Budgeting skills are as important as what your portfolio is doing—probably, more important really, because budgeting is an everyday issue. If a person can scale back appropriately so that they can actually survive on a 4 percent withdrawal rate, they’re good. Any reasonably designed retirement portfolio will last with a 4 percent withdrawal rate. Eight percent? You’re going to have to get really lucky in your investments.

We love reading his work and he’s a very sharp, knowledgeable finance maven. But his claim about the 4 percent withdrawal rate seems a tad glib–there are many assumptions built-in to this claim that need explanation. Would you really like to bet on such a simple number for your retirement? We think not.

Intuitively, at 4% withdrawal rate,  if your return is 4%/YR and inflation is nil, then in fact you can simply withdraw the gain each year and never deplete the principal. But if, for example, inflation is 2%/YR and your return is 4%/YR, then we can show 4% withdrawal rate would last you 34 years. Not bad. But if your return is 3%/YR and inflation is 4%/YR, then this account will deplete after 22 years if withdrawals are at 4%/YR.  That’s probably a big difference. We show you how to handle all these “What Ifs”.

This post introduces the idea of the Safe Withdrawal Rate (SWR), a concept that has recently captured the attention of many investment advisors and publications. We introduce our own focus on this topic now. We announce two initiatives. First, we published a descriptive piece in Advisor Perspectives, a highly respected and popular website for investment professionals. This piece explains SWR ideas without math for the average investor. Second, we published our full research results in detail here, in our permanent pages (see Investing Tools drop-menu above, or click this link):

Investing Tools> Safe Withdrawal Rate

This page introduces our technical analysis and methodology to determinine your own, personal SWR. Our innovation: we capture each individual’s beliefs about his own future returns and inflation to find the expected value of his SWR, irrespective of market history. Ultimately, your personal beliefs about how future returns and inflation evolve is all that matters for your planning purposes.

We set forth a somewhat formal answer in our post on the three main economic scenarios, deflation, neutral and inflation. We want to present a more intuitive answer below.

First, we need to set the stage.

As we have discussed, the Efficient Markets Hypothesis (EMH) is an idea fiercely defended by a variety of senior finance professors, in spite of massive evidence to the contrary. Our post here gives a good summary of what the EMH is, why it is wrong and how it leads to mistakes.

The issue revolves around the implication of EMH that active management is a waste of time and money, since no amount of work can produce more insight than everyone else in market has or can get, and so an investor can get only the market ROI overall over the long run. Thus, according to the EMH, one should just invest in index funds.

OK, let’s stipulate EMH is useless. Now what? How should we invest? Before answering this question, let’s also stipulate, for obvious reasons, we cannot avoid this question.

One answer could be, just give our money to an advisor and let him invest for us. But of course, that raises the question as to how one chooses an advisor who if not sufficiently skilled, is sufficiently lucky. So we need to define an investment strategy.

In spite of all the confusion and uncertainties, one can still make some rational investments, while staying emotionally calm. Let’s define assumptions for a strategy:

The goal is to maximize our ROI, subject to a level of risk we can tolerate. Clearly, the ROI and the risk level are both subjective. We are willing to take more risk to get larger ROI. But the relationship between those two large factors is not known in advance.

We believe the current economic condition is mainly deflationary (prices are dropping and being a creditor is good).

We want to hold securities in such a way that when we discern inflation signs, we can switch easily from the current deflationary position to an inflation stance.

In our case, we want to preserve capital, but have growth reasonably better than that of money market rates (which are now ~0%/YR). This is the risk avoidance component of the strategy. Additionally, we want exposure to some upside to growth. The allocation between our risk avoidance securities and the upside-capture securities is where emotion enters the framework.

Our specific recommendation: account for deflation buy owning a variety of bonds and bond funds. Position the portfolio for upside by owning equities in companies in sectors which we believe are especially promising in the current political-economic environment. This idea, of course, is a standard approach, but modified by a strong emphasis on a small amount of very high risk/high payoff equities. The portion devoted to capturing future innovations or even disasters through equities can of course be enhanced by using various combinations of long dated puts and calls.

Using this broad approach, we can manage risk simply through the allocation between fixed income and equities, and focus on higher risk equities to be exposed to upsides from innovation.

This is not what is called well-diversified….rather, it’s a bet on specific beliefs. Remember, if you diversify enough, you effectively index everything.

Finally, some examples: First, the online, medical records sector, which will be quite actively converting old medical records to electronic format, as well as creating new records electronically, and the semiconductor industry, which continues to grow and also acts as a leading indicator of economic revival.

Scenario Planning is an important component of strategic planning for any corporate or government organization that intends to prosper and succeed over time. It applies to individuals, too. Of course, it applies to investing as well.

Wired magazine published a clear, concise description of how to do Scenario Planning for yourself. The author, Peter Schwartz, is one of the pioneers in the field. He uses an example of an aerospace engineer planning for his career in quite uncertain times.

Read the Wired Magazine Article

Fraction of Actively Managed Fixed Income Funds Beaten by the Benchmark

According to this result, you should buy only passively managed bond funds if you like their underlying index benchmark. The only exception to this interpretation is for the high yield, or junk, bond funds (Barclay’s High Yield Index in the Table). These funds seem to require deep knowledge of the issuers, since they are all by definition high risk, and so active management works better than benchmark to extract risk. (Note: the original research from IndexUniverse won’t be available directly online until early August 09. We got this table from the “webinar” by Index Universe called “Advanced Fixed Income: Not Your Grandfather’s Bonds” today, 30 JUL 09.)

http://www.amazon.com/Demon-Our-Own-Design-Innovation/dp/0471227277

John Paulson, a hedge fund manager, shorted the bank stock index and made a $3B profit. Robert Shiller warned of the housing bubble about to burst. So the crisis was certainly not a Black Swan Event to these folks. But what about the rest of us? Were we surprised? Were we warned?

This video focuses on the psychological roots of some mental biases and how they can lead us to big mistakes. The video (2009-1-27)  takes 59 min, but in our humble opinion, it’s exceptionally stimulating.

Kahneman researched biases of human decision making and gained so many deep insights he was awarded the Nobel Prize in economics. Taleb popularized the idea of the Black Swan, and endlessly talks about the huge risks many people accept blindly, when they could know better.

Kahneman/Taleb Video Conversation

Skill vs Luck in Money Manager Choice. How Can You Decide?

we discussed some of the research that shows that while money management skill does exist, it is extremely rare and there are no criteria for identifying individuals who are skillful. We then touched a few ideas for you to apply when choosing a money manager.

We’ll be more comprehensive and specific in this post. We’ll follow and elaborate on the points raised today in an article in the Wall St. Journal:

Seven Questions to Ask When Picking a Financial Adviser

by Shelly Banjo

13 APRIL 2009

http://online.wsj.com/article/SB123913983139498483.html

The key assumption is that the client doesn’t have the time or expertise to manage his own investments and seeks a professional advisor to help.

In the end, it all boils down to having wise conversations for action.

1. What’s in the advisor’s background?

Investors should know the difference between advisors who have a fiduciary duty to their clients, and those, like stock brokers, who do not. Registered investment advisors have a fiduciary duty to make their highest priority their client’s best interest, even over the advisor’s own interests.

Registered investment advisors (such as your humble servant) must pass a test (Series 65 Uniform Investment Advisor Law Examination) or have certain forms of certification, such as being a Certified Financial Planner (CFP), as a necessary qualification to legally be an advisor.

A registered investment advisor must also disclose a substantial amount of detail about his business such as any formal investigations and disciplinary actions initiated by regulators, along with any customer disputes, certain criminal charges and financial disclosures, including bankruptcies, and education, address and fee structure. These disclosures (form ADV part 2) are found online at

http://www.adviserinfo.sec.gov/IAPD/Content/Search/iapd_OrgSearch.aspx

2. What do the advisor’s clients say?

Ask for references from the candidate advisor, and try to get references not initially named by the candidate. References can give you lots of information about how the advisor actually operates.

By the way, registered investment advisors are legally forbidden from soliciting or using testimonials themselves in advertising, but of course, references are free to volunteer anything they choose.

3. How does the advisor get paid?

Advisors get paid according to what they do for you. The main issues in compensation these days are to use structures that avoid conflicts of interest (such as sales commissions on financial products) and which also reward performance. Stock brokers, whose job includes selling financial products, are often thus conflicted and should tell you so. Registered investment advisors are usually not conflicted (if they don’t sell financial products) , but they must disclose any conflicts and commissions if such exist.

Advisors are forbidden to charge a fraction of profit to any client. While paying your advisor proportionally to his profit generated seems like a good idea to align advisor interests with your own, the SEC believes such an incentive structure would entice advisors to take excessive risk to achieve high profit (even though such high risk could possibly cause losses for both advisor and client).

The usual solution is for advisors to charge a small fraction of the assets under management each quarter. Fees will rise and fall with the asset base.

4. Where are the advisor’s checks and balances?

The client should get a written description of how the candidate advisor would choose a third party money manager in any situation for which the advisor himself wouldn’t be managing the money himself.

5. What’s the advisor’s track record?

We showed how uninformative track record can be. However, clients should demand a formal description of the process by which the advisor makes investment decisions (selecting, entering, holding and closing positons). Most registered investment advisors describe this in an Investment Policy Statement (IPS). The IPS  also defines the universe of permissible asset classes. The advisor’s process must be formally constrained to support the client’s risk profile (obtained from  extensive interviews of client). Clients can use the IPS to decide if the advisor’s process suits the clients style and preferences.

6. Can the advisor put it in writing?

These days, it is fully expected that professional advisors will specify their services in a Client Contract along with their detailed fee structure for those services. This contract is a great document for client and advisor to formally define their relationship and make formal disclosures. In this context, the SEC requires the advisor to provide his Form ADV Part 2 directly to the client five days before the contract is signed.

7. What do other pros think?

Clients should get third party opinions on the advisor and his decisions from time to time.

Even if a manager has a history of high ROI, his next year could be awful. These days, almost every manager has a rather terrible performance record for 2008. So there are probably lots of very highly skilled managers who performed horribly due to the massive economic collapse. Similarly, a poor history could precede a great year, e.g., because of learning. So it’s natural to want to pick a manager on the presumed likelihood of good future performance. But is ROI track record a useful predictor of skill or future performance? No.

Investment skill is a property of human mind, and thus cannot be specified or observed independently of its behavioral results, in this case, ROI. Thus, we must measure past investment performance and try to infer if some unobservable factor, called “skill” even exists. That still leaves open the question of how to detect skill in a particular manager.

One empirical approach to determine if skill exists takes a set of mutual funds with active managers (who rely on presumed skills) and compiles their performance over some time period. Through statistical  comparison with passively managed funds (non-skilled), researchers try to find explanations for the results that cannot be explained by “chance”, in which case the results are caused by an “X factor” loosely named “skill”.

Keep in mind that passive management requires the manager to track some reference benchmark.  Active management picks securities expected to have superior performance compared to the benchmark, but with no more risk.

The research results show that passive money management usually beats active, and that skill exists but is quite rare. (See the paper linked below, to review the details and subtleties of the research; emphasis added).

Luck_vs_skill_in_active_mutual_funds

The research still cannot predict who is the “most skillful” manager, and certainly cannot say which manager will have the best ROI next year.

An entirely new line of inquiry shows even persistent differences in ROI over time are not necessarily reliable indicators of differences in managers’ skills. Here’s the link (emphasis added):

Nickel-vs-black-swan-strategies

The differences may simply reflect differences in reputational concerns. Some managers may be so concerned to maintain their reputation they select an overly conservative strategy and perform worse than they otherwise could. Thus we now have two major factors, skill and reputational concern, that could account for a manager’s ROI results.

Obviously it’s hard to isolate the set of traits and reputational concerns sufficient to select a money manager. So, with all this difficulty isolating skilled managers, how can you choose?

First, ask yourself, and answer truthfully: Do I want to manage my own money? If yes, then do it. As your own manager, you will be picking securities and funds. You will necessarily decide for yourself  passive versus active.

If no, you must find another, even if you could do the job better yourself. This last point is really annoying, but it goes with the territory when you outsource. There are many things you pay others to do that you could do better yourself.

To select someone to manage your money, choose a manager who will wisely steward your money. Select based on your assessment that the manager will pay sufficient attention to your account and make your interests his highest concern. (The commitment to your interests is a fiduciary duty of Registered Investment Advisors, but not of stock brokers.)  He also should have the technical competence to handle various economic and market situations as they arise. In this context, “technical competence” is not the same as the delightful “investment skill” we all seek.

Technical competence can be observed, based on experience and education. Note than even passive management still requires portfolio adjustments from time to time, if for no other reason than to ensure meeting allocations or maintaining diversification. So the decision comes down to relationship building based on observable but subjective traits of commitment, competence and trust.