Friday, 30 May 2014

A Lifelong Portfolio and Investing Plan for the Reluctant Investor - Aims and Plausible but Inadequate Options

"Everything should be made as simple as possible, but not simpler." Albert Einstein
Some people enjoy investing, but many do not, looking upon it as a necessary evil that is daunting for its complexity and potential danger. Even the slimmed down list of essential topics for the self-directed investor we presented in our last post may be too much for many, whether due to time or interest. Are those people to be forced to avoid self-directed investing altogether?

Today we take up Einstein's challenge for the Canadian self-directed reluctant investor, the person who just wants to be told told what to do in the least amount of time in the least technical manner possible but who insists on something that is effective. First, let's be more specific in defining what the portfolio should do.

Objectives of the Portfolio
We set the following demanding objectives for our portfolio. Our solution is necessarily a compromise to some degree as there are trade-offs amongst several objectives.
  • Suitable for all ages and phases of life from savings through to withdrawal in retirement - the same securities, which will be Exchange Traded Funds (ETFs), in the same proportions, forever; the portfolio never needs to change
  • Suitable for any type of account - RESP, RRSP (and all the other registered retirement account variations like RRIF, LIRA, LIF), TFSA or even taxable
  • Suitable for any investment time horizon - the portfolio should be good enough to do an ok job whether it will be cashed in a tomorrow or in 40 years. Thus, we try to remove the planning headache of figuring out when we will need the money and trying to adapt the portfolio's holdings to match. Can we really be sure anyway when we will want or need the money? Things change and life is full of surprises. We want a portfolio that copes well with uncertainty. 
  • As automatic as possible in every way, from contributions, to investment, to on-going management like re-investment of interest or dividends received, to withdrawal
  • As low cost as possible - the lower the fees incurred, the more stays in the investor's pocket
  • As tax effective and simple as possible - investments should be put in tax-advantaged accounts like TFSA and RRSP where no tax reporting is required and, when those are filled to maximum contribution limits, in a regular taxable account. Should tax reporting be required, we want that process to be as straightforward as possible too. Einstein had it right on this point too, when he said, "The hardest thing in the world to understand is the income tax." This is one area where we could not eliminate complexity entirely. The problem is with taxable accounts and the calculation of capital gains, where the investor must keep track of Adjusted Cost Base. 
  • Incorporating diversification to limit volatility at all times and to benefit from the longer term re-balancing boost to returns
  • Avoid the potential complexities of dealing with foreign exchange, while gaining the return and diversification benefit of foreign investments. The foreign investment objective is the biggest compromise of our Reluctant Investor Portfolio, as our proposal is Canadian investments only. 
  • Minimize mental stress and danger of panic reaction of selling at the wrong time (e.g. late 2008 after the stock market plunge in the financial crisis) by limiting volatility. At the same time, the portfolio is very orthodox mainstream, so that the investor can feel comforted doing what the average of everyone does, reducing the risk of regret. 
Testing the Portfolio through Historical Performance - To see what kind of performance the Reluctant Investor Portfolio would have provided, we will turn to the Stingy Investor Asset Mixer tool.

Alternatives, with the Trade-offs that led to rejection
Before we reveal the portfolio and investing plan that we believe best fits the objectives, let's look at some options that don't quite work in our view.

1) iShares Balanced Income CorePortfolio™ Fund (TSX symbol: CBD) - That's right, a single fund, only one thing ever to buy or sell. This ETF is a serious contender that might still appeal to some.

  • Maximum convenience and simplicity: a single ETF that avoids any need for the investor to do rebalancing, it is all done automatically within the ETF by the iShares managers; this ETF is part of iShares' free DRIP, PACC and SWP plans meaning you can set up instructions for regular contributions or withdrawals; no worries of questions about which ETF goes into which account; only one ETF for which to keep track of Adjusted Cost Base for eventual capital gains reporting if held in a taxable account
  • Well diversified with many types of stock and bond holdings, including foreign holdings; in this aspect it is better than the Reluctant Investor portfolio
  • Annual fees at 0.72% is starting to be a bit high, eating into net returns
  • Volatility is higher despite the variety of holdings - in its short history from 2007 startup, it declined about 25% by early March 2009. Though it has recovered strongly since, that might be too un-nerving for some to stick with it. Plus the effect of withdrawals at that point when in retirement mode, would seriously harm the portfolio.
2) All Bonds, whether a broad Total Market mix or Short-term Bonds

  • Convenience and simplicity, due again to holding only a single fund
  • A bit less volatility - there were fewer down years than for our winning choice according to Stingy Investor, though the difference is slim and not always favorable when it included annual retirement withdrawals of 4%
  • Lower returns and much less total accumulation during savings mode per more historical calculations and very slim returns in retirement withdrawal mode. The clincher for us looking forward is that we know bond returns since 1980 have been greatly boosted by falling interest rates. That trend has stopped now at the bottom so betting all on bonds cannot produce the same juicy returns. That's an important principle of our winning portfolio - it hedges the uncertainty of whether stocks or bonds will do better.
  • No tax efficiency if held in a taxable account - interest income is taxed at the highest marginal rate
3) GICs only

  • Simplicity - everyone knows and understands how they work
  • Stability - their price never varies (though there is an implicit but not visible change in value when interest rates change) and the price paid back is known in advance
  • Convenience - Minimum purchase amounts start at $500, but how is an investor to manage purchases on a regular basis. Avoiding having a multiplicity of small GICs that will require constant effort to track and reinvest as they mature, as well as time to look up the best rate, which changes constantly from the different financial institutions. Automatic reinvestment with the same financial institution won't get the best rate. Getting the best rate also means tieing up money in non-cashable GICs, which makes it impossible to get all, or even most, of your money fast if you suddenly want to make a big purchase, especially if one implements the oft-suggested 5-year ladder of GICs.
  • Returns are lower over the long term, as this historical table from London Life of GICs against TSX stocks and other investments shows
  • No tax efficiency if held in a taxable account - interest income is taxed at the highest marginal rate
Nest week, we will reveal what we believe is the winning formula for Einstein's challenge - the portfolio and the investing plan to go with it.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 23 May 2014

HowToInvestOnline Guide to Self-Directed Investing

May 2014 marks the 6th anniversary of our blog. Many of the posts we have published have enduring value, as statistics on accumulating reader visits on old posts demonstrate. But there are now so many posts that it has become difficult to track old ones down. To help readers find their way around, we have now selected, organized and categorized posts into the key investing topics. We've ignored some of our posts, topical at the time, which have become outdated.

Investing 101 - posts in green: the investing basics, which we believe every self-directed investor should know to successfully build and manage a portfolio.

1) Setting Objectives

2) Getting the Thinking & Decision-Making Right

3) Setting Expectations Grounded in Reality

4) Risk

5) RRSP, TFSA, RESP, In-Trust vs Taxable Accounts

6) Asset Allocation and Portfolio Construction

7) Model Portfolios

8) Portfolio Components – the Actual Securities to Buy and Sell


b) Canadian Stocks

c) Preferred Shares, Split Shares and Closed-End Funds

d) Real Estate Investment Trusts (REITs)

e) Preferred Shares

f) Convertible Debentures

g) Fixed Income – Cash, Bonds, GICs

h) Commodities

i) Alternative & Fringe Assets

9) Taxes

10) Retirement

11) Sustainable Investing – Incorporating Environmental, Social & Governance Factors

12) Tactical Investing – Looking for Market Bargains

13) Leveraging – Borrowing to Invest

14) Tools

Guide updated to 31 December 2014

Disclaimer: This post and those linked-to above also written by me, are my opinion only and should not be construed as investment advice. Readers should be aware that any comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Tuesday, 20 May 2014

Retirement Income Design: Making Sure Your Portfolio Survives as Long as You

In last week's post, we briefly touched on some ideas - diversification and spending buckets - for minimizing the effects of poor returns early on during retirement, termed sequence of returns risk. Today we'll delve further into diversification and a number of other techniques for controlling sequence of returns risk and the follow-on risk of the portfolio running out of money during retirement.

1) Diversification
As we noted lest week, diversification works well through the counter-balancing effects of un- or weakly-correlated asset classes. Here are some ways to exploit this best:

  • Additional asset classes - Every additional asset that is less than perfectly correlated with the others helps, though the effect tails off. The basic combination to create the simplest possible portfolio of two-holdings is Stocks/Equities and Bonds. Additional holdings that help diversify include: real estate (REITs), real return bonds, cash/T-Bills, commodities or just gold, and foreign equities, sub-divided into developed markets and emerging markets.
  • Consistently low-correlation combinations of asset classes - One reason gold has been so useful in the Permanent Portfolio, is its consistent lack of correlation with every other asset class, including during the 2008 financial crisis stock meltdown when gold went up strongly. In contrast, in 2008 some asset classes, like all the equities and REITs, that had formerly exhibited beneficial reasonably low correlations suddenly became highly correlated. 
2) Low Volatility Funds
Within equity ETFs, in the last few years some funds have come on the market explicitly designed to be much less volatile than traditional broad cap-weighted ETFs while still being fairly representative of the broad market. Examples are the BMO Low Volatility Canadian Equity ETF (TSX symbol ZLB) and the Powershares S&P 500 Low Volatility Portfolio (NYSE: SPLV), both of which have, in the two or three years since their inception at least, been much less volatile (2 to 3% less annualized standard deviation of daily returns) than respective broad index funds, as can be seen by plugging their symbols (use ZLB.TO) into the handy calculator. In addition to ZLB and SPLV, there are a number of other domestic and foreign low volatility funds - see our review of the concept and the pros/cons in this post of January 2012.

Similarly, many dividend stocks and dividend ETFs exhibit less volatility than broad cap-weight index funds, as we saw back in January when we compared Canadian dividend ETFs.

Lower volatility can also be found among bond funds less exposed to interest rate shifts due to the shorter term and duration of their holdings, though there is the downside that returns will be less too. This can be seen, for example, in iShares Canada's table of fixed income funds.

A variation on the theme of reducing volatility is to directly balance the volatility risk of the portfolio holdings, as we showed in this post. The result, however, is a significant shift in weighting towards generally lower return bonds.

3) Rising Equity Allocation during Retirement
Completely opposite to what many people have long been told, as expressed in the rule of thumb to hold your age in more stable bonds and the rest in equities (e.g. a 65 year-old would have 65% in bonds and 35% in equities, a 75 year-old 75% in bonds and 25% in equities), retirement researchers Wade Pfau and Michael Kitces tell us in Reducing Retirement Risk with a Rising Equity Glide-Path that a retiree has less chance of running out of money at all before dying, and less of a shortfall (running out fewer years sooner) when a portfolio did run out early, if the equity allocation at age of retirement was a relatively low 20% to 40% and then was increased steadily year by year to the 40% to 80% range. This makes intuitive sense - having less of volatile equities when one is most vulnerable to sequence of returns risk early limits the possible downside. 

The study looks at a number of scenarios, a sobering one being future returns much lower than past history: 3.1% (vs 6.46% historical long term average) compounded after-inflation for equities and more or less nothing 0.06% (vs 2.35%) for bonds. Using those lower assumptions, which reflect current market conditions, the initial 4.0% withdrawal rate of portfolio value at start of retirement, upped yearly by inflation thereafter, cannot be sustained. Only a rate of 3.0% withdrawal would be feasible, per the chart below in the outlined green cell, and even that leaves a 10% chance of portfolio failure before death assumed to be 30 years after retirement. Scary! 

Of course, a retiree is not obliged to continue taking out 4% annually no matter what. Probably that wouldn't happen if a retiree saw money running out, spending would be curtailed. There are other portfolio withdrawal strategies that vary the amount of money withdrawn each year.

4) Flexible and Variable Portfolio Withdrawal Strategies
  • Constant percentage of portfolio value at start of year - A retiree could take a snapshot of portfolio value every January 1st and withdraw 4% of the balance, or some other percentage. The problems with this approach are that i) market shifts could mean large differences in amount available to spend, as even those with diversified portfolios have experienced and ii) setting the percent withdrawal too high, much above 5% or so, would still risk depleting the portfolio. Though by definition the portfolio would never run out of money, it could get very small quickly.
  • Floor and ceiling spending - This type of strategy sets a minimum real dollar spending level, after years of down markets and a maximum for good market return years. Financial advisor and author William Bengen, in his classic book Conserving Client Portfolios During Retirement, calculated that based on historical returns in the USA, which slightly exceeds those in Canada, a spending range of +/- 5% permitted a starting withdrawal rate of 4.9%. On a $500,000 portfolio at start of retirement, that would allow withdrawals of $24,500 in the middle and a range from $23,275 to $25,725.
Fund provider Vanguard makes an insightful comparison of the two above strategies plus the fixed 4% case in this paper

Another Kitces article that seems not to be available free online discusses a series of variables, such as diversification through additional asset classes, fees, differential taxes on interest, dividends and capital gains, spending flexibility, varying time horizon, good/bad economic environment, and their impact on possible withdrawal rates. AUM in a Box blog summarizes the key findings in this post.

One approach that no one seems to propose to retirees is to plan spending according to the rising-with-age percentage withdrawal rate that is imposed for RRIFs and other types of registered retirement plans in Canada. It may be a way for the government to force the deferred taxes in such plans to be paid back but it isn't a useful retirement income strategy, though ironically it does reduce sequence of returns risk by keeping withdrawals lower at the start of retirement.

5) Annuitize 
Purchasing an annuity, which pays out a pre-determined amount,  completely avoids the risk of market fluctuations in a retirement portfolio for whatever proportion or amount that is annuitized. The reluctance of the majority of retirees to buy annuities, which is what economists think is the rational action, puzzles economists to the point they call the reluctance the "annuity puzzle". The annuity puzzle is much debated.,as can be seen in advisor Michael Kitces' Annuities vs Safe Withdrawal Rates: Comparing Floor/Upside Approaches, which has many thought-provoking comments from other advisors who put forward practical reasons for and against annuities.

6) Safe Savings Rate
A final method, which applies to younger people near the start of their working and savings phase, is Wade Pfau's proposed Safe Savings Rate. According to Pfau a person can, based on historical data, set and carry out throughout his/her working life a rate of savings as a percentage of income that ensures a certain level of retirement income. 

7) Toss that Bucket
By the way, the possibility of using a strategy of different buckets was also examined by financial advisor Jim Otar of Retirement Optimizer. In his 10 Bucket Strategies that Don't Work, he calculated what would have happened using actual market returns for any retiree from 1900 onwards and found none of the ten bucket strategies provided failsafe portfolio survival.

Pfau's blog post includes a note investors must remember - despite all the on-going research on retirement, it is still very hard to assure success and to know if we are a path that will ensure success: "The new article also emphasizes how hard it really is to know if one is on track to meeting a wealth accumulation target by a given date." Even the experts cannot tell, so we individuals must stay flexible and be ready to adjust as required.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 12 May 2014

Why Retirees Need to be More Concerned about Portfolio Volatility

Whether or not retiree investors have a more cautious attitude, often termed lower risk tolerance, the fact is they should look to build a portfolio that is less volatile. Why? The reason is something termed sequence of returns risk, the chance that the year by year order of portfolio returns may have significant downside early on during retirement, even when over the long term returns are strongly positive.

To demonstrate, let's have a look at some simple examples, comparing i) a retiree making annual withdrawals from a portfolio, ii) another investor in savings mode putting in an annual contribution and, iii) a third investor who invests a large lump sum, perhaps an inheritance, and leaves it to grow. We'll use identical returns across various sequences of returns to see how dramatically the end results can differ.

The Returns and Investor Scenarios
  • Retiree: Starts with $100k retirement portfolio and withdraws $20k a year
  • Accumulator: Starts at zero and puts in $20k per year
  • Inheritor: Receives $100k and invests it, making no further contributions or withdrawals
  • Five years, combining 20%, 0%, 20%, 15% and minus 5% with the negative year being either at the beginning the middle, or the end. 
  • As a variation we change the 15% and minus 5% to 21.38887% and minus 10%, keeping the other three years the same. 
  • Our sets of numbers all correspond exactly to a smooth equal compound annual return of 9.485546% (spreadsheets are just as easy for making numbers precise as approximate).
Inheritor - This situation is simplest, since there is absolutely no variation in end value, no matter what the sequence of returns turns out to be. Any order of returns gives exactly the same end result, $157,320 after five years. Volatility doesn't matter to such an investor. Unfortunately, most investors live in a different more complicated world with either contributions or withdrawals.

Accumulator and Retiree - For both these types of investor, the end value varies, but especially so for the retiree. Building a similar table to the one above, we have summarized the results in the chart below, which shows how much after five years the end value of the portfolio varies from the simple case of smooth constant annual returns of 9.485546%. The worrisome situation for the retiree is under-performance at the beginning of withdrawals and it is most worrisome when the drop is larger, even when it is followed by large gains afterwards. As is often said, taking money out a portfolio when it has endured a market value loss can permanently damage it.

In contrast, the accumulator doesn't suffer nearly as much. Intuitively that makes sense since he/she doesn't yet have much money at stake.

How to counter these damaging effects?

Reduce portfolio volatility by diversifying
Holding a number of types of assets whose returns move as little as possible in sync is the most powerful method for reducing the overall volatility of a portfolio. We recently illustrated this idea in analyzing the Permanent Portfolio's reason for success, discussed how to do it directly last year in a post on how to minimize portfolio volatility and compared the volatility of several model portfolios in this 2013 post.

Retirees to avoid the problem of volatility by a bucket strategy?
A more controversial, though often used, strategy is for retirees to keep enough non-volatile cash or short term bonds to fund several years of retirement spending and thus avoid having to sell volatile assets like equities after a market drop. Noted retirement researcher and finance professor Moshe Milevsky doesn't think much of this approach calling it a financial placebo and dangerous mirage, while financial planner Michael Kitces writes that it more or less works out to the same as a conservative asset allocation. One technique that works for sure, because it takes some of the investment funds and leaves them inside the portfolio to work like the lump sum investor's experience, is for the retiree to reduce spending in down market years.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.