mardi 28 novembre 2017

Are Bonds more safe than Equity? - volatility vs return

One of the fallacies there's out there is that Bonds are less risk than equity. Well, the first though that come to mind is what risk? In a diversified portfolio, the "risk" is often define as the volatility of the asset. In that sense, yes, Bonds are less volatile than equity. But, this is not the end of the story.

Let's do a though experiment. Say a person where to invest 150,000$ at age 35 and invest say 5,000$ per year (adjusted for salary increase of 3%). What would be his starting Safe withdrawal at age 65 for it to last until age 105. The answer is it depends. 

Here's a summary table for this :

Metrics 100%/0% 90%/10% 80%/20% 70%/30% 60%/40% 50%/50%
SWR Rate 3,48% 3,62% 3,74% 3,85% 3,94% 3,93%
SWR Ruin 0,00% 0,00% 0,00% 0,00% 0,00% 0,00%
initial CF on 1,000,000$  $          34 800  $          36 200  $        37 400  $        38 500  $        39 400  $        39 300
Initial CF max  $        170 218  $        156 079  $     141 719  $     127 831  $     114 280  $        99 274
Initial CF 95 percentile  $        128 905  $        119 263  $     103 894  $        95 394  $        89 602  $        81 813
Initial CF 75 percentile  $          89 137  $          81 174  $        72 301  $        68 248  $        60 829  $        54 465
Initial CF avg  $          65 132  $          62 149  $        58 863  $        55 512  $        52 006  $        47 450
Initial CF 25 percentile  $          33 526  $          34 400  $        34 881  $        35 645  $        35 948  $        34 822
Initial CF 5 percentile  $          24 920  $          26 479  $        27 577  $        28 263  $        28 459  $        27 537
Initial CF min  $          20 550  $          21 648  $        22 481  $        23 084  $        23 380  $        22 897
Stdev of Initial CF  $          35 662  $          30 945  $        26 715  $        23 133  $        20 184  $        17 532
Avg CF  $        146 423  $        138 439  $     129 954  $     121 499  $     112 879  $     102 168

As you can see the safe withdrawal rate would be about 3.94% in a 60% equity/ 40% bond portfolio. The highest Rate in all portfolio. However, if we look at the actual amount that this means, its only 52,000$. It's about 13,000$, or 80%, of what a full equity portfolio would produce. 

I argue that while the volatility of the equity is greater, it doesn't mean much if you can actually have a much much higher retirement at the end of the day. 

Let's consider bad timing come up and we are in the worst historical time frame for retirement. That is start at 1929, age35 and retire at 1949, age 65. The 60% bond portfolio would have produce a 23,084$ vs a 20,550$ in a full equity portfolio. In other word, you effectively trading the risk of having a 88% lower pension for that on average you lose 80% of the pension.  I would say that this is a bad trade. Why in the world would you on average want to lose the 80%, to boost that worst case? 

Let's also remember that for that retiree, his fund would actually would have actually double in the next 3 years. I'll deal with this in a future article. 

And if we look at the other side of the risk, you trade a 127,831$ maximum for a 170,217$, or 75% loss. 

I argue that we must not be blindsighted by all the fear. Risk mitigation is a great tool; but we must focus on the actual goal and see what is the actual risk. 

mardi 7 novembre 2017

The raving mad market estimate - ways to denies its grasp

Typically, humans have short life spans. They are afraid much risk adverse due to their short time frame. For some reason they see their imminent death as the reason they should take on less risk.

I don't understand.

When you want to invest or want to withdraw you must get an estimate on the value of the asset you want to buy or sale. How can you tell?  When you plan your financial investing strategy, how do you budget the current and future value of your fund?

Say that you want to buy some blood in your local black-market. In the past, the cost of a cold pint of AB+ was just over 10 bucks. However currently, the black-market can only offer it to you for 20 bucks due to a shortage in Pakistan. Then a month later the pint is worth back 10 bucks.

We human have all seen it in the price of fruit, gas and pretty much everything. From a budgeting perspective, we simply average it out.  We set an average budget monthly for food and transportation.  This further average, the average cost by bringing diversification from the various food items (ie: yogurt, banana…) and transportation cost (ie: parking, car, train, bus…) However when we go to the market, we simply accept the price given and buy it if we need it. At best, we try to wait for a sale before we buy.

In the investing world, you can ask the market guy to give you the price of any security. That guy is so confident that he takes less than a micro second to give you the price. However, that guy is not like your local bar where beer price stays the same for years, but change its quote at each micro second. Truly, that market guy is a raving lunatique which can be quite scary.

Why not apply the same concept to your fund.

In the case of equity and fixed income, who set the price? The raving mad market set the price. It’s so efficient that at every single micro second it goes up and down by a few percent.

The raving mad market is a great tool to get the current price for you to buy and sale. Indeed, no one* will be willing to buy at a higher than the market price. If there was, he would lose money versus going to the market. That settle it then, when you want to know today(exact micro second) then go for Marked-to Market price. 

Do you fear Market plunge? Uncertainty of the market?

A not well known free strategy to implement is to use a Moving Average Value (MA) instead of Market Value(MV) to estimate the value of the portfolio.

More specifically I recommend to use a Moving Average that is the average of the last 5 years Market Value multiply by two times a conservative return for a simple investor. Here's some exemple of the math using 6.8% as a conservative return.

Year MV
2017   284 067  
2016   235 207  
2015   264 722  
2014   276 271  
2013   258 520  

The average at 2017 is 263,757 $ and the Moving Average is 300,848 $. The experience average return was 3.1%.

Year MV
2001   213 007,01  
2000   211 837,35  
1999   147 543,38  
1998   131 198,18  
1997   100 000,00  

The average at 2001 is 160,717$ and the Moving Average is 183,318$.  The experience average return was 21.9%.

As you can see the MA paint the reality a bit more rose in the first case (extra 17,000) and bleak the second case (less 30,000). This is great and exactly what you need to be more rational in making a long term decision. 

The moving average technique should please the risk adverse in you where ever you stand on the issue. From a full investment risk (100% Equity), you would feel a yearly variation of less than a very conservative portfolio (50% Corporate bond/50% T-Bills).

The main benefit is that it reduces your blood pressure (if you have any) you experience an economic crash. Instead of sensing your full investment risk fund sink by 37% as in the last 2008 crash, you will feel only a  2% drop. That's huge. Even using a 50% T-Bills / 50% US Equity, you would still have sense a lower volatility compare to a marked-to-market metric.

The main negative is that if use alone as a single metric, it hides the current state of affairs. If your objective is to take a small portion of the fund each year (less than 25%) than using a smoothing metric makes sense. If you want to buy a boat with it, then perhaps consider using the current fund value. 

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