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Absent leaving the portfolio intact (save for rebalancing), Johnson/Samoan Express needed to monitor the economy for the statistical occurrence of another 1973/74 where losses over 45% were evidenced. Further, periods of substantial performance are usually followed by far lower returns. Such an event would have devastated a portfolio in the extreme since significant losses for a retirees portfolio cannot be made up. Again, from Fireseeker, "Taking money out of the portfolio when the market is down depletes the future earning power of the portfolio, potentially to the point where it cannot recover." The economic and financial debacle of 2000- 2003 was not a statistical aberration- it certainly had happened previously. Samoan Express and Johnson were therefore responsible for any adjustments to a portfolio to reflect an economy that would significantly devastate a retirees portfolio particularly since they obviously had not identified adequate funds for Brumlow's retirement in the first place. (See Exhibit attached)
However, neither Samoan Express nor Johnson undertook a formal endeavor to adjust the portfolio even as the economy was dropping into recession. After the tech market meltdown in March 2000, any viable adviser was well in tune with the economy- certainly addressing the inverted yield curve, FED policy on interest rates, productivity, manufacturing statistics- the entire gamut of leading, coincident and lagging indicators. That they apparently deferred the effort over to a totally unsophisticated client who recognized that his portfolio was declining precipitously and wanted/needed professional assistance that was not competent is not acceptable. Samoan Express has innumerable analysts who follow the economy and were cognizant of the past failures of the market and the implications on a retiree. They (obviously) failed to adjust Brumlow's portfolio for the debacle. This is not to say that some losses would not be sustained. But at some point in 2000, the portfolio had to be adjusted to reflect the economy's weakness. And the market's. Additionally, it should have been obvious to Samoan Express and Johnson that if a portfolio's returns are negatively impacted at the beginning of a problem, the retirees income would almost never recover. Of course, with the inadequate assets to begin with, Smith had lost his retirement availability almost in total. Samoan Express was clearly aware of this implication since, on the "Proposed Investment Plan", Risk Tolerance wherein it states that there is a 98% chance of realizing a return which is greater than the worst case return and a 2% chance of exceeding the best case (see illustration). It states that "the range of returns illustrated by the left bar in the graph represents the statistically calculated worst case
to best case range of returns for your proposed portfolio. Further, "over time, the combination of annual returns should move your average return ever closer to the portfolio's expected return." That's all very nice and an inducement to enter the market place with equity investments even with the caveats. Smith and literally all other Samoan Express clients would essentially feel the same since the "computer program" said so and they were buying the plan from an adviser they "trusted". But what the plan failed to indicate is the flip side of the bell shaped curve. If a 2% "problem" (I see it more as 4%) should impact a portfolio at the initial stages, the losses could not be made up from a retiree's portfolio. I refer to the real life time frame of 1973/74 that was clear reference to losses in real life. That the 90's were supporting unreasonable and unsustainable returns is no rationalization that such extreme losses could not occur again. That Samoan Express and Johnson were caught in the same euphoria as consumers is no defense of their fiduciary responsibility for not recognizing the extreme volatility of the stock market. That there was a psychological block to the reality of stock market volatility is a reflection of behavorial finance that has been known for decades in the industry and certainly known to the professional entities at Samoan Express. But such professional advisors do not have the luxury of mistaking inaction for responsible activity. That they made be "afraid" of making a mistake is no defense for not attempting a rational and competent adjustment. Of course, they would be liable no matter what the occurrence if the errors were based on totally nonexistent study and research.
Per Ken Fisher regarding standard deviations and volatility, "if you take your average advisor, he or she knows that the long-term history of stocks has averaged about 10%, which is true. In his bones, he will believe a return in any given year of 0% percent to 20% is more likely than a return above or below those levels. The history of Western markets, however, is exactly contrary to that. Returns are higher or negative 70% of years in America. They are between 0% and 20% only in the remaining 30% of the calendar years since 1926. In overseas Western developed markets, returns of zero to 20% happen in only 25% to 40% of years. Returns greater than that or negative happen 60% to 75% of years. Overwhelmingly, markets are more volatile than people think." Those are not esoteric comments- they are pure facts. Facts that were always known to Samoan Express. Facts that demanded activity.
Dollar Cost Averaging (DCA)
Dollar cost averaging was identified in the material as a supposedly valid way of investing. "Supposedly" since there was no identification of what was being accomplished. While DCA is bandied about the industry as a standard method of investing, it has not worked in the past, does not
work today and, almost assuredly, will not work in the future. (Two researchers (Williams and Bacon) have discounted dollar cost averaging by statistically showing that putting all the funds in at one time
outproduces dollar cost averaging by two to one. They invested a theoretical sum in 90 day T-bills and moved into the S&P 500 over a year's period. They compared these results with investing all the funds
at once- starting with different periods from 1926 to 1991. "Nearly two thirds of the time, a lump sum strategy significantly outperformed dollar cost averaging".) DCA only works with lump sums. It means the spreading out of the monies over a period of time- generally referenced as 12 months- though some have even suggested years. It can reduce the risk of loss since it can avoid purchases at the very extreme prices. But so does leaving assets in all cash. The point is that DCA underperforms the market approximately 2/3rds of the time. It is almost always better to put all the funds in at one time. And this makes sense if you are going to get higher returns in 66% of the historical patterns. That said, lump sum investing into a bad economy tanks is a fallacy in itself.
While DCA is only thought of as a "conservative" process, it can nonetheless be an extremely risky proposition when the market has an extended downtrend. For example, the use of DCA from 2000- 2002 would have meant putting in monthly payments into a declining market. Effectively every purchase was at the highest price for that period. The next month's prices was even lower- hence the previous purchase would have lost and the new purchase was going to go down as well. No valid reasoning exists either for leaving risky securities to more exposure nor to adding significantly to the risk with more monies that were almost guaranteed to lose in value. I submit that Samoan Express was well aware of the articles addressing the fallacy of DCA and should have recognized the failure to keep doing it in a completely dropping market. A professional article by Moshe Milevsky notes, "because of the higher standard deviation with dollar cost averaging, you would have higher odds of ending up with less money overall." And "amongst the general public, DCA appears to be an axiom of prudent investing....... In contrast to this widespread practice, financial economists have shunned this strategy and repeatedly demonstrated its irrationality. .......... and mean variance inefficiency."
First, to review standard deviation over time. If you potentially held the security for five years and the annual volatility measured by one standard deviation was a high 30%, the standard deviation is reduced to "only" 13.42% because you simply divide the annual deviation by the square root of the years held- in this case 5 years. That number is 2.236. And if you held it for 10 years, you divide by 3.16 for a volatility of just 9.48%. If you had started with just 20% volatility, then a 5 year deviation would result in a 8.94% volatility and a 10 year deviation of only 6.32%.
(Since the historical annual standard deviation for the market is about 20%, I have a significant concern for the standard deviation as stated on the plan; Asset mix comparison- Non Qualified Assets. I cannot confirm that an annual standard deviation of a portfolio consisting of 44.29% large capital stocks; 16.47% small capital stocks; 20.59% international stocks and just 17.64% intermediate bonds would yield an annual standard deviation of 12.19%. Without the corresponding correlations it is impossible to know what internal calculations were being made, what historical dates were used, etc. I believe that the correlations are not that offsetting and that the combinations would not offer a singular starting year of 12.19%. (The correlations used, weightings, and the overall calculations represented by Samoan Express software will need to be established before trial. This is critical to validate the standard deviations used in their presentations.)
However, a great fallacy to the Smith plan is the continuing reference to how risk (standard deviation) goes down over time and simply leaving it at that. Professional analysts have always known that risk goes up. The book on Investments by Bodie, Kane and Marcus, 1989, page 222, Appendix C, called "The Fallacy of Time Diversification". The comments addressed the 30% deviation identified above and that a investor would be "emotionally relieved" that over a 5 year period, the volatility would be reduce to an "acceptable" 13.42%. But it notes that the impact of a one time standard deviation over the entire portfolio could reduce the amount anticipated by almost 50%. (Probably earlier Investment books also identify the statistical fallacy, but that is the book I have used.) "A standard deviation in the average return over the five year period will effect final wealth by a factor of (1- .1342) to the fifth power = .487. (That's the formula. One minus the standard deviation for the time period selected and the resulting number multiplied to the "X" power where x represents the number of years in question.) That means that final wealth will be less than one half its expected value." "Time diversification does NOT reduce risk. It is true that the per year average rate of return has a smaller standard deviation for a longer time horizon. It is also true that the uncertainty compounds over a greater number of years. Unfortunately, this latter effect dominates in the sense that the total return becomes more uncertain the longer the investment horizon."
"The lesson is that one should NOT use the rate of return analysis to compare portfolios of different size. Investing for more than one holding period means that the amount at risk is GROWING. This is analogous to an insurer taking on more insurance policies. The fact that these policies are independent of each other does not offset the effect of placing more funds at risk. Focus on the standard deviation of the rate of return should NEVER obscure the more proper emphasis on the possible dollar values of a portfolio strategy".
