Handling A Market Downturn

Edited Photo. Source: Flickr - Gregoire Lannoy
Edited Photo. Source: Flickr - Gregoire Lannoy

The masses are very skeptical about early retirement. They are insecure, their own choices reflect financial servitude, and they believe a life of forty-hour work weeks for forty years is predetermined for them.

When you run around with these mental blinders on it's easier to condemn financial freedom than make the changes in your life that open up early retirement for you.

Many people are critical of early retirement by pointing out failure with two main questions:

  • What would you do all day? and
  • How will you handle a scary market downturn?

The first question assumes that you will turn into a deviant or a useless blob if you don't have an outside commitment of forty hours a week to keep you in line. We talked about that here.

Dealing With the Markets

We all know that stock markets go up and down. Market movements often dominate media. Financial media is a narrative between market optimists and pessimists. The talking heads and the predictors who strive to provide entertainment value.

Depending on where you go and what you read, the talking heads predict roaring bull markets that will go straight up and make everyone rich. Or they make your fear investing because markets are on the edge of a collapse.

Truth is they don't know. I don't either. In the last 100 years, the U.S. stock market had four occasions where stocks crashed 50% or more (inflation adjusted). It will likely happen again at some point.

A net worth that moves like this freaks people out!

S&P500 1995-2011. Source: Yahoo! Finance

The fear of losing half your money is enough to make most people just avoid the markets all together. They huddle together and put their money in "safe" GICs, bonds, and real estate. They try pay off their mortgage.

Many don't save at all and wait for the government to spoon feed them a promised stipend sometime in the future.

Rational thinkers who pursue independent thought and understand risk know there are strategies to help deal with these massive, and generally temporary, downturns.

Saving Enough

You can't retire early if you don't have enough money. Not having enough money and hoping for outsized returns or perfect conditions is a recipe for disaster. Accumulation of investable net worth matters.

If you have 30x your annual spending needs invested in productive assets, you will virtually never fail financially in retirement. You can increase your spending with inflation every year, you can maintain various asset allocations, you can "set and forget". The margin of safety at this level is immense.

Even if you have 25x your annual spending invested in productive assets, you are very likely to avoid a financial catastrophe. But you must be broadly invested, follow a sound strategy, and watch your spending. You would theoretically be far more likely to die before running out of money.

Diversify

The next easiest guard is diversification. Successful investors reduce exposure to any single market.

Way too many people have too much of their portfolio permanently in one broad asset class. It might be U.S. stocks and bonds, it could be Canadian dividend stocks, it could be rental houses. Concentration is dangerous.

Simply put, you don't want to be an infallible Japanese early retiree in 1989 fully invested in the roaring, never-goes-down Japanese stock market.

In the next two decades, you would see your portfolio fall off a cliff and plunge into the depths of the Pacific. This epic market crash might never come back; nearly three decades later, Japanese stocks are still at around half their peak level.

Nikkei225 1989-2009. Source: Yahoo! Finance

If the same Japanese retiree would have invested in a global stock portfolio (in yen currency), their investment account would have chugged along averaging 7% per year since 1989.

While others sweat a salary job and jump off buildings because they're bankrupt, the diversified retiree would be tending to their bonsai and calligraphy with nary an ulcer.

You can diversify across countries, currencies, asset classes, and strategies to guard yourself from financial failure.

Strategies

Proper use of investment strategies is very helpful in preventing a market downturn catastrophe. Some strategies are complementary while others are correlated.

Buy-and-hold 100% in a stock index is probably among the most dangerous in early retirement because you can't dollar cost average into a falling price scenario. You're basically rolling the dice that you don't retire just before a market crash or high inflation period.

If you are withdrawing money from a falling asset, the effects of the fall are exacerbated. This is known as sequence of returns risk.

To limit sequence of returns risk, you can hold a cash cushion, invest in complementary assets, or you can follow a disciplined timing strategy.

Cash cushions are effective in their purpose of limiting withdrawals in a drawdown environment, but they also reduce overall returns. Big bond allocations can actually reduce your financial success rate.

Complementary assets allocations, such as mixing a hedged strategy (like long/short or managed futures) with a stock strategy, can reduce the full effect of a stock market crash.

Hedged strategies tend to do well in market downturns while holding their own in bull markets. However, the best of these are often only accessible to larger investors.

I invest in a disciplined timing strategy. I'm always trying to simply, simplify, simplify while maintaining an edge. So far it has worked out well. In the future I believe the lessons learned will mean better discipline, fewer mistakes, and better results.

Confidence in Strategy

The biggest advantage going into early retirement is having complete confidence in your chosen strategy. I don't mean blind confidence because you read a few good books and read an amateur blog or two.

Rather, I mean having experience and controlling your emotions. Ignoring market swings and sticking to a sound process is how you win the long game.

This is why I'm a huge fan of managing your own money instead of hiring a financial advisor – especially if you are young. An honest, fee-only financial advisor can do a great job of steering your investments and helping you avoid big mistakes.

But they can't outperform broad markets over the long term and they can't prevent you from overriding their advice. They're basically just there to help you make good money decisions, promote tax efficiency, and manage your investments using basic models.

Nothing is better than making your own mistakes when you are young, learning from each experience, and forging your own confidence.

It's easier to have true confidence in yourself than to rely on confidence in others.

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Finding a Good Financial Adviser (Part 2)

In Part 1, I talked about keeping track of incentives when it comes to financial advice. I didn't want to make the post too long, so I decided to split it in two parts.

Let's look at the factors that identify good advisers: compensation structure, encouragement of complacency, corrupt practices, and over-complication of investment choices.

Compensation

Compensation is a very important factor. After all, if you want to look at incentives this is the first stop. Let me be clear though, do not expect anyone to work for free. Good advisers should earn a good living and you should willingly pay them fairly for their services without having unreasonably expectations.

In the financial advice world, the two main compensation structures couldn't be more disparate: clear asset-based compensation that you pay directly, or murky kick-back compensation that the funds pay (and you pay indirectly).

Always choose an adviser with compensation arrangements you fully understand.

Good advisers charge a transparent fee which covers all money management costs along with other financial advice. Fees usually start at 1% of invested assets and can drop to 0.5% of assets for large accounts. The higher your assets, the lower the percentage.

Good advisers will not make any money other than this fee. No bonuses, kick-back schemes, referral schemes, or Cayman Island vacations paid for by the fund companies they recommend. Any extra money they earn should be passed directly to you.

As a general rule, avoid advisers who earn money from commissions, sales charges, bonuses, etc. Usually you have no clue how they are paid and they often don't make a big point of volunteering that information either. The less you know and the quicker you pass by that information, the happier they are.

Here's how it works with these other guys. You invest in a fund or insurance product they recommend and they take 3-5% right off the top in sales fees. Then they get another 0.5-1.0% of your assets in hidden annual commissions.

Often, they get an extra bonus if they sell products over $xxx from one fund company. This could incentivize them to push you into bad products so they hit their bonus targets.

These advisors will also collect fees and commissions by selling you loans and insurance products. This can push them to sell you loans and insurance you don't need (or are over-priced compared to the broader market).

These advisors might also get referral bonuses (money or gifts) from people they refer you to. This could include a mortgage broker, real estate seller, car dealership, or travel agent. These handshake deals can be very lucrative and totally unknown to you or even their bosses.

It's one big murky system but unfortunately it's the most common form of compensation in the Canadian personal finance world. The largest advisory firms in Canada work this way because it's lucrative for them—stay far away!

Complacency

All too often clients with advisers are way too complacent with their investments. Almost stupidly, they trust everything their adviser does... until a market crash that is. Communication can be poor and portfolio risk levels are often inappropriate.

Good advisers take the time to explain everything to you and should answer all questions you have in a way that you easily understand. No industry jargon or doctor's office Latin. They should be clear and reassuring, but blunt and honest.

Good advisers will freely admit they can't control the market and neither can you or anyone else. The only thing they can do is structure your portfolio so that in most situations it will meet your needs: your risk tolerance, volatility tolerance, income needs, tax efficiency, and return expectations.

They should encourage you to stick to the strategy you developed together regardless of current market performance. The only time investment strategies should change is if something drastically changed in your personal situation. Market corrections should not affect investment strategies!

Good advisers will provide you with good information that compares your investment returns with the market benchmarks on at least an annual basis. That is the MSCI ACWI Index (in Canadian dollars) for all stocks and the FTSE TMX Universe Bond Index for bonds. *Let me know by way of comment if these links are changed*

If your portfolio exposes you to 60% stocks and 40% bonds, the real benchmark comparison should be 60% MSCI ACWI and 40% FTSE TMX Universe Bond Index. Do not accept performance comparison to a compilation of multiple indices.

Do not be fooled by advisers recommending a complicated portfolio and then comparing to a complicated benchmark. Comparisons should always be made in the exact proportions of major asset classes that were specified in your original financial plan which they developed with you! Don't forget, complicated plans are simply your adviser believing their complicated portfolio will outperform a simple portfolio.

Bad advisers will turn to jargon when they are asked questions they don't understand. They try to appear much smarter than you through terminology. They will sound very wishy-washy on investment strategy and will promote "tinkering" with your portfolio when you aren't happy with returns.

Bad advisors will also be hesitant to provide you with clear investment return information. They will rarely compare your performance to the real benchmarks.

Never trust an adviser who compares your performance to a "custom benchmark" established by the fund company. Also, never accept a comparison to "comparable funds". That's slang for we picked the crap out there to make you believe we look good. Don't forget, less than 20% of actively managed funds outperform their benchmarks so there's lots of crap to choose from when picking comparable funds.

Corrupt Practices

Good advisers develop investment plans with you based on your personal situation. They will be very clear about how they are diversifying and structuring your portfolio to meet your risk tolerance, tolerance for volatility, financial situation, and expected return on investment.

Once this plan is in place, good advisers will stick with it regardless of market performance. The only trading they should be doing is the initial buying in the desired proportions and the maintenance to keep the desired allocations as the market moves. The portfolio adjustments should be periodic and systematic. Once a quarter, twice a year, annually, when the allocations are off by more than 5%, or another similar standard.

Bad advisers love to play on your emotions. They over-promise returns and under-explain risk. They put you in assets based on your naive beliefs or their gut instincts. Run far, far away as fast as you can if an adviser suggests you buy what they believe should "outperform". Or is "currently trending upwards". Or if they can "guarantee an easy X% with minimal risk". The only investment with minimal risk is government bonds—they will return 2-3% a year.

Bad advisers also promote portfolio tinkering. Gold goes up, they put you in their 'Assertive Gold Miners Value Fund'. Oil prices crash, they suggest you move out of the 'Global Oil Opportunities Fund' and into their 'European Banks Disciplined Equity Fund'. They simply are not sticking to any plan, if there even is one to begin with. It's emotional investing, performance chasing, and you will lose in the long run.

To make matters worse, this portfolio tinkering by bad advisers is borderline criminal. Every time they move you out of a product and into another they can collect a sales charge (3-5% of the purchase value remember). Not only that, by the time the next fund is "hot", its sector is probably already overbought and won't continue climbing the same way.

Research has shown that funds which outperformed their sector over the previous five or ten years are very likely to underperform the sector benchmark in the next similar time frame.

Dalbar, a U.S.-based financial industry analytics company, publishes an insightful report annually on investor and adviser behaviour. Year after year Dalbar finds that mutual fund investors substantially underperform broad indices. So what are Dalbar's recommendations to advisers? Stop over-promising clients on performance, pay attention to client risk tolerance and properly control risk exposure, and make accurate promises in clear terms of probabilities.

Complicated Portfolios

Good advisers have you invested in products you easily understand. It should be so easy that you could do it yourself if you had the time, discipline, or confidence. Index ETFs, larger individual companies, gold bullion, farmland or timber funds, office or apartment building funds, you get the drift.

Stay away from any funds that charge more than 1% in management fees. Hell, stay away from funds that charge more than 0.50% in management fees. It's unnecessary and no, they will not perform better because their managers are "smarter". Very, very, very few investment managers are able to consistently outperform the comparable index.

Good advisers also limit your portfolio holdings to a reasonable number of investment products. For sure less than 20 holdings, probably less than 10. Warren Buffett's $150 billion investment portfolio owns less than 50 different stocks; the top 10 holdings account for 80% of his total portfolio. If the Oracle himself can invest $120 billion in just 10 holdings, a good adviser can definitely keep your six or seven-figure portfolio down to 10 holdings.

Bad advisers push you into complicated products that you don't understand. This includes funds with other creative names like "disciplined", "balanced", "special", "concentrated", "strategic", and so on. Fancy words that translate to under-performing, overpaid, stock-picking, not-so-magical investment managers who are probably plain greedy to boot.

Bad advisers also put you into portfolios with an enormous number of holdings. If the portfolio proposed suggests you invest in 50, 80, or even 100 different funds, stocks, and other products, run away. It's a tell-tale sign that your adviser is massaging products into computer software programs in order to present you with implied future performance based on past performance that fits your wants and needs just right. Or he is presenting complicated portfolios to appear more valuable and knowledgeable.

Bad advisers tend to sell you into products which are very similar. I can almost guarantee the 'Opportunity Senior American Fund' will perform similar to the 'US Strategic Equity All-star Fund' over the long haul: very poorly. Don't get fooled into thinking two shitty products are actually different. Shit is shit. Period.

A Good Adviser Is...

A good adviser is honest and clear about their compensation. They encourage the use of low-cost products, like ETFs, because it doesn't impact how they get paid.

Good advisers work with you to structure a portfolio with 20 or fewer holdings which aligns with your risk tolerance and financial circumstances. They promise you realistic, or even cautious, expected long-term investment returns.

Good advisers acknowledge they cannot help you outperform the market benchmarks, but they can keep you from drastically underperforming those benchmarks.

Good advisers help you stick to the investment plan that you created together, regardless of market performance and your emotions.

A good adviser is like a good sports coach—they use their knowledge and confidence to push you farther than you could go on your own while protecting you from injury.

Comments & Questions

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