volatility and/or greater expected returns, we will add these investments to the extent they are prudent.”
In English, what the above means is that we are constantly educating ourselves: reading books and blogs by the greatest thought leaders in the industry, attending seminars, collaborating with thought provoking peers and continuously researching to see if there’s a better way to do any of the things we do.
And, while my main refrain has in no way changed, three recent developments have allowed me to alter my tune a bit: 1) recent advances in technology vastly improving access to otherwise difficult asset classes, b) structural regulatory improvements for the individual investor allowing access to otherwise difficult, expensive and non-transparent asset classes and 3) enough statistically significant data to support a change around the edges for folks in certain situations.
First, a refresher on my major investment/investor philosophies:
1) Ownership of the greatest companies in the world (aka, the stock market) provides an exponentially greater chance
at growing long term wealth than lending to governments and/or corporations (the bond market).
2) A dollar bill is not money. Pause. Let me say that again. A dollar bill is NOT money. It is currency. Currency and money are not the same thing. Take $1,000 and put it under your mattress. Now, watch the cost of the stuff you want to buy (otherwise known as inflation) rise at about 3% per year (the average over the past 100 years or so). Next, wait 23 years and take your money out from under the mattress. You still have one thousand dollars, hooray! BUT… You’ve lost half your money. How? Well, at a modest 3% inflation rate, your costs will have literally doubled in 23 years. You have the same 1,000 units (dollars), but half the purchasing power. So, remember, currency is not money. Money is purchasing power.
3) Now, over long periods – let’s say 23 years as an example – owning a diversified basket of companies (yes, stocks) have NEVER been worth less than owning a diversified basket of bonds. Never in any 23 year time period since the data has been collected (including the Great Depression). So, not only are stocks better at growing wealth, they are also far better at
protecting your money, if you properly define money as purchasing power.
4) The superior long term return of stocks to bonds is directly a function of their greater volatility. But, just like currency isn’t money, so is it that volatility isn’t risk. Let’s take a look at some of that volatility:
a. Since the end of World War II, we have averaged a 14% drop from top to bottom in the stock market every year, and drops of greater than 20% (bear markets) happen on average once every 5 years. And worse, those bear markets of greater than 20% that happen every 5 years or so? Those drops actually average a 33% drop from high to low. Awful, right?
b. Yet, despite these terrifying statistics, the S&P 500 has grown over 100 times since 1946, and that does not include ever increasing dividends. Note, the cost of the stuff you buy only went up about 9 times.
5) So then, what is the real risk of owning equities? It’s not in the long term values of the companies or the long term growth of the global economy, but it’s the emotions of the investor – that is the proclivity that’s hard wired into all of us to fear that a significant temporary decline is actually the onset of some apocalypse.
6) My primary role – above and beyond helping you craft a financial plan, think thru and conceptualize your true goals, helping you recognize and address your fears, building a portfolio that provides you the greatest chance to succeed in your plan, etc. – above all of that, my greatest role is to help manage your investor behavior – against panic in falling markets and against euphoria in soaring markets to name just two – as investor behavior is the dominant determinant in real life investor returns.
This is my song. I sing it loud, I sing it proud. I sing it on a plane and on a train, in a box or with a fox…
Now: all of that said – and this is where it may get a little nerdy (though abbreviated, as nobody wants to read this much) –
If most people had the choice to earn, say, 8% expected returns with 12% volatility or 8% expected returns with 8% volatility, every single person who is drawing money regularly from their investments should elect the latter choice. Some people in accumulation mode may prefer the latter as well (although the argument for accumulators is far from clear).
So, to all my accumulators, thank you for making it this far. You have heard my song once again, and you may now go in peace.
For my folks that are regularly taking withdrawals from your investment portfolio, you’re going to have to hang on a hair longer.
There are a handful of risks as you enter retirement, some controllable some uncontrollable, but let’s talk about the one risk that only affects folks who are regularly drawing from their portfolios (distribution mode).
Drawdown Risk: The risk of your portfolio dropping significantly while you’re taking distributions, thus requiring you to withdraw a greater percentage than recommended, and thus making your chance of running out of money all the greater.
Conventional wisdom states that as one reaches retirement and/or as they get older in retirement, it is prudent to continually dial up the percentage of bonds in their portfolio and dial down the percentage of stocks. Very few of my retired clients are holding 100% stocks, so I no doubt agree with this logic to some extent; I simply think the vast majority of investors take the logic too far. (Because, remember, over longer periods, stocks have historically returned greater returns and LESS risk.)
In my mind, the justified reason to dial up bonds is to lower Drawdown Risk. Although justified, the problem is twofold: 1) you’re significantly sacrificing long term expected returns, especially given today’s interest rates, 2) If someone is in a 60/40 portfolio, their volatility is still going to be dominated by the stock side of the ledger. We witnessed this in 08/09′: The global stock market had a drawdown of 51% while a 60/40 global portfolio had a drawdown of 32.6% (64% of the full down move).
We’ve known this perceived conundrum for quite some time, but the question has remained – is there a better alternative?
After years of research and due diligence, I have concluded that there is. We have introduced certain Market Neutral Funds to several of our clients who are regularly taking distributions, and we are going to continue to introduce to these assets to clients and increase this exposure to clients with current exposure. Further, as stated above, technology and certain regulatory rules have opened the door to another intriguing asset class. I am still in the process of further exploring, but this is an asset class that I am encouraged can lead to greater “risk adjusted” returns for all clients. For those of you who enjoy getting into the weeds, let’s discuss, I’m happy to go into more detail. For all the others, please continue to rest assured that we continue to look out for what’s best for our clients, and we will always continue to do so.
Thanks for reading.