The Illusion of Control

The Illusion of Control

The Wall Street Journal ran a recent article on a new variation of target-date and life-cycle mutual funds (which automatically adjusts the stock and bond allocation as a targeted retirement date approaches). The new “target payout” and “managed payout” funds adjust the stock and bond mix to provide a steady, above-market rate of return to the investor.  It has the perfect appeal for retiring baby boomers who wish to replicate the income of a steady paycheck, but do not have a large enough nest egg from which to generate sufficient income from the meager yields currently offered on bonds or fixed annuities.

Sounds terrific.  Does it work?  No.

It is standard financial planning gibberish to create a portfolio compiled from historically-derived investment returns and volatility.  And in spite of the disclaimers, the typical lay client has the distinct understanding that these investments are appropriately conservative, and will provide a lifetime of security.

Unfortunately, the only assured investment returns are from fixed income investments held until maturity.  Stock and bond investment returns cannot be managed, or adjusted like the temperature on a thermostat.  The returns are not guaranteed, and in a bear market, the portfolio (and all future income) can be devastated.  Frankly, the entire approach is disingenuous, since the portfolio is constructed to address a target nominal yield, rather than the yield necessary to maintain purchasing power (which is the only reason to take investment risk in the first place).  So even if the target yield is achieved over time, the client may still run out of money if inflation requires a much higher investment rate of return.

Individuals are by no means the only investors vulnerable to the siren song of high yield with low risk.  The sub-prime mortgage crisis was fueled in part by institutional investors with the same perspective.  Endowments and pension plans must plan for an eventual payout, and implicit in the calculations is some estimation of minimum and aggregate rate of return.  During the low return years, when even the highest fixed income rates were insufficient, the sub-prime and collateralized debt obligation packages offered an unbeatable combination of high yield and low statistical risk.  The institutional investment demand enabled the creation of all those now-worthless debt products.

Even today, it is standard practice among institutional investors and their consultants to evaluate money managers and hedge funds on their ability to deliver high compounded returns with low volatility, as if risk and return are utterly unrelated.  They are not.