Archives for February 2011

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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.

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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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.

Total Bond Market Fund vs. Treasury Bonds

As I mentioned recently, the bond portion of my own portfolio consists of a Treasury bond fund rather than Vanguard’s Total Bond Market fund. That choice drew questions from several readers.

For the record, I do not think there’s anything wrong with using Vanguard’s Total Bond fund. It’s a super low-cost fund that does a fine job of reducing the risk of an otherwise-equity portfolio. In other words, I think you can safely file this under the heading of “not likely to make or break your retirement plans either way.”

Still, many people asked for my reasoning, so here goes.

What’s the Difference?

The expense ratios are essentially the same, so the only meaningful difference between the funds is what bonds each one holds. According to Vanguard’s site, the Total Bond fund is made up approximately as follows:

  • 43% Treasury bonds,
  • 28% government mortgage-backed securities,
  • 24% corporate bonds, and
  • 5% foreign bonds

In contrast, a Treasury bond fund is made up exclusively of Treasuries (of varying maturities depending upon which Treasury fund you choose). So the primary question is this: Do you want mortgage backed securities and corporate bonds in your portfolio?

For me, the answer is “not particularly.”

Corporate Bonds

I don’t place a ton of faith in historical statistics about returns, and that includes historical data about correlations. However, I think one thing that we can assume will often be true is this: Stocks will usually be more highly correlated to corporate bonds than to Treasury bonds.

There’s a very common-sense reason for it: When the economy and stock market are doing poorly and companies are struggling, more companies than usual will be seeing their credit ratings downgraded. Result: Those companies’ bond prices go down at the same time their stock prices go down.

In my portfolio, the role of the bond allocation is to reduce the portfolio’s overall volatility. And since I have a very stock-heavy allocation, the low correlation that Treasuries have to stocks makes them quite good at performing that role–better than corporate bonds, in my opinion.

Mortgage-Backed Securities

Mortgage-backed securities are essentially bonds made up of a tiny slice of numerous different mortgages. Government mortgage-backed securities (like those included in Vanguard’s Total Bond fund), are backed by the Federal government, so they have no credit risk.

Mortgage-backed securities do, however, carry a risk that Treasury bonds do not: prepayment risk.

To explain, consider a mortgage from the perspective of a homeowner. If you have a high-rate mortgage and market interest rates go down, what do you do? You refinance.

So from the perspective of the bond-holder, you don’t actually know what the maturity of your mortgage-backed security will be (because when any of the underlying mortgages are prepaid, you get some of your cash back early). And, unfortunately, mortgage-backed securities tend to be prepaid the most at exactly the worst time: When interest rates are lowest.

This prepayment risk would not necessarily be a concern if mortgage-backed securities tended to earn higher returns to compensate for it. But, as Larry Swedroe has pointed out, that has not been the case historically.

Should I Avoid Vanguard’s Total Bond Fund?

Despite the above arguments, I can’t state strongly enough that of all the bond funds out there, Vanguard’s Total Bond Market Index Fund is one of the very best. It’s a super-cheap bond fund consisting mostly of Treasuries and government-backed bonds, and it has no management risk. In my book, that’s not bad.

For example, if you have access to Vanguard’s Total Bond fund in your 401(k), consider yourself lucky.

Or, if you’re an investor who finds the idea of a target retirement fund appealing, the fact that Vanguard’s target funds use the Total Bond Market fund as opposed to a Treasury fund would not give me any hesitation whatsoever about recommending them.

I’m happy to exclude government mortgage-backed securities and corporate bonds from my portfolio because doing so doesn’t introduce any additional complexity or increase my expenses at all. If that were not the case, I wouldn’t really mind including them.

Investing Life Insurance Proceeds

Imagine this situation: A married couple has one spouse who is a stay-at-home parent (who generates no income). The income-generating spouse dies at age 30, with an appropriately-sized life insurance policy. How should the surviving spouse invest the life insurance proceeds?

It’s a tricky question, and I don’t have a perfect answer. (I’m not sure there is one.) Still, I think that anyone who could potentially find himself/herself in such a situation would be wise to make a plan ahead of time.

It’s akin to planning a super-long retirement. We have to determine how to invest a portfolio from which you want to take a stream of inflation-adjusted withdrawals over a very lengthy period (potentially more than 50 years).

  • What asset allocation would you use?
  • What rate of withdrawal would you be comfortable using?

A part of what makes these questions so difficult to answer is the fact that we can’t learn much from backtesting various asset allocation/withdrawal rate combinations to see how they’d hold up over historical 50-year distribution phases. After all, we only have two such independent 50-year data sets–not exactly a large sample size.

Asset Allocation

On the one hand, for such a lengthy period, it seems that it would be difficult to achieve the long-term returns necessary to sustain 50+ years of withdrawals without a hefty stock allocation.

On the other hand, the “sequence of returns risk” problem that plagues retirement planning becomes even worse when we’re looking at such a long period. If the investor uses a stock-heavy allocation and the first few years go particularly badly, the portfolio could easily fail to generate the desired income for another 50+ years.

Personally, I’d attempt to minimize sequence of returns risk by using a fairly conservative allocation–something like 40% stock, 60% bond (with a healthy portion of the bond allocation being invested in TIPS). But I’d only be comfortable using such a conservative allocation because I’d also make sure to…

Use a Low Withdrawal Rate.

The most important piece of the puzzle is to use a very low starting withdrawal rate (3% or lower). The goal is for the portfolio to last almost indefinitely. If you aim for the portfolio to be depleted at the end of the 50-ish-year expected time horizon, but you overestimate the sustainable withdrawal rate by even 1%, you could run out of money far earlier than desired.

What Would You Do?

As I mentioned above, there simply isn’t enough data to get a very conclusive idea of how well any given strategy would have held up historically over 50+ year periods. As such, the above thoughts are what I would do with the money, but I absolutely cannot say that there would be no better approach.

What would be your plan if you were faced with the prospect of having to draw from a portfolio for (potentially) more than five decades?

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