Tuesday, November 9, 2010

Volatility Gremlins

The term 'Volatility Gremlins' was coined by Ed Easterling of Crestmont Research to describe how volatility impacts the growth of investment portfolios. The term is perfect. Gremlins are annoying, but not particularly dangerous - unless there are a great many of them. They might take food while you aren't looking, or throw your laundry on the floor. Maybe they'll play little jokes on you, like hiding your keys, or your wallet. You wouldn't want one as a pet, but neither would you be frightened if you encountered one on a hike.

Volatility Gremlins play similar tricks with your portfolio. You may hear that markets have gone up by 8 percent per year, but you've only seen 5%. Your financial plan might say you can safely take $70,000 per year in retirement income, but your nest egg is shrinking more quickly than expected. What's going on?

Volatility Gremlins work by tricking you into thinking average returns are the same as compound returns. Let's work through an example.

If you experience returns of 5%, -15%, and 25% over three years, your average return over the 3 years is 5% per year. However, your compound return is just 3.7%. Those sneaky Volatility Gremlins snatch away 1.3% per year, or over 25% of your returns! Not so harmless now, eh? Table 1. and Chart 1. show more examples of how a wider disparity (or volatility) in returns results in lower compound returns, even while average returns are constant at 5%. The example above is 'Case E' below.

Table 1. Volatility Effect on Average and Compound Returns
Source: Crestmont Research, Butler|Philbrick & Associates

Chart 1. Volatility Effect on Average and Compound Returns
Source: Crestmont Research, Butler|Philbrick & Associates

Volatility Gremlins really hit above their weight class when you are taking money from your retirement portfolio to meet living expenses. In this case, the nasty critters can make off with a very substantial portion of your annual income, if you aren't careful. This is because of the impact of taking money from your portfolio during periods when it has declined in value. Money that is withdrawn when markets are down can not be used to help the portfolio recover.

So how much of your annual retirement income might Volatility Gremlins be snatching from your wallet when you aren't looking? The amount could be quite substantial. Chart 2. illustrates the impact of increasing levels of volatility on the retirement income of an average retiree.

Chart 2. Higher Volatility in Retirement Portfolio Results in Lower Safe Portfolio Income

Source: Milevsky (2005), Faber (2010), Shiller (2010), Butler|Philbrick & Associates. For Illustrative Purposes Only

Astute readers will notice that Volatility Gremlins get very excited at the idea of pilfering income from retirement portfolios. In Chart 2. we can see the effect of increasing volatility on a $1 million retirement portfolio which:

  1. delivers 7% per year growth after inflation;
  2. for a retiree who expects to live another 25 years, and;
  3. who wants to be 85% confident that he won't run out of money.
Observe that a retiree with a low volatility portfolio, at say 7% annualized volatility (green bar), can safely withdraw over $71,000 per year. In contrast, a retiree with a volatile portfolio, at say 17% annualized volatility (red bar), can safely withdraw less than $52,000 per year. The Volatility Gremlins make off with 36% of the latter retiree's income!

I have spilled much ink describing ways for investors to lower risk in portfolios, so I won't go into the details here. You will note in Chart 2. that I make reference to Faber's Tactical Asset Allocation portfolio as a lower risk alternative. Readers who are interested in methods to capture robust returns while dramatically lowering portfolio volatility are invited to visit our web site (http://www.macquarieprivatewealth.ca/specialist/butlerphilbrick/case-studies) for more articles and studies.

Monday, September 27, 2010

Paul Volcker Invalidates Modern Portfolio Theory

US Federal Reserve ex-Chairman Paul Volcker, whose policies under President Carter in the later 1970s and early 1980s single-handedly stuffed the inflation genie back into its bottle, and laid the foundation for the world's longest period of uninterrupted growth, set aside his prepared remarks at a Federal Reserve of Chicago event yesterday and instead delivered a "blistering, off-the-cuff critique leveled at nearly every corner of the the US financial system", according to the Wall Street Journal. In addition to rants about "relentless corporate lobbying by banks and politicians to soften the rules" and candid remarks about how the "financial system is ... absolutely broken", Volcker had this to say about financial markets:
"Normal distribution curves - if I would submit to you - do not exist in financial markets. It's not that they are fat tails - they do not exist. I keep hearing about fat tails, and Jesus, it's only supposed to occur every 100 years, and it appears every 10 years!"

This statement is a startlingly frank denouncement of the very foundation of contemporary investment theory. The primary assumption of Modern Portfolio Theory, and its corollaries, the Efficient Markets Hypothesis, and the Black-Scholes Merton model, is that financial market returns conform to a normal distribution. If we acknowledge the possibility that financial market returns do not conform to a normal distribution, we must by extension reject the validity of MPT.

Readers might be familiar with this chart, which plots the distribution of actual monthly stock market returns from 1870 through 2009. Note the spikes on the curve far out to the left and right. If you look closely (or click to bring up a larger version of the chart), you can see the statistical likelihood of these monthly returns occurring if we assume returns ARE normally distributed. Note the month at the far left which, under MPT assumptions, would be expected to occur just once since the big bang - how unlucky for us that it happened to occur in our lifetime.

Source: Shiller (2009), Butler|Philbrick & Associates

Of course, this is not news to clients of Butler|Philbrick & Associates and readers of this blog. We have posted often about the fallacy of MPT and the normal distribution, and how this fallacy affects investors (see here, here, here, here, here...). However, Mr. Volcker's statement should inspire substantial anxiety among the 'Thundering Herd' of Advisors and Consultants to the world's wealthy, who allocate billions of dollars of pension and wealthy investor capital to funds, managers and strategies which depend entirely on the veracity of MPT.

If you have observed a gap between the actual growth experienced by your portfolio, and the growth you expected to see in your portfolio, we may have discovered the culprit. Here's a 'back-of-the-napkin' theory:

Source: Butler|Philbrick & Associates

Tuesday, September 7, 2010

Do Past Returns Predict Future Returns? Not Very Well - In the Short Term.

An article in this week's Barron's (subscription required) cites a study by Eaton Vance where they analyzed 10-year rolling returns on the S&P 500 back to 1926. The study found that just 4% of 12-month periods experienced negative returns. They also discovered that average annual returns to stocks in the 10 years that followed periods with negative 10-year returns were 9.8%, with a range of 7.2% to 15%.

Unfortunately, the Eaton Vance study fails the sniff test in a number of important ways. First, while 10-year returns have been very poor, the current 10-year period began with market valuations over 4 standard deviations from long-term averages (See chart 1.) Current valuations, with a Shiller PE of 20.6, place stocks within the top quartile of valuations going back to 1870, despite stocks' poor performance over the past decade.

Source: Shiller (2010), Butler|Philbrick & Associates (2010)

In fact, an optimized regression of forward 10-year returns against prevailing Shiller PE provides for a mean expected real return to stocks over the following 10 years of 4.6%, versus a long-term average real-total return of 6.6% (see chart 2.)
Source: Butler|Philbrick & Associates

Further, a simple regression of 10-year returns to 10-year forward returns demonstrates conclusively that the relationship is statistically weak. In fact, the R-square of the regression yields an explanatory factor of just 10%. In other words, prior 10-year returns explain just 10% of future 10-year returns (See chart 3.).

Source: Shiller (2010), Butler|Philbrick & Associates

What we do know is that long-term returns can be quite volatile indeed. The following charts show rolling 10, 20 and 30 year real returns to the S&P since 1870. 

Source: Shiller (2010), Butler|Philbrick & Associates (2010)

Source: Shiller (2010), Butler|Philbrick & Associates (2010)

Source: Shiller (2010), Butler|Philbrick & Associates (2010)

Sunday, July 25, 2010

Reuters Interviews Butler|Philbrick & Associates' Adam Butler

Behavioral investing gains traction
Fri, Jul 23 2010

By John McCrank

TORONTO (Reuters) - Irrational reactions to the market chaos in recent years have led many investors to get an old market truism backwards: they've been buying high and selling low, and one result has been much more cynicism toward financial advisers.

To steady the ship, so to speak, many wealth management firms have embraced behavioral investing, which aims to eliminate emotions from investment choices.  When the market meltdown was at its worst, many investors panicked and moved from equities to cash. After seeing great swaths of their wealth wiped out, they sat on the sidelines as the market rebounded, only buying back in when the opportunity for bargains was gone.

Then the Dow dropped another few hundred points, and the masses surged for the exit once more.

"Everybody has behavioral biases that will get in the way of them making smart decisions unless they actively take steps to avoid it," said Adam Butler, a director of wealth management, and portfolio manager, with the Butler|Philbrick and Associates practice at Richardson GMP.

He said behavioral investing counters some of the problems of modern portfolio theory (MPT), which says that humans are always rational and will always make the right decisions to maximize wealth.

"Behavioral investing attempts to define how people actually behave as opposed to how they are assumed to behave in MPT," he said. From there, the process seeks to gauge investors' tolerance to risk and eliminate or reduce decisions that are based more on fear, or excess optimism, than on logic.

Butler's systems rely on quantitative data to identify trends early on and to identify when the trends have likely ended, which he said has helped his team to get better returns for clients than just a simple buy and hold strategy.

"Our systems have been validated in real time with existing portfolios and additionally, the systems that we use have been validated using data going back to 1973 and in fact, with one of our systems, going back to 1870."

"If we find that investors operate under a herd mentality, which is in fact what we see experimentally, then why don't we identify early on where the herd is going and position ourselves to ride those waves?"

Butler said people are about 2.5 times as sensitive to taking losses as opposed to gains, which often causes them to optimistically hold on to losing positions well past any reasonably expiry date, and to cash in winning positions too quickly.

He said the key is to have risk management processes in place before a position is purchased that can "short-circuit" behavioral biases, so that when the numbers say it's time to get out, there is no second guessing.

When dealing with new clients, Butler has them bring in their portfolios from their previous advisers.

"What we often find are a bunch of positions on the statement that have been there for a very long time, that are down a lot and that nobody has ever taken the initiative of selling in order to move into more prospective opportunities."

In its recent 2010 Global Wealth Report, Bank of America Corp's Merrill Lynch Wealth Management said that "while behavioral finance has not been widely integrated into wealth management to date, it is gaining momentum as firms seek to navigate the new challenges in the investing environment."

It said that as part of the approach, firms were looking to help clients identify their true risk tolerance by more deeply trying to understand the investor's overall goals.

Butler said he thinks that means that big firms are beginning to realize that the risk that people say they are able to tolerate when markets are calm, changes dramatically when markets go haywire, and that puts investors in a position to make bad choices.

The solution? "Avoid putting investors in a position where they are likely to make poor, emotionally based choices," he said.

"Our systems took us to about an 85 percent cash level by the end of May, and so at the end of July, we will re-evaluate and see what the systems tell us.

"We don't act inter-month, because the volatility is just too high in that time frame."

(Reporting by John McCrank; editing by Rob Wilson)

Friday, July 23, 2010

Market Update: July 23rd, 2010

This is a quick update on markets and models.

As you know, markets swooned in April, May and June, culminating in a nearly 12% loss for average Canadian investors in global stocks at the deepest stage of the decline. Market risk doubled between April and June as measured by standard volatility measures.

The three primary risk management layers in our models were extremely effective during this period:
  1. Put options bought in late April as insurance paid off as markets fell from their April peak
  2. Many positions were sold on the first wave down in early May as stop losses were hit
  3. The small number of remaining positions, ex gold, were sold for cash at the end of May
Models, and hence client portfolios, are essentially flat from their peak in April. We are currently over 90% cash and bonds, and awaiting fresh signals.

Whither Markets?

That said, we are on the verge of something meaningful happening. We are currently managing three scenarios:
  1. Global stocks turn lower immediately and we proceed into a deeper plunge
  2. We break higher, with commodities leading, but we fail between S&P 1130 and 1160 and then reverse into a deeper plunge
  3. We break higher for a sustainable multi-month trend
Models are currently positioned for scenario 1, but we will know if the next day or so whether we need to position short-term for Scenario 2. Our long-term trend indicators will then provide direction at the end of July so that we can position for a possible Scenario 3.

It is important to remember that it is not enough for the economy, or the companies that operate within it, to deliver strong results. If the participants in the market are already expecting strong results, then the economy must do even better than expected to drive markets higher. John Maynard Keynes draws a worthwhile comparison with a beauty contest:
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).
We are thus awaiting signals based on actual capital flows to determine whether average market participants are more impressed, or less impressed than they expected to be. In investing, the large drives the small, so we focus on the biggest, most liquid, most important markets around to judge major changes in trend. It has been the case since 2003 that Asian markets have driven global growth, and this is no less so today. Given the amount of debt (leverage) in the system, Asian growth trends are even more important today than ever. Thus, we are focused on the strength of a basket of Asian currencies (excluding the Japanese Yen), as an indicator of broad Asian growth. The chart for this index is below (Chart 1.)

Chart 1. Asian Dollar Index
Source: Bloomberg, Butler|Philbrick & Associates

Note that this index of Asian currencies has been moving sideways since late April. Should the index break through the upper trend-line near 111.50, this would trigger Scenario 2 by sending a meaningful signal that markets are prepared to allocate capital to growing Asian countries, and this would be a positive signal for markets. We would layer into model positions for Aggressive clients on a break of this line. A break of the 112 line would signal Scenario 3 represent a higher intermediate term high for the index, and send a strong signal of a sustainable up-trend, and would lend confidence to a decision to reinvest cash in all client portfolios.

The exchange rate between the Australian dollar and the Japanese Yen has been an excellent indicator of investor confidence in global growth, as Australia is a major provider of commodities to the Asian growth countries, while Japan is a net importer of nearly every commodity. This indicator has also been consolidating since late April. A break of the upper trendline (Chart 2.) would signal Scenario 2, confirming renewed optimism in global growth, and would lend further confidence to our decision to reinvest client cash. A close above 78.60 would confirm this new up-trend defined by Scenario 3.

Chart 2. Australia Dollar / Japanese Yen Cross

Source: Stockcharts, Butler|Philbrick & Associates

Last, but certainly not least, the U.S. Treasury market has indicated a high degree of skepticism regarding the very recent optimism as reflected in rising stock prices. The debt markets swamp the equity markets in terms of size and sophistication, so we watch Treasury yields closely for confirmation of stock and commodity price moves. So far, Treasuries have NOT confirmed the recent stock price rally, so we would like to see Treasury yields break the upper trendline (Chart 3.). A break of this upper trendline would signal Scenario 2. If U.S. Treasury Yields trade above 3.10% (31 on the chart below), we would interpret that as a final trigger for Scenario 3.

Chart 3. U.S. 10-Year Treasury Yields

Source: Stockcharts, Butler|Philbrick & Associates

Tuesday, July 20, 2010

Jekyll or Hyde Market

Readers will undoubtedly be familiar with Robert Louis Stevenson's famous tale, The Strange Case of Dr Jekyll and Mr Hyde. The story centers around a well respected (though hardly innocent) physician, Dr. Henry Jekyll, who produces a potion which causes him to transform into a cruel, sadistic, evil Mr. Edward Hyde. Wikipedia asserts that the story is, in fact, "an examination of the duality of human nature (that good and evil exists in all), and that the failure to accept this tension (to accept the evil or shadow side) results in the evil being projected onto others." This article takes the position that markets have a duality of nature that mirrors the personalities of Jekyll and Hyde, and that traditional investment techniques ignore the existence of Hyde, thus inflicting pain and suffering on unsuspecting investors.

It is a foundational principle of modern investment theory that market volatility is utterly random, with major swings up or down interspersed with minor moves with no discernible pattern. This principle is put to use in the construction of trillions of dollars of investment portfolios, and is an argument commonly put forth by large investment firms in marketing and sales material to justify their buy and hold approach. If volatility can not be predicted, they claim, then why try to avoid it?

To supplement this argument, firms and Advisors often show statistics or charts which allegedly demonstrate how missing the best days or months in the market will result in dramatically lower returns. They go on to conclude that these best months are impossible to predict in advance, so investors must be fully invested all the time in order to experience these great returns. However, a simple review of the evidence should cast doubt on the validity of this assertion.

Is It So Bad to Miss the Best Months In the Market?

The chart below (Chart 1) shows the returns to 3 portfolios invested in U.S. stocks from 1870 through 2009. The red line shows the returns to a portfolio which managed to avoid the 10 best performing months over the past 140 years. The purple line shows the returns to an investor who bought and held stocks for the entire period. Note that the investor who missed the best 10 months was left with about $16,000 at the end of the period, versus the buy and hold investor with $85,000. This is the message that many Advisors deliver to clients: buy and hold works because you must be invested during the best periods.

Chart 1. U.S. Stock Market Returns, 1870 - 2009, Excluding Best and Worst Months
Source: Shiller (2009), Butler|Philbrick & Associates

Unfortunately, this assertion does not stand up to the evidence. To whit, the blue line in the chart shows the returns to an investor who managed to avoid the 10 worst months in the markets. This investor earned $563,000 in comparison to the buy and hold investor's $85,000. Perhaps we should be seeking to avoid losses, rather than seeking to maximize our exposure to strong returns...

The most important line on the chart, however, is the green line, which shows the returns to an investor who managed to avoid both the 10 best, and the 10 worst months of the past 140 years. You will notice that the green line tracks the purple line (buy and hold) very closely over the entire period. Amazingly, an investor who is able to avoid the 20 most extreme months, both positive and negative, experiences virtually the same growth as a "buy and hold" investor.

What the "buy and hold" shills inevitably fail to reveal is that the best months in the markets occur directly adjacent to the worst months in the markets. For example, 6 of the 10 best months in the stock market occurred during the Great Depression, 2 occurred during the secular bear market of the 1970s, and 1 occurred during the 2008/2009 market crash. These are long periods where investors would have been much better off in cash than in stocks, despite the intermittent sharp monthly rallies that occurred.

The phenomenon whereby the strongest months and the weakest months occur right next to each other is called 'volatility clustering'. Remember that Modern Portfolio Theory (MPT) is founded on the principle that market volatility is random and unpredictable. Instead, we find that market volatility clusters and is quite predictable. In fact, the best predictor of future volatility is current volatility. This contradiction with the assumptions of Modern Portfolio Theory is just one more nail in the coffin.

Boil and Bubble, Toil and Trouble

It turns out that markets do not transition smoothly and randomly from periods of low volatility to periods of high volatility. The evidence shows that, in stark contrast to MPT assumptions, markets are either very calm, or utterly terrified; further, there is no middle ground. 

There is a term for this type of dynamic, where a system is either in one state or another, that is derived from the physical sciences: phase transition. A simple example of this is when water turns to ice or steam. During this phase transition there is no middle ground; water is either a solid (ice), liquid (water), or gas (steam). In the same way, markets are either calm or terrified.

If markets behaved as Modern Portfolio Theory asserts, then market returns should be distributed according to a standard  bell curve. The charts below show the actual distribution of market returns against the theoretical bell curve expectations of MPT (Chart 2), and the differential between them (Chart 3.). The dotted line in Chart 2. is the standard bell curve; notice that the actual return distribution is much taller in the middle (lots of small returns), and has lots of spikes way out on the sides.

Chart 2. Daily Return Histogram, S&P 500 1978 - 2007 vs. Bell Curve
Source: Mauboussin, 2007

Chart 3. simply subtracts the actual frequency of returns from the expected frequency of returns (subtracts the solid line from the dashed line in the chart above), to show the difference between the two curves. Notice how the market delivers far more small daily returns than the model predicts. This makes sense given the tall spike in the middle of Chart 2. Also notice that the market delivers far more extreme returns than expected by the model, which are reflected in the spikes far out on either side of Chart 2. Perhaps even more interestingly, the market delivers very few days with mid-sized returns. You can clearly see this on Chart 3. depicted as points below the zero line.

Chart 3. Daily Return Histogram: Frequency Difference vs. Bell Curve, S&P 500 1978 - 2007
Source: Mauboussin, 2007

We can deduce from this frequency distribution that markets are almost always in one of two distinct states: calm or panic; kind or cruel; Jekyll or Hyde. Volatility is either very high, or very low, with few periods in between. So where would we find the 10 best and 10 worst return periods on the charts above? That is, where would we find volatility clusters? Clearly they would occur during cruel and crazy Mr. Hyde markets, not during kind, calm Dr. Jekyll markets. So is there a way to identify when markets are likely to reflect Dr. Jekyll (risk is low), and when they are likely to transform into Mr. Hyde (risk is high)?

Diagnosing Panic

Fortunately, it is quite possible to identify when markets are likely to be transitioning from periods of calm to periods of panic, and vice versa. It turns out that one can use a simple 10-month moving average, for example, to signal when a market is vulnerable to such a phase transition. This moving average does an excellent job of dividing markets into states of low and high volatility. When markets trade above the 10-month moving average, average returns to stocks are high, and volatility is well below average. In contrast, when markets close out the month below the 10-month moving average, investors should prepare for a period of high volatility and low returns. Chart 4. shows a simple 10-month moving average against the S&P 500 stock market.

Chart 4. Example of 10-Month Moving Average Line versus S&P 500
Source: Faber (2009)

The following charts divide the market into periods of calm, and periods of panic, and compare returns and volatility during each these periods. We have chosen to draw the 'panic line' at the 10 month moving average, so the blue bars in the charts show returns and volatility when each of the various asset classes is trading above its respective 10-month moving average. The red bars show returns and volatility when markets are trading below their 10-month moving averages.

Chart 5. Returns to markets above and below a 10-month moving average (1973 - 2008).
Faber (2009), Butler|Philbrick & Associates

Chart 6. Volatility of markets above and below a 10-month moving average (1973 - 2008).
Faber (2009), Butler|Philbrick & Associates

It should be obvious from the charts that returns (blue bars) are much higher when markets are trading above their 10-month moving averages, while volatility is substantially lower. In fact, on average over the 5 markets tested, calm markets trading above their 10-month moving averages delivered returns over 6 times higher (13.83% vs. 2.19%) than panicky markets, and at just 75% of the volatility (14.35% vs. 18.86%). Further, the average volatility is skewed higher by commodities, which tend to move higher under panicky conditions (wars, blockades, earthquakes, etc.), in contrast with the other asset classes which tend to drop.

I Know It When I See It
"I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description [pornography]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that." 
Associate Justice Potter Stewart, Concurring, Jacobellis v. Ohio, 378 U.S. 184 (1964)

It is instructive to discuss the bipolar nature of markets in the aggregate by contrasting the natures of the two characters (Jekyll and Hyde) via a discussion of average returns and volatility. But it is, perhaps, equally instructive to demonstrate how these different personalities manifest in the market. To that end, the charts below show the S&P 500 stock index during periods where the market is calm and Jekyll-like, and during periods when it is cruel and Hyde-like. The two personalities are unmistakable, even to the untrained eye!

Chart 7. S&P 500 Jekyll Market 1995 - 2000

Chart 8. S&P 500 Hyde Market 2000 - 2003

Chart 9. S&P 500 Jekyll Market 2003 - 2007

Chart 10. S&P 500 Hyde Market 2007 - 2009

Chart 11. S&P 500 Jekyll Market 2009 - Mar 2010

Chart 12. S&P 500 Hyde Market Mar 2010 - Today

It helps to look at charts of actual market behaviour to get a sense for what Jekyll and Hyde markets look like in real time. Note that last chart; it sure has been nice to be in cash during Hyde's recent appearance!


Investment markets have a dark side that is not generally acknowledged by the firms, advisors and consultants who manage portfolios according to the precepts of Modern Portfolio Theory (MPT). In contrast, investment firms and many advisors loudly and confidently assert that investors should own stocks in a fixed allocation through any and all types of markets. In marketing literature, these advisors point to MPT's assertions that market risk is unpredictable and randomly distributed as evidence that investors shouldn't try to time the market.

In examining actual market data, it is clear that markets have two independent personalities, and that investors would be well served to avoid markets when they are panicky and cruel. We see that market volatility 'clusters' around periods of market panic, rather than being randomly distributed, and that these periods of panic can often be confidently identified by using a simple monthly moving average. Investors who take the extra step of identifying the general personality of the markets will likely be rewarded with higher returns and less emotional distress.

Friday, July 2, 2010

The Three Horsemen of Retirement Apocalypse

We have stated many times in past articles that the brain uses facts as factors, but makes decisions on emotion. This article will present some extraordinarily important facts for people approaching, or already in retirement. Unfortunately, the facts alone are unlikely to motivate readers to change their behaviour; for most of us, it generally takes substantial emotional trauma to compel us to change. For example, smokers may continue to smoke until someone close to them is diagnosed with lung cancer. Interestingly, it has been established that even doctors are vulnerable to this type of cognitive dissonance. To whit, the likelihood that a physician is a smoker relates directly to how much their individual specialty relates to the lungs. Respiratory and cardiovascular specialists are least likely to smoke, while psychiatrists and podiatrists are most likely.

In the same way, most investors will not come to grip with the new realities of retirement until it is too late. The investment industry spends billions every year to maintain the illusion of certainty about long-term market returns, and most investors buy into this because it supports their emotional need to feel like they are in control. As humans, we do not handle ambiguity very well, so most of us avoid it where possible, even when it means potentially sacrificing our future. It is not the policy of Butler|Philbrick & Associates, however, to tell our clients what they want to hear. There are thousands of Advisors across Canada who will be happy to accommodate you in this. Instead, we are committed to telling our clients the truth, so that we can make smart decisions today that provide the greatest likelihood of future happiness.

The 3 Threats to Retirement Success

In light of our continuing effort to promote a more scientific approach to managing wealth, this post will focus on the three biggest threats to retirement success. These threats are (drum-roll please):
  • The threat of inflation eroding purchasing power
  • The threat of living longer (or less long), than you expect
  • The threat of poor or negative investment returns, especially early on in retirement

Most investors are aware of these threats, but most Advisors do not effectively address the tug of war that exists between them. For example, most investors would avoid the stock market roller coaster in favour of safe bonds and cash, if they felt this solution would deliver retirement success. Unfortunately, retirees have to deal with the fact that safe assets like bonds do not effectively protect them against inflation. At the same time, stocks carry a significant risk of losses, especially over short time periods like ten years. Chart 1. shows that stocks have delivered between -6% and +20% over 10-year periods during the past 140 years. So what is one to do?

Chart 1. Annualized 10-Year Stock Market Returns, 1870 - 2010
Source: Butler|Philbrick & Associates, Shiller (2010)

Risk #1: Inflation

Inflation occurs when the price of goods and services increases slowly over time. The mechanism by which inflation occurs is actually subject to some debate, but this is less important to retirees. What is important is how inflation can impose significant restrictions on lifestyle over time. 

Inflation can be a difficult thing to wrap one's mind around, so examples are helpful. Postage costs are one good example: in 1950, a 1st class Canadian stamp cost 4 cents. Today, it costs 57 cents + GST to send a letter in Canada. This represents 4.53% per year in inflation over that time period. If we apply the same rate of inflation to a $1.00 bottle of Coke today, that same can would have cost 7 cents in 1950.

The chart below shows how the purchasing power of income declines over time due to inflation. Put another way, the chart shows how a fixed retirement income can purchase fewer and fewer more expensive goods and services. Note that $100,000 will only buy $70,000 worth of goods and services after just 10 years; purchasing power is cut in half after 19 years.

Chart 2. Purchasing power of $100,000 erodes over time due to inflation
Source: Butler|Philbrick & Associates

Most Advisors incorporate some sort of inflation forecast into portfolio return expectations when creating financial plans. This is better than completely ignoring the effects of inflation, but it ignores that fact that inflation also impacts the returns to other asset classes, like bonds and stocks. For example, bonds do especially poorly during periods of high inflation, so a high allocation to bonds 
would have very negative consequences should inflation accelerate higher. Conversely, stocks do very poorly in periods of negative inflation, or deflation, such as during the Great Depression when stocks dropped almost 90%.

Our methodology does not use a specific inflation forecast. Instead, we use monthly portfolio return numbers based on actual market returns that go back to 1870, and are already adjusted for inflation. This is an important difference, as this method explicitly incorporates the relationship between inflation and portfolio returns, rather than assuming that it doesn't exist. Traditional models assume that inflation rolls merrily along at 3% per year, even during the Great Depression. This assumption has serious implications for investors that are drawing retirement income.

Risk #2: Longevity

Longevity risk really refers to two related risks:

  1. The risk that you save too little, or spend too much, because you end up living longer than you expect. In this case, you run out of money before you pass.
  2. The risk that you save too much, or spend too little, because you end up living less long than you expect. In this case, you make needless sacrifices to lifestyle.

Traditional financial plans use a specific point estimate for lifespan; they usually assume death on a person's 86th or 91st birthday. This is tragically misguided however, as you can see from the table below. Table 1. shows the likelihood that a man, woman, and at least one person in a couple, will live to various ages, assuming that the person/couple has already reached age 65.

Table 1. Probability of Survival at Age 65
Source: The Society of Actuaries RP-2000 with full projection

You will note that the table indicates that 75 out of every 100 couples will see one person in the couple reach at least age 85; 50 out of every 100 couples will see one person live to age 90 or beyond
! With this knowledge, it seems foolhardy in the extreme to rely on a plan in which between 50 and 75 couples out of every 100 will run out of money.

If you are uncomfortable with a 50% to 75% chance of retirement failure, imagine instead being able to tailor your plan to minimize your chance of retirement ruin, while maximizing your lifestyle. Butler|Phlibrick & Associates applies a different approach that accounts for the wide range of possible lifespans, and their respective probabilities. Our approach enables clients to tailor their plan to accomplish their individual level of comfort and confidence. As an example, some of our clients are comfortable with a higher chance that they will run out of retirement funds before they pass. These clients may be able to accept as much as a 30% chance that they will have to dramatically cut back on their lifestyle in their later years, in order to maximize current spending. On the other hand, more conservative clients require near certainty that their retirement funds will see them through with comfort to the end.

Of paramount importance, our approach allows us to update clients on exactly how their spending and portfolio performance during each year has impacted their chances of retirement success d
uring annual review meetings. If markets have not cooperated, or if there was unanticipated spending during the year, we will discover that spending needs to be cut back, or portfolio risk needs to be adjusted, in order to move the plan back into an appropriate comfort zone. If on the other hand performance has been stronger than expected, clients may discover they have a surplus of cash. These fortunate clients have the option of maintaining their current standard of living, but enjoying a higher confidence in a successful retirement, or withdrawing a higher income to boost lifestyle expenditures. Image 1. below shows how retirement plans should be tracked over time to ensure clients remain in 'The Zone' to maximize their chances of balanced retirement success.

Image 1: Keeping clients in 'The Zone' during annual reviews
Source: Financeware.com

Risk #3: Poor or Negative Market Performance

You may have noticed that the first two risks are long-term risks. In the face of long-term risks like inflation, investors tend to behave like the proverbial frog in a pot of water that boils slowly. If you place a frog in boiling water, he will leap out quickly, grumpy but unharmed. However, if you place a frog in cool water and then boil it slowly, the frog will slowly die from the heat. In the same way, investors are unlikely to notice the effects of inflation over a period of a few years. Instead, they will wake up one morning many years from now to discover that their money only goes half as far as it used to. Perhaps they can no longer afford their membership at the golf course. Perhaps they are astounded at how much food costs, or how much of their monthly income is consumed filling the tank of their car with gas. Longevity risk manifests in the same way; slowly, and then all at once.

In contrast, market risk is often front and center in people's attention. They are bombarded with stock market prices every evening on the news, and every day in the papers. They receive a monthly statement and obsess over whether the value of their portfolio is higher or lower than in the previous month. Investors celebrate their peaks and grind their teeth at the troughs, mostly cursing the annoying roller-coaster ride of stock markets.

Strangely though most investors, and indeed Investment Advisors, fail to account for the volatility of stocks and bonds when they build retirement plans. Traditional plans are constructed with the inconceivable assumption that markets go up consistently every year. For example, many Advisors assume an 8% rate of return, and that investors will receive this 8% return every year, without fail. We have yet to meet an investor who has experienced the same return on their portfolio every single year. 

Rather, contemporary investors are used to seeing a wide range of returns, especially over the past ten years. Since June 2000, stock markets have lost over 25% of their value after accounting for inflation. This is catastrophic for people in or near retirement. Readers may be interested in reviewing some of our previous posts (click here for an explanation of our Gestalt Architecture), where we demonstrate how we strive to avoid these major long-term losses while still providing substantial exposure to growth assets.

Dr. Moshe Milevsky is a professor at York University School of Business, and sits on the boards of many Canadian and international life insurance companies. He may know more about retirement risks than any other person on the planet. In the following video, Dr. Milevsky discusses the importance of considering market risk, or what he calls 'Sequence of Returns Risk' when formulating retirement plans.

Video 1: Moshe Milevsky Discusses Sequence of Returns Risk

Source: ClientInsights.ca

In his presentations, Dr. Milevsky often performs a thought provoking exercise that illustrates how important it is to address 'Sequence of Returns' risk in retirement plans:

Sequence of Returns Example:
  • Couple age 65 with $1,000,000 in retirement wealth
  • Couple withdraws $7,500 per month in income from the portfolio
  • Annual expected investment return of 7% after inflation

He then introduces the idea of a rotating sequence of returns, where investors receive 7%, -13%, and 27% returns in years 1 through 3, and then the series repeats for years 4 through 6, 7 through 9, etc. He then changes the order of returns to see how this impacts the age at which the couple will run out of funds. This is illustrated in the Retirement Merry-Go-Round below.

Image 2:The Retirement Merry-Go-Round
Source: The IFID Centre

There are 4 unique ways that an investor can experience the returns from the Merry-Go-Round. In the table below, we show how these 4 sequences of returns affect when the couple described above runs out of money (Ruin Age), and how the actual results differ from what would be expected from a traditional retirement plan (the +7%, +7%, +7% example below).

Table 2. Ruin Age Under Different Sequence of Return Assumptions
Source: The IFID Centre

It is important to understand that the couple receives a 7% average return under each of the scenarios in the table above. However, despite the fact that average returns are constant, the order of those returns can impact the age at which the clients run out of funds by as much as 14 years! Poor returns early on would cause the couple to run out of funds in their 81st year, while strong early returns would see them safely through to age 95. The sequence of returns in the example may seem extreme, but in fact the example assumes a volatility of 20%, which is comparable to the historical volatility of stock markets.

You may be wondering whether it is better to have higher returns, or a more predictable sequence of returns. The following example (Table 3.) shows that it is much more important to avoid poor returns early on in your retirement than it is to increase overall average returns. The investor on the right, which receives 8% average returns, but has poor early returns (-12% in the first year), runs out of funds before her 85th birthday. In contrast, the investor on the left earns 7% average returns, but her funds last through age 95 because of strong early returns (+27% in her first year).

Table 3: Is It Better to Receive Higher AVERAGE Returns, or Better EARLY Returns?
Source: The IFID Centre

Two things should be clear by now:

  1. It is extremely risky to rely on a financial plan that does not account for 'Sequence of Returns' risk 
  2. It is extremely important to avoid large investment losses, especially early on in retirement 

Fortunately, Dr. Milevsky has provided a framework that allows us to model the risk of poor or negative market returns. His model also enables us to account for the range of potential lifespans and inflation expectations. His framework differs from traditional financial plans in the following ways:

For illustrative purposes, we provide an example of our proprietary model, which is based on Dr. Milevsky's research papers, found here and here. Note the table of inputs in the upper right of the image. The 'Expected Real Return' input is the return we expect on the portfolio, after accounting for inflation. The 'Expected Portfolio Volatility' input allows the model to account for 'Sequence of Returns' risk, while the 'Median Remaining Lifespan' input is related to longevity risk.

Image 3: Sample Sustainable Income Model with Confidence Interval
Source: Butler|Philbrick & Associates

So what happens when we plug some numbers into our model, using assumptions based on actual market returns, and including very conservative fees? The chart below shows the safe withdrawal rate from an all-stock retirement portfolio assuming 4.6% annual average returns (see posts here and here for why we chose this return), and assuming 0.5% in management fees (about what you would pay for a diversified basket of ETFs if you were to manage the portfolio on your own).

Chart 3: Safe Rate of Withdrawal for A Diversified Global Stock Portfolio
Source: Butler|Philbrick & Associates

The chart above demonstrates that, if one were to create a pure diversified global stock portfolio through ETFs, and manage it on one's own, current assumptions would provide for a safe income of 3.1% of current portfolio value. This means that, for every $1million in portfolio value, an investor can take $31,000 per year from the portfolio, adjusted each year for inflation. This is interesting, but unrealistic as most investors would, quite rightly, feel that a pure stock portfolio is too risky in retirement. So what happens if we invest in a balanced portfolio, with 50% stocks and 50% bonds (See Chart 4.)?

Chart 4. Safe Rate of Withdrawal for A Balanced Portfolio
Source: Butler|Philbrick & Associates

Interestingly, the model arrives at the same 3.1% safe withdrawal rate for a balanced portfolio, despite significantly lower expected returns of just 2.18%. This is because we have reduced our 'Sequence of Returns Risk' input by almost 50% by introducing a 50% bond allocation, because bonds are generally much less volatile than stocks. This underlines the importance of accounting for sequence of returns risk, or the risk of poor returns early in retirement.


We hope this article has helped to drive home the importance of explicitly accounting for all three of the major threats to a successful retirement. To reiterate, a realistic and useful financial plan must account for the following three risks:

  1. The risk that inflation erodes purchasing power from the portfolio over time 
  2. Longevity, or the risk of living longer, or less long, than we expect 
  3. 'Sequence of Returns Risk', or the risk of poor or negative returns early on in retirement

Most financial plans today do not account for the wide range of possible outcomes in either of the above variables. Please visit our web site to see how our Gestalt Architecture can deliver higher confidence, flexibility, and a substantially better lifestyle in retirement.

Thursday, June 10, 2010

CNBC Appearance

As promised, CNBC went ahead with an interview to discuss some of our team's more troubling findings. Click on the video below to see Butler|Philbrick & Associates' own Adam Butler discuss risky retirement planning, as well as some potential solutions, live on air with host Erin Burnett.

If you have any questions about points made in the video, please feel free to contact us directly by clicking our team photo on the right.

Friday, June 4, 2010


Parents will be familiar with the age-old question, ‘But why?’, repeated ad nauseum by children everywhere as they try to understand cause and effect in the world around them. My daughter, who is learning to spell, recently stumped me with this question in reference to the alphabetic keyboard on her word game console. She was typing away in the car when she asked, ‘Dad, why are the letters on the keyboard all mixed up?’ I asked her what she meant, and she described how her keyboard didn’t match the order of letters she had learned, namely ‘A, B, C…’. I told her it was because standard adult computer keyboards are arranged differently. This, of course, elicited the ubiquitous ‘But why?’

I decided to do some digging. The standard computer keyboard is arranged in a QWERTY pattern, so named because these letters comprise the top left-hand row of letter keys. This arrangement is actually quite inefficient. It turns out that only 32% of keystrokes for common English words use keys on the second row, while 52% of words use keys on the upper row. Remember, the second row is the ‘home row’, where experienced typists rest their fingers between words. Some very uncommonly used letters, such as J and K are both positioned on the home row.

So why are the letters arranged so strangely? It turns out the keys were configured in such a way to accommodate the mechanics of old fashioned typewriters. Recall that each arm of a typewriter had a small letter on it that, when the corresponding key was pressed, was drawn up to strike an ink ribbon. This left an ink letter on the paper. When the keys were struck in rapid succession however, they would often jam together. So the QWERTY keyboard was laid out in such a way as to slow down the typist to avoid jamming the machine. In other words, the QWERTY keyboard was introduced to offset the mechanical limitations of the original typewriter.

Of course, those mechanical limitations don’t exist anymore with computer keyboards. So why do we keep on using this poor configuration? ‘Buy why?’ As with so many things in life, the answer is simple: ‘Because that’s the way we’ve always done it.’

This got me thinking about how most Investment Advisors approach the investment process. Most Advisors still advocate for an archaic long-term investment approach called ‘Strategic Asset Allocation’, which suggests that an investor should decide on a basic allocation to stocks, bonds, and cash, and then stick with this allocation over the long-term, no matter what. With this approach, a growth investor that meets with an Advisor in January of 2000, at the peak of the technology bubble, will receive the same allocation to stocks as an investor who meets with his Advisor in March of 2009, at the bottom of the recent financial meltdown. Does it make sense that an Advisor should recommend the same allocation, say 70% to stocks, when markets are expensive and future returns are likely to be low (January 2000), as when markets are cheap and future returns are likely to be higher (March 2009)? That’s like recommending sandals, shorts and a t-shirt all year round in St. John’s. It makes sense sometimes, but certainly not all the time!

Most people, if they gave it some thought, would probably conclude that the QWERTY keyboard is not ideal, the same way they wouldn’t recommend that a visitor wear shorts and a t-shirt in St. John’s all year round. Yet Advisors and investors take for granted that a 70% allocation to stocks makes sense in all environments. ‘But why?’

Not surprisingly, the founding fathers of modern investing, like Warren Buffet’s mentor Benjamin Graham, did not adhere to this silly approach. Instead, they used simple but time-tested methods to tell if markets were cheap or expensive, and therefore if they offered the promise of strong or poor future returns. Their preferred method for valuing markets provides a very reliable estimate of future returns to stocks going back as far as 1870. Dr. Robert Shiller at Yale University makes the data to calculate this ratio available to the public, so it is a simple matter to demonstrate what this ratio has meant for inflation adjusted stock returns over time.

In the chart below, we show that investors experience successively worse returns from stocks when they invest in increasingly expensive markets. For example, investors lucky enough to start investing in the 20% of months where markets are least expensive, such as late 1982, 1974, and 1932, received average returns of 11% per year over the following 10 years. However, investors that invested in the 20% of months where markets are most expensive, such as 1929, 1967, and 2000, experienced just 1.7% per year in returns over the following 10-years. Would you knowingly take on the risk of a 70% allocation to stocks if you expected to receive average returns of just 1.7% per year, or might you look for somewhere else to put your money to spare yourself the stress?

Chart: 10-year returns following an investment in increasingly expensive markets.

You might be wondering whether markets are currently cheap or expensive according to this model. Unfortunately, markets are currently expensive, with valuations in the top 25% of all months back to 1870. A more detailed analysis of the data suggests that the average expected return over the next 10 years is under 5% per year. Investors may want to consider whether they are being adequately compensated for assuming high levels of stock market risk given return expectations in the bottom 30% of all periods since 1870.

Fortunately, investors need not be held hostage to a ‘Strategic Asset Allocation’ if they choose to follow some simple rules that identify whether it is favourable to own stocks, or whether the risks currently outweigh the rewards. We’ll be touching on these techniques, and the evidence that supports them, in future issues. In the meantime, those readers who would like an alternative to their QWERTY keyboard should investigate the Dvorak Simplified keyboard – Google it!