"I'm up 25% on the year! Isn't that great? Who needs a professional money manager anyway? Heck, I was talking with a fee-only financial advisor the other day, asking him what he charged and how his clients were doing and he wouldn't even give me a straight answer! Guy probably can't walk and chew bubble gum at the same time let alone beat my investing returns this year!" (Individual investor speaking gives himself an air high-five and chest bumps the wall). "Baby I am hot!"
Or is he?
Academic research shows that most individual investors don't accurately track their investment returns from year to year and, on average, substantially over-estimate their returns. One study done a few years back concluded that individual investor returns were actually less than half of what individual investors thought they were - seems most folks don't actually tote up the numbers, instead relying on memory. It also seems that most folks have a very selective memory, remembering their winning investments and conveniently forgetting their losers. Or they just plain forget to back out current year contributions to their portfolio, lumping them in with their returns.
But what about the chest bumping, high-fiving dude who did do the math and was up 25% in 2009? He's kicking butt right? Well, maybe...
It turns out that measuring returns is different from measuring performance. Performance isn't just about accurately capturing a portfolio's return (although that can be difficult enough to do). It is also about measuring the amount of risk in the portfolio and making an apples to apples comparison with an unmanaged benchmark. In fact, the prestigious CFA Institute now offers The Certificate in Investment Performance Measurement (CIPM) program, which is the industry’s only designation dedicated solely to the specialized field of investment performance evaluation and presentation. The CIPM curriculum emphasizes the application of investment principles and is based on a body of knowledge defined by global best practices in investment performance evaluation and presentation. The coursework includes: Rate of Return Calculations; Benchmark Selection; Attribution Analysis; Ex Post Risk Measures; Performance Evaluation; and The GIPS Standards (don't ask, they are boringly extensive).
Okay, so on the one hand you have many individual investors shooting from the hip on their returns, with really only the vaguest notion of how their portfolio's performance compares to a comparable benchmark, and, on the other hand, you have those CIPM weenies who will put you to sleep explaining your performance and how it REALLY measures up. The individual investor and the CIPM geek might both be speaking English, but I can assure you that they are almost certainly not communicating!
And we aren't even talking about the tidal wave of emotions that pour forth when investors are talking about their nest eggs. I've gotta tell you folks that trying to have a performance discussion with an individual investor can get pretty dicey sometimes! You don't want to offend them when they proudly trot out that big return number, but you do want to find out whether that big number represents good performance or not. After all, if you made your 25% putting all of your money into a single stock, then your risk-adjusted return is gonna suck, considering that the unmanaged S&P 500 index was up about 25% on the year! (a lot less risky to buy the entire index than invest in just one stock). Conversely, making 25% in a bunch of low-beta defensive stocks means you knocked the cover off the ball in 2009. Why? Because a low-beta portfolio should lag the S&P 500 return, not match it. Here's how that works...
Any unmanaged index has a beta of one with itself, by definition. The S&P 500 goes up 10% when the S&P 500 goes up 10%. An S&P 500 stock that tends to go up only 8% when the S&P 500 goes up 10% will have a beta of 0.80. Likewise, a stock that tends to go up 12% when the S&P 500 goes up 10% has a beta of 1.2. The second stock is 50% more volatile than the first stock. Build a low-beta stock portfolio and still keep up with the S&P 500 return and you are adding value! Conversely, build a high-beta stock portfolio and merely perform in-line with the S&P 500 and, well, you are destroying value (even if you are making money) because you aren't making as much as you should. As well, you are going to lose more money than the index on the way back down with the higher beta stocks!
Bottom line here is that accurately measuring performance can be complicated. And if you can't measure your performance then it's tough to know whether you need to makes changes to your investing process.
A couple of real life examples to make the point. I recently exchanged e-mails with a friend who was initially interested in getting my thoughts on how to best hedge against the risk of inflation. I e-mailed him my two cents worth, but then encouraged him to let me buy him a cup of coffee so that we could talk more fully about the subject. I didn't want him making investment decisions based on my brief reply to his inflation concerns. He shot me back an e-mail wanting to know my fees. He also let me know that his portfolio was up 22% year-to-date (about the same as the S&P 500 at the time). Uh-oh, a tricky performance conversation looming! What to do what to do?
I mean, do I tell him that my personal all-stock portfolio is up well north of 50% on the year? Do I tell him that Biechele Royce's stock and bond portfolios are up on average 24.58% on the year, 230 basis points ahead of his (likely) all stock portfolio? Do I put him on the spot by asking him if he realizes that his return was merely in-line with the S&P 500 return and, boy, I sure hoped he wasn't loaded up with a bunch of high-beta dogs when he would've done just as well with a lot less effort (and risk) by owning an S&P 500 index fund? Tricky situation, very tricky!
Well, guess what I did do...
None of the above, because this turnip didn't fall off the truck yesterday, and I know from past experience that all three courses of action are non-starters when trying to help an individual investor understand investing results. So I ignored the performance thingy and simply reiterated that my advice was free - in fact I was going to buy HIM the coffee - and that he should give me a holler when he had some time. Epilogue: Apparently he didn't believe I was really free because I didn't hear back from him. Or maybe he didn't get back to me because I ducked the whole performance issue and he mistook my bobbing and weaving for an implicit admission that he'd outperformed us and didn't really need any advice from me...
The second real-life example involved a family member. She apparently is subscribing to a newsletter of some sort and thinks the guy is pretty good. One of his investment ideas in the first half of 2009 was a sector ETF (I think that's what she said - I was reading up on my fantasy football team and only half listening) which was up 20% since she'd bought it. Without thinking (my focus was on my fantasy football team, which was really floundering) I shot back "And how does that compare to the S&P (500)?"
Blank look from Sis as in "What the heck are you babbling about?"
So I reluctantly pulled myself away from my fantasy football team (which had sunk into second on less than spectacular play and a HUGE run by my brother's steroid using players) and made an effort to explain. Modern portfolio management is a very logical sequencing of decisions. First you decide on a strategic (long-term) asset allocation based on the clients strategic (long-term) financial goals and risk tolerance. Once the allocation decision between stocks, bonds, real estate, commodities, and cash is made (along with allocations to sub-classes such as international, emerging market, investment grade, and high-yield), the institutional investor must implement the plan. As part of the implementation process, each investment within an asset class must be benchmarked to an unmanaged index in order to determine whether active management is adding value and the active managers are earning their fees. Clearly you shouldn't be paying a manager (or newsletter author) if they aren't able to add value by outperforming an appropriate benchmark on a risk-adjusted basis. Which means in my sister-in-laws case...
Her 20% return in the sector ETF was likely top-notch if it was a utility ETF and pretty much a bust if it was a semiconductor ETF (like I said, I was distracted when she started talking so I can't honestly tell you what she had bought). But I can tell you that she didn't have the foggiest notion of how to evaluate her performance in order to evaluate her newsletter writer (they count on that by the way - make enough suggestions and a few are bound to pan out big. Point to the winners and ignore the losers and you can make most people think you're doing quite well for them!).
The bottom line here is that returns are not the same as performance and measuring performance is a complicated, yet necessary, step in deciding whether your investing strategies are really working.... or not.
Oh, and by the way, I finished second behind my big brother in my fantasy football league (having also finished second to him in 2009 in fantasy baseball!). Which means I definitely underperformed in 2009....
Tuesday, December 29, 2009
Saturday, December 26, 2009
The Retirement
The old man lay quietly beneath the heavy blankets, listening in the dark to the hushed sounds of the small apartment. Somewhere overhead the heating unit hummed as warm air attempted to breach the barrier of cold that had settled heavily in the small bedroom. The old man could feel cold's nip on his sunken cheeks and crag of a nose; he had taken to wearing a nightcap to protect his balding head. Wisps of white peaked out from underneath. He wore his hair long these days, what little he had left. No longer an executive, the other workers at the plant could've cared less that the straggly wisps worked their way down almost to his shoulders. Barber's were a luxury and his wife's hands shook so much from the palsy that he would no longer let her near him with anything sharp.
Colder than normal, he thought, and that was saying something. He and is wife, whose labored breathing was muffled, but still audible, even buried as she was under the heavy, woollen blankets, kept the thermostat turned down as far as they could tolerate during the cold winter months. What with electricity rates having climbed steadily over the years, it was just too big a hit to their budget to keep the apartment heated to more than the bare minimum. He felt the cold gnawing away at his joints and settling into his bones, despite the extra blankets.
He could just make out the muted rush of winter's cold breath on the nearby window as gusts pushed against the concrete and brick complex. It was going to be another windy, cold day by the sound of it, he thought, already dreading the walk to the nearby bus stop. It would take him perhaps ten minutes to shuffle the six blocks to the metro stop. He didn't move very fast anymore. Both hips had been replaced a while back, along with his left knee. He'd been fortunate that his employer still provided medical coverage, not many did anymore since the government had entered the business. His employer's coverage was more expensive, took a bigger bite out of his meager salary, but at least he could get into see a doctor without a six month wait. Medicare wasn't an option since he still worked; the government had dropped coverage for seniors who were still working as part of the 2030 "austerity" initiative, designed to save America from having to declare a formal bankruptcy.
A soft, steady tick tick tick brought him back to the apartment. The alarm clock hadn't gone off yet, it wasn't quite 5:30, but he'd awakened a few minutes early. The ticking came not from the alarm clock, but from what many would consider an antique these days, an old-fashion wind up grandfather's clock that stood in the corner of the small bedroom, next to the single wooden dresser. The grandfather's clock was really the only thing the old couple owned of any interest. The rest of the furniture was cheaply made from pressed wood. It was merely functional at best. The old man knew his wife desperately wanted to replace the worn out furniture. Many of the wooden pieces were scratched and even splintered, but who could afford new furniture these days? Still, the furniture served its purpose, and they'd gotten it years ago before prices had risen sharply, the result of the rest of the world outbidding Americans for lumber... and for everything else for that matter. The U.S. dollar just could not compete, which meant everything cost more in dollars.
It wasn't a big apartment building, perhaps a hundred units in all, populated by those who couldn't afford more spacious quarters uptown. The apartments were efficiency units, kitchen, small dining area, a living room and a bedroom, no more than 750 square feet all in. Still, it was a roof over their head and only cost a couple week's wages, and it was definitely better than the barracks that'd been built a few years back to hold the indigent - baby boomers who weren't even able to afford a place of their own, all 35 million of them.
He exhaled as he shifted in bed, making sure not to let the covers slip from him, not yet. He might have a couple more minutes before the alarm went off. He didn't want to look at it, didn't want to see that it was time. A few more minutes to rest before getting ready, in the cold and dark, for another day at the plant. The irony of working at a coaling station did not escape him. After all, he'd spent most of his career as an economist working for Big Oil, much of his time taken up trying to figure out an economically viable solution to transitioning the energy industry to a successor energy source, one that would satisfy the Green movement, proving to them that Big Oil was serious about developing clean alternate energy sources. It was actually true of course. The energy industry quite understood that oil was a finite and diminishing resource that would need to be replaced with something else. The problem was how to economically make the transition to whatever that something else was while staying in business. Of course the lack of a strategic energy policy and the sharp drop in the value of the U.S. dollar had forced the U.S. to abandon most environmental goals. It had turned out that much of the Green movement was a luxury for the rich.
Coal had come back in a big way in the United States after the dollar's slow motion collapse sent the price of oil to $200 a barrel. The environmentalists howled their outrage when Congress passed the legislation lifting all bans on the use of coal by utilities and what few manufacturing plants remained in the country. The politicians had even cleared the way for the return of coal fired heating units in multi-unit housing, recognizing that 79 million baby boomers and countless younger voters would turn them out of office if they didn't let Americans keep their electricity. After all, America was the Saudi Arabia of coal, and it only made sense to use those natural resources that the country still controlled, regardless of the environmental impact.
The inflation that had swept the country over the last decade had wiped out many retirement nest eggs besides his own. He recalled having read years earlier that 50% of all baby boomers would run out of money before they died, an estimate based on a mere 3% inflation rate, below the historical 4.5%, and well below the high single digits that had prevailed for much of the last twenty years. He'd been confident he wouldn't be one of them though. He'd already saved close to $2 million by the time he'd turned fifty, a retirement portfolio capable of throwing off $80,000 in income per annum while still lasting at least 30-years, or so he'd been taught. His defined benefit plan would pay him an additional $950,000 lump sum when he turned 59-years old, and he was still saving in his 401(k). No, he'd been downright smug at the time! He simply hadn't realized what high-single digit inflation could do to an investment portfolio. Hadn't realized that the dollar was losing 37% of its value every 10-years at the historical 4.5% inflation rate that had prevailed post World War II and had lost 97% of its value since the Federal Reserve's creation in 1913.
The old man let his mind wander back over the decades to a time when he'd just turned fifty, a time when both the Republican and Democratic parties had lost their senses and were spending money they didn't have on initiatives that provided no long-term benefits to America, saddling generations of Americans with debt they couldn't possibly pay back. The politicians had recklessly created credit, encouraging asset bubble after asset bubble in an attempt to jump start the economy and, in so doing, buy votes for themselves. The madness had continued right up until the riots. The high unemployment rates and rising inflation had led to millions struggling simply to survive. Some of those millions eventually took to the streets to protest $8 bread and $10 gas. The price controls hadn't worked, nor had the government's attempts to run the country's farms through a combination of price controls and tax incentives.
The old man shifted once again under the heavy blankets. The cold was still gnawing at his face, his wife was still sleeping heavily at his side, but he knew it was almost time. He rolled onto his side and silenced the alarm before it went off. His wife worked nights at a meatpacking plant and had only come in a few hours ago. He knew she was bone-weary and arthritic pain made it hard for her to sleep. He didn't want to wake her unnecessarily. Slowly he slid from under the covers, shivering as the cold air enveloped him in its icy embrace. He sat momentarily on the side of the bed, taking a mental inventory of his aches and pains, wiggling his toes and ankles to make sure he'd be able to stand up without losing his balance and falling. He couldn't afford anymore broken bones. Damn lucky they even had jobs!
Satisfied that he could stand, he rose slowly and shuffled to the closet. Getting dressed before the cold invaded his very core was important he'd found, otherwise he tended to stay cold all day. Reaching the closet, he slid open the door and hurriedly reached for one of his two heavy woollen shirts. Thank god his wife had been able to mend it, he thought as he slipped it on, a new shirt was definitely not in their budget this year! As he reached for his blue jeans another thought struck him and he grunted in mild surprise. Eighty years old today, he thought, as he slipped into the jeans...
Colder than normal, he thought, and that was saying something. He and is wife, whose labored breathing was muffled, but still audible, even buried as she was under the heavy, woollen blankets, kept the thermostat turned down as far as they could tolerate during the cold winter months. What with electricity rates having climbed steadily over the years, it was just too big a hit to their budget to keep the apartment heated to more than the bare minimum. He felt the cold gnawing away at his joints and settling into his bones, despite the extra blankets.
He could just make out the muted rush of winter's cold breath on the nearby window as gusts pushed against the concrete and brick complex. It was going to be another windy, cold day by the sound of it, he thought, already dreading the walk to the nearby bus stop. It would take him perhaps ten minutes to shuffle the six blocks to the metro stop. He didn't move very fast anymore. Both hips had been replaced a while back, along with his left knee. He'd been fortunate that his employer still provided medical coverage, not many did anymore since the government had entered the business. His employer's coverage was more expensive, took a bigger bite out of his meager salary, but at least he could get into see a doctor without a six month wait. Medicare wasn't an option since he still worked; the government had dropped coverage for seniors who were still working as part of the 2030 "austerity" initiative, designed to save America from having to declare a formal bankruptcy.
A soft, steady tick tick tick brought him back to the apartment. The alarm clock hadn't gone off yet, it wasn't quite 5:30, but he'd awakened a few minutes early. The ticking came not from the alarm clock, but from what many would consider an antique these days, an old-fashion wind up grandfather's clock that stood in the corner of the small bedroom, next to the single wooden dresser. The grandfather's clock was really the only thing the old couple owned of any interest. The rest of the furniture was cheaply made from pressed wood. It was merely functional at best. The old man knew his wife desperately wanted to replace the worn out furniture. Many of the wooden pieces were scratched and even splintered, but who could afford new furniture these days? Still, the furniture served its purpose, and they'd gotten it years ago before prices had risen sharply, the result of the rest of the world outbidding Americans for lumber... and for everything else for that matter. The U.S. dollar just could not compete, which meant everything cost more in dollars.
It wasn't a big apartment building, perhaps a hundred units in all, populated by those who couldn't afford more spacious quarters uptown. The apartments were efficiency units, kitchen, small dining area, a living room and a bedroom, no more than 750 square feet all in. Still, it was a roof over their head and only cost a couple week's wages, and it was definitely better than the barracks that'd been built a few years back to hold the indigent - baby boomers who weren't even able to afford a place of their own, all 35 million of them.
He exhaled as he shifted in bed, making sure not to let the covers slip from him, not yet. He might have a couple more minutes before the alarm went off. He didn't want to look at it, didn't want to see that it was time. A few more minutes to rest before getting ready, in the cold and dark, for another day at the plant. The irony of working at a coaling station did not escape him. After all, he'd spent most of his career as an economist working for Big Oil, much of his time taken up trying to figure out an economically viable solution to transitioning the energy industry to a successor energy source, one that would satisfy the Green movement, proving to them that Big Oil was serious about developing clean alternate energy sources. It was actually true of course. The energy industry quite understood that oil was a finite and diminishing resource that would need to be replaced with something else. The problem was how to economically make the transition to whatever that something else was while staying in business. Of course the lack of a strategic energy policy and the sharp drop in the value of the U.S. dollar had forced the U.S. to abandon most environmental goals. It had turned out that much of the Green movement was a luxury for the rich.
Coal had come back in a big way in the United States after the dollar's slow motion collapse sent the price of oil to $200 a barrel. The environmentalists howled their outrage when Congress passed the legislation lifting all bans on the use of coal by utilities and what few manufacturing plants remained in the country. The politicians had even cleared the way for the return of coal fired heating units in multi-unit housing, recognizing that 79 million baby boomers and countless younger voters would turn them out of office if they didn't let Americans keep their electricity. After all, America was the Saudi Arabia of coal, and it only made sense to use those natural resources that the country still controlled, regardless of the environmental impact.
The inflation that had swept the country over the last decade had wiped out many retirement nest eggs besides his own. He recalled having read years earlier that 50% of all baby boomers would run out of money before they died, an estimate based on a mere 3% inflation rate, below the historical 4.5%, and well below the high single digits that had prevailed for much of the last twenty years. He'd been confident he wouldn't be one of them though. He'd already saved close to $2 million by the time he'd turned fifty, a retirement portfolio capable of throwing off $80,000 in income per annum while still lasting at least 30-years, or so he'd been taught. His defined benefit plan would pay him an additional $950,000 lump sum when he turned 59-years old, and he was still saving in his 401(k). No, he'd been downright smug at the time! He simply hadn't realized what high-single digit inflation could do to an investment portfolio. Hadn't realized that the dollar was losing 37% of its value every 10-years at the historical 4.5% inflation rate that had prevailed post World War II and had lost 97% of its value since the Federal Reserve's creation in 1913.
The old man let his mind wander back over the decades to a time when he'd just turned fifty, a time when both the Republican and Democratic parties had lost their senses and were spending money they didn't have on initiatives that provided no long-term benefits to America, saddling generations of Americans with debt they couldn't possibly pay back. The politicians had recklessly created credit, encouraging asset bubble after asset bubble in an attempt to jump start the economy and, in so doing, buy votes for themselves. The madness had continued right up until the riots. The high unemployment rates and rising inflation had led to millions struggling simply to survive. Some of those millions eventually took to the streets to protest $8 bread and $10 gas. The price controls hadn't worked, nor had the government's attempts to run the country's farms through a combination of price controls and tax incentives.
The old man shifted once again under the heavy blankets. The cold was still gnawing at his face, his wife was still sleeping heavily at his side, but he knew it was almost time. He rolled onto his side and silenced the alarm before it went off. His wife worked nights at a meatpacking plant and had only come in a few hours ago. He knew she was bone-weary and arthritic pain made it hard for her to sleep. He didn't want to wake her unnecessarily. Slowly he slid from under the covers, shivering as the cold air enveloped him in its icy embrace. He sat momentarily on the side of the bed, taking a mental inventory of his aches and pains, wiggling his toes and ankles to make sure he'd be able to stand up without losing his balance and falling. He couldn't afford anymore broken bones. Damn lucky they even had jobs!
Satisfied that he could stand, he rose slowly and shuffled to the closet. Getting dressed before the cold invaded his very core was important he'd found, otherwise he tended to stay cold all day. Reaching the closet, he slid open the door and hurriedly reached for one of his two heavy woollen shirts. Thank god his wife had been able to mend it, he thought as he slipped it on, a new shirt was definitely not in their budget this year! As he reached for his blue jeans another thought struck him and he grunted in mild surprise. Eighty years old today, he thought, as he slipped into the jeans...
Most Individual Investors Still Wrong!
The investing year isn't quite over but the returns are in for Treasury bonds in 2009 - and it ain't pretty. We wrote last week that individual investors fled in droves to supposedly risk free Treasuries in 2009, dumping $357 billion into bond mutual funds (much of it going into Treasuries) through the first 11 months of the year, while actually pulling money out of stock mutual funds. The S&P 500 is up over 20% on the year while Treasury bonds have lost almost 15% because of the (inevitable) backup in interest rates from record lows in 2008. No straight lines in nature or the markets, but rising interest rates are waiting for all of us over the next few decades as we pay the piper for our bumbling Federal Government's complete mismanagement of fiscal and monetary policy over the last 20-years. Of course, forecasting rising interest rates is the same as forecasting rising inflation, since real interest rates (interest adjusted for inflation) are fairly constant at between 1% and 2%.
Wednesday, December 23, 2009
Using Market Forecasts
A quick note on how we use our market forecasts. We are big believers in the KISS principal. Complicated strategies are hard to execute and prone to major failures. Knowing that the stock market is likely to sell off 20% or so sometime in 2010 is not the same as having the ability to capture the profit, either through short selling, or a timely exit (and subsequent re-entry). Rather, we use our forecasts to help with the valuation process and with risk management. Stock selection for us starts with basic business valuation; it is impossible to value a business in a vacuum. Consumer discretionary businesses are worth less currently given the likelihood that it will be years before consumers have the wherewithal to spend robustly once again. Consequently, we require a larger discount than previously before buying retailers, restaurants, and other consumer discretionary businesses. Likewise, we would like a bigger margin of safety in general before purchasing a share of a business right now, given our view that the market is overbought, and some 25% over valued. Conversely, we are also likely to sell a successful investment more quickly than otherwise in order to prevent price risk from building in the portfolio in a higher risk market.
We urge individual investors to always stay properly diversified and to avoid allowing certainty to rise too high in a very uncertain world!
Happy Holidays!
We urge individual investors to always stay properly diversified and to avoid allowing certainty to rise too high in a very uncertain world!
Happy Holidays!
Saturday, December 19, 2009
2010 Market Forecast
"Why Are Most Investors Mostly Wrong Most of the Time?" was the title of Dr. Marc Faber's October Market Commentary. It's a great question and one that deserves at least an attempt at answering. But perhaps you disagree with the basic assumption of the question? Are most investors mostly wrong most of the time? The data would strongly tend to support that belief. Take a study by Dalbar, a Boston research firm, that was released a few years ago. Dalbar found that individual stock mutual fund investors earned an average return of 5.23% per annum from 1984 to 2000 - a period during which the unmanaged S&P 500 returned 16.3% per annum on average. The average fixed income (bond) investor earned 6% per annum on average during that period while the Lehman Brothers Long-term Bond index returned 11.83%. Mind boggling isn't it? Anyone care to calculate how much wealth individual stock mutual fund investors managed to leave on the table during one of the greatest secular bull markets of all time? I'll save you the trouble - $1,060,000 in foregone profit on a $100,000 initial investment. Incredible! A $100,000 investment in the S&P 500 index in 1984 would have grown to $1,301,000 by the end of 2000. Meanwhile, the typical individual investor's $100,000 would have grown to a whopping $241,000. Yikes!
Okay then, most individual investors are mostly wrong most of the time, just as Dr. Faber contends - but why? Well, the field of behavioral finance offers us some clues. Behavioral Finance is the study of how human psychology effects decision making in the investment arena, and it has produced some very intriguing findings over the years. One commonly observed tendency is for individual investors to place a much higher probability on an investment outcome than is warranted. High levels of (undeserved) certainty lead many investors to pursue concentrated investment portfolios lacking sufficient diversification. Certainty also leads investors to dive into and exit markets at the wrong time. For instance, investors seem to gain confidence the longer a trend is in place, leading them to load up on an investment at just the wrong time. Individual investors were fully invested in stocks and real estate in 2007, seemingly convinced that stocks and home prices had nowhere to go but up, despite strong evidence that prices had disconnected from the real economy. Likewise, many investors bailed out of the stock market in the spring of 2009 at a time when the S&P 500 was demonstrably undervalued and likely to deliver well above average returns going forward.
Currently, investors seem to be buying into the notion that deflation is the greatest risk out there - how else to explain the huge demand for bond mutual funds in 2009? Well, perhaps it is simply the fear of owning stocks that is forcing people into bonds by default, rather than a conscious fear of deflation. Regardless of what is driving investors to load up on bond funds in 2009 and ignore stock funds, it is likely that most individual investors will be mostly wrong once again. Year to date U.S. bond funds have attracted net inflows of $357 billion while stock mutual funds had outflows of $11 billion, according to Barrons (stock mutual funds currently hold about $4.5 trillion in assets while bond funds hold about $2 trillion). Furthermore, according to Morningstar, nine of the year's ten best selling mutual funds invest in bonds. A disconcerting development for all of those folks who chose to buy bond funds in 2009, thus missing a $4 trillion dollar increase in the value of the S&P 500 from the March lows (to put that number in perspective the U.S. economy currently produces $14 trillion in goods and services annually). Put another way, individual investors chose to buy bonds, which have a superb 10 and 20-year trailing track record, apparently on the assumption that the long-running trend will continue. They bought bonds despite the fact that every time the 1-year rate of return of the Ryan index of 30-year Treasury bonds was above 30% the subsequent return was negative - the return in 2008 was 41%! They bought bonds near record low yields even while stocks were available at a sharp discount to any reasonable estimate of fair value (the S&P 500 companies probably have the ability to earn $60 per share in "normalized" earnings, which means the index was available for 11x earnings in March at the 666 low). They chose to buy bonds despite huge government borrowing needs, and despite a U.S. dollar that is likely to continue to fall in value over the long run (circumstances which will normally lead to rising yields and inflation, and falling bond prices), instead of buying stocks at a time when the 10-year compound annual total return is the worst ever - by a HUGE amount. In fact, except for a brief period of time in the late 1930s, trailing 10-year compound returns had never been negative, going all the way back to 1827. As of February 11 2009, the 10-year compound annual total return was minus 4%!
Acting on our belief that most individual investors are mostly wrong most of the time, I would maintain that stocks are a better buy right now than bonds in the United States. However, the S&P 500 returned more in a shorter period of time between March and October of 2009 than at any other time since the Dow's humongous recover rally in 1933! Furthermore, fair value for the S&P 500 is likely somewhere between 800 and 900 based on that $60 per share earnings estimate, making the index over valued by around 25%. Finally, stock mutual fund investing inflows hit their second highest level of the year in the week ending October 23, after net outflows in August and September (five months after the bottom), indicating that individual investors may finally be ready to embrace a rising stock market (the S&P 500 has essentially moved sideways since October and may be in the process of putting in an intermediate top).
Add it all up and it is more than a little likely then that the stock market will correct, giving up at least some of it's heady 2009 gains. Of course the $64,000 dollar question is when and by how much!
Uncertainty is a fact of life and a fact of investing. Capital preservation should be any investor's first priority. Losing money is an investing sin due to simple mathematics. A 20% decline in one's portfolio requires a 25% gain simply to get back to even. There is a reason that Warren Buffet's first rule of investing is don't lose money and his second is: refer to rule one! Proper diversification is an essential tool in any investor's tool box. We are already on record as liking stocks more than bonds for 2010, but what about cash, given that we will likely see a pullback in the stock market sometime in 2010 (likely beginning in the next few months) that could breach 20% (a common definition of a bear market). Cash is an asset class after all, although one that currently yields a negative real rate of return ( return adjusted for inflation).
The Federal Reserve has increased the monetary base (currency in circulation plus reserves) from approximately $850 billion to around $2.1 trillion since the financial crisis began. Furthermore the Fed has continued to grow the monetary base at an almost 100% per annum rate, indicating that it does not see a quick end to the financial crisis. Our government is basically flooding the economy with paper money and hoping that it will start to circulate sooner rather than later. In very simple terms, the more paper money circulating the more everything will cost in that paper money - inflation is coming! In fact, it is likely that inflation is already here. Actual inflation is currently closer to 6% than the 1% reported by the government (perhaps we'll blog on the government's systematic under reporting of inflation next). Cash then is a wasting asset! It is not holding its value now and is likely to be worth substantially less 10 years from now. Most Americans don't truly understand the pernicious nature of inflation. Inflation has averaged 4.5% post world war II (using the government's own highly distorted metrics). At a 4.5% rate of inflation, a $20,000 car will cost $31,000 ten years from now! We like cash even less than bonds, except in the very short term.
To summarize, we see a correction in the stock market sometime next year that could hit 20% and is likely to occur sometime in the next few quarters. It is likely however that the market will not make fresh bear market lows and that the Federal Reserve and government will support the market, pushing it back toward current levels by year end. Bonds are a disaster waiting to happen, particularly if the Fed ends quantitative easing on schedule in March, leaving the corporate bond market and foreign central banks to absorb some $2 trillion in Federal debt in 2010. Finally, we like cash even less, given the huge increase in the monetary base over the last 18 months and the likelihood of continued irresponsible government spending. It is more than possible, however, that the dollar rallies for a few quarters as it works off its currently oversold state. Any non-dollar assets are preferable once the current dollar rally sputters and dies, including gold.
Our 10-year forecast is for rising inflation, rising taxes, rising interest rates, and rising commodity prices. We do not see stocks advancing much in real terms over the next 10-years, but they might manage to hold their own against inflation, thus preserving your purchasing power. Our favorite investing assets remain commodities, international stocks and international bonds. Our favorite area to invest remains Asia. Our favorite sectors remain Asian consumers, U.S. multinationals, and world infrastructure. We would avoid the U.S. consumer discretionary sector (for example retail and restaurants) unless the purchase price is literally a steal.
However, the future is always uncertain and no one should feel so certain of it that they load up on any one asset class, sector, or theme.
Most individual investors are mostly wrong most of the time. We do not condone market timing or concentrated investing for individuals. Rather we recommend that you build a properly diversified portfolio that makes sense given your individual circumstances and financial goals. Your strategic allocation should change only as your individual big-pictures circumstances change. As far as executing your investing plan... well, we advocate contrarian investing in all asset classes all of the time, and by now you can probably guess why!
Okay then, most individual investors are mostly wrong most of the time, just as Dr. Faber contends - but why? Well, the field of behavioral finance offers us some clues. Behavioral Finance is the study of how human psychology effects decision making in the investment arena, and it has produced some very intriguing findings over the years. One commonly observed tendency is for individual investors to place a much higher probability on an investment outcome than is warranted. High levels of (undeserved) certainty lead many investors to pursue concentrated investment portfolios lacking sufficient diversification. Certainty also leads investors to dive into and exit markets at the wrong time. For instance, investors seem to gain confidence the longer a trend is in place, leading them to load up on an investment at just the wrong time. Individual investors were fully invested in stocks and real estate in 2007, seemingly convinced that stocks and home prices had nowhere to go but up, despite strong evidence that prices had disconnected from the real economy. Likewise, many investors bailed out of the stock market in the spring of 2009 at a time when the S&P 500 was demonstrably undervalued and likely to deliver well above average returns going forward.
Currently, investors seem to be buying into the notion that deflation is the greatest risk out there - how else to explain the huge demand for bond mutual funds in 2009? Well, perhaps it is simply the fear of owning stocks that is forcing people into bonds by default, rather than a conscious fear of deflation. Regardless of what is driving investors to load up on bond funds in 2009 and ignore stock funds, it is likely that most individual investors will be mostly wrong once again. Year to date U.S. bond funds have attracted net inflows of $357 billion while stock mutual funds had outflows of $11 billion, according to Barrons (stock mutual funds currently hold about $4.5 trillion in assets while bond funds hold about $2 trillion). Furthermore, according to Morningstar, nine of the year's ten best selling mutual funds invest in bonds. A disconcerting development for all of those folks who chose to buy bond funds in 2009, thus missing a $4 trillion dollar increase in the value of the S&P 500 from the March lows (to put that number in perspective the U.S. economy currently produces $14 trillion in goods and services annually). Put another way, individual investors chose to buy bonds, which have a superb 10 and 20-year trailing track record, apparently on the assumption that the long-running trend will continue. They bought bonds despite the fact that every time the 1-year rate of return of the Ryan index of 30-year Treasury bonds was above 30% the subsequent return was negative - the return in 2008 was 41%! They bought bonds near record low yields even while stocks were available at a sharp discount to any reasonable estimate of fair value (the S&P 500 companies probably have the ability to earn $60 per share in "normalized" earnings, which means the index was available for 11x earnings in March at the 666 low). They chose to buy bonds despite huge government borrowing needs, and despite a U.S. dollar that is likely to continue to fall in value over the long run (circumstances which will normally lead to rising yields and inflation, and falling bond prices), instead of buying stocks at a time when the 10-year compound annual total return is the worst ever - by a HUGE amount. In fact, except for a brief period of time in the late 1930s, trailing 10-year compound returns had never been negative, going all the way back to 1827. As of February 11 2009, the 10-year compound annual total return was minus 4%!
Acting on our belief that most individual investors are mostly wrong most of the time, I would maintain that stocks are a better buy right now than bonds in the United States. However, the S&P 500 returned more in a shorter period of time between March and October of 2009 than at any other time since the Dow's humongous recover rally in 1933! Furthermore, fair value for the S&P 500 is likely somewhere between 800 and 900 based on that $60 per share earnings estimate, making the index over valued by around 25%. Finally, stock mutual fund investing inflows hit their second highest level of the year in the week ending October 23, after net outflows in August and September (five months after the bottom), indicating that individual investors may finally be ready to embrace a rising stock market (the S&P 500 has essentially moved sideways since October and may be in the process of putting in an intermediate top).
Add it all up and it is more than a little likely then that the stock market will correct, giving up at least some of it's heady 2009 gains. Of course the $64,000 dollar question is when and by how much!
Uncertainty is a fact of life and a fact of investing. Capital preservation should be any investor's first priority. Losing money is an investing sin due to simple mathematics. A 20% decline in one's portfolio requires a 25% gain simply to get back to even. There is a reason that Warren Buffet's first rule of investing is don't lose money and his second is: refer to rule one! Proper diversification is an essential tool in any investor's tool box. We are already on record as liking stocks more than bonds for 2010, but what about cash, given that we will likely see a pullback in the stock market sometime in 2010 (likely beginning in the next few months) that could breach 20% (a common definition of a bear market). Cash is an asset class after all, although one that currently yields a negative real rate of return ( return adjusted for inflation).
The Federal Reserve has increased the monetary base (currency in circulation plus reserves) from approximately $850 billion to around $2.1 trillion since the financial crisis began. Furthermore the Fed has continued to grow the monetary base at an almost 100% per annum rate, indicating that it does not see a quick end to the financial crisis. Our government is basically flooding the economy with paper money and hoping that it will start to circulate sooner rather than later. In very simple terms, the more paper money circulating the more everything will cost in that paper money - inflation is coming! In fact, it is likely that inflation is already here. Actual inflation is currently closer to 6% than the 1% reported by the government (perhaps we'll blog on the government's systematic under reporting of inflation next). Cash then is a wasting asset! It is not holding its value now and is likely to be worth substantially less 10 years from now. Most Americans don't truly understand the pernicious nature of inflation. Inflation has averaged 4.5% post world war II (using the government's own highly distorted metrics). At a 4.5% rate of inflation, a $20,000 car will cost $31,000 ten years from now! We like cash even less than bonds, except in the very short term.
To summarize, we see a correction in the stock market sometime next year that could hit 20% and is likely to occur sometime in the next few quarters. It is likely however that the market will not make fresh bear market lows and that the Federal Reserve and government will support the market, pushing it back toward current levels by year end. Bonds are a disaster waiting to happen, particularly if the Fed ends quantitative easing on schedule in March, leaving the corporate bond market and foreign central banks to absorb some $2 trillion in Federal debt in 2010. Finally, we like cash even less, given the huge increase in the monetary base over the last 18 months and the likelihood of continued irresponsible government spending. It is more than possible, however, that the dollar rallies for a few quarters as it works off its currently oversold state. Any non-dollar assets are preferable once the current dollar rally sputters and dies, including gold.
Our 10-year forecast is for rising inflation, rising taxes, rising interest rates, and rising commodity prices. We do not see stocks advancing much in real terms over the next 10-years, but they might manage to hold their own against inflation, thus preserving your purchasing power. Our favorite investing assets remain commodities, international stocks and international bonds. Our favorite area to invest remains Asia. Our favorite sectors remain Asian consumers, U.S. multinationals, and world infrastructure. We would avoid the U.S. consumer discretionary sector (for example retail and restaurants) unless the purchase price is literally a steal.
However, the future is always uncertain and no one should feel so certain of it that they load up on any one asset class, sector, or theme.
Most individual investors are mostly wrong most of the time. We do not condone market timing or concentrated investing for individuals. Rather we recommend that you build a properly diversified portfolio that makes sense given your individual circumstances and financial goals. Your strategic allocation should change only as your individual big-pictures circumstances change. As far as executing your investing plan... well, we advocate contrarian investing in all asset classes all of the time, and by now you can probably guess why!
Tuesday, November 24, 2009
Create Your Own Income Stream!
Once again I'm electing to postpone my annual forecast for the economy and capital markets due to a more pressing issue - the need to debunk the slick variable annuity sales pitches making the rounds. Annuity salesmen from insurance companies such as The Hartford, Prudential and Mass Mutual, and stock brokers from the likes of E. D. Jones, Wachovia, and Morgan Keegan (Regions Financial) are preying on peoples' fear of running out of money before they die to sell them variable annuities. Variable annuities are expensive, restrictive, and usually poorly performing investment vehicles that were designed to shelter high-income earners from paying more taxes than absolutely necessary; they've morphed into guaranteed income investments for the elderly. However, they are wildly inappropriate for most individuals who are simply looking to ensure a certain level of income in retirement. At least one retired couple has learned to just say NO to variable annuities after getting a complete explanation of what these expensive insurance contracts actually could and couldn't do for them. The husband related how the E.D Jones broker was "pushy" when told that the insurance contract was about to be cancelled (during the free look period); clearly Mr. Broker didn't like the idea of losing his big, fat commission. Fortunately, the husband and wife had had a change of heart once they'd read the prospectus (which they finally received) and realized how much they were paying and how little they were actually getting once the boilerplate was boiled down to reality.
Nevertheless, the retired couple's basic problem still remains - how to earn a sufficient return on their savings to meet their retirement needs? (in a perpetually low interest rate environment that continues to punish savers and reward borrowers - thank you for nothing Federal Reserve!). Fortunately there is an answer that is far less expensive and far less restrictive than the Variable Annuity. It's called a diversified stock and bond portfolio!
A properly constructed, diversified portfolio will contain assets (stocks, commodities, real estate) that hedge against inflation in order to preserve purchasing power over the long run. The portfolio will also contain sufficient fixed income assets to generate a minimum level of current income to meet current liabilities. The wonderful thing about bonds is that they throw off a well defined stream of cash that can be used to meet liabilities as they come due! You don't even have to take credit risk if you stick with Treasuries and investment grade corporates and municipals. It is relatively easy for a qualified investment advisor (as opposed to a broker-dealer representative aka fee-based advisor) to construct a diversified bond portfolio that will yield 4% or so without taking any meaningful credit risk. As well, it is fairly easy currently to build a diversified portfolio of blue chip, dividend paying stocks with an average yield of 3.5%. The 4% rule tells us that a 60/40 stock/bond portfolio will last a minimum of 30 years, which gives us a starting point, at least, for positioning a portfolio for the decumulation phase of an investor's life cycle. The math: a bond portfolio yielding 4% and comprising 40% of the overall portfolio yields 1.6% to the investor, while a stock portfolio yielding 3.5% and comprising 60% of the overall portfolio yields 2.1% to the investor. Total yield of the 60/40 stock/bond portfolio is 3.7%.
Let's take a $1,000,000 portfolio as a case study to see what kind of current income we could generate while still positioning ourselves for a 30 year retirement. We would allocate $400,000 to bonds and currently could construct a portfolio of investment grade corporates and municipals that would give us an average yield of at least 4% with a duration of between 5 and 10 years. Interest produced would run at least $16,000 per year. We would allocate $600,000 to a diversified portfolio of blue chip stocks and could currently easily get a 3.5% average dividend yield, which would throw off at least an additional $21,000 in dividends. Total income generated by the entire $1,000,000 portfolio is at least $37,000, or approximately 3.7% per annum (almost meeting our 4% rule). Careful stock selection focusing on high-quality companies with well-covered dividends will provide an additional benefit in that the dividend income will rise over time as the companies raise dividends. Companies like Proctor and Gamble, Johnson and Johnson, Coke, and Microsoft can provide an annual and growing annuity unencumbered by the strait jacket restrictions placed on Variable Annuities sold by insurance companies.
And there you have it: a portfolio of stocks and bonds becomes that low-cost variable annuity that can provide a payout of (in this example) 3.7% per annum without touching principal - something you aren't allowed to do anyway in most variable annuities for between 5 and 10 years if you wish to qualify for the minimum income guarantee. The portfolio's overall yield will rise over time as the dividend paying stocks in the stock portion raise dividends regularly. Additionally, the 3% plus per year in average variable annuity expenses stays in your pocket rather than going to the insurance company. And finally, should your situation change and you need access to your money because of an unforeseen emergency... well, you have access without having to pay any of the penalties or forgo any of the guarantees.
One last thought:
Individuals with a shorter time horizon (less than 30 years) could construct portfolios with a greater allocation to bonds and reduced allocation to stocks, thus increasing the overall portfolio yield. Likewise, investors with excess wealth can reduce their allocation to stocks, if they wish to reduce variability in cash flows, since purchasing power risk isn't as much of a concern. After all, someone with $5 million of assets and a time horizon of only 15 years is likely to be able to survive on a 3% draw ($150,000) or even a 2% draw ($100,000) to meet everyday basic needs.
Our retired couple made a good call cancelling the annuity contract. They were looking at paying an up front commission of 3.5% and better than 3% annually in costs for a contract that was unlikely to benefit their income needs in any meaningful way. Now they need to construct a properly diversified stock and bond portfolio that will throw off sufficient income to meet their everyday needs while still protecting them from the long-term risk of inflation. By saying no to high-cost, restrictive and poorly-performing variable annuities and YES to low cost, flexible, diversified portfolios of blue chip stocks and bonds, our retired couple will get an acceptable level of income and still retain control of their assets!
Nevertheless, the retired couple's basic problem still remains - how to earn a sufficient return on their savings to meet their retirement needs? (in a perpetually low interest rate environment that continues to punish savers and reward borrowers - thank you for nothing Federal Reserve!). Fortunately there is an answer that is far less expensive and far less restrictive than the Variable Annuity. It's called a diversified stock and bond portfolio!
A properly constructed, diversified portfolio will contain assets (stocks, commodities, real estate) that hedge against inflation in order to preserve purchasing power over the long run. The portfolio will also contain sufficient fixed income assets to generate a minimum level of current income to meet current liabilities. The wonderful thing about bonds is that they throw off a well defined stream of cash that can be used to meet liabilities as they come due! You don't even have to take credit risk if you stick with Treasuries and investment grade corporates and municipals. It is relatively easy for a qualified investment advisor (as opposed to a broker-dealer representative aka fee-based advisor) to construct a diversified bond portfolio that will yield 4% or so without taking any meaningful credit risk. As well, it is fairly easy currently to build a diversified portfolio of blue chip, dividend paying stocks with an average yield of 3.5%. The 4% rule tells us that a 60/40 stock/bond portfolio will last a minimum of 30 years, which gives us a starting point, at least, for positioning a portfolio for the decumulation phase of an investor's life cycle. The math: a bond portfolio yielding 4% and comprising 40% of the overall portfolio yields 1.6% to the investor, while a stock portfolio yielding 3.5% and comprising 60% of the overall portfolio yields 2.1% to the investor. Total yield of the 60/40 stock/bond portfolio is 3.7%.
Let's take a $1,000,000 portfolio as a case study to see what kind of current income we could generate while still positioning ourselves for a 30 year retirement. We would allocate $400,000 to bonds and currently could construct a portfolio of investment grade corporates and municipals that would give us an average yield of at least 4% with a duration of between 5 and 10 years. Interest produced would run at least $16,000 per year. We would allocate $600,000 to a diversified portfolio of blue chip stocks and could currently easily get a 3.5% average dividend yield, which would throw off at least an additional $21,000 in dividends. Total income generated by the entire $1,000,000 portfolio is at least $37,000, or approximately 3.7% per annum (almost meeting our 4% rule). Careful stock selection focusing on high-quality companies with well-covered dividends will provide an additional benefit in that the dividend income will rise over time as the companies raise dividends. Companies like Proctor and Gamble, Johnson and Johnson, Coke, and Microsoft can provide an annual and growing annuity unencumbered by the strait jacket restrictions placed on Variable Annuities sold by insurance companies.
And there you have it: a portfolio of stocks and bonds becomes that low-cost variable annuity that can provide a payout of (in this example) 3.7% per annum without touching principal - something you aren't allowed to do anyway in most variable annuities for between 5 and 10 years if you wish to qualify for the minimum income guarantee. The portfolio's overall yield will rise over time as the dividend paying stocks in the stock portion raise dividends regularly. Additionally, the 3% plus per year in average variable annuity expenses stays in your pocket rather than going to the insurance company. And finally, should your situation change and you need access to your money because of an unforeseen emergency... well, you have access without having to pay any of the penalties or forgo any of the guarantees.
One last thought:
Individuals with a shorter time horizon (less than 30 years) could construct portfolios with a greater allocation to bonds and reduced allocation to stocks, thus increasing the overall portfolio yield. Likewise, investors with excess wealth can reduce their allocation to stocks, if they wish to reduce variability in cash flows, since purchasing power risk isn't as much of a concern. After all, someone with $5 million of assets and a time horizon of only 15 years is likely to be able to survive on a 3% draw ($150,000) or even a 2% draw ($100,000) to meet everyday basic needs.
Our retired couple made a good call cancelling the annuity contract. They were looking at paying an up front commission of 3.5% and better than 3% annually in costs for a contract that was unlikely to benefit their income needs in any meaningful way. Now they need to construct a properly diversified stock and bond portfolio that will throw off sufficient income to meet their everyday needs while still protecting them from the long-term risk of inflation. By saying no to high-cost, restrictive and poorly-performing variable annuities and YES to low cost, flexible, diversified portfolios of blue chip stocks and bonds, our retired couple will get an acceptable level of income and still retain control of their assets!
Friday, November 13, 2009
The New Variable Annuities
I had planned on updating our macroeconomic view and laying out a likely course for the stock market over the next year, but have decided to put that blog on hold for a week in order to write once again about variable annuities. The catalyst for my change of mind? A seeming rash of variable annuity sales to folks who have no need for the expensive, restrictive, and even punitive insurance contracts (yes they are heavily regulated insurance contracts). The insurance sales representatives and the insurance companies themselves have stepped up their game and are preying on peoples' fear of running out of money before they die like never before. The seemingly too-good-to-be-true contracts are exactly that - too good to be true. Yet like the snake-oil salesmen of yesteryear, the variable annuity peddlers of today promise that these almost impossible to understand insurance products are the panacea for all that ails you.
Are you worried that you might end up in a long-term care facility? No problem! Your variable annuity will double the amount of your money you are allowed to take out if you do (if you pay extra for the privilege). Worried that you will run out of money before you die? No problem! Your handy dandy variable annuity will guarantee you a monthly payout for life (if you pay extra). Worried about dying early with your annuity investment under water? No problem! Your variable annuity will reimburse your beneficiary your original investment (if you pay extra and - in many cases - aren't 75 or older). Of course all of these guarantees come with a heavy price - most variable annuities will charge you more than 3% each and every year that you own the contract, although the fees are difficult to tease out of the offering documents and most people are blissfully unaware that they are paying so much for so little (an assertion that I will back up here shortly). Additionally, the investment choices given are usually extremely limited relative to the broad investment universe available to IRA owners, and typically are mutual funds that the insurance company manages in-house (more fees for them) or are managed by a "preferred provider" who kicks back fees to the insurance company (isn't that a cozy relationship?). And did we mention that these insurance contracts take a PhD in nuclear physics to understand?
There are now more than 1,100 different annuities on the market according to SmartMoney Magazine, up from 295 a decade ago. Variable annuities are suppose to be sold by prospectus because of their complexity and heavily regulated status, but the truth is many people aren't even aware that they are buying a variable annuity, or have only the vaguest idea of what they are buying. Russell Schellenberger was a successful business man who "didn't even know he'd bought one (variable annuity), according to Janet Paskin of SmartMoney. The word "annuity" hadn't even been mentioned during the sales process. It is a safe bet that Mr. Schellenberger wasn't given a prospectus, not that the highly legalized boilerplate would have necessarily enlightened him much. I'm a Chartered Financial Analyst (CFA)r with twenty years of forensic financial statement analysis under my belt. Nevertheless, I was recently put to the test on behalf of a nice, older couple who handed me their prospectus in the hope of getting an explanation of what they'd just purchased (They weren't given the prospectus before they signed on the dotted line, but instead received it after I explained to them that they were suppose to have gotten one and that the prospectus would explain the investment to them). After wading through the legal document I can honestly claim that I was only half right... they were suppose to have gotten a prospectus.
It's important to understand that the new-age variable annuity is an expensive, yet untested product. Traditional insurance works by using large numbers of people to spread risk out; the insurance company keeps the difference between the premiums collected and the insurance paid out. Variable annuities concentrate risk in the stock market. There is more than a little concern within the industry that insurance companies will not be able to meet their obligations if the stock market continues to under perform expectations. York University professor Moshe Milevsky has studied annuities for decades and believes that the new products are under priced to cover the cost of protecting investors in a crash. Moody's has raised red flags recently over concerns that insurance companies will not be able to meet their promises to investors under plausible worst case scenarios. And annuities do fail. Exhibit A is U.K. Equitable, a major British insurance company. U.K. Equitable was forced to sharply reduce the minimum guaranteed payout to annuity holders in the late 1990's because interest rates didn't do what actuaries had predicted.
Turns out then that the minimum income guarantee that is available (for an extra cost) is only as good as the financial strength of the insurance company selling the annuity. But what about the basic product itself (assuming that the insurance companies will survive the next big downturn in the stock market) - is the minimum income guarantee really a panacea for investors who have under saved and are now worried that they will outlive their assets? The answer is not really. Here's how the typical product works these days:
An investor buys a variable annuity, placing the money into an investment account that then disburses the money to sub accounts composed of typically high cost mutual funds (remember that cozy relationship between the insurance company and the either captive mutual funds or "preferred providers"?) The mortality and expense fees for the variable annuity usually run around 1.65% per year while the underlying funds usually suck out another 1.5% to 2.0% of the investors money every year. A 3.0% plus per annum expense ratio is a high hurdle to overcome and almost guarantees under performance of the contract relative to owning individual stocks and bonds or low cost, no-load mutual funds. Your broker is often receiving the 12b-1 trailers on the funds in which you invest inside the variable annuity by the way.
Your investment account is left to grow, and the insurance company hopes it grows sufficiently to cover the guaranteed income payments once you start to take them down the road. One product I recently reviewed for an investor had been bought when the investor was 60 years of age. He was guaranteed a minimum income benefit of $30,000 per year if he left the money in place for at least 10 years. He bought a $300,000 variable annuity which was placed into stock mutual funds. The insurance company moved the bulk of the money into a fixed account earning 2% per annum when the bottom fell out of the market in 2008 - it will remain their for the rest of the contract life in order to protect the insurance company. The investor will be allowed to take $30,000 of his own money out of the contract every year until he dies, starting when he turns 70. Of course, the average life expectancy for a man of his socioeconomic background and health is around 78. It is still barely possible that his investment account will make it back close to the original $300,000 level before he turns 70, since he does still have $29,000 invested in stock mutual funds within the annuity - perhaps it will double in the next 8 years, although that is unlikely.
Regardless, this investor has taken $300,000 from his tax deferred IRA (in which he had absolute freedom to invest in any number of low cost mutual funds or directly in a portfolio of blue chip stocks) and put the money into a restrictive, condition-filled insurance product that might actually return all of his original investment to him by the time he turns 80 (if he lives that long and the insurance company is still solvent). Should he manage to make it to 85-years of age he will have hit the jackpot! By 85 he will have been allowed to withdraw $450,000 over a 15-year period (some of the money likely the insurance company's). Whoop dee do!
Why the facetious celebration? Do the math! Our investor will have taken out $450,000 from an original investment of $300,000 made 25-years earlier. A fifty percent gain over 25- years comes to exactly 2% per annum compounded (and that's before paying income tax on the withdrawals). You can better than double that return right now in 20-year tax-free Treasuries, and easily construct a bond portfolio that allows you a substantially higher guaranteed income stream than the annuity, without the onerous restrictions placed on you by the insurance companies - who might not even be in business in 25-years!
Yep! Ya really gotta love those variable annuities and the snake-oil salesmen who peddle them!
Are you worried that you might end up in a long-term care facility? No problem! Your variable annuity will double the amount of your money you are allowed to take out if you do (if you pay extra for the privilege). Worried that you will run out of money before you die? No problem! Your handy dandy variable annuity will guarantee you a monthly payout for life (if you pay extra). Worried about dying early with your annuity investment under water? No problem! Your variable annuity will reimburse your beneficiary your original investment (if you pay extra and - in many cases - aren't 75 or older). Of course all of these guarantees come with a heavy price - most variable annuities will charge you more than 3% each and every year that you own the contract, although the fees are difficult to tease out of the offering documents and most people are blissfully unaware that they are paying so much for so little (an assertion that I will back up here shortly). Additionally, the investment choices given are usually extremely limited relative to the broad investment universe available to IRA owners, and typically are mutual funds that the insurance company manages in-house (more fees for them) or are managed by a "preferred provider" who kicks back fees to the insurance company (isn't that a cozy relationship?). And did we mention that these insurance contracts take a PhD in nuclear physics to understand?
There are now more than 1,100 different annuities on the market according to SmartMoney Magazine, up from 295 a decade ago. Variable annuities are suppose to be sold by prospectus because of their complexity and heavily regulated status, but the truth is many people aren't even aware that they are buying a variable annuity, or have only the vaguest idea of what they are buying. Russell Schellenberger was a successful business man who "didn't even know he'd bought one (variable annuity), according to Janet Paskin of SmartMoney. The word "annuity" hadn't even been mentioned during the sales process. It is a safe bet that Mr. Schellenberger wasn't given a prospectus, not that the highly legalized boilerplate would have necessarily enlightened him much. I'm a Chartered Financial Analyst (CFA)r with twenty years of forensic financial statement analysis under my belt. Nevertheless, I was recently put to the test on behalf of a nice, older couple who handed me their prospectus in the hope of getting an explanation of what they'd just purchased (They weren't given the prospectus before they signed on the dotted line, but instead received it after I explained to them that they were suppose to have gotten one and that the prospectus would explain the investment to them). After wading through the legal document I can honestly claim that I was only half right... they were suppose to have gotten a prospectus.
It's important to understand that the new-age variable annuity is an expensive, yet untested product. Traditional insurance works by using large numbers of people to spread risk out; the insurance company keeps the difference between the premiums collected and the insurance paid out. Variable annuities concentrate risk in the stock market. There is more than a little concern within the industry that insurance companies will not be able to meet their obligations if the stock market continues to under perform expectations. York University professor Moshe Milevsky has studied annuities for decades and believes that the new products are under priced to cover the cost of protecting investors in a crash. Moody's has raised red flags recently over concerns that insurance companies will not be able to meet their promises to investors under plausible worst case scenarios. And annuities do fail. Exhibit A is U.K. Equitable, a major British insurance company. U.K. Equitable was forced to sharply reduce the minimum guaranteed payout to annuity holders in the late 1990's because interest rates didn't do what actuaries had predicted.
Turns out then that the minimum income guarantee that is available (for an extra cost) is only as good as the financial strength of the insurance company selling the annuity. But what about the basic product itself (assuming that the insurance companies will survive the next big downturn in the stock market) - is the minimum income guarantee really a panacea for investors who have under saved and are now worried that they will outlive their assets? The answer is not really. Here's how the typical product works these days:
An investor buys a variable annuity, placing the money into an investment account that then disburses the money to sub accounts composed of typically high cost mutual funds (remember that cozy relationship between the insurance company and the either captive mutual funds or "preferred providers"?) The mortality and expense fees for the variable annuity usually run around 1.65% per year while the underlying funds usually suck out another 1.5% to 2.0% of the investors money every year. A 3.0% plus per annum expense ratio is a high hurdle to overcome and almost guarantees under performance of the contract relative to owning individual stocks and bonds or low cost, no-load mutual funds. Your broker is often receiving the 12b-1 trailers on the funds in which you invest inside the variable annuity by the way.
Your investment account is left to grow, and the insurance company hopes it grows sufficiently to cover the guaranteed income payments once you start to take them down the road. One product I recently reviewed for an investor had been bought when the investor was 60 years of age. He was guaranteed a minimum income benefit of $30,000 per year if he left the money in place for at least 10 years. He bought a $300,000 variable annuity which was placed into stock mutual funds. The insurance company moved the bulk of the money into a fixed account earning 2% per annum when the bottom fell out of the market in 2008 - it will remain their for the rest of the contract life in order to protect the insurance company. The investor will be allowed to take $30,000 of his own money out of the contract every year until he dies, starting when he turns 70. Of course, the average life expectancy for a man of his socioeconomic background and health is around 78. It is still barely possible that his investment account will make it back close to the original $300,000 level before he turns 70, since he does still have $29,000 invested in stock mutual funds within the annuity - perhaps it will double in the next 8 years, although that is unlikely.
Regardless, this investor has taken $300,000 from his tax deferred IRA (in which he had absolute freedom to invest in any number of low cost mutual funds or directly in a portfolio of blue chip stocks) and put the money into a restrictive, condition-filled insurance product that might actually return all of his original investment to him by the time he turns 80 (if he lives that long and the insurance company is still solvent). Should he manage to make it to 85-years of age he will have hit the jackpot! By 85 he will have been allowed to withdraw $450,000 over a 15-year period (some of the money likely the insurance company's). Whoop dee do!
Why the facetious celebration? Do the math! Our investor will have taken out $450,000 from an original investment of $300,000 made 25-years earlier. A fifty percent gain over 25- years comes to exactly 2% per annum compounded (and that's before paying income tax on the withdrawals). You can better than double that return right now in 20-year tax-free Treasuries, and easily construct a bond portfolio that allows you a substantially higher guaranteed income stream than the annuity, without the onerous restrictions placed on you by the insurance companies - who might not even be in business in 25-years!
Yep! Ya really gotta love those variable annuities and the snake-oil salesmen who peddle them!
Thursday, October 22, 2009
Stock Brokers and Dictatorships
It's a twofer today for those of you willing to indulge me by reading on...
The securities and exchange commission (SEC) found that 76% of main street investors (the public) don't know the difference between a representative of a broker-dealer and a registered investment adviser. Score one for the stockbrokers who have successfully managed to fool the public into thinking they are investment advisers. These guys (and gals) are good at what they do, which is trick the public into thinking they get paid for giving advice when, in fact, they do not. In plain English from a recent article in the Investment News: "The broker-dealer rep does not get paid to give advice and is not licensed to provide advice, and hence is not an "adviser". Such reps get paid when they sell a product: thus they are salespeople."
It would appear obvious that when Broker-Dealers (Wachovia/Wells Fargo, E.D. Jones, A.G. Edwards, Morgan Keegan, Merrill Lynch/Bank of America, Morgan Stanley and numerous others) refer to their salespeople as financial advisers, financial counselors, financial planners, and financial consultants that they are intentionally trying to mislead the public. (My own personal favorite is the guy I met recently who referred to himself as a "financial health coach". Sometimes you just have to laugh at the snake oil salesmen and the lengths they will go to hide behind pithy self-made descriptions!) Personally, I think their titles ought to reflect what they really do so that the public isn't misled. How about "financial services sales representative"? Or perhaps "vice president of mutual fund and variable annuity sales"? After all, when is the last time a "vacuum cleaner adviser" knocked on your door looking to advise you on your need for a new vaccuum?
Of course Wall Street owns the regulators (it's called regulatory capture by the academics) and is able to twist and turn them however they choose. Which is why Big B-Ds are now allowed to also register as RIAs and dual register their brokers. The problem, of course, is that the public has no way of knowing when the stockbroker has his registered adviser hat on and is giving actual objective advice (is that even possible with a juicy commission at stake?) as opposed to trying to sell product. Just ask yourself, when is the last time your broker representative put you into a no-load mutual fund that paid him nothing for doing so? Exactly! After all, there is a reason why fewer than 5% of all financial advisers are fee-only! Fee-only advisors are required to provide sound advice over a period of years before they will make what a broker can make in a single transaction.
Dictatorships confiscate property from individuals as a matter of course. The dictator takes what he wants when he wants it. The American constitution specifically protects property rights, or at least it did until recently. One recent and particularly egregious example (but certainly not the only one) involves the shameful manner in which the current administration stole from hospitals, pension funds, and nonprofit endowments - among others - in order to enrich its political supporters. Sound like a wild, inflammatory accusation? I'll walk you through it and you be the judge.
The Chrysler near-bankruptcy provides a very telling case in point of what can happen when a tyrannical government acts for the "good of (some of) the people". The Chrysler auto bank-debt restructuring committee consisted of four big banks and Elliott Associates. The committee proposed that collateralized senior debt holders should be paid in full (since the debt was collateralized by all of Chrysler's assets). Four hundred years of contract law (going back well into English history) and the American Constitution stood behind the committee's proposal. (There is a well-defined pecking order in bankruptcies and restructurings with senior, secured creditors getting paid before unsecured creditors and unsecured creditors getting paid before stockholders. It is that well-defined pecking order that allows lenders to calculate the risk they assume when lending money to companies which need capital to grow or restructure.)
Unfortunately for the senior lenders to Chrysler (whom were investing on behalf of pension funds - including Indiana's PERF, hospitals, and non-profit endowments among others), the Obama administration decided to reward its political supporters by leapfrogging the unsecured creditors to the front of the line. The unsecured creditors represented the UAW's pension fund and post-retirement health-care-related claims.
It was widely reported that the Obama administration gave the creditors an ultimatum, telling them to accept 32 cents on the dollar for their bonds or be named and blamed by the president of the United States as the cause of Chrysler's bankruptcy. Meanwhile, the administration was offering unsecured creditors (the unions) 60 cents on the dollar for their pension and health care claims, standing hundreds of years of contract law on its head and shredding the U.S. Constitution's protection of property rights in the process. Resisting debt holders, who are required by law as fiduciaries to the hospitals, pension funds and non-profits whom they represented, to do their utmost to act in their investors best interests, received threatening phone calls from governors, senators, and congressional representatives to apply additional pressure. It has also been reported that lenders received threats of SEC and IRS investigations, according to Grant's Interest Rate Observer, if they resisted accepting the government's "generous" offer. (Anyone else picturing Chavez seizing private assets down in Venezuela and strong arming private industry into submission? Anyone else remembering the history of the "Worker's Revolution", in the darkest days of the rise of the Soviet Union, as private industry was wiped out by centralized government planning?)
You, my dear reader, are sadly mistaken if you don't think any of this will eventually impact you more than it already has (remember, it was our "Big-Brother" government that got us into this mess in the first place with more than 50 years of fiscal and monetary mismanagement accompanied by a pernicious mission creep that threatens to completely destroy a once vibrant free-market economy). One of the most obvious unintended consequences of the theft is that the cost of money will rise as lenders require higher interest rates to compensate them for government's capricious "taking" of their property. Credit is the life blood of our economy; there is no economic growth, or only very slow economic growth without abundant credit. A lack of economic growth means a lack of job creation, and that means millions of Americans will remain unemployed due to Big Government's oppressive actions, which are creating a chilling effect in the credit markets even as the Federal Reserve attempts to stimulate lending through its irresponsible spending of taxpayer's money. The bill for the great rape of the American Constitution and American contract law has not yet even begun to be calculated.
The securities and exchange commission (SEC) found that 76% of main street investors (the public) don't know the difference between a representative of a broker-dealer and a registered investment adviser. Score one for the stockbrokers who have successfully managed to fool the public into thinking they are investment advisers. These guys (and gals) are good at what they do, which is trick the public into thinking they get paid for giving advice when, in fact, they do not. In plain English from a recent article in the Investment News: "The broker-dealer rep does not get paid to give advice and is not licensed to provide advice, and hence is not an "adviser". Such reps get paid when they sell a product: thus they are salespeople."
It would appear obvious that when Broker-Dealers (Wachovia/Wells Fargo, E.D. Jones, A.G. Edwards, Morgan Keegan, Merrill Lynch/Bank of America, Morgan Stanley and numerous others) refer to their salespeople as financial advisers, financial counselors, financial planners, and financial consultants that they are intentionally trying to mislead the public. (My own personal favorite is the guy I met recently who referred to himself as a "financial health coach". Sometimes you just have to laugh at the snake oil salesmen and the lengths they will go to hide behind pithy self-made descriptions!) Personally, I think their titles ought to reflect what they really do so that the public isn't misled. How about "financial services sales representative"? Or perhaps "vice president of mutual fund and variable annuity sales"? After all, when is the last time a "vacuum cleaner adviser" knocked on your door looking to advise you on your need for a new vaccuum?
Of course Wall Street owns the regulators (it's called regulatory capture by the academics) and is able to twist and turn them however they choose. Which is why Big B-Ds are now allowed to also register as RIAs and dual register their brokers. The problem, of course, is that the public has no way of knowing when the stockbroker has his registered adviser hat on and is giving actual objective advice (is that even possible with a juicy commission at stake?) as opposed to trying to sell product. Just ask yourself, when is the last time your broker representative put you into a no-load mutual fund that paid him nothing for doing so? Exactly! After all, there is a reason why fewer than 5% of all financial advisers are fee-only! Fee-only advisors are required to provide sound advice over a period of years before they will make what a broker can make in a single transaction.
Dictatorships confiscate property from individuals as a matter of course. The dictator takes what he wants when he wants it. The American constitution specifically protects property rights, or at least it did until recently. One recent and particularly egregious example (but certainly not the only one) involves the shameful manner in which the current administration stole from hospitals, pension funds, and nonprofit endowments - among others - in order to enrich its political supporters. Sound like a wild, inflammatory accusation? I'll walk you through it and you be the judge.
The Chrysler near-bankruptcy provides a very telling case in point of what can happen when a tyrannical government acts for the "good of (some of) the people". The Chrysler auto bank-debt restructuring committee consisted of four big banks and Elliott Associates. The committee proposed that collateralized senior debt holders should be paid in full (since the debt was collateralized by all of Chrysler's assets). Four hundred years of contract law (going back well into English history) and the American Constitution stood behind the committee's proposal. (There is a well-defined pecking order in bankruptcies and restructurings with senior, secured creditors getting paid before unsecured creditors and unsecured creditors getting paid before stockholders. It is that well-defined pecking order that allows lenders to calculate the risk they assume when lending money to companies which need capital to grow or restructure.)
Unfortunately for the senior lenders to Chrysler (whom were investing on behalf of pension funds - including Indiana's PERF, hospitals, and non-profit endowments among others), the Obama administration decided to reward its political supporters by leapfrogging the unsecured creditors to the front of the line. The unsecured creditors represented the UAW's pension fund and post-retirement health-care-related claims.
It was widely reported that the Obama administration gave the creditors an ultimatum, telling them to accept 32 cents on the dollar for their bonds or be named and blamed by the president of the United States as the cause of Chrysler's bankruptcy. Meanwhile, the administration was offering unsecured creditors (the unions) 60 cents on the dollar for their pension and health care claims, standing hundreds of years of contract law on its head and shredding the U.S. Constitution's protection of property rights in the process. Resisting debt holders, who are required by law as fiduciaries to the hospitals, pension funds and non-profits whom they represented, to do their utmost to act in their investors best interests, received threatening phone calls from governors, senators, and congressional representatives to apply additional pressure. It has also been reported that lenders received threats of SEC and IRS investigations, according to Grant's Interest Rate Observer, if they resisted accepting the government's "generous" offer. (Anyone else picturing Chavez seizing private assets down in Venezuela and strong arming private industry into submission? Anyone else remembering the history of the "Worker's Revolution", in the darkest days of the rise of the Soviet Union, as private industry was wiped out by centralized government planning?)
You, my dear reader, are sadly mistaken if you don't think any of this will eventually impact you more than it already has (remember, it was our "Big-Brother" government that got us into this mess in the first place with more than 50 years of fiscal and monetary mismanagement accompanied by a pernicious mission creep that threatens to completely destroy a once vibrant free-market economy). One of the most obvious unintended consequences of the theft is that the cost of money will rise as lenders require higher interest rates to compensate them for government's capricious "taking" of their property. Credit is the life blood of our economy; there is no economic growth, or only very slow economic growth without abundant credit. A lack of economic growth means a lack of job creation, and that means millions of Americans will remain unemployed due to Big Government's oppressive actions, which are creating a chilling effect in the credit markets even as the Federal Reserve attempts to stimulate lending through its irresponsible spending of taxpayer's money. The bill for the great rape of the American Constitution and American contract law has not yet even begun to be calculated.
Tuesday, September 29, 2009
Bonds For The Long Run?
Wharton professor Jeremy Siegel wrote a very popular book in the 1990s called Stocks for the Long Run, in which he made a case for building equity-centric portfolios. Professor Siegal's thesis is that stocks beat bonds over long periods of time by so much that investors must have meaningful exposure to stocks in order to accumulate sufficient wealth for retirement. The fact that stocks have beaten bonds on average by more than 3% per year from 1871 through 2008 would seem to support Siegal's point of view. Further, Siegal maintains that the recent horrendous performance of stocks is exceedingly rare and that investors need to maintain substantial buy-and-hold exposure to equities.
However, not everyone agrees that investors should heavily weight their portfolios toward equities. Boston University professor Zvi Bodie believes that equities are simply too risky over the long run and the core of a retirement portfolio should be Treasury Inflation Protected Securities (TIPS). He contends that a portfolio of stocks doesn't become less risky the longer you hold it because, historically, there have been multi-decadal periods in which bonds have beaten equities (periods long enough to encompass an individual investors entire investment life). Furthermore, Bodie claims that stocks are a poor way to hedge against an investor's future income needs - which is, after all, the main reason for investing in the first place. Bodie believes that inflation-indexed bonds are the best asset for matching future liabilities.
However, not everyone agrees that investors should heavily weight their portfolios toward equities. Boston University professor Zvi Bodie believes that equities are simply too risky over the long run and the core of a retirement portfolio should be Treasury Inflation Protected Securities (TIPS). He contends that a portfolio of stocks doesn't become less risky the longer you hold it because, historically, there have been multi-decadal periods in which bonds have beaten equities (periods long enough to encompass an individual investors entire investment life). Furthermore, Bodie claims that stocks are a poor way to hedge against an investor's future income needs - which is, after all, the main reason for investing in the first place. Bodie believes that inflation-indexed bonds are the best asset for matching future liabilities.
Now facts are facts and the S&P 500 has outperformed bonds by about 3% over the last 137 years. Why on earth would anyone not want maximum exposure to the stock market if they had a sufficiently long time horizon? Well, that turns out to be the rub - the time horizon. As pointed out by Bodie, bonds have outperformed stocks for long periods of time in the past. In fact, bonds beat stocks over the 68 year period ending in 1871. Bonds outperformed stocks from 1929 to 1949 - a 20-year stretch that saw the stock market lose some 89% of its value at its nadir. Currently bonds have outperformed stocks over a 41-year period going back all the way to 1968! And now comes the $64,000 question: Do you really care that stocks are likely to outperform bonds by about 3% over the very long run if you happen to be the poor slob investing in them during one of those horrible, multi-decade long stock market debacles? After all, average returns are all well and good, but you only get to live your life once! There are no redo opportunities!
But how likely is it that you will be one of those unfortunate investors living through a down period in the stock market? Well, there is a 1-in-20 chance that the S&P 500 will underperform a broad U.S. bond index by 130% over a ten-year period. There is a 1-in-5 chance that stocks will underperform bonds by 50% cumulatively over a ten-year-period. Knowing that, on average, the S&P 500 will outperform a broad bond index by 50% over a 10-year period is of small comfort to those investors who don't happen to get the average stock market return during the period that THEY are invested in the stock market. The fact that the shortfalls in stocks vs bonds over 10-year periods are much greater than the shortfalls generated over a single year is also exactly why Bodie argues that stocks are not less risky over longer periods of time. His point made another way is simply that looking at average returns does not address the question of the magnitude of a shortfall when one does occur. In Bodie's own words from his original 1995 paper, "But as has been shown in the literature, the probability of a shortfall is a flawed measure of risk because it completely ignores how large the potential shortfall might be."
What then to do with your investment portfolio. The reality is that most of us do not have an investment portfolio big enough to stick 100% into bonds - we need the extra capital appreciation kick that will come to us from stocks over 10 and 20 year periods... on average. Yet it seems apparent that heavily overweighting stocks is far too risky as well. Put another way, meaningful exposure to assets other than bonds increases investors chances of successfully funding their retirement by reducing longevity risk - the probability of outliving your assets. Building a diversified portfolio of stocks, bonds, commodities, and real estate increases the likelihood of creating a sufficient, sustainable income stream during retirement while still being able to withstand a worst-case scenario in the stock market - a worst-case scenario that seems to come along all too frequently!
One last comment: we are writing from the point of view of buy-and-hold investing, which is the same point of view that Professor Siegel has in his book. Biechele Royce Advisors is not a buy and hold investor on behalf of its clients. We add value and control stock market risk by refusing to overpay for a business. We buy good companies at great prices and great companies at good prices. We sell those same companies when they return to fair value. Our price discipline and focus on stockpicking gives us a big advantage over buy-and-hold investors during secular bear markets!
Tuesday, September 1, 2009
It's the Government Stupid!
Public opinion appears to blame the free market system for the current state of affairs in which we find ourselves. Voters have turned overwhelmingly to the federal government for answers to the economic malaise that exists throughout the 50 States. The Obama administration has spent hundred of billions of dollars already and pledged trillions more in an effort to get consumers spending and the economy expanding once again - to the applause of a majority of U.S. citizens. Yet, it is the misguided fiscal and monetary policies of the last 50 years (with the exception of a brief period in the 1980s) that have culminated in the worst recession since the Great Depression. It is the continued application of those policies that will almost certainly lead to more economic pain in the coming decades. Americans must get a clue! It is the Federal Government which bears overwhelming responsibility for the current mess. It is the Federal Monster that must be reigned in and subjugated to the will of the free people of the United States of America, or most of us will die poor.
Not interested in politics? You should be. Politics is the process by which groups of people make decisions, among the most important of which are how to allocate scarce economic resources. Politics, when left to run amok, can ruin an economy, as has happened in Zimbabwe, where inflation is running at 11,200 percent per annum. The United States is not immune to hyperinflation and, in fact, may be barreling head on into just such an environment. Highly inflationary environments are not typically good investing environments. Wealth preservation becomes problematic to say the least, never mind wealth creation.
Right now the markets are running nicely and many economists and political pundits are declaring victory over the recession that has been with us now since sometime in 2007 (the precise start of the economic contraction is still open to debate and will likely be moved back closer to 2006 (once the government is finished massaging the data for political purposes and the academics move in to correct the record). The folks at ECRI say that their leading indicators are pointing toward a very strong recovery in the economy; they are far less sanguine about the chances of a sustainable recovery.
The problem is that the Obama Administration is not addressing the underlying structural problems with our economy, choosing instead to simply stimulate the economy with additional credit, which may have positive short term consequences, but is unlikely to provide a lasting source of economic expansion. We have too much debt; the government is loading more debt on at a furious rate. We have too little manufacturing; the government is doing nothing to address the hollowing out of American industry, which has occurred over the last 30 years. We are fighting two wars, but do not have the money to pay for either. The cold war is over. We need to pull out of most parts of the world. We are not the world's policeman; there is no money in our Treasury for it and the world does not reward us for it.
Get the Federal Government out of state and local affairs. Shut down the giant spending machine that is increasingly sapping our national vitality and robbing us of our individual initiative. Get government out of business so that businessman can compete against one another, rather than having to compete against a government that can change and manipulate the rules at will to ensure supremacy. Let American ingenuity have free reign once again. Let small businesses grow unfettered by government interference! Job growth will follow. Real income growth will follow (Real income is currently below 1973-1975 recession levels.)
The stock market isn't likely to keep its gains. The consumer is 70% of the economy and the consumer has no money to spend other than what the federal government is handing out. The economy is highly likely to slip back into recession more or less as soon as the federal government stops giving people money to spend. The profit recovery implied by the stock market rally from the March lows is unlikely to materialize. We are entering silly season in the stock market - that period where the boys on Wall Street underpin the market in an effort to maximize year-end bonuses. The most likely outcome of this secular bear market rally is a nasty sell-off sometime early next year, perhaps around the March time-frame.
We are maintaining our price discipline by refusing to pay up for businesses that are no longer undervalued, and by taking profits on companies that are up 40% or more since the March lows (business valuations do not change so rapidly as that in the real world). We are acknowledging the lunacy of our federal government's (this isn't a Democrat/Republican thing by the way - both parties are responsible) fiscal and monetary policy by favoring tangible assets over financial, and international assets over domestic.
We strongly urge investors to tread with extreme caution over the next six months as the government's massive spending winds down and the underlying structural problems reassert themselves. The piper has not yet been paid for 30 years of over consumption, over spending, and easy credit.
Not interested in politics? You should be. Politics is the process by which groups of people make decisions, among the most important of which are how to allocate scarce economic resources. Politics, when left to run amok, can ruin an economy, as has happened in Zimbabwe, where inflation is running at 11,200 percent per annum. The United States is not immune to hyperinflation and, in fact, may be barreling head on into just such an environment. Highly inflationary environments are not typically good investing environments. Wealth preservation becomes problematic to say the least, never mind wealth creation.
Right now the markets are running nicely and many economists and political pundits are declaring victory over the recession that has been with us now since sometime in 2007 (the precise start of the economic contraction is still open to debate and will likely be moved back closer to 2006 (once the government is finished massaging the data for political purposes and the academics move in to correct the record). The folks at ECRI say that their leading indicators are pointing toward a very strong recovery in the economy; they are far less sanguine about the chances of a sustainable recovery.
The problem is that the Obama Administration is not addressing the underlying structural problems with our economy, choosing instead to simply stimulate the economy with additional credit, which may have positive short term consequences, but is unlikely to provide a lasting source of economic expansion. We have too much debt; the government is loading more debt on at a furious rate. We have too little manufacturing; the government is doing nothing to address the hollowing out of American industry, which has occurred over the last 30 years. We are fighting two wars, but do not have the money to pay for either. The cold war is over. We need to pull out of most parts of the world. We are not the world's policeman; there is no money in our Treasury for it and the world does not reward us for it.
Get the Federal Government out of state and local affairs. Shut down the giant spending machine that is increasingly sapping our national vitality and robbing us of our individual initiative. Get government out of business so that businessman can compete against one another, rather than having to compete against a government that can change and manipulate the rules at will to ensure supremacy. Let American ingenuity have free reign once again. Let small businesses grow unfettered by government interference! Job growth will follow. Real income growth will follow (Real income is currently below 1973-1975 recession levels.)
The stock market isn't likely to keep its gains. The consumer is 70% of the economy and the consumer has no money to spend other than what the federal government is handing out. The economy is highly likely to slip back into recession more or less as soon as the federal government stops giving people money to spend. The profit recovery implied by the stock market rally from the March lows is unlikely to materialize. We are entering silly season in the stock market - that period where the boys on Wall Street underpin the market in an effort to maximize year-end bonuses. The most likely outcome of this secular bear market rally is a nasty sell-off sometime early next year, perhaps around the March time-frame.
We are maintaining our price discipline by refusing to pay up for businesses that are no longer undervalued, and by taking profits on companies that are up 40% or more since the March lows (business valuations do not change so rapidly as that in the real world). We are acknowledging the lunacy of our federal government's (this isn't a Democrat/Republican thing by the way - both parties are responsible) fiscal and monetary policy by favoring tangible assets over financial, and international assets over domestic.
We strongly urge investors to tread with extreme caution over the next six months as the government's massive spending winds down and the underlying structural problems reassert themselves. The piper has not yet been paid for 30 years of over consumption, over spending, and easy credit.
Thursday, August 6, 2009
Investing in Stocks
We wrote about portfolio diversification a while ago - we related how a 15 - 25 stock portfolio can give you 90% of the benefits of diversification and how a 40 stock portfolio can give you 99% of the benefits. (Diversifying away non-systemic - company specific - risk is important in achieving the highest possible return for the amount of risk taken). We work hard educating our clients on the importance of building properly diversified and appropriate portfolios consisting of stocks and bonds. Properly diversified to us means eliminating all unnecessary risk while appropriate means putting our clients at a risk (and return) level that works for their financial situation and temperament.
But what about individual stock selection? If strategic asset allocation (the percentage of a portfolio allocated to stocks, bonds, real estate, commodities, and cash) accounts for most of the variation in returns over the long run (and it does), why even bother with individual security selection?
A very good question indeed!
Because we can add to returns with careful security selection and reduce taxes through tax loss harvesting. The empirical evidence overwhelmingly shows that we can outperform the market using a common sense approach to investing - buying businesses when they are trading for less than a knowledgeable buyer would pay for the entire company in an arms length transaction. In other words, buying companies when they are trading cheaply. It only makes sense! An investor should outperform the market over the long run by purchasing undervalued businesses and avoiding overvalued businesses - and the academic data supports that view.
How is it possible that the market is inefficient enough to give value investors a known edge over other types of investors? Economics 101 teaches us that excess profits in a capitalistic system are eventually competed away. Why don't the majority of investors recognize that value investing brings superior returns and join the gravy train?
The answer lies with some well-known investor biases that endure, despite wide recognition that they exist. People will be people! It is estimated that only about 10% of investors are value investors while the other 90% chase growth and momentum. Value investors are able to take advantage of investor biases which create excess profit opportunities for them. For instance, investors routinely associate good companies with good investments and are willing to pay a premium for them in the stock market. The Behavioral Finance term is "representativeness". Good companies are usually widely recognized as such and are highly priced as a result - and on average they under perform the market going forward. Likewise, investors routinely associate low growth (bad) companies with poor investments and shun them, creating a profit opportunity for the savvy value investor.
As well, a majority of investors expect stocks with poor liquidity (thinly traded) to have lower returns, yet the empirical evidence shows otherwise. Also, investors expect lower returns from stocks that are not widely followed by the financial analyst community, yet the evidence contradicts that expectation. Less widely followed stocks actually tend to outperform.
It really isn't rocket science. Rather, it is having the patience and discipline to buy a good company at a great price (or a great company at a good price) and waiting for the herd to recognize that it was overly pessimistic. It is also about having the discipline NOT to buy a stock just because the entire stock market it rising. We will not pay up for an investment - ever! Price discipline makes for successful investing and we never forget it at Biechele Royce Advisors. Although we aren't willing to market time per se, we are willing to let cash build up in our client accounts if we can not find good businesses at great prices or great businesses at good prices. Price discipline is risk management and risk management is a must during a secular bear market.
But what about individual stock selection? If strategic asset allocation (the percentage of a portfolio allocated to stocks, bonds, real estate, commodities, and cash) accounts for most of the variation in returns over the long run (and it does), why even bother with individual security selection?
A very good question indeed!
Because we can add to returns with careful security selection and reduce taxes through tax loss harvesting. The empirical evidence overwhelmingly shows that we can outperform the market using a common sense approach to investing - buying businesses when they are trading for less than a knowledgeable buyer would pay for the entire company in an arms length transaction. In other words, buying companies when they are trading cheaply. It only makes sense! An investor should outperform the market over the long run by purchasing undervalued businesses and avoiding overvalued businesses - and the academic data supports that view.
How is it possible that the market is inefficient enough to give value investors a known edge over other types of investors? Economics 101 teaches us that excess profits in a capitalistic system are eventually competed away. Why don't the majority of investors recognize that value investing brings superior returns and join the gravy train?
The answer lies with some well-known investor biases that endure, despite wide recognition that they exist. People will be people! It is estimated that only about 10% of investors are value investors while the other 90% chase growth and momentum. Value investors are able to take advantage of investor biases which create excess profit opportunities for them. For instance, investors routinely associate good companies with good investments and are willing to pay a premium for them in the stock market. The Behavioral Finance term is "representativeness". Good companies are usually widely recognized as such and are highly priced as a result - and on average they under perform the market going forward. Likewise, investors routinely associate low growth (bad) companies with poor investments and shun them, creating a profit opportunity for the savvy value investor.
As well, a majority of investors expect stocks with poor liquidity (thinly traded) to have lower returns, yet the empirical evidence shows otherwise. Also, investors expect lower returns from stocks that are not widely followed by the financial analyst community, yet the evidence contradicts that expectation. Less widely followed stocks actually tend to outperform.
It really isn't rocket science. Rather, it is having the patience and discipline to buy a good company at a great price (or a great company at a good price) and waiting for the herd to recognize that it was overly pessimistic. It is also about having the discipline NOT to buy a stock just because the entire stock market it rising. We will not pay up for an investment - ever! Price discipline makes for successful investing and we never forget it at Biechele Royce Advisors. Although we aren't willing to market time per se, we are willing to let cash build up in our client accounts if we can not find good businesses at great prices or great businesses at good prices. Price discipline is risk management and risk management is a must during a secular bear market.
Friday, July 10, 2009
Mutual Funds and Benchmarks
Many people are invested in mutual funds. Most people have no clue how to tell if their mutual funds are better or worse than average. Many people allow their financial advisor, planner, accountant, or fee-based advisor (broker) to put them into mutual funds but must take their advisors word for the "best-in-breed" claim. Unfortunately the reality is that actively managed mutual funds do not out perform their unmanaged benchmarks on a risk-adjusted basis after taking fees into account. Furthermore, the mutual funds that do outperform their benchmarks on a risk-adjusted basis over trailing five and ten year periods are unlikely to outperform going forward. In other words, the top ten performing mutual funds in a market segment - say large cap - over the trailing ten year period are unlikely to be the same funds that out perform over the following ten year period. Bottom Line? There is no way to know in advance which funds will outperform their benchmarks on a risk-adjusted basis, net of fees, over five and ten year periods.
Now stop and think through what I just wrote. Most financial advisors tout their mutual fund picking ability as a primary reason to hire them (never mind the fact that their advice is often skewed by which funds pay the best commission!). Yet the brainiacs ensconced in the ivory towers of Wharton, the University of Chicago, and Harvard will tell you in excruciating detail why it is impossible to know a priori which mutual funds will out perform their benchmarks. John Bogle of Vanguard has it right! Index funds will beat the majority of actively managed mutual funds over long periods of time and, therefore, are above average!
Now stop and think about THAT for a moment. You can actually outperform the majority of mutual funds over the long run simply by indexing. Furthermore, since an index fund merely matches its benchmark's risk (average risk) yet outperforms the majority of peer group funds, you are able to know in advance that you are investing in a fund with a favorable risk/reward relationship (average risk and above average reward). And you didn't even need a Morningstar report to figure it out!
But since many of you are determined to speculate on mutual funds much in the same way that many of you speculate on individual stocks, here's the appropriate way to measure your actively managed fund's performance. You must compare your fund to the asset subclass in which it invests. A large cap growth fund should be bench marked against the Russell 1000 growth index and a large cap value fund should be bench marked against the Russell 1000 value index. In both cases, you should adjust for risk. Unfortunately, even then it isn't quite so simple since most fund managers cheat. Large cap fund managers will add small and mid cap stocks, or foreign stocks to their portfolio in an effort to beat their benchmark by going outside the appropriate universe of stocks. Of course they will sell those stocks before the required reporting period so that no one is the wiser - the practice of cleaning up the portfolio prior to reporting holdings is known as window dressing and is a common Wall Street practice.
To recap: Investors who use mutual funds should index. The academic case is overwhelming. Index funds outperform the majority of their actively managed peer group with only average risk. You don't need a fee-based financial advisor (aka broker) to pick actively managed mutual funds for you, since he's whistling in the dark anyway, while collecting commissions on those A, B, and C shares. What you need is someone to help you arrive at an appropriate strategic asset allocation and then implement that allocation with index funds. Better still, seek out a financial advisor that employs Chartered Financial Analysts capable of building low-cost stock portfolios chock full of businesses purchased at less than their fair market value, because the same academic research that categorically shows it is better to index than attempt to pick mutual fund outperformers, also shows that value investing outperforms the market over the long run!
Now stop and think through what I just wrote. Most financial advisors tout their mutual fund picking ability as a primary reason to hire them (never mind the fact that their advice is often skewed by which funds pay the best commission!). Yet the brainiacs ensconced in the ivory towers of Wharton, the University of Chicago, and Harvard will tell you in excruciating detail why it is impossible to know a priori which mutual funds will out perform their benchmarks. John Bogle of Vanguard has it right! Index funds will beat the majority of actively managed mutual funds over long periods of time and, therefore, are above average!
Now stop and think about THAT for a moment. You can actually outperform the majority of mutual funds over the long run simply by indexing. Furthermore, since an index fund merely matches its benchmark's risk (average risk) yet outperforms the majority of peer group funds, you are able to know in advance that you are investing in a fund with a favorable risk/reward relationship (average risk and above average reward). And you didn't even need a Morningstar report to figure it out!
But since many of you are determined to speculate on mutual funds much in the same way that many of you speculate on individual stocks, here's the appropriate way to measure your actively managed fund's performance. You must compare your fund to the asset subclass in which it invests. A large cap growth fund should be bench marked against the Russell 1000 growth index and a large cap value fund should be bench marked against the Russell 1000 value index. In both cases, you should adjust for risk. Unfortunately, even then it isn't quite so simple since most fund managers cheat. Large cap fund managers will add small and mid cap stocks, or foreign stocks to their portfolio in an effort to beat their benchmark by going outside the appropriate universe of stocks. Of course they will sell those stocks before the required reporting period so that no one is the wiser - the practice of cleaning up the portfolio prior to reporting holdings is known as window dressing and is a common Wall Street practice.
To recap: Investors who use mutual funds should index. The academic case is overwhelming. Index funds outperform the majority of their actively managed peer group with only average risk. You don't need a fee-based financial advisor (aka broker) to pick actively managed mutual funds for you, since he's whistling in the dark anyway, while collecting commissions on those A, B, and C shares. What you need is someone to help you arrive at an appropriate strategic asset allocation and then implement that allocation with index funds. Better still, seek out a financial advisor that employs Chartered Financial Analysts capable of building low-cost stock portfolios chock full of businesses purchased at less than their fair market value, because the same academic research that categorically shows it is better to index than attempt to pick mutual fund outperformers, also shows that value investing outperforms the market over the long run!
Monday, June 29, 2009
Diversified Portfolios
Many people believe they have too little money in their investment portfolio to own individual stocks. They feel that mutual funds give them the "safety" of diversification. I often review portfolios for prospects and find that they are invested in five, six, ten different mutual funds. The prospects believe they are adequately diversified; after all, they own multiple mutual funds which hold one hundred plus stocks each on average. They are often surprised when I tell them that they are not very well diversified at all. They are down right disbelieving when I tell them they could get almost the same diversification with a portfolio of 25 carefully chosen stocks. The reality is that 15 to 25 well chosen stocks provide 90% of the benefits of diversification and that a 40 stock portfolio can provide 99% of the benefits of diversification. The hundreds of additional stocks owned by the mutual funds in which our prospects are invested provide almost no additional diversification benefits. Have $100,000 allocated to equities? More than enough to build a 25 stock portfolio that will adequately diversify away your non-systemic (company-specific) risk. However, you aren't properly diversified just because you own a properly diversified stock portfolio.
A properly diversified stock portfolio provides nowhere near the diversification benefits of investing among different asset classes. Small, large, domestic, and international stocks are sub-asset classes, not truly separate asset classes. After all, stocks tend to move together because companies tend to prosper or suffer together as economies expand or contract. Rather than limiting oneself to a single asset class, investors should build a properly diversified portfolio containing all four major asset classes (the historical data indicates that a four asset class portfolio composed of stocks - domestic and international, bonds, real estate, and commodities provides high levels of return per unit of risk).
The famous Brinson, Hood, and Beebower (BHB) study done in 1986 indicated that approximately 92% of a portfolios' variation of returns is due to the mix of asset classes chosen. BHB used stocks, bonds, real estate, and cash in their study. Simply put, the percentage of each asset included in your portfolio will go a long way in determining your returns and the volatility of your returns over the long run. Individual security selection and market timing are not major determinants of long run returns and variation of returns relative to the asset classes in which you choose to invest. (Importantly, the value style of investing does outperform so-called growth and momentum styles over the long run and therefore does add to an investor's returns).
Consider that approximately 80% of actively managed stock mutual funds don't beat their benchmarks. Most large cap funds don't beat the S&P 500 index (large cap). Most small cap funds don't beat the Russell 2000. Furthermore, the funds that do beat their benchmarks vary from year to year and there is no evidence whatsoever that a savvy financial advisor can pick a priori (in advance) which funds will outperform (Connecting the dots - your financial advisor or planner is blowing smoke when he confidently informs you that he'll only put you into the best mutual funds, since he can't possibly know which ones those will be. Unfortunately, too many financial advisors put their clients in mostly, or only, stock mutual funds and they tend to use the ones with the highest commissions!)
Okay, to review: a 25 stock portfolio will get you 90% of the benefits of diversification and a 40 stock portfolio will get you 99% of the benefits (assuming diversification is your goal). But is that a properly diversified portfolio? Stock portfolio - yes, investment portfolio - NO!
Multiple-Asset-Class investing offers demonstrably superior results to investors, providing high rates of return with less volatility than one, two, and three asset class portfolios. For instance, an equally weighted four asset class portfolio (composed of domestic stocks, international stocks, bonds, and commodities) returned 11.24% per annum from 1972 through 2008 with a standard deviation of only 14.11%, resulting in a Sharpe ratio of 0.46 (high). What that means for us individual investors is that we want to create portfolios containing stocks (domestic and international), bonds, real estate and commodities for the long-term. Importantly, we can adjust volatility by adjusting the mix. Also importantly, we can add additional return by using value investing (paying less for a business than its worth) rather than growth investing (paying a premium for a business) or momentum investing (buying a stock simply because it is going up).
A properly diversified stock portfolio provides nowhere near the diversification benefits of investing among different asset classes. Small, large, domestic, and international stocks are sub-asset classes, not truly separate asset classes. After all, stocks tend to move together because companies tend to prosper or suffer together as economies expand or contract. Rather than limiting oneself to a single asset class, investors should build a properly diversified portfolio containing all four major asset classes (the historical data indicates that a four asset class portfolio composed of stocks - domestic and international, bonds, real estate, and commodities provides high levels of return per unit of risk).
The famous Brinson, Hood, and Beebower (BHB) study done in 1986 indicated that approximately 92% of a portfolios' variation of returns is due to the mix of asset classes chosen. BHB used stocks, bonds, real estate, and cash in their study. Simply put, the percentage of each asset included in your portfolio will go a long way in determining your returns and the volatility of your returns over the long run. Individual security selection and market timing are not major determinants of long run returns and variation of returns relative to the asset classes in which you choose to invest. (Importantly, the value style of investing does outperform so-called growth and momentum styles over the long run and therefore does add to an investor's returns).
Consider that approximately 80% of actively managed stock mutual funds don't beat their benchmarks. Most large cap funds don't beat the S&P 500 index (large cap). Most small cap funds don't beat the Russell 2000. Furthermore, the funds that do beat their benchmarks vary from year to year and there is no evidence whatsoever that a savvy financial advisor can pick a priori (in advance) which funds will outperform (Connecting the dots - your financial advisor or planner is blowing smoke when he confidently informs you that he'll only put you into the best mutual funds, since he can't possibly know which ones those will be. Unfortunately, too many financial advisors put their clients in mostly, or only, stock mutual funds and they tend to use the ones with the highest commissions!)
Okay, to review: a 25 stock portfolio will get you 90% of the benefits of diversification and a 40 stock portfolio will get you 99% of the benefits (assuming diversification is your goal). But is that a properly diversified portfolio? Stock portfolio - yes, investment portfolio - NO!
Multiple-Asset-Class investing offers demonstrably superior results to investors, providing high rates of return with less volatility than one, two, and three asset class portfolios. For instance, an equally weighted four asset class portfolio (composed of domestic stocks, international stocks, bonds, and commodities) returned 11.24% per annum from 1972 through 2008 with a standard deviation of only 14.11%, resulting in a Sharpe ratio of 0.46 (high). What that means for us individual investors is that we want to create portfolios containing stocks (domestic and international), bonds, real estate and commodities for the long-term. Importantly, we can adjust volatility by adjusting the mix. Also importantly, we can add additional return by using value investing (paying less for a business than its worth) rather than growth investing (paying a premium for a business) or momentum investing (buying a stock simply because it is going up).
Monday, May 18, 2009
The Really Big Picture
I had a prospective client ask me the other day how we were handling the current stock market rally. He wanted to know if we planned on raising cash as the rally progressed or whether we thought this was the start of a new bull market. My prospect's question certainly isn't unusual. In fact, CNBC and the other popular media outlets spend hours debating those same questions. Speculating on where the stock market is going, what interest rates will do, whether commodity prices will rise once again this year - these are the questions to which people want answers. And, Wall Street provides those answers in abundance, although many of the answers contradict one another and most of the answers turn out to be wrong - predictable once you realize that it is all just speculation about an unknowable future.
Yet most individuals are so indoctrinated into the Wall Street mindset of prediction that they view it as a normal part of investing. Buy a stock because it may go up in the next six to twelve months - that's what the typical mutual fund manager tries to do. Look at ways to predict that a stock will rise in the short term - for surely six to twelve months is the short term. Upside earnings surprises, stock price momentum, rising earnings estimates, beating revenue forecasts - all designed to capture a short term stock price move. The problem? Not much in the way of business valuation gets done by the majority of investors, which is the core of any true investment methodology. Successful investors buy businesses for less than they are worth and sell them for more than they are worth. Business valuation is the core and price paid is the THE key.
I did answer my prospects questions. After all, I have just as much fun as the next guy trying to predict what the economy and the stock market will do next. It's fun, fascinating and endlessly entertaining, but I don't forget for one instant that it is still speculation and I make very sure to use my forecasts only as a backdrop for our core investing discipline in order to help us with risk management. For the record, I don't think this is the start of a new bull market; the economy is not yet on the mend, despite all of the cheer leading now emanating from the government and the talking heads on the Street. As well, any expansion is likely to be short lived once the economy does begin to respond to the massive fiscal and monetary stimulus that has been applied. The United States has simply taken on too much debt and has an insufficient ability to earn enough to pay it off. In short, the economy will continue to founder for years (perhaps decades) under the weight of the ever growing mountain of debt our government and corporate America have assumed.
Enough of the macroeconomics though. Now I want to answer my prospects question on how we are handling the current rally in the hope of passing along something useful to you.
We buy businesses when they are selling for substantially less than what we think a knowledgeable third party would pay for the entire business in an arm's length transaction. Bear markets create plenty of opportunities to buy good companies for great prices and great companies for good prices. We are currently buying hand over fist because we are finding plenty of bargains. Conversely, bull markets make for far fewer opportunities to make great investments, which means we will often end up holding cash toward the end of a bull market because we can't find a worthwhile investment.
We do adjust our buy discipline for macroeconomic factors. It was obvious to us in late 2007 and early 2008 that the financial sector was toast. The red flags were everywhere. We will not buy a business at any price if we don't think the business is viable, which means the balance sheet must be strong enough to allow a company to survive. The banking system is currently insolvent as a whole and the rules of the game change daily as the government attempts to salvage it - we will not buy into the banks at any price right now.
Likewise, we adjust our sell discipline for macroeconomic factors. During the great secular bull market of the 1990s it was reasonable to hold businesses longer than we normally would as the bull market pushed valuations further than justified. Rather than selling a business as it returned to fair value, we commonly held them a bit longer if the chart indicated that the uptrend was intact. However, price risk is not something you want to take during a secular bear market, which means we are currently much more aggressive selling investments as the market pushes them back near fair value.
And that is how we're handling the current rally. We are aggressively buying good businesses at great prices and great businesses at good prices but with the expectation of selling them as they approach fair value because we do not think that the next great bull market is anywhere close at hand.
Yet most individuals are so indoctrinated into the Wall Street mindset of prediction that they view it as a normal part of investing. Buy a stock because it may go up in the next six to twelve months - that's what the typical mutual fund manager tries to do. Look at ways to predict that a stock will rise in the short term - for surely six to twelve months is the short term. Upside earnings surprises, stock price momentum, rising earnings estimates, beating revenue forecasts - all designed to capture a short term stock price move. The problem? Not much in the way of business valuation gets done by the majority of investors, which is the core of any true investment methodology. Successful investors buy businesses for less than they are worth and sell them for more than they are worth. Business valuation is the core and price paid is the THE key.
I did answer my prospects questions. After all, I have just as much fun as the next guy trying to predict what the economy and the stock market will do next. It's fun, fascinating and endlessly entertaining, but I don't forget for one instant that it is still speculation and I make very sure to use my forecasts only as a backdrop for our core investing discipline in order to help us with risk management. For the record, I don't think this is the start of a new bull market; the economy is not yet on the mend, despite all of the cheer leading now emanating from the government and the talking heads on the Street. As well, any expansion is likely to be short lived once the economy does begin to respond to the massive fiscal and monetary stimulus that has been applied. The United States has simply taken on too much debt and has an insufficient ability to earn enough to pay it off. In short, the economy will continue to founder for years (perhaps decades) under the weight of the ever growing mountain of debt our government and corporate America have assumed.
Enough of the macroeconomics though. Now I want to answer my prospects question on how we are handling the current rally in the hope of passing along something useful to you.
We buy businesses when they are selling for substantially less than what we think a knowledgeable third party would pay for the entire business in an arm's length transaction. Bear markets create plenty of opportunities to buy good companies for great prices and great companies for good prices. We are currently buying hand over fist because we are finding plenty of bargains. Conversely, bull markets make for far fewer opportunities to make great investments, which means we will often end up holding cash toward the end of a bull market because we can't find a worthwhile investment.
We do adjust our buy discipline for macroeconomic factors. It was obvious to us in late 2007 and early 2008 that the financial sector was toast. The red flags were everywhere. We will not buy a business at any price if we don't think the business is viable, which means the balance sheet must be strong enough to allow a company to survive. The banking system is currently insolvent as a whole and the rules of the game change daily as the government attempts to salvage it - we will not buy into the banks at any price right now.
Likewise, we adjust our sell discipline for macroeconomic factors. During the great secular bull market of the 1990s it was reasonable to hold businesses longer than we normally would as the bull market pushed valuations further than justified. Rather than selling a business as it returned to fair value, we commonly held them a bit longer if the chart indicated that the uptrend was intact. However, price risk is not something you want to take during a secular bear market, which means we are currently much more aggressive selling investments as the market pushes them back near fair value.
And that is how we're handling the current rally. We are aggressively buying good businesses at great prices and great businesses at good prices but with the expectation of selling them as they approach fair value because we do not think that the next great bull market is anywhere close at hand.
Tuesday, May 5, 2009
Medicare Supplements
Medicare isn't the end all and be all of medical care for seniors. The truth is that most seniors need supplemental insurance if they can't afford to reach into their pockets repeatedly as they grow older and require increasing amounts of medical attention. In fact, practically everyone needs a Medigap or Medicare Supplement policy. The only folks who probably don’t need a supplement are those who qualify for Medicaid or another government assistance program. It is important to sign up during the 6-month window provided by law after turning 65 to avoid having to qualify medically. The six month window allows you to enroll in any plan you like; you may lose that freedom of choice if you miss the window and your health is questionable.
You need to understand what Medicare is and isn't to understand the value of a supplemental policy. Medicare is a federally funded health insurance plan for citizens of the US who are age 65 and above. Medicare Part A is an automatic enrollment and costs nothing. This is the “Hospital” coverage portion of Medicare. Individuals must enroll in Medicare Part B which covers out of hospital charges; doctor’s visits, lab work, outpatient surgeries and the like. Part B coverage is paid out of your social security benefit and currently costs $98.00 per month.
One of the most misunderstood things about Medicare is how it pays benefits. Many seniors think that it will pay for all their medical expenses and that can be a costly error. The reality is that Medicare comes in two parts. The 2009 Part A Deductible is $1068.00 annually and is for hospital stays. The 2009 Part B Deductible is $ 135.00 annually and is for non hospital expenses. Now here is the IMPORTANT part. Medicare does not pay 100% after the deductible is met, instead paying only 80% of the costs. And that is very important to understand because if an individual with Medicare parts A & B goes into the hospital and generates a $100,000.00 bill from their stay, then that individual would owe approximately $20,000.00 to the provider. Yikes!
But that is where Medigap policies enter the picture as they are designed to pay one or both deductibles and the 20% remaining balance that Medicare does not pay. Remember that $20,000 bill we generated with our single hospital stay, even after Medicare had paid its portion? Your bill would drop to $0.00 with a Medigap policy.
Now you do have choices to make regarding which plan is right for you. There are 10 STANDARD Medicare supplement plans (standardized by the federal government a few years back). Pricing and the actual plan details are the key as every insurance company must provide an identical standardized plan by law. Of course, the financial strength of the insurance company is also a front and center issue. One important attribute of the standardized plans is that they allow policyholders to go to any doctor/hospital that accepts Medicare assignment. It is critical that prospective buyers understand that Medicare Select policies and some of the newer policies such as the "Advantage Plans" severely restrict your access to doctors and hospitals and also require you to make co-payments for services, as well as limit some benefits. Non-standardized plans are not necessarily wrong for you, but you do need to make sure you understand what you are and aren't getting for your money.
Seniors who currently have a plan can shop for another, cheaper one as long as they qualify by answering a few health questions. There are no lengthy exams and the underwriting decision is usually made within a few hours. Premiums for Standard plans are determined by age, take into account whether you are a smoker, and sometimes are adjusted based on medicines prescribed. You should expect to pay around $100.00 per month for age 65 up to around $240.00 per month for a 90 year old depending on the plan you choose.
It is worth while talking to an agent when shopping around for a plan. Agents are paid a commission from the insurance company so no direct fees to the client are involved. Of course, the insurance company will seek to recoup those commissions with a portion of the premiums paid. A knowledgeable agent should be able to help a senior with the choice of a supplemental plan that makes sense for the senior while also advising on an Rx plan under Medicare Part D (the prescription drug portion of Medicare that currently offers 75 different options). Another service that an agent can provide is accessing a clients qualifications to see if they are eligible for free or discounted medications. Any agent you choose should have some experience in the insurance industry, the ability to review part D for you, have an understanding of low cost Rx plans, and also be able to advise the client on other senior products, such as long term care planning.
In summary: Medicare Standard plans allow the owner the most flexibility and best coverage. They are a commodity product though so shop price. While Select and “Advantage” plans may be less expensive, you are restricted in choice of providers and may have poorly disclosed co-pays for each service. It is important that you understand exactly what you are and aren't getting in these non-standard plans. And don't forget that you may replace your current plan for less benefits, more benefits, or a lower price.
(I'd like to thank Bob Dorman of Dorman Benefit Consultants for providing invaluable help with researching the article.)
You need to understand what Medicare is and isn't to understand the value of a supplemental policy. Medicare is a federally funded health insurance plan for citizens of the US who are age 65 and above. Medicare Part A is an automatic enrollment and costs nothing. This is the “Hospital” coverage portion of Medicare. Individuals must enroll in Medicare Part B which covers out of hospital charges; doctor’s visits, lab work, outpatient surgeries and the like. Part B coverage is paid out of your social security benefit and currently costs $98.00 per month.
One of the most misunderstood things about Medicare is how it pays benefits. Many seniors think that it will pay for all their medical expenses and that can be a costly error. The reality is that Medicare comes in two parts. The 2009 Part A Deductible is $1068.00 annually and is for hospital stays. The 2009 Part B Deductible is $ 135.00 annually and is for non hospital expenses. Now here is the IMPORTANT part. Medicare does not pay 100% after the deductible is met, instead paying only 80% of the costs. And that is very important to understand because if an individual with Medicare parts A & B goes into the hospital and generates a $100,000.00 bill from their stay, then that individual would owe approximately $20,000.00 to the provider. Yikes!
But that is where Medigap policies enter the picture as they are designed to pay one or both deductibles and the 20% remaining balance that Medicare does not pay. Remember that $20,000 bill we generated with our single hospital stay, even after Medicare had paid its portion? Your bill would drop to $0.00 with a Medigap policy.
Now you do have choices to make regarding which plan is right for you. There are 10 STANDARD Medicare supplement plans (standardized by the federal government a few years back). Pricing and the actual plan details are the key as every insurance company must provide an identical standardized plan by law. Of course, the financial strength of the insurance company is also a front and center issue. One important attribute of the standardized plans is that they allow policyholders to go to any doctor/hospital that accepts Medicare assignment. It is critical that prospective buyers understand that Medicare Select policies and some of the newer policies such as the "Advantage Plans" severely restrict your access to doctors and hospitals and also require you to make co-payments for services, as well as limit some benefits. Non-standardized plans are not necessarily wrong for you, but you do need to make sure you understand what you are and aren't getting for your money.
Seniors who currently have a plan can shop for another, cheaper one as long as they qualify by answering a few health questions. There are no lengthy exams and the underwriting decision is usually made within a few hours. Premiums for Standard plans are determined by age, take into account whether you are a smoker, and sometimes are adjusted based on medicines prescribed. You should expect to pay around $100.00 per month for age 65 up to around $240.00 per month for a 90 year old depending on the plan you choose.
It is worth while talking to an agent when shopping around for a plan. Agents are paid a commission from the insurance company so no direct fees to the client are involved. Of course, the insurance company will seek to recoup those commissions with a portion of the premiums paid. A knowledgeable agent should be able to help a senior with the choice of a supplemental plan that makes sense for the senior while also advising on an Rx plan under Medicare Part D (the prescription drug portion of Medicare that currently offers 75 different options). Another service that an agent can provide is accessing a clients qualifications to see if they are eligible for free or discounted medications. Any agent you choose should have some experience in the insurance industry, the ability to review part D for you, have an understanding of low cost Rx plans, and also be able to advise the client on other senior products, such as long term care planning.
In summary: Medicare Standard plans allow the owner the most flexibility and best coverage. They are a commodity product though so shop price. While Select and “Advantage” plans may be less expensive, you are restricted in choice of providers and may have poorly disclosed co-pays for each service. It is important that you understand exactly what you are and aren't getting in these non-standard plans. And don't forget that you may replace your current plan for less benefits, more benefits, or a lower price.
(I'd like to thank Bob Dorman of Dorman Benefit Consultants for providing invaluable help with researching the article.)
Monday, April 27, 2009
Fiduciary Standard
Fee-only is different from fee-based... period, and don't let your fee-based advisor tell you any differently (and they'll try). I recently talked with a stock broker from Raymond James Financial (of course he called himself an advisor) who wanted to split hairs in an effort to get me on board with the idea that someone such as himself was really the same as a fee-only advisor. Baloney!
I politely explained to him that only a firm that gets paid solely by the client, and not by a third-party, can legally claim to be a fee-only advisor. He looked a bit puzzled and asked me what I meant. I said it was really quite simple. A fee-only advisor doesn't accept money from anyone other than their client. A fee-only advisor works for their client and their client only. When I asked him if the many mutual funds he sells his clients pay him a sales commission (a loaded fund) he reluctantly admitted that they did. Bingo! Major conflict of interest since the advisor now has a vested interest in selling you products that will make him money, paid to him by a third-party, rather than products that are in your best interest.
Fee-only, independent advisors registered with the SEC can claim fiduciary status; the manufacturers and sellers of financial products (mutual funds, variable annuities etc.) can not. In the words of Evan Cooper of InvestmentNews, "the providers of products and advice (whether known as brokers, representatives, financial consultants, financial advisors or any other title that connotes investment advice-giving) must recommend only those products that are suitable for a client," (a much looser standard that does not require the client's best interests to be placed first.) Mr. Cooper goes on to write that, "Wall Street wants to keep the suitability standard as long as it can, because it permits principal trades. If a brokerage firm can sell a bond from its inventory when a client comes in to buy, it's a lot more profitable for the firm than having to shop the order among other dealers to get the best price. There's a lot of money to be made by the brokerage business by putting the broker-dealer ahead of the investor."
Not a problem you say to yourself? You don't buy bonds from your fee-based advisor? How about stocks? Your boy gets a commission every time you buy one of his recommendations, incentivizing him to sell you stocks, whether it is in your best interest or not. And how about those front-loaded, high operating cost, 12b-1 mutual funds that are still so prevalent in the industry? Your boy gets paid every time you pony up your hard earned money to make an investment in an average performing fund that almost certainly has a no-load, lower operating cost alternative. I mean for crying out loud! There are something like 10,000 mutual funds out there now, more funds even than stocks.
Want to know the saddest part? The academic evidence overwhelming shows that no one can pick a mutual fund that will outperform its peer group a priori (in advance), which means that everyone should be focusing on costs and tax efficiency when it comes to mutual fund selection. That's right, all of those so-called advisors out there who tout their ability to put you into the best performing mutuals funds are full of you know what. The fact is (and it is a fact) that the top twenty performing mutual funds from the prior five-year investing period will not be the same top twenty who outperform over the coming five-year period. In fact, few if any names will repeat.
Oh, and one last pearl of wisdom from Mr Cooper of InvestmentNews that I couldn't agree with more, "The rules should be crystal clear. If you are licensed to give financial advice in any way, shape or form, you must put clients' interest first. If brokerage firms (and fee-based advisors) can't comply, let them reorganize themselves, or label their advice as sales promotion."
Amen!
I politely explained to him that only a firm that gets paid solely by the client, and not by a third-party, can legally claim to be a fee-only advisor. He looked a bit puzzled and asked me what I meant. I said it was really quite simple. A fee-only advisor doesn't accept money from anyone other than their client. A fee-only advisor works for their client and their client only. When I asked him if the many mutual funds he sells his clients pay him a sales commission (a loaded fund) he reluctantly admitted that they did. Bingo! Major conflict of interest since the advisor now has a vested interest in selling you products that will make him money, paid to him by a third-party, rather than products that are in your best interest.
Fee-only, independent advisors registered with the SEC can claim fiduciary status; the manufacturers and sellers of financial products (mutual funds, variable annuities etc.) can not. In the words of Evan Cooper of InvestmentNews, "the providers of products and advice (whether known as brokers, representatives, financial consultants, financial advisors or any other title that connotes investment advice-giving) must recommend only those products that are suitable for a client," (a much looser standard that does not require the client's best interests to be placed first.) Mr. Cooper goes on to write that, "Wall Street wants to keep the suitability standard as long as it can, because it permits principal trades. If a brokerage firm can sell a bond from its inventory when a client comes in to buy, it's a lot more profitable for the firm than having to shop the order among other dealers to get the best price. There's a lot of money to be made by the brokerage business by putting the broker-dealer ahead of the investor."
Not a problem you say to yourself? You don't buy bonds from your fee-based advisor? How about stocks? Your boy gets a commission every time you buy one of his recommendations, incentivizing him to sell you stocks, whether it is in your best interest or not. And how about those front-loaded, high operating cost, 12b-1 mutual funds that are still so prevalent in the industry? Your boy gets paid every time you pony up your hard earned money to make an investment in an average performing fund that almost certainly has a no-load, lower operating cost alternative. I mean for crying out loud! There are something like 10,000 mutual funds out there now, more funds even than stocks.
Want to know the saddest part? The academic evidence overwhelming shows that no one can pick a mutual fund that will outperform its peer group a priori (in advance), which means that everyone should be focusing on costs and tax efficiency when it comes to mutual fund selection. That's right, all of those so-called advisors out there who tout their ability to put you into the best performing mutuals funds are full of you know what. The fact is (and it is a fact) that the top twenty performing mutual funds from the prior five-year investing period will not be the same top twenty who outperform over the coming five-year period. In fact, few if any names will repeat.
Oh, and one last pearl of wisdom from Mr Cooper of InvestmentNews that I couldn't agree with more, "The rules should be crystal clear. If you are licensed to give financial advice in any way, shape or form, you must put clients' interest first. If brokerage firms (and fee-based advisors) can't comply, let them reorganize themselves, or label their advice as sales promotion."
Amen!
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