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Picking Mutual Funds: Don’t Just Look at the Winners

Have you ever read The Millionaire Next Door? It’s an insightful book that looks for common traits among people who have been particularly successful at accumulating wealth.

For example, one trait that’s common among “prodigious accumulators of wealth” is that they’re frequently self-employed. From this, we can conclude that self-employment is likely to increase one’s wealth. Right?

Well, no, we can’t.

What if self-employment simply increases the likelihood of extreme outcomes at both ends of the spectrum? That is, what if self-employment increases not only the likelihood of becoming very wealthy but also the likelihood of going bankrupt? If we only look at the success stories, we have no way to know whether or not that’s the case.

In order to determine whether or not self-employment, on average, increases one’s wealth, we need to do a survey of self-employed people–and not just those who are wealthy.

Same Thing Goes for Picking Mutual Funds.

One approach many investors take to picking mutual funds is to find several funds that have been successful and see what they have in common. For example (and I’m completely making this up), if the top 5 international stock funds over the last 5 years all had the following characteristics at the beginning of that period:

  • Expense ratios between 1% and 2%,
  • Fund managers with 3-7 years of experience, and
  • Less than $1 billion in assets.

…then it would make sense to look for funds that have those characteristics today, right?

Again, no, not necessarily. Because that’s only half the picture.

Going Back in Time

To test whether or not such a fund selection strategy might be successful, we have to go back in time. We have to go back to the beginning of the period in question, look to see what other funds also had the same characteristics, and evaluate their performance as well.*

If all (or nearly all) of the funds with those characteristics performed well, then we might be on to something. (Though even then, it requires a great leap of faith–one I’m personally not comfortable making–to assume that the same pattern will hold true in the future.)

But if half of the funds with those characteristics performed very well and half performed very poorly, then this probably isn’t a great strategy.

In other words, even if all of the top-performing mutual funds share a few characteristics, that doesn’t necessarily mean a darned thing. We also need to check to make sure that those characteristics are underrepresented among poorly-performing funds in order to conclude that they might be useful as predictors of success.

*It’s probably worth pointing out that most of us individual investors don’t even have the resources to do this kind of research. In fact, I’m only aware of two products that make such research possible: CRSP’s Survivorship-Bias-Free US Mutual Fund Database and Morningstar Direct, neither of which is exactly intended for individual investor use.

Investing Blog Roundup: Who Needs an Investment Advisor?

Happy Friday, Dear Readers.

Just a quick collection of links this week. I hope you enjoy them. :)

Investing and Tax-Related Articles

Other Money-Related Articles

Blog Carnivals

Thanks for reading!

Asset Allocation is a Sloppy Science

Imagine this: You’re baking a cake for your Aunt Edna’s birthday under rather unusual circumstances. You know that when you’re finished mixing everything, your cousin Eddie will come along and add anywhere from 1-3 eggs and 1-2 cups of sugar to the mix before you bake it.

How do you account for that?

Naturally, you use a recipe that would be appropriate for 2 eggs and 1.5 cups of sugar so as to minimize the problems in either direction. But your cake is unlikely to be perfect–that’s just the nature of the game.

Asset allocation is kind of like that.

You have control over what you put in your portfolio. But you have to make the decision without knowing what returns each asset class will provide, so there’s no way to determine the “perfect” asset allocation ahead of time.

We have lots of historical data, but we don’t know how well future results will conform to past results. The end result is that we can be pretty confident in the most basic of asset allocation concepts:

  • Stocks have higher expected returns than bonds, but at the cost of higher short-term volatility, and
  • Bonds have higher expected returns than cash, but at the cost of higher short-term volatility.

But the further we move beyond that, the less clear things become. Trying to determine, for example, whether 20% or 25% of your portfolio should be in international stocks is a bit silly. It’s draping a thin sheet of precision over a mountain of guesses.

Does Asset Allocation Matter? (Will I Run Out of Money in Retirement?)

Since my recent posts discussing my own asset allocation and my thoughts on Treasury bonds vs. Vanguard’s Total Bond Market Fund, I’ve gotten a steady stream of emails about asset allocation–especially for retirees or soon-to-be retirees.

That’s good. It’s an important topic.

But I think it might be helpful to back up and remind ourselves that asset allocation isn’t everything. For example, any of the following factors can play a larger role than asset allocation in determining how likely you are to run out of money during retirement:

  1. How long your retirement lasts,
  2. What withdrawal rate you use (including amounts paid for mutual fund expenses, brokerage commissions, or advisor fees as part of your withdrawal rate),
  3. What portion of your portfolio you choose to annuitize, and
  4. Whether or not you make any big mistakes (bailing out near a market bottom, for instance).

Withdrawal Rate and Length of Retirement

Acting in combination, length of retirement and withdrawal rate are the most important factors as to whether you outlive your money or vice versa.

For example, if you’re looking at an expected retirement length of just 10 years, and you can afford to (and plan to) use a withdrawal rate of just 3%, then regardless of what asset allocation you use, it’s almost impossible for you to run out of money.

On the other extreme end of the spectrum, if your retirement could end up lasting 30 years or more, and you’re looking at a starting withdrawal rate of 8%, that’s a problem. Before fiddling with your asset allocation, you need to find a way to retire later and/or reduce your level of spending.

It’s only in the middle range–the “maybe I have enough, maybe I don’t” range–that asset allocation comes to play an important role.

Annuitizing (a Portion of) Your Portfolio

Next in order of importance comes the decision of how much of your portfolio to annuitize. [Reminder: A lifetime immediate fixed annuity with inflation adjustments functions very much like a pension–the annuity provider (an insurance company) pays you a predictable amount of money every year until you die, at which point the money disappears.]

If you decide to annuitize enough of your portfolio to completely satisfy your basic spending needs, then you can afford to use either a high-risk or low-risk allocation with the remainder of your portfolio–neither choice puts you at risk of running out.

Avoiding Mistakes

Finally, there’s the behavioral factor. You can choose an allocation that’s exactly perfect for your withdrawal rate and expected retirement length, but if you can’t stick to your allocation–specifically, if you bail out of stocks at a market low or go all-in on stocks at a market peak–you’re in for trouble. (That said, your likelihood of making mistakes may of course be impacted by your asset allocation.)

Covering All Your Bases

Asset allocation is important. But even the most well-researched, well-planned allocation can’t create a miracle, so be sure to tend to the other aspects of investment success as well:

  • Keep your spending under control so that you can save enough during your working years and withdraw little enough during your retirement years.
  • If you’re in the range where you’re not confident a typical stock/bond portfolio will be able to sustain the level of spending you’d like, consider annuitizing part of your portfolio.
  • Stick to the plan. Don’t get fearful or greedy at the wrong time.

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Investing Blog Roundup: Tax Protesters and Audit Likelihood

Happy Friday, Dear Readers.

Not much in the way of news here, as I’ve been pretty well consumed by studying for my first portion of the CPA exam next week (Financial Accounting and Reporting, for those familiar with the exam). :)

Investing and Tax-Related Articles

Other Money-Related Articles

Blog Carnivals

As always, thanks for reading!

Financial Simulations: Should You Trust Them?

Financial simulators–broadly grouped into a) historical return calculators and b) Monte Carlo simulators–are popular tools for financial planning. But it’s important to recognize their limitations.

Historical Return Calculators

Historical return simulators (e.g. FireCalc) allow you to test a given strategy against historical returns to see how often it would have worked. For example, you can check how often a 4% starting withdrawal rate would have been successful over a 30-year retirement given various stock/bond allocations.

Such calculators are useful for showing what has not worked in the past. Showing that a strategy has worked only occasionally tells us that we should have little confidence that it will work in the future. That’s why, for example, we know that it’s unwise to plan to withdraw 7% of your portfolio every year during retirement.

Monte Carlo Simulations

Monte Carlo simulators allow you to perform similar tests. But instead of testing a proposed strategy using actual historical sequences of returns, they ask you to provide statistical descriptors of investment returns (average return, standard deviation of returns, correlation to other investments, etc.), then they test the proposed strategy against numerous return sequences generated using those descriptors.

Monte Carlo simulations are especially useful for testing how much a plan’s probability of success will change as a result of changing assumptions. (For example, if stocks end up being 10% more volatile over annual periods than they’ve been historically, will that be a major problem?)

Are Historical Returns Meaningful?

Consider this analogy: You’re trying to determine the average height of a group of people (as well as other facts such as the standard deviation of heights among the group). With every additional person from the group that you measure, your data set grows and you can be more confident in your conclusions.

We try to do the same thing with historical returns–collect an ever-growing pile of data and use it to determine things like average annual stock market return.

But there’s a problem here: As our sample size grows, our population could be changing. For example, I’d assert that the financial markets and world economies are meaningfully different from, say, 50 years ago in several ways (examples: instantaneous information on stock, bond, and commodity prices; automated trading in very large amounts by institutional investors).

What effect will those changes have on investment returns in the future? I don’t know. But I don’t think we can simply assume that such changes will have no effect.

As such, any data older than 50 years is of limited value. As we continue to collect more data, we have to keep throwing our old data out as it becomes less and less relevant. Even today’s data may not be particularly relevant if you’re concerned with returns several decades into the future.

Conclusion: The predictive value of any simulations based purely on historical data must be taken with a healthy dose of skepticism.

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