We’ve written about sequence risk on many occasions in the past. While most investment projections are based on average returns, the reality is that returns don’t happen that way. There is a sequence to them, and for those recently retired, or close to retirement, sequence risk is an extremely important consideration. Losses taken early in retirement, while your costs are usually higher as well, can sometimes force one to sell stocks into a declining market, which is highly undesirable. We take these factors into consideration as we tailor each portfolio based on the individual client’s needs.
Once upon a time when we were in a normal interest rate environment, it was easy to simply allocate a larger portion of the portfolio of a retiree into bonds, as retirement neared. In fact, many of these “target funds” and “robo-advisors”, are doing just that, as they follow a formulaic approach. The problem with simply using heuristics to build a portfolio, is that it doesn’t take into consideration the dramatic shift in valuations and interest rates. The 20-year Swiss bond has a negative yield…….Do you really want that in your government bond fund, simply because you are 65 years old and close to retirement? The 10-year Treasury is now at 2.1%, and most municipal bonds offers similarly paltry returns. Many junk bonds yield less than 5%, despite high leverage ratios and worsening credit prospects.
These yields are before taxes and inflation, which obviously reduce the real return rates. With the decline in rates, the 10-year Treasury and the dividend yield of the S&P 500 are about equal. With stocks you get growth, where with bonds, your best hope is that you get your money and the interest back. By focusing on buying undervalued and financially strong stocks, we can greatly improve our odds for long-term success, far beyond simply buying the index in our opinion.
With markets being at elevated valuations, we have been more conservative in our investment decisions for the last few years. We have really emphasized selling cash-secured put options, as opposed to aggressively buying stock. Usually these options are out of the money and are targeting a double-digit return assuming the options expire worthless. In the case of a major decline in the market and in the stocks, we would end up owning them at much cheaper prices, which also correlates to higher earnings and dividend yields.
Once we own the stocks, we might decide to do a covered call to enhance the yield further, if we are willing to sell the stock at the call price. The other option is just to hold on to it if we expect further appreciation. Options on stocks are not the same as simply owning a stock portfolio, and the return characteristics are very different. You don’t always see this on a day to day basis, because increasing volatility, can mask some of the benefits. As we get closer to options expiration, the benefits shine through. Since most of our options usually tend to expire in late January, that is usually the best time to get a read at where things are at.
Sometimes when we buy international stocks, we don’t have the flexibility of selling puts and calls, but we are fine with it, as long as we firmly understand the companies and their prospects, and can buy them at bargain prices. We are finding companies with mid-teens earnings yields, in countries where the respective sovereign debt has negative yields. That is a pretty crazy paradox, so the opportunities are there, but we must be willing to be different to succeed in my estimation.
All of these strategies that we are discussing tend to generate quite a bit of cash flow to the portfolio via dividends and option premiums. The securities are almost always liquid, but usually the best time to take cash out is late January when we get the bulk of the options expiring, or giving at least 60 days notice for large planned withdrawals. These cash flows make it easier to pay for living expenses without having to actually sell stocks. We are not immune to adverse market conditions, but the strategy is somewhat anti-fragile in that it allows one to acquire stocks more cheaply when markets do rapidly deteriorate, as opposed to simply selling them and booking losses.
We’ve had good success with other types of securities such as preferred stocks, REITS, high-yield debt, and warrants, and we will use them when they are available at attractive prices. The bottom line is that we have to be dynamically thinking to nullify the risks of sequence risk. This is not a 1980s or 1990s market. What occurred in an era where rates fell from being in the teens to low levels, isn’t going to occur again over these next 30 years, and we can’t be blind to that. Instead we must look at current facts and employ them into a system positioning us to succeed into the future.
As always, if you have any questions, please never hesitate to ask. In May the market was down about 7%, and it is flat over the last 17 months. There is a lot of noise regarding trade, tariffs, antitrust etc. There is always noise and the same circumstances that cause the volatility in the first place, can lead to its remedy. Think potential interest rate cuts and lower valuations. This is no different than when the Fed changed tact after the 4th quarter bear market, propelling stocks higher. The strategy is built for changing circumstances and we don’t need everything to go smoothly to be successful, but time and patience are the critical characteristics to be successful.
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