Category Archives: Asset Allocation

What Benjamin Graham Would Do With Bonds Today

Benjamin Graham10-year treasuries are at 2%. High-yield bonds dance around historical lows and you are probably wondering if there will be anything left after inflation. Welcome to today’s bond environment where safety of principal is being exchanged for the most minimal of returns.

When speaking to advisors, their concern about today’s fixed-income environment is a recurrent topic of conversation. Just like them you are rightly worried about the returns your clients can expect and whether they will meet their retirement goals.

I wanted to find some sort of solution (or a least some solace) regarding this problem, so I turned to Benjamin Graham. The so-called “Dean of Wall Street” and mentor to Warren Buffett. Below is an old copy of Graham’s Intelligent Investor with my notes scribbled across the pages.

Intelligent Investor

Graham On Bonds

Graham was a fan of U.S. government bonds stating their safety is “unquestioned” this is because of the protection of principal they provided. On taxable vs non-taxable bonds Graham believed this was largely a matter of “arithmetic” in which high earners (and thus likely high tax payers) should gravitate towards non-taxable bonds. On high-yielding junk bonds Graham stated that the ordinary investor was “wiser to keep away” from such issues largely because of the individual risks. Given the development of high yield bond funds where risk is diversified Graham would probably not be so against them.

Graham In 2015 

So what would Graham do in 2015 given the current environment? Two items come to mind based on Graham’s works.

  • Firstly, there is Graham’s “fundamental guiding rule” – Never hold more than 75% of a client’s portfolio in bonds or stocks. Always balance between 25% on the low end and 75% on the high-end.
  • Stocks are usually attractive if the earnings yield is twice the Aa corporate bond yield. Today the earnings yield of the S&P 500 is 5.11%, 80% above the 2.83% Aa corporate bond yield.  This means stocks are preferred but they are not a bargain.

So the conclusion is that in this environment Benjamin Graham would have preferred stocks marginally. There are probably still bargains to be had for the “enterprising investor” (active). However, for the passive indexing investor, the market as a whole is not cheap. Unfortunately, Graham doesn’t talk too much about holding cash therefore I took a look at his disciple Warren Buffett’s current cash allocation at Berkshire Hathaway. At the end of 2014, 12% of the company’s assets were in cash or cash equivalents. Worthwhile food for thought.

Do Knowledgeable Investors Need A Financial Advisor? [A Mathematical Approach]

BrainA never-ending challenge for the financial advisory industry is quantifying the value it produces for its clients. We know advisors help people set goals, choose investments and sleep well at night but what about the dollars and cents impact? As clients get smarter they’ll be able to construct their own passive, well-diversified and regularly rebalanced portfolio. They’ll become Knowledgeable.

As Michael Kitces mentioned a few months back “a well-diversified passive strategic portfolio is on its way to being totally commoditized”. Instead of catering to the average investor, advisors will have to work for the client of tomorrow. The Knowledgeable investor.

So the question is, what is the quantifiable value of a financial advisor for the Knowledgeable investor?

First, let’s define the knowledgeable investor. In my eyes the knowledgeable investor understands the following, which an average investor may not…

  • They understand they should have a financial plan. It may not be complicated or consider all the variables but they should have something.
  • A passive diversified portfolio is likely to meet their investment needs over the long term. Most active investment strategies don’t beat the index over sustained (10 year plus) periods.
  • They should rebalance regularly.
  • They should minimize fees (fund fees, transaction fees etc).
  • Investor psychology (i.e. overconfidence, loss aversion, mental accounting etc.) can lead to actions that limit investment returns.
  • Getting started with investing today means they will benefit more from compounding.

Importantly, the knowledgeable investor may understand the points above but never act on them and this gives an advisor the opportunity to force good behavior.

Quantifiable Benefits of a Financial Advisor

 1.    A Financial Plan

Knowledgeable investors understand they should have a plan and probably have something in their head but it is not a formalized IPS, a strict budget or a retirement number. It’s more like “max out my 401k and hope for the best”. This puts them ahead of most people but may not be enough for them to live the life they want. Even for those who have used retirement calculators or read the books the variables can be overwhelming. A financial advisor will give a knowledgeable investor a specific actionable plan. In my opinion this is the most valuable contribution an advisor can make to a person’s future.

 So what is the quantifiable benefit of a financial plan? Likely several years even a decade or more of retirement. That means you can spend less time working and more time with your loved ones. Put a price on that!

 2.    Managing Investor Behavior

The DALBAR studies (which compared dollar weighted investor returns with index returns) popularized the idea that the average investor jumps in and out of investments, buying high and selling low resulting in poor performance. Their conclusion was that “The average equity investor underperformed the S&P 500 by 4.32% for the past 20 years on an annualized basis.”

Further investigation led by Harry Sit and Michael Edesess showed these numbers were exaggerated and possibly even completely false. The DALBAR methodology failed to account for the fact that poor equity market performance during the 2000’s accounted for poor dollar weighted investment performance not investors jumping in and out of the market. Furthermore, earlier this year another DALBAR study showed that 55% of the reason investors fail to meet the index is because they didn’t have the capital to invest and buy at the lows. Therefore we must conclude that the importance financial advisors have in managing behavior has been overstated.

Despite the apparent failing of the DALBAR studies others have attempted to quantify average investor behavior. Russell Investments recently showed that if you had invested in the Russell 3000 index in 1984 and done nothing you would have performed 2.2% better than the average investor (using ICI’s monthly fund flow data to mimic the average investor). I had difficulty getting all the methodological details of this study so I’ll take it with a grain of salt.

What we can say is that the importance of managing investor behavior has probably been exaggerated but it is still significant. If an advisor can save an investor 1-2% a year through managing behavior this more than covers their advisory fee.

But what happens if you are a knowledgeable investor who needs little behavioral management? Then you’ll end up paying for something you do not need.

That’s the question knowledgeable investors have to ask themselves. Without an advisor how good will my behavior be throughout my investing lifespan? If you have serious doubts about your behavior an advisor could well be smart investment.

 3.    Fund Selection and Rebalancing

Another area where having an advisor could have a quantifiable benefit on the bottom line is in fund selection and rebalancing. Russell Investments have shown that a regular (monthly, quarterly annually) rebalancing policy can juice your returns from 0.51-0.93% annually.

However, knowledgeable investors are now well versed in passive fund selection and the importance of rebalancing. Any knowledgeable investor who has done a modicum of research knows Vanguard is highly recommended when it comes to minimizing fees and with their Life Strategy Funds you don’t have to worry about the rebalancing.

Frankly the knowledgeable investor doesn’t choose an advisor to help pick funds and rebalance unless they believe in active investing.

 4.    Tax Planning

A further quantifiable benefit of working with an advisor is the tax planning. Unfortunately, it’s difficult to find any statistics on the tax savings people accumulate from working with a financial advisor. Anecdotally it’s not uncommon to hear of advisors saving their clients 10’s of thousands of dollars. If these savings are invested, grow and compound the benefit of working with an advisor could be worth a lot more than managing behavior or selecting the right funds.

What investors have to ask themselves is whether their tax situation is complicated enough to realize significant savings. A regular W2 employee with a fixed salary is unlikely to benefit as much as business owner, with stock options and investment real estate. If I were to hazard a guess I’d estimate someone with a tax situation that is more complicated than a regularly salaried employee could save several percentage points on an annualized basis over their lifetime through working with an advisor.

 Dollar and Cents Return

So let’s put this into an example. Let’s assume you are a knowledgeable investor who is considering working with a financial advisor. Is it worth it? Well based on the details above the answer would be an emphatic yes….

Advisor Makes You Advisor Costs You
Proper Financial Plan – You end up saving an extra 5% a year Annual Advisory Fee – 1.5%
Managing Behavior – 1.5%
Fund Selection and Rebalancing – 0%
Tax Planning – 2%

Using the numbers above if we assume you have a $100,000 salary and have $250,000 in savings/investments.

Financial Plan  = +$5,000

Managing Behavior = +$1,500

Fund Selection and Rebalancing = +$0

Tax Planning = +$2,000

Advisory Fee = -$3,750

Net Benefit per Year = $4,750

 A knowledgeable investor working with a competent financial advisor is likely see a positive ROI over the long term so long as the expense is not too high.

I find it unlikely that for 20 years even knowledgeable investors can create a viable financial plan, which they can stick to, while simultaneously managing their behavior, keeping up with changes in the industry and optimizing their tax situation. It’s just a very difficult thing to do over a long period of time. Not impossible but very difficult.

The greatest achievers in any field have always needed coaches, advisors and people to keep them accountable. When it comes to investing doing it alone is as tough as it comes.

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Lessons from FPA conference: Increase equities in retirement

I recently returned home from the annual Financial Planning Association conference in Seattle. There were lots of great breakout sessions but the one that got me thinking the most was Michael Kitces’s presentation about the “Rising Equity Glidepath”. If you have a chance to see him speak, please do. He delivers his points intelligently with lots of energy and great humor. Simply put, increasing the amount of equity a client has in retirement will improve outcomes and reduce the chance that they will run out of money.

This is because of the threat of sequence risk (retiring as the market collapses). If the first years of retirement happen to be during a downturn then by slowly increasing the equity exposure over time the client will be dollar cost averaging into markets at “cheaper and cheaper valuations” and if markets are good then they have little to worry about. Below is a diagram I put together to illustrate this point.


Obviously, this approach flies in the face of conventional wisdom. Luminaries like Jack Bogle, the founder of Vanguard have long preached you should have your age in bonds.

What Kitces has observed however, is that many advisors are already unwittingly increasing their client’s equity exposure over time by having a bucket strategy. By having a portion of the portfolio in cash for near time spending, another block in bonds for spending in the next 5-7 years and then the rest in equities the exposure to the stock market will increase over time as the cash and/or bond interest is spent.

If we are already “secretly” increasing equities in retirement why not be open about it with clients and optimize for better results? I spoke to one financial advisor at the conference who said they had floated the idea with clients but they were met with consternation. Openly and directly increasing equities in retirement is far too contrarian for most clients. Perhaps the bucket strategy is the only way to get this past client psychology.

During his session Kitces also talked about the impact of market valuations on choosing the right equity glidepath in retirement. Using the Shiller PE Kitces explained that retiring in “overvalued” periods tends to lead to a lower safe withdrawal rate. Unsurprisingly, the best way to recover is to increase equity exposure during the downturn.

Lastly, Kitces said he would be doing research on the best way to reduce equity exposure, as one gets closer to retirement. I’ll be writing about that, as soon as it is published.

Is An All Cash Emergency Fund Stupid? Academics Say Yes!

 Cash Emergency FundSeptember’s Journal of Financial Planning has a controversial article about emergency cash funds.  Titled “Is an All Cash Emergency Fund Strategy Appropriate for All Investors?” the paper argues that a 6-month cash emergency fund comes with an “exorbitant opportunity cost” resulting in lower levels of wealth at retirement.

It’s become a sort of dictum that you should save at least 3-6 months of monthly expenses in case of emergencies. It’s the kind of advice people instinctively agree with and follow. The authors tear down this cornerstone of financial prudence and provide an impressive argument for a change in thinking.

First Things First

The authors begin their argument by invoking utility theory, which simply states investors should seek to maximize returns while minimizing volatility. Too often investors use “mental accounting” and see their wealth in buckets when they should be focused on the total portfolio. If for example they complete a risk tolerance quiz and they are shown to have a high-risk tolerance then they should apply a similar level of risk to their emergency fund.

The authors do add some important caveats. A more aggressive emergency fund should only apply to people in the “accumulation phase” of wealth building rather than those in retirement.

Secondly, it should apply to “more affluent” clients of financial advisors rather than the average Joe. I accept the first caveat but I feel the second is a little strict. Their analysis and insight can apply to people further down the income scale.

Before jumping into the reasons why an all cash emergency fund might be sub-optimal it’s necessary to state its purpose. The authors see emergency funds as having two main goals. Protect against “income shocks” (unemployment) and savings for future consumption. It is with this definition that they question what has become commonplace financial planning.

1. Insurance – The authors point to the myriad of insurance products that can protect people from income shocks. We have income protection insurance, incapacity insurance, mortgage protection insurance and many others that would soften the blow of any unemployment period. The risk of loosing a job and being unable to survive is slim given the range of products that exist.

2. Diversification – For those who want to invest their emergency fund in more volatile assets they can diversify some of their risk and see greatly improved returns. People tend to invest emergency funds in cash because it’s safe however, that does not mean investing in stocks for example is unsafe. The risk can be reduced.

3. Human Capital – The authors suggest that investors neglect to evaluate their human capital when making investment decisions. For example a college professor is likely to have a high degree of job security and could probably afford to take more risk with their emergency fund than a stockbroker. Certain jobs are safer and certain people are highly employable. If you fit into one of these categories then a more aggressive emergency fund could be appropriate to maximize utility.

4. MAIN ARGUMENT – Opportunity Cost – To conclude their argument the authors created a model to calculate how much wealth a person would loose by not investing their emergency funds into stocks and bonds. They took an example of someone working from age 25 to 65 assuming average levels of unemployment. Stock and bond data ran from 1926 to 2011.

The results were staggering.  If an individual invested their 6-month emergency fund in a 60/40 portfolio instead of cash they could expect to have up to 20% extra in retirement savings. This clearly calls into question the requirement for a 6-month emergency cash fund given the assumption you want to maximize returns. The question investors need to ask themselves is whether the peace of mind of having cash in the bank, is worth loosing up to 20% of potential retirement savings.

Emergency Cash

Concluding Thoughts

The authors make a compelling argument against the 6-month emergency cash fund. However, beyond a client’s risk tolerance and the possible use of a risk tolerance questionnaire they didn’t look at other risks. Notably, counter party risk (getting access to your insurance or investment from a provider).

Utility theory might tell us what is optimal but it fails to account for the behavioral psychology aspect of the human mind when it comes to investing. Regardless, the authors have made a compelling argument and if they can’t get investors to entirely drop the 6-month emergency cash fund I am sure more than a few would consider switching to three months.

Is it time for you to trash Modern Portfolio Theory?

Modern Portfolio Theory (MPT) needs little introduction. Developed by Nobel Prize winning economist Harry Markowitz in 1952, the theory forms the basis of portfolio construction for large swathes of the money management industry. MPT is an approach to how you can optimize returns for a given level of risk. Choosing a selection of assets that form an efficient frontier.  See the diagram below.

Modern Portfolio Theory

Despite its popularity the approach has come under attack largely due to the 2008/2009 financial crisis. The hallowed 60/40 stock bond portfolio saw losses close to 15%. While those with an 80/20 mix lost a quarter of their money.  The fact is MPT based portfolios performed exactly as intended during the crisis, optimizing returns for a given level of risk (volatility). What the crisis did however is open up a debate about the effectiveness of the theory. This leaves you with a fundamental question. Is it time to trash Modern Portfolio Theory?

Risk Is Not Volatility

In his 2011 paper “Is Portfolio Theory Harming Your Portfolio” Scott Vincent starts with something all money mangers implicitly understand. “Risk is in the eye of the beholder”.  MPT defines risk as variance from the mean (volatility).  As JJ Abodeely noted in his excellent blog post about the failings of MPT, Harry Markowitz chose volatility because it was “mathematically elegant” and “computationally simple”.

What does this mean for you? It means choosing a portfolio that provides an appropriate amount of risk and return depends heavily on how you define risk. For some clients capital preservation (downside risk) is a lot more important than variance (keeping up with the long run average).  If this is the case for your clients then it might be time to trash MPT.

Some of the advisors I speak to would call this a mute point. What matters is a client’s goals then you construct the portfolio to get you there taking an appropriate amount of risk. However, notice how risk still needs to be considered regardless of whether a client’s goals are the first step in portfolio construction.

Enter Post-Modern Portfolio Theory (PMPT). PMPT measures risk by looking at the downside. Essentially, how bad are the bad times rather than simply how are the times on average (MPT).  The theory can then be used to construct a portfolio that has limited downside yet meets the required goals of your client. The result is often portfolios that look wacky at first (e.g. The Permanent Portfolio) but deliver results. Take a look at the portfolio below for an example proposed by Unified Trust that has a historical return of 11.54% with a downside deviation of 2.2%.


The problem with such a portfolio is that it flies in the face of conventional wisdom. If advisors are to trash MPT and switch to something like PMPT they need to be brave. MPT has Nobel prizes and decades of support. Inertia is on its side. It would take a brave advisor to recommend the portfolio above and stick with it when the markets (and the wider investing community) favor a traditional 60/40 stock bond portfolio. If it’s true that downside risk is your client’s biggest concern and you are targeting a 8-10% average annual return then using PMPT and trashing MPT must be the way to go.

Historical Performance Is No Guarantee Of Future Returns

Practically every financial product comes with this boilerplate warning.  “Historical performance is no guarantee of future returns”. Yet MPT relies heavily on back testing to justify its position. The cornerstone of this back testing is using the historical correlations between asset classes to choose a diversified portfolio.  The table below from Wealthfront outlines the correlations between different asset classes.

 Screen Shot 2013-09-19 at 2.32.09 PM

The problem with using historical correlations to inform your decision-making is that correlations change. Stocks and bonds may have been uncorrelated yesterday but that doesn’t mean they will be tomorrow. Furthermore, during wars or a general market collapse various asset classes can move in sync canceling out any diversification.

So what does this mean for you as an advisor? It means we cannot simply rely on historical correlations to justify an asset allocation. We have to exercise some judgment. Use historical correlations as one weapon in your arsenal but do not base your entire strategy on it.

 What Next After Modern Portfolio Theory?

It’s clear that MPT has some serious flaws. Its definition of risk is questionable and it relies too heavily on back testing to justify its existence. That being said I don’t believe we should embrace market timing either.

Post Modern Portfolio Theory sets us on the right track by having a realistic definition of risk. Taking this definition we can find an asset allocation that minimizes downside risk yet yields a healthy average annual return. We just have to make sure it is a portfolio that minimizes costs, is easy to manage and has reason for its construction beyond historical performance.