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.
Wednesday, October 14, 2009
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.
Thursday, July 30, 2009
Is Now the Time to Buy Commodities?
Bert Whitehead, M.B.A., J.D. ©
Commodities are hot! When is the best time to buy?
Most of us are inclined to try to figure out the best time to buy an investment. However, studies by academicians, pension funds, and other objective sources, however, have shown that market timing never works. It is useful to know the three rationales for market timing to better understand why it is futile: the Past, the Present, and the Future. We also explain the alternative to market timing.
The Future: Doomsday scenarios are generally based on some ‘inevitable’ future event which is unprecedented although it may have some basis in truth. Buy commodities because the world is running out of oil! Buy gold because China has too much of our debt! Inflation will cause worldwide financial collapse…so buy commodities! Timing systems based on outlandish possible scenarios sell investment newsletters, and get headlines.
Sometimes a prediction will actually come true, e.g. in the early 90’s globalization and computerization were predicted to dramatically drive the stock market up. That did happen, but the Dow never got to 36,000 as some predicted. There are too many countervailing forces in the economy to predict the future, and exaggerated claims don’t come true because they are offset by other economic changes.
Real estate was supposed to crash by the end of the 1990’s because of demographic trends, e.g. the end of the baby boomer house-buying era. Instead, real estate boomed because more boomers bought 2nd homes, households became smaller, people live longer, immigration swells our population, etc. These other factors offset the expected drop in demand for housing. When housing did crash about 10 years later, it was totally unexpected by the experts – and caused by artificially low interest rates!
The Present; The ‘recency effect’ occurs when you expect that what ever is happening now, or has been happening, will continue to happen. When the stock market is falling, people generally believe it will continue dropping and run for the exits. When it is rising, people become convinced it will always keep rising and pile investment dollars on just as the market peaks.
The market seeks balance by testing extremes. If anything, it is likely that whatever is happening now will not continue, certainly not indefinitely. Again, other economic factors come into play that offset existing trends. Relying on current trends to continue is a financial recipe for heartburn.
The Past: Our whole investment industry is predicated on analyzing past performance of a stock, or group of stocks, or a money manager to determine future performance. As you probably know the tagline on every investment recommendation is: ”Past performance is no guarantee of future returns!”
There are long-term 15-20 year trends in the markets that are remarkably consistent over any 15-20 year period. For example, a portfolio of 50% stocks and 50% bonds over the past 80 years has averaged 8.2%. Interestingly, most of the 15-20 year periods during that time frame show an annual return in that range.
That is no guarantee that this long-term historical trend will continue, but it is useful for long-term planning purposes. Most importantly, a 15-20 year trend offers no clues about how you should invest your money now.
The Alternative: So if market timing based any of these three rationales is unreliable, how do you know whether you should invest in commodities now? We espouse an approach based on balancing your portfolio according to your particular situation. We do not predict or rely on timing of any exogenous factors such as oil prices, the likelihood of war, the possibility of a California earthquake, etc.
What is important is that your portfolio takes into account the endogenous factors in your life. This includes job stability, how many kids you have to send to college, the amount of risk you take outside the portfolio (e.g. owning a business, real estate investments, etc.). A key factor is: “How much risk do you need to take to reach your goals?” If you are comfortably retired, it is ridiculous to measure your portfolio’s suitability based on your rate of return…it’s more important to make sure you don’t lose what you’ve got!
Our approach is known as ‘Functional Asset Allocation.’ It addresses the reality that there are only three possibilities that your portfolio has to deal with: Deflation (what we are experiencing now); Inflation (which we may have to deal with next); and prosperity (which hopefully will return soon).
Treasury bonds are the absolute best protection against deflation. Yes, they always have a very low yield, but when deflation hits – ‘safety trumps yield.’ A good mixture of large cap, small cap and international stocks has proven to be the best approach in times of prosperity. Inflation is hedged by having sufficient cash reserves (since short term interest rate increase during inflation), having a long-term fixed rate mortgage, as well as unhedged foreign mutual funds or gold which protect against a drop in the dollar.
With these simple investments in your portfolio, you don’t have to guess what will happen next. Whatever happens, your portfolio will be able to handle and grow. This approach runs counter to the advice you get from the media and most investment advisors because they base their theories on the assumption that you want to get the best rate of return you can…and only they can help you time the markets. Maybe that is true of billion dollar pension funds, but for real people it is nonsense because you have a finite lifespan. Your portfolio has to reflect the realities in your life.
So what exactly is the function of investing in commodities? For ordinary people, investing in commodities is actually dysfunctional – it doesn’t reliably protect against inflation, deflation, or necessarily rise during prosperity. It is a gamble, pure and simple. I suggest that it is preferable to take the $25,000 you have been told to invest in commodities and take it to the craps table in Las Vegas. At least there when you lose it, they give you a really nice room and free dinners. Charles Schwab never does that…
Commodities are hot! When is the best time to buy?
Most of us are inclined to try to figure out the best time to buy an investment. However, studies by academicians, pension funds, and other objective sources, however, have shown that market timing never works. It is useful to know the three rationales for market timing to better understand why it is futile: the Past, the Present, and the Future. We also explain the alternative to market timing.
The Future: Doomsday scenarios are generally based on some ‘inevitable’ future event which is unprecedented although it may have some basis in truth. Buy commodities because the world is running out of oil! Buy gold because China has too much of our debt! Inflation will cause worldwide financial collapse…so buy commodities! Timing systems based on outlandish possible scenarios sell investment newsletters, and get headlines.
Sometimes a prediction will actually come true, e.g. in the early 90’s globalization and computerization were predicted to dramatically drive the stock market up. That did happen, but the Dow never got to 36,000 as some predicted. There are too many countervailing forces in the economy to predict the future, and exaggerated claims don’t come true because they are offset by other economic changes.
Real estate was supposed to crash by the end of the 1990’s because of demographic trends, e.g. the end of the baby boomer house-buying era. Instead, real estate boomed because more boomers bought 2nd homes, households became smaller, people live longer, immigration swells our population, etc. These other factors offset the expected drop in demand for housing. When housing did crash about 10 years later, it was totally unexpected by the experts – and caused by artificially low interest rates!
The Present; The ‘recency effect’ occurs when you expect that what ever is happening now, or has been happening, will continue to happen. When the stock market is falling, people generally believe it will continue dropping and run for the exits. When it is rising, people become convinced it will always keep rising and pile investment dollars on just as the market peaks.
The market seeks balance by testing extremes. If anything, it is likely that whatever is happening now will not continue, certainly not indefinitely. Again, other economic factors come into play that offset existing trends. Relying on current trends to continue is a financial recipe for heartburn.
The Past: Our whole investment industry is predicated on analyzing past performance of a stock, or group of stocks, or a money manager to determine future performance. As you probably know the tagline on every investment recommendation is: ”Past performance is no guarantee of future returns!”
There are long-term 15-20 year trends in the markets that are remarkably consistent over any 15-20 year period. For example, a portfolio of 50% stocks and 50% bonds over the past 80 years has averaged 8.2%. Interestingly, most of the 15-20 year periods during that time frame show an annual return in that range.
That is no guarantee that this long-term historical trend will continue, but it is useful for long-term planning purposes. Most importantly, a 15-20 year trend offers no clues about how you should invest your money now.
The Alternative: So if market timing based any of these three rationales is unreliable, how do you know whether you should invest in commodities now? We espouse an approach based on balancing your portfolio according to your particular situation. We do not predict or rely on timing of any exogenous factors such as oil prices, the likelihood of war, the possibility of a California earthquake, etc.
What is important is that your portfolio takes into account the endogenous factors in your life. This includes job stability, how many kids you have to send to college, the amount of risk you take outside the portfolio (e.g. owning a business, real estate investments, etc.). A key factor is: “How much risk do you need to take to reach your goals?” If you are comfortably retired, it is ridiculous to measure your portfolio’s suitability based on your rate of return…it’s more important to make sure you don’t lose what you’ve got!
Our approach is known as ‘Functional Asset Allocation.’ It addresses the reality that there are only three possibilities that your portfolio has to deal with: Deflation (what we are experiencing now); Inflation (which we may have to deal with next); and prosperity (which hopefully will return soon).
Treasury bonds are the absolute best protection against deflation. Yes, they always have a very low yield, but when deflation hits – ‘safety trumps yield.’ A good mixture of large cap, small cap and international stocks has proven to be the best approach in times of prosperity. Inflation is hedged by having sufficient cash reserves (since short term interest rate increase during inflation), having a long-term fixed rate mortgage, as well as unhedged foreign mutual funds or gold which protect against a drop in the dollar.
With these simple investments in your portfolio, you don’t have to guess what will happen next. Whatever happens, your portfolio will be able to handle and grow. This approach runs counter to the advice you get from the media and most investment advisors because they base their theories on the assumption that you want to get the best rate of return you can…and only they can help you time the markets. Maybe that is true of billion dollar pension funds, but for real people it is nonsense because you have a finite lifespan. Your portfolio has to reflect the realities in your life.
So what exactly is the function of investing in commodities? For ordinary people, investing in commodities is actually dysfunctional – it doesn’t reliably protect against inflation, deflation, or necessarily rise during prosperity. It is a gamble, pure and simple. I suggest that it is preferable to take the $25,000 you have been told to invest in commodities and take it to the craps table in Las Vegas. At least there when you lose it, they give you a really nice room and free dinners. Charles Schwab never does that…
Wednesday, July 15, 2009
What Have We Learned?
Bert Whitehead, M.B.A., J.D.
Who knows what will happen in the next few weeks, but the markets have bounced off their lows from March (except real estate…). Some say we are in recovery mode, but I’m not so sure. Maybe it’s time we take a deep breath and ask ourselves what we have learned from this experience. Here are 5 lessons most of use should have learned before, but had to re-learn.
1) This recession caught everyone off guard. Most economists didn’t see it coming, nor the government, not even the money managers who are always bragging about their superior market timing. There were a couple of experts who now are claiming that they did indeed predict this, and it is inevitable that some did accurately predict this.
So can we conclude that we should find out who these prescient money mavens were, and start doing what they tell us to do?
I think not. To begin with, market predictions are a lot like fortune cookies: usually they are a bit vague and so, after the fact, can be construed to be ‘right on the money.’ For example, a forecast in 2007 noted that “the market near-term can be expected to be very volatile and the winners will be not the stocks you would generally predict.” Looking back, that seems to be what happened…but it is hardly specific (or maybe you have to subscribe to the newsletter to get the specifics!).
It is obvious that if a newsletter publisher could predict the market, they wouldn’t be spreading their secrets – they would be making a killing trading stocks. “There is no ‘guru’ and many false prophets.”
2) When we think back to the earlier part of this decade, we all knew that the government was stretching to make mortgages affordable to increase the percentage of homeowners, a noble social goal. Maybe we shook our heads at how much the standards had changed, and how easy credit was to obtain. Of course the banks certainly knew what they were doing.
Now it is easy to see how this house of cards couldn’t last. But few could see the huge impact it would have in the financial markets. Most stock brokerages and financial advisors don’t even advise their clients on real estate. To them, the world of finance was all about stocks and bonds. Most consumers have to rely on commission-driven mortgage brokers. So that’s one thing we have learned: “Real estate is an important financial asset and people need good independent advice to make sound decisions.”
3) When interest rates started to rise, especially ‘safe bonds’ like municipal bonds, or GM bonds, it seemed to be very savvy to start chasing yields. Then we find out that these high-flying securities are much more risky than they used to be. This shouldn’t be a new lesson: “Higher returns always mean higher risks.” Often we just have to learn it again every ten years or so (remember dot-coms?).
4) Everywhere we turned frantic financial advice abounded: “Get out now, the market is going to tank!” “Now’s the time to buy – stocks are very undervalued!” When people ask me where the market is going, I review last week’s survey results of the 5% of the money managers who do 95% of the trading. Exactly half of them were convinced the market was headed up, and half were sure the market was going to drop.
The survey is run every day, and the results are always the same. Why? Because for every buyer there always has to be a seller…and one of them is wrong! It’s not the smart people selling to stupid people, because these 5% of the traders do 95% of the trades. The media is like financial pornography. They get you excited, and encourage you to act on impulse; you act on your ‘gut instincts.’ Then you are inevitably disappointed and discouraged with the result. Another lesson re-learned: “To be a successful long-term investor, you must ignore the investment media hype.”
5) If you were a prudent investor, you would analyze every investment or have your advisor do it professionally. There is historical data going back decades, and it is much easier to see the trends when the data is displayed in colorful charts and graphs. Alas, none of those trends forecast what would happen in the past 2-3 years. Could this be a new lesson learned(?):
“Past performance does not guarantee future results.”
Many investment models, including many derived from Modern Portfolio Theory, proved useless in this market. In our next blog we will review the defeats and successes of current investment theories…unless a more critical development arises which requires comment.
Who knows what will happen in the next few weeks, but the markets have bounced off their lows from March (except real estate…). Some say we are in recovery mode, but I’m not so sure. Maybe it’s time we take a deep breath and ask ourselves what we have learned from this experience. Here are 5 lessons most of use should have learned before, but had to re-learn.
1) This recession caught everyone off guard. Most economists didn’t see it coming, nor the government, not even the money managers who are always bragging about their superior market timing. There were a couple of experts who now are claiming that they did indeed predict this, and it is inevitable that some did accurately predict this.
So can we conclude that we should find out who these prescient money mavens were, and start doing what they tell us to do?
I think not. To begin with, market predictions are a lot like fortune cookies: usually they are a bit vague and so, after the fact, can be construed to be ‘right on the money.’ For example, a forecast in 2007 noted that “the market near-term can be expected to be very volatile and the winners will be not the stocks you would generally predict.” Looking back, that seems to be what happened…but it is hardly specific (or maybe you have to subscribe to the newsletter to get the specifics!).
It is obvious that if a newsletter publisher could predict the market, they wouldn’t be spreading their secrets – they would be making a killing trading stocks. “There is no ‘guru’ and many false prophets.”
2) When we think back to the earlier part of this decade, we all knew that the government was stretching to make mortgages affordable to increase the percentage of homeowners, a noble social goal. Maybe we shook our heads at how much the standards had changed, and how easy credit was to obtain. Of course the banks certainly knew what they were doing.
Now it is easy to see how this house of cards couldn’t last. But few could see the huge impact it would have in the financial markets. Most stock brokerages and financial advisors don’t even advise their clients on real estate. To them, the world of finance was all about stocks and bonds. Most consumers have to rely on commission-driven mortgage brokers. So that’s one thing we have learned: “Real estate is an important financial asset and people need good independent advice to make sound decisions.”
3) When interest rates started to rise, especially ‘safe bonds’ like municipal bonds, or GM bonds, it seemed to be very savvy to start chasing yields. Then we find out that these high-flying securities are much more risky than they used to be. This shouldn’t be a new lesson: “Higher returns always mean higher risks.” Often we just have to learn it again every ten years or so (remember dot-coms?).
4) Everywhere we turned frantic financial advice abounded: “Get out now, the market is going to tank!” “Now’s the time to buy – stocks are very undervalued!” When people ask me where the market is going, I review last week’s survey results of the 5% of the money managers who do 95% of the trading. Exactly half of them were convinced the market was headed up, and half were sure the market was going to drop.
The survey is run every day, and the results are always the same. Why? Because for every buyer there always has to be a seller…and one of them is wrong! It’s not the smart people selling to stupid people, because these 5% of the traders do 95% of the trades. The media is like financial pornography. They get you excited, and encourage you to act on impulse; you act on your ‘gut instincts.’ Then you are inevitably disappointed and discouraged with the result. Another lesson re-learned: “To be a successful long-term investor, you must ignore the investment media hype.”
5) If you were a prudent investor, you would analyze every investment or have your advisor do it professionally. There is historical data going back decades, and it is much easier to see the trends when the data is displayed in colorful charts and graphs. Alas, none of those trends forecast what would happen in the past 2-3 years. Could this be a new lesson learned(?):
“Past performance does not guarantee future results.”
Many investment models, including many derived from Modern Portfolio Theory, proved useless in this market. In our next blog we will review the defeats and successes of current investment theories…unless a more critical development arises which requires comment.
Monday, June 22, 2009
Maddoff Schemes and 5 More Financial Pitfalls
Bert Whitehead, M.B.A., J.D. © 2009
You probably know someone who knows someone who invested in Maddoff’s Ponzi Scheme. These ‘investments’ pay handsome returns, but not because the money is actually invested, but because investors who cash in on their ‘profits’ are paid off with cash received from new suckers.
With the recent market collapse, we are hearing of more and more of these frauds. That’s because these scams run out of cash when people take money out faster than new ‘investors’ are putting new money in. As Ben Bernanke quipped, “When the tide goes out, we can see who’s naked.”
This blog will discuss the Maddoff scheme as well as other classic ways investors lose money in investments -- and how you can protect yourself. Some of the safeguards I will discuss have been outlined in a series of articles by my colleague, George Marrotta, a Research Fellow at Stanford’s Hoover Institution which I have linked if you are interested in perusing.
1) The simple rule that Maddoff’s investors ignored is: “Don’t Let Your Advisor Have Custody of your Investments.” Maddoff’s investors sent their money directly to him; the paper statements they received were made up by him and his staff. Using Schwab or other independent custodians allows you to review your statement directly on-line at any time. Always make out your checks to Schwab with your account number on it, and check your statements to make sure the deposit was received. Cf. www.emarotta.com/article.php?ID=320
2) Even with the safeguard of having an independent custodian custody your assets, it is still possible to get embezzled. There were recently two cases which individual advisors stole several million dollars from client accounts. In these cases, the advisors had very elderly clients and instructed them to sign transfers from their Schwab accounts to the advisor’s account, or the advisor had check writing authorization on their account.
This of course could happen to any of your accounts at a bank. The safeguard is simple: Make sure you review your bank and brokerage statements yourself every month and review withdrawals and transfers out to make sure you know what they were for and you received the money.
3) As we get older, it is much more difficult to keep track of everything in our lives. Your finances are one of the first areas impacted by old-age forgetfulness. If you find yourself becoming confused and forgetful with your finances, it is important to have someone in your life that you trust to review your finances with you. They can double-check to make sure mistakes aren’t being made. Where we notice that a client is becoming forgetful, we will bring it up and suggest a neurological exam, since this condition can greatly impact your financial situation if not dealt with appropriately.
4) The biggest scam I see our clients exposed to are private investment ‘opportunities.’ These usually have very nice glossy sales brochures and a salesman/organizer with a smooth line of snappy patter. These often involve unregistered securities which are virtually impossible to evaluate because there is not adequate financial information, disclosures, conflicts of interest, etc. to work with. We suggest you don’t even consider unregistered securities, even with (or especially with) friends and family. Time-shares are one of these scams.
5) If offered the opportunity to get in on the ground floor, ask them to email you a prospectus or ‘offering memorandum.’ I review a number of these deals every month for clients. Then I explain the risks involved, how the money is being used including payment of the organizers, the conflicts of interest involved, etc. This is the information which is technically ‘disclosed’ but that most people don’t read or understand. Once these factors are explained, clients generally take a more sobering approach to these deals.
6) It is also important to recognize and avoid financial hooks. In many investments the salesperson earns hefty commissions. This is disclosed in the fine print which no one reads. One clue is that you are charged a hefty surrender charge or penalty to get out in the first 5-10 years. For more information, go to www.emarotta.com/article.php?ID=324.
I do believe that a financial advisor should save a client more than the advisory fee charged. Often the savings in taxes, lower investment costs, avoiding commissioned products, insurance evaluation, getting better mortgage deals, etc. produce savings which are readily apparent.
But over my 37 years of doing financial planning, I think I have saved clients even more money by talking them out of inappropriate investments and keeping them from getting scammed.
If you have been dissuaded from an investment by your advisor, I’d like you to let me know about it. I’d like to do a blog someday on ‘Investment Horror Stories!’
You probably know someone who knows someone who invested in Maddoff’s Ponzi Scheme. These ‘investments’ pay handsome returns, but not because the money is actually invested, but because investors who cash in on their ‘profits’ are paid off with cash received from new suckers.
With the recent market collapse, we are hearing of more and more of these frauds. That’s because these scams run out of cash when people take money out faster than new ‘investors’ are putting new money in. As Ben Bernanke quipped, “When the tide goes out, we can see who’s naked.”
This blog will discuss the Maddoff scheme as well as other classic ways investors lose money in investments -- and how you can protect yourself. Some of the safeguards I will discuss have been outlined in a series of articles by my colleague, George Marrotta, a Research Fellow at Stanford’s Hoover Institution which I have linked if you are interested in perusing.
1) The simple rule that Maddoff’s investors ignored is: “Don’t Let Your Advisor Have Custody of your Investments.” Maddoff’s investors sent their money directly to him; the paper statements they received were made up by him and his staff. Using Schwab or other independent custodians allows you to review your statement directly on-line at any time. Always make out your checks to Schwab with your account number on it, and check your statements to make sure the deposit was received. Cf. www.emarotta.com/article.php?ID=320
2) Even with the safeguard of having an independent custodian custody your assets, it is still possible to get embezzled. There were recently two cases which individual advisors stole several million dollars from client accounts. In these cases, the advisors had very elderly clients and instructed them to sign transfers from their Schwab accounts to the advisor’s account, or the advisor had check writing authorization on their account.
This of course could happen to any of your accounts at a bank. The safeguard is simple: Make sure you review your bank and brokerage statements yourself every month and review withdrawals and transfers out to make sure you know what they were for and you received the money.
3) As we get older, it is much more difficult to keep track of everything in our lives. Your finances are one of the first areas impacted by old-age forgetfulness. If you find yourself becoming confused and forgetful with your finances, it is important to have someone in your life that you trust to review your finances with you. They can double-check to make sure mistakes aren’t being made. Where we notice that a client is becoming forgetful, we will bring it up and suggest a neurological exam, since this condition can greatly impact your financial situation if not dealt with appropriately.
4) The biggest scam I see our clients exposed to are private investment ‘opportunities.’ These usually have very nice glossy sales brochures and a salesman/organizer with a smooth line of snappy patter. These often involve unregistered securities which are virtually impossible to evaluate because there is not adequate financial information, disclosures, conflicts of interest, etc. to work with. We suggest you don’t even consider unregistered securities, even with (or especially with) friends and family. Time-shares are one of these scams.
5) If offered the opportunity to get in on the ground floor, ask them to email you a prospectus or ‘offering memorandum.’ I review a number of these deals every month for clients. Then I explain the risks involved, how the money is being used including payment of the organizers, the conflicts of interest involved, etc. This is the information which is technically ‘disclosed’ but that most people don’t read or understand. Once these factors are explained, clients generally take a more sobering approach to these deals.
6) It is also important to recognize and avoid financial hooks. In many investments the salesperson earns hefty commissions. This is disclosed in the fine print which no one reads. One clue is that you are charged a hefty surrender charge or penalty to get out in the first 5-10 years. For more information, go to www.emarotta.com/article.php?ID=324.
I do believe that a financial advisor should save a client more than the advisory fee charged. Often the savings in taxes, lower investment costs, avoiding commissioned products, insurance evaluation, getting better mortgage deals, etc. produce savings which are readily apparent.
But over my 37 years of doing financial planning, I think I have saved clients even more money by talking them out of inappropriate investments and keeping them from getting scammed.
If you have been dissuaded from an investment by your advisor, I’d like you to let me know about it. I’d like to do a blog someday on ‘Investment Horror Stories!’
Wednesday, June 3, 2009
How Long Does It Take to be a Long-Term Investor?
Bert Whitehead, M.B.A., J.D. © 2009
This year’s market bottom in March wiped out all the market gains in your portfolio since 1996 (13 years)! This has left many commentators sniveling about the stock market as an inferior investment vehicle. But I’m sure everyone reading this has consistently been told that you have to be a ‘long-term investor’ to profit in the stock market.
So if 13 years isn’t long enough, how long is long enough?
When I started as a Financial Advisor in 1972 we were in the recession that started in 1967. The Dow hit 1000 in 1967 and didn’t get beyond 1000 again until 1982 (15 years). There was a widespread belief in the 70’s that the market could never go over 1000.
The financial pundits at that time subscribed to the theory that whenever stocks went beyond 1000, companies would always issue more stock. The additional supply would force the stock prices down, So the supply/demand curves intersected at 1000.
This year the market bottomed at 6600 in March ‘wiping out all the gains’ since 1996! But if you look at the peak in 1982 when the Dow was at 1000 and compare it to the peak in 2007 when the Dow hit 14,000, the market rose 9.8% per year ‘peak-to-peak over that 24 years. Clearly the ‘permanent market cap’ at 1000 the academicians theorized has been discredited.
Even measuring the ‘trough-to-trough’ bottoms from 607 in 1974 to 6600 this year (25 years), the market increased an average of 10.0% per year. On top of this add in the 4-6% in historical dividend payouts and the total average annual returns are easily over 12%.
The stock market has consistently been the most accessible investment over the long term! These kinds of returns are available to every person by simply consistently dollar-cost-averaging into a large cap indexed mutual fund over the long term.
Deciding not to invest in the market now, especially for younger people, could be the worst financial decision you could make in your life. And remember: you are younger now than you will ever be for the rest of your life .
This analysis explains why Cambridge Bond Ladders are for 15 years, rather than the 5 years many other advisors suggest. Fifteen years cash flow will last you through any recession. To fully reap the profits of the stock market an investor should have a 25 year horizon. That’s how long is long enough!
This year’s market bottom in March wiped out all the market gains in your portfolio since 1996 (13 years)! This has left many commentators sniveling about the stock market as an inferior investment vehicle. But I’m sure everyone reading this has consistently been told that you have to be a ‘long-term investor’ to profit in the stock market.
So if 13 years isn’t long enough, how long is long enough?
When I started as a Financial Advisor in 1972 we were in the recession that started in 1967. The Dow hit 1000 in 1967 and didn’t get beyond 1000 again until 1982 (15 years). There was a widespread belief in the 70’s that the market could never go over 1000.
The financial pundits at that time subscribed to the theory that whenever stocks went beyond 1000, companies would always issue more stock. The additional supply would force the stock prices down, So the supply/demand curves intersected at 1000.
This year the market bottomed at 6600 in March ‘wiping out all the gains’ since 1996! But if you look at the peak in 1982 when the Dow was at 1000 and compare it to the peak in 2007 when the Dow hit 14,000, the market rose 9.8% per year ‘peak-to-peak over that 24 years. Clearly the ‘permanent market cap’ at 1000 the academicians theorized has been discredited.
Even measuring the ‘trough-to-trough’ bottoms from 607 in 1974 to 6600 this year (25 years), the market increased an average of 10.0% per year. On top of this add in the 4-6% in historical dividend payouts and the total average annual returns are easily over 12%.
The stock market has consistently been the most accessible investment over the long term! These kinds of returns are available to every person by simply consistently dollar-cost-averaging into a large cap indexed mutual fund over the long term.
Deciding not to invest in the market now, especially for younger people, could be the worst financial decision you could make in your life. And remember: you are younger now than you will ever be for the rest of your life .
This analysis explains why Cambridge Bond Ladders are for 15 years, rather than the 5 years many other advisors suggest. Fifteen years cash flow will last you through any recession. To fully reap the profits of the stock market an investor should have a 25 year horizon. That’s how long is long enough!
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