There was a place to hide in the perfect storm...

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor.

There was a place to hide in the perfect storm...

Postby yielder » 15 Mar 2009 10:19

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I started this exercise to prove a foregone conclusion using Norm's Crystal Ball: you need a significant weighting of bonds in your portfolio as a dampening effect against equity market swings and as protection against shit happening, specifically the perfect storm. For the equity weighting, I chose the old RRSP 30% foreign content limit. For the bond weighting, I chose short term bonds for a couple of reasons. We've been in a 25 year bull market for bonds and long rates have gotten about as low as they can get. Similarly, inflation risks - as opposed to inflation - have been rising steadily for 10 years although they aren't reflected in long bond prices. I've included a couple of twists such as a 10% gold weighting and RRBs instead of short term bonds.

And then I switched the asset mix from 50/50 bonds to equity to 25/75 bonds to equity. Average returns and total returns don't change much but variability almost doubles and 2008 becomes a disastrous year rather than just a bad year. Disastrous years have long term and even permanent effects. IIRC, correctly GeorgeH has alluded to the effect the 70s bear had on him.

The results were as I expected. They may be even better than the results indicate. If Norm's model doesn't rebalance annually, then the returns are understated and the variability may be overstated. They are nominal not real which does have an impact. It's worth the exercise for people to run real numbers.

We can't say we didn't know. Norm's tool and ones like it (although not as good) have been around for a long time. His cautionary note says it all: This tool is much like a scalpel. In competent hands it is useful but the amateur may wind up cutting themselves. The amateur should seek professional advice. I suspect that most people would use this tool to find the optimal asset mix that gives the highest return over the longest period of time and ignore the variability of the returns. I suspect also that people would accept the numbers without trying to understand what was happening. The numbers say that long bond annual returns of 10% from 1970 to date are great. Adjust for inflation and 10% becomes 5.5%. Looking inside the numbers shows a more detailed picture of inflation. From 1982 to the present returns are 12% but only 6% from 1970 to 1981. Adjust for inflation and the results become 8.9% and -1.8%. Using numbers without trying to understand them is a recipe for disaster.

Let me put a behaviourist's spin on things. As with all animals, we herd. When market returns are good, we focus on returns and think they will continue and even get better. So we chase the returns. We buy dotcons; we buy income trusts; we buy oil trusts; we buy dividend stocks at inflated prices; we buy houses at inflated prices. Unlike other herd animals, we tend to ignore risk until it becomes a reality. Sheep run when they smell a bear; we don't. Neither do we learn very well. Sheep learned a long time ago what the smell of a bear means. We read about tulips, the South Seas and other bubbly times, and then smile and think that we've learned because we're so much more knowledgeable and sophisticated now.

Bottom line: A diversified portfolio that focuses on risk rather than return would have produced a loss last year of 10% (11.4% real). The impact of tha kind of number can easily be offset to zero with a bit of cost cutting on the consumption side.
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Re: There was a place to hide in the perfect storm...

Postby adrian2 » 15 Mar 2009 10:49

yielder wrote:Bottom line: A diversified portfolio that focuses on risk rather than return would have produced a loss last year of 10% (11.4% real).

Bottom line: I may be delusional, but I still can't justify any bonds in my portfolio.

As they say, lies, damned lies and statistics: of course, in hindsight, it would have been nice to have bonds, but all we have going forward is the crude reality of near zero nominal yields - theory aside, I can't justify putting my money in something that yields one or two percent, with the clear (?) sound of inflation coming up in the near to medium term future. One can argue about semantics, but IMO government bonds are in a bubble; yes, short term bonds will have less to fall, but they still have zero appeal to me.

For a couch potato portfolio, I have no objections of including bonds, once again for myself I have no regrets of owning none.

yielder wrote:Let me put a behaviourist's spin on things. As with all animals, we herd. When market returns are good, we focus on returns and think they will continue and even get better. So we chase the returns. We buy dotcons; we buy income trusts; we buy oil trusts; we buy dividend stocks at inflated prices; we buy houses at inflated prices. Unlike other herd animals, we tend to ignore risk until it becomes a reality.

I'll argue that buying (instead of keeping) government bonds now is chasing the returns - best of a bad smelling lot, perfectly characterized in the paragraph above: "we focus on returns and think they will continue and even get better" - what's the chance of that happening in the future for government bonds?
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Postby Taggart » 15 Mar 2009 11:08

Sorry if I don't see much difference from the original "All Weather Portfolios" brought out in the 1980's by Gerald Perritt. Harry Browne had something similar at the time which he called "The Permanent Portfolio". Only difference is you can now do it cheaper and add RRB's which didn't exist then.

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Re: There was a place to hide in the perfect storm...

Postby NormR » 15 Mar 2009 11:12

yielder wrote:If Norm's model doesn't rebalance annually, then the returns are understated and the variability may be overstated.


The calculator assumes annual rebalancing.

But variability is very likely understated because annual data is used. Monthly or daily data will show higher highs and lower lows. (i.e. peak-to-trough declines will be larger based on daily data.)
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Postby Brix » 15 Mar 2009 12:14

yielder wrote:you need a significant weighting of bonds in your portfolio as a dampening effect against equity market swings and as protection against shit happening, specifically the perfect storm.


In a better, more financially literate, world this would not be news to anyone, especially anyone approaching or actually in retirement when withdrawal requirements are based on a progressively shorter time-scale and time for recovery from losses is plainly decreasing.

If general declines in asset values can endanger a pooled pension plan with a stream of contributions as well as a stream of payouts, the effect on comparably-structured individual savings when the stream is 100% withdrawal will likely be disastrous by comparison. Something like the generic 60/40 balance may be optimal for a growing group pension fund, but it should be obvious that individuals approaching and in retirement are obliged to be progressively more conservative -- unless they can somehow be 100% certain that luck will be with them as the curve of their future needs contends with the curve of future returns.

That said, reflecting on this now that a candidate 'perfect storm' is actually under way is a pretty extravagant case of bad timing. If I did happen to feel I had too much in equities for life-cycle reasons, I'd be very cautious about shifting the balance away from them at this point.
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Re: There was a place to hide in the perfect storm...

Postby George$ » 15 Mar 2009 14:07

yielder wrote:... Using numbers without trying to understand them is a recipe for disaster.
.....
Bottom line: A diversified portfolio that focuses on risk rather than return would have produced a loss last year of 10% (11.4% real). The impact of tha kind of number can easily be offset to zero with a bit of cost cutting on the consumption side.

A good lesson Mike. Appreciate the post. I'm always agast when retirees or about-to-be retirees complain about how much they have lost (recently) because of a major equity position that late in life.

And in particular I like your emphasis on real return numbers, not just nominal numbers. I wish more financial numbers were posted as 'real'.
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Postby scomac » 15 Mar 2009 14:18

Brix wrote:That said, reflecting on this now that a candidate 'perfect storm' is actually under way is a pretty extravagant case of bad timing. If I did happen to feel I had too much in equities for life-cycle reasons, I'd be very cautious about shifting the balance away from them at this point.


Maybe and maybe not. Not all bonds are in the same sort of pricing premium relative to equities as gov't bonds at this time. Long corporate bonds now yield 7.6% which provides the investor with a 400 basis point risk premium over long Canadas. By moving some of the equity exposure over to corporate bonds, you might be able to have your cake and eat it too. You aren't chasing an asset class that has recently out-performed so as to potentially lock-in a permanent loss via risk reduction rebalancing. You have still effectively reduced your risk exposure (by up-grading to a senior claim position) without having to give up all of the additional return potential that could be available by remaining full-weight in equities. If it is determined that a 60/40 equity/income split is too aggressive for the plan in question, then a move to a 40/60 equity/income split (for example) could be achieved simply by moving 20 points of the equity slice into investment grade corporate bonds.
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Postby Shakespeare » 15 Mar 2009 14:19

I'm considering adding a teeny bit to my PH&N HYB, which has held up pretty well. As of Dec 31 the yield was 9.0%.
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Postby parvus » 15 Mar 2009 15:13

Thanks for the post, yielder. Interesting results with gold and short-term bonds. The RRB results are something to chew over,
however.
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Postby Clock Watcher » 15 Mar 2009 15:34

I can imagine realistic scenarios where bonds would get clobbered, and stocks would be flat to negative. There is overwhelming acceptance today that a balanced portfolio of stocks/bonds would prevail over the long term, but as many are discovering, you only have to be "wrong once" to end up equivalent to being "wrong for the rest of your life".

IMO investing is about side-stepping the type of exceptions that only occur twice in a generation.
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Postby brucecohen » 15 Mar 2009 20:55

So Yielder's excellent post led me to Norm's excellent calculator which led me to try to research what the good doc refers to as the "safe portfolio" which led me to this interesting and almost universally overlooked point about the 4% "safe withdrawal rate."

The linked page notes that the research which produced the 4% SWR used market indices which, of course, include no MERs. So, as the reader suggests, a SWR for a portfolio invested in actively managed mutual funds is likely more in the 1-2% range.

Norm, except for your site, google found no hits for a "safe portfolio." Did you create it?
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Postby NormR » 15 Mar 2009 21:54

brucecohen wrote:So Yielder's excellent post led me to Norm's excellent calculator which led me to try to research what the good doc refers to as the "safe portfolio" which led me to this interesting and almost universally overlooked point about the 4% "safe withdrawal rate."

The linked page notes that the research which produced the 4% SWR used market indices which, of course, include no MERs. So, as the reader suggests, a SWR for a portfolio invested in actively managed mutual funds is likely more in the 1-2% range.

Norm, except for your site, google found no hits for a "safe portfolio." Did you create it?


Humm, perhaps you're referring to the Safe Potato portfolio? In which case, I believe I made that one up to have a portfolio with a higher bond weighting in the bunch of sample portfolios.
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Postby brucecohen » 15 Mar 2009 21:57

Yes, I was referring to the Safe Potato Portfolio. Thanks
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Postby BRIAN5000 » 15 Mar 2009 22:08

Page 94 in "How to invest if you can't afford to lose" Four safe portfolio's. I htink there is a page that shows them all can't find it right now, pokering.

Can be downloaded free from http://thomasnogales.com/index.htm
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Postby brucecohen » 15 Mar 2009 22:34

BRIAN5000 wrote:Page 94 in "How to invest if you can't afford to lose" Four safe portfolio's. I htink there is a page that shows them all can't find it right now, pokering.

Can be downloaded free from http://thomasnogales.com/index.htm

Thanks. Very interesting, but I'm too tired to give it a good examination tonight. I've determined that I can retire comfortably to age-95 with a 0% real return. IOW, all I have to do is match inflation. So I've become quite interested in "safe" portfolios.
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Postby Shakespeare » 15 Mar 2009 22:38

IOW, all I have to do is match inflation
So why wouldn't you go sufficient RRBs to get your return to 95 at the current RRB rate and spread the rest around for some extra insurance?
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Postby NormR » 15 Mar 2009 23:05

brucecohen wrote:
BRIAN5000 wrote:Page 94 in "How to invest if you can't afford to lose" Four safe portfolio's. I htink there is a page that shows them all can't find it right now, pokering.

Can be downloaded free from http://thomasnogales.com/index.htm

Thanks. Very interesting, but I'm too tired to give it a good examination tonight. I've determined that I can retire comfortably to age-95 with a 0% real return. IOW, all I have to do is match inflation. So I've become quite interested in "safe" portfolios.


RRBs currently yield ~2% ...
http://www.bankofcanada.ca/en/rates/bonds.html

So, what Shakes said. :wink:


But you still suffer from counterparty risk. Say Quebec splits/civil war/GOC bonds go up in smoke. Etc.
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Postby Shakespeare » 15 Mar 2009 23:12

But you still suffer from counterparty risk.
Which is why the extra moneys should be spread around.
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Postby couponstrip » 15 Mar 2009 23:44

NormR wrote:But you still suffer from counterparty risk. Say Quebec splits/civil war/GOC bonds go up in smoke. Etc.


And this risk exists (for the bond portion of your portfolio) whether your allocation to bonds, real or otherwise is 1% or 100%. Obviously, the overall counterparty risk to your portfolio is greater the higher the bond allocation. For the bond risks you mention, I always have this nagging urge to diversify fixed income using US and international debt, although I had posted on it a couple of years ago, and the responses were somewhat mixed, but mostly negative.

One reasonable explanation is that if you have an equity component that includes international equities including US equities, then perhaps your international/currency diversification is sufficient to protect you against lending to only one country. However, the problem as I see it, is that an even more perfect storm (ultraperfect?) might ravage your equity portfolio as the current bear has, and simultaneously through some political (war, separatism etc) or economic (GOC default) disaster destroy your bond portfolio....the very portion of your portfolio that is supposed to bring stability (and generate income) in a severe bear. Far-fetched, perhaps, but then again, we have seen some "far-fetched" events take place several times in the past 12 months.

For an all-bond portfolio (I know, I'm dreaming), I would think that international bond diversification would be a significant portfolio consideration.
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Postby brucecohen » 16 Mar 2009 09:15

I recently made my first RRB purchase and would buy more but, with only four maturities available, they can't fully support my ladder. I've heard that there are some Quebec RRBs, but I don't trust Quebec's economic managers.

I'm not interested in foreign bonds because of the currency risk and added cost. Might buy US but won't go outside North America.

These may be famous last words :wink: but I'm not particularly concerned about the doomsday counterparty risks cited. I see Alberta separation as a bigger risk than Quebec leaving, but assign extremely low probability to both and expect an orderly divorce in either case. Back when Quebec separation was on the front burner, the prevailing view among civil servants-turned-academics that the financial settlement would take 10 years. In any event, I doubt that any Canadian security -- bond or equity -- would be immune from a short-term blow. The other doomsday scenarios -- civil war (in Canada????) and federal default -- are likely only in the midst of a global disaster that would clobber virtually every financial instrument virtually everywhere.

I disagree with the view that we've seen "far-fetched" events in the past 12 months. The world has a long and pretty consistent history of huge companies failing. And, from what I gather, the world financial system has come close to collapse at least once before: the MBA loans fiasco. (FWIW my brother -- a railroad buff -- suggested months ago that there was no reason for the US govt to agonize over what to do about Detroit because there was already a template: the failure of Penn Central and other major northeastern railroads in the 1970s. Now NY Times has picked up on that.)
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Postby Brix » 16 Mar 2009 09:19

brucecohen wrote:The linked page notes that the research which produced the 4% SWR used market indices which, of course, include no MERs. So, as the reader suggests, a SWR for a portfolio invested in actively managed mutual funds is likely more in the 1-2% range


Looking on the bright side, we can be thankful that in contrast to the SWR fund fees remain merely a percentage of existing/remaining assets and aren't adjusted for inflation. :twisted:
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Re: There was a place to hide in the perfect storm...

Postby DanH » 16 Mar 2009 09:35

yielder wrote:Image


To Norm's point, be careful with these numbers. My own (offline) calculator doesn't include gold or withdrawals, but it does use monthly returns. For instance, your portfolio number 1 (50% ST Bonds, 20% TSX, 15% S&P, and 15% EAFE), you show a -10.19% decline for 2008 but that was not the biggest drop.

Assuming NO FEES, I get (Jan 1980 through Feb 2009)...

Compound Annualized Return: 9.51%
Best Rolling Year: 42.5%
Worst Rolling Year: -15.7% (year ending Feb/09)
% of Losing Rolling Years: 15.6%
% of Rolling Years < 5%: 25.4%
Biggest Drop: -19.0% (9 months, and counting, through Feb 2009)

And if you use daily data, you're sure to get a slightly fatter loss - and that's with half in ST bonds.

The previously biggest drop was -15.21% (tech bust).
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Postby Taggart » 16 Mar 2009 10:46

brucecohen wrote:I disagree with the view that we've seen "far-fetched" events in the past 12 months. The world has a long and pretty consistent history of huge companies failing. And, from what I gather, the world financial system has come close to collapse at least once before: the MBA loans fiasco. (FWIW my brother -- a railroad buff -- suggested months ago that there was no reason for the US govt to agonize over what to do about Detroit because there was already a template: the failure of Penn Central and other major northeastern railroads in the 1970s. Now NY Times has picked up on that.)


To add to what Bruce mentioned, back in 1989 Outstanding Investor Digest did a lengthy two part interview with Walter Schloss. I think you may at least notice one similarity with what's happening in today's financial crisis:

Walter Schloss: One of the great investment successes we had was with the Penn Central bankruptcy. The only mistake we made was in buying the first mortgage bonds. They worked out well but the junior bonds worked out even better. New York Central bonds, which were selling for $50 on a $1000 bond, worked out at par whereas the senior bonds, which we bought at $150, worked out at par.
But I was trying to be conservative. Anyway we did very well with the Penn Central bankruptcy.

OID: Not bad.

Walter Schloss: It was a fabulous success. And in retrospect, you wonder why it worked so well. I guess it was in the 70's and people were scared.
The problem in investing, I think, is timing. You may be right. But in the long run, we're all dead. Even, if you're right, if it takes 20 years to work out, it can be a disaster.
Things usually take longer to work out but they work out better than you expect.
In the meantime the economic cycle can change.
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Re: There was a place to hide in the perfect storm...

Postby yielder » 16 Mar 2009 12:35

adrian2 wrote:Bottom line: I may be delusional, but I still can't justify any bonds in my portfolio.


If you figure you can stomach market volatility and there's no consequence to life plans, you're not delusional.


in hindsight, it would have been nice to have bonds,


Exactly. Tomorrow is the near future until tomorrow is today and then the future becomes hindsight. If you don't like nominal bonds, use real return bonds. I wasn't advocating buying bonds. In fact, someone who was using a diversified portfolio would have the difficult task right now of buying equities to rebalance. If someone was starting a diversified portfolio, they'd have a tough call to make right now. Sit on the sidelines and try to time it, jump in, dollar cost average, dollar value average.

For a couch potato portfolio, I have no objections of including bonds, once again for myself I have no regrets of owning none.


If you are in the accumulation stage and can stomach the volatility and replace the lost capital from current earnings, then it's not surprising that you have no regrets. I submit though that as you near retirement or are in retirement, you're playing with fire if you don't have a fixed income component in some form. A DB pension, which is effectively fixed income, that covers most of your living expenses would allow you to have a far greater equity component. Risk taking should give way to risk reduction and elimination as you age.

I'll argue that buying (instead of keeping) government bonds now is chasing the returns


And I'd agree with you but one still has to eat.

Taggart wrote:Sorry if I don't see much difference


There isn't. I'm not claiming anything original here.

Brix wrote:That said, reflecting on this now that a candidate 'perfect storm' is actually under way is a pretty extravagant case of bad timing. If I did happen to feel I had too much in equities for life-cycle reasons, I'd be very cautious about shifting the balance away from them at this point.


It's been said many times before, both here and elsewhere. I started the thread because there have been comments here that there was no place to hide. That's not true. I wasn't suggesting any immediate course of action but rather pointing out the importance of adequate age based diversification and commenting on how we get trapped into mistakes.

parvus wrote:Interesting results with gold and short-term bonds. The RRB results are something to chew over, however.


Be careful, it's a cherry picked 10 year period. Something more rigorous would involve perhaps using a rolling 10 year period to smooth the results. What I found interesting about gold was what it did to variability. I'd want to look at that over different periods.

Clock Watcher wrote:I can imagine realistic scenarios where bonds would get clobbered, and stocks would be flat to negative.


And I'd be interested in hearing them.

DanH wrote:For instance, your portfolio number 1 (50% ST Bonds, 20% TSX, 15% S&P, and 15% EAFE), you show a -10.19% decline for 2008 but that was not the biggest drop.


That wouldn't surprise me. I didn't go looking for the worst case.


The previously biggest drop was -15.21% (tech bust).


So what does the table that I presented look like during the tech bust? What happens with a 25/75 bond to equity mix? I can guess but I don't how exactly how much worse than -15.21% the results were.

What I did was a very specific cherry pick to look at the impact of diversification during a period when equity markets are a disaster. I was making the case for bonds in a diversified portfolio as a way of dampening equity market swings and as protection against shit happening.

Does it cover all scenarios? No. Norm's data doesn't cover a period of asset deflation. Nor does it cover a period of inflation higher than the teens.
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Re: There was a place to hide in the perfect storm...

Postby DanH » 16 Mar 2009 15:11

yielder wrote:So what does the table that I presented look like during the tech bust? What happens with a 25/75 bond to equity mix? I can guess but I don't how exactly how much worse than -15.21% the results were.


For your portfolio #4 (45% TSX, 25% ST Bond, 15% each of S&P and EAFE both C$), Assuming NO FEES, I get (Jan 1980 through Feb 2009)...

Compound Annualized Return: 9.30%
Best Rolling Year: 56%
Worst Rolling Year: -26% (year ending Feb/09)
% of Losing Rolling Years: 21%
% of Rolling Years < 5%: 30%
Biggest Drop: -31% (10 months, and counting, through Feb 2009)

The previous biggest drop was -29% for the twenty six months ending Sept/02. It took an additional 33 months to break even to the previous high at the time. That means almost five years from top to bottom to recovery.


What I did was a very specific cherry pick to look at the impact of diversification during a period when equity markets are a disaster. I was making the case for bonds in a diversified portfolio as a way of dampening equity market swings and as protection against shit happening.

Does it cover all scenarios? No. Norm's data doesn't cover a period of asset deflation. Nor does it cover a period of inflation higher than the teens.


There's nothing wrong with your illustration. I was simply attaching some context to Norm's warning re: greater downside with more frequent data.
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