Thursday, March 21, 2013

The Stock Market Risk

Risky stocks

Stock market risk is the risk of the decrease in the market value of an investment.
In contrast to the sequence of returns risk, the risk that a market downturn reduces the capital base near the time of retirement, stock market risk is a period of poor performance in the stock market that results in investment returns lower than expected.

In both cases, the portfolio runs out of money sooner than expected, leaving little or no funds to pay living expenses. One measure of riskiness of a stock or portfolio is volatility -- how much the value deviates from its average over time. In statistical terms, it's the "standard deviation".

For example, we can calculate the average and the standard deviation of monthly investment returns
of a security over a number of years. The standard deviation gives a clue to the extent of the fluctuations for the security above and below its average.

The more wildly a portfolio fluctuates, the more likely the odds that it can irreversably deplete your assets.

Risk premium

In the stock market, there is a strong relationship between risk and return. In general, the greater the risk, the greater the return. Based on past volatility and the lack of guarantee of any equity investment, investors expect to be compensated duly for taking a greater level of risk. This compensation is called the risk premium.

Risk is therefore central to stock markets or investing because without risk there can be no gains. You need risk management strategies to minimize the risk and maximize the gain and meet your invetment return objectives.

Stocks and markets

In financial markets there are two major types of risk: the market risk and the specific risk. Market risk cannot be eliminated through diversification, though it can be hedged. Specific risk is tied directly to the  performance of a particular security and can be protected against through investment diversification. Sources of market risk include recessions, political turmoil, changes in interest rates and natural disasters.

Managing risk

There are a few strategies that you can use to mitigate the stock market risk.

Diversification irons out risks in a portfolio. Investing in a wide variety of stocks reduces risk compared to a poorly diversified portfolio. Diversification works if the securities in your portfolio are not perfectly correlated. When one asset or sector is faring poorly, the gains on other assets can make up for this loss.



Lack of diversification can give rise to a liquidity risk if significant assets are held in stocks that are traded in low volumes and they cannot be sold in a timely manner.

The percentage of assets held in equities should be in line with your risk tolerance level, time horizon and financial goals.

Even with a low tolerance, there is a need to maintain a share of assets in equities to boost potential investment returns. Common stocks have historically outperformed other investments over time, and are a necessary component of your portfolio.

You will experience low or negative investment returns on your stock returns from time to time. While these losses are painful, recoveries from market declines have been surprisingly quick in recent times. Selling to prevent losses from getting worse means that you may miss a recovery that boosts your account value. Holding good companies that are trading at a lower value are only a paper loss.

In other words, you should follow the trend of the market and recognize that short term trends are "noise" and what really matters are long term trends. However, it is also possible that you will experience a long period of stock market losses. So as you get older, you should be careful to limit your stock market exposure and gradually reduce it to a level that cannot adversely impact your financial security.

A related approach to diversification is holding investments that have a low correlation or are negatively correlated to each other. This is less effective today as markets across the world tend to be highly correlated and stocks and bonds have a low correlation.

If performance is lower than expected, then lowering spending may be the only option if a phased or postponed retirement is not possible.

Transferring risk

There are ways to transfer the stock market risk. A annuity is an obvious solution, but the income it provides may create issues for managing other risks, such as the long-term care risk (insufficient income to pay rising health care costs) and inflation risk (if the annuity income does not have automatic increases to maintain purchasing power). Inflation and annuities are discussed in greater detail in this blog post.

The stock market risk can also be removed by investing in financial products that hold stocks, but guarantee against the loss of principal, such as segregated funds or index-linked  notes. Again, fees and loss of liquidity have to be carefully considered when assessing the benefits of these investments.

What's in store for the future

With low economic growth, high government debt and low interest rates, many have a pessimistic view for the stock markets. What can we expect when formulating expectations for future stock returns?

Vanguard Research published an excellent study entitled "Forecasting stock returns: What signals matter, and what do they say now?" (October 2012).

The Vanguard research looked at U.S. stock returns since 1926 to assess the predictive power of more than a dozen metrics. They found that many commonly cited metrics have had very weak and erratic correlations with actual subsequent returns, even at long investment horizons.

Their research has shown that forecasting stock returns is difficult for the long-term and impossible in the short term. Over a long time horizons, few metrics have predictive ability. While valuations (price/earnings ratios) have been the most useful measure, they have performed modestly, leaving nearly 60% of the variation in long-term returns unexplained.

The study indicates that using the current valuation metrics points to a positive outlook for the stock market over the next ten years. However, it cautions that investing must account for the fact that the future is difficult to predict, meaning that investors should not rely on point forecasts from a forecasting model but instead turn their attention to the distribution of potential future outcomes.

The study concludes:
"A focus on the distribution of possible outcomes highlights the benefits and trade-offs of changing a stock allocation: Stocks have a higher average expected return than many less-risky asset classes, but with a much wider distribution, or level of risk. Diversifying equities with an allocation to fixed income assets can be an attractive option for those investors interested in mitigating the tails in this wide distribution, and thereby treating the future with the humility it deserves."
Planning for uncertainty

A study by Russell Investments entitled "Adaptive Investing: A responsive approach to managing retirement assets" suggests that the risk to manage is running out of money, not volatility. It is possible that a higher volatility portfolio could actually reduce the chance of an investor running out of money.

The authors suggest planning for 10 years at a time and plan to have enough money to purchase an annuity at the end of the ten year period. The portfolio must supply cash flows for an uncertain period, we may not live as long as expected, or live much longer. So it is impossible to have a plan that is cast in stone forever. The plan must be flexible enough to account for changes in circumstances such as health, expenses, interests and marital status.
This can be achieved by having a retirement plan that is monitored and revised periodically.

By modeling retirement cash flows, we can see evaluate the risk of a shortfall.

The key metrics to monitor are:

  • Funded ratio: the ratio of assets over liabilities; it shows whether assets exceed the value of liabilities today.
  • Probability of success: the probability that assets will be greater than liabilities at a future date.
  • Magnitude of failure (or expected surplus): the average size of the shortfall (or excess) at the end of ten years in unsuccessful scenarios.

If adequately funded, i.e. a funded ratio around 100%, you can test to see if an increase in exposure to equity risk improves the funded ratio.

If the plan is underfunded, i.e. a funded ratio lower than 100%, the investor has a lower capacity for market risk. It then becomes a gamble to shoot for higher short-term investment returns by taking more risk.

However, if an underfunded plan has a significant probability of success, then increasing market risk could be a good strategy. But if the probability is lower, the optimal approach may be revising the spending plan rather than counting on strong returns.

Lowering planned spending will immediately reduce the liabilities of the plan and improve the funded ratio.

Monday, March 11, 2013

Sale of Principal Residence



Question:

I have completed entering data for my wife & myself. The data includes selling the principal residence and using a portion of the capital for future income.

However the program results ignore that instruction. Principal residence value continues unchanged and cash flow goes negative.

Answer:

Ensure that you selected 'Personal Residence' as a Source of Income' on the Options page.

The same applies for the sale of another property, business or other future assets.

Detailed Cash Flow



Question:

Is there a way to see the cash flow for the asset and income in a table format?

Answer:

There are links in the last part of each of the Accumulations, Income Forecast and Savings tabs in the View results page.

The links open a pop up window that display the full cash flow.

Pension Income Splitting



Question:

Does the software take into account defined benefit plans and post retirement income splitting?

Answer:

Yes, you can enter in the 'Pensions' page a current or past defined benefit pension plan.

There is an option for splitting pension income, and if selected the program will apply the splitting in the years it is advantageous to do so.

Economic Forecast



Question:

Can the rates of returns be adjusted by the user or are they fixed?

Answer:

If you have the professional or DIY version, you can modify the rates and have your own forecast.

Otherwise, the RetireWare defaults will apply.

Compliance



Question:

Does this software comply with IIROC Guidelines?

Answer:

A review of IIROC's Guidance Note 11-0349 "Guidelines for the review, supervision and retention of advertisements, sales literature and correspondence" indicates that it is not in breach of the policy.

However, you may want to ask your compliance department. If you do, give a link to this blog post for background.

What is RetireWare?

RetireWare a Web-based risk management and retirement planning collaborative software for advisors designed to build referral networks using social media.

The software provides an assessment for the main post-retirement risks: market, longevity, inflation, health care costs and early death and others.

It also integrates in the analysis an investor risk profile questionnaire, budget and net worth statement and detailed retirement goal setting.

All results are based on accurate income tax calculations, OAS clawback and income splitting between spouses.

Relevant links on the Website

How it works for advisors:

http://www.retireware.com/advisors.aspx

How it works from the user's point of view and also some information on privacy:

http://www.retireware.com/overview.aspx

Data security:

http://retirefaq.blogspot.ca/2012/12/question-im-bit-concerned-about-having.html

Product features for advisors:

http://www.retireware.com/features.aspx

Post-retirement Budget



Question:

I am retired and the software seems to ignore the post retirement budget data I’ve entered for my wife and I. The budget statement is empty.

Answer:

There are two budgets: pre-retirement and post-retirement. The budget that applies in your case is the post-retirement budget.

Since you're retired, the post-retirement will show as the budget; if you're not retired, the pre-retirement will show in the results.

Ensure the retirement income goal is "based on expenses", otherwise it will not use the post-retirement budget as the retirement income goal.

Incomplete or no 'View' Page



Question:

I have entered all information into an advanced retirement plan and the only result that shows up under “View” is one chart.

There is no Monte Carlo, risk analysis, accumulations, income forecast, etc.

Answer:

For a few users who use Internet Explorer 9 (and sometimes the recent version of Firefox (19.x), the 'View' or 'Review' page sows as incomplete.

You can fix this by clicking the 'compatibility icon' in the address bar. When clicking the 'compatibility icon', after a few seconds the page redisplays along with all the tabs and button functionality.

Here are a couple of links for background:

http://windows.microsoft.com/en-CA/internet-explorer/use-compatibility-view#ie=ie-9

http://www.sevenforums.com/tutorials/1196-internet-explorer-compatibility-view-turn-off.html

Here are a few other suggestions:

1. If the page does not completely load, try refreshing the page (you can hit the F5 key on your keyboard, or click the refresh icon in the address bar of your browser).
2. Use Google Chrome, which does not have these issues.
3. Ensure you do not have add-ons that interfere with page display and that javascript are allowed to run.

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