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When people retire, they face some crucial financial decisions that will determine the quality of the rest of their lives. One of the most basic is how to invest whatever resources they have accumulated.
My purpose in this article is to open a window for you into how we manage the best retirement strategy we use for our managed accounts. I can’t disclose all the details of what we do, but I can tell you enough to give you a good general idea about it. I’ll show you six tables of numbers that are among the most popular handouts at our free workshops.
There are two major elements in this strategy.
The first element is active risk management, a discipline that many retirees can use to increase their peace of mind and decrease their risk of running out of money. In this article I’ll describe a simple but effective active risk management system you can use with many no-load mutual funds.
The second element is asset allocation, your choice of the assets in which you will invest. I’ll tell you what we invest in for our clients, using examples of no-load mutual funds for each asset class.
Let’s start with active risk management, which we define as a mechanical system to try to invest in an asset when its price is rising and to be in cash when its price is falling. Active risk management (or ARM) invariably reduces the risk of investing, because it requires investors to have their money in cash at least some of the time. Every day your money is in cash is a day it is not exposed to the risk of a bear market.
No ARM system is even close to perfect at calling the tops and bottoms of market swings. So if you’re looking for perfection, you should look elsewhere. But if you can be satisfied with catching most of the wave of bull markets while avoiding most of the undertow of bear markets, the system I’m about to describe could be just the ticket for you.
Nothing Magic
There’s nothing magic about this system, called the 100-day moving average. But it works. We know a lot of Boeing employees who have used it to successfully manage parts of their company’s 401(k) program.
Here’s how to use it: Every day, calculate the average of the most recent 100 days closing prices of the fund to which you’re applying ARM. Then compare the current price of the fund with the moving average.
If the current price is above the average, buy the fund or hold it if you already own it. If the current price is below the average, sell it if you own it. After you sell, park your proceeds in a money-market fund until the fund price is once again above the average. That’s all there is to it.
(Pick your fund carefully, because some fund families impose fees or even block transactions of investors who trade too actively.)
This system may seem like a recipe for “buying high” and “selling low,” but that’s not its intent. A moving average ARM system does not forecast future trends. Because it won’t trigger a trade until after a change in the trend, it will issue a buy signal only after the market has started to recover from a bottom and a sell signal only after the market has started to decline from a peak. This can be maddening to investors who don’t understand it and who expect to buy at the bottom and sell at the top.
You can think of this as a system that tells you when you want to be invested and when you want to be in cash. To make money, you want to be invested when prices are going up (above the average). To protect yourself from losses, you want to be on the sidelines when prices are going down (below the average).
We’re often asked why we chose 100 days. The only thing special about the number 100, which corresponds to about 20 weeks, is that it’s easy to calculate and it’s a reasonably good tradeoff between tracking very short-term trends and long-term ones.
For any period of history and any particular investment, you could calculate the hypothetical results of hundreds of simple moving averages based on different numbers of days. For any period and any asset, you could identify the number of days that gave the optimum results. But that would do you no more good than knowing what one stock did the best last year.
Please note: The 100-day moving average is not an ARM system we use to manage our clients’ accounts. The systems we use are similar in concept but more complex. For obvious reasons, we do not disclose the details of these proprietary systems.
Diversification
The second element of our active risk management retirement strategy is asset allocation, or proper diversification. In most of the retirement accounts we manage for clients, we use mutual funds that invest in seven asset classes: U.S. large-cap stocks, U.S. small-cap stocks, U.S. mid-cap growth stocks, U.S. mid-cap value stocks, international stocks, investment-grade bonds and high-yield bonds.
Table 1: 7 asset classes, 1984-2002, buy and hold 
Table 1 shows the year-by-year performance, without ARM, of each of those asset classes from 1984 through 2002. Each asset class is represented by one mutual fund. The left-hand column of annual returns represents the return on cash, as measured by commercial paper.
One of the single biggest reasons investors reach the breaking point is that they invested their money without understanding the risks. This is a vital topic, and I want to be sure you understand how we measure investment risk.
- Standard deviation is meaningful to statisticians but doesn’t correlate very well to the real-world experience of investors. It measures the variability of a series of results; lower numbers indicate less variability, therefore greater predictability.
- Worst month returns, including worst three months, 12 months and so forth, simply identify the returns during the worst periods of those lengths. (These figures are cumulative gains and losses, not annualized.)
- Worst drawdown shows the biggest loss from a peak to a trough in price, without regard to months or years. These were quite significant in every case, and they show the magnitude of the “storms” that investors had to endure in order to stick with these assets through thick and thin, which is to say without any active risk management.
- Average of worst five drawdowns shows the magnitude of repeated disappointments that an investor had to weather. This may be the easiest figure to grasp. It tells you that, for instance, if you are going to invest in large-cap stock funds, you’d better be prepared for occasional losses averaging about 29 percent again and again.
- The Ulcer Index is a quantitative measure of the emotional difficulty an investor is likely to feel. It measures two things, the size of all the drawdowns and the time for each one to break even from the most recent peak. The higher the Ulcer Index figure, the more stress you can expect.
Bond Fund Returns
Before we move on, I want to call your attention to the average worst drawdowns of the final two columns, both representing bond funds. Those losses, 9.2 percent and 11.9 percent, are quite significant for bonds, which are generally considered to be low-risk investments. Even when you invest in bond funds, you must be prepared for some tough times.
If you’re a conservative investor, you will also note that the annualized returns for the bond funds, 8.8 percent and 8.9 percent, seem very attractive. But I think those returns are too high to be the basis for realistic expectations in the future. The reason is simple: For most of these 19 years, interest rates were declining. Notice that in the first two years, 1984 and 1985, the commercial paper rate was very high compared with the rate in 2000 and 2001. The same is true of the bond returns.
And as you probably know, when interest rates fall, bond prices rise. To expect the same thing to happen again, starting in 2003, would be asking the unlikely.
Table 2: 7 asset classes, 1984-2002, using 100 day moving average 
Let’s look at Table 2, which shows the same seven asset classes during the same period, but this time governed by timing using the 100-day moving average system. The “trade statistics” part of the table tells the average number of times per year an investor had to buy or sell the fund.
You’ll also see the percent of the entire 19 years that the investor was exposed to the market (in other words, not in cash). The “Win/Lose Ratio” is the percentage of the individual temporary investments (a buy followed by a sell) that were profitable. You’ll find the average gains on profitable sales and the average losses on unprofitable sales. (Notice that nearly 70 percent of the sales of the high-yield bond fund were profitable, vs. less than a third of the sales of Janus Fund.)
Drawdowns and Ulcers
If you look at the average of the five worst drawdowns for each fund and compare the figures in Table 1 and 2, you’ll see they are significantly lower with ARM. And in every case, active risk management produced a lower Ulcer Index. Six of the seven funds’ returns were higher with ARM, one was lower.
In Figure 1 below, you’ll see an easy fund-by-fund comparison of active risk management vs. buy-and-hold.
| Fund |
Buy and Hold |
Active Risk Management
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Buy and Hold Worst 5 Drawdowns
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Active Risk Management Worst 5 Drawdowns
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Janus
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10.9
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9.0
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-29.1
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-21.1
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Invesco Dynamics
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9.8
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12.1
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-41.0
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-20.4
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Mutual Series
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13.5
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14.2
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-20.3
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-7.5
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Price New Horizons
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9.4
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10.2
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-37.2
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-19.7
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Scudder International
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9.6
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13.2
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-31.3
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-12.7
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Dreyfus A+ Bond
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8.8
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8.9
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-9.2
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-6.2
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Scudder High Yield Bond
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8.9
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12.1
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-11.9
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-3.8
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Seven-fund average
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10.1
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11.4
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-25.8
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-13.1
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The bottom line in the table tells the story: Active risk management raised the average return modestly and cut the risk in half.
If you’re retired and living off your investments, the major risk you face is that your portfolio value might drop sharply. Therefore, retirees should be very interested in any system that will reduce drawdowns. Active risk management does exactly that, and in this illustration it increased investment returns at the same time. That’s what I call a win-win combination.
Active risk management has some drawbacks, of course. It’s a discipline that requires watching the market every business day, something that many investors can’t or won’t do.
Mixing Equities and Bonds
We don’t advocate investing in any one or two of these funds. But we do advocate investing in a portfolio made up of all these asset classes. Therefore, in Tables 3 and 4, we focus on the most basic asset allocation choice: How much should be in stock funds and how much in bond funds?
Table 3: Portfolio performance, 1984-2002, buy and hold 
Table 4: Portfolio performance, 1984-2001, using 100 day moving average 
The columns are labeled, from left to right, with the percentage of the portfolio in equity funds, weighted 40 percent in diversified international stocks and 15 percent each in U.S. large cap, mid-cap growth, mid-cap value and small-cap funds. The remaining percentage, if any, is split equally between investment grade and high-yield bond funds.
Table 3 shows results for a buy-and-hold portfolio, while Table 4 shows results using the 100-day moving average ARM system.
There are several ways you can use these tables. You can choose an annualized return that you believe will meet your needs, then check the risk measurements to see what you would have had to endure to achieve that return. For example, if you determine you need 11 percent, Table 3 shows that, without ARM, a portfolio of 100 percent equities would have provided that. Along the way, you would have had to endure a one-month loss of 24 percent and a worst single drawdown of 52 percent. If you then turn to Table 4 and look for an 11 percent annualized return with ARM, you’ll find it with a portfolio of 20 percent equities and 80 percent bonds. In this case, the worst month was a loss of only 4.3 percent and the worst single drawdown was only 4.7 percent.
This is an example of choosing the lowest-risk way to achieve the return you need or want.
You can also use these tables to seek the highest return you can get for a given level of risk. If you decide you are willing to endure a worst drawdown of no more than 20 percent, you’ll find it in the buy-and-hold table with a portfolio of 30 percent stock funds and 70 percent bond funds; this combination had a return of 9.7 percent. In the active risk management table, you’ll find you can go to 90 percent stock funds and 10 percent bond funds and still be well within your maximum risk tolerance – and in the process you have found a strategy that returned 12.3 percent.
Table 3 shows that the 100 percent equity portfolio without ARM had a return of 11 percent, and its five worst drawdowns averaged 29 percent. Table 4 shows that active risk management not only increased the return of this portfolio, it cut the drawdowns by 57 percent. And ARM reduced the portfolio’s emotional risk, measured by the Ulcer Index, by 49 percent, from 13.1 to 6.7.
At the other end of the spectrum on these two tables, active risk management raised the return of the all-bond portfolio from 8.9 percent to 10.5 percent, an 18 percent increase, while it reduced the five-worst-drawdown average by 56 percent (from 8.1 to 3.5) and the Ulcer Index by 61 percent, from 2.6 to 1.0.
Figure 2, below, shows another way active risk management can help risk-averse retirees. You’ll see a comparison of the returns and risks of an all-bond portfolio without timing (from Table 3) vs. an ARM portfolio with 60 percent equities.
| |
Buy and Hold All-bond portfolio
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ARM 60% Equity portfolio
|
Annualized Return
|
8.9 |
11.7
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Worst month
|
-6.0
|
-5.9
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Worst 3 months
|
-10.3
|
-5.5
|
Worst 12 months
|
-7.7
|
-5.2
|
Worst 36 months
|
3.1
|
-5.5
|
Worst 60 months
|
9.1
|
29.4
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Worst drawdown
|
-11.1
|
-10.6
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Avg. worst 5 drawdowns
|
-8.1
|
-7.0
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Ulcer Index
|
2.6
|
3.3
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If your priority is to obtain the highest return within your risk parameters, this shows that active risk managementcan let you take advantage of the higher returns of equity funds with even less risk than an all-bond portfolio without ARM.
Spending Sooner Vs. Spending Later
Now let’s turn our attention to Tables 5 and 6. These are two of the most popular tables in our workshops. They compare active risk management and buy-and-hold results of two possible retirement portfolios – one with all equities and the other with 60 percent equities and 40 percent bonds.
Table 5: Buy and hold vs. ARM (6% distribution rate) 
Table 6: Buy and hold vs. ARM (8% distribution rate) 
The tables assume a retiree begins with $1 million and, at the start of every year, takes out either 6 percent or 8 percent of the previous year-end balance for living expenses.
Each scenario thus starts with a distribution of $60,000 or $80,000 in 1984. But by the start of 2003, the distributions in the 6 percent scenarios vary from a low of $120,396 (Global Buy and Hold 60% Equity /40% bonds) to a high of $171,165 (ARM 100% Global Equity). In the 8 percent scenarios, the 2002 distributions vary from a low of $106,682 (Global Buy and Hold 60% Equity /40% bonds) to a high of $151,668 (ARM 100% Global Equity).
Wait a minute! Isn’t something backwards here? Shouldn’t the 8 percent scenarios yield higher distributions than the 6 percent ones?
The answer is yes and no, and that’s why these two tables are so interesting. The 8 percent scenarios indeed pay out more money to the retiree at the start -- $20,000 more in 1984, to be exact, than the 6 percent scenarios.
But you can’t keep digging deeper into a portfolio forever without feeling the effects. To see what’s happening, let’s make a few comparisons using the upper-left portfolio of each table, the buy-and-hold all-equity portfolio. If you look at the payout in 1997, you’ll see that the 8 percent scenario was paying more than the 6 percent scenario – but not very much more: $165,941 vs. $164,603. And by 1998, the 6 percent scenario was paying more than the 8 percent one.
The reason is easy to understand. The 6 percent scenario leaves more money in the portfolio to grow, and that growth gradually produces more money to pay out. By taking out less in the early years of retirement, an investor made it possible to take out more later.
In case after case that we have studied, the higher payout of 8 percent distributions vanishes in 14 or 15 years. After that, the 6 percent scenario pays more each year. If you knew you wouldn’t live much longer than 15 years after retirement, you could confidently take out 8 percent. But if you live longer than that, you might wind up wishing you had withdrawn less in the early years.
This is a tough decision for retirees, who cannot afford to run out of money and must be conservative in what they withdraw. On the other hand, most people’s health declines with age, and those who are tightwads in the early years of retirement may later find themselves with more money to spend yet less ability to enjoy it.
If you want to have more money to spend eventually and more money to leave to your heirs, 6 percent distributions are for you. The cost: You’ll have less to spend in the early years of your retirement and you might not live long enough to enjoy the fruits of your frugality.
If you want more money to spend in the earlier years of retirement, and if enjoying your money is more important than leaving it to your heirs, then the 8 percent distribution is for you. The cost: Your yearly distributions won’t grow so fast, and you put yourself at somewhat higher risk of eventually running out of money.
There’s no magic answer, and this issue requires thoughtful consideration by retirees and their spouses.
If you aren’t sure, lean toward being conservative instead of aggressive in your spending. If you spend less at the start, you can much more easily raise your standard of living later. But if you overspend early in retirement, you leave yourself with fewer options and choices later on.
Good News, Bad News
Finally, I’d like to leave you with some good news and some bad news.
First the bad news: The 19 years in this study included a major bear market in 2000, 2001 and 2002. But it didn’t include a “catastrophic” market meltdown like that of 1973 and 1974, when the value of almost every asset class declined. Should that level of stress hit the markets again, returns might be lower than they were from 1984 through 2002.
The good news, ironically, is that investors can probably get better returns than those shown here. The returns in these tables are those of a relatively simple portfolio, with only seven asset classes, governed by one relatively simple active risk management system.
There are two ways you can try to improve on these results, and you’ll be likely to succeed if you take these steps over a long time period.
First, diversify more widely, investing in more types of equity funds. Equity asset classes worthy of consideration that are not included in this study include emerging markets, Pacific Basin, international value, international small-cap, real estate and industry sectors.
Second, hire an advisor to manage your money instead of doing it yourself. This will give you several important advantages.
- You’ll be assured that your active risk management systems, whatever they are, will be followed. Your trades will be executed when they should be, regardless of what else you might be doing.
- You’ll have access to more sophisticated active risk management. For our clients, we use multiple ARM systems that measure more factors than simply current vs. recent average prices. We have fine-tuned those systems as well as we can so they are responsive to the market while avoiding excessive trading.
- You’ll have access to better funds than the ones we are showing here for illustration purposes. There’s nothing wrong with the funds in this study, but we chose them because their track records go back far enough for this study, not necessarily because we would recommend them. A professional manager can give you access to numerous funds in ways that would be impractical for an individual investor. For example, whenever one of our ARM systems signals a buy, we use relative strength rankings of dozens of funds to identify those most likely to outperform in the short-term future.
Unfortunately, I can’t guarantee that any combination of investments will provide all the income you need for as long as you need it. But I can promise you this: If you want your money to work hard for you in retirement while you keep your risks limited, you’ll greatly improve your chances of success if you have the proper balance of assets and use the discipline of active risk management.
This combination works for our clients. It can work for you, too.
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