An alternative to the dynamic lifecycle strategy

Larry McDonald commented on a paper called Dynamic Lifecycle Strategies for Target Date Retirement Funds, and of course Michael James hit the nail on the head with his response: if you guess too high on the expected market return, you will stay 100% in stocks until retirement, which is unwise.

A more sensible approach occurred to me while reading the paper. Suppose you are invested in a traditional Lifecycle fund, and then suddenly, the market takes a nosedive. You should move your money into another Lifecycle fund that is aimed at the target date at which you could expect to retire considering the market losses.

To explain what I mean, consider someone with $1 million invested, who wants $2 million in order to retire. Suppose they're in a lifecycle fund that unwinds linearly over 20 years, going from 100% stocks (at say 10% nominal return) to 100% fixed-income (at say 4% return). Suppose that he is contributing $20k per year. This person could expect to reach his $2M goal in 12 years.

Now, suppose the market crashes, losing half its value. Since our investor's target date was 12 years away, he was still 60% in stocks, so his portfolio is now worth $700k.

Going on the same assumptions as before, he would simply move his money into a fund with a 17-year target date. This move has the effect of increasing his stock exposure from 60% to 85%, which is almost as aggressive as the dynamic lifecycle strategy. If the market recovers, he can move his money back where it was.

This approach is much less sensitive to errors in the expected rate of return. If you overestimate returns by 1%, this scheme may have you making minor adjustments to your portfolio every so often as you find your actual returns diverging from your plan. In contrast, the dynamic lifecycle approach would have you 100% in stocks until the day you retire, which is clearly unwise.

It also seems more realistic to admit that your target retirement date has been impacted by the market crash and to adjust your plans accordingly, rather than try to go double-or-nothing with the market and risk your retirement entirely.

The statistical analysis of this strategy is left as an exercise for the reader.

Magnitude of Credit Default Swaps

Imagine being able to turn a single dollar into $7 million. If you handle it wisely, you could retire and live very comfortably indefinitely. $7 million represents more than a lifetime of earnings for most people.

Now, imagine turning each of those 7 million dollars into $7 million. That's a mindboggling amount of money, but it would still be less than the amount of money involved in credit default swaps.

Mutual funds: "manager risk"

A recent Motley Fool article on picking mutual funds highlighted the importance of researching the fund manager. My reaction is simply this: it is a systemic flaw of mutual funds that their performance depends so much on the skill and temperament of the individuals running them.

"Manager risk" can outweigh all other risks when picking mutual funds. If you're lucky, you get Peter Lynch; if you're not lucky, you get his successors, your funds go sideways for two decades, and you lose 10% of your assets in fees for the privilege.

Bottom-up asset allocation

Over at Thicken My Wallet is an article on The Role of Cash in Your Portfolio. There, he gives an opinion how much cash is the right amount. It's decent advice, but it contains some numbers that seem rather arbitrary, as does all advice I've seen in this area.

My approach is different. I don't start from the top with a target percentage; I derive that percentage from my financial situation.

My allocation is based on two rules:

1. Never be forced to sell stocks. I want to sell them at a time of my choosing, when the market value is fair.

2. Strive for the highest possible return, subject to rule #1.

To handle #1, we keep our expenses down below our income, we have an emergency fund amounting to several months' expenses, and we have other savings accounts for anticipated expenses such as our next car. This puts us in a position where we'll only be selling stocks under extreme circumstances where getting the best value for our stocks will no longer be our highest priority.

Then, rule #2 amounts to investing the rest in a diversified portfolio of stocks. It also includes a small amount of bonds and cash to allow for rebalancing, since it has been shown that a portfolio with rebalancing can outperform every one of the individual assets in that portfolio. Paradoxically, adding some bonds and cash into your portfolio can help it outperform a portfolio of pure stocks over the long term.

I'm aware that maximizing returns, in theory, requires leverage. Personally, I abhor paying interest on debt, and I don't like the additional risk, so I'm not leveraged. I'll just have to live with the returns I can get from my own money in the stock market.

Rebalancing with a vengeance

Michael James asks, Do You Have the Nerve to Rebalance Right Now? My answer is a resounding "yes!"

At the start of this year, I calculated that we had a 57:43 split between stocks and bonds+cash, which I considered to be too conservative for us. However, the market being what it was back then, I thought stocks were overpriced, so I held off on rejiggering our assets.

My first rejiggering happened on September 9, after the TSX had fallen from 15,000 to 12,000. The second occurred on Friday, when the TSX dipped below 9,000. Now our ratio is 76:24, which is where I've wanted it for months; and I'm delighted that there are folks out there willing to sell me stocks at such bargain prices.

Can someone reconcile these two statements for me?

Flaherty yesterday:

"We are not looking at a bailout for banks."

Today:

Ottawa takes $25 billion in mortgages off banks' books to loose credit

Ok, I don't own an SUV

Lest my faithful readers (and I flatter myself by using the plural) think I've lost my mind, I'd like to make perfectly clear that my last post was not about gas prices. It's about fretting over the price of an asset that you were never planning to sell anyway.

I'm in the stock market for the long haul, so lower prices just mean that my biweekly paycheque deductions are buying more shares than before. My May contribution bought me just 33 units of one fund I invest in, while the same contribution last week bought me 51 units. That suits me just fine.