Financial Architects

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Other Risk Reduction

I’ve written about portfolio risks, insurable risks, silly risks, etc., but I thought I’d spend a few minutes here on a few other things you can do to reduce other types of risk.

Here are a few things that all of us here at Financial Architects do personally that we think many (most?) people probably don’t:

  1. Freeze your credit. At a minimum you should check your credit reports every year or so to make sure nothing is awry, but we think it is worth going to the next level and actually freezing your credit. Here’s how.
  2. Use a password manager. At a minimum you should be using strong passwords and not reusing them between sites. That’s pretty difficult do without using a password manager. Here’s a list of the top ones. In addition, for key sites such as financial institutions, we use two-factor authentication.
  3. Use a VPN. When out of your secure environment (your office, home, etc.) it is best to use a VPN when connecting to an unknown WiFi network. This risk has been decreasing as most sites now use secure connections (“https” rather than the old “http”). More here.
  4. Install updates. Always keep current versions of software not only on your phones and computers, but also on your routers and other internet connected devices (there are a lot these days). The updates include patches that fix security issues that have been uncovered. If you don’t update your software you are undoubtedly using tools with known security issues. More here.
  5. Wipe electronic devices before donating or discarding. It is amazing how many people and organizations donate or discard computers and phones with personal information still on them.
  6. Call organizations back on a public number. It is almost always a good idea to turn an incoming call into an outgoing call. When you get a call from “your bank” or “the IRS” the easiest way to know it is legitimate is to get the person’s name and extension and call them back on a number that you know is legitimate. In other words, don’t get the number from the caller!

There are many, many other things you could do but those six are those that we do ourselves yet we think most people don’t do. (I.e., you know to shred things by now so that isn’t on the list, and using disposable or multiple email addresses for security seems like overkill so we don’t do that.)

Let’s be careful out there!

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Forecasting

I read an excellent post last year, There will Always Be Sorcerers. I have written on forecasts before, here for example, and at that link, I included some good quotes on planning and prognosticating.  Howard Marks came out with a memo (here) which gave me a few more:

  • There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. – John Kenneth Galbraith
  • The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge. – Daniel J. Boorstin
  • Forecasts create the mirage that the future is knowable. – Peter Bernstein
  • The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait. – G. K. Chesterton
  • Forecasts usually tell us more of the forecaster than of the future. – Warren Buffett
  • I never think about the future – it comes soon enough. – Albert Einstein
  • It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on. – Amos Tversky
  • The inability to forecast the past has no impact on our desire to forecast the future. Certainty is so valuable that we’ll never give up the quest for it, and most people couldn’t get out of bed in the morning if they were honest about how uncertain the future is. – Morgan Housel
  • No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future. – Ian H. Wilson (former GE executive)

(The memo is worth reading in its entirety. If you get to the end of it, I am clearly in the “I don’t know” school.)

The point made in that final quote is known in philosophy as Hume’s Problem of Induction – and I think investment management is mostly applied epistemology!

The penultimate quote above from Morgan Housel reminds me of this WWII story (from Peter Bernstein’s Against the Gods):

One incident that occurred while [Nobel Laureate Ken] Arrow was forecasting the weather illustrates both uncertainty and the human unwillingness to accept it. Some officers had been assigned the task of forecasting the weather a month ahead, but Arrow and his statisticians found that their long-range forecasts were no better than numbers pulled out of a hat. The forecasters agreed and asked their superiors to be relieved of this duty. The reply was: “The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”

And here are two more quotes I have often used (though not in the sources above):

  • We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. – Warren Buffett
  • I think everybody who predicts the future with a straight face should be required to change out of the business suit, wrap himself in a gypsy shawl, wear one of those pointed wizard’s hats with a picture of a crescent moon on it, and make conjuring sounds over a crystal ball. That way, everybody would know exactly what’s going on and how much credibility to give it. – Bob Veres

In other words, we should just predict the market will go up. We will be right about 75% of the time, which isn’t great, but almost certainly better than any other prediction.

I wrote more elaborately on this a few years ago: What’s the Market Going to Do?

(TL; DR: “Most likely between a 33% loss and a 50% gain, but there is about a 1-in-20 chance it could be outside that range.”)

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Bucket Strategies, etc.

A fellow advisor wrote in a professional online forum last year, “[I]n rocky times I turn off dividend reinvestment and let the cash build so if they need money from me, we don’t have to sell principal.”

I want to comment not only on that, but also on so-called bucket strategies that I don’t think I’ve written up anywhere.

This strategy doesn’t make any sense. (Mathematically, that is. It may feel good emotionally to “do something” rather than just strategically rebalance.)

When a company pays a dividend, the stock price goes down by the amount of the dividend. You are essentially selling the stock. Imagine a company that paid no dividends, and you sold an amount equal to their earnings yield. That is equivalent (mathematically) to not reinvesting the dividends of a company with a 100% payout ratio. But I don’t think anyone would think selling some shares of AMZN or BRK isn’t selling.

Now I suspect what was meant was at the asset class (not company) level. But still, why would changing the asset allocation (from stocks to cash) by an amount that happens to be equal to the dividend yield be optimal? When dividend yields are 1.3% (2021) that’s the right amount to go to cash (annually) but when they are 7.4% (1950) that’s the right number?

Are we avoiding invading principal in real or nominal terms? So today you need to reinvest everything (plus some) to maintain a real principal balance or in the 1970’s you can spend all your “income” even though the purchasing power of the portfolio is plummeting? Both seem silly, but you get either one silly outcome or the other if you follow these types of rules. The 4% rule (and most variations) and MPT are based on expected returns and risk. There is no place for “but the return comes from dividends not appreciation so it’s different.” It’s not different. Total return matters, not yield (except as a component of the total return).

In addition, “in rocky times” probably means the market is already down so you are (effectively) selling stocks lower. (Unless this is an actual VIX strategy that actively allocates based on the VIX and goes more to cash when stocks spike up as well as down.)

This is actually just disguised market timing because you have to make a subjective call on “rocky” and “not rocky” – not only to stop/start dividend reinvestment, but also to determine when to redeploy the cash that has accumulated.

Similarly, some advisors (including some I respect) employ a “bucket strategy” that divides the client’s funds into short-term and long-term buckets (and sometimes into intermediate-term too). While I’m sure that has psychological benefit, I don’t think it works the way people think. The idea (as I understand it) is that the client has some amount in cash to cover the next 2-5 years of expenses, so they don’t have to sell if/when the market is down.

First, that is market timing (again) because it makes the decision of when to replenish the cash account subjective (it implies you can tell when the market is “too low” to replenish the cash). If you always keep X years in cash then it’s just an allocation with a fixed dollar amount in cash – which seems odd, and I don’t think that has any empirical support in the literature as an optimal allocation strategy.

Second, it doesn’t work that way! In any significant downturn you would be buying stocks even after taking a draw, not selling them. Here’s the math:

Suppose we have a client who is 60/40 stocks/bonds with a 4% initial draw. Assume the market value of the 40% doesn’t change. How much would the 60% have to decline before we are buying stocks anyway? 10%. Let’s use dollars. On a $1 million portfolio, the $600k declines to $540k. $40k is withdrawn from bonds (you are overweight bonds now) for the client’s living expenses, leaving $360k. Total portfolio value is $900k. $540k/$900k is 60% and (obviously) $360k/$900k is 40%. Any decline larger than 10% in stocks would lead to buying stocks to rebalance back to target.

In short, if you rebalance, you can skip the bucket strategy as it makes no sense (mathematically) unless the investor has a pretty high equity allocation, or a pretty high withdrawal rate. I think people just say this because it sounds smart, but they never actually thought about it and certainly didn’t do any math!

At a 20% stock underperformance relative to bonds, you would need an 8% withdrawal rate (off the original values, which would be over 9% of the current values) before you were selling stocks. Again, the worse the bear market, the less likely you are to be selling stocks. If there is a 50% stock decline you would need a 20% withdrawal rate policy to be selling stocks (again off the original value, it would be almost 29% of the value after the drop).

But what if you were 80/20 to begin with rather than 60/40? Then on a 20% downturn you would take anything over a 4% withdrawal from the stocks (again of the original values, I’m using the “4% rule” methodology where you don’t change the withdrawal due to market returns, but I’m ignoring inflation for simplicity of exposition) and you would be “selling” in a bear market. If we are 80/20 and had a 50% market underperformance you would need a 10% withdrawal rate (pre-drop, almost 17% of the new value) before you sold any stocks.

In the most catastrophic downturns, you are never going to be selling stocks – so I have no idea what a bucket strategy is supposed to do, but I’m pretty sure it doesn’t do it.