Investment advisors talk about the long run because markets are variable. We don't have nearly enough long-term data and, at best, short-term data is mere noise in a turbulent process. We have only crude approximations for risk premiums, and in fact, they may change over time. So we look at what pitiful little data we have, and we try to make reasonable judgments about what the long-term performance might be.
Investment advisors talk about the long run because markets are variable. We don’t have nearly enough long-term data and, at best, short-term data is mere noise in a turbulent process. We have only crude approximations for risk premiums, and in fact, they may change over time. So we look at what pitiful little data we have, and we try to make reasonable judgments about what the long-term performance might be.
Given 1,000 years, we think we have a tolerably close approximation of what returns might look like. We freely admit we don’t have a clue about what the next 12 or 24 months might look like. Investing is about risk and risk management. Risk happens! Elegant theory collides with real life events. It’s a messy process.
It turns out that the long run can be a very long time. For instance, in the 1970s and ‘80s there was a 19-year period during which Treasury Bills outperformed the S&P 500. Even Business Week threw in the towel, proclaiming “The Death of Equities” boldly across its front page. This capitulation by the voice of capitalism almost exactly marked the beginning of the longest strongest bull market in history. So much for expert opinion!
Unfortunately, investors talk and think about the short run because their horizons are limited. Their first response to a discussion about long-term results is likely to be: “I don’t have a thousand years!” They have every right to think that way. After all, this is their life, they only get one shot at it, and a 2- or 3-year market downturn might seem like an eternity, especially if it starts right after they retire. Few of them have the patience to wait a thousand years for things to work themselves out to approximate the averages. Retirees are particularly sensitive to this issue, because they typically need income now.
While retirees may not have 1,000 years, they may very well need to plan for 40 years. With inflation ever present, fixed income or guaranteed accounts will simply not do the job. If we think only in the short term, and if we don’t provide for adequate growth, we risk a catastrophic loss of buying power.
The investor has a real dilemma. On the one hand, almost all investors need the higher returns and inflation protection that only equity investments provide. On the other hand, risk premiums do not reliably show up each and every year as theory predicts they should over the long haul. In fact, the predicted risk premiums (expected returns) may not show up for a long time. A few bad years early in retirement and the retiree cold liquidate her entire nest egg.
So, we must have a strategy that provides for some growth and at the same time will withstand market downturns. The Depression, 1973-1974, the crash of ‘87, the crash of ‘89, and the horrible slump of 2000-2002 were all real events that destroyed the financial security of millions. No one should want to place themselves at risk of that.
Given that returns are random and totally unpredictable in the short term, what’s an investor to do? Without the ability to predict the future, how should the investor construct her portfolio to meet her unique requirements of safety, income, and growth?
There is an approach that maximizes the probability of long-term success and provides protection against short-term market loss. In other words, the investor need not give up hope of some long-term growth of principal and income in order to hedge against short-term market uncertainty. Within reasonably defined limits, the investor can have her cake and eat it too.
As a first cut, the investor must segregate her nest egg into two parts. The first part should be enough to satisfy all of her income needs for at least 5 to 7 years (preferably 10). That part must be invested in a rock-solid, safe instrument such as high quality short-term bonds. This portion of the fund hedges against those nasty occasional market downturns of unknown and unknowable duration.
The remaining part of the portfolio should be in a globally diversified portfolio of equities to provide for the real return and growth necessary to meet the investor’s objectives. Particular care must be taken to achieve an equity portfolio with the lowest possible risk as measured by annual fluctuation or standard deviation. This is best accomplished by wide diversification of asset classes.
Having sufficient funds rat-holed away in rock-solid, highly liquid investments allows the investor to weather the storms that will certainly arrive. The investor should never be faced with having to liquidate any of the volatile equity investments at inopportune times.
We can back-test this approach to determine whether it would have survived any past market conditions (at least back to 1926). Monte Carlo analysis gives us another useful tool to stress test our assumptions. Neither technique is perfect, but we can get a very good feel for a “range of reasonableness.” While there is never a guarantee in the markets, this technique has stood the test of time.
Assuming sustainable withdrawal rates, appropriate asset allocation, and reasonable portfolio costs, this approach offers the best probability of success over the long haul, while meeting the investor’s needs for short term protection against down markets.
Frank Armstrong, CFP, AIFA
Frank Armstrong III is founder and CEO of Investor Solutions, Inc., an independent, fee-only investment management firm in Coconut Grove, Florida. The firm has been named on Bloomberg’s list of Top Wealth Managers, rated a “Five Star” on the Paladin Registry, and selected by Barron’s as one of the top “100 Best” Independent Financial Advisors in the country. Frank has more than 35 years experience in the securities and financial service industry. He contributes to major publications and appears regularly on television and radio. He is the author of the forthcoming book, SINK OR SWIM: Enjoy a Successful Retirement in an Age of Cradle-to-Grave Insecurity and the bestseller, THE INFORMED INVESTOR: A Hype-Free Guide to Constructing a Sound Financial Portfolio.