The Price of Mispricing

June 11, 2017

In an April 2016 Gallup poll  52% of Americans said that they had some stocks in their portfolio. In this annual survey, the two decade high occurred in 2007 when 65% of those surveyed said stocks were a part of their savings. Asked what they thought was the safest long term investment, surveyed respondents answered: stocks/mutual funds. The stock market hit a high in the fall that year.

Turn the dial to April 2008. The market had declined 10% from its October 2007 high but there was still five months to go till the onset of the financial crisis in September. Americans surveyed by Gallup said that savings and CDs were the safest (Poll ). At that time, a 5 year CD was paying 3.7% according to Bankrate . What happened to turn sentiment from rather risky stocks to safe cash and CDs? The decline in the SP500 might have been responsible. A more likely cause was the recent headlines concerning the failure of the investment firm Bear Stearns. The Fed provided a temporary bailout, then arranged a sale of the firm to JPMorgan Chase.

When real estate prices were rising in the early 2000s, people thought real estate was the safest long term investment. Each of us should ask ourselves an honest question. Do I treat relatively short term shifts in asset pricing as though they were long term trends?

Here’s another thought. Do we mentally treat changes in asset pricing as though it were cash income? If I see that the value of my stock portfolio has gone up $10,000 since my last quarterly statement, do I think of that as kind of a dividend reward for my willingness to take a bit of a risk? The statement confirms that I’m a prudent investor. Do I mentally “pocket”  that $10,000 as though someone had sent me a check?

On the other hand, if my statement shows a decrease in value, I have not only lost money but now I may question my prudence. Am I taking too much risk? I might even think that “the market” is wrong. Can I trust a market that could be wrong? What if there’s another financial crisis? Should I sell my stocks and put the money in CDs? A 5 year CD is only paying a little bit above 2% but at least I won’t lose any money.

Let’s crawl out of our heads and into the pages of history. In the early 1950s, two people published ideas that have come to dominate the investment industry.

In 1951, John Bogle wrote his Princeton college thesis “The Economic Role of the Investment Company.” The paper was an in-depth analysis of mutual funds, a product that was less than 30 years old. (Excerpts). At that time, only 8% of individual investors owned stocks.

Two decades later, Mr. Bogle would go on to found Vanguard, the giant of index mutual funds.  Contrary to the founding principle of Vanguard, Bogle’s 1951 paper did not champion indexing.  In Chapter 1, he objected to the portrayal of a mutual fund as settling for the average returns of an index of stocks.  Bogle touted the active management that a mutual fund provided to an investor.  In a quarter century after he wrote the paper, Mr. Bogle’s conviction in the superiority of active management shifted toward passive indexing. Indexing is the averaging of the decisions of all the buyers and sellers in a particular marketplace.

When Bogle wrote his paper, two types of funds competed for an investor’s attention. The earliest funds were closed end (CEF) and date back to the middle of the 19th century. The Adams Diversified Equity Fund was founded in 1854 and continues to trade today under the symbol ADX. After the initial offering a CEF is closed to new investors. The shares continue to trade on the market like a company stock but investors can no longer buy or redeem shares with the company that manages the fund.

A mutual fund is an open end product, meaning that the fund is open to new investors and investors can redeem their shares at any time. The early mutual funds touted this feature but it was not statutory until the enactment of the Investment Act of 1940.

When Bogle wrote his thesis, the market was still in what is called a secular bear market. The beginning of this period was marked by the brutal crash of 1929 and would not end till 1953, when the price of the SP500 finally rose above the highs set in 1929. The 1920s had been a decade of rapid growth in the new radio industry and manufacturing. The automobile and stock markets were fueled by easy credit. In response to this short era of explosive growth, investors elevated their long term expectations. From 1926 to 1929 the stock market doubled in price, a rapid mispricing that finally corrected in the October crash of 1929.

In 1951, Bogle summarized the previous two decades:
“The depression and the great capital losses to investors which resulted from it caused a greater desire for safety of principal, but gradually confidence in stocks (and especially in a diversified group of them) returned, and during the same period bond rates fell. The combination of high income and safe principal thus shifted in favor of the common stock element. In spite of the fact that many funds urge that part of the investor’s capital should be devoted to bonds, after he has cash reserves and insurance needs filled, it seems doubtful that this advice has been widely followed. “[my emphasis]

In his analysis, Bogle identified several metrics that gave open-end mutual funds superiority over closed-end funds: prudent management to keep the fund attractive to new investors, diversification, liquidity, and income.

Bogle concluded his thesis with a caution that is timeless: “That the market will fluctuate is certain, and merely because it has experienced a general upward trend in the decade of the investment company’s greatest growth may have made many investors fail to realize that the share value, like the market, is liable to decline.”

He looked toward the future of mutual funds, and expressed what would become the business plan of Vanguard: “perhaps [the mutual fund industry’s] future growth can be maximized by concentration on a reduction of sales loads and management fees.”

In the past 15 years, only 15% of active large cap managers have beat the returns of the SP500 index.  The performance is even weaker for small cap stock managers.  Only 11% beat their index.  Individual investors have withdrawn money from actively managed funds and put that money to work in their passive counterparts.  As more money flows to index funds, the danger is that those funds will be averaging the decisions of a smaller pool of active managers. That objection is raised by advocates for active management but it seems unlikely that the pool of active managers will diminish to the point that a few remaining managers will essentially control the direction of the market.  Although recent flows of money have favored passive indexing, actively managed mutual funds and ETFs still control two-thirds of all assets (Morningstar).

In the following year, Harry Markowitz, a graduate student at the University of Chicago, wrote a paper titled “Portfolio Selection” which proposed a systemic approach to diversification called Modern Portfolio Theory. Bogle had noted the prudent rule of thumb that an investor should devote some capital to bonds as well as stocks to stabilize a portfolio. Markowitz mathematized this rule of thumb. The key to portfolio stability was a strategy of asset selection that minimized risk in the face of uncertainty. Any two assets, not just stocks and bonds, that were normally non-correlated would provide stability. When one asset zigged in value, the other asset zagged. Both assets could be risky but if one asset responded opposite the other, then the net effect of owning both assets was to lower the risk.

The key word in any talk of historical correlation is “normal.” There is no theory which can explain investor trauma, a total lack of confidence in most assets. In October 2008, every asset but one fell. Both stocks and gold fell 16%, commodities sank 25% and REITs fell a whopping 32%. Even bonds, a safe haven in times of uncertainty, fell 3%. In a world where every asset class was losing value, investors bought short term Treasuries, which rose 1%, but avoided long term Treasuries, which declined 2%. There was no safety to be found outside of the U.S. Emerging markets fell 26%, European stocks sank 23% and international real estate nose dived 32%.

But the correlation in normally non-correlated assets could not last. During the following two months, bonds rose 9%, and gold shot up 20%. Stable or defensive stocks like health care continued to lose value but at a slower pace. Some investors stepped in to pick up quality stocks at bargain prices. The stock market continued to stagger to a bottom until the passage of the American Recovery and Reinvestment Act in February 2009, soon after the inauguration of Barack Obama.

50% market repricings are relatively infrequent. That we experienced two such events in less than a decade in the 2000s caused millions of investors to abandon risky assets entirely. The SP500 index did not recover the ground lost till January 2013, more than five years after the high set in October 2007. The recovery after the dot-com bubble burst in 2000 lasted a similar time, 5-1/2 years.

When was the last time we had back to back severe downturns? We need to turn the dial back to the fall of 1968 when the market began a 1-1/2 year decline of 33%. After a few years of recovery, stocks fell again. Provoked by the Arab-Israeli war, the oil embargo and high inflation, the market began a repricing in 1973. The recovery lasted almost seven years.

In 1975, Bogle founded Vanguard, what some called “Bogle’s Folly.”  Four years later, the SP500 was barely above its high in 1968. Investors had so little confidence in stocks as a long term investment that, in August 1979, Business Week declared that stocks were dead. Since that declaration, the price of the SP500 has gained about 8-1/2% annually.  Add in 2 – 3% in dividends and the total return exceeds 10% annually.

Bogle and Markowitz have had a profound influence on the investment industry by developing two deceptively simple ideas for investors who can’t know the future.  Bogle’s thought: don’t bet on which chicken can lay the most eggs.  The complimentary idea from Markowitz: don’t put all your eggs in one basket.

Next week – what’s so special about market averages?  They’re not your average average.


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 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

The Long Game

April 16, 2017

Happy Easter!

Successful investing requires a far sighted vision. At the end of each year Vanguard sends its customers their long term outlook. This last one contained a few caveats: “the investment environment for the next five years may prove more challenging than the previous five, underscoring the need for discipline, reasonable expectations, and low-cost strategies.”

Vanguard’s ten year estimate of annualized returns is about 8% for non-US equities, 6.5 – 7% for the US stock market, 5% for REITs (real estate) and commodities, and 2% for bonds.

Vanguard’s team projects that a diversified portfolio of 60% stocks/ 40% bonds will return 5.6% annually over the next ten years. An agressive 80/20 mix they estimate at a 6.6% return, and a very conservative 20/80 mix at about 3.3%. Insurance companies typically adopt this safe approach. (Source)



Investors near or in retirement must often turn to their investments for supplemental income. Annuities are sold as a safe “set it and forget it” solution, but they come with upfront fees and currently pay low interest.

In early 2008, before the fianncial crisis, a 65 year old man could get an average annuity (the average of a 10 year and life) for 5.5% a year. That provided a guaranteed income that was more than the classic 4% “safe” withdrawal rate for retirees. That 4% withdrawal rule would normally ensure that a retiree did not run out of money before they died.

The average annuity rate for that same age is now half that interest rate (Source). For an investment of $100K, a 67 year old male living in Colorado can get a lifetime annuity of $7212 per year (CNN Annuity Calculator) For 14 years, the insurance company providing the annuity is essentially returning the investor’s money to them. If that male investor lived for 20 years till age 87, they would receive a total of $144K, an annual return of only 1.84%. If the retiree lived to 97, their annualized return would increase to 2.5% over the thirty year period. Clearly, an investor is paying for safety.

Wade Pfau is a CFP whom I have cited in previous blogs. Here he compares the advantages and disadvantages of investments vs. insurance. He makes an argument that an annuity that covers one’s essential needs allows a person to take more risk with the rest of their portfolio. The potentially higher return from the investment side of the portfolio can thus make up for the lower returns of the annuity, an insurance product. He does caution, however, that most annuities do not protect against inflatiion. A investor who needed $1000 extra dollars in monthly income in 2017, would need more than $2000 in 30 years at a 2.5% inflation rate.

Managed Payout?

One alternative is a managed payout fund. The Vanguard Managed Payout Fund VPGDX lists the fund’s holdings as 60% stocks with an almost 20% allocation to alternative strategies. Alternatives vary in volatility depending on the intent of the investment but let’s treat them as though they were mostly a stock, giving the fund a simple effective allocation of 75% stock, 25% bonds. This fund lost 43% from April 2008 through March 2009, less than the 50% loss of the SP500 index but not by much. A broad composite of bonds (BND) actually gained 3% in price during that time. Here is some info from the investing giant Black Rock on alternative investments.

The return of the fund since its inception in April 2008 is 4.28%. Vanguard’s broad bond composite fund VBMFX, with far less risk, had a ten year return of 4.12% and gained value during the financial crisis. Although some mutual funds have trade restrictions, the prospectus on this fund lists no such restrictions, so that one could set up a monthly withdrawal from the fund.

A Vanguard target date 2030 fund (VTHRX), which has an allocation of 70% stocks, 30% bonds, had a ten year return of 5.31%. That fund lost 45% during the eleven month downturn in 2008-2009, slightly more than the Managed Payout Fund.  The additional 1% annual return is the reward for that slightly greater drawdown. A 1/4 of that additional 1% return can be attributed to lower fees.

The advantage of a Managed Payout Fund – simplicity and regularity of income flows – does not outweigh the disadvantages of volatility and some tax inefficiency. An investor could conveniently set up a monthly withdrawal from a broad based bond fund and enjoy the same return with much greater safety of principal, lower fees, and control over the withdrawal amount, if needed.

When it comes to retirement income, most investors would prefer the simple arithmetic of our grade school years.  Both Social Security and traditional defined benefit pension programs use that kind of math.  Each year, a retiree gets ‘X’ amount that is adjusted for inflation.  No choices needed.  However, most employees today have defined contribution, not benefit, plans. A retiree owns their savings, the capital base used to generate that monthly income, and it is up to the retiree to  navigate the winding channel between risk and return.

It’s Never Happened Before

July 24, 2016

It’s often been said that everyone is entitled to their own opinion but not to their own facts.  Repeated experiments have shown that, through a process of cognitive filtering, we do form our own set of facts. First we filter what we recognize, then we assign different degrees of importance to what we do recognize.  The world is a big lump of Play-Doh that we pull parts from then shape it into a personal ball that we call reality.

Several decades ago when computer development and design was still fairly primitive, computer scientists envisioned the develpment of algorithms that allowed computers to act with the mental versatility of human beings. Many hoped that this new technology, called artifical intelligence, or simply AI, would be implanted in robots which would handle menial or dangerous tasks, making our lives both safer and less tedious.  Soon robots were deployed on factory floors and were highly effective at repetitive tasks.  The deployment of AI was but a few years distant, it seemed.

The AI project soon ran into difficulties when robots tried to navigate a room with only a few obstacles.  What was a routine task for a two year old toddler was extremely difficult for a robot.  Programmers struggled to write algorithms to distinguish and describe just the shadows of objects, and were especially frustrated that a puppy a few weeks out of the womb could do a better job at navigating a room than the most beautifully complex algorithm they could devise.

A decade or so later, Google and other tech firms are test driving cars with autonomous navigation.  How have AI algorithms progressed from negotiating the obstacles in a room to navigating a highway at 65 MPH?  Working with behavioral scientists and psychologists, programmers began to uncover a rather unflattering but powerful model of human learning, one that philosopher David Hume had posited almost three hundred years ago.

Hume was just a teenager when Isaac Newton, perhaps the greatest scientist that ever lived, died in 1726.  Newton formulated the fundamental laws of motion and gravitation.  Hume, on the other hand, put forth the radical notion that we can not know cause and effect, only the correlation of events. We can imagine that Newton rolled over in his grave a few times at this proposal. Hume contended the forces of motion that Newton had proposed were highly probable correlations only.

Scientists dismissed Hume’s skepticism.  For all practical purposes, the universe was bounded by the laws of classical mechanics that Newton had devised.  Scientists went on to develop a model of a clockwork universe created by God that obeyed a set of rules invented by God and thank you very much.  There was apparently little more to discover until two scientists, Albert Michelson and Edward Morley, went to measure the aether, a fundamental component of the clockwork universe.  They couldn’t measure it.  This “undiscovery” rocked the world of physics because it undermined the theories of planetary motion, of gravitation, and the behavior of light.  Undiscoveries are as important as discoveries.  A hundred years before the Michelson-Morley experiment, chemists were unable to find phlogiston, the supposed fundamental cause of combustion, and caused a radical revision of chemical theory.

Twenty years after the Michelson-Morley experiment, Albert Einstein presented his Special Theory of Relativity but even that theory could not fully explain gravity.  A decade later and a hundred years ago, Einstein theorized that our perception of falling was an illusion based on our perspective, a vantage point as we were falling along the surface, or field, of space time.  The system of relative motion that he introduced has radically altered the science of physics since.  Einstein had introduced the same skepticism to the physical sciences that Hume had introduced to philosophical inquiry.

During the past two hundred years mathematicians have developed a number of statistical tools to measure not only the correlation between events, but the correlation of our past predictions based on correlation. As processors became more powerful and memory storage more compact, programmers turned to those statistical tools to enrich their AI algorithms. A baby can not find its own hands at first.  Through trial and error the baby develops a sensory system called proprioception that is not confused by the conflicting data from the baby’s eyes.  When the baby moves both hands in opposite directions to the center of her vision, the hands have more of a chance of colliding together.  The sense of touch confirms the contact of the two hands.  There may be a slight sound. The brain learns the coincidence, the correlation of these phenomena and forms a learning model of cause and effect.

Shortly after the financial crisis in 2008, the former head of the Federal Reserve, Alan Greenspan, testified before Congress about his personal set of beliefs of cause and effect in finance. Because this set of circumstances had not happened before, Mr. Greenspan thought that it could not happen.  Didn’t he see the dangers of 30-1 leverage ratios by major banks in the U.S.?, Greenspan was asked.  Yes, he saw them but did not fully appeciate the degree of danger.  The rash stupidity of bank officers, the disregard for their own welfare, surprised and disturbed him most.  He could not understand that intelligent people could act with such utter disregard for their own self-interest.  Of course, the bankers didn’t have to look our for themselves.  They paid politicians in Washington to do that for them.

Greenspan is a very smart man, as are most of the economists and financial wizards who did not understand the dangers of the synthethic debt instruments that were being created and traded.  Why?  Because it had not happened before.  We are all subject to this fault in judgment.  We are so guided by past experience that it skews our judgment, our ability to assess both risk and opportunity.

 It has been seven years since the market low in March 2009, seven years since the official end of the recession that began in December 2007 and ended in June 2009.  The Shiller price earnings ratio of the SP500 index is very much higher than average.  Even the conventional P/E ratio, the TTM or Trailing Twelve Months ratio, is about 23; the historical average is less than 17. Here is an excellent recent review of P/E ratios.  Low oil prices have helped cripple earnings growth for the SP500 index as a whole but even when excluding energy stocks, both revenue and earnings growth has shrunk.  Yardeni Research has put together several graphs to illustrate the trend.

The Money Flow Index (MFI) is an oscillating measure of buying and selling pressures based on both volume and price.  This index usually ranges from 20 to 80 on a scale of 0 to 100.  This month, the 12 month reading of the SP500 fell below 40.  Such a low reading has been associated with a long period of a rather flat market as happened in 1994-1995.  More often, a low reading is associated with subsequent falls in equity prices, as in early 2000 and late 2007.  Toward the end of 2008, this index fell below 20, indicating extreme selling pressure.  We only have past correlations to guide us.

Bond prices are high.  Vanguard’s ETF of intermediate term bonds, those with maturities of five to ten years, are now yielding less than 2%.  As bond and stock valuations have climbed, have we adjusted our portfolio allocation to stay within our guidelines?  Oops, did we kind of forget to even look anymore?  Did we get lulled into a sense of security?

Saving money is a gamble on the fact that we will get older.  Most of us will experience some reduction in our physical abilities, and a corresponding decrease in the amount of income we earn from our labor.  Saving money therefore seems like a really safe bet.  Once the money is saved, though, another series of gambles begins and these bets are far less certain.  Where to put those savings so that we can get a reasonable balance of return and risk?

 For a short time both the stock and bond markets can experience a surge in selling as they did in 2008. When investors are scared, they run like deer into the safety of cash. After the initial reaction, one or the other of these asset groups will continue to feel selling pressure.  This is why most advisors recommend some balance of stocks and bonds. If the stock market were to drop 50%, or the bond market drop 20%, and stay down for five years, would we be able to meet our income needs?  Such a downturn might be welcome to a 35 year old who can buy equities at a lower price.  For seniors near or in retirement who might have planned to convert some of those higher valuations into income, such a downturn can be devastating.  If such a scenario would be a crisis for you, then it is time to assess your situation and perhaps make changes.

Leverage And Risk

In a 9/23/09 WSJ op-ed, Andy Kessler, a former hedge fund manager, argues against the current administrations proposal to curtail excess bonuses that reward employees of banks and investment firms for taking excessive risks.

Mr. Kessler writes “It wasn’t reckless schemes and excessive risk that sunk banks and Wall Street; it was excessive leverage.” Wall Street investment firms had used that excessive leverage to make what they thought were fairly low risk bets. The complexity of oversight and of rule making to control employee pay makes it difficult to manage.

Kessler’s proposal is a sound one. Instead of a cap on bonuses, Wall Street firms should be charged appropriately for the “insurance” that the Federal Reserve and the FDIC provide Wall Street. That risk adjusted insurance charge will reduce the profit for more leveraged trades, effectively squeezing an employee’s pay on the trade. Kessler argues “let the Fed and the FDIC use to market to protect the market.”

Asset Allocation

A portfolio analysis adds up your investments in various categories to determine your asset allocation, a measure of the anticipated risks and returns of a portfolio.

The historical returns of stocks are higher but so are the risks. Bonds have less risk and less return. More importantly, there is a historical inverse correlation between stocks and bonds so that bond prices usually rise when stock prices fall and vice versa.

These historical trends were broken during the past year as almost all asset classes fell. Since March 2009, both bond and stock prices have risen dramatically. The recent crash and credit crisis has made people more cautious and we can expect that money will continue to flood into the perceived safety of bonds. How long can both stocks and bonds rise? When will the inverse relationship reassert itself? Which is the more powerful emotion? Will fear continue to drive money into bonds or will greed goad investors into the more risky stock market?

Asset allocation can dampen the emotional driving forces behind your investment decisions.

In an October 1999 WSJ article, Jonathan Clements examined the finer points of asset allocation with some investment professors. Most people calculate their asset mix by adding up the value of their stocks, bonds and cash. An old maxim is that the percentage of bonds and cash in your portfolio should approximate your age. The truest maxim may be “Go with your gut.” If you can’t sleep at night worrying about your investment portfolio, then it’s time to ease up on the risk in your investments.

So what about your house? House prices historically rise 3 – 4% per year, a return that approximates the return on a bond. When calculating your asset mix, should you include the equity of your house in with the total of your bond investments? A real estate professor that Clements interviewed maintains that a house is not a conservative investment. Historical data shows that, over a period of three years, housing prices have sometime fallen 40%. Remember, this article was written in 1999. How many people heeded that advice and treated the equity in their house as though it were more like an investment in a stock fund?

An investments professor interviewed by Clements “suggests treating your mortgage as a negative position in bonds”, subtracting the amount of the mortgage from the total bonds in your portfolio.

The point of analyzing a portfolio is to assess the risks that your investments are exposed to and that you personally are comfortable with. In this past year, too many older Americans found out that they were exposed to a lot more risk that they thought.