Beneath the Surface

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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.

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Avoid unnecessary fees and expenses

You can’t invest without incurring some fees and expenses. When you buy and sell individual securities through a broker, you pay a transaction fee. When you invest in a mutual fund, you pay the fund’s annual management expenses. If you have a retirement plan like a 401(k), you pay a fee to the plan manager. If you buy financial advice, you pay your advisor in one way or another, whether it’s an hourly fee, a flat fee for a financial plan, a commission on financial products you buy, or an annual management fee to manage your investments for you.

The challenge here is to determine what you are actually getting for what you are paying. When something in my house needs fixing, I’m often willing to pay someone to fix it because I can tell the difference between an expert repair and one that I try to do myself. But how many investors can tell the difference between a cost-effective investment and an overpriced mediocrity, or between sound financial guidance and a bum steer? Investors may not even be aware of some of the expenses they are incurring because they’re quietly deducted without showing up explicitly on a statement. And the impact of costs on investment results is hard to assess because so many other factors affect financial performance, not the least of which are general market conditions and luck. Your financial service provider isn’t to blame if the market falls, but may be to blame for promoting products whose excessive costs aren’t justified by superior performance. Unfortunately, the complexity of financial products provides many opportunities to take advantage of unwary consumers.

Although the question won’t have an easy answer, the right question to ask is whether you are achieving any added value for your portfolio by incurring a particular expense.

No-load, low-expense funds

The post on diversification discussed mutual funds as a convenient way of investing in a wide variety of securities. Now consider how to get the benefits of mutual funds without unnecessary fees and expenses.

First, give preference to no-load funds. Loads are sales commissions on mutual funds purchased through a broker, ranging anywhere from 3% to 8% of the money invested. Frequently you have a choice of different fee structures, such as a choice between a one-time up-front commission or higher expenses in every year you own the fund. If you intend to own the fund for a long time, the up-front commission (the “A” shares) can be the better choice. But often an even better option is to contact a mutual fund company that sells its funds directly to the public, such as Vanguard or T. Rowe Price. There you can probably find an acceptable fund with neither a sales load nor high expenses. You don’t have to sacrifice performance when you go this route. The American Association of Individual Investors says, “Funds with loads, on average, consistently underperform no-load funds when the load is taken into consideration in performance calculations. For every high-performing load fund, there exists a similar no-load or low-load fund that can be purchased more cheaply.”

Every mutual fund prospectus is required to list the fund’s fees and expenses. Ideally you will see “none” in the fees part, or only some very small fees for good reasons, such as a fee for redeeming shares within one year, in order to protect the fund and its shareholders against the costs of short-term trading. What you do have to pay in any fund is annual management expenses, but you can pay very different expenses for quite similar products. This is especially true for the kinds of funds whose returns are otherwise fairly predictable, such as money market funds and bond funds holding similar types of bonds. Expense ratios may seem to vary in a narrow range (1.5% per year for one fund vs. 0.5% for another, for example), but over time, such small differences compound into large variations in investment returns. If you invest $10,000 and let it compound for 20 years, you will have $56,044 if you get a 9% return, but only $46,610 if you get an 8% return because of an extra 1% in expenses. The longer you invest in a fund, the more of your investment return you will forfeit if the fund underperforms the market because of its fees. A study by Stewart Neufeld found that underperforming the market by just 1% will cost you about 30% of your total gain over 30 years and about 40% over 50 years (Journal of Financial Planning 12/11).

When trying to hold your fund expenses down, consider exchange-traded funds (ETFs) as well as traditional mutual funds. You will pay at least a small transaction fee to purchase an ETF through a broker, but annual expenses should be as low or lower than the least expensive mutual funds. Many new kinds of ETFs are appearing, however, and not all of them are designed to provide a market return at low cost.

Index funds vs. actively managed funds

The lowest expenses are generally found in index funds because they save money by doing less research and making fewer trades. An S&P 500 index fund will hold the same 500 stocks until Standard and Poor’s changes the stocks included in the index itself. This is also known as passive investing. Its goal is to get as close to a market return as possible, unencumbered by high fees, and it can achieve that goal pretty reliably. In contrast, actively managed funds buy and sell more frequently in order to try to beat the market, so they incur additional expenses for trading and researching companies. The additional costs to shareholders can easily knock two or three percentage points off your investment return. One of the most hotly debated questions in the industry is how often active management adds enough value in skillful security selection to offset and justify the higher costs. Is active management worth paying for, or is it more cost-effective to invest primarily in low-cost index funds?

Both sides in this debate agree that an index fund can only provide a market return (minus a very small amount for expenses), while an actively managed fund has at least some potential to beat the market. The question is how often actively managed funds actually live up to that potential. Researching that question isn’t a simple matter, since there are so many kinds of funds, so many management styles, so many fluctuations in performance, so many old funds closing and new ones opening, and so forth. One of the key issues is what “benchmark” to use when comparing a particular fund to the market. The S & P 500 stock index is a good benchmark for comparing US large-cap stock funds, but appropriate benchmarks are less obvious for funds with less common specializations. The best research does appear to support these broad generalizations:

• Index funds provide a return that is close to the market average, but an actively managed fund can do either better or worse than the average
• Fewer actively managed funds beat their market benchmark than fall short of it
• The longer the time period considered, the more likely it is that an actively managed fund will underperform the market

The last point is a particularly interesting one, since it calls into question not only the ability of most active managers to beat the market, but the ability of investors to identify the ones who can be relied on to beat the market in the long run. Studies of mutual fund performance do find some tendency for performance to persist from year to year, but the finding must be carefully qualified. One of the reasons for continuity is that many of the same overpriced, low-performance funds do badly year after year. Those can be avoided. But choosing among the remaining funds is hard, since continuities in market-beating performance tend to be short-lived. Most of today’s winners probably won’t be the highest performers a few years from now. That leaves the active investor with two alternatives: either chase performance by frequently moving assets to “hot” funds (running a significant risk of losing money by buying high and selling low), or stay in one fund hoping that it’s one of the very few that can beat the market in the long run despite the burden of its management and trading costs.

Beating the market is both very appealing and theoretically possible, but it’s harder than most people realize, contrary to the message of some financial media and some financial services sales forces. Since there are thousands of funds, some of them are on winning streaks at any given time, either because they’re lucky or because market conditions happen to favor their particular investing style. Apparent winners get a lot of play in the media, both in advertising and press coverage, creating the impression that their managers have extraordinary abilities. But the more spectacular the performance over a few years, the greater the chance of deteriorating performance over the next few years (a familiar statistical phenomenon known as “regression toward the mean”).

Why is beating the market so hard? One reason is the inherent difficulty of stock picking, since stock movements depend so heavily on earnings surprises (discussed in the risk section). The second is the fact that so much of the market consists of mutual funds, so that professional fund managers are competing against one another: If some are performing above the market average, others must be performing below it. The third problem is the higher costs associated with active management, which tend to drag even more of the funds below the market average. When Andrew Feinberg reported that only one out of every eight mutual funds beat the S&P 500 index over a twenty-year period, he titled his article “Lake Wobegon in Reverse” because so many of the funds were below average (Kiplinger’s 11/03).

A few managers probably are truly superior, but only a long and consistent track record can distinguish skill from luck. By the time the true superiority of a fund becomes apparent, it may be closed to new investors, or the manager may switch jobs or retire. Fidelity Magellan did very well while Peter Lynch was managing it, but not so well after he retired. If the fund does remain open with the same manager, it may get so large that it has to buy too many stocks in order to avoid bidding up the price of the fewer companies it would most like to buy; so it becomes less selective and more mediocre. Many big fund managers are really “closet indexers,” too unselective to have any hope of beating the market, but charging fees as if they could! If all you need is an index fund, then that’s all you should pay for.

Consider one additional point, requiring a bit of reflection. Suppose that actively managed funds had a wide range of performance (that much is true), but on the average performed as well as the general market (that part is not quite true because expenses are a drag on performance). Would you be willing to risk underperforming the market for an equal chance at outperforming the market? Suppose your employer let you choose between receiving your regular salary or randomly selecting from different envelopes with varying amounts of money, some more than your salary but some less. Would you gamble with your livelihood, knowing that in the long run you have no rational expectation of coming out ahead? Where is the added value, especially if your employer starts charging you a fee to select an envelope!? I repeat that the issue is hotly debated, but many financial planners are skeptical about the added value of actively managed funds for the ordinary investor. Dan Wheeler says, “The most rigorous studies–those with adequate sample sizes and periods, benchmarks that control for risk and survivorship bias–reveal a trend: the pros don’t add value on a consistent enough basis to warrant their fees” (Financial Planning 11/06).

That’s why many financial planners, as well as many of the most sophisticated investors like Warren Buffet, recommend that most ordinary investors make index funds the core of their investment holdings. Investors who would also like to have some potential for outperforming the market should seek actively managed funds with moderate expenses, relatively high returns for several years, and managers who have been with the fund a long time. But recognize that you will need some luck to avoid underperformance, so there is an element of gambling in this approach.

Insurance costs

Insurance companies have developed a number of products that combine insurance with investment. Part of what you pay to the insurance company is invested on your behalf, and may have a potential for a high return. Another part insures that you will receive at least some benefit, such as a death benefit or a guaranteed minimum annual payment. In general, these products are both more expensive and more complicated than direct investment in mutual funds, so consumers should tread carefully in this area. The insurance features of the product should add enough value to justify the added cost, but that is often difficult to determine.

First, consider a case in which insurance does appear to add value. You are retired with a nest egg large enough to live on for many years, but you have a reasonable probability of living long enough to run out of money someday. One solution is to take a portion of your nest egg and purchase an immediate life annuity, guaranteeing that you will have at least some income for life. Another alternative is to buy longevity insurance, which starts paying an annuity only if you live beyond a certain age. There is added value here in the form of a potential to receive something you wouldn’t otherwise have gotten, an income if you live a very long time. (If you live too short a time, you won’t recover your premium cost.) Immediate annuities and longevity insurance will be discussed further in a later post.

What you want to avoid is buying insurance you don’t really need, or that doesn’t do enough for you to justify its cost. One insurance product that companies are often accused of overselling is the variable deferred annuity. Many financial professionals earn commissions from selling them, but others neither sell them nor encourage their clients to buy them. A variable annuity is an investment through an insurance company in assets that can fluctuate in value, especially stocks. You fund the account with a lump sum or with periodic payments over time. Eventually the account will be annuitized–converted to a series of regular payments, often for life. “Deferred” means that this will happen sometime in the future rather than immediately. Investment returns are sheltered from taxation until withdrawals begin, but are taxed as ordinary income when withdrawn. (This additional tax shelter appeals to investors who are already maxing out their contributions to their retirement plans, as well as to aggressive traders who want to be able to buy and sell in the account without worrying about capital gains taxes.) Variable annuities have a death benefit that is paid if the owner dies before withdrawals begin. Many also have “living benefits” that guarantee some minimum value when the account is annuitized. In effect, you are paying the insurance company to insure you against some of the risks of investing in fluctuating markets.

The special features of variable annuities come at high cost, since you are paying for a layer of insurance protection in addition to the costs of managing the investments themselves. Total fees can be many times what you would pay for a mutual fund, substantially reducing your returns. For that you are getting the promise of an annual payment for life someday. (But then, you could get that by annuitizing whatever nest egg you accumulate yourself.) You are also being protected against catastrophic losses, but a properly diversified portfolio of mutual funds or ETFs can provide much of that protection at lower cost.

Variable annuities have other disadvantages: The data needed to evaluate them as investments, such as risk-adjusted performance measures, are not as readily available as they are for mutual funds. Variable annuities are not very liquid, since they often carry surrender charges or other penalties for terminating the contract before a certain number of years. And although investment returns are tax-sheltered until you begin withdrawals, this provides no benefit if the annuity is held within an account that is already tax sheltered, such as an IRA or 403(b). Annuities can even have adverse tax consequences, since dividends and capital gains will ultimately be taxed at ordinary income rates instead of at the lower rates that otherwise would apply.

The main argument for variable annuities is that they can provide a moderate income for life even if markets perform badly. Investors who have that guarantee may feel more comfortable allocating a larger portion of their portfolios to stock. The high return from stock could offset the costs of the annuity and produce a superior return for the entire portfolio. But few purchasers of variable annuities may understand that point or feel comfortable acting on it. Investors who don’t like to invest aggressively may not get much added value from a variable annuity. They might do just as well–and keep their portfolios simpler, clearer and more liquid–with a balanced portfolio of stocks and bonds. Then their portfolio may not be risky enough to require insurance.

An even more controversial version of the variable annuity is the equity indexed annuity. On the one hand it offers the security of a minimum fixed return on one’s investment. On the other hand it offers a potentially higher return based on some portion of the stock market’s gains. (For example, if the market is up 15%, your gain might be capped at 7%. Since stock investors make most of their money in the really good years, this is a significant limitation.) You get some protection from downside risk, but at the cost of high fees and a cap on upside potential. This is another complex arrangement that is hard for a buyer to evaluate. Most independent evaluations I’ve seen have concluded that it doesn’t offer enough advantage over a balanced portfolio of stocks and bonds to justify its higher cost, so that most investors will come out behind by buying it.

Paying for financial advice

The same principles apply to buying financial advice: Don’t pay for more than you need, and expect added value for any costs you incur. You may be able to manage your own investments just fine with a little occasional help. If so, you don’t have to pay someone an annual fee of 1% to 2% of your assets to manage them for you. That can easily add up to thousands of dollars a year and put a heavy drag on performance. You may find it more economical to pay a one-time fee for help in formulating a plan, and then deal directly with mutual funds in order to avoid sales commissions.

Some people pay an annual fee for a financial manager, who may also be a salesperson with products to promote; then they pay commissions to buy mutual funds or annuities; then they pay high fees and expenses for active fund management or insurance features they may not need. So they pay and pay and pay without getting much added value, and they end up with much less than they could have had with a simpler and less expensive approach. A later section will deal with options for getting financial advice.

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Allocate among asset classes sensibly

One of the most important investment decisions is how to allocate your investment dollars among the different asset classes, such as stocks and bonds. The different classes can have very different returns in any given year, resulting in large variations in earnings among investors with different asset allocations.

As discussed in the post about risk, investments such as stock offer the potential for higher returns at the cost of higher risk, while investments such as bonds offer lower average returns but lower risk. How to allocate a portfolio among assets with varying degrees of risk is probably the most basic question an investor will face. To simplify the discussion, we will speak of the choice as being between stocks and bonds, but those categories will be understood to include other assets that are either high or low on the risk/reward continuum. Optimal diversification requires investing at least a portion of the portfolio in assets besides stock and bonds, a point that will be reiterated later.

Three factors to consider in allocating between stocks and bonds are your time horizon, your personal tolerance for risk, and your income security.

Time horizon

Time horizon involves the question of what you are saving for, or more precisely, when you are saving for. If you are saving for your children’s college educations, it makes a big difference whether they are teenagers or toddlers. If they are very young, it is reasonable to invest heavily in stock, because you have time to ride out some of the ups and downs of the market. And you are generally rewarded for doing so, because stocks have usually outperformed bonds over long periods. But many parents have made the mistake of leaving the college savings in stock too long. If you’re still in stock when the child is 16, you run the risk of losing a big chunk of your savings in a down market just when you need it.

This way of thinking about asset classes has strong logical and mathematical support. The riskier asset class is more volatile, and so one can easily lose money in it in the short run. But the riskier asset class should also carry a risk premium that provides a better return in the long run. By investing for long periods, one takes advantage of the statistical tendency for results to even out in the long run. In the long run, below-average returns are offset by above-average returns, leaving investors with the average return for the asset class, which includes the risk premium. Jeremy Siegel is one of the many analysts who have popularized this theory, in his book Stocks for the Long Run.

Here is an example of the kind of evidence that is often cited in support of this theory: Over the years 1926-2005, the average annual return from large-company stocks was 10.4%. Investing for only one year would be quite a gamble, since the annual returns varied from a high of 54% to a low of minus 43%. But the average annual return for all possible 20-year periods (1926-1945, 1927-1946, etc.) varied in the narrower range from 18% per year to 3% per year. Investors who remained invested for many years were much less likely have disappointing returns.

The observant reader will have noticed that these figures do not include the market crash of 2008, which wiped out many years of stock market gains. Even a very long period of investing can have a disappointing return if it includes even one very bad year, assuming it occurs late in the period. For the 40-year period ending in 2008, stock investors received no benefit from investing in stocks rather than bonds (unless of course they were lucky enough to sell before the crash). Furthermore, In addition to the risk of having a bad year just when your nest egg is at its largest, there is the risk of entering an era in which stock returns will be poor relative to other eras. Going back all the way to 1803, Robert Arnott has identified several lengthy periods in which investors would have been better off in Treasury bonds (Journal of Indexes, May/June 2009). We won’t know what kind of an era we’re in now until we’re in a position to look back on it!

These dangers have led some analysts to question the entire logic of relying on stocks for retirement investing. However, one reason for doing so is simply mathematical, the tendency of returns to even out in the long run. We can still say with some confidence that:

• On the average over a very long time, stocks have outperformed bonds by several percentage points a year, which can compound into a very large advantage over time
• Investments that are held for many years are more likely to realize this risk premium, because of the evening out of returns in the long run
• But even holding stock for decades cannot completely guarantee receiving that risk premium

Consider stock a long-term investment, and reserve it for time horizons of at least five (and preferably at least ten) years. Let stock investing play a fairly large role in saving for distant goals, especially retirement. Not only is the pre-retirement period long enough to ride out many periods of market decline, but retirements themselves have been getting longer because of increasing longevity. Most people should leave at least some of their retirement savings in stock even after they retire, so that they can generate a high enough return to sustain a long retirement.

Long-term bonds should also be considered a long-term commitment, because of the risk of having to sell them at a discount if you sell them long before maturity. (And even then the risk premium, in the form of a higher interest rate compared to shorter-term bonds, may not be big enough to justify the commitment.) Intermediate-term bonds are a safer way of saving for needs that are a few years off. Money for very short-term needs (within a year) is best kept in short-term bonds or cash accounts, for the sake of greater liquidity and stability of principle.

Risk tolerance

Before allocating a large portion of your portfolio to riskier asset classes, you also have to consider your personal tolerance for risk. It is one thing to grasp intellectually the benefits of riding out a bear market. It is another thing to handle it emotionally when it happens. When the downturn comes, no one knows for sure whether it is a “ten-year storm,” a “twenty-year storm,” or the “storm of the century” from which stocks won’t recover for many years. If you are likely to lose your nerve and sell during a severe bear market, then you can’t expect to gain much from stock investing, because you’re likely to lose money by selling at the worst time.

Risk tolerance is largely a psychological matter, and you probably can’t change it very easily. But you may benefit from becoming more conscious of it. At least consider the possibility that you are too far toward one extreme or the other on the risk tolerance scale. The two extremes have been described, somewhat pejoratively, as fear and greed. You are dominated by fear if you are so afraid of losses that you avoid even reasonable risks. Then you may be saving a lot of money, but sacrificing high returns by keeping too much of it in cash. You are dominated by greed if you are so eager for big gains that you accept even unreasonable risks. Then you may be gambling too much of your money on the hope that some volatile investment will go up in the short run. The wise course for most investors probably lies somewhere in between.

Many financial publications and investment companies have questionnaires that you can use to assess your own risk tolerance.

Income security

A third factor to consider is the security of your non-investment income. A person with solid job qualifications, steady employment, or a good pension can afford to allocate more capital to riskier, but potentially more rewarding, investments. If some of that capital is lost, it can more easily be replaced with current income. A person whose future income is uncertain and who may have to rely on savings just to pay basic expenses needs to be more cautious.

Allocation as diversification

The previous post discussed diversification within asset classes as a way of reducing risk. Allocating among asset classes also reduces risk, since it reduces the likelihood that all your investments will lose money at the same time. When stocks are down, bonds may be holding their value or even appreciating, as Treasury bonds did during the Great Recession. The technical way of saying this is that the returns from different asset classes are less than perfectly correlated. The lower the correlation between two assets, the more you can reduce the volatility of your portfolio by investing in both of them.

Let’s assume that your time horizon is long enough to justify a large investment in stock, say at least half of your portfolio. Holding some other assets besides stock can dampen volatility and reduce the risk of spectacular losses in any one year. Bonds are very good for risk management, since their returns are less volatile than those of stock and fluctuate at least somewhat independently of them. A portfolio of stocks and bonds is much less volatile than an all-stock portfolio, and it’s even less volatile than an all-bond portfolio.

However, bonds don’t give you ideal diversification because of their relatively low return. If stocks go down, you won’t usually get a high bond return to compensate. That has led financial planners to recommend some diversification toward the higher end of the risk/reward continuum, toward assets with potentially higher returns than bonds, such as real estate, precious metals, commodities or commodity futures, and direct investments in business startups. Including such assets improves the odds of maintaining a high return in fluctuating markets. Some of these, such as commodity futures, can be especially volatile, so ordinary investors should limit their exposure to a small portion of their portfolios.

A note on computerized asset allocation

Financial planners use sophisticated computer models to help clients allocate their portfolios. These models project the probable results of various allocations, based on historical experience. Remember, however, that any such model is only as accurate as the assumptions on which it is based, assumptions that can be invalidated by unforeseen events. The model may assume that annual market returns will vary within a certain familiar range, but future returns could fall outside that range. An asset allocation that appears “optimal” from the standpoint of the model could turn out to be the wrong allocation under future market conditions.

Then why bother with such tools? Because without them, the typical investor could easily make even more simplistic assumptions than the computer models make. An investor might assume that a particular stock, or the market as a whole, will continue to go up at a constant rate, while the financial planners at least know how to build some volatility into their models. A model can also implement a disciplined approach to investing, one less prone to emotional overreactions to recent market swings. The optimal allocation will always be an elusive goal in an uncertain world, and you should take any claims to have achieved it with a grain of salt. But rational analysis can at least protect you from making the most obvious financial blunders, such as putting money you need in the near future into highly volatile investments.

Limitations of diversification

The ideally diversified portfolio would contain a variety of investments with such high but uncorrelated returns that losing investments would be offset by winners every year. Unfortunately, experience has shown that even the most diversified portfolios are limited in their ability to maintain high returns and manage risk. On the average, diversifying beyond stocks and bonds only adds a point or two to investment returns. And the correlations among different asset classes remain high enough to allow many different investments to lose money at the same time.

The 2008 financial crisis was so severe that even investors with reasonable diversification within and among asset classes were not protected against serious losses. Stock prices fell so much that even portfolios with modest allocations to stock were hit hard. Losses were not confined to US stocks, but also occurred in foreign stocks, high-yield bonds, real estate and commodities. The number of different asset classes that all fell at the same time was very upsetting, especially to those who had regarded diversification as a magic bullet that could kill off risk. (Even then some assets performed well, especially long-term Treasury bonds.) The financial crisis has dramatized the limitations of asset allocation models, warning us against assuming that an allocation that would have worked under most historical conditions will necessarily work today.

Perhaps the most serious problem with standard allocation models is that they may overlook the issue of valuation. Including real estate in your portfolio isn’t a great idea when housing is overvalued and the bubble is about to burst. Some analysts recommend a different approach to allocation, one that bases the allocation to a particular asset class more on current market conditions. Although no such method has been perfected, some planners do believe in allocating less to assets that appear currently over-valued and more to assets that appear currently under-valued. This opportunistic, tactical approach is discussed in the section on Opportunity.

Asset allocation in brief

In summary, here are a few guidelines for allocating investments among asset classes:

• Include a range of assets in your portfolio to reduce risk without sacrificing good returns
• Diversify into conservative investments like short-to-medium-term bonds to reduce volatility
• Diversify (cautiously) into more aggressive investments like commodities to maintain high returns
• Tilt toward more conservative investments if your time horizon is short, your risk tolerance is low, and/or your income is insecure
• Tilt toward more aggressive investments if your time horizon is long, your risk tolerance is high, and/or your income is secure
• Allocate less to asset classes that appear currently overvalued, and more to classes that appear currently undervalued