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'Til Death Do Us Part

'Til Death Do Us Part

| October 22, 2018

This quarterly update is going to be one of the more important ones that we publish.  I promise, we haven’t changed the focus of our business to marriage counselling – although Dave did take the plunge into marriage as promised over the Labor Day weekend!  Instead, we are going to be focusing today on another important item in our lives that we all hope to never part ways with until such time that we leave this earth.  That being, our money…..

We found it particularly important to write this piece now as the current financial environment is becoming increasingly ripe for investors committing the first and most deadly sin of investing and financial planning.  That sin is taking risks you can’t afford in favor of potential returns you can no longer (emotionally) handle missing.  More commonly, this is known as “buying high and selling low”, the exact opposite of what any of us strive to do with our savings and investments.  When this occurs, it causes anxiety and lower long-term returns at best, and can lead to financial ruin at worst.  How many of you know someone that lost half or more of their entire retirement savings chasing tech stocks in the late 90s?  More recently, how many know of investors that rode stocks all the way down during the “great recession”, only to sell everything and never recover those losses?

Many of the investors in the booming tech sector of the 90s had little to no understanding of what they owned – they owned it because they saw the returns reported on TV, or their advisor or neighbors suggesting they needed to “not miss the boat”.  Many that lost a majority of their savings during the great recession - and turned it to cash when they could “take it no more” - honestly felt they could weather the storm should markets take a turn for the worse.  It’s easy to say that while things are good, much more difficult when you see your life savings dwindling with each passing day.

This update is not meant to scare anyone.  In fact, it will have quite a positive conclusion.  As we have stated emphatically in the past, we are not predicting a collapse in financial markets.  At the same time, we are aware of and choose not to ignore the financial conditions present that might predicate such an outcome.  We will not be discussing those risks in detail in this update, but feel free to peruse our past writings (found on our website) for our thoughts on the topic.  As is the case with any “mass communication”, it does not and should not apply to all investors equally.  Ignoring one’s tolerance for risk (which should never be done), there will be 20-somethings reading this for which the next significant downturn will likely prove as nothing more than an opportunity to “buy low”.  There are retired investors that simply have more money than they could ever plan to spend in their lifetime.  These types of investors should spend significantly less mental energy contemplating much of what we are discussing here, assuming they have a full understanding of their own tolerance for risk.  But to those readers already in retirement (or planning on retiring in the near future) - and relying on their investments as a significant source of income for the rest of their lives – we reiterate that this update might be the most important one we can ever write.

Let’s start the discussion with what we adamantly believe to be the most important financial goal for any investor.  That goal is to never run out of money during your lifetime.  The goal should not be to beat the S&P 500.  It should not be to have higher returns than your neighbor.  It should not be to always be fully invested in the hottest asset class of the time. It should not be to never lose money.  Let me repeat this one more time – any investor’s number one financial priority should be to not outlive their money.  And so we are clear, that is our number one priority for every single one of our clients (and for ourselves in managing our own savings).

Why exactly do we believe this to be so important?  To illustrate, let’s look at a simple and purely hypothetical example.  Joe Smith has $100,000 of investable assets and needs $4,000 per year for the rest of his life from that $100,000.  That means (ignoring inflation), he needs 4% per year of his original investment, and for the rest of his life.  That 4% “drawdown” rate is widely considered a responsible one (albeit increasingly difficult in the current environment).

Now, let’s say Joe was growing tired of the miniscule returns currently offered in many fixed income and cash investments – heck, he’s not even earning the 4% he needs - so he invests all of his $100,000 into stocks.  In the next 12 months, the S&P 500 (and Joe’s portfolio with it) drops 50% (which it has done twice since the year 2000 by the way).  He still needs the same $4,000 per year to live, but now only has $50,000 with which to generate it.  That means, he is now withdrawing 8% per year from his portfolio.  And if Joe then panics thinking he can’t afford to lose any more of his savings – and takes it all out of the market – he then has virtually no chance of recouping the losses, nor can he generate anything close to the 8% per year that he is now withdrawing.  His long-term goal of never outliving his money went from very sound to completely decimated, all because his focus was on short-term returns.  That’s what financial ruin looks like.

We again reiterate that the above example is very basic and purely hypothetical, but one thing it is not is unrealistic.  When we mentioned previously the investors that were most hurt by the “tech crash” or “great recession”, it looked a lot like what we described above with good ole Joe Smith.

So why is this important now, and what do we mean by the current financial environment “becoming increasingly ripe” for investor (or advisor) behavior as described above?  To bring it back to our wedding theme, “let us count the ways”…..

For one, the current bull market is officially the longest in recorded history.  By itself, that doesn’t mean much.  What it does mean is that we are now in the longest period of investors hearing over and over about the stock market making “brand new highs”.  This is fertile ground for the part of our brains responsible for the incredibly dangerous - yet powerful - “I’m missing the boat” narrative.  It tends to also breed co-workers bragging of 401k performances, TV commentators making repeated and ridiculous comments such as “stocks are the only game in town” or “you would have to be crazy to own anything but stocks right now”, and countless advertisements on how to get rich day trading stocks.

None of this is new with the current environment as compared to previous, late-cycle bull markets.  But this one has one extremely noteworthy and significant difference.  That difference is the virtually non-existent returns on fixed income investments, due mainly to a Fed on monetary steroids.  The “responsible” investor of the past who resisted the temptation to chase returns was at least earning something on the assets not invested in stocks.  This time is very different.  Interest rates were lowered to historically low levels – in no small part facilitating the potential “bubble” environment we find ourselves in now – and returns on more conservative assets have suffered accordingly.  For the most part, there has been little relief in terms of rising rates for savers – although we are finally starting to see that trend reverse a bit.

You don’t need us to remind you, but there is a huge difference (both real and psychological) between mid-single digit (think 5,6,7%) and low-single digit (think 1,2,3%) portfolio returns – especially when the stock market continues to make new highs.  When you consider everything discussed above, it’s easy to see why investors in the current environment would be tempted to take on risk that they would not otherwise be comfortable with – and at potentially the worst possible time. Worse yet, we fear that the unique aspects of the current environment are testing advisor resolve to be responsible at least as much as the investors who hire them.  I can tell you that Dave and I are about as mentally drained right now as we were in the midst of the last two “market crashes” in 2000 and 2008 – and that’s with the markets at all-time highs.  That should tell you something, and it is bizarre at best.

At the same time, it all makes perfect sense.  We began this update by stating that the number one goal of any investor or their advisor should be for the investor to not outlive their money.  As it pertains to the investments available to meet that goal, there are two main variables the investor must address – that being return and risk.  Simply put, the investor will likely need a certain return to meet their long-term goals, but also have a level of protection needed so that the potential downside of the portfolio will not decimate the plan.  In an environment where the only way of generating returns is to take risk, it becomes an almost impossible dilemma.  Stay conservative, and it’s nearly impossible to achieve needed returns.  Get more aggressive, and you run the risk of realizing losses you can’t afford.  This is a problem – a dangerous one – that investors have been facing for several years now…..  

(It is also a problem the Fed and politicians have created themselves over the years, but that is a story for another update.)

And we haven’t even touched on the risks present in various fixed income vehicles (both rate and credit) that have been taken to a whole new level during this cycle, for all of the exact same reasons (the need for return / income).  For the sake of your time and sanity, we will again refer you to the website for previous commentary on the topic.

At the end of the day, here is what we believe every investor must understand – in the current environment, you must take on significantly greater market and/or interest rate risk to generate the same returns you may have previously been accustomed to (or need).  It’s a fact, and anyone stating otherwise is fooling themselves.

But we promised a positive conclusion to this update, and darn if we are not going to deliver!  It’s actually not very difficult to do, and we believe this with every ounce of our being (even though the Fed makes it extraordinarily hard at times):

This won’t last forever. 

None of the following – FINRA, the SEC and / or LPL’s compliance department – will allow us to make guarantees.  This is extremely wise on their parts.  But we can say that history would have to completely re-write itself for the following two things to never happen again:

Interest rates will rise.

Stock prices will fall.

As we discussed previously, the statement about interest rates is more important to the conservative investor.  This is because interest earned on savings accounts, CDs and many other types of fixed income investments will again “normalize” higher toward historical averages – though we must also keep an eye on interest rate risk for current holdings as they go through the process.  This alone means greater return potential for the “responsible” investor going forward as interest earned on fixed income vehicles rises in conjunction with rates overall.

Now we fully realize how bizarre it sounds for us to claim that “stock prices will eventually fall” as part of a positive conclusion.  But valuations do in fact matter.  We are hardly alone in our opinion that return expectations for stocks should be significantly tempered going forward based on the lofty valuations present today.  So, for the investor maintaining or reducing risk levels today for the sake of protection, a decline in stock valuations provides the opportunity to add risk at more reasonable valuations.  In other words, the opportunity to “buy low” instead of “buying high”.

In many ways, putting the goal of never outliving your money at the top of your list can remove much of the anxiety and frustration you may be feeling in the current environment. Update and review your financial plan. Look at different – and most importantly - realistic scenarios. And if you like what you see, remind yourself (and that voice in your head) that no potential return is worth the risk of decimating that plan. It just isn’t.

Remember that interest rates will eventually rise, and that valuations of stocks and other riskier asset classes will once again normalize.  They always do.

In closing, a quote from Benjamin Graham - one of the truly great (and genuine in our opinion) investors of our time:

“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”

To all of our clients, we can never thank you enough for the trust and confidence you have placed in Round Hill Wealth Management.