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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.
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.
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