The 4% rule lives despite what the NY Times says

OK, deep breaths, deep breaths….The drivel the passes for reporting on retirement issues never ceases to amaze me. But this time I found a real howler. The “paper of record”, the venerable NY Times, recently published a piece on the 4% safe withdrawal rule, titled “4% Rule for Retirement Withdrawals Is Golden No More”, that is truly a piece of garbage. I can only hope that it wasn’t really read that much but I cringe at the potential fear caused among many older Americans. I’m going to quote extensively from the piece here to shed light on this whole flawed concept of the 4% rule no longer being valid.

Ok, lets get to it. The premise of the article is that the 4% withdrawal rule in retirement is no longer valid. Due to the widely accepted premise that future returns will be low due to high stock prices and low bond yields retirees can no longer rely on the 4% rule. The first piece of data we get is in the second paragraph;

That percentage was calculated at a time when portfolios were earning about 8 percent. Not so anymore. Today portfolios generally earn much less, about 3.5 percent to 4 percent, and stocks are high-priced, which is linked historically to below-average future performance. Many financial advisers are rejecting the 4 percent rule as out of touch with present realities.

What portfolios earn 3.5% to 4% today? I wanted to give the author the benefit of the doubt so I had to really search for such portfolios. Going with the traditional 60% stocks, 40% bonds portfolio referenced elsewhere in the article and going back to the beginning of the year 2000 you get a compound annual return for the portfolio of 3.16%. Wow, scary right? But that’s the worst I could find. All other periods since 2000 are higher. And if you held a more broadly diversified portfolio like the IVY buy and hold portfolio or the Permanent portfolio your returns over this period would have been 6.5% and 7.9% respectively. Seems like poor returns are more a problem of asset allocation than a poor general return environment. Also, the highest safe withdrawal rates even using only US stocks and gov’t bonds comes from a 70% stock 30% bond allocation, not 60/40. If only we could get some good financial advice….but I digress.

Next, compound returns are only one component of successful retirement withdrawal rates. Inflation, volatility, and the sequence of returns are just as important. For example, lower compound returns at lower volatility lead to higher safe withdrawal rates (see here). A better question is how is the poor year 2000 retiree, who suffered 2 market crashes, doing using the 4% rule doing compared to history? Turns out that he/she is just fine and doing better than the worst times to retire in history. As I discuss in this post, the 4% rule is doing just fine for the year 2000 retiree, better than the worst times in history to retire – 1966, 1965, 1929, and 1973. And the 4% rule worked during those times as well.

But maybe the future will turn out to be different. That’s what some experts say.

Michael Finke, a professor in the department of personal financial planning at Texas Tech University in Lubbock, is a co-author of a paper critical of the rule, “The 4 Percent Rule Is Not Safe in a Low-Yield World.” He says Mr. Bengen’s rule doesn’t acknowledge the new economic reality of prolonged low returns. “There haven’t been any historical periods that look like today,” Mr. Finke said. “We’ve never had an extended period where rates of returns on bonds have been so low and valuation on stocks so high.”

Is this correct? Maybe but lets check the historical record first. The worst time to retire in history was 1966. What were stock prices, bond yields, and inflation back then? In 1966 stock valuations were similar to where they are today, based on the Shiller PE, the 10 year bond yielded 4.8%, and inflation was 2%. In 1929 stock valuations were much higher than today, the 10 yr note yielded 3.4%, and inflation was practically zero. History says we’ve had higher stock valuations before but that real bond yields today are lower than at these two times in history. Lower real bond yields could possibly lower safe withdrawal rates going forward but the data is not conclusive. In the 1929 and 1966 periods bonds went on to suffer massive bear markets in real terms with inflation peaking at 18% in 1947 and 12.2% in 1980. Imagine inflation adjusting your retirement withdrawals back then. Still, what if we have zero real yields going forwards as far as the eye can see? I went back to the historical data and forced real bond yields to zero and re-ran the safe withdrawal rate analysis. Guess what? Yes the SWR went down but  from 4.39% to 4% for a 70% stock 30% bond allocation. Still safe. What studies suggesting that the 4% rule is not safe anymore rely on is a combination of lower stock returns AND low bond returns AND higher inflation. I’m sorry but you’re cooking the books. You’re taking a forecast of low future returns for stocks and bonds and forcing it into a model.  I’d rather rely on history without much flawed human forecasting. By the way, the 100% safe withdrawal rate for a 30 year period that comes out of the study linked above is 1.8%! You could even easily construct a 100% bond portfolio to destroy that.

The next 3 paragraphs in the article are pure drivel.”Strict application of the rule also does not factor in how important returns are in the early years of retirement, something known as the sequence of returns.” Uh, yes it does. That’s how safe withdrawal rates are calculated. Next, we get “High inflation early in retirement can have a similar impact, especially if earnings are also low. Taking out more money just to keep up with the rising cost of living will accelerate the depletion of savings, Mr. Finke said” Duh. Again, safe withdrawal rates take this into account by adjusting withdrawals for inflation. Like some old commercial used to say…its in there! Next, “Many advisers recommend maximizing earnings by moving away from the 60 /40 portfolio allocation on which the 4 percent rule is based, says Jay Wertz, director of wealth advisory services at Johnson Investment Counsel“ Wait we may actually get some advice here…..nope, sorry, see link so you can pay fees.

Now comes the worst part of the article. “Retirees wanting more certainty in the future might consider investing in a deferred income annuity”…..”The annual income usually ranges from 5 to 6 percent of the amount paid for the annuity…” OK, wait. We are supposedly living in this new low return world right? How are the supposed professional investment managers at insurance companies supposed to generate 5-6% payouts in a world of low returns that you just told me I can’t even safely withdraw 4% from. These people buy the same asset classes at the same prices that we do. In a low yield world annuities tend to be a raw deal. Not to mention the fees, and the risk you take on by going with an insurance company. That’s the advice we get, buy annuities? Stunning is all I can say.

Finally, at the end of the article we get some common sense from the founder of the 4% rule, “Mr. Bengen still feels his rule is a good benchmark, but advises clients to spend more conservatively. When he first came up with the 4 percent rule, “people said, ‘How can anyone live on so little?’ Now they are saying it’s too high. I think it’s a lot to ask people who have saved their whole lives to live on 3 percent.” Exactly. After all this drivel your best advice for retirees is sorry you need to live on 3% or less, you better keep working. No other solutions to be offered? Better asset allocation models which maybe give you exposure to market beating assets like value and small cap stocks or lower valued equities like international or dividend payers? How about strategies to reduce volatility like the IVY timing model? How about starting with 4% but having an early warning indicator to tell us if/when we’re in trouble? Nothing. Just live on less and maybe buy an annuity.

In summary, the demise of the 4% rule is greatly exaggerated. It hasn’t failed yet. Even that year 2000 retiree is doing just fine. But yes the future is uncertain, there are no guarantees. The 4% rule may fail in the future. But before we go telling soon to be retirees or worse current retirees, sorry, your only option is to spend less or keep on working to save more, many other options should be considered. When other options are considered, like better asset allocations, volatility/drawdown reduction strategies, early warning indicators, and smarter withdrawal methods retirees can still enjoy 4% and even higher withdrawal rates. Articles like the NYT piece don’t help at all.

 

Fairfax Financial vs Berkshire Hathaway

When people talk about Fairfax Financial and its chairman Prem Watsa, the description used most often is the ‘ Warren Buffett/Berkshire of Canada’. This is fitting in many ways as the companies are in similar lines of business, insurance, and have impressive investment track records. But how do they compare in term of returns to shareholders and their prospects for the future? This is kind of like picking between two stellar athletes. Your odds with either are much better than average but there are some important differences that I think give one the edge.

First, we turn to historical comparisons. Both companies use change in book value as the key measure of company performance. Over the long run the stock price tracks the change in book value very closely. Starting in 1985, the first year Fairfax was public $1 invested in Berkshire in 1986 would be worth $69.60 at the end of 2012 for a compound annual return of 17%. A $1 invested in Fairfax in 1985 would be worth $245 at the end of 2012 for a compound annual return of 23%. All numbers are from the companies’ annual reports. Both easily trouncing any index. Now this is somewhat unfair to Berkshire since in 1985 they were already around for 20 years. Berkshires returns in the period from 1965 to 2012 are 19% per year, so pre-1985 they did better than the 17% post 1985. What about more recent returns? The chart below compares returns and the growth of a $10K portfolio in both companies over the last 10 years.

 

Over the last 10 years, Berkshire has slightly beaten the S&P500 (8.68% vs 7.98%) while Fairfax has handily beaten it with a return of 18.13% per year. Here is where we start to see some subtle differences between the companies. Look at the composition of returns between the two companies. Fairfax returns are ‘lumpier’, some amazing years – some not so good years, while Berkshire tends to track the S&P500 more closely. Also, note the difference in returns during the financial crisis. In 2008 Berkshire lost 32% while Fairfax was up 11%. Again, both great investments with Fairfax having the edge. Now, the most important question. What does this imply for future returns?

Going forward Fairfax still has the edge over Berkshire for two simple reasons; size and leverage. Berkshire is a $300B market cap company while Fairfax is about $18B. Its easier for smaller cap companies to grow vs large ones. This is why small cap tends to outperform large cap in general as I’ve discussed before. Even Buffett himself has said the Berkshire going forward will slightly outperform the index. Second, an equity investor has more leverage in Fairfax than Berkshire. When I say leverage for an insurance business I’m talking about float, the insurance premiums insurance companies get to invest up front. Fairfax is still primarily an insurance business while Berkshire is much more of an operating company than it used to be. That means Berkshire has less float per dollar of book value than Fairfax. That it means its quite reasonable to expect forward returns of 8-9% a year for Berkshire and 15% per year for Fairfax (the company’s own stated goal). A final few points for Fairfax are that an investor gets paid to wait with a decent dividend (about 2.5%), and that its returns are more uncorrelated to the index than Berkshire thus making it a good portfolio diversifier.

In summary, an investor has a great chance of beating the market indexes with an investment in either Berkshire or Fairfax but Fairfax has the cards stacked more in its favor simply due to size and the leverage present in the insurance business.

Beating the market to maximize retirement income – part II

A while back I wrote about some historical analysis I had done that showed several ways that an investor could achieve market beating returns and thus maximize retirement income. It has been known for a long time that several ‘factors’ or characteristics of stocks generate market beating returns. The two classic factors are value and size. Value stocks outperform the market over long periods of time. Small cap stocks outperform as well. The third and newest factor, at least relative to value and size, is momentum. I also showed that contrary to efficient market theory these extra returns do not come with extra risk, or that the extra risk, is more than compensated by extra return. Below I reproduce the key table from that post.

Now, the question that I left open at the time is how does an investor best gain exposure to these market beating factors? That’s what I’d like to talk about briefly in this post. Briefly because its pretty simple. The best way to gain exposure to the value and size factors is through ETFs. I’ll come back to momentum in a bit. Today there are a ton of ETF offerings in the value and small cap styles for an investor to choose from. And ETFs that combine small cap and value. For, example, here is a list from ETFdb of all the value ETFs they keep track of. There are 100 ETFs on the list. The small cap list has 107 ETFs. By the way, for dividends fans like myself out there, dividend ETFs for the most part are considered as value investments. As far as selecting ETFs, I always start with Vanguard first (because fees matter a lot and they have the lowest overall fees) and then go from there, unless I’m looking for something very specific. I would then look for the ETF on my broker’s commission-free ETF list to further reduce my cost (here is the list for my broker TD Ameritrade). Below are the Vanguard choices for value and small cap stocks.

That’s the easy part, finding value and small cap ETFs. The harder part is constructing portfolios around them. But its not all the difficult either. You start with the concept of holding a broadly diversified portfolio and then add value and small cap exposures to it. Lets look at an example using the IVY portfolio as a model to start from. In the table below I picked out a few value and small cap offerings and inserted them into the overall IVY allocation. The concept is the same whatever your starting portfolio, 60/40, Permanent Portfolio, etc… Notice that there are even value ETFs for the real estate sector. There are tons of ETFs out there and these are by no means meant to be the ‘best’ ETFs for value and small size.

I chose allocation percentages that I see recommended often. Basically, they have the majority of the allocation to the broad index in a given asset class and then gain exposure to factors like value and size through small allocations to them (e.g the 5% allocation to VBR). Now, if value and size give an investor such outperformance over the long run why not have all of the asset allocation geared towards these factors? Like any strategy there will be periods of time when it will outperform and periods of time it will underperform. Anyone remember for how long value stocks underperformed in the late 90s tech bubble? I think it was 6-7 years. Most investors don’t have the emotional tolerance to underperform the market for extended periods of time and often end up abandoning strategies like value investing during those times, even though over the long run they would be better off. But you have to respect investor psychology and adjust portfolios accordingly. If you are a tried and true value or small cap investor maybe you could have equal allocations among a broad index and the factors like value and size.

What about the last factor, momentum? This one is a bit harder because only recently have ETFs been announced to gain exposure to momentum. The ETFdb list only shows 3 momentum ETFs so far. Probably a bit early to include one of these in a portfolio allocation. I’d like to see then grow in size and see how well they do. So, lets leave it at that for now. But this does bring up another way that many professional investors and funds gain exposures to the factors I’ve discussed here (value, size, and momentum) and many others. It’s called Quantitative Investing. In the simplest sense quantitative investing is basically mechanical investing, the use of a computer to choose a portfolio of stocks based on any factor an investor chooses. Usually quant strategies are associated with very complex models that are used by large hedge funds (see here) but that doesn’t have to be the case. They can also be quite simple. I’ll be introducing the concept more in subsequent posts and how it can be simple and applied by individual investors.

In summary, an investor can increase portfolio returns over the long term by tilting their portfolios to factors that have been proven to outperform the market over time. Size, value, and momentum have been proved to increase investor risk adjusted returns and also increase withdrawal rates in retirement. Investors should consider allocation and least some of their assets to these factors.

Fairfax Financial 2012 results update

It’s been a long time since I’ve written about Fairfax Financial. Last time was in October 2011 (see here for previous posts). Fairfax recently held their annual shareholder meeting which had some great information about the company, its results, and why it is a good investment. I’ll discuss some of the highlights of the meeting in this post.

First, my investment thesis for Fairfax is pretty simple. Great long term returns, a super conservative and competent management team, and a leveraged but hedged investment. I’ll explain. In 27 years, Fairfax has generated a compound return of 23.3% a year on book value. Easily up there with Buffett. The investment team, led by Prem Watsa – CEO, always has the company positioned conservatively and ready for the next potential crisis. Lastly its the only investment that I have found where my equity dollars are leveraged, due to insurance float, and hedged due to the conservative investment stance of the company. I’ll talk a bit more about this below but Fairfax comes as close to a disaster hedge with upside that I can think of. And I get a 2.5% yield while I wait. On to the annual meeting. Slides from the annual meeting can be found here….

First, Fairfax is primarily an insurance company. Good insurance companies make money on just writing insurance. Its called an underwriting profit which is measured by the Combined Ratio. Insurance companies charge premiums for policies and pay out claims when they are made. A well run company makes sure that the premiums they charge cover the claims plus the expenses to run the business. That’s what the combined ratio measures. A ratio less than 100% you’re making money on the insurance alone, over 100% you’re not. No one does it better than Berkshire Hathaway and Fairfax ain’t too shaby either. Below is a slide that shows Fairfax’s combined ratio.

Making money on basics over a period of years. Check. Now, insurance companies get to hang on to those premiums waiting for the claims, if any. That money is called float. During the time they hold that money they get to earn investment returns on it. So, as an equity investor what you get is a leverage effect due to the nature of the insurance business and the capital structure of the company. Lets take a look at how it plays out at Fairfax.

For every share you own in Fairfax, $378/share of book value, you are exposed to the return on $1,289/share of investments in the company’s portfolio. That’s a little over 3X leverage. That’s the power of float if managed properly. The last piece of the puzzle is the company’s investment performance. And here again Fairfax has a great track record as seen below.

Since 1986 their dollar weighted compound total investment return has been 9.4% per year. With the leverage of float that has yielded the 23.3% return on book value. Going forward, Fairfax’s stated goal is to grow book value at 15% per year in the future. Based on historical results, the leverage you get as an equity investor, and the strong insurance business, it looks like an easily achievable goal to me. Lastly, one of the things that I like about Fairfax is their conservative portfolio positioning. The chart below shows their portfolio allocation as of the end of 2012.

30% cash, 43% bonds, 24% stocks (100% hedged), and 3% other. Pretty darn conservative. In addition, they also own a chunk of de-faltion hedges (CPI-linked derivative contracts) just in case the world slips into deflation. On the other side, insurance is pretty much an inflation hedged business. This conservative positioning is why I view Fairfax as kind of a disaster hedge, just one I expect to make 15% per year on!

One thing about Fairfax is that their results and stock returns tend to be lumpy. They have historically under performed for significant periods of time. Also, due to their conservative nature they tend to do well when the rest of the market is doing bad. Which makes it great as portfolio diversification. The table below shows how lumpy their results can be.

In summary, I still think Fairfax is a great long term investment which can also act as a disaster hedge and great portfolio diversification tool. Their results for 2012 support all these themes. Q1 2013 interim results are due at the end of this week and I expect more of the same.

IVY Portfolio April 2013 signals

Time for the IVY timing portfolio trading signals for the end of April 2013.

You can see the signals at world beta or my preferred source dshort. Below are the signals for the end of April 2013. Another source I’ve found for IVY updates is Scott’s Investments. He updates a spreadsheet that details the calculations. The only difference is that he uses the BND ETF instead of IEF for the bond allocation.

 

In the March update that I missed, IEF triggered a buy signal. There we no changes from March in this month for the IVY portfolio. The portfolio remains 80% invested and 20% in cash.

For previous posts on the IVY timing model and its performance see here and here.

What’s next for MLPs?

For my first post back I want to update the last post I did before my hiatus. On Feb 10, I posted on how well the MLP sector did in January, with it being the second best January ever, and that good early year performance usually leads to strong results going forward. Lets see what the MLP sector has been up to since then.

The chart below shows the performance of the AMJ ETF that tracks the MLP sector. What a year so far is all I can say! The MLP index total return for Q1 2013 was 19.7%, far outpacing the SP500. That’s a dam good year of performance in just 3 months. MLP s have advanced a little further in April as expected, given that April is a dividend capture month and historically does well as I’ve discussed before. I hope you enjoyed some these gains – this was a great risk/reward setup at the beginning of the year and at the end of January.

 

The performance in many individual names has been even more impressive. YTD performance, price-only, even with the recent pullbacks: EPD – 25%, NGLS – 27%, TRGP – 28%, PAA – 28%, WMB – 18%, KMI – 12%, KMP – 18%. OKS was about the only real dog among the big MLPs and even that horrible performance was 2% up plus the dividend. Some of the more spec names like LNG and GEL are up almost 50% and 34% respectively. Needless to say that this kind of performance in such a short time doesn’t come around very often. Obviously, the next question is what now?

A couple items to look at to give us an idea of what MLPs could do from here are valuations and historical patterns. First, historically, May is not a good month for MLPs. Its the second worst month, after November. You get the fade of the dividend capture trade, you get equity issuance by many MLPs, and you get part of the general market ‘sell in May’ effect. Second, MLP valuations are not as compelling as the were in November of last year, nor at the beginning of this year. The chart below is the one I like to use for MLP valuation.

 

On a yield basis, MLPs are approaching lows in yield since the 2008 crash, but not by much. On a yield spread basis MLPs are not as compelling either and are approaching the average spread. However, historically even these average spreads have led to good returns in the past. Also, compered to other yield based investments MLPs, even at these ‘low’ yields of 5.8% look pretty darn attractive especially against what I think are over valued yield investments like REITs, Utilities, and Junk bonds. Basically. I’d be looking here for a mild pullback in May generating some good setups for the rest of the year. As always, I prefer individual names vs the ETFs and I prefer to have more growth over yield. WMB, ARP, CLMT, and TRGP are some of the more growth oriented names that I like. And I’m always looking for ways to own some of the big boys especially Kinder Morgan and Enterprise Products and good prices.

Hope that helps.

Disclosure: currently long CLMT, ARP, and WMB with some tight stops.

Rejuvenated and refreshed

Its been about 2.5 months since my last post and after some consideration as to whether continue blogging or not I’ve decided to keep at it.

I was recently inspired by a recent Frontline documentary called ‘The Retirement Gamble”. You can watch it on-line here. Its well worth your time. Two things really struck me in the piece:

1. How little most people know about basic investing and retirement. When you’ve been at investing for a while and build up a base of knowledge it’s easy to forget the lack of basic knowledge out there. There is such a dearth of basic knowledge out there in particular about retirement.
2. The morons and/or bold faced liars that run some of the biggest investment outfits. I almost fell out of my chair during one of the interviews in the documentary where the head of investments or something or other from one huge investment shop says that she is not aware of the research that says that most mutual funds fail to outperform the market! No, really. I’m not kiding. Go watch it.

Well, these two did it for me. If I can do anything, even a little bit, to help some people learn about retirement and investing and avoid some of the biggest mistakes and traps out there then I will feel pretty damn good.

So, I’ll start writing again but with a slight twist. More of my posts will reflect what I am currently doing with my investments. You’ll see a combination of long term focused posts and a lot of shorter term, even trading type, posts.

Lets see how it goes.