An intensive look at the fiduciary failure of the industry to the middle and lower income investors (via 401ks primarily) regarding the exposure to risk- specifically when the economics go bad and a recession is effectively preordained.
Research has entailed comments by some of the leading authorities in mathematics as to statistical reality versus what is antiquated and irresponsible, imperfect correlations, definition of diversification, rebalancing, economics, inverted yield curve, etc. along with behavioral characteristics, choosing an advisor, client questionnaire, artificial intelligence bias, useless theories with old inputs, and much more.
This is not a ‘regular report’ for arbitration or the like but presented in a format that is more ‘acceptable’ to be presented to a jury or 401k participants or simply an engaged consumer who needs all the help they can get.
It is tough sledding for those unfamiliar with vernacular and will take extra effort beyond a two hour read. But the research to keep losses to around 10% to 15% (S&P 500) is firm and can help the multitude of ‘regular’ consumers to considerably lessen losses regarding both financial and emotional.
There really ain’t none. You are going to find that most texts actually do not address risk properly.
This is the type of graph in instruction and it can include other sub categories. But no matter how one wishes to use one type versus another, what one is really concerned about in bottom line of investing is
How Much Can You Lose?
And that is refined into HOW MUCH ARE YOU WILLING TO LOSE
If you do NOT specify that risk, then what are you doing?
Assume the market always goes up
Use market timing
I will digress slightly. Market timing does not work but I bet you do not know why. Actually neither do brokers nor financial planners, your mama, small furry animals, etc. It is simply not taught. So here is the answer is in this chart.
What you want to look at is the pink bars which show recessions. In terms of the extension of the chart for 2020, a recession was stated by the FED in February 2020- roughly a month before the Covid crisis.
So do you see the pattern for gauging the recessions
Here is a clue- Do you see the statistical evidence for the recessions?
No you don’t- though I have left a hint for awareness.
The recessions and economic issues are drastically different from one recession to another.
There is nothing where one can attempt to use some type of relevance from the spread around 1980 that correlates to the 1973 recession to………2020.
Are there offerings that would identify the highs and lows of a market?
Same discussion- you are not going to find someone or thing- even artificial intelligence- that can do it.
Will someone, however, actually do it? Sure.
When you are close to a high or a low- say a month away- take a guess for the date or the actual high and low.
Someone will hit it on the head and will then be the next great stock picker or timer.
Inverted Yield Curve
Now I WILL provide a 100% indicator of an upcoming recession- but you still cannot do market timing with it.
Is it taught to securities licensees, CFPs, CFAs, insurance agents, ChFCs etc?
They may show what it is but not the implications thereof- and that is a problem with a lot of the securities, planning and insurance industries. It is NOT based on going back to previous times or simply beating to death some data so it conforms to some weary contrived formula that they want to corroborate. And that is because it is a ‘current’ occurrence in an economic market that has preceded every recession.
The graph references when the 10 year yield drops below the 2 year yield. For the 2020 recession, there was an inverted curve in early 2019.
(it is important to note just use the 2 year and 10 year treasuries. 1 month or 3 months or 7 years or whatever are used for some articles that say that the curve is not that reliable, etc., etc.
Just use 2 and 10
View this What is the Boglehead opinion of the inverted yield curve? - Bogleheads.org
You will find countless arguments all over the place but their initial graph is wrong. They are using 3 month and 10 year. That’s incorrect but it reflects the lack of knowledge/research of some ‘heavy hitters’ (at least as they define themselves. You cannot define risk if you use bad research.)
Does the curve reflect ‘anything in particular/specific and ongoing’ as to why the imbalance occurs.
You will find ‘studies’ that attempt what’s going on in some inane fashion. The problem is, it is not the same reasons from one recession to another.
Sure, I can indicate what the imbalance may be due to ‘xyz’ (which will probably be different each time) but I am focusing on whether the 2 and 10 year treasuries will invert.
An inverted curve does not indicate a correction- identified below
The inversion is NOT a guarantee of a recession but one does not dismiss a 100% correct signal over 60 years. It does not tell you when it will happen, nor how bad it will be nor how long it will last.
So what can one say about the ‘correction’ in March 2020 when the market plummeted 34%. First of all, the FED had declared a recession in February 2020.
Secondly that weren’t no correction. That was a full off recession where I thought losses would be greater than 2008 at 57% (and it sure looked that it would- and quickly).
But with Covid, the FED BOUGHT the U.S. economy with trillions of dollars. As a result most analysts, financial magazines, et al are saying that was the shortest correction ever.
A correction is generally a loss from about 10%/15% to ‘maybe’ 22%- though I might push a little given circumstances. But that’s it. 34% almost straight down is NOT reflective of a correction. It’s a blood bath to a very deep recession.
Monte Carlo Simulations- any good for risk and retirement? Not really.
These are used in many types of industries to run thousands of simulations to figure out what the probabilities are for “x” scenario. They are also used extensively in determining if your retirement will be successful- or not.
Here is what they do. You take maybe 100 different scenarios and put them in a hopper- something like a bingo "machine."
You put all 100 pieces of data and run through them all and tally the each number. Then you do this again. And again. And again. And each series will be different than the last.
You can do thousands and then graph them. For example put 100 years of historical economic into the hopper and then do 10,000 runs. And/or you can use the monthly returns…………….
The subsequent graphs can look like a rat’s nest but it is the extremes that might be the focus of the runs.
These are used very extensively in the planning/investment for returns in an effort to show how well the probabilities of success will be in the future. The key with U.S. historical returns is that certain patterns of returns can show you tons of money- or not having enough for your lifetime.
Here are a few pictures that show you some Vanguard iterations with various probabilities
I realize they may be a little tough to read but the basic formula of how long you are going to live, what your portfolio amounts to at the time of retirement, how much you expect to take out each year as a percentage are then dropped in a hopper of old returns and then Monte Carlo indicates your success rate …………….
You can run these till you are blue in the face. Take 4% out; or 6%; have $500,000; $1,000,000- the list is infinite. Vanguard allows you to calculate literally all percentages. But remember that all the Monte Carlo returns are all based on OLD returns that are how well correlated with today’s economics? Therein lies the rub.
Real life however will get in the way. Assume you started with $1,000,000 in 2000. You’d lose 49% over the recession. Your retirement is toast.
If you started with $1,000,000 in 2008, you would lose 57% in the next couple years. Your retirement is worse
Note that we also have this caveat;
Monte Carlo generally uses MARKET returns. And I repeat, OLD numbers that vary depending on the whim of the advisor or software programmer. It is therefore a speculative position rather than objective (to be described further on)
However was your risk leveI (which is the whole point of this exercise and is established further on) so low since you or your advisor or the software indicated that your allocation had to be reduced down to 80% stocks, or 60% or 40% or whatever with the rest in some form of bonds and perhaps a little cash.
But if you are in bonds- whatever the amount- recognize that you will barely break even with inflation.
The allocations of bonds as suggested by Monte Carlo will be absolutely correct in the math and totally wrong in real life. Sure your bonds can lower volatility but you screwed you entire returns for over a decade of very strong equity returns.
What about cash- forgeddabotit
Advisors and analysts think this is a great way to plan and they use yearly returns going back even a 140 years.
But let’s look at 100 years.
When you look at the 1920’s, you had the roaring 20’s and the stock market crash… but why would you think that is reflective of a society that we have now
You can look at the 1930’s with the great depression and MASSIVE unemployment- but why is that to be correlated at 100% for 2021?
1940s had the second world war where we lost hundreds of thousands of soldiers and saw the atrocities of Hitler, the TV had just been invented but how does that compare to what we have now.
Think of 1990’s with the arrival of true cell phones, the ability to use a personal computer, the availability of an internet- and of course, my favorite, Google for research.
But we also had a 2000 recession and the dire comments on the internet and tech as well.
Then a total breakdown of basic real estate in 2008.
(The False Promise of U.S. Historical Returns)
I have gone through this effort in other writings but suffice to say that using historical outdated data that the analyst thinks is perfectly correlated to our current completely unique economics is a SUBJECTIVE input by the analyst/advisor that is simply wrongheaded thinking.
What about this- doing a Monte Carlo whatever on cars over the past 100 years and figuring out the future course of what they will look like, size, features, advanced computers
To suggest the design, fuel, batteries, etc., of 100 years of extraordinary changes and think that is reflective of what to do now??
I have no idea how one would correlate the first Fords to something like a Tesla. The only true correlation is that cars have evolved but the insight of past history is NOT a one to one correlation and a direct reflection of the world of today,.
The transformation is not a one off, but exactly, ‘what is it?”
It is a subjective variable where all factors are totally unique and cannot be resolved by the user.
You can also address cell phones, solar power, Spacewalks, rovers on Mars, heart replacements, Twitter- the list is endless.
Anyway, what’s the point in establishing benchmarks if there are no standards/weightings to how it must be done?
If you are wondering if this could get worse- here is a direct link to an article that clearly establishes a confusion amongst the (supposed) top advisors today
Why 50% Probability Of Success Is Actually A Viable Monte Carlo Retirement Projection
Talk about subjectivity!!!!
Using old numbers, old allocations, very imperfect theories (Modern Portfolio Theory, standard deviation and volatility as risk, rebalancing, Efficient Market, Rationality, Capital Asset Pricing. P/E ratio and many more) are based on an unknown and subjective interpretation of investing risk that the end result is inevitably flawed when 95% of the analyses is a glob of old non correlated stuff. And artificial intelligence is not going to change that.
Standard Deviation / Volatility
Here is THE major position on risk by the industry. It is not taught to licensees so the bulk of securities brokers nor is it required for Registered Investment Advisors.
But even where it is taught, it’s wrong since texts and instructors do not want to recognize its real life massive imperfection.
The problem in analyzing investment risk is that standard deviation/volatility is NOT risk per se.
It is A risk that needs to be addressed but it is not THE risk of investing that has been universally identified in most texts.
Same thing- different perspecive.
What I have done in the bottom chart is simply said that the market risk (universally the S&P 500 for the U.S.) statistically has shown a 10% annual return with a +15% increase annually or a negative 15%. (Currently about 18% plus or minus though it was about 12% before Covid).
So in 68% of the time, it is a negative 5% or a plus 25%. You should feel very/reasonably comfortable therefore when investing in the basic S&P 500 fund.
No you shouldn’t since the standard deviation of the standard deviation may not be standard. (Yes, that is gobbledygook- but it also calls out why periods of time when standard deviation is useless in defining real life risk)
I started viewing risk back in the 80s when I taught various securities courses for the SEC licenses (4, 7, 8, 24, 27, 63, etc.) as well as financial planning and real estate that included courses for University of California at Irvine and then Berkeley, etc.
Early on, it became readily apparent that the industry had no clue to what is needed to know.
That said, my understanding was limited at best since the licensing courses did not address standard deviation, Modern Portfolio Theory etc., probably because those that were writing the questions had not had to confront them either in their work. Or were ignorant of their real life implications.
It is true that MBAs, CFAs and the like were taught some basics of standard deviation/volatility- but essentially only to the implications of an unacceptable graph that inferred a very limited breadth of dispersion. (Or, it ain’t wide enough)
While some may want to dispute the overall (derogatory) statement, recognize that there is NO requirement before or since that brokers nor insurance agents have to have and know how to use a personal financial calculator.
Hewlett Packard 12c calculator.
Additionally, and which is even worse, Registered Investment Advisors, those acting as fiduciaries do NOT have to have that capability. It’s like going to a doctor who does not know how to use a stethoscope.
You are committing financial/economic suicide if you or your adviser cannot use a financial calculator. You have to know why figures, graphs, perceived solutions, various software et al simply are not real life.
It is the same for attorneys working on trusts, divorces, securities arbitration, etc.
When viewing the returns in the 1970s, I noted that the losses in 73/73 were 44%. How was that to occur? It was not ‘normal’.
When viewing the massacre in 1987 (black Monday) the losses were 508 points for a Dow loss of 22.6%. That was a 25 sigma event- meaning that a herd of herbivore dinosaurs was found in Cleveland- wearing thongs- eating sushi. It was impossible. A level of statistical significance known as “five sigma,” is a threshold that most agree means you can be 99.999+% sure that you REALLY covered everything
Needless to say this was a shocking event for the simple reason that, as shown in the chart below, the largest one-day drop in S&P 500 from 01/1960 to 10/16/1987 was 6.7% on May 28, 1962. Possibly few expected more than a 10% drop in S&P 500 on a single day.
(EFM- This could not exist per basic standard deviation. It sure put a lot of university professors scratching their heads- though they continued teaching from the standard graphs.)
However you had: The Asian Financial Crisis: On Oct. 27 1997, the Dow fell more than 7%. Chance of that happening: one in 50 billion.
The Russian Crisis of 1998: August 4, the Dow was down 3.5%, three weeks later down 4.4% and then again on August 31, down 6.8%. Viewed through the lens of modern portfolio theory, the odds of that final event was one in 20 million, the odds of all three in a single month: 1 in 500 billion.
Moving to 2000, the losses sustained in that recession was 49%. Where would that exist on the standard graph. It could not exist.
Go to 2008 where the losses were 57%.
Even go to March 2020 where the market dropped 34% in the blink of an eye. Actually, if the FED had not bought the U.S. economy with about $4 trillion, I figured the losses would be greater than 2008.
For that matter, why couldn’t standard deviation analysis contemplate something like that?
Simple- it would have to go back and effectively eradicate decades of bad instruction. Even then, what was the correct thinking?
From Financial Planning Fiduciary Standards under Dodd Frank, EF Moody, 2012,
“Michael Kitson, a macroeconomics lecturer at the University of Cambridge's Judge Business School, says the field had become far too dependent on mathematical modeling, and needs to open up to different methodologies as well as diverse schools of thought. "Economics needs to become broader, and less arrogant. It doesn't always have the explanations for human behavior."
Scholars on both sides of the Atlantic have made progress with models that take account of the real-life complexities of financial markets, which are rife with disagreement and diversity, rather than simply explaining away any divergence from so-called rational pricing. (Making progress is far from a complete program whenever the human element is concerned.)
Most major university economics departments are dominated by the mathematical approach, as are the journals in which academics must publish if they want to advance. The problem with economists is they believe the whole world operates according to their models. "We need a bit more variety and a bit more pluralism. Not just there's a problem and we solve the equation and get the answer."
EFM- The business sector did the same thing in thinking the models from decades past would be viable forever.
Standard deviation are nice crutches of the investment community which is very clear in stating that the 34% drop in 2020 was merely a correction- the shortest on record. No- it was a recession in February 2020 as signaled by the FED that then was clobbered by COVID .
Read that again. That was NOT a correction. What you are reading is some tripe that the writers use to rationalize what was going on. $4 trillions was what was going on:
I have dealt with the above in previous writings but one word above should really address is rationality- the idea that humans act in the best terms and manners to optimize their investing opportunities.
Going a step further, this process was endemic in economics even through the 90s. If you were to look at FED reports, you would see the most convoluted, sophisticated formulas that only the few and mathematically inclined could understand, never mind master.
The key was that people would always react in a rational manner and therefore one could calculate a clear path to economics by just using the ‘right’ equations.
If that one was unclear, this should help.
There will be a quiz later………………..
“Everything We’ve Learned About Modern Economic Theory Is Wrong
Economic models assume something called “ergodicity.” That is, the average of all possible outcomes of a given situation informs how any one person might experience it. But that’s often not the case, which Ole Peters says renders much of the field’s predictions irrelevant in real life. In those instances, his solution is to borrow math commonly used in thermodynamics to model outcomes using the correct average.
“We can trace back the reasons for this to the 17th century, but it’s important, first of all, to state clearly that something is not the way it should be, and that any statements coming from economics must be evaluated carefully because they may be based on flawed reasoning.”
Peters takes aim at expected utility theory, the bedrock that modern economics is built on. It explains that when we make decisions, we conduct a cost-benefit analysis and try to choose the option that maximizes our wealth.
The problem is the model fails to predict how humans actually behave because the math is flawed. Expected utility is calculated as an average of all possible outcomes for a given event. What this misses is how a single outlier can, in effect, skew perceptions. Or put another way, what you might expect on average has little resemblance to what most people experience.
“There’s a sense that ergodicity economics can’t possibly be right because it’s too simple.. However, it “made a very bold, falsifiable prediction” that stood up”
EFM- The point here is that human behavior began to be recognized as a major distortion in economic theory- which progressed over to investing as well.
There are a couple of names that ‘started’ the revolution in human behavior (Daniel Kahneman and Amos Tversky) and has been accepted by universities worldwide as a necessary component of investment behavior (and many other areas).
There are probably 25 major behaviors recognized with many subsets thereof.
It is impossible to cover the myriad of examples but this will give you a grasp of how involved it is to figure out who is doing what, when, why.
The following are some of the most common psychological biases. Some are learned while others are genetically determined (and often socially reinforced). While this essay focuses on the financial implications of these biases, they are prevalent in most areas in life.
[A] Incentives. It is broadly accepted that incenting someone to do something is effective, whether it be paying office staff a commissions to sell more healthcare products, or giving bonuses to office employees if they work efficiently to see more HMO patients. What is not well understood is that the incentives cause a sub-conscious distortion of decision-making ability in the incented person. This distortion causes the affected person - whether it is yourself or someone else - to truly believe in a certain decision, even if it is the wrong choice when viewed objectively. Service professionals, including financial advisors and lawyers, are affected by this bias, and it causes them to honestly offer recommendations that may be inappropriate, and that they would recognize as being inappropriate if they did not have this bias. The existence of this bias makes it important for each one of us to examine our incentive biases and take extra care when advising physician clients, or to make sure we are appropriately considering non-incented alternatives.
[B] Denial. Denial is a well known, but under-appreciated, psychological force. Physicians, clients and professionals (like everyone else) are prone to the mistake of ignoring a painful reality, like putting off an unpleasant call (thus prolonging a problematic situation and potentially making it worse) or not opening account statements because of the desire not to see quantitative proof of losses. Denial also manifests itself by causing human beings to ignore evidence that a mistake has been made. If you think of yourself as a smart person (and what professional doesn't?), then evidence pointing to the conclusion that a mistake has been made will call into question that belief, causing cognitive dissonance. Our brains function to either avoid cognitive dissonance or to resolve it quickly, usually by discounting or rationalizing the disconfirming evidence. Not surprisingly, colleagues at Kansas State University and elsewhere, found that financial denial, including attempts to avoid thinking about or dealing with money, is associated with lower income, lower net worth, and higher levels of revolving credit.
[C] Consistency and Commitment Tendency. Human beings have evolved - probably both genetically and socially - to be consistent. It is easier and safer to deal with others if they honor their commitments and if they behave in a consistent and predictable manner over time. This allows people to work together and build trust that is needed for repeat dealings and to accomplish complex tasks. In the jungle, this trust was necessary to for humans to successfully work as a team to catch animals for dinner, or fight common threats. In business and life it is preferable to work with others who exhibit these tendencies. Unfortunately, the downside of these traits is that people make errors in judgment because of the strong desire not to change, or be different (“lemming effect” or “group-think”). So the result is that most people will seek out data that supports a prior stated belief or decision and ignore negative data, by not “thinking outside the box”. Additionally, future decisions will 15 be unduly influenced by the desire to appear consistent with prior decisions, thus decreasing the ability to be rational and objective. The more people state their beliefs or decisions, the less likely they are to change even in the face of strong evidence that they should do so. This bias results in a strong force in most people causing them to avoid or quickly resolve the cognitive dissonance that occurs when a person who thinks of themselves as being consistent and committed to prior statements and actions encounters evidence that indicates that prior actions may have been a mistake. It is particularly important therefore for advisors to be aware that their communications with clients and the press clouds the advisor’s ability to seek out and process information that may prove current beliefs incorrect. Since this is obviously irrational, one must actively seek out negative information, and be very careful about what is said and written, being aware that the more you shout it out, the more you pound it in.
[D] Pattern Recognition. On a biological level, the human brain has evolved to seek out patterns and to work on stimuli response patterns, both native and learned. What this means is that we all react to something based on our prior experiences that had shared characteristics with the current stimuli. Many situations have so many possible inputs that our brains need to take mental short cuts using pattern recognition we would not gain the benefit from having faced a certain type of problem in the past. This often-helpful mechanism of decision-making fails us when past correlations or patterns do not accurately represent the current reality, and thus the mental shortcuts impair our ability to analyze a new situation. This biologic and social need to seek out patterns that can be used to program stimuli-response mechanisms is especially harmful to rational decision-making when the pattern is not a good predictor of the desired outcome (like short term moves in the stock market not being predictive of long term equity portfolio performance), or when past correlations do not apply anymore.
[E] Social Proof. It is a subtle but powerful reality that having others agree with a decision one makes, gives that person more conviction in the decision, and having others disagree decreases one’s confidence in that decision. This bias is even more exaggerated when the other parties providing the validating/questioning opinions are perceived to be experts in a relevant field, or are authority figures, like people on television. In many ways, the short term moves in the stock market are the ultimate expression of social proof – the price of a stock one owns going up is proof that a lot of other people agree with the decision to buy, and a dropping stock price means a stock should be sold. When these stressors become extreme, it is of paramount importance that all participants in the financial planning process have a clear understanding of what the long-term goals are, and what processes are in place to monitor the progress towards these goals. Without these mechanisms it is very hard to resist the enormous pressure to follow the crowd; think social media.
[F] Contrast. Sensation, emotion and cognition work by contrast. Perception is not only on an absolute scale, it also functions relative to prior stimuli. This is why room temperature water feels hot when 16 experienced after being exposed to the cold. It is also why the cessation of negative emotions “feels” so good. Cognitive functioning also works on this principle. So one’s ability to analyze information and draw conclusions is very much related to the context with in which the analysis takes place, and to what information was originally available. This is why it is so important to manage one’s own expectations as well as those of clients. A client is much more likely to be satisfied with a 10% portfolio return if they were expecting 7% than if they were hoping for 15%.
[G] Scarcity. Things that are scarce have more impact and perceived value than things present in abundance. Biologically, this bias is demonstrated by the decreasing response to constant stimuli (contrast bias) and socially it is widely believed that scarcity equals value. People who feel an opportunity may “pass them by” and thus be unavailable are much more likely to make a hasty, poorly reasoned decision than they otherwise would. Investment fads and rising security prices elicit this bias (along with social proof and others) and need to be resisted. Understanding that analysis in the face of perceived scarcity is often inadequate and biased may help professionals make more rational choices, and keep clients from chasing fads.
[H] Envy / Jealousy. This bias also relates to the contrast and social proof biases. Prudent financial and business planning and related decision-making are based on real needs followed by desires. People’s happiness and satisfaction is often based more on one’s position relative to perceived peers rather than an ability to meet absolute needs. The strong desire to “keep up with the Jones” can lead people to risk what they have and need for what they want. These actions can have a disastrous impact on important long-term financial goals. Clear communication and vivid examples of risks is often needed to keep people focused on important financial goals rather than spurious ones, or simply money alone, for its own sake.
[I] Fear. Financial fear is probably the most common emotion among physicians and all clients. The fear of being wrong - as well as the fear of being correct! It can be debilitating, as in the corollary expression on fear: the paralysis of analgart.
- Fear of making the wrong decision: ameliorated by being a teacher and educator.
- Fear of change: ameliorated by providing an agenda, outline and/or plan.
- Fear of giving up control: ameliorated by asking for permission and agreement.
- Fear of losing self-esteem: ameliorated by serving the client first and communicating that sentiment in a positive manner.
EFM: Did you get all that?
Analysts and advisors have introduced these (and many more) aspects into building managed mutual funds with various human characteristics that can move in different directions depending on the artificial intelligence formulas that select which BEHAVIORAL elements will dominate at that time.
So how is the weighting determined?
That is the problem because the weighting of the many inputs is determined by the programmers. And also by fallible artificial intelligent formulas. Or no weightings at all. There is no independent way of determining. They are all different. Maybe some professor/firm/small furry animal has written some explanatory paper but I have not seen anything objective because it cannot be.
Subjectivity all over again.
Further, as per the articles and examples above on Monte Carlo- there are NO standards of what will happen under dire circumstances (like Covid).
There are NO standards that can figure out how the MASSIVE debt the U.S.- and of the entire world- will impact any (subjective) commentary towards normalcy after the vaccinations.
You need to recognize the huge debts of corporations and nations were what brought the recession upon us in February 2020.
That was BEFORE the Covid mess.
You may find highly marketed firms like Fisher Investments in the U.S. whose founder- Ken Fisher- said just a few months back (seminar offered through AAII(American Association of Individual Investors) where he clearly presented that the world was doing phenomenally well before Covid, etc.
He was obviously ‘uninformed’ (or maybe stupid) not to recognize that the FED had raised rates four times in 2018 (the last one I thought was ill timed) only to reverse EVERYTHING in 2019 when they lowered rates three times to try and evert a recession.
For those that don’t see the tie-in to fundamentals, there was an inverted yield curve in late 2018.
Fisher has spent millions in advertising since Forbes dropped him like a hot potato after his highly inflammatory misogynistic comments were publicized. But since he has billions under management, he is spending millions to get back to some norm. Can he do it?
Why not. You can buy much of anything with a whole lot of money.
How do people choose what economic advice to heed? We develop a set of validated multiple-choice questions on economic policy problems, to examine empirically the persuasiveness of expert versus populist advice. We define populism as advice that conforms to commonly held beliefs, even when wrong. Two (computerised) advisers suggest answers to each question, and experimental participants are incentivised to choose the most accurate adviser. Do participants choose the high-accuracy adviser (`the Expert'), or the low-accuracy one (`the Charlatan'), whose answers are designed to be similar to the modal participant's priors? Our participants overwhelmingly choose the Charlatan, and this is only slowly and partially reversed with sequential feedback on the correct answer. We develop Bayesian models to determine optimal choice benchmarks, but find that behaviour is best explained by a naive choice model akin to reinforcement learning with high inertia.
"Providing all necessary information about the Charlatan’s modus operandi, short of actually telling the participants who the Charlatan actually is, does not significantly reduce the chances of choosing him over the simple experiment where subjects do not know anything about him. This is a strong indication of confirmation bias. Subjects followed a simple heuristic, believing naively that the person with the most common answers with them must be the Expert. Of course, an alternative interpretation is that participants derive direct utility from believing that the adviser with the most common answers with them is the high-accuracy adviser (motivated reasoning)."
EFM: I am not stating Ken Fisher is a charlatan per se. He did not get billions under management without knowledge. But the recent firing by Forbes and, to me, the even worse ‘wrong’ commentary about the economics in the AAII seminar leads me to wonder where does the consumer go to for concrete and real life answers.
I have stated for decades that the inverted yield curve is NOT a guarantee of anything but you do not dismiss a 100% correct indicator for the past 60 years. And per the Bogleheads noted above, the same ‘crisp’ repudiation.
Clearly, investors had followed Forbes/Fisher for decades with wrong headed investment advice but Forbes only derailed the train because he talked about getting into some woman’s pants.
Forbes was right in doing that but wrong in that they did not know some of the fundamentals of investing had been clearly lacking.
I did inform AAII about the obvious ‘error’- but in never receiving a reply only reinforces that they did not know or care. Probably both.
Client Questionnaire, Asset Allocation, Risk
The institutional necessity of a client questionnaire is utilized by effectively every institutional and independent financial planner.
A ‘basic’ client questionnaire is mandatory in getting objective information about a client(s): age, retirement age, health, children, employment income, other income, assets, employment history, business, social security- the list can be extensive and even intrusive (though limited at first meeting).
Outside the needed client info, the one major use is to figure out the risk profile(s) based on questionnaires developed by a professor at some named university; a behavioral scientist tailoring 25- 50 human behaviors into a cohesive pattern; some simplistic old pattern since no one will ever know what is in the software; a demented banana slug, who or whatever.
Yes, I am well aware of the industry marketing but if you use Vanguard, Fidelity, Prudential, any Wealth Manager, etc, you will find altogether different numbers developed for risk.
The assemblage of facts about you, your family, business et al will be factually complete (mostly) but the 25 to 100 questions for risk in the software programs will offer dramatically different risk profiles.
(If a firm/adviser/mutual fund company presents a 5 or 10 question risk analysis questionnaire, you are probably going to get screwed. Don’t even bother playing with something so simplistic.)
As an example of such mediocrity, here is a Vanguard questionnaire (this is not about their products). Eleven questions to determine your allocation over the next 25+ years. With a number of questions that are drivel or simply oriented to force the consumer into an area that should have been identified well before the problem arose.
Holding onto a fund once it loses more than 15% in a major downturn doesn’t make sense (I am assuming that they were working with a prior advisor that did not inform them of the potential loss. Or they were trying to do allocations by themselves.)
For those inclined to go further……………. you need to grasp the overall failure of using subjectivity for inputs
The Sorry State Of Risk Tolerance Questionnaires For Financial Advisors - Michael Kitces
RISK PROFILING AND TOLERANCE: INSIGHTS FOR THE PRIVATE WEALTH MANAGER - CFA Institute
Risk of Loss
If you have gotten this far (probably just one person) I will provide the element of risk- how much are you willing to lose.
As addressed just above, the risk part of the client questionnaire will come up with all sorts of qualifying statements based on an infinite number of risk pyramids which everyone has seen no matter their investment sophistication.
Check out a couple (I further suggest doing a Google search of investment or risk pyramid. The images will haunt you for a lifetime).
And this is truly subjective since, whether it be a 10 question questionnaire (useless- do not even consider)- or a 100 question questionnaire universally come out with all DIFFERENT types of risk analysis and applications.
How is that possible?
Because each question can have a different impact on the software programming because of the interpretation of risk of the specific question has already been entered into the program. Then the one question will be melded into, potentially a 100 question questionnaire, all with different weightings which are all subjective.
These graphs are used extensively supposedly addressing the emotional curve of average investors as identifying the fallacy
At this point, I direct readers to Capital Ideas by Peter Bernstein. The best critique ever written on the vast array of economic thinking for generations. One issue notable is the significant disagreement between the theorists on what might be the best way of defining the movements and risks of the market. As you go forward with the critique of each entity, it became more difficult to ferret out which one to use and when. Lastly, and most critically, is the fact that almost all the theory, save for a few till most recently, felt that the market was rational and efficient and followed a relatively simple bell shaped curve of standard deviation.
Standard deviation/volatility is NOT risk ipso facto. Merely a type of risk.
One of the key efforts in doing portfolio allocation is the determining how one group of investments may work with another over time. Addressed more definitively herein, it is a statistical effort (correlation) to see how two investments move when any occurrence happens to either side. Does the other asset move in lockstep and for the same amount in the same manner and at the same time? Or absolutely opposite. Or somewhere in between. Most importantly, is there some consistency in year after year after year- that is the heart of the matter.
There is the theoretical concept by using computer software where they plot the (supposed) daily or monthly correlations of various securities. But where do the correlations used come from? And just view the numbers and how close they are between daily and monthly values. Well, they are not.
Maybe it is ‘noise’. Maybe it’s the wild inconsistency. So why not look at past history. But apparently few bothered to do it. Because if they had, it would have been perfectly obvious that the correlations were wildly inconsistent
From Financial Planning Fiduciary Standards under Dodd Frank, EF Moody, 2012, When it all goes really bad, all the products/allocations/portfolios/correlations move together in the same manner at the same time for the same reason and finance students have known that. The correlation offset is nil since the products move to correlations of +1. A recession puts a great risk/high stress on an allocation and, save for cash and perhaps gold, the all suffer the same consequences. This is where the entire industry has faltered. They have been taught that correlations remain constant/acceptable over long periods of time and that is where the focus must be (Bill Bernstein and others).
To Paul Wilmott, Gaussian (simple curve statistics‑ see the bell shaped curve for standard deviation) is an example of how dangerously abstract quant (application of obtuse mathematical techniques to financial investment analysis) finance has become. "We need to get back to testing models rather than revering them," he says. "That's hard work, but this idea that there are these great principles governing finance and that correlations can just be plucked out of the air is totally false. The correlations between financial quantities are notoriously unstable."
William Coacker: “The severity of how much correlation changes, even over longer periods of time, has not been adequately understood. His paper analyzed the changing correlation of 15 asset classes measured against the S&P 500 over a 35‑year period, and the impact of those changes on asset allocation decisions. It measures the correlations in rolling one‑, three‑, five‑, and ten‑year time series, from 1970 to 2004. The article also evaluates whether 15 asset classes have helped or hurt in years the S&P 500 has declined, and whether growth or value styles are more correlated to the index.
Some of the conclusions: The average variance in correlation measured 0.98 over one year and 0.25 over ten years. In short, the relationship among many of the asset classes appears to be inherently unstable.
“Rather than rely on historical correlations, a more comprehensive and dynamic approach is needed in making asset allocation decisions.”
From Wharton Professors:
“Diebold: I think there are two key issues, or at least two, both of which are very difficult and related. The first is understanding correlations across banks, financial institutions ...
Herring: And understanding how they vary over time.
Diebold: That's number two. And they certainly are different in crises just as volatility is different in crises. And, of course, the way that they're different is often in very adverse ways. Correlations rise just when you don't want them to rise and you lose, for example, portfolio diversification benefits just when you need them the most.
Herring: The dirty little secret of diversification is that it disappears when you need it most. The only thing that rises in falling markets is correlations.”
Lastly per Nassim Nicholas Taleb, hedge fund manager and author of The Black Swan, “Co‑association between securities is not measurable using correlation," because past history can never prepare you for that one day when everything goes south.
"Anything that relies on correlation is charlatanism."
This is not intended to cover every item of resistance to other theories- Dollar Cost Averaging (doesn’t work about 2/3rds of the time versus lump sum), rebalancing, asset allocation (has there been a reason to use bonds in the last 10 years), Modern Portfolio Theory, beta, etc., though commentary on all of these issues flows through most of my research and analysis.
Chapter 2 - What Is Risk?
The list of failed theories is almost unlimited because of being just plain wrong or becomes one when they meet the real world.
It is also clear that I do not like efforts in the use of old numbers since trying to correlate them by weighting is impossible. There are so many variables that there are NO formulas that can adjust to extreme volatility with such changes.
Risk Of Loss
These two ‘chapters’ you are viewing are the basis for videos which will be accepted by the Bar Association for Continuing Legal Education. Its purpose is to show the real world application of the Risk of Loss- something the industry has been amiss in offering since it focuses on biased inputs and failed theories. And software that may have little viability but no way of checking
After close to 5 decades of sifting through thousands upon thousands of texts, documents, articles, etc., and teaching hundreds of students for real estate, insurance, financial planning and more, I found it quite difficult to cut the tons of chaff and ferret out the nuggets of knowledge and wisdom.
Why so hard? Because the bulk of qualified information through the last 3+ decades has been overshadowed by the marketing skills of thousands of pedestrian brokers, sales people and organizations.
That will not change since marketing is what rules the United States and most of the world, where If one can find the right words at the right time, the capability of performing ‘adequately’ is acceptable.
The necessity of critical thinking has been lost since fewer and fewer people will delve into the hard work. You can say it really started with the advent of the television- more likely today it is the internet and its ability to move markets, politics and new products we don’t need but are ’coerced’ to buy or believe by social pressure. Certainly no one thought an idea of Facebook could evolve into the behemoth is has become and the ability to not only change thought- but to introduce a new stream of conscious that really never existed. And I am enthralled with knowing about the daily activities Britney Spears- what she had for breakfast, 5 minutes to groom her eyelids, taking her dog for a walk that lasted 47 minutes. And the Kardashian’s- I just can’t till the next episode……………..
Heavy thinking is not admired since, why bother, the internet has all the answers in just a few seconds.
And there is the major problem.
Illiterate means you cannot read
Aliterate means you Can read but Don’t
So it is no wonder that our society has degraded. It’s no wonder that what is marginally acceptable is now ingrained into areas where the results can impact thousands upon thousands of middle and lower income consumers and easily screw up their lives AND their retirement.
From The Expert and The Charlatan: an Experimental Study in Economic Advice, by: Aristotelis Boukouras; Theodore Alysandratos; Sotiris Georganas; Zacharias Maniadis
“Citizens who lack the capacity to think deeply about a topic are likely to believe theories and analyses that sound intuitive to their ears. In fact, the well-known Cognitive Reflection Test (Frederick, 2005) purports to distinguish between people who solve problems using the automatic and effortless ‘system 1’ vs. the slower and more costly and analytical ‘system 2’ (Kahneman, 2011). If laypeople address matters of expertise on the basis of system 1, populists who pander to them by giving intuitive, but wrong, answers are likely to be more successful. According to Kahneman (2011), when faced with an unknown domain, people are unable to ask the question “What type of information would I need in order to answer this question?” Instead, they use a System-1 heuristic: “Can I make a convincing-sounding story about this?"
For those that truly wish to see the underpinnings of my thought process, read Peter Bernstein, Nassim Taleb, Benoit Mandelbrot, Daniel Kahneman, Simon Singer, Charlie Munger, Michael Edesess, Fareed Zakaria.
I do not always agree with their positions but the point is to take their effort and see if there is a way to make a cohesive package of knowledge that can be used by the ordinary consumers. They are NOT going to find the nuggets of wisdom they need in 401k presentations or the great percentage of registered Investment advisors/financial planners who have never used a personal financial calculator.
Not gonna happen!
Here is a clue to ineptness- what is diversification.
Literally everyone has heard about it but effectively no one knows the statistics. (How many stocks must you have in a portfolio in order to insulate it from unsystematic risk.)
It is not taught.
It is bandied around with some serious verbiage that sounds plausible. But therein, few have a clue-consumers or industry- to the risk of loss. That means how bad are you going to be gored when things get really bad. 401k presentations are a good way to lose money. Ever heard of Target Date Funds? They have been presented as a way to one stop shopping for investments for the rest of your life.
Impressive aren’t they. Less risk as you get older.
There are no real statutes for this material presented simply because, while the State and Federal law including ERISA, DOL, Departments of Insurance, Department of Securities, et al, can mandate a fiduciary duty to consumers, they all effectively run off the rails with no description of what it is for given situations.
You have already review some elements: Retirement and Investment bogus risk questionnaires, allocations; Monte Carlo, bonds, standard deviation/volatility, etc. and this effort will cover even more banal assumptions by the industry.
It was developed for the 90% to 95% of the American consumers- middle and lower income where they generally are confused about the market and how it can and cannot work for them; those that already know they are not saving enough; those that need more help during retirement in a manner that universally was buy and hold; all where the industry has heretofore been unable or unwilling to assist.
Well, thems ‘fighting words’.
Ah, but it’s true- those needing most of the assistance do not have enough money to make the planners and firms very wealthy. Those that pursue such consumers are probably taken by the insurance agents pushing indexed annuities.
Admittedly they are not all bad but the way in which they are sold to the unsuspecting consumers in that they are ladened with fees, have money tied up for 10 years or even longer, may not pay out the money necessary to cover retirement…………………..
(For heavy hitters- the use of ‘cheap’ life insurance (meaning the most amount of money you can put in) is a very good way of reducing taxes WAY down to even zero during retirement. Heavy hitters have a lot more opportunities to use various IRS code sections. That will be somewhat covered later but this commentary is more about basics.)
The one singular issue that does not matter your income and wealth- it IS possible to keep losses low during the worst times of stress. Buy and hold, rebalancing allocations, reversion to the mean, Target date funds and more will be seen as methods that can destroy retirement for 75%+ of Americans.
And why is that so important? The 2000 recession was a 49% loss; 2008 was 57% and the drop in 2020 was 34% and was ‘supposed’ to be a horrendous recession with the Covid on top of it. IT WAS NOT A CORRECTION. If you have enough money you can turn the world around- or at least the U.S..
And the amount was roughly 4 trillion. A lot of news articles say that has to be the shortest recession/correction on record BUT THEY ARE WORNG. We are really in an unknown economy that will get worse as more debt is added. So far, the stock market hasn’t cared.
4/2021 ‘Illusion’ of stability hides unsustainable borrowing and rising poverty.
In short order the U.S.- actually the entire world- will have to come to grips with an unsustainable debt and the market will have to address it.
It will not be pretty. It could be absolutely devastating. And I have no idea at the current time as to when this will occur but my Process, described in detail below, will allow investors to simply look at the market losses and decide what to do. It is not based on esoteric formulas with inbred human biases. It is visual. Either there is a bad economic patch or there isn’t. Either market losses (S&P500) exceed 10% or they don’t.
This 4 part Process has taken many years to develop, review, refine and finalize that fits the ups and downs of the market in real life and helps keep the losses to around 12% to 15% (S&P 500) no matter how bad the economy gets. It is not market timing since that is an impossibility. (You already know why.) And it also provides a time to get back into the market that is also independent of guessing. It is not perfect- but it is darn good.
I will address the Risk of Loss first in detail and then move to the specifics.
Obviously, all mutual funds of any type, ETFs and more always make sure you recognize the risk of the market overall and the specific risk of the particular investment. I watched Morningstar in the 1990’s mature to the point where they now position each mutual fund into various categories of risk which corresponds to some element of standard deviation.
And you have Fidelity, Vanguard, Schwab, Blackstone and all the other investment firms (to infinity) stating standard deviation/volatility is risk ipso facto.
You already know that standard deviation is a FORM of risk only. Remember the dinosaurs in thongs?
I know that another financial devastation is not just probable but a certainty. Same comments from those involved with pandemics. We WILL have another.
I figured in the early 2000’s that a pandemic would occur by 2025/2030. I thought that the bird flu in 2006 was the one.
I finally ended up right but it was simply an analysis of pure numbers- mostly being that the world was growing a bunch of humans unabated and sooner or later there would be too many people messing up Mother Earth. I still figure another one by 2035 and probably by 2030.
And within that mess, the insidious market will drop putting yet another group of middle and lower income into another retirement that will leave them without sufficient assets for their lifetime. I know the market will plummet - but I ‘really don’t care’ if it is possible to keep investment losses to around 12% to 15% (S&P 500).
And anyone can do it without fancy/illogical/completely subjective formulas that no one can validate. The impact of this Process is objective and mostly visual. (To be fair, there are two ‘subjective numbers ‘ in my formula that stay constant)
(Note- I am referencing this material in everyday parlance- though even that word will not ring true to many. It’s more preachy than if one was technically defining each area but I want to get across such issues as if one was testifying in court. If you cannot make it real life so that the average consumer will be able to grasp, then it’s basically worthless.)
Part one- the Basics
The standard client questionnaire is to determine the client’s risk.
That is a good idea but the problem immediately arises in that- as identified in the first chapter- you can come out with wildly different risk scenarios that few could probably validate.
Phase 1: describes the use of a new and simplified risk ‘brackets’ where the client can determine the actual risk slots/brackets they are in and how much they might lose for each category.
Phase 2: I mathematically identified some basic funds prior to a recession so that one could indicate to clients and advisors the exposure to loss during a recession Corrections are identified separately later
Phase 3: And from this point, the development of a plan that can be put into place to reduce losses to a reasonable level (phase 3) that is visually available to recognize. Simple stated, if there are no losses exceeding the limits indicated, ‘What’s the problem?’.
None- don’t do nuthin'
Phase 4 is the use of a government statistic to gauge the value of going back into the market.
Client risk has been a subjective examination of client “input” via all sorts of questions to determine if they are Conservative, Moderate, Aggressive, Speculative- with all sorts of biased interpretations therein. The questions initially started with something similar to the required document used by brokers just to sell a stock. They are still bogus since it is necessary to know if the client is/will be diversified. But diversification is not taught for the Series 7 exam nor for any other licensees save that it is ‘important’.
Registered Investment Advisors are not required to understand diversification by the numbers. In fact, they are not even required to have competency with a person financial calculator (it is not taught to series 4, 6, 7, 8 24,27, 52, 63, 65) brokers nor their supervisors and even less exposure for insurance agents who must carry state licenses. (The spread sheets for insurance are WAY out of whack and should not/cannot be used in marketing material.)
I am taken aback by advisors- be they securities brokers or supervisors, insurance agents, attorneys involved in securities and arbitration cases, divorces, estate planning and the bulk of financial planners et al who accept the software as the be all and end all of what the advisor must do in order to be found in acceptance to fiduciary mandates.
Admittedly it is difficult for those who do not have competency with ‘numbers’- they still have to determine what is actually going on internally with the software. But those without the capability breached their fiduciary obligations.
Just so we are clear- if you give money to someone who does not know how it works, you are committing financial and economic suicide. Relegating the effort over to a software programmed by Attila the Hun serves no purpose.
These are overseen first by the standard risk of loss that heretofore will be the one that will need to be used by almost all judging allocations made up of various mutual funds and ETFs.
Risk Guideline Definitions
A correction in the market is defined by a 10% to 15% loss. To be considered an investor, they need to accept this possibility. If there is no willingness to accept ANY losses, they are NOT investors and need to look at annuities et al.
The categories assume the investors do nothing to stop the losses.
Not an investor- unwilling to accept any loss or anything approaching 10%
Conservative: Willing to assume losses up to 20%
Moderate: Accepts losses to 45%
Aggressive: Accepts losses to 65%
Speculative: Accepts losses to 100% (leverage can clearly topple all the assets)
Losses under the Dotcom were 49%; Losses from the Great Recession, top to bottom, were 57%. The ‘short’ pandemic recession of 34% was simply stopped with $4 trillion (it’s only money) input into the economy. Otherwise expected losses would potentially exceed those of 2008 (57%).
I do admit in making slight adjustments to the lower end of conservative and moderate- basically 5% to a maximum of 10%. We have almost insurmountable financial obstacles for the middle and lower income families which Biden hopes to rectify/reduce. But the U.S. economy- with the addition of new turmoil with China, North Korea, Afghanistan, Syria et al- makes the stock market nobody’s friend. It looks like it is but we have not gotten that far with 2021.
One comment made recently seems illogical- but is worthy of a thought process. Can the stock market crash while the economy is going strong- even booming. Interesting though illogical. That said, simply because that has not happened does not mean it cannot.
Biden’s money is needed for the here and now. And correcting our infrastructure- roads, bridges, etc. has been a major project that has been sloughed aside for decades. Another 2 trillion contemplated. But we- and most all other countries- do not have the money. The comeuppance will be brutal.
Obviously, taxes will increase. Probably the higher brackets are those with incomes over about $400,000. Corporate taxes will increase. Capital gains taxes will have higher percentages. Estate tax exemptions will go down. I think the step up in basis for real estate will remain. But the bonus depreciation and other significant tax benefits will drop- though the bonus depreciation just started. Section 179 will be more restricted. Always, ALWAYS remember that taxes do not have to make sense. (Along with a lot of other stuff in life)
As stated in Chapter 1, a new client is required to fill out a client questionnaire which is designed to determine the risk the client is ‘willing to accept’.
One of the worst questions was to ask how many years of experience they have had in investments. Ye gods, the idea that having purchased stocks or mutual funds over their lifetime in a 401k gives no credence to knowledge. If brokers et all are not taught diversification, then why is this question even there.
Actually, the whole concept of figuring out the risk they NEED to take determines the risk that they HAVE to take in order to have a reasonable financial retirement.
And that starts with a budget.
No budget? And the client is asking for assistance?
If there is no way of determining how much they are going to spend- or they refuse to do so, then you can just throw away the questionnaire. If you subsequently deal with the clients with no clue what you are doing except mainly for the money…………..you know what can happen. Arbitrations may not be full court but they are still a pain. As a side comment addressed in another book, The Failure of Securities Arbitration, EF Moody 2012, the clients are the ones that lose the most. Financially- obvious. Emotionally- extremely difficult since they are called all sorts of names by the defense. Not fair. Not ethical. But legal.
Decades ago, articles in Money etc. simply said take a percentage of what you are now spending (for those clients still working) and the ‘formula’ will guide you now for your retirement years.
The set percentages are not real life and should not be used- certainly to cover for 30 years of retirement.
I am fully aware that the budget and a number of areas will change over time. But if the budget is squirrely to begin with, the process becomes extra difficult if not impossible
Admittedly, some questionnaires will show some basic line items- utilities, rent/mortgage, and the like but that may be the extent of effort in figuring out what will exist during retirement.
I have used a very detailed budget where the attempt to cover all expenditures- and I do mean all. (I have a formal budget video and these are just the main takeaways.)
In a class many, many years ago in the San Francisco, a woman had put in a monthly allowance for parking tickets.
My first reaction was ‘say what?’
If you know of SF, there are homes upon homes upon homes that have no garages- which makes sense on the extreme city hills. So it is street parking and whoever gets there first is the winner. Parking one or two streets over was not an option for a woman late at night. So she would park in the no parking areas to be close to her home. Parking tickets became a fact of life- and debt- with her.
And clients must get good numbers of insurance on everything- the point being that some bills are annual and may not immediately come to mind. But if there is a line item for such bills- it means that they have to find the number.
If the clients are 55 and older, they fill out the current budget and then another one as though they were retired.
Once this is done, you use those numbers to determine what one would need to have in assets upon retirement for income.
(Note- you must include taxes essentially greater than current. But just what does that mean? Don’t know when you look at retirement lifetimes of 25+ years. You can do a couple different rates with one at least 5% higher than today. I know Biden wants to keep taxes low for the middle and lower income and is trying to increase taxes for those couples above $400,000. And he also wants to lose the step up in basis on real estate upon death. So I do a matrix of high and low inflation and returns, keep the lifetime the same and squeeze the budget as low as possible and therefore get a ‘feel’ in my mind what might be needed/possible/impossible.) AND PUT ALL OF THIS RECORD ON PAPER.
It is an exercise in futility to try a case when it is all oral. I have a law degree but am not an attorney. In years past I acted as an arbitrator and more so as an expert intermittently till around 2010. (Poor health precluded much extra activities till most recently)
Pulling out your trusty HP12c, one can get an idea by doing:
Budget goes into PMT
Investment rates of return- most people are now aware of the uncertainty of the U.S. budget but are even more aware that the stock market does not care. Be it Trump, Biden or some small furry animal running the ship, many feel that we are going to get back to a normal society.
Not for a long time. I repeat again, the budget deficit will hurt big time in the near term (2 years max).
Note- the adviser should be cognizant of economic conditions worldwide if they are to address investment and bond yield/ risk, real estate et al since even the slightest change in worldwide interest rates will impact inflation- and that impacts everything else. China has been doing well and this can be shown with the building of islands in the South China Sea, stopping the pandemic quickly, crushing Hong Kong with tentacles for Taiwan next, entry into much of Africa…………with the U.S. a slow second after a tumultuous and insincere positioning by Trump. We will gain part of our authority under Biden but the continuing debt here and abroad could easily slow us down for awhile. China’s export will slow but it is trying to get more of its citizens to ‘Buy China’.
As regards returns, many consumers hear that it is possible to earn 10% per years with no risk. It might be/will be impossible to discuss financial issues with them if they push this. I know some firms let the ‘investors’ pick their own returns and inflation. That is a lawsuit waiting to happen. They came to an advisor- then advise. No 10%. 8% tops and I am stretching my upper limit by 0.5%. I do not know the future, I must subjectively consider returns of a 30 year period of time. I would use a range of 5.5% on the low end. Returns prior to Covid were 6% to 8% but the pandemic will drop that down due to HUGE costs of ‘balancing’ (laughter) the budget. I cannot fathom an economy continuing its blindness of the deficit.
The Economist magazine makes a picture worth a thousand words. Or maybe better phrased as $4 trillion. And another $2 trillion for infrastructure.
Next is inflation.
Another toughee. The FED has tried to get to 2% for years but had been unsuccessful. Given the past market performance, money flowing through Biden (Note- this is not about Biden per se)- I believe the largess of the democrats will kick up inflation to about 4%. Maybe 5%. Christine LaGarde head of the World Bank,, in a conversation with Janet Yellen about a 3.2021 said inflation for Europe would not be a problem and expected under 2% for 2022.
Talk about a dichotomy between the U.S. and Europe!!
Actuarial lifetime: Actually the term is a misnomer in that while it is easy enough to look at how long the average man/woman will live at 65 or 75, you need to look at the physical health. If the man is smoking a cigar, eating a day old pizza (he ordered two just to be on the safe side), weighs more than an ice cream truck- you get the idea that the actuarial life time would be the top end of his life with a more realistic reduction of at least 5 years and quite probably 10.
Years ago, I had a client that had both grandmothers live to 100+. Needless to say, you up the lifetime- and in this case you could easily use age 100. Makes retirement tough to figure out since that is a long time for someone who was on a teacher’s salary.
If there is nothing ‘spectacular’ about health, I still always add in 5 more years as a hedge.
So now you have the annual payment/budget, years of life, the expected rates of return and inflation, you do a matrix to cover the low and high ends by hitting PV- present value.
Then add up the assets and is the current number more or less that the PV computed?
If the assets are realistically greater than the PV- the client may have a comfortable retirement and therefore the amount of risk they have to take is small to nil.
(Yes, this is simplistic because a number of iterations have to be run- but this is just the basics. For example, taking no risk in Treasuries earns effectively nothing.)
If the assets are LESS than the PV, now the hard work is to figure out ow the shortfall.
The first adjustment is in the budget.
Though it has been tamped down since one- or both clients- are not working, there needs to be a second look at what might be reduced or eliminated.
The lifetime is effectively set so that leaves inflation and/or returns that must be adjusted.
My first concern is inflation. As evidenced in this material and identified every day in my (almost) daily blog, Financial and Economic Daily Commentary (EFMoody.com/gripes.html), the HUGE deficits in the near term will cause a rise in inflation beyond, potentially, the 4% assumed above. In any case, regardless of when you read this, this is a comment from the UN, 4/2021- UN chief warns of coming debt crisis for developing world - the ‘Illusion’ of stability hides unsustainable borrowing and rising poverty.
Frankly, that will reverberate to the first tier countries. The U.S. cannot escape world economics.
The only measure left is returns. In most cases I look at an estimate for the S&P 500. The returns are expected to be below past current history. Actually, considering the costs of the pandemic, there is still going to be a lot of people without jobs- further many will have problems even getting back to even before the pandemic hit.
I’d use 5.5% to 7.5%.
But due to a prior visit to a financial planner, their firm questionnaire suggested they were very conservative and therefore came up with a 60/40 percentage of equities and bonds. The ever-ubiquitous ‘popular’ pie charts
Target date fund: Are they better?
This is several years old- no matter, it is horrendously flawed at almost any point in time. (Some of Target funds CANNOT make changes PERIOD) My point is Target Date funds were set for risk percentages considered to be everyone’s friend. Lower risk as you get older. Retirees dream. Hyped by effectively all the major Broker Dealers to 401ks as the be all and end all of the necessity for rebalancing, identifying allocations etc. and you can sit back and your returns will, over time, will bring you success.
This is like taking Monte Carlo simulations (from I don’t know when) and then using some formula designed by (You and I don’t know whom- and never will) that, perhaps, uses artificial intelligence (truly artificial) in coming up with a totally illogical piece of pie that will accommodate the bulk of middle and lower income workers
I don’t care who you are, but it you were using these in 2008 and had 90% of your allocation in equities, you would have lost 57% (S&P 500). Further, if you have just 10% in bonds……..why bother? The offset of risk seems like someone in the Target Date meeting (probably marketing) thought it would be a good idea to throw in a little as though it truly could help(?).
Marketing won. Marketing runs the U.S. economy. Marketing rules our lives.
If you were 65+ during the last 10+ years, what would 47% in bonds (how in the world did they end up with 47%- why not rounded to 45%. Must be a supremely accurate program that chose the 47% so I guess everyone should be impressed) have done to the 53% of equities when bond returns effectively went to nothing and then stayed there. Had it not been for the stimulus, we might have seen negative rates.
You need to recognize that those in the middle and lower incomes almost universally have no insight to the underpinnings of any of the concepts of investing.
Nor necessarily do the advisors.
Remember that the use of a personal financial calculator is NOT required in licensing for brokers, insurance agents, financial planners, Registered Investment Advisors (RIA) nor your neighbor’s cat
If you give money to someone who does not know how it works, you are attempting financial/economic suicide.
Those of limited capacity, interest, time, et al, have depended on the valuable insight of meetings conducted as part of 401k education to help them feel comfortable in looking forward to retirement.
The fiduciary duty to these individuals has been breached.
Is this better…….For what period of time?
Is this better?
Is this better?
‘A’ risk and ‘THE’ risk are critical interpretations. But they cannot be made since there are no numbers
Once again ‘A’ risk is identified but it is just a word in a sentence with no interpretation. Further, ‘THE’ risk in terms of a loss also means nothing since it, obviously, cannot be interpreted as well when there are no numbers.
Look at the first comments on G Fund but I have zero idea what the author is addressing. 5% loss, 10% loss????
Not a clue as compared to most equities which will have a ‘…..higher risk.’
Without anything viable in the sentence, why has it been included in the first place.
It is deceptive if it has no real life application.
Yes, I am aware that the SEC et al lawyers needed to say ‘something’ that appeared useful/valuable/nondebatable. But I don’t give them a gold star because there are enough morons in the business that could come up with something palatable to the arbitrators and that is all that is needed.
Some pundits have said risk is what the attorneys will draw out during a case.
Not as a fiduciary.
If someone attempts an investment or insurance breach and they don’t know diversification by the numbers or recognize the mandatory use of a personal financial calculator, they may still win a case but it could be because the arbitrators are not knowledgeable either.
I have never met an ‘average’ consumer who used a financial calculator for investments. They may use one for real estate and the like- but the point is that sifting through some commentary on Schwab’s site or dealing with Robinhood- does not present a knowledge in the basics. They end up using some type of subjectively imbedded software as the ‘tool’ for success. Remember that buying an index fund statistically beats managed funds in almost every time frame.
When Buffet dies, he leaves his wife a trust fund where 10% is in Treasuries and 90% is in a S&P 500 index fund WITH NO MANAGEMENT AT ALL. Just leave it alone.
I had a slightly different allocation where there was some developing countries and maybe a little pure tech but considering all the subjective pros and cons, the index is fine. And his wife can take 49% and 57% losses and still buy all of Manhattan. But the middle and lower income families do not have that latitude and that has been my focus for several decades. The industry has shown that large losses hurt the asset value when occurring early in retirement. A 50% loss on $100,000 at the get go leaves $50,000 that requires 100% on the remaining principal to get back to the original value. $50,000 at 5% will take 15 years to reach $100,000. At 7%, 11 years and it you get lucky, at 8% it is 10 years.
True numbers and pure crap. The numbers are correct as they stand but the retiree is still taking funds OUT of the remaining kitty in order to survive. Further, taking big hits at any point in the retirement is financially and emotionally devastating. Large losses can be reduced via the next three phases of my Process.
Anyway, somebody in court or in arbitration has to have an ability to recognize that risk of loss for the portfolio must be presented to the client BEFORE the purchase. And have the ability to simply convince a jury or arbitration panel what ‘A’ and ‘The’ really mean.
(I just lied- I have no idea- save for some commentary below- to simply do that. Certainly a statistician ‘par excellance’ can do it- but only using old numbers and a highly subjective interpretation.)
The consumers have little idea of their exposure. Sure, the detail about risk is acceptable to the SEC and state’s requirements but it says nothing specific and really lowers the bar of fiduciary that it should not be allowed in its current format.
This was a formula developed over several years that incorporates only current data- save for two numbers that are subjective but stay the same. It indicates at the time of review what a potential loss might be if a recession were to occur at that time. It is not involved with economics per se, nor the inverted yield curve, not much else since it simply indicates what exposure the fund or ETF has.
However, as time goes on, the data used will vary for all sorts of reasons and as the economy suffers further and the potential loss needs recalculation since the real inputs change. Numbers should be run every 3 months.
The closer the economy comes to a recession or even a correction, the percentage loss will increase.
I offer a few tables that show what the exposure was for certain funds close to the beginning of the recession and the amount of losses actually sustained.
NASDAQ: The greatest hit was the Dotcom. Leading up to the peak of 2000 the RoL indicated a 72% to 79% loss
Potential Risk of Loss 2000 Actual Loss 2000
72% to 79% 76%
Potential Risk of Loss 2008 Actual Loss 2008
28 to 33% 54
Wilshire 5000- covers a large section of the entire market
Potential Risk of Loss 2000 Actual Loss 2000
30% to 35% 41%
Potential Risk of Loss 2008 Actual Loss 2008
43% to 47% 54%
Russell 3000- Another decent size section of the market
Potential Risk of Loss 2000 Actual Loss 2000
30% to 35% 42%
Potential Risk of Loss 2008 Actual Loss in 2008
40% to 46% 49%
Russell top 200- A small section of top companies
Potential Risk of Loss 2000 Actual Loss 2000
21% to 25% 47%
Potential Risk of Loss 2008 Actual Loss in 2008
58% to 65% 52%
MSCI EAFE is a very well known international index
Potential Risk of Loss 2000 Actual Loss 2000
N/A no data
Potential Risk of Loss 2008 Actual Loss in 2008
35% to 39% 52%
What about a projected drop in the S&P 500 in late 2019: 47% to 51% which was quite a bit higher than the numbers in the mid 2010’s.
If you add in Covid in March of 2020- anybody’s guess. But the economic catastrophe was stopped/slowed with a $4 trillion bailout. The market loss was stopped at 34%. 34% losses going almost straight down is NOT a correction.
So, Phase 2 perfect?
No- nor can it be
From my standpoint, Yes.
It makes the investment process more transparent
This effort should be available to investors BEFORE they invest since they need to realize
1. Question of another recession is 100% positive. We will have another in 20….. I don’t know. Then after that, we will have another in 20….. I don’t know.
2. What is the advisor going to do when the losses start. That’s the key
Are they suggesting buy and hold? No one can suggest a buy and suck with losses of 49%, 57% and 34%
Rebalancing- but when? Every year? To equalize the risk of the first go around? Where real life risk was not identified? How about after all the losses have been tallied?
Buy more on the dip? That is really is insufferable since the middle and lower income don’t have ‘no more money.’
IMPORTANT- VERY IMPORTANT
You have come to one of the most critical issues that debunks a lot of risk and human behavior that the industry has avoided.
Daniel Kahneman is the foremost thought leader on human behavior and recognized internationally as a true pioneer.
I look to his work and attempt to utilize his theories but kept coming back to the questions and software and the ’ability’ of same to determine the risk (of loss). Subjectivity reined supreme. It was the risk that the client supposedly outlined in their client (bogus/highly controversial) questionnaire.
The risk is determined by what they need to take in order to make it through retirement. That is the guide that- as identified above through the budget- that one uses. Then to keep major losses at a preset amount- that being 12% to 15% (S&P 500). It is not suggesting 4% annual payment or some esoteric formula. You give me a firm budget and I can tell you within a defined range what you can do within the parameters addressed.
The idea that the clients determine the risk they are willing to take is a clear breach of the fiduciary duty. The advisor determines the risk. Then again, if the advisor is clueless to the underpinnings of the software, there is nonetheless another breach.
I had tended to state that once losses got to 10%, one had to start selling the most aggressive funds first. (For the record, I do not deal with single issue stocks as a portfolio because they are so difficult to manage all the complexities.)
But this Kahneman quote validated what I had thought/used. How much risk do people REALLY identify with? Earlier in 2018, Kahneman noted, “We had people try to imagine various scenarios, in general, bad scenarios and the “question was, at what point do you think that you would want to bail out? That you would want to change your mind?” It turns out, that most of the people — even very wealthy people — are extremely loss averse.” There is a limit to how much money they’re willing to put at risk,” he said. “You ask, ‘How much fortune are you willing to lose?’ Quite frequently you get something on the order of 10%.”
Decades of the most intensive work on human behavior- and there it is.
Reduction of loss
Obviously, the loss can be limited by not investing in stock funds at all. Just take your chance with bond funds as well.
Illogical in the extreme. Only is viable when the client has more than enough money to be risk free through retirement.
The bulk of retirees are already on the cusp of not making it. The inference that bonds have a chance of making returns worth noting in, quite probably, the next 10 years is laughable.
It is true that if they go heavy in stocks with no outside ‘management’- well, we have already seen what happens.
So what is the answer? The client MUST get more to make it through retirement- certainly when addressing health care costs and long term care. History however shows that acceptance of such risk will be dealt a nasty blow about 3 to 5 times in a 30 year retirement with recessions. It is mandatory to limit the risk when such potential extremes are evident. .
A correction is 10% to 15% of the market due to mispricing, emotionalism and/or every other rationale. Once the loss exceeds the 10% and keeps going (and with validation of other economic factors), the odds for a deeper loss becomes clearly evident. Therefore a 10% correction is a warning of further losses. (The benchmark is the S&P 500 or the Extended Market). When losses reach 11%, 20% of the riskiest allocation is sold. When losses reach 12%, 40% of the remaining balance is sold. When losses reach 13%, the remainder is sold. The 12% is a rough average of the reduction since the sales are not going to occur perfectly at each specific percentage.
And the loss only reflects the S&P 500. If an allocation were heavy into a leveraged ETF, the losses sustained would be greater than the S&P because by the time the ‘trigger’ is met, the leveraged fund would have dropped further.
The trigger of losses is solely from the S&P500. It is NOT possible to use other indexes- far too much subjectiveness- or almost all would be required. And then artificial intelligence. It would be transparent, but seeing something that is wrong headed to begin with is obviously useless.
Market (S&P ) suffers 10% loss
Adviser/Investor must become very aware of continued downward movement
Market drop 11%
Sell 20% of most risky assets. Strict adherence to 20% is not necessary. Can simply be 1/3rd or Whatever
Market drops to 12%
Sell 40% of remaining equities or1/3rd
Market drops to 13%
Sell remaining 40% or last 1/3rd
In most cases the cash may be invested and earn some income until more fortuitous. This not covered herein due to a non normal global economy and the lowest of interest rates ever. I recognize the ability to do so and was successful in 2000 and 2008 in using various bonds and CDs. But I question the value of investing cash where rates might not exceed 2%.
Just to annoy the pundits- there is nothing foretold as to what will happen with the inverted Yield curve even being at 100% correct for 60 years. Unless a subsequent drop in the market should occur, nothing happens. And there is nothing that would trigger PRIOR to the top that I know of- nor that could I configure from my research. Nor would I even touch this since I do not have the mathematical skills. But I haven’t read that Taleb does it either.
Below however is a graph from Michael Edesess, a master mathematician who has dissected a lot of the absurdities in financial planning.
He nailed Dalbar on its numbers and you can read the full article through this link. Most notable is the graph indicating what investors need to do and provided an example of what consumers should to. (https://www.advisorperspectives.com/articles/2016/07/19/the-fallacy-behind-investor-versus-fund-returns-and-why-dalbar-is-dead-wrong) Wherein he notes “…….investors don’t buy precisely at market tops and sell precisely at market bottoms. Perhaps they do sell on market panic and buy on exuberance, but that’s a long way from selling at bottoms and buying at tops. The figure below shows my hypothetical example of a more likely scenario of panic-selling and greed-buying, one in which the buys and sells are not so perfectly market-timed but are more realistically random.
Totally independent views. His is ‘subjective’ in terms of when to get out and in, after the fact. Mine just goes further in identifying the points which enables specific losses as a trigger to get out ‘before the fact’ and the National Bureau of Economic Research commentary of when to get back in.
My graph shows when to get back into the market via a press release from the National Bureau of Economic Research. Both dates merely provide a date when the troughs occurred in each recession. However the issuance of the release provides an independent point to re-enter the market. Partial commentary on July 13, 2003 noted “the Committee does not have a fixed definition of economic activity. ……………….the committee determined that a trough in business activity occurred in the U.S. economy in November 2001. The trough marks the end of the recession that began in March 2001 and the beginning of an expansion. The recession lasted 8 months, which is slightly less than average for recessions since World War II. In determining that a trough occurred in November 2001, the committee did not conclude that economic conditions since that month have been favorable or that the economy has returned to operating at normal capacity. Rather, the committee determined only that the recession ended and a recovery began in that month……”
It has been assumed, imagined and taken as fait compli that the consumer/investor is reticent to point of absolute reluctance to get back into the market. It was and still is repeated so frequently that it became a ‘fact’ within the industry. It is true that part of that of that reluctance is basically the emotion that losses are now preordained (recency bias).
But the flip side is that the industry really has not investigated the use of a transparent trigger(s) because the industry wanted to maintain control of funds for which they would get an additional commission(s) with other products (i.e. Alternatives) and/or to stay ‘fully invested’ and charge a higher total fee for all the accumulated Assets Under Management (AUM). Removal of assets will be a death knell for some advisors now required (or will be required) to act in the client’s best interest. Not knowing risk and how to deal with the financial and emotional devastation of large losses is not in the best interests of any consumer.
The 2020 ‘recession/correction’, Covid, Stimulus
Charlie Munger noted- “Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. You've got to have models in your head. And you've got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. What are the models? Well, the first rule is that you've got to have multiple models because if you just have one or two that you're using, the nature of human psychology is such that you'll torture reality so that it fits your models, or at least you'll think it does.
And the models have to come from multiple disciplines because all the wisdom of the world is not to be found in one little academic department.”
EFM: The above commentary is mandatory since most analysts/advisors stick to the regimen of various statistics that many times are illogical and clearly wrong (Fisher on 2019 economics previously).
As to the current situation, I had not encountered anything like the ‘recession/pandemic’ since it had not happened before. And what was it that I needed to address, change, discover.
First of all, the equities would have been sold at the 12% to 15% loss. No problem with that.
The flip side was that the recession was stopped and the $4 trillion turned into an illogical buying spree that moved the market back up.
If I was seeing this as a correction only, which means there are short term losses not exceeding more than 15% to 20% with the market going back to business in the near term- nothing like a recession.
In such case, you get back in at the point where you got out. But this was 34%, not a standard correction at all.
And there was NOT going to be a NBER statement down the road that would trigger in buying back in.
So I treated the runup where one gets back in at the point they go out.
Admittedly, I ‘should’ have gotten back in as soon as the market turned. But since I had no insight to the pandemic, I was cautious- perhaps overly cautious.
No matter, funds were to then to be reinvested and are still there.
However, my commentary herein is that I am really annoyed/upset/cannot believe that we will NOT have a worldwide economic calamity in the near term. We may escape 2021 but the more I read, the less comfortable I am.
There will probably be no inverted yield curve this time and it will be how- or if- Biden attacks the problem with more debt.
No crystal ball- just a mess going forward. However, my whole point still remains- you cannot suffer large losses and expect to remain in control of your life- certainly your retirement life. And absolutely your emotional stability.
I leave you with the same quote from Benjamin Graham that I started with
“The essence of investment management entails the management of risk, not the management of returns.”