What Hides Below

November 3, 2019

by Steve Stofka

Think the days of packaging subprime loans together is gone? Nope. They are called asset-backed securities, or ABS. The 60-day delinquency rate on subprime loans is now higher than it was during the financial crisis (Richter, 2019). The dollar amount of 90-day delinquencies has grown more than 60% above the high delinquencies during the financial crisis. Recently Santander U.S.A. was called out for the poor underwriting practices of its subprime loans. In this case, Santander must buy back loans that go into early default because of fraud and poor standards.

Credit card delinquencies issued by small banks have more than doubled since Mr. Trump took office (Boston, Rembert, 2019). Did a more relaxed regulatory environment encourage these banks to take on more risk to boost profits?

In the last century, geologists have developed new measuring and analytical tools to better understand the structure of the Earth. GPS technology can now detect movements of the earth’s crust as little as ¼” (USGS, n.d.). The same can’t be said for human foolishness. During the past half-century, financial analysts and academics have developed an amazing array of statistical and analytical tools to understand and measure risk. Despite that sophistication, the Federal Reserve has mismanaged interest rate policy (Hartcher, 2006). Government regulators have misunderstood risks in the banking and securities markets.

Earthquake threats happen deep underground. I suspect that the same is true about financial risks. To gain a competitive advantage, companies try to hide their strategies and the details of their financial products. On the last pages of quarterly and annual reports, we find a lot of mysterious details in the notes. After the Arthur Anderson accounting scandal in 2002, the Sarbanes-Oxley Act was passed to bring greater transparency and accountability to financial reporting. Six years later, the financial crisis demonstrated that there was a lot of risk still hiding in dark corners.

The financial crisis exposed a lot of malfeasance and foolishness. Some folks think that investors are now more alert. After the crisis, corporate board members and regulators are more active and aware of risk exposures. Are those risks behind us? I doubt it. Believing in the power of their risk models, underwriters, bankers and traders become victims of their own overconfidence (Lewis, 2015).

Each decade California experiences a quake that is more than 6.0 on the Richter scale. Following the quake come the warnings that California will split away from the North American continent. Still waiting. The recession was due to arrive eight years ago. We did experience a mini-recession in 2015-16, but it wasn’t labeled a recession. The slowdown wasn’t slow enough and long enough. Eventually we will have a recession, and all those people who predicted a recession in 2011 and subsequent years will claim they were right. In many areas of life, being right is all about timing. Few of us are that kind of right.

The data demonstrates the difficulty of financial fortune telling. The Callan Periodic Table of Investment Returns shows the returns and rank of ten asset classes over the past two decades (Callan, 2019). An asset class that does well one year doesn’t fare as well the following year. An investor who can read the past doesn’t need to read the future. Does an investor need to diversify among all ten asset classes?  Many investors can achieve some reasonable balance between risk and reward with four to six index funds and leave their ouija boards in the closet.



Boston, C. and Rembert, E. (2019, October 28). Consumer Cracks Emerge as Banks Say Everything Looks Fine. Bloomberg. [Web page]. Retrieved from https://www.bloomberg.com/news/articles/2019-10-28/consumer-cracks-emerge-as-banks-say-everything-looks-fine

Callan. (2019). Periodic Table of Investment Returns. [Web page]. Retrieved from https://www.callan.com/periodic-table/

Hartcher, P. (2006). Bubble man: Alan Greenspan & the missing 7 trillion dollars. New York: W.W. Norton & Co.

Lewis, M. (2015). The Big Short. New York: Penguin Books.

Richter, W. (2019, October 25, 2019). Subprime auto loans blow up. [Web page]. Retrieved from https://wolfstreet.com/2019/10/25/subprime-auto-loans-blow-up-60-day-delinquencies-shoot-past-financial-crisis-peak

Szeglat, M. (n.d.) Photo of lava flow at Kalapana, HI, U.S. [Photo]. Retrieved from https://unsplash.com/photos/NysO5Rdn7Mc

USGS. (n.d.). About GPS. [Web page]. Retrieved from https://earthquake.usgs.gov/monitoring/gps/about.php

Portfolio Performance & Presidents

October 6, 2019

by Steve Stofka

The employment report released Friday was a Goldilocks gain of 136,000 jobs for the month of September. Why Goldilocks? Not as weak as some feared following news this week that manufacturing was getting hit hard in the trade war with China (Note #1). Not so strong that it ruled out the possibility of another rate cut from the Fed this year. Just weak enough to speculate on another rate cut by year’s end. After several days of big losses, the market rallied on Friday.

Although manufacturing has been contracting, a report on the rest of the economy was more encouraging, although a bit lackluster (Note #2). Service businesses are continuing to hire but the pace has slowed. New export orders have accelerated but new orders in total slowed significantly from August. Something to like, something not to like.

Billions of dollars around the world are traded as soon as the employment report is released each month. During Mr. Obama’s tenure private citizen Donald Trump accused Obama of fudging the employment numbers. Larry Kudlow, now Mr. Trump’s economic advisor, took him to task for that. Mr. Kudlow worked in the Reagan administration and knew well how sacrosanct the employment numbers were. The BLS is an independent agency working in the Department of Labor and its 2400 employees try to collect and publish the most accurate data it can accomplish. The agency’s Commissioner is the only political appointee in the BLS and once confirmed by the Senate, serves four years, the same as the head of the Federal Reserve (Note #3). According to Mr. Kudlow, the White House gets the number the night before only to prepare a press release when the report is released.

Mr. Trump’s reckless behavior helped him take out 16 other Republican presidential candidates in the 2016 election. He acts quickly and aggressively. That lack of caution has led to several bankruptcies, and because of that, no bank in the world will loan him money (Note #4). What if, on an impulse, Mr. Trump tweeted out the employment number shortly before its official release time? Some traders pay a lot of money so that the news will hit their trading desk a split second faster than a conventional news release. It’s that important. An early leak of the employment numbers would cost a lot of influential people big money around the world and would prompt a national if not a global crisis. Forget about the phone calls to foreign leaders to discredit Joe Biden. That would be an act of treason for sure – against the global financial community. Can’t happen? Won’t happen?

Mr. Trump knows no rules. His father protected him when his rash behavior got him into trouble as a child. The elder Trump sheltered Donald from his own mistakes in the real estate industry and his foolish foray into the Atlantic City gambling business. Now that Mr. Trump’s father is no longer there, he depends on others to protect him. He has enlisted a long line of people in that effort. They have come in the revolving door to the White House and left. The list is longer than I imagined (Note #5). John Bolton, the third National Security Advisor under Mr. Trump’s tenure, was the last high-profile team member to leave.

Mr. Trump has said that Americans would get tired of winning so much while he was President. To use a baseball analogy, when he takes the mound, the team doesn’t win very often. People who lose a lot either give up or blame everyone and everything else for their losses. They need to have an ideal environment or get lucky to win. Mr. Trump berates the independent Fed because he wants them to protect him. He needs every crutch he can get. He couldn’t succeed in a war or in the financial crisis because he is not disciplined or organized.

What does this mean for the average investor? Take a cautious approach and keep a balanced portfolio. Betting that Mr. Trump will pitch a good game is a poor bet.

Or is it? At an event on Friday, he claimed that the stock market has gone up 50% since he was elected. Not quite but it is up 42% since the day after he was elected (Note #6). It’s been about 35 months. That’s pretty good. A 60-40 stock-bond portfolio has gone up 30% in that time. Under Obama’s tenure the market only went up 27%. A balanced portfolio went up almost 40% and he had to deal with the worst recession since the Great Depression. The budget battles with Republicans put a big dampener on investor enthusiasm during Obama’s first term.

35 months after the Supreme Court awarded the presidency to George Bush, the market was down 25% but a balanced portfolio was up 21%. Even Mr. Clinton could not best Mr. Trump, although he comes close. 35 months after the 1992 election the market was up 38%. A balanced portfolio was up 40%. The winner? A balanced portfolio.

What might an investor expect? At today’s low interest rates and inflation, a break-even return might be 5% a year, for a total gain of 22% in four years. Will Mr. Trump’s first four years be one of his few wins? Check back in a year. It’s bound to be a tumultuous year.



  1. Institute for Supply Management (ISM). (2019, October 3). September 2019 Manufacturing ISM Report on Business. [Web page]. Retrieved from https://www.instituteforsupplymanagement.org/ISMReport/MfgROB.cfm
  2. Institute for Supply Management (ISM). (2019, October 3). September 2019 Non-Manufacturing ISM Report on Business. [Web page]. Retrieved from https://www.instituteforsupplymanagement.org/ISMReport/NonMfgROB.cfm?navItemNumber=28857&SSO=1
  3. Bureau of Labor Statistics. (n.d.). About the U.S. Bureau of Labor Statistics. [Web page]. Retrieved from https://www.bls.gov/bls/infohome.htm
  4. Business Insider. (2019, August 28). The world is talking about Trump’s relationship with Deutsche Bank. [Web page]. Retrieved from https://markets.businessinsider.com/news/stocks/trump-tax-returns-deutsche-bank-relationship-drawing-intense-scrutiny-2019-8-1028482268#why-it-matters2
  5. Wikipedia. (n.d.). List of Trump administration dismissals and resignations. [Web page]. Retrieved from https://en.wikipedia.org/wiki/List_of_Trump_administration_dismissals_and_resignations
  6. Prices are SPY, the leading ETF that tracks the SP500. Clinton: 42 to 58 (approximately) – up 38%. Bush: 138 to 103 – down 25%. Obama: 91 to 116 – up 27%. Trump: 208 to 295 – up 42%. Balanced portfolio returns from Portfolio Visualizer calculated using a mix of 60% U.S. stock market, and 40% of an evenly balanced mix of intermediate term government and corporate bonds. Dividends were reinvested and the portfolio re-balanced annually.

Spring Cleanup

March 11, 2018

by Steve Stofka

Today time springs forward. Tufts of grass turned green, and some trees are beginning to bud. It was still light after 6 P.M. even before the time change. Great flocks of cranes fly north. In the springtime evening we can hear the siren call of the booby headed tax deadline.  2017 IRA contributions are due by April 15th.

This is a good time to check our game plans. Are we saving enough? In the accumulation, or pre-retirement, phase, 10% or more of our income is a good savings goal. 5% is an absolute minimum. Savings should be used to pay down any debt that has an interest rate more than 5%. High interest rate loans are a weight we must drag around with us. Consider working part time for a while and using that money to pay down high interest rate debt.

New car loans now average over $30K with an average maturity (length of payment period) of 67 months. The average interest rate is 4.21% but anyone with less than a FICO score of 690 is paying 5% or more. This article has breakdowns by credit score, lending institution, length of loan, and other factors.

Of the money we have saved – any annual portfolio realignments to be done? This is a good time to not only think about it but to do it.

In the distribution phase of a portfolio, we begin to withdraw funds from the portfolio that we have accumulated through a lifetime of saving.  Using Portfolio Visualizer, I’ve compared two portfolios with a 60/40 mix – 60% stocks, 40% bonds and cash.  These backtests include an annual rebalancing that may be more difficult for funds in a taxable account because buying and selling may generate taxable capital gains.

Let’s pretend a person retired in May of 1998 at the age of 68 and just died last year. During this twenty years, there were two times when the stock market fell 50%. The beginning year 1998 is near a high point in the stock market. The ending year 2017 was the 8th year of the current bull market. The test begins and ends at strong points in the market cycle, a key feature of a test like this.  Beginning a backtest with a trough in the market cycle and ending with a peak only distorts the results.


At the time of retirement, our retiree had a $1 million portfolio, although the amount could have been $100,000 or $10 million.


Although the stock allocation is the same for both portfolios, Portfolio 2 is totally simple. Put all the money in Vanguard’s Total Stock Market fund and forget about it. Portfolio 1 manually diversifies the 60% stock portion of the portfolio among four classes: Large capitalization, mid cap, small cap value stocks in the U.S., and European large cap stocks. Think of Goldilocks sitting down to a table with four bowls of soup – big, medium, small and European.  If that person retired today, a diverse stock portfolio would include an emerging markets index fund like Vanguard’s VEIEX.  In 1998,  emerging markets were not part of a core portfolio as they are today.  For this test, I left out emerging markets.

The bond portion of the portfolio is an index fund of the total bond market. Both portfolios hold 10% in cash for emergencies and living expenses.


A portfolio is like snow in the Rocky Mountains that melts and flows toward the Pacific Ocean. Will the water make it to the ocean? Each year this retiree withdrew 4% of their portfolio balance for expenses. That percentage is considered safe during most twenty-year retirement periods. Note that some advisors are using a thirty-year retirement period to test a portfolio mix. As the years go by and the purchasing power of a $1 erodes, will 4% be enough to meet a retiree’s income needs? The more diverse portfolio allowed the retiree to withdraw a larger amount every year, and the annual withdrawal did keep up with inflation.  Secondly, the ending balance was about the same as the beginning balance after adjusting for inflation.



The more diverse Portfolio 1 (marked complex in graphic below) has a better return over this twenty-year period. See the Internal Rate of Return (IRR) column, which adjusts for the withdrawal amounts each year.

The drawdown, or greatest decline in value, in the time series is a critical test of a portfolio mix. The retiree needs that portfolio to generate a certain amount of income every year. If the portfolio falls to zero, the income stream has dried up. In the chart below, look at the dip in the portfolio value during the 2008 Financial Crisis. The more diverse Portfolio 1 (blue line) dipped below the starting $1 million figure, but not by much. The investor who was 100% invested in the stock market, the 500 Index portfolio (yellow line), fared the worst during most of the twenty-year period.  In a sign that the bull market has matured, the 500 Index has overtaken the simple 60/40 mix (red line) and is about to overtake the diversified 60/40 mix (blue line).

The diverse portfolio is not complex. There are no gold or commodity assets, no energy or natural resource funds, and no real estate REITs to manage.  If emerging markets were added to the Goldilocks mix, there would now be five equal bowls of soup, each of them taking 12% of the portfolio. This portfolio would have earned 4/10% better each year.


We could add a Pacific stock index like Vanguard’s VPACX to the mix, but when do we stop adding indexes? In this time period, that index had a slight negative effect on returns. As the number of indexes grow, we are less likely to adjust our allocation.

Our portfolios can get cluttered and too complicated to be effective and easily managed.  Can we simplify?  It’s worth a look see. In taxable accounts, de-cluttering and re-balancing can generate taxable capital gains, so it might not be advisable to make any changes.

Ten Year Review

January 14, 2018

by Steve Stofka

To ward off any illusions that I am an investing genius, I keep a spreadsheet summarizing the investments and cash flows of all my accounts, including savings and checking. Each year I compare my ten year returns to a simple allocation model using the free tool at Portfolio Visualizer. Below is a screen capture showing the ten-year returns for various balanced allocations during the past several years.

The two asset baskets are the total U.S. stock market and the total U.S. bond market. A person could closely replicate these index results with two ETFs from Vanguard: VTI and BND. Note that there is no exposure to global stocks because Portfolio Visualizer does not offer a Total World Stock Asset choice in this free tool. An investor who had invested in a world stock index (Vanguard’s VT, for example) could have increased their annual return about 1.3% using the 60/40 stock/bond mix.

I include my cash accounts to get a realistic baseline for later in life when my income needs will require that I keep a more conservative asset allocation. An asset allocation that includes 10% cash looks like this.

In the trade-off between return and risk, a balanced portfolio including cash earns a bit less. In 2017, the twenty-year return was not that different from the ten-year return. From 2009 through 2011, ten-year returns were impacted by two severe downturns in the stock market.


The Hurt

Falling agricultural prices for seven years have put the hurt on many farmers. This decade may turn out to be as bad as the 1980s when many smaller farms went belly up because of declining prices. Remember the Farm Aid concerts?

The Bloomberg Agriculture Index has fallen about 40% over the past five years. While farmers get paid less for their produce, the companies who supply farmers with the tools and products to grow that produce are doing reasonably well. A comparison of two ETFs shows the divergence.

DBA is a basket of agricultural commodity contracts. It is down 33% over the past five years.
MOO is a basket of the stocks of leading agricultural suppliers. The five-year total return is 31%.

The large growers can afford to hedge falling prices. For family farmers, the decline in agricultural prices is a cut in pay. Imagine you were making $25 per hour at the beginning of 2017 and your employer started cutting your pay bit by bit as the year progressed? That’s what its like for many smaller farmers. They work just as hard and get paid less each year.

A Decade Of Change

June 25. 2017

This week I will review a decade of change to help illustrate a fundamental fact about investing:  most of us are clueless about the future because we are bound by comfortable habits of thinking.

Ten years ago this month, June 2007, Apple launched the iPhone. The touch screen was innovative but I found the keyboard had a lack of responsiveness. The ability to use the internet was cool but the connection was slow. There was no camera built into the phone. Cameras took pictures, not phones.  Apple did not introduce the App Store till July 2008 so users got whatever Apple thought they needed. Apple controlled both the hardware and software. People stood in line when the first phone was released because Apple people are a little bit nuts. The phone was suitable for geeks who had money to burn.  Or so it seemed.

Phones were tools, not toys. People who used their phones for work used a Blackberry, a phone with a keyboard that kicked butt over the iPhone and had a great email interface to boot. The low cost workhorse phones were Nokia models. They stood up to daily wear and tear and the little screen was adequate for reading text messages.

The previous year, a relatively new company called Facebook notched 12 million monthly users (Guardian) and their user count was growing fast. Facebook was a social networking site for people who had time on their hands and the desire to connect with their friends. A passing fancy for the kids, no doubt, just like rock and roll was to an earlier generation of parents.  Or so it seemed.

That same year, the internet search company Google developed a beta version of a phone operating system (OS) that could compete with Apple’s iOS.  In the fall of 2008, a year later, Google released version 1 of the OS.  It was built with an open source code that Google called Android. That same month, the wheels came off the global economy. As millions of people lost their jobs, they worried more about paying their bills than a phone operating system.  By November 2008, both Google and Apple had lost half of the value they had in the summer.  Blackberry lost 2/3rds of its value.

In June 2009, two years after the launch of the iPhone, the electronics division of the conglomerate Samsung introduced the Galaxy smartphone.  The phone used the new Android OS and, to compete with Apple’s App Store, hundreds of apps were available for the phone.

Clickety-click as we turn the time dial to the present.  At $10, Blackberry’s stock sells for 7% of its price in June 2008.  Hillary Clinton likes her Blackberry but too many people switched. Until the fourth quarter of 2016, Samsung sold more phones than Apple, but Apple makes more profit on their phones and is the largest company by market capitalization.   Since the iPhone launch Apple’s stock price has soared 900%. Together the two companies account for almost half of all smartphones. They have become wearable computers and cameras and music players and podcast devices.

The iPod was the marriage of a CD player and a portable radio – a consolidation of two functions. Following its introduction in 2001, the iPod became the dominant music player.  Umpteen million songs were available on the device through the iTunes store.  In April 2007, Apple announced that they had sold 100 million iPods in 5-1/2 years, and by the end of 2014, that figure stood at 390 million.  But smartphone users were now using their phones to play music.  In 2014, sales of the iPod fell by half to 15 million. In 2015, Apple stopped reporting the number of iPods sold.  Consolidation had been the key to the iPods success and its demise.

The iPhone and the various Android models of smartphones have depended on increasing network availability and quality – “can you hear me now?” – and the thousands, or millions, of apps available for the phones. I can read email on my phone as well as my newspaper, a book or magazine. Students can read their textbooks on their phones. In addition to music, I can listen to podcasts or radio stations from far away.

The sophistication and accuracy of Google maps is science fiction made fact. I was recently in the middle of beautiful Idaho. The topographic map published a few years ago indicated that a particular county road was improved but unpaved. Google maps marked the road as paved for about ten miles. Google was right. Portions of Nevada that were blurred a few years ago on Google maps now show roads that lead to where? Maybe some alien city in the middle of the desert.

As I mentioned last week, the top 5 companies in the SP500 are tech companies. Ten years ago, the top 5 were Wal-Mart, Exxon, GM, Chevron and ConocoPhillips (Fortune), a mix of retail, automotive and oil sectors. Now there is only one sector at the top: technology. As a rule, concentration is not a good thing.

Let’s turn from tech to banks.  Since 2007, America has lost a third of its banks, a continuation of a trend that began after the Savings and Loan crisis in the late 1980s. The number of commercial banks in the U.S. is about a third of what it was in 1990. New York has lost half of its banks in that time. California has lost about 60% of its banks. You can check your state at the Federal Reserve Database  and search for [postal abbreviation for state]NUM. As an example, Colorado is CONUM. New York is NYNUM. California is CANUM. The U.S. figures I mentioned earlier come from the series USNUM.

Consolidation is spreading throughout the economy. In the last 12 months, more retail stores closed than during 2008, the year of the financial crisis. The stocks of the retail sector (XRT) have fallen 20% from their highs.

Adding to the pressure on brick and mortar retail stores, Amazon recently announced that they were buying Whole Foods. Amazon’s sales have grown by more than 1000% since 2007, and America’s stores have felt the pain.

The consolidation in the retail space has been going on since the 2001 recession and the demise of the dot-com boom. The population has grown 14% since then but the number of employees in retail has grown less than 3%. Inflation adjusted sales per employee have grown by 61% in the past 16 years but the inflation adjusted wages of retail workers have declined 1%.

We ourselves are concentrating. For the first time in the nation’s history, more people live in urban areas than rural areas. That concentration has pushed home prices up in the larger metropolitan areas. The S&P/Case-Shiller 20 city home price index has doubled since 2000, easily outpacing the 45% gain in prices, averaging 2% better than inflation.
Smaller cities and rural areas have not done as well. Below is a 40 year chart of inflation adjusted residential prices for all of the U.S. The average yearly gain is 1.7% above the inflation rate, slightly below the 20 city gains of the past 16 years. But the ten year average tells a story of crisis, erratic recovery and migration. The 20 city price index has lost only 1/4% per year since the highs of 2007. The country as a whole has lost 2% per year.


(Sources: National sources, BIS Residential Property Price database)

Where will this consolidation lead?
Less competition
Less responsiveness to customer needs
More political power to create a regulatory environment which guards against competition.



Mutual funds and ETFs usually specify their historical performance for several time frames, i.e. 1 year, 3 year, 5 year, 10 year, Lifetime. Four years ago, I noted the diffiiculties of getting a reasonable appraisal of performance if the comparison period begins with a trough in price and ends near a peak.

It is best to disregard the five year performance of many large cap stock funds this year because they include the 13% gain of 2012 and the 33% gain of 2013. A more honest appraisal is the ten year performance. Comparisons start in 2007, near the highs of the market before the start of the 2007-2009 recession and the financial crisis.

Vanguard’s SP500 index fund VFINX reports a ten year average annual return of 7.39%.  Their blended corporate bond fund VBMFX has an annual return of 4.12% over the past ten years.  If I had nothing but these two funds in my portfolio since 2007, my portfolio of 60% stocks, 40% bonds would have gained about 6.1%.  With a conservative allocation of 40% stocks, 60% bonds the annual return was about 5.5%.  The .6% percent difference in returns is slight but it adds up over ten years.  In the first case, a $100,000 portfolio would have grown to $181,000.  In the second case, about $171,000.

Let’s compare those returns to two actively managed blended funds that Vanguard offers.  VWINX is a balanced fund oriented toward income.  The mix is about 40% stocks, 60% bonds and it has earned 6.7% per year over the past ten years.  The Wellington fund VWELX has a mix of 65% stocks, 35% bonds and cash and earned 7.13% each year since 2007.  Both funds have fees that are slightly higher than Vanguard’s index funds but are relatively low at .22% and .25%.  Depending on allocation preference, either fund could serve as a core “gone fishing” fund.  You can use these as a basis for comparison with products that your fund company offers.

Next week I’ll put my ear to the ground and listen for….


May 14, 2017

Surprises, the good, the bad and the ugly. When we are in retirement, we are less resilient when the bad or ugly surprises happen. There are event surprises and process surprises. An event surprise might be the damage and loss from a weather related event. A process surprise can be even more deadly because it happens over time.

Misestimates and unrealistic expectations are two types of process surprises. Let’s look at the first type – misestimates. In a recent survey, Boomers were asked to estimate the percentage of income they would have to spend on healthcare. The average estimate was a bit less than 25%. The actual average is a third of retirement income. Let’s say a couple gets $4000 in monthly income from Social Security, interest and dividends. If they had budgeted $1000 (25%) of that for healthcare costs, then discover that they are spending over $1300 a month, that extra cost will slowly eat at their savings base.

A good rule of thumb is to estimate that, in the first few years of retirement, we will spend as much if not more than we spent before we retired. If we are wrong and we spend less, that’s a good surprise. In those first years we may find that we are spending more in one area of our lives and less in another.

The second type of process surprise – unrealistic expectations. Let’s say I expect to make 8% per year on my savings with a small amount of risk. People with a lifetime of experience in managing money struggle mightily to accomplish this and all but a few fail. Either they must take on more risk or lower their expectations of return.

Vanguard and other financial companies provide the expected risk and returns of several different allocations over many decades. Here‘s a chart at Vanguard that does not include a cash allocation in its calculation.  These long term calculators have another drawback: they include rather unusual times in history – the 1930s Depression era and World War 2.

We could use the last twenty years of actual returns to guide our expectations for the next twenty years. In past articles, I have linked to the free tools available at Porfolio Visualizer and there is a permanent link on the Tools page.

I select 1997 for the starting year and 2016 for the ending year. I leave the default settings at the top of the screen alone for now. If I input 40% into the U.S. Stock Market, 40% into the Total U.S. Bond Market, and 20% into Cash, I have chosen a conservative allocation – 40/40/20. I click the Analyze Portfolios button and see that the return was a bit over 6% in the CAGR (Compound Annual Growth Rate) column. How likely am I to achieve 8% over the next 20 years? Not very likely.

I’ll input a moderate allocation of 60% stocks, 30% bonds and 10% cash. The result is an almost 7% annual return so I am getting close to my 8% but there was a nasty time when I lost 1/3 of the value of my portfolio. If I am 70 years old, how comfortable would I be if I watched my portfolio sink almost 33%? I think I would have some restless nights worrying whether I would have to go back to work. How up to date are my skills? Would my prospective employer allow me to take a short nap in the afternoon? I feel so rested and ready to rock and roll after a nap. Well maybe not.

Wait a minute, I tell myself. The past 20 years included the busting of a tech bubble, 9-11 and the 2008 financial crisis. Two of those were rather extraordinary events. So I pick a different 20 year time period, 1987 – 2006. That still includes some serious shocks like the tech bubble and its pop, as well as 9-11. My conservative allocation of 40/40/20 made 8-1/2% CAGR and the moderate allocation of 60/30/10 made 9-2/3%.

But I’m not happy with the risk. I could even decrease my risk and make my 8% return by choosing a very conservative allocation of 30% stocks, 50% bonds and 20% cash. My portfolio lost less than 10% in its worst year ever – the maximum drawdown. If I go to Vanguard’s risk return chart they estimate a 7.2% average return over 90 years, which included a horrible depression that lasted a decade and a world war. It’s to be expected that my 20 year period 1987 – 2006 would do a bit better than the 90 year average because the catastrophic shocks are not included.  I think my 20 year period is more representative of the risks I will face in the next 20 years.

I could have picked the 20 years from 1981-2000 and that would have been unrealistic. The conservative allocation earned more than 10% and the annual return on the moderate allocation was almost 12%.

So I have now set what I think is a realistic 20 year time frame that gave me the historical risk and reward that met my expectations. But that’s not realistic. Not yet. I am going to be taking money from this portfolio to supplement my retirement income. So now I go back up to the top of the screen where the defaults are and under “Periodic Adjustments” I select the “Withdraw fixed percentage” option and under that I input 4.0%. This is supposed to be the safe withdrawal percentage. The next row is the “Withdrawal frequency.” I’ll select Annual.

Since I am now taking cash out this portfolio, I will turn to the IRR column of the results because the Internal Rate of Return calculation considers cash flows. My very conservative allocation of 30/50/20 has an IRR of almost 8.5% with a drawdown of less than 15%. The column that says “Final balance” shows that I have more than double the money I started out with and I have been able to withdraw 4% per year. I would have liked to get the drawdown below 10% but I think I can live with 13-1/2%. I’ll be worried but I don’t think I will lose sleep over it. So now I have made what I think is a reasonable expectation of risk and reward based on historical returns.

There’s one last thing I need to do. I know that the 20 year period from 1929 to 1948 was bad but I can’t check that in Portfolio Visualizer because the year selection only goes back to 1972. So I select a really bad ten year period, 2000 – 2009. This was from the heights of the dot.com boom to a short time after the financial crisis. After taking 4% per year, the IRR on my very conservative allocation was 4% and I still had the money I started out with at the beginning of the ten year period. I could probably withstand a 20 year period like this as long as I stay true to my allocation.  But, the maximum drawdown (see here) was 21%, something that I am not comfortable with.

I am left with some hard choices.   In the case of another bad ten year period, I can lower my withdrawal percentage a bit or I can learn to have faith in the allocation process and accept the drawdown.  I have done this with a free tool. I could pay for more sophisticated tools that gradually transition from one allocation to another allocation over a 20 year period.  That would be more realistic still since I will probably get more risk averse as I get older. At least this gets me started.

We often can’t avoid the suprise events. Some surprises are both event and process like the diagnosis of a  life-threatening illness. We can understand and be alert to the process surprises that we may inflict on ourselves. Understanding involves some frank self-assessment and difficult questions. Am I prone to wishful thinking? Do I overestimate my tolerance for risk? How well do I live with the consequences of my decisions?



A few weeks ago I mentioned that I might calculate a 20 year CAPE ratio. The CAPE that Robert Shiller uses is a ten year period. As of the end of 2016 the 20 year CAPE was 31 vs the 70 year average of 21. Whichever calculation we use, the market is priced a good deal above average. The 20 year CAPE first crossed above the average in the late summer of 2009.



Over the past 5 years California’s economy has grown faster than any other developed country except for China. Bloomberg article

Ten Year Review

January 15, 2016

10 Year Review

Before I begin a performance review, I’ll refer to an article  on the errors of comparing our real world portfolio returns to the optimized returns of a benchmark index.  An index stays fully invested, has no trading costs, taxes or fees.  An index has survivor bias; companies that go out of business or don’t meet the capitalization benchmark of the index are effortlessly replaced, so there is no risk.  Share buybacks benefit an index but not our portfolio.

The article contains some prudent and realistic recommendations: the importance of preserving our savings, a balance of risk and return that will meet our goals, AND our time frame.  As we review the performance of the following portfolio allocations, keep those caveats in mind.  If a model portfolio earned 8% per year, use that as a rough guideline only.

A 60/40 stock/bond portfolio returned an annual 6.3% over the past ten years with a maximum drawdown (MDD) of 30%.
A  50/50 mix returned 6% with an MDD of 25%.
A 40/60 mix returned 5.75% with a MDD of 20%.

A difference of 10% in allocation equalled a .3% in annual return, and a 5% change in MDD.  Let’s put that .3% difference in dollars and cents.  Over a ten year period, a $100,000 portfolio earning .3% extra return per year equalled about $43 extra per month, or about $1.40 per day.  Why is this important?  For whatever reason, some people worry more than others and may be willing to accept a lower return in order to sleep better at night.

Not all ten year periods will have the same response to various allocations.  The majority of ten year periods will include a recession, but this past ten years included the Great Recession. Let’s look at the historical effect of portfolio allocation during the past ten years.  In the chart below you can see the annual returns of various balanced allocation mixes shown in the left column.  At the end of 2009, the 10 year results show the results of two downturns: the 2001 – 2003 swoon and the 2007 – 2009 crash.

Note that the more aggressive 60/40 allocation has a lower return than the cautious 40/60 allocation during the years 2009-2011.  As we move forward in time, the effects of the 2001-2003 swoon diminish and, starting in 2012, the more aggressive allocation earns a better return.

Not shown in the chart are the results of a 100% allocation to stocks during the ten year period 2000-2009, the first column in the chart above.  A 40/60 allocation had a return of 3.8%.  A 100% allocation to large cap stocks had a LOSS OF 1% per year.

During the 10 year period 2007-2016, a 100% allocation to stocks returned 6.8% annually, a 1/2% higher return than the 60/40 mix, but the drawdown was 51%, far more than the 30% drawdown of the 60/40 portfolio.

High Winds or Hurricane?

A person who spends twenty years in retirement can count on at least two market downturns during that time.  Here’s how MDD, or drawdown, can affect a person’s portfolio.  I’ll present a more extreme example to illustrate the point.  Imagine an 80 year old retiree with a portfolio devoted 100% to stocks.  For several years, she had been withdrawing $40,000 from a portfolio that had a balance of $600,000 in the fall of 2007.  Projecting that her portfolio could earn a reasonable return of at least 7% per year, or $42,000, the balance looked secure.

But by March 2009, a period of only 18 months, the high winds had turned to a hurricane.  Her portfolio, her shelter in the storm, had lost 50% of its value, an MDD or drawdown of approximately $300,000.  During those 18 months, she had also withdrawn $60,000 for living expenses, leaving her with a balance of about $240,000 in the spring of 2009, the low point of the stock market.

Only 18 months earlier she had projected that she could maintain a minimum portfolio balance of $600,000. She had gnawed her nails raw as the market lost 20% by the summer of 2008, then sank in September when Lehman Bros. went bankrupt, then continued to lose value during the winter of 2008-09.  When would it end?

In March 2009, she had only 6 years of income left before her savings were gone.  Unable to stand the loss of any more value, she sold her stocks for $240,000 – at exactly the wrong time, as it turned out.  Her $240,000 earned little in a money market, forcing her to: 1) cut back the amount of money she withdrew from her portfolio to about $24,000 per year, and 2) hope she died before she ran out of money.

Of course, most advisors would NOT recommend that an 80 year old devote 100% of their savings to stocks.  BUT, some retirees might – and have – adopted a risky strategy to “whip” a portfolio to get more income or capital appreciation the way a jockey might do with a tired horse.  On the other hand, some 80 year olds with a very low tolerance for any kind of risk might have all of their savings in cash and CDs, a 0/100 allocation.

Now let’s imagine that our retiree had a cautious 40/60 balanced mix.  She would have had a drawdown of 20%, or $120,000, during the Great Recession.  After withdrawals for living expenses, she still had a balance of about $420,000 in March 2009. At a conservative estimate of a 5.5% annual return, she could have prudently drawn down her portfolio $25,000 – $30,000 for a year and waited. This is important for seniors: an allocation that allows some temporary flexibility in the withdrawal amount from a portfolio.

By the end of 2009, her portfolio had gained about 24%.  After living expenses of about $22,000 taken from the portfolio during the last 9 months of 2009, she had a balance of more than $500,000.  Her balanced allocation allowed her to wait longer for the market to recover.

In 2010, she could once again take her $40,000 living expense withdrawal and still have a $530,000 portfolio balance by the end of that year.  She has weathered the worst of the storm. At the end of 2016, she continued to take out $40,000 (adjusted upward for inflation) and still has a portfolio balance of $486,000.

Finally, her 40/60 allocation mix kept to a rule I have mentioned from time to time: the five year rule. If she wanted to take approximately $40,000 from the portfolio each year, she should have a minimum of 5 years, or $200,000 in bonds and cash – the “60” in the 40/60 allocation mix.  In the fall of 2007, she had $360,000 (60% of $600,000) in less erratic value investments.  This rule helped her withstand the storm winds of the Great Recession.


Seniors at Risk

Although the number of loans to those 65+ are less than 7% of the total of student loans, a shocking 40% of these loans are in default.  Most of these loans were cosigned by seniors for their children or grandchildren. The law allows the Federal Government to garnish or lien Social Security and other federal payments to cure the loan defaults.  Readers with a WSJ subscription can read the article here or Google the topic.


Hot Housing Markets

In a recent analysis, western cities rule Zillow’s top 10 housing markets for valuation increases.


Take this job and shove it!

The latest JOLTS report from the Labor Dept. shows the highest quits rate in private industry since the housing boom in 2006. Employees confident of finding another job are more willing to voluntarily leave their job, and have driven the rate up to 2.4% from a low of 1.4% in the 2nd half of 2009.

Statista compiles data from around the world, including this revealing tidbit: 26% of jobs in the U.S. are unfilled after 60 days, the highest percentage in the developed world. Germany ranks 2nd at 20%, and our neighbor to the north, Canada, comes in at nearly 19%.

What lies behind this data is a mismatch.  Employers may be requiring skills that job applicants don’t have.  Job applicants may want more money or other benefits than employers are willing to pay.


Obamacare Repeal

The Committe for a Responsible Federal Budget (CRFB) – yep, it’s a mouthful – has projected costs to repeal Obamacare in whole and in part.  Using both conventional, or static, budget scoring and dynamic scoring (google it if you’re interested), they guesstimate a 10 year cost of $150 to $350 billion for full repeal of the ACA.

Repeal of ACA’s insurance coverage would actually save a lot of money, more than $1.5 trillion. The net effect is a cost, not a savings, because of the $2 trillion in tax revenue on higher incomes that is built into the ACA law.

CRFB analysts have put a lot of work into these projections, including a breakdown of repealing just parts of Obamacare or delaying repeal of certain ACA provisions.  Since the Republican Congress is likely to keep some provisions, readers who are interested might want to come back to this link in the coming weeks as the discussion of this issue unfolds.