Thursday, September 03, 2015

The Pundits Are Wrong, Maybe You Should Panic and Sell

Nearly everything I read from personal finance professionals and columnists after the most recent dramatic stock market events is “not to panic.” The worst thing you can do after stocks take a big hit is to panic and sell, unless of course it's the absolute right thing to do. Perhaps you should be selling some of your portfolio right now, what follows is my reasoning.

Today, right now, this very moment might be the best opportunity you have to sell assets that you shouldn’t have owned in the first place.

This current bull market, while long in the tooth could continue for several more years and if you sell now you will lose out on those potential gains, but so what?

The vast majority of people mis-diagnose their own risk tolerance and take on to high a level of risky assets in their portfolio. Most people do the exact opposite of what they are supposed to do when investing, they buy high and they sell low. But stocks are NOT low right now, they are high when compared with historical valuations. They could go higher, perhaps much higher, but that doesn’t change the fact that they are currently overvalued. When stocks are overvalued they are likely to have lower future returns and more likely to experience "air-pockets", times of significant downward volatility.

The last week (and month) might have jolted you and reminded you that stocks don’t always go up. Recent market events may have reminded you that you aren’t comfortable with your portfolio dropping by 50%. Perhaps you are taking on too much risk right now because you were lulled by the long bull and very low volatility. The seemingly never ending upward movement of the stock market has turned people who were scared to death of stocks in late 2008 and early 2009 into fanboys who have lost that healthy fear.

I’m telling you now that it’s ok to sell, I give you permission.

If waking up to the market being down 1,000 points leads you to experience anxiety and makes you extremely uncomfortable you probably have too much money in stocks.

I’m not saying to go 100% to cash. What I am saying is that NOW is a good time re-evaluate your need for risk, your ability to handle risk and whether or not you are taking on too much risk. If in that evaluation you determine you are too heavily invested in risky assets - sell. Stocks are down, but in the scheme of things, not by much. We are still higher than we were about a year ago and we are WAY OFF THE BOTTOM. If stocks were selling at what they were in early March of 2009 I’d tell you DO NOT SELL. But stocks are not trading at generational lows, they are trading at what historically is a very high mark and selling now won’t hurt you.

Think of this recent market drop as an opportunity and a warning sign, you may not get another. You need to re-evaluate your risk tolerance and determine if you are taking on too much risk, if so, sell what you need to sell to reset to what feels more comfortable and fits within your long term financial plan (you all have one of those, right?). Don’t trust the media who have an absurd obsession with stocks.

Stocks are not a holy grail. There is nothing special about them. They are an asset. An asset that can be under or overvalued and SHOULD certainly be in most portfolios, but in moderation and with proper understanding. Don’t let the punditry first SCARE you and then tell you not to reduce equity exposure. Now may be a good time to reduce your exposure.

What if I sell and stocks go up you ask? So what if they do? Who cares? What matters is if you are on track to meet your goals and if your portfolio is positioned to get you where you need to go and is within a range that you can be comfortable with.

This recent selloff just might be the wake up call you needed to get out before the real drop (if it ever comes and I'm not saying it will).

Imagine it’s early 2008 and stocks are beginning to drop. You realize that you are over invested in risky assets and that you made a mistake being so aggressive. But you listen to the media pundits and decide to stay put because the market is off 10% from its highs. Instead of selling at what were still reasonable prices and reducing the exposure in your portfolio (notice I didn’t say go to cash) you hold on….and experience the entire 50% loss…and then you actually make the mistake of selling. Many, many people did this. Timing the market is not a great idea, but designing a portfolio that fits within your plan and risk tolerance is a good idea and if you currently are invested in a manner that is too risky for your plan and tolerance, now is a fine time to sell.

So there you have it, you have permission to re-asses, re-allocate and reset so that IF the next crash comes you don’t have a real panic attack and sell at what are actual lows. Sell some now and relax.

Scott Dauenhauer, CFP, MPAS, AIF

Monday, August 11, 2014

Prag Cap - Reserves Don't Really "Go Into" Loans

Monday, June 10, 2013

The Disconnected Reality of Today's Target Date Funds

 “...only 7% of investors can stand to have more than 75% of their total investments in stock, and only 1% can handle more than 87%”            Finametrica

Target Date Mutual Funds (TDFs) are big business, attracting assets at a blistering pace.  Assets in TDFs now top $500 billion according to a recent Morningstar report, a 21% increase over the previous year.

Nearly $100 billion now flow into TDF products annually from defined contribution plans around the country.  A recent study by The Vanguard Group predicts that 55% of all defined contribution (DC) participants and 80% of new entrants will have assets in TDFs by 2017.  The Target Date concept as a product, has been a huge success for the industry, whether this success transfers to the participant is another question.

I believe there is evidence participants are being exposed to more risk than they are comfortable taking.  TDF providers in general appear to be building their products disconnected from the risk tolerance of the participant.

As a financial advisor I’ve witnessed the rise of TDF’s with both optimism and fear.  My optimism is based on the simplicity that TDFs offer DC programs and participants.  My fear is based in watching how the TDF has become a vehicle to promote the concept of “Stocks for the Long Run” without regard to a participant’s risk tolerance.

In short, I believe TDF’s underlying equity allocations are disconnected from participant’s comfort level with those allocations.

I believe this disconnection will ultimately lead to significant problems for plan sponsors and a retirement that is less dignified for participants.

A common assumption underlying most TDF’s and many professionally managed portfolios is the younger you are the more loss you can handle (because you have a long time period to make up for it). 

The conclusion being that young people need higher allocations to equities.  Another common assumption is that inflation is a major threat to a retiree’s portfolio and the only way to combat that inflation is high equity allocations.

Both assumptions have underlying truth’s to them, but represent only one facet of a person’s risk profile.

Risk Profile is a combination of the following (for an in-depth analysis of Risk Profile, please see the September 2008 edition of The Kitces Report which you can access by becoming a subscriber at

Risk Need              The minimum rate of return required to meet a person’s goals.

Risk Capacity       Bob Veres (another must read industry personality, defines risk capacity as “a (participant’s) ability to sustain a market decline without suffering an unacceptable loss of lifestyle or quality (of) life now or in the future.” In other words, how much loss can a participant “afford” to absorb.

Risk Attitude        How much a person is comfortable with fluctuation in their portfolio, this can be interchanged with the term Risk Tolerance.

Risk Perception     “...Evaluates the extent to which the client understands the financial markets, and thus heavily influences how “risky” the client perceives the market to be.” Michael Kitces September 2008

Under the above Risk Profile paradigm the various components of a person’s risk profile are split out and analyzed separately by a financial professional and this information is used to make a recommendation.  TDFs do not have access to Risk Need, Risk Attitude (Tolerance) or Risk Perception - only, to some extent Risk Capacity.

Yet, TDFs are built as a one-stop portfolio for all.  TDFs assume that if someone is 25 years of age, they can handle a 50% drop in their portfolio.  A retiree may (or may not) need an engine for growth in their portfolio to combat inflation, but what if they can’t handle the fluctuation that comes with that engine? TDFs ignore this reality.

Fund companies claim to have sophisticated methods for developing glidepaths, but the primary data point used to determine which portfolio a defined contribution participant is defaulted into is their date of birth (DOB).  While an informative data point, DOB does not convey general or specific information about what the proper asset allocation of a participant should be, it’s a partial component of their overall Risk Profile.  DOB does not communicate the need, perception or tolerance for risk.

None of this is a secret, everyone already knows that TDFs are geared toward the general; the problem is that from my perspective, they get the “general” very wrong.

In my opinion Risk tolerance should be the main driver in the portfolio development process.  There are many other factors that one should consider (required return, wealth, human capital, etc), but accurately determining how much fluctuation a participant can handle is foremost.

A participant who bails on an asset allocation at the worst possible time (buying high and selling low) will never achieve their goals and will likely become discouraged, afraid to invest in stocks ever again after experiencing the inevitable large drawdown. In this regard a lower allocation to equities may produce more wealth for many participants (or at a minimum, less nervousness).

Measuring risk tolerance is not simple. Many recordkeepers, mutual funds and broker-dealers routinely put prospective clients through a short 5 or 10 question test to place them into a portfolio, yet these tests are typically inadequate and do not actually measure risk tolerance in a scientific fashion.

FinaMetrica, a company out of Australia has created a risk profiling system that claims to accurately measure a person's ability to assume risk.  FinaMetrica describes their system as follows:

“The system provides a scientific assessment of an individual's personal financial risk tolerance in plain English. The system uses psychometrics to ensure validity and reliability. The 25-question risk tolerance questionnaire can be completed in 15-20 minutes and the comprehensive risk profile report is available immediately.”
Money magazine ran a profile of the FinaMetrica system in October of 2009 and made the following observation:

“FinaMetrica, an Australian company that has developed a respected risk questionnaire used more than 250,000 (nearly 500,000 as of 2013) times by financial planners, has found that only 7% of investors can stand to have more than 75% of their total investments in stock, and only 1% can handle more than 87%. "The investment industry tends to encourage people to take on more risk than they're emotionally equipped to handle," says FinaMetrica co-founder Geoff Davey.”

Only 1% of investors can handle equity allocations above 87%, only 7% above 75%.  If true, it seems that TDFs are negligent in their management of participant assets (or Plan Sponsors in choosing the TDF).

If the FinaMetrica system can be relied on (and all evidence points to this being the case), the implications for glidepath construction are significant.

The following chart links different age groups and their corresponding target date retirement year with their mean FinaMetrica score (derived from the above mentioned study) and then compares the Big Three TDF provider’s (T. Rowe Price, Fidelity and Vanguard) equity allocation with what the FinaMetrica score would suggest for an allocation to equity assets.

***Age 65 assumed retirement

****This represents the range of growth assets that FinaMetrica defines as “Comfort,” an allocation to growth assets above this range is “significantly greater than (a person) would normally choose to take on.”

Glidepath Equity Allocation Comparison of The Big Three

A FinaMetrica score of 62, which is the mean score for the age cohort of 20 - 29 equates to a portfolio that is 54 - 73% in equities.  Anything higher than 73% in equities and these participants (on average) begin feeling what FinaMetrica terms “Marginal Discomfort.”

If the average twentysomething begins feeling discomfort when their equity allocation reaches above 73% and the average equity allocation of the “big three” for this age group is 90%, doesn’t this suggest a disconnect?

A 60 year old would most typically be in the 2020 target year and would have an allocation between 60 - 72% in equities with the “Big Three.”  The average 60 year old has a FinaMetrica score of 51 suggesting the allocation to equities should be between 38 - 57%.  Even the lowest equity allocation (Fidelity) exceeds the highest comfort level.

If we look at the whole universe of TDFs there is one 2020 fund that is 80% in equities.   There appears to be a major difference between what the fund companies believe a participant’s risk tolerance is and what current research shows it to be.

Even if it were the case that participants were highly risk tolerant near their retirement date, the data shows that the vast majority of participants remove their money within three years of retiring.
Could it be that the fund companies have confused Risk Tolerance with other aspects of a person’s Risk Profile?  It appears that the major fund companies have placed greater importance on participant’s Risk Capacity and Risk Need than on their Risk Tolerance.

This begs the question, which pieces of the Risk Profile are more important?

In a great post on his blog, Nerd’s Eye View, Michael Kitces had the following to say:

“...I have always been a strong advocate that a client's risk tolerance must be the driving factor in determining someone's maximum exposure to investment risk. Long time horizons may be an appropriate factor to encourage someone to invest up to their risk tolerance, but clients should never go beyond that comfort level. I don't care if you're 22 years old and you have a 70 year investment horizon until the end of your retirement; owning investments that are riskier than your comfort level is simply a recipe for disaster (emphasis mine), even if you "have time to recover", as the inevitable downturn eventually comes and the dramatic losses destroy your willingness to save and invest. Who wants to save more when all you can do is look at your existing savings, the losses it has experienced, and think about how you could have enjoyed the money more by spending it instead of losing it investing!

The bottom line is that as planners, we need to bear in mind that clients do have an emotional experience to investing, and that even if risky portfolios experience declines that turn out to be temporary, the adverse impact on client savings behaviors can be far longer lasting.”
I’ve long shared the same opinion, which is why I’ve been a critic of TDFs almost as long as they’ve been around.

I want to be clear that I’m not saying Risk Capacity is a useless metric, simply that a person shouldn’t invest above their Risk Tolerance, even if their Risk Capacity is a higher number.  Tolerance should act as a ceiling (not a floor) on Risk Capacity when setting an allocation.

The FinaMetrica data gives a voice to the participant where they had none before.

Another area that the FinaMetrica data shows a disconnect is with gender.

Target Date Funds treat equity allocations among genders the same.  In “TDFLand,” if you’re a female born in 1950, your portfolio should be the same as a male born in 1950.  FinaMetrica data on gender risk tolerance reveal that treating genders the same may not be appropriate.

The average 60 year old female begins to feel ‘discomfort’ when equities reach 53% of her portfolio, yet males the same age don't feel the same level of discomfort until equities reach 68%.  TDFs treat the genders the same even though the data appears to show a measurable difference in risk tolerance at all levels.

I realize it might not be sensible to create male and female target date funds, my larger point is that TDFs appear to be taking more risk than a significant portion of their population is ready to assume and they ignore ALL demographics of the population except date of birth.

If an Investment Advisor based their recommendations solely on date of birth, they’d be breaching their fiduciary duty.  Even a Registered Representative would likely find themselves in hot water.
No competent financial advisor would assign a client a portfolio solely based on their birthday.
Yet, the vast majority of new participants entering retirement plans are defaulted into portfolios which they may not be comfortable with.  Even more are holding higher levels of equities than the data would indicate they are comfortable with.

The FinaMetrica questionnaire may not be perfect, but it does have a reputation for accurately portraying a participant’s risk tolerance.

I'm not saying we should base all TDFs’ equity allocations on FinaMetrica data alone, but I think the data indicates a disconnect between the risk taken by the fund companies and the comfort of the participant with that risk.  This is a significant concern - an entire population is being defaulted into portfolios that appear to be to risky for them.

What Can A Plan Sponsor Do?

First, I think additional research is warranted into the demographics of Risk Tolerance.  I believe better defaults can be built by including additional demographics.  It’s impossible to determine a participant’s correct Risk Profile purely from demographic data, but building better defaults is a step in the right direction.  Surely a default based on additional data, such as gender, income and job title would be more precise than the current one size fits all method.

I’m going to sidestep the question for now in deference to more thoughtful dialogue that I hope this blog post creates.


We will never be able to default a participant into the perfect portfolio, but if a spectrum of portfolios exist from “Terribly Wrong” to “Perfect” and we are currently closer to the “Terribly Wrong” end...should we not strive for perfection, even if we fall short?  Perhaps improving our shortfall will help participants improve theirs.

My Thoughts on The Big Three

While it looks like I’m attacking Price, Vanguard and Fidelity I want to make it clear that I do like these companies in other areas.  I think Vanguard is one of the most amazing companies in the history of money management, I believe T. Rowe Price is one of the best active money managers in the world.  Fidelity has some amazing products and programs (full disclosure, I custody asset at Fidelity).  I simply have a fundamental disagreement on their glidepaths.  I am happy to see that T. Rowe Price is set to release a less aggressive version of their TDF suite and am looking forward to analyzing it.

Scott Dauenhauer, CFP MSFP, AIF

Disclosure and Thank You:  Any opinions in this piece belong to me as do any errors.  I do want to give a special thank you to Michael Kitces for helping me flesh out my concerns, but this does not mean he does or does not endorse my conclusions.  The same goes for FinaMetrica, I used their data, but my conclusions are my own.

Wednesday, March 20, 2013

Wall Street Rant: Is This Bull Market Fundamentally Driven?

Those who read this blog know that I have a great appreciation for the Shiller PE10, also known as CAPE – Cyclically Adjusted Price Earnings. I came across a nice post from blogger Wall Street Rant asking the above question and providing some haunting data.
The post starts with the observation:

Fundamentally driven bull markets should rely more on cyclically adjusted earnings growth and less on investors willingness to pay ever increasing multiples on those earnings. To look into this I decided to focus only on bull markets of 100% or more. I looked at the Starting and Ending Shiller PE using Robert Shiller’s online data and updated it with daily pricing data for the important dates (as he only has monthly prices). Then I divided the Bull Market gains by the amount of PE expansion to see how much gains investors were receiving per unit of PE expansion. The results are below, sorted by most fundamentally driven to least fundamentally driven. The results are quite interesting.

The referenced chart is below:

The blogger ends with this observation (emphasis mine):

Take a look at the 1974-1980 Bull Market compared to today….The magnitude of the advance is similar between the two but the 1974-1980 advance only relied on a PE expansion of 2.2 vs 11.1 today. You will also notice that those that relied least on PE expansion tended to experience smaller subsequent bear markets. The top 5 averaged a bear market loss of 30.4% vs the bottom 4 which averaged a 48.5% loss. If history is any guide people should expect that the next bear market will be deeper then average because this bull market is lacking a fundamental underpinning.

UPDATED: 3/19/2013 – Corrected chart to reflect the proper starting PE of 8.8 for the bull market starting 6/13/1949. However, this did not change the overall ranking of any of the bull markets.

Doug Short or at Advisor Perspectives blog had the following exchange with Wall Street Rant author:

In an email exchange with the author I pointed out that the current bull market came within a hair’s breadth of a 20% decline at 19.39% in early October 2011, based on daily closes.

I received the following thoughtful response:

It’s true that 10/2/11 only missed the 20% threshold by a hair (someone also made a post about it crossing if you count intraday) but that is also the case in many other bull markets. For instance, for the 1987-2000 bull market in 1998 the market went from 1186.75 to 957.28 or a fall of 19.34% (and using intraday highs and lows you can get beyond the 20% threshold as well…intraday 7/20/1998 to 10/8/1998). Or in 1990 the market fell from 368.95 to 295.46 or 19.9%.Then also for the 1974-1980 Bull market the market went from 107.46 on 12/31/76 to 86.9 on 3/6/1978 or down 19.1%. Haven’t looked at all the others but I’m sure there are similar pullbacks….now that I look at these things maybe this is why the seemingly arbitrary 20% level is often used. Also, If 2011 was the start of a bull market then it’s the second highest starting PE ratio for a bull market by a long shot (only 2002 matches it…and it is a big outlier).
Count this as another in a long series of posts pointing out the overvaluation of the market and what drives it, the last one was last week.

Scott Dauenhauer CFP, MSFP, AIF
Meridian Wealth Management

Monday, March 18, 2013

Idiocracy: Why Cyprus Matters

Cross-Posted from the Official Meridian Blog at Meridian Wealth Management.

Late Friday night news began to break of a deal to provide support to failing banks in Cyprus.

Disregarding other details, the deal required all bank deposits under 100,000 Euro (in any Cyprus bank) to have a levy of 6.75% imposed.  For bank depositors with balances over $100,000 Euro, the levy would be 9.99%.  Those who lent money to the bank, known as senior bond holders would continue to be made whole.

In one announcement, a chaos was unleashed on the world that could have far reaching consequences. For a complete run down of what happened and updates see PragCap's post "Sowing the Wind."

Imagine waking up to find you had 6.75% less money in your bank account.  This has not yet happened in Cyprus, it must be voted on, but the banks are on Holiday until that vote happens and no one can move their money.  If the vote happens and passes (my guess is it won't), when the citizenry awakes they will find their bank accounts lighter.

This proposed solution to recapitalize the Cyprus banking system is important to the US and the world for several reasons.

It turns out that the President of Cyprus said that "haircuts" for deposit holders was not a negotiating point just a few weeks ago, but let's take a step back.

When a bank becomes insolvent and is in need of recapitalization there are several ways it can do so, a few of which are:  issue additional stock, convert debt to equity, receive a bail out, tap deposit holders.  In the United States we have something called the FDIC which in addition to providing some banking regulation and resolution also insures deposits against bank failure up to a certain dollar amount, currently $250,000 (its a bit more complicated than that, but you get the picture).  No matter how badly capitalized your bank is in the U.S., even if it fails you are guaranteed to get back every penny of your deposit as long as it isn't above the $250,000 mark.  Cyprus has a similar insurance program, but up to 100,000 Euros...which is why this "levy" is so important and such a stupid idea.

Confiscating 6.75% of a person's wealth who you have guaranteed will never lose a penny is an abdication of a promise.  When a banking system goes back on its word, it loses all credibility and panic ensues. Panic leads to bank runs.  Bank runs lead to collapse and contagion.  The biggest problem with this "levy" is that it comes from (or appears) to be come from the European Central Bank (ECB) (and more so, Germany) and thus sets a precedent of how other troubled nation banking systems could be approached.  If it could happen in Cyprus, why couldn't it happen in Spain, Italy, Portugal or any weak country with the ECB as its banker? A bank run in Cyprus could lead to capital flight in other countries as depositors fear confiscation. Such contagion could lead to meltdown.

Another issue is that the senior bondholders are not getting hurt.  Granted, if you converted all the senior debt to equity, you haven't come close to solving the problem - but requiring insured depositors to take a hit and making bondholders whole is sending a bad message.  Worse, by levying against smaller depositors who were supposed to be insured against loss, the levy against the very rich (in this case Russian Oligarchs) depositors only needed to be 9.99%.  Remember, those with balances above 100,000 Euro are taking a chance with their deposits, they have counterparty risk and knowingly accept this - in effect they are creditors of the bank (yes, technically all deposit holders are creditors, but not in reality if there is real deposit insurance).  By hitting the insured depositors with a 6.75% levy the rich deposit holders avoided what likely would have been a 30 - 40% hit to their account balance.

Again, this sends the wrong message - we will defend the rich at the expense of the less powerful poor.

Not allowing insolvent banks to fail and not wiping out bondholders and unsecured creditors may be the right thing to save the "system" (though I doubt it), but it sends the message that the elites will be protected at all costs.

Cyprus matters both because of the deal that was made (but not yet voted on) and for how the deal ends up being implemented, if at all.  If insured bondholders are forced to take losses, panic and contagion may be the outcome in other weak Euro nations.

I don't believe the vote will pass, after all, these politicians don't have very far to run - it is an island after all.  This begs the question of what happens next, either way it will be interesting to watch.

Regardless of what happens, you can chalk this up to complete idiocracy.

Scott Dauenhauer CFP, MSFP, AIF