The 4% Rule is Dead

TODAY’S FINANCIAL NEWS

The 4% Rule

Imagine you are in an airport looking for one of those reader boards displaying flight information. You need to know if your flight is on time or delayed, what gate it’s at and when it’s boarding. But, you come across a different type of display. All the flights are listed, airlines, flight numbers, departure times, and then on the far right you see a percentage. You wonder what the heck that’s all about and see at the top of the column “Flight Destination Chances.” It’s the percentage chance that once you take off, your plane will actually make it to its destination! You gaze down the list and notice there are no flights listing 100%. In fact, your flight has an 89% chance of arriving at its destination. How confident would you feel about getting on your flight? What would you do?

As crazy as the illustration sounds, it is comparable to current thinking on retirement income planning. Those facing retirement are discovering the wisdom of a 4% withdrawal is not the sure bet it once was thought to be. In fact, a recent T. Rowe Price study shows some results that would cause most to be concerned on the runway of retirement.

T. Rowe Price’s recent study about drawing retirement income during Bear markets is enlightening. Their study looked at a 30 year retirement scenario starting January 1, 2000 with an account balance of $500,000. The account was invested in a conservative mix of 55% equities and 45% bonds. The retiree withdrew 4% a year ($20,000), with a 3% inflation factor and played it out over the ensuing decades. They played out 10,000 market scenarios in the study and found that the success rate was about 89%. In other words, 11% of the time the retiree would have run out of money before the 30 years ran out. They also found that the balance of the initial $500,000 would have sunk to $334,578 at the end of 2009 and would only have a 29% chance of succeeding for the next 30 years. In fact, the chances of success were only 6% at the conclusion of the Bear market that ended in 2009.

Again, would you get on that flight?

Many people are so used to the typical Wall Street retirement flight information that they are willing to take excessive risk in their portfolios in an attempt to acquire the gains they need to fund their retirement.

Would you get on any other plane? Really?

Average Rate of Return vs. Real Rate of Return

Many wirehouse advisors quote an average rate of return that sounds great. Maybe a 5%, 7% or even better rate over a specific period of time, and that sounds pretty good in the current environment. However, if you dig deeper to understand the math behind the averages, you will see that they may not be as good as they initially sound. Consider the fact that you could actually have a positive average rate of return and still lose money.

Please see the two examples below. Both show an average rate of return that is not negative, but in both examples the accumulation value is negative. These examples demonstrate how an average rate of return can make it sound like you are making money or maintaining your savings, when in fact you are losing money.

Example 1 shows a deposit of $100,000 and an average rate of return of 5%, but in this case, they actually lost $5,750 from their original $100,000.

Example 2 shows that a market decrease of 25% in the first year, but then it recovers 25% in the second year. One might think that will just put you right back where you started, considering an average rate of return of 0%. However, in this case, the account value actually declined $6,250.

The large wirehouses and brokers may not be the best place to get professional advice

A long time ago, a visitor from out of town came to a tour in Manhattan. At the end of the tour, they took him to the financial district. When they arrived at Battery Park, the guide showed him some nice yachts anchoring there, and said, "Here are the yachts of our bankers and stockbrokers."

"And where are the yachts of the investors?" asked the naive visitor.

While I don’t want to seem jaded, you have to at least acknowledge that something is wrong here. This little story illustrates a common perception in the country that brokers make a lot of money on the backs of their investors. You may agree or disagree, but it is definitely a perception, and we are often told that perception and reality are not far apart.

In case you are unsure what a “wirehouse” is, it is a large brokerage firm with many branch offices and brokers. The branch offices operate under the jurisdiction of the main firm, share financial information and research through a common computer system.

Many investors are attracted to the big names because they want the comfort of doing business with a large, well-known firm. After all, what could go wrong? If the events of 2008 and beyond have not shaken the confidence of the American public in that philosophy, I’m not sure what would. When major firms file bankruptcy like Lehman Brothers, or are bought out before they fail like Bear Stearns, or when Goldman Sachs is investigated by the government for what is at least considered questionable conduct, you have to wonder if the advice you receive is in your best interest.

Not only that, but brokers are reportedly leaving Wall Street firms in droves. After 2008 and 2009, brokers began to consider the possibility that large wirehouse firms might be more of a liability than a benefit to their careers. The independent advisor used to be looked on as a second-class option for those seeking financial advice. However, many brokers who are leaving the failed large wirehouses are going independent. Clearly, they see the need to disassociate themselves with the Wall Street muck being exposed in the daily news.

In typical Wall Street fashion, these firms were selling stocks, proprietary mutual funds and IPOs to their clients who believed they were receiving unbiased advice. The reality is, they were being sold products which best suited the firm’s bottom line rather than bettering the client’s positions. Their fiduciary responsibility was in question, and the public began to realize it. Lawsuit after lawsuit began to show a broken culture's motivations were highly suspect.

In addition, if you only go to the large wirehouses for advice, then you leave out the largest group of advisors who happen to be independent. Most of these advisors are highly qualified professionals with the client’s best interests at heart. They don’t want any part of a large company telling them what they have to “sell” their clients. They are independent insurance agents, Registered Investment Advisors, and brokers with smaller independent firms concentrating on the needs of individuals as a priority.

Yes, I am biased. I am an independent advisor and train advisors nationally. They are an incredible group of men and women with high integrity, skills, and passion for what they do. Sure, there are bad apples in every barrel, but my experience with advisors across the country is incredibly positive. They work long, hard hours serving their clients, and the majority of these exceptional men and women don’t own yachts. Their motto is not “Greed is Good,” but “People First, Money Second.”

So, with brokers leaving large wirehouses in great numbers, receiving financial advice from a failing, “out-of-touch with reality system” seems equally questionable. If those giving the advice are leaving, why would you want to stay? Large wirehouses are the best place to get professional advice, Myth or Maxim? You decide.

I haven't lost until I sell?

This Wall Street saying actually comes from a reality in the world of taxes. If you bought a stock for $10 a share, and four years later it’s worth $20 a share, you have good news. You made money. If you sell the asset at this point, you will have a gain to report on your taxes of $10 a share. You have “realized” your gain. You also have some bad news, a tax due on the gain. This is called a “capital gains tax,” which is a tax on the gain in the asset. You are only taxed if you sell the asset, thus you “realize” the gain only by selling the asset.

If however, the share price went down to $5 a share, you have lost money in your investment, and if you sell, you will “realize” a loss. You can use that loss on your tax return to wipe out certain gains. You would not be able to use this to your advantage on your tax returns, unless you sold. In reality, you haven't lost until you sell, is only true when it comes to taxes. It is not true when it comes to investing.

People come to my office every week, bringing in their statements for me to evaluate. As I analyze them, I began to see gains and losses in assets as discussed above. I look at the dollar figure on the statement and it may say they have $500,000 worth of assets. The statement puts dollar figures on assets for people to see how much money their assets are worth. The dollar figure tells you how much money you have in the account.

Sometimes I look at their statement from the previous month, and they might have had $600,000 worth of assets. When I asked them how much money they have, they tell me they have $500,000. When I point out that they have lost $100,000, they look at me a little conflicted. They know their statement says they lost the money, but they are trained to believe “I haven't sold it yet, so I really haven't lost.”

How can this be true? They have exactly how much money is represented on their statement. If they needed cash today they would have $500,000. In the real world, the dollar amount listed on their statement is what they have. In what other areas of finance would they ever look at a statement so specific in totals and not believe it? Instead, they believe their broker, who doesn’t want to lose the account. He’s perpetuating the lie, telling them “you haven’t lost because you haven’t sold.”

People will often want to believe a lie because the truth is too painful to live with. They are in total disbelief of the realities communicated in their statement. The same broker, however, will call them when their assets have grown in value bragging, “See how much money I’ve made you? Don’t you want to invest more?”

When you think about it, if you received a statement from your utility company showing a large increase over your previous month, wouldn’t you believe the statement? Surely you wouldn’t pay the same amount as last month? Wouldn’t you believe what’s written in black and white? You might think they made a mistake and call to clarify, yet you would eventually come to an understanding with the utility company on the exact amount you owed.

How can this double standard be true? It’s NOT! The old saying, “I haven't lost until I sell,” is actually Wall Street manipulating our thinking into believing we didn't lose anything when we actually did. This is a lie spawned from a broken culture bent on deceiving you for their advantage.

If “I haven't lost until I sell” is true, then all bad mortgages would just be a paper loss, and the black abyss of 2008 would never have happened. The mindset that an actual loss of value in any asset is only a “paper loss” is the way creative accounting starts. There are no paper losses when it comes to investing. There is only lost money. Sure, you can write it off your taxes, but that is my point exactly. It’s a tax reality. For investors, we can’t afford to be unrealistic in our outlook, especially in our beliefs about money. We can't afford to take a soft passing glance at our statements and believe a convenient lie.

We have to take a hard look at our statements. We have to tell ourselves the truth. “You haven't lost until you sell” and “it's only a paper loss” is akin to believing Santa Claus really lives. If your broker wants you to keep believing a myth and take you for another ride around the block, I urge you to believe what your statement tells you. If you have $500,000 on your statement, please, believe what’s written in black and white. You only have $500,000.

The truth is the market goes up and down. Your accounts may very well recover to their old levels, but until then, “you have what you have” is a better catchphrase to use. Reality is always a better place to begin when evaluating how to move forward. You can even say that you have lost money in your investments, and if you keep them, they may one day regain their value. I’m sure that’s what the owners of Enron stock said.

“I haven't lost until I sell” and Santa Claus - Myth or Maxim? You decide.

 

A diversified portfolio of stocks, bonds, and mutual funds may not be safe over the long haul

“Wide diversification is only required when investors do not understand what they are doing.” - Warren Buffett

My question is simple. If you don't have a clue what you are doing, what are you doing in the market in the first place? An even better question may be “Does diversification actually provide the safety a conservative investor really desires?”

I was with a bunch of advisors from around the country recently and told them the industry uses the word “diversification” like pixie dust. They laughed of course, because they know it’s true. All you have to do is tell a client you are putting an asset in a portfolio to add a little “diversification” and the client will shake their head in agreement. It’s really weird! After all, who can argue with “diversification?” Just throw it on anything, and people will agree with you.

“Sir, would you like your office furniture to be diversified?”

“Ma’am, are you looking for a little diversification in your wardrobe?”

See? People are trained to agree with you. You can’t go wrong with offering diversification.

The only people this doesn’t work on our children. They haven’t been trained yet by Wall Street. Children don’t care about “toy diversification.” They just want more toys. I guarantee you one day they will be equally enchanted, because Wall Street has some powerful media mo-jo.

Okay, enough fun. What is the theory behind the pixie dust? Basically, diversification implies you can reduce your overall risk by investing in assets which move in different directions over time and in response to market conditions. You might buy individual stocks and bonds, large cap and small cap, domestic and foreign, financial sector and manufacturing sectors, hoping that if one asset class goes south the other area will go north. This has been the practice for Wall Street firms for decades, based on years of studies.

In an editorial for Investment Advisor Magazine, July 2009 an advisor, commenting on the market collapse in 2008 and 2009, makes the point that Wall Street was broken (again!) and the diversification models used by wealth management advisors failed their largest test ever. The author suggests the following reason:

“What went wrong? The fixed income substitutes pushed by the major investment houses” low volatility hedge funds, preferred stocks, asset-backed securities or other structured products, closed-end bond funds, income/mortgage REITs, and master limited partnerships weren’t fixed income substitutes at all. None of them is a substitute for the most important characteristic that investors should be looking for from the fixed income portion of their portfolios: safety of principal.”

The editorial goes on to imply that bonds are the only fixed-income asset that should be used to balance risk in portfolios for investors seeking a safe diversification. The problem with bonds, which we'll discuss in a later chapter, is they can also lose money. If you held Bear Stearns bonds, or Lehman Brothers bonds, or if you currently hold California municipal bonds, you may very well have experienced losses or soon will. At the very least, you are or were very nervous.

I can't even imagine how a hedge fund or a preferred stock could be listed as a fixed income asset. Yet, this is exactly what happened to wirehouse clients. That is why Wall Street is a broken culture. They just don't get it.

In the end, conservative investors in or approaching retirement got sacked in 2008. They just can’t afford to lose, because their investment horizon is shortened. Sure diversification in a portfolio might lower volatility over the “long haul” of 50 years. When you have to draw income now and make it last for 30 years, you can’t afford a broken Wall Street approach.

A diversified portfolio of stocks, bonds, and mutual funds are safe over the long haul. Myth or Maxim? You decide.

 

 

Buy & Hold may not be an Effective Conservative Strategy

 

“Buy and hold as a strategy is very questionable... It’s worked in the past, but in time of severe market stress it just doesn’t work.” Ben Stein, author, lawyer, actor, and financial commentator

Mr. Stein is certainly not THE authoritative voice for financial matters, but I think he says here what many advisors, post-2008, believe. Buying a stock, bond, or mutual fund, then sitting on it while it fluctuates up and down is at best an era gone by. The reason is simple. Economic trends move so fast in today’s culture, what could be a good bet today could have a change in direction after the day’s news cycle. Information travels at the speed of the internet and a tactical approach to investing would seem to be more appropriate unless you are Warren Buffet and losing millions wouldn’t affect your current strategy.

The simple reason “buy & hold” is better named “buy & hope” is because it lacks the ability to respond to markets in a timely manner. Tactical management, in my opinion, is a more up-to-date management style for conservative investors. The average broker or investment advisor does the best he can by picking stocks, bonds and mutual funds that fit a client’s risk tolerance. Then for the most part, they sit on those assets come hell or high water, only liquidating in extreme situations. The reasons they change assets are to try to find “relative strength” in a sector or underpriced assets in a growing segment of the economy. Some use outside sources to get counsel on where they should invest next. These sources are investment advisors themselves trying to figure out the market. Usually what happens is the advisor picks a hot mutual fund manager and hopes he continues his track record. The whole system seems to look at returns over 1 year, 3 years, and 5 years to see who has the best record, or which fund or stock is “on the rise.”

The problem with this mentality is it doesn’t have a solid plan for how to manage risk. The markets do two things very well: they go up and they go down. Volatility is inherent in the markets. How you deal with volatility and risk should be the focus, not trying to compare returns. Comparing returns is tempting, and you can make a case that certain fund managers have done well over time. Yet, everybody lost in 2008. When fear and panic set in, a buy and hold strategy will kill a retiree’s portfolio. A fund manager has to pick stocks, and in an environment like 2008 where the normal logic went out of the market, the fund manager was lost. He certainly couldn’t sell everything, that’s just not how they do it. And so they sat and painfully watched as their mutual funds value plummeted.

The numbers below show why the buy and hold theory can be a struggle for the average conservative investor to stomach. Yes, you made 31% over a 15 year period, but that’s only about 2% a year, a pretty wild ride!

I’m sorry, but you have to do better than that if you are managing money for a conservative investor.

While there is no perfect system, a tactical approach doesn’t make decisions based on returns; rather it looks at price movements in the markets along with other trend data to make portfolio adjustments. Suffice it to say, that “buy & hold” is an antiquated model at best.

Buy and Hold is an effective conservative strategy, Maxim or Myth? You decide.

Just buy a no-load index fund?

I have heard it said if you just bought index funds rather than mutual funds, whose goal is to outperform the S&P 500 index, you would have done better over the last ten years. There is probably some truth to that, depending on which “manager of the year” your advisor selected for you. The theory is the S&P 500 index fund from whatever company you choose will simply follow the index and beat the fund managers.

Let’s say you were a conservative-minded investor in 2000 that didn’t buy into the tech-bubble and invested heavily in the S&P 500 Index. You listened to John Bogle, founder of Vanguard, and purchased no-load, low expense index funds from several sources, investing $500,000. You were 55 years old and looking to retire in January 1, 2010, at age 65. Here is what happened to you.

Obviously, this is an oversimplified illustration, and you probably didn’t have all of your money invested in the index funds. However, if you listened to the advice of those who believed this was a conservative strategy, you would have been incredibly disappointed with the funds you allotted to this strategy. Even if one-third of your retirement accounts were in fixed assets that averaged 3%, over the decade, you still would have lost about 8%. The important question is, would you want to retire with those losses or have to continue working?

Some say a decade like that will never happen again. Really? Are you willing to gamble your retirement on it not happening again? Is this truly a conservative strategy? I don’t care if it’s a no-load, low expense, Vanguard, Fidelity, VOYA, or any other group of index funds. If you just get the index with no way to secure your previous year’s gains, your future is incredibly insecure.

Just buy an Index Fund, Maxim or Myth? You decide.

Index Annuities are likely not dangerous

If you listen to a certain segment of the brokerage community, you would think index annuities are like great white sharks - they will jump out of the water and eat you whole! It seems that there is a war going on between Wall Street and the Insurance industry. It’s all about money, as usual. Every year between twenty to thirty billion dollars leaves the securities industry for these products. So, it is no surprise the securities industry, who wants to stop the loss of commissions and fees from leaving their brokers, have created an onslaught of negative publicity regarding index annuities.

There are tons of articles railing on Fixed Index Annuities (FIA) by supposed experts quoting their own research. Yet none of them compare with the most recent study completed in 2008 by David F. Babbel, Professor of Insurance and Finance, at the University of Pennsylvania’s, Wharton School of Business.

Tom Cochrane interviewed Professor Babbel for AnnuityDigest.com. He is quoted in Mr. Cochrane’s blog, July 2009:

“There has been a lot of misinformation in the popular press regarding FIAs. The vast majority of newspaper and magazine accounts vilify FIAs based on the results of alleged academic studies. The in-depth studies we conducted took over two years to complete and involved six Ph.D. financial economists and a pair of very well known senior actuaries... Our findings regarding actual products show that since their inception in 1995 they have performed quite well – in fact, some have performed better than many alternative investment classes (corporate and government bonds, equity funds, money markets) in any combination.”

Did you hear that? This professor from the well-known Wharton School of Business does the definitive study to date on FIAs, and the findings are very revealing and very positive. These studies are done by academicians who, by their own admission, “don’t have a dog in the fight.” They are truly unbiased studies done for peer review and educational purposes.

Professor Babbel’s study actually shows when FIAs are compared to alternatives like Vanguard’s S&P 500 Index Fund, money markets, and the S&P 500 itself, they gave better returns since 1995, and for each year they were issued. He makes the case that for those investors who have a conservative to moderate risk tolerance, FIAs provide what these investors desire.

Contrary to what some critics have stated, Babbel asserts that “Moderately risk-averse individuals will always choose the annuity over alternative investments.” While the critics of FIAs have questioned whether people who could invest in alternative investments, such as Treasury securities and equity mutual funds, would not rationally invest in FIAs. Babbel concludes that many rational investors would actually prefer annuities over alternative investments.

There is a lot more to say about FIAs, but for now let’s just agree that though there has been unwarranted negative press about the actual products themselves, it’s obvious they are not the great evil as some misinformed brokers portray them. In fact, they are a positive option for the conservative investor.

Index annuities are dangerous, Maxim or Myth? You decide.

While I have been critical of a broken Wall Street culture, I don’t want you to believe that all brokers are an altogether worthless group. In fact, the independent brokers who are out of the large wirehouse system are a hard-working crew with the best of intentions and, more often than not, excellent abilities. They are often well-trained and well-educated professionals. It’s the myths that the culture perpetuates and the bias it comes from that need to change.

Well, are you at least questioning some of the wisdom of Wall Street?

 

 Order your FREE Video explaining

"The Best Retirement Savings Vehicle You've Never Heard Of... "

Call (800) 694-5133 press option 4

www.KevinBrunner.com

 

 

 

 

 

===