Why avoiding large market downturns is important was recently well spelled out by GMO, an investment firm that has been around since 1977. GMO manages $117 billion in assets and has a $10 million minimum per client. These folks are darn good. They have invested in all kinds of markets. They anticipated the market downturns in 2000 and 2007 and they are warning investors of the current stock market overvaluation. Their key measure of future stock market behavior is overvaluation. Overvaluation does not predict short term market direction, only long term market direction. They are in complete agreement with our approach that the valuation of the stock market matters and you must shift your risk accordingly. This is not rocket science (buy low, sell high) but unfortunately many or most portfolios are not managed this way. This is partly due to the misinformation disseminated by Wall Street on stock market values.
In GMO’s recent white paper, “Who Ate Joe’s Retirement Money?” by Peter Chiappinelli and Ram Thirukkonda, they provided evidence that “sequence risk” is as damaging to a portfolio before you retire (especially the last several years of work) as it is when you are retired. They showed that two people can earn the identical return (they used 5% real return after inflation or ~ 8% nominal return before inflation) over 40 years but if one investor experiences bad returns (large losses) toward the end of their career and the other has great returns toward the end of their career the difference in their portfolio value at retirement can be significant. In their research of 1400 different portfolios the luckiest employees had over $1 million when they retired and the unluckiest had close to $300 thousand. I know you are thinking, “How can that be possible if they both had the identical 5% real return over the 40 years?” The reason is what I have been noting in quarterly commentaries, preaching to 401(k) participants and others, speaking to groups about for years; that the timing of your returns can be the difference between success and failure (a comfortable lifestyle in retirement).
How can you increase your odds of success?
According to GMO, use Robert Shiller’s Smoothed Price/Earnings ratio to ascertain value and shift the risk of your portfolio to more or less risk based on market over and undervaluation. This is exactly what we do! You can move yourself from the unlucky probability group to the middle group or lucky group.
In their white paper GMO commented on the same thing I commented on in our last quarterly commentary. The biggest offenders who subject investors to the “unlucky group” who don’t have enough money at retirement are managers of “Target Date” funds because they don’t take the value of the market into account. In fact, they follow a belief that future gains and losses cannot be known. This is blatantly wrong. Professor Robert Shiller won a Nobel Prize in 2013 due to his work on asset class valuation and its predictive nature.
Target Date funds are great for their simplicity. However they can be devastating to a retirement plan if not used with caution. When we recommend using them we recommend a more conservative allocation than your age would dictate when the market is extremely overvalued. We also recommend a more aggressive allocation than your age would dictate when the market is extremely undervalued. Investors must never get complacent in either good or bad markets; the market valuation will change. When the market value is favorable you want to dive into the riskier investments. In fact GMO also noted in their white paper that when the market is a good value the losses are muted as compared to overvalued markets. In their research, using stock market history from 1940 to present, investors experienced a market loss of over 50% (on average) during times when the market is significantly overvalued (market value cut in half), as it is today. In contrast, in an undervalued market the loss is only less than 5%! This is something you have probably heard me say and write countless times; when values are better you need to add to riskier investments (e.g. stocks) because the downside risk is much less.