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.
Friday, July 22, 2011
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.
Tuesday, May 24, 2011
Financial Advisors vs. Money Managers
By: Bert Whitehead, M.B.A., J.D. Copyright 2011
Recently an ACA member’s client emailed me to comment that we were being paid to manage assets – stocks, bonds, real estate, etc. - and that I should be suggesting some opportunities to help increase his portfolio during these exciting times. This is a widespread attitude among clients, and I think it is a fair comment and merits addressing.
There is a significant difference between ‘Money Managers’ (or ‘Investment Advisors’) and ‘Financial Advisors’ (or ‘Financial Planners’). Money Managers generally charge based on the size of a client’s portfolio, i.e. assets under management (AUM). They claim to add value by finding ‘opportunities’ for clients and timing the market. Some claim they also advise clients on insurance, estate planning, taxes, etc., but they generally are not adequately trained in these areas. Moreover, people generally do what they are paid to do, and if they are paid based on AUM, they focus on gathering assets and new, exciting investments.
Financial Advisors take a much more comprehensive approach. We are trained and credentialed to coordinate all of the financial aspects of a client’s life, with a focus on meeting their life goals. Certainly investments are an important part of this, and our job is to recommend and monitor suitable Money Managers for clients. To do this we use the principles of “Functional Asset Allocation” (FAA) and eschew the ‘carnival barker’s’ approach of touting the ‘next hot stock’, or the next investment “frontier”, or other market timing approaches.
Many new advisors start out with the belief that they can add value by selecting investments. I’ve been at this for 39 years, and when I started out I tried to convince clients that I could add value by my superior investment knowledge. I managed portfolios of covered options, came up with strategies using fundamental principles for building portfolios, used technical analyses to determine when clients should switch asset classes, etc.
In my early career, I did beat the market a couple of years in a row…and then I got whipsawed and was grateful to be able to get my clients’ funds out while they were still ahead. Given that there are thousands of professional investors in the market, the theory of large numbers will always produce some who consistently beat the market year after year.
Indeed, Peter Lynch managed Fidelity Magellan for 13 years and reportedly beat the S&P for 11 of those for an average 29% annual return. The smartest thing he ever did was to quit while he was ahead. His successors used his same formulae and strategies and have underperformed the market ever since.
(It’s also worthwhile to note that during those years the S&P index was the highest performing general index for only one year. For four of the 11 years the small cap index dominated, international stocks won in 5 of those years, and bonds won out the other 3 times.)
Interestingly, most ‘financial advisors’ are really ‘investment managers.’ Their proposition is basically: “Give me your money and I’ll make you rich!” When I look up and down the street, from small financial firms to large wire-houses, they all make the exact same claim: “We’re smarter! We know how to beat the market!” As a matter of fact, most newer advisors, as well as day-traders, stockbrokers and insurance sales people, ultimately pin their success on their ability to convince themselves and their clients that they can produce superior results.
At some point we have to realize that we don’t live in Lake Woebegone, where all the children are above average. Every investment guru in the phone book can’t be beating the market at the same time unless they have a Madoff scheme.
I happened to visit Wall Street during Lynch’s era and saw the office buildings filled with people and computers. They spent most of their working lives trying to figure out the best investments. How would I ever be able to outsmart them? When I researched this more closely, I was struck by the fact that the S&P index outperforms 85% of large cap money managers!
When I delved into managers who claimed to beat the market and carefully analyzed their performance, I noticed that their success was based on fudging the indexes or benchmarks they used. Many managers today are ‘closet indexers’ who invest most of their clients’ money in line with an established index but with small modifications that, they hope, will help outperform the index.
I finally realized that most investment managers were charging extremely high fees because they could convince their clients – and their clients wanted to believe – that they produced higher returns. John Bogle’s new book (“Enough: True Measures of Money, Business and Life”) is a classic expose of how the financial industry has overcharged consumers by creating the myth that there really are gurus out there who can improve investment performance because of their advanced understanding of markets.
Take note that, of the thousands of studies done in academia, and by pension funds and investment houses, there has never been a single study that has shown that any market-timing scheme worked consistently. All the credible studies have shown that the keys to investment success are consistent investment, reinvesting profits, and basic diversification. Investors who jump from one investment to another, or even one asset class to another, consistently show lower returns than the market. Much of these inferior results are due to excess transaction costs, taxes, and not being invested during up-markets because of wrong decisions based on fear and greed.
This is when I developed FAA. I found I didn’t have to decide what the next hot stock was, or if interest rates were going up or down, or if small cap stocks were going to beat large cap stocks. All I had to do was balance my clients' portfolios to include a range of large cap, small cap, and international diversified no-load mutual funds or index funds. This portfolio features a rock solid bond-ladder as a foundation to keep clients from jumping in and out of the market every time they listen to Jim Cramer tout the stock du jour on his nightly investment circus.
The real value added by FAA is due to the comprehensive approach used to grow client portfolios. Real estate is regarded as a key asset, clients are coached to not do stupid things, inflation is dealt with intelligently, a bond ladder is used as a hedge and to assure consistent cash flow, wealth is preserved by cutting losses, behavioral obstacles are addressed, and tax strategies are employed to improve overall investment return.
The key advantage for my clients is that, no matter what new investment frontier is touted as “hot”, our clients are already invested in it because they stay balanced. When I look back at the thousands of successful investors I have known, none of them did it by ‘smart investing.’ Most wealthy people attain wealth by investing ‘sensibly’ and avoiding stupid mistakes. The worst stupid mistake is to start believing in carnival barkers.
The unique perspective of ACA members comes from being able to advise a client from a comprehensive view of their situation, which requires a higher level of credentials than is available in a field dominated by sales people. We can include tax advice along with investment strategies, sensible insurance approaches to enhance estate planning, etc.
The major problem in financial advice is not the lack of ideas about new opportunities. The fact remains that the majority of financial advisors are not true fiduciaries and are incentivized to give advice that is better for their own pocketbooks rather than their clients’.
Note: This review has been helpful in that it made me realize that many of the strategies we do use are unique and don’t require market timing (e.g. Cambridge Index, the no-lose Roth conversion, etc.) I will elaborate more on those in the future.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Recently an ACA member’s client emailed me to comment that we were being paid to manage assets – stocks, bonds, real estate, etc. - and that I should be suggesting some opportunities to help increase his portfolio during these exciting times. This is a widespread attitude among clients, and I think it is a fair comment and merits addressing.
There is a significant difference between ‘Money Managers’ (or ‘Investment Advisors’) and ‘Financial Advisors’ (or ‘Financial Planners’). Money Managers generally charge based on the size of a client’s portfolio, i.e. assets under management (AUM). They claim to add value by finding ‘opportunities’ for clients and timing the market. Some claim they also advise clients on insurance, estate planning, taxes, etc., but they generally are not adequately trained in these areas. Moreover, people generally do what they are paid to do, and if they are paid based on AUM, they focus on gathering assets and new, exciting investments.
Financial Advisors take a much more comprehensive approach. We are trained and credentialed to coordinate all of the financial aspects of a client’s life, with a focus on meeting their life goals. Certainly investments are an important part of this, and our job is to recommend and monitor suitable Money Managers for clients. To do this we use the principles of “Functional Asset Allocation” (FAA) and eschew the ‘carnival barker’s’ approach of touting the ‘next hot stock’, or the next investment “frontier”, or other market timing approaches.
Many new advisors start out with the belief that they can add value by selecting investments. I’ve been at this for 39 years, and when I started out I tried to convince clients that I could add value by my superior investment knowledge. I managed portfolios of covered options, came up with strategies using fundamental principles for building portfolios, used technical analyses to determine when clients should switch asset classes, etc.
In my early career, I did beat the market a couple of years in a row…and then I got whipsawed and was grateful to be able to get my clients’ funds out while they were still ahead. Given that there are thousands of professional investors in the market, the theory of large numbers will always produce some who consistently beat the market year after year.
Indeed, Peter Lynch managed Fidelity Magellan for 13 years and reportedly beat the S&P for 11 of those for an average 29% annual return. The smartest thing he ever did was to quit while he was ahead. His successors used his same formulae and strategies and have underperformed the market ever since.
(It’s also worthwhile to note that during those years the S&P index was the highest performing general index for only one year. For four of the 11 years the small cap index dominated, international stocks won in 5 of those years, and bonds won out the other 3 times.)
Interestingly, most ‘financial advisors’ are really ‘investment managers.’ Their proposition is basically: “Give me your money and I’ll make you rich!” When I look up and down the street, from small financial firms to large wire-houses, they all make the exact same claim: “We’re smarter! We know how to beat the market!” As a matter of fact, most newer advisors, as well as day-traders, stockbrokers and insurance sales people, ultimately pin their success on their ability to convince themselves and their clients that they can produce superior results.
At some point we have to realize that we don’t live in Lake Woebegone, where all the children are above average. Every investment guru in the phone book can’t be beating the market at the same time unless they have a Madoff scheme.
I happened to visit Wall Street during Lynch’s era and saw the office buildings filled with people and computers. They spent most of their working lives trying to figure out the best investments. How would I ever be able to outsmart them? When I researched this more closely, I was struck by the fact that the S&P index outperforms 85% of large cap money managers!
When I delved into managers who claimed to beat the market and carefully analyzed their performance, I noticed that their success was based on fudging the indexes or benchmarks they used. Many managers today are ‘closet indexers’ who invest most of their clients’ money in line with an established index but with small modifications that, they hope, will help outperform the index.
I finally realized that most investment managers were charging extremely high fees because they could convince their clients – and their clients wanted to believe – that they produced higher returns. John Bogle’s new book (“Enough: True Measures of Money, Business and Life”) is a classic expose of how the financial industry has overcharged consumers by creating the myth that there really are gurus out there who can improve investment performance because of their advanced understanding of markets.
Take note that, of the thousands of studies done in academia, and by pension funds and investment houses, there has never been a single study that has shown that any market-timing scheme worked consistently. All the credible studies have shown that the keys to investment success are consistent investment, reinvesting profits, and basic diversification. Investors who jump from one investment to another, or even one asset class to another, consistently show lower returns than the market. Much of these inferior results are due to excess transaction costs, taxes, and not being invested during up-markets because of wrong decisions based on fear and greed.
This is when I developed FAA. I found I didn’t have to decide what the next hot stock was, or if interest rates were going up or down, or if small cap stocks were going to beat large cap stocks. All I had to do was balance my clients' portfolios to include a range of large cap, small cap, and international diversified no-load mutual funds or index funds. This portfolio features a rock solid bond-ladder as a foundation to keep clients from jumping in and out of the market every time they listen to Jim Cramer tout the stock du jour on his nightly investment circus.
The real value added by FAA is due to the comprehensive approach used to grow client portfolios. Real estate is regarded as a key asset, clients are coached to not do stupid things, inflation is dealt with intelligently, a bond ladder is used as a hedge and to assure consistent cash flow, wealth is preserved by cutting losses, behavioral obstacles are addressed, and tax strategies are employed to improve overall investment return.
The key advantage for my clients is that, no matter what new investment frontier is touted as “hot”, our clients are already invested in it because they stay balanced. When I look back at the thousands of successful investors I have known, none of them did it by ‘smart investing.’ Most wealthy people attain wealth by investing ‘sensibly’ and avoiding stupid mistakes. The worst stupid mistake is to start believing in carnival barkers.
The unique perspective of ACA members comes from being able to advise a client from a comprehensive view of their situation, which requires a higher level of credentials than is available in a field dominated by sales people. We can include tax advice along with investment strategies, sensible insurance approaches to enhance estate planning, etc.
The major problem in financial advice is not the lack of ideas about new opportunities. The fact remains that the majority of financial advisors are not true fiduciaries and are incentivized to give advice that is better for their own pocketbooks rather than their clients’.
Note: This review has been helpful in that it made me realize that many of the strategies we do use are unique and don’t require market timing (e.g. Cambridge Index, the no-lose Roth conversion, etc.) I will elaborate more on those in the future.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Wednesday, April 6, 2011
Surviving World Upheaval
By Bert Whitehead, M.B.A., J.D. ©2011
We are witnessing two astonishing world events that erupted in the past three months, both of which were unpredictable. Since the revolutions in the Mideast and the nuclear crisis in Japan both involve significant energy resources worldwide, the impact may be staggering. It is interesting how quickly we normalize the impact of such calamities, perhaps because we don’t think we are directly affected. After all, these things aren’t happening here: they are half a world away.
Of course it is entirely possible, maybe even probable, that everything will work out fine. The Middle Eastern tribal structure will give way to real democracy, without needing dictators to keep folks in line. Japan will mop up their nuclear reactors, and we all will find a way to counteract the spread of radiation before any real harm is done.
But this is not the only possibility. For all we know, the amount of damage could be astounding and may permanently affect the way we live our lives. These events will likely cause major shifts in the way we produce energy as well as the way we use electrical and mechanically driven power.
The situation in the Arab world is evoking keen uncertainty. It certainly will not result in more oil becoming available from that part of the world. Current prices, near $110 per barrel, reflect the market’s concern that the supply of oil will be interrupted. The political outcome is unknowable, and our range of options as the primary consumers of oil is probably nil, or extremely limited at best.
Providing cover for Libyan revolutionaries was intended as a humanitarian gesture. But if the effect of NATO’s intervention actually prolongs and intensifies the conflict, we are caught in the dilemma of watching the human slaughter continue in slow motion, or committing more military support. Then there’s a significant problem in that we don’t really know who we want to win control of the country. We are likely to be disappointed based on the options available to the people of Libya.
Regardless of how the Libyan adventure plays out, we are starting to realize that this is a very long string of dominos just starting to fall. The revolutionaries in all seven-plus other Arab countries will certainly expect support for their fledgling democratic efforts, yet it is not likely that the people in the NATO countries have much of an appetite for more wars.
The bottom line in the Mideast is that the world’s largest suppliers of oil are all on the brink of collapse. They could be replaced, but even if there is the political will to ‘drill, baby, drill’ it will be a couple of years after our strategic reserves are exhausted to even start replacing this supply vacuum.
Then we get to Japan. No matter where it goes from here, it will be a long time before anybody builds more nuclear reactors. Japan must plan to import all the oil it can to just replace the power plants they have lost. So the restrictions on the availability of energy will compound exponentially while the demand increases.
But of course that can’t happen, because we will have to act before it all caves in. I’m not hyping this scenario, but it is possible and the effects are likely to affect our lives endogenously. It will affect the way we live.
What’s the smart thing to do? Well, first, don’t do anything stupid! You’re not going to save your skin by buying oil futures, or oil stocks, or gold. The markets will sort out these problems; government intervention may be more of a hindrance than helpful. The advice you get from the media is likely to be self-serving for the provider. Don’t count on ‘alternative energy’ during our lifetimes – too many problems/costs with infrastructure and storage issues. We will have to turn to more coal and natural gas.
So start looking at sensible things you can do in your life to reduce the amount of energy you need. This goes beyond turning out the lights when you leave a room; change the light bulbs! The energy credits mostly expired last year, but this is the time to look at the energy we use in our households from a purely financial perspective. If you’re buying a car, maybe it makes sense to get one that is energy efficient. The ‘pay-back’ period for energy savings is likely to shrink from today’s period of 10-15 years to only 5-7 years, and that shrinkage may happen sooner than later.
The reality of our brave new world is that we will be paying much more for energy of all kinds. It’s not a question of “If…”, but a question of “When…” And this short survey of today’s World Upheaval suggests that, during the past three months, we may have moved much closer to having to do something about it ourselves!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
We are witnessing two astonishing world events that erupted in the past three months, both of which were unpredictable. Since the revolutions in the Mideast and the nuclear crisis in Japan both involve significant energy resources worldwide, the impact may be staggering. It is interesting how quickly we normalize the impact of such calamities, perhaps because we don’t think we are directly affected. After all, these things aren’t happening here: they are half a world away.
Of course it is entirely possible, maybe even probable, that everything will work out fine. The Middle Eastern tribal structure will give way to real democracy, without needing dictators to keep folks in line. Japan will mop up their nuclear reactors, and we all will find a way to counteract the spread of radiation before any real harm is done.
But this is not the only possibility. For all we know, the amount of damage could be astounding and may permanently affect the way we live our lives. These events will likely cause major shifts in the way we produce energy as well as the way we use electrical and mechanically driven power.
The situation in the Arab world is evoking keen uncertainty. It certainly will not result in more oil becoming available from that part of the world. Current prices, near $110 per barrel, reflect the market’s concern that the supply of oil will be interrupted. The political outcome is unknowable, and our range of options as the primary consumers of oil is probably nil, or extremely limited at best.
Providing cover for Libyan revolutionaries was intended as a humanitarian gesture. But if the effect of NATO’s intervention actually prolongs and intensifies the conflict, we are caught in the dilemma of watching the human slaughter continue in slow motion, or committing more military support. Then there’s a significant problem in that we don’t really know who we want to win control of the country. We are likely to be disappointed based on the options available to the people of Libya.
Regardless of how the Libyan adventure plays out, we are starting to realize that this is a very long string of dominos just starting to fall. The revolutionaries in all seven-plus other Arab countries will certainly expect support for their fledgling democratic efforts, yet it is not likely that the people in the NATO countries have much of an appetite for more wars.
The bottom line in the Mideast is that the world’s largest suppliers of oil are all on the brink of collapse. They could be replaced, but even if there is the political will to ‘drill, baby, drill’ it will be a couple of years after our strategic reserves are exhausted to even start replacing this supply vacuum.
Then we get to Japan. No matter where it goes from here, it will be a long time before anybody builds more nuclear reactors. Japan must plan to import all the oil it can to just replace the power plants they have lost. So the restrictions on the availability of energy will compound exponentially while the demand increases.
But of course that can’t happen, because we will have to act before it all caves in. I’m not hyping this scenario, but it is possible and the effects are likely to affect our lives endogenously. It will affect the way we live.
What’s the smart thing to do? Well, first, don’t do anything stupid! You’re not going to save your skin by buying oil futures, or oil stocks, or gold. The markets will sort out these problems; government intervention may be more of a hindrance than helpful. The advice you get from the media is likely to be self-serving for the provider. Don’t count on ‘alternative energy’ during our lifetimes – too many problems/costs with infrastructure and storage issues. We will have to turn to more coal and natural gas.
So start looking at sensible things you can do in your life to reduce the amount of energy you need. This goes beyond turning out the lights when you leave a room; change the light bulbs! The energy credits mostly expired last year, but this is the time to look at the energy we use in our households from a purely financial perspective. If you’re buying a car, maybe it makes sense to get one that is energy efficient. The ‘pay-back’ period for energy savings is likely to shrink from today’s period of 10-15 years to only 5-7 years, and that shrinkage may happen sooner than later.
The reality of our brave new world is that we will be paying much more for energy of all kinds. It’s not a question of “If…”, but a question of “When…” And this short survey of today’s World Upheaval suggests that, during the past three months, we may have moved much closer to having to do something about it ourselves!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Sunday, March 20, 2011
Tony’s Story
By Bert Whitehead, M.B.A, J.D. © 2011
Some of the most important lessons I have learned didn’t come from classrooms or continuing education sessions, but rather from observing real life experiences of my clients. One such lesson I learned 35 years ago was from Tony. It was very impactful for me, and so I have decided to share it.
Tony was a 30ish manager who worked for a large Detroit corporation. He was raised in the ghetto, but managed to struggle through college and earned an M.B.A. He was recognized as a rising star in his company, and in our relationship he was what we term ‘a compliant client’ – which is an understated high praise. He regularly saved 10-12% of his earnings and invested prudently.
At one of our appointments, which he had been forced to reschedule, he explained that his father had died the month before. He was the beneficiary of a life insurance policy for $25,000. This was a tidy sum in the early 1970’s, equivalent to about $100,000 today. He wanted advice on how best to invest it, since it basically doubled his investment portfolio.
His father lived in Seattle. While he didn’t know him as a child, they became close later in life. He was somewhat embarrassed to admit that he had already spent $5,000 on a first class ticket to go to his father’s funeral (this was before airline rates were deregulated). I was startled by this, and mentioned that spending that much money on a plane ticket was quite a splurge.
Tony felt it was important to explain himself. He confided that he didn’t see his dad much while he was growing up, but he and his father had grown very close since he graduated from high school. His dad, who never graduated from high school, would always brag of his achievements.
His dad was so proud of him that he flew back to Detroit to attend both of his college graduations. The last time he saw his dad, his dad had told him that when he was boarding his last flight, walking through the first class cabin, the thought came to him that someday his son would be able to fly first class.
So that was why Tony decided to fly first class to his dad’s funeral.
Interestingly, less than a year later, Tony came home from work exhausted and laid down on his bed and died. He was 33. The cause was something related to a congenital heart problem he didn’t even know he had.
A few days after his death, I had vivid memories of going to his funeral and seeing him laid out. As I sat through the ceremony, it occurred to me that I was really glad that Tony had decided to buy that first class ticket.
That’s when I learned that how clients decide how to use their money is ultimately a very personal decision that reflects their deepest values. It is not my job to set their priorities on how they spend their wealth. As long as a client is saving 10% of what they earn, come what may, it will accumulate and compound through the years to assure they can maintain their lifestyle after they retire.
Through life, I have seen the importance that clients use their surplus however they deem appropriate. Some do save it. Others use it for their kids’ educations. Or perhaps they take their family on trips and invest in memories. The point is that as we live our lives, financial planning isn’t a process of sheer deprivation.
Sometimes it is important to splurge on a first class ticket.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Some of the most important lessons I have learned didn’t come from classrooms or continuing education sessions, but rather from observing real life experiences of my clients. One such lesson I learned 35 years ago was from Tony. It was very impactful for me, and so I have decided to share it.
Tony was a 30ish manager who worked for a large Detroit corporation. He was raised in the ghetto, but managed to struggle through college and earned an M.B.A. He was recognized as a rising star in his company, and in our relationship he was what we term ‘a compliant client’ – which is an understated high praise. He regularly saved 10-12% of his earnings and invested prudently.
At one of our appointments, which he had been forced to reschedule, he explained that his father had died the month before. He was the beneficiary of a life insurance policy for $25,000. This was a tidy sum in the early 1970’s, equivalent to about $100,000 today. He wanted advice on how best to invest it, since it basically doubled his investment portfolio.
His father lived in Seattle. While he didn’t know him as a child, they became close later in life. He was somewhat embarrassed to admit that he had already spent $5,000 on a first class ticket to go to his father’s funeral (this was before airline rates were deregulated). I was startled by this, and mentioned that spending that much money on a plane ticket was quite a splurge.
Tony felt it was important to explain himself. He confided that he didn’t see his dad much while he was growing up, but he and his father had grown very close since he graduated from high school. His dad, who never graduated from high school, would always brag of his achievements.
His dad was so proud of him that he flew back to Detroit to attend both of his college graduations. The last time he saw his dad, his dad had told him that when he was boarding his last flight, walking through the first class cabin, the thought came to him that someday his son would be able to fly first class.
So that was why Tony decided to fly first class to his dad’s funeral.
Interestingly, less than a year later, Tony came home from work exhausted and laid down on his bed and died. He was 33. The cause was something related to a congenital heart problem he didn’t even know he had.
A few days after his death, I had vivid memories of going to his funeral and seeing him laid out. As I sat through the ceremony, it occurred to me that I was really glad that Tony had decided to buy that first class ticket.
That’s when I learned that how clients decide how to use their money is ultimately a very personal decision that reflects their deepest values. It is not my job to set their priorities on how they spend their wealth. As long as a client is saving 10% of what they earn, come what may, it will accumulate and compound through the years to assure they can maintain their lifestyle after they retire.
Through life, I have seen the importance that clients use their surplus however they deem appropriate. Some do save it. Others use it for their kids’ educations. Or perhaps they take their family on trips and invest in memories. The point is that as we live our lives, financial planning isn’t a process of sheer deprivation.
Sometimes it is important to splurge on a first class ticket.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Tuesday, February 15, 2011
The New Normal
By Bert Whitehead, M.B.A., J.D.
A number of clients have expressed alarm at the recent clamor of commentators who have been predicting a cataclysmic economic change worldwide. These pundits claim that we are facing an economic “New Normal” and express concern that the ‘old’ economic rules on which we rely no longer operate.
Their conclusions? Drastic changes are needed in our lives and investments to accommodate the “New Normal!”
Usually they question the viability of the U.S. dollar and offer the possibility that China, or perhaps a block of other nations, are somehow positioned to ‘take over’ the U.S. because they hold so many U.S. bonds. Another variation of this calamity centers on the recent collapse of the real estate market, the precipitous drop in the stock market, and extraordinarily low interest rates. Taken together, these developments presage the end of American prosperity for our children and ourselves.
Of course these apocalyptic pronouncements are more effective if they are tied to some political viewpoint, the more extreme the better. More often than not, far right political viewpoints proclaim that doomsday is the certain result of left-wing politics. Leftist views generally emphasize the inevitable revolution that suppression of the masses will cause.
(Note to “Investment Advice” file: Never let your politics drive your investments!)
It’s time to confront these ridiculous assertions. Yes, it is true that the investment and economic travails of the past decade have been severe and have impacted many people worldwide. Some of these changes have not occurred before during many of our lifetimes. It is enticing to point the finger of blame and shame at our financial, economic, investment and political leadership. But that is not the whole story.
The power of momentum in democratic economies is easily underestimated. Although dramatic from time to time, the impact of severe financial shifts must be kept in proportion and viewed within a broader historical perspective. We need to recognize that most extreme economic shifts are self-correcting.
Even with unemployment at over 9%, over 90% of our citizens are employed. Real estate crashes, weather-related disasters, stock market crashes, low interest rates, etc. have all happened before. Indeed the damage done by seismic economic shifts during the Great Depression, the severe stagflation in the 1970’s, and the collapse of S. & L.’s in the 1980’s were all worse than we have seen today…and all of these are relatively minor when compared to the disruption of the financial markets in the 19th century. And whatever happened to the “New Economy” theory that gave rise to the ‘dot-com’ frenzy of the 1990’s?
It is folly to fret about how much of our debt is owned by the China (interestingly, Japan owns nearly as much U.S. debt as China, even though that fact is not usually noted). What can the Chinese do with our debt? They can’t dump it on the White House lawn and demand to be paid off with gold. They can’t go on the world markets and exchange dollars for Euros or Yen, or even buy gold. Any of these moves would be self-defeating because dumping huge amounts of money in any market would decrease the value of their remaining dollars. Actually, their only realistic option is to spend it in the U.S.!
There is a concern that the U.S. dollar is at a “tipping point” and will soon lose its status as the world’s reserve currency. But no other currency is in a position to take its place. The Euro’s stability is much too questionable. The Yuan doesn’t have a long enough history to be relied upon, especially when a dictatorial government can arbitrarily determine its value. Neither these nor other ‘respectable’ currencies such as the Yen, the British Pound, the Swiss Franc, etc. have enough depth to support a global economy.
Those who espouse extreme economic outcomes are invariably selling something. Usually it is their newsletter or book, or some strategy to beat the market, or gold itself. The most eminent economists in the world have never been able to predict any economic cycle with a meaningful consensus. Why should you believe the extreme voices of charlatans who use their advanced marketing techniques to dupe the fearful?
What can you do? I suggest that you sit back and follow sensible advice. The Functional Asset Allocation model, which is used by nearly 200 fee-only members of ACA (Alliance of Cambridge Advisors), focuses on the basics.
Consider this…there are only three possible economic scenarios: we can have inflation, deflation, or prosperity. It is a waste of time to try to determine which is coming next. The prudent approach is to be prepared for all three possibilities. As the ancient wisdom of the Torah exhorts: “Invest a third in land, a third in business, and a third in reserves!”
Today, that translates into a balanced portfolio of real estate, equities (i.e. stocks in companies), and cash and bond reserves. Trying to market-time and pick the next ‘hot investment’ is foolhardy. If you allow the vagaries of global economics, i.e. exogenous factors, to be the focus of your attention, you risk making decisions based on emotion rather than rational thought. In truth, it is the ‘endogenous factors’ in your life that determine your financial future.
As Pogo once said, “We have met the enemy, and he is us!” Instead of dithering about what will happen in the Mideast, or where interest rates are headed, or when will real estate level off, look at the things in your life that make a difference. Are you saving at least 10% of your gross income? Are you living within your means? Do you have enough liquidity to ride out a financial setback? Do you have a long-term fixed rate mortgage to protect you from inflation? Do you have government bonds to weather another bout of deflation?
Obsessing about the various complexities and possible outcomes in today’s global economy inevitably leads to rash and unwise leaps. Keep an eye on the issues within your reach! It is the key to a confident journey and a serene financial future.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
A number of clients have expressed alarm at the recent clamor of commentators who have been predicting a cataclysmic economic change worldwide. These pundits claim that we are facing an economic “New Normal” and express concern that the ‘old’ economic rules on which we rely no longer operate.
Their conclusions? Drastic changes are needed in our lives and investments to accommodate the “New Normal!”
Usually they question the viability of the U.S. dollar and offer the possibility that China, or perhaps a block of other nations, are somehow positioned to ‘take over’ the U.S. because they hold so many U.S. bonds. Another variation of this calamity centers on the recent collapse of the real estate market, the precipitous drop in the stock market, and extraordinarily low interest rates. Taken together, these developments presage the end of American prosperity for our children and ourselves.
Of course these apocalyptic pronouncements are more effective if they are tied to some political viewpoint, the more extreme the better. More often than not, far right political viewpoints proclaim that doomsday is the certain result of left-wing politics. Leftist views generally emphasize the inevitable revolution that suppression of the masses will cause.
(Note to “Investment Advice” file: Never let your politics drive your investments!)
It’s time to confront these ridiculous assertions. Yes, it is true that the investment and economic travails of the past decade have been severe and have impacted many people worldwide. Some of these changes have not occurred before during many of our lifetimes. It is enticing to point the finger of blame and shame at our financial, economic, investment and political leadership. But that is not the whole story.
The power of momentum in democratic economies is easily underestimated. Although dramatic from time to time, the impact of severe financial shifts must be kept in proportion and viewed within a broader historical perspective. We need to recognize that most extreme economic shifts are self-correcting.
Even with unemployment at over 9%, over 90% of our citizens are employed. Real estate crashes, weather-related disasters, stock market crashes, low interest rates, etc. have all happened before. Indeed the damage done by seismic economic shifts during the Great Depression, the severe stagflation in the 1970’s, and the collapse of S. & L.’s in the 1980’s were all worse than we have seen today…and all of these are relatively minor when compared to the disruption of the financial markets in the 19th century. And whatever happened to the “New Economy” theory that gave rise to the ‘dot-com’ frenzy of the 1990’s?
It is folly to fret about how much of our debt is owned by the China (interestingly, Japan owns nearly as much U.S. debt as China, even though that fact is not usually noted). What can the Chinese do with our debt? They can’t dump it on the White House lawn and demand to be paid off with gold. They can’t go on the world markets and exchange dollars for Euros or Yen, or even buy gold. Any of these moves would be self-defeating because dumping huge amounts of money in any market would decrease the value of their remaining dollars. Actually, their only realistic option is to spend it in the U.S.!
There is a concern that the U.S. dollar is at a “tipping point” and will soon lose its status as the world’s reserve currency. But no other currency is in a position to take its place. The Euro’s stability is much too questionable. The Yuan doesn’t have a long enough history to be relied upon, especially when a dictatorial government can arbitrarily determine its value. Neither these nor other ‘respectable’ currencies such as the Yen, the British Pound, the Swiss Franc, etc. have enough depth to support a global economy.
Those who espouse extreme economic outcomes are invariably selling something. Usually it is their newsletter or book, or some strategy to beat the market, or gold itself. The most eminent economists in the world have never been able to predict any economic cycle with a meaningful consensus. Why should you believe the extreme voices of charlatans who use their advanced marketing techniques to dupe the fearful?
What can you do? I suggest that you sit back and follow sensible advice. The Functional Asset Allocation model, which is used by nearly 200 fee-only members of ACA (Alliance of Cambridge Advisors), focuses on the basics.
Consider this…there are only three possible economic scenarios: we can have inflation, deflation, or prosperity. It is a waste of time to try to determine which is coming next. The prudent approach is to be prepared for all three possibilities. As the ancient wisdom of the Torah exhorts: “Invest a third in land, a third in business, and a third in reserves!”
Today, that translates into a balanced portfolio of real estate, equities (i.e. stocks in companies), and cash and bond reserves. Trying to market-time and pick the next ‘hot investment’ is foolhardy. If you allow the vagaries of global economics, i.e. exogenous factors, to be the focus of your attention, you risk making decisions based on emotion rather than rational thought. In truth, it is the ‘endogenous factors’ in your life that determine your financial future.
As Pogo once said, “We have met the enemy, and he is us!” Instead of dithering about what will happen in the Mideast, or where interest rates are headed, or when will real estate level off, look at the things in your life that make a difference. Are you saving at least 10% of your gross income? Are you living within your means? Do you have enough liquidity to ride out a financial setback? Do you have a long-term fixed rate mortgage to protect you from inflation? Do you have government bonds to weather another bout of deflation?
Obsessing about the various complexities and possible outcomes in today’s global economy inevitably leads to rash and unwise leaps. Keep an eye on the issues within your reach! It is the key to a confident journey and a serene financial future.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Friday, January 7, 2011
Cut Your Losses!
BY: Bert Whitehead, M.B.A., J.D.
When should you sell an investment if the value drops?
Investors agonize over this and often let themselves be guided by the old adage: “Buy low, sell high.” Based on this logic, they decide they will hold any investment they buy until they can at least break even. Once a client adopts this mantra, it is difficult to convince them to sell their holding at a loss, even when it keeps dropping in price.
There is a strategy of ‘averaging down’ when an investment drops in price. For example, suppose that you buy a mutual fund or stock when it is $20 a share and then it drops to $15 a share. If you had decided it was a good buy at $20 then, logically, you should buy more because it is even a better buy at $15. And if it drops to $10, then buy even more.
This is an aggressive strategy, and requires undaunting confidence in the investment. It can work out, but it often doesn’t. When it doesn’t, the results can be catastrophic. Employees who buy their company stock are particularly prone to make this mistake. I have seen situations where clients have stubbornly held on to Pan Am, GM, Chrysler, Enron, etc. and continued adding to their holdings only to end up losing it all. On the other hand, Ford shareholders have done well using this strategy over the past few years.
A more sound investment approach is to decide that, when you buy an investment, you will reevaluate it if it drops. You evaluate the losing investment with other investments, and then make a “keep or sell” decision. For example, let’s go back to your $20 per share stock. Rather than wait until it drops to $15 you could have decided that, if it drops 10% or 15% (i.e. to $18 or $17), you will reconsider the investment. If there are other investment options with better upside potential, sell your loser and reinvest in something with better prospects. This prevents you from blindly holding on to the shares hoping they will go back to $20.
For many people, selling a loser means they made a mistake, and they are adamant about not losing money on their investments. The blatant truth is that holding on to the stock means you still have a loss, you just haven’t ‘realized’ it yet.
One technique I have used with some success is to explain to clients that by selling the stock, they are ‘harvesting’ their losses for tax purposes. The tax loss will save them tax dollars by offsetting other gains, thereby reducing the capital gains tax. It often gives them an additional $3,000 deduction against other ordinary income, which can save them about $1,000 in taxes at the 33% tax bracket.
The beauty of this is that the client can buy the stock back after 31 days. If bought back sooner, the ‘wash sale rule’ precludes them from taking the tax loss. It’s interesting to note that, no matter how resistant the client was to selling the stock at a loss initially, once they sell it they never buy it back!
Of course we do not recommend ‘market timing.’ When managing clients’ portfolios we take into consideration other factors such as the overall balance of the portfolio, the amount of the single investment relative to the total portfolio, as well as tax issues and clients’ long term goals.
For example, we don’t sell stripped Treasuries in a client’s ladder just because the market value drops. The function of this investment is to assure that the maturity value provides the cash flow necessary for spending goals (usually in retirement), without fail. We know and expect that the market value will fluctuate in the meantime, but the ending value is government guaranteed.
On the other hand we don’t hesitate to sell a mutual fund that has underperformed its peers significantly for two or more quarters in a row. We also take losses in the Cambridge Index Portfolio when we can capture them as short-term, which are the most tax advantaged.
Cutting losses isn’t limited to securities like stocks, bonds, and mutual funds. A huge concern of many clients today is whether they should ‘dump’ their real estate in this depressed market or wait until they can ‘get their money back out.’ This issue is more complex, but here are some guidelines I consider.
If the home is your personal residence, and you like it and can afford the payments, keep the house unless you have to move (e.g. new job, changing neighborhood). If it is a vacant house or vacant property, it is generally better to sell (even at a loss) because the carrying costs of keeping vacant property and running the risk that the value will continue to drop generally makes this type of real estate a bad investment at this time. You may want to review my previous blog of April 29, 2010 titled “What To Do When Your House Is Underwater.”
The issue of when to “cut your losses” is also perplexing when applied to employment and other relationships, but my expertise in these areas is limited (though I have done a lot of research…). The best approach usually is to get a therapist!
In any situation, cutting your losses sooner rather than later is usually the better course of action. Not only does it minimize financial losses, but it also reduces stress. Continually dealing with these kinds of decisions is emotionally toxic.
So make a New Year’s resolution to cut your losses in three areas that have been plaguing you. Get the monkeys off your back, and get on with a rich fulfilling new year!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
When should you sell an investment if the value drops?
Investors agonize over this and often let themselves be guided by the old adage: “Buy low, sell high.” Based on this logic, they decide they will hold any investment they buy until they can at least break even. Once a client adopts this mantra, it is difficult to convince them to sell their holding at a loss, even when it keeps dropping in price.
There is a strategy of ‘averaging down’ when an investment drops in price. For example, suppose that you buy a mutual fund or stock when it is $20 a share and then it drops to $15 a share. If you had decided it was a good buy at $20 then, logically, you should buy more because it is even a better buy at $15. And if it drops to $10, then buy even more.
This is an aggressive strategy, and requires undaunting confidence in the investment. It can work out, but it often doesn’t. When it doesn’t, the results can be catastrophic. Employees who buy their company stock are particularly prone to make this mistake. I have seen situations where clients have stubbornly held on to Pan Am, GM, Chrysler, Enron, etc. and continued adding to their holdings only to end up losing it all. On the other hand, Ford shareholders have done well using this strategy over the past few years.
A more sound investment approach is to decide that, when you buy an investment, you will reevaluate it if it drops. You evaluate the losing investment with other investments, and then make a “keep or sell” decision. For example, let’s go back to your $20 per share stock. Rather than wait until it drops to $15 you could have decided that, if it drops 10% or 15% (i.e. to $18 or $17), you will reconsider the investment. If there are other investment options with better upside potential, sell your loser and reinvest in something with better prospects. This prevents you from blindly holding on to the shares hoping they will go back to $20.
For many people, selling a loser means they made a mistake, and they are adamant about not losing money on their investments. The blatant truth is that holding on to the stock means you still have a loss, you just haven’t ‘realized’ it yet.
One technique I have used with some success is to explain to clients that by selling the stock, they are ‘harvesting’ their losses for tax purposes. The tax loss will save them tax dollars by offsetting other gains, thereby reducing the capital gains tax. It often gives them an additional $3,000 deduction against other ordinary income, which can save them about $1,000 in taxes at the 33% tax bracket.
The beauty of this is that the client can buy the stock back after 31 days. If bought back sooner, the ‘wash sale rule’ precludes them from taking the tax loss. It’s interesting to note that, no matter how resistant the client was to selling the stock at a loss initially, once they sell it they never buy it back!
Of course we do not recommend ‘market timing.’ When managing clients’ portfolios we take into consideration other factors such as the overall balance of the portfolio, the amount of the single investment relative to the total portfolio, as well as tax issues and clients’ long term goals.
For example, we don’t sell stripped Treasuries in a client’s ladder just because the market value drops. The function of this investment is to assure that the maturity value provides the cash flow necessary for spending goals (usually in retirement), without fail. We know and expect that the market value will fluctuate in the meantime, but the ending value is government guaranteed.
On the other hand we don’t hesitate to sell a mutual fund that has underperformed its peers significantly for two or more quarters in a row. We also take losses in the Cambridge Index Portfolio when we can capture them as short-term, which are the most tax advantaged.
Cutting losses isn’t limited to securities like stocks, bonds, and mutual funds. A huge concern of many clients today is whether they should ‘dump’ their real estate in this depressed market or wait until they can ‘get their money back out.’ This issue is more complex, but here are some guidelines I consider.
If the home is your personal residence, and you like it and can afford the payments, keep the house unless you have to move (e.g. new job, changing neighborhood). If it is a vacant house or vacant property, it is generally better to sell (even at a loss) because the carrying costs of keeping vacant property and running the risk that the value will continue to drop generally makes this type of real estate a bad investment at this time. You may want to review my previous blog of April 29, 2010 titled “What To Do When Your House Is Underwater.”
The issue of when to “cut your losses” is also perplexing when applied to employment and other relationships, but my expertise in these areas is limited (though I have done a lot of research…). The best approach usually is to get a therapist!
In any situation, cutting your losses sooner rather than later is usually the better course of action. Not only does it minimize financial losses, but it also reduces stress. Continually dealing with these kinds of decisions is emotionally toxic.
So make a New Year’s resolution to cut your losses in three areas that have been plaguing you. Get the monkeys off your back, and get on with a rich fulfilling new year!
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
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