Paul Winkler: Welcome to “The Investor Coaching Show.” I’m Paul Winkler, talking about money and investing. We talk about the news of the day in the investing world.
A lot of times I like to talk about questions people are asking, and sometimes you get into conversations with people in the course of the week and it raises a question that you might have.
Income From an Investment Portfolio
So a question came up about income from an investment portfolio, and I’m going to talk a little bit about that.
We can take income from your investment portfolio, and let’s say you’re wanting to set this up.
I always tell people, “You don’t have to memorize this stuff.” This is something that from the advisor standpoint, the advisor should be doing this.
When I was a broker working for an investment firm, I never did it this way. It was only when I was introduced to academic investing principles that all of a sudden this was introduced and it made so much sense to me.
I remember Jonathan — one of the guys who runs our Gallatin office — talking about when he worked for one of the big banks and he said, “Well, you have four mutual funds and you take one fourth of your money from each of the four funds that you own.”
And it was like, “No, that’s kind of silly. You don’t want to do that.” It really depends on which one of the funds has done better. That is the way I like to approach this because you think about it: What do we want to do? What’s the golden rule of investing? “Buy when prices are low, sell high.” And you want to pull money from that thing that has just done well.
So it’s going to be relatively high compared to everything else. So taking it equally would mean that some of the other areas are down.
When you’re investing, you’re diversifying.
You’re putting things together that don’t move with each other.
If one goes up, the other one may be just doing not much of anything, or maybe one area may be going down, and that commonly happens.
Let’s say, you have stocks that are just rocking, they’re doing really, really well and bonds may be just doing nothing but meandering, or your fixed-income portion of your portfolio. And stocks, you only have years, single years, where an asset class like small US stocks or small international stocks where you’ll see a 70% return. I mean, only single years where you’ll see a big return in one year.
So what’ll happen is that creates an overrepresentation of that asset category relative to everything else. Now, there will be some years it might be up 10% or more modest amounts but that’s rare that it’s 10%. It is usually up 30%, up 25%, down 15% — it’s back and forth, and you go, “That’s so unnerving.”
Well, if we look at something that always goes up, expect maybe 3 — and you look at treasury bills going back through history and the rate of return is about 3, the inflation rate is about 3, and the rate of return after inflation is zero.
What’s more unnerving is having an investment portfolio that has no real return, which is an inflation adjusted return or having an investment portfolio that fluctuates in value. But you got a lot of different things, and some of them move up and while others are moving down and then the others are moving down.
And when you design it, you’re looking to make it so that no matter what happens, there’s going to be something in your portfolio that is holding value. You’ll have a year where maybe stocks and bonds move together. And when they move together, it would be cash that’s holding, and if they’re moving downward together … Like last year, that would be a good example of that.
Now some asset categories went way down, like large US stocks went way down last year. Whereas small value companies went just a little bit down comparatively, like down 3%, that was it.
But you might have bonds that go down because interest rates are going up, which drives bond prices down. And then when that happens, cash may be your only friend in the portfolio.
You want to have something that is holding value no matter what happens.
Like I said, this isn’t something you memorized, but there’s work that goes into doing this, because you may be looking at asset categories on a daily basis and looking at what did better than the other on any given day.
Driving Up Demand
So what you’re doing is you’re cash-flowing out of the thing. If you’re taking income, the thing had done better, so it’s taking up more of your portfolio. It’s overrepresented because it did better relatively, and trees don’t grow to heaven.
Just because it did well yesterday or over the last week or over the last month, doesn’t mean that it’s going to do well over the next day, week, month, year, or whatever.
So when you’re taking that income, you just basically go, “I don’t know what’s going to do best next. I don’t know. I have no way of knowing.”
Because if I knew, I probably wouldn’t tell you. People are going to try to keep that information to themselves, right? Because you can profit more if you have information that nobody else knows, and then you can go and make moves and transit.
And by the way, a lot of times what happens is people will act like they know something that nobody else does.
They’ll try to convince you to do what they did yesterday.
What I mean by that is this: Have you ever received those faxes — back when people actually got faxes — saying, “You need to buy X stock. This stock is going to go through the roof and blah blah blah,” and then you read why you ought to buy X stock?
And what you don’t know is that the person telling you to buy X stock probably bought it the day before, and it’s a thinly traded company. In other words, there are not a lot of shares traded on a daily basis. So if they can get you to buy it the day after they bought it, just the sheer volume and demand for the stock that they create can drive the price up so that they can sell it into an upward moving market.
So that’s one of the games that is played, but the reality of this, nobody knows where things are going to go. So what we do is when something has done well, we say, “Well, it’s supposed to take up 5% of my portfolio and it’s taking up 7%. It’s over where it’s supposed to be. Let’s just take our income from there because I don’t know if tomorrow it’s going to do the same.”
I’m not doing it because I am predicting that it’s going to drop in value. I’m doing it because the risk of my portfolio has changed when I am getting more concentration in one segment of the market.
Let’s say I’m only supposed to have 5% of my money in large US stocks, and now I’ve got 10% because of a run-up in that area of the market. Now, yes, relatively the price is higher than it used to be, right? But now here’s the issue: Now that I have 10% of my money there, if it does drop in value, it has a bigger impact on me in a negative way than if it were only taking up 5% of my portfolio, which is what it should have been doing because the asset mix was chosen based on it not being any more than that. So that if it does go down in value, I’m not that negatively affected by it.
That’s why we diversify in the first place.
If I put a whole bunch of money in any particular company and that company goes down in value, that can put me in a world of hurt. So what I do is I mix it around — I cast my bread upon the water, to quote Solomon — and then what I do is spread it out so that if anything goes wrong with any one of those companies or any of those market areas, it’s not the end of the world.
Now, it does become the end of the world if I end up overly concentrated. I had one meeting with a client this weekend. I’ve been working with these people. And what ended up happening is retirement takes place and you’d go, “Hey. Okay Paul, now it’s time. Let’s come out.” And where a lot of times people make changes is when they have a big life change, and that’s when they tend to call up and say, “Okay. Now it’s time, let’s do something.”
When I was looking at this portfolio I said, “Well, you got 91% of your money in one asset category, large US stocks.” And they’re like, “Oh my goodness.” Yeah. “And you don’t really have really good diversification. So we want to make sure that we get this spread out a lot better because of that area of the market.”
We started talking about that particular area of the market, which normally sells for about 16 times earnings. And now it’s selling for over 20 times earnings. And there are other market segments selling for like 12 and 7 times earnings.
I’m not predicting that large US stocks, which is the most commonly held area of the market for American investors, is going to come crashing down. But I’m also not going to take the bet that it’s going to continue to go up in value either because that would not be a good idea.
So when we’re taking income, that’s what we’re doing is we’re looking around at relative valuations, what these things are, how they’re represented in the portfolio, and what percentage of the portfolio, and then spreading between these various areas.
Capturing Asset Categories
Now, that’s one thing. The other thing that I pointed out in this particular instance that I think is helpful for people to know is I’m also looking at the funds that are capturing the asset categories.
Now I said large US stocks; you might have small US stocks in your portfolio as well. I know that for large US stocks historically, the rate of return going back to the 1920s was about 10%, and for small US stocks was about 12%. But if I look at the year-to-year returns, it’s never that. It’s never 10%, 10%, 10%, or hardly ever even 10% period. It may be up 25%, down 6%, up 15%, down 3%, up 4%, or whatever.
So what I’m looking at is the return to the fund. I can take that long-term return and then what I do is I subtract from that.
This is how you analyze; it’s called a “sharpe ratio.” What you’re doing is you’re looking at return minus the risk-free rate. What’s the rate of return of fixed-income investments that have no risk whatsoever? Like government bonds, treasury bills, or something like that would be risk-free. So that gives me my return premium above something that is super, super low risk. That is my extra return.
That’s why we invest in the stock market historically.
The reason we do that is because we want to have something. Remember treasury bills after inflation got zero return. So I want to have something that helps me make sure that I don’t run myself dry of money.
A lot of people think, “Oh, I don’t want to run out of money.” And they go for safety all the way through, and they go, “I just want safety, safety, safety.”
I go, “Well, do you realize you’re taking a huge amount of risk, but you just don’t perceive it?” Because your investments are basically fixed income, and historically the rate of return after inflation is zero. So you’re taking a tremendous risk that because of inflation, you could run yourself into the ground from a standard of living standpoint. Your standard of living could drop significantly because your investments aren’t keeping up with the cost that your standard of living is rising by. And we know that as what? Inflation, right?
So when we do this with an investment portfolio, we’re looking at making adjustments and holding both of these things. We have the stocks and historically, we’re going to use different types of asset categories, large and small and so on and so forth.
And then we’re going to diversify across those, and that’s what protecting us. We look at where we’ve gotten protection against inflation. Which prices are going up? Who’s raising prices? Companies. What do you own when you own stocks? You own the companies that raise prices. And you get that protection against inflation, and then on the other hand, you get the protection against the market fluctuations with your fixed income and your bonds.
So that’s the idea behind it.
Risk vs. Returns
Now when I look at, let’s say, large US stocks, what I want to look at now is I want to look at the return above the risk-free rate. Remember, I’ve got my historic return of stocks, minus something that has no risk, bonds. So let’s say that the return for large US stocks is historically 10%, right? And then we say, “Okay, what’s the return for treasury bills historically?” Let’s say 3%, okay?
So we say, 10 minus 3 is 7. That’s my premium; my risk premium for stocks is what we call that.
Now we divide that by the standard deviation, the risk, how much up and down, how much volatility you might see as an investor. And one thing we can look at is alpha, and we say, “Well, what’s the alpha?” This is typically how I’ll teach this.
Now you’ll hear people call themselves alpha investors, and what they’re saying is that, “We’re going to try to use our great skill to get returns above the market or get higher returns.” But it’s not just returns above the market, it’s also returns above the market on a risk-adjusted basis. Remember, we’re talking about return and risk in this little equation that I’m telling you about. And what we’re doing is we’re hoping we can get more return for the level of risk.
And you might hear people say, “I would love to have stock market returns with treasury bill risk.” And in the academic world, there’s a joke. I said, “That’s what people want. I want stock market returns with treasury bill risk.”
You know what investors end up getting? Treasury bill returns with stock market risk, because they mess up and then they end up selling at the wrong time or buying at the wrong time.
They take all of this risk and then they end up lowering the returns because of bad decision making.
So what we’re looking for when you hear “alpha” is “I want to be able to use my skill to get higher returns without the risk”. And you’ve heard me a million times if you heard me at all here on the show say that, “Professional managers get lower returns than the market most of the time.”
I’ve quoted the returns, and if you look at the 15-year returns, it’s like 93% of professional managers are beaten by what the market does. You see people throwing darts at the stock tables, being the professional. So I’ve beaten that into the ground. I’m not going to talk about that right now, but you look at that and go, “You’re gambling when you try to do that.”
The Alpha Concept
But I will use that alpha concept when I’m talking to people about their 401(k). I will take their funds and I’ll go, “Hey, let’s take a look at the alpha on the funds and your 401(k).” And then I’ll look and go, “Oh.”
There were a couple of them I had this week. One person came in, and we were looking at funds and we just pulled up just three funds out of it, just out of the portfolio.
And I said, “This fund had an alpha of negative seven,” meaning that the returns should have been 7% higher based on the risk that they took. And they were going, “Ooh.”
Now, it didn’t mean that the fund had a bad return; it had a decent return. The return was okay, but the risk was so much higher. You took a risk to get the same return you could have gotten for a fraction of the risk.
Why is that important? It is so important because if you’re taking income from your portfolio and that portfolio is going up and down more than it should, then when it goes down, you’re having to sell more shares to get the same level of income.
You can end up with a drastically different result when you do that because you have to sell more shares. And then, you’ve sold those shares when the market was down or when the portfolio was in that downward risk pattern. Then when the market comes back, you don’t own them; you’re not there. So therefore, you can’t recover, and that’s the problem with this. It’s a significant problem.
Another fund had an alpha of negative five or negative six or something like that. Now one fund was negative one, so it wasn’t a big deal; it wasn’t really bad but it was still bad. It was still negative. I said, “Now, here’s what we’re looking for.”
Now for different asset categories, I might be looking for different alphas. Like large US stocks. If I have an S&P 500 fund — let’s say, a fund that is tracking that area of the market — the alpha may be negative 0.3 or negative 0.03, or something like that. And it’s because of the management fee that you’re going to have a return that’s slightly less than it should have been based on the risk taken. But you can’t invest directly in the index, you have to have a fund that replicates the index.
Now in other areas, you can actually have positive alphas just because of the way the portfolio is managed. You’re looking at it versus the asset class.
Too complicated for here, but the point I want you to get is this:
You do not want to take risks you are not getting paid to take.
If you can avoid that as much as you possibly can, that’s what you want to do. And that is something that most people aren’t even aware of; they don’t even know that it exists or don’t even understand how it works. And I see statistics used all the time that people don’t even know what they’re talking about when they talk about it.
“Well, I’ve got this portfolio with a beta of this” and they’re like, “What does that mean? I don’t know.”
So in essence, when you get to income time, my bottom line is you really have to start focusing as an investor on risk and how to take an income. If you are dealing with a portfolio with more volatility than it should have, it can sink you because of that sales of assets when markets are down.
Yes. So I was just talking a little bit about risk measures and things like that. I guess it probably makes sense to explain how you measure risk just really quickly here. We look at standard deviation. That’s the best thing that we’ve got. There are a few other measures that are being talked about in the academic world.
Nothing really has caught on like standard deviation.
Let’s use beta for example. Let’s just talk about that.
So if I have a beta of 1.2 of a particular stock fund, let’s say, and you go, “What is that?” Well, let’s say if the market has a 10% return, I would look at that and say, “Well, the return of the fund ought to be 12%.” So it’s simply 10 times 1.2. So 12% return. And then if the market goes up, it goes up 20% more than the market. If the market goes down, it goes down 20% more. So that would be a measure of risk.
Well, sometimes what can get confusing in all of that is this: What if the additional return was gotten through just sheer luck of the draw? What if the fund actually had higher returns than the market during periods of time, just because it got lucky and it timed the market better than, let’s say, their peers? What if it just got a decent return versus the index due to just getting lucky and picking better companies than what the index return was?
So let’s say that they picked companies and maybe they weren’t in a couple companies that had a bad return in the index.
Now again, going back and saying, “Well why did the return come in better than the index?”
Gene Fama, he’s a University of Chicago guy that won the Nobel Prize for economics, he would say, “Well, you can get lucky. You can do that.” Now is there any possibility for skill in the investing process where you get a higher return than the market? And he would tell you, “Yeah, there could be.” And he says, “But in order to determine whether the additional return was due to skill or luck, it takes about 60 years.” And you go, “Well, after 60 years, either I’m dead or retired, or it’s just too late, or the fund manager’s retired.”
So let’s say we find out, “Oh, the fund manager definitely had a better return than the market, and it was due to skill. Let me put my money with that person because they’re apparently skilled.” But that fund manager is going, “Sorry, I’m retired.” That doesn’t do you any good. And that’s with a T statistic of at least two. So it has to be statistically significant whether we know whether it was due to skill or luck.
How to Use Standard Deviation
So in effect, what we’re looking for when we’re looking at beta is, “Well where did the return come from with additional risk?” So that’s not a great measure of risk. Now, what we do is we look at the level of volatility of an asset category and we look at as much historical data as we possibly can.
So I’m not digging, going, and looking at three years of data to determine standard deviation — or 10 years of data, or even 20 years of data. That’s way, way too short. I want a hundred years if I can get it. I want as much data as I can possibly get and use that to determine: What’s the likely volatility of this asset category? How much does the return change from year to year? Or how big of a swing might I expect?
And how do I know how much risk I’m taking? Well I know because if I know the standard deviation of my portfolio, I can tell you how much it might vary from the expected return.
So if the expected return is 8, and the standard deviation is 10, I can say, “Well two out of every three years, my return is going to be somewhere in the range of 8 plus 10, or 18. Or 8 minus 10, which is 2.” So 68% of the time my returns are going to fall between (I said two-thirds, but it’s technically 68) those two numbers, negative 2 and positive 18. So that’s going to be a range.
Now 95% of the returns are going to be between 28 and negative 12, so that’s just a definitional thing on standard deviation. It’s just how we define risk. And if I know that, if I know what that range is, then what I can do is I can go, “Oh, okay, it was down 15, but that’s not out of expectations. That was within expectations.” I can breathe easy knowing that something weird didn’t happen that no one could have expected. Not that something weird can’t happen that nobody expects, but that’s how I judge whether the portfolio is operating within expectations.
What that does is it helps me not to worry a whole lot about that. You see?
It is so key to have a measurement of risk.
Now what I can do with that measurement of risk is I can determine: Can I take an income from this portfolio? Is this portfolio designed to take an income, or is it something that I really have to keep myself up at night over because I’ve got a portfolio that is not designed to deliver income very well?
Remember, if I go all fixed, then yeah, I don’t have any risk. I have a very low standard deviation, but I have no return either. And after inflation, I’m basically going backwards, backwards, backwards. So that is why this is all so important.
You are listening to “The Investor Coaching Show,” right here on Super Talk 99.7 WTN. I am Paul Winkler.
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