The Distribution Problem Part 3 – An Alternative Solution

It’s been a busy and exciting fall season at USA Financial with all kinds of projects and opportunities on the horizon.  I’ve finally had a chance to circle back around to some of my musings on social media and in particular the distribution series.

In case you need a refresher, part 1 discussed the unique challenges of the distribution stage for investors.  Then in part 2 we elaborated specifically on sequence of returns risk and how that will present an even greater challenge to investors going forward.  Finally, as promised, I will suggest an alternative solution to this problem that many retirees are facing – a solution that is simple in concept yet profound in effectiveness.

The status quo of portfolio management in the distribution stage can be summarized primarily by two strategies.  Option 1 is a constant proportion method where the portfolio is rebalanced every year to a specific equity/fixed income mix – 60% stocks, 40% bonds as an example.  The other method generally gets more conservative as the client ages so that a 60/40 mix turns into a 40/60 mix over time – age-in-bonds and linear glidepath are a couple variations that take this approach.  The shortcoming of both of these approaches is that neither allocation strategy actually adjusts according to how the market has been performing.  In fact, both of these strategies in the distribution stage actually force equities to be liquidated while they are down in value, locking in those losses, and stunting their ability to ever come back in value.

An Alternative Approach

What if instead we built a portfolio where you didn’t have to liquidate equities while they were down in value, thereby mitigating sequence of returns risk?

Here is an overview of the approach we take with our Summit Series Descent Composites:

Descent Pic

The idea is to start with 3 years of a spending reserve bucket within the portfolio that is allocated to cash.  For example: 12% allocation to cash for a 4% spend rate, 15% for a 5% spend rate, 18% for a 6% spend rate, etc.  All withdrawals come from this cash component within the portfolio.  The remainder of the portfolio is primarily geared toward equities in order to generate the growth needed to sustain the spend rate over the course of a long retirement and to offset the silent risk of inflation.

Every quarter the portfolio will be rebalanced according to what the market has been doing.  If the market is up, then the cash reserve bucket will be replenished from the equity component.  However, if the market is down, the portfolio will not be rebalanced in order to give the portfolio more time to recover losses.

This all sounds good in theory, but I’m a numbers guy.  So how has this type of distribution strategy worked historically?  Our friends at Horizon Investments have put together a detailed research report comparing the effectiveness of an intelligent rebalance to the other prevailing distribution strategies out there.  Here is a summary of their findings:

Blog Pics

Source: Horizon Investments Research, Retirement Planning: Solving for the Major Risks in Retirement


What Horizon calls Real Spend in green is the very same concept we are discussing here.  As you can see, probability of success (defined as not running out of money) is dramatically increased when using an intelligent rebalance strategy for distributions.  This objective study looked at all the rolling 20, 25 and 30-year periods going back to 1926, so as to not cherry pick any specific time period.

There are other income distribution strategies out there that are not discussed here (annuities, insurance, alternatives, etc.) and every strategy has pro’s and con’s that need to be considered, but for those investors and advisors seeking to utilize a more traditional mix of equities and bonds to generate income, this is a strategy that should be considered.  Feel free to reach out to me for more information regarding anything discussed in this series or to request a copy of the full research report or information on our composite models.

The strategies discussed do not guarantee a profit or prevent against a loss. Investing carries an inherent element of risk, and it is possible to lose money while utilizing any strategy that includes equity or bond investments. Past performance is no guarantee of future results.

The Summit portfolio may seek to allow more time for the portfolio to recover and postpone rebalancing, increasing the duration of market exposure and potential for loss.

Summit Portfolio Series is offered through USA Financial Exchange. A Registered Investment Advisor. Eric Gritter is an Investment Advisor Representative of USA Financial Securities. USA Financial Securities and USA Financial Exchange are affiliated companies.

The post The Distribution Problem Part 3 – An Alternative Solution appeared first on Tulip Bulbs and Beta.

Not All Guarantees Are Created Equal

Not All Guarantees Are Created Equal – An Independent Review of the Brighthouse Financial Shield Annuity

financial comparison

Ever since Brighthouse Financial was established by Metlife, they have been on a marketing blitz.  I’ve seen Brighthouse ads pop up several times during various sports broadcasts.  Last summer, I was walking through the Charlotte airport and felt like there was a Brighthouse banner every ten feet – granted they are headquartered directly outside of Charlotte.

Every top selling product in the financial services industry has a good story to go along with it.  The Shield VA from Brighthouse is no exception to this principle and has been one of the company’s most successful product lines.  Right on their brochure it states, “Growth is realized in up markets… Protection is provided in down markets.”  Oh, and it comes with no annual fees.  If I didn’t know any better, I would think this is a brochure for their latest Fixed Indexed Annuity.  With that in mind, I set out to compare the Shield annuity to a run-of-the-mill FIA to determine if the product is as good as the story.

The way Shield works is fairly simple – there is an 11% cap on the upside of the S&P 500.  On the downside, Brighthouse will eat the first 10% of any loss for the contract year.  Any gain beyond 11% in the market will be forfeited and any loss below 10% will have a negative effect on the account value.  The annuity offers other term lengths and protection levels as well.  However, for the best “apples to apples” comparison, I am solely looking at annual resets based on the S&P 500 for both Shield and the FIA.  I did not use a specific FIA product, rather just made some assumptions based on what is generally available in the FIA space right now.  Current participation rates on FIAs are approximately 45% of the upside and, by definition, there is no downside risk.

FIA Return Difference by Period
Starting Year 5-year 10-year 20-year
1988 -5.4% -4.3% 0.2%
1989 -4.1% 1.5% 47.3%
1990 -5.2% -1.7% 45.0%
1991 -1.5% -1.5% 38.2%
1992 -3.9% 0.8% 37.1%
1993 1.1% 19.2% 34.1%
1994 5.8% 24.6% 42.1%
1995 3.7% 19.0% 34.6%
1996 -.1% 12.6% 29.5%
1997 4.9% 9.5% 25.4%
1998 17.9% 4.7% 19.7%
1999 17.8% 45.1%
2000 14.7% 47.5%
2001 12.7% 40.3%
2002 4.5% 36.0%
2003 -11.2% 12.6%
2004 23.2% 14.0%
2005 28.6% 13.1%
2006 24.5% 15.0%
2007 30.2% 14.5%
2008 26.7% 14.3%
2009 -7.5%
2010 -12.0%
2011 -7.6%
2012 -12.1%
2013 -9.8%
Average: 5.2% 16.0% 32.1%

(Values show in each of the 5, 10 and 20-year columns are illustrative and represent the hypothetical excess return (over the Brighthouse Shield Annuity) of a Fixed Index Annuity with a 45% participation rate when applied to a rolling period of S&P 500 index performance beginning January 1 of the starting year)

Going back 30 years, I looked at all the rolling 5, 10 and 20-year periods and determined the cumulative outperformance of an FIA compared to the Shield annuity.  As you can see from the chart, there were 15 periods – only 35% of the time – where the FIA underperformed the VA.  All of those periods were within the 5-year timeframes.  Put another way, as you stretch out the time horizon, there were only a few rolling periods over a 10 or 20-year timeframe that the VA even came close.

Before I move on to an explanation for the outperformance of an FIA vs. the Shield VA, I want to address what many readers may be thinking: “Is this comparison intellectually honest?”  After all, neither of these products were available for the last 30 years.  Furthermore, I am assuming constant cap and participation rates for both products.  True enough – varying interest rates and volatility would have had a significant impact on the options pricing behind both of these products.  But that’s the key here.  I’m more interested in the comparison on a relative basis, not so much on an absolute basis.  Any swings in interest rates and volatility would have had a similar effect on both products.

Getting back to the reasoning, it seems as though the Shield annuity was designed around both recent history as well as the average return on the market.  If the S&P 500 has averaged roughly 9-10% historically, it should stand to reason that the annuity with an 11% cap rate would capture nearly all of the upside of the market.  Except that’s not even close to being accurate.  In fact, over the last 90 years, the S&P 500 returned between -10% and +11% in only 30% of the years.  For the other 70% of the time the client would have either eaten losses below -10% or forfeited gains above 11%.  More succinctly put, markets don’t move up in a straight line.

In case there are still questions about the pricing comparison of the annuities, Brighthouse initially offered a Shield annuity with 100% downside protection.  However, the trade-off is a lower cap rate of 2.8%. In essence,  this structure is  an FIA.  FIAs structured with a cap rate (as opposed to participation rate) have been in the range of 4%-6% over the last year.  Brighthouse has since stopped offering the 100% downside protection level, likely because it shed too much light on their poor competitive pricing.

As with all sales literature, it pays to dig into the numbers behind the brochure.


It is important to note that there are a number of important factors used in determining and calculating an annuity’s policy values. These factors can drastically differ insurance carrier by insurance carrier and product by product.

This hypothetical index annuity example used the following assumptions:
1) FIA product returns based on the SP500 Index generally use price returns.  Since the Brighthouse annuity also uses price returns, the historical S&P500 data used in the analysis are based on price returns, which do not include dividends.  SP500 values are for illustrative purposes only, since investors cannot directly invest in the SP500 index. Past performance is not a guarantee of future results. 2) Annuity performance is calculated using an annual point-to-point measurement. 3) The index annuity shown used a 0% asset fee.  4) The index annuity shown is calculated using annual participation rates on the interest that is credited, at 45%. Index annuity participation rates are based on a number of factors, including but not limited to: whether or not the policy offers any bonus, as well as the surrender charge percentage and duration of the surrender schedule.

In applying the information provided in this material, you should consider your clients’ other assets, income, and investments – such as the equity in their home, Social Security benefits, any IRAs, savings accounts, and other plans that may provide retirement income, as those other assets may not be included in this discussion, model, or estimate.

This analysis should not be interpreted as a recommendation or as investment advice. Before recommending any investment company product, please review and provide a copy of the prospectus.

The Distribution Problem Part 2 – Sequence of (future) Returns

A few weeks ago, I wrote the first in a series of blogs dedicated to the distribution problem that advisors and retirees are facing today.  Part 1 focused on the clarifying the unique challenge that comes with the distribution stage of investing.  Indeed, as investors begin to start liquidating their accumulated assets as a replacement paycheck after they stop working, the math changes.  Inflation and sequence of returns are two key risks associated with this investor stage.  Today, I am going to zero in on sequence of returns risk and shed some light on how many advisors are inadvertently setting inappropriate expectations for their clients in retirement.

Just in case anyone is wondering how the math changes in the distribution stage, allow me to illustrate.  The first chart that you see shows the growth of $100,000 based on historical returns of the S&P 500 Index (total return) since the beginning of 2000 in blue.  The orange line represents that same $100,000 growing over the last 18 years – except the order of returns have been reversed.  So, although the accumulation path is drastically different, both scenario’s end up with the same exact value today.  In other words, the order of returns does not matter.

Growth of $100k 

Now, take that same scenario but pull out withdrawals of 5% per year (with a 3% cost of living adjustment).  The original order of returns (2000 thru Q2 2018) runs out of money 15 years into the hypothetical.  The reverse order of returns (Q2 2018 – 2000) has a positive balance of $124000 at the end.  The order of returns clearly matters in the distribution stage.  That’s what we mean by sequence of returns risk.

5% Distribution Chart

The primary way that many advisors attempt to mitigate this risk for their clients in the distribution stage is to take some risk off the table and diversify the portfolio.  Here’s what a 60/40 mix of the S&P 500 and the US Aggregate Bond Index would look like in the same distribution scenario:

MS Hypo 60-40 SP500 US Agg 5% Withdrawal

Clearly, the diversification benefits the client in this scenario.  Instead of running out of money 15 years into retirement, the client has a little over $37,000 left after the full 18 years.  The assets won’t last much longer, but at least this is an improvement.  The problem I have with an advisor presenting this as a solution to a client for their income needs is that it’s all based on historical returns.  Yes, I get it – no one knows how stocks will perform over the next 10-20 years, so the next best thing is to use a long historical time period as a reference point.  I don’t have any better idea than the next person as to the performance of stocks going forward.  We could continue to see significant corporate earnings growth and valuation expansion that underpin high returns over the next 10 years,  or we could see a significant downturn due to any number of reasons.

The 40% allocated to fixed income is a different story.  We do have a better understanding of bond returns going forward relative to the past 15-20 years.  Either rates will continue to stay low and bonds will earn the yield they are paying.  On the flip-side, if rates increase that will increase the yield return, but will be partially offset by the decrease in the price of bonds that investors are currently holding.  In either scenario, it’s hard to imagine that the US Aggregrate Bond Index will average the 5% annualized return over the next 18 years that it has since 2000.  A more appropriate rate of return for the 40% fixed income allocation might be 3% going forward.  If we adjust to those expectations for “future” sequence of returns risk, here’s what that impact on the portfolio looks like:

MS Hypo 60-40 SP500 Cash 5% Withdrawal

As you can see, lower interest rates going forward will make it more difficult for portfolios to last through retirement compared to previous generations.  Here’s a quick read from FS Investments that I came across outlining the difficulty of the traditional 60/40 portfolio going forward.

History is a useful guide to the future when examining potential market cycles.  However, when it comes to conservative asset classes, advisors and investors should be careful to not expect the next 20 years to look like the previous 20 years.  Next time, in the final installment of this series, I will discuss some of the prevailing distribution strategies and present a viable alternative that income oriented investors should consider.

June Webinar

If you missed my June webinar, I’ve posted it below. If you prefer to read what I discussed, keep scrolling. For more of my webinar series, join me every third Tuesday of the month and feel free to reach out to me with questions. I enjoy hearing from you!


This is not your typical market commentary.  There are plenty of resources out there with all of your asset class performance and economic and market indicators.  This update will normally focus on three segments.  My goal is to highlight a couple of significant overarching themes from all that data in more of an educational format.  I’ll also hit on some of the challenges that every day investors and advisors are facing from a practical standpoint.  And then finally, we’ll wrap up with some things on the horizon to keep an eye on.

Market Highlights: Fed Focus

Many of you may be aware that the Federal Reserve has what’s known as a dual mandate from Congress.  What does that actually mean?  Since 1977, the FOMC, or Federal Open Market Committee, which is the committee within the Federal Reserve that determines US monetary policy and sets the quarterly fed funds rate, has been tasked with maintaining maximum sustainable employment and stable prices.  That committee has lightly indicated that this means a target of 4.5% unemployment rate and 2% rate of inflation.

 “In 1977, Congress amended the Federal Reserve Act, directing the Board of Governors of the Federal Reserve System and the Federal Open Market Committee to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Chicago Fed Dual Mandate Bullseye

Source:; Inflation is measured by the core PCE price index.

This is a diagram from the Chicago Fed showing that dual mandate.  So why am I starting with this exciting topic of the Fed?  Well, we’ve had a regime change this year at the Fed in both person and focus.  Jay Powell is the first Fed Chair in over a decade to have to focus on the inflation side of the dual mandate.  With unemployment near 4%, they can check that one off.  But I would say they need to update this diagram slightly, with nearly all inflation measures now firmly in the 2-2.5% range.  The market will certainly be watching if Powell and team can normalize interest rates without removing too much oxygen from this economy.

Market Outlook

Ok, real quick on what’s been going on in the market this year.  Any of you that have worked with my firm, USA Financial, know that we are not big on market predictions.  It’s one of those things you can’t control and yet there’s so much focus on it.  We prefer to look unemotionally at the data as it comes in.  But I will say this – for the last six years price growth has increased faster than earnings growth.  In other words, for the last half dozen years P has grown faster than E.  So it’s no wonder we entered this year with fairly high valuations.  This year has the possibility of snapping that streak.  According to Factset, earning projections for the full year are roughly 19%.  In fact, first quarter earning with nearly all companies in the S&P 500 reporting, actual earnings growth came in at 24.5%.  We are almost half way thru the year with the market up a modest 2 percent.  If the second half of the year mirrors the first half in terms of earnings growth and returns – we would finally get some significant valuation compression and I think that would be very healthy for this bull market to continue on.

Earnings Scorecard: For Q1 2018 (with 93% of the companies in the S&P 500 reporting actual results for the quarter), 78% of S&P 500 companies have reported a positive EPS surprise and 77% have reported a positive sales surprise. If 78% is the final number for the quarter, it will mark the highest percentage since FactSet began tracking this metric in Q3 2008

 Earnings Growth: For Q1 2018, the blended earnings growth rate for the S&P 500 is 24.5%. If 24.5% is the actual growth rate for the quarter, it will mark the highest earnings growth since Q3 2010 (34.0%).

Source: Factset

Nitty Gritty

For this month’s Nitty Gritty, I want to explore some stock market idioms.  These are the popular sayings that get tossed around in conversations as quasi-investing advice.  You’ve likely heard of them:

  • January Effect: Meaning that stocks generally have above average returns in the first month of the year
  • Dogs of the Dow: Basically buying highest dividend yields in the Dow, based on the premise that those stocks are near their business cycle bottom and should rebound.
  • Santa Claus Rally: Which is self explanatory…
  • Super Bowl Indicator: I’m not sure why this one even got started, other than the fact that it’s actually been correct 80% of the time over the last 50 years. In short, it states that if the AFC wins the Superbowl we should expect a down market. If the NFC wins the market should go up.  Statisticians call this type of observation spurious correlation – in other words, correlation alone does not indicate causality.  This is something that we should be careful with in the financial industry.  There can be a tendency to discover some correlation in the past and use that as an investment strategy in the future, when in reality there was never any logical basis for that correlation other than complete random luck.
  • Sell in May and go away: Given the time of year, I’m going to take a deeper look at the “sell in May and go away” notion.  It’s basically the idea that you’d be better off staying on the sidelines from May through October and invest back into the market the other six months of the year.  So what does the data say?

Annualized price returns of S&P 500 (not including reinvestment of dividends), thru April 30, 2018:

Sell in May and go away - chart

I ran the annualized returns of the 2 six-month periods over short, mid, and long term time periods.  And you can see, although the 5-year comparison is close, there is a consistent out-performance of the November thru April time-frame compared to May thru October.

So, does this mean that “Sell in May” has validity?  Well, I’m willing to concede that the data indicates a performance edge to the winter months.  And in fact, I was quite surprised how much of an edge there has been over the last 10 and 30-year periods.  But before you go cashing in your chips right now, there are a couple things to consider:

  • One, all the summer periods still have positive returns. And so, while going to cash would reduce your volatility, you’d also be giving up gains on average.
  • Second, and I think this is the biggest issue with Sell in May, is investor behavior comes into play. Any strategy can go through a long stretch where it doesn’t appear to be working.  In fact, for the last 6 years Sell in May hasn’t worked.  You’d have to go all the way back to 2011 where it worked to your advantage to be completely out of the market.

Making significant portfolio shifts and trying to time the market every 6-months opens the door to negative behavioral alpha (in other words, making emotional decisions that negatively impact your long-term plan).  This line of thinking goes for any strategy that you may be considering.  Even if the numbers look good on paper, how does that translate to practical, real world implementation?  When in doubt, simplicity trumps complexity in most situations.

On the Horizon

  • If you haven’t explored my other posts yet, I’ve been trying to ramp up the content recently.  Those posts have a similar feel to these webinar updates, but with a much wider range of financial topics.
  • Upcoming things to keep an eye on: employment to continue to stay below 4%? Wage growth key. Summit held with North Korea June 12 in Singapore.  Regardless of anyone’s political views, it’s quite a turn of events over the last year considering last summer North Korea was shooting missiles over Japan and just this January the two leaders were comparing the size of their respective nuclear buttons on social media.

Alright, that’s all for this month.  Thanks for being here and make it a great day!

The Distribution Problem Part 1 – Clarifying the Unique Challenge of the Descent

During the Q&A session of the recent June market update, I answered an open-ended question on fixed income.  Part of my answer centered around the distribution challenge that advisors and retirees are facing today.  Due to the complexities and nuances of this topic, I am going to break this up into a three-part series.

Today, my goal is to set the stage for the challenge that retirees are facing in the distribution phase.  Part two will then take a deeper dive into some of the risks pertaining specifically to distribution and shed some light on the dangers of how some advisors are setting expectations for income in retirement.  Finally, part three will present an alternative way to approach the challenge of income distribution compared to the prevailing strategies used by many advisors and investors currently.

When most people think about investing and their personal financial plan, they tend to view it as a fairly linear progression.  They take a snap shot of where they are today, financially speaking, and project what their goals are 20-30 years down the road.  Some investors will break that path up into two distinct phases – the accumulation phase and the distribution phase.  Regardless if they view their financial life as one long continuum or two distinct phases, most investors assume that the risks in investing remain constant and similar no matter where they are on the path.

Our approach to investing is quite different.  We view investing more like a mountain trek that has three distinct phases, each with its own unique challenges and risks – Ascent (Accumulation), Acclimate (Risk Mitigation), and Descent (Distribution).

During the Ascent phase, the investor is accumulating assets during their earning years.  The primary risk inherent in this phase is volatility.  Volatility in and of itself is not a bad thing despite what media often portrays.  In fact, without a certain level of volatility it would be impossible to earn more than the risk-free rate that cash or treasuries are paying over the long term.  The key is to appropriately gauge the investor’s appetite and ability to handle volatility and mirror that same level of risk within their portfolio.

Once the investor nears retirement, they enter the Acclimate phase.  The primary risk at this point during the investor trek is loss.  This is not to be confused with volatility.  Absolute loss, or drawdown, at this stage can have a permanent negative effect on an investor’s financial goals.  One reason is that they are much closer to the point in time that they will begin to take distributions from their accumulated assets to live on during retirement.  Related to that issue, negative investor behavior (i.e. panic selling after losses) becomes more acute.

The final phase of the trek is the Descent, otherwise known as the distribution phase where investors begin to convert their accumulated assets into a replacement paycheck after they stop working.  This is the phase that I will focus on for the remainder of this blog post and the two follow-up posts.  The primary risk that investors face here is longevity – at its core, this is the risk of running out of money.

Before I move on, our friends at Horizon Investments recently issued a whitepaper detailing this redefinition of risk based on the investor stage.  I would encourage you to check that out if you are interested in more information on the rationale for this investment philosophy.  Here is a visual of what we’ve discussed so far:Mountain

Longevity as a risk can be a bit abstract to think about.  I find it easier to grasp when breaking it down into the two core risk components:

  • Sequence of returns risk – experiencing early losses in the distribution phase increases the probability of running out of money due to liquidating assets that are down in value, thereby locking in those losses permanently.
  • Inflation – the loss of purchasing power over time.

The difficulty here is that these are competing risks.  On the one hand, you need conservative assets within your portfolio to mitigate sequence of returns risk.  On the other, equities are a better hedge against inflation than fixed income over time.

Hopefully that clarifies for you the unique challenge that investors are facing in retirement.  Over the course of the next couple weeks I will shed some light on how advisors are attempting to solve this distribution riddle and also present a viable alternative.

Even if you had a crystal ball…

Everyone who works even remotely close to the investment management industry inevitably gets asked the question, “So what do you think is going to happen with the market?”  A cute answer that I’m sure I’ve used along the way is, “Well, my crystal ball has a crack in it at the moment.”  In other words, no one is a clairvoyant with market predictions.  I’ll go one step further though, even if you had a working crystal ball that could foresee significant events that could move the market, you still wouldn’t be any better off.

Many financial firms have complex models with dozens of inputs, all with the goal of predicting the behavior of some niche area of the capital markets.  The difficulty with this forward-looking process is that even if you get the majority of the inputs correct, you are still under your own assumption of how the market will react to each and every input.

Here are some examples over the last several years of how even the foreknowledge of significant events could have led you astray.

2016 Election

If there’s one thing the stock market abhors, it’s uncertainty.  When outcomes of various events don’t go according to plan, the market must recalibrate in order to adjust for different inputs that were  initially forecasted.  We saw this with Brexit when the polls in the U.K. turned out to be wrong.  We saw this when Lehman Brothers filed for the largest bankruptcy in U.S. history, despite A-rated credit ratings the morning of September 15, 2008.

Enter the 2016 Presidential election where  Donald Trump was widely regarded as the most unpredictable candidate of our time.  He was down in the polls and there was no way he was going to crack the blue wall.  Then, once the dust settled early Wednesday morning, candidate Trump became President-Elect Trump.  What was the market’s reaction to this uncertainty?  The day following the election the S&P 500 was up 1.1% and a cumulative 5% increase over the following month.  So, unless you were one of the small fraction of investors who were trading futures on the night of November 8th along with Carl Icahn, the only volatility you experienced was to the upside.

US Debt Downgrade

In August of 2011, Standard & Poor’s downgraded their credit rating of US sovereign debt, marking the first time in history that the US did not enjoy the AAA rating from all thee major credit rating agencies.  Bond pricing models have to account for many factors including maturity, liquidity, inflation and credit quality.  When credit quality decreases, (i.e. the chance of default increases) the bond issuer must compensate new investors with a higher yield.  When the US Treasury received a negative outlook in April of 2011 and the formal downgrade in August from S&P, one would’ve thought that the yield on treasuries would have increased.  Instead, this is what 2011 looked like:

The 10-Year US Treasury yield began the year at 3.4% and had a steady decline to end the year substantially lower at 1.9%.

Nuclear War on Social Media

January 3, 2018

Donald J. Trump(@realDonaldTrump)

“North Korean Leader Kim Jong Un just stated that the “Nuclear Button is on his desk at all times.” Will someone from his depleted and food starved regime please inform him that I too have a Nuclear Button, but it is a much bigger & more powerful one than his, and my Button works!”

This was one of my favorite tweets from our President.  As little as a couple years ago one might have expected that a flexing of nuclear muscles on social media would have created quite a commotion in the market.  I can find humor in it and discount the seriousness because the market has done the same.  How did equities react to this tweet?  The S&P 500 was up for the first 6 trading days of the year and 7.5% through the first 3 weeks of January – clearly traders were not pricing in a potential nuclear conflict on the Korean Peninsula.


Earnings season tends to encourage water cooler talk around stock performance.  Sometimes the outcomes are confounding when a stock drops in value after the company reports better than expected earnings, revenue growth, and forward guidance.  We are left scratching our heads.  Perhaps analysts were looking for higher growth in a particular area of the company that they viewed as critical to long term sustainable growth (i.e. health care within GE, cloud services within MSFT).  Headlines are forced to come up with some kind of explanation – usually it’s something along the lines of “the expectations were already priced into the stock leading up to the report…” leaving yourself to ask, “what’s the point of analyst consensus earnings expectations then?”  True enough.

Federal Reserve Stimulus

I found this one most interesting.  If you knew in advance what the purchasing activity of treasuries looked like for the Federal Reserve during the 6-year period covering QE2 and QE3 (QE = Quantitative Easing), would that have given you an edge in the treasury market?  In the following chart I pulled the Fed Balance sheet info and overlaid that with the yield on the 10-year treasury.

FRED, Federal Reserve Bank of St. LouisSource: FRED, Federal Reserve Bank of St. Louis

Bonds 101 tells us that an increase in demand drives up the price of bonds, thereby decreasing the yield.  At first glance, the six-year picture does show an overall decrease in yield as the Federal Reserve purchased a trillion dollars’ worth of treasuries (roughly half the balance sheet is treasuries).  However, it gets more interesting when you look at the four distinct regimes of QE2, QE3, and the periods between and after, when the Fed was not purchasing assets.

Period Beginning Yield Ending Yield Change
QE2 2.50% 3.20% 0.70%
Between QE2 & QE3 3.20% 1.60% -1.60%
QE3 1.60% 2.30% 0.70%
Post-QE3 2.30% 1.50% -0.80%

You can see that during both periods of quantitative easing, yields actually increased.  Then in the periods where the Fed let off the gas (demand went down), yields decreased.  In a vacuum, this is the exact opposite of what you would expect.

But that’s my whole point; when it comes to capital markets, nothing ever happens in a vacuum.  There are always more inputs than you think, and the market reaction to those inputs is always more nuanced than expected.  Next time you catch yourself saying “if only I had known,” don’t sweat it.  It may not have helped you anyway.

Before they leave the nest – financial advice for my kids

Nest imageGraduation season is wrapping up.  During this time of year, many parents in that stage of life feel a sense of pride, exhilaration and anxiety all wrapped up into one package.  I am lucky enough to have four kids, but I won’t experience those feeling for another decade or so.  Our two boys and two girls range in age from two through nine.  Recently, I asked myself this question: “Fast forward ten years, what financial advice would I give to my kids (assuming they wanted to hear it) as they begin to leave the safety of the nest?”  These are the first ten pieces of advice that came to mind:

  • Spend less than you take in. Most call this a budget, telling your money where to go, etc.  I don’t really like the B-word because it has a negative connotation of limiting our financial freedom.  Admittedly, I am not good at sticking to a detailed budget.  Never have been.  It’s not for lack of effort as I’ve tried multiple times.  I’ve read Dave Ramsay’s books, listened to his radio program and even attended a live event of his many moons ago.  I prefer to have the first two line-items in my expenditures every month go to my church and my savings account.  Then I know I simply have to live on the rest.  Ultimately, find what works best for you; as long as you are spending less than you take in.  Give yourself some grace though, as you likely won’t get it right the first few go-arounds.
  • Mitigate lifestyle creep. This ties in with the first point and is incredibly difficult in practice.  Delayed gratification goes against every natural human tendency, but for those who can master it, the rewards are immense.
  • It’s not always a spending issue. Sometimes it’s an income problem.  The income side of the equation can be boiled down to one word: rare.  People, both customers and employers, will pay a premium for something that is uncommon.  Find that “something” in your life and you will most likely increase your income.  Here are some things that fall into the category of rare:
    • Strong work ethic. At minimum, this will help you keep your job.  In all likelihood, this will make you stand out among your colleagues over time.
    • Willingness to take risk. Business owners tend to do very well financially as compensation for the amount of both up front and ongoing risk that they take.  Employ vs employed.
    • Education. There is a reason doctors get paid extremely well (not to mention this field has a wide moat around it against the DIY trend).  Very few people have the discipline to handle another seven to ten years of post-undergraduate education.  Of course, an internship, certification or graduate degree will also apply here.
    • Sales. People don’t like to hear “no”, let alone hear that word 20 times a day.  Those who can handle it, move on and say, “who’s next” have an increased probability of earning six-figures.                
  • Build up a liquid cash cushion. Most guru’s will say anywhere from 3-12 months of expenses.  The biggest reason for the wide range is that it depends on your personal circumstances.  The more volatile your employment situation, the more you will need in savings.
  • 401k match. It’s free money.  If you don’t contribute at least up to the match, you are throwing away a guaranteed 100% 1st year return on your money (or whatever the match happens to be).
  • Start investing in your early 20s. 60-year-old self will thank you. Returns on your money early on are not nearly as important as getting the snowball rolling for later use.  Compound interest will blow your mind, but not in the first ten or twenty years.
  • Allocation.  I am a big believer in equities over the long term.  Assuming my kids start investing in their 20’s, they may have several decades to put their money to work.  In addition to that, when you first start investing by dollar cost averaging into the market, equities make even more sense.  The single best-case scenario could be that the market absolutely tanks for a few years, allowing them to start accumulating shares at a discount.  There is no need to get too complex out of the gate either.  I would simply encourage them to avoid home country bias and invest a portion of their funds into international equities.
  • Avoid carrying an ongoing credit card balance like the plague. By paying off your credit card balance, you are saving the 15-20% annual interest rate you would otherwise be paying to the card company.  I don’t know of anything else in finance paying 15-20% annual return.
  • Go into marriage eyes wide open about the financial behaviors and situation of your potential spouse. When in doubt, look to their parents as a leading indicator – after all, your spouse has had two (or more) decades of exposure to their financial habits.  Every other piece of financial advice hinges on this.  You don’t have to be on the same financial page as your spouse, but you certainly must be reading from the same book.
  • Be grateful. Understand where your financial resources have come from.  Be a steward of those resources and do not hold onto them too tightly.  Money should be a tool.  Master it; never let it master you.

One of the benefits of writing thoughts like this down is that I can revisit them in another 10 years and see how they might have changed over time.  Who am I kidding anyway?  When my kids are ready to spread their own wings, they’ll be too smart to listen to their parents anymore.

The (Misguided) Active vs Passive Debate

“A great year in the markets, but few managers beat their indexes”

“Their long-term record is even worse, according to a report on indexes versus active managers”

Source: InvestmentNews, 3/16/2018

Every year  you can count on articles like this popping up like clockwork.  The short version goes something like this: active managers for the most part, underperform their respective benchmarks or indexes.  Typically, over the last one to three years, only 40% of active managers outperform the index.  So, in conclusion, why would anyone pay higher fees for active management when they could just invest in the index and have higher returns over time?

This seems like a fair conclusion.  After all, fees will have an appreciable impact on performance over time.  Case closed.  Except it’s not because we live in the real world.  First, allow me to discuss a couple issues with these studies.  The tone of such articles seems to indicate that simply because an investment manager charges a fee, they should outperform the index.  There’s this notion that it’s possible for 100% of active managers to outperform the index.  The problem is that the performance of each index is not some arbitrary number pulled out of thin air.  The performance of an index is derived from the cumulative effect of active trades.  For every winning trade by an active manager, there must be a losing trade on the other side.  As such, we’ll never have 90% of active mangers beat an index.  I don’t believe we can even have 60% of active managers over time beat the index.  Add in the effect of costs and that number drops below 50%.

The second issue I have is that these reports aren’t asset weighted. A small startup fund with limited experience is treated the same as much larger funds.  So, when Growth Fund of America with $180B in assets outperforms the index by 4% last year, that means a whole lot of smaller funds are likely on the other side of those trades and consequently will underperform the index.

There is a more constructive conversation that I believe we need to pivot to.  Dalbar puts out a study every year that compares returns of the index (or sometimes actual equity funds) to the actual returns that investors experience.  Here is what that looks like over various time periods:Dalbar Investor Returns

Fees alone cannot come close to explaining the difference.  Dalbar cites investor behavior as the primary culprit for investor underperformance – specifically behavioral biases of loss aversion and herding.  Loss aversion simply means that the pain of a 20% loss is much greater than the pleasure of a 20% gain.  This bias typically leads to panic selling on the downside.  The herding effect is akin to chasing returns.  Investors will invariably follow the latest trends which perpetuates the cycle of buy-high, sell-low.

10% vs 4% over a 30-year time horizon – that equates to a greater than 5-fold difference.  Ultimately, that’s where a good advisor earns their keep.  You can have the best MoneyGuidePro, Emoney or name-your-software report, but if the client can’t stick to it, it’s just a 30-page pile of paper worth about 25 cents.  A good investment plan that a client can stick to is infinitely better than a perfect investment plan that they abandon.