Stop losing value from a declining price

March 4, 2017


The market value of your stock equals your principal (i.e., the amount you invested) plus any profit or loss from price fluctuation. The market price that moves below what you paid to purchase the stock will produce a loss of principal if you sell the investment. Here are several risk factors that may drive stock prices downward:

  1. Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
  2. Industry performance. Business cycles can affect the sales of products from an entire industry. For example, sales of new automobiles declined during the Recession of 2008.
  3. Market cycles. Aside from business performance, the entire stock market is subject to periods of declining prices due to massive selloffs by investors.

The risk of an extreme loss can be prevented by setting a stop-loss price (“stop”) to sell part or all of your shares.

ways of setting the stop

The systematic way is quite simple. If the market value is below your invested principal, then select an absolute loss or a fraction of the principal. Examples:

  1. Absolute loss. Suppose you invest $5,000 in 100 shares of stock (i.e., $50/share) and you can tolerate a loss of $1,000 should the price start to fall. Regardless of future prices, you choose to stop the decline at $1,000 below the original $5,000 value. In this example, the stop would be $40/share [stop = (value – loss)/shares = ($5,000 – $1,000)/100].
  2. Fraction of value. Suppose you can tolerate a 10% loss from an investment originally valued at $5,000 for 100 shares.  Ten percent is one-tenth of 100, which is equivalent to a decimal number of 0.10. The stop would be $45/share [stop = (1.00 – decimal)*value/shares = (1.00 – 0.10)*$5,000/100].

The technical way is based on the stock’s historical prices. If you want to minimize the chance of a sale, set the stop at the lowest price from the past 5-10 years. Beware that setting the stop at a historical low may incur a steep loss. Other ways involve the more complicated analyses of trendlines, moving-average lines, or price statistics.

Another way is to adjust the price gap (gap = market price – stop) to the growth of capital gains. As the market price increases over time, choose a narrow gap to protect the capital gain or a wide gap to reduce the chance of a trade. Generally speaking, widening the price gap will reduce the chance of a trade at the risk of incurring a bigger loss.

add a limit price (“limit”) for extra protection

A brokerage firm will enforce your stop order for 30-90 days depending on the firm’s trading platform. The firm’s computer activates the order when the latest market price reaches the stop. The order is then filled at the next available price. In a chaotic market, the price could plunge below your stop to an exceptionally low value at the next available trade, resulting in a bigger loss than you planned. You might be able to prevent this result by setting a limit slightly below the stop. The trading order would be filled somewhere within the stop-limit price zone unless the transaction is cancelled, unfilled, when the next available price dips below the limit. The limit helps protect the extent of your loss.

who should worry about an extreme loss?

Nobody’s immune, but long-time investors have the least concern. Investment strategies such as dollar-cost-averaging and automatic-dividend-reinvestment plans will help protect against damages from periodic bear markets. Short- and intermediate-time investors are at greater risk for incurring an extreme loss from market down-cycles. For example, families who are saving to pay college fees or to buy a home risk big losses from a bear market.


Stop orders are used to set the price for buying or selling exchange-traded products such as stocks, ETFs, and REITs. This article discussed the use of a stop-limit order to sell a stock in a declining market. Brokerage firms may restrict the duration of stop-limit orders to 30-90 days after which the order is cancelled without a transaction until you renew the order. Periodic renewals allow you to reconsider your strategy in light of the prevailing price trend. In a downtrend, simply renew the order. In an uptrend, you may wish to protect a growing profit by resetting the stop-limit order to higher prices. Click on this link to skimming a profit for another perspective on protecting a growing profit.

Copyright © 2017 Douglas R. Knight


January 14, 2017

My SmallTrades portfolio holds stocks and four classes of exchange-traded index funds (ETFs).

chart 1

chart 1

Investment plan

The goal is to outperform a reputable benchmark, the Standard & Poors 500 Total Return Index, on a sustained basis.  The ETFs are diversified and rebalanced in order to partially offset the losses of a declining market. A small group of stocks are used to boost the investment returns.


In FY2016 the portfolio’s market value increased by 8.3% due to a 9.1% gain in stock value and 8.1% gain in ETF value. Charts 2 and 3 illustrate the nominal (solid lines) and real (dashed lines) growth in unit value for shares of the portfolio, ETF group, stock group, and benchmark. The number of shares for each entity was the initial market value divided by $1 of U.S. currency.  Assume that the initial unit value of $1 was a real value unaffected by inflation.

Chart 2 shows the pattern of unit-value growth for the benchmark (black lines) and portfolio (blue lines) since December 31, 2007.

chart 2

chart 2

The unit value of both entities declined in year 2008 and began to recover in year 2009. The benchmark (black lines) recovered in year 2011 while the portfolio (blue lines) is still struggling to recover [notes 1,2]. The effect of inflation was to devalue real growth (broken lines) compared to nominal growth (solid lines). The real unit value signifies the purchasing power of the investment. The investment has greater purchasing power than uninvested money when the real unit value exceeds $1.

Chart 3 shows the result of implementing the current investment goal [note 2] with a small group of stocks (red lines) and large group of ETFs (blue lines). In chart 3, the initial unit value was re-calculated on December 31, 2013.

chart 3

chart 3

Since 2013 the stock group clearly outperformed the benchmark (black lines) and ETF group. The success of the Stock group is attributed to investing in ‘good’ companies for the long term [note 3].

Stock group

Chart 4 shows the market sector and market cap diversity of the stock group defined in chart 1.

chart 4

chart 4

Several stock trades were made during FY2016 to improve the chance for success.

  • Alibaba Group (BABA), for 10% capital gain, to exit the Chinese market.
  • Geely Automobile (GELYF), for 14% capital gain, to exit the Chinese market.
  • Corning Inc. (GLW) for no gain.
  • iRobot Corp. (IRBT) for 10% capital gain.
  • ITC Holdings (ITC) for 14% capital gain, due to the stock’s delisting.
  • Stericycle (SRCL) for 34% capital loss, to stop further loss.


  • Biogen (BIIB), an innovative biotechnology firm.
  • Cal-Maine (CALM), a leading producer of shelled eggs.
  • Express Scripts Holdings (ESRX), a large mail order pharmacy
  • Royal Bank of Canada (RY), a well-capitalized bank.

ETF group

Chart 5 shows the distribution of asset classes among the ETFs. All asset classes drifted from an allocation plan of 30% stocks, 30% REITs, 20% bonds, and 20% gold [note 4].


chart 5

The SmallTrades portfolio’s primary strategy for risk management is holding a large group of diversified ETFs that are rebalanced to correct a significant allocation error. In theory, a significant drift of asset classes occurs when one asset class surpasses a 28% allocation error.  At the end of FY2016, the existing allocation errors (blue bars) were within 24% error limits (red dashed lines) as illustrated in Chart 6.

chart 6

chart 6

Chart 6 reflects the portfolio’s response to an incline in equity markets compared to decline of the bond and gold markets. History has shown that a decline in equity markets tends to be offset by a rise in the bond and gold markets.

Plan for FY2017

The SmallTades portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. I would like to own fewer large cap stocks in favor of small- and mid-cap stocks issued by good companies with potential growth of earnings.


  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in the Roth account. During 2007-2010 the mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’. Several mistakes led to a big loss:  A) after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of that company’s large debt and lost $45,000 during its decline to bankruptcy.  B) substantial long term profits from good companies were lost by selling holdings for short term profits. I was trying to earn a quick 30% annual rate of return and immediately re-invest in the next set of winners. It was too difficult to identify the next winners.  C) day trading also prevented a 30% return.  It was a game of chance that I played without a strategy and I was fortunate to break even.  D) a trial of investing in leveraged ETFs resulted in losses due to negative compounding.  Leveraged ETFs were very high-risk investments that I made without a sound strategy.
  2. I abandoned the goal of a 30% annual rate of return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad market ETFs and 20% stocks for the long term.
  3. ‘Good’ companies attract and retain investors for many years. I search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, participating in investment club discussions, using stock screeners, and attending investor conferences.  I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  4. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since I don’t depend on making withdrawals from the SmallTrades Portfolio, I increased my exposure to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

Copyright © 2017 Douglas R. Knight

R-squared, the linearity of investment returns.

December 24, 2016

[updated 12/25/2016: R2 is a useful measure of indexing]

The R-squared (R2) statistic describes a pattern of plotted data with respect to a straight line. R-squared is called the coefficient of determination (ref 1,2).


The black dots in figure 1 represent investment returns that are poorly related to market returns. There is a random distribution of investment returns with respect to market returns. The blue line is an inadequate representation of the relationship simply because there is no relationship. The R2 score for this distribution is 0.03. Conversely, the black dots in figure 2 show the ‘herding’ of data around a straight line.


Figure 2’s investment returns are highly related to market returns with an R2 of 0.997.


The R2 score represents the degree of alignment of data to a best-fit line as determined by regression analysis. The lowest possible score of 0 indicates a random pattern of data with absolutely no alignment. The highest possible score of 1 represents complete alignment.

The product of R2 X 100 represents the percent of variation in investment returns that are related to market returns (ref 1,2). In other words, R2 measures the relavance of the best-fit line to a set of data. Relavance increases as the R2 score varies from 0 to 1.

The lowest score of 0 defies any financial analyst to draw a meaningful line for investment returns as they relate to market returns. In figure 1, the incline (β) and Y-intercept (⍺) of the blue line are unreliable measurements of investment performance.

The highest R2 score of 1.00 identifies a straight line of near-perfect predictions of returns. Any R2 above 0.75 identifies a straight line for making predictions of returns. Lower scores represent increasingly random events. In figure 2, the incline (β) and Y-intercept (⍺) are reliable measurements of investment performance.

R-squared is an excellent measure of index fund performance.  Websites for index mutual funds and ETFs publish R2 as a measure of alignment between fund returns and the market index.   Funds that have an R2 score of nearly 1.00 track the index very closely.


1.  Lain Pardoe, Laura Simon, and Derek Young. STAT 501, Regression Methods. 1.5- The coefficient of determination, r-squared. Pennsylvania State University, Eberly College of Science, Online courses.
2.  R-squared. 2016, Investopedia

Alpha is a point on a straight line, plus more.

December 22, 2016

{update on 12/23/2016: the significance of technical and operational alpha}

Alpha (⍺) is the cherished -but overrated- measurement of superior investment. Here are several interpretations:

  • A measurement of how well an investment outperforms its market index (ref 1).
  • The observed characteristic of a mutual fund that predicts higher fund performance (ref 2).
  • A portfolio’s return that’s independent of market returns (ref 3).
  • The excess (or deficit) return compared to the market’s return. Used this way, ⍺ is called Jensen’s Alpha.

Alpha represents a unique risk of outperforming the market’s returns. It is classically calculated as the “Y intercept” of a straight line attributed to the CAPM model (see appendix). In the last century, famous investors outperformed the market either by choosing exceptional investments or by investing in exceptional market sectors. The investment could be a single security (e.g., a stock) or a portfolio of capital assets (e.g., a mutual fund) (footnote 1, refs 1, 2). Now in this century, those alledged ‘alpha’ strategies are increasingly difficult to achieve. There’s an emerging sentiment among investors to avoid wasting time and money on attempting to outperform the market, the so called “loser’s game”. The current “winner’s game” is to seek ‘beta’ (refs 1, 2, 4, 5).

‘Beta’ is the portfolio’s return generated by market returns. Therefore, beta represents the risk of earning the market’s returns. The beta statistic, β, is currently calculated and reported by financial research firms as a coefficient for the incline of a straight line attributed to the CAPM model (see appendix).

Straight line of imaginary returns

(refs 5-8)

A straight line of imaginary returns presumably offers the best possible comparison of investment returns to a market index (footnote 2). ‘Returns’ and ‘performance’ are interchangeable terms that indicate the direction and movement of prices over time. An investment’s rate of return is calculated as the percentage change in price at regular intervals of time [likewise, the market’s rate of return is a percentage change in value of the market’s index at regular intervals of time]. Any rate of return is easily converted to a risk premium by subtracting the guaranteed interest rate for a Treasury bill (“T bill”). The risk premium is an investor’s potential reward for purchasing a security other than the T bill.

The straight line is drawn on a graph that shows actual measurements of investment returns plotted against market returns. The returns may either be measured as the rate of return or the risk premium depending on the goal of analysis. In the following chart, black dots represent a series of investment returns plotted against corresponding market returns.


The blue line of imaginary returns is the best possible comparison of investment returns to market returns. The position of the line on the graph is governed by its incline (β) and intersection (⍺+ε) with the vertical axis.

⍺, the intersection

(refs 1-3, 5-8)

Alpha resides at the intersection of the theoretical line with the vertical axis for investment returns (chart). Since the vertical axis crosses the horizontal axis at 0% market returns, ⍺ is the theoretical investment return at 0% market returns. A positive value for ⍺ implies that the investment tends to outperform its market index. Likewise, ⍺ = 0 implies no inherent advantage of the investment and a negative value for ⍺ implies that the investment tends to move less than the market index.

There’s a degree of error (ε) involved in drawing the line of imaginary returns, which means that its intersection is defined by the term ⍺+ε. The ε declines when a series of returns lie close to the line. The chart shows plots for 2 different series of returns; one series of black dots and another series of white circles. Both series have an equally small ε as illustrated by the close alignment of data to each straight line. Alpha of the blue line is 0% return and ⍺ of the orange line is 5% return, both occuring when the market return is 0. The series of open-circle returns outperformed the series of black-dot returns by 5%.


(refs 1, 2, 4, 5)

Alpha measures how well an investment outperforms the market. Yesterday’s ‘technical’ ⍺, shown in the preceding chart, applied to measuring superior stock-picking skills.  Today, the technical ⍺ of stocks is not reported by the most popular financial websites.

Today’s ‘operational’ alpha is really a beta loading factor of multi-factor models (see appendix).  Operational alpha is more relevant to measuring the performance of actively managed mutual funds and investment portfolios. The investment goal of an actively managed mutual fund is to outperform its market index. Active management may be the “loser’s game” of paying excessive fees in contrast to passive management, which may be the “winner’s game” of paying minimal fees.


1. Capital assets are securities and other forms of property that potentially earn a long term capital gain(loss) for the owner.

2. The straight line has other names that precede my use of the term ‘imaginary returns’. The straight line is also called a regression line or security characteristic line (ref 6).


1. Larry E. Swedroe and Andrew L. Berkin. Is outperforming the market alpha or beta? AAII Journal, July 2015. pages 11-15.

2. Yakov Amihud and Rusian Goyenko. How to the measure the skills of your fund manager. AAII Journal, April 2015. pages 27-31.

3. Daniel McNulty. Bettering your portfolio with alpha and beta. Investopedia.

4. John C. Bogle. The little book of common sense investing. John Wiley & Sons Inc., Hoboken, 2007.

5. Investing Answers. Alpha Definition & Example. 2016.

6. Professor Lasse H. Pederson. The capital asset pricing model (CAPM). New York University Stern School of Finance. undated.

7. MoneyChimp. Regression, Alpha, R-Squared. 2016.

8. Invest Excel. Calculate Jensen’s Alpha with Excel. undated.

APPENDIX: models for pricing assets and managing portfolios

(refs 1-3, 5-8)

The original one-factor model was called the Capital Assets Pricing Model (CAPM). The single factor is market returns (M).  The investment returns (I) are predicted by a best-fit line with incline (βm) and intersection with the vertical axis (⍺ + ε) (equation 1).

I = ⍺ + ε+ βmM,     equation 1, CAPM

Subsequent series of three-factor and four-factor models were sequential upgrades of CAPM. Equation 2 is an example of a four-factor model for the risk premium of an investment fund (F) comprised of separate portfolios for the broad market (M), asset size (S), asset value (V), and asset momentum (U).

F = ⍺ + ε + βmM + βsS + βvV + βuU,     equation 2, four-factor model

⍺ is the excess risk premium attributable to skillful management of the Fund.
ε is the model’s error
βm, βs, βv, and βu are portfolio loading factors assigned by the Fund’s manager

The four-factor model offers a spectrum of possibilities.

  • During 1927-2014, the average annual returns of indices for the the four-factor model were 8.4% for the broad stock market, 3.4% for stock size, 5% for stock value, and 9.5% for stock momentum.  The sum of average annual returns, 26.3%, represented the alpha-threshold for superior fund returns (ref 1).
  • Passive management could be predicted by setting βm to 1.00, measuring the market index return, and setting the remaining loading factors to 0.  A market index fund would  be expected to generate a risk premium that matches the market index risk premium with an ⍺ of 0 and slight ε for tracking error.
  • Active management involves designing loading factors and portfolio assets to outperform the fund’s predicted returns.

Copyright © 2014 Douglas R. Knight

Book review: How to Make your Money Last. The Indispensable Retirement Guide. by Jane Bryant Quinn.

March 22, 2016

Jane Bryant Quinn, 2016, Simon & Shuster, New York. 366 pages.


This book should be read by everyone who needs to plan for retirement from the workforce.  Author Jane Bryant Quinn is an acclaimed financial journalist with excellent credentials. In this book, she draws from credible research to describe principles and checklists for retiring with a practical financial plan. She speaks from firsthand experience about reinventing life after leaving the workforce: “once again the future is a blank slate” that needs to be filled with activities for a meaningful life (chapter 1). Those activities need the support of a dependable income managed by a practical financial plan.

In her opinion, your default plan is to maximize social security benefits and gradually increase the market value of your retirement portfolio (a.k.a. retirement savings) while maintaining a monthly paycheck for the duration of retirement. The financial core of a good retirement plan is based on 3 principles (chapter 12):

  1. Estimating your budget gap in advance of retirement (chapter 2)
  2. Maintaining a cash reserve throughout retirement (chapter 9)
  3. Making safe withdrawals from your retirement portfolio (chapters 8, 9)

Quinn provides practical checklists for transforming various sources of retirement income to a homemade paycheck.  In addition to building a retirement portfolio by ‘bucket’ investing (chapter 9) are the supplemental sources of income from Social Security benefits (chapter 3), traditional pensions (chapter 5), simple annuities (chapter 6), and home equity payments (chapter 10).  She also provides practical checklists for securing retirement income with the help of spending rules (chapter 8). Quinn’s valuable checklists help manage the financial risks of inflation (chapters 2-4, 8), taxes (chapter 7), costs of healthcare (chapter 4), and spousal protection (chapters 3, 4, 6, 7, 10, 11).

Janet Quinn’s Core principles

BUDGET GAP (chapter 2). The 3 important numbers in your retirement plan are its budget gap (chapter 2), cash reserve (chapter 9), and safe withdrawal (chapter 9). Calculate your budget gap before retirement. It is the difference between future income and expenses. The future gap can be minimized by staying in the workforce (to build a larger retirement portfolio) and spending less money.  Significant adjustments to financial assets and regular income may be necessary to support your desired level of spending later on. Estimate the future annual amount of money you can safely spend by using the following formula (chapter 2):

safe spending = (0.04*financial assets) + regular annual income – estimated taxes

CASH RESERVE (chapter 9). Create a cash reserve at the start of retirement. It will be an important source of money to pay for any budget gap that develops during 2 years of decline in the financial markets.

SAFE WITHDRAWAL (chapter 9). The “safemax” is a percentage of your retirement portfolio that you can safely withdraw in the first year of retirement (chapter 8;“safe’ means “as far as we can tell”). The amount withdrawn, plus an adjustment for inflation, practically dictates how much you can withdraw every year to ensure the 30-year longevity of your retirement portfolio.

Here’s the 4% rule (chapter 8): Withdraw 4% of your retirement portfolio at the start of the first year and safely store the money to pay bills throughout the year. At the start of the second year, withdraw the previous year’s amount adjusted for inflation. For example, assume your retirement portfolio holds a $50,000 investment in stocks and $50,000 investment in bonds for a total of $100,000. Even if you make no more contributions to the porfolio, the following annual withdrawals could be sustained for 30 years when adjusting the previous year’s withdrawal for a 3% rate of inflation and rebalancing the portfolio to maintain a mixture of 50% stocks and 50% bonds:

year 1- $100,000 * 0.04 = $4,000 withdrawal
year 2- $4,000 * 1.03 = $4,120 withdrawal
year 3- $4,120 * 1.03 = $4,244 withdrawal
legend- $100,000 is the portfolio’s initial value, 0.04 is the safemax, $4,000 is the first annual withdrawal, 1.03 is the inflation factor, and $4,120 is the second annual withdrawal.  there is no adjustment for taxes in this calculation.

NOTE: The amount withdrawn by the 4% rule is directly related to the initial market value of the retirement portfolio. For example in year 1, the amount safely withdrawn from a $200,000 portfolio would be $8,000, etc.

Protect yourself from the hidden risks of greedy salespeople as you get older and less interested in managing your accounts. Appoint a trustworthy person as your durable power of attorney and use a written investment plan.

Life-time income

Life-time incomes offset the risk of outliving your retirement portfolio. The reliable life-time incomes of retirement are Social Security, Pensions, and Annuities.

SOCIAL SECURITY (chapter 3). Social security benefits include a guaranteed income for life, protection against inflation, tax benefits, and protection of your spouse without the risk of market fluctuations and without paying investment fees. Beneficiaries can maximize their income by delaying the onset of benefits to age 70 instead of starting at age 62 (be sure to enroll in Medicare at age 65). A survivor’s benefit is based on the earnings-record of the deceased. The spousal benefit is automatically upgraded to a higher survivor benefit.

PENSIONS (chapter 5). Traditional pensions offer either a monthly lifetime payment or a lump sum payment that can be rolled over to an Individual Retirement Account (IRA). The rollover incurs an investment risk (investment risk is the possibility of incurring a loss from your choice of investment or the investment’s fluctuation in market value).  Government pensions (except municipal pensions) are reliable.  Most private pensions are protected by the Pension Benefit Guaranty Corporation ( If you are ineligible for a pension, consider buying a lifetime annuity.

ANNUITIES (chapter 6). Annuities aren’t a do-it-yourself investment; they are a tool for managing the risk of outliving your portfolio. Find a good advisor who isn’t a salesperson and avoid buying variable annuities with living benefit guarantees. Simple annuities are purchased with a lump sum in return for monthly lifetime income.

  1. The Single Premium Immediate Annuity (SPIA) pays benefits until death unless purchased with payments “Certain”. The SPIA is not designed to create a legacy fund. Its advantage is the payment of benefits that exceed the interest of bonds and dividends of stocks. The insurance company’s rating should be at least AA- (Fitch, S&P), A (AM Best), or Aa3 (Moody’s). [The tax deferred variable annuity can be converted to an SPIA. Find the best available benefit-payments in and switch companies.]
  2. The Immediate Pay Variable Annuity pays monthly benefits that change with the market. The benefit is a percentage of the investment portfolio value. The assumed interest rate (air) is your selected rate of withdrawal from the investment portfolio. The investment risks are volatility and choice of investment portfolio.
  3. The Inflation Adjusted Immediate Annuity pays monthly benefits adjusted to last year’s inflation. There is no inflation or investment risk. The monthly benefits are lower at the beginning than later on. This annuity is more appropriate for younger people with a longer life expectancy.
  4. Fixed Increase Annuities pay monthly benefits that rise at a fixed rate of 1-5%.
  5. With a Deferred-income Annuity (“longevity insurance”) there is a time delay to the initial benefit followed by monthly payments for life. The reasons for owning this annuity are 1) protection from outliving retirement portfolio, and 2) providing your spouse with guaranteed income after death.
  6. Fixed-term Annuities start paying benefits immediately. This is desirable for people with illiquid investments such as delayed social security.
  7. The Charitable Gift Annuity gives a lump sum to charity that guarantees a fixed monthly income for life.

The variable annuity is a pure investment that risks poor performance in the market. Its insurance company offers a guaranteed living-benefit rider (LBR) that provides a minimum lifetime income regardless of the investment’s performance. Taxes on the accumulating returns are deferred until withdrawal, then taxed as regular income (unless “qualified” in a Roth). The tax is proportional to the ratio of investment return to invested capital.  The goal of a variable annuity is to allow growth of your investment above the guaranteed minimum. Success depends on a 90% allocation of stocks in the investment, yet most insurance companies limit the stock fund to 65% stocks. Why? The insurance company is protecting itself by using fixed income from the portfolio to pay the LBR instead of the company’s own money. Living benefits are first taken from the investment portfolio while you continue to pay the annual fee! This seems unfair, so try to exercise your right to withdraw from the investment every year up to a fixed percentage amount. Even if you draw down to $0, the company will continue to pay your benefit. Spouses are usually not covered by a variable annuity. Rather, the death benefit is an insurance payout that doesn’t replace the annuity’s investment return a survivor might lose. If you bought a variable annuity, it’s too late to extend to your spouse. But you can switch to a better annuity in a tax-free exchange or buy more insurance. Variable annuities often charge excessive management fees of 3-5%.  For a second opinion, consult the Marco Consulting Group at Annuity Review ( They will analyze 2 variable annuities for a fee of nearly $300.

HOME EQUITY (chapter 10). The equity of your home is a ‘piggy bank’ that can be used for income or passed to your heirs. There are several ways of squeezing income from your home equity:

  1. take a Reverse Mortgage to create a 20-30 year spending plan
  2. borrow to pay a large bill
  3. eliminate a traditional mortgage.
  4. refinance your traditional mortgage
  5. take a boarder after first checking on possible restrictions imposed by homeowners associations, zoning laws, etc.
  6. sell the house and lease it from the new owner (i.e., Sale/Leaseback). Consult a lawyer before selling the house.

The reverse mortgage is a loan against the equity of your home in which the lender makes tax-free payments to you because they are loans. You pay all maintenance costs. Don’t repay the loan while living in the house; proceeds of the sale will repay the loan. You keep the excess proceeds, but otherwise are not responsible for a loss on the sale.

The Home Equity Conversion Mortgage (HCEM) is issued by private lenders and insured by the FHA. The HCEM offers 3 types of payments:

  1. lump sum at the beginning
  2. monthly payments
  3. borrowings from the principal

At your death and before selling the house, your heirs will have the option of buying or selling the house before foreclosure. Seek more information and advice from Jack Guttentag on his website,

Portfolio management

SPENDING RULES FOR THE HOMEMADE PAYCHECK (chapters 8, 9). The basic rules are to make buy-and-hold investments in your portfolio, withdraw funds using the 4% rule, and rebalance the portfolio after you make an annual withdrawal. Based on Quinn’s research up to the year 2016, the 4% safemax may be modified in one of several ways:

  • 4.5% if your stock allocation is 45-65%
  • 5.5% if you reduce the withdrawal in declining markets
  • 3% to ensure surviving the next 30 years
  • adjustments to the Shiller PE Ratio
    • 4% if P/E10 >20
    • 5% if P/E10 = 12-20
    • 5.5% if P/E10 <12
  • 6% is too high and your portfolio may only last 15 years. Instead, borrow on your house through a reverse mortgage.

The amount of annual income withdrawn from your retirement portfolio is determined by your safemax rate of withdrawal (discussed above in the core principles). Be consistent in withdrawing from your portfolio except when the market is depressed. Then withdraw from your cash reserve to pay bills. When the market starts to recover, tap the investments to restore the cash reserve and resume withdrawing at the safemax.

Skip an annual withdrawal when you don’t need it. If the required minimum withdrawal from tax-deferred accounts exceeds your planned annual withdrawal, reinvest the excess amount. Here are 2 ways to preserve capital:

  1. Withdraw from investments that have increased in value, otherwise from investments with the lowest potential return.
  2. Withdraw from taxable accounts before tax-deferred accounts. Within the taxable accounts, withdraw a blend of gains and losses to minimize taxes.

PORTFOLIO INVESTMENTS (chapters 8, 9). Bucket investing is done by putting money into different funds (‘buckets’), each having a specific purpose. First, create a cash reserve (‘cash bucket’) that will pay bills for 2 years when added to pension checks. 90% of the remaining retirement portfolio is allocated to investments and 10% to a discretionary bucket. Allocate 40-65% of the investments to stocks and the remainder to bonds [the author discussed additional guidelines for adjusting your allocation of stocks and bonds according to age (chapter 8)]. The discretionary bucket is used for big, extra items (e.g., new car).

Your allocation of bonds and stocks depends on your capacity for risk, not your tolerance for risk. The capacity for risk depends on how well you are funded and able to pay bills with pension funds. If your risk capacity is low, don’t risk too much on incurring a loss in the stock market. Do you need to risk a stock investment? Not if all your expenses, including health, are covered for life. People older than 80 tend to fall into this category. Younger people with at least a 10 year horizon have more time to survive market fluctuations. The S&P500 Total Return index has never declined over 15 years. Otherwise, you need to invest in stocks if all expenses are not covered for life. The reasons for investing in stocks are to hedge inflation (low allocation of 20-30%) or create a legacy fund for heirs (high allocation of 40-80%).

There are several important advantages to investing in index funds instead of individual stocks and short-term bonds.

  • index funds are easier to rebalance each year
  • you will earn the return of the whole market
  • you will own a portfolio of diversified investments
  • index funds are easily converted to cash
  • short term bond prices aren’t as volatile as long term bond prices

What if you don’t want to rebalance the retirement portfolio?

  • invest in a target-date fund
  • use a rebalancing program
  • pay a low-cost online advisor (e.g., )
  • hire a good fee-only financial advisor and avoid paying high fees. consult for help finding a reputable financial advisor.
  • seek advice from a no-load mutual fund company

Risk management

TAXES (chapter 7). The main categories of tax-deferred retirement savings accounts are employer-sponsored plans and personal IRAs. The typical employer-sponsored plan allows investments in mutual funds. After leaving an employer you can keep the plan, merge it into that of a new employer, or convert it to a rollover IRA. Personal IRA’s expand your investment choices, some of which require a trustee to make the transactions (e.g., precious metal trust, real estate trust). Be aware of the costs of converting a traditional IRA to a Roth IRA. At the time of conversion you must pay regular income tax on the investment returns. You may also incur a higher medicare premium and pay possible tax on unearned income. To minimize taxes when you withdraw funds to pay bills, withdraw from the taxable portion of your portfolio first, the traditional IRA second, and the Roth IRA last.

If you inherit an IRA from your spouse, your choices are these:

  • ask the trustee to name you as owner
  • rollover to a new IRA owned by you
  • rollover to an IRA already owned by you
  • create an inherited IRA if you are younger that 59 1/2 years.

If you inherit an IRA from someone else, your choices are these:

  • take your full inheritance now and lose the tax shelter
  • retitle it as an inherited IRA to keep the tax shelter

HEALTH INSURANCE (chapter 4).  The Affordable Care Act guarantees your eligibility for health insurance irrespective of your state of health. There are 3 general healthcare plans: HMO (Health Maintenance Organization), POS (Point of Service), and PPO (Preferred Providers Organization).  In each plan, your cost share is capped by the annual maximum out-of-pocket payment.

The government’s Medicare program is comprised of part A for hospitalization, part B for outpatient services, part C for extra benefits plus prescriptions, and part D for prescriptions. You pay premiums for parts B-D, but not for part A. There are cost-sharing charges for services in parts A-D. Medigap is a private healthcare insurance designed to supplement Medicare and used to replace Part C of Medicare. Don’t miss the enrollment dates or else pay a higher premium!

LONG TERM CARE (chapter 4). If you become incapacitated and require long term healthcare outside the hospital, your costs may exceed $85,000 per year. Consider purchasing long term care insurance, but don’t spend more than 5% of your retirement income on insurance premiums for long term care. Group policies are cheaper. Minimize your premiums by choosing a 3-year benefit period (instead of 5 years), avoid paying for inflation adjustments later in life, insure 50-75% of your expected cost, and extend the waiting period to 6 months. The alternatives to long term care insurance are:

  1. join a continuing care retirement community that offers a nursing home benefit.
  2. self insure by selling your home
  3. use Medicaid as a safety net.

LIFE INSURANCE (chapter 11). Don’t buy any if you are a single retiree without dependents. You’re better off investing the saved-premiums. Consider owning life insurance if you have dependents and want to leave a legacy fund or charitable gift. Chapter 11 describes how to extract more value from a life insurance policy.

SHELTER (chapter 10). Younger retirees like living in an active community and older retirees like their “independent living” in a more secure location. The choices for independent living are to remodel your existing home as needed to compensate for a handicap (e.g., wheelchair) or change homes. For example, move to an active adult community (consult; ensure that you will continue to receive healthcare).

Retirees seek “assisted living’ when they need help with the basic functions of living.  The choices for assisted living are to receive in-home healthcare or move into an assisted living facility (consult for choices).

Downsize to make life easier!

Websites for retirement-planning

February 19, 2016

[updates: 3/4/2016, 3/18/2016]


http://DOL.GOV/EBSA/PDF/RETIREMENTTOOLKIT.PDF , federal programs and retirement calculators
http://SOCIALSECURITY.GOV , benefits & ‘retirement estimator’
http://MEDICARE.GOV health insurance for retirees
http://WISERWOMEN.ORG Women’s Institute for a Secure Retirement
http://HHS.GOV/AGING , health- and legal information
http://USA.GOV/BENEFITS-GRANTS-LOANS , federal benefits
http://AGING.OHIO.GOV , quality of life , to plan retirement, reduce debt, find work, and cut spending.

Money management (‘financial planning’)

http://DOL.GOV , search for “Taking the mystery out of retirement planning” and download this excellent pamphlet of useful advice.
http://MYRA.GOV , A safe, affordable Roth savings account for wage earners.
http://WESTERVILLELIBRARY.ORG , search for “Investments 101”

Portfolio management , find link to “required minimum distribution”
http://BANKRATE.COM , click on “RETIREMENT” tab, then on “Retirement Calculators” subtab, then on “Asset allocation calculator”
http://53.COM, click on “Financial calculators”, then click on the “Retirement Planning” tab, then click on the “Retirement Income Calculator” to estimate your longevity of savings; click on the “Retirement Account Calculator” to compare retirement savings accounts.

Risk management

http://IRS.GOV , search “identity protection”, about Identity theft
http://FINRA.ORG (securities help line for seniors, 844-574-3577), Check the credentials of a broker or financial advisor; about Investor protection; to assess your risk for Financial fraud
http://NELF.ORG , about Elder Law
http://ELDER.FINDLAW.COM  , about Elder Law
http://LONGTERMCARE.GOV , about LTC health insurance
http://PBGC.GOV ,  to assess pensions , to shop for simple annuities , obtain a second opinion about variable annuities

Low income assistance nationwide and in Ohio


January 17, 2016

The investment goal of the Small Trades Portfolio is to outperform its benchmark index, the Standard & Poor’s 500 Total Return.  Regretfully, this has not happened (chart).

portfolio performance 2015

The chart compares the growth of $1.00 invested in the portfolio to a theoretical investment in its benchmark index and the inflation of U.S. consumer prices.  A decline of the benchmark during the 2008 Recession recovered in 2012 and grew to $1.66 (66% above baseline) by the end of 2015.  But the portfolio declined and never fully recovered.   Revised operations after the Recession managed to stabilize the portfolio by reallocating 80% of the portfolio’s principal to exchange-traded funds (ETFs).  The ETFs are invested in underperforming asset classes that will eventually recover.

There are encouraging signs of investment performance found in the trends of compound annual growth rates (next chart) and stock performance (subsequent chart).

portfolio CAGRs 2015

The compound annual growth rates of the benchmark index are leveling off while those of the portfolio are rising.

stock performance 2015

Revisions in my investment philosophy for stocks also show an encouraging response.  For every $1.00 invested in the portfolio on 12/31/2013,  the portfolio’s stocks outperformed the benchmark index and portfolio ETFs for two successive years.


The portfolio is intentionally overweighted by index ETFs.  Among these, the equities ETF (ticker: VT) has 75% of holdings in developed markets and 25% in emerging markets. The returns from emerging markets were disappointing due to economic and political factors in foreign countries. The 2015 decline of gold prices was expected, given the global deflation of prices.


I prefer to invest in healthy emerging markets and when that occurs, I will trade the world-market ETF (ticker: VT) to a riskier emerging-market ETF (ticker: VWO). A continued decline of gold prices will likely cause me to rebalance the ETFs to equal portions of 25% among four asset classes of emerging markets equities, U.S. real estate, U.S. bonds, and gold bullion.  25% allocations of emerging markets equities, U.S. real estate, gold bullion, and U.S. bonds collectively impose a higher risk-return quality to the ETF portfolio compared to a 60:40 allocation of U.S. stocks and bonds.

My investment strategy for stocks is evolving from placing conditional trading orders on cyclic stocks to buying good growth stocks for the long term.

Douglas R. Knight




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