By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
Investment advisors talk about the long run because markets are variable. We don’t have nearly enough long term data, and at best, short term data is mere noise in a very turbulent process. We have only very crude approximations for risk premiums, and in fact, they may change over time. So we look at what pitiful little data we have, and try to make reasonable judgments about what the long term performance might be. Given a thousand years, we think we have a tolerably close approximation of what returns might look like. We freely admit we don’t have a clue about what the next twelve or twenty four months might look like. Investing is about risk, and risk management. Risk happens! Elegant theory collides with real life events. It’s a very messy process.
It turns out, that the long run can be a very long time. For instance, in the 1970s and ‘80s there was a 19 year period during which Treasury Bills outperformed the S&P 500. Even Business Week threw in the towel, proclaiming “The Death of Equities” boldly across their front page. This capitulation by the voice of capitalism almost exactly marked the beginning of the longest strongest bull market in history. So much for expert opinion!
Unfortunately, investors talk and think about the short run because their horizons are limited. Their first response to a discussion about long term results is likely to be: “I don’t have a thousand years!!!” They have every right to think that way. After all, this is their life, they only get one shot at it, and a two or three year market downturn might seem like an eternity, especially if it starts right after they retire. Few of them have the patience to wait a thousand years for things to work themselves out to approximate the averages. Retirees are particularly sensitive to this issue because they typically need income NOW.
While retirees may not have a thousand years, they may very well need to plan for forty years. With inflation ever present, fixed income or guaranteed accounts will simply not do the job. If we think only short term and if we don’t provide for adequate growth we risk a catastrophic loss of buying power.
The investor has a real dilemma. On one hand, almost all investors need the higher returns and inflation protection that only equity investments provide. On the other hand, risk premiums do not reliably show up each and every year as theory predicts that they should over the long haul. In fact, the predicted risk premiums (expected returns) may not show up for a very long time. A few bad years early in retirement and the retiree cold liquidate his entire nest egg.
So, we must have a strategy that provides for some growth and at the same time will withstand market downturns. The Depression, 1973-1974, the crash of ‘87, the crash of ‘89, and the horrible slump of 2000-2002 were all real events that destroyed the financial security of millions. No one should want to place themselves at risk of that.
Given that returns are random and totally unpredictable in the short term, what’s an investor to do? Without the ability to predict the future, how should the investor construct his portfolio to meet his unique requirements of safety, income, and growth?
There is an approach that maximizes the probability of long term success, and provides protection against short term market loss. In other words, the investor need not give up hope of some long term growth of principal and income in order to hedge against short term market uncertainty. Within reasonably defined limits, the investor can have his cake and eat it too.
As a first cut, the investor must segregate his nest egg into two parts. The first part should be enough to satisfy all of his income needs for at least five to seven years (preferably ten). That part must be invested in rock solid safe instrument such as high quality short term bonds. This portion of the fund hedges against those nasty occasional market downturns of unknown and unknowable duration.
The remaining part of the portfolio should be in a globally diversified portfolio of equities to provide for the real return and growth necessary to meet the investor’s objectives. Particular care must be taken to achieve an equity portfolio with the lowest possible risk as measured by annual fluctuation or standard deviation. This is best accomplished by wide diversification of asset classes.
Having sufficient funds rat holed away in rock solid highly liquid investments allows the investor to weather the storms that must certainly come. The investor should never be faced with having to liquidate any of the volatile equity investments at inopportune times.
We can back test this approach to determine whether it would have survived any past market conditions (at least back to 1926). Monte Carlo analysis gives us another useful tool to stress test our assumptions. Neither technique is perfect, but we can get a very good feel for a “range of reasonableness”. While there is never a guarantee in the markets, this technique has stood the test of time.
Assuming sustainable withdrawal rates, appropriate asset allocation, and reasonable portfolio costs, this approach offers the best probability of success over the long haul, while meeting the investor’s needs for short term protection against down markets.