Are You Playing Roulette with Your Retirement- Should you be playing Blackjack?

     Many investors nearing retirement are taking risks that they are unaware that they are taking.  I would like to share with you an analogy, that I will hope can make the concepts I am presenting easier to understand.  It is between 2 casino games Roulette and Blackjack.  The risks that some people are taking can be like playing Roulette.  In the game of Roulette, you make a bet on Red or Black.  If your color comes up you win, if it doesn’t you lose.  So, this is a game of chance.  There is nothing that you can do to increase your odds. Neither practice nor strategy will improve your odds of success.  You are just hoping it will all work out.  Hope and luck are your strategy.  In contrast to this, the game of Blackjack is a game of strategy and probabilities when played by experts.

     Let’s look at how Blackjack is played.  You are dealt 2 cards and so is the dealer.  One of the Dealers cards are face up, this give you an idea of what his next move might be.  Once it is the Dealer turn, he has to turn over cards until his score reaches 17 or more. So, you can use strategy and probabilities when taking your cards, based upon what you think the dealer might do next. By knowing these probabilities, you can increase your odds of success.  It doesn’t mean you will always be successful but being a knowledgeable/ skilled player will allow you to improve your chances at winning vs. Roulette. With practice and strategy, you can improve your odds of success.  How does this relate to investors nearing retirement?

     I believe that that the typical investor does not understand that their current investment strategy is based somewhat on hope. They hope that what they are doing will get them to the end.  The typical investor turns their money over to a financial person.  This person tells them they will build them a diversified portfolio based upon their risk tolerance using Modern Portfolio Theory. I will define this as a Strategic Portfolio for our conversation.  Another version of this is using a Target Date fund in your 401k.  Many investors use these funds and because it is considered the easy button (maybe your company defaulted you into it).  Why do I say these strategies are based on hope? 

     The reason these strategies are based upon hope is because what happens to in the first couple of years of your retirement will have the greatest impact if you are using a consistent distribution strategy.  To try to provide confidence to their clients, most financial advisors use planning software that incorporates Monte Carlo Theory.   What Monte Carlo Theory does is runs a bunch of scenarios and then gives you a probability of success.  Then advisor tells their client the probability success. They might say your odds of success are 92%.  The client goes away feeling pretty good, because they won’t be in the 8% of unsuccessful people.  If your portfolio takes large loses in the first years of retirement, you have a much greater chance of running out of money.  Let me show you a recent example of how this could have happened.

     Let’s look at 2 friends, one is going to retire on January 1, 1998 (Tom) and the other on January 1, 2000 (Jerry).  After meeting with their advisors, they determine they need to take 5% from their investments each year to live on.  They each have $1 million dollars in the year they start retirement.  So, 5% is $50,000 and to keep up with expected inflation they will increase their distributions by 3% per year.  With the great stock market in late 90’s, they decide to go with a 100% equity portfolio, invested in the S&P 500.  Let’s see how they do.

Tom

 

 

 

 

Jerry

 

Year

Return %

Withdrawal $

Ending Value $

 

Withdrawal $

Ending Value $

1997

 

Retires

1,000,000

 

Still working

 

1998

28.6

50,000

1,228,602

 

Still working

 

1999

21.0

51,500

1,429,841

 

Retires

1,000,000

2000

-9.1

53,045

1,249,971

 

50,000

862,121

2001

-11.9

54,636

1,047,901

 

51,500

709,218

2002

-22.1

56,275

765,230

 

53,045

504,329

2003

28.7

57,964

917,039

 

54,636

585,186

2004

10.9

59,703

952,451

 

56,275

588,182

2005

4.9

61,494

935,082

 

57,964

556,603

2006

15.8

63,339

1,013,911

 

59,703

579,606

2007

5.5

65,239

1,004,161

 

61,494

549,753

2008

-37.0

67,196

580,822

 

63,339

297,511

2009

26.5

69,212

650,908

 

65,239

297,422

2010

15.1

71,288

668,648

 

67,196

266,525

2011

2.1

73,427

609,759

 

69,212

203,336

2012

16.0

75,629

628,614

 

71,288

161,688

2013

32.4

77,898

743,821

 

73,427

130,715

2014

13.7

80,235

759,689

 

75,629

67,591

2015

1.4

82,642

686,988

 

67,591

0

2016

12.0

85,122

677,533

 

0

0

2017

21.8

87,675

729,250

 

0

0

2018

-4.4

90,306

613,701

 

0

0

Total

 

Withdrawals

 

 

Withdrawals

 

 

 

$1,433,824

 

 

$997,878

 

 

     Now that you have seen the numbers, I would like to point out a couple of things that I think are important.  Even though the both used the same investment over basically the same time period their results are very different.  If I had asked before I showed, you the chart above who would have a higher account balance Tom (made distributions of $1.4 million) or Jerry ($0.9 million).  I would think most people would say Jerry because Tom took out $400,000 more over that time period.  But not only does Tom have more money, Jerry ran out of money. How is that possible you may ask. It is the power of reverse compounding. 

You may say hold on, no one is going to invest 100% of their money is stocks if they are about to retire.  They would have a moderate portfolio instead.  A typical moderate portfolio might consist of 60% stocks 40% bonds.  So, let’s look at how a 60% S&P 500 40% Barclays Aggregate Bond Index portfolio performed over this period. 

Tom

 

 

 

 

Jerry

 

Year

Return

Withdrawal

Ending Value

 

Withdrawal

Ending Value

1997

 

Retires

1,000,000

 

Still working

 

1998

 

50,000

1,154,605

 

Still working

 

1999

 

51,500

1,238,172

 

Retires

1,000,000

2000

-1

53,045

1,173,480

 

50,000

940,683

2001

-3.7

54,636

1,075,285

 

51,500

854,265

2002

-9.8

56,275

915,382

 

53,045

719,184

2003

18.5

57,964

1,020,474

 

54,636

791,698

2004

8.3

59,703

1,042,109

 

56,275

797,966

2005

4.0

61,494

1,020,486

 

57,964

770,203

2006

11.1

63,339

1,066,452

 

59,703

792,287

2007

6.2

65,239

1,066,452

 

61,494

778,964

2008

-22.1

67,196

772,754

 

63,339

552,050

2009

18.4

69,212

836,472

 

65,239

579,670

2010

12.1

71,288

860,752

 

67,196

577,240

2011

4.7

73,427

826,709

 

69,212

534,174

2012

11.3

75,629

842,246

 

71,288

521,101

2013

17.6

77,898

906,339

 

73,427

533,622

2014

10.6

80,235

918,241

 

75,629

510,792

2015

1.3

82,642

847,116

 

77,898

439,193

2016

8.3

85,122

828,897

 

80,235

392,177

2017

14.2

87,675

853,531

 

82,642

360,100

2018

 

90,306

746,607

 

85,122

269,742

Total

 

Withdrawals

 

 

Withdrawals

 

 

 

$1,433,824

 

 

$1,255,843

 

  

     These results look much better.  The bonds really helped Tom and Jerry out.  Neither one of them have run out of money.  Tom ended up at $746,607 and Jerry is at $269,742.    So again, even thou Jerry took out about $200,000 less than Tom he significantly underperformed him.  Tom has almost $500,000 more.  Their success came down to did you turn 65 in 1998 or 2000.  This is where I came up with the analogy of Roulette.  You were born (spin the wheel) did retirement land on 1998 or 2000.  

     Back to traditional financial planning, 3 of these results would be considered a success, you made it thru retirement without running out of money!  This is what the simulation says happened if our 2 retirees could hang in during those periods without panicking.  Although, I wonder what Jerry’s emotional state was when in 2008 he was down over 40% from his original investment (60/40 portfolio). Also, what if we have a period like the 1970’s where you had stock market declines and rising rates.  How would that affect the results? 

     So, I hope I explained why I feel a lot of investors are playing Roulette with their investments.  Now let me talk about some alternative strategies that many investors may not be aware of.  These strategies I would define as Tactical investments.  A tactical strategy is one in which a portfolio manager is using some process that helps them determine when to take risk and when to reduce it or is using a strategy that hedges investment risk.  So back to my analogy, in Blackjack the player sees the dealer’s face up card.  He then uses strategy to determine if he wants to take more cards or not.  He also thinks about his odds to help him determine if it is a good time to place additional money at risk.  He doesn’t know what the outcome will be, but he uses probabilities to help him decide his next move.  The player is not always successful, but by using strategy, he is able to increase his odds of success.  I would like to relate this to tactical money management.  While each manger has their own process, they are looking at their past research and how they feel it aligns with current situation to help them determine their next move.  Should they buy more stocks or sell some.  Should they rotate to international vs domestic?  If their investments hit a trigger do they sell? Based upon their methodology they believe it will help them achieve a better result over time.  They are not trying to beat at index in any given year, they are trying to get the investor to their goal with less risk.  If you would like to read why risk management is important check out The Tale of Two Investors.

     There are many different types of tactical strategies.  Today, I just want to mention a few of them.  If you would like to discuss if these types of strategies might be beneficial for you, please feel free to contact my office.

     While there are many different types on Tactical strategies today, I want to share with you 5 different types.  My goal is to introduce these methodologies and to encourage you to learn more about them. These strategies are: 1. Hedged Equity 2. Trend Following, 3. Moving Average, 4. Rotational, 5. Seasonal.  To fully explain each of these strategies could be a blog post on their own.

Hedged Equity- Manager invests in Equities and then buys Puts on the portfolio to hedge the risk.

Trend Following- Often called Managed Futures.  The money manager has the ability to take positions in different securities that can make money if the markets are going up or down.

Moving Average- Managers will use different time periods but the 200 day is very common.  So, the manager averages the closing price over the last 200 days.  If the price of the security being tracked is above the average, they will stay invested.  If it falls below, they will sell their position.

Rotational- The manager will decide what time frame they will trade, monthly is very common.  They will also decide what basket of securities can be invested in.  So, each month they will decide which of those securities to hold for the next month.  They will then repeat the process again.

 

Seasonal- One of the most popular is Sell in May go away.  In this methodology, the manager will sell all of his stocks say April 30thand then buy them back on November 1st.

With each of these strategies different money managers will put their own twist on the concept.  As you review these concepts, I would encourage you to talk with someone that understands them.  You will find many “advisors” who don’t understand and will dismiss them, saying tactical doesn’t work.  One example of this is Sell in May Go Away.  Every time the market is positive in the summer the pundits come out and say see that strategy is not providing value.  From 1950-2017 the market was positive 60% of the time during the May 1- Oct 31 period.  So that is more than half of the time.  Sounds like the pundits are right.  Let’s did one step deeper, $10,000 invested during this period grew to $11,031.  What happened if you invested from November 1 – April 30th, an investment of $10,000 grew to $1,018,721.  The Dow was only positive 79% during this period.

     I am not giving anyone investment advice in reading this article.  The example above about seasonal investing is not a recommendation that you should invest this way.  You need to meet with a qualified financial advisor to access your own personal situation.  My goal in sharing this information with you was to hopefully expand how you view investing and to give you a reason to learn more.

 

This article is to illustrate some concepts to cause investors to speak with a financial professional to evaluate their strategy. It will hopefully give them some questions that they can discuss with this professional.  The writer understands that to fully explore this conversation would take a book or several books to cover ever topic or concept fully.  The information in this article is not to be considered investment advice.  This writer does not equate investing to gambling. The references to Casino games was to help the readers visualize the concepts the writer wanted to illustrate.