An answer to a discussion on LinkedIn about my "Bonds and Stocks" article

I posted a question about "mixing bonds and stocks" on LinkedIn with a link to my article on TheStreet.com.

I didn’t plan to “answer the answers” but given that some of the answers are quite sharp and say, “you are a bad, bad advisor”, let me reply and explain why they are mistaken in both their understanding of what I was talking about, and in that they don’t know what I really do with my clients and jump to conclusions (and bad ones at that).

Fundamentally, the mistake many financial advisers make is using short-term decision making for the long-term. Exactly what their clients do, unfortunately.

The answers below can be divided to three groups. The first completely agree. The second does acknowledge the importance of the time horizon discussed and how one defines risk, and then falls into the trap of discussing volatility. The third group provides volatility-based arguments, with or without citations of studies and publications, some of which are indeed by noble laureates.

I clarify: The time horizon discussed in the article is 20-30 years with 25 being mentioned as the basis for discussion. I define risk at the end of the article as “Not having what you need or want when you need or want it.” If you examine this definition carefully, you’d find that ALL risks falls under it. Those include loss of principal, liquidity risk, inflation risk, but most importantly, the client (or you) not having what you need/want when you need/want it.

What is volatility?

It is a factor that affects your risk. It is not risk by itself. Additionally, there seems to be some confusion between variance and volatility. Variance is, of course, a measure of the distribution around the mean. Volatility is the up and down movement. The research quoted is talking about low or negative co-variance between different parts of the portfolio, and not volatility. However, low co-variance is NOT important in this case because you are freezing the money for 25 years.

By the way, it’s not variance that kills you. It’s the losses. You can have a return of 8.1%, for example, if you don’t have losses, but you’d need 10.5% if you do have losses even though you have a similar variance.

Volatility can have two effects in particular:
1. Loss of principal – this only happens due to losses, not volatility per se, and of course, not due to variance.
2. Losses at the beginning of the distribution phase that coupled with withdrawals move the portfolio to below the threshold to support the desired distributions for the term projected. In plain English – you lose too much at the beginning and if you draw a fixed amount, that fixed amount represents too much in terms of percentage, and more than your return, thereby decreasing the principal until it is gone (too quickly).

The second part is not relevant because I didn’t talk about distributions at all! I only asked about the accumulation phase.

The first risk, the loss of principal, is mitigated by using a well diverse basket (index of sort) of stocks. If ALL the stocks in the S&P 500 have lost all the value, why, do you think ANY bond would not default? Or that you’d get ANY return on any fixed instrument?

The point is that over periods of 25 years, well-diversified stock portfolios (essentially indexes) have good returns (10.4% for the S&P500 for example) with relatively low variance. You don’t care about volatility along the way! Because you don’t keep trading in and out you don’t need bonds to counter that variance in the opposite way. After all, the “countering” is only illusionary because you HOLD YOUR BONDS TO MATURITY, and therefore they have NO VARIANCE!

It’s dangerous to give mathematical models to two groups:
1. Those who don't understand them.
2. Those who are too enamored with the mathematics of it to forget the real purpose.

The second group is more dangerous because its members tends to convince the first group they know what they are doing by dazzling them with mathematics.

Example: say you split your money, of 100K to two piles and put them in two safes. One is the 80 in S&P500’s safe (80%) and the other is 20K in bonds’ safe. You open the safes after 25 years and look at the piles. Your 80K grew by 10.4% average annual compounded rate (AACR for the technicians amongst you). Your 20K grew by 5% AACR. Would you have been better off by moving the 20K to the S&P500 safe?

You bet ya.

What do I do with my clients?

I cut the loss-of-principal risk by using an Equity indexed universal life insurance policies that are MAXIMALLY funded (not over funded). As a result my clients enjoy the following benefits:

1. No losses because the minimum they can get is usually 2%
2. S&P 500 like returns as the cash value gets, basically, the S&P500 returns (between the min cap of 2% and the max cap of commonly 13%-17%).
3. Tax free growth!
4. Tax free access! This means an ability to draw MUCH MORE than if the money grew in a regular tax deferred account.
5. Shielding from the danger of losses at the beginning of the distribution phase.
6. Liquidity.
7. Total cost of insurance (and all fees) that amounts to 1% - 1.5%
8. Higher returns to the beneficiaries in case they die (because of the death benefits that are higher than the cash value).
9. Tax free Transfer to the beneficiaries (when coupled with the appropriate Trust configuration to avoid sending the proceeds to the Estate, which could trigger taxes at the estate level).


If that doesn’t satisfy you – what will? ☺