Will your investments lead to caviar or cat food?

By Bruno A. Giordano

If you are about to retire or have just retired, that question is aimed directly at you.

If you will have to depend on your savings, investments, etc., to augment or support your lifestyle, then the decisions you make now about what investment strategy or philosophy to follow will determine whether it’s caviar or cat food for you.

If you are in the luxurious position of having so much money or income that you can put it all in government bonds, or can put it all in quality stocks and live on the dividends regardless of stock prices, then you need read no further unless you are one of those that hates to lose money.

You see, if you believe as I do, that inflation will eventually return (can you afford to bet that it won’t?), then your income need will increase as the years go by. That being the case, and having a finite sum to withdraw from, then the finite sum has to grow at the same rate as inflation after you have removed your ever-increasing stipend to meet lifestyle requirements.

If you make the wrong decision as to how to invest that finite sum, the result can be devastating. Allow me to explain.

If you had invested 50 percent in the S & P and 50 percent in Government Bonds (a very typical ratio for the simple-minded) in 1973 and had withdrawn 6.7 percent per year to make ends meet, and then adjusted withdrawals to keep up with inflation, you would have been broke in 13 years. Not down slightly, but broke. Well, you say, we could always cut back. I guess you could, but I sure don’t want my clients to have to cut back!

Now the artful broker/investment advisor enters the scene and says, “What you need to weather the storm is a properly diversified portfolio”, i.e., 30 percent S & P, 10 percent small stocks, 10 percent foreign stocks, 35 percent intermediate bonds and 15 percent treasury bills. Great idea! Now your portfolio lasts 15 years! If you had invested in such a portfolio in 1966 and withdrawn 5 percent per year to augment lifestyle, you would have been broke in 18 years. How about that!

A likely criticism of my discussion so far is that I am giving examples that start at the beginning of protracted Bear Markets.

Exactly!

What I’m trying to communicate is that there’s virtually no specific portfolio that will carry the day if we have conditions that are similar to what we had from 1966 on or 1973 on. Who knows what the future will bring? If you think that this Bull Market is going to last for another 15 or 20 years, then go for it. But you better be right. What if you are wrong?

To repeat for emphasis, this argument is aimed at people who are about to retire or have just retired who need to take about 5 percent or 6 percent per year from their finite lump sum to augment their lifestyle.

So what do I recommend? As I see it you have three choices.

• Invest in a fixed income, guaranteed type portfolio, e.g., government bills and bonds, fixed annuities, CDs, etc. and hope that inflation won’t be too rough on you, or plan to have your lifestyle degrade as you age in direct proportion to any inflation we may have.

• Invest in a diversified equity-driven portfolio (made up of several different asset classes, i.e., asset allocation) and hope that there won’t be any serious, protracted, Bear markets or that there won’t be any at all.

Devotees of this approach say things like: “The baby boomers are putting so much money into the market that it can’t crash.”

“The government won’t allow the economy or the market to crash” (George Maynard Keynes, he of the Keynesian theory that said government debt will keep the economy going, died broke after he lost it all in the 1929 crash).

“It’s different this time” (I was lucky enough to spend several days with Sir John Templeton (probably the greatest) at his place in Lyford Cay several years ago, and one of the nuggets that I left with was “The most expensive words you will ever utter are, ‘It’s different this time.’”

Since we don’t know what the future holds, how in the world can we bet our futures on any predicted outcome. What if we’re wrong? Invest in a diversified, equity-driven portfolio of several different asset classes and manage the risk in each asset class.

What does manage the risk mean? My definition is, watching each asset class every day and when the risk of staying invested is not worth the perceived reward AND the asset class starts to deteriorate (not after it has hit rock bottom), exit a portion or all the asset class depending on the circumstances and don’t return until it starts to improve. While you are waiting, that portion of your portfolio that’s not in the asset class is in cash (money market).

In order to accomplish this without inordinate cost, it is essential to use mutual funds (no cost of any kind to move from a fund to a money market and back within the same family of funds).

Wait a minute, you say, how can anyone possibly get out at the top and back in at the bottom? The answer is you can’t. But you don’t have to! All you need do is avoid major loss.

If you can avoid 80 percent of the major losses (a major loss is defined as 20 percent or more), and capture 80 percent of the major gains, you will not only be able to sleep at night because of sharply reduced risk, but your long-run returns will be market returns or better. As a matter of fact, a recent study published in Forbes magazine demonstrated that being “out” of the market for 1/2 of the 50 worst months and being “in” the market for 1/2 of the 50 best months would out-perform the buy and hold investor while at the same time sharply reducing risks.

No one knows what the future holds, so why bet your financial life on any one given strategy? Be nimble! Manage the risk! Using a risk management approach typically under-performs in a raging Bull Market (like 32 percent instead of 40 percent in 1995) but nicely over-performs in a bad market, (like +10 percent instead of -18 percent in 1990). Taken over the long haul (and that’s what it’s really all about), this technique will give decent returns and most importantly, reduce risk.

If you need to take money from your investment portfolio to augment your lifestyle, you absolutely, positively cannot afford to lose money in a protracted Bear Market.

As the great Benjamin Graham said a long time ago and I quote, “There are only two rules to investing: 1) Don’t lose money and 2) Never forget rule #1.”

Bruno A. Giordano is a contributing author of the book, Wealth: Enhancement and Preservation, and is President of Dorset Financial Services Corp. in Devon, PA.