For funds with a time horizon of 5 years or more
The Advisor monitors and estimates value for the stock markets of about 40 countries. When many of the countries have a favorable valuation, the Advisor will pick 5 to 12 countries and put 70% to 99% of the clients portfolio in low cost funds focused on these countries. If the prices of most countries’ stock indexes are above the estimated value, the Advisor will hold mainly defensive positions in bonds, bond funds or other short-term investments.
This is further described (on pages 4-6 of the Disclosure Brochure).
Risk: Time to Think Differently
To avoid running out of funds and make your purchasing power last requires balancing risk. The so-called “safe” investments increase the risk of losing that purchasing power. This article aims to inform your strategy by looking at history.
People in retirement often avoid stocks since a big downturn might mean their investments don’t recover before they need the funds. This makes perfect sense when you measure risk by volatility in the price of an asset. Under the traditional risk paradigm short term Government securities know as Treasury Bills or T-Bills are considered risk free. In risk and return they are considered slightly less risky than money markets and bank CDs.
These types of investments are appropriate for the money you are going to spend for food or keeping a roof over your head in the next few years. The standard measure of risk is appropriate for money that will be consumed in about the next five years.
However, these “risk free” investments do not protect from purchasing power risk. This risk is measured by how deep the decline in purchasing power goes and how long it takes to recover. When inflation is higher than the interest rate, T-Bills lose purchasing power.
The chart below shows the purchasing power of T-Bills where all the interest is reinvested and the value is adjusted for inflation. Due to high inflation and low yields between 1933 and 1951 T- Bills lost 45% of their purchasing power. Even if you reinvested every dime of interest it would have taken till 1994 for the T-Bill portfolio to recover its purchasing power. In 9 of the last 10 years a T-Bill portfolio was also underwater when it comes to purchasing power.
If you consume the income from T-Bills or other short term fixed income securities inflation eats away the value of the principal. In the last 24 years inflation cut the value of a dollar in half. In the 1970s the value was cut in half in about 9 years. In addition to purchasing power risk T-Bills have interest rate risk. The yield on T-Bills has ranged from about 0.1% to 17% so you don’t really know what your income in the future will be.
Interestingly, the higher inflation trend of the last 70 years that made T-Bills more risky improved the long-term risk reward ratio of stocks. In the modern era the best-fit line suggests the stock market returns 6.9% a year after inflation, which is slightly better than the earlier period.
Stock market declines in purchasing power can be much deeper than in T-Bills, but are usually shorter in duration. For example, from 1929 to 1932 the stock market lost 77% of its purchasing power; then briefly set a new high just 4 years later in 1936.
In the last 110 years the stock market has had three 15 to 20 year periods where after inflation the stock market lost purchasing power. We started a fourth one in 2000. Interspersed with the weak periods have been 10 to 20 year periods of unusually high returns.
There are measures of valuation that historically have indicated within one to three years when the strong periods would begin and when the weak ones would. When the stock market reaches high valuation a weak period followed. When the valuation was low a strong period of return followed. Valuation gives a good idea of what the return will be over a long period, but does not aid in timing the market or picking tops and bottoms. This is further explained (here).
Volatility doesn’t matter in the long term. In a given year, an individual stock could quadruple in price or fall to nothing. The whole stock market might double or fall by half. The amount of volatility has no influence on whether an investment will gain or lose purchasing power over the next 5 years. Non-volatile T-Bills can gain or lose as well.
Value has a significant relationship with whether an asset will gain or lose purchasing power in the next 5 years. In the long term buying or holding stocks that are undervalued both reduces the risk of losing purchasing power and increases the likely return on investment. This is just the opposite of using volatility as a short-term measure of risk where the assets with the higher expected return have higher risk.
The optimal balance of risk probably holds funds that are likely to be consumed within the next 5 years in assets that have little or no price fluctuation. Funds with a longer time horizon should be held in assets that are undervalued or at least not overvalued.