Quiz!

Which of the following statements are true?

  1. Borrowing to invest can make anyone wealthy.
  2. Borrowing to invest in a volatile fast growing investment, leads to higher long-term security at the price of lower short-term security.
  3. Borrowing to invest is never smart for young people.
  4. Borrowing to invest is never smart for retirees.

When Increased Leverage can Improve Your Short-Term Security

Borrowing to invest can let you enjoy excess returns equaling the investment growth minus the loan interest. While you commit to a fixed cost, to enjoy a volatile benefit, there is a case that can increase your overall short-term security, in addition to the typical higher long-term security. An example can demonstrate this point. Please read carefully the assumptions & notes below – most people are better off not borrowing to invest.

  1. Say you have $100k in investments (in Extended-Term Component), a $1M house with no mortgage, and you spend $100k per year. If you lost your job for more than about a year, you can be wiped with no cash to support yourself.
  2. Now, assume that you borrow $800k at 5% interest-only, and add to your investments. Even under tough investment scenarios, you can survive the 2 years out of a job.

The following table summarizes the impact of the borrowing-to-invest:

Impact of different leverage choices, with $100k in investments (in Extended-Term Component), $1M house, and a 2-year job loss, leading to $200k withdrawals

Case No mortgage $800k mortgage @ 5%
Good: Starting at 2003 Out of cash after 1.5 years +$1.74M after 2 years, owe $800k
Bad: Starting at 2008 Out of cash after 0.8 years +$410k after 2 years, owe $800k

The leverage helped you avoid bankruptcy, by turning your illiquid house into a liquid source of cash. Surprisingly, whether your unemployment occurs during a stock surge, or the worst crash of your lifetime, it helps you survive an extended period of unemployment.

Important assumptions & notes:

  1. This article reviews only one aspect of leverage. The topic is complex and requires a thorough risk analysis.
  2. While the short-term security goes up in this case, and the long-term security would typically be higher, there could be a combination of an extreme decline combined with many years of withdrawals, that can negate the long-term benefits, resulting in an overall loss.
  3. The key to the increased short-term security is the improved spending/assets ratio. In the example above, there is a dramatic improvement from 100% ($100k/$100k) to 16% ($140k/$900k). If the interest on the loan is higher than your current spending rate, the loan will hurt your short-term security. This is typical of retirees. For example, if you have $4M and spend $120k/year, your spending rate is a comfortable 3%. Adding the loan, will increase your spending rate to 3.33% ($160k/$4.8M). While your long-term security can still benefit, it is not recommended for retirees, especially if the new withdrawal rate is high enough to lead to problems under severe declines.
  4. The loan cannot be called. This is typical of mortgages in the US, assuming you make all payments on time. This is not true for margin loans that may be called at the worst time – at the depth of a market decline.
  5. You invest the entire loan amount.
  6. Your spending habits stay the same, and you don’t get tempted to increase your spending with the extra $800k in the bank.
  7. You don’t sell in a panic after a decline like 2008, and don’t get a heart-attack. Either can turn the temporary decline into a permanent loss.
  8. As soon as you find another job, you go back to saving regularly. You never withhold investing at low points (after big declines).
  9. You may enjoy some of the short-term benefits above using a HELOC – a home equity line of credit, that is left not borrowed until the need comes up. There are some pitfalls to HELOCs to watch out for: (1) in rare cases it may be frozen to new borrowing, and (2) the interest rate is usually higher than mortgage rates. Also, without the actual borrowing to invest, you can’t get the long-term benefits.
  10. In the example above, you may be able to sell the house, but there are a number of issues with this plan: (1) When selling the house, you turn a temporary problem (job loss) into a longer-term issue – selling a house, moving, maybe later buying another house, and paying realtor fees; (2) You would not want to sell too soon, while hoping to find a job, but if you wait too long, you may need to sell in a rush, leading you to get underpaid for the house.

Quiz Answer:

Which of the following statements are true?

  1. Borrowing to invest can make anyone wealthy.
  2. Borrowing to invest in a volatile fast growing investment, leads to higher long-term security at the price of lower short-term security.
  3. Borrowing to invest is never smart for young people.
  4. Borrowing to invest is never smart for retirees.

None of the statements are true! Explanations:

  1. If you can qualify for large loans, you invest the full proceeds in a fast growing investment, you never panic and sell at a decline, you do a careful risk plan and a host of other conditions, you have a chance to become wealthy. If you mess up any of the conditions, you can go bankrupt, even if you started as a billionaire.
  2. See this month’s article – under certain conditions, you may enjoy higher short-term security along with a typical higher long-term security.
  3. Borrowing to invest may be smart for young people under the right conditions, and after a careful risk analysis.
  4. Borrowing to invest is typically not smart for retirees, but there may be unusual circumstances, where a retiree can maintain a very low withdrawal rate despite the borrowing, and also prefers the higher potential growth despite the higher volatility.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

  1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%.
  2. Buy well established companies that are not going anywhere.
  3. Buy obscure small companies that you don’t understand.
  4. Buy companies you clearly understand.

The Secret to Getting Rich

Have you ever heard a secret for getting rich? As an investment advisor, I hear such ideas frequently, and evaluate each of them with a critical eye. There is one thing in common with most, maybe all, ideas that work: they go against human nature, or deeply engrained human biases. If this sounds surprising, a few examples may help:

Good Action

Bias

Biased Action / Human Nature

Defer spending to invest, and enjoy compounded growth

Present Bias

Emphasize the present over the less tangible future

Invest in fast growing (and volatile) investment classes

Myopic Loss Aversion

Avoid declines, even temporary

Buy low: value stocks (low Price/Book), AND investments at a low point of the cycle (after years of declines)

Recency Bias

Prefer investments that did best in the recent 5-10 years

Diversify across countries

Home Bias

Buy familiar stocks that are close to home

Own small stocks

Familiarity Bias

Buy large stocks that are more familiar

Enjoy momentum

Disposition Effect

Sell too soon, after seeing a gain, and too late after seeing a loss

Buy small & unknown profitable companies

Familiarity Bias

Focus on known profitable companies over less known ones

A couple of notes about the list above:

  1. If some of the profitable actions listed in the first column seem natural to you, you are in luck, having strategies that are uncomfortable to others, but comfortable to you, letting you likely enjoy excess gains compared to the average investor.
  2. An issue that makes most of the above especially difficult is that they tend to show poor results for extended series of years. It requires a big commitment, to enjoy the long-term benefits.

If you hear of an idea for getting rich that is easy to implement, both technically and also in terms of human nature, you should be skeptical. The ideas that survive the test of time tend to be difficult or go against human nature. Otherwise, many people will pursue the investment, bidding up its price and hurting future returns.

Now that you realize how difficult it is to follow the good advice for growing your money, should you give up? No. Here are some ideas:

  1. Think of tangible examples for the tradeoffs. For example, would you give up spending $10,000/year for the next 20 years, in return for $38,700/year for the following 20 years (assuming 7% real growth), or one lump sum of $521,000 in 20 years? Think about a specific dream you can fulfill with these amounts.
  2. Get the longest data you can, for the asset classes of your investments (e.g. US large stocks, International value stocks, real estate in various locations), and get a sense for the length of cycles. If some past cycles reached 15 years, never use the past 5-10 years to conclude that there is a new normal.
  3. After a long tough stretch, when the media may be most discouraging, try to identify the recent peak or bottom. If the peak was a good number of years back, or the bottom was fairly recent, you should become more optimistic. If you see low valuations (low Price/Book for stocks or high affordability for real estate), it should further support your optimism.

Quiz Answer:

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

  1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%. [Correct Answer]
  2. Buy well established companies that are not going anywhere. [Correct Answer]
  3. Buy obscure small companies that you don’t understand.
  4. Buy companies you clearly understand. [Correct Answer]

Explanations:

  1. Recency Bias. An investment that did exceptionally well (relative to its average) for 5 years may be overvalued, and is at an elevated risk.
  2. Familiarity Bias. Well established companies tend to be well known, and you may pay a premium for the comfort of the familiar, well established name.
  3. As long as you stay diversified, and stick with small companies throughout the cycle, you are likely to get a return premium for holding these less familiar and less comfortable investments.
  4. Familiarity Bias. See #2.
Disclosures Including Backtested Performance Data

Quiz!

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

  1. -70%
  2. -62%
  3. -14%
  4. 0%
  5. +24%
  6. +66%

Can you Guess the Top Performing Country Last Year?

As an Investment Advisor, a fiduciary that is responsible for the life’s savings of entire families, you would expect to count on me to follow the economic news closely and be ready to react to any new developments. Do I do this? I do the exact opposite – I separate my investment decisions from economic news. If I were to depend on the news for investment decisions, I could hurt your life’s savings badly.

A recent example from 2016 can demonstrate this counterintuitive point. Brazil spent the entire year in a devastating recession – the worst on record (over more than 100 years). Unemployment climbed throughout the year from 9% to 11.9%. The president was impeached and there were numerous corruption scandals. Predicting this year could have made you a fortune by shorting (making money when stocks decline) Brazilian stocks in 2016, right? Not so fast. The Brazilian stock market gained +66% in 2016. Not only did it not decline – it was the top performing country for the year.

How is it possible to get stellar returns during the worst economic decline on record? The answer is simple – ignoring prices. The consensus view was for a long and deep economic decline, which would hurt Brazilian companies. In reaction, people sold Brazilian stocks to avoid the declines. The problem was that people kept selling these stocks without regard to prices. Why is this a problem? Say that in normal times a basket of Brazilian stocks is worth $100. Now comes a big recession, and the new realistic value is, say, $80. You would expect rational people to sell until the price reaches $80. But many investors see a struggling economy and sell with disregard to the price. Others cannot imagine a turnaround and sell to reflect a multi-year depression. So, the continued selling brought the basket to a much lower value, say $40. This reflects an unusually bad expectation – far worse than reality. Now comes additional moderately negative news, lowering the realistic value from $80 to $75. With the news being far less negative than expected, people become more positive, and are more likely to accept a value closer to reality. They are ready to correct some of the excess decline, leading to a surge from $40 to, say, $66.40 (a gain of 66%), all while the economy is doing poorly. While the numbers in this example where made up, the mechanism explains what could have led to the surge of Brazilian stocks.

As of 9/30/2016, Brazil represented 6.82% of emerging markets, while the allocation to it in the emerging market portion of QAM’s portfolios was 9.19%. This emphasis reflects the deep value focus (a focus on low priced stocks) of these portfolios, something that often leads to outperformance compared to the general market during recovery years.

Quiz Answer:

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

  1. -70%
  2. -62%
  3. -14%
  4. 0%
  5. +24%
  6. +66% [The Correct Answer]
Disclosures Including Backtested Performance Data

Quiz!

If the longest possible decline (peak-to-peak) for ET (Extended-Term Component) were 12 years (a hypothetical assumption, which was chosen as a punitive example given current conditions), and you were to invest money in ET today, what would be the longest possible decline for this investment?

  1. Less than 3 years
  2. 3 years
  3. 12 years
  4. More than 12 years

Look for the answer below and read this month’s article for a discussion.

Volatility is not the best Measure of Investment Risk

Volatility is the most common measure of investment risk.  There are a number of reasons:

  1. Some investors panic and sell at a low point.  Selling a high-growth high-volatility investment at a low point can negate the entire benefit of the high average growth.
  2. Some investors build concentrated portfolios, where volatility involves the risk of a loss that extends beyond a market cycle.
  3. When the horizon of the entire investment is shorter than a cycle of a volatile investment, volatility can lead to a permanent loss if it is fully sold at a lower point in the cycle.

What if you are a disciplined investor, saving for retirement (or being in retirement, with limited annual withdrawals), and are able to stick with your plan throughout the cycle?  In such a case, seeking low volatility at the price of lower average returns, can lead to higher overall risk, given the risk of outliving your money – the opposite of what is intended.  If you are going to stick with your plan throughout the cycle, a higher-growth diversified investment is less likely to leave you bankrupt as a result of regular retirement withdrawals.

Another factor is the position in the cycle.  While it is impossible to identify the precise peaks and bottoms of the cycle, there are certain factors that are not typical for peaks:

  1. Valuations are lower than usual.  The beginning of the worst declines tend to occur at very high valuations, not low.
  2. The investments are in the midst of a deep and long decline.  For example, if the recent peak was 9 years ago, and you are at a 28% decline, your risk level is much lower today.  And, to continue the example, if the total decline is 12 years long, you get a 39% gain in the remaining 3 years.

Quiz Answer:

If the longest possible decline (peak-to-peak) for ET were 12 years (a hypothetical assumption, which was chosen as a punitive example given current conditions), and you were to invest money in ET today, what would be the longest possible decline for this investment?

  1. Less than 3 years  [The Correct Answer]
  2. 3 years
  3. 12 years
  4. More than 12 years

Explanation:  Since we are over 9 years into the current decline, if 12 years were the longest decline, the remainder would be at most: 3 years.  With the portfolio currently 28% below the 10/31/2007 peak, not only would you recover any decline within 3 years – you would enjoy an addition gain of 39% (to revert the starting point of -28%).  This means that the longest decline to recovery of an investment made today would be substantially less than 3 years.

Disclosures Including Backtested Performance Data

Quiz!

What are the outcomes of consistently adding to a portfolio during declines of 20% + 20% followed by a 2 year recovery (25% + 25%), instead of using a stable 10%-per-year investment for the new money?

  1. You throw good money after bad – you lose money while feeling lousy.
  2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
  3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio.
  4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

Can You Make Money in a Down Market?

Imagine living through a long decline period. If you are retired and your entire life’s savings are invested in your portfolio according to your plan, you can relax knowing that your low withdrawal rate is likely to sustain your money for as long as you live.

If you are still in saving mode, or have money that was not put to work in your portfolio, you have choices. Let’s review two different options:

  1. You wait for the portfolio to recover to gain more comfort, and after it proved itself, you add more money to it. You don’t add money to a losing portfolio.
  2. You add all money available, whether it is savings from work, money invested elsewhere, equity in your home that you can borrow (subject to a risk assessment), or an inheritance.

Let’s continue with an example: Say you had 1M that declined for 2 years, and then recovered in 2 years. Also, say you had 100k to add per year. During the declining period, you choose between diverting to a portfolio that gained 10% per year and adding to the portfolio that simply declined and recovered with no new gains (as described in 1 & 2 above, respectively). Let’s see the financial impact of the 2 options:

1M Portfolio state Value of

original 1M

Value of new investments
Option #1: Invest at 10% Option #2: Invest in portfolio
20% decline + saved 100k 800k 100k 100k
20% decline + saved 100k 640k 100k + 10% + 100k = 210k 100k – 20% + 100k = 180k
25% gain + saved 100k 800k 210k + 10% + 100k = 331k 180k + 25% + 100k = 325k
25% gain to full recovery 1M 331k + 10% = 364k 325k + 25% + 100k = 506k
Performance of deposits 364k / 300k – 1 = 21% 506k / 300k -1 = 69%

After 4 years, option #1 would result in 364k, while option #2 would result in 506k.

In option #1, your entire mental focus is on the wait for a recovery, to regain comfort with the portfolio. You have no good feelings about the portfolio until you fully regained the lost grounds. In the meantime, you feel good about growing your new savings at 10% per year, and are happy that you did at least one smart thing.

In option #2, you keep adding to the portfolio, ignoring its behavior. At first, you feel good buying low. As the decline continues, you are tempted to feel that you are throwing good money after bad, but you remind yourself that the portfolio is far more attractive the lower it gets, and the new money can enjoy this benefit. After one year of gains, you can already celebrate the impact on your recent deposit. So, instead of focusing on the remaining path to recovery, you can enjoy the hard dollars that you gained during the initial part of the recovery. By the full recovery, you enjoy far better results than 10% per year even though you added to a portfolio that had 0% returns from peak to the new peak.

Quiz Answer:

What are the outcomes of consistently adding to a portfolio during declines of 20% & 20% followed by a 2 year recovery, instead of using a stable 10%-per-year investment for the new money?

  1. You throw good money after bad – you lose money while feeling lousy.
  2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
  3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio. [The Correct Answer]
  4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

The article above provides an explanation.

Disclosures Including Backtested Performance Data

Quiz!

Which are conditions that are all necessary for not thinking about small expenses?

  1. Your income covers your expenses.
  2. You are withdrawing less than 3% or 4% of your portfolio, every year.
  3. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong.
  4. You feel that you are using your money in a way that maximizes your happiness.

Sweat the Small Stuff

You can skip this article if all of the following are true:

  1. Your total annual spending equals less than 3% or 4% of your stock portfolio, depending on its allocation. Make sure to include infrequent items such as car upgrades, roof replacements, uncovered medical expenses, and a long stay in a nursing home. You can deduct amounts covered by guaranteed lifelong income such as social security payments, pensions or inflation-adjusted annuities.
  2. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong.
  3. You feel that you are using your money in a way that maximizes your happiness.

Since I still have your attention, this article may help increase your happiness. You probably know that big financial decisions have a meaningful impact on your finances. Buying a large house, boat or a private jet will have substantial impact given the initial price and high maintenance costs. Having a high paying job, or two sources of income for a household can have a big positive impact.

As you work on getting the big picture right, you may follow the advice “don’t sweat the small stuff”. Indeed, you don’t need to sweat the small annoyances in life, but you may benefit from sweating the small expenses, especially the recurring ones. Here are examples.

  1. Subscriptions that you don’t utilize significantly. This could be cable TV with many channels, various software & apps, credit cards with annual fees and infrequently visited clubs.
  2. Infrequently used appliances that consume energy and require maintenance, including various refrigerators, lights, and computer systems.
  3. More employees than necessary, including nannies for older children, cooks and various maintenance staff.
  4. Eating out in expensive restaurants that you don’t appreciate in line with the cost.

The list above is a random sample of expenses. The list of expenses that can be reduced without a significant impact on your happiness is personal. You have to go through your expenses and find out what doesn’t makes you happy in line with the cost. One person may greatly appreciate a nice restaurant, while another may take great pleasure in having plenty of choices for TV programs.

Quiz Answer

Which are conditions that are all necessary for not thinking about small expenses?

  1. Your income covers your expenses.
  2. You are withdrawing less than 3% or 4% of your portfolio, every year. [Correct Answer, but read below]
  3. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong. [Correct Answer]
  4. You feel that you are using your money in a way that maximizes your happiness. [Correct Answer]

Explanations:

  1. Jobs can come and go, bonuses can be reduced, and businesses can have fluctuating revenues. Income from work typically provides only temporary security.
  2. It is true that you need to withdraw less than 3% or 4% of your portfolio annually, but there is a much stronger condition – the 3% or 4% should be your total spending, ignoring income from work. Also, this applies to a stock portfolio. Bonds don’t grow fast enough to support lifelong withdrawals at 3% or 4%, growing with inflation.
  3. Even if you are at a sustainable withdrawal rate from your portfolio, if you are stressed with volatility or surprise expenses, you should build your resources to the point of a relaxed financial life.
  4. If you are sustainable financially (explanation #2) & relaxed about finances, but feel constrained, and are not happy with what money can buy you, you can be careful with your small expenses to free up money for other spending that may improve your happiness.
Disclosures Including Backtested Performance Data

Quiz!

What is the most useful measure of a person’s financial health?

  1. Net worth (total assets minus total liabilities).
  2. Income.
  3. Annual savings: income minus expenses.
  4. Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio.
  5. Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
  6. Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
  7. Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.

Your Financial Health in a Single Number

People use various numbers to measure their financial health. Let’s review some common ones, and see where they fail, through examples:

 

Measure Person 1 Person 2 Person 2 has better financial health
even though… because…
Net worth (total assets minus total liabilities) Net worth: $10M

Annual spending: $1M

Net worth: $1M

Annual spending: $50k

His net worth is x10 smaller His money can support double the years of living expenses
Income Income: $1M per year

Savings: $0 per year

Total saved: $0

Income: $100k per year

Savings: $20k per year

Total saved: $200k

Her income is x10 lower She has some financial security in case she loses her job
Annual savings Income: $1M per year

Income taxes: $400k

Annual spending: $500k Annual savings: $100k

Liquid assets: $200k stocks

Income: $100k per year

Income taxes: $20k

Annual spending: $50k

Annual savings: $30k

Liquid assets: $60k stocks

His annual savings is x3.3 smaller He is building security faster, saving 60% of annual spending vs. only 20%. His savings in stocks are also greater relative to spending.
Withdrawal rate from stock portfolio (annual withdrawals from the stock portfolio divided by its value) Expenses: $1M per year

Stocks: $1M

Annual withdrawals: $0k

Expenses: $40k per year

Stocks: $1M

Annual withdrawals: $20k

Her withdrawal rate is infinitely greater Her total spending (4%) can be sustained with no work, while the other has only 1 year of expenses saved
Spending rate from liquid assets (total annual spending divided by the value of all liquid assets) Liquid assets: $1M cash

Spending: $40k per year

Liquid assets: $1M stocks

Spending: $44k per year

His spending rate is 10% greater Stocks provide growth, and are more likely to sustain a 4.4% withdrawal rate than 4% from cash

Is there a single number that can give some indication of your financial health? Yes! It is the spending rate from your stock portfolio: total annual spending divided by the value of your stock portfolio. This assumes that the stock portfolio is diversified, and held for the long run, with no market timing, and no panic sales during stock declines. Also, you can reduce your spending measure by any amount that is guaranteed for life by an inflation-adjusted source, such as social security.

Why does this measure work?

  1. It shows progress towards financial freedom / financial security / retirement. Once your spending rate is below 3%-4%, depending on the specific portfolio allocation, the portfolio is likely to sustain the spending for as long as you live. If your spending rate is 6%-8%, you know that, between savings and investment growth, 100% increase will make you independent of work.
  2. It is not sensitive to a loss of job. It ignores income from work, that can be lost in various ways. In addition, if you want to ever be independent of the need to work, you want to measure your position assuming no income.
  3. It can withstand high inflation, given the focus on stocks.
  4. It does not suffer from liquidity concerns related to real estate, private equity and small businesses. Exception: If you have a diversified collection of properties, you can consider their income, after accounting for vacancies and repairs, if they are diverse geographically (and ideally enjoy country diversification, same as with stocks).
  5. It focuses on current health instead of potential. Even if you save a large amount every year, the saving can stop completely if you lose your job. What matters is money on hand (prior savings).

What are the implications? How can you improve your financial health?

  1. Maximize your allocation to stocks, but not beyond the point of risking getting into trouble during stock declines, either through large withdrawals, or panic sales. This requires a careful risk analysis.
  2. Keep your spending under control. A 10% reduction in spending provides an instant 10% gain in your financial health – this is powerful.
  3. Maximize your savings, either through lower spending or higher earnings. Note that higher earnings will not have any immediate impact, but the saved money from your increased earnings will build up gradually.

Quiz Answer

What is the most useful measure of a person’s financial health?

  1. Net worth (total assets minus total liabilities).
  2. Income.
  3. Annual savings: income minus expenses.
  4. Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio. [The Correct Answer]
  5. Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
  6. Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
  7. Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.

Explanations: See article above. Note that the last option “withdrawal rate from liquid assets” is not addressed by the article, since it suffers from the combination of flaws of the two options above it (5 & 6).

Disclosures Including Backtested Performance Data

Quiz!

Starting in 3/2/2009, Extended-Term Component enjoyed gains while there were great concerns about the world economies. If anyone were to sell this investment for 6 months, what would be the missed gain, and what would have been the impact on the 10 year performance?

  1. 12% gain in 6 months = 1.1% lost per year over 10 years.
  2. 26% gain in 6 months = 2.3% lost per year over 10 years.
  3. 47% gain in 6 months = 3.9% lost per year over 10 years.
  4. 76% gain in 6 months = 5.8% lost per year over 10 years.
  5. 102% gain in 6 months = 7.3% lost per year over 10 years.

Don’t Worry, Climb a Wall of Worry

When stock prices go up in spite of many concerns, it is said that the stocks are climbing a wall of worry. How is it possible that stocks go up while there are many concerns? This is the result of stocks reacting to two things: (1) changes and not an absolute situation; (2) expectations and not just the current situation. A few examples:

– There was an expectation for a very low price of oil, but the price spiked by 35% in just over a month, given an expectation for limited supply and increased demand.

– There was an expectation for 4 interest rate increases in the US this year, and this expectation went down to 2.

– There were a number of stimulus actions in Europe and China.

The improved expectations did not eliminate the worries, but they presented a more positive outlook, leading to big gains in stocks.

While a climb on a wall of worry can happen at any level of valuations, it is more typical when valuations are very low, and that is when you need to pay special attention. You can expect surges from low valuations to involve a climb on a wall of worry, since deep bottoms occur due to a long list of concerns, and these concerns are typically removed gradually over months or years. Avoiding an investment when valuations are low is risky, and can result in a negative impact that can be felt for a decade or longer. A good example is the 6 months starting at 3/2/2009. During that time, Extended-Term Component gained 102%. Missing such a period would lower the 10-year performance by 7.3% per year.

Quiz Answer:

Starting in 3/2/2009, Extended-Term Component enjoyed gains while there were great concerns about the world economies. If anyone were to sell this investment for 6 months, what would be the missed gain, and what would have been the impact on the 10 year performance?

  1. 12% gain in 6 months = 1.1% lost per year over 10 years.
  2. 26% gain in 6 months = 2.3% lost per year over 10 years.
  3. 47% gain in 6 months = 3.9% lost per year over 10 years.
  4. 76% gain in 6 months = 5.8% lost per year over 10 years.
  5. 102% gain in 6 months = 7.3% lost per year over 10 years. [The Correct Answer]
Disclosures Including Backtested Performance Data

Quiz!

As of March 31, 2000, US value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years. How many years did it take for value stocks to make up for these 10 years of underperformance?

  1. We are still waiting
  2. 10 years
  3. 5 years
  4. 3 years
  5. 1 year
  6. Less than 1 year

A Vanishing Value Premium?

By Weston Wellington, Vice President, Dimensional Fund Advisors

Value stocks underperformed growth stocks by a material margin in the US last year. However, the magnitude and duration of the recent negative value premium are not unprecedented. This column reviews a previous period when challenging performance caused many to question the benefits of value investing. The subsequent results serve as a reminder about the importance of discipline.

Measured by the difference between the Russell 1000 Growth and Russell 1000 Value indices, value stocks delivered the weakest relative performance in seven years. Moreover, as of year-end 2015, value stocks returned less than growth stocks over the past one, three, five, 10, and 13 years.

Unsurprisingly, some investors with a value tilt to their portfolios are finding their patience sorely tested. We suspect at least a few will find these results sufficiently discouraging and may contemplate abandoning value stocks entirely.

Total Return for 12 Months Ending December 31, 2015

Russell 1000 Growth Index 5.67%
Russell 1000 Value Index −3.83%
Value minus Growth −9.49%

Before taking such a big step, let’s review a previous period when value strategies underperformed to gain some perspective.

As many growth stocks and technology-related firms soared in value in the mid- to late 1990s, value strategies delivered positive returns but fell far behind in the relative performance race. At year-end 1998, value stocks had underperformed growth stocks over the previous one, three, five, 10, 15, and 20 years. The inception of the Russell indices was January 1979, so all the available data (20 years) from the most widely followed benchmarks indicated superior performance for growth stocks. To some investors, it seemed foolish for money managers to hold “old economy” stocks like Caterpillar (−3.1% total return for 1998) while “new economy” stocks like Yahoo! Inc. appeared to be the wave of the future (743% total return for 1998).

Many value-oriented managers counseled patience, but for them the worst was yet to come. In 1999, growth stocks shone even brighter as value trailed by the largest calendar year margin in the history of the Russell indices—over 25%.

Total Return for 1999

Russell 1000 Growth Index 33.16%
Russell 1000 Value Index 7.36%
Value minus Growth −25.80%

In the first quarter of 2000, growth stocks bolted out of the gate and streaked to a 7% return while value stocks returned only 0.48%. As of March 31, 2000, value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years and by 1.49% per year since the inception of the Russell indices in 1979. A Wall Street Journal article appearing in January profiled a prominent value-oriented fund manager who regularly received angry letters and email messages; his fund shareholders ridiculed him for avoiding technology-related investments. Two months later he was replaced as portfolio manager amidst persistent shareholder redemptions.

With value stocks falling so far behind in the relative performance race, it seemed plausible that value stocks would need a lifetime to catch up, if they ever could.

It took less than a year.

By November 2000, value stocks had delivered modestly higher returns than growth stocks since index inception (21 years, 11 months). By month-end February 2001, value stocks had outperformed growth over the previous one, three, five, 10, and 20 years and since-inception periods.

The reversal was dramatic. Over the period April 2000 to November, value stocks outperformed growth stocks by 26.7% and by 39.7% from April 2000 to February 2001.

This type of result is not confined to the technology boom-and-bust experience of the late 1990s. Although less pronounced, a similar reversal took place following a lengthy period of value stock underperformance ending in December 1991.

We can find similar evidence with other premiums:

  • From January 1995 to December 1999, the annualized size premium was negative by approximately 963 basis points (bps), amounting to a cumulative total return difference of approximately 113%. Within the next 18 months, the entire cumulative difference had been made up.
  • From January 1995 to December 2001, the annualized size premium was positive by approximately 157 bps.

The moral of the story?

Prices are difficult to predict at either the individual security level or the asset class level, and dramatic changes in relative performance can take place in a short period of time.

While there is a sound economic rationale and empirical evidence to support our expectation that value stocks will outperform growth stocks and small caps will outperform large caps over longer periods, we know that value and small caps can underperform over any given period. Results from previous periods reinforce the importance of discipline in pursuing these premiums.

Quiz Answer

As of March 31, 2000, US value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years. How many years did it take for value stocks to make up for these 10 years of underperformance?

  1. We are still waiting
  2. 10 years
  3. 5 years
  4. 3 years
  5. 1 year
  6. Less than 1 year [The Correct Answer]
Disclosures Including Backtested Performance Data

Quiz!

Which of the following should be elements of a plan to provide lifelong income through all market cycles? (Multiple correct answers)

1. Hold a rainy day fund.

2. Maximize diversification, and include at least the following: stocks, bonds, real estate.

3. Commit to low spending relative to your assets.

4. Diversify your stock allocation across companies and countries.

5. Start a profitable business.

6. Dedicate your money to high growth investments.

7. Limit your mortgage(s).

How Does the Book “The High-Beta Rich” Apply to You?

This article discusses an issue raised by the book “The High-Beta Rich” by Robert Frank, and explains how QAM’s plans address it.

Historically, wealthy families were more immune to market cycles than the general population. The book shows that starting in 1982, the income of the top 1% earners became more volatile than the income of the overall population. While they enjoyed high growth, their income declined further during economic downturns. This is due to more of their income depending on volatile investments, including leveraged real estate, individual companies and concentrated stock investments.

The book presents stories of people that amassed substantial wealth, and later lost most or all of it. A common strategy to avoid losing it all, is to hold some money in stable investments. While this solves one problem, it introduces another one – it slows down the overall growth, which increases the risk of outliving your money.

Is there a solution that lets you enjoy the high growth without taking excessive risks?

Such a solution exists in certain cases. Here is a list of goals with details of how to achieve them:

1. Having your money last: Dedicate your money to high growth investments – stocks of profitable companies that are priced low (value stocks).

2. Recover from declines: Diversify across thousands of stocks in many countries.

3. Provide stable income through the declines: Commit to low spending relative to your assets, with a clear trend towards 3%-4%.

The beauty of this solution is that it doesn’t require lifelong financial sacrifices. What it does require is:

1. Disciplined spending, even as you see your savings reach high levels, or when your income is much higher than 3%-4% of your savings. Lack of this discipline is a big reason some wealthy people get into trouble during downturns.

2. Strength in the face of downturns, and commitment to the investment plan.

3. Permanent diversification at all times; avoiding the temptation to put a substantial portion of the money in a single company or real estate investment.

Does the list of these requirements seem too easy to follow? During over 11 years of service, QAM learned that many people find these requirements to be very difficult to adhere to. If you are able to adhere to them, you have a good chance at sustaining lifelong (and multigenerational) growing income. In addition, successive downturns are likely to become easier to handle, if you limit the growth in spending.

Quiz Answer

Which of the following are key elements of a plan to provide lifelong income through all market cycle? (Multiple correct answers.)

1. Hold a rainy day fund. Sometimes correct: A rainy day fund, such as 3-6 months of living expenses in cash, is necessary for surviving declines early in your saving years, especially if you have low job security. Once you build meaningful savings, the benefit of such an allocation gradually becomes outweighed by the benefit of maximizing the growth of your investments, for lifelong income.

2. Maximize diversification, and include at least the following: stocks, bonds, real estate. Incorrect: While maximal diversification helps survive declines, including slower growing investments hurts the necessary growth for lifelong income that grows with inflation.

3. Commit to low spending relative to your assets. Correct: This is a key element. There are a number of benefits to low spending relative to your assets: (1) It helps handle declines combined with lack of work without depleting your money; (2) It helps build your savings faster, to provide the nest egg needed for lifelong income.

4. Diversify your stock allocation across companies and countries. Correct: Diversification helps avoid total loss during declines.

5. Start a profitable business. Sometimes correct: Running a business combines pay from work and profits of the business ownership. As a small business, it has the potential of outperforming stock investments. The benefit of higher growth comes at a price of liquidity constraints and the risk of a total loss. Therefore, for the goal of lifelong income, it is best to limit your investment in your business to a small portion of your savings.

6. Dedicate your money to high growth investments. Correct: As long as you stick with high-growth investments, diversification provides a benefit of higher low points during declines, without the price of hurting your average returns.

7. Limit your mortgage(s). Usually incorrect, but read further: Real estate with no (or limited) mortgages tends to grow more slowly than diversified stocks, and is less liquid. If you are going to limit your mortgage for any reason (can’t qualify for high mortgage, short-term risk is too high, don’t like volatile investments along with the mortgage obligation), you are better off investing in diversified stocks instead of owning a home, for the purpose of lifelong income. There are non-financial benefits to owning your home, which may lead to accepting a lower mortgage along with less optimal lifelong income.

Disclosures Including Backtested Performance Data