We’re here today with Chris Minnucci, author of the brand new book on investing The Death of Buy and Hold. Chris, how did you get interested in investing?
My background is in engineering, not finance, and at first my interest was driven more by necessity than by any desire to learn about investing. I had hired a financial planner to develop my retirement plan, and was expecting to have him manage my portfolio going forward. He was probably expecting, or at least hoping, the same. But he made two mistakes. First, as kind of an offhand comment he told me that with my math background, I could probably do alright managing my investments on my own. And second, he told me the fee for his services. It would have worked out to about $10,000 per year! Now I’d be OK spending $10,000, if I thought he could increase my returns by, say, $11,000. But I had my doubts about that.
So I decided to give the do-it-yourself approach a try, and began reading up on the subject. At first it was a chore. But I was very fortunate to have stumbled on three investment classics early on in my reading: Burton Malkiel’s A Random Walk Down Wall Street, and William Bernstein’s The Intelligent Asset Allocator and The Four Pillars of Investing. Not only do those three books set out a clear, logical and compelling analysis of what does, and doesn’t, work when it comes to investing, but they do so in very interesting, entertaining ways. They weren’t at all the dry, boring tomes I was expecting. Reading Malkiel’s and Bernstein’s books, investing started to really grab my interest, and on multiple levels. The science-based theories they described—modern portfolio theory, the Efficient Market Hypothesis, CAPM, and such—appealed to my analytical, engineering side. The financial history they brought to life—Holland’s tulip mania, the South Sea Bubble, the 1929 stock market crash—brought out the history buff in me. And their discussions of behavioral finance piqued my interest in psychology. By the time I finished those three books, I was hooked on the subject, and was reading anything and everything I could find that followed their scientific approach to investing. What started as a chore became a hobby, and then something of an obsession.
You mentioned that your educational background is in engineering, not finance. How does that background qualify you to write about investing?
Well, beyond the obvious point that engineers are comfortable with numbers and math, I think my background gives me an unusual, and useful, perspective on investing—and especially on risk. The first and foremost concern of an engineer is to minimize the risk of catastrophe. For example, an engineer in charge of building a bridge will have as his or her top priority ensuring that the bridge will not collapse. Similarly, my top priority is to teach my readers how to prevent the ultimate personal financial catastrophe: outliving one’s money. Whereas finance professionals tend to equate risk with stock market volatility, as an engineer my book focuses on the broader, more useful definition of risk as the possibility of outliving one’s savings. This risk, which I have termed the retirement risk, is the jumping off point for my book, and it is the touchstone that I return to again and again throughout the book. The Death of Buy and Hold is offered as the solution to the catastrophic risk posed by financial ruin.
My engineering background informs not only my definition of risk, but also my approach to minimizing risk. As an engineer, I believe in the power of applied science to improve and even transform lives. And my belief in science includes the science of investing. Beginning in the 1950s, with the development of modern portfolio theory, academia has made tremendous strides in understanding, scientifically, the behavior of the financial markets. This science-based approach to investing has been proven to work in the real world beyond academia, by amateur investors as well as professional money managers responsible for multi-billion dollar portfolios. Examples of practitioners successfully implementing the scientific approach include David Swensen, manager of the Yale endowment, who used the principles of modern portfolio theory to beat the S&P 500 by nearly 4 percentage points per year from 1985 to 2008. I’ve used these same principles to successfully safeguard and grow my own portfolio; my application of the science-based approach to investing enabled me to switch to part-time consulting work at age 49, and to retire fully at age 57. The Death of Buy and Hold likewise adopts the scientific approach to investing. It focuses on explaining the principle of correlation underpinning modern portfolio theory in a clear, easy-to-understand manner, and then goes on to show how the application of this principle would have succeeded in reducing portfolio volatility without reducing returns over the past 40 years.
But The Death of Buy and Hold does not begin and end with the principle of correlation. Engineers use multiple safeguards to protect against catastrophic risk; for example, nuclear engineers build power plants with multiple backup or failsafe mechanisms to prevent a catastrophic meltdown in the event that the first line of defense fails. Similarly, The Death of Buy and Hold offers multiple solutions to the risk of financial ruin, including, for example, well known strategies such as index investing, lesser-known approaches including portfolio rebalancing with precious metals equities, and new ideas based on my own analyses. I show how to combine all of these solutions into a powerful defense in depth, with multiple failsafes against the risk of a financial meltdown.
Be it a bridge, a dam, a nuclear power plant, or infrastructure in general, engineers build things to last decades, and even centuries. The number one goal of my book—really its only goal—is to teach readers how to build and maintain an investment portfolio that will last them a lifetime.
The economist John Maynard Keynes spoke of the “animal spirits” that drive speculators, and more recently Alan Greenspan coined the term “irrational exuberance.” Isn’t the scientific approach to investing based on the assumption that investors are rational? How accurate is that assumption?
That’s a very good question. There’s a great quote from William Bernstein in his book The Four Pillars of Investing: “I’m often asked whether the markets behave rationally. My answer is that it all depends on your time horizon. Turn on CNBC at 9:31 AM any weekday morning and you’re faced with a lunatic asylum described by the Three Stooges.”
I think that in general the markets do behave more or less rationally—except every now and then, when they go completely nuts. So while math and science offer important insights into the behavior of the financial markets, it will never be possible to reduce this behavior to a series of mathematical equations. Psychology is every bit as important as math-based theories in explaining the markets. I have been a history buff since my teenage years, and I’ve always been fascinated by the mass euphoria and mass fear that governs market bubbles and panics. I’ve read widely and deeply on the subject of financial history. Nothing can impress upon the mind a better understanding of the inherent instabilities of the financial system, its proclivity toward great upheavals, and its unending capacity to shock and humble investors than a familiarity with its history. The Death of Buy and Hold is informed as much by my interest in stock market history and the psychology of investing as by my math and science background.
Let’s dive into the book. Despite the title, you actually recommend the buy and hold strategy for amateur investors, right?
That’s right. Calling the book The Death of Buy and Hold was just my attempt to be cool and ironic. It’s a reference to the ongoing, apparently endless debate between the proponents and opponents of buy and hold. It seems like there’s always a group of investment gurus out there ready to declare that buy and hold is dead. Their ranks swell whenever the stock market struggles to gain ground, as was the case during the so called “Lost Decade” of 2000-09. Back then the “buy and hold is dead” crowd would point to an index like the S&P, and say how can you possibly earn a decent return buying and holding when the S&P has done nothing but move sideways for the past ten years? On the surface what they were saying might seem to make sense, until you start looking at their assumptions. Yes, the S&P 500 delivered lousy returns between 2000 and 2009. But buy-and-hold investing is all about holding a diversified portfolio of investments. I don’t know anyone who would consider a portfolio consisting of a single investment in an S&P 500 index fund to be diversified. So it’s false logic to point to an index like the S&P and say that because it’s gone down over an extended period, buy and hold is dead. It all depends on what you buy and hold—and you should never limit your portfolio to a single stock market index for a single country.
But isn’t it just too hard for most investors to stick with a buy-and-hold strategy?
I don’t want to sugarcoat buy and hold, and I don’t sugarcoat it in the book. They say that democracy is the worst form of government—except for all the other forms of government. Well, in a lot of ways buy and hold is like democracy—it’s the worst investment strategy, except for all the other strategies. In the book I go through the empirical evidence against some of the most popular alternatives to buy and hold—market timing and performance chasing—and show how they almost invariably lead to lower returns and increased risk of bankruptcy. And as long as times are good, buy and hold is an almost perfect strategy for the amateur investor, since it requires no stock market expertise and almost no effort to implement. It’s a “do nothing” strategy, and what could be easier in normal times than doing nothing?
But when the market turns ugly, like back in 2008, it becomes very difficult to maintain a buy and hold strategy. It was difficult for me, too. Even though I’ve studied market history and know that stocks have recovered, rapidly, from every one of the twenty or so market crashes we’ve experienced in the last 100 years, there was this voice in the back of my head saying “what if this time is different?” The reality is, you cannot be 100% certain that you will recover from a decline. There’s always a possibility, however small, that by holding your stock investments during a crash you’ll experience an unrecoverable loss. And if there is a slight chance of a truly catastrophic loss, then it’s not entirely irrational to sell your stocks when the market is going down. This is one of the two fundamental problems at the heart of buy and hold—you cannot be certain that you’ll recover your losses. But in the face of that uncertainty, unfortunately many investors sell in situations that pose no real danger to their portfolios’ survival. They wind up selling low and buying back into the market high. And that actually increases the risk that they will eventually run out of money.
So the book recognizes this problem of uncertainty, and tackles it head on with a set of tables that show portfolio survival rates for past market crashes. For example, if you are retiree using a 60/40 stocks/bonds portfolio and your withdrawal rate rises to 5% during a market decline, the tables will show you the percentage of past market declines that your 60/40 portfolio would have survived for an additional 30 years, 25 years, 20 years, and so on. For example, the tables might for a particular withdrawal rate show that your portfolio has a 100% chance of surviving 20 more years, and a 90% chance of surviving 30 more years. The tables don’t eliminate the uncertainty at the heart of buy and hold, but they replace that uncertainty with a set of probabilities. The book then explains how you can use the tables to define your own “danger zone” based on how your withdrawal rate changes during a market crash. If you remain outside the danger zone then you can take comfort in the fact that your portfolio will most probably survive. If you start to get too close to the danger zone then there is a hierarchy of actions you can take to reduce the danger—with selling being the option of last resort.
So you do consider the possibility that selling might be better than holding, in some cases?
Yes, it is possible, although not likely if you are following the other recommendations in the book. It all depends on what happens to your withdrawal rate. At a high enough withdrawal rate the probability that a particular portfolio will survive 30 years drops to zero percent based on past history; the tables will show you the withdrawal rate corresponding to that zero percent survival probability. So if you’re a sixty-year old retiree you would want to sell long before your withdrawal rate rose to that level. That said, there are better ways to deal with a rising withdrawal rate than selling your stocks. First you should try cutting back on expenses or taking a part-time job. Selling is always the option of last resort, because it risks locking in your losses and increasing rather than decreasing your chances of going broke.
You said that uncertainty—the slight chance of an unrecoverable loss—is one of the two main problems with buy and hold. What is the other problem?
The other problem is the emotional one—the difficulty of sticking with buy and hold when the market is crashing, or when it is bubbly. In the book we tackle this problem head on, too. Part of the answer lies in coming to a rational understanding of the dangers of trying to time the market during a crash, or chasing hot investments during a raging bull market. So the book spends some time explaining the reasons why market timing and performance chasing will probably increase, not decrease, your risk of outliving your money.
But while it’s important to understand the problem from a rational perspective, for many investors reason alone isn’t enough. Fear and greed are such powerful emotions. Faced with the immediate pain of losses incurred during a bear market, and the prospect of further losses, many investors will give in to their fears even when they know that, rationally, selling when stock prices are low is most likely a bad move. For many, probably most, people, reason just isn’t powerful enough to overcome the strong emotions that come with financial losses or gains.
So rather than trying to drive emotion completely out of the investment process and replacing it with reason, the book explains how to harness and use powerful positive emotions—such as the desire a parent or grandparent feels to protect their children and grandchildren from harm, including financial harm—to counterbalance the negative emotions of fear and greed. It’s different from the approach taken by most others who’ve written on the subject of emotion in investing. The more typical approach is to educate people on the findings of behavioral finance, which has shown investors to be far from the rational decision makers economists once assumed them to be. I think there’s tremendous value to be gained by this approach—by understanding the many ways our emotions and cognitive biases sabotage our reason, and cause us to make foolish mistakes when it comes to money. But I also think that one of the main lessons, if not the main lesson, of behavioral finance is that while we may be able to recognize and “unlearn” some of our irrational behaviors, we are and always will be driven in our decisions in large part by emotion. We’re human, we’re probably never going to be able to approach investing the way a computer or Dr. Spock would do it. The Death of Buy and Hold recognizes and accepts our human, emotional nature, and shows how we can overcome the danger to our nest eggs posed by some of our emotions with the help of other emotions.
That idea, of taking something like emotions, normally thought of as a bad thing in investing, and using it for good, seems to have a parallel in the “black-belt investing” you describe in the book.
Yes, there is a strong parallel there. Black-belt investing is just my new name for what is an old idea: by combining investments that tend to “zig” with investments that tend to “zag”, you can reduce your portfolio’s volatility without sacrificing returns. I call it black-belt investing because it is similar in concept to the idea behind judo. In judo, a black belt can defeat a larger, stronger opponent by using that opponent’s superior weight to throw him off balance. Similarly, a black-belt investor can take a highly-volatile investment that has some tendency to go up when the stock market goes down, like precious metal equities (PME), and use it to reduce the overall volatility of the investor’s portfolio. You can’t change the volatile nature of the stock market, it’s a given. So the idea is to take what is normally seen as a problem or disadvantage—namely, the volatility of the stock market—and turn it to your advantage. Just as the black-belt in judo uses his opponent’s size and weight to his own advantage. It is very similar to the concept of using helpful emotions to counterbalance harmful emotions. You can’t change your human, emotional nature, so the trick is to find a way to use your emotions to your advantage.
How does the concept of black-belt investing fit in with the buy and hold approach?
I view buy and hold as the overall framework for an integrated investment strategy designed to minimize what I call the retirement risk—the risk of outliving your money. Black-belt investing is one piece of that integrated, holistic strategy. It is a very important piece of the strategy—in fact the entire first half of Death of Buy and Hold is focused mainly on explaining how black-belt investing works, and on demonstrating how portfolios constructed using the principles of black-belt investing would have performed during the bull and bear markets of the past four decades. The backtests show that these kinds of well-diversified portfolios have done a good job of smoothing out volatility without sacrificing much in the way of returns. And this ability to reduce volatility without having to give up returns is key to reducing the retirement risk.
And that’s because there are two components to the retirement risk?
That’s right. As the first chapter of the book explains, there are two main ways you can go broke in retirement. First, you can encounter too much negative stock market volatility—in other words, a big bear market or a series of bear markets so severe or ill-timed you are unable to recover from them. That’s the path to bankruptcy that all investors know about, and fear. The second way to go broke is if you don’t earn enough returns to outpace inflation. That second path is a more gradual, less dramatic and frightening way to go broke—but it can nonetheless lead to bankruptcy just as surely as market volatility can. Unfortunately, in an attempt to reduce the big, scary risk posed by market volatility, many investors wind up putting too much of their nest eggs in low-returning, supposedly safe investments like bonds and CDs. Now bonds have a very important role to play in a well-diversified portfolio. But if you put all or almost all of your nest egg in bonds, you may wind up with returns that are insufficient to keep up with inflation. Investors who try to reduce the volatility of their portfolios to a bare minimum by relying too heavily on bonds often wind up increasing, rather than decreasing, their risk of going broke. That’s especially true today, when bond yields are at historic lows. Current bond yields have proven to be a good predictor of future bond returns. Currently, the yield on the 10-year Treasury note is about 2.5%. But over the long-run, inflation has averaged 3%. Given these numbers, you’re at best going to barely keep up with inflation using a portfolio weighted very heavily (80% or more) towards bonds. More likely your nest egg will be slowly eaten away by inflation.
So you want to add bonds to your portfolio—an all stock portfolio is simply too volatile for most investors to be able to stomach. But you have to add bonds in moderation, because the more you reduce the risk posed by stock market volatility using bonds, the greater the risk posed by inflation. And that’s the basic limitation of bonds. When you use them to reduce one component of the retirement risk—market volatility—you have to accept an increase in the other component of the retirement risk—returns insufficient to keep pace with inflation. Once you understand that there are two components to the retirement risk, the key characteristic that will be shared by all the best solutions to this risk become clear. All the best solutions will reduce both components of the retirement risk—or at the very least, they will reduce one component without increasing the other component. Bonds can’t do this, but black-belt investing, using highly-volatile hedges like PME (precious metal equities) can.
You mention PME—gold mining stocks. In Death of Buy and Hold you recommend them highly. What is it that makes them such a good hedge?
Mutual funds that invest in gold mining have very unusual characteristics. They are really downright weird. Considered in isolation, they are really lousy investments. For one, they are extremely volatile—much more so than the broader stock market. Plus they tend to have lower returns than most other categories of stocks.
But, when you add them to a well-diversified portfolio of stocks and bonds, they don’t behave at all the way they do when in isolation. For one, they reduce the portfolio’s volatility. This happens even though PME is much more volatile than the rest of the portfolio. Of course this idea isn’t new. It has long been known that when you add a highly-volatile asset like PME, which has a low correlation to other stocks, the volatility of the portfolio goes down.
What is much less widely known is that adding a PME fund can also raise the returns of a stock portfolio. It can do this even though the long-run returns of the PME fund are typically less than the returns of the other stock funds comprising the portfolio. So you take an investment that has relatively low returns, and extremely high volatility, add it to a portfolio, and you can wind up with higher returns and less volatility! This is the proverbial free lunch, which is not supposed to be available in the stock market. If a free lunch ever does become available, it is supposed to be grabbed by professional arbitrageurs long before an amateur investor can ever enjoy it. Yet a free lunch is precisely what PME offers. It’s not supposed to happen; in the book I explain why it can happen. The key is that you have to rebalance your portfolio on a regular basis. Rebalancing gives you the opportunity to buy low and sell high, and that opportunity is maximized with PME. William Bernstein did the original analyses demonstrating the existence of the rebalancing bonus, and the relationship between the rebalancing bonus and PME. As Bernstein emphasized, there is no guarantee that you will earn a rebalancing bonus over any given time period. But just the possibility that you might earn such a bonus with PME, while at the same time reducing the volatility of your portfolio, makes PME special—a potential win-win solution to both components of the retirement risk.
And the book explains other solutions which, like black-belt investing with PME, can address both components of the retirement risk?
It turns out there are quite a few ways to either reduce both risk components, or to at least reduce one component without increasing the other. Once you set as your goal reducing the risk of outliving your money, solutions to this risk seem to start coming out of the woodwork. For example, a liability matching bond portfolio can virtually eliminate the risks posed by both market volatility and inflation—at least for a while. And index investing will increase your returns and reduce the risk posed by inflation, but without simultaneously increasing volatility. These are just a couple of the other solutions to the retirement risk that are explored in the book. But the ultimate solution to this risk is achieved by combining all these individual solutions into a holistic investment strategy—what I refer to in the book as defense in depth—within the framework of buy and hold.
In addition to the book, you’ve started a blog on the subject of early retirement and Obamacare. How did that come about?
It came directly out of my own experiences as an early retiree. No matter how you might feel about Obamacare, and whether you think it is a good or bad thing for the country as a whole, there is no doubt that it is a huge improvement for early retirees. Back when I first retired, I didn’t even know if my insurance company would convert my employer’s group plan to an individual policy. My insurer insisted they couldn’t tell me whether they would do the conversion until after I had retired. And then, when I did retire, they refused to do the conversion. Back then you were completely at the mercy of the individual insurers. If they didn’t want to convert your group plan to an individual plan, then you were just out of luck. As you can imagine, the uncertainty and capriciousness of it all was a major obstacle for everyone who wanted to retire before they became eligible for Medicare.
In my own case, I was eventually able to get a policy through a different insurer. But it was very expensive. Those were the bad old days for early retirees, and early retiree wannabes. Obamacare has changed everything for the better. Now, not only are early retirees guaranteed access to healthcare insurance, but they can pay rock-bottom prices as long as they know how to maximize the subsidies available through Obamacare. I’m saving nearly $5,000 in premiums annually, compared to what I used to pay. The key to achieving these kinds of savings is to understand that your eligibility for the subsidies, and the size of the savings you’re entitled to, depends on your income. And many early retirees can, through a combination of tax-efficient investing and careful use of IRAs and 401(k)s, in effect set their own income level. In fact, many early retirees should be able to use Obamacare to get the IRS to pay them to convert their tax-deferred savings to tax-free Roth savings. It’s a perfectly legal, legitimate way to minimize not only your healthcare costs, but also your future income taxes for years to come.
But it is a bit tricky. There is a narrow income range you have to precisely hit to minimize your healthcare costs. This range varies depending on factors including your family’s size, your children’s ages, and your state of residence. In order to maximize my own savings I’ve taken the time to educate myself on the technical details of Obamacare. Having done so, I decided to share what I’ve learned via the blog.
How often will you be posting to the blog?
I plan to post once a week, on Mondays. The first few posts will explain the basics of Obamacare. In later posts I’ll be explaining a variety of strategies early retirees can use to control their income level and get it to fit in that narrow range that will maximize the Obamacare subsidies. I’m going to be describing multiple strategies because this is not a situation where one strategy will fit all. For example, early retirees with little or no savings in tax-protected accounts like IRAs will need to use a different approach than those who have a lot of tax-deferred savings. But the nice thing about all of the various strategies is that they are by and large compatible with best practice when it comes to minimizing your taxes. In other words, the actions you will need to take to minimize your healthcare costs are to a large extent things you should be doing anyway. In the blog I may occasionally veer slightly off-topic to discuss related subjects like tax-efficient investing. I’ll also tackle some special topics, such as how Obamacare may impact your decision on when to start collecting Social Security.