A DIFFERENT INVESTMENT STRATEGY DESIGNED FOR RETIREES

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Is your investment strategy the right one for you?

Well if you are retired, then probably not. There are two primary investment strategies in existence today. They are:

1. Buy-and-Hold
2. Timing

Since 95% of all financial advisors are practicing the buy-and-hold strategy for everyone, then chances are very good that you are using that strategy. And for retired investors, I contend it is a faulty strategy.

As I will explain, the buy-and-hold strategy is based on some assumptions that don’t fit the retired investor. In fact, I don’t think they fit many investors, but for sure, they don’t fit the retired investor.

First, let me explain what the buy-and-hold strategy is.

The buy-and-hold strategy has been the predominant strategy in the marketplace for the last several years. This strategy was developed out of Modern Portfolio Theory.

Modern Portfolio Theory is an investment theory devised by two Nobel Prize-winning economists, Dr. William Sharpe, a professor at Stanford University, and Dr. Harry Markowitz, a professor at New York University. Modern Portfolio Theory is currently being taught in all the major universities around the world as the proper method for investing in stocks. I learned it when I got my MBA, and it is still being taught today.

The bottom line is that these professors concluded that buying stocks and holding them for the long term was the best method for providing investors with the maximum return.

Source: Ibbotson Associates, SBBI, 2001 Yearbook

This chart shows the returns of blue-chip stocks from 1926 to 2000. Professor Sharpe developed probability statistics that showed the stock market’s rate of return had a 95% probability of falling within the ranges shown in the chart. As you can see, the longer you hold stocks, the less likely you are to have a negative return.

In fact, in year 20, there was a 95% chance that your return would have fallen between 17.9% and 3.1%. The average return over the 74-year time period was 11%.

The theory of the Buy and Hold strategy is that you can outperform all other investment strategies by buying stocks and holding them for a long enough time period until the stocks have risen in price enough to outperform all other strategies.

I couldn’t disagree more.

This theory, which is prevalent in the financial advice industry, is full of faulty assumptions and incorrect conclusions. Particularly for the retired investor.

Please continue, and I will explain:

1. Why most investors, and particularly retired investors, are not long-term investors and therefore should not be using the Buy and Hold strategy.
2. Why do most investors not have the goal of outperforming all other strategies at the expense of an undefined long-term holding period? And
3. Why Professor Markowitz’s and Professor Sharpe’s conclusions are incorrect or, at best, incomplete. In other words, a timing strategy can outperform the Buy and Hold strategy in both the short term and the long term.

From 1970 to 1982, a 12-year time period, the Dow Jones Industrial Average had a return of around 0%.

From 1921 to 1940, a 19-year time period, the Dow Jones Industrial Average had a return of around 0%.

From 1929 to 1954, a 25-year time period, the Dow Jones Industrial Average had a return of around 0%.

(Source of the holding period failures are BigCharts.com and StockMarketTiming.com. Please note that these holding periods were not necessarily from the beginning of a year to the end of a year, but were from a monthly time period in the first year to a monthly time period in the ending year.)

Are you aware that the NASDAQ lost more money from 2000 to 2002 than the stock market lost in the crash of 1929? How many years will it take to recover your money? Are we in the middle of our second 25-year holding period that will not make money?

Nobody knows for sure. But the real question is, can you afford to wait 12, 19, or 25 years for your account to recover? I have no doubt that the Buy and Hold strategists are correct in that the stock market will eventually recover and restore your lost funds. However, I must ask, when is “eventually?”

Buy-and-hold strategists never define a long-term holding period. Obviously, at times, 12 or 19 or 25 years was not considered long term. At other times, 7 years are considered long-term. When I first got into the investment advice and financial planning business, many annuity companies would guarantee that you wouldn’t lose money in the stock market if you left it in there for 7 years. But the last 7 years (1997–2003) resulted in a negative return. These annuity companies obviously considered 7 years to be “the long term.” Now they are changing their guarantee to 10 years.

Now 10 years has become “the long term”.

The fact is, nobody knows how long you will have to wait for the stock market to recover. It is possible we are in our second 20-year holding period and will not make money. Can you afford to take that chance?

If you are retired, then probably not. Retired people don’t truly know their investment horizon.

I don’t believe that most retired investors are truly long-term investors. Holding periods of 10 years or longer do not suit well with most investors, but even less so with retired investors. There are several situations that have led me to this conclusion:

1. Many retired people are using their investment accounts in order to supplement their social security and pension incomes. In other words, they are using their investment accounts to create a portion of their income needed to meet living expenses. They know that investing in fixed income investments will cause their income to erode over time due to the impact of taxes and inflation. So they have to invest in stocks and bonds, and yet these stocks and bonds CANNOT lose them money.

If you are working for a paycheck, and you lose that job, then you can always find another job. In retirement, your retirement assets are your job. However, if you lose these assets, you are going to have a difficult time replacing them. Retirees cannot afford to lose retirement assets.

And yet, if they are investing in stocks or bonds, they are taking a chance of losing retirement assets if they should have to sell in the middle of a long-term holding period. These people are not truly long-term investors, as the chances are good they will have to sell stocks to create income some time during the long-term holding period. Having to sell stocks in the middle of a three-year bear market, for example, can have devastating consequences.

2. Other retirees are not relying on their personal investment accounts to create income; their social security and pension plans are all they need. However, their personal investment accounts act as their emergency and opportunity money. Things come up where they may have to use this money, or where they may just want to use this money.

Some examples:

A grandchild got sick, and the only way to cure him was with an experimental treatment that the insurance company would not pay for. The grandparents offered to pay.

A couple’s son took a job transfer to Australia. They used their money to go and visit him and the country of Australia. Something they had never planned on doing.

A couple met new friends who went RVing a lot. They decided to buy an RV and join them occasionally.

I could go on and on forever. There are numerous opportunities that you cannot plan on that could cause a retiree to want to spend their money. What if this occurs in the middle of a three-year bear market? Then they would have to sell at a loss and not be able to complete the needed holding period. Again, they are not truly long-term investors.

3. And finally, many people, not just retirees, are not emotionally suited to ride out the ups and downs of the stock and bond markets. They think they are when things are going up, or when losses are small, but when losses hit 50%, they bail out. Emotionally, they just aren’t capable of handling the wild swings that stocks and bonds can offer. Were you one of the thousands of retirees who took money out of the stock market in 2001 or 2002, even though you didn’t use the money when you took it out?

Who does this leave? This leaves the retirees who don’t need to use their money from their investment account and plan on leaving it to their children. They are emotionally prepared for the steep declines the markets can offer and are prepared to just leave their money alone. Is this you? If not, then you are probably not a good candidate for the buy-and-hold strategy.

When Professor Markowitz first came out with his Modern Portfolio Theory, he showed that to try and time the ins and outs of the stock market, the investor would have to be right 84% of the time in order to outperform the Buy and Hold strategy. That isn’t likely to occur. But the key word here is “outperform.” For most retired people, outperforming the S&P 500 (or any other index) is not their primary objective. Asset protection is. They can’t afford to lose their retirement assets.

The long-term average of the stock market is approximately 11%. And the best way to achieve this return is by owning stocks for the long term. What is the long term? Nobody really knows. It is however long it takes to reach that rate of return.

Now, most retired investors know that to offset the tremendous impact of taxes and inflation on their wealth, they must invest for growth. And they have repeatedly been told that the only way to reach a growth level higher than the lethal combination that taxes and inflation present is to invest in stocks. But do you really need to obtain an 11% return to do that.

Would you be happy with a 9% return that took considerably less risk? If the protection of your retirement assets is your primary goal, then most retirees are very happy with that scenario.

However, the assumption of the buy-and-hold strategy is that it will outperform all other strategies. I do not believe that to be true, as I will discuss later, but let's for a moment assume that it is. The buy-and-hold investor must be willing to wait for an undefined length of time for that to occur. I have found that most retirees and in fact most investors would prefer to take a slightly lower rate of return in order to be assured that their account won’t decline too much in the short term.

Look at the following chart and choose which investment you would rather have. We are assuming an initial investment of $500,000.

Professor Markowitz reached his conclusion based on the assumption that a market timer is either in the stock market or in cash. In other words, when the market timer thought that the stock market would head down, he moved his money to cash. When he thought the stock market would go up, he moved his money into stocks. Those were the only two investments considered: stocks or cash.

But what if you were to consider other investments rather than just cash? Cash does not earn much of a rate of return. However, other investments could earn pretty high returns, thus negating the requirement to be correct 84% of the time. The market timer, when not invested in stocks, could be invested in bonds, commodities, or real estate, or even be shorting the market (an investment that profits when stocks fall in value). If a substantial return could be made when not in the stock market, then the market timer could feasibly be correct a whole lot less of the time and still outperform the Buy and Hold strategy. And even better, he could do this in either the short term or the long term.

I could find no definitive research indicating anybody has ever done a study to determine if this may be true or not. However, in my efforts to find this research, I did come across an economist who works for the Federal Reserve Bank in Kansas City who did a research paper on whether market timing systems could outperform the Buy and Hold strategy.

This economist, whose name was Pu Shen, wrote a research paper in May 2002 in which he analyzed 5 different stock market timing systems. (His research can be found at www.kc.frb.org. Click on Economic Research & Data, then click on Research & Publications, then click on Research Working Papers, then click on 2002. His work is at the bottom of the page). Without going into technicalities, his conclusion was that market timing can work, as 4 of the 5 timing systems he reviewed outperformed the S&P 500 over a 30-year time period. And these systems also only invest in cash or stocks.

The point is that market timing can work if you find the right timing system. It CAN outperform the buy-and-hold strategy that is so predominant in the investment industry today. And since retired investors are not truly long-term investors and retired investors would prefer slightly lower performance in exchange for shorter holding periods, the buy-and-hold strategy just does not make sense for them.

And yet, 95% of all retired investors are using this strategy. And on top of that, a whole host of retired investors are so fearful of investing in the stock market that they will sacrifice a known loss of purchasing power and invest only in fixed-income investments that take no stock market risk.

A recent mutual fund study showed that 72% of mutual fund investors do not trust their mutual funds. Yet 74% intended to stay with the mutual funds anyway. No conclusion was reached by the firm that did the study, but my conclusion is that people don’t know where else to invest. They don’t know that a better way is out there.

(The study was conducted by DALBAR and Associates.)

Now you do, because I’m telling you. There is a better way to invest.

A way that determines when to be in the stock market and when to be out. It determines when to own bonds and when not to own bonds. It will consider all forms of investments, such as currency investments, inflation investments, interest rate investments and bear market investments. It is designed to make money in any kind of market. But mostly, it is designed to protect your money.

It is designed as a safety-first approach to investing. It is designed to give you the superior returns needed to offset the impact of taxes and inflation, while still making sure that your money is available when you need it.

There are five major investments for the average investor:

• Stocks
• Bonds
• Cash, which includes CDs, money market accounts, etc
• Real Estate
• Commodities

Commodity investing is a very specialized investment for advanced traders only. Real estate is an illiquid investment and, as a result, often becomes a specialized investment as well – mainly for those willing to work and be very active with their investment.

The vast majority of investors are going to choose among the top three. Since this is where the vast majority are, this is where we make our comparisons.

Investors are going to choose to invest in either stocks, bonds, or cash, depending on what they think is right for them. Five years ago, most investors were in stocks. Where are they now (April 2004)? They are in cash. I am sure your current financial advisor has told you that there is approximately $3 to $7 trillion in cash that had previously been in the stock market and is now currently in cash investments. And when that cash starts moving back into the stock market, the market will shoot up rapidly.

In my timing system, I will compare the earnings yields on stocks and bonds to determine which presents the best opportunity. Unlike many mutual fund managers, I use past earnings and not future earnings. Future earnings are too hard to predict. Do you know how often analysts get these right? (The average margin of error is 54%.) Earnings yield for bonds is easily known, but for stocks, it is the opposite of the price/earnings ratio (P/E Ratio). Therefore, if the price of the stock goes down, then the earnings yield is higher.

If stocks have a higher earnings yield, then stocks are the correct investment. If bonds have a higher yield, then bonds may be the correct investment. Why “may be” instead of “will be”? Because bonds can suffer due to inflation expectations, even if bonds have a higher yield, I will check to see if inflation expectations are present. If so, then Treasury Bills (cash) become the investment of choice. If inflation expectations are not present, then bonds would be the investment of choice.

If any of you have read the book Beating the Dow with Bonds, by Michael B. O’Higgins, (O’Higgins was also the inventor of the Dogs of the Dow investment strategy that was and still is so popular), you will notice that my timing strategy is not much different than his. At least up to this point.

Unlike O’Higgins, I repeat this scenario not just with the U.S. markets but with the European and Asian markets. I avoid emerging market countries because I consider them too risky and too volatile. While the U.S. and Europe are well-established and stable markets, some in Asia are not. I avoid those parts of Asia I consider unstable.

Just because I know which investment offers the best value doesn’t mean I am quite ready to invest. The markets (both stock and bond) often work like a pendulum. It swings back and forth, and it is important to know which way the pendulum is swinging. Imagine the stock market as the pendulum on a grandfather clock. If, for example, the pendulum is swinging upward, we can assume that when it starts swinging downward, it will swing almost as far in the other direction – unless some force comes in to stop the pendulum (economic forces might include interest rate cuts, tax cuts, increased government spending, new technology, etc.; any of these could stop or slow down its swing).

So just because stocks or bonds may present a better value, we shouldn’t invest until we know which way the pendulum is going. We may find that stocks show an earnings yield that is 25% higher than bonds, but the pendulum is still swinging and is eventually going to move that figure to 50% higher than bonds. The only way the 50% figure can be reached is for stock prices to fall much further. In short, the pendulum had not reversed its direction yet, and it was not time to begin investing in stocks.

Therefore, I use a second method to help me determine which way the pendulum is swinging. Until I see that there is a positive trend over an extended time period that a market is heading in a particular direction, then the investment will be avoided regardless of its valuation.

And on top of all this, I add a third safeguard. If, for some reason, all my calculations still don’t work, then I will recommend getting out of any investment after it has dropped 10%. In no circumstances should any loss exceed 10% by too much (sometimes the market is dropping so rapidly that a 10% loss may be exceeded when we can’t react quick enough, but it shouldn’t be too much below).

The types of investments will differ as well. I use mainly Exchange-Traded Funds (ETFs). Exchange-traded funds track various indexes but sell like stocks. Unlike index-tracking mutual funds, ETFs can be bought and sold during the day and are much more tax-efficient and less expensive than mutual funds. I will occasionally use a mutual fund when I cannot find the ETF in the area I am looking for. But as more and more ETFs get invented, I am finding that mutual fund investing is becoming less and less likely.

In Europe and Asia, I will recommend ETFs that represent countries or perhaps the continent as a whole. However, in the US, the ETFs will be sector funds and, on occasion, the major index.

It is possible, in major bear markets, that other investments will be used. I bring this up because we may be spending some time in a major bear market. And money can still be made in primary bear markets. Some of these investments would include shorting the stock market to take advantage of falling stock prices, shorting the bond market to take advantage of rising interest rates, buying gold to take advantage of an inflationary economy, shorting gold to take advantage of a deflationary economy, buying real estate to take advantage of rising real estate prices, shorting real estate to take advantage of falling real estate prices, etc.

Are there any disadvantages to the timing system? Maybe. There is a possibility that there will be more transaction costs. If you have ever looked at the transaction costs associated with your mutual fund, I find this hard to believe. The basic earnings yield on stocks or bonds doesn’t change that rapidly. As a result, it does not create many transactions. The trend analysis portion does create a few more, but I don’t anticipate more than 5 or 6 trades a year. It could be more if we reach our 10% stop loss and need to sell off everything. In that scenario, we could be talking about 10 to 20 trades a year. Compare this to the 100s your mutual fund makes. Your mutual fund hides their transaction costs as part of your total expenses, which in turn lowers your return. In my system, you would pay a brokerage fee for each transaction (this cannot be avoided), but that is all. The current fee is approximately $25 per transaction.

(As of June 30, 2003, the average mutual fund had a portfolio turnover of over 100%. Data is per MutualFundExpert.com.)

I find it difficult to believe that there is any scenario where investing with me would not be cheaper than investing in the average mutual fund.

Another possible disadvantage might be in the area of taxes. If you are in a non-IRA type of account, then each transaction will result in a taxable event. Whereas in the Buy and Hold strategy, theoretically, you could hold one stock and no taxes are due until the stock is sold.

In reality, most buy-and-hold strategists hold mutual funds, so while they preach the buy-and-hold strategy, they do not practice it. Therefore, most buy-and-hold strategists end up with gains taxed at ordinary income tax rates. It is possible that you could pay more taxes with a timing strategy, but I feel it is more likely you will pay quite a bit less.

And finally, the third possible disadvantage of a timing system is that at times you will be out of the stock market when it is going up. If our model indicates the market is overvalued and therefore risky, you will be out of it. That doesn’t mean it won’t go up, and in fact often does. You will not get those returns.

A good example of this is 1999. The stock market was very overvalued, and our models said to be out. But the market had a great run up in 1999. In fact, the NASDAQ went up 99% that year. You would have missed those gains. Of course, you would have also missed the losses that occurred in 2000, 2001, and 2002 that more than ate up all of the gains from 1999. But be aware that at times your friends may be making money in the stock market when we feel it is too risky and are sitting on the sidelines.

They do this by charging commissions, either upfront or on the back end, or, in the case of annuity companies, they charge surrender charges. Either way, it is going to cost you – either to get into the investment or to get out of it. As a result, the investor often falls for their trap and refuses to leave a bad investment because it “costs them too much to get out.” This is exactly what the mutual fund companies and the annuity companies want. They want to keep your money, so they make it difficult to leave.

Unfortunately, I have seen a number of retired investors stay in poor investments in order to avoid the extra charges required to leave. This is a huge trap, and unfortunately I have seen more investors fall for it than I have seen avoid it. But if something much better comes along, you really should consider paying whatever it takes to get out and then don’t fall for that kind of trap again. Usually a better investment will pay for itself pretty quickly.

Another reason the buy-and-hold strategy is popular is because it is easy to sell. It is also easy to teach. As a result, brokerage firms can hire salespeople instead of financial experts. And once a sale is made, there is really nothing else for the financial salesperson to do. They just watch the account, and in many cases, they just watch it go down. Therefore, many of the financial services institutions were quick to jump on the buy-and-hold bandwagon.

All investments carry risk. CDs carry no market risk, but they do carry purchasing power risk. Bonds carry not only market risk but interest rate risk and credit risk as well. All investments have some type of risk. A timing strategy such as the one I am proposing carries market risk. Therefore, we cannot guarantee that you will make money by investing in this strategy. No strategy works all the time, and I am certain there will be times when my timing strategy does not perform well.

However, I believe this approach to investing is far superior for retired people and most other investors as well. I believe you have a better chance of success with this strategy.

The recent bear market has convinced many investors, maybe even yourself, that maybe their advisor doesn’t know as much as they thought. And remember, if you are retired, then the basic assumption of Buy and Hold (that you are a long-term investor and that your performance is your primary goal) probably does not hold true for you.

Let’s use each side of our brain individually. First, use the logic side of your brain for just a second and think about what I have written. It makes sense, doesn’t it? Now use the emotional side of your brain. It just feels right, doesn’t it? I know it does because your brain works the same way mine does. And in my heart, I just know this is the proper way for you to invest.

You’ve probably thought all along that you were just “missing” something with investing. You probably kept thinking that there was something you could do, you just didn’t know what it was. Now you know. Do something. Give me a call at (512) 218-8100, and let’s get you on the road to successful investing.

Don’t sit around and wait for the market to come back. It might not.

Do you want to know where I recommend you invest right now? Give me a call at (512) 218-8100, and let's discuss it.