Chapter 1: Protecting your 401K from yourself:  classification of ad-hoc investment strategies

1. Introduction
2. Popular 401K investors delusions
3. Fashionable mutual funds mix
4. Follow the leader
5. Naive siegelism
6. "Financial alchemist" strategy
7. Stable value only or "Depression might start tomorrow" strategy.
8. Bonds-based strategy
9. "Gold always shines bright"  and "Commodities rulez" strategies
10. Lifecycle strategies
11. Economic cycle based market timing
12. Combination of lifetime strategies with market timing.
13. Conclusions
14. Webliography
15. Old News

Introduction

All the middle-class 401K frogs are welcomed
to the slowly warming stagflation pot

The problem facing virtually every IT professional who got crushed back in 2001-2003 was not only because the game was rigged, but also because most people including myself were greedy and ignorant. Granted, people got hurt by dishonest research and media pumping tech stocks of dot-com bubble, but they amplified  losses due to their ignorance.

As legendary trader Jesse Livermore observed, the market moves to reward the fewest possible number of participants.

First of all event of 2001-2003 speaks against "buy and hold" approach for stocks and connected with it fraudulent notion of "risk tolerance": the key here is that  proof of the pudding is in the eating and speaking about your risk tolerance is not the same as behaving this way in dire circumstances. In other words the "risk tolerance" questionnaires is snake oil salesman trick designed to lure you into stocks as your answer will for sure be different if you answered the same questionnaire in the market situation of December 2008  ( Money Magazine, Dec. 3, 2008):

During such good years, you tend to believe that you have a high tolerance for risk. At times like these, your willingness to take chances drops sharply.

Such mood swings can lead you to jump in and out of the market and chase good performance, with devastating results.

The key question here is the explicit or implicit investment strategy that we were using. A lot of 401K investors  are using strategy which can be called the maximum absolute rate of return, which is looking at funds with maximum returns during previous year and allocating money accordingly the next year. 

But the real question here is "How much risk do you need to take in order to get to the return to achieve reasonably secure retirement?"  If you can achieve the goal while having only bond portfolio it is clear that for your 20% stocks and 80% bonds defensive portfolio is better than more aggressive 80% of stocks and 20% of bonds.

I personally have spent many hours  "inventing" various "winning "investment strategies and back testing them on data available. As a professional programmer and educator I am definitely able to create complex simulation models. But after all this efforts, which greatly improved my understanding of Excel, I became convinced that unless you want to slip into data mining simpler strategies are more viable then complex and those were are the only one which are able to withstand different test periods say 200 different ten year periods starting from Jan 1992 to Dec 1998 (I used exact ten year investment periods for testing) and still have statistically significant advantage over all cash, 50-50 and all S&P500 cost averaging strategies. Also fully passive strategies are nonsense.  All of them can benefit from trading (aka rebalancing) at certain (very rare) points.

Another interesting result is that it is pretty tough to beat a very simple 100-your age strategy, the strategy that is much less risky then 100% stock strategy and which might provide better returns then 100% cash strategy (but not 100% TIPS strategy).

In comparison with 100% S&P500 or other mutual funds such a strategy provides very similar average rate of returns for "good" periods and significant defense in "bad period"  (I testes almost exclusively ten years periods, I do not know why I became attracted to them, but that how it was). But the difference between worst and best outcomes as well as median outcome are closer to each other as you have less stocks in your portfolio and more TIPs. This reduction of risk (which is the same as implied probability of negative returns) is actually often grossly underestimated by 401K investors brainwashed by servile to Wall Street shenanigans financial press. An anonymous reader noted:

I agree the 401k has been a huge Wall-street scam supported by your beloved government. People whom I started work with long ago still don't have anything worth while in their 401k's. People with $500k in the 401k probably put in $500k. Here's reality folks. There is no easy way of making money. You either work for it or hope you get lucky by gambling. That is it. There is no magic formula that allows you to sit on your fat asses and make money.

I don't care what Ray Luchia says. It's all an illusion thanks to the Fed's money printing press.

The investment risks are difficult to value as they are multidimensional:

• There is currency/inflation risk which by the way is maximum in stable value fund due to low returns).

• There is volatility risk (the latter can be judged on max drop of a particular stock of mutual fund during previous recession) that can test you ability to tolerate losses in your portfolio hoping for bounce back (few were able to do this in 2002 and 2003; most 401K capitulated and took the losses). 

• There is also a valuation risk (stocks are fiat currencies of the companies and buying stocks or baskets of stocks (aka mutual funds) at the peak (for example S&P500 in March of 2000 almost guarantee low or negative returns for the next ten years).  Large companies use fuzzy accounting and it is difficult to understand what's going on.

There is also "fat tail" outcomes or "panic rush to the exit" risk when an investor finds himself in the situation the probability of which should be very low if we assume normal distribution of underling data.  But due to non-normal distribution there are significant chances that it occurs during his investment periods and he/she will withdraw from the market due to size of the losses incurred and the fact that his internal model of the market now looks broken and unrealistic.  

A lot of 401K investors were burned by this type of risk in 2002 and 2003 then S&P500 dropped 50% from the peak (from 1560 to 773) converting 401K into 201K :-).  That should not had happen but it happened anyway and now we know why: regulators were asleep at the wheel. The same thing happened with subprime mess.

Recently we've seen that people are now drawing down their 401Ks to make their mortgage and as a source of consumption. A major market decline would be a two-pronged attack on their savings, which aren't large enough anyway.

Such shocks as happened in 2001-2003 should generally encourage rational long-term 401K strategies but for some reason that did not happened. Despite very expensive and painful lessons of dot-com crash many 401K investors after five years of  calm tend to forget them and again adopt a psychology of short-term traders. Among those very expensive lessons:

• Don't chase yield.
• Don't buy something you do not understand.
• There is no free lunch. Analysts ratings and rating agencies opinions are essentially worthless because they are never timely enough and because their business model creates enormous credibility as well as conflict of interest issues.
• Don't trust Citigroup, Bear Stearns, Merrill Lynch or any other "biggies"...  They first and foremost promote their own interests (and bonuses). Retail and 401K investors for them are the cow to milk not a partner to respect ("financial despotism")
• Average stock fund (including S&P500) returns for a ten year period are actually between 6 and 7% not 10% as some claim. Andrew Smithers of London-based Smithers & Co and Geoffrey Wood of the Cass Business School at the City University London have found that long-run real returns on equity in the US have been a little below 7%. Another study estimated the global real return on equity in the 20th century to be close to 6%.

The period of extremely lax regulation (Greenspanism) and the culture of greed created "stock pumping by analysts" mania but after the bubble burst this destruction of trust did not have a meaningful impact on the puppeteers behind the curtain until the subprime mess.  Paradoxically after the dot-com crash they did not lose their credibility. Both stock and bond markets in the era of fiat currencies are a confidence game and once confidence is lost the player is in deep trouble: trust once lost, is not easily restored.

First of all  expectation of returns in high single digits in 401K accounts is unrealistic. Something around 5-6% is more reasonable estimate.  As Warren Buffet put it:

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.

This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the thCentury, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% 20when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.

Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.

It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?

Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high-priced managers (“helpers”).

Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple:

1. Investors, overall, will necessarily earn an average return, minus costs they incur;
2. Passive and index investors, through their very inactivity, will earn that average minus costs that are very low;
3. With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double-digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

In search of rational investing strategy

The first observation that needs to be made is that if you do not know what strategy you are using you are probably following some (often very poor) financial strategy.  May one of the following:

• Fashionable mutual funds mix
• Naive siegelism
• "Financial alchemist" strategy
• "All money in bonds" or "Depression might start tomorrow" strategy.
• "Gold always shines bright"  and "Commodities rulez" strategies

My key point is that for any professional, especially IT professionals need to back test the chosen strategy using Excel or scripting language like Perl. That tremendously improves both understanding of strategy chosen and returns that can be expected. Such "dry runs" can definitely helps to prevent huge losses. It even might improve your returns but this is less important as this is a casino: everything is stack against small investor. Keep in mind that part of the returns will be directly or indirectly paid to financial middle-men not to you. That's the beauty of managing somebody else money ;-)

Most 401K plans provide at least three major classes of financial assets: stocks, bonds, and cash (ultra short bonds).  My point is that it is prudent to combine them all into a coherent strategy that at least worked well in the past for various ten year periods.  Often Wall Street gurus talk about diversification in regard to stocks, but in reality diversification first of all means diversification between stocks funds and cash (ultra-short bonds)/bonds funds. I would argue that using diversified bond funds like Vanguard Bonds funds  (or even Institutional Pimco fund, although expenses are somewhat high (~0.5%)) or even BB-bond fund like Vanguard High-Yield Corporate ( VWEHX ) and 100-your_age strategy, as well as keeping the portfolio extremely simple actually might improves returns in the "long run" (which actually is not that long for most investors, and say, usually is limited to ten years holding period and most 401K assets are accumulated from, say, 45 to 55; after 55 a lot of IT professionals like programmers lose highly paid jobs).  In the November 2007 article Are you really such a daredevil Financial News Money magazine senior editor Paul J. Lim, noted:

...More turbulence, in other words, is a distinct possibility. And, collectively, investors are heading into this uncertain period with highly aggressive portfolios.

Employees in 401(k) plans recently held nearly 70 percent of their accounts in stocks, marking their biggest bet on equities since July 2001, according to Hewitt Associates. And, many of those portfolios have gravitated toward some of the riskiest types of stocks.

...  ... ...

In an article he co-wrote for the Journal of Financial Planning, Pompian argues that sometimes financial advisers need to create an investment plan "that suits the client's natural psychological preferences," even if it means leaving some potential return on the table.

The point is to position your portfolio in a way that makes it less likely that your emotions will get the better of you in a sharp downturn, and to do so while giving up as little as possible of the long-term gains that stocks offer. There are several sensible ways to do that.

• Change the types of stocks you own, not the amounts
• After several years of big gains in riskier types of equities, "the average investor is probably overweight emerging markets and small-cap stocks," says Richard Bernstein...
• ...For example, by going from an aggressive 80 percent stock-20 percent bond portfolio to a 60-40 mix - and using Money 70 low-risk funds - your worst short-term losses would have been cut in half over the past 10 years.

My impression is that very simple and time tested N-your_age strategy of stocks/bonds funds allocation is better that many more modern and more complex approaches.  I tested this hypothesis (and this is just a hypothesis, which actually can be wrong,  as future is unpredictable by definition) by simulations for ten years historical periods starting from 1990 to 1996.  Of course no stocks/bonds allocation strategy can save you from multi-year slump like Japanese recession but if reallocation has age as a variable it diminishes risks as we grow older. 

Based on results of those limited simulation experiments I came to conclusion that this strategy is difficult to beat especially taking into account various restrictions in actual 401K plan (selection of mutual funds in most 401K accounts is often very limited and pretty arbitrary.)

Actually cash (stable value funds) is an important substitute for bond funds as bond funds that have interest rate below 5% are too risky to hold in 401K. Therefore you can treat bond portion of the portfolio as cash without losing any sleep. Please remember that bond funds are not bonds: they are more complex financial instrument which don't guarantee the return of your principal.

In my simulations for the historical period mentioned above stock-(bond/cash) mixes with higher (bond/cash) component (35 up to 65%) in most 10 years time periods tested provided higher median returns (median return is return that is higher that one half of particular simulation experiment returns), although like in any simulation that use historical data those results are no guarantee for the future. Still it's important that this classic life-cycle strategy and its derivatives meet the "kiss" ("keep it simple, stupid") test.  It is easy to understand and along with higher median returns it provides some cushion against additional risk of holding excessive percentage of stock in your 401K portfolio in periods when you are close to retirement.

Continued

Etc

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Last modified: March 12, 2019