Posted by Robert on January 31, 2011
This is a guest post by Robert, who lives in Calgary and works as a financial adviser. He is married, has three kids and plans to retire at age 35. Robert and his wife then plan to return to school and become teachers, eventually living and working overseas.
Fund flows are almost entirely ignored by mainstream and academic thinking about investing and financial advice. The term “fund flows” refers to deposits and withdrawals that are made by individuals into or out of their own investment account as well as retail funds such as mutual funds. It turns out that fund flows have a large impact on investment results and should be accounted for in financial planning scenarios.
Over the last couple years, I always print a performance report for clients when I meet with them to discuss their investments and their financial plans. We give similar investment advice to each of our clients, so I struggled to understand why they have 10 year returns varying from 3% to over 8% per year. Upon looking closer at the portfolio, it was usually as consistent with other clients as I expected. The difference, however, was the timing of deposits or trades. Could it really make such a difference at what point people make their deposits or rebalance their accounts? It turns out that the sequence of returns, normally ignored, actually matters. Early in my career, it was presented to me that stock market returns matter a great deal for retirees. The average return of 2%, 8%, 17%, -3% and 10% is the same (6.8%), no matter what order you put the numbers in. But if a person is taking money out, they have a different amount of capital moving with the market. As an example, if they are withdrawing 5% per year, using the returns above, the average return will be something like 100% x 2%, 95% x 8%, 90% x 17%, 85% x -3%, 80% x 10% (while also accounting for growth). This is very different from 100% x -3%, 95% x 2%, 90% x 8%, 85% x 10%, 80% x 17%. The -3% year has a much greater impact and the 17% year has a much smaller impact.
So it turns out that the sequence of returns matters greatly to retirees. But is it unimportant for savers? The assumption that it doesn’t matter only holds if there are no deposits. For a person saving a set amount of their salary, eg. $750 per month, the sequence of returns matter for the same reason as the retiree. The saver has a smaller amount of capital responding to early market returns and a larger amount of capital responding to later market returns. This becomes exaggerated in the case of people who focus entirely on repaying their mortgage in early years, then plan to invest a large proportion of their income between ages 45 and 65. Instead of spreading returns over smoothly growing capital over 40 years, the capital is only exposed to 20 years of returns, meaning that market performance in later years will have an even more pronounced effect on the final average.This is referred to as “dollar-weighted returns.”
This probably affects most baby boomers, and it has a particularly marked effect on early retirement candidates. In my case, I will probably end up working (my current job) for 10 years. If I save around 50% of my income each month (in a mortgage offset account) and invest it once a year in the market, the timing of those 10 deposits becomes very important. Part of the reason I have done very well is that I invested in October 2008 and January 2009 (remember how weak the market was?) A large proportion of my capital experienced returns of over 30% as the market recovered. But those returns could easily be diluted by the investments I am making now and over the next two years. It could easily turn out that my largest deposits experience only mediocre returns, dragging down the performance of my entire savings regime.
Dollar cost averaging may provide a partial answer. Although there is no magic to dollar cost averaging, it could help to avoid one of the biggest differences I’ve noticed between clients with impressive returns and weak returns. The investors who maintained their monthly deposits all through the market crash, between September 2008 and August 2009, easily outperformed investors who stopped their deposits during the scary times. As long as the market crashes and rebounds, this will always be the case. But this brings up the problems of asset allocation and rebalancing. Asset allocation has been shown to have a huge impact on future returns. The highest returns have gone to a portfolio of 100% stocks, except during certain periods like 1929-1954. Suppose an investor wants to add some safety and chooses an asset allocation of 70% stocks, 30% bonds. If they rebalance mechanically each year, they will sell the strongest performer (stocks, in this example) and buy the weaker performer (bonds). This means that more and more of their capital will be exposed to the lower growth of bonds, permanently impairing their returns. The only course of action that could have a beneficial impact on performance is strategic rebalancing, that is to not rebalancing until an extraordinary event (market crash). When the stocks are worth less, selll bonds to buy more stocks, benefit from the rebound, then sell the more valuable stocks to buy back bonds. This is theoretically sound, but it flies in the face of our emotional nature. Recall that a market crash is, by definition, the moment that everyone wants to sell their stocks (and buy bonds) and fear is at its peak. This strategy goes counter to human nature.
Herein lies the value of advice. I’ll be the first to admit that neither financial advisors nor stock brokers have any predictive powers. We can help investors pick better companies, but those companies are usually safer, better run or stronger than their peers, but don’t necessarily have better prospects in the stock market. But where the real value of advice lies is in persuading an investor to remain invested at a market bottom, when they would prefer to sell all their investments, and to invest more at the most opportune time. Market tops are impossible to call, but market crashes are pretty easy to recognize. Helping investors to control their fear should translate to far better real life, dollar-weighted returns.