What Would You Tell a 60-Year Old About to Retire?

A journalist recently asked me this question in an interview. To be honest, I might as well have been asked what the causes were of the Civil War. From the perspective of a trained financial planner and the Chief Investment Officer of a private wealth management firm, the question is, well….difficult. The writer was writing for the Wall Street Journal, and he was looking for some sound investment advice for folks who have been buy and hold, strategic investors for their entire investing life. Now they are faced with the rapidly changing paradigm in the investment community that buying and holding is actually a high risk strategy in expensive markets. As you may have guessed, I flunked the test. My answer wandered all over the place, and I didn’t make it into the article. However, I’ve been thinking about it a lot since then, so let me try again.

Mr. or Mrs. 60-Year Old, don’t spend too much. Americans are used to a certain lifestyle which is apparent in the size of our homes, the amount of traveling we do, our taste in home electronics, our…everything. Spend the money to work with a legitimate financial planner (a Certified Financial Planner, CFP®) and find out what lifestyle you can afford and learn to live within your means. Next, actively manage your portfolio. You can’t afford to buy and hold if the financial markets are going to deliver less than average returns for the next five to ten years. No one can accurately predict the future, but smart people are worried about the amount of debt in the world, and you had better plan for a low return world early in your retirement. Low returns won’t last for the rest of your life, but the portfolio returns you earn early in retirement are disproportionately important to you, so be prepared. Active management can add two or three percent (or more) per year to your returns over time if executed successfully, which could be critical to your success.

If you’ve invested your own money for years and that’s why you’re reading the Wall Street Journal (or fill in the blank financial periodical), you have to invest the time and treasure to become a different kind of investment expert. You can’t be a successful active manager of your money by reading the morning paper and watching CNBC when you come home from work. If you can’t see yourself doing the work, then hire someone to do it for you. Find a professional wealth manager that specializes in building globally diversified, actively managed portfolios. You may have always been a “do it yourselfer” when it comes to investing, but beware. The market is not likely to provide a tailwind to your investment mistakes going forward. You have to know what you are doing in the tough market environment ahead. Good luck.

Here Come the “Tactical Overlays”

The avalanche of press this year about the death of buy and hold investing has surprised even me, and I have been forecasting this change in our industry for just about a decade. Now that financial advisors and professional pension and endowment investors are paying attention, I am watching to see how the industry is going to address this problem. You have an industry that is populated by professionals who have passionately followed the buy and hold dictums of strategic asset allocation for their entire careers, and all of the sudden they need to come up with “the quick fix.” What should they do as pragmatic business people when the status quo about the “right” way to invest has changed, virtually overnight?

When it comes to personal financial advisors, those Certified Financial Planners (CFP®) who are my peers in providing “sophisticated” asset management for affluent investors, I have long predicted that the solution will appear in the form of some kind of technical analysis-driven process. Clearly the least expensive method for active management, in terms of both time and treasure, is to focus on technical trading methods. I can see new institutional level software (i.e., expensive) that will cater to big firms looking to add a “tactical overlay” to their current buy and hold, strategic asset allocation portfolios. In the world of pensions and endowments, my partner, John Hill, recently told me that the consultants to a non-profit board that he sits on recently offered exactly that. The endowment investment committee could remain strategic (buy and hold), or they could purchase the new razzle-dazzle tactical overlay that would change the asset allocation based on their new, proprietary, techno-sizzle methodology. If professional money managers are afraid that their clients are going to demand active management, I think the tactical overlay will be an easy sale.

Of course, the technical solution will not require that the consultant firms that have advised their clients to buy and hold for decades have an actual track record in active management. Or, for RIA’s (Registered Investment Advisors) catering to affluent clients, their new tactical overlay will not require them to actually learn about market fundamentals, do the research, invest in knowledge and people, or be responsible for the asset allocation changes that are integral to active management. They will instantly have a credible, saleable, technologically marvelous, scientific, and relatively cheap, solution to their problem. Since we (Pinnacle Advisory Group, Inc.) are still slogging along reading the research and actually doing the work, a theme that is mentioned several times in my book, I wonder if we somehow got it wrong?

The Oh-So-Sweet Sleep of the Certain

Recently I had the opportunity to review the investment results of two different money managers who had correctly called the market top in 2007 and by January of 2008 had safely invested 100% of their investment capital in cash.  The resulting investment results are, as you can imagine, spectacular.  Both firms are quantitative in nature, meaning that they use proprietary technical-analysis-based methods to determine market trends in order to make their investment calls.  In one case, the manager has a trade-marked trend identification system that protects their clients from downturns.  While I tip my hat to these managers, I continue to view any portfolio construction that is either all-in in terms of stocks and risk assets, or all-out in terms of cash, as a somewhat high risk proposition.

To me, going 100% to cash screams that the investor has 100% conviction that his or her forecast is correct.  I just don’t know how anyone can get to that level of certainty.  I’ve often said that they must sleep the sweet sleep of the certain, with no doubts about their forecast, their trading system, their proprietary models, their decision making process, and the well documented irrationality of their fellow investors.  I’m envious.  When Pinnacle portfolios are positioned to be widely divergent with our benchmarks, as they were in January 2008 with our correct bear market forecast, I don’t sleep well at all.  Experience has taught me that financial markets are notoriously fickle, and that making large bets about market direction…either direction….takes a certain amount of courage, or a certain amount of hubris.  I suppose it is fair to say that we (Pinnacle) are either very wise in recognizing that the irrationality of markets should be approached with the greatest of respect, or we simply lack the courage of our convictions.  I believe that the correct assessment is the former.

From a portfolio construction point of view, it turns out that being fully invested in risk assets still allows a portfolio manager a great deal of latitude to “hide in the market” and still manage risk.  Being 100% in U.S. stocks but owning staples, health care, and utilities is likely to result in capturing 50% of the market’s volatility in a bear market.  If the market rallies and you were wrong in your short-term assessment of market direction, you will still crush cash returns to the upside.  On the other hand, going 100% to cash, when cash pays 1%, is truly a high risk proposition from the standpoint of generating total returns.  There is no “repair strategy” from there that I’m aware of.  Investors must be 100% certain that the market is not about to rally.  For our part, we prefer to actively manage portfolios where our equity exposure varies with our forecasts but we don’t end up at either extreme of market timing.  It allows us to sleep the oh-so-sweet sleep of the uncertain!

The Ongoing Perils of PE Ratios

One of the interesting things about writing a book is that you get feedback from lots of folks about what they liked and disliked the most about your writing.  Recently, someone told me they read and re-read the chapter on P/E (price-to-earnings) ratios (The Incredible, Amazing P/E Ratio) several times and still “didn’t get it.”  It’s not surprising that someone didn’t get it, because clearly the huge majority of investors don’t “get it” either.  If you are a proponent of value investing, and one of the basic tenants of your portfolio construction is to be wary when the market is expensive, then understanding this basic valuation measure is very important.  Unfortunately, as I say in the book, it’s also an ongoing mystery where bulls and bears will look at the same data and reach vastly different conclusions.

At Pinnacle, we look at a wide variety of valuation measures involving earnings and price.  Last week we routinely updated our valuation data and came up with the following P/E measures: (Note: we actually look at more than a dozen earnings-based indicators.)

The current range of P/E’s is fairly wide from a low of 10.83 based on a variation of John Hussman’s price-to-peak earnings methodology, to a high of 18.47 based on a ten-year average of S&P earnings.  Obviously different investors using different methodologies will reach different conclusions from this data.  Even investors who get the same numbers will reach different conclusions.  For example, the 10-Yr normalized GAAP (Generally Accepted Accounting Principals) P/E ratio looks expensive when comparing to the median P/E of around 15 going back to the late 1800’s, but if you exclude the Great Depression and only compare to post WW-II data the median rises to about 17 and the current 18 figure doesn’t look too bad.

The bottom line:  Buy and Hold investors who are looking for a simplistic, quantitative solution to fundamental value investing will be hard pressed to find it.  It turns out that finding value is as much “art” as it is “science.”

Investors are Scrambling?

I couldn’t help but notice the headline for Tom Lauricella’s front page article in the Wall Street Journal, called Failure of a Fail-Safe Strategy Sends Investors Scrambling.  The article does an admirable job of covering the basic problems and issues with traditional asset allocation…the themes that I cover in the first half of my book.  Here’s a quote: “The financial crisis has sent many financial advisers, academics and investors back to the drawing board.”  For financial advisors whose business model is to charge fees to manage their client’s assets, this really IS a crisis.  They will have to change the culture of their firm, change the message to their clients, and potentially endanger a very profitable business model, all in the pursuit of a solution to a problem that is not easily solved.

Let’s start with culture.  All of those advisors with crystal balls in their lobby that they use to explain why buy and hold investing avoids having to “predict the future” will be putting that crystal ball away.  They will be left to explain to clients who have been taught over the past 25 years that market forecasts are futile why it is that they (or fund managers that they buy) are now going to engage in exactly that pursuit.  Since we made the same transition in 2002, I don’t envy them these conversations, especially for the firms who most vociferously defend passive, buy and hold strategies.  To change the underlying fundamental approach to investment strategy is no small matter to registered investment advisors who earn their fees based on the confidence of their clients that their advisor is professional, scientific, “state of the art,” and trustworthy.

But it gets even worse, because once advisors leave “buy and hold” behind, they will have to “scramble” for another investment approach.  It is the scrambling that results in major problems for the industry, because advisors literally don’t know what to do next.  I believe that advisors will begin a desperate search for quantitative models that will relieve them of the responsibility of making investment decisions.  They will turn to much larger allocations to hedge funds and other alternative investments that they can “buy and hold” but offer a different approach to asset allocation.  Unfortunately, neither of these approaches will solve the problem of becoming a different kind of investment expert, where the ability to change portfolio asset allocation is done “in-house” based on the expertise of the advisor.  Of course, at Pinnacle, we’ve been engaged in writing, lecturing, and executing active management for years.  I will be interested to see if the media is interested to talking to us as experts, or if they want to keep interviewing the advisors who “are scrambling.”

“Crystal Ball Gazing” and the Horrors of Subjective Forecasting