If you read the Money & Markets section of the Wednesday (May 27, 2009) Oregonian, you may have noticed a little article titled “The steady investors wins.” The article briefly describes how most investors realize investment returns that are substantially below those that the market itself produces. This should be a big wake up call for investors who continue to believe that they can “beat the market” through strategies like timing when to get in and out of the market, selecting “hot” mutual funds or relying an advisor to pick “winning” stocks. These strategies consistently result in poor performance.
In the scenario offered in The Oregonian the slow and steady investor put $10,000 in a S&P 500 Index fund and did nothing more. She simply let the money grow. At the end of 20 years, the account has grown to $49,725 based on the 8.35% return of the index.
The other investor is described as “squirrelly.” He also starts with $10,000. But instead of investing and holding steady, he attempts to improve his performance by moving in and out of the stock market. Twenty years later this investor ends up with $14,485 or a 1.87% return. This is the result earned on average by investors in stock mutual funds for period 1988-2008 according to Dalbar, a research company.
The difference in the two results is over $35,000. This is enough money to pay for a year at a private college, a brand new car, or the down payment on a place at the beach. If the starting value had been $150,000, then the cumulative difference would have been over a $500,000.
Intelligent investors are smart. They know they cannot “beat” the market. So, they make no such effort. Instead they build well diversified portfolios, minimize their investment costs. Intelligent investors are also disciplined. They know how to manage their emotions during the most difficult periods in the stock market. They simply wait patiently for the storm to pass. They know the market will eventually reward them for maintaining remaining vigilant.
Friday, May 29, 2009
Friday, May 22, 2009
Monte Carlo is Risky
Last week I discussed Monte Carlo Analysis as a tool financial planners use to model retirement scenarios for clients. The process involves applying random values to the assumptions inside a plan. With the use of modern computers we can run thousands of iterations each with a unique set of assumptions. The results can be reviewed to determine how often the client actually meets their objectives. Most advisors like to see a “success rate” of at least 90%.
Unfortunately, Monte Carlo Analysis is not without its flaws. A recent article in The Wall Street Journal (“Odds-On Imperfection: Monte Carlo Simulation”) discussed how Monte Carlo simulation may be less reliable than most advisors (and their clients) realize. The problem is that Monte Carlo assumes that stock market returns fall along a normal bell-curve shaped distribution. This would suggest that returns fall proportionately along the curve. If the average annual return of the stock market has been 10% (a reasonable view), then a return of 5% (5% below the norm) or 15% (5% above the norm) would not be surprising. However, a decline of 50% (60% below the norm) would be highly unlikely.
The reality is that stock market returns are more random than the bell-curve would suggest. Morningstar points out, for example, that the Standard & Poor’s 500-stock index has declined more than 13% in a month at least 10 times since 1926. The conventional bell-shaped curve would not predict this.
To address these limitations, some are moving away from the normal distribution and instead considering a “fat-tailed” distribution. This distribution assigns higher probabilities to extreme market events. This allows advisors and clients to anticipate how a deep bear market would affect the client’s portfolio.
Within the last decade we have experienced two stock market crashes. One was caused by the speculative bubble in technology-oriented stocks that took place from 1995 through 2001. The Nasdaq lost 39.3% in 2000, 21.1% in 2001 and 31.5% in 2002. The Dow lost 6.2% in 2000, 5.4% in 2001, and 16.8% in 2002.
We are still dealing with the aftermath of the crash began in the fall of 2007 and occurred when large financial institutions faltered under the load of packaged securities that failed to perform. The Nasdaq was up 9.8% in 2007 and down 40% in 2008. The Dow was up 6.4% in 2007 and the Dow lost 33.8% last year. Year to date the Nasdaq is up 1.97% and the Dow is down 4.4%.
The stock market is volatile. The static returns that are assumed in basic retirement plans are unrealistic and unreliable. Traditional Monte Carlo Analysis is helpful in modeling other scenarios. However, stock market returns do not follow the normal that underlies Monte Carlo simulation. Therefore, the investment advisory industry needs to develop other methods which will better enable investors to plan for retirement. Let’s hope this happens soon.
Unfortunately, Monte Carlo Analysis is not without its flaws. A recent article in The Wall Street Journal (“Odds-On Imperfection: Monte Carlo Simulation”) discussed how Monte Carlo simulation may be less reliable than most advisors (and their clients) realize. The problem is that Monte Carlo assumes that stock market returns fall along a normal bell-curve shaped distribution. This would suggest that returns fall proportionately along the curve. If the average annual return of the stock market has been 10% (a reasonable view), then a return of 5% (5% below the norm) or 15% (5% above the norm) would not be surprising. However, a decline of 50% (60% below the norm) would be highly unlikely.
The reality is that stock market returns are more random than the bell-curve would suggest. Morningstar points out, for example, that the Standard & Poor’s 500-stock index has declined more than 13% in a month at least 10 times since 1926. The conventional bell-shaped curve would not predict this.
To address these limitations, some are moving away from the normal distribution and instead considering a “fat-tailed” distribution. This distribution assigns higher probabilities to extreme market events. This allows advisors and clients to anticipate how a deep bear market would affect the client’s portfolio.
Within the last decade we have experienced two stock market crashes. One was caused by the speculative bubble in technology-oriented stocks that took place from 1995 through 2001. The Nasdaq lost 39.3% in 2000, 21.1% in 2001 and 31.5% in 2002. The Dow lost 6.2% in 2000, 5.4% in 2001, and 16.8% in 2002.
We are still dealing with the aftermath of the crash began in the fall of 2007 and occurred when large financial institutions faltered under the load of packaged securities that failed to perform. The Nasdaq was up 9.8% in 2007 and down 40% in 2008. The Dow was up 6.4% in 2007 and the Dow lost 33.8% last year. Year to date the Nasdaq is up 1.97% and the Dow is down 4.4%.
The stock market is volatile. The static returns that are assumed in basic retirement plans are unrealistic and unreliable. Traditional Monte Carlo Analysis is helpful in modeling other scenarios. However, stock market returns do not follow the normal that underlies Monte Carlo simulation. Therefore, the investment advisory industry needs to develop other methods which will better enable investors to plan for retirement. Let’s hope this happens soon.
Friday, May 15, 2009
Black Swans & Monte Carlo
Imagine heading off into retirement with a financial plan that you took great care in developing. You carefully determined your budget including adjustments over time for various lifestyle changes … Perhaps more travel early in retirement, but less in your later years … Increasing medical expenses as you grow older … You assumed a conservative rate of withdrawals from your investments of 4-5% with the expectation that you would be able to maintain your purchasing power against inflation and that you would not run out of money … even if you lived to be 100. You entered into your Golden years confident that you future was secure.
Then along comes an event that is considered to happen perhaps once in a generation. That event is a dramatic drop in the stock market. It profoundly changes your finances and forces you to consider radical changes to the plan you felt was nearly infallible. The author Nassim Nichosals Taleb calls this a Black Swan event. The term comes from the assumption that “all swans are white.” In this sense, a Black Swan is a metaphor for something that cannot happen. However, in the 18th century, Black Swans were discovered in Western Australia.
If Black Swans exists and we know it, then perhaps we can plan for the possibility that we will experience one. In the financial planning field, advisors use computer modeling technology called Monte Carlo Analysis to test the sustainability of a client’s plan. The problem is that basic retirement planning software relies on values that are assumed to be static. For example, the rate of inflation and the growth rate for investments are assumed to never change. This is, on the surface, wholly unrealistic. Inflation is hardly fixed and the returns in the stock market are far from a steady X (pick your return) percent.
Monte Carlo Analysis attempts to resolve the problem of static variables inside a retirement plan. It randomly assigns different values to each of the key variables inside a retirement plan. The plan is then simulated to determine that unique outcome. With modern computers this can be done for tens of thousands of scenarios in a matter of seconds.
The good Financial Planner wants to know how many of these iterations results in an outcome that is satisfactory to the client. This might mean not running out of money before age 100 or it could mean leaving behind a substantial inheritance to one’s heirs. The computer will tell us how many of these outcomes were “failures” and how many were “successes” depending on our definition. At our firm we prefer to see a success rate of at least 90%. Anything less than that suggests a level of risk we feel is too great to bear.
Black Swans exist. Events that are unexpected and profound occur. Rather hope you never experience one (because you will), it’s better to plan for them. Monte Carlo Analysis is one tool that can help you.
Then along comes an event that is considered to happen perhaps once in a generation. That event is a dramatic drop in the stock market. It profoundly changes your finances and forces you to consider radical changes to the plan you felt was nearly infallible. The author Nassim Nichosals Taleb calls this a Black Swan event. The term comes from the assumption that “all swans are white.” In this sense, a Black Swan is a metaphor for something that cannot happen. However, in the 18th century, Black Swans were discovered in Western Australia.
If Black Swans exists and we know it, then perhaps we can plan for the possibility that we will experience one. In the financial planning field, advisors use computer modeling technology called Monte Carlo Analysis to test the sustainability of a client’s plan. The problem is that basic retirement planning software relies on values that are assumed to be static. For example, the rate of inflation and the growth rate for investments are assumed to never change. This is, on the surface, wholly unrealistic. Inflation is hardly fixed and the returns in the stock market are far from a steady X (pick your return) percent.
Monte Carlo Analysis attempts to resolve the problem of static variables inside a retirement plan. It randomly assigns different values to each of the key variables inside a retirement plan. The plan is then simulated to determine that unique outcome. With modern computers this can be done for tens of thousands of scenarios in a matter of seconds.
The good Financial Planner wants to know how many of these iterations results in an outcome that is satisfactory to the client. This might mean not running out of money before age 100 or it could mean leaving behind a substantial inheritance to one’s heirs. The computer will tell us how many of these outcomes were “failures” and how many were “successes” depending on our definition. At our firm we prefer to see a success rate of at least 90%. Anything less than that suggests a level of risk we feel is too great to bear.
Black Swans exist. Events that are unexpected and profound occur. Rather hope you never experience one (because you will), it’s better to plan for them. Monte Carlo Analysis is one tool that can help you.
Thursday, May 7, 2009
Variable Annuities: Watch Your Wallet
Given the performance of the stock market over the past few years, many consumers have become interested in annuities. These insurance products offer a guarantee of principal. They also allow the contract holder to defer taxes on the growth inside the annuity.
Advisors often market variable annuity products as a way to participate in the upside potential of the stock market while preserving the original value in the contract. The idea is to invest in the policy’s sub-accounts which are very similar to mutual funds. If these funds perform well the owners account value grows. If they perform poorly, at least the principal is protected. This is pretty compelling.
Unfortunately, this is only part of the story. These products are actually very expensive. An article in the May 4, 2009 issue of The Wall Street Journal (“Get Less, Pay More”) points out that the annual fees in variable annuities total close to 4% (according to annuitygrader.com).
Most consumers have no idea how much annuities cost. They tend to not read the prospectus or ask about fees. Many Advisors do not properly disclose these expenses or the commissions which may be as high as 10%.
If you are considering investing in an annuity, ask the agent for a complete disclosure of the fees (mortality and expense, surrender charges, management fees, commissions). Also, keep in mind there are low cost annuities available through TIAA-CREF, Vanguard, USAA, Ameritas and other companies.
We believe in transparency. You have a right to know all of the costs associated with the financial products you purchase. To learn more about “intelligent investing,” please visit our web site, cascadewealth.com.
Advisors often market variable annuity products as a way to participate in the upside potential of the stock market while preserving the original value in the contract. The idea is to invest in the policy’s sub-accounts which are very similar to mutual funds. If these funds perform well the owners account value grows. If they perform poorly, at least the principal is protected. This is pretty compelling.
Unfortunately, this is only part of the story. These products are actually very expensive. An article in the May 4, 2009 issue of The Wall Street Journal (“Get Less, Pay More”) points out that the annual fees in variable annuities total close to 4% (according to annuitygrader.com).
Most consumers have no idea how much annuities cost. They tend to not read the prospectus or ask about fees. Many Advisors do not properly disclose these expenses or the commissions which may be as high as 10%.
If you are considering investing in an annuity, ask the agent for a complete disclosure of the fees (mortality and expense, surrender charges, management fees, commissions). Also, keep in mind there are low cost annuities available through TIAA-CREF, Vanguard, USAA, Ameritas and other companies.
We believe in transparency. You have a right to know all of the costs associated with the financial products you purchase. To learn more about “intelligent investing,” please visit our web site, cascadewealth.com.
Monday, May 4, 2009
Index Funds Beat Active Funds
The Sunday Oregonian ran an article in the business section (“In bear market, index funds outperform active investing”) about how poorly active managers have performed since the market reached its peak in the fall of 2007. It states that in 2008, 64% of actively managed U.S. stock funds were beaten by a broad market index, The Standard & Poor’s Composite 500.
Traditionally active managers were expected to protect investors during bear markets. The data does not bear this out. “The strident belief that active managers do well in a down market is a myth,” said Srikant Dash, head of research and design at Standard & Poor’s.
Cascade Wealth Management is one of the few investment advisory firms in the region that uses passive investment vehicles to build portfolios. Further, our investment advisory fees (0.75%) are significantly lower than those charged by most firms (1.0%). We are convinced that this approach results in lower expenses, greater tax efficiency and better long term performance.
I was not able to find a link to the article on the OregonLive web site. Please contact us if you would like more information about how passive investing can benefit you.
Traditionally active managers were expected to protect investors during bear markets. The data does not bear this out. “The strident belief that active managers do well in a down market is a myth,” said Srikant Dash, head of research and design at Standard & Poor’s.
Cascade Wealth Management is one of the few investment advisory firms in the region that uses passive investment vehicles to build portfolios. Further, our investment advisory fees (0.75%) are significantly lower than those charged by most firms (1.0%). We are convinced that this approach results in lower expenses, greater tax efficiency and better long term performance.
I was not able to find a link to the article on the OregonLive web site. Please contact us if you would like more information about how passive investing can benefit you.
Friday, May 1, 2009
May Day 2009
Did you know that this day has ancient origins? It was a pagan holiday that marked the end of the winter season in the Northern Hemisphere. The spread of Christianity throughout the European continent resulted in the abandonment of the raucous celebration of pagan holidays. Instead May Day became a secular holiday to honor the arrival of spring. You may recall the dancing of the Maypole, the Queen of May and May baskets. May Day is also the International Workers’ Day, a celebration of labor achievements around the world.
What does any of this have to do with investing? Actually there is a significant movement in this country to increase the size and strength of organized labor. Unions are seeking to make it easier to enlist new members through more liberal sign up provisions called “card check.” Under this procedure, if the National Labor Relations Board were to verify that over 50% of the workers signed authorization cards, the traditional secret election would be bypassed and the union would automatically form.
If this legislation were to pass into law, it would strengthen labor’s ability to form unions. Historically, organized labor has bargained with employers over a wide range of compensation, benefits and rights issues. This would potentially cause a shift in the balance of power between labor and management.
We invest in companies, because we believe the people who work in the company will produce products and services that will results in profits for the company. It is the balanced and fair relationship between the employer and the workers that results in harmony in the work place. Stable companies are more likely to thrive than those characterized by rancor and strife. They are also more likely to reward their shareholder’s through dividends and capital gains.
What does any of this have to do with investing? Actually there is a significant movement in this country to increase the size and strength of organized labor. Unions are seeking to make it easier to enlist new members through more liberal sign up provisions called “card check.” Under this procedure, if the National Labor Relations Board were to verify that over 50% of the workers signed authorization cards, the traditional secret election would be bypassed and the union would automatically form.
If this legislation were to pass into law, it would strengthen labor’s ability to form unions. Historically, organized labor has bargained with employers over a wide range of compensation, benefits and rights issues. This would potentially cause a shift in the balance of power between labor and management.
We invest in companies, because we believe the people who work in the company will produce products and services that will results in profits for the company. It is the balanced and fair relationship between the employer and the workers that results in harmony in the work place. Stable companies are more likely to thrive than those characterized by rancor and strife. They are also more likely to reward their shareholder’s through dividends and capital gains.
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