Money can be an emotional topic.  It can raise feelings of greed, fear, entitlement, or shame, among others.  It is important to have emotions impact money in one stage of the investment process:  when defining your goals.  Here are a few examples:

  1. You expect to have great emotional suffering when your portfolio declines.  This may lead you to have a greater allocation to low-volatility investments (CDs or bonds) than financially called for.  It can make sense when done in the planning phase, and not during a deep decline.
  2. You may be stuck in the rat race for too long, and decide to take actions to live within your means.  As a part of the solution, you are willing to accept short-term volatility for the ultimate goal of having sustainable spending relative to your assets.

Once you are done defining your goals, emotions can harm your investment results.  Here are a few examples:

  1. Fear:  After a big market crash, the media is very negative about the economy and stocks, and you are ready to sell stocks low, or stop investing new savings.
  2. Greed:  After unusual gains in stocks, you decide to increase your stock allocation (buy high) beyond what you planned for originally.
  3. Familiarity Bias:  You fall in love with a company, believe in their product and business plan, and decide to invest in it, without looking at valuations (price relative to book value or earnings) and other information.

The solution is easy to describe and tough [psychologically] to implement:

  1. When developing the plan, view its impact on your entire life, and balance the various risks.  Accept that there is no safe investment – you simply choose which risk you can tolerate most.  Examples of risks to account for are: a need for money during a big decline, panic selling during a decline, outliving your money, and inflation.
  2. Once the plan is developed, be cautious of making changes without changes in your personal circumstances.  Unless you have very substantial assets relative to your expenses, and you don’t watch your investments frequently, you have to expect to feel uncomfortable with your investments at various points in life.  The difference between success and failure can be the action you took against your interests under the emotional stress of an uncomfortable period.
Disclosures Including Backtested Performance Data

Did your income jump significantly at any point in your life?  If you are fortunate enough to experience that, you may face a tradeoff between feeling wealthy and being wealthy.

If you feel wealthy, you are likely to increase your spending significantly, which can make you less wealthy very quickly.  If this doesn’t make sense to you, Sports Illustrated estimated in 2009 that 78% of National Football League (NFL) players are either bankrupt or in serious financial trouble within two years of retirement.  This is a group of people who typically make several millions each year.  While this is an extreme example, you can get in trouble even without feeling adventurous or being irresponsible.

Say your income jumped from $100,000/year to $300,000/year.  You make the following adjustments to your annual expenses:  $1.5M house, with $72,000/year mortgage payments (30-year fixed loan with 4.5% interest), $18,000 property taxes, $15,000 repairs & improvements, $10,000 utilities + cleaning + gardening, $40,000 private schools for 2 children, $5,000 classes for the children, $20,000 food, $10,000 car payments, maintenance, gas & insurance, $10,000 travel & vacations, $10,000 various types of insurance, including medical & dental & medical bills for the family, $10,000 clothes, toys, household items, etc..  If you don’t have children, you may spend more on nice clothing, eating out, jewelry, hobbies, etc.

I didn’t include all categories of spending, and already consumed your entire net income of $220,000, with nothing left to save.  If you lose your job, you are left with high expenses and low savings.  Furthermore, you have no money left to help your children with higher education, or to fund your own retirement.  By feeling wealthy, and spending accordingly, your financial security dropped lower than before the big raise.

Instead, you can decide to not feel wealthy.  You increase your spending to $120,000 – a significant jump, but low enough to leave $100,000 to save.  Within a few years, you accumulate meaningful savings.  If you lose your job, your savings can carry you for a much longer period of unemployment.  In addition, finding a job to cover your $120,000 in spending will be much easier than replacing the $300,000 salary.  Here are some key ideas for making this work:

  1. Keep your focus on spending-to-assets, and strive to reach a sustainable ratio of 3%-4% per year.  While it would be impossible for most people to reach this rate for a long time (even with $300,000 or $600,000 in annual earnings), use any big jump in earnings to increase your spending modestly and your saving rate significantly.
  2. Never feel wealthy thanks to high income.  No matter how much you earn, you can end up with no financial security, and no wealth.  It can start with nicer cars, expensive jewelry, a nicer home, vacation home, full-time staff in each of your houses, yacht, private jet, private island, or private jumbo jet.
  3. Once you approach sustainable finances, you can increase your spending along with your assets, and enjoy the continued increase in standard of living without losing your peace of mind.
Disclosures Including Backtested Performance Data

Say you inherited $10,000.  Would you use it the same way you use $10,000 you got for weeks of work?  How about if you won it in a bet, casino, or found it on the street?  If you are more likely to spend easily found/won money because you didn’t work hard for it, you are not alone, and you are subject to a bias called Mental Accounting.  You associate different meanings to money depending on the source.  But, in reality, all money is the same, no matter how you got it.  Specifically:

  1. If you would save hard earned money, you would rationally save found money.
  2. If you would spend money you earned on overtime work or a bonus, you would rationally spend the same amount from an inheritance.

Here are some ways to avoid mental accounting:

  1. Put all money earned, found, won, or inherited into the same account (see exceptions below).  Now you can look at it as one pot of money, and forget about its source.
  2. Put any money that needs to be in a separate account for tax purposes in the account that fits the tax requirements.  Examples are:
    • Retirement:  IRA, Roth IRA, 401k, Roth 401k
    • Inherited Retirement: Inherited [Roth] IRA
    • Education: Coverdell ESA, 529
    • Different Individuals or entities: children, businesses.
  3. Do not use separate accounts for different goals, unless required for tax- or accounting-purposes. Set priorities for money.  Here is one potential ordered hierarchy:
  4. Set priorities for money. Here is one potential ordered hierarchy:
    1. Basic necessities, including: rent/mortgage, food, children’s education, cars, etc..
    2. Retirement/sustainability.
    3. Children’s education accounts.
    4. Discretionary (fun/non-critical) spending.
Disclosures Including Backtested Performance Data

Money can buy many things that give happiness in life.  But, once you cross a moderate standard of living, more money leads mostly to temporary increases in happiness until you get used to the new normal (e.g. new car, private jet).

One thing that can stick is the ability to stop worrying about money.  This happens when you save money, and have enough available for surprise needs, beyond the routine expenses, such as a major repair or unexpected health care expenses.

The key factor that makes this work is the extra unused money.  $1M invested in Quality Asset Management’s portfolio Long-Term Component is likely to provide perpetual annual income of $40k, growing with inflation.  Any unexpected expenses up to this amount can be handled with great piece of mind.

The ultimate worry-free life (financially) is reached when your investments can cover all of your ongoing + unexpected expenses perpetually (e.g., $5M providing $150k for routine expenses + $50k for surprise expenses, at 4% annual withdrawals).  At that point, you can avoid worrying about money, and feel the lasting happiness.

The good news is that you don’t need to wait for decades to reach the ultimate goal, to start reaping the benefits.  With every bit of increased savings (relative to spending), you get reduced stress and increased happiness.

Disclosures Including Backtested Performance Data

I read many articles every week, and came up with ways to filter out misleading articles. This is critical for me, so I can keep my investment decisions rational and unbiased. Using the wrong article to affect investment decisions can cost you real money. Here is a quick checklist to uncover many of the misleading articles:

  1. Focuses on recent history without offering a long-term perspective.
  2. Talks to your emotions, without accompanying with data or logic.
  3. Presents recent history in present tense to imply that it will continue the same way (“stocks/bonds/pesos/you-name-it are currently out of favor”).
  4. Focuses on a narrow asset class (e.g., large U.S. stocks, the S&P 500, Japanese stocks, the BRIC countries) when discussing stock investments in general, or diversified asset classes.
  5. Presents only partial returns (e.g., index returns without dividends).
  6. Provides opinions of well-known people to give credibility, without hard data or logic to back the claims.
  7. Depends on traditions to back the claims, without providing logic (e.g. shift allocation to bonds with age, regardless of the total picture).
  8. Provides specific advice without any comments qualifying who this applies to (e.g. referring to a retiree without discussing their withdrawal rate).
  9. Offers a prediction of the near-term future of an investment (stocks, bonds, gold, etc.) with high certainty.
Disclosures Including Backtested Performance Data

In the article  6 Problems with Dividends for Income [December 2013] you saw a long list of disadvantages of dividends when compared to selling from your investments to generate any required income.  Yet, retirees still like dividends.  Why is that?  The reasons are psychological, and several are listed below:

  1. Disciplined spending:  By limiting spending to dividends, you can resist the temptation to spend the principal.  It gives structure.
  2. Avoiding selling at a loss:  Dividends are given whether the investments are up or down.  A dividend withdrawal at a decline doesn’t require actual selling at a loss.
  3. Avoiding regrets over missed gains:  If you spent dividends, it feels like you spent cash.  But, if you sold from your investments, and they gained substantially, you may regret the sale.  People tend to regret action more than inaction.

Since income can be generated by selling from the portfolio instead of dividends, it is best to avoid focusing on high-dividend investments just for the sake of income generation.  By sticking with selling, you gain control over the amount, timing and regularity of income, as well as investment choice and improved tax-loss harvesting.

The missing piece is the psychological comfort.  That can be obtained by sticking to a conservative cap on withdrawals from the portfolio (typically 3%-4% of the peak value of the investments).  Having an outsider (investment advisor, family member, close friend) track the withdrawals can strengthen the discipline.  As a Quality Asset Management client, you receive the available withdrawal amount in your quarterly email, so you can view your investments very clearly as a sustainable income stream.

Disclosures Including Backtested Performance Data

International markets offer a tradeoff of higher potential returns at the price of higher volatility, when compared to the U.S.

Emerging markets offer even higher potential returns, at the price of even higher volatility, when compared to both the U.S. and international markets.

While these characteristics are well publicized, emerging markets investments hold two additional benefits that are typically not discussed:

  1. Technology Leaps: The technologies developed in the U.S. and other developed countries are readily available to emerging markets, allowing for leaps to the newest technologies.
  2. Rotating Countries: The most advanced countries keep being replaced by less advanced countries in emerging markets funds. As long as there are countries that are not advanced enough to be part of emerging markets funds, we get a fresh supply of countries that can leap forward.

These benefits are the key for emerging markets investments sustaining a very high growth rate.

Disclosures Including Backtested Performance Data

If you own a company with a $1 share price, and it pays a 5c per share dividend, you get 5% in investment income.  While this is a natural solution for retirement income, it has problems.  Some of them stem from the way dividends work:  The share value goes down to 95c (reflecting the cash that the company paid out and no longer has) + you get 5c in cash, leaving you with an unchanged total of $1.  That is, until tax time.  You have to pay taxes on the 5c, reducing the value of your investments.  Below is a list of problems, created by this effect among other factors:

  1. Amount:  More dividends than needed result in unnecessary taxes.
  2. Timing:  The dividend is in cash, not invested, until using the money (called “cash drag”).
  3. Irregularity:  Dividends can be increased or decreased unpredictably – too much creates cash drag & too little creates income stress.
  4. Tax Loss:  If your stock is down, you use dividends for income instead of selling losing shares for income.  Selling losing shares can provide a reduction in taxes.
  5. Limited Growth:  Companies tend to pay dividends when they have limited growth prospects (e.g. utility companies).  Some of the fastest growing companies pay no dividends.
  6. Rebalancing:  By using the dividends for income, you miss out on selling from the biggest gainers in your portfolio to rebalance while generating cash.

Selling from stock investments is far superior:  you can sell from your fast-growing companies, the exact amount needed, when needed, combined with rebalancing & tax-loss harvesting.

Advisors often avoid this optimal solution, since it requires more work and careful planning.  Specifically, it requires setting dividends to reinvest, while carefully planning when to sell to avoid wash sales (i.e. selling at a loss within 30-days of the automatic dividend reinvestment).

Disclosures Including Backtested Performance Data

At times of economic uncertainty, demand for stocks tends to decline, leading to lower than typical stock prices relative to their book value, or liquidation value (low price-to-book, or P/B).  The media tends to be negative about stock investments, and recommends rethinking your stock allocation.  Contrary to the media’s message, this article demonstrates that returns following low P/B tend to be higher than typical.

Very Important Disclaimers

  1. The analysis was done for QAM’s stock portfolios Long-Term Component & Extended-Term Component.  The results may be different for different portfolios.
  2. The time inspected involved 14 years, and is not statistically significant.  The future may show very different results.  Read below to see the limited applicability of the results.

The Findings

Below are annual returns following years since 1998 that ended with P/B < 1, until P/B > 1:

Annual Returns in Years Following P/B < 1, 1998-2012
Year P/B < 1 Annualized Returns to
P/B > 1
Multiple year detail 1
Long-Term Component
1999 0.83 38%
2001 0.81 20% 1%, -6%, 63%, 31%
2009 0.73 53%
2012 0.80 20%
Extended-Term Component
1999 0.69 82%
2001 0.83 19% -2%, -3%, 75%
2009 0.92 90%
2012 0.94 18%

2013-10 Annualized Returns after PB under 1

Highlights from the Data

  1. All annualized returns were positive and high.
  2. The returns were higher than typical, with averages of 33% & 52%.
  3. The P/B recovered quickly – typically in one year, leading to high returns in 1-3 years.

What you shouldn’t do, given the lack of statistical significance?

Since we have P/B data for a mere 14 years, the pattern seen so far may be different than the typical.  It is possible that very negative returns will persist following low valuations in the future.  Therefore:

  1. Do not try any market timing based on this data.
  2. Do not take any risk that you wouldn’t take normally with stock investments.

How can you use the results to your benefit?

Despite the limited applicability of the results, there are two beneficial uses of the data:

  1. When the media recommends reducing the stock allocation, check the P/B of your QAM portfolio.  If it is below 1, there is a possibility for unusually high returns in upcoming years.  You can stay strong sticking to your plan when others are telling you to bail out.
  2. If you keep varying levels of cash, or debate taking a mortgage loan for the purpose of investing, and, financially speaking, you can clearly tolerate the short-term risk, seeing P/B < 1 should make you feel comfortable that the risks may be lower than typical.
Disclosures Including Backtested Performance Data

The combination of the 2008 stock market crash and the wave of retirees brought volatility to the spotlight, and many are looking for any way to reduce it. This article questions the idea of sacrificing returns to reduce volatility, and suggests ways to be happy in retirement while investing in a volatile portfolio.

The article is aimed towards retirees who want income for as long as they live. To achieve that, a limited annual withdrawal from the investments is assumed (e.g. 4% of Long-Term Component by QAM, and 3% of Extended-Term Component). With higher withdrawal rates, you take a real chance of outliving your money.

Volatility is the movement of the portfolio price up and down around its average growth. The greater the volatility, the further the returns tend to go below and above the average. A simple way to reduce volatility is to combine multiple investments that don’t all move in the same direction at all times. Ownership of one fast growing company can provide substantial returns, or a total loss. By adding many companies from various industries and countries, you virtually eliminate the risk of total loss.

Even without a total loss, substantial declines can be problematic for retirees. Retirees depend on their investments for immediate income. They cannot decide to stop eating because a 50% decline occurred. A withdrawal of $1 at a 50% decline costs $2, resulting in a substantial loss on the withdrawn amount. This leads retirees and financial professionals serving them to try to minimize volatility. It seems logical, at first.

If volatility were not a consideration, retirees could put all of their money in stocks and get nice long-term average returns. In order to reduce the volatility, most retirees put a meaningful portion of their money in less volatile investments such as bonds. This allocation indeed moderates the declines, and can significantly reduce the excess cost of withdrawals during deep declines of stocks.

Volatility Cost

Assume that you are a retiree living on 4% of your stock portfolio Long-Term Component, or 3% of Extended-Term Component. The total effect of declines on the annual withdrawals during the 3 most harmful declines as simulated since 1970 is:

Cost of Retirement Withdrawals from Stock Portfolios During Severe Declines

4% annually from Long-Term Component

3% annually from Extended-Term Component

Decline to New Peak Cost 1 Decline to New Peak Cost 1
4/1973 – 12/1975 2.5% 7/1973 – 12/1976 2.7%
4/2000 – 5/2003 1.4% 1/2000 – 11/2003 4.8%
11/2007 – 6/2013 2 7.3% 11/2007 – 6/2013 2 6.5%

Even severe declines resulted in very small losses to a retiree thanks to limited withdrawals and global stock diversification.

Volatility Tradeoff

The next table shows the long-term average cost of withdrawals during declines, and impact on the returns:

Cost of Retirement Withdrawals from Stock Portfolios During Declines

Annual Average 1/1970 – 6/2013

Portfolio & Annual Withdrawal Rate Returns Cost 1 Net Returns 3
4% from Long-Term Component 16.4% 0.35% 16.1%
3% from Extended-Term Component 19.2% 0.46% 18.7%

The withdrawals during declines reduced the returns only minimally. The net returns above are the returns achieved with a portfolio that never experienced a decline.

Solutions that reduce the volatility of stock portfolios (only partially), cost far more than the costs above (<0.5%), and result in far lower average returns, erasing the entire financial benefit of volatility reduction. As an example, bonds don’t provide annual returns much higher than 5%-8%. 

Happy Retirement with Volatility

So far, we saw that reducing volatility is likely to hurt the retiree’s financial security. Yet, living through the decline periods can be tough psychologically. How can you stay happy while going through deep and prolonged declines?

  1. Remember that the impact of severe declines on your limited withdrawals is very small.
  2. When investing in a globally diversified stock portfolio, declines don’t sustain. The declines are like pressing a spring very tight – at some point it is released and there is a surge. While the well-publicized concentrated investment – the S&P 500 – had extended downturns, the returns for the globally diversified portfolios were much better in all 10-year periods as simulated since 1970.


    Range of 10-year annualized returns 1/1970-6/2013

    Portfolio Worst Average Best
    S&P 500 -3.4% 10.2% 19.5%
    Long-Term Component 6.3% 16.4% 28.3%
    Extended-Term Component 4.4% 19.2% 40.5%

    If your average returns in recent years were on the low end of this scale, or even below it, you can be optimistic that your chances are for better than usual returns (no guarantees).

  3. Supporting the point above is a simple view of valuations (price/book, or liquidation value) of your portfolio. Typically, after extended periods of poor performance, the valuations of the portfolios become much lower than typical. They reflect the fact that people tend to over-sell investments when there is bad news or uncertainty. Supporting the “over-selling” theory is the fact that deep and long declines don’t start with low valuations – they start with high valuations. So, when valuations are low you can be much more optimistic than usual.
  4. The expectation for returns to be meaningfully positive over time is logical. Companies use materials, labor and capital to generate added value. While a number of companies can fail, the whole system of efficient production is likely to stay with us, since people typically want things done for them in the cheapest and most efficient way possible.
  5. If you listen to the economic news frequently enough, you are likely to expect every large decline to be “the new normal”, where returns don’t revert back to the typical. This has been predicted many times before, and always turned out to be wrong. In addition, the news typically focuses on concentrated portfolios in just one or a few countries.

1 For example, a year-long 20% decline combined with a 4% withdrawal, costs 1% calculated as: 4% of the remaining 80% = 4 / 80 = 5% = 4% of the peak + 1% penalty for selling during the decline.

Note: Investment taxes (taxes on dividends, capital gains distributions, and capital gains) are not accounted for, as they are dependent on the investor’s tax rate. They are not material enough to change the conclusions of this article.

2 A peak was reached, but the portfolio declined since then. While there are no guarantees, conservative assumptions lead to a small expected additional cost of 0%-2%.

3 Net Returns = Returns – Cost [of withdrawals during declines]

Disclosures Including Backtested Performance Data