Friday, December 31, 2021

Short Takes: The Party in Stocks, Guessing a Person’s Salary, and more

A friend was asking for some financial advice.  It involved what to do with the proceeds of selling a rental property.  It turns out his sister’s financial guy made her a lot of money lately.  I tried to explain that she made money because the stock market went up.  A financial guy can help you find an appropriate mix of stocks, bonds, and cash, but whether you make or lose money in the short term has nothing to do with the financial guy.  

People always look skeptical at this point.  They seem to firmly believe that whether or not their investments do well is 100% attributable to the “moves” their financial guy makes.  I always lose credibility by saying something that is true but the opposite of what is widely believed.  Such is life.

Here are my posts for the past two weeks:

Behavioural Issues with Variable Asset Allocation

The Boomers Retire

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand says investors are dancing like it’s 2007.

Big Cajun Man shows how you can determine someone’s income if they reveal when during the year CPP stopped coming off their pay.

Ellen Roseman
interviews Dan Bortolotti, a.k.a. Canadian Couch Potato, on the Moneysaver podcast.  They discuss index investing with ETFs and robo-advisors and Dan’s new book Reboot Your Portfolio.

Andrew Hallam
tells an interesting story about people making the mistake of trading life satisfaction for more money.  It’s worth reflecting on whether we’re doing the same thing.

Thursday, December 30, 2021

The Boomers Retire

It’s no secret that the interests of financial advisors and their clients are not well aligned.  Even financial advisors who mean well can believe that a choice is best for the client when it’s really best for the advisor.  That’s the nature of conflicts of interest.  These conflicts will shape how advisors use the book The Boomers Retire: A Guide for Financial Advisors and Their Clients, whose fifth edition was written by Alexandra Macqueen and David Field.  Lynn Biscott wrote the earlier editions.

Throughout my review of this book, I will sometimes be commenting on the substance of its contents and sometimes on how financial advisors might use or misuse the contents, which is arguably not the fault of the authors.

The book covers a wide range of important topics that financial advisors should understand, including government benefits, employer savings plans, personal savings, investing, tax planning, where to live in retirement, insurance, and estate planning.  Here I discuss a few of the subject areas that stood out for me.

Life Expectancy

A big challenge with managing money through retirement is not knowing how long you’ll live.  I sometimes hear people talk about planning for a retirement that will end in their early 80s.  There are two problems with this.  One is that it is based on life expectancy from birth.  If you make it to age 60 or 65, your median life expectancy is longer than it was when you were born.  The second is that it makes little sense to make a plan with a 50% chance of failure.

The authors address these problems sensibly.  FP Canada standards “recommend that planners project life expectancy to the 25th percentile,” which is 94 for men and 96 for women when starting anywhere from age 55 to 70.  “For some clients, who are longevity-risk averse, a 25 percent probability will not be sufficient and advisors will want to plan to the more conservative 10 percent probability.”  This adds about 4 years to the planned retirement length.

When to take CPP

Canadians can start collecting CPP anywhere between age 60 and 70, with 65 considered the “standard” starting age.  Starting CPP at 60 reduces benefits by 36%, and starting at 70 increases benefits by 42%.  These percentages are higher when the average industrial wage grows faster than inflation, as it has done on average.  The 36% reduction might be somewhat smaller if there are non-contributing years between age 60 and 65.

These decreases or increases in CPP benefits are permanent.  Consider twin sisters, Anna and Brie with identical CPP contribution histories.  Anna takes CPP at 60 and Brie waits until she’s 70.  Anna receives CPP payments for 10 years that Brie doesn’t get, but from age 70 for as long as they live, Brie’s monthly benefits will be 2 to 2.5 times those of Anna.

There are many factors to take into account in choosing when to start collecting CPP.  However, if we consider only an advisor’s financial interests, the decision is easy.  If the client takes CPP at 60, she will spend less of her savings, leaving more assets under management to generate income for the advisor.  With this in mind, let’s look at the authors’ list of “factors” to consider in the timing of CPP benefits.

“If the client receives the retirement benefit at an early age, does that reduce or eliminate the need to draw on investments to cover expenses?”  It’s important not to spend your savings down to zero leaving no margin for error, but as written, this question makes it seem like preserving all savings is vital.  There’s nothing wrong with spending down savings somewhat in anticipation of larger CPP benefits in a few years.  Focusing too much on preserving savings serves the advisor’s interests more than the client's.

“Many people believe that it’s best to take the benefit as soon as possible so as not to miss out should they die prematurely.  This approach has some merit for couples where each spouse is entitled to CPP/QPP is his or her own right [because CPP survivor benefits may be modest].”  It’s true that many people think this way, but the truth is that most people will ultimately get more from CPP if they wait to start.  Income for a surviving spouse is a consideration, but the advisor’s job is to work out what’s best for the client even when it goes counter to the client's emotional preference.

“If the client stops working at 60, but waits until 65 to apply for the benefit, … her record will show five years of zero contributions — which may reduce her entitlement when the retirement benefit is calculated.”  This is true, but the effect is often small enough that it’s still best for the client to delay CPP.

Among the techniques listed to smooth income over time and reduce “clawbacks and higher taxes rates” are “Taking CPP/QPP and OAS as early as possible,” and “Starting RRSP withdrawals earlier than required.”  In most cases, RRSP/RRIF withdrawals can be used to hit any desired level of taxable income.  Wealthy clients without RRSP savings could realize capital gains to hit an income target.  Needing to use CPP and OAS to increase income in a client's 60s appears to be rare.

All the information the authors provide about CPP would be useful to an advisor planning to do all the calculations necessary to determine what’s in the client’s best interests.  However, there is no direct guidance for doing these calculations.  This part of the book is more directly useful as a playbook for self-interested advisors to encourage their clients to take CPP early.

Pension or Commuted Value

When leaving a job with a pension plan, a big decision is whether to take the eventual monthly pension or take the commuted value of the pension to invest in a Locked-in Retirement Account (LIRA).  This is another example of a choice where advisor and client interests are not aligned; the advisor has nothing to manage if the client doesn’t take the commuted value.

In this case the authors do a good job explaining the considerations that go into making this choice.  I’ve seen too many cases where people (helped by an advisor) took commuted values when they shouldn’t have.  However, advisors not blinded by self interest could use the authors’ advice to come to a sensible decision for their clients.

Rolling RRSPs into RRIFs

Clients need to “make a new beneficiary designation when they roll an RRSP into a RRIF.”  “The designation that was made on the RRSP does not automatically carry over to the RRIF.”  That’s definitely something I could miss.  We’ll see if the calendar reminder I set will still be there that far into the future.

“Originally, financial planners were taught that the best approach to drawing funds from a RRIF was to wait until” age 71 to maximize “tax-deferred accumulation of funds.”  “The problem with this approach is that it sometimes results in a low taxable income between retirement and age 71, followed by required RRIF withdrawals that are higher than the client needs.”  The client may end up “in a higher tax bracket” and “may be subject to clawback of their OAS benefits (including GIS) and their age credit.”

“Today, most astute planners would agree that a more sensible approach is to create a level stream of income, including both registered and non-registered sources, throughout the retirement period.”  This is consistent with various retirement simulations I’ve done.

“To take advantage of the [$2000] pension income tax credit at age 65,” a client could “transfer at least a portion of his or her RRSP into a RRIF or annuity at that age.”  This makes sense, particularly if you’ve already decided to start drawing from RRSPs.

Annuities

A big problem with common annuities is that their payments aren’t indexed to inflation.  I’m not aware of any insurance company in Canada that sells CPI-indexed annuities.  It seems the best you can do is add a fixed percentage annual increase to annuity payments, such as 2%.  However, the authors dismiss such increases as “costly as it increases the purchase price of the annuity.”

In a later section on choosing an annuity or a RRIF, inflation isn’t mentioned as a factor to consider.  Few people, including both clients and advisors, seem to understand the devastating effect decades of inflation can have on a retiree's income.  Even seemingly low inflation builds up significantly over time.  Clients considering fixed annuity payments seem unable to understand how much their buying power will erode after a decade or two have passed.

Reverse Mortgages

In an otherwise thorough discussion of reverse mortgages, not mentioned is a common clause that retirees must properly maintain their homes.  It’s common for people who’ve always kept nice homes to become old and unable to maintain their homes to a reasonable standard.  They stop caring about a broken deck, squirrels in the attic, or cat pee on the basement floor.  A motivated lender could use this clause to force such people out of a home when the reverse mortgage is no longer profitable for the lender.

Index Investing

It was good to see low-cost passive investing mentioned among more questionable investment choices such as segregated funds, guaranteed minimum withdrawal benefits, index-linked GICS, and principal protected notes.  As for mutual funds, according to Morningstar, in 2019 “the asset-weighted median expense ratio of equity funds in Canada is 2.28 percent, while the fixed-income funds come in at 1.49 percent.”  It would have been nice to see these costs illustrated with their effects over 25 years, 43% for equity funds and 31% for fixed-income, but at least these high costs were mentioned.  Index (passive) investing cuts these costs considerably.

RRSP vs. TFSA

At one point the authors describe TFSAs as “an even better shelter than registered savings, which are only tax-deferred.”  Some readers may take this to be true in general (it isn’t); it only sort of makes sense in the context where the comment appeared.  The context is the strategy of smoothing income in retirement by drawing down RRSPs before age 71.  If the withdrawals aren’t needed to live on, moving them to a TFSA has tax advantages.

In general, if your marginal tax rate (adjusted for relevant clawbacks) is the same when you contribute to an RRSP as when you withdraw, then RRSPs and TFSAs shelter you from taxes equally.  In the context of the strategy the authors were describing, a client would be changing the timing of RRSP/RRIF withdrawals to get a lower marginal tax rate.  The fact that a TFSA is involved in this strategy doesn’t somehow make TFSAs better than RRSPs.

Medical Expenses

“To maximize the benefit of the [medical expenses] tax credit, the lower-income spouse or partner should consider claiming the expenses for both.”  I ran into a case where this advice isn’t right.  If the lower-income spouse’s income is too low, it might be better for the higher-income spouse to make the claim.

Low Income Retirees

“Many Canadians will have modest incomes in retirement, but retirement planning advice often focuses on people with higher incomes.”  Very true.  It’s good to see a section on lower income retirees in a book aimed at financial advisors.

“Advice targeted at higher-income Canadians can be unsuitable for people retiring with lower incomes, because following it can lead to low-income retirees paying more tax in retirement or receiving smaller benefits from government programs.”  The existence of the GIS and other income-tested benefits causes low income retirees to have very high “marginal effective tax rates,” which changes what strategies they should follow.

Where to Live

The chapter on where to live in retirement is excellent.  It covers country property, seniors communities, snowbirds, moving to another country, foreign income taxes, retirement homes, and long-term care.  I found the extensive checklists for buying new or used condos valuable.

I have power of attorney documents set up, but something I’ve never thought about is that “Power of attorney documents should also be created in any place where you will be spending a lot of time.”  My POAs may not work well outside of Canada.

Insurance

The chapter on insurance paints a picture of critical illness insurance and long-term care insurance as necessary for most retirees.  I would have thought Canada’s health care system would make these forms of insurance less important once you’re not protecting an income, but I don’t claim to have much expertise in this area.

On the subject of dental insurance, the authors make the sensible point that “the amount of coverage is rarely more than the cost of the insurance.  With the low amount of reimbursement, it can barely be considered insurance, and functions more like a ‘cost-smoothing’ mechanism.”  “A retiree is often better off opting out of dental insurance entirely.”

Some good advice on travel insurance: “When evaluating travel insurance providers, plans that pay for medical care directly instead of reimbursement for expenses is best.  It is also important to understand what the insurance company’s claim service is like.  Some provide an international number to call and then they take over.  Not all insurance providers will give that level of service.”  “The cost of travel insurance may be claimed as an eligible medical expense on your yearly tax return.”

The authors offer some reasons why a retired couple would need permanent life insurance, including “lost ability to income split,” and “any reduced benefit from the Canada Pension Plan.”  The fate of a surviving spouse is important to consider.  Not mentioned is the need for detailed calculation.  To start with, a single retiree eats less food, buys less clothing, and spends less than a couple in other ways.  So, it’s important to estimate the reduction in cash flow required by a single retiree compared to a couple.  Then comes calculating how after-tax income would drop if one spouse passed away at various ages.  Only then do we see if any life insurance is needed.  It could be that none is needed, or possibly just term life insurance for a decade.  Without performing these calculations, the image of a lonely retiree losing a spouse and struggling with money becomes just a way to sell expensive life insurance.

Estate Planning

I found the estate planning chapter to be a helpful overview.  An interesting problem I’ve seen multiple times is that “Some financial institutions incorrectly insist that their own form be used to convey POAs.  Clients should think carefully before they sign these forms.  Doing so could cause a previously drafted POA to be revoked.”

“One way for clients to [reduce probate fees] is to gift assets while they are still living.  Many retirees choose to help family members in this way, so that they have the pleasure of seeing their gift put to good use and benefiting others.”  This is what I plan to do.

Conclusion

This book addresses the many complex issues where clients need help from their advisors.  In general, the relevant factors in making these decisions are discussed.  However, advisors seeking to serve their clients’ best interests will need other resources for how to go about performing the necessary calculations to make these decisions.  Advisors blind to their own self interest will find that deciding these matters in their own favour requires few calculations, and they won’t need additional resources beyond pulling quotes selectively from the book.  The authors can’t be blamed if their book is misused in this way; after all, any tool can be used for good or bad purposes.  However, I would like to have seen parts of the book explore how to do the calculations behind making an important decision.

Monday, December 20, 2021

Behavioural Issues with Variable Asset Allocation

I recently adopted a specific type of dynamic asset allocation for my personal portfolio.  I call it Variable Asset Allocation (VAA).  It only deviates from my original long-term plan when the world’s stocks become pricey, but any time you change your long-term investing plan, there’s the possibility you’re just looking for a smart-sounding justification for giving  in to your emotions.

It’s certainly true that I’ve been concerned for some time that stock prices are high and that the chances of a stock market crash have been rising.  But I know better than to join the chorus of talking heads predicting the imminent implosion of the stock market.  I don’t know what will happen to stock prices in the future.

I’m not tempted to just sell everything and wait for the crash.  It’s possible that stocks will keep rising, and when they finally do decline, it’s possible they’ll remain above today’s prices.  It must be sickening to wait for a crash that doesn’t happen.  This would have been the fate of someone who decided 5 years ago that prices were too high and sold out.

Whenever an investor sells completely out of stocks, the problem is when to get back in.  Sometimes, it’s a significant market decline that causes investors to sell all their stocks in fear.  Then they have to decide when it feels safe enough to buy back in.  Too often, they wait until prices are much higher than when they sold.  The same thing can happen to those who sell because they think stock prices are too high.  They can sit in cash waiting for the big crash that never comes.

So, could some form of this happen to me with my VAA?  The answer is no, but only if I follow VAA strictly.  With VAA, if my portfolio’s blended Cyclically-Adjusted Price-Earnings (CAPE) ratio exceeds 25, I add CAPE minus 25 (as a percentage) to my bond allocation.  For example, when the blended CAPE of my portfolio sits at 32, I add 32-25=7 percentage points to the bond allocation I would have had if the CAPE were below 25.

If stock prices rise, the CAPE rises, and if my bond allocation rises enough to trip my rebalancing threshold, I rebalance from stocks to bonds.  However, given that I’ve chosen to adopt VAA, selling stocks is easy because that’s what my emotions are already telling me to do.

What if stock prices go down by just enough to trip my rebalancing threshold?  VAA would have me buy back some stocks.  But what if I’m still nervous about owning too many stocks?  I might delay rebalancing, or worse, I might tinker with my VAA rules so that I don’t have to buy stocks.  This is the danger of constantly tinkering with long-term plans.  Even if each change has a smart-sounding reason, I might really be just giving in to emotions.

So, the real test of whether my switch to VAA is a fixed long-term plan will come if stock prices drop enough that my spreadsheet calls for rebalancing from bonds back to stocks.  I admit that when this happens, I likely won’t feel good about buying stocks, but my intention is to obey the spreadsheet.

Friday, December 17, 2021

Short Takes: Dynamic Asset Allocation, Canadian Bank Profits, and more

My post describing my plan to shift slowly out of stocks as the CAPE exceeds 25 drew some good comments.  Only one comment indicated a lack of interest in such a plan, but I suspect the majority of readers with indexed portfolios intend to stick with a fixed asset allocation that doesn’t take into account the CAPE.  For these investors, I wonder if they would keep owning the same percentage of stocks even if the CAPE doubles from its current level into the range of Japanese stocks before 1990.  If there is some stock price level at which you’d take some money “off the table”, then the difference between your plan and mine is that I start shifting slowly out of stocks at a CAPE of 25, and your threshold is higher.

I wrote one post in the past two weeks:

What to Do About Crazy Stock Valuations

Here are some short takes and some weekend reading:

Mikhail Samonov
explains why trying to use Shiller’s CAPE ratio to make hard switches between stocks and bonds is likely to fail.  Some form of dynamic asset allocation that makes gradual shifts between stocks and bonds is more likely to give satisfactory results.  My Variable Asset Allocation (VAA) approach is one I designed to try to reduce risk in expensive markets.

Steadyhand keeps tabs on Canadian bank profits.  “Nowhere in the world do banks earn this level of profit from their individual customers.”

Justin Bender brings us part two of his series on asset location strategies.  He explains the strategy he has named “Ludicrous”.  Any DIY investor who truly understands portfolio taxes and how they affect portfolio risk would never use this strategy.  It is based on the idea of maximizing your expected portfolio gains subject to the constraint of a particular before-tax asset allocation (BTAA).  However, it is your after-tax asset allocation (ATAA) that determines your expected returns and portfolio risk.  By following the Ludicrous strategy, you’re taking on more risk than you realize if you’re focusing on your BTAA, and you have all your low-return bonds in a tax-advantaged account.  This may be sensible for an advisor who wants to create riskier portfolios than the client realizes, but makes no sense for DIY investors.  I understand that there are also regulatory reasons why advisors are constrained to focus on BTAA, even though it is the ATAA that will determine the client’s financial fate.

Monday, December 13, 2021

What to Do About Crazy Stock Valuations

The last time I had to put a lot of effort into thinking about my finances was back when I retired in mid-2017.  I had ideas of how to manage my money after retirement, but it wasn’t until a couple of years had gone by that I felt confident that my long-term plans would work for me.  I had my portfolio on autopilot, and my investing spreadsheet would email me if I needed to take some action.

I was fortunate that I happened to retire into a huge bull market.  I got the upside of sequence-of-returns risk.  The downside risk is that stocks will plummet during your early retirement years, and your regular spending will dig deep into your portfolio.  Happily for me, I got the opposite result.  My family’s spending barely made a dent in the relentless rise of the stock market.

However, stock prices have become crazy, particularly in the U.S.  One measure of stock priciness is Robert Shiller’s Cyclically Adjusted Price-Earnings (CAPE) ratio.  In the U.S., the CAPE ratio is now just under 40.  The only other time it was this high in the last 150 years was during the dot-com boom in the late 1990s and early 2000s.  Just before the 1929 Black Tuesday stock market crash, the CAPE was only about 30.

Outside the U.S., prices aren’t as high, but they are still elevated.  My stock portfolio's blended CAPE is a little under 32 as I write this article.  Even if stock prices were cut in half, this would just bring the CAPE close to the average level over the past century.  To say that these thoughts made me think hard about whether I should change how I manage my portfolio is an understatement.

A change in thinking about high stock prices

For a long time, my thinking was to ignore inflated stock prices and just rebalance my portfolio as necessary to maintain my chosen asset allocation percentages.  I have a planned “glidepath” for my stock/bond mix that has me about 20% in bonds at my current age and increasing as I get older.  My bond allocation consists of cash and short-term bonds, and the rest is spread among the world’s stock indexes.  I saw no reason to change my plan as my portfolio grew.

Then a question changed my thinking.  If the CAPE rises to 50, or 75, or even 100, would I still want such a high stock allocation?  It’s not that I expect the U.S. or much of the rest of the world’s stocks to become as overvalued as Japanese stocks in 1990, but I should be prepared for how I’d respond if they do.

At a CAPE of 50, I wouldn’t want more than about half my money in stocks, and at 100, I wouldn’t want much in stocks at all.  So, even though I’m comfortable with 80% stocks at a blended CAPE of 32, something would have to change if the CAPE were to rise from 32 towards 50.

A first attempt

Once I realized I definitely would reduce my stock allocation in the face of ridiculously inflated markets, I had to work out the details.  I started with some rules.  First, I don’t want any sudden selloffs.  For example, I don’t want to hold a large stock allocation all the way up to a blended CAPE of 39.9 and suddenly sell them all if the CAPE hits 40.  A second rule was that I don’t want any CAPE-based adjustment to apply unless the CAPE is above some threshold level.

As the CAPE kept climbing, I felt some urgency to choose a plan.  My first attempt was to change nothing if the CAPE is under 30, and when it’s above 30, I multiplied my bond allocation by the CAPE value and divided by 30.  I implemented this idea in my portfolio as an interim plan before I analyzed it fully.

Another adjustment I made a little earlier was to reduce my expectation for future stock returns.  When the current CAPE is above 20, I now assume the CAPE will drop to 20 by the end of my life.  This doesn’t directly affect my portfolio’s asset allocation, but it reduces the percentage of my portfolio I can spend each year during retirement.  When stocks rise and the CAPE rises, my portfolio grows, and this increases how much I can spend.  But then this new rule reduces my assumed future stock returns, and reduces my safe spending percentage somewhat.  Increasing stock prices still allow me to spend more, but this rule slows down the increase in my spending.

A new simpler rule for adjusting my stock allocation based on high CAPE values

I’m still happy with the way I’ve adjusted my expectation for future stock returns when the CAPE is high, but I’ve changed the way I adjust my bond allocation to the CAPE.  I now have a simpler rule I named Variable Asset Allocation (VAA) that better matches my thinking about what I’d want if the CAPE got to 50 or 100.

VAA: If the CAPE is above 25, I add CAPE minus 25 (taken as a percentage) to my age-based bond allocation.  

For example, without VAA my current bond allocation based on my age is about 20%.  The current blended CAPE of my portfolio is about 32, so I add 32–25=7% to my bond allocation.  So, I’m currently 27% in bonds and 73% in stocks.

This might not seem like much of a bond allocation adjustment in percentage terms, but it’s a bigger adjustment in dollar terms.  Consider the following example.  Suppose a $500,000 portfolio with a 20% bond allocation sees a jump in the CAPE from 25 to 32.  This is a 28% increase in stock prices.  So, we started with $100,000 in bonds and $400,000 in stocks, and the stocks jumped in value to $512,000 for a total portfolio size of $612,000.  When we adjust the bond allocation to 27% in accordance with VAA, we have $165,000 in bonds and $447,000 in stocks.  Of the $112,000 jump in stock value, we shifted $65,000 over to bonds, and left only $47,000 of it in stocks.  Although the bond allocation went from 20% to 27%, a 35% increase, the dollar amount in bonds rose 65%.  This is a substantial shift, and it leaves a healthy bond buffer if stock prices subsequently crash.

Some analysis

One concern I had with adjusting my asset allocation based on the priciness of stocks is whether it produces reasonable stock and bond allocations across a range of CAPE values.  By design, VAA matches my intuition about bond allocations at different CAPE levels.  If the CAPE gets to 50 sometime soon, my bond allocation would go to 20+(50–25)=45%, which seems reasonable.  At a CAPE of 75, my bond allocation would be 70%, which also seems reasonable.  It’s possible that something about the world might change that makes high CAPE values seem sensible and that I’d want to own more stocks, but for now I’m happy to shift automatically away from stocks as the CAPE rises through crazy levels.

The following chart shows how a hypothetical portfolio using VAA responds to the CAPE rising from 25 all the way to 105.  We begin with $100,000 in bonds and $400,000 in stocks with the CAPE at 25.  The curves look smooth, but there are 27 rebalancing operations as the CAPE rises from 25 to 105.  Initially, as stock prices and the CAPE rise, we shift most of the stock gains to bonds.  As the CAPE gets into the low 40s, all stock gains are shifted to bonds, and as the CAPE exceeds 45, VAA shifts all the stock gains and more into bonds.


It’s not until the CAPE reaches about 60 that the dollar amount in stocks dips below the initial $400,000.  However, the dollar amount in bonds doubles by the time the CAPE reaches 35, and doubles again with the CAPE in the low 50s.  The idea of VAA is to take the huge stock gains that come with a rising CAPE and preserve them in safe bonds.  Why keep playing the risk game when you’ve already won?

Observe that if we had invested the whole $500,000 in stocks and the CAPE had risen from 25 to 105, we’d have $2.1 million instead of only $1.04 million with VAA.  So why bother with VAA?  The answer is that the CAPE almost certainly isn’t going to 105.  The higher it gets, the more likely stocks are to crash.

If stocks are going to crash, why not shift everything into bonds instead of messing about with VAA?  Stocks are certain to fluctuate, but we don’t know if or when they’ll have a big crash.  I have no interest in making a high-conviction bet about the stock market.  The idea of VAA is to capture some upside if stocks keep rising, and limit the damage if stocks crash.

The following chart shows the amount of stock gains we’d preserve if stocks start at a CAPE of 25 and later crash back to a CAPE of 25 after a period of rising.  We give three scenarios: VAA, maintaining an 80/20 stock/bond allocation, and 100% stocks.  As we see from the chart, if the CAPE gets to 45 before crashing back to 25, an all-stock portfolio preserves none of the stock gains, an 80/20 portfolio preserves $17,000, and VAA preserves $265,000.  VAA is the clear winner if stock prices to decline enough to bring the CAPE back to historical levels at some point.


So far we’ve been talking about CAPE movements resulting from changes in stock prices.  Another way for the CAPE to move is from changes in corporate earnings, the denominator in a P/E ratio.  The chart above shows VAA’s margin of victory over other strategies when corporate earnings remain constant.  If the decline in the CAPE that brings it back to 25 is partially due to rising corporate earnings, then VAA’s margin of victory would be smaller.  However, VAA shines in any scenario with a significant drop in stock prices.

Rebalancing frequency

Another potential concern is whether I’d ever be rebalancing too often.  For example, could a very small change in stock prices trip a rebalancing trigger?  The short answer is no.  To protect me from trading too often, I have set my rebalancing thresholds such that the profits arising from rebalancing once in each direction are 20 times the trading costs in commissions and spreads.  Determining these thresholds requires some calculations that I have implemented in a spreadsheet.  For details, see the newly added section 8 of my paper Portfolio Rebalancing Strategy.

The main way I could end up trading too often is if there are anomalies with computing the CAPE that lead to its calculated value jumping up and down by enough to trigger spurious rebalancing.  I plan to protect against this by waiting until I see it happen and use my judgment in not rebalancing back-and-forth too often.

If my spreadsheet emails me with instructions to rebalance from bonds to stocks one week, and from stocks to bonds the next week, I can examine whether stock prices have really moved enough to justify rebalancing.  If not, I might suspect that the trigger for rebalancing is jitter in the calculated CAPE.  So far I’ve seen no indication of this problem.

Conclusion

I’m hopeful that I’ve chosen ways to respond to extreme CAPE levels that are measured, reasonable, and won’t need to be changed in the future.  Most importantly, I’ve implemented these plans in an emotionless spreadsheet that does all the work for me while I get distracted by more interesting pursuits than portfolio watching.

Friday, December 3, 2021

Short Takes: Safe Retirement Income, Buying Less Stuff, and more

BMO has expanded its marketing to me.  It used to just alternate between low-interest credit card balance transfer offers and offers to give me a few thousand dollars if I deposit a few million dollars in my account.  They seemed to figure out that I’m between those two extremes.  Now they want me to come in for a personalized financial plan because “Research shows that advised households accumulate 2.31 times more assets after 15 years!”  Of course, this research is deeply flawed.  Further, I’m not interested in their ridiculously overpriced mutual funds.

I wrote one post in the past two weeks:

A Conversation about Wealth Inequality

Here are some short takes and some weekend reading:


Morningstar Research
says the 4% rule is now more like a 3.3% rule, but that we can spend more safely if we’re flexible about adapting to market returns.  One part of the report that I disagree with is too much reliance on spending less as you age.  It’s true that you’ll probably naturally want to spend less when you’re 85 than when you’re 65.  However, it doesn’t make sense to plan for reduced real spending at too young an age.

Andrew Hallam makes a strong case for becoming happier by buying less stuff.

Justin Bender explains some key concepts about asset location strategies in both text and video.

Doug Hoyes
explains how debt settlement firms exploit people who need to file a consumer proposal.