What investors can learn from Wall Street's failures

What do Wall Street investment banks and retired investors have in common? They both must live off the return on their capital. Here are three important portfolio survival lessons retired investors and their advisers can learn from Wall Street’s failures. DEBT KILLS The more debt a retired investor carries, the higher the probability is that the obligation to repay the debt will destroy the investor’s capital in a declining market. It is that simple. As the capital declines in value, the opportunity to generate income or gains falls as well, but the cash flow required to make the debt payments doesn’t. A repayment obligation that looked manageable with a specific amount of capital can be devastating with half of that amount. Over the last several years, more individuals have been retiring with debt, particularly mortgage debt. Carrying debt into retirement is often a losing strategy no matter how the investor approaches it. Assume an investor has a $300,000 mortgage at 6%, thus costing the investor $18,000 a year in interest. To secure a guaranteed interest stream to cover those payments, the investor will need a portfolio of high-quality fixed income securities. At best, in today’s environment, the yield might be 5%. This means the investor needs $360,000 of capital to generate the income necessary to cover the $300,000 mortgage debt. Since that doesn’t look like a good strategy, investors often make the mistake of allocating their savings to the stock market in hopes of creating gains in excess of the interest. But if the stock portfolio falls 50% (as in this current market), the investor will have no choice except to liquidate the portfolio to pay the mortgage, which will cost twice as much. Wall Street firms learned how painful this type of cycle can be. If investors have not eliminated substantially all of their debt, then it is unlikely they are prepared to retire and live off the returns on their capital. COMPLEXITY KILLS The more complex an investment strategy, the more likely it is to fail in a crisis. Complex strategies have many moving parts based on multiple assumptions about how the world should work. As Wall Street discovered, things don’t always work out as planned and human behavior is not normally distributed. A simple strategy that will help investors control risk is to focus on the fundamental split between diversified stocks and high-quality government and corporate bonds. For instance, at the time of this writing, the S&P 500 Stock Index is down about 45% from its October 2007 high, and the Lehman Aggregate Bond Index is actually up about 2% over the same time frame. Therefore, if an investor had 100% of their assets in diversified equities, they have probably lost close to half their capital. If they had 100% of their investments in diversified government and high-quality corporate debt, they have likely lost none of their capital. To control risk for retired investors, simply dial up or down the percentage in these two asset classes. Or, you can make elaborate assumptions about the correlation between domestic and international stocks (“de-coupling” comes to mind), commodity prices, real estate values, high yield bonds and currencies. As Wall Street found out, many of these correlation assumptions don’t hold up in a crisis, which means you have much less control over the risk than you thought. Simpler is better. ALPHA IS MEANINGLESS In assessing the quality of an investment strategy, how many years of data is enough? One, two, five, ten? The answer is none of the above. Throughout this crisis, we have seen 5, 10 and 15 years worth of manager alpha destroyed in a few months. And when a firm goes bankrupt, one can wipe out 50 or 100 years worth of alpha in a weekend. Thus, alpha is somewhat meaningless because it can be destroyed so quickly. If a client is in the business of attempting to live off the returns on their capital, they are playing a dangerous game by aggressively seeking alpha. To capture the elusive alpha, they need to consistently zig when everyone else is zagging. And sometimes you zig right into a world of hurt. Some advisers might wonder if pursuing alpha is meaningless. After all, what are clients paying them to do? However, it is important to remember that for retired clients, the objectives are different. Retirement income management is primarily about managing global financial risks so that your clients don’t end up in the poor house from the “once in a thousand year financial crisis” that seems to happen every five years. Clients need you to help them protect their capital, generate consistent income and provide some opportunity for long-term growth. Instead of more offense and little defense, think more defense and a little offense.