Saturday, December 8, 2018

My Year-End Review and Planning Regime

I am frequently asked how I manage my own retirement finances. Retired households can have dramatically different financial situations so my regime won’t work for everyone but it does demonstrate some of my retirement finance philosophies.

It amazes me to learn how often some people check their portfolio balance. Weekly or even daily? Are you just looking for something to stress about?

I check my portfolio balance about once a year, usually in December. I have a 40% equity allocation, so if the market declines 10%, my portfolio declines about 3% or 4%. For me, that's clearly in the “who cares” zone.

(My portfolio fell 15% during the Great Recession. I cared, but I never considered selling.)

About 70% of my wealth is contained in my portfolio, so a 4% decline in my portfolio value represents about 2.8% of my wealth, which crosses the line into “why did I bother looking” territory. I check my net worth a lot more often than my portfolio value, maybe once every couple of months. (You can link accounts at Yodlee.com or most large investment service websites, like Vanguard, to check your net worth in less than a minute.)

Viewing portfolio losses as a percentage of your net worth can be a lot less scary than looking at portfolio losses in absolute dollars.

Frequent portfolio checking may be a sign of an equity allocation that exceeds your risk tolerance.

When I do check my portfolio balance I also check my asset allocation, though I rarely do anything about it. In thirteen years of retirement, I have rebalanced perhaps three times. One of those times was a year in which I paid off a large mortgage balance, significantly changing my asset allocation. The other two times were years in which I took advantage of some tax-harvesting opportunities. I only "tax harvest" when I have equities I no longer want to own.

Given all the studies and advice regarding the advantages of rebalancing, why am I so nonchalant about my asset allocation? First, I recall reading a William Bernstein post that said there’s a good argument for never rebalancing.

Second, I am cognizant of my short-term risk tolerance. Were I told that my optimal asset allocation was 80% equities, for example, I would ignore that advice because I know that I can’t stomach the short-term volatility of an 80% equity portfolio.

Third, I have a strong safety-net, or "floor", so market crashes are less likely to lower my standard of living.

Lastly, let’s talk about “optimal asset allocation.” Gordon Irlam published a study[1] in which he noted that, while it would be tremendously helpful to know the optimal allocation, his estimate of the 95th percentile confidence interval for equity allocation was roughly between 10% and 80%. Based on that analysis, I can’t know with any certainty at all whether rebalancing would move me closer or farther from optimal. Tweaking an asset allocation within 5% tolerance is, I believe, an example of the massive overconfidence prevalent in many areas of retirement planning. We feel certain about things that aren’t certain, at all.


My year-end review and planning regime.
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Another important part of my end-of-year regime is reviewing my overall expenses and comparing them to my previous year’s budget. I do this largely to check for trends but I don’t believe expenses in retirement are very predictable.

Non-recurring annual expenses are somewhat predictable, though David Blanchett, who publishes extensive research on retirement spending, tells me that there is significant volatility in year-to-year retirement spending. Include spending shocks and expenses aren’t predictable at all.

Spending shocks are by definition low-probability events. Nassem Taleb tells us (and, in fact, told Congress[2]) that low-probability events are simply unpredictable. Last December, for example, I didn’t expect to have to replace two HVAC systems and a car this year. I expected to paint my house but wasn’t prepared for the extensive carpentry repairs that painters would find I needed. I didn’t expect to have substantial uninsured medical bills.

I have learned to expect significant unplanned expenses. Those who think they can predict retirement spending are, again, overconfident.

Once I review previous year spending, planned spending for the coming year, and my portfolio allocation, I recalculate a  budgetary spending amount for the coming year, knowing that if a storm takes off my roof I will have it repaired and if a child has uninsured medical expenses I will pay them, budgeted or not.

This annual recalculation of spending risk is a basic concept. Regardless of what the 4% Rule suggests that you can spend every year of retirement, the actual "safe-spending" amount varies up and down, often significantly, depending on your market returns, unexpected expenses, marital status, and age. There is no reasonable fixed amount that you can safely spend throughout retirement from a volatile portfolio.

Unfortunately, this notion has been accepted by many retirees. I overheard two college profs discussing retirement one morning at my local coffee shop. One declared that she simply had no idea how much of her retirement savings she could spend. The other replied, “It’s simple. Just spend 4%.”

It’s simple but wrong. Retirement finance has no cruise control.

Mention end-of-year planning and most people immediately think of taxes. I have always found tax-planning to be more tactical than strategic because you never know when Congress will make major changes to the tax code, as they did in 2017, and destroy your plans.

In the past, I have used excess deductions to generate tax-free or low-tax Roth conversions in December. After my taxes were calculated the following spring, I would recharacterize any part of the conversion that generated more tax. Recharacterization is no longer allowed but the rest of the tactic is still viable if you are careful not to "over-convert." You can no longer put money back into your IRA the following year.

I estimate my taxes with a calculator called “TAXSIM” provided by NBER.[3]

That’s basically my end-of-year regime. It isn’t very complicated but it works for me. I also record my data to compare to next year’s results.

I don't spend hours and hours on my year-end reviews and planning because I know that any answer I produce will be at best an educated guess that will need to be updated next December. The critical factors of my plan are largely unpredictable – how long I will live, my health, market returns, and expenses.

I don't lose sleep over market declines or check my portfolio balance excessively because my portfolio reflects my risk tolerance.

If any of these are problems for you, then you might need a more suitable retirement plan.

Either way, enjoy the holidays!




REFERENCES

[1] Asset Allocation Confidence Intervals in Retirement, by Gordon Irlam.



[2] 2011 Congressional Testimony, Nassem Taleb.



[3] Internet TAXSIM Version 27, National Bureau of Economic Research.





Tuesday, November 13, 2018

Mean Reversion of Equity Returns and Retirement Planning

Do stock returns exhibit long-term mean reversion? That's an economist's way of asking if stocks get safer the longer we hold them.

Long-term mean reversion would act like a spring returning prices back to a trend line when they advance above that trend or fall below it. The strength of this spring is referred to as its "half-life", the time it would take to recover half of a loss or — often conveniently overlooked — how long it would take to lose half of a gain.

A Society of Actuaries report[6] from 2014 states:
"In a survey by Ivo Welch (UCLA and Yale) in 2000, only 36 of 102 surveyed financial economists said that they believed in long-term mean reversion for stock returns (17 had no opinion and 49 did not believe). "
Among those economists who believe mean-reversion exists, a common half-life is believed to be about 17 years. The longer the half-life, the weaker the effect.

This is an important question for investors because, if stock returns do mean-revert in the long run then stocks are a little less volatile on an annualized basis than a random walk would imply.

As retirees, we have to ask some follow-up questions beyond whether stock returns mean-revert. Does mean reversion equate to less risk? If we believe they do mean-revert, what impact would that process have on retirement plans? How would its impact compare to other factors of retirement planning? How should a retiree bet on mean reversion?

Let's look at the big question first. Do stock returns exhibit long-term mean reversion? Despite extensive research for decades, there is no consensus among economists.

Daniel Mayost of the Office of the Superintendent of Financial Institutions Canada wrote a nice review[1] of the seminal research on the topic in which he concludes,
"The claim that equity returns revert to the mean over the long term is not completely unfounded, and cannot be dismissed out of hand. However, there is at least as much evidence to refute this claim as there is to support it, and there is certainly no consensus answer within the economics profession."
Well said. So, a definite "maybe."

Despite the lack of consensus, many stock traders have developed strategies to attempt to profit from mean reversion of equity returns. Do the strategies work? They probably do, sometimes, if for no other reason than because nearly all strategies will work sometimes.

James Davis, VP of Research at Dimensional, studied the prospects for trading strategies and found that "Evidence of mean reversion is weak, and 780 simulated trading strategies show very limited evidence of reliably positive abnormal returns [profits]."[2]

If we assume that equity returns do mean-revert, how would that impact a retirement plan?

Many have the impression that the mean-reversion "spring" only pushes below-average returns back up toward the underlying average after a market decline. If you read my explanation above carefully, however, you will note that it would also push higher-than-average returns back down toward the average in the future.

That means that long-term mean-reversion might help or hurt retirement finances depending on initial conditions. When returns have been low for a long time, we would expect mean-reversion to slowly lift returns in the future back toward a growth trend line. But if they have been high for a long time, we should expect it to slowly push them lower toward that trend line. It would help when we're below the line and hurt when we're above it, keeping in mind that we don't really know where the line is or, more importantly, where it will be. (In the example below, the red line was added by the author.)

  Created at MacroTrends
Commenting on the CAPE 10 equity valuation measure's level of 34, Larry Swedroe recently wrote[3],
"The concern about future returns is justified by the fact that, while the academic research shows valuations are an extremely poor forecaster of stock returns in the short term, they are the best predictor of long-term returns. A CAPE 10 of 34 translates into a real-return forecast for U.S. stocks of just less than 3%. Add in 2 percentage points for expected inflation and you get a nominal return of about 5%, half the size of the historical return."
If the market is currently highly valued, as the CAPE 10 seems to suggest, mean-reversion implies that future returns are more likely to trend downward back to the mean. So, presently, mean reversion suggests less annualized uncertainty (risk) about an expected return that is likely to be smaller — less risk but a lower expected return. Mean-reversion isn't always a winner.

The popularity of the concept of stock risk declining with time grew with Jeremy Siegel's Stocks for the Long Run[4]. Siegel noted that over long periods of time, stocks do seem to be safer than a random walk would imply.

Economist, Zvi Bodie argues vehemently that stocks are risky no matter how long we hold them. He demonstrates with the following charts that the annual compound risk measured by variance of returns does, in fact, decline with time, as statistics predicts.


But Bodie argues that annual volatility is less a concern for retirees than the uncertainty of terminal portfolio values, which continues to increase with time.


Bodie further argues that if stocks become safer with longer holding times, then the cost of insuring against a loss should also decline. (Please see Dr. Bodie's further qualification in the first comment below.) We can insure against stock losses by purchasing a put option but puts become more expensive as their expiration date extends into the future, not cheaper.

(If you are unfamiliar with options, a put option, or "put", is a contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time frame. If you want to ensure that you will be able to sell a stock or index for at least some price in the future, for instance, you may be able to purchase a put to do just that. Be forewarned, however, that this insurance can be quite expensive. An excellent chapter on options can be found in Bodie and Merton's Financial Economics, 2e[8].)

Bodie and Siegel are brilliant economists and each score a point or two, but like the broader population of economists, they ultimately disagree. (Here is a transcript of a fun debate between Bodie and Siegel on the topic.[5])

You can also find papers that argue that one or the other's argument is flawed. These aren't arguments about the existence of mean reversion, however. They're arguments about the quality of the arguments about the existence of mean reversion in equity returns. You can chase the issue all over the Internet and you will always end up with "there is some evidence it exists." The problem is that we have too little historical data to argue with any certainty.

There is also a behavioral aspect that could affect retirement plans. Retirees who choose to believe that stocks get safer with holding time might choose a higher equity allocation with little actual evidence to support that decision.


Mean reversion and retirement plans — don't be so sure.
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Next, let's consider how mean reversion of equity prices might impact retirement plans compared to other factors of retirement planning.

Retirement plans entail massive uncertainty. The greatest risk is longevity, in that nearly everyone could fund a one-year retirement but far fewer of us could fund one of thirty-five years. I'd rank expense risk second, as a catastrophic expense would destroy most plans. Market returns are extremely unpredictable, as are interest rates but, of course, that's only important to retirees heavily dependent upon stock investments for retirement income.

The amount of retirement risk explained by long-term mean reversion would likely be quite small compared to these. I've read postings from other researchers who played around with mean reversion in their retirement models until they realized that any risk-reducing effects were swamped by the huge remaining retirement risks. That's one of the reasons I don't bother modeling long-term mean reversion — along with the fact that I don't know if it exists or how powerful it might be, so I'm not sure what I would model. (Regardless of what you've read, Monte Carlo models can be built with mean-reverting processes.)

My final question is "how should a retiree bet on mean reversion of equity prices?"

Mayost addresses this point for the bank when he states,
"Given the large reduction in segregated fund guarantee reserve and capital requirements that would result from assuming mean reversion in equity returns, it would not be prudent for OSFI to approve equity return models that are based on the assumption of mean reversion without strong evidence that mean reversion actually occurs in the market and is likely to continue in the future. The current state of research does not provide such evidence to a sufficiently high degree of certainty.
That's a long way of saying, "No one seems to know but it would be imprudent to bet that equity returns mean-revert without stronger evidence."

I believe retirement planners have little to gain by betting that mean reversion exists unless and until research resolves the issue. (The issue has been around for a long time and it could be a thousand years before we have enough data.) There is significantly more downside to incorrectly guessing there is less risk than there is to incorrectly guessing there is more risk.

To summarize for those of you planning retirement who aren't interested in reading dozens of papers on long-term mean reversion of equity prices that come to significantly different conclusions with no consensus, I suggest the following.

As DeNiro said in Donnie Brasco, "Fuggedaboutit."

Do stocks get safer the longer you own them? There is some evidence that they might and some evidence that they don't. Do you want to bet your retirement on that?

As a retirement planner, I care far less about whether or not equity returns may mean-revert over a couple of decades than I care about how mean reversion, whether or not it exists, might affect my retirement plan. In other words, is it something I need to worry about?

There is no consensus among economists regarding how powerful mean-reversion of equity returns might be or if it even exists.  The only thing you can know for sure is that whether you believe stocks mean-revert or not, there is a really good argument that you are wrong.

(Note the lack of consensus among economists compared to the number of retirees and advisors who claim to know with certainty that it does exist.)

The evidence supporting mean-reversion of equity prices is somewhat weak, as the mean-reversion force also appears to be.

It is debatable (literally[5]) whether mean-reverting equity prices would actually mean that stocks get safer with holding time. It depends on whether you define "safer" as less annualized portfolio volatility or as a narrower range of possible wealth-generation.

Whether or not stocks get a little safer on an annualized basis the longer you hold them is unlikely to have a large impact on your retirement plan. Your plan contains far more risk than mean-reversion would explain and those risks are where you should spend your planning time.

There are actually two larger issues here. First is how much of our planning efforts we should spend on factors that will probably have little impact on our retirement plans. And second, there is a real risk in feeling "certain" about assumptions that actually have limited supporting evidence.

The most important thing I have learned from two decades of studying retirement finance is how little I know for certain. Unfortunately, overconfidence extends to many retirement planning assumptions beyond the nature of mean reversion of equity returns.

I once had a conversation with a healthy 60-year old client about claiming Social Security benefits and he assured me with great confidence that he would never see age 80.



REFERENCES


[1] Evidence for Mean Reversion in Equity Prices, Mayost, D., 2012.



[2] Mean Reversion in the Dimensions of Expected Stock Returns, James Davis, Dimensional.



[3] Seeing Valuations Clearly, Larry Swedroe.



[4] Stocks for the Long Run, Jeremy Siegel.



[5] The Great Debate, Siegel and Bodie.



[6] Simulation of Long-Term Stock Returns: Fat-Tails and Mean Reversion, Rowland Davis.




[7] Are Stocks Really Less Volatile in the Long Run?, Pastor and Stambaugh. See also, video interview with Lubos Pastor.



[8] Financial Economics, Bodie and Merton.