Confidence

What comes to mind when you hear the word confidence? You might think about the assurance of your own ability to accomplish a task or to succeed in some endeavor, great or small. You might also consider it as faith in somebody else; that they will do right or act in a trustworthy manner. Confidence in this light can also be associated with things that act in a predictable or reliable manner. It can mean a secret shared and it can describe the relationship of trust that exists to make sharing the secret possible.

One of the great fascinations during my thirty years plus in this industry has been observing how fragile and fleeting confidence can be in most every sense of the word - especially as it applies to self and to others. When things are going well and markets are rising, self-confidence reigns. Confidence in others, such as fund managers, is strong too, but it is quite fickle, landing on whomever produces the best results. And the faster markets rise, the shorter the duration that confidence remains in one place.

When the tide turns and markets begin falling, and doom and gloom replace the good news nearly overnight, self-confidence begins to fade for the stalwarts, and it evaporates like water on a hot skillet for the rest. They begin heading for the exits as fast as they can, with little regard for anything but getting into the relative safety of cash. This reaction is an understandable one. When there is nothing more than price to gauge confidence, its easy to understand how a sharp drop can elicit fear.

Others, instead of heading for the exits will choose to ‘hunker down’ and ride it out even though confidence in their managers is severely shaken, or even broken. Here is a fascinating phenomenon where people make a conscious decision to stick with managers in whom they have lost all confidence, yet still believe they are better off with them than leaving them. In other words, they have lost confidence in their own ability to choose better managers or more strangely, their need for continuity and consistency ironically supercedes their need for confidence.

There is another definition of confidence that we believe shines like a bright beacon for anyone struggling with uncertainty regarding his or her financial goals. It is that of statistical confidence. We use sophisticated probabilities analysis referred to by many as Monte Carlo analysis to provide confidence for our clients. But the process is complicated. You may not be completely clear on how it works and you might resaonably wonder if you can have confidence in the statistical results it produces.

Our process begins with a database of actual historical market returns (stock and Treasury) and  statistically possible returns. As Dave Loeper (designer of our system) points out, we are “able to measure not only the uncertainty of historical returns but also potential returns. This additional step [of including possible returns] helps us make sure we are not ignoring the chance that we have not yet seen the worst (or the best) of what the markets might produce.

So while we cannot predict the future of markets and how they will impact our client’s lives, we can measure the uncertainty of our client’s plan. The system does this by ‘living’ our client’s life plan (cash flow amounts and timing) virtually through all kinds of markets and it does it for 1,000 ‘lifetimes.’ The computer randomly draws market returns and calculates the impact that distinct return has on our client’s wealth relative to his cash flows, one year at a time for every year of his life and then it does it all over again 999 more times. The purpose is to gain an understanding of how confident we can be that our client will exceed his goals considering the uncertainty of market returns, including the very worst of them. With these numerous trials, our client ends up with many more outcomes than the one he was planning for; in other words, we've modeled the uncertainty of the future.

The figure below represents the potential outcomes for a couple living out a 32-year retirement on $65,000 annually (adj. for inflation without Social Security to keep it simple) using a $2 million portfolio (60% stocks, 40% US Treasuries, and cash). Each colored line represents a 10^th percentile (there are 100 virtual lifetimes between each line). While the chances for any one of the outcomes to occur are equal, notice how wide the range of potential outcomes is on the right-hand side of the graph. The analysis suggests our couple could end their lives $3.1 million in debt or they could just as likely die with $12.1 million in wealth; and there are 998 additional possibilities in between.

(C) Wealthcare Capital Management, Inc.                                            

So how do we gain any confidence from all these lines and uncertainty? The graph clearly demonstrates how vulnerable to uncertainty one is if historical market returns are his only guide to financial confidence; he can only react to what has happened. We take a proactive approach. With this tool, we can measure the uncertainty our clients will experience as they demand from the markets the wealth required to accomplish or exceed their goals.

Notice that most of the lines end above zero. In fact, 830 of them representing virtual lives lived experienced market returns sufficient to meet or exceed our couple’s needs for $65,000 annual spending, adjusted for inflation. Remember, we used a $2 million portfolio (60%/40%) that would be drawn down to zero. Based on the analysis then, our couple can be 83% confident of meeting or exceeding their goals.

But confidence is fleeting, you might say. What happens in the real world when a 2008 comes crashing in and the S&P drops 38%? Let’s say our couple began a relationship with us December 31, 2007. During 2008 our Balanced model (60%/40%) lost 19.7% so our couple’s portfolio would be down to $1,541,000 after taking their $65,000 withdrawal for income. Certainly, that drop might rattle anyone who has nothing more than CNBC or the hollow promise that 'it will come back in time' on which to base his confidence.

During our hypothetical December client meeting, we informed our clients that there was a 17.3% chance of their portfolio becomming under-funded in its first year due to market volatility. In wealth terms that translated to $1,436,072. As their portfolio stood at $1,541,000, the couple's confidence remained above our comfort threshold of 75% so no portfolio or spending changes were required.

(C) Wealthcare Capital Management, Inc.

The plan report that we presented our clients would have included a lifetime snapshot of where their investment portfolio needed to be in today’s dollars for each of their remaining years in order to provide sufficient confidence of meeting or exceeding their income goals.

A picture of confidence is worth a thousand virtual lives !

(C) Wealthcare Capital Management, Inc.

Look again at the table entitled "Chance of Falling Outside the Comfort Zone." It indicates that just in the first year, there is a 41.6% chance our couple will be outside what we consider an acceptable range of confidence. Because of this broad range of potential outcomes in a relatively short period of time we continually stress test our clients' plans against new information to indentify opportunities or risks when their plans become over- or under-funded, respectively. Without a tool like this, determining life-plan confidence is nothing more than guesswork and guesswork is not effective life planning.

Have a nice weekend.

Boomers Take Note

The week’s economic numbers continued their trend toward improvement with manufacturing store sales, consumer confidence, and jobs growth all moving ahead. Even Greece looks to end the week on a strong note as arm-twisting forced enough bondholders to swallow losses of more than 100 billion euros ($132 billion) and allow the beleaguered country to move forward with its next phase of debt re-structuring.

Jobs growth continued at a reasonably healthy pace in February, according to the government. The gain of 227,000 jobs followed gains of 284,000 in January and 223,000 in December. Jobs were produced primarily in the services industries of the private sector. By industry, job gains were strongest in professional and business services, health care and social assistance, and leisure and hospitality, according to Econoday. Average hourly earnings rose a modest 0.1% in February, following a 0.1% gain the month before. The average workweek for all workers in February was unchanged at 34.5 hours. According to the household survey, the unemployment rate remained steady at 8.3% as the pool of available workers rose as fast as new jobs were created.

Consumer confidence is on the rise as more Americans said the economy was improving, according to the Bloomberg Consumer Comfort Index. The index rose to a minus 36.7 in the period ended March 4^th, the highest since April 2008 and up from minus 38.8 in the prior period. The gauge on the state of the economy reached a one-year high while the buying-climate measure climbed to a level last exceeded in December 2009. Joe Brusuelas, a senior economist at Bloomberg said consumers are much more comfortable about their own personal financial situations, which is largely negating the recent rise in gasoline prices.” But he also noted index remains at the low end of its historical range.

Consumers took their improved moods shopping last week according to Goldman Sachs and Redbook. Goldman’s weekly same-store sales index rose 1.3% in the week ended March 3^rd, while Redbook’s index saw a 3.0% rise of year-on-year same store sales ended March 2^nd. This rate compared to a 3.4% gain the prior week. Redbook sees stronger sales ahead for the month ahead.

The ISM reported that its non-manufacturing index rose 0.5% to 57.3. Econoday says the composite may understate underlying strength in the bulk of the nation's economy where order levels are building with new orders up nearly two points to a very strong 61.2 vs. January's already very strong 59.4. The index is comprised of agriculture, mining, construction, transportation, communications, wholesale trade and retail trade companies.

The manufacturing sector cooled modestly as factory orders fell back 1.0% following very strong gains in the prior months of 1.4% and of 2.2%. Weakness was centered in durable goods orders which fell 3.7%. Orders for non-durable goods, which always reflect price swings in commodities especially oil, rose 1.3%.

Boomers Take Note

An article this week caught my attention as an example of how terrible financial advice can be taken as sound by it's association with the presenter; in this case the Wall Street Journal. The article was titled Testing the 4%-a-Year Retirement Rule and features Bill Bengen, a financial planner in Southern California who developed the 4% rule.

The following description of his rule is excerpted from the article: “In a study published in 1994, he said that if retirees withdrew 4% of their nest egg in the first year, and then increased the dollar amount by the inflation rate every year, their savings would easily last 30 years. He assumed that the portfolio was held in a tax-deferred account and was evenly split between large-company stocks and U.S. Treasury bonds. In a subsequent study, Mr. Bengen added U.S. small-company stocks to the mix, which increased the portfolio's volatility and potential return. To adjust for this, he revised the withdrawal rule to 4.5%.”

The first problem is with the article itself. There was no testing to be found. The author merely points out that as stocks have become more volatile, many wonder whether Mr. Bengen's rule still holds. The answer?: Well, Mr. Bengen says he thinks it does. However, he says the next five years could be crucial, particularly for individuals who retired in 2000 and have experienced two major stock-market downturns since then. He expects stock returns to be low for a while; if that is coupled with high inflation rates, "then retirees have a big problem," he says.

In my view Mr. Bengen’s ‘rule’ has several problems. While it seemingly addresses inflation, it ignores capital market uncertainty. Uncertain returns (portfolio values) mean that spendable income (4.5% of portfolio plus inflation) will swing wildly from one year to the next. My experience is that people really don’t like their income to swing.

Take for example a couple with a million dollars to spend over their remaining 30-year retirement. Mr. Bergen’s examples use a deferred account invested in a balanced portfolio (60% equities and 40% fixed) so we will too. Using our Monte Carlo system to live our couple’s lives virtually 1,000 times through randomly generated capital market returns (against an allocation of 60% equities and 40% fixed) we find that their income would range significantly depending upon the kinds of market returns they would experience.

	Lowest	Highest
	Income	Income
25th Percentile - Good Markets	$34,376	$65,038
50th Percentile - Average	$36,335	$66,382
75th Percentile - Poor Markets	$30,396	$49,012
In today's dollars

Here’s how the cash flows look under these three lifetime scenarios.

The picture above illustrates why so many throw their hands up and buy annuities, which are basically contracts which pay the insurance company to give them back their own money.

There’s another huge problem with Mr. Bengen’s rule of 4.5%. Look below at all the money our couple would have left over at their deaths; money that they may have wanted to use during their lives. Even at the 75^th percentile, the most pessimistic of our examples above, the couple left $783,832 in the bank, unspent. OK, they may have heirs to whom the money might have gone. But shouldn’t the donors get the chance say how much?

Here’s a better way.

Take our same couple, assuming the same portfolio and risk allocation of 60% stocks and 40% bonds. But this time, let’s suggest that instead of accepting a lifestyle dictated by their returns let’s give them the opportunity to do some dictating themselves. We would ask them what level of spending might be ideal as well as what would minimally suffice if other more important goals required it. In this case our only other goal is to leave something for the kids.

Our couple tells usthat it would be ideal for them to spend $45,000 (after-tax) annually (adj. for inflation) for the rest of their retired lives. If necessary their spending could be reduced to $40,000. They would ideally like to leave their children $100,000, but not less than $50,000.

We inform our couple that they could accomplish both goals at their ideals and have an 81% confidence of exceeding both goals. Our objective is to maintain, to the extent possible, our clients’ income and estate goals through actual market turbulence and the uncertainty of future markets. By continually measuring uncertainty in our clients’ plan we can make adjustments to their spending, estate, and portfolio risk (allocation) according to their priorities to maintain a comfortable level of confidence.

The table above illustrates the broad range of potential outcomes for a $1 million portfolio delivering an annual after-tax income level of $45,000 (adj for inflation) and ending with $100,000. There is a 75% chance the portfolio will be worth more than $300,000 at death and a 25% chance that it will exceed $2.1 million. It is a picture of why our couple needs professional assistance in managing the uncertainty ahead of them and why a simple 4.5% rule of thumb simply won’t do.

Have a nice weekend.

Tick . . . Tock . . . Tick . . . Tock

It is now two and a half years since the Great Recession officially ended. The 18-month downturn was the longest and most severe since World War II according to the National Bureau of Economic Research, a private, nonprofit research group which officially calls the beginning and ends of recessions. But things are getting better you say. Why bring up the ugly past?

Some economic data have indeed shown improvements, particularly of late. Manufacturing has been a steady stalwart of the recovery. Exports have persisted strongly for months, while the much touted automobile industry has made a ‘remarkable’ turnaround domestically. GM regained the lead over Toyota for goodness sake.

Yesterday the Commerce Department announced that it revised fourth quarter GDP growth up to 3.0% (GDP is a measure of the nation’s economic output) from an initial estimate of 2.8%. This figure compares to .4% 1.3% and 1.8% for the prior three quarters of 2011. So the near-term trend looks pretty good, but look a little deeper.

Unemployment is getting better, but at rates not even approaching previous recoveries. And the rates of growth in consumer spending are slowing. Remember, rising employment doesn’t bring more spending, it’s the other way around. Businesses don’t hire until they begin selling more stuff that they will have to replace. And they are not. The rise in employment could well roll over just like that red line below in GDP. 

Since the Great Recession started, the US government has invested/spent/squandered (depending upon your viewpoint) an unprecidented $4.5 trillion more than it has realized in taxes and TARP paybacks. That’s just on the fiscal side. On the monetary side, the Fed is giving it away for free (when inflation is considered) and promises to do so for another two years.

With free money guaranteed well into the future and literally trillions already washing around in the economy, shouldn’t we expect to be doing far better than the chart above indicates we are? The gray bars on the right are shorter than they should be relative to the years ‘03-‘06 and the red line demonstrates a big rollover after peaking at growth of 3.5%. With all these great incentives, why arent we partying like’s it’s 1999?

Since the Great Recession was officially declared ended in June of 2009 the S&P has rallied almost 50% (not including dividends), but there’s not much celebrating there either. The average still remains 7% below the level it occupied when the recession officially began. Adding to the conumdrum is the fact that Treasuries (as measured by the Barclay’s 7-10 year index), which should have been clobbered as stocks rose 50%, are 16% higher (not including interest) since the recession ended.

Bond buyers typically look much further into the future than do stock buyers. This is because they are making a relativly long-term commitment to a steady stream of income payments that will not change as prices rise or fall. Inflation is their biggest concern, and strong economies are much more apt to gnerate rising prices than weak ones.

Stock investors, on the other hand, invest with the hopes that companies will increase their earnings at the expense of their competitors or more often when the broad economy grows. It could well be that stock investors are beginning to question whether prices may already reflect the potential ahead. This week State Street announced that confidence among institutional investors may be breaking down. Their monthly index fell to a weak 86.5 in February which reflects an easing in demand for equities. State Street said that the North American sample shows the greatest weakness, at 80.5, representing its lowest reading in more than three years. Europe is at 95.2 and Asia is at 96.3. A reading below 100 indicates demand for safety (bonds – Treasuries in essence).

Now, back to the question of why this recovery seems to be so anemic given the gigantic stimulus measures thrown at it. The usual suspects like Europe, high energy and food costs, high unemployment, and falling home prices seem daunting, but our economy has tossed aside hurdles more challenging than these with impressive growth in previous recoveries. Could it possibly be that a significant majority of our collective economy have become like bond buyers? Are more of us coming to the conclusion that the stimulus is no longer nourishing, but poisionous, that the deficits and mounting debt will eventually swamp our productive capacity or will?

Since December of 2009 our government has spent $4.5 trillion that’s $4,500,000,000,000 more than it brought in. This number represents a full third of the US economy and that’s on top of the $9.1 trillion government collected and spent during the same period. US Government debt now stands at $15.4 trillion which is very close to 100% of the nation's total economic output. Projections take it to 108% in 2014. The last time debt was this high relative to our output we were at war on two fronts with Nazi Germany and Imperial Japan. As a country we were perhaps more united than any time in our history, including our fight for independence. Today its hard to imagine we were ever more divided and still at peace within our borders.

Some like to to blame the nation’s financial problems on presidents. After all, they are the guys who submit the spending budgets. But if you like to speak from a political point of view, the numbers below don’t provide much moral high ground for either party. They do however suggest a trend.

Obama Deficits
		% Spending
FY 2012	1,327	35%
FY 2011	1,300	36%
FY 2010	1,293	37%
Bush Deficits
		% Spending
FY 2009	1,413	40%
FY 2008	459	15%
FY 2007	161	6%

In trillions of dollars

Others realize that it is the Congress and the “Washington Machine” that are to blame. That’s where the money is appropriated and spent, and overspent. In fact the Congress has increased the US debt limit 74 times since 2001. Do they even know what 'budget' means?

And there are a very few who remember that we are a democracy and that “WE THE PEOPLE” are ultimately to blame for the mess in which we find ourselves trapped. Out of abject neglect we have stood by for decades and allowed an elected few to squander the greatest natural and material blessings ever bestowed on a single nation. As a result our very future is now nearly 'underwater,’ buried in a rising sea of debt. 

In the language of an investor, the US's next quarter ends this November with few signs of improvement. Analysts estimate that profits and growth are expected to be sub-optimal for years, possibly decades to come due to an inexperienced, self-serving management, a lousy balance sheet (near-bankrupt in many industries), an aging physical plant, an outdated, inefficient corporate bureaucracy and culture, inept training, little innovation, and union incalcitrance. If and only if the shareholders can somehow replace the bad management at all levels with more competent, visionary leaders, then there is a chance this giant enterprise may once again become that "shining city on a hill" as once proudly proclaimed by a former CEO. If not, maybe the bonds will prove a better way to go. Their meager 2% returns may prove safe from inflation or deflation as there will be little chance that the US economy will grow fast enough to erode spending power.