Income Outlook—December 2007

Investor Roulette Meet Pete Seeley View pdf

Many investors play a variation of Russian roulette with their investment portfolios. In Russian roulette, a player places a bullet in one chamber of a revolver before spinning the cylinder, putting the pistol to his head, and pulling the trigger. A typical version of investor roulette is to select a strategy in which one or more economic or geopolitical outcomes could cause unacceptable financial results.

In the Russian version, players know the odds and consequences for a negative outcome. In the investor version, investors often do not know the circumstances that might cause a poor outcome, the probabilities associated with these circumstances, or how the outcome might affect their lives.

In some cases, investors stack the odds against themselves. Many do not save enough for retirement. Others spend all of their investment income and returns, which results in their portfolios failing to pace inflation. Just 2 percent inflation per year eventually will erode the average retired couple’s real investment income by over 40 percent, if nothing is reinvested to protect the inflation-adjusted value of the portfolio.¹ Worse, some retirees then implode the principal when income becomes inadequate.

The St. Petersburg paradox may help to explain why investors play roulette games.² The paradox is that a decision maker may only consider the expected result rather than a range of possible results when deciding on a course of action. For example, in Russian roulette, if one could double his or her wealth with each pull of the trigger, one’s expected wealth would approach infinity but one’s probability of surviving would approach zero.³ In this case, the expectation for death may be more obvious than the theoretical possibility of infinite wealth. Why do many investors play a similar game? For some, the potential for financial harm may not be obvious, and the potential for accumulating wealth may seem to be almost certain. Perhaps they don’t remember periods in which equity prices have declined for several years and then taken many more years to recover.⁴

To be sure, many investors seek to lessen the likelihood for adverse outcomes by building diversified portfolios, although diversification does not guarantee against loss. So, prudent investors may seek to avoid too much exposure to a bubbly asset class such as technology stocks in the late 1990s or potentially bubbly sectors today such as emerging market equities, energy stocks, and precious metals. Savvy investors will consider indirect exposures as well as direct exposures. Within the roulette analogy, diversified investors may be like disciplined gamblers who try not to risk more than they can afford to lose. In my view, disciplined risk takers who leverage their investments with a genuine understanding of the markets tend to be the most successful investors.

My greater concern is for investors who risk unacceptable outcomes without understanding the risks that they take. For some outcomes, it may not be worth considering a Plan B, as in the case of some Doom’s Day event. Other outcomes may be globally catastrophic but may not be terrible for financial markets, as may be the case with global warming. But what if the outcome is one that could be difficult for some stock and bond investments, but need not be for certain other investments? Shouldn’t investors want to know about and consider the potential consequences of their choices?

The last chapter of Alan Greenspan’s The Age of Turbulence outlines the basis for such a choice.⁵ For the most part, his vision of a “Delphic Future” echoes my earlier June 2007 “Emerging Megatrends” commentary which sets out why labor participation rates are likely to fall throughout the industrial world, global increases in labor force productivity are likely to subside, and global savings rates appear destined to decline.⁶ Mr. Greenspan and I both conclude that interest rates will tend to rise and that the increasing cost of borrowing is likely to decrease potential bond and equity returns during the next quarter century. So far, this view might be considered cautionary but not catastrophic. However, Mr. Greenspan adds an additional dimension to his “Delphic Future” that is a bit more foreboding for investors.

Chairman Greenspan’s Lead Bullet
Mr. Greenspan believes that the Federal Reserve (the Fed) will succumb to populist pressures and will let inflation rise. He suggests that inflation could rise to a long-term average rate of 5 percent, resulting in 8 percent Treasury bond yields with occasional forays into double-digit yields. While I personally do not believe that the Fed will be so short-sighted as to permit such an outcome,⁷ the former Chairman’s view should not be taken lightly.

Experience suggests that such an outcome could be difficult for many investors. Consider, for example, that a rise in long-term Treasury yields from around 4 to 5 percent today to 8 percent 10 years from now could cause the price of long-term Treasury bonds to fall to about 65 cents on the dollar. A rise in yields to the lower end of Mr. Greenspan’s “double-digit” range (a 10 percent yield) would mean a decline of about 50 cents on the dollar. Equities also would be likely to decline because the inflation-adjusted value of future earnings would decline.

Such a negative effect on the markets is illustrated by what actually happened from the early 1960s through the mid-1970s. The table below compares the current period (as of October 2007) with the earlier period:

There are some interesting parallels. U.S. Treasury yields are about where they were at the end of 1965, and the stock market has enjoyed a similarly strong performance. CPI inflation was lower in the early 1960s than it is today, but during the decade through 1975, the Fed let inflation creep up to an average of 5.7 percent per year (similar to Mr. Greenspan’s predicted 5 percent). This contributed to a rise in Treasury yields to 7.76 percent (similar to Mr. Greenspan’s predicted 8 percent), and bond prices fell accordingly. During that same decade, the S&P 500’s total return, net of CPI inflation, was -21 percent. While the 1965-to-1975 period may not be typical of the next 10 years, the point is that such an outcome can happen.

Those who have ample nest eggs or who can continue working to offset any investment loss might take investment losses in stride. What happens to those who long since have retired and who depend on their portfolios for their incomes?⁸ An impaired financial future may not be as dramatic as the Russian roulette outcome, but the life consequence still may be troubling.

The discussion of Greenspan’s bullet is not intended to suggest that this particular outcome will come to pass. Rather, it is intended to illustrate that fundamental risks may cause adverse outcomes and that investors should consider such possibilities when developing their investment strategies.

Where’s Waldo?
Several years ago, there was a popular “Where’s Waldo” game in which observers had to pick Waldo faces out of a crowd. I really don’t want to suggest that investors need to see potentially sinister Waldo faces in every market picture. Nor do I believe that each investor needs to be trained to pick out Waldo faces. But I do believe that every investor needs a thoughtful financial advisor who can provide guidance in developing investment strategies that may be appropriate for potentially difficult circumstances.

The most appropriate strategies will vary widely depending on each investor’s needs and objectives. For many, the answers may include allocations to investments that may be less vulnerable to higher inflation or to slower economic growth. Particularly with respect to the possibility for higher interest rates, some of these allocations may involve strategies that seek to capture attractive yields relative to short-term interest rates. Others may involve “absolute return” strategies.⁹ For some, it may mean considering annuities, which may have income step-up features that potentially could offset the effects of inflation. In my view, funding for these investments may involve reducing allocations to long-term fixed income investments, which may be relatively vulnerable if interest rates rise.

For equity investors, increases in inflation and interest rates, higher costs of capital, smaller increases in productivity, and/or reduced corporate shares of the economic pie could lead to less robust long-term returns. Particularly adverse outcomes may be no more likely than the one-in-six chance from spinning a cylinder; but they should be considered when constructing a long-term investment strategy. As with one’s income investments, reallocations from traditional equities to alternative strategies may be appropriate, depending on individual investors’ needs and objectives.

Considering investment strategies that may be appropriate for less favorable market environments, building a healthy war chest for the future, and being careful not to place too much demand on a portfolio for current income may not guarantee satisfactory results. But adhering to these principles may lessen the chance of realizing a mistake after the damage is done. After all, we just may not see a Waldo staring up at us. Worse, even if we see a Waldo, we may see a pleasant face without appreciating the potential for a less pleasant outcome.

I am deeply excited by today’s investment opportunities. I expect those who include suitable alternatives to traditional stocks and bonds in their asset allocations and who adhere to sound risk management to prosper in a challenging investment environment.

^* The Standard and Poor’s 500® Index (S&P 500) is a broad-based index, the performance of which is based on the performance of 500 widely held common stocks chosen for market size, liquidity, and industry group representation. The index does not include expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index. This is for informational purposes only and is not meant to depict the performance of any investment.

¹ See: http://www.census.gov/popest/national/asrh/NC-EST2005-sa.html.For a couple aged 65, at least one member of the couple is expected to live to age 86. From age 86, the surviving member is expected to live to age 93. Without reinvestment to offset 2 percent inflation, the inflation-adjusted value of the portfolio declines to about 57.44 cents on the dollar.

² The paradox is named from Daniel Bernoulli’s presentation of the problem, published in 1738 in the Commentaries of the Imperial Academy of Science of Saint Petersburg. Daniel’s cousin, Nicolas Bernoulli, first stated the problem in 1713. See http://en.wikipedia.org/wiki/St._Petersburg_paradox.

³ For example, within 56 turns, a single $1 would multiply to $36 quintillion (or 36 million times one trillion) for a lucky winner, but the probability for survival would fall to less than four in 100,000. Mathematically, with continuing play, expected wealth approaches infinity as the likelihood for survival approaches zero.

⁴ The last 80 years have included three lengthy episodes totaling 41 years in which U.S. broad market averages showed no return, net of inflation. These periods were 1929 to 1945, 1965 to 1982, and 1999 to present. In each case, years of recuperation followed years of decline. So, all of the net positive return for stocks is from only two particularly ebullient periods (1945 to 1965 and 1982 to 1999). Even the periods of strong performance included some significant downdrafts. See my commentary, “A Fresh Look at the Future”, available upon request.

⁵ Alan Greenspan, The Age of Turbulence: Adventures in a New World, Penguin Press, New York, 2007, pages 464 – 505.

⁶ See my commentary, “Emerging Megatrends” available upon request.

⁷ Before the rise in inflation during the 1960s and 1970s, the Fed’s role in creating inflation and its ability to restrain inflation were not well understood. In fact, Fed Chairman Arthur Burns, who presided over the beginning of the inflationary buildup, believed that “Excess government spending causes inflation”. (See Bob Woodward, Maestro: Greenspan’s Fed and the American Boom, Simon and Schuster, New York, 2000, p. 56.)

I agree with Alan Greenspan (op. cit.) that the Fed has the ability to ward off inflationary pressures. My disagreement with Mr. Greenspan is whether or not the Fed will use its ability. In my view, the Fed won political support for sound policy during the Volcker-Greenspan years (1979-2006). See Woodward, op. cit., especially pp. 15-25, 50, 54, 62-64, 88. Today, it is widely known that the benefits from inflation are fleeting and that the adverse consequences are pernicious and difficult to reverse. Even if the Fed were to let inflation ratchet higher, I believe that alert bond investors would mete out appropriate punishment, meaning that a sharp rise in interest rates would short-circuit any temporary economic advantage. Indeed, just such a threat kept President Clinton, who was elected on a populist platform, from going down the path that Mr. Greenspan warns against. See Woodward, op. cit., pp. 125-126.

⁸ See my commentary, “An Investor’s Need for a Balanced Perspective”, at http://www.vankampen.com/vksite/news/commentary/index.asp under "Archives".

⁹ “Absolute Return” strategies are strategies that are intended to provide satisfactory results regardless of the performance of traditional bond or equity markets. That is, these are strategies that are expected to provide positive absolute returns rather than performance relative to some market-based benchmark. See my commentary, “Evaluating Alternatives”, at http://www.vankampen.com/vksite/news/commentary/index.asp under “Archives”. All investment strategies involve risks, including the risk of loss of principal. Investors should read prospectuses and /or offering documents carefully before investing.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.