10/06: Moral Dilemma Facing Today's Investors
We are forecasting low returns in the US investment markets with significant volatility. Investors who spend 5% or more (of the value of their portfolio) each year and who have more than 40% in US equities may be at risk.
The Moral Dilemma Facing Today’s Investors
A call to Action from Benchmark Asset Managers
Treasurers and fund managers are confronting a significant moral dilemma in crafting asset allocations and investment programs that meet the needs of our communities in the coming decade. This dilemma is particularly intense for those who have responsibility for the well being of retired church workers or the sole support of missions such as schools, relief, and care for poor people.
A brief statement of the dilemma is this: Returns from traditional portfolios may well be significantly below the experience of the last 20 years. This dilemma will be particularly acute for investment funds whose annual spending is more than 5% of the fund’s value. The symptom of this dilemma will be below average investment returns from US stocks and bonds. The cause of poor financial returns is discussed in a separate analysis, but Benchmark projections can be found at: www.benchmarkam.com
The practical implication is that portfolio income will not be adequate to fund the spending needed to support our work with retired workers and mission program. If we must continue to spend at rates greater than 5% our ability to generate income in the future will be diminished. A typical 60% US equity / 30 % US bond / 10% cash portfolio is projected to provide a 5% annual return in the next decade. Funds that are spending 5% or more will find that their purchasing power is significantly eroded over a ten year period. A 5% spending rate with a steady return of 5% will produce shrinkage of capital over twelve years, after inflation, of almost 15%. At the end of the period spending as a percentage of asset values will need to be significantly higher just to maintain current purchasing power. If in the following 13 years returns recover to 10% annually, then asset values will recover most of the earlier losses, but spending, adjusted for inflation, grows to 10% of portfolio values. This is a moral hazard! If returns fall in subsequent years there will be no recovery. Some of the years from 1 to 25 are shown below assuming steady returns and adjusting spending for 3% inflation:
What If Returns Are Not Smooth?
We all know that returns are not smooth. Big down phases are often followed by up trends. If we assume (as we do) that the 5% projected return over the next 12 years for a 60% equity/30% bond/ 10% cash portfolio will feature at least two big down years and two big up years then the moral hazard may be even more serious. Assuming down markets in year one and two (-20% and -10% respectively) followed by a 20% up year and a 15% up year and then with a 6% steady return to complete the 12 year cycle (this also produces 5% annualized return over the 12 year period), followed by 13 years of 10% total return annualized, the outcome is much worse as shown below:
This outcome is a disaster and is the raison d’etre of this discussion. Asset values fall to less than half their beginning value and spending rises to 20% of the portfolio’s value.
This possible market behavior has a higher probability than many investors think. Most importantly there are very few investment managers or consultants that are encouraging their clients to consider these possible outcomes.
The question to consider is this: Can we afford this level of risk?
In light of the market’s behavior over the past twenty years a stock allocation of 60% seems conservative. It is not. In the current context, for funds spending at 5% or more, it entails potentially disastrous risk. One need only revisit the experience of 1966 to 1982 or 1932- 1948 to see that US markets have historically alternated between long periods of above average returns and long periods of below average returns.
Benchmark Asset Managers LLC believes we may be in a long period (through 2017?) of below average returns.
Can we say for certain that this will be the outcome? No.
Is there historical precedent for such outcomes? Yes.
Who Should Worry?
If your fund portfolio is conservatively invested across 6 or more asset classes and you do not have 40% or more invested in US stocks you may well be immune from this risk
If you are narrowly diversified (that is have only bonds, stocks and money markets), have 40% or more in US stocks and/or are spending 5% or more (on the total value of your portfolio) then you should revisit your investment policy and asset allocation.
If your advisors are not having this discussion with you, please invite us in to expand on these ideas. We will challenge your assumptions (and your advisor’s).
Is there anything to lose?
O. Sam Folin, CFA
May 2005
The Moral Dilemma Facing Today’s Investors
A call to Action from Benchmark Asset Managers
Treasurers and fund managers are confronting a significant moral dilemma in crafting asset allocations and investment programs that meet the needs of our communities in the coming decade. This dilemma is particularly intense for those who have responsibility for the well being of retired church workers or the sole support of missions such as schools, relief, and care for poor people.
A brief statement of the dilemma is this: Returns from traditional portfolios may well be significantly below the experience of the last 20 years. This dilemma will be particularly acute for investment funds whose annual spending is more than 5% of the fund’s value. The symptom of this dilemma will be below average investment returns from US stocks and bonds. The cause of poor financial returns is discussed in a separate analysis, but Benchmark projections can be found at: www.benchmarkam.com
The practical implication is that portfolio income will not be adequate to fund the spending needed to support our work with retired workers and mission program. If we must continue to spend at rates greater than 5% our ability to generate income in the future will be diminished. A typical 60% US equity / 30 % US bond / 10% cash portfolio is projected to provide a 5% annual return in the next decade. Funds that are spending 5% or more will find that their purchasing power is significantly eroded over a ten year period. A 5% spending rate with a steady return of 5% will produce shrinkage of capital over twelve years, after inflation, of almost 15%. At the end of the period spending as a percentage of asset values will need to be significantly higher just to maintain current purchasing power. If in the following 13 years returns recover to 10% annually, then asset values will recover most of the earlier losses, but spending, adjusted for inflation, grows to 10% of portfolio values. This is a moral hazard! If returns fall in subsequent years there will be no recovery. Some of the years from 1 to 25 are shown below assuming steady returns and adjusting spending for 3% inflation:
What If Returns Are Not Smooth?
We all know that returns are not smooth. Big down phases are often followed by up trends. If we assume (as we do) that the 5% projected return over the next 12 years for a 60% equity/30% bond/ 10% cash portfolio will feature at least two big down years and two big up years then the moral hazard may be even more serious. Assuming down markets in year one and two (-20% and -10% respectively) followed by a 20% up year and a 15% up year and then with a 6% steady return to complete the 12 year cycle (this also produces 5% annualized return over the 12 year period), followed by 13 years of 10% total return annualized, the outcome is much worse as shown below:
This outcome is a disaster and is the raison d’etre of this discussion. Asset values fall to less than half their beginning value and spending rises to 20% of the portfolio’s value.
This possible market behavior has a higher probability than many investors think. Most importantly there are very few investment managers or consultants that are encouraging their clients to consider these possible outcomes.
The question to consider is this: Can we afford this level of risk?
In light of the market’s behavior over the past twenty years a stock allocation of 60% seems conservative. It is not. In the current context, for funds spending at 5% or more, it entails potentially disastrous risk. One need only revisit the experience of 1966 to 1982 or 1932- 1948 to see that US markets have historically alternated between long periods of above average returns and long periods of below average returns.
Benchmark Asset Managers LLC believes we may be in a long period (through 2017?) of below average returns.
Can we say for certain that this will be the outcome? No.
Is there historical precedent for such outcomes? Yes.
Who Should Worry?
If your fund portfolio is conservatively invested across 6 or more asset classes and you do not have 40% or more invested in US stocks you may well be immune from this risk
If you are narrowly diversified (that is have only bonds, stocks and money markets), have 40% or more in US stocks and/or are spending 5% or more (on the total value of your portfolio) then you should revisit your investment policy and asset allocation.
If your advisors are not having this discussion with you, please invite us in to expand on these ideas. We will challenge your assumptions (and your advisor’s).
Is there anything to lose?
O. Sam Folin, CFA
May 2005
