The essence of investment management entails the management of risk, not the management of returns."

Benjamin Graham

Despite the fact that asset allocation is something that has been around for a long time and modern portfolio theory is the way we kind of determine what the asset allocation is,” there haven’t been many “big advancements” during the first 50 years or so of portfolio construction research."

James Peterson

I have never felt that the suitability rule was inherently valid since those acting as investment advisors did not have to have, nor recognize, the necessity of using a personal financial calculator. That is because it is not required for licensing nor for recognition as a registered investment advisor. That said, pundits point to sophisticated software- that may now include behavioral input and AI insight- that covered all the bases for investing. Get real. Effectively none of the users has a clue to what is occurring internally in the calculations but everyone figures- and certainly consumers accept- that something that comes out of a computer must be good/correct. Now we are going back to a Best Interests element where the value/use/absolute necessity of a personal calculator is still not going to even get nickels worth of time. It is going to remain a constant of the industry that client questionnaires will continue to be filled for use with software that is even becoming more involved with subjective human behavior (and mistakes). And in none of the suitability, best interests or fiduciary rules is a formal focus on Risk- specifically a Risk of Loss- taught. Risk is the major issue in investments but is ill/nil defined. The regulators need to step up to a real world that has left them behind. I am very concerned that they will make the necessary effort.

EFM

Note: This is an article addressing the Risk of Loss and the third and fourth phase where the ‘rubber hits the road’ in terms of real life financial/investment planning that was primarily designed as a guide to middle and lower income workers (and all military personnel) who cannot afford another hit like 2000- 49% market loss and 2008 with a 57% loss. This text will include some highlights addressed in these previous articles but offers additional objective and factual info and data supporting the Process and use. 

Revolutionary Method for Asset Allocation- Increase Returns, Reduce Risk

Rebuttal to NY Times Retirement article. Terrible Advice & High Risk

EF Moody's Mutual Fund Value at Risk/Stress Test

EF Moody’s Daily Commentary

 

As I was finishing the article, I noted material from The Center for Retirement Research at Boston College (How Would More Saving Affect the National Retirement Risk Index? https://crr.bc.edu/briefs/how-would-more-saving-affect-the-national-retirement-risk-index/) addressed some of the main difficulties for retirement and felt that this article would address them as well. Readers would be well advised to subscribe to their mailing list.

  • 50 percent of working-age households are at risk of falling short in retirement.
  • EFM- agreed
  • The question is how much would additional retirement saving improve the picture?
  • EFM- that is fine but the benefit is limited if they are going to lose 50% every 7.5 to 10 years (recessions).
  • The results show that boosting the 401(k) contribution rate for eligible workers by 5 percentage points would only modestly reduce retirement risk overall.
  • EFM- The Process herein would reduce the major losses by 75%. But by doing that, and using equities almost exclusively, the rate of return is perhaps/probably 25% higher than historical averages, with less risk and help hundreds of thousands of retirees and pre retirees. 
  • The impact would be a bit larger if all workers had access to an employer-based retirement plan, but – even then – many households would still be at risk.
  • EFM- The reason for my work was to enable those at risk to use the Process to ‘automatically’ deal primarily with Risk of Loss be it within a 401k, IRA et al.
  • The only way to make dramatic progress is to combine saving more with working two years longer, which cuts the share of “at risk” households to about 25 percent.
  • EFM- That is not the only way but it is what has been promoted for decades. The Process is significant adjustment to ‘guaranteed’ losses as dictated by current methodologies. 

 

‘About two-thirds of households do not have the recommended six weeks of emergency savings, according to a survey by JPMorgan Chase that looked at 6 million active checking accounts over a six-year period. Another survey by the AARP Public Policy Institute showed that half of American families did not have an emergency savings account’

Well, if you keep losing 50% of your equities every 7.5 to 10 years…………..

 

Overview

Almost four decades ago, I started teaching some financial courses. This was well before the personal computer and certainly the internet (and Google in particular) that subsequently offered articles and university papers that otherwise would have never seen the light of day. I got the CFP in 1984 but it simply left me knowledgeably unprepared. I said, upon completion, that “I don’t think I know that much”. Tough to be right. But part of it was that there were few avenues to take where a better experience was to be had. The only viable option was a Masters of Science in Financial planning. The American College was first and the College for Financial Planning came later (now such offerings are available in many universities and a couple have PhDs). I got the Masters’ in 1991 and while it offered more intensive material, it nonetheless was obvious that the degree still left a lot of holes where there wasn’t much real life in either investments nor insurance (one of the toughest to firmly grasp).

So I kept at it. One of the issues became obvious and unsettling- but apparently only to me. It involved the review of the S&P 500 versus a variable life policy or a variable annuity. The S&P obviously came out ahead simply due to all the embedded fees. But that was not what troubled me. It was when you looked at real life and a recessionary period such as 1973/74 where the market hit a 44% loss. It did not make sense to me to try various allocations to beat the market or to make allocations via various price/book, sales/book, P/E, alpha, Sharpe, Markowitz  et al but then lose almost 50% of the equities in bad times.

There was, and is today, a major failure in trying to help those that are little served by the industry- particularly where the marketplace focus is now on fee planners who seek higher net worth individuals who can pay larger fees. The middle class et al is simply going to be the continuing grist mill of high commissions, poor or no service from planners, a very simplistic cookie cutter asset allocation and complete frustration/exacerbation with large losses.

My effort then and now is to recognize the times when a market drop is occurring and then to shed the excessive RISK so that major losses are kept in check. This effort was really focused for those investors who are effectively clueless to the real world of investing and need an objective real life Process that will (almost universally) increase returns over time but absolutely will reduce losses by as much as 75% in recessionary periods. (It should be obvious that if you reduce losses such as that sustained in 2000 and 2008, you will increase overall return. Don’t need a calculator for that. To that is coupled a set time (Phase 4 discussed later) to get back in the market for the bulk of the runup (though there is no guarantee that such runup will occur in the future. That, by itself, voids buy and hold, stay the course, et al.)

 The necessity was clearly apparent with the many or soon to be retirees who lost the bulk of retirement assets in the recessions and were subsequently unwilling to reinvest after 2009.  Admittedly the wealthy lost as well either through their own ego flaws or because they may have hired the wrong advisers. Well, that last sentence is only partly true. If you don’t know that you don’t know and no entity is keying you into the Real World, the whole investing element is a great tool when growing but an absolute farce is you lose about half of it every 10 years or less. Nonetheless, the Process works the same with almost all mutual funds, many ETFs, all investment retirement programs and all socioeconomic classes.

(If anyone deals with an adviser, they must ask them about their analysis of the inverted yield curve as well as what they did in 2000 or 2008 and what they intend on doing in this next mess. If you pick an advisor that has not at least been around for the 2008 recession, then that is your fault. I am fully aware of that being ‘tacky’. But I have seen planners who are considered at the top of their game, years of Monte Carlo spreadsheets, miniscule identifications of equity niches and yet knew nothing of the inverted yield curve (and more). They dug out a hole of ignorance/stupidity and invited others to drop in. It has filled to overflowing primarily because real life education has been stifled. The most egregious error is the failure to put risk at the front of analysis. 

If the industry wants to be shown as professional, they need to step up their game. However if a planner is not a member of an independent planning organization that requires annual education, they may not be required to do any additional continuing education annually. (That also infers that the continued education has real life merit- not a given.)

In terms of FINRA, NASAA, SEC, DOL and more, their diligence is wanting to the point of non existence. The SEC- actually all such organizations state and government- make wholesale gaffes as to who is what in the licensing game. These issues fall around the definition of Investment Advisor when in fact the bulk of same call themselves Financial Planners. The two titles require different tasks and knowledge but the major overseers offer no discussion at all and thereby render their commentary seriously wanting or just a waste of time. I have covered that previously but consider the entities- universally staffed by attorneys- have never required that practitioners know how to use a financial calculator. This will be addressed later many times. But the main issue is that most fee financial planners CANNOT act as fiduciaries- because they are not legal. A financial planner doing fee work must cover effectively all areas of personal products and usage. They need more than a cursory understanding of the issues. One of the hardest is life and disability insurance, long term care, annuities, etc. These are not miscellaneous items to be trivialized. Unfortunately, few fee advisors are knowledgeable in those areas or only tangentially so. Further, many states require a separate license and exam (beyond just being a sales agent) to offer such advice. But just about nil advisors have done the additional work to become legal. For specific reference, I offer the Life and Disability Insurance license required under

“Authorizing Act: Section 1848 of the California Insurance Code (CIC) reads, in part: A Life and Disability Insurance Analyst is a person who, for a fee or compensation of any kind, paid by or derived from any person or source other than an insurer, advises, purports to advise, or offers to advise any person insured under, named as beneficiary of, or having any interest in, a life or disability insurance contract, in any manner concerning that contract or his or her rights in respect thereto.”

There are many other states that require a separate license.

Kitces offers the following: “Even in today’s environment where consumers are better educated and it’s much easier for someone to ‘do their due diligence’, the bar is still so low that, not only can anyone call themselves an “advisor”, but they can still extract nearly 10% of the wealth of every person they meet by selling a low-quality high-cost product, with little worry about any legal recourse… since the bar to prove their sale was “unsuitable” is so low and easily cleared.”

So is a fiduciary required to be legal to be a fiduciary?

Pursuant to the organizations encompassing CFPs, NAPFA, CPA PFS, ChFC etc. the answer is NO. 

This will be covered in a separate article in the future but the formal regulatory entities- that demand the highest fiduciary standard- need to recognize a lot of crap goes on in front of their eyes and they need to wake up and stop it. 

Changing values/Theories Debunked

Peter Bernstein was a financial historian who will never be matched. Two of his books- Capital Ideas: The Improbable Origins of Modern Wall Street and Capital Ideas Evolving cover the inception of financial growth going back centuries..  Bernstein wrote other books (most notable in my mind was Against the Gods:The Remarkable Story of Risk), numerous articles and ran his own Investing firm up to his death in 2009. He slowed down after that. If you are in the business, these first two books above offer the who, what, when, where, why of the evolution of leaders in the theory and analyzation of the efforts to define and redefine what was going on and ………”describes these changes, a virtual revolution in the practice of investing that (now) relies heavily on complex mathematics, derivatives, hedging, and hyperactive trading.”

What I noticed was his detailed analysis of how each new improvement/idea/change/adjustment was almost unilaterally met with heresy, derision- at a minimum, skepticism. Notable was his commentary that new “valid’ ideas might languish for decades……….then meet with more acceptance as the old farts died off and the once described aberrations became main stream. The predominant example was John Bogle and his move to indexing (he did this in spite of wholesale pundits).  Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly".  He was in his 40s.  Think about that in how his demand for lower fees coupled with the inherent ‘failure’ of actively managed funds has FINALLY become solidly ingrained in the industry. And still making advancements.

There are those who have taken the bulk of homilies and pushed the envelope further than John Bogle. These include Warren Buffett, Charlie Munger, Benoit Mandlebrot (deceased), Nassim Taleb, Peter Bernstein (deceased), and a few others that have brought to the forefront new thoughts and positions (Kahneman). Even when segments are chosen for acceptance/derision, the industry and advisors may misunderstand, misapply or simply annihilate any real life validity.

The following detail a number of such issues and effectively leads to the use of The Process. It makes little sense in reviewing/analyzing old, semi useful and outdated theories and homilies. They do not help those most in need. Time to grow up to a new world of thinking.

 

Market Timing, Inverted Yield Curve, Recession

Risk is the absolute first issue in investing. The industry cranks out all sorts of marketing showing how this fund will work with buy and hold, stay the course, market timing doesn’t work, etc.

Here is some commentary on timing

Actually, market timing CANNOT work but the only thing you hear or see is ‘simply the statement’. This is the point. Let’s forget Ouija boards etc. In order to ‘figure out market timing’, you must have a pattern in history where you can pick out certain characteristics and statistically show that ‘timing’ is possible.  (I am not talking about someone calling the bottom after one quarter of negative GDP- that’s a ridiculous ‘look into the future’.) Market timing is the ability to define when a recession occurs at least 6 months prior to.

 

 

 

Look at the number of recessions for the past 48+ years (vertical grey bars). If you only have a few recessions but where there was an obvious chance of a pattern……whoa-  that’s the stupid statement. There ain’t enough numbers, there is no pattern, THERE IS JUST NOTHING where a human or artificial intelligence can work with. At least if someone is having a baby, you know it’s going to take 9 months. So it is not that difficult to guesstimate the date and maybe you get lucky and win a raffle. The spacing of recessions here have no pattern save ‘that they happen every so often.’ It is not necessary to kick up the market timing statement anymore, anyplace.

In terms of how bad a recession might be- prior to 2000 the internet was the Holy Grail of investing/growth. There were not going to be business cycles anymore, yada, yada. And yet over three years it lost 49%. 2008 saw 57% losses but I remember Fed Chairman Bernanke stating that we were not going to have a recession. There were some analysts that indicated major loses would ensue but that is not the same as an indication of WHEN.   

Inverted Yield curve and recessions. MOST IMPORTANT

 It was- and is- apparent to address risk in a different/knowledgeable/real life manner. I made continued reference/relevance to the inverted yield curve via FED articles in the late 90s. But with the Dotcom, RISK never went in one ear of the students and out the other- it got blown away with the noise of the internet and the ‘fact’ that business cycles were a thing of the past.

Pretty much the same thing with 2008. I did see at least a few articles on the inverted yield curve but they were not mainstream. The curve is not the reason for a recession but a 100% indicator for the last 50 years of a forthcoming one. It does not say when, how bad, nor how long. As noted, Bernanke said in 2007 that he did not expect a major problem. And the market lost 57%. Shiller is now suggesting about 22%. Swedroe says it is not going to happen this time. My position is that losses will be over 40% but as I sit here today with the bombing of the Kurds, a possible/probable impeachment of Trump, and many countries working with negative interest rates, I can see it even higher than 50%. But no matter the ego, intellect, insight- a plan MUST be in place prior to the problem or one is just playing with a big accident.

As noted both in 2000 and 2008, there was effectively no way to figure out when the recession would start. Actually, you won’t know if a recession is occurring until after the fact since you have to have two quarters of negative growth. For the purpose of the Process, I do ‘not’ care when it happens. I am only interested in the percent drop since it is only then that it is worthwhile to really pay attention (see also false positives herein).  Further, it is not unrealistic to see the market actually increase prior to the start of losses since the FED’s effort to right the economy may increase positive trades until the market goes splat. I repeat, you do not know when the recession will start, how long it will last nor how bad it will be. Though I think the next one could be real messy.

Bad statistics

The point is not to slam forecasters, experts and others per se but to clearly show that almost all the industry stands together spouting ridiculous homilies, stay the course through thick and thin, take 100 minus your age to determine equities, behavioral humans that do everything wrong, etc. Others suggest that rebalancing annually- or whenever- can reduce such losses while providing a good return. (Not necessarily.) If you really want statistics, you can check out Dalbar which shows that humans are emotional failures and definitely sell at the bottom and buy at the top. Some articles may show the cute little drawings like the one below.

 

Adorable, isn’t it? But a couple things are wrong. First of all, there is a mathematician, Michael Edesess, who has shown that the numbers calculated by Dalbar are incorrect.     https://www.advisorperspectives.com/articles/2014/06/17/a-simple-explanation-for-dalbar-s-misleading-results

Though that still leaves the emotionalism of regular investors doing the wrong thing at the wrong time and the reason you see that graph by a number of major magazines.

In contradiction, there is a new study by Morningstar that categorically, emphatically and unequivocally (yes I know the words are the same but it’s my article) state that the facts used in Dalbar’s study are not real.

Dalbar notes. “Dalbar conducts ongoing quantitative analysis of investor behaviors. They reported that as of 2015, the S&P 500 twenty-year average return was 8.19%, but the average equity fund investor had only earned 4.67% over the same period. It got worse the longer out they went. Over the thirty-year period ending December 31, 2015, the S&P 500 averaged 10.15%, but the average equity fund investor earned only 3.66%. So, yes, there is a big difference between investment returns and investor returns.”

Wait for it…………….

Morningstar notes, : Morningstgar Mind the Gap

“We calculate Morningstar Investor Returns to understand how investors actually fared in a fund when you take cash flows into account. Essentially, we are asking, How did the average dollar in a fund do over a certain time period? Specifically, we can say the average investor lost 45 basis points to timing over five 10-year periods ended December 2018.”

EFM- This is a controversy that will continue to be hotly debated for some time to come. (I have not done a review on the Morningstar analysis.) But does it change my Process? No. What’s the issue? Morningstar- as with all the other entities in the cartoon- keep generating returns that maintain the idiocy of sitting and taking huge hits (with certain offsets) during a recession. They will show beta, R2, standard deviation, Sharpe ratio and more as elements of risk but only in general and superfluous terms- not what the real life risk could be at increments of 7.5 to 10 year spans. That leaves all advisors/consumers with an incomplete, hollow and specious view of real life risk of loss.

Here is the fault with stay the course- there is nothing, I repeat NOTHING that states that the market will come back after a recession. In one defense, it can- but you might be dead by then. Second defense is look at the number of recessions once again and go back to 1965. Note that it wasn’t till 1990/1995 till you saw a massive up market and a lot of volatility. I admit that I do not like to use backtesting as a guide to the future, but it is not much of a stretch in this world to see stagnant growth as in sections of the past. In fact, most experts already state that the future returns will be far less than the most recent past. Therefore the idea of buy and hold, buy on the dip et al should (probably) not be stressed as completely viable options with recessionary losses.

 

Some pundits may say that such flat economics are actually a statistical  anomaly- an outlier. However I am sure that effectively 99 44/100% of advisors never thought an outlier like Japan’s could remotely occur. I kept stating that there was no way that Japan would not snap out of its doldrums and become a powerhouse again. I I kept saying it and ………. I finally gave up. But it will come back, won’t it???? Not a clue.

That said, I am comfortable with the inverted yield curve probabilities since, in totality, it references an economy under extreme pressure where certain elements can break its back. I am not stating that the economic pressures are the same each time. They definitely are not. That is another reason market timing does not work. Lack of comparable factors.  

Below are homilies and broken theories primarily about RISK. Risk is the first and foremost critical item to investing. If you do not get that right……….

Standard Deviation/Volatility as a measure of risk?

Standard deviation "is a measure that is used to quantify the amount of variation or dispersion of a set of data values. A standard deviation close to 0 indicates that the data points tend to be very close to the mean (also called the expected value) of the set, while a high standard deviation indicates that the data points are spread out over a wider range of values."

The standard deviation of S&P 500 returns from 1928 to 2015 averaged 19.7028%. Now it is only a little over 12% (Totally separate comment- notice how there are 4 decimals after the 19. The necessity/value of that type of detail is ‘just a waste of time’. It can adversely reflect on the author’s understanding of ‘accuracy’. Think about it- going back to 1928 where there is almost nothing to suggest correlation with 2019?? Use 19.7%.)  

Consider this from Warren Buffett:

“The measurement of volatility: it’s nice, it’s mathematical and wrong. Volatility is not risk. Those who have written about risk don’t know how to measure risk. Past volatility does not measure risk.     ……..Volatility is useful for people who want a career in teaching. I cannot recall a case where we lost a lot of money due to volatility. The whole concept of volatility as a measure of risk has developed in my lifetime and isn’t any use to us.” 

From Benoit Mandelbrot and Nassim Taleb

“The professors who live by the bell curve adopted it for mathematical convenience, not realism.

It asserts that when you measure the world, the numbers that result hover around the mediocre; big departures from the mean are so rare that their effect is negligible. This focus on averages works well with everyday physical variables such as height and weight, but not when it comes to finance. One can disregard the odds of a person's being miles tall or tons heavy, but similarly excessive observations can never be ruled out in economic life.

The problem with all these measures is that they are built upon the statistical device known as the bell curve. This means they disregard big market moves: They focus on the grass and miss out on the (gigantic) trees. Rare and unpredictably large deviations ……….. have a dramatic impact on long-term returns --but "risk" and "variance" disregard them.

The inapplicability of the bell curve has long been established, yet close to 100,000 MBA students a year in the U.S. alone are taught to use it to understand financial markets. For those who teach finance, a number seems better than no number--even if it's wrong.”

EFM- Past volatility/standard deviation only show what happens with relatively small changes- meaning overall they avoid/ mask/ delete the risk as to how bad it really can get. The problem becomes this- I have never seen a S&P500 beta chart (it’s out there someplace?) where the real life Risk of Loss (50%) is on the chart itself or is identified in texts as an occurrence every 7.5 or 10 years.

How can an advisor guide a client to invest in XYZ fund while knowing it took a bath in the last recession and very well do the same with the upcoming recession.                                

 

The 50% losses are displayed on this simple graph

But the 10 year graph does not have to include 2000 nor 2008

Looks a lot different- and with nil risk of loss- than 2000- 6/2009

The BETA Blues

Beta (Investopedia)  beta coefficient is a measure of the volatility, or systematic risk, of an individual stock in comparison to the unsystematic risk of the entire market. 

More from Benoit Mandelbrot and Nassim Taleb

Your mutual fund's annual report, for example, may contain a measure of risk (usually something called beta). It would indeed be useful to know just how risky your fund is, but this number won't tell you. Nor will any of the other quantities spewed out by the pseudoscience of finance: standard deviation, the Sharpe ratio, variance, correlation, alpha, value at risk, even the Black-Scholes option-pricing model.

“Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no.”

 

Markowitz Theory/ Capital Asset Pricing Model

The following identifies the general comments on the CAPM. You can get a reasonable feel for it if you want to use it for a portfolio allocation.

 

“Investopedia notes, The CAPM and the Efficient Frontier

Using the CAPM to build a portfolio is supposed to help an investor manage their risk. If an investor were able to use the CAPM to perfectly optimize a portfolio’s return relative to risk, it would exist on a curve called the efficient frontier, as shown on the following graph.

The graph shows how greater expected returns (y-axis) require greater expected risk (x-axis). Modern Portfolio Theory suggests that starting with the risk-free rate, the expected return of a portfolio increases as the risk increases. Any portfolio that fits on the Capital Market Line (CML) is better than any possible portfolio to the right of that line, but at some point, a theoretical portfolio can be constructed on the CML with the best return for the amount of risk being taken.”

EFM- An examination of the good and bad parts of the CAPM is available from industry experts but it tends to be utilized in some manner as a part of ‘good investing’. My point is not whether or not the fundamentals may be applied to generate a higher return overall but simply to look at the graph. The x horizontal  axis shows the real life expected risk of the ideal portfolio.

No it doesn’t.

Do you see anything addressing the expected risk of every 7.5  years with a 50% loss. Pundits might rail at a recession occurring that quickly (I opted for 4 recessions in a 30 year period. Considering a world in complete disarray, I do not find my interpretation wanting) but readers can opt for 3 in 30 years as a minimum. Less than that is not real life.

Once again the risk universally shown in the CAPM graphs obfuscates the reality of a 50% risk to equities that should/must be presented to investors. The graph- which is used in almost any text on investing- is irresponsible instruction on risk even if it was possible to confirm that the securities selected perfectly conformed to correlation, beta and so forth. If one can realistically interpret 40%- 50% loss every 7.5 years- even 10  years- does not that change the entire focus of Markowitz’s theory? At least it demands a countering argument that the theory as stated/shown does not mirror risk in real life.

Advisors, private risk analytic and fund analyses firms have deceptively provided graphs and charts that unilaterally dismiss or fraudulently avoid how real life economic activities can and will devastate a consumer’s life on a repeatable basis.

REBALANCING

Rebalancing does not necessarily work in providing a higher return than buy and hold. Edesess provides another article Edesess, Michael, Rebalancing: A Comprehensive Reassessment (November 21, 2017). Available at SSRN: https://ssrn.com/abstract=3075023 or http://dx.doi.org/10.2139/ssrn.3075023

“Contrary to common belief and to the misguided conclusions of most of the articles in academic finance journals, it is that rebalancing offers no “free lunch,” either in terms of enhanced return or reduced risk. The choice of rebalancing as an investment discipline as compared with an alternative such as buy-and-hold is simply a risk-return tradeoff – though one that is a little more subtle than most.  At the more common middling levels of performance of portfolio assets, or when portfolio assets perform similarly, rebalancing will slightly outperform buy-and-hold*. But in less common cases (about one in three) when one or more of the assets performs very well, buy-and-hold will markedly outperform rebalancing. This choice may not be easy to make; either of the choices may be regarded as satisfactory. But it is a far cry from saying that it has been proven that rebalancing is something you absolutely must do.”

* EFM- recognize that both issues are maintaining the losses due to recessions. If the major losses were avoided (i.e.  eradication of “Sequence of Returns”), the returns for buy and hold would be significantly greater than noted above.  The Process substantially lowers the Risk of Loss in recessionary economics, per phase 3, where equities will be reduced when the funds/allocations are stressed beyond a correction (10% to 15%).  

The greatest flaw is an entrenched industry that never has stress tested mutual funds to recognize and treat the real life Risk of Loss.

Phase One

New Risk of Loss Categories

Phase 1: This is the new Risk of Loss the defines the various categories

Not an investor: No loss ever – certainly that of a basic correction of 10% 

Conservative: Willing to assume losses up to 15%  (10% to 15% is now a standard correction- up from 10% in the 1990s)*

Moderate: Accepts losses to 40%

Aggressive: Accepts losses to 65%

Speculative: Accepts losses to 100%+ (leverage)

Client Questionnaires and Risk

One of the critical areas of investing- that is finally getting some attention during the last couple years is the fact that client questionnaires are an ineffective way of determining a client’s risk profile- certainly as the inputs now use behavioral characteristics in the mix of ‘data’. I note my negative opinion as early the mid 1990s. Advisors unilaterally used a firm’s questionnaires to pop into the firm’s software that would identify the client’s risk and the associated portfolio allocations (basically managed mutual funds) for the individual or couple. Most advisors- since a capability with a personal financial calculator was not required nor taught as part of licensing- used these cookie cutter strategies- with the pretty pie charts- to mesmerize clients. Even those who did have instruction with a financial calculator universally used the packages software since it was impressive looking, used nice technical jargon and provided the ubiquitous nicely colored pie chart- to engage clients. The difficulty I had was no one had a clue to the internal machinations whirling inside the computer.

In a recent survey, 78 of the 92 respondents (85%) stated risk questionnaires are not effective. Interestingly, 19 out of 20 financial professionals (95%) stated they were not effective, and fifty-nine out of seventy-two individual investors (82%) stated they were not effective as well. I find this quite alarming on a few levels (especially since the advisors were even more critical of the questionnaires than the investors) since the statistics have not made any difference in their use .

Decision theorist and economics professor Shachar Kariv says they are a poor way to gauge risk tolerance….., Client surveys and questionnaires are "the source of all evil and bad in the financial-services industry."

No matter, it was necessary and preferable that the end results of allocation were verified by separate analysis. Wasn’t going to happen by corporate since the nice looking binders was just great marketing. But, as noted many times was the 49% loss in 2000 and 57% in 2008. Risk of Loss was never taught.

From an article I know not where- but the words/comment mirror hundreds of other mewling articles on risk. “There are many things to consider when determining the answer to a seemingly simple question, "What is my risk tolerance?" The answer will vary based on your age, experience, net worth, risk capital and the actual investment or trade being considered. Once you have thought this through, you will be able to apply this knowledge to a balanced and diversified program of investing and trading.”

EFM- The idea that the client is going to determine their risk is offensive. You can add in all the elements of age, etc. and the industry still doesn’t get it. To repeat- the Process I developed was not for the heavy hitters- though it works the same. It is to align the middle and lower income investors- and I include as a group, the military- with 401k, IRAs and the like, that are unknowledgeable on what to do either by recognizing it is too difficult or simply don’t care no matter the necessity (or are overseas). I unequivocally state that the factors above (age, experience, net worth, etc.) are the suitability requirements that the defense uses in securities arbitration cases. (The industry was successful in beating back a fiduciary requirement to consumers.) Supposedly if a broker addresses these issues, they can/may be absolved of wrongdoing. These items are required input on the client questionnaire. However, the inputs then swirl around in the underpinnings of debatable software that few have ever researched and, voila, there is a printout confirming the funds that meet the perceived investor risk profile.

WRONG!

You cannot even remotely address suitability unless and until you have recognized the Risk of Loss to investors.

Just to make another point regarding the superficial questionnaires is the value of ‘Investors experience’. The investor is ‘assumed’ that there is adequate experience if they had been using a 401k for 10 years, bought some stocks, et al.  Get real. The buying of stocks, the use of options, etc.  cannot be unilaterally correlated to a ‘causation’ of sophistication nor even knowledge.

As regards age- being older does not equate to superior knowledge nor overall intellect. Some simply were stupid when they were 80, stupid when they were 60 all the way down to where they were stupid when they were 20. By the same token, not all the elderly are dumber than a post and they need to take more responsibility to their actions. The idea of crass simplistic generalizations are used a lot in arbitrations where they can work for either side since the bulk of attorneys don’t know about risk and can neither exploit nor defend many issues being addressed.

Time marches on and behavioral elements were being introduced as part of Artificial Intelligence software that defined risk.

For the uninitiated, Behavioral economics studies the effects of psychologicalcognitive, emotional, cultural and social factors on the economic decisions of individuals and institutions and how those decisions vary from those implied by classical theory.[1]

Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychologyneuroscience and microeconomic theory.[2][3] The study of behavioral economics includes how market decisions are made and the mechanisms that drive public choice. The three prevalent themes in behavioral economics are:[4]

This short definition in no way describes how the financial industry has attempted to incorporate the number of facets of human behavior into a risk profile that is more closely tied to reality (whatever that means). Frankly, while this issue will remain a top priority in the future, the industry is struggling mightily since there is no consensus with the nuances of each topic. Software vendors even have significant differences in their risk profiles from their least costly programs to their more ‘advanced’. (So much for truth in advertising) And there has been all sorts of criticism from one company to another regarding they are right and the other company is ‘….. something else’.

Once again, the use of software with its subjective inputs and potentially artificial intelligence makes if difficult if not impossible to figure out since the weightings for each type of influence is whatever one wants to make it.

There you have it- most client questionnaires are huge guesstimates. So what is a body to do for a risk estimate? At this point, some may be aware of the teaching of Kahneman and Tversky who are considered the pioneers in the field of human behavior. Kahneman won a Nobel prize for his work and his most recent book “Thinking Fast, Thinking Slow” continues to delve into all areas of behavior.

But then came an article that contained an interview with Kahneman that was worth a thousand trials for client risk. In early 2018, Kahneman noted, “We had people try to imagine various scenarios, in general, bad scenarios and the “question was, at what point do you think that you would want to bail out? That you would want to change your mind?” It turns out, that most of the people — even very wealthy people — are extremely loss averse.” There is a limit to how much money they’re willing to put at risk,” he said. “You ask, ‘How much fortune are you willing to lose?’ Quite frequently you get something on the order of 10%.”

I therefore had the preeminent expert in the field with thousands of test subjects over decades of time corroborate what is generally considered to be a correction.  And the result is the New Risk of Loss Categories above- though I extended a correction up to 15%. The necessity of all sorts of subjective meanderings of the human condition with snippets of artificial intelligence was brought down to earth by a huge number of tests over decades of time by the pre-eminent  authority on how people act and react.  

Use consumer/client questionnaires sparingly- if at all.

Phase 2

Stress Testing /Value at Risk for Mutual Funds

Phase 2 is a stress test just for recessionary losses. It will also work with large corrections- such as that in December 2018 but its main benefit is to give an approximation of losses to the allocations being selected. Given the losses in 2000 (49%) and 2008 (57%), it should not be any stretch of logic that even the ‘mediocre/conservative’ risk of basic index funds were causing the unknowing investor the greatest risks of loss.

   

The Stress Testing or Value at Risk for Mutual Funds takes fund data and then computes at the time of purchase or review the potential Risk of Loss of that fund during a recession. You can see how close the ranges were to actual losses. The potential Risk of Loss will also work in a correction simply because it is unknown how far the losses will go.

The projected losses at specific times will change as the economy changes. Nonetheless, this risk must be brought to the investor’s attention at least at the time of purchase to address and discuss what the advisor did in past recessions and/or how they will respond at the advent of significant losses going forward.

The figures apply managed and passive but the Risk of Loss for managed funds will be as identified (Phase 2) and assume that managers will reduce some equity exposure during a recession. However, passive index funds do not materially change the equities invested and therefore all index funds’ Risk of Loss must be manually increased by 10%.

Target Date Funds/Managed funds allowed full discretion in allocation

There are funds that do not have a set allocation over time- TDF- Target Date Funds are the most ‘notorious’. In their initial offerings years ago, the percentage of stocks and bonds changed per a set allocation identified in the prospectus. The Process could adjust to some changes, but when the industry effectively allowed most TDFs to do almost anything they want at any time they want, the ability to stress test the fund is lost.

Most managed funds, may/would change its allocation within certain limited percentages (I use a 10% adjustment to cash) and the Process could deal with. But if a managed fund could radically change its allocation to something entirely different, it therefore becomes impossible to know what any fund would do at any time.  

The simplistic overview of beta, alpha, correlation, standard deviation, Monte Carlo and more cannot pass legal muster by a fiduciary. You simply cannot sell something that has significant losses inserted in any relatively short period of time without informing potential investors. More so when the retirement advice is for a 30+ year period of time peppered with 50% losses that, for the most part, are unilaterally missing from view. It really is a bait and switch.

Example of invalid data

During the last year I have written several articles addressing RISK as the most important element in investing. It is the first and dominant criteria in investing but the industry rarely gives it the thrift it deserves- mainly, I feel, since they would have to recognize that a lot of the homilies they push are very, VERY lacking in real life use. Not that some do not have merit- just that the level of use has been elevated to a point of excess without much value.

Here is one simple example: one can look at the 3 year average volatility of the S&P 500 at 12.10%. Is that the risk of the fund as many advisors suggest it is? It is WAY down from 21% in the 1980s.  So the current risk of the 500 index fund today is almost half of previous, right??? So you can sure invest a lot more with the statistics well in your favor, right??? And even if things go bad, your losses will be minimal even with a recession, right???

But how does that fit in with a loss of 49% in the 2000 recession or a 57% loss in 2008? Morningstar says it has an average risk. Say what? It can’t be for loss. It has a Sharpe ratio of 0.92. Beta of 0.99. And anything else you want to throw in the pile- Sortino ratio? How about Monte Carlo- 30 to 120 years of historical dissimilarities to match what has occurred since 2000? (Effectively everything since the mid 90’s and the vast technological changes that dwarf the last 100 years (primarily personal computers/phone and the internet) is so totally different now that it stretches credulity.) Going forward, how should Monte Carlo work? How many recessions during that time frame do you want to enter into the allocation software. Will software even give you that flexibility?

Then you have to subjectively pick a return. Then inflation. Even worse is selecting a recession upon occurring right at the initial deposit. Real life? Look at 11/2019. Does anyone think that investing at this point in time is going to lead to Nirvana? Even New Jersey. You have an inverted yield curve, trade wars, Yemen, Saudi Arabia, Brexit, Royhingya, Iran, Kurds, Hong Kong, North Korea, Russia, a totally unhinged Trump, Ukraine, Turkey, Amazon fires, China, a political riptide of disagreement and Congressional nonsense, impeachment, HUGE budget deficit and more that in some(???) unknown reality says, ‘let’s invest now’.

The idea, however, that humans are irresponsible during every economic period is not valid.

- though it is also true that general public is not that swift in analyzing the fundamentals of investing. I answer a lot of tweets from submitted questions that come my way and it is clear that the young have little comprehension of finance. The adults seem little better. Unfortunately many in the industry are inadequately knowledgeable- certainly towards the element of risk. Risk is not taught and when it is addressed it is only tangentially.

 

Risk Factor Allocations

The industry through its various minions offers all sorts of theory- (do not read the following too closely. I am not kidding- you will hurt yourself)

“This tool supports optimizing the portfolio asset allocation based on the targeted risk factor exposures. The returns of the given portfolio are first regressed against the selected risk factor model consisting of equity risk factors (e.g. market, size, value), fixed income risk factors (e.g. term, credit), custom risk factor series, or any combination thereof. Based on the regression results, the portfolio exposures to specific risk factors can then be adjusted. The optimizer identifies the closest portfolio to the desired risk factor exposures based on the given cost criteria, which can be based on either expected rebalancing costs or maintaining the other risk factor exposures as close to original as possible. You can also specify a list of optional assets that the optimizer can choose to add to the portfolio in order to meet the targeted risk factor exposures.”

                 Huh????

 

 

If you don’t like that one, then try one of these.

 

And of course, all readers (3?) know the Black Litterman Model: Investopedia- The Black-Litterman model uses a Bayesian approach to combine the subjective views of an investor regarding the expected returns of one or more assets with the market equilibrium vector of expected returns (the prior distribution) to form a new, mixed estimate of expected returns. (Don’t feel uninformed/stupid- Never came across it myself. Would find no reason to use it.)

Here is yet another idea of spreading the knowledge to attain the proper allocation/return

Style Factors:

  • Accumulation vs Distribution
  • Probability vs Safety First
  • Optionality vs Committed
  • Front Loading vs Back Loading Retirement Income
  • Implementation Factors:
  • Perpetuity vs Time Based
  • Systematic vs Unsystematic
  • Technical Liquidity vs True Liquidity
  • Financial Goals & Risks
  • Longevity
  • Lifestyle
  • Liquidity
  • Legacy
  • Psychological Factors:
  • Self-Efficacy
  • Behavior Finance- Heuristics

Is it possible to create an algorithm that would couple certain styles for the best correlation?

Not really- probably none that could be proven. Think about this though- you would have to have an innate knowledge of EACH one in order to evaluate any particular one objectively as being better than another.

 

 

Here are some comments about diversification and Tracking error. You do NOT have to understand the comments below- but you do need to scan to recognize how superior egos can work to deny the rest of the human race even an inkling of understanding to what is printed. O.K. maybe half a dozen can- but I do not want to meet them.

“It is almost as important to get the balance between diversification and tracking-error (Tracking error is the difference between a portfolio's returns and the benchmark or index it was meant to mimic or beat. Tracking error is sometimes called active risk) regret right as it is to determine the appropriate equity/fixed-income allocation. If you have the discipline to stick with a globally diversified, passive asset class strategy, you are likely to be rewarded for your discipline.* The same holds true for investments in other risky assets, such as alternatives, including AQR’s Style Premia Alternative R6 (QSPRX) and Alternative Risk Premia R6 (QRPRX) (both long-short, factor-based strategies), as well as Stone Ridge’s Alternative Lending Risk Premium Fund (LENDX) (small business, consumer and student loans), Reinsurance Risk Premium Interval Fund (SRRIX) and All Asset Variance Risk Premium Fund (AVRPX)”.

* The point is that some type of formula above is expected to do what? Beat the market. So, say it can. By what?- 50 basis points over 10 years? Why not 75 basis points? So what? Both returns and the default market will have to include a 50% loss of equities over one recessionary period and covering at least two years.  

Take $100,000 at 6.50% and at 7% for 8 years- then a recession for last two years.  

A 6.5%, 8 years, 100,000 =  165,500

B 7.0%  8 years, 100,000= 171,818

Difference is $6,300 

Then a recession of 50% over a period of the last two years.

(When using hypotheticals, it’s close enough to round numbers all over the place. Being absolutely ‘correct’ when all the numbers are guesstimates is illogical)

  1. $82,750 loss/remaining
  2. $85,909 loss/remaining

Why not reduce losses to just 12%- 15% via Phase 3? Used 15% for example

A 165,500 x .15= 24,825 round to 25,000

B 171,818 x .15= 25,775 round to 25,000

Differences in losses

A 82,750- 25,000= $58,500 round to $58,000

B 85,900- 25,000 = $60,900 round to $61,000

So look at the simple math. You use some type of formula where B makes $6,300 more than the default index A over 10 years. But by not paying attention to real life risk, the investor sacrifices $83,500 (rounded) of losses. If the investor uses Phase 3, the losses from 12% to about 15% or about $25,000. That is a savings of roughly  $60,000.

$60,000

 

If an adviser acts as a fiduciary, they know- or ought to know- or must know- what the loss exposure roughly is for a recession.  After all, they are giving all sorts of estimates on returns, various allocations, your risk profile (get real) etc. while knowing full well that business/economic cycles are peppered with recessions. But effectively 99 44/100% of advisers and about the same with magazines, articles, organizations and even educational entities litter their material with an excessive retention of recessionary losses.

I repeat, investors need identification of losses as identified above. They need to know what will be done to their assets.  Such recognition is not offered to investors. If one person- me- can figure out how to stress test a fund and portfolio………….. I don’t believe it. With CFAs, PhDs, and millions upon millions of dollars at Morningstar, Barron’s, Wall Street Journal et al, there has to be an entity(ies) somewhere, who have done this. I can however understand why it never got notoriety since it would make the planning effort cover more real issues of risk than ever as well as demand capability with personal financial calculator. (If you sit with a planner who cannot use a PERSONAL FINANCIAL CALCULATOR, get out! Software cannot even remotely cover all the issues that pop up that need a functional brain rather than AI.)

Most importantly, those investors that have no advisors, are clueless to risk- in fact most of the issues of investing, need a default position that can be implemented automatically through 401k plans, certain broker dealer firms, consumer groups and are absolutely mandatory for Robo advisors.

That is what the Process provides- risk categorization that investors can understand, a method of stress testing mutual funds and ETFs utilized (must have track history), a default scenario for those who are clueless to a Risk of Loss and an independent manner to get back in .

Consumer Reliance/Gullibility and Behavior and Unbalanced Reporting

The Process is (almost) solely identified with the Risk of Loss of mutual funds and ETFs. Real Estate requires use of a CIA- Comparative Investment Analysis form- and is quite involved and beyond this scope of this review.

The subsequent material identifies why the industry has refused to examine real life Risk of Loss. As noted above, a recessionary risk is what an advisor/industry is supposed to identify. But that isn’t enough

Phase 3

Consumer questionnaires and risk parameters

 

“When it comes to determining your risk tolerance, your level of investing experience must also be considered. Are you new to investing and trading? Have you been doing this for some time but are branching into a new area, like selling options? It is prudent to begin new ventures with some degree of caution, and trading or investing is no different. Get some experience under your belt before committing too much capital. Always remember the old cliché and strive for "preservation of capital." It only makes sense to take on the appropriate risk for your situation if the worst-case scenario will leave you able to live to fight another day.”*

*EFM- And therein lies the rub. The bulk of average retirees have little insight to where they are as well as what they should do. But the last sentence is wrong since it only provides a solution that an investor designs a portfolio allocations so that the equities section can never lose that much. And what is that? Well, you can’t know without doing a budget and then figuring out the nest egg you need to fulfill that expense.

For the uninitiate with a financial calculator, the budget is the PMT; lifetime projected (actuarially and generally plus a fudge- say 5 years) is N; end value is 0 (all assets are gone on the last day of N). That is FV. The value of i includes a guesstimate for inflation as well as a guesstimate for investment return; (1+r/1+i)- 1 x 100 . Hit PV for the value of needed gross total assets. Generally Social Security is subtracted for a net PV. (For simplicity, I am excluding any other investments, the house, etc.)

Assume the investor will NOT have enough. Assume the budget is as tight as it can get. The length of the lifetime can easily be adjusted but that has rarely made sense to me. Assume inflation for the calculation is at the low end of the guesstimate and that the return is what is being calculated. What happens if the numbers require a 6.5% annualized return to make it to and through 30 years. And since the investor is scared of losing too much that they decide on a 50/50 split of stocks and bonds. If stocks were to return 7% (85% to 95% probability for 5 years) and 3% on bonds (guesstimate only) the overall return would be 3.5% plus 1.5% or 5%. That is not enough return for that required (6.5%). Now what?

Well, the investor could more to 70/30. In such case, the equities would now produce 7 % x 70% or 4.9% plus 30%x 3% is .9% for a total of 5.8%. Still too short. And I submit that these type numbers reflect 75%+ of pre retirees or already retired and that they will have insufficient assets to acquire for retirement or during retirement. And once they have been hammered by 2000 (49% loss) and 2008 (57% loss), they are simply put out as a statistic that they will not be successful for retirement- or certainly make it through 25+ years.  The industry presents them as a lost ‘generation’ where nothing can be done.

WRONG!!

As a current note 11/4 from JP Morgan The traditional investor portfolio — which is made up of 60% stocks and 40% bonds — will return just 4.1% over the next 10 years. Valuation proves “far more accurate than any other variable in determining what the 5- or 10-year experience of an investor will be.

Morningstar noted ONE percent return on stocks for next 10 years. (If that should be the case, our society will break down rapidly. The Process will save some funds automatically but the significance of such a return would undoubtedly make almost all retirement moot. I cannot fathom the economic devastation.)

Then you can add younger consumers to the mix who will be unprepared. According to a 2018 Gallup poll, 52 percent of adults under 35 say they owned stocks in the seven years leading up to the crash. By 2017 and 2018only 37 percent did. By contrast, an average of 66 percent of Americans over 35 invested before the crashand though the share is lower now it's still at 61 percent.

The numbers from various research organizations and public reports are, at times, varying widely. No matter, the great numbers of any age (and the military) just cannot be left in the lurch for savings and retirement because they don’t know what to do, cannot lose any more money or simply refuse to do anything and leave life to chance.

It seems like an intractable situation-at least as identified by the industry and consumer groups

 

Phase 3

The Taming of Risk, the reduction of losses, the increases in return

The industry has a duty to fully explain risk to investors. For whatever reason- ineptness and an inability that is unconscionable - they have failed to both advise investors of the exposure to a Risk of Loss as well as to what is needed to lower losses in a real life exercise.

I will give a short comment here and then expound on it as we go forward. If you can avoid major losses, you can take what would normally be excessive risk (though you will not be told as such by the industry as addressed above), and can then invest in stronger equities allocations almost all of the time.

While this maybe heretical to readers, recognize that this is what Warren Buffett is doing for his wife when he dies. All monies are to be put into the S&P 500 ONLY (there is smaller account in treasuries for personal expenses) and then LEFT ALONE. No rebalancing, no adjustments, no nothing. The value of that type of allocation has been analyzed above by Edesess.

You cannot do market timing- that is a given. But what becomes obvious is that you can become aware of a correction since the bulk of the industry identifies it as such. Those commenting for a correction 5%- 8%+ are not rational since there is so much noise in the market that it should not be of much of an objective  concern. Note that in my new risk profile (Phase 1) however that a correction goes from 10% to (now) 15% to reflect greater volatility.

Let’s look at the 2000 recession. Once again I note the inverted yield curve in early 2000. No one really could know what would happen but as a 100% indicator of a recession, it could not be dismissed then nor cannot be dimissed now for current evaluation. Immediately the tech stocks got hammered. But for the year, the market lost just over 10%. Did Phase 3 kick in and ‘demand a sale’. No- the first stage of Phase 3 is only a red flag warning at 10%. Only when the losses were greater in year 2, was there a partial sale of equities. Year 2 had an additional loss and rest of the equities sold netting a 12% total loss.* Year 3 had an additional loss for a total of 49% but no additional loss under the Process since all equities had been sold in the second year.

 

*Phase 3 only works with the S&P 500 and the 12% therefore only addresses those losses. But since the investor can invest in anything they want- say the NASDAQ- losses were far greater than just the 12% by the time each sale point of the S&P500 was reached. Hence, as an average, I chose a range of losses to as much as 15%. The Process is not invovled with the loss of individual funds- just the market overall.

For the purposes of the 2000 recession, net losses for the S&P 500 were 12%, total loss of the market was 49% or a difference of 37% saved. If the losses were based on an initial $100,000,  the savings represent $37,000.  

 

Take a look at 2008. Once again the inverted yield curve had inverted in late 2006. Note that the market still went up pretty decently till late in 2007 and then dropped like a stone. It passed a correction very quickly and past all the other limits so that the 12% was reached quickly.  Total losses were 57% but since the investor ‘only’ lost 12%, the net savings was 45%- or with a $100,000 starting value, the savings was $45,000. 

Phase 4

Time to go back into the Market

While I was comfortable with setting up the percentages to reduce risk, it was a difficult issue trying to figure out the best time to get back in. No matter the objectivity I attempted- noticeable in 2008- my focus was not concise as to ‘timing’ and as to the type of investment(s) to consider. So over the years, I researched many issues to create a distinct point in the Process to re-enter the market. I found a public statement by the National Bureau of Economic Research that identifies a most ‘acceptable’ point back into the market. Notice that the reentry points are well below the time of sale. This entry increases overall return.

Bear Market

Essentially all elements of the Process have been addressed save for scenarios of an increasing correction or a bear market. To reiterate, a bear market is roughly a high of a 25% loss and expected to last just for a few months.    

False Positives

Phase 3 is automatic in that it has no idea of whether or not a recession is starting or that the market is in a formal correction. In Phase 1, I indicated that a recession is a minimum of 10% but that I now include 15%.  So the 10% is now a red flag before any sales of equities occurs. But by the time market losses reach 13%, all equities have been sold.

Note that Phase 3 does start immediate sales at 10% but leaves a buffer for ‘noise’. I further decided not wait till 15% to sell the rest of equities. See Have You Sold Your Equities Yet https://www.linkedin.com/pulse/have-you-sold-your-equities-yet-errold-moody-phd-msfp-llb-mba-bsce/ that was published in December 2018.  The Process does work in a correction but requires careful viewing by the investor and/or advisor. If the drop is ‘just’ a correction, the market tends to respond fairly quickly with a runup. If that be the case, the Process requires that you re-enter the market at least by the time the previous sales price is reached. (Note that I did NOT believe the market would return quickly. It doesn’t matter I was wrong. The securities have to be bought back. The positive to this is that ego and emotion do not control the Process. You do what it says you do. Obviously since the Process Is NOT a mandatory element as though it was a mutual fund, it can be changed/adjusted as required or wanted. But the more outside influences, the more risk that emotions and ego will destroy or negate part of the Process.) 

Look at the graph for 2008. When you look at the independent buy in date, almost immediately thereafter was a 19% loss that I really thought ‘was going to be a continuation of the 2008 recession’. Even the best think tank in Washington stated that all the elements of a continuing recession were there. This was also at the time of the second budget deficit travails with what I thought was going to be yet another mass Occupy Wall Street. So what happened? Nothing. And then there was a very good holiday spending which I could not believe would happen. Wrong again. But the Process provided the protection necessary.

Advisors mandatory

The Process is the first major change in Risk for at least 30+ years. The entire Process details a very concise manner in how the investing for the underserved can be made with far less risk- though it does the same for the upper class. But the underserved will never become aware of the Process nor can be expected to perform the mandatory sales and purchases to help themselves. Procrastination, fear, procrastination, fear, ……….pick what you want, but such ‘investors’ are not true investors. They do not understand and probably never will even recognize the intricacies of the market. They are frozen or don’t care to be involved.  

The bulk of such ‘investors- probably 75% in 401k plans- that require the most needed assistance with whatever equities are part of the portfolio allocation- will never even remotely hear of the Process because, while they recognize the word ‘risk’, the industry never addresses the Risk of Loss and has subsequently failed to instruct/protect retirement participant from major losses.

As such, advisors must offer and advise investors with a simple outline/image/visualize to grasp the fundamentals and pursue automatic adjustments to their portfolio.

The most concise method however is where a true consumer entity (AARP) or large organization (Google, Amazon, Alibaba, Facebook) would offer this to their group (once again I point out the necessity to the military) where they would/could offer the Process to members as part of their ongoing product enhancement. Remember, this is not a fund- just a method to control the Risk of Loss. It entails a decent amount of computer storage for members to utilize phase 2- the approximation of loss to mutual funds and ETFs that meet the necessity of at least a 3 year history.

It is not necessary to have any agents to assist in the development of their allocations. In fact, it needs to be made clear that any allocation is solely the decision of themselves or outside advisors. It is an informational tool ONLY. The Process is a tool for Risk of Loss and the mitigation thereof. It would/could work with ROBO systems quite well and would be an incentive for such use since there are no other systems that offer a real life review of risk. 

Conclusion 

This is first major investment change/upgrade to Risk of Loss in the last 30+ years. It is devoted only to the mitigation of risk. But it also increases returns with close to 100% invested in equities during the pre and post retirement timeframe- in essence for their entire lifetime. (I fully admit that the probabilities of a continuation of any projection past 10 years is simply not grounded in the reality of change. It is necessary however to do some type of rendering  to soothe investors and (at least) temporarily smooth over major hurdles we will obviously encounter.

The Process requires no involvement with investment advice per se in the selection of products and is totally independent of any outside involvement or sales. The investor is acting alone or through a separate advisor. There are NO licensed agents required. There is no market timing- in fact no timing in any manner.

Phase 1 is a New real life risk profile that consumers can understand. It certainly will open the eyes of effectively everyone to the potential losses in an allocation and where the investors are clueless to such impacts. Many funds that Morningstar and others rate as moderate risk can reach losses of 40%+. Recognize the S&P500 lost 49% in 2000 and 57% in 2008 putting it into the aggressive range.  

Phase 2 is the mandatory stress test of the mutual funds/ETFs that are under review. The probability of losses is derived from a formula that is not driven by artificial intelligence. It is not a formal statement of losses that will positively accrue- it is however, a number that the consumer can identify as potential loss rather than receiving no direction at all.

Phase 3 of the Process only occurs if losses exceed a correction - and then it reduces/lowers the risk to about 12% to 15% rather than the potential losses in a recession as identified by Phase 2.  It completely changes the industry’s effectively trivial reflection on risk to a real life exposure of financial devastation bout every 7.5 to 10 years. And then provides a logical, straightforward method to keep said losses to a minimum. All it takes is a phone call to institute.

Most importantly, it allows the investor to use the maximum allowable in equities in their allocation since the major losses to the equities is monitored as the market drops. Once it passes various set points, the equities are sold. There is no market timing since if the market does not go down, nothing happens. If the market goes down, something happens. There is no illusion, no Ouija Board- nothing that is involved in some form of quackery.

The investor makes more money during the good times while avoiding major losses about every 7.5 to 10 years. If implemented correctly over a large audience,  those of the middle class and the military will secure more assets during both the pre-retirement and post retirement time frames.

Phase 4 is an independent date from the National Bureau of Economic Research. I do not believe the statement will change in fact by the FED. It is not an absolute perfect entry as was addressed by my comments on the 2011 market. But it appears to be the best logical point to re-entry into the market

 

The is the first real upgrade to risk in at least 3 decades. It can change the behavior of investing for millions of ‘consumers’ at a very limited cost and an ease of understanding far greater than the tools used by the industry that are almost impossible to grasp.

 

Errold F Moody Jr

PhD MBA MSFP LLB BSCE

EFM@EFMOODY.COM

352 794 0212

 

 

  

 

The essence of investment management entails the management of risk, not the management of returns."

Benjamin Graham

Despite the fact that asset allocation is something that has been around for a long time and modern portfolio theory is the way we kind of determine what the asset allocation is,” there haven’t been many “big advancements” during the first 50 years or so of portfolio construction research."

James Peterson

I have never felt that the suitability rule was inherently valid since those acting as investment advisors did not have to have, nor recognize, the necessity of using a personal financial calculator. That is because it is not required for licensing nor for recognition as a registered investment advisor. That said, pundits point to sophisticated software- that may now include behavioral input and AI insight- that covered all the bases for investing. Get real. Effectively none of the users has a clue to what is occurring internally in the calculations but everyone figures- and certainly consumers accept- that something that comes out of a computer must be good/correct. Now we are going back to a Best Interests element where the value/use/absolute necessity of a personal calculator is still not going to even get nickels worth of time. It is going to remain a constant of the industry that client questionnaires will continue to be filled for use with software that is even becoming more involved with subjective human behavior (and mistakes). And in none of the suitability, best interests or fiduciary rules is a formal focus on Risk- specifically a Risk of Loss- taught. Risk is the major issue in investments but is ill/nil defined. The regulators need to step up to a real world that has left them behind. I am very concerned that they will make the necessary effort.

EFM

Note: This is an article addressing the Risk of Loss and the third and fourth phase where the ‘rubber hits the road’ in terms of real life financial/investment planning that was primarily designed as a guide to middle and lower income workers (and all military personnel) who cannot afford another hit like 2000- 49% market loss and 2008 with a 57% loss. This text will include some highlights addressed in these previous articles but offers additional objective and factual info and data supporting the Process and use. 

Revolutionary Method for Asset Allocation- Increase Returns, Reduce Risk

Rebuttal to NY Times Retirement article. Terrible Advice & High Risk

EF Moody's Mutual Fund Value at Risk/Stress Test

EF Moody’s Daily Commentary

 

As I was finishing the article, I noted material from The Center for Retirement Research at Boston College (How Would More Saving Affect the National Retirement Risk Index? https://crr.bc.edu/briefs/how-would-more-saving-affect-the-national-retirement-risk-index/) addressed some of the main difficulties for retirement and felt that this article would address them as well. Readers would be well advised to subscribe to their mailing list.

  • 50 percent of working-age households are at risk of falling short in retirement.
  • EFM- agreed
  • The question is how much would additional retirement saving improve the picture?
  • EFM- that is fine but the benefit is limited if they are going to lose 50% every 7.5 to 10 years (recessions).
  • The results show that boosting the 401(k) contribution rate for eligible workers by 5 percentage points would only modestly reduce retirement risk overall.
  • EFM- The Process herein would reduce the major losses by 75%. But by doing that, and using equities almost exclusively, the rate of return is perhaps/probably 25% higher than historical averages, with less risk and help hundreds of thousands of retirees and pre retirees. 
  • The impact would be a bit larger if all workers had access to an employer-based retirement plan, but – even then – many households would still be at risk.
  • EFM- The reason for my work was to enable those at risk to use the Process to ‘automatically’ deal primarily with Risk of Loss be it within a 401k, IRA et al.
  • The only way to make dramatic progress is to combine saving more with working two years longer, which cuts the share of “at risk” households to about 25 percent.
  • EFM- That is not the only way but it is what has been promoted for decades. The Process is significant adjustment to ‘guaranteed’ losses as dictated by current methodologies. 

 

‘About two-thirds of households do not have the recommended six weeks of emergency savings, according to a survey by JPMorgan Chase that looked at 6 million active checking accounts over a six-year period. Another survey by the AARP Public Policy Institute showed that half of American families did not have an emergency savings account’

Well, if you keep losing 50% of your equities every 7.5 to 10 years…………..

 

Overview

Almost four decades ago, I started teaching some financial courses. This was well before the personal computer and certainly the internet (and Google in particular) that subsequently offered articles and university papers that otherwise would have never seen the light of day. I got the CFP in 1984 but it simply left me knowledgeably unprepared. I said, upon completion, that “I don’t think I know that much”. Tough to be right. But part of it was that there were few avenues to take where a better experience was to be had. The only viable option was a Masters of Science in Financial planning. The American College was first and the College for Financial Planning came later (now such offerings are available in many universities and a couple have PhDs). I got the Masters’ in 1991 and while it offered more intensive material, it nonetheless was obvious that the degree still left a lot of holes where there wasn’t much real life in either investments nor insurance (one of the toughest to firmly grasp).

So I kept at it. One of the issues became obvious and unsettling- but apparently only to me. It involved the review of the S&P 500 versus a variable life policy or a variable annuity. The S&P obviously came out ahead simply due to all the embedded fees. But that was not what troubled me. It was when you looked at real life and a recessionary period such as 1973/74 where the market hit a 44% loss. It did not make sense to me to try various allocations to beat the market or to make allocations via various price/book, sales/book, P/E, alpha, Sharpe, Markowitz  et al but then lose almost 50% of the equities in bad times.

There was, and is today, a major failure in trying to help those that are little served by the industry- particularly where the marketplace focus is now on fee planners who seek higher net worth individuals who can pay larger fees. The middle class et al is simply going to be the continuing grist mill of high commissions, poor or no service from planners, a very simplistic cookie cutter asset allocation and complete frustration/exacerbation with large losses.

My effort then and now is to recognize the times when a market drop is occurring and then to shed the excessive RISK so that major losses are kept in check. This effort was really focused for those investors who are effectively clueless to the real world of investing and need an objective real life Process that will (almost universally) increase returns over time but absolutely will reduce losses by as much as 75% in recessionary periods. (It should be obvious that if you reduce losses such as that sustained in 2000 and 2008, you will increase overall return. Don’t need a calculator for that. To that is coupled a set time (Phase 4 discussed later) to get back in the market for the bulk of the runup (though there is no guarantee that such runup will occur in the future. That, by itself, voids buy and hold, stay the course, et al.)

 The necessity was clearly apparent with the many or soon to be retirees who lost the bulk of retirement assets in the recessions and were subsequently unwilling to reinvest after 2009.  Admittedly the wealthy lost as well either through their own ego flaws or because they may have hired the wrong advisers. Well, that last sentence is only partly true. If you don’t know that you don’t know and no entity is keying you into the Real World, the whole investing element is a great tool when growing but an absolute farce is you lose about half of it every 10 years or less. Nonetheless, the Process works the same with almost all mutual funds, many ETFs, all investment retirement programs and all socioeconomic classes.

(If anyone deals with an adviser, they must ask them about their analysis of the inverted yield curve as well as what they did in 2000 or 2008 and what they intend on doing in this next mess. If you pick an advisor that has not at least been around for the 2008 recession, then that is your fault. I am fully aware of that being ‘tacky’. But I have seen planners who are considered at the top of their game, years of Monte Carlo spreadsheets, miniscule identifications of equity niches and yet knew nothing of the inverted yield curve (and more). They dug out a hole of ignorance/stupidity and invited others to drop in. It has filled to overflowing primarily because real life education has been stifled. The most egregious error is the failure to put risk at the front of analysis. 

If the industry wants to be shown as professional, they need to step up their game. However if a planner is not a member of an independent planning organization that requires annual education, they may not be required to do any additional continuing education annually. (That also infers that the continued education has real life merit- not a given.)

In terms of FINRA, NASAA, SEC, DOL and more, their diligence is wanting to the point of non existence. The SEC- actually all such organizations state and government- make wholesale gaffes as to who is what in the licensing game. These issues fall around the definition of Investment Advisor when in fact the bulk of same call themselves Financial Planners. The two titles require different tasks and knowledge but the major overseers offer no discussion at all and thereby render their commentary seriously wanting or just a waste of time. I have covered that previously but consider the entities- universally staffed by attorneys- have never required that practitioners know how to use a financial calculator. This will be addressed later many times. But the main issue is that most fee financial planners CANNOT act as fiduciaries- because they are not legal. A financial planner doing fee work must cover effectively all areas of personal products and usage. They need more than a cursory understanding of the issues. One of the hardest is life and disability insurance, long term care, annuities, etc. These are not miscellaneous items to be trivialized. Unfortunately, few fee advisors are knowledgeable in those areas or only tangentially so. Further, many states require a separate license and exam (beyond just being a sales agent) to offer such advice. But just about nil advisors have done the additional work to become legal. For specific reference, I offer the Life and Disability Insurance license required under

“Authorizing Act: Section 1848 of the California Insurance Code (CIC) reads, in part: A Life and Disability Insurance Analyst is a person who, for a fee or compensation of any kind, paid by or derived from any person or source other than an insurer, advises, purports to advise, or offers to advise any person insured under, named as beneficiary of, or having any interest in, a life or disability insurance contract, in any manner concerning that contract or his or her rights in respect thereto.”

There are many other states that require a separate license.

Kitces offers the following: “Even in today’s environment where consumers are better educated and it’s much easier for someone to ‘do their due diligence’, the bar is still so low that, not only can anyone call themselves an “advisor”, but they can still extract nearly 10% of the wealth of every person they meet by selling a low-quality high-cost product, with little worry about any legal recourse… since the bar to prove their sale was “unsuitable” is so low and easily cleared.”

So is a fiduciary required to be legal to be a fiduciary?

Pursuant to the organizations encompassing CFPs, NAPFA, CPA PFS, ChFC etc. the answer is NO. 

This will be covered in a separate article in the future but the formal regulatory entities- that demand the highest fiduciary standard- need to recognize a lot of crap goes on in front of their eyes and they need to wake up and stop it. 

Changing values/Theories Debunked

Peter Bernstein was a financial historian who will never be matched. Two of his books- Capital Ideas: The Improbable Origins of Modern Wall Street and Capital Ideas Evolving cover the inception of financial growth going back centuries..  Bernstein wrote other books (most notable in my mind was Against the Gods:The Remarkable Story of Risk), numerous articles and ran his own Investing firm up to his death in 2009. He slowed down after that. If you are in the business, these first two books above offer the who, what, when, where, why of the evolution of leaders in the theory and analyzation of the efforts to define and redefine what was going on and ………”describes these changes, a virtual revolution in the practice of investing that (now) relies heavily on complex mathematics, derivatives, hedging, and hyperactive trading.”

What I noticed was his detailed analysis of how each new improvement/idea/change/adjustment was almost unilaterally met with heresy, derision- at a minimum, skepticism. Notable was his commentary that new “valid’ ideas might languish for decades……….then meet with more acceptance as the old farts died off and the once described aberrations became main stream. The predominant example was John Bogle and his move to indexing (he did this in spite of wholesale pundits).  Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly".  He was in his 40s.  Think about that in how his demand for lower fees coupled with the inherent ‘failure’ of actively managed funds has FINALLY become solidly ingrained in the industry. And still making advancements.

There are those who have taken the bulk of homilies and pushed the envelope further than John Bogle. These include Warren Buffett, Charlie Munger, Benoit Mandlebrot (deceased), Nassim Taleb, Peter Bernstein (deceased), and a few others that have brought to the forefront new thoughts and positions (Kahneman). Even when segments are chosen for acceptance/derision, the industry and advisors may misunderstand, misapply or simply annihilate any real life validity.

The following detail a number of such issues and effectively leads to the use of The Process. It makes little sense in reviewing/analyzing old, semi useful and outdated theories and homilies. They do not help those most in need. Time to grow up to a new world of thinking.

 

Market Timing, Inverted Yield Curve, Recession

Risk is the absolute first issue in investing. The industry cranks out all sorts of marketing showing how this fund will work with buy and hold, stay the course, market timing doesn’t work, etc.

Here is some commentary on timing

Actually, market timing CANNOT work but the only thing you hear or see is ‘simply the statement’. This is the point. Let’s forget Ouija boards etc. In order to ‘figure out market timing’, you must have a pattern in history where you can pick out certain characteristics and statistically show that ‘timing’ is possible.  (I am not talking about someone calling the bottom after one quarter of negative GDP- that’s a ridiculous ‘look into the future’.) Market timing is the ability to define when a recession occurs at least 6 months prior to.

 

 

 

Look at the number of recessions for the past 48+ years (vertical grey bars). If you only have a few recessions but where there was an obvious chance of a pattern……whoa-  that’s the stupid statement. There ain’t enough numbers, there is no pattern, THERE IS JUST NOTHING where a human or artificial intelligence can work with. At least if someone is having a baby, you know it’s going to take 9 months. So it is not that difficult to guesstimate the date and maybe you get lucky and win a raffle. The spacing of recessions here have no pattern save ‘that they happen every so often.’ It is not necessary to kick up the market timing statement anymore, anyplace.

In terms of how bad a recession might be- prior to 2000 the internet was the Holy Grail of investing/growth. There were not going to be business cycles anymore, yada, yada. And yet over three years it lost 49%. 2008 saw 57% losses but I remember Fed Chairman Bernanke stating that we were not going to have a recession. There were some analysts that indicated major loses would ensue but that is not the same as an indication of WHEN.   

Inverted Yield curve and recessions. MOST IMPORTANT

 It was- and is- apparent to address risk in a different/knowledgeable/real life manner. I made continued reference/relevance to the inverted yield curve via FED articles in the late 90s. But with the Dotcom, RISK never went in one ear of the students and out the other- it got blown away with the noise of the internet and the ‘fact’ that business cycles were a thing of the past.

Pretty much the same thing with 2008. I did see at least a few articles on the inverted yield curve but they were not mainstream. The curve is not the reason for a recession but a 100% indicator for the last 50 years of a forthcoming one. It does not say when, how bad, nor how long. As noted, Bernanke said in 2007 that he did not expect a major problem. And the market lost 57%. Shiller is now suggesting about 22%. Swedroe says it is not going to happen this time. My position is that losses will be over 40% but as I sit here today with the bombing of the Kurds, a possible/probable impeachment of Trump, and many countries working with negative interest rates, I can see it even higher than 50%. But no matter the ego, intellect, insight- a plan MUST be in place prior to the problem or one is just playing with a big accident.

As noted both in 2000 and 2008, there was effectively no way to figure out when the recession would start. Actually, you won’t know if a recession is occurring until after the fact since you have to have two quarters of negative growth. For the purpose of the Process, I do ‘not’ care when it happens. I am only interested in the percent drop since it is only then that it is worthwhile to really pay attention (see also false positives herein).  Further, it is not unrealistic to see the market actually increase prior to the start of losses since the FED’s effort to right the economy may increase positive trades until the market goes splat. I repeat, you do not know when the recession will start, how long it will last nor how bad it will be. Though I think the next one could be real messy.

Bad statistics

The point is not to slam forecasters, experts and others per se but to clearly show that almost all the industry stands together spouting ridiculous homilies, stay the course through thick and thin, take 100 minus your age to determine equities, behavioral humans that do everything wrong, etc. Others suggest that rebalancing annually- or whenever- can reduce such losses while providing a good return. (Not necessarily.) If you really want statistics, you can check out Dalbar which shows that humans are emotional failures and definitely sell at the bottom and buy at the top. Some articles may show the cute little drawings like the one below.

 

Adorable, isn’t it? But a couple things are wrong. First of all, there is a mathematician, Michael Edesess, who has shown that the numbers calculated by Dalbar are incorrect.     https://www.advisorperspectives.com/articles/2014/06/17/a-simple-explanation-for-dalbar-s-misleading-results

Though that still leaves the emotionalism of regular investors doing the wrong thing at the wrong time and the reason you see that graph by a number of major magazines.

In contradiction, there is a new study by Morningstar that categorically, emphatically and unequivocally (yes I know the words are the same but it’s my article) state that the facts used in Dalbar’s study are not real.

Dalbar notes. “Dalbar conducts ongoing quantitative analysis of investor behaviors. They reported that as of 2015, the S&P 500 twenty-year average return was 8.19%, but the average equity fund investor had only earned 4.67% over the same period. It got worse the longer out they went. Over the thirty-year period ending December 31, 2015, the S&P 500 averaged 10.15%, but the average equity fund investor earned only 3.66%. So, yes, there is a big difference between investment returns and investor returns.”

Wait for it…………….

Morningstar notes, : Morningstgar Mind the Gap

“We calculate Morningstar Investor Returns to understand how investors actually fared in a fund when you take cash flows into account. Essentially, we are asking, How did the average dollar in a fund do over a certain time period? Specifically, we can say the average investor lost 45 basis points to timing over five 10-year periods ended December 2018.”

EFM- This is a controversy that will continue to be hotly debated for some time to come. (I have not done a review on the Morningstar analysis.) But does it change my Process? No. What’s the issue? Morningstar- as with all the other entities in the cartoon- keep generating returns that maintain the idiocy of sitting and taking huge hits (with certain offsets) during a recession. They will show beta, R2, standard deviation, Sharpe ratio and more as elements of risk but only in general and superfluous terms- not what the real life risk could be at increments of 7.5 to 10 year spans. That leaves all advisors/consumers with an incomplete, hollow and specious view of real life risk of loss.

Here is the fault with stay the course- there is nothing, I repeat NOTHING that states that the market will come back after a recession. In one defense, it can- but you might be dead by then. Second defense is look at the number of recessions once again and go back to 1965. Note that it wasn’t till 1990/1995 till you saw a massive up market and a lot of volatility. I admit that I do not like to use backtesting as a guide to the future, but it is not much of a stretch in this world to see stagnant growth as in sections of the past. In fact, most experts already state that the future returns will be far less than the most recent past. Therefore the idea of buy and hold, buy on the dip et al should (probably) not be stressed as completely viable options with recessionary losses.

 

Some pundits may say that such flat economics are actually a statistical  anomaly- an outlier. However I am sure that effectively 99 44/100% of advisors never thought an outlier like Japan’s could remotely occur. I kept stating that there was no way that Japan would not snap out of its doldrums and become a powerhouse again. I I kept saying it and ………. I finally gave up. But it will come back, won’t it???? Not a clue.

That said, I am comfortable with the inverted yield curve probabilities since, in totality, it references an economy under extreme pressure where certain elements can break its back. I am not stating that the economic pressures are the same each time. They definitely are not. That is another reason market timing does not work. Lack of comparable factors.  

Below are homilies and broken theories primarily about RISK. Risk is the first and foremost critical item to investing. If you do not get that right……….

Standard Deviation/Volatility as a measure of risk?

Standard deviation "is a measure that is used to quantify the amount of variation or dispersion of a set of data values. A standard deviation close to 0 indicates that the data points tend to be very close to the mean (also called the expected value) of the set, while a high standard deviation indicates that the data points are spread out over a wider range of values."

The standard deviation of S&P 500 returns from 1928 to 2015 averaged 19.7028%. Now it is only a little over 12% (Totally separate comment- notice how there are 4 decimals after the 19. The necessity/value of that type of detail is ‘just a waste of time’. It can adversely reflect on the author’s understanding of ‘accuracy’. Think about it- going back to 1928 where there is almost nothing to suggest correlation with 2019?? Use 19.7%.)  

Consider this from Warren Buffett:

“The measurement of volatility: it’s nice, it’s mathematical and wrong. Volatility is not risk. Those who have written about risk don’t know how to measure risk. Past volatility does not measure risk.     ……..Volatility is useful for people who want a career in teaching. I cannot recall a case where we lost a lot of money due to volatility. The whole concept of volatility as a measure of risk has developed in my lifetime and isn’t any use to us.” 

From Benoit Mandelbrot and Nassim Taleb

“The professors who live by the bell curve adopted it for mathematical convenience, not realism.

It asserts that when you measure the world, the numbers that result hover around the mediocre; big departures from the mean are so rare that their effect is negligible. This focus on averages works well with everyday physical variables such as height and weight, but not when it comes to finance. One can disregard the odds of a person's being miles tall or tons heavy, but similarly excessive observations can never be ruled out in economic life.

The problem with all these measures is that they are built upon the statistical device known as the bell curve. This means they disregard big market moves: They focus on the grass and miss out on the (gigantic) trees. Rare and unpredictably large deviations ……….. have a dramatic impact on long-term returns --but "risk" and "variance" disregard them.

The inapplicability of the bell curve has long been established, yet close to 100,000 MBA students a year in the U.S. alone are taught to use it to understand financial markets. For those who teach finance, a number seems better than no number--even if it's wrong.”

EFM- Past volatility/standard deviation only show what happens with relatively small changes- meaning overall they avoid/ mask/ delete the risk as to how bad it really can get. The problem becomes this- I have never seen a S&P500 beta chart (it’s out there someplace?) where the real life Risk of Loss (50%) is on the chart itself or is identified in texts as an occurrence every 7.5 or 10 years.

How can an advisor guide a client to invest in XYZ fund while knowing it took a bath in the last recession and very well do the same with the upcoming recession.                                

 

The 50% losses are displayed on this simple graph

But the 10 year graph does not have to include 2000 nor 2008

Looks a lot different- and with nil risk of loss- than 2000- 6/2009

The BETA Blues

Beta (Investopedia)  beta coefficient is a measure of the volatility, or systematic risk, of an individual stock in comparison to the unsystematic risk of the entire market. 

More from Benoit Mandelbrot and Nassim Taleb

Your mutual fund's annual report, for example, may contain a measure of risk (usually something called beta). It would indeed be useful to know just how risky your fund is, but this number won't tell you. Nor will any of the other quantities spewed out by the pseudoscience of finance: standard deviation, the Sharpe ratio, variance, correlation, alpha, value at risk, even the Black-Scholes option-pricing model.

“Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no.”

 

Markowitz Theory/ Capital Asset Pricing Model

The following identifies the general comments on the CAPM. You can get a reasonable feel for it if you want to use it for a portfolio allocation.

 

“Investopedia notes, The CAPM and the Efficient Frontier

Using the CAPM to build a portfolio is supposed to help an investor manage their risk. If an investor were able to use the CAPM to perfectly optimize a portfolio’s return relative to risk, it would exist on a curve called the efficient frontier, as shown on the following graph.

The graph shows how greater expected returns (y-axis) require greater expected risk (x-axis). Modern Portfolio Theory suggests that starting with the risk-free rate, the expected return of a portfolio increases as the risk increases. Any portfolio that fits on the Capital Market Line (CML) is better than any possible portfolio to the right of that line, but at some point, a theoretical portfolio can be constructed on the CML with the best return for the amount of risk being taken.”

EFM- An examination of the good and bad parts of the CAPM is available from industry experts but it tends to be utilized in some manner as a part of ‘good investing’. My point is not whether or not the fundamentals may be applied to generate a higher return overall but simply to look at the graph. The x horizontal  axis shows the real life expected risk of the ideal portfolio.

No it doesn’t.

Do you see anything addressing the expected risk of every 7.5  years with a 50% loss. Pundits might rail at a recession occurring that quickly (I opted for 4 recessions in a 30 year period. Considering a world in complete disarray, I do not find my interpretation wanting) but readers can opt for 3 in 30 years as a minimum. Less than that is not real life.

Once again the risk universally shown in the CAPM graphs obfuscates the reality of a 50% risk to equities that should/must be presented to investors. The graph- which is used in almost any text on investing- is irresponsible instruction on risk even if it was possible to confirm that the securities selected perfectly conformed to correlation, beta and so forth. If one can realistically interpret 40%- 50% loss every 7.5 years- even 10  years- does not that change the entire focus of Markowitz’s theory? At least it demands a countering argument that the theory as stated/shown does not mirror risk in real life.

Advisors, private risk analytic and fund analyses firms have deceptively provided graphs and charts that unilaterally dismiss or fraudulently avoid how real life economic activities can and will devastate a consumer’s life on a repeatable basis.

REBALANCING

Rebalancing does not necessarily work in providing a higher return than buy and hold. Edesess provides another article Edesess, Michael, Rebalancing: A Comprehensive Reassessment (November 21, 2017). Available at SSRN: https://ssrn.com/abstract=3075023 or http://dx.doi.org/10.2139/ssrn.3075023

“Contrary to common belief and to the misguided conclusions of most of the articles in academic finance journals, it is that rebalancing offers no “free lunch,” either in terms of enhanced return or reduced risk. The choice of rebalancing as an investment discipline as compared with an alternative such as buy-and-hold is simply a risk-return tradeoff – though one that is a little more subtle than most.  At the more common middling levels of performance of portfolio assets, or when portfolio assets perform similarly, rebalancing will slightly outperform buy-and-hold*. But in less common cases (about one in three) when one or more of the assets performs very well, buy-and-hold will markedly outperform rebalancing. This choice may not be easy to make; either of the choices may be regarded as satisfactory. But it is a far cry from saying that it has been proven that rebalancing is something you absolutely must do.”

* EFM- recognize that both issues are maintaining the losses due to recessions. If the major losses were avoided (i.e.  eradication of “Sequence of Returns”), the returns for buy and hold would be significantly greater than noted above.  The Process substantially lowers the Risk of Loss in recessionary economics, per phase 3, where equities will be reduced when the funds/allocations are stressed beyond a correction (10% to 15%).  

The greatest flaw is an entrenched industry that never has stress tested mutual funds to recognize and treat the real life Risk of Loss.

Phase One

New Risk of Loss Categories

Phase 1: This is the new Risk of Loss the defines the various categories

Not an investor: No loss ever – certainly that of a basic correction of 10% 

Conservative: Willing to assume losses up to 15%  (10% to 15% is now a standard correction- up from 10% in the 1990s)*

Moderate: Accepts losses to 40%

Aggressive: Accepts losses to 65%

Speculative: Accepts losses to 100%+ (leverage)

Client Questionnaires and Risk

One of the critical areas of investing- that is finally getting some attention during the last couple years is the fact that client questionnaires are an ineffective way of determining a client’s risk profile- certainly as the inputs now use behavioral characteristics in the mix of ‘data’. I note my negative opinion as early the mid 1990s. Advisors unilaterally used a firm’s questionnaires to pop into the firm’s software that would identify the client’s risk and the associated portfolio allocations (basically managed mutual funds) for the individual or couple. Most advisors- since a capability with a personal financial calculator was not required nor taught as part of licensing- used these cookie cutter strategies- with the pretty pie charts- to mesmerize clients. Even those who did have instruction with a financial calculator universally used the packages software since it was impressive looking, used nice technical jargon and provided the ubiquitous nicely colored pie chart- to engage clients. The difficulty I had was no one had a clue to the internal machinations whirling inside the computer.

In a recent survey, 78 of the 92 respondents (85%) stated risk questionnaires are not effective. Interestingly, 19 out of 20 financial professionals (95%) stated they were not effective, and fifty-nine out of seventy-two individual investors (82%) stated they were not effective as well. I find this quite alarming on a few levels (especially since the advisors were even more critical of the questionnaires than the investors) since the statistics have not made any difference in their use .

Decision theorist and economics professor Shachar Kariv says they are a poor way to gauge risk tolerance….., Client surveys and questionnaires are "the source of all evil and bad in the financial-services industry."

No matter, it was necessary and preferable that the end results of allocation were verified by separate analysis. Wasn’t going to happen by corporate since the nice looking binders was just great marketing. But, as noted many times was the 49% loss in 2000 and 57% in 2008. Risk of Loss was never taught.

From an article I know not where- but the words/comment mirror hundreds of other mewling articles on risk. “There are many things to consider when determining the answer to a seemingly simple question, "What is my risk tolerance?" The answer will vary based on your age, experience, net worth, risk capital and the actual investment or trade being considered. Once you have thought this through, you will be able to apply this knowledge to a balanced and diversified program of investing and trading.”

EFM- The idea that the client is going to determine their risk is offensive. You can add in all the elements of age, etc. and the industry still doesn’t get it. To repeat- the Process I developed was not for the heavy hitters- though it works the same. It is to align the middle and lower income investors- and I include as a group, the military- with 401k, IRAs and the like, that are unknowledgeable on what to do either by recognizing it is too difficult or simply don’t care no matter the necessity (or are overseas). I unequivocally state that the factors above (age, experience, net worth, etc.) are the suitability requirements that the defense uses in securities arbitration cases. (The industry was successful in beating back a fiduciary requirement to consumers.) Supposedly if a broker addresses these issues, they can/may be absolved of wrongdoing. These items are required input on the client questionnaire. However, the inputs then swirl around in the underpinnings of debatable software that few have ever researched and, voila, there is a printout confirming the funds that meet the perceived investor risk profile.

WRONG!

You cannot even remotely address suitability unless and until you have recognized the Risk of Loss to investors.

Just to make another point regarding the superficial questionnaires is the value of ‘Investors experience’. The investor is ‘assumed’ that there is adequate experience if they had been using a 401k for 10 years, bought some stocks, et al.  Get real. The buying of stocks, the use of options, etc.  cannot be unilaterally correlated to a ‘causation’ of sophistication nor even knowledge.

As regards age- being older does not equate to superior knowledge nor overall intellect. Some simply were stupid when they were 80, stupid when they were 60 all the way down to where they were stupid when they were 20. By the same token, not all the elderly are dumber than a post and they need to take more responsibility to their actions. The idea of crass simplistic generalizations are used a lot in arbitrations where they can work for either side since the bulk of attorneys don’t know about risk and can neither exploit nor defend many issues being addressed.

Time marches on and behavioral elements were being introduced as part of Artificial Intelligence software that defined risk.

For the uninitiated, Behavioral economics studies the effects of psychologicalcognitive, emotional, cultural and social factors on the economic decisions of individuals and institutions and how those decisions vary from those implied by classical theory.[1]

Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychologyneuroscience and microeconomic theory.[2][3] The study of behavioral economics includes how market decisions are made and the mechanisms that drive public choice. The three prevalent themes in behavioral economics are:[4]

This short definition in no way describes how the financial industry has attempted to incorporate the number of facets of human behavior into a risk profile that is more closely tied to reality (whatever that means). Frankly, while this issue will remain a top priority in the future, the industry is struggling mightily since there is no consensus with the nuances of each topic. Software vendors even have significant differences in their risk profiles from their least costly programs to their more ‘advanced’. (So much for truth in advertising) And there has been all sorts of criticism from one company to another regarding they are right and the other company is ‘….. something else’.

Once again, the use of software with its subjective inputs and potentially artificial intelligence makes if difficult if not impossible to figure out since the weightings for each type of influence is whatever one wants to make it.

There you have it- most client questionnaires are huge guesstimates. So what is a body to do for a risk estimate? At this point, some may be aware of the teaching of Kahneman and Tversky who are considered the pioneers in the field of human behavior. Kahneman won a Nobel prize for his work and his most recent book “Thinking Fast, Thinking Slow” continues to delve into all areas of behavior.

But then came an article that contained an interview with Kahneman that was worth a thousand trials for client risk. In early 2018, Kahneman noted, “We had people try to imagine various scenarios, in general, bad scenarios and the “question was, at what point do you think that you would want to bail out? That you would want to change your mind?” It turns out, that most of the people — even very wealthy people — are extremely loss averse.” There is a limit to how much money they’re willing to put at risk,” he said. “You ask, ‘How much fortune are you willing to lose?’ Quite frequently you get something on the order of 10%.”

I therefore had the preeminent expert in the field with thousands of test subjects over decades of time corroborate what is generally considered to be a correction.  And the result is the New Risk of Loss Categories above- though I extended a correction up to 15%. The necessity of all sorts of subjective meanderings of the human condition with snippets of artificial intelligence was brought down to earth by a huge number of tests over decades of time by the pre-eminent  authority on how people act and react.  

Use consumer/client questionnaires sparingly- if at all.

Phase 2

Stress Testing /Value at Risk for Mutual Funds

Phase 2 is a stress test just for recessionary losses. It will also work with large corrections- such as that in December 2018 but its main benefit is to give an approximation of losses to the allocations being selected. Given the losses in 2000 (49%) and 2008 (57%), it should not be any stretch of logic that even the ‘mediocre/conservative’ risk of basic index funds were causing the unknowing investor the greatest risks of loss.

   

The Stress Testing or Value at Risk for Mutual Funds takes fund data and then computes at the time of purchase or review the potential Risk of Loss of that fund during a recession. You can see how close the ranges were to actual losses. The potential Risk of Loss will also work in a correction simply because it is unknown how far the losses will go.

The projected losses at specific times will change as the economy changes. Nonetheless, this risk must be brought to the investor’s attention at least at the time of purchase to address and discuss what the advisor did in past recessions and/or how they will respond at the advent of significant losses going forward.

The figures apply managed and passive but the Risk of Loss for managed funds will be as identified (Phase 2) and assume that managers will reduce some equity exposure during a recession. However, passive index funds do not materially change the equities invested and therefore all index funds’ Risk of Loss must be manually increased by 10%.

Target Date Funds/Managed funds allowed full discretion in allocation

There are funds that do not have a set allocation over time- TDF- Target Date Funds are the most ‘notorious’. In their initial offerings years ago, the percentage of stocks and bonds changed per a set allocation identified in the prospectus. The Process could adjust to some changes, but when the industry effectively allowed most TDFs to do almost anything they want at any time they want, the ability to stress test the fund is lost.

Most managed funds, may/would change its allocation within certain limited percentages (I use a 10% adjustment to cash) and the Process could deal with. But if a managed fund could radically change its allocation to something entirely different, it therefore becomes impossible to know what any fund would do at any time.  

The simplistic overview of beta, alpha, correlation, standard deviation, Monte Carlo and more cannot pass legal muster by a fiduciary. You simply cannot sell something that has significant losses inserted in any relatively short period of time without informing potential investors. More so when the retirement advice is for a 30+ year period of time peppered with 50% losses that, for the most part, are unilaterally missing from view. It really is a bait and switch.

Example of invalid data

During the last year I have written several articles addressing RISK as the most important element in investing. It is the first and dominant criteria in investing but the industry rarely gives it the thrift it deserves- mainly, I feel, since they would have to recognize that a lot of the homilies they push are very, VERY lacking in real life use. Not that some do not have merit- just that the level of use has been elevated to a point of excess without much value.

Here is one simple example: one can look at the 3 year average volatility of the S&P 500 at 12.10%. Is that the risk of the fund as many advisors suggest it is? It is WAY down from 21% in the 1980s.  So the current risk of the 500 index fund today is almost half of previous, right??? So you can sure invest a lot more with the statistics well in your favor, right??? And even if things go bad, your losses will be minimal even with a recession, right???

But how does that fit in with a loss of 49% in the 2000 recession or a 57% loss in 2008? Morningstar says it has an average risk. Say what? It can’t be for loss. It has a Sharpe ratio of 0.92. Beta of 0.99. And anything else you want to throw in the pile- Sortino ratio? How about Monte Carlo- 30 to 120 years of historical dissimilarities to match what has occurred since 2000? (Effectively everything since the mid 90’s and the vast technological changes that dwarf the last 100 years (primarily personal computers/phone and the internet) is so totally different now that it stretches credulity.) Going forward, how should Monte Carlo work? How many recessions during that time frame do you want to enter into the allocation software. Will software even give you that flexibility?

Then you have to subjectively pick a return. Then inflation. Even worse is selecting a recession upon occurring right at the initial deposit. Real life? Look at 11/2019. Does anyone think that investing at this point in time is going to lead to Nirvana? Even New Jersey. You have an inverted yield curve, trade wars, Yemen, Saudi Arabia, Brexit, Royhingya, Iran, Kurds, Hong Kong, North Korea, Russia, a totally unhinged Trump, Ukraine, Turkey, Amazon fires, China, a political riptide of disagreement and Congressional nonsense, impeachment, HUGE budget deficit and more that in some(???) unknown reality says, ‘let’s invest now’.

The idea, however, that humans are irresponsible during every economic period is not valid.

- though it is also true that general public is not that swift in analyzing the fundamentals of investing. I answer a lot of tweets from submitted questions that come my way and it is clear that the young have little comprehension of finance. The adults seem little better. Unfortunately many in the industry are inadequately knowledgeable- certainly towards the element of risk. Risk is not taught and when it is addressed it is only tangentially.

 

Risk Factor Allocations

The industry through its various minions offers all sorts of theory- (do not read the following too closely. I am not kidding- you will hurt yourself)

“This tool supports optimizing the portfolio asset allocation based on the targeted risk factor exposures. The returns of the given portfolio are first regressed against the selected risk factor model consisting of equity risk factors (e.g. market, size, value), fixed income risk factors (e.g. term, credit), custom risk factor series, or any combination thereof. Based on the regression results, the portfolio exposures to specific risk factors can then be adjusted. The optimizer identifies the closest portfolio to the desired risk factor exposures based on the given cost criteria, which can be based on either expected rebalancing costs or maintaining the other risk factor exposures as close to original as possible. You can also specify a list of optional assets that the optimizer can choose to add to the portfolio in order to meet the targeted risk factor exposures.”

                 Huh????

 

 

If you don’t like that one, then try one of these.

 

And of course, all readers (3?) know the Black Litterman Model: Investopedia- The Black-Litterman model uses a Bayesian approach to combine the subjective views of an investor regarding the expected returns of one or more assets with the market equilibrium vector of expected returns (the prior distribution) to form a new, mixed estimate of expected returns. (Don’t feel uninformed/stupid- Never came across it myself. Would find no reason to use it.)

Here is yet another idea of spreading the knowledge to attain the proper allocation/return

Style Factors:

  • Accumulation vs Distribution
  • Probability vs Safety First
  • Optionality vs Committed
  • Front Loading vs Back Loading Retirement Income
  • Implementation Factors:
  • Perpetuity vs Time Based
  • Systematic vs Unsystematic
  • Technical Liquidity vs True Liquidity
  • Financial Goals & Risks
  • Longevity
  • Lifestyle
  • Liquidity
  • Legacy
  • Psychological Factors:
  • Self-Efficacy
  • Behavior Finance- Heuristics

Is it possible to create an algorithm that would couple certain styles for the best correlation?

Not really- probably none that could be proven. Think about this though- you would have to have an innate knowledge of EACH one in order to evaluate any particular one objectively as being better than another.

 

 

Here are some comments about diversification and Tracking error. You do NOT have to understand the comments below- but you do need to scan to recognize how superior egos can work to deny the rest of the human race even an inkling of understanding to what is printed. O.K. maybe half a dozen can- but I do not want to meet them.

“It is almost as important to get the balance between diversification and tracking-error (Tracking error is the difference between a portfolio's returns and the benchmark or index it was meant to mimic or beat. Tracking error is sometimes called active risk) regret right as it is to determine the appropriate equity/fixed-income allocation. If you have the discipline to stick with a globally diversified, passive asset class strategy, you are likely to be rewarded for your discipline.* The same holds true for investments in other risky assets, such as alternatives, including AQR’s Style Premia Alternative R6 (QSPRX) and Alternative Risk Premia R6 (QRPRX) (both long-short, factor-based strategies), as well as Stone Ridge’s Alternative Lending Risk Premium Fund (LENDX) (small business, consumer and student loans), Reinsurance Risk Premium Interval Fund (SRRIX) and All Asset Variance Risk Premium Fund (AVRPX)”.

* The point is that some type of formula above is expected to do what? Beat the market. So, say it can. By what?- 50 basis points over 10 years? Why not 75 basis points? So what? Both returns and the default market will have to include a 50% loss of equities over one recessionary period and covering at least two years.  

Take $100,000 at 6.50% and at 7% for 8 years- then a recession for last two years.  

A 6.5%, 8 years, 100,000 =  165,500

B 7.0%  8 years, 100,000= 171,818

Difference is $6,300 

Then a recession of 50% over a period of the last two years.

(When using hypotheticals, it’s close enough to round numbers all over the place. Being absolutely ‘correct’ when all the numbers are guesstimates is illogical)

  1. $82,750 loss/remaining
  2. $85,909 loss/remaining

Why not reduce losses to just 12%- 15% via Phase 3? Used 15% for example

A 165,500 x .15= 24,825 round to 25,000

B 171,818 x .15= 25,775 round to 25,000

Differences in losses

A 82,750- 25,000= $58,500 round to $58,000

B 85,900- 25,000 = $60,900 round to $61,000

So look at the simple math. You use some type of formula where B makes $6,300 more than the default index A over 10 years. But by not paying attention to real life risk, the investor sacrifices $83,500 (rounded) of losses. If the investor uses Phase 3, the losses from 12% to about 15% or about $25,000. That is a savings of roughly  $60,000.

$60,000

 

If an adviser acts as a fiduciary, they know- or ought to know- or must know- what the loss exposure roughly is for a recession.  After all, they are giving all sorts of estimates on returns, various allocations, your risk profile (get real) etc. while knowing full well that business/economic cycles are peppered with recessions. But effectively 99 44/100% of advisers and about the same with magazines, articles, organizations and even educational entities litter their material with an excessive retention of recessionary losses.

I repeat, investors need identification of losses as identified above. They need to know what will be done to their assets.  Such recognition is not offered to investors. If one person- me- can figure out how to stress test a fund and portfolio………….. I don’t believe it. With CFAs, PhDs, and millions upon millions of dollars at Morningstar, Barron’s, Wall Street Journal et al, there has to be an entity(ies) somewhere, who have done this. I can however understand why it never got notoriety since it would make the planning effort cover more real issues of risk than ever as well as demand capability with personal financial calculator. (If you sit with a planner who cannot use a PERSONAL FINANCIAL CALCULATOR, get out! Software cannot even remotely cover all the issues that pop up that need a functional brain rather than AI.)

Most importantly, those investors that have no advisors, are clueless to risk- in fact most of the issues of investing, need a default position that can be implemented automatically through 401k plans, certain broker dealer firms, consumer groups and are absolutely mandatory for Robo advisors.

That is what the Process provides- risk categorization that investors can understand, a method of stress testing mutual funds and ETFs utilized (must have track history), a default scenario for those who are clueless to a Risk of Loss and an independent manner to get back in .

Consumer Reliance/Gullibility and Behavior and Unbalanced Reporting

The Process is (almost) solely identified with the Risk of Loss of mutual funds and ETFs. Real Estate requires use of a CIA- Comparative Investment Analysis form- and is quite involved and beyond this scope of this review.

The subsequent material identifies why the industry has refused to examine real life Risk of Loss. As noted above, a recessionary risk is what an advisor/industry is supposed to identify. But that isn’t enough

Phase 3

Consumer questionnaires and risk parameters

 

“When it comes to determining your risk tolerance, your level of investing experience must also be considered. Are you new to investing and trading? Have you been doing this for some time but are branching into a new area, like selling options? It is prudent to begin new ventures with some degree of caution, and trading or investing is no different. Get some experience under your belt before committing too much capital. Always remember the old cliché and strive for "preservation of capital." It only makes sense to take on the appropriate risk for your situation if the worst-case scenario will leave you able to live to fight another day.”*

*EFM- And therein lies the rub. The bulk of average retirees have little insight to where they are as well as what they should do. But the last sentence is wrong since it only provides a solution that an investor designs a portfolio allocations so that the equities section can never lose that much. And what is that? Well, you can’t know without doing a budget and then figuring out the nest egg you need to fulfill that expense.

For the uninitiate with a financial calculator, the budget is the PMT; lifetime projected (actuarially and generally plus a fudge- say 5 years) is N; end value is 0 (all assets are gone on the last day of N). That is FV. The value of i includes a guesstimate for inflation as well as a guesstimate for investment return; (1+r/1+i)- 1 x 100 . Hit PV for the value of needed gross total assets. Generally Social Security is subtracted for a net PV. (For simplicity, I am excluding any other investments, the house, etc.)

Assume the investor will NOT have enough. Assume the budget is as tight as it can get. The length of the lifetime can easily be adjusted but that has rarely made sense to me. Assume inflation for the calculation is at the low end of the guesstimate and that the return is what is being calculated. What happens if the numbers require a 6.5% annualized return to make it to and through 30 years. And since the investor is scared of losing too much that they decide on a 50/50 split of stocks and bonds. If stocks were to return 7% (85% to 95% probability for 5 years) and 3% on bonds (guesstimate only) the overall return would be 3.5% plus 1.5% or 5%. That is not enough return for that required (6.5%). Now what?

Well, the investor could more to 70/30. In such case, the equities would now produce 7 % x 70% or 4.9% plus 30%x 3% is .9% for a total of 5.8%. Still too short. And I submit that these type numbers reflect 75%+ of pre retirees or already retired and that they will have insufficient assets to acquire for retirement or during retirement. And once they have been hammered by 2000 (49% loss) and 2008 (57% loss), they are simply put out as a statistic that they will not be successful for retirement- or certainly make it through 25+ years.  The industry presents them as a lost ‘generation’ where nothing can be done.

WRONG!!

As a current note 11/4 from JP Morgan The traditional investor portfolio — which is made up of 60% stocks and 40% bonds — will return just 4.1% over the next 10 years. Valuation proves “far more accurate than any other variable in determining what the 5- or 10-year experience of an investor will be.

Morningstar noted ONE percent return on stocks for next 10 years. (If that should be the case, our society will break down rapidly. The Process will save some funds automatically but the significance of such a return would undoubtedly make almost all retirement moot. I cannot fathom the economic devastation.)

Then you can add younger consumers to the mix who will be unprepared. According to a 2018 Gallup poll, 52 percent of adults under 35 say they owned stocks in the seven years leading up to the crash. By 2017 and 2018only 37 percent did. By contrast, an average of 66 percent of Americans over 35 invested before the crashand though the share is lower now it's still at 61 percent.

The numbers from various research organizations and public reports are, at times, varying widely. No matter, the great numbers of any age (and the military) just cannot be left in the lurch for savings and retirement because they don’t know what to do, cannot lose any more money or simply refuse to do anything and leave life to chance.

It seems like an intractable situation-at least as identified by the industry and consumer groups

 

Phase 3

The Taming of Risk, the reduction of losses, the increases in return

The industry has a duty to fully explain risk to investors. For whatever reason- ineptness and an inability that is unconscionable - they have failed to both advise investors of the exposure to a Risk of Loss as well as to what is needed to lower losses in a real life exercise.

I will give a short comment here and then expound on it as we go forward. If you can avoid major losses, you can take what would normally be excessive risk (though you will not be told as such by the industry as addressed above), and can then invest in stronger equities allocations almost all of the time.

While this maybe heretical to readers, recognize that this is what Warren Buffett is doing for his wife when he dies. All monies are to be put into the S&P 500 ONLY (there is smaller account in treasuries for personal expenses) and then LEFT ALONE. No rebalancing, no adjustments, no nothing. The value of that type of allocation has been analyzed above by Edesess.

You cannot do market timing- that is a given. But what becomes obvious is that you can become aware of a correction since the bulk of the industry identifies it as such. Those commenting for a correction 5%- 8%+ are not rational since there is so much noise in the market that it should not be of much of an objective  concern. Note that in my new risk profile (Phase 1) however that a correction goes from 10% to (now) 15% to reflect greater volatility.

Let’s look at the 2000 recession. Once again I note the inverted yield curve in early 2000. No one really could know what would happen but as a 100% indicator of a recession, it could not be dismissed then nor cannot be dimissed now for current evaluation. Immediately the tech stocks got hammered. But for the year, the market lost just over 10%. Did Phase 3 kick in and ‘demand a sale’. No- the first stage of Phase 3 is only a red flag warning at 10%. Only when the losses were greater in year 2, was there a partial sale of equities. Year 2 had an additional loss and rest of the equities sold netting a 12% total loss.* Year 3 had an additional loss for a total of 49% but no additional loss under the Process since all equities had been sold in the second year.

 

*Phase 3 only works with the S&P 500 and the 12% therefore only addresses those losses. But since the investor can invest in anything they want- say the NASDAQ- losses were far greater than just the 12% by the time each sale point of the S&P500 was reached. Hence, as an average, I chose a range of losses to as much as 15%. The Process is not invovled with the loss of individual funds- just the market overall.

For the purposes of the 2000 recession, net losses for the S&P 500 were 12%, total loss of the market was 49% or a difference of 37% saved. If the losses were based on an initial $100,000,  the savings represent $37,000.  

 

Take a look at 2008. Once again the inverted yield curve had inverted in late 2006. Note that the market still went up pretty decently till late in 2007 and then dropped like a stone. It passed a correction very quickly and past all the other limits so that the 12% was reached quickly.  Total losses were 57% but since the investor ‘only’ lost 12%, the net savings was 45%- or with a $100,000 starting value, the savings was $45,000. 

Phase 4

Time to go back into the Market

While I was comfortable with setting up the percentages to reduce risk, it was a difficult issue trying to figure out the best time to get back in. No matter the objectivity I attempted- noticeable in 2008- my focus was not concise as to ‘timing’ and as to the type of investment(s) to consider. So over the years, I researched many issues to create a distinct point in the Process to re-enter the market. I found a public statement by the National Bureau of Economic Research that identifies a most ‘acceptable’ point back into the market. Notice that the reentry points are well below the time of sale. This entry increases overall return.

Bear Market

Essentially all elements of the Process have been addressed save for scenarios of an increasing correction or a bear market. To reiterate, a bear market is roughly a high of a 25% loss and expected to last just for a few months.    

False Positives

Phase 3 is automatic in that it has no idea of whether or not a recession is starting or that the market is in a formal correction. In Phase 1, I indicated that a recession is a minimum of 10% but that I now include 15%.  So the 10% is now a red flag before any sales of equities occurs. But by the time market losses reach 13%, all equities have been sold.

Note that Phase 3 does start immediate sales at 10% but leaves a buffer for ‘noise’. I further decided not wait till 15% to sell the rest of equities. See Have You Sold Your Equities Yet https://www.linkedin.com/pulse/have-you-sold-your-equities-yet-errold-moody-phd-msfp-llb-mba-bsce/ that was published in December 2018.  The Process does work in a correction but requires careful viewing by the investor and/or advisor. If the drop is ‘just’ a correction, the market tends to respond fairly quickly with a runup. If that be the case, the Process requires that you re-enter the market at least by the time the previous sales price is reached. (Note that I did NOT believe the market would return quickly. It doesn’t matter I was wrong. The securities have to be bought back. The positive to this is that ego and emotion do not control the Process. You do what it says you do. Obviously since the Process Is NOT a mandatory element as though it was a mutual fund, it can be changed/adjusted as required or wanted. But the more outside influences, the more risk that emotions and ego will destroy or negate part of the Process.) 

Look at the graph for 2008. When you look at the independent buy in date, almost immediately thereafter was a 19% loss that I really thought ‘was going to be a continuation of the 2008 recession’. Even the best think tank in Washington stated that all the elements of a continuing recession were there. This was also at the time of the second budget deficit travails with what I thought was going to be yet another mass Occupy Wall Street. So what happened? Nothing. And then there was a very good holiday spending which I could not believe would happen. Wrong again. But the Process provided the protection necessary.

Advisors mandatory

The Process is the first major change in Risk for at least 30+ years. The entire Process details a very concise manner in how the investing for the underserved can be made with far less risk- though it does the same for the upper class. But the underserved will never become aware of the Process nor can be expected to perform the mandatory sales and purchases to help themselves. Procrastination, fear, procrastination, fear, ……….pick what you want, but such ‘investors’ are not true investors. They do not understand and probably never will even recognize the intricacies of the market. They are frozen or don’t care to be involved.  

The bulk of such ‘investors- probably 75% in 401k plans- that require the most needed assistance with whatever equities are part of the portfolio allocation- will never even remotely hear of the Process because, while they recognize the word ‘risk’, the industry never addresses the Risk of Loss and has subsequently failed to instruct/protect retirement participant from major losses.

As such, advisors must offer and advise investors with a simple outline/image/visualize to grasp the fundamentals and pursue automatic adjustments to their portfolio.

The most concise method however is where a true consumer entity (AARP) or large organization (Google, Amazon, Alibaba, Facebook) would offer this to their group (once again I point out the necessity to the military) where they would/could offer the Process to members as part of their ongoing product enhancement. Remember, this is not a fund- just a method to control the Risk of Loss. It entails a decent amount of computer storage for members to utilize phase 2- the approximation of loss to mutual funds and ETFs that meet the necessity of at least a 3 year history.

It is not necessary to have any agents to assist in the development of their allocations. In fact, it needs to be made clear that any allocation is solely the decision of themselves or outside advisors. It is an informational tool ONLY. The Process is a tool for Risk of Loss and the mitigation thereof. It would/could work with ROBO systems quite well and would be an incentive for such use since there are no other systems that offer a real life review of risk. 

Conclusion 

This is first major investment change/upgrade to Risk of Loss in the last 30+ years. It is devoted only to the mitigation of risk. But it also increases returns with close to 100% invested in equities during the pre and post retirement timeframe- in essence for their entire lifetime. (I fully admit that the probabilities of a continuation of any projection past 10 years is simply not grounded in the reality of change. It is necessary however to do some type of rendering  to soothe investors and (at least) temporarily smooth over major hurdles we will obviously encounter.

The Process requires no involvement with investment advice per se in the selection of products and is totally independent of any outside involvement or sales. The investor is acting alone or through a separate advisor. There are NO licensed agents required. There is no market timing- in fact no timing in any manner.

Phase 1 is a New real life risk profile that consumers can understand. It certainly will open the eyes of effectively everyone to the potential losses in an allocation and where the investors are clueless to such impacts. Many funds that Morningstar and others rate as moderate risk can reach losses of 40%+. Recognize the S&P500 lost 49% in 2000 and 57% in 2008 putting it into the aggressive range.  

Phase 2 is the mandatory stress test of the mutual funds/ETFs that are under review. The probability of losses is derived from a formula that is not driven by artificial intelligence. It is not a formal statement of losses that will positively accrue- it is however, a number that the consumer can identify as potential loss rather than receiving no direction at all.

Phase 3 of the Process only occurs if losses exceed a correction - and then it reduces/lowers the risk to about 12% to 15% rather than the potential losses in a recession as identified by Phase 2.  It completely changes the industry’s effectively trivial reflection on risk to a real life exposure of financial devastation bout every 7.5 to 10 years. And then provides a logical, straightforward method to keep said losses to a minimum. All it takes is a phone call to institute.

Most importantly, it allows the investor to use the maximum allowable in equities in their allocation since the major losses to the equities is monitored as the market drops. Once it passes various set points, the equities are sold. There is no market timing since if the market does not go down, nothing happens. If the market goes down, something happens. There is no illusion, no Ouija Board- nothing that is involved in some form of quackery.

The investor makes more money during the good times while avoiding major losses about every 7.5 to 10 years. If implemented correctly over a large audience,  those of the middle class and the military will secure more assets during both the pre-retirement and post retirement time frames.

Phase 4 is an independent date from the National Bureau of Economic Research. I do not believe the statement will change in fact by the FED. It is not an absolute perfect entry as was addressed by my comments on the 2011 market. But it appears to be the best logical point to re-entry into the market

 

The is the first real upgrade to risk in at least 3 decades. It can change the behavior of investing for millions of ‘consumers’ at a very limited cost and an ease of understanding far greater than the tools used by the industry that are almost impossible to grasp.

 

Errold F Moody Jr

PhD MBA MSFP LLB BSCE

EFM@EFMOODY.COM

352 794 0212