by Harold Evensky, CFP®, AIF®
Harold Evensky, CFP®, AIF®, is chairman of
Evensky & Katz in Coral Gables, Florida. He is an
internationally recognized speaker on investment and financial
planning issues and is the author of Wealth Management and
co-editor of The Investment Think Tank: Theory, Strategy, and
Practice for Advisers.
It's no secret to practitioners that for the last few years we've
been living through what the old Chinese curse would describe as
"interesting times." Well, according to a number of thoughtful
researchers, interesting times may be the norm for the future.
Needless to say, any fundamental change in future market
expectations will have significant influence on the advice we
provide those of our clients moving from the accumulation to the
distribution stage of their lives. Managing these issues continues
to be the subject of some of the most important research of
interest to practitioners. That subject is the primary focus of
this month's research review. However, for a bit of variety,
rounding out this quarter's column I'll wrap up with an excellent
paper on one of the "in" subjects this year, namely: Roth
rollovers—yes or no, and a thoughtful paper on the role of
MPT and financial engineering in recent financial crises by Nobel
Laureate Harry Markowitz. Finally, I'll conclude with big
news regarding the Investment Research column, but you'll have
to read to the end to find out what that is.
The Future Ain't What It Used to Be
Cornell, Bradford. 2010. "Economic Growth and Equity Investing." Financial Analysts Journal (January/February): 54–64. For practitioners still basing their recommendations on the rear view mirror of historical returns, this paper may provide a valuable wake-up call to the reality of today's markets. Back in 2002, when I wrote, "Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation," urging practitioners to reconsider their implementation strategy based on the likelihood of a low return investment environment, I assumed a forward looking real return of 6 percent. In this study, Professor Cornell makes a compelling case that "… over the long run, investors should anticipate real returns on common stock to average no more than about 4 percent." Practitioners will ignore this possibility at their clients' peril.
Zhou, Guofu, and Yingzi Zhu. 2010. "Is the Recent
Financial Crisis Really a 'Once-in-a-Century' Event?" Financial
Analysts Journal (January/February): 24–27.
If the prior paper isn't adequately depressing, this paper, based
on both simple and complex asset pricing models, concludes that
although a market drop of 50+ percent is rare in the short term,
and the expected value of long-run investments grows over time, so
does the probability of seeing a large swing of a fixed size. To
highlight this reality, the authors provide the following analogy
of individual mortality. "On any given day or in any given year,
death is a small-probability event; over a hundred years, however,
such an event is almost certain to occur." Bottom line, "…
long-term investors should have prepared for a market drop of more
than 50 percent." However, the authors add John Bogle's advice,
"For most of us, I think, with a good asset
allocation—very diversified, very low cost—this
is not a time to flee the stock market or, for that matter, the
bond market."
Kamara, Avaham, Xiaoxia Lou, and Ronnie Sadka. 2010. "Has
the U.S. Stock Market Become More Vulnerable over Time?"
Financial Analysts Journal (January/February):
41–52. According to this research, the answer is
"yes." "The findings suggest that the vulnerability of the U.S.
equity market to unanticipated events has increased over the past
few decades." So, not only do we need to factor in lower equity
returns and the reality of "once-in-a- century" events,
we also need to consider that the historical reduction in
systematic risk and liquidity provided by diversification in the
large-cap universe may be significantly less than we may expect.
However, for portfolio design, there may be a silver lining.
Namely, while the authors' research found a significant increase
for large-cap stocks, they found an equally significant reduction
for small-cap company stocks. The question practitioners will have
to consider is whether an increase in small-cap allocations reduces
risk and if so, what should the large/small relationship be?
What to Do?
Garrison, Michael, Carlos Sera, and Jeffrey Cribbs. 2010. "A Simple Dynamic Strategy for Portfolios Taking Withdrawals: The Case for Using a 12-Month Simple Moving Average." Journal of Financial Planning (February): 51–61. As we're all probably trying to figure out strategies for protecting our clients from the sort of Black Swan event that would lead to a once-in-a-century loss, I've included this paper, although I assume it's likely to be controversial. I don't necessarily agree or disagree with the paper's conclusion, but I found its simplicity attractive and the presentation thoughtful. Basically, the authors' research suggests that "a dynamic asset allocation based on using a 12-month simple moving average is a consistently better strategy over statically allocated portfolios for investors in both the accumulation and withdrawal phases." Anticipating some of the more obvious objections, the authors consider the effect of fees and expenses and maximum drawdowns compared to alternative strategies.
Decumulation
Okunev, John. 2010. "What Should Your Asset Allocation Be When You Retire?" Journal of Wealth Management (Spring): 60–67. This paper, contributed by a practitioner from Down Under (that is, Australia), extends the asset allocation/draw-down study to cover 1870–2008. The basic conclusion is confirmation of the familiar 4 percent real draw-down rule. Other conclusions are more surprising (and controversial). First, the author concludes that an appropriate equity allocation is much higher than most prior studies suggest. "The simple allocation of 80 percent equity and 20 percent bonds seems to be a good rule of thumb." Second, recognizing that the volatility associated with a significant equity allocation can potentially result in a significant principal loss, the study investigated a number of tactical allocation strategies and concluded that "… all outperform the static 80/20 strategy."
Liu, Qianqiu, Rosita Chang, Jack De Long, and John Robinson. 2010. "Reality Check: The Implications of Applying Sustainable Withdrawal Rate Analysis to Real World Portfolios." Financial Services Review 18: 122–139. As one might expect from the respected Financial Services Review, this peer-reviewed study is substantively more academic in its orientation; however, the goal of the authors is to "… bring portfolio sustainability research closer to practical application …" Although their conclusion is that "… there is no single optimal retirement asset allocation, but rather a continuum of ideal allocations …" is not likely to be a surprise to practitioners, the nature of that continuum may be. Namely, the ideal "… becomes increasingly equity-weighted as the investor's required withdrawal rate … increase[s]." One major conclusion is that a strategy based on spending down the bond portion of the allocation first appears to be superior to the constant allocation approach most practitioners use today.
Lemoine, Craig, David Cordell, and William Gustafson. 2010. "Achieving Sustainable Retirement Withdrawals: A Combined Equity and Annuity Approach." Journal of Financial Planning (January): 40–47. I've written in earlier columns regarding how important I believe annuities will be in the design of our clients' retirement portfolios. This research tests five retirement portfolios, with two incorporating annuity contracts. The strategies include a traditional 50 percent bonds/50 percent stock; 100 percent stock; an equity allocation equal to 128 minus attained age; a variable annuity with a living benefit; and a 100 percent equity allocation with a fixed annuity lock. The conclusion supports earlier studies that incorporating an annuity payment increases the likelihood of success. However, the annuity strategy tested is different than prior studies. Referred to as an annuity lock, the strategy is based on 100 percent allocation to equities until a "trigger date" occurs. The trigger date is that point when the portfolio has grown large enough so that transfer to an annuity can provide the funds "… necessary to cover the projected series of retirement withdrawals from age 65 to age 100." The paper concludes, "The 100 percent equities with annuity lock approach had superior success in meeting the retirement withdrawal requirements when contrasted with other tested methods."
Xiong, James, Thomas Idzorek, and Peng Chen. 2010. "Allocation to Deferred Variable Annuities with GMWB for Life," Journal of Financial Planning (February): 42–50. Consistent with the prior paper, these authors conclude that incorporating annuities into the allocation process increases a client's probability of financial success. Focusing on the use of variable annuities with guaranteed minimum withdrawal benefits (GMWB), they find that the appropriate allocation is dependent on a number of factors. The higher the client's risk tolerance and the older the client, the lower the VA+GMWB allocation; a longer life expectancy suggests a higher VA+GMWB allocation. Surprising (at least to me) is the conclusion that preference for bequest has almost no effect on the allocation.
Lee, Shelley A. 2010. "10 Questions with Zvi Bodie on Financial Planners and 'First, Do No Harm.'" Journal of Financial Planning (February): 16–19. Although not a research piece, I believe this interview with Professor Bodie is worth the read. His premise is that practitioners all too often focus on the positive aspects of the equity risk premium and ignore (or at least underestimate) the risk of equities. His recommendation is "safety first," a policy that leads him to recommend a primary, if not 100 percent, allocation to fixed income; most specifically TIPs.
Lagniappe
Horan, Steve, and Ashraf Zaman. 2009. "IRAs Under Progressive Tax Regimes and Income Growth." Financial Services Review 18: 195–211. Given that one of the major questions facing practitioners this year will be making recommendations regarding possible Roth rollovers, this study should be required reading. Warning that simplistic approaches used to make this decision often ignore the realities of progressive tax rates, income growth, and exogenous retirement income, the authors provide guidance for practitioners who wish to do more thoughtful planning.
Markowitz, Harry. 2009. "Modern Portfolio Theory, Financial Engineering, and Their Roles in Financial Crisis." CFA Institute Conference Proceedings Quarterly (December): 1–5. Finally, given the beating MPT has taken in the popular press and in many industry publications, I've included this short article by Professor Markowitz, the father of MPT.
Big News
That's it for this quarter's reviews—now for the big
news. As much as I've enjoyed writing these quarterly reviews, I've
been uncomfortable that they are inherently myopic, as they're
solely my opinion regarding what's new and worthwhile. I've
attempted to mitigate this problem by occasionally inviting a guest
columnist, but that's been more stopgap than a solution. I'm now
very pleased to report that with the gracious assistance of the
prestigious Academy of Financial Services (AFS) I'll be kicking up
my installments of the Investment Research column a notch (or a
bunch of notches).
The AFS is an organization of academics and practitioners with the
mission to encourage basic and applied research in the area of
personal financial planning and financial services; encourage the
development of the curricula in the financial services field at the
university level; and encourage interaction between financial
services professionals and academicians. The AFS has a
well-established relationship with FPA, currently holding its
annual meeting in conjunction with FPA. Now, the AFS will join me
as a partner in bringing you insightful introductions to the most
pertinent current research in the field of personal financial
planning. Each quarter, rather than having a single individual
(that is, me) determine what's important, a different academic
member of the AFS will contribute his or her thoughts. So next
quarter, I'll look forward to welcoming you to the exciting new and
improved Investment Research column, featuring contributions from
AFS members.
