By Bert Whitehead M.B.A, J.D. © 2012
Some days it seems like our economy is improving, then you turn the page and major world problems (Mideast, Europe, Korea, etc.) are just getting worse.
So what if you are a baby-boomer (or older) and are starting to think that your retirement isn’t going to be as joyful as you expected? Or maybe you are younger than that but wonder about your ability to take care of your parents, put your kids through college, and ever have enough money to retire yourself?
To evaluate yourself financially you need to answer four basic questions:
1)Are you living within your means?
2)Are you saving at least 10% of your gross income?
3)Are you covered for possible catastrophes in your life?
4)What is your ‘Plan B?’
You will note that these four questions have nothing to do with the worldwide currency crisis, the future of the stock market, or the political outcome of the next election. Instead, they refer to issues that you can directly control.
1)Are you living within your means? I have a short cut to figure this out. Do you pay off your credit cards in full every month? If you do, you are generally living within your means. If not, or if you have to take out loans (home equity, more credit cards, etc.) to pay off your credit cards, you are living beyond your means.
If the latter applies, you are probably spending more than your take-home pay and the shortfall shows up on your credit card. If you have tried to restrain your spending and have not been successful, it is usually because you have ratcheted up your standard of living beyond what you can afford. Being ‘house poor’ often causes this. That means that you have too much house, and to cut your spending you will have to downsize. Downsizing is much easier if you are relocating into another housing market.
2)Are you saving at least 10%? When we talk about ‘saving’ in this context, we are talking about long-term permanent savings, i.e. your investment portfolio. People sometimes emphatically assure me that they have been saving money regularly for years, but they have not accumulated an investment portfolio. They confuse ‘saving up to spend later’ with ‘saving for long-term investments.’
The financial objective of long term permanent savings is to invest enough during your working years so that later in life you can live off the money your money makes, rather than from the sweat of your brow. This is required if you are to be truly ‘free.’ Those without an investment portfolio are destined to have to work their whole lives, depend on the benevolence of others, or live in poverty.
3)Have you protected yourself against catastrophes? The best-laid plans can be derailed by unexpected calamities. Sudden medical conditions or disability, loss of car or home, unexpected death, lawsuits, etc. are all dangers than you seldom have to deal with, but they do happen and they can be devastating.
Basic insurance coverage and simple estate planning can shield you from these hardships. Although you might set these protections up, it is easy to forget about reviewing them. Then when you need them, they may be stale or inadequate. Make sure they are updated at least every five years, or whenever your life situation shifts (marriage, children, family deaths, etc.).
4)Do you have a ‘Plan B’? Even when people have done everything ‘right’ (i.e. #’s 1, 2, and 3 above), life can present unexpected challenges that they can never prepare for. Even with a college education, you will never be certain to have a job. You may take risks that flop, like starting a business. Shadowy medical conditions, like depression, might go unrecognized and can be debilitating.
For some younger people, Plan B is moving back with their folks. For some older people, Plan B is moving in with their adult children. Plan B might simply entail a willingness to drastically reduce your living standards so you can maintain your independence.
Sadly, my experience has shown me that many people live lives of quietly repressed panic, with an intangible sense of deprivation anxiety. They may not recognize it themselves, but a sense of financial foreboding shadows their lives every day. This can lead to behaviors like intense miserliness or as denial expressed by mindless spending. Others distract themselves by focusing on the possibility of widespread debacles due to economic and social issues. They spend their time playing “Ain’t it awful…” with their comrades in fear. They may overreact by radically altering their financial positions (“gold and canned goods.”)
I find that our present times have not changed much from past times. I recently saw the movie “The Iron Lady” which reminded me that we were dealing with the same issues 30 years ago as we are now. Somehow we, as a people, are able to rise up and defeat fear.
The real danger is not outside of us in the economy or the country. Our biggest danger lies within ourselves. We cannot control our individual destiny by anxiously reading the papers and watching TV. After all, magnifying the negative is much more profitable for journalists than reporting slow, steady progress.
Review your own situation and make the changes you need to make so that you can answer ‘Yes!’ to each of the four questions above. Then I can assure you, it is not time to panic!
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Wednesday, January 25, 2012
Wednesday, November 2, 2011
How to Get the Best Mortgage
By Bert Whitehead M.B.A, J.D. © 2011
The most popular client questions these days are about what kind of mortgage they should get. If you are somewhat knowledgeable about mortgages and just want the bottom line, you can skip to the last paragraph of this blog. If you are interested in a more detailed explanation, please continue reading.
Not only are mortgages more available now for new homes, but current mortgage holders can also find great opportunities to refinance at a lower rate. The federal government has just announced a new refinancing program for homeowners who are “under water” on their homes (i.e. they owe more on the house than it is worth). The last two similar programs never got much traction, and it is doubtful that the new program will bring serious relief to many people.
To get a new mortgage or refinance at the lowest rates you have to be able to show that you “qualify” for the mortgage. Here is a quick summary of the standards banks seek:
1. Clean credit record (FICO = 700+).
2. 80% loan-to-value (LTV). The mortgage should be less than 80% of the value of the home.
3. Currently employed.
4. Monthly payments on current debts (including mortgage) less than 40% of income.
There are some exceptions to these standards, e.g. if you replace a mortgage on your primary residence and you have always made the payments, some banks let you refinance 90-100% of the home’s value. But, in general, you won’t get the best rates available unless you meet the above criteria.
Mortgage financing is a very competitive field so you should check with at least 3 banks or mortgage companies. Rates move daily, so it’s preferable to call all three institutions on the same morning. I suggest that clients request a quote on “a 30-year fixed rate mortgage with no points, no prepayment penalty, and with the closing costs rolled in.”
Be aware that even with no points and no prepayment penalty, there will still be certain costs that you are expected to pay at the closing. The appraisal fee, for example, is an out-of-pocket cost to the lender. Property taxes also have to be paid as well as interest payable from the date you close to the beginning of the next month. Many people prefer that property tax and insurance costs be “escrowed” so that an amount is added to the monthly payment to pay for these costs as they come due.
Having your closing costs “rolled into the mortgage” means adding any costs that are normally due at closing to your mortgage balance. The cost of those will be covered by your monthly payment. You should ask each lender to email you a “good faith estimate” of the mortgage they propose. Then you can verify that the terms offered are those you requested and compare the closing costs.
The most common stumbling blocks encountered by clients are:
1. The house doesn’t appraise high enough. You can get your own appraiser to see if the bank’s appraisal is wrong, but they won’t accept it to lend you money. If it is under-appraised significantly you might apply at another lender and they will have it appraised again. While there can be wide variations in appraisals, there are no guarantees.
2. Unanticipated black marks appear on your credit score. You have to contact the credit bureau to correct these.
3. Your income is insufficient. This often happens to retirees who live on investment income. We have clients set up a monthly transfer from their investment account to their checking account for the same amount each month on the 1st of the month. If you do this for a couple of years, lenders will accept these transfers as a reliable stream of retirement income.
Don’t let lenders talk you into a shorter-term or adjustable rate mortgage, which can be more profitable to the mortgage institutions. Other mortgage options may seem attractive have a lower interest rate. But a 30-year mortgage has three huge advantages:
1. You receive the lowest payments so you have more cash flow. If you regularly invest this extra cash, preferably in a retirement account, you will earn more in a balanced portfolio than you will save in interest when compared to other mortgage options.
2. Since mortgage interest is tax deductible, a longer mortgage provides more tax shelter than shorter-term mortgages at a lower rate.
3. Most importantly, a 30-year fixed rate mortgage is your best protection against inflation. If interest rates stay stable for the next 30 years, your worst case is that you break even plus a bit more. But if interest rates drop, you just refinance and your monthly living expenses drop. If we have a return of high inflation (as occurred in the 1970’s) – you win! You have borrowed thousands of dollars at a low fixed rate, your money market rate increases to 8%, 10%, or even 15%, AND you get to repay with cheaper dollars!
Summary: Call three different mortgage companies on the same morning to ask for quotes (we can suggest a couple and your Credit Union may be a good source). Get a 30-year fixed rate mortgage with no points, no prepayment penalty, and have closing costs rolled into the mortgage. Have each institution email you a good faith estimate. Each estimate should show no closing costs paid out of your pocket, except to fund escrow. By comparing the monthly payments, you can easily determine which is the best deal.
By the way, if any of the offers sound too good to be true, then that likely is the case. But be sure to pay attention to any offers made by your current lender. They want to keep their customers happy…so you might find some excellent offers made by a relationship that is already in place!
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
The most popular client questions these days are about what kind of mortgage they should get. If you are somewhat knowledgeable about mortgages and just want the bottom line, you can skip to the last paragraph of this blog. If you are interested in a more detailed explanation, please continue reading.
Not only are mortgages more available now for new homes, but current mortgage holders can also find great opportunities to refinance at a lower rate. The federal government has just announced a new refinancing program for homeowners who are “under water” on their homes (i.e. they owe more on the house than it is worth). The last two similar programs never got much traction, and it is doubtful that the new program will bring serious relief to many people.
To get a new mortgage or refinance at the lowest rates you have to be able to show that you “qualify” for the mortgage. Here is a quick summary of the standards banks seek:
1. Clean credit record (FICO = 700+).
2. 80% loan-to-value (LTV). The mortgage should be less than 80% of the value of the home.
3. Currently employed.
4. Monthly payments on current debts (including mortgage) less than 40% of income.
There are some exceptions to these standards, e.g. if you replace a mortgage on your primary residence and you have always made the payments, some banks let you refinance 90-100% of the home’s value. But, in general, you won’t get the best rates available unless you meet the above criteria.
Mortgage financing is a very competitive field so you should check with at least 3 banks or mortgage companies. Rates move daily, so it’s preferable to call all three institutions on the same morning. I suggest that clients request a quote on “a 30-year fixed rate mortgage with no points, no prepayment penalty, and with the closing costs rolled in.”
Be aware that even with no points and no prepayment penalty, there will still be certain costs that you are expected to pay at the closing. The appraisal fee, for example, is an out-of-pocket cost to the lender. Property taxes also have to be paid as well as interest payable from the date you close to the beginning of the next month. Many people prefer that property tax and insurance costs be “escrowed” so that an amount is added to the monthly payment to pay for these costs as they come due.
Having your closing costs “rolled into the mortgage” means adding any costs that are normally due at closing to your mortgage balance. The cost of those will be covered by your monthly payment. You should ask each lender to email you a “good faith estimate” of the mortgage they propose. Then you can verify that the terms offered are those you requested and compare the closing costs.
The most common stumbling blocks encountered by clients are:
1. The house doesn’t appraise high enough. You can get your own appraiser to see if the bank’s appraisal is wrong, but they won’t accept it to lend you money. If it is under-appraised significantly you might apply at another lender and they will have it appraised again. While there can be wide variations in appraisals, there are no guarantees.
2. Unanticipated black marks appear on your credit score. You have to contact the credit bureau to correct these.
3. Your income is insufficient. This often happens to retirees who live on investment income. We have clients set up a monthly transfer from their investment account to their checking account for the same amount each month on the 1st of the month. If you do this for a couple of years, lenders will accept these transfers as a reliable stream of retirement income.
Don’t let lenders talk you into a shorter-term or adjustable rate mortgage, which can be more profitable to the mortgage institutions. Other mortgage options may seem attractive have a lower interest rate. But a 30-year mortgage has three huge advantages:
1. You receive the lowest payments so you have more cash flow. If you regularly invest this extra cash, preferably in a retirement account, you will earn more in a balanced portfolio than you will save in interest when compared to other mortgage options.
2. Since mortgage interest is tax deductible, a longer mortgage provides more tax shelter than shorter-term mortgages at a lower rate.
3. Most importantly, a 30-year fixed rate mortgage is your best protection against inflation. If interest rates stay stable for the next 30 years, your worst case is that you break even plus a bit more. But if interest rates drop, you just refinance and your monthly living expenses drop. If we have a return of high inflation (as occurred in the 1970’s) – you win! You have borrowed thousands of dollars at a low fixed rate, your money market rate increases to 8%, 10%, or even 15%, AND you get to repay with cheaper dollars!
Summary: Call three different mortgage companies on the same morning to ask for quotes (we can suggest a couple and your Credit Union may be a good source). Get a 30-year fixed rate mortgage with no points, no prepayment penalty, and have closing costs rolled into the mortgage. Have each institution email you a good faith estimate. Each estimate should show no closing costs paid out of your pocket, except to fund escrow. By comparing the monthly payments, you can easily determine which is the best deal.
By the way, if any of the offers sound too good to be true, then that likely is the case. But be sure to pay attention to any offers made by your current lender. They want to keep their customers happy…so you might find some excellent offers made by a relationship that is already in place!
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Thursday, October 6, 2011
What's the Worst Case?
By Bert Whitehead M.B.A, J.D. © 2011
Headlines scream doomsday to us: “The Dow is down 14%!” “Who can fix Europe?” “Even gold is crashing!” “Could the Dollar become worthless?”
I have been hearing concern from clients lately, especially since it looks like we are headed for a ‘double dip’ recession. Other than Treasury bonds, all other investment options --- from stocks to junk bonds to real estate --- look awful, except to those few among us who can stand the risk of buying into a downward spiraling market. And with the 30-year Treasury yielding less than 3%, forget about finding a safe haven. So what is the worst that could happen?
Right now there are few signs of near-term hope anywhere in the globe. Worldwide manufacturing is down, and even China is facing the possibility of explosive inflation and rising unemployment. Greece and other weak EU countries have imposed severe austerity programs, but still can’t balance their budgets. Understandably, their EU partners are more and more reluctant to lend them more money. While the US dollar is still the world’s reserve currency, it is universally acknowledged that our country is significantly less credit-worthy than anytime in the past 75 years.
While we complain about gridlock in our federal system, there is a wide chasm of disagreement among intelligent, reasonable people as to whether the right approach is strict austerity, or more stimulus. Even the ‘balanced’ proposals clearly lean sharply toward one side or the other.
Greece gives us a glimpse of the worst case. They avoided cutting their spending for decades and now the forced austerity measures require cutting pensions, reducing bloated government employment, and clamping down on welfare, etc. Greek citizens are spooked by large tax increases and concern that Greece will be expelled from the European Union. These extreme reactions are creating civil unrest including riots, attacks on banks and bank employees, strikes, and more backlash across the country.
Since Greeks don’t have enough Euros to sustain themselves, local alternative currencies (dubbed ‘TEM’ ) have sprouted. Basically this is a hybrid of a local currency and a barter system. Used most heavily in personal services, people are paid in TEMs for baby-sitting, computer support, language services, and they may receive discounts at some local stores. They sign up online for accounts that track their transactions using a data network firm. Since these local financial systems provide many social services, the government has given them encouragement and non-profit status.
Pensioners, unemployed people, and even children are now tending gardens to produce food to sell, opening bicycle repair shops, expanding open-air markets, etc. Individuals perform many social services that the state can’t pay for. In short, Greeks are able to create their own jobs and increase national productivity by tapping individual initiative. All of this is ‘under the table’ so taxing these transactions to support critical government services, like police and fire departments, has become a problem.
This approach has elements that appeal to both sides of the political spectrum. It bypasses the government, bank and corporate ‘establishment’, it is viewed as energy-efficient, and it mends the social network. On the other hand, it champions entrepreneurship, ducks government regulation, and is a primitive nursery for laissez-faire capitalism while promoting individual freedom. What’s not to like?
This system is likely to work more smoothly in small towns than in large cities despite the fact it carries the dangers of insufficient regulation (e.g., contaminated food, untrained doctors, etc). Furthermore, it does not provide capital necessary for investment in mass production, so in the long run many people would suffer a reduction in their standard of living (only 3 pairs of shoes, smaller variety of food choices, forced to use public transportation, etc.).
While playing out in Greece now, this scenario could spread to other countries that are on the brink of economic collapse.
The worst case in the US at this point is rising unemployment, lower wages, and a return to the discomforts our forefathers experienced during the Great Depression. This is far from likely. And while the dollar is not very desirable internationally, every other currency alternative is even less desirable.
The thing to remember is that, at the end of the day, your individual future is more likely to be affected by endogenous factors: the health of you and your family, your personal employment situation, and living within your means. Your real ‘worst case’ is to spend days fretting about what’s on TV or in doomsday newsletters, and then deciding to pursue some extreme reaction such as putting everything in gold, or putting the cash under the mattress.
This blog is intended to assure you that even in the worst case, the sun will rise tomorrow. It is unlikely that the dire consequences outlined above will occur, but the transition from where we are back to ‘happy days are here again!’ may be challenging for us. Nonetheless, what we do in our own lives is more important than whatever ‘they’ are doing.
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Headlines scream doomsday to us: “The Dow is down 14%!” “Who can fix Europe?” “Even gold is crashing!” “Could the Dollar become worthless?”
I have been hearing concern from clients lately, especially since it looks like we are headed for a ‘double dip’ recession. Other than Treasury bonds, all other investment options --- from stocks to junk bonds to real estate --- look awful, except to those few among us who can stand the risk of buying into a downward spiraling market. And with the 30-year Treasury yielding less than 3%, forget about finding a safe haven. So what is the worst that could happen?
Right now there are few signs of near-term hope anywhere in the globe. Worldwide manufacturing is down, and even China is facing the possibility of explosive inflation and rising unemployment. Greece and other weak EU countries have imposed severe austerity programs, but still can’t balance their budgets. Understandably, their EU partners are more and more reluctant to lend them more money. While the US dollar is still the world’s reserve currency, it is universally acknowledged that our country is significantly less credit-worthy than anytime in the past 75 years.
While we complain about gridlock in our federal system, there is a wide chasm of disagreement among intelligent, reasonable people as to whether the right approach is strict austerity, or more stimulus. Even the ‘balanced’ proposals clearly lean sharply toward one side or the other.
Greece gives us a glimpse of the worst case. They avoided cutting their spending for decades and now the forced austerity measures require cutting pensions, reducing bloated government employment, and clamping down on welfare, etc. Greek citizens are spooked by large tax increases and concern that Greece will be expelled from the European Union. These extreme reactions are creating civil unrest including riots, attacks on banks and bank employees, strikes, and more backlash across the country.
Since Greeks don’t have enough Euros to sustain themselves, local alternative currencies (dubbed ‘TEM’ ) have sprouted. Basically this is a hybrid of a local currency and a barter system. Used most heavily in personal services, people are paid in TEMs for baby-sitting, computer support, language services, and they may receive discounts at some local stores. They sign up online for accounts that track their transactions using a data network firm. Since these local financial systems provide many social services, the government has given them encouragement and non-profit status.
Pensioners, unemployed people, and even children are now tending gardens to produce food to sell, opening bicycle repair shops, expanding open-air markets, etc. Individuals perform many social services that the state can’t pay for. In short, Greeks are able to create their own jobs and increase national productivity by tapping individual initiative. All of this is ‘under the table’ so taxing these transactions to support critical government services, like police and fire departments, has become a problem.
This approach has elements that appeal to both sides of the political spectrum. It bypasses the government, bank and corporate ‘establishment’, it is viewed as energy-efficient, and it mends the social network. On the other hand, it champions entrepreneurship, ducks government regulation, and is a primitive nursery for laissez-faire capitalism while promoting individual freedom. What’s not to like?
This system is likely to work more smoothly in small towns than in large cities despite the fact it carries the dangers of insufficient regulation (e.g., contaminated food, untrained doctors, etc). Furthermore, it does not provide capital necessary for investment in mass production, so in the long run many people would suffer a reduction in their standard of living (only 3 pairs of shoes, smaller variety of food choices, forced to use public transportation, etc.).
While playing out in Greece now, this scenario could spread to other countries that are on the brink of economic collapse.
The worst case in the US at this point is rising unemployment, lower wages, and a return to the discomforts our forefathers experienced during the Great Depression. This is far from likely. And while the dollar is not very desirable internationally, every other currency alternative is even less desirable.
The thing to remember is that, at the end of the day, your individual future is more likely to be affected by endogenous factors: the health of you and your family, your personal employment situation, and living within your means. Your real ‘worst case’ is to spend days fretting about what’s on TV or in doomsday newsletters, and then deciding to pursue some extreme reaction such as putting everything in gold, or putting the cash under the mattress.
This blog is intended to assure you that even in the worst case, the sun will rise tomorrow. It is unlikely that the dire consequences outlined above will occur, but the transition from where we are back to ‘happy days are here again!’ may be challenging for us. Nonetheless, what we do in our own lives is more important than whatever ‘they’ are doing.
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Monday, September 12, 2011
Why Not China?
By Bert Whitehead M.B.A, J.D. © 2011
With virtually all investment options so sour these days, clients are increasingly interested in the opportunities offered by investing in China. The stock market is totally unpredictable and, for many people, downright scary. Interest earned on savings accounts at banks is next to nothing, and now banks actually charge fees to large cash depositors (like corporations) for just accepting deposits. U.S. Bond returns are the lowest in history, making junk bonds tempting even though they yield less than Treasuries did 10 years ago.
So China’s economy seems like the bright spot in an otherwise bleak investment landscape. The People's Republic of China (PRC) has ranked as the world's second largest economy after the United States since 2010. It is one of the world's fastest-growing major economies, with consistent growth rates of 5% - 15% over the past 30 years. Many investors believe that the Chinese economy is poised for continuing growth, even in the face of economic downturns in other parts of the world.
However, there are some serious dangers that cannot be ignored when you consider investing in China. The principal dangers are debt and inflation. Keep in mind that the ‘Cultural Revolution’ ended 30 years ago and the recent 30 years of growth started from a very low base. Since then, China has become the largest exporter to the world (as well as the largest importer). To accomplish this China lent massive amounts to its cities and provinces for huge infrastructure development. Many of these projects have not worked out as expected, e.g. the bullet train project recently derailed. A notable cause of these problems is the rampant corruption in Chinese government.
Although China’s large low-paid labor pool is a huge advantage, government spending has also created very high rates of inflation. Inflation rates have been running at 6.5% nationally but reach 20-25% in urban areas. As a result, Chinese workers have been on strike in major industries, often forcing wage increases of 50-100%. That caused labor intensive industries to begin moving out of China to lower cost countries like Vietnam, Indonesia, and Malaysia.
From an investment point of view, China does not offer any of the market disciplines and infrastructure offered in developed countries. It is difficult to be sure that the stock you bought is actually registered in your name. And a dictatorial government can nationalize and seize ownership of companies and whole industries at the whim of the ruling class.
Socially, China’s ‘one child’ policy is now coming back to haunt them. Over the past 30 years over 400,000,000 girls have not been born, often through selective abortion. This is more than the entire U.S. population. As a result there are now 118 men for every 100 women. This imbalanced sex ratio can be a social scourge, which forces the government to rein in the excess testosterone. Societies with a high male sex ratio have historically been prone to war, and often exhibit leadership by severe autocratic rulers (such as in the Middle East where polygamy is the rule for the most powerful). China’s demographic projections likewise are dismal. Current population distortions make it a near-certainty that in the next 30-40 years, four younger workers will be required to support each person over 65.
While concerns have been raised about China’s military prowess, particularly its ‘Million Man Army” (which is now actually 2.8 million), these fears are unfounded. The Chinese are than woefully unprepared for their own defense, much less aggression. They spend less than 2% of their budget on defense. More importantly, there is not a single officer (or enlisted person) in the huge Chinese army who has any experience whatsoever in battle. China’s last battle with a worthy opponent was 60 years ago when it was allied with North Korea.
China will pay a steep environmental price for trying to sustain its growth. Like all Communist countries, economic progress trumps their environmental concerns. Their garbage problem is totally unmanageable, the air is hopelessly polluted, and the water in most rivers and streams is virtually toxic. China’s primary competition is probably India, which also has over one billion people. India’s growth rate has been more restrained, and it has a better democratic foundation despite the problems peculiar to its society. Interestingly, India has the largest population of English speaking people in the world (over 500,000,000)! India also attracts much more Research and Development employment due to its advantage in education. Over the past 10 years U.S. companies have switched to investing in India rather than China due to the Chinese government’s overbearing demands that they be privy to US trade secrets.
All in all, investing in China is far from a sure thing. It may provide higher returns in the short term but remember that there is always a tradeoff between risk and return. Don’t overlook that your potentially high returns exist because China is one of the riskiest major country in which to do business. To my mind, its much-reported progress has the sound of another bubble getting ready to burst.
Investing in today’s environment is challenging, particularly because there are so many economic variables. The Mideastern societies are being reshaped, the European Union is teetering on the edge of insolvency, and many countries including Japan and Mexico are dealing with unprecedented turmoil. It is tempting to reach out for some arcane investment strategy like currency trading just because the alternatives are so unsatisfactory.
In this situation, Ockham’s Razor suggests that when there are many competing variables, the simplest course of action is generally the correct one. This would suggest that with current economic variables in the investment arena the most correct approach is simply maintaining a balanced and diversified portfolio. It can be foolhardy to take rash action in these times and try to ‘hit a home run’ to salvage your portfolio by putting everything in gold, burying it in the back yard, or buying Chinese Yuan. As Warren Buffet has noted: “Investors have lost more money chasing high yield than at the point of a gun!”
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY
With virtually all investment options so sour these days, clients are increasingly interested in the opportunities offered by investing in China. The stock market is totally unpredictable and, for many people, downright scary. Interest earned on savings accounts at banks is next to nothing, and now banks actually charge fees to large cash depositors (like corporations) for just accepting deposits. U.S. Bond returns are the lowest in history, making junk bonds tempting even though they yield less than Treasuries did 10 years ago.
So China’s economy seems like the bright spot in an otherwise bleak investment landscape. The People's Republic of China (PRC) has ranked as the world's second largest economy after the United States since 2010. It is one of the world's fastest-growing major economies, with consistent growth rates of 5% - 15% over the past 30 years. Many investors believe that the Chinese economy is poised for continuing growth, even in the face of economic downturns in other parts of the world.
However, there are some serious dangers that cannot be ignored when you consider investing in China. The principal dangers are debt and inflation. Keep in mind that the ‘Cultural Revolution’ ended 30 years ago and the recent 30 years of growth started from a very low base. Since then, China has become the largest exporter to the world (as well as the largest importer). To accomplish this China lent massive amounts to its cities and provinces for huge infrastructure development. Many of these projects have not worked out as expected, e.g. the bullet train project recently derailed. A notable cause of these problems is the rampant corruption in Chinese government.
Although China’s large low-paid labor pool is a huge advantage, government spending has also created very high rates of inflation. Inflation rates have been running at 6.5% nationally but reach 20-25% in urban areas. As a result, Chinese workers have been on strike in major industries, often forcing wage increases of 50-100%. That caused labor intensive industries to begin moving out of China to lower cost countries like Vietnam, Indonesia, and Malaysia.
From an investment point of view, China does not offer any of the market disciplines and infrastructure offered in developed countries. It is difficult to be sure that the stock you bought is actually registered in your name. And a dictatorial government can nationalize and seize ownership of companies and whole industries at the whim of the ruling class.
Socially, China’s ‘one child’ policy is now coming back to haunt them. Over the past 30 years over 400,000,000 girls have not been born, often through selective abortion. This is more than the entire U.S. population. As a result there are now 118 men for every 100 women. This imbalanced sex ratio can be a social scourge, which forces the government to rein in the excess testosterone. Societies with a high male sex ratio have historically been prone to war, and often exhibit leadership by severe autocratic rulers (such as in the Middle East where polygamy is the rule for the most powerful). China’s demographic projections likewise are dismal. Current population distortions make it a near-certainty that in the next 30-40 years, four younger workers will be required to support each person over 65.
While concerns have been raised about China’s military prowess, particularly its ‘Million Man Army” (which is now actually 2.8 million), these fears are unfounded. The Chinese are than woefully unprepared for their own defense, much less aggression. They spend less than 2% of their budget on defense. More importantly, there is not a single officer (or enlisted person) in the huge Chinese army who has any experience whatsoever in battle. China’s last battle with a worthy opponent was 60 years ago when it was allied with North Korea.
China will pay a steep environmental price for trying to sustain its growth. Like all Communist countries, economic progress trumps their environmental concerns. Their garbage problem is totally unmanageable, the air is hopelessly polluted, and the water in most rivers and streams is virtually toxic. China’s primary competition is probably India, which also has over one billion people. India’s growth rate has been more restrained, and it has a better democratic foundation despite the problems peculiar to its society. Interestingly, India has the largest population of English speaking people in the world (over 500,000,000)! India also attracts much more Research and Development employment due to its advantage in education. Over the past 10 years U.S. companies have switched to investing in India rather than China due to the Chinese government’s overbearing demands that they be privy to US trade secrets.
All in all, investing in China is far from a sure thing. It may provide higher returns in the short term but remember that there is always a tradeoff between risk and return. Don’t overlook that your potentially high returns exist because China is one of the riskiest major country in which to do business. To my mind, its much-reported progress has the sound of another bubble getting ready to burst.
Investing in today’s environment is challenging, particularly because there are so many economic variables. The Mideastern societies are being reshaped, the European Union is teetering on the edge of insolvency, and many countries including Japan and Mexico are dealing with unprecedented turmoil. It is tempting to reach out for some arcane investment strategy like currency trading just because the alternatives are so unsatisfactory.
In this situation, Ockham’s Razor suggests that when there are many competing variables, the simplest course of action is generally the correct one. This would suggest that with current economic variables in the investment arena the most correct approach is simply maintaining a balanced and diversified portfolio. It can be foolhardy to take rash action in these times and try to ‘hit a home run’ to salvage your portfolio by putting everything in gold, burying it in the back yard, or buying Chinese Yuan. As Warren Buffet has noted: “Investors have lost more money chasing high yield than at the point of a gun!”
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY
Friday, August 5, 2011
Smart Moves vs. Stupid Moves
By Bert Whitehead, M.B.A., J.D.
Financial chaos is so annoying. We are going along, wary but hopeful, and suddenly everything in the financial arena comes crashing down. The stock market drops 500+ points, the Euro tumbles, oil gets hit hard, and even gold is dropping. What are you going to do?
What Smart People are Doing: Really smart people aren’t doing anything right now; their portfolios are already prepared for this possibility. This may be hard to believe, but the only investment going up is U.S. Treasuries! Smart people (who of course include all of our ‘compliant clients’) have solid bond ladders, particularly if they are retired. This is the bedrock of safety which is the result of long-term, patient financial planning. If we slide into long-term deflation, this is your only safe haven.
Smart people are also dollar-cost-averaging into the stock market. Especially for younger people, this is the time to be buying stocks on a regular basis – not trying to time the ups and the downs. Looking back 20 years from now, it will be clear that this was your opportunity to be building an enjoyable retirement. For retired people it is important to keep a balance between bonds and stocks so that your bond ladder can be replenished when the economy comes up for air. Stocks are your assurance of long-term prosperity. Over time the stock market will continue to go up as long as we can maintain our productive and innovative heritage to compete in world markets.
Smiling people have a healthy mortgage on their house, on which they can comfortably make their regular payments. If there is enough equity, it is time to check on refinancing since mortgage rates are falling. When you refinance, you essentially cut your cost of living. Now is not the time to pull more money out, or pay off part of your mortgage if your appraisal comes in too low.
Stupid Moves People Do: Selling all your stocks in a panic, or because you think you can time the market. If you have already done this, now you have to decide when to buy back into the market – so you will have had to make two decisions right to come out ahead! The result usually is that market-timers become obsessed with the market which is a waste of time and produces needless anxiety for no long-term gain.
People who don’t have enough liquidity (i.e. cash) can easily be wiped out if hit with personal setbacks (illness, lay-off, etc.). It is also dysfunctional to hold on to too much cash, frozen by fear of loss if it is invested. You’re not making any progress if you have been sitting on excess cash earning 0.25% for the last couple of years. You would be much better off having bought long-term Treasury bonds 2-3 years ago with a fixed rate of 3.5%-4.0%. Even though those rates seemed ridiculously low then, you would have been much better off now, and this condition may well continue for a few years.
Having a home all paid off is psychologically appealing to people, especially when times get bad. It is counter-intuitive, but it is imperative now to protect yourself against future inflation which eventually will come roaring back! A 30 year fixed rate mortgage is your best protection against inflation. It will also give you additional cash for liquidity, to build your bond ladder, and to start or increase dollar-cost-averaging into today’s market, where all the stocks are on sale!
ACTION ITEMS: Contact your ACA fee-only financial advisor to:
• Make sure you have adequate liquidity
• Start/increase your bond ladder
• Start/increase dollar cost averaging into the stock market
• Get a mortgage on your home (yes, the interest can be deductible if you use it for investments!) or check into refinancing.
In my last blog, I correctly noted that the debt-ceiling fiasco panic would likely be the Y2K non-event panic of this decade. The outcome of this controversy, however, highlighted the severe problems in our national economy. We seem to be sucked into a vortex of malaise, as Jimmy Carter called it, with employment and housing stuck in a inexorable downslide. The government’s application of Keynesian tactics has reached the point of miniscule marginal utility.
This financial reaction is reflective of a genuine concern on Wall Street about the increase in overspending in the past couple of years. The federal government is borrowing 40 cents of every $1.00 it spends. The economic collapse and impending defaults in many over-spending European countries may foreshadow our own fate. It is politically debatable as to the cause of the widespread lack of confidence, and economic imbalances have a way of being self-correcting in the long run, but the US probably deserves to have it’s credit rating downgraded.
The lesson to be learned here is our own challenge. We can’t do anything about the national economy; it is our job to get our own house in order. Households cannot spend more than they earn. Your future depends on your saving 10% of your income and keeping a balanced and diversified portfolio, not on whatever the economic commentators argue about.
I am convinced that the contribution of professional financial advisors to our clients lies not in feverishly buying and selling securities, but helping clients do smart things in their own lives, and helping them avoid doing stupid things.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY and my partner Pamela Landy, M.B.A., J.D., C.F.P.
Financial chaos is so annoying. We are going along, wary but hopeful, and suddenly everything in the financial arena comes crashing down. The stock market drops 500+ points, the Euro tumbles, oil gets hit hard, and even gold is dropping. What are you going to do?
What Smart People are Doing: Really smart people aren’t doing anything right now; their portfolios are already prepared for this possibility. This may be hard to believe, but the only investment going up is U.S. Treasuries! Smart people (who of course include all of our ‘compliant clients’) have solid bond ladders, particularly if they are retired. This is the bedrock of safety which is the result of long-term, patient financial planning. If we slide into long-term deflation, this is your only safe haven.
Smart people are also dollar-cost-averaging into the stock market. Especially for younger people, this is the time to be buying stocks on a regular basis – not trying to time the ups and the downs. Looking back 20 years from now, it will be clear that this was your opportunity to be building an enjoyable retirement. For retired people it is important to keep a balance between bonds and stocks so that your bond ladder can be replenished when the economy comes up for air. Stocks are your assurance of long-term prosperity. Over time the stock market will continue to go up as long as we can maintain our productive and innovative heritage to compete in world markets.
Smiling people have a healthy mortgage on their house, on which they can comfortably make their regular payments. If there is enough equity, it is time to check on refinancing since mortgage rates are falling. When you refinance, you essentially cut your cost of living. Now is not the time to pull more money out, or pay off part of your mortgage if your appraisal comes in too low.
Stupid Moves People Do: Selling all your stocks in a panic, or because you think you can time the market. If you have already done this, now you have to decide when to buy back into the market – so you will have had to make two decisions right to come out ahead! The result usually is that market-timers become obsessed with the market which is a waste of time and produces needless anxiety for no long-term gain.
People who don’t have enough liquidity (i.e. cash) can easily be wiped out if hit with personal setbacks (illness, lay-off, etc.). It is also dysfunctional to hold on to too much cash, frozen by fear of loss if it is invested. You’re not making any progress if you have been sitting on excess cash earning 0.25% for the last couple of years. You would be much better off having bought long-term Treasury bonds 2-3 years ago with a fixed rate of 3.5%-4.0%. Even though those rates seemed ridiculously low then, you would have been much better off now, and this condition may well continue for a few years.
Having a home all paid off is psychologically appealing to people, especially when times get bad. It is counter-intuitive, but it is imperative now to protect yourself against future inflation which eventually will come roaring back! A 30 year fixed rate mortgage is your best protection against inflation. It will also give you additional cash for liquidity, to build your bond ladder, and to start or increase dollar-cost-averaging into today’s market, where all the stocks are on sale!
ACTION ITEMS: Contact your ACA fee-only financial advisor to:
• Make sure you have adequate liquidity
• Start/increase your bond ladder
• Start/increase dollar cost averaging into the stock market
• Get a mortgage on your home (yes, the interest can be deductible if you use it for investments!) or check into refinancing.
In my last blog, I correctly noted that the debt-ceiling fiasco panic would likely be the Y2K non-event panic of this decade. The outcome of this controversy, however, highlighted the severe problems in our national economy. We seem to be sucked into a vortex of malaise, as Jimmy Carter called it, with employment and housing stuck in a inexorable downslide. The government’s application of Keynesian tactics has reached the point of miniscule marginal utility.
This financial reaction is reflective of a genuine concern on Wall Street about the increase in overspending in the past couple of years. The federal government is borrowing 40 cents of every $1.00 it spends. The economic collapse and impending defaults in many over-spending European countries may foreshadow our own fate. It is politically debatable as to the cause of the widespread lack of confidence, and economic imbalances have a way of being self-correcting in the long run, but the US probably deserves to have it’s credit rating downgraded.
The lesson to be learned here is our own challenge. We can’t do anything about the national economy; it is our job to get our own house in order. Households cannot spend more than they earn. Your future depends on your saving 10% of your income and keeping a balanced and diversified portfolio, not on whatever the economic commentators argue about.
I am convinced that the contribution of professional financial advisors to our clients lies not in feverishly buying and selling securities, but helping clients do smart things in their own lives, and helping them avoid doing stupid things.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY and my partner Pamela Landy, M.B.A., J.D., C.F.P.
Friday, July 22, 2011
The Debt Ceiling Fiasco
By Bert Whitehead, M.B.A., J.D.
Politicians are commanding center stage as they debate the best way to keep the country from defaulting on our debt, and how to change the government’s finances to control the deficit. The play-by-play progress (or lack thereof) is amplified by the media. This leaves financial commentators foisting their favorite last chance investment strategies for people to avoid the worst case dreaded outcome.
The investing public is understandably alarmed and confused by these developments. We get questions from clients who have started thinking they should sell all their investments and put everything in cash. Others seriously ask if they should switch most of their investments to gold. Some are wondering if they can realistically plan on retiring when they planned.
I would like to suggest that this has been blown out of proportion. It is a perfect opportunity for the media to sell more newspapers and attract more viewers. Just like the Casey Anthony debacle, the media is impelled to fan the flames of this story, running interviews, cameo performances by ‘experts,’ and endless repetition of every piece of the story ad nauseam.
Of course this is an extraordinary opportunity for politicians to parade their platforms and get their faces on TV and on page one. Suddenly talk show hosts, movie stars, as well as professors have an opportunity to explain economics to the masses.
This issue is much ado about nothing. Those who want to raise taxes, at least a little bit, want to use this to further their agenda. Others insist this isn’t a revenue problem, but rather is a spending problem – they insist on pure spending cuts. Every vested interest wants to protect their turf, whether it is their cherished entitlements or their industry’s tax loopholes.
At the end of the day, everyone knows that default would be self-sabotage for our economy. What will happen is this: when we are near the precipice, there will be some sort of compromise which will enable all sides to take credit, and then this will be forgotten just as past games of deficit brinkmanship have become forgotten asterisks of the past.
Yes, the market will bounce up and down as market timers try to grab an advantage. The president and congress will likely kick the can down the road for awhile more to milk this panic for all they can. But in the end they will come to some resolution which will satisfy no one, but which everyone will take credit for.
I advise my clients to keep focused on their own business, and the endogenous issues that actually have an impact on their lives. None of us can do anything about the debt ceiling fiasco. The best thing we can do for our peace of mind is simply to stop watching the news on TV.
Politicians are commanding center stage as they debate the best way to keep the country from defaulting on our debt, and how to change the government’s finances to control the deficit. The play-by-play progress (or lack thereof) is amplified by the media. This leaves financial commentators foisting their favorite last chance investment strategies for people to avoid the worst case dreaded outcome.
The investing public is understandably alarmed and confused by these developments. We get questions from clients who have started thinking they should sell all their investments and put everything in cash. Others seriously ask if they should switch most of their investments to gold. Some are wondering if they can realistically plan on retiring when they planned.
I would like to suggest that this has been blown out of proportion. It is a perfect opportunity for the media to sell more newspapers and attract more viewers. Just like the Casey Anthony debacle, the media is impelled to fan the flames of this story, running interviews, cameo performances by ‘experts,’ and endless repetition of every piece of the story ad nauseam.
Of course this is an extraordinary opportunity for politicians to parade their platforms and get their faces on TV and on page one. Suddenly talk show hosts, movie stars, as well as professors have an opportunity to explain economics to the masses.
This issue is much ado about nothing. Those who want to raise taxes, at least a little bit, want to use this to further their agenda. Others insist this isn’t a revenue problem, but rather is a spending problem – they insist on pure spending cuts. Every vested interest wants to protect their turf, whether it is their cherished entitlements or their industry’s tax loopholes.
At the end of the day, everyone knows that default would be self-sabotage for our economy. What will happen is this: when we are near the precipice, there will be some sort of compromise which will enable all sides to take credit, and then this will be forgotten just as past games of deficit brinkmanship have become forgotten asterisks of the past.
Yes, the market will bounce up and down as market timers try to grab an advantage. The president and congress will likely kick the can down the road for awhile more to milk this panic for all they can. But in the end they will come to some resolution which will satisfy no one, but which everyone will take credit for.
I advise my clients to keep focused on their own business, and the endogenous issues that actually have an impact on their lives. None of us can do anything about the debt ceiling fiasco. The best thing we can do for our peace of mind is simply to stop watching the news on TV.
Friday, June 10, 2011
Long-Term Treasuries vs. Inflation
By Bert Whitehead, M.B.A, J.D. © 2011
The federal government has been grappling with ballooning debt as the cost of government programs and entitlements outstrip tax revenue. Politics will ultimately determine whether to cut spending, increase taxes (or both) to solve the problem. This blog is not political commentary, but rather a response to the media’s concern about how these deficits, and the corresponding debt increases, will impact the financial markets.
Will U.S. Treasury Bonds become worthless?
Historically, the danger of not backing paper money with gold or silver is that governments will spend more than they can afford to repay over the long term. To cover the accumulating debt, the easy solution is to print more money to pay back borrowers. But the result is that the currency becomes inflated and prices rise as the value of the currency shrinks – the result of too many dollars chasing too few goods. The most recent global example of this took place in Zimbabwe, which ended up printing $100,000,000,000,000 bills (that’s 100 trillion dollars) that would buy about $5 worth of goods in US dollars.
History is replete with examples of countries that inflated their currency to the point that citizens insisted on being paid with gold, another country’s money, or else they resorted to bartering. This included the notorious Weimar Republic in Germany after World War I, as well as most South American countries (called “banana republics” because they used locally produced bananas to settle their debts). Even in the U.S. there have been four instances in which the government suspended backing of the US dollar. This resulted in financial panics, probably aggravated the Great Depression, and triggered ‘stagflation’ in the 1970’s.
As dismal as this background is, there is no attractive alternative. The US dollar is well entrenched as the world reserve currency. China and other foreign countries are owed more than half the US debt. But they can’t dump it on the White House lawn and insist on gold…dollars are not backed by gold. They can sell dollars and buy Euros, or Yen, or British Pounds, but those currencies are as bad as the US dollar. The Swiss Franc and currencies of other fiscally conservative countries are not ‘deep’ enough, i.e. not available in sufficient quantities to support world commerce.
How do you protect yourself from inflation?
Many countries (including the US) have significant stores of gold, and this reserve is attractive to many citizens. But now that gold shares can be bought and sold on stock exchanges, buyers don’t have to take actual delivery of the gold. As a result, the price of gold has become very volatile and is probably in a bubble now as speculators trade gold frenetically. I should note that inflation was not offset by the stock market in the 1970’s and the price of gold was basically flat for the 20 years from 1980 to 2000 while inflation increased over 100%.
There is some protection against the falling dollar when you buy mutual funds that invest in international stocks and do not hedge the dollar. We have used this approach for many years to temper the impact of the dollar’s devaluation. As we increase our participation in the global economy, currencies of other countries (many of which are backed by dollars) have tended to track the dollar’s value.
Interestingly, real estate has historically been considered an inflation hedge, but current worldwide prices are either very depressed (as in the US) or have wildly increased (e.g. Canada).
The absolutely best protection against inflation is to have a long-term mortgage at a fixed rate on your home. Many people flinch at the thought, but it is a huge advantage to owe a couple hundred thousand dollars at 5% fixed for 30 years if we see inflation mushroom over the next 5-10 years. Not only will your money market rates increase to 7-10% on money that is costing you 5%, but you are also repaying the mortgage with cheaper money.
The beauty of a long term fixed mortgage is that, if interest rates go down, you can just refinance and reduce your monthly living costs (which protects you from deflation). The worst-case scenario with a mortgage is when interest rates stay the same. Even then, on an after-tax basis, your return is about the same as your cost so it is a breakeven.
Now back to those Treasuries: the trading value of all bonds, including Treasuries, varies inversely with interest rates. So the market value drops when interest rates go up. Interest rates can rise very rapidly during times of inflation. However, we recommend that clients hold Treasuries to assure cash flow in later years, not to maximize yield. My mantra when it comes to bonds is: “Safety Trumps Yield!” Holding on to long-term Treasuries in a balanced portfolio protects you against deflation…which is still a significant danger. Regardless of short-term price moves, hold a Treasury until maturity and you will get your money back, including accrued interest. Your investment is insulated against inflation.
Holding cash in money markets will usually stay even with inflation, since the increase in interest rates will offset inflation. The worst mistake is to try to ‘chase yield’ by always seeking bonds with a higher rate. As Warren Buffet once commented: “People have lost more money chasing yield than they have at the point of a gun…”
At ACA, we use the principles of Functional Asset Allocation and design your portfolio to protect you during times of inflation (using cash and a long-term mortgage on your home). We maintain properly diversified stocks so that you will gain during times of prosperity. And we still recommend that you hold long-term Treasuries to protect you against deflation and assure cash flow during retirement.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
The federal government has been grappling with ballooning debt as the cost of government programs and entitlements outstrip tax revenue. Politics will ultimately determine whether to cut spending, increase taxes (or both) to solve the problem. This blog is not political commentary, but rather a response to the media’s concern about how these deficits, and the corresponding debt increases, will impact the financial markets.
Will U.S. Treasury Bonds become worthless?
Historically, the danger of not backing paper money with gold or silver is that governments will spend more than they can afford to repay over the long term. To cover the accumulating debt, the easy solution is to print more money to pay back borrowers. But the result is that the currency becomes inflated and prices rise as the value of the currency shrinks – the result of too many dollars chasing too few goods. The most recent global example of this took place in Zimbabwe, which ended up printing $100,000,000,000,000 bills (that’s 100 trillion dollars) that would buy about $5 worth of goods in US dollars.
History is replete with examples of countries that inflated their currency to the point that citizens insisted on being paid with gold, another country’s money, or else they resorted to bartering. This included the notorious Weimar Republic in Germany after World War I, as well as most South American countries (called “banana republics” because they used locally produced bananas to settle their debts). Even in the U.S. there have been four instances in which the government suspended backing of the US dollar. This resulted in financial panics, probably aggravated the Great Depression, and triggered ‘stagflation’ in the 1970’s.
As dismal as this background is, there is no attractive alternative. The US dollar is well entrenched as the world reserve currency. China and other foreign countries are owed more than half the US debt. But they can’t dump it on the White House lawn and insist on gold…dollars are not backed by gold. They can sell dollars and buy Euros, or Yen, or British Pounds, but those currencies are as bad as the US dollar. The Swiss Franc and currencies of other fiscally conservative countries are not ‘deep’ enough, i.e. not available in sufficient quantities to support world commerce.
How do you protect yourself from inflation?
Many countries (including the US) have significant stores of gold, and this reserve is attractive to many citizens. But now that gold shares can be bought and sold on stock exchanges, buyers don’t have to take actual delivery of the gold. As a result, the price of gold has become very volatile and is probably in a bubble now as speculators trade gold frenetically. I should note that inflation was not offset by the stock market in the 1970’s and the price of gold was basically flat for the 20 years from 1980 to 2000 while inflation increased over 100%.
There is some protection against the falling dollar when you buy mutual funds that invest in international stocks and do not hedge the dollar. We have used this approach for many years to temper the impact of the dollar’s devaluation. As we increase our participation in the global economy, currencies of other countries (many of which are backed by dollars) have tended to track the dollar’s value.
Interestingly, real estate has historically been considered an inflation hedge, but current worldwide prices are either very depressed (as in the US) or have wildly increased (e.g. Canada).
The absolutely best protection against inflation is to have a long-term mortgage at a fixed rate on your home. Many people flinch at the thought, but it is a huge advantage to owe a couple hundred thousand dollars at 5% fixed for 30 years if we see inflation mushroom over the next 5-10 years. Not only will your money market rates increase to 7-10% on money that is costing you 5%, but you are also repaying the mortgage with cheaper money.
The beauty of a long term fixed mortgage is that, if interest rates go down, you can just refinance and reduce your monthly living costs (which protects you from deflation). The worst-case scenario with a mortgage is when interest rates stay the same. Even then, on an after-tax basis, your return is about the same as your cost so it is a breakeven.
Now back to those Treasuries: the trading value of all bonds, including Treasuries, varies inversely with interest rates. So the market value drops when interest rates go up. Interest rates can rise very rapidly during times of inflation. However, we recommend that clients hold Treasuries to assure cash flow in later years, not to maximize yield. My mantra when it comes to bonds is: “Safety Trumps Yield!” Holding on to long-term Treasuries in a balanced portfolio protects you against deflation…which is still a significant danger. Regardless of short-term price moves, hold a Treasury until maturity and you will get your money back, including accrued interest. Your investment is insulated against inflation.
Holding cash in money markets will usually stay even with inflation, since the increase in interest rates will offset inflation. The worst mistake is to try to ‘chase yield’ by always seeking bonds with a higher rate. As Warren Buffet once commented: “People have lost more money chasing yield than they have at the point of a gun…”
At ACA, we use the principles of Functional Asset Allocation and design your portfolio to protect you during times of inflation (using cash and a long-term mortgage on your home). We maintain properly diversified stocks so that you will gain during times of prosperity. And we still recommend that you hold long-term Treasuries to protect you against deflation and assure cash flow during retirement.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
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