The financial service industry is shrinking – bankers, traders, and brokers are losing jobs en masse – but, remarkably, assets-under-management and fees for independent investment advisors have continued to grow steadily throughout the financial carnage of the past 5 years; as noted by the title of this article in last week’s Wall Street Journal – “It’s an RIA (Registered Investment Adviser) World, Everyone Else Just Lives in it”

Why are investors increasingly relying on investment advisors?

2011 was another dreadful year for actively managed funds (funds which seek to select individual winners and losers). Equity mutual funds had their worst year since 1997 relative to the Standard & Poor’s 500 Index, as record-high correlation and price swings made it harder for money managers to pick stocks according to Bloomberg.com. The 50-day correlation of S&P 500 stocks to gains or losses in the full index increased to a record 0.86 in October

What this means is that investors were better to put their money in broad index funds which track asset classes such as large-cap stocks, municipal bonds, or commodities. These asset classes soared and plummeted over the course of the year in tandem with the latest financial headlines, and with so much turmoil, most investors felt more comfortable going to bed at night knowing they were paying a professional to select and re-balance their portfolio of index funds.

But isn’t 1% still an awful lot to pay for asset allocation and a little hand-holding when markets are crashing?

 There is no question that experienced professional advice can be extraordinarily valuable for building a long-term financial plan and avoiding the behavioral finance pitfalls that plague the vast majority of individual investors. Most investors are likely to benefit from some form of outside financial assistance. But a fee based on 1% of your assets can add up to a staggering amount of your wealth over time (especially in today’s low-yield environment).

Asset allocation can be challenging (and those index funds aren’t going to pick themselves). But in 2012, with asset allocation models (ours and others) available on the internet, it is a very, very do-able task for the average investor to manage their own portfolio. Investors can accomplish much of the fund management services provided by investment advisors by following the set-up and re-balancing instructions from these web-based models and then making the suggested low-cost index fund trades through an online brokerage account or mutual fund company like Vanguard.  Investment Advisors can then be consulted on an hourly fee basis for periodic strategic planning and advice.  

Americans are zealously pursuing value in other areas of their lives from online coupons to do-it-yourself home repair.  So it is surprising how well the traditional Investment Adviser business and fee structure is holding up.

After suffering through wrenching volatility throughout 2011, investors in US Equities looking at their year-end statements find that the value of their portfolios were largely unchanged -- the S&P500 Index rose approximately 2% for the year.  Small-caps gained only 0.66% and the mid-cap index dropped -0.12%.  

These returns may not seem particularly rewarding given all the risk and volatility markets experienced. Surprisingly the US markets were relative winners in 2011 - global equity markets dropped almost 15% in 2011 and promising growth economies like India and Brazil saw their equity markets plummet by more than 20%.

An even bigger surprise in 2011 was the identity of the biggest winner among the 11 broad asset classes we track - TIPS (Treasury Inflation Protected Securities).   Who would have guessed that this conservative asset class - a hedge against inflation - would easily outperform riskier asset classes?  Especially given the largely benign inflation environment in 2011.

At the start of 2011 many advisers recommended moving away from bonds given the low returns and risk of rising interest rates. This would have likely proved a mistake for most investors given bond's relative strong performance among asset classes.

We expressed concern about emerging market allocations (in the context of asset allocation). We still have concerns about emerging market exposure, but we encourage investors to maintain their recommended allocation to emerging markets over the long-term. We also suggested conservative investors consider shortening the duration on their bond holdings - a move which would have reduced returns in 2011, but a move which we think remains prudent for 2012. TIPS low returns may seem even more absurd now, but TIPS remain an important component of our risk-controlled portfolios.

Volatility, as measured by VIX (CBOE's Volatility Index) dropped significantly in December, possibly signaling better equity market conditions ahead.  Volatility is one of the key drivers of Portfolio Research's allocation algorithm. This may be the light at end of the tunnel.  (Or it may be an approaching collision). Either way your best bet is a diversified portfolio.

December was a relatively quiet month for equity markets with the "Santa Claus Rally" failing to materialize amidst concerns about sovereign default in Europe.  The patterns we saw for all of calendar year 2011 -- Bonds out-performing Stocks,  US Large Caps out-performing smaller stocks, and international equity markets lagging badly -- continued for the month of December. 

November was a rough month for asset returns.  Most risky assets suffered losses in November, reversing a large chunk of October's rally. Hardest hit in November: emerging market stocks, developed world equities and US REITs. The only winners among our broadly defined list of major asset classes: Inflation-indexed Treasuries, which advanced 0.77% for the month and commodities, which eked out a 0.14% return.  

It’s widely accepted that a new retiree can safely withdraw 4% of their savings, a 4% drawdown in the first year of retirement and adjust this amount for inflation in subsequent years. Analyses of historical US  return data has shown that this drawdown rate is safe in the sense that the strategy will not lead the retiree to exhaust all of his or her remaining assets for at least 30 years. How safe should you feel about this rule in the years ahead?

According to this study, below even a 4% retirement drawdown rate is too aggressive when it is based on international market returns -
http://www.advisorperspectives.com/newsletters11/An_International_Perspective_on_Safe_Withdrawal_Rates.php

The 4% drawdown rule is based on US financial market returns since 1926, a time period which may have been a "particularly fortuitous" one for the United States. The fear is that using this time period will produce dangerously overinflated retirement drawdown rates if asset returns fail to be so strong in the future. Over the time period mentioned, the US consistently enjoyed among the world's highest inflation-adjusted returns and lowest volatilities for stocks, bonds, bills and inflation.

From an international perspective, a 4% drawdown rate has been problematic. According to the same study as above:

The calculated safe withdrawal rate exceeds 4% in only three of the other 16 countries: Canada, Sweden, and Denmark. As for other countries, the most unfortunate retiree of all was a Japanese person retiring in 1940, whose maximum SWR (safe withdrawal rate) was a miserably low 0.47% as high inflation and low real returns plagued Japan during and after the war. Six countries experienced withdrawal rates below 3%: Spain, Italy, Belgium, France, Germany, and Japan. In Italy, the 4% rule failed 62.5% of the time, and in Japan, such high withdrawals were sustainable for only three years in the worst-case scenario.

Should Americans expect or at least prepare for lower asset returns in the future, such as those that many other countries have experienced?   We can hope that asset returns in this century will continue to be strong supporting necessary drawdown rates, but such assumptions may prove to be too optimistic for current times.

"80 is the new 65" according to this recent Wells Fargo survey on retirement savings and investing  -- Americans are recognizing they may need to work past 65 to finance retirement, and 25% expect to work at least until the age of 80.

But how realistic are their expectations?  The survey indicated that the average American had saved a median of $25,000 towards retirement and estimated they would need to accumulate a median of $350,000 to support themselves in retirement.  The majority of respondents expressed reluctance about investing in the stock market with 45% preferring bank certificate of deposits over stocks or mutual funds. Those surveyed expect to withdraw about 18 percent on average from their savings each year in retirement.

We plugged these numbers into our Portfolio Research Retirement Planner to see how realistic American investors have become. In the case of a 45 year-old contributing $3,000 per year to a conservative portfolio, the $350,000 goal could in fact be met by working until the age of 80 and not withdrawing any funds, so in this respect Americans appear to be coming to grips with reality. However withdrawing $63,000 per year (18% of the balance upon retirement) will drain this individual's savings in less that seven years so this assumption appears more wishful thinking (but perhaps this is less problematic for individuals working until such an advanced age).

Investing these amounts in a more risky portfolio might enable the investor to retire much earlier - between the age of 70 to 75 years in the median scenario, and draw down $63,000 per year for a longer period, but of course they would face more volatility. 

So it seems that Americans have become a bit more realistic about funding their retirements, at least in terms of a willingness to work later in life. However a more aggressive investment plan might make the process easier and retirement draw-down assumptions remain murky.

Portfolio Research's riskier portfolios skyrocketed in October.  The highest risk RT-15 portfolio jumped 9.7% for the month, and the other 5 portfolios rose in accordance with their respective exposure to riskier asset classes.    

While there is a considerable volatility in the market affecting our model portfolios (markets are panicking about the debt situation in Italy), allocations remained largely stable going into November. The portfolios are well positioned for the unknown ride ahead. 

In October financial markets decided that US economic woes and European default risks were not so bad after all. The riskiest broad asset classes soared - US small caps up 15% and emerging markets up 13%.  US REITs also joined the party, gaining 13.5%. TIPS and Commodities were both up for the month based on renewed expectations of global growth and US inflation, while Bonds experienced small declines.  

For the 30 year period ending September 30 Treasury Bonds outperformed the general stock market. This is the first time this has happened since the Civil War.

 The financial press has made much of this event, using the opportunity to pick on equities and lavish praise on Treasury Bonds.

 Prominent financial gurus, Bill Gross, Meredith Whitney, Jeremy Siegel are castigated in this Bloomberg article, for their bets earlier this year against bonds.  This seems unfair.  

Thirty years is a rather arbitrary time-frame.  Investors, (well at least journalists), do seem to fixate on these arbitrary performance metrics. Recall the noise these same folks made when US equities suffered negative prices during the 10-year period from January 1, 2000 to December 31, 2009.  This particular 30-year period during which bonds outperformed equities stretches from Federal Reserve Chairman Paul Volker's assault on stagflation back in 1981 through the de-leveraging of 2011.  These particular circumstances were uniquely suited for interest rates declining and thus bond values to rise.

 Jeremy Siegel, author of the 1994 book “Stocks for the Long Run,” said in a telephone interview Oct. 25: “The rally in bonds is a once in a millennium event, but it’s absolutely mathematically impossible for bonds to get any kind of returns like this going forward whereas stock returns can repeat themselves, and are likely to outperform,” he said. “If you missed the rally in bonds, well, then that’s it.”

While we agree with Professor Siegel's point above, we would also remind investors that bonds could still outperform for some time as evidenced by the deflationary situation that has prevailed in Japan for years.  Portfolio Research's Dynamic Portfolios continue to maintain bond exposure, because we believe in diversification and controlling risk.

Investors have long been seduced by the simplicity of calendar-based investing - selling in May and buying back in autumn, January's predictive power, high returns in the 3rd year of a US presidency, Super Bowl winners determining market moves, etc.  Most of the results of these seemingly predictive rules are pure randomness; but so far in 2011 the market seems to be following the predicted patterns. This graph from the WSJ makes it starkly clear that your portfolio would have out-performed if you adhered to some horoscope-like rules:

In fact, based on past statistics, September and October are historically two of the three worst months to own stocks. November and December, on the other hand, rank as the fourth and second best months to own stocks, respectively. But here we see that October has bucked the trend. What does this mean?

Well, according to the mystic arts, October has been a "bear-killer". So, apparently we can count on a new bull market - or at least gains through the remainder of 2011. 

Looking at past returns is always interesting, but at Portfolio Research we like to keep the snake oil and other charms at bay. We encourage disciplined, efficient, long-term investing. So please don’t spend all the anticipated gains on the upcoming Santa Claus, post-Christmas rally quite yet. Wait and enjoy the post Christmas sales.