S&P 500 Benchmarking Is Broken

Much has been made this year of the incredibly narrow leadership in the S&P 500's performance year to date, the NASDAQ too for that matter. The 'Magnificent Seven' of Amazon, Microsoft, Meta, Nvidia, Apple, Alphabet and Tesla account for the vast majority of the gain in the S&P 500 so far. This group recently grew to 30% of the index so if you don't have 30% of your portfolio in those names, you are very likely lagging behind the index. I certainly am. 

A normal investor who goes narrower than the broadest index funds will have years where they lag and years where they outperform and this is a year where I am lagging so far. There's simply no way I am going to concentrate 30% into so few names pretty much all from the same sector (AMZN is consumer discretionary in tech clothing). These names grew to 50% of the NASDAQ prompting a special rebalance. 

 

RSP is the Invesco S&P 500 Equal Weight ETF. This fund typically outperforms the market cap weighted (MCW) S&P 500 but with more volatility. For years, RSP outperformed, this year has obviously been a different story. That 7.7% gain for RSP on the chart can be thought of as "the average stock in the S&P 500 is up 7.7%" but because of how lopsided the index is, it is miles behind MCW. Dispersion of this magnitude in the favor of MCW is not unprecedented but it is very rare. 2020, is the only incidence I can find since RSP started trading. The market was similarly narrow as the internet bubble built up but that predates RSP.

So, is it time to switch benchmarks? In my opinion, no. I don't think changing benchmarks due to what amounts to an anomaly makes sense. It is an undisciplined behavior that stems from impatience. We talk about this all the time, no portfolio strategy is perfect. Usually the context is that some given strategy, even a great strategy, will at times lag. But it applies too to what I will say is a potential flaw in market cap weighting. This happens every so often, probably does not indicate a healthy market but as we saw in 2020, it can resolve by the rest of the market catching up, it doesn't have to result in a 2000-era bubble popping. 

I have no idea if the rest of the market will catch up or if this one will end very badly, we have no control over that. What we can control though is maintaining a reasonably diversified portfolio that won't go down with the index basis point for basis point in case it does end badly. It is much easier to talk to people about being up less than it is to talk about following something that turns out to be a bubble all the way down. 

If you have 30% of your portfolio in those seven names then you are exposed to a lot of risk right now. If you're an indexer then you should not care. And again, there may never be a consequence for that risk, but not realizing the risk you're taking until after the blow up is not good portfolio/risk management. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. 

401ks Are A Scam? They're The Worst Scam?

Ok, here we go.

So that's quite a bit to chew on even if it isn't a new idea. Is he right? Some, yes. Is he wrong? Some, yes. That makes for a great topic to explore. 

Generally speaking, pensions are less viable than they used to be, the math doesn't work as well. Problems have been long in the making and seem to have gotten worse. About 40 years ago employers started to pivot away from pensions to 401k, they started to pivot away from defined benefit plans to defined contribution plans. There are fewer pensions and many of the ones left are in trouble for being underfunded. 

The only pension I am remotely close to is the Arizona Public Safety Personnel Retirement System. It's been underfunded for a long time, I gave my two cents about interest rates and expected returns at the Arizona Fire Chief Association meeting seven or eight years ago and while it is still underfunded, I don't know if it has improved or gotten worse. 

The concept of pensions is that they provide a security net to retired workers. Workers are not on the hook for managing their portfolios, don't have to manage withdrawal rates and have some security that their monthly check is what it is, maybe there's a COLA or maybe not but no surprises.

On the downside, pensions can go bust and of course you don't have control over the money or any say in how it is managed. The control issue won't matter at all to some but be very high on the priority list for others. It would be high on my priority list. When pensions go bust, pensioners can get some help from the Pension Benefit Guarantee Corporation but that is typically not a full payout, pensioners are taking hit if it gets to that point. 

A 401k does shift the burden to the employee. The contribution match certainly is a nice benefit but the responsibility to enroll is usually on the employee (or they have to stay enrolled in circumstances where companies auto enroll), make investment decisions perhaps with no understanding of what to do, have the wherewithal to avoid catastrophic mistakes during their accumulation phase, not make costly tax mistakes rolling it over when they retire, manage their withdrawals intelligently, understand how to manage the assets once retired versus just buying the same 2-4 mutual funds every paycheck while still working. Some portion of this population will seek some form of help but plenty never will. 

With pensions it takes many years to vest, 30 years is fairly typical although it is usually 20 in the fire service. It has become exceedingly rare now for people to stay at one company for anywhere near 30 years. 401ks are portable, you just rollover what you've accumulated when you move to the next job. Portability is an advantage over pensions.

Was it a money grab for Wall Street? Did somehow the financial services industry lobby to get the law that created the 401k passed? And then somehow push companies to do this? As I understand it, the law, law might be the wrong word, that allowed the 401k plan to happen was not about 401ks, that somehow there was just a blurb or small piece the dominoed into becoming the 401k. If correct, that argues no. Where 401ks are cheaper for employers than pensions, an investment bank advising companies to do this argues that yes, the IBs could see the potential benefit for mutual fund companies. Intended or not, 401k money has radically altered the mutual fund landscape, bringing trillions in managed assets that generate fees. Another possible argument in favor of being an orchestrated money grab is with all the terrible conflicts of interest that have emerged in recent years related to so many things, health care and the food industry just to name a couple, it doesn't make sense to me that behavior has changed just that it is now harder to hide conflicted behavior. That last one is certainly biased so fee free to dismiss out of hand. 

If we concede it was an orchestrated money grab, ok, that was 40+ years ago and if what you have is a 401k then that is what you have to make work. If the Joe Moglia quote that I cite all the time about no one caring more about your retirement than you resonates then it is up to you to make the 401k work. Spend a little time learning or get some help like maybe HR has something in place for employees to get input from professionals. 

I am always going to prefer the path where I play a role in determining my own outcome but I readily accept that a huge portion, maybe the majority, will retire with little more than an emergency fund built up in their 401ks. They were essentially left to sink or swim on their own. If correct then there will be some sort of retirement crisis even if I am not exactly sure what that means or will look like. 

We know that average balances are horribly low. Numbers vary but we all know the numbers in aggregate are too low to provide sustainable retirements. Is that unfair? Probably, but <harshness coming> life is often unfair and it is up to us to solve our own problems. No one will care more about your problem than you.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. 

Bernstein on Bulletproof

Barron's had a fun article that looked at some ideas from William Bernstein titled The Trick To A Bullet Proof Portfolio? Invest For The Very Worst Of The Worst. I'm a sucker for this sort of article. Based on the title, it would seem to be in the neighborhood of creating an all-weather portfolio which we've looked at in several different forms over the course of my full 19 years of blogging.  

We've studied the Permanent Portfolio and 75/50 going way back to more recently the Cockroach Portfolio and the Dragon Portfolio. 75/50 seeks to capture 75% of the upside with only 50% of the downside. That is difficult to pull off but if you do the math on that it shows long term outperformance. The Permanent Portfolio equal weights equities, long bonds, cash and gold with the theory that no matter what, at least one of those four will be doing well. 

Cockroach and Dragon both seem to be heavily influenced by Permanent with the basic building blocks of asset allocation as follows;

Cockroach 20% each I believe

• Stocks
• Volatility
• Trend
• Income
• Gold/Crypto

Dragon appears to be the following

• Equity 24%
• Long volatility 21%
• Gold 19%
• Long Bonds 18%
• Trend 18%

Volatility, trend (managed futures) and gold usually have negative correlations to equities. Having that much in asset classes that are intended to not look like equities should mean that the long term result won't look anything like the stock market. A 25% allocation to equities for someone who needs equity market growth for their plan to work won't get it done. Something close to a normal allocation to equities with smaller weightings to the other asset classes these portfolios own very well could get it done. 

This is why we talk about taking bits of process from various sources. Some managed futures to help manage volatility makes sense to me but not a 20% allocation. Same with the others.

Now to weave in some of Bernstein's ideas. If you design your portfolio to survive the absolute worst, then you're going be more conservative than might be comfortable. This implies it would be emotionally difficult to watch the stock market go on a multi-year run without you. I don't think protection needs to be that extreme. The Financial Crisis reasonably could be considered the worst of the worst couldn't it? Someone who was cognizant of sequence of return risk could have, without trying to predict anything, set a couple of years worth of planned expenses aside in cash or a cash proxy so that no matter what might happen or when they wouldn't be forced sellers in size after a large decline. That is not guessing what markets will do, that is just managing asset allocation and cash needs. Remember, the peak in the S&P 500 in October, 2007 was 1565. Then it more than cut in half but is now at 4400. As bad as 2008 was, we're 3x from there.

A belief about corporate bonds that he has come to have is that their prices fall along with equities in down markets. "You want the riskless part of your portfolio to be absolutely riskless. Corporate bonds don't belong in your portfolio." Buying longer dated corporates at the wrong time can certainly take on equity beta in a big decline, we saw that last year. I mentioned seeing some portfolios in our reorg that owned bonds that were the poster child for what Bernstein is talking about. Corporates bought when yields were low that are due in the 2030's are down massively. Sitting on them means 10 or more years of below market yields and selling them probably means permanently impairing your capital. 

One of the commenters on the article pushed back that when you own a bond, you own it for the carry (the yield) and because you will get your money back, the volatility in the meantime doesn't matter. That is true except when it isn't. The mechanics of what he described are correct but sitting on a 2% carry sounds bad. Getting a 5-6% yield though for 10 years seems pretty good to me even if two years later prevailing yields are in the sevens. That's mental accounting on my part, draw your own conclusion but a normal yield for ten years is fine with me, an all time low yield for 10 years or more is not. 

He makes a good point about not relying solely on math to assess markets and portfolio construction, that the psychology of markets is important too. I'll put a non-behavioral spin on that comment to discern between how things should work versus how they actually work. Simple examples come from REITs and MLPs. They were lauded for their diversification attributes, that investors should have 20% in those segments. I  pushed back on that pretty hard way back when, along came the bear market associated with the Financial Crisis and of course they imploded just like everything else. There's a cogent argument why they should hold up better but I don't think that argument is reliable.

Bernstein thinks people over estimate their tolerance for risk and/or volatility. I agree with him. A long time ago, our firm had a client who wanted a lot of equity exposure because he could handle the volatility, 20% declines wouldn't scare him. Then of course some decline happened that very few people would even remember and he panicked out right away. It was so obvious that was going to happen, I told my colleague it would happen and it did. Going back to the above, risk and volatility become much easier to endure when you know that your cash needs for x number of months are all set and you truly understand that bear markets end and eventually there will be a new high even if that takes longer than you'd like. 

"The name of the game with investing is not to get rich, but to avoid getting poor." That will not resonate with everyone but it is valid. He says the way to get rich is to find the next Apple but the problem is they all sound like the next Apple. I've said before that I am a sucker for a good story, they all sound good. Being aware of this flaw has helped me avoid picking a lot truly bad stocks. That being said, I don't think I agree with him. I think the point he is making is about the the difficulty of picking stocks. I think from other writings, he doesn't believe in using individual stocks (please comment to correct me) and if that is the case then I do not agree. People need to draw their own conclusion on this point. 

Take the time to read the comments too. One said owning dividend stocks is the only way. Another said investors should just use index funds. There are countless valid strategies for long term stock market success. I would define success as having enough money when you need it. Dividends did very well last year and are lagging by a ton this year. Indexing got pasted last year and MCW indexing is having a great year this year. Nothing will be best for every market environment but many will get the job done.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. 

Defining Freedom For Yourself

This seems like an appropriate conversation for July 4th. 

If you understand what you really value in life, we could say your own definition of what constitutes freedom, then every other aspect of life becomes easier. Quoting our friend Bill from here in Walker, "you can figure it out now or you can figure it out later but if you can figure it out now, you'll be much happier."

Figuring out what is actually important to us is a part of maturing and true to Bill's quote, I bet we all know people who seemed to figure it out early on and others who still haven't figured it out. 

A young man (you can define what you think of as young) might think he wants a Ferrari and a really big house. How much is a big house where you live? The other day I learned that the median home price in Flagstaff runs about $779,000 per a grant application to the foundation where I am a research volunteer. That is an astounding number to me. Anyone living in a bigger city than Flagstaff, ex the southwest and mid-west is probably looking at a bigger number and that is just for a regular house. How much would a "really big house" be? I don't even know, double that? What about a Ferrari? It looks like there are two entry level Ferraris and they both cost about $240,000. If you were to finance one (I realize most people don't) for 5 years at 5%, it would cost $4529/mo. Putting down 20% on a $1.6 million house at 5% would cost $6871/mo for 30 years or $10,122 for 15 years. 

Now imagine thinking you want those things, somehow getting them and realizing you were wrong about wanting those things. That $11,000/month plus all the rest of the expenses is couldn't be more opposite of free. You can see where getting this wrong for lack of self awareness is pretty bad.

Self-awareness then seems like it would important for how we define freedom for ourselves. No judgment on what someone else's idea of freedom should be just that to get to it takes self awareness.

Would most people think of being able bodied as an ingredient for freedom? I'm not being snarky with that question because statistically, most people do not put in an effort to stay able bodied for as long as possible, we do not exercise enough. I don't know how this is not a priority for everyone but I accept that it isn't.

Being an investment advisor and a financial blogger, I am of course inclined to associate some form of financial freedom with overall freedom. Some will think of this as being unambiguously rich or merely comfortable or no debt or any other measure, it's all fair game but things like not having debt or having a robust emergency fund or being on pace to retire are much easier to attain than being unambiguously rich. 

Self awareness, being able bodied and some measure of financial flexibility (might be a more attainable outcome for someone a little younger) are maybe thought of as building blocks to then build our individual ideas of freedom on top of. If you even agree with those three building blocks, from there our respective ideas probably start to diverge considerably. That makes perfect sense, we have the freedom to pursue the things we value. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.

Ok Boomer

Barron's wrote about boomers having too much equity exposure for being on the cusp of retiring or being newly retired. They are making a sort of sequence of return risk point. The article featured four advisors and what they say to clients who have too much in equities. 

It seemed like one of the advisors answered with a sort of sales pitch, one guy is a total jerk and the other two, regardless of whether you agree with them or not, sincerely tackled the question. 

This has long been a favorite subject to write about, it's a real portfolio construction challenge to be solved. Bonds went on a 40 year run where rates declined, causing bond prices to rise. It got to the point where with no yield to speak of, bonds looked more like equities than what people tend to think of for how bonds should perform. That 40 year run favorably skewed a lot of backtests and I would submit, skewed the results of the 4% rule for retirement withdrawals. Sitting here today, it is important to understand that it is not mathematically possible for that 40 year run to be repeated. When can have that discussion if bond yields ever get up to 15% again.

If you own any fixed income, what do you hope it will do for your portfolio? If you own individual bonds, the desired end result is that you get back 100 cents on the dollar. Whether you buy it at a premium or a discount to the par value you're getting the prevailing market interest rate. Yeah, maybe a small capital gain or loss might have utility for you somehow or if you paid par for a 20 year issue and it gets to 120, then it might make sense to sell but is that what you're expecting going in?

I want yield with as little price volatility as possible. Keeping maturities with individual issues and funds mostly short term delivers that even if with funds it is somewhat relative. I've been saying for awhile that intermediate and longer term maturities have become sources of unreliable volatility. If that is correct then putting 40% of a portfolio into longer term bonds might not be the protection against equity volatility that it use to be. I would say it is definitely not.

Putting 40% in 1-2 year paper yielding in the high fours to low fives probably accomplishes the little to no volatility objective but you have to understand the risk of that which is reinvestment risk, the risk that two years from now rates are much lower. If short rates stay where they are forever (not realistic of course) then you could roll the maturities forever keeping them short and reliably protecting against equity market volatility and addressing sequence of return risk. 

Addressing sequence of return risk and making sure expected income needs aren't disrupted regardless of what markets are doing is certainly a top priority close to or in retirement and I would argue the top priority. Markets come back, that is their nature, but "sorry, it would be a bad idea for you to take normal withdrawals for a while" isn't something you can get back.

There are many valid ways to get money out of your accounts. Have some number of months worth of expenses already raised in cash. Six months, 12, 24, whatever number makes you comfortable. Where possible I try to lean to more months expenses in cash not less. If stocks are going up and you sell some to keep in balance, that seems ok to me but I would think about tax consequences and try to offset where possible. If you own something that is intended to go up when stocks go down, then selling that holding when it is up, when stocks are down seems timely and you'd be increasing your net exposure to equities after a large decline. You can hold alternative strategies that are intended to trade sideways much like T-bills. You're not permanently impairing your capital by selling something that has traded sideways, exactly as intended. 

Selling stocks that are down a lot is not ideal under any circumstance. You aren't necessarily permanently impairing your capital because stocks have always come back and gone to new highs. Sell too much and yeah, that's real damage but if you panic out of 5% of your equity holdings, you've made a bad trade but haven't broken anything. 

Bonds are more difficult. I've seen some accounts lately (not my clients) that are heavy in exactly the types of maturities I've been saying to avoid for the last 15 years. They are down 20-30% getting below market yields. Time will bail out those positions when they eventually mature at par but that is a long stretch to get what are now crappy yields. Selling paper due in the mid 2030's at 77 cents on the dollar is probably a true permanent impairment of capital. There could be a way to trade around it if prevailing yields were close to current levels closer to maturity and of course if prevailing yields were to some how go back down to all time lows again, that would also bail out that type of position. Either way, that's a lousy way to manage sequence of return risk. 

I believe it is poor long term portfolio strategy to meaningfully lighten up on equities close to retirement or early in retirement, like in the first half of retirement, whatever that might mean to you. Manage for cash needs, absolutely, but undercut equity exposure too much, no, unless you're way ahead. 

At 63, planning to retire at 65 thinking you need $1,200,000 and you have $1,400,000. You have a nice buffer, you're not way ahead. Assuming this person is relying on their $1.x million for income, a gross underweight to equities is a very risky proposition. This person probably doesn't need 70% in stocks but I'd say 20-30% is way too low...again assuming this piece of money plays a big role in the retirement plan. I'd go with a normalish allocation to equities to get some growth and as we've learned in the last couple of years, the wrong kind of bonds can permanently impair capital which is the last thing someone on the verge of retiring needs. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.