Archives For Volatility

Quiz!

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that.
  3. No, it is risky to sell low.

2 Hidden Risks of Selling Stocks Temporarily Now

It may seem appealing to sell stocks now, and buy lower, when seeing signs of the end of the coronavirus damage. There are two hidden risks in such a strategy:

  1. Hidden Risk #1: A decline never comes, so you buy 10%+ higher. After the gain, the portfolio turns much lower. Now your investments bottom at an even lower point than without the temporary selling.
  2. Hidden Risk #2: Fast forward to the next peak. Another big decline follows. During the entire decline – from peak to bottom – you have less money.

A variation is to sell stocks now, and wait to buy until we are completely done with the coronavirus impact. This is likely to eliminate Hidden Risk #1, but it makes Hidden Risk #2 far worse. By the time we are completely done with the coronavirus impact, your investments could potentially be 100%+ higher. The impact on all future declines can be devastating.

You may be desperate for some relief from the stress of staying invested at a low point, and are still tempted to sell. The relief is an illusion:

  1. If you are stressed now, imagine the stress after selling, reinvesting higher and then going to the bottom with less money.
  2. You may be tempted to sell and not buy until far into the future. As strong as it is at relieving the current stress, it is devastating at the depths of the next decline – lowering its bottom dramatically.

By holding onto your investments, you ultimately get the portfolio returns. While stocks may face long periods with poor returns, it is much better than risking making future declines deeper and longer.

Mirroring the risks above, if you still have income and are able to invest at today’s low levels, you can boost your financial security in future declines for the rest of your life.

Quiz Answer:

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that. [Correct Answer]
  3. No, it is risky to sell low.

Explanation: See this month’s article.

Disclosures Including Backtested Performance Data

Quiz!

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment.

5 Rules of Thumb to Avoid Making a Painful Investment Change

Have you ever seen your diversified investments perform poorly for an extended period of 5-10 years, and felt that it would be prudent to diversify to reduce your risks? Have you moved money to an investment that felt much safer based on those years? In most cases, such activity would increase your risk – the opposite of your intended action. In some cases, the results could be painful.

How can a shift to reduce risk end up being painful? Diversified investments tend to be cyclical. The risk of a tough decade following a tough decade is lower than typical, not higher. Furthermore, the risk of a tough decade after an exceptional decade is higher than typical. Here is a case that may be familiar to you: In the late 1990’s US Large Growth stocks seemed like the safest stocks in the world. A switch to these seemingly safe stocks could have led you to losing 30% of your money over the following 10 years (total returns, including dividends, starting 3/1999). If you would have switched away from the seemingly risky Value or Emerging Markets stocks, your pain would have compounded, by missing phenomenal growth.

How can you avoid making a flawed change? Here are a few rules of thumb:

  1. Compare your investment performance in the past 10 years to the long-term performance (ideally 30+ years). If the past 10 years were below average, the investment is likely to be less risky than usual, not more. Don’t make a change!
  2. Do the same for the target investment you want to diversify into. If the past 10 years were above average, the investment is likely to be more risky than usual, not less. Don’t make a change!
  3. Do the same when comparing valuations, as presented by Price/Book. If the change would increase your Price/Book, you would sell low and buy high, something that can hurt you.
  4. Imagine living through a period with the opposite recent performance – would you still feel that you are reducing your risk with the intended change? If not, the alarm bells should be ringing.
  5. Say that someone urges you to diversify your portfolio, given the risk of your current portfolio, as presented by recent performance. Check how diversified your current portfolio is. If it includes 100’s or 1,000’s of stocks, split over many sectors in many countries, you are probably already diversified. The phrase: “You should diversify”, is a disguise for the real intent: “You should buy the recent winners, no matter what it does to your diversification.”

How can you use the information above today?

  1. Just like in the 1990’s, US Large Growth stocks performed far better than their long-term average. They averaged about 13% per year over 10 years, compared to a 10% long-term average. You should realistically expect the returns in the next 10 years to be much lower, not just below 13%, but far below 10%. In addition, the P/B of these stocks is far above average, another warning sign for poor upcoming returns.
  2. The reverse is true for Emerging Markets stocks. They grew far below their average. For example, the portfolio Extended-Term Component grew by a mere 2% per year in the past 10 years, compared to 15%+ long-term average (includes simulated data). In addition, the valuations of this portfolio are far below average. Returns above the 15%+ average in the next 10 years are the likely outcome.

A few words of caution: cycles don’t have a fixed length. Returns that are better or worse than average can continue longer or shorter than expected. In addition, long-term averages can fluctuate. While no result is guaranteed, the information above can help you work with the odds, and not against them.

Quiz Answer:

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed unusually well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment. [Correct Answer]

Explanations:

  1. Answers 1-3: Diversified investments tend to be cyclical – selling after 10 tough years, is likely selling low. Buying an investment that performed unusually well at the same time, is likely buying high. This will likely increase your risk.
  2. Answer 4: While future returns are likely to be above average, and risks below average, no change will keep your risk profile at the same reduced level.
  3. Answer 5: Buying extra at a very low point may reduce your risk, if valuations (Price/Book) are far below average and the investment is diversified.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

  1. You hold a company with a strong track record.
  2. You hold a company with market dominance.
  3. You take some risk off, and switch to bonds.
  4. You take some risk off, and switch to cash.
  5. You take some risk off, and switch to a well proven investment that did well over an entire decade.

Can you be Happy with your Volatile Stock Portfolio Whether it is Up or Down?

High investment growth comes with volatility, and is treated as the price for enjoying the high long-term gains. What if you could stay happy even during declines?

Conditions:

  1. When working, live according to your income. Don’t spend beyond what you make.
  2. When retired, spend a small percentage of your portfolio every year. Don’t plan on running out of money in your lifetime. 3%-4% is appropriate for most diversified portfolios with a high enough stock allocation.
  3. Invest in a highly diversified stock portfolio, without any specific bets (specific companies, countries, etc.).
  4. Structure the portfolio for high growth (emphasize stocks, value investing, small stocks, fast growing countries).
  5. Maintain iron discipline to stick with your portfolio for life, and never make changes at low points (unless you move to another investment with at least equally low valuations and equally high long-term returns).

If you follow the conditions above, you can be happy in up and down times, as follows:

  1. By nature, you have a fast growing portfolio in the long run, a cause for underlying happiness.
  2. When you enjoyed high past gains, you can be happy with the past results.
  3. When recent returns have been poor and valuations (price/book) are low, you can be happy about the high expected returns.
  4. If you have any new money to invest (savings from work, inheritance, money elsewhere), you can be very happy, because investing this money at a low point turns a temporary decline into a permanent excess gain (the gains on buying low).
  5. Over the cycles, the dollar value of the percent spending can go up as you reach higher peaks, leading to happiness about growing cash flows.

Most people struggle with such a plan, because the media pushes them to think about parts of the cycle, e.g. 5-10 years. This leads investors to be unhappy during downturns, and sometimes even destroy their life’s savings by selling low and buying something else high. Any high-growth investments can go through downturns of 5-10 or more years (e.g. the S&P 500 lost 30% of its value in the 10 years from 3/1999-2/2009), so it takes strength to stay disciplined. The best tool to maintain discipline is to watch valuations (price/book). After your high-growth investment goes through a long tough stretch, you can compare it to another investment that performed very well in recent years, and you are likely to see that your investment is enjoying substantially lower valuations, leading to substantially higher expected returns in upcoming years. While there is no guarantee for a specific turning point, you enjoy the nice combination of lower risk and higher expected returns.

Quiz Answer:

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

  1. You hold a company with a strong track record.
  2. You hold a company with market dominance.
  3. You take some risk off, and switch to bonds.
  4. You take some risk off, and switch to cash.
  5. You take some risk off, and switch to a well proven investment that did well over an entire decade.

Explanations: None of the answers are correct!

  • 1-2 depend on concentrated investments. History taught us repeatedly that single companies aren’t immune to irreversible downturns.
  • 3-4 may feel good at the moment, but they turn a temporary downturn (assuming your investment is diversified and consistent) into a permanent loss.
  • 5 may also feel good at the moment, but investments are cyclical, and the best performer of the past 10 years is likely to underperform your poor performing investment in the next 10 years. A glance at the relative valuations (price/book) of the investments can confirm this risk.
Disclosures Including Backtested Performance Data

Quiz!

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50%

How to Use Volatility to Make Money

Investment volatility is the investment’s movements up and down away from its average growth. It is commonly viewed as a negative, but for a disciplined long-term saver, it is typically a positive. A hypothetical example can demonstrate it. Let’s compare 2 portfolios with identical returns, and different volatility:

Portfolio 1

Portfolio 2

Year 1

0%

-50%

Year 2

0%

100%

Average

0%

0%

If you start with $100, both portfolios will be worth $100 after 2 years. Specifically, Portfolio 2 will go through the following values: (Year 1) $100 – 50% = $50. (Year 2) $50 + 100% = $100. The portfolios have identical average growth, but Portfolio 2 is far more volatile.

Let’s see the final balance if you add $100 in the beginning of each year:

Portfolio 1

Portfolio 2

Year 1

($100 + 0%) = $100

($100 – 50%) = $50

Year 2

($100 + $100) + 0% = $200

($50 + $100) + 100% = $300

Even though both portfolios have the same average growth, when adding to both portfolios identical amounts each year, the more volatile portfolio ended up 50% higher ($300 vs. $200).

How is this possible? The percentage going back up is greater than the original percentage going down. When a portfolio recovers from a 50% decline it goes up 100%. This is because the percentage going up is relative to a lower starting amount. While old money simply recovers, new money that was invested low goes up $100 – double the -$50 impact of the decline.

Notes:

  1. Some investors lose faith in their portfolio after declines, and hold off on investing (or even sell). If you do that, you can negate the entire benefit of volatility and even hurt your returns.
  2. Even with discipline, there is a special case that can lead to a negative effect. The case involves no up period after a down period, for example, only up years followed by only down years. This is not a concern for disciplined lifelong investors, because such a sequence is limited to one cycle or less.

Quiz Answer:

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50% [The Correct Answer]

Explanation: See this month’s article for an analysis of this scenario.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following are true?

  1. You cannot deduct interest on any mortgage above 750k.
  2. You can only deduct interest on a mortgage above 750k if the mortgage was established before 12/15/2017.
  3. You can deduct interest on a mortgage above 750k only if its lowest balance before the tax reform was over 750k, and even if you refinanced it since then.
  4. You can deduct interest on a mortgage above 750k for any mortgage that was taken before the tax reform.
  5. You may get a deduction on mortgage interest, for mortgages above 750k, regardless of when the mortgage was taken.

Mortgage Deduction Strategies Under The Tax Reform

The tax reform that was signed on 12/22/2017 (Tax Cuts and Jobs Act), reduces the mortgage deduction from $1M to $750k and eliminates the home equity debt interest deduction of $100k. This article presents how it can impact you, and strategies for lessening the impact.

  1. Enjoy Grandfathering: While new mortgage debt above $750k does not get a tax deduction, you can continue to enjoy up to $1M deduction on existing mortgages & loan amounts preserved through refinances. Strategy: Refinance with a larger and/or interest-only mortgage, and keep refinancing to keep the mortgage from dipping below $1M (or below your existing balance between $750k and $1M). Examples for the grandfathering:
    1. You took a 1M mortgage in the past and by 2017 the balance was down to 600k. Deductions on future refinances will be limited to interest on 600k, even if you increase the borrowed amount. If the balance goes down to 500k in 2020, deductions through future refinances are limited to interest on 500k.
    2. You took a 1M mortgage in the past and by 2017 the balance was down to 900k. If you refinance to 1.2M, you keep getting a deduction on interest on 900k, as long as the balance is over 900k.
    3. You took a 2M mortgage in the past and by 2017 the balance was down to 1.5M. The balance keeps declining to 1.4M by 2018, and then you refinance with a 2.2M mortgage. At all times, you get to enjoy the full deduction of interest on 1M.
  2. Get Investment Interest Expense Deduction: Whether you have a new mortgage above $750k, an old mortgage above $1M, or a HELOC (Home Equity Line of Credit), you may be able to get a partial or full deduction vs. investments income (interest, dividends or capital gains). This deduction is called “Investment Interest Expense”, and is given because you technically borrow to invest, whether you intended to do so or not. This is evident if you compare your current reality relative to selling from your investments to pay off your home loans. By keeping both the loan and the investments, you are borrowing to invest. A few notes:
    1. The deduction is available regardless of the source of investment income. For example, if you have a $100k HELOC costing you $5k per year in interest, and a $500k investment generating 1% realized annual income = $5k, you can use that.
    2. If you don’t have enough investment income in any given year, you can defer the disallowed interest amount to the next year, and continue to do so indefinitely. If your investment has high average growth and generates income and/or capital gains, you may have a chance of enjoying the disallowed deduction later on.
    3. Taking the deduction vs. investment income that is taxed at your marginal tax rate (i.e. short-term gains & non-qualified dividends) gives you the full benefit, like the mortgage & HELOC deductions.
    4. If you don’t have enough of the ideal investment income mentioned above, you can elect to take deductions vs. long-term gains & qualified dividends. You have to decide whether taking the lesser deduction today is better than the full deduction later on, requiring some analysis. This decision may not apply to state taxes where there is the same tax rate for both types of investment income.

Important notes:

  1. You should only borrow to invest if the investments are likely to provide materially higher growth than the interest on your loans, or you are seeking liquidity as part of your risk plan and willing to accept the interest costs.
  2. Do a very careful risk analysis that prepares you for a great deal of bad luck. Don’t forget what happened to those who skipped this step in 2008.
  3. You need perfect discipline through the market cycles. The best risk analysis won’t protect you if you panic-sell at the bottom of a decline.
  4. Always do a full comparison of the current picture vs. the new one you are considering, to see if the change is beneficial. The most common failure results from considering one or two factors in isolation, without the remaining moving parts. For a refinance, start with risk planning, then include: estimated refinance costs, change in rate, impact of cash flow change (e.g. between interest-only and fully amortized), and any change in tax benefits. Sometimes the decision will be simple, and sometimes it will require a full simulation in a spreadsheet.

Also, remember that I am not a CPA, and I recommend consulting with a CPA on all tax matters.

Quiz Answer:

Which of the following are true?

  1. You cannot deduct interest on any mortgage above 750k.
  2. You can only deduct interest on a mortgage above 750k if the mortgage was established before 12/15/2017.
  3. You can deduct interest on a mortgage above 750k only if its lowest balance before the tax reform was over 750k, and even if you refinanced it since then. [Correct Answer]
  4. You can deduct interest on a mortgage above 750k for any mortgage that was taken before the tax reform.
  5. You may get a deduction on mortgage interest, for mortgages above 750k, regardless of when the mortgage was taken. [Correct Answer]

Explanations:

  1. If the mortgage was taken before the tax reform and was kept or refinanced to a similar/higher balance, you can get a deduction up to 1M.
  2. If you refinance a >750k mortgage and keep the balance higher than 750k, your deduction is grandfathered.
  3. Old borrowed amounts are grandfathered. Specifically, as long as you sustained your mortgage balance above 750k, you get to keep the deduction on interest up to 1M. This holds even through refinances.
  4. Not true if the mortgage balance went below 750k at any point.
  5. A bit tricky, and is true because you can get a partial or full investment interest expenses deduction on disallowed mortgage interest amount, depending on your investment income. The article explains this further.
Disclosures Including Backtested Performance Data

Quiz!

If you are retired, can stick to an investment plan, and spend 3%-4% of your money per year, which of the following are important for handling your biggest risks (any number of answers may be correct):

  1. Limiting yourself to fast growing investments.
  2. Picking the right stocks, to avoid big losses.
  3. Diversifying into various asset types, including stocks, bonds & real estate.
  4. Staying disciplined with your plan, and avoiding panic sales.

Outpacing the Longevity Escape Velocity

Ray Kurzweil, director of engineering at Google & inventor, predicts that in 10-12 years we will reach longevity escape velocity. This is the point when science and technology will add more than a year to our lifespan for every year we remain alive, leading to an infinite life. With an 86% accuracy rate for his prior predictions about the future, there is some chance that this will be true as well. He may be almost completely wrong, with a lifespan of a mere 200 years or 2,000 years, instead of infinity. When planning my investments, I wouldn’t bet with 100% confidence that he is completely wrong, especially when losing the bet would mean spending most of my long life broke.

Unfortunately, many retirement plans do make this bet. A retirement plan with a 95% chance of providing 30 years of retirement income is typically considered appealing. That means a 1-in-20 (5%) chance that if you live for 30 years, you will go broke later in life, just when financial stress is the toughest to handle. If you live longer than 30 years, the odds of failure go up. I have personally known a retired woman that gradually depleted her assets, and faced one of two tough cases: dying soon or going broke. This memory is carved in my mind, and I am not ready to see any of my clients reach the same position.

Accepting some chance of an infinite life, or simply a very long one, requires infinite income. While the word infinite sounds dramatic, it is not impossible to plan for infinite income with very high odds. You simply need to apply a similar principle of escape velocity to your investments, with more growth than spending, in an average year. Stable investments (bonds, money market) grow too slow to support long-lasting withdrawals that accelerate with inflation. So, we need to seek faster growing investments, and handle the volatility, by accounting for withdrawals during downturns. By using investments that grow fast enough, you can make up for the penalty of withdrawals during declines, as long as the investments are diversified, and the withdrawal rate is low enough. Two stock portfolios fit the requirements:

  1. Long-Term Component (LT) is likely to support 4% withdrawals forever.
  2. Extended-Term Component (ET) is likely to support 3% withdrawals forever.

For the disciplined investor with low withdrawal rates, longevity risk turns some common risk-planning principles on their heads: bonds and cash become risky, and diversified stocks become safe! This is because running out of money becomes a greater risk than losing it all during a temporary decline (through small withdrawals).

Once your withdrawal rates from these portfolios go below the stated rates, you would likely reach escape velocity, providing you with income for as long as you live, even infinitely. But instead of just solving the longevity financial risk, you get a big bonus. After reaching a sustainable withdrawal rate, your portfolio is expected to keep growing over full cycles despite your withdrawals. You can choose between higher security or higher income (or some of each) with every new peak.

My clients tend to be conservative, and don’t count on any specific limited lifespan. I tend to reject more aggressive investors.

Quiz Answer

If you are retired, can stick to an investment plan, and spend 3%-4% of your money per year, which of the following are important for handling the biggest risks you may face (any number of answers may be correct):

  1. Limiting yourself to fast growing investments. [The Correct Answer]
  2. Picking the right stocks, to avoid big losses.
  3. Diversifying into various asset types, including bonds, stocks & real estate.
  4. Staying disciplined with your plan, and avoiding panic sales. [The Correct Answer]

Explanations:

  1. If you end up living a long life, you need high enough growth to support annual withdrawals that grow with inflation. With low growth, you can run out of money.
  2. Trying to pick the right stocks introduces the risk of picking the wrong ones – this is a big risk to take when your lifelong income depends on it.
  3. Low-volatility investments are necessary for high withdrawal rates for a short horizon, and for people who panic during stock declines. You have the benefit of discipline and low withdrawal rates, and may face a long horizon.
  4. It is critical to stay disciplined with your plan, and avoid panic sales. A couple of panic sales can negate the entire benefit of the high average gains.
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