Hi Guys,
The active-passive portfolio management debate is legitimate. Which approach is most attractive to an individual investor depends, to a large extent, upon time horizon, on risk profile, and on goals.
Likewise, the Efficient Market Hypothesis (EMH) and its companion Modern Portfolio Theory (MPT) are legitimate subjects of controversy. Both the EMH and MPT are evolving models, and models are always simplified versions of the real world. Ultimately, their legitimacy rests upon the robustness of their assumptions and upon their success in reproducing historical data.
The EMH and MPT do yield some deployable insights, but also suffer from warts. For example, on the positive side, these concepts introduced risk considerations into investment assessments. On the negative side, they are not perfect formulations like hard physics laws; nothing new or exciting here.
From my earlier postings, I’m sure you all realize that I am a proponent for a mixed passive-active total portfolio. A total commitment to either strategy escapes me; a complete commitment is not necessary. Since retirement, I have gravitated more heavily towards the passive end of that mix.
I fully recognize the limitations and imperfections of both the EMH and MPT, but conclude that they offer positive guidelines to foster more robust portfolio construction. We certainly are not fully rationale investors, but we strive for that esoteric goal. Standard deviation (volatility) is certainly not a complete measure of risk. Risk is truly multidimensional in character and has many measures (value at risk, maximum loss for a specified timeframe, Sortino Ratio), and standard deviation is merely one of them. But it is a significant risk component, especially when assessing the longevity of a drawdown retirement portfolio.
I used these investment concepts with the historical market returns database when making my retirement date and my portfolio withdrawal rate decisions. I remember when Peter Lynch improperly recommended a permissible drawdown schedule at a 7 % annual rate. I used a Monte Carlo code to refute that overly optimistic judgment. The actual drawdown reality is closer to a more conservative 4 % allowable rate that will sustain a retirement portfolio over the long haul.
The volatility (variability, standard deviation) of annual market returns is the primary culprit to the diminished permissible withdrawal rate for portfolio sustainability. Monte Carlo simulations use randomly selected returns from statistical sets of input data that model expected returns from various asset classes to drive their analytical solutions. The Monte Carlo approach is the direct progeny from MPT and Markowitz’s portfolio asset selection theory.
The basic finding from these analyses is that asset class diversification realizes a portfolio volatility reduction outcome (by factors from 1.5 to 2.0) while simultaneously maintaining a constant expected returns level. During the required service lifecycle of the owners portfolio (usually 20 to 30 years), that reduction in annual returns volatility dramatically increases the portfolio’s survival rate prospects (survival likelihood, the odds or probabilities of survival) for any required drawdown schedule. Alternately, if a higher withdrawal rate is deemed necessary, the reduced portfolio volatility enhances the portfolio’s survival chances.
The portfolio owner gets to choose his own poison, but risk control, in terms of attenuated portfolio standard deviation. is a powerful and easily implemented tool to decrease bankruptcy likelihood during retirement.
None of this stuff is unknown to the seasoned members of the MFO community. However, it just might be an eye opener for a few neophyte investors. An endless list of books exhaustively cover this topic. Within that array, I often recommend a freebie written by fund advisor Frank Armstrong. It is a clearly and concisely composed summary of the subject matter. The title of the book is “Investment Strategies for the 21st Century”. Here is a Link that will secure you a complimentary copy:
http://thetaoofwealth.files.wordpress.com/2012/09/investment-startegies-for-the-21st-century-by-frank-armstrong.pdfI do not quarrel with much that Armstrong integrated into his investment and retirement guide. Enjoy.
Recently I discovered that the Armstrong organization prepared several videos that succinctly summarize many of the tenets reported in his book. The following two Links provide the basic philosophy and rules that Armstrong advocates. Each is a little over 10 minutes in running length. Armstrong and his staff have remained constant proponents for an Index-dominated investment approach for decades. The EMH and MPT provide a semi-theoretical anchor for their philosophy. Here are the YouTube Links that are especially directed at folks nearing or entering retirement:
The Link to the Part 2 session is:
These videos have a concise crystal clarity that is expected when written and delivered by a man with military training and experience. The marching orders are clearly defined; the confusion factor is largely eliminated.
You may not agree with the message, but the message is not muddied with spurious allusions to the gambling arena that are, at best, loosely coupled to the investment discipline.
Armstrong emphasizes that costs and taxes always matter. Surely the croupier gets his share, but that can be mostly contained. When viewed globally, history demonstrates that it is not a zero sum game. It becomes a less-than-zero-sum game for the active fund cohort only when contrasted against a passively managed benchmark. That realization itself should be an approach selection buying signal for uncommitted investors.
Frank Armstrong is decidedly in the globally diversified Index-product camp. He evaluated and rejected other investment policy options. William Bernstein, of Efficient Frontier fame and author of “The Four Pillars of Investing” strongly endorses Armstrong’s work and ethics. I mostly (not completely) join in that expanding chorus that now includes a growing group of institutional investors.
Please take a few moments to explore the Links that I have assembled. In short order, they will reward you with valuable investment lessons.
I grant that the lessons are not particularly kind or forgiving to the active fund management and investment advisor professions, but that is the commonsense conclusions arrived at from Armstrong’s extensive practical experience. There is still plenty of headroom for legitimate disagreement on this controversial subject matter.
Happy New Year everyone.
Best Regards.
Comments
I haven't yet reached the draw down phase, but I started investing with this "moment" in mind. In my younger years...Instead of a taxable emergency fund account I invested in a Roth account. Since they are both after tax investments I took the aproach that "in an emergency" my Roth contribuions would be there for me. Roth is mentioned quite often in the presentstions as well as investing with taxes in mind...many investors miss this point.
I like the withdrawal stratgeies that are laid out in the two videos. I am little surprised that 6% is a comfortable withdrawal rate, but I'm all for the optimism. Capturing profits...periodic outperformance...seem worthy of further discussion. I use 10% as a trigger. I use my bond position as the performance reference. When my equity investments outperform my bond investments by a 10% margin I take profits by selling these profits into my bond investments. If possible I would like to also buy into equities when they are trailing my bond performance by 10% or more.
Thank again for the thread.