Bert Whitehead, M.B.A., J.D.
Unless you are in the wealth category of Bill Gates and Warren Buffet, you probably realize that many people are richer than you are. So how did they get that way?
• Did they have the advantage of a large inheritance?
• Was it because they were self employed?
• Could they have married into a wealthy family?
• Were they “penny pinchers” for their whole life?
• Did they have high I.Q.’s?
None of these reasons fully explain the ‘millionaire’ phenomenon. I have read the popular books on this topic (The Millionaire Next Door, The Automatic Millionaire, Rich Dad, Poor Dad, etc.) I have also reviewed academic studies on this topic. But most of my insights come from working with clients for over 30 years, many of whom did become millionaires. These are my observations and conclusions:
1. Wealthy people are made, not born. 80% of millionaires are the first generation of their family to become wealthy. Interestingly, most of the very wealthy families leave a major portion of their estates to charity. Children, who inherit significant wealth, without achieving it on their own, seldom manage money well. As one wealthy man told me, “If money comes too easily, it isn’t properly respected.” A large inheritance can often undermine the character of the recipient because they don’t need to focus on adding value to the world. This often happens when parents continue to support adult children.
2. Self-employed people are more likely to become wealthy. Overall 20% of our population is self-employed, while 75% of millionaires are self-employed. This high percentage is largely attributable to self-employed professionals like attorneys and physicians. The others, who are entrepreneurs, are as likely to go bankrupt as they are to become wealthy. Those entrepreneurs, who do accumulate wealth, as well as the professionals, have other attributes.
3. Most millionaires became wealthy because they picked a spouse who helped them realize a dream. Seldom do people become millionaires totally by themselves. On the contrary, one of the significant obstacles to accumulating wealth is choosing partners poorly, especially spouses. I call divorce “the process of mutual impoverishment.”
4. Some wealthy people are very frugal, even to the point of being penny pinchers. Popular writers often glorify this trait as the path to riches, urging readers to forego lattes, drive old cars, and to never move to better neighborhoods. While living within one’s means is critical, as discussed below, developing a penurious character is a form of financial dysfunction. Misers never know ‘how much is enough’ and develop an obsession to save more money. In my opinion this trait is a barrier to good socialization and prevents people from enjoying the wealth they do accumulate.
5. The people that I have seen become wealthy are smart – but not necessarily the kind of “smart” measured by an I.Q. test. They have come to recognize and appreciate their unique gifts and advantages, and use their abilities to create value for others. When a high I.Q. is coupled with an expectation that one deserves special treatment, it is a hindrance to achieving wealth.
How much does it take to be wealthy? I think that financial wealth is measured by a balance sheet listing assets vs. liabilities, rather then an income statement because it demonstrates the resources that can be put to work to create more money. Statistically only 3.5% of the 115 million households in this country have net assets of over $1 million. 98% of those have a net worth between $1 million and $10 million. The 2% who are ‘super-rich’ are not addressed in this blog.
I have noted two attributes which apply to most millionaires. The first is that they value education, and are generally well educated themselves. As my mother often said, “Investment in education is the best investment that can be made, because it can never be taken away from you!” Education is the strongest predictor of future earning capacity.
A high income alone doesn’t make someone a millionaire. There are many athletes, movie stars, gamblers (including lottery winners), and highly paid executives who never are able to accumulate wealth. The reason is that they keep ratcheting up their standard of living to keep up with their income. So when their income drops, they don’t have the financial resources to provide the cash flow to maintain their life style.
This doesn’t only apply to high income people; many low income people stay poor because they live beyond their means. I find that the easiest way to tell whether a new client is living within their means is to examine their credit card statements. If someone consistently carries a balance on their credit cards, they are living beyond their means.
Thus the second attribute of the wealthy is their ability to live within their means. This translates into a life-long habit of always saving at least 10% of their income. Even those who aren’t fortunate enough to have a good education can become financially independent if they consistently live within their means and save 10% of what they make starting at an early age.
It’s that simple: to help your children become wealthy, make sure they get as good an education as possible, and teach them to save a dime of every dollar that they earn starting with their first allowance!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Monday, February 1, 2010
Friday, January 8, 2010
Lessons from the ‘Lost Decade’
Bert Whitehead M.B.A., J.D.
The ‘Dow’ and the ‘S&P’ are the most common indexes of U.S. large company stock valuations. At the end of 2009 they closed lower than their opening values at the beginning of 2000. As a result, many economists have dubbed the ‘aughts’ (2000-2009) the ‘Lost Decade.’ They claim that there were no investment gains in the large cap stock market for these past 10 years.
Active money managers will point to the performance of these indexes to crow about the futility of ‘buy and hold’ investing. These managers insist that they are able to add value to an investment portfolio by buying low and selling high, instead of just holding onto stocks. This observation is, of course, tainted with self-interest.
Many ordinary people have sworn off stock market investing because they lost so much money during this period. And with current short term interest rates so close to zero, they are tempted to simply invest in junk bonds or municipal bonds, ignoring that these may be today’s outsized risks.
The truth is that the loss of 8.7% in the Dow during the ‘Lost Decade’ is mostly attributable to the selection of the “starting line.” The beginning of 2000 was near the peak of the ‘dot-com’ bull market. If you start the chart just two months later at the end of Feb. 2000, “voila!” … the market shows a gain! Start the chart two years later in Feb. 2002 and there is a 30+% gain by the end of 2009.
The S&P index outperforms 85% of money managers in the large cap arena over most any 20-year period. The reason? Money managers keep cash in their portfolios, whereas indexes are by definition fully invested. Therefore, managers tend to underperform less in bear markets, and underperform more bullish markets.
If there are any lessons to be learned during the ‘Lost Decade’ it is not about the investing prowess of the active money managers but rather: 1) the advantage of dollar-cost averaging (DCA), especially in down markets; and 2) the necessity of having a diversified portfolio.
DCA is a strategy by which you invest new money on a regular basis, usually monthly, instead of investing all your cash at once. It protects you from investing at the WRONG TIME because you are investing all the time. Most people use their 401Ks or other retirement accounts for their primary investing activity, so they use DCA by default. Investing a fixed sum each month helps you buy more shares of a stock when the price drops. Investing $1,000 per month (plus dividends) over the past ten years would have resulted in a small gain (3.2%) rather than a loss.
Diversifying your holdings beyond large cap stocks protects you from investing in the WRONG TYPE of investment. You shouldn’t invest in any one thing but, rather, in everything. For example, during the past 10 years, small cap and foreign stocks on average appreciated over 30% including reinvestment of dividends. The Vanguard REIT (Real Estate Index) was up over 50%. 20-year Treasury bonds had an average yield of over 5% increasing over 60% during the period.
Dollar Cost Averaging and Diversification are the two primary strategies you can use to avoid investment mistakes. But having said that, the average annual return of a well-balanced portfolio from 2000-2009 (6-7%) fell short of returns for similar prior periods. We usually use assumptions of 7-8% returns for conservatively balanced portfolios over the long term.
Interestingly, the return of a conservatively balanced portfolio achieved the 7-8% long-term return if you start the chart 15 years ago…there’s that starting line issue again.
All of this is small comfort if you bought a home five years ago. Depending on location the value of your home may have dropped over 50%. This is made even worse if your 401Ks have decreased in value despite your contributions over the past ten years. If you lost your job on top of these other setbacks, the last ten years have been ruinous.
No matter what your level of loss, beware the temptation to offset your losses by timing the stock market. It only aggravates your misfortune. Studies repeatedly show that, on average, individual investors who buy and sell stocks in their portfolio underperform the market by a wide margin of 5-7%. They constantly fall prey to trying to select the best time to invest and the best type of investment. It’s far better to avoid this situation by not capitulating to your fears when the market drops, only then having to face buying in a greedy frenzy when the market rises quickly.
The final lesson of the Lost Decade is that it’s merely a story line for writers and editors who need to sell their publications with “new ideas” and “what to buy now!” insights. The Lost Decade is merely the last decade. Select a different time to measure and you come up with different results and story lines.
Unfortunately, the most boring story of all, that consistent investing during good times and bad, is also the most successful for those willing to stick to it. The only problem with it is that it just doesn’t sell this month’s magazine!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
The ‘Dow’ and the ‘S&P’ are the most common indexes of U.S. large company stock valuations. At the end of 2009 they closed lower than their opening values at the beginning of 2000. As a result, many economists have dubbed the ‘aughts’ (2000-2009) the ‘Lost Decade.’ They claim that there were no investment gains in the large cap stock market for these past 10 years.
Active money managers will point to the performance of these indexes to crow about the futility of ‘buy and hold’ investing. These managers insist that they are able to add value to an investment portfolio by buying low and selling high, instead of just holding onto stocks. This observation is, of course, tainted with self-interest.
Many ordinary people have sworn off stock market investing because they lost so much money during this period. And with current short term interest rates so close to zero, they are tempted to simply invest in junk bonds or municipal bonds, ignoring that these may be today’s outsized risks.
The truth is that the loss of 8.7% in the Dow during the ‘Lost Decade’ is mostly attributable to the selection of the “starting line.” The beginning of 2000 was near the peak of the ‘dot-com’ bull market. If you start the chart just two months later at the end of Feb. 2000, “voila!” … the market shows a gain! Start the chart two years later in Feb. 2002 and there is a 30+% gain by the end of 2009.
The S&P index outperforms 85% of money managers in the large cap arena over most any 20-year period. The reason? Money managers keep cash in their portfolios, whereas indexes are by definition fully invested. Therefore, managers tend to underperform less in bear markets, and underperform more bullish markets.
If there are any lessons to be learned during the ‘Lost Decade’ it is not about the investing prowess of the active money managers but rather: 1) the advantage of dollar-cost averaging (DCA), especially in down markets; and 2) the necessity of having a diversified portfolio.
DCA is a strategy by which you invest new money on a regular basis, usually monthly, instead of investing all your cash at once. It protects you from investing at the WRONG TIME because you are investing all the time. Most people use their 401Ks or other retirement accounts for their primary investing activity, so they use DCA by default. Investing a fixed sum each month helps you buy more shares of a stock when the price drops. Investing $1,000 per month (plus dividends) over the past ten years would have resulted in a small gain (3.2%) rather than a loss.
Diversifying your holdings beyond large cap stocks protects you from investing in the WRONG TYPE of investment. You shouldn’t invest in any one thing but, rather, in everything. For example, during the past 10 years, small cap and foreign stocks on average appreciated over 30% including reinvestment of dividends. The Vanguard REIT (Real Estate Index) was up over 50%. 20-year Treasury bonds had an average yield of over 5% increasing over 60% during the period.
Dollar Cost Averaging and Diversification are the two primary strategies you can use to avoid investment mistakes. But having said that, the average annual return of a well-balanced portfolio from 2000-2009 (6-7%) fell short of returns for similar prior periods. We usually use assumptions of 7-8% returns for conservatively balanced portfolios over the long term.
Interestingly, the return of a conservatively balanced portfolio achieved the 7-8% long-term return if you start the chart 15 years ago…there’s that starting line issue again.
All of this is small comfort if you bought a home five years ago. Depending on location the value of your home may have dropped over 50%. This is made even worse if your 401Ks have decreased in value despite your contributions over the past ten years. If you lost your job on top of these other setbacks, the last ten years have been ruinous.
No matter what your level of loss, beware the temptation to offset your losses by timing the stock market. It only aggravates your misfortune. Studies repeatedly show that, on average, individual investors who buy and sell stocks in their portfolio underperform the market by a wide margin of 5-7%. They constantly fall prey to trying to select the best time to invest and the best type of investment. It’s far better to avoid this situation by not capitulating to your fears when the market drops, only then having to face buying in a greedy frenzy when the market rises quickly.
The final lesson of the Lost Decade is that it’s merely a story line for writers and editors who need to sell their publications with “new ideas” and “what to buy now!” insights. The Lost Decade is merely the last decade. Select a different time to measure and you come up with different results and story lines.
Unfortunately, the most boring story of all, that consistent investing during good times and bad, is also the most successful for those willing to stick to it. The only problem with it is that it just doesn’t sell this month’s magazine!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Tuesday, December 8, 2009
How to Spot a Bubble
Bert Whitehead, M.B.A., J.D.
If you are younger than 40, you will likely be telling your kids and grandkids about the ‘Great Recession’ of 2007-2009. Our recent experience is likely to impact your investment decisions for the rest of your life. So what advice will you give the next couple of generations?
I’d suggest you start with: “Beware of Bubbles!” Hindsight is a huge advantage in recognizing dangerous financial bubbles. We are all familiar with the stock market crash which kicked off the ‘Great Depression.’ If you are over 40, you probably remember your elders caution to ‘Stay out of the Stock Market!’ That was the wrong lesson; the real lesson is to be wary of leverage. The stock market then was a huge bubble, aggravated by the ability of even small investors to leverage stock purchases on margin requiring an investment of only 5%.
Surely over-leveraged investments, spurred by easy credit is a hallmark of bubbles. In the 1970’s however, bond investors lost their shirts and inflation ravaged the stock market. It’s not so clear that leverage aggravated that recession as much as excessive government spending, high oil prices, and built-in cost-of-living increases which contributed to spiraling inflation. But when the fed raised interest rates, the reduced leverage eventually sucked the air out of the economy and resulted in new federal reorganization of the banking system. The S&L collapse soon followed.
The ‘Dot.Com’ bubble in the 90’s was fueled by an astounding amount of capital chasing new ideas. Tech stocks soared to incredible heights and seemed to be invulnerable to fundamental requirements. They had no P/E ratio because they could sell stocks without a revenue, much less profit. Those entrepreneurs failed miserably at being able to leverage the capital effectively.
In our current situation, there’s no question that easy money accessed by low mortgage rates and virtually no vetting of borrowers artificially inflated housing prices, and the financial industry tanked taking down the rest of the economy. It’s by no means certain that the government spending intended to create employment will solve the problem, and there is a real danger that excessive government debt will create worse problems down the road.
Looking at our present worldwide condition, there are at least three possible bubbles on the horizon: China, Gold, and most recently the financial disruption in Dubai and other closely allied emirates in the U.A.E.
The red flags in all three situations are all related to the same phenomenon: unsustainable rapid increase in expansion.
China, and many other emerging nations, have experienced a growth in production capability which carries the danger eventually of excess capacity. Hundreds of millions of Chinese moved to the cities for employment. Now they are without jobs because there simply isn’t enough worldwide demand to keep the factories operating. In the process China basically subsidized exports by keeping its currency, the Yuan, pegged artificially low to the dollar.
This enabled them to keep prices of exports low, so US purchasing essentially provided the capital for Chinese expansion in their private sector. The anomaly is that that the US has begun using Chinese lending power to fuel its public sector. This is ripe to start unraveling with unforeseen consequences, but the fallout will surely hurt investors who have rushed in to make a quick buck in China.
Gold is now at record highs. Since 2000 the price of gold has jumped from $252 to $1,100 per oz. and has been touted as the best antidote for inflation which has increased about 18% during that period. But it hasn’t fared so well in the past: the price of gold dropped the beginning of the 1980’s through the 1990’s (from $934 to $252 per ounce) while inflation surged 50%. Since there hasn’t been an increase in demand for production, the recent price increase is likely due to speculation. Gold ETF’s became available, which buy actual gold to hold for investors. So instead of having to buy gold, have it shipped, and then store it, speculators can buy and sell positions in one day’s trading. Bubbles that are created by speculative demand are very likely to collapse, even faster than their rise.
Recent news that Dubai is defaulting on $80 billion in debt has spooked the worldwide markets and undermined the assurance that Oil Sheiks would step in to back any debt. The massive construction in Dubai, which dwarfed the construction bubble in Las Vegas, was based on a conviction that ‘if you build it, they will come.’ Well it turns out that they’re not coming. There is no financial underpinning for a new city built in a desert without any existing industry or commercial basis.
What China, Gold, and Dubai have in common is that they experienced such spectacular growth that financial realities were increasingly ignored. A naïveté around basic economics inexplicably overtake even seasoned investors, then speculators start rushing to cash in the new hot investment, and finally the small investors pile on. Bubbles are built on an irrational belief that ‘this time it’s different’ and the balloon will never burst.
We have learned a valuable lesson, and bubbles will continue to form regardless of government regulation and our supposed increased financial sophistication. Our experience should be passed on. So be sure to lecture your children and grandchildren to “Beware of Bubbles!”
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
If you are younger than 40, you will likely be telling your kids and grandkids about the ‘Great Recession’ of 2007-2009. Our recent experience is likely to impact your investment decisions for the rest of your life. So what advice will you give the next couple of generations?
I’d suggest you start with: “Beware of Bubbles!” Hindsight is a huge advantage in recognizing dangerous financial bubbles. We are all familiar with the stock market crash which kicked off the ‘Great Depression.’ If you are over 40, you probably remember your elders caution to ‘Stay out of the Stock Market!’ That was the wrong lesson; the real lesson is to be wary of leverage. The stock market then was a huge bubble, aggravated by the ability of even small investors to leverage stock purchases on margin requiring an investment of only 5%.
Surely over-leveraged investments, spurred by easy credit is a hallmark of bubbles. In the 1970’s however, bond investors lost their shirts and inflation ravaged the stock market. It’s not so clear that leverage aggravated that recession as much as excessive government spending, high oil prices, and built-in cost-of-living increases which contributed to spiraling inflation. But when the fed raised interest rates, the reduced leverage eventually sucked the air out of the economy and resulted in new federal reorganization of the banking system. The S&L collapse soon followed.
The ‘Dot.Com’ bubble in the 90’s was fueled by an astounding amount of capital chasing new ideas. Tech stocks soared to incredible heights and seemed to be invulnerable to fundamental requirements. They had no P/E ratio because they could sell stocks without a revenue, much less profit. Those entrepreneurs failed miserably at being able to leverage the capital effectively.
In our current situation, there’s no question that easy money accessed by low mortgage rates and virtually no vetting of borrowers artificially inflated housing prices, and the financial industry tanked taking down the rest of the economy. It’s by no means certain that the government spending intended to create employment will solve the problem, and there is a real danger that excessive government debt will create worse problems down the road.
Looking at our present worldwide condition, there are at least three possible bubbles on the horizon: China, Gold, and most recently the financial disruption in Dubai and other closely allied emirates in the U.A.E.
The red flags in all three situations are all related to the same phenomenon: unsustainable rapid increase in expansion.
China, and many other emerging nations, have experienced a growth in production capability which carries the danger eventually of excess capacity. Hundreds of millions of Chinese moved to the cities for employment. Now they are without jobs because there simply isn’t enough worldwide demand to keep the factories operating. In the process China basically subsidized exports by keeping its currency, the Yuan, pegged artificially low to the dollar.
This enabled them to keep prices of exports low, so US purchasing essentially provided the capital for Chinese expansion in their private sector. The anomaly is that that the US has begun using Chinese lending power to fuel its public sector. This is ripe to start unraveling with unforeseen consequences, but the fallout will surely hurt investors who have rushed in to make a quick buck in China.
Gold is now at record highs. Since 2000 the price of gold has jumped from $252 to $1,100 per oz. and has been touted as the best antidote for inflation which has increased about 18% during that period. But it hasn’t fared so well in the past: the price of gold dropped the beginning of the 1980’s through the 1990’s (from $934 to $252 per ounce) while inflation surged 50%. Since there hasn’t been an increase in demand for production, the recent price increase is likely due to speculation. Gold ETF’s became available, which buy actual gold to hold for investors. So instead of having to buy gold, have it shipped, and then store it, speculators can buy and sell positions in one day’s trading. Bubbles that are created by speculative demand are very likely to collapse, even faster than their rise.
Recent news that Dubai is defaulting on $80 billion in debt has spooked the worldwide markets and undermined the assurance that Oil Sheiks would step in to back any debt. The massive construction in Dubai, which dwarfed the construction bubble in Las Vegas, was based on a conviction that ‘if you build it, they will come.’ Well it turns out that they’re not coming. There is no financial underpinning for a new city built in a desert without any existing industry or commercial basis.
What China, Gold, and Dubai have in common is that they experienced such spectacular growth that financial realities were increasingly ignored. A naïveté around basic economics inexplicably overtake even seasoned investors, then speculators start rushing to cash in the new hot investment, and finally the small investors pile on. Bubbles are built on an irrational belief that ‘this time it’s different’ and the balloon will never burst.
We have learned a valuable lesson, and bubbles will continue to form regardless of government regulation and our supposed increased financial sophistication. Our experience should be passed on. So be sure to lecture your children and grandchildren to “Beware of Bubbles!”
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Thursday, November 19, 2009
What Deflation Looks Like
Bert Whitehead, M.B.A., J.D.
For years we have been told about the evils of inflation. But now we are witnessing deflation, which most people have never experienced since 1950. What does deflation mean for you today? How is the economy affected? How bad can it get?
Inflation is an economic phenomenon that has been described as too many dollars chasing too few goods. Deflation occurs when the opposite happens -- too few dollars are being used to buy the available goods.
For most of this decade credit has been abundant and too much money was lent, especially to people without a strong financial foundation. It was easy to buy houses, cars, take trips, etc. As borrowers defaulted en masse on mortgages, student loans, car loans, etc., the banks and other lending institutions curtailed lending to consumers and to businesses. This resulted in an alarming drop in sales of cars, houses, etc. Retail sales across the board have shrunk as people became very frugal.
The downturn is compounded by a significant increase in the average family savings rate from about 1% of household income a few years ago to 6%+ now. The stock market dropped to the lowest level in 50 years, which caused working people to be alarmed about their retirement prospects. Seeing your house drop in value along with your 401-k is gut wrenching. So people are improving their “balance sheets” by paying off debt and increasing their savings at a feverish pitch.
These developments are good in many ways because we are weaning ourselves off the spending binge that lasted until about 2007. The downside is that companies have trouble making a profit because they have to cut their prices so much to sell their goods and services. This impacts suppliers. New orders for their products drops. To survive, all businesses are cutting staff. Then unemployment rises, there are even fewer purchasers, and people refrain from buying things because they either don’t have the money or they expect prices to drop further. This cycle creates a vicious vortex which sucks the wind out of our economy and causes deflation.
The big danger is that this downward spiral can worsen over time. As more people lose their jobs they can’t buy goods and services, sales continue to drop, and employers lay off more people, etc. Economists call this a drop in ‘velocity of money’ and, if it continues, it could cause a severe depression. At that point, it is very difficult to regain economic momentum. The Great Depression of the 1930’s only ended when we went to war in 1941. War increases employment, and creates a strong demand for armaments (which keep getting blown up and have to be replaced).
Deflation also causes the value of our dollar to drop against other currencies. For American workers, this means that the price of imports and the cost of travel abroad increases. For non-U.S. residents this situation is a bonanza: for example, Europeans can not only buy more dollars with each Euro, but those dollars will buy more U.S. goods, and travel to the U.S. is a real bargain. As foreigners buy more U.S. goods and services and travel here to spend their money our balance of trade is favored.
Swings in economic activity are often self-correcting. As prices drop during deflation, the value of the dollar for U.S. residents actually increases and we can buy more for less money. For example, the price of real estate has plummeted in many areas, the negotiated price of cars has dropped, and most retail stores, restaurants, etc. are offering enticing specials.
The U.S. is not the only country facing this situation: the whole world is experiencing deflation. But a free market economy like ours is affected sooner because a higher degree of our spending is non-governmental compared to many other mature economies. To address the danger of deflation, the U.S. government had to inject money into the economy using stimulus spending. Most countries have a stronger social ‘safety-net’ like unemployment benefits and free health care. They have decided that, for now, additional government spending in the form of a stimulus is not necessary.
Most of the U.S. stimulus money, however, is being spent on government jobs that do not create additional employment. The ‘TARP’ money earmarked to shore up our banking system isn’t being lent out by banks to create economic activity, as was expected, but is rather being used by the banks to repair their own balance sheets and recapitalize. So the ‘law of unintended consequences’ has kicked in to further complicate the situation.
Investors are faced with very low interest rates on their savings. Series I Savings Bonds, which accrue interest on an inflation-adjusted basis, are now paying zero interest due to deflation. As you well know, it’s all but impossible to find bank savings accounts or money market accounts that even pay 1%!
What can you do to combat deflation? The best hedge is U.S. Treasury bonds, which have a fixed interest rate over the life of the bond and are non-callable (i.e. cannot be paid off earlier than the original maturity date). Including them in your portfolio preserves your purchasing power when equities in your portfolio decline.
Although infrequent, deflation has its particular perils and it is important that you build protection into your portfolio to shield you from its devastating effects. It is actually more important to protect a portfolio against deflation with fixed rate Treasuries than to try to sidestep inflation by filling a bond portfolio with TIP’s (inflation adjusted Treasuries) that leave no defense against deflation.
We are a resilient nation, and we will survive this economic cycle. Indeed there are simple, sensible approaches you can take to ready yourself for all economic environments - deflation, inflation, or prosperity. The key is to build and maintain a balanced approach that positions you for any economic scenario. You’ll be able to stop trying to predict what might happen because you’ll know that you are prepared to face whatever does happen. Isn’t that one of the best “returns” your portfolio could ever provide?
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
For years we have been told about the evils of inflation. But now we are witnessing deflation, which most people have never experienced since 1950. What does deflation mean for you today? How is the economy affected? How bad can it get?
Inflation is an economic phenomenon that has been described as too many dollars chasing too few goods. Deflation occurs when the opposite happens -- too few dollars are being used to buy the available goods.
For most of this decade credit has been abundant and too much money was lent, especially to people without a strong financial foundation. It was easy to buy houses, cars, take trips, etc. As borrowers defaulted en masse on mortgages, student loans, car loans, etc., the banks and other lending institutions curtailed lending to consumers and to businesses. This resulted in an alarming drop in sales of cars, houses, etc. Retail sales across the board have shrunk as people became very frugal.
The downturn is compounded by a significant increase in the average family savings rate from about 1% of household income a few years ago to 6%+ now. The stock market dropped to the lowest level in 50 years, which caused working people to be alarmed about their retirement prospects. Seeing your house drop in value along with your 401-k is gut wrenching. So people are improving their “balance sheets” by paying off debt and increasing their savings at a feverish pitch.
These developments are good in many ways because we are weaning ourselves off the spending binge that lasted until about 2007. The downside is that companies have trouble making a profit because they have to cut their prices so much to sell their goods and services. This impacts suppliers. New orders for their products drops. To survive, all businesses are cutting staff. Then unemployment rises, there are even fewer purchasers, and people refrain from buying things because they either don’t have the money or they expect prices to drop further. This cycle creates a vicious vortex which sucks the wind out of our economy and causes deflation.
The big danger is that this downward spiral can worsen over time. As more people lose their jobs they can’t buy goods and services, sales continue to drop, and employers lay off more people, etc. Economists call this a drop in ‘velocity of money’ and, if it continues, it could cause a severe depression. At that point, it is very difficult to regain economic momentum. The Great Depression of the 1930’s only ended when we went to war in 1941. War increases employment, and creates a strong demand for armaments (which keep getting blown up and have to be replaced).
Deflation also causes the value of our dollar to drop against other currencies. For American workers, this means that the price of imports and the cost of travel abroad increases. For non-U.S. residents this situation is a bonanza: for example, Europeans can not only buy more dollars with each Euro, but those dollars will buy more U.S. goods, and travel to the U.S. is a real bargain. As foreigners buy more U.S. goods and services and travel here to spend their money our balance of trade is favored.
Swings in economic activity are often self-correcting. As prices drop during deflation, the value of the dollar for U.S. residents actually increases and we can buy more for less money. For example, the price of real estate has plummeted in many areas, the negotiated price of cars has dropped, and most retail stores, restaurants, etc. are offering enticing specials.
The U.S. is not the only country facing this situation: the whole world is experiencing deflation. But a free market economy like ours is affected sooner because a higher degree of our spending is non-governmental compared to many other mature economies. To address the danger of deflation, the U.S. government had to inject money into the economy using stimulus spending. Most countries have a stronger social ‘safety-net’ like unemployment benefits and free health care. They have decided that, for now, additional government spending in the form of a stimulus is not necessary.
Most of the U.S. stimulus money, however, is being spent on government jobs that do not create additional employment. The ‘TARP’ money earmarked to shore up our banking system isn’t being lent out by banks to create economic activity, as was expected, but is rather being used by the banks to repair their own balance sheets and recapitalize. So the ‘law of unintended consequences’ has kicked in to further complicate the situation.
Investors are faced with very low interest rates on their savings. Series I Savings Bonds, which accrue interest on an inflation-adjusted basis, are now paying zero interest due to deflation. As you well know, it’s all but impossible to find bank savings accounts or money market accounts that even pay 1%!
What can you do to combat deflation? The best hedge is U.S. Treasury bonds, which have a fixed interest rate over the life of the bond and are non-callable (i.e. cannot be paid off earlier than the original maturity date). Including them in your portfolio preserves your purchasing power when equities in your portfolio decline.
Although infrequent, deflation has its particular perils and it is important that you build protection into your portfolio to shield you from its devastating effects. It is actually more important to protect a portfolio against deflation with fixed rate Treasuries than to try to sidestep inflation by filling a bond portfolio with TIP’s (inflation adjusted Treasuries) that leave no defense against deflation.
We are a resilient nation, and we will survive this economic cycle. Indeed there are simple, sensible approaches you can take to ready yourself for all economic environments - deflation, inflation, or prosperity. The key is to build and maintain a balanced approach that positions you for any economic scenario. You’ll be able to stop trying to predict what might happen because you’ll know that you are prepared to face whatever does happen. Isn’t that one of the best “returns” your portfolio could ever provide?
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Wednesday, October 14, 2009
Once Burned, Twice Shy
Bert Whitehead, M.B.A., J.D.
Investors are feeling almost euphoric. While the market hasn’t rebounded to a Dow topping 14,000 (where it was in Oct, 2007), it is up 58% flirting with 10,000 from the 6,500 bottom we experienced on March 9th of this year. This sharp rebound is a relief but can be scary in its own right.
SELL NOW! Many investment gurus are predicting another round of market
setbacks. P/E ratios (i.e. the relationship of earnings to the price of stocks) are high at about 20. (15 is considered normal.) Their observations focus on the negative realities we are still experiencing, such as unemployment, the housing collapse, and unprecedented government spending and impending inflation. The ‘smart money,’ they say, is going into hibernation or reinvesting in exotic currency and commodity offerings.
BUY, BUY, BUY! Other investment mavens are optimistic. On this side the ‘smart money’ notes that the steepest market drops are historically followed by higher and higher stock prices. The market is a leading indicator and is looking ahead 9-18 months. The stage is set for a global recovery and owning stocks is the place to be.
Who can you believe? Keep two things in mind: 1) the ‘smart money’ in both groups represents only 5% of the traders but accounts for 95% of the stock transactions every day, and 2) every day a ‘survey’ is taken, and 50% of the ‘smart money’ thinks the market is going up while the other half thinks it’s going down. It has to be that way, because for every buyer there must be a seller – and one of them is wrong!
It is enticing to try to forecast what will happen next, and the experts can be very convincing. Usually they focus on one or two factors that support their conclusion, and their position appeals to one of the two most dangerous emotions for investors: Fear and Greed.
Fear made some people jump out of the market at the end of last year or the start of this year. They panicked and sold all of their stocks. Perhaps they felt burned, yet satisfied knowing that they were ‘right’ as the market tumbled downward until March 9. Now many of them are kicking themselves for turning shy and not getting back in as they watched stock prices spiral upward. They wonder if they should buy back into the market now is it too late? Is the market due for a correction?
This is the market timer’s dilemma: they first have to decide when to sell. Then they have to decide when to get back in. So both decisions have to be right. Statistically, they will get both right 25% of the time; the other 75% of the time they will make an error.
If Greed wins out and they put everything back in the market now, they run a 50% chance of being ‘whipsawed.’ As soon as they buy back in, the market nosedives. So their Fear kicks into gear and they sell out again and take a large loss to avoid a huge loss. Then, of course, stocks skyrocket. I have experienced this myself. It is a very depressing experience.
Market timers can get so caught up in their timing schemes that the market takes over their whole lives. They constantly watch ‘the market’ and listen to talking heads expound while reading about the latest investment fad. In the end, they would be better off financially and emotionally if they had a clear plan and stuck to it.
We use Functional Asset Allocation, an investment strategy format that is designed for real people. It incorporates real estate as well as stocks and bonds/cash. We seek to balance the portfolio in relation to total net worth, rather than try to time the market. As we balance our clients’ investments, we want to lower their investment costs, reduce the overall volatility of the portfolio, and, especially, make their portfolio tax efficient. We make decisions about things we can control by understanding the difference between what is certain and what is speculation. We position clients to enjoy a ‘market rate of return.’
By using a 15year bond ladder with Treasury bonds, we provide clients with a safety net so they don’t have to time their investing activity. They keep their real estate, even when the market tanks. They continue to dollar cost average into the stock market when it falls and rises. By maintaining a balanced portfolio, our clients are always positioned for any economic environment. They have investments to hedge against inflation, deflation and to participate when prosperity returns.
An investment advisor once commented to me that we could get a much higher rate of return by using municipal bonds and junk bonds instead of U.S. Treasuries. I acknowledged that, if an investor can time interest rates successfully over a long period of time, the gains might offset the extra taxes and transaction costs involved. But I explained that all our clients need to do is to get a market rate of return. We don’t take the extra risks that are required to try to ‘beat the market.’ We sell sleep.
You may be a bit shy about getting back into the stock market now because you got burned badly during the last downturn, which was the worst in the last 50 years. The key to not getting burned is to adjust your expectations and have a balanced portfolio that is geared for your particular situation. It’s the best way to experience the rewards of long-term investing and protect yourself against emotion-induced investment losses.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Investors are feeling almost euphoric. While the market hasn’t rebounded to a Dow topping 14,000 (where it was in Oct, 2007), it is up 58% flirting with 10,000 from the 6,500 bottom we experienced on March 9th of this year. This sharp rebound is a relief but can be scary in its own right.
SELL NOW! Many investment gurus are predicting another round of market
setbacks. P/E ratios (i.e. the relationship of earnings to the price of stocks) are high at about 20. (15 is considered normal.) Their observations focus on the negative realities we are still experiencing, such as unemployment, the housing collapse, and unprecedented government spending and impending inflation. The ‘smart money,’ they say, is going into hibernation or reinvesting in exotic currency and commodity offerings.
BUY, BUY, BUY! Other investment mavens are optimistic. On this side the ‘smart money’ notes that the steepest market drops are historically followed by higher and higher stock prices. The market is a leading indicator and is looking ahead 9-18 months. The stage is set for a global recovery and owning stocks is the place to be.
Who can you believe? Keep two things in mind: 1) the ‘smart money’ in both groups represents only 5% of the traders but accounts for 95% of the stock transactions every day, and 2) every day a ‘survey’ is taken, and 50% of the ‘smart money’ thinks the market is going up while the other half thinks it’s going down. It has to be that way, because for every buyer there must be a seller – and one of them is wrong!
It is enticing to try to forecast what will happen next, and the experts can be very convincing. Usually they focus on one or two factors that support their conclusion, and their position appeals to one of the two most dangerous emotions for investors: Fear and Greed.
Fear made some people jump out of the market at the end of last year or the start of this year. They panicked and sold all of their stocks. Perhaps they felt burned, yet satisfied knowing that they were ‘right’ as the market tumbled downward until March 9. Now many of them are kicking themselves for turning shy and not getting back in as they watched stock prices spiral upward. They wonder if they should buy back into the market now is it too late? Is the market due for a correction?
This is the market timer’s dilemma: they first have to decide when to sell. Then they have to decide when to get back in. So both decisions have to be right. Statistically, they will get both right 25% of the time; the other 75% of the time they will make an error.
If Greed wins out and they put everything back in the market now, they run a 50% chance of being ‘whipsawed.’ As soon as they buy back in, the market nosedives. So their Fear kicks into gear and they sell out again and take a large loss to avoid a huge loss. Then, of course, stocks skyrocket. I have experienced this myself. It is a very depressing experience.
Market timers can get so caught up in their timing schemes that the market takes over their whole lives. They constantly watch ‘the market’ and listen to talking heads expound while reading about the latest investment fad. In the end, they would be better off financially and emotionally if they had a clear plan and stuck to it.
We use Functional Asset Allocation, an investment strategy format that is designed for real people. It incorporates real estate as well as stocks and bonds/cash. We seek to balance the portfolio in relation to total net worth, rather than try to time the market. As we balance our clients’ investments, we want to lower their investment costs, reduce the overall volatility of the portfolio, and, especially, make their portfolio tax efficient. We make decisions about things we can control by understanding the difference between what is certain and what is speculation. We position clients to enjoy a ‘market rate of return.’
By using a 15year bond ladder with Treasury bonds, we provide clients with a safety net so they don’t have to time their investing activity. They keep their real estate, even when the market tanks. They continue to dollar cost average into the stock market when it falls and rises. By maintaining a balanced portfolio, our clients are always positioned for any economic environment. They have investments to hedge against inflation, deflation and to participate when prosperity returns.
An investment advisor once commented to me that we could get a much higher rate of return by using municipal bonds and junk bonds instead of U.S. Treasuries. I acknowledged that, if an investor can time interest rates successfully over a long period of time, the gains might offset the extra taxes and transaction costs involved. But I explained that all our clients need to do is to get a market rate of return. We don’t take the extra risks that are required to try to ‘beat the market.’ We sell sleep.
You may be a bit shy about getting back into the stock market now because you got burned badly during the last downturn, which was the worst in the last 50 years. The key to not getting burned is to adjust your expectations and have a balanced portfolio that is geared for your particular situation. It’s the best way to experience the rewards of long-term investing and protect yourself against emotion-induced investment losses.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Tuesday, September 22, 2009
The Inflation Bogeyman
Bert Whitehead, M.B.A., J.D. © 2009
“Inflation Adjusted” projections are the standard in the financial planning industry. I don’t use ‘inflation adjusted’ numbers, and haven’t for over 20 years. This raises eyebrows and sparks wonderment.
It’s not that I deny that prices increase over time and that the dollar becomes less valuable. The point is that inflation is not the key economic driver for real people, except perhaps those who are living at a subsistence level (keep in mind that the average household income is ~$50,000 per year). When gasoline prices spiked to over $4.00 a gallon, it is likely that you complained about it, but it didn’t really affect your lifestyle. But, if you were living on a subsistence level, expensive gasoline probably did take a toll.
Inflation adjustments became the rage in the 1970’s when oil prices, wages, and expectations devastated the value of the dollar. The financial planning industry, which encompassed mostly life insurance sales people at that time, found a terrific tool. By simply adjusting the inflation assumptions upward by 2-3% and projecting out over 30-40 years, it was easy to make a convincing case that you needed to buy more life insurance!
It’s like holding a yard-stick level while grasping one end in one hand. If you barely move your wrist so the stickmoves up by a teeny amount near your hand, the ‘long-term’ end of the yardstick jumps up a foot or two. Very scary.
Back then inflation was raging at 14-15% a year. Most financial planners made their projections using a 10-12% inflation adjustment. Being conservative, I used an 8% per year inflation adjustment. Some of my clients then are still my clients…so, tell me: was an 8% assumption too high or too low?
Most people, including professionals who have the benefit of a rear-view mirror, quickly respond that 8% was much too high. If compared to the actual annual increase in the Consumer Price Index (CPI), it was indeed too high – the actual rate of inflation over a 30-year period starting in the late 1970’s was in fact only 3.7%!
But when I meet with clients now who were clients then, their own ‘standard of living’ increased at about a 10% rate. Why? Because one spouse went to law school and the other became a tenured professor at a college, and their increasing affluence enabled them to move from a Chevy to a Pontiac to a Cadillac. Now they vacation in Europe instead of trekking ‘up north’ to camp. So the ‘inflation rate’ is not the predictor of future living expenses: it’s the increase in your standard of living that matters.
“But the dollar won’t buy as much in my retirement as it does now!” exclaims a client. Yes, that is true for the most heavily weighted goods and services in the CPI calculation. But when you are retired, you don’t need to worry about rising costs in education, real estate, or medical (assuming you have insurance or Medicare).
In my experience, retired clients in their late 70’s or early 80’s actually see their living expenses shrink – even if the CPI is increasing. Why? Because they have ‘been there, done that, and have the T-shirt.’ As we age we generally become less mobile. Keeping up with the latest fashions is no longer an imperative. Our cars last longer, and we keep our outdated computers and telephones longer, dreading the ordeal of having to ramp up another learning curve. Recent industry studies have confirmed this phenomenon.
Again, the real driver in financial projections for real people is your standard of living, not the U.S. CPI. Once you accept that fact, a key endogenous reality becomes apparent … financial independence depends on your own spending habits. Handling this is not difficult. Usually your earnings outpace inflation while you are working, and if you save 10+% of your earnings, your savings and market increases in a well-balanced portfolio will more than offset inflation.
There is a problem, of course, if your income increases substantially and you increase your standard of living accordingly. Movie stars, rock bands, athletes, etc. with meteoric incomes often don’t moderate their standard of living. They think their popularity will never end. When their gravy train stops, they are faced with bankruptcy.
The reason we focus on clients’ net worth rather than the return on their investments (ROI), is because it is net worth that should correlate with increases in standard of living. The rate of return on your investments is one variable that can affect your financial success. But other more important variables include how much you save (yes, even when you are retired!), how you manage debt, your spending patterns, and certainly how much you earn.
Money managers focus on quarterly investment returns (inflation adjusted, of course). They evaluate returns on their investment portfolio in relation to various stock indexes to justify their value-added in a client relationship. They are not comprehensive financial advisors and, to our way of thinking, they are tracking the wrong variable. Real people are impacted much more by how much they pay in taxes, how much they save, real estate decisions, and their spending patterns than by their investment ROI.
We focus on achieving market returns in a client’s overall portfolio. A market rate of return is usually all a client needs if they live within their means. Our “value-added” certainly includes keeping clients’ portfolios properly allocated with solid investments. But we concentrate first on what we can help clients control by helping them pay less taxes, manage their debt, recognize the risks they are taking outside their portfolios, and warn them about dangers they may face.
This is a long way from figuring out how much your inflation adjustment should be. Indeed, the Inflation Bogeyman is not as scary to your financial future as most people think!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
“Inflation Adjusted” projections are the standard in the financial planning industry. I don’t use ‘inflation adjusted’ numbers, and haven’t for over 20 years. This raises eyebrows and sparks wonderment.
It’s not that I deny that prices increase over time and that the dollar becomes less valuable. The point is that inflation is not the key economic driver for real people, except perhaps those who are living at a subsistence level (keep in mind that the average household income is ~$50,000 per year). When gasoline prices spiked to over $4.00 a gallon, it is likely that you complained about it, but it didn’t really affect your lifestyle. But, if you were living on a subsistence level, expensive gasoline probably did take a toll.
Inflation adjustments became the rage in the 1970’s when oil prices, wages, and expectations devastated the value of the dollar. The financial planning industry, which encompassed mostly life insurance sales people at that time, found a terrific tool. By simply adjusting the inflation assumptions upward by 2-3% and projecting out over 30-40 years, it was easy to make a convincing case that you needed to buy more life insurance!
It’s like holding a yard-stick level while grasping one end in one hand. If you barely move your wrist so the stickmoves up by a teeny amount near your hand, the ‘long-term’ end of the yardstick jumps up a foot or two. Very scary.
Back then inflation was raging at 14-15% a year. Most financial planners made their projections using a 10-12% inflation adjustment. Being conservative, I used an 8% per year inflation adjustment. Some of my clients then are still my clients…so, tell me: was an 8% assumption too high or too low?
Most people, including professionals who have the benefit of a rear-view mirror, quickly respond that 8% was much too high. If compared to the actual annual increase in the Consumer Price Index (CPI), it was indeed too high – the actual rate of inflation over a 30-year period starting in the late 1970’s was in fact only 3.7%!
But when I meet with clients now who were clients then, their own ‘standard of living’ increased at about a 10% rate. Why? Because one spouse went to law school and the other became a tenured professor at a college, and their increasing affluence enabled them to move from a Chevy to a Pontiac to a Cadillac. Now they vacation in Europe instead of trekking ‘up north’ to camp. So the ‘inflation rate’ is not the predictor of future living expenses: it’s the increase in your standard of living that matters.
“But the dollar won’t buy as much in my retirement as it does now!” exclaims a client. Yes, that is true for the most heavily weighted goods and services in the CPI calculation. But when you are retired, you don’t need to worry about rising costs in education, real estate, or medical (assuming you have insurance or Medicare).
In my experience, retired clients in their late 70’s or early 80’s actually see their living expenses shrink – even if the CPI is increasing. Why? Because they have ‘been there, done that, and have the T-shirt.’ As we age we generally become less mobile. Keeping up with the latest fashions is no longer an imperative. Our cars last longer, and we keep our outdated computers and telephones longer, dreading the ordeal of having to ramp up another learning curve. Recent industry studies have confirmed this phenomenon.
Again, the real driver in financial projections for real people is your standard of living, not the U.S. CPI. Once you accept that fact, a key endogenous reality becomes apparent … financial independence depends on your own spending habits. Handling this is not difficult. Usually your earnings outpace inflation while you are working, and if you save 10+% of your earnings, your savings and market increases in a well-balanced portfolio will more than offset inflation.
There is a problem, of course, if your income increases substantially and you increase your standard of living accordingly. Movie stars, rock bands, athletes, etc. with meteoric incomes often don’t moderate their standard of living. They think their popularity will never end. When their gravy train stops, they are faced with bankruptcy.
The reason we focus on clients’ net worth rather than the return on their investments (ROI), is because it is net worth that should correlate with increases in standard of living. The rate of return on your investments is one variable that can affect your financial success. But other more important variables include how much you save (yes, even when you are retired!), how you manage debt, your spending patterns, and certainly how much you earn.
Money managers focus on quarterly investment returns (inflation adjusted, of course). They evaluate returns on their investment portfolio in relation to various stock indexes to justify their value-added in a client relationship. They are not comprehensive financial advisors and, to our way of thinking, they are tracking the wrong variable. Real people are impacted much more by how much they pay in taxes, how much they save, real estate decisions, and their spending patterns than by their investment ROI.
We focus on achieving market returns in a client’s overall portfolio. A market rate of return is usually all a client needs if they live within their means. Our “value-added” certainly includes keeping clients’ portfolios properly allocated with solid investments. But we concentrate first on what we can help clients control by helping them pay less taxes, manage their debt, recognize the risks they are taking outside their portfolios, and warn them about dangers they may face.
This is a long way from figuring out how much your inflation adjustment should be. Indeed, the Inflation Bogeyman is not as scary to your financial future as most people think!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Wednesday, August 26, 2009
Getting the Highest Yield Today
Bert Whitehead, M.B.A., J.D. ©2009
How can you expect to make money with your money when short-term interest rates are lower than you have ever seen? Short term Treasury Bills (T-Bills) for 30-90 days pay virtually zero percent. Lock in your money for 1-2 years and you can expect 0.5% to1.0% these days. As with every investment, higher returns mean higher risks. Let’s review your alternatives.
Bank C.D.’s – There is a significant spread in yields offered by various banks. Today you will find FDIC insured banks paying 1.0 to 2.0% on 1-2 year C.D.’s. This is twice as much as Treasuries are paying, and your money is still guaranteed by the US government, right? So what’s the catch?
There are a couple of minor considerations, e.g. interest from Treasuries is exempt from state income tax but interest earned on CD’s is not. Also, if you cash in a CD early, you are charged a penalty equal to 3 months interest. A short term ‘T-Bill’ cashed in early may be sold at a small premium or discount, depending on which way interest rates move – so this is generally a small overall advantage of T-Bills.
The biggest danger with high-yield CD’s is that the best yields are generally offered by the weakest banks. If the bank fails, the FDIC moves in and takes over and usually sells it to another bank. You are guaranteed to get back the balance of your account including accrued interest to the date the bank is closed (up to $250,000 now). Normally this takes only a short time, like a couple of weeks or less. But if there are problems (bad record keeping, fraud, etc.) your money could be tied up over a year – and you are not paid any interest from the time the FDIC shuts the bank down.
There can be other inconveniences, such as ATM’s shut down, checks not honored for awhile, etc. but that would not necessarily affect you if you only have CD’s at the bank.
Money Market Funds – These funds buy very short term commercial paper (30-90 days) and have been long considered very safe as they are committed to maintained $1.00 par value ( so you couldn’t lose your principle). But a large fund (Reserve) ‘broke the buck’ last year and the net asset value dropped to $.93. This set off a panic, so the feds stepped in and guaranteed deposits up to $250,000 until Sept. (since extended…probably forever). These funds are immediately available, but are paying generally less than 0.10% -- so on $1,000 you would earn $1.00 in one year.
Municipal Money Market Funds -- These funds hold very short term municipal bonds (less than one year maturity). Many municipalities have huge unfunded pension liabilities and are facing lower tax revenues, and so are considered ‘junk bond’ quality. They are paying less than 0.25% - so they really aren’t usually worth the bother for the extra risk/reward ratio.
Short Term Muni Bonds – these pay somewhat higher yield than muni money market funds, currently around 0.5-1.0%. Usually clients don’t have enough money to diversify buying individual bonds, so diversification provided by short term muni bond funds is attractive…of course the fund passes on their expenses so the yield is less. I consider this very risky because bond funds generally add lower quality in their mix to improve their yield. These bonds are so risky that current issues are not insurable. Consider that the state of California has had to resort to sending IOU’s to their citizens for tax refunds because they don’t have enough money.
Other High Yield Offerings – We are always glad to review investment options for clients, Most of the time there is significant risk involved in these offering. Some however merit consideration. For example, Schwab Bank is offering FDIC insured savings accounts that pay 1.35% (guaranteed up to $250,000).
Obviously Schwab only offers this to its own best clients, so they aren’t tempted to switch their deposits elsewhere. So you’re not likely to see it advertized to the general public. We can provide information and assistance to client who is interested in reviewing this option.
One advantage is that you can get a Schwab Bank checking account along with it so the funds are easily transferable on-line to other Schwab brokerage accounts or by writing a check to other institutions as desired. Keep in mind however that this is likely a ‘teaser rate’ and so it may be reduced without notice.
In summary, there are few good options to invest short-term cash. Unless you have a very large sum of cash I don’t think it’s worth the bother to hop from one bank to another to chase an extra ½% for three months. We do stay on top of this for you and monthly update the ‘Cash Options’ we maintain to give clients advice on current rates. If you have any questions or concerns, please contact your Cambridge Advisor.
How can you expect to make money with your money when short-term interest rates are lower than you have ever seen? Short term Treasury Bills (T-Bills) for 30-90 days pay virtually zero percent. Lock in your money for 1-2 years and you can expect 0.5% to1.0% these days. As with every investment, higher returns mean higher risks. Let’s review your alternatives.
Bank C.D.’s – There is a significant spread in yields offered by various banks. Today you will find FDIC insured banks paying 1.0 to 2.0% on 1-2 year C.D.’s. This is twice as much as Treasuries are paying, and your money is still guaranteed by the US government, right? So what’s the catch?
There are a couple of minor considerations, e.g. interest from Treasuries is exempt from state income tax but interest earned on CD’s is not. Also, if you cash in a CD early, you are charged a penalty equal to 3 months interest. A short term ‘T-Bill’ cashed in early may be sold at a small premium or discount, depending on which way interest rates move – so this is generally a small overall advantage of T-Bills.
The biggest danger with high-yield CD’s is that the best yields are generally offered by the weakest banks. If the bank fails, the FDIC moves in and takes over and usually sells it to another bank. You are guaranteed to get back the balance of your account including accrued interest to the date the bank is closed (up to $250,000 now). Normally this takes only a short time, like a couple of weeks or less. But if there are problems (bad record keeping, fraud, etc.) your money could be tied up over a year – and you are not paid any interest from the time the FDIC shuts the bank down.
There can be other inconveniences, such as ATM’s shut down, checks not honored for awhile, etc. but that would not necessarily affect you if you only have CD’s at the bank.
Money Market Funds – These funds buy very short term commercial paper (30-90 days) and have been long considered very safe as they are committed to maintained $1.00 par value ( so you couldn’t lose your principle). But a large fund (Reserve) ‘broke the buck’ last year and the net asset value dropped to $.93. This set off a panic, so the feds stepped in and guaranteed deposits up to $250,000 until Sept. (since extended…probably forever). These funds are immediately available, but are paying generally less than 0.10% -- so on $1,000 you would earn $1.00 in one year.
Municipal Money Market Funds -- These funds hold very short term municipal bonds (less than one year maturity). Many municipalities have huge unfunded pension liabilities and are facing lower tax revenues, and so are considered ‘junk bond’ quality. They are paying less than 0.25% - so they really aren’t usually worth the bother for the extra risk/reward ratio.
Short Term Muni Bonds – these pay somewhat higher yield than muni money market funds, currently around 0.5-1.0%. Usually clients don’t have enough money to diversify buying individual bonds, so diversification provided by short term muni bond funds is attractive…of course the fund passes on their expenses so the yield is less. I consider this very risky because bond funds generally add lower quality in their mix to improve their yield. These bonds are so risky that current issues are not insurable. Consider that the state of California has had to resort to sending IOU’s to their citizens for tax refunds because they don’t have enough money.
Other High Yield Offerings – We are always glad to review investment options for clients, Most of the time there is significant risk involved in these offering. Some however merit consideration. For example, Schwab Bank is offering FDIC insured savings accounts that pay 1.35% (guaranteed up to $250,000).
Obviously Schwab only offers this to its own best clients, so they aren’t tempted to switch their deposits elsewhere. So you’re not likely to see it advertized to the general public. We can provide information and assistance to client who is interested in reviewing this option.
One advantage is that you can get a Schwab Bank checking account along with it so the funds are easily transferable on-line to other Schwab brokerage accounts or by writing a check to other institutions as desired. Keep in mind however that this is likely a ‘teaser rate’ and so it may be reduced without notice.
In summary, there are few good options to invest short-term cash. Unless you have a very large sum of cash I don’t think it’s worth the bother to hop from one bank to another to chase an extra ½% for three months. We do stay on top of this for you and monthly update the ‘Cash Options’ we maintain to give clients advice on current rates. If you have any questions or concerns, please contact your Cambridge Advisor.
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