With Federal Reserve rates at 0 percent there is virtually no upside to buying bonds except for the potential of stabilizing a portfolio for risk averse investors. Taking on duration risk or credit risk is an option ─ and as a result many investors are considering their options as it relates to stocks.
Before I offer my opinion as to which category of stocks make the most sense, I feel it is very important to identify a sensible risk management technique called “aging of portfolios.”
Most financial advisors recommend an allocation that is in line with an investor’s risk profile, which was identified by a flawed document called a risk profile questionnaire.
These documents identify how an investor feels about risk in the moment, but nothing more. An investor who answers these questions in 2019 would display a high degree of confidence and tolerance towards a market correction or even a bear market.
End of Long Running Bull Market
The reason was because we were at the end of the longest running bull market in American history. There was no volatility. Almost every large company was meeting or beating earnings estimates.
This year shows a completely different story as everyone grapples with the challenges around the coronavirus. Ask that investor those same risk profile questions this year and you are likely to get a very different set of answers about risk.
The aging process completely ignores the investor’s risk tolerance and adjusts risk exposure based on the distribution date of the purpose-based account. The highest assignment of risk occurs at the point farthest from that distribution date and is moved first towards income producing asset classes, then to liquid asset classes each year as the distribution date nears. Some compare this method to target-date investing, but there are subtle differences that make this method more conservative than target-date investing.
The benefit of this method is the investor sees the risk management occurring each year as risk is gradually reduced and the investor is never fearful of a large market drop near a major life event like college tuition payments, retirement, or funding a child’s wedding.
Squeezing Additional Return from Risk Management
For those who are wondering how much additional return can be squeezed from this risk management method by picking the right stocks at the right time, the answer is not all that much. However, if an investor can squeeze just 1% in additional return over a long period of time, the difference might mean successfully funding a family financial obligation or falling short.
Here is an example: Using the Dynamic Map app (a free financial planning calculator available on the app store), I can see that a 45-year-old who has $1.5 million saved for retirement, saves $1,000 per month and assumes a 6% annualized rate of return over the remainder of his accumulation phase and distribution phase will successfully fund his retirement beyond age 95 (assumed life expectancy).
For this exercise, I assumed a 3% inflation rate and a monthly draw in retirement of $10,000 in today’s dollars.
As you can see, the 6% assumed annual return for Jeff’s lifetime left him with over $6 million, net of his retirement income withdrawals at age 95.
However, if Jeff assumed he made only 5% annualized over the remainder of his life, uncertainty creeps into the equation. In fact, the loss of that 1% annualized left him going into debt at age 91.
So, which stocks should investors consider in this low to no interest rate environment and in a post-pandemic world?
I will confess I grew up a value investor. I was patient and owned stocks that had low PE (price to earnings) ratios that were temporarily out of favor. This strategy was made famous by Warren Buffett who has been one of the most successful investors in American history. Value investors have always been forced to remain very patient while opinions of their chosen stocks changed. Value stocks have gone through a very long struggle to show significant upside while growth stocks have soared and continue to soar.
Artificial Intelligence: A Catalyst
About five years ago I made a major shift in the way I viewed stocks. The catalyst: artificial intelligence. Companies are using artificial intelligence to eliminate the inefficiencies within their operations that have existed for decades. There is certainly a human cost to this trend, but that is a different story for a different day.
One example I heard a few years ago involved a major wire house that used artificial intelligence to monitor their call centers. The technology identified certain clients who would call under certain market conditions with concerns about their accounts. Once enough data was collected, the technology would notify the advisor the market conditions were approaching that critical mass and these clients should be contacted proactively to ease their fears.
This is an excellent way of keeping long-term relationships that might have otherwise been lost. The bottom line on this technology is that the elimination of inefficiencies that previously existed will result in rising earnings, even if top line revenues flatline!
The last time I looked, nobody follows “price to revenue” ratios. They follow “price to earnings” ratios. Everyone always thinks of tech companies when it comes to artificial intelligence, but I believe any company that employs artificial intelligence has the opportunity to increase earnings for a significant period of time. This new dynamic changed the way I looked at stocks and could even accelerate in a post-pandemic world.
The reason is many companies will continue to embrace social distancing in the workplace, video conferencing in place of business travel, and potentially close some office space.
This cost savings will be significant and will contribute to rising earnings for the near future. Does this mean value investing is dead? No. It means value investors may need to be more patient than they ever have been before. There will, ultimately, come a day when growth stocks are just too expensive to ever meet earnings expectations.
Dividend Paying Stocks ─ Option or Threat?
Equity income (dividend paying stocks) is a category that has become popular with people who can’t get yield from other sources, like bonds. It is true that the dividend story is compelling. It has worked quite well in a rising stock market due to the strong yield and rising stock price.
The scary part of this strategy, however, is when someone truly does replace all of their bonds with these stocks and the market crashes. In that scenario, the investor’s losses could be large enough to convince them to sell which repeats the mistakes investors have made so many times in the past.
My suggestion for managing the income sleeve of an aged portfolio would be to find income from various sources. Include equity income stocks, bonds (take the duration risk rather than the credit risk at this point in time), and covered calls as part of the income producing portion of the aged-based strategy.
My opinions on the portfolio aging process are driven by my firm belief that the institutional method is flawed for families and investors who grow tired of advisors telling them to remain calm and stay the course in the face of crashing markets. The institutional method should be reserved for institutions, like pensions, foundations and endowments.
By removing risk as a distribution date nears, the aging of portfolios strategy eliminates the fear about not being able to successfully fund family obligations, even during market declines.
Although the selection of either growth stocks, value stocks or equity income stocks within the framework of an aged portfolio strategy won’t significantly improve the overall return, it could be just enough over the long haul to improve your outcome!
Jeff Mount is president of Real Intelligence LLC. Jeff has been active in the financial services business for the last 25 years.
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