Beneath the Surface

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Consider socially responsible investing

A broader concept of sound investing

This principle is different from the others because it broadens the idea of “sound investment” to include more than the pursuit of good financial returns. Many investors wish to select investments that will not only meet their personal financial objectives, but also contribute to a better society. They would like the companies in which they are shareholders to be working toward desirable social goals, or at least trying to avoid doing harm.

Not all economists and financial planners like to distinguish between what is profitable and what is good for society, but the economic concept of “externalities” provides a rationale for making the distinction. Economic transactions can have costs and benefits for people who aren’t party to the transaction. Corporations and those who buy their specific products don’t bear the full costs of damaging the environment, or reap the full profits from developing new ideas that spread widely in society. Markets sometimes reward individuals for doing things that have negative externalities (social costs), and sometimes fail to reward individuals for doing things that have positive externalities (social benefits). In theory, socially responsible investors can help correct this by favoring “good” companies over “bad” ones.

The devil, of course, is in the details. How does one go about rating companies by social criteria? In his book With Charity for All: Why Charities Are Failing and a Better Way to Give, Ken Stern shows how hard it is to find out if a charitable organization is actually doing good work. If organizations whose mission is the betterment of society rarely publish adequate data about their effectiveness, one can hardly expect profit-making corporations to provide a fair assessment of their social costs and benefits. One approach to selecting companies is to avoid industries whose products you disapprove of, such as armaments, or fossil fuels, or beef. If your concern goes deeper, including not just the product but the specific environmental or labor practices by which it is produced, you will probably need the guidance of social investment specialists.

Social investment funds

A number of mutual funds now specialize in socially responsible investing, and their assets have been growing rapidly. Today about one out of eight investment dollars flows into this type of investment. A lot of that money comes from large institutional investors like pension funds, whose investment decisions can have a large impact on society.

Socially responsible investing takes several different forms. The most common form is screening securities so as to include in a portfolio only those that meet certain social criteria. Many social investment funds avoid investing in companies associated with tobacco, alcohol, gambling, weapons, or animal testing; and many look for good records on environmental protection, human rights, and employment policies. Secondly, funds often engage in shareholder advocacy by voting their proxies in support of responsible corporate policies, or proposing their own resolutions at shareholder meetings. Finally, a few funds invest in community development in low-income areas where capital is hard to obtain. These funds may operate community development banks, credit unions and loan funds to help finance small businesses, affordable housing and community services. Socially responsible investing may be referred to as SRI, or more recently as ESG, for environmental, social and governance.

A good source of information is the Forum for Sustainable and Responsible Investing at www.socialinvest.org. It reports the investment policies, performance and fees of many different funds.

A financial sacrifice?

Critics of social investing suggest that investors may be sacrificing superior returns by basing their investing decisions on anything but strictly financial considerations. Some investors might be willing to make such a sacrifice, but they may reasonably ask how large a sacrifice, if any, is involved.

Some of the criticism is based on the assumption that investors can get market-beating returns by investing in the highest-performing mutual funds. Investors who limit themselves to the relatively small number of SRI funds may be overlooking most of the best performers. However, this argument may exaggerate the connection between past and future performance, and as a result underestimate how difficult it is to achieve consistently above average results even with conventional funds. In theory, an investor who could always be in the most successful funds would make more money than the social investor, but in practice, most investors who chase performance fail to outperform the market in the long run, and more often underperform it once trading costs and expenses are factored in (see my discussions of expenses and opportunity). It may be more relevant to compare the social funds to the market averages than to the highest performing funds in any given year.

Advocates of index funds argue that most investors do better in the long run by accepting the average return of the market than by paying active managers high fees to try and select superior stocks. From that perspective, SRI funds are financially sound investments only if they can offer broad diversification at low cost. Many social funds are quite selective and have relatively high fees because of the research that has to go into company screening. Although it is easy to screen companies for obvious things like selling cigarettes, it is much harder to evaluate a company’s environmental and human rights record, especially if the company has many different enterprises in many different countries. On the other hand, some funds have tried to emulate index funds by developing as diversified a list of companies as they can, consistent with social screening. Funds that want to hold down their own research costs can obtain such lists from others. Overall, social investing is probably more cost-effective than it used to be, but still a bit costlier than straightforward indexing. While the least expensive index funds have expense ratios under 0.1%, expenses for social funds are usually at least 0.5%, with many over 1.0% or even 2.0%. Performance data tracked by the Forum for Sustainable and Responsible Investing shows most social funds underperforming the S & P 500 over the past ten years, many by several percentage points a year. This is due partly, although probably not entirely, to their expenses.

One of the largest and most cost-effective index funds is Vanguard’s 500 Index Fund Admiral Shares, with an expense ratio of 0.05% and average annual return of 8.52% from 2003 to 2013. Vanguard also offers the FTSE Social Index Fund. It tracks the FTSE4Good index, which screens companies according to such criteria as environmental sustainability, human rights, labor standards, and avoidance of tobacco products and nuclear weapons. With an expense ratio of 0.29% and average annual ten-year return of 6.88%, FTSE Social Index is one of the most cost-effective social funds. Still, $10,000 invested in 2003 would have grown only to $17,860 by 2013, while it would have grown to $20,732 in the 500 Index Fund.

Your bottom line

In the end, the best investment plan is the one that is most appropriate for your particular goals and circumstances. Your financial goals don’t exist in a vacuum, but they connect to your life goals and to all that you care about in your family and your community. Investment income can contribute to the quality of life, but it can also detract from that quality if it comes at the expense of a clean environment or of human rights. Your real “bottom line” is not financial profit, but value however you define it.

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Plan to make your assets last

“Live long and prosper”

When we save and invest, we are always trying to gain a degree of control over a future that is inherently uncertain. One of the biggest uncertainties is how long we will live. Average life expectancy is some help, but it is only an average. For example, if a man and a woman are both 65, on the average the woman can expect to live to age 84 and the man to age 81, based on current US mortality rates. (The gender gap is smaller at age 65 than at birth because the men have already survived some of their most dangerous years, when they have higher mortality from such causes as accidents and acts of violence.) But people should plan for the possibility of living long beyond the average, at least 90 or 95. Fortunately, retirement portfolios can continue to grow after retirement begins. In fact, they typically grow much more during retirement than in the accumulation phase leading up to retirement.

In order to finance a long retirement, our 65-year-old couple should still have a diversified portfolio. If they invest too much in stock, they could lose too much of their nest egg in a severe bear market, just when they need it to live on. But if they don’t invest in stock at all, their savings may not grow enough to finance a long retirement. Many planners recommend an allocation of as much as 50% stock for those who are in the early stages of retirement. As always, time horizon is an important consideration. Elderly retirees who expect to spend down their assets in the near future should not risk them in the stock market. On the other hand, financially secure seniors who expect to leave most of their assets to their heirs have a longer horizon and can better afford to ride out the volatility of the markets.

Retirees may also wish to adjust their asset allocation to take into account income from other sources besides investments, such as a pension or immediate annuity. A lifetime income stream has a substantial present value that may be added to one’s investments when calculating total financial assets. A pensioner who wishes to have 40% of total financial assets in stock might put more than 40% of invested assets into stock, to offset the pension as an uninvested fixed-income asset.

Safe withdrawal rates

Once you reach the point of living off an accumulated nest egg, how much can you safely withdraw from it each year? That’s another area where sophisticated mathematical tools are useful. If we know the allocation of your portfolio and the number of years you want to plan for, we can calculate a withdrawal rate that has a high probability of making your savings last. For example, if you have 50% in stock, 40% in bonds and 10% in cash, and you want your savings to last for 30 years, many mathematical models suggest an initial withdrawal rate of 4%. That means that in the first year you can withdraw an amount equal to 4% of your retirement savings, then increase the dollar amount by the rate of inflation each year.

A withdrawal rate of 4% may sound very low. That would mean that you need $250,000 in investments just to take out $10,000 the first year. But a nest egg that large is not an unreasonable goal for an ordinary household, when you consider the power of compounding (see the discussion of getting time on your side).

Recently, a number of analysts have questioned the simple 4% rule, arguing that it relies too heavily on average historical returns and neglects current economic conditions. If you retire at the end of a bear market, when stock prices are low relative to corporate earnings, then you can probably sustain a higher rate of withdrawal, since chances are good that stock prices will rise over the course of your retirement. But if you retire at the end of a bull market, your portfolio may not get too much larger than it is already, so a very conservative withdrawal rate may be called for. One rule of thumb is to withdraw more than 4% a year if the Price/Earnings ratio of the S&P 500 when you retire is below its historical average (about 16), but withdraw less than 4% a year if P/E is above its historical average. The bull market that preceded the crash of 2008 had an especially high spike in P/E (over 40), leading some analysts to warn those who retired at the peak that they could run out of money if they took annual withdrawals of more than 2%!

Some mutual fund companies now offer special funds to manage your withdrawals for you. Some of them adjust the mix of investments to sustain a given withdrawal rate, while others adjust the withdrawal rate to make the funds last for a given number of years. These funds cannot guarantee that you won’t run out of money, but they reduce that risk.

Savings rates reconsidered

Recognizing that unfavorable economic conditions can easily reduce the amounts available for retirement income, you shouldn’t assume that your retirement will be secure if you are on track to accumulate a nest egg of a certain size or intend to withdraw a set percentage each year. That doesn’t mean you can’t plan with some confidence of success, however. Wade Pfau argues that your savings rate before retirement is a more reliable predictor of your retirement income than the size of your nest egg at retirement or your withdrawal rate after retirement (Journal of Financial Planning, 5/2011). To see why, consider two workers. John wants to accumulate a nest egg of $500,000 and then withdraw $20,000 a year (4%) for life. The trouble is that he doesn’t know what savings rate is necessary to get there, since it depends on whether he is investing in good times or bad; nor can he know that a 4% withdrawal rate will be sustainable under the economic conditions in retirement. Jane on the other hand doesn’t worry about hitting particular numbers, but just saves at a rate of 13% per year. If economic conditions are better before retirement than after, her savings do surprisingly well, so she can get by with a relatively low withdrawal rate in retirement. If conditions are better after retirement than before, her nest egg will be smaller, but growth during retirement will allow her to compensate by sustaining a higher withdrawal rate. Her chances of success are excellent under a variety of conditions.

Looking back over the last century, the savings rate necessary to support a comfortable retirement has varied somewhat, but it hasn’t varied as much as the savings rate necessary to accumulate a nest egg of a given size, or as much as the withdrawal rate necessary to live on a nest egg of a given size. The prudent savings rate has been within a range of 11% to 15%, with the higher part of the range providing the greatest probability of success.

Immediate annuities

There is a way of insuring a lifetime income while spending a little more than the conventional percentage of savings, such as 4% per year. You can take a lump sum and convert it to an immediate fixed annuity (not to be confused with the deferred variable annuity discussed in the posts on expenses and taxes). The issuer of the annuity, usually an insurance company, assumes the risk that you will live beyond your average life expectancy, because it has to keep paying you no matter how long you live. The company makes that up from somebody else who dies sooner than expected. The advantage for you is that the annuity can give you a higher payment than you can safely give yourself. The downside is that the money you use to buy the annuity isn’t available to your heirs (unless you accept a reduced payment in return for a guaranteed number of payments). If you die in the first year, the insurance company has your money. If you want to preserve your estate for your children, then you shouldn’t spend your whole nest egg on an annuity. You might want to compromise, by annuitizing part of your savings and holding onto the rest. The higher the proportion of your savings you annuitize, the higher the guaranteed income you can expect to receive, but the smaller the estate you can expect to leave.

When you buy a large annuity at one time, you could be locking in a low income because of low interest rates at the time of purchase. Your income could also be eroded by inflation. You can deal with the second problem by buying an inflation-protected annuity. Your initial payment will be smaller, but it will rise with inflation. You can deal with the timing problem by laddering your annuities, buying a series of smaller annuities over a period of years. As interest rates fluctuate, lower-rate annuities have a good chance of being balanced by higher-rate annuities.

Some planners argue that once you have secured a lifetime income with fixed annuities, then you can afford to be more aggressive with the rest of your investment portfolio, favoring stocks over bonds. On the average, retirees who adopt that strategy will probably end up with a larger estate. But outcomes will differ greatly depending on stock market performance. If you may need to use your nest egg for yourself, such as to buy into an expensive retirement community or assisted living facility, then you may want both a guaranteed annual income and some conservative, wealth-protecting investments.

Longevity insurance

Still another approach to making your money last is a relatively new insurance product called longevity insurance. This is an income annuity with a long deferral period, typically 20 or 30 years. You might buy it at age 65 but schedule payments to start at 85. You would do this if you expect your nest egg to cover you pretty well unless you live beyond 85. It costs a lot less than an immediate annuity because it will pay out for a shorter time, and maybe not at all. If you live an unusually long life, you’re covered. If you die young, the loss to your estate is smaller than if you bought an immediate annuity.

Multiple sources of income

Hopefully you will have other sources of retirement income besides investments. Financial planners sometimes talk about the “three-legged stool” supporting retirement: Social Security, pension and personal savings. Increasingly they are talking about some form of continuing employment as a fourth leg. So your own investments don’t have to carry the full load. But investment earnings are becoming increasingly vital, now that fewer employers are offering traditional pensions and the Social Security system is facing a possible cash-flow problem as the baby-boomers retire. Although more workers expect to remain in the labor force longer, the economy may be hard-pressed to create employment for both older and younger workers. That is all the more reason to incorporate the principles discussed here into your life plans, so that the investment leg of the stool will be on a solid foundation.

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Look for opportunity, but don’t chase performance

Chasing performance Chasing performance is buying what’s hot, whatever type of investment has been performing well lately. When you hear about the spectacular performance of some stock, or fund, or asset class, it’s tempting to jump on the bandwagon and buy it. If it goes down, then you may sell it in order to jump on some new bandwagon.

However, the very idea of chasing performance suggests that one is always one step behind, buying something after it’s gone up and selling it after it’s gone down. So chasing performance often means buying high and selling low, which is the best way to lose money. It may also mean paying a lot of brokerage commissions on the frequent trades.

Choosing mutual funds on the basis of recent performance can also be a losing strategy. In fact, it can explain something that seems paradoxical about mutual fund returns. Consider a successful fund with an average annual return of 15% over a five-year period. Sounds great, but it’s very unlikely that the average investor in the fund actually got that 15%. In fact, recent research shows that the typical investor does substantially worse than the funds in which he or she invests. How can that be? It can happen whenever most of the investors come late to the party, buying a fund only after they hear about its success from their broker or the media. Since as we’ve seen, market-beating performance is difficult to sustain, many investors miss the outstanding years, which may have been a lucky streak, but are still in the fund when it has some more disappointing years.

Some mutual fund companies have taken advantage of performance-chasing investors by rushing to market new funds focused on whatever type of security has been hot recently. They have made millions in fees while setting their investors up for disappointing returns. When these losses are added to the other costs of mutual fund investing, such as unnecessarily high turnover of holdings and high fees not justified by superior performance, a substantial portion of potential returns can be lost to investors. For a critique of the mutual fund industry along those lines, see John Bogle’s The Battle for the Soul of Capitalism. Bogle is the founder of Vanguard and the foremost advocate for low-cost index funds.

Looking for buying opportunity

What everyone would prefer to do is anticipate good years in advance, so they can buy low and sell high. Trying to anticipate the ups and downs of the market is known as “market timing.” Whether that is really possible is a matter of debate. Many financial planners discourage trying to time the market, because the markets are just too unpredictable. They recommend a buy-and-hold strategy. Put together a balanced portfolio, hold onto it for a while, and don’t worry too much about the market fluctuations.

One weakness of the traditional asset-allocation approach, however, is that it pays little attention to the current valuation of different assets. Markets sometimes suffer from what Alan Greenspan called “irrational exuberance,” over-valuing an asset that is currently popular, such as technology stocks in the 1990s or real estate in the 2000s. Or investors may get discouraged about recent returns and under-value an asset, such as stocks in the 1970s. The tendency to follow the crowd exaggerates these movements, as people rush to buy or sell because everyone around them seems to be doing so. Such behavior creates opportunities for a “contrarian” approach, one that tries to go against the prevailing market psychology. You would want to buy more stock when pessimism about the economy has driven prices down to unreasonably low levels. You would want to buy more bonds when pessimism about rising interest rates has driven bond prices down. You have to be able to take the long view, and be optimistic about the long-run outlook for stocks or bonds or real estate when other people are overreacting to recent bad news. You must also be willing to sell when others are still bidding up the price of what you have bought. Sell too early and you miss a lot of the gains; sell too late and the bubble may already have burst.

Historical data on stock returns support the reasonable idea that buying stocks when they are less expensive usually results in a higher long-run return than buying stocks when they are more expensive. A common indicator of how expensive they are is the price/earnings ratio of the entire market, which can be obtained from many financial magazines or websites. A P/E over 20 indicates that stocks are unusually expensive; a P/E under 12 indicates that they are unusually cheap. (Because of anomalous fluctuations in reported earnings, it is best to use an average of earnings for the past five or ten years as the E in the ratio.)

Historical data on bond returns suggest that the current interest yield is a pretty good guide to average annual return over the life of the bond. (The current yield is the annual interest payment divided by the price of the bond. For bonds bought at face value rather than at a premium or a discount, it’s the same as the bond’s “coupon,” its stated annual interest rate.) Other things being equal, bonds are a better bargain when interest rates are high, allowing you to lock in a high return for many years. Since the financial crisis of 2008, interest rates have been at a historic low, making bonds relatively expensive.

Many financial planners distinguish this kind of “tactical asset allocation” from the more radical and less desirable practice of market timing. At its extreme, market timing would mean moving a large portion of your assets out of a market when you think it is peaking, and moving back in when you think it is bottoming out. Tactical asset allocation maintains a reasonably balanced portfolio at all times, but does more buying of a given asset when it is cheap and less when it is expensive. The timing of transactions is simply a tactic to carry out a long-term strategy based on a reasonable asset allocation. The allocation to a particular asset class can be flexible, such as a range of 40-60%, allowing for increases when that class is less expensive and reductions when that class is more expensive.

Portfolio rebalancing

Even a constant allocation, such as 50% stock, can help you take advantage of market opportunity. If stocks underperform your other investments, the stock portion of your portfolio will fall below your target, and you can then buy enough stock to restore the desired allocation. If stocks outperform your other investments, you sell some stock. As a result, you will naturally tend to buy when prices are lower and sell when they are higher. Prices fluctuate all the time, so you don’t need to rebalance every time a financial statement shows a change in asset values. But if a particular asset trends up or down over a period of months, that creates a rebalancing opportunity.

Taking advantage of opportunity means resisting the natural tendency to chase performance. Buying an asset class that has been trending downward or selling one that has been trending upward requires courage and imagination.