Showing posts with label Investments. Show all posts
Showing posts with label Investments. Show all posts

Friday, April 22, 2016

Time to Lighten Up on U.S. Stocks?

As those of you who follow my financial blogs know, I am a believer that the largest component of long-term investing results is one’s asset allocation. To maintain a proper allocation, one must periodically rebalance portfolios.

Since the beginning of the year, the S&P 500 has risen about 3.9%, which does not seem like a huge change. However, the year started off with a sizeable correction, so from its low this year, the S&P 500 is up over 14%.

And since it’s low in 2009, the S&P 500 is up over 200%, demonstrating why bailing on stocks when all seems gloomiest is exactly the wrong approach. And, I would argue, so is going all in on stocks as the markets continue to appear rosy. (That would be now.) Rebalancing forces one to sell off relative winners to buy relative losers.

If you haven’t rebalanced in a few months, it might be a good time to determine if your portfolio needs attention.

Only rarely do I change the allocation percentages of my various investment categories. Now, however, is one of those times. My sense is that U.S. stock markets are overpriced. As noted, The S&P 500 has already risen over 200% in the last seven years. That’s past. What matters is the future, and current price has everything to do with collective future expectations.

My expectations are a bit gloomy:

The bull market is already seven years old, but still propped up by expansive fiscal and monetary policy. The Fed still keeps interest rates artificially low. The U.S. Federal government stills pumps money into the economy. Its projected deficit for the year is $500 billion. Continually applied, these types of polices lead to bubbles.

Interest rates are much more likely to rise than decline (a negative to both stocks and bonds), unless a recession occurs.

Commodity prices have fallen substantially, temporarily boosting profits (consider airlines, for example). The five-year decline is likely to reverse.

The dollar has risen substantially over the last five years compared to major currencies (Euro and Yen by 30+%). This means U.S. based exports are more expensive and foreign earnings for U.S. companies have less value.

Much of the U.S. unemployment slack has been erased. This means corporations will have to pay more for talent they need. At the same time, much of the increased profit margin they have wrung out of labor costs by converting full-time positions into part-time and on call employees, outsourcing, and eliminating defined benefit pension plans and the like has already been fully reflected in earnings.

When (not if) the next recession occurs, the Fed will have fewer resources to counteract the liquidity crises that will surely occur because it has kept interest rates artificially low. Similarly, with the U.S. debt at record levels, Congress will be unlikely to approve appropriate economic relief measures.

Thus, the next recession will likely last longer and be deeper than would be the case if the U.S. economy were not starting from a position where expansionary measures are constantly in effect.
All of which says to me that U.S. stocks are riskier than usual in my portfolio. Recall that I am older and retired, which means I have fewer years to recover from any bear market and (worse) I do not have the ability to purchase more investments through savings from future earnings.

So my situation is different from yours, as may be my analysis of what to expect. But I figured I’d share my thinking and maybe learn something from everyone’s reactions.

~ Jim

Monday, March 3, 2014

“Bitcoin is Still in Beta”

So says Bitcoin’s executive director, Jon Matonis as reported by CNN. Now, I’m sure that bit of information, combined with Matonis’s further advice that “You should only invest in trade what you can afford to lose,” is very comforting to people who used Mt. Gox to store their investment.

In other words, the executive director classifies bitcoin as an extremely risky investment, not a monetary store of value. I suppose that’s obvious for anything which has had its value jump to over $1,000 and subsequently slump to under $600. Notice from the chart below that this is not the first slump since Bitcoin went stratospheric. Also notice since Mt. Gox’s demise that bitcoins have been trading higher. I suppose you could attribute that to classical economics: since the supply of bitcoins has decreased, all other things equal, the price should go up. Alternatively, you could view it as whistling past the graveyard.

Mt. Gox has filed for bankruptcy protection in Hong Kong, so perhaps their account holders will receive pennies on the dollars for their accounts when the debacle is finally resolved. Apparently even before Mt. Gox was hacked and “lost” 1.5 million bitcoins, they were under financial pressures that should have been sufficient to alert investors that the exchange was unsustainable. Again, according to CNN it appears Mt. Gox’s 2012 revenue was less than $400,000 and its expenses included $5 million seized by the U.S. government for alleged false answers on bank documents.

All of that was news to me because I had no reason to follow Mt. Gox. However, those with bitcoin “investments” are now surely warned (if they weren’t before) to perform careful due diligence of the organization holding their bitcoins.

Bitcoin’s Jon Matonis thinks in five years bitcoins will be mainstream, with apps that are as easy to use as Skype. That comparison is not fully reassuring to me. In the meantime, may the Force be with you and your bitcoins. I’ll continue to enjoy the action from the outside looking in.

~ Jim

Tuesday, February 18, 2014

A Skeptic Looks at Bitcoins

One of my rules for evaluating potential investments is how well I understand them. Unless I have developed a basic understanding of the investment and its attendant risks, I’m not willing to invest in it. No amount of written and verbal advice given by “experts,” is sufficient to overcome my need to understand. After all, these selfsame experts are the ones who have missed numerous bubbles.

The value of Bitcoins is market-based, determined by supply and demand. Supply is purportedly regulated by the software. There are currently approximately 12.4 million bitcoins, and the programming calls for a maximum of 21 million. That means the currency is designed to inflate almost 70%, but at ever-slower rates until finally reaching the 21 million maximum.

Bitcoins, unlike gold or silver for example, have no industrial use; they have no intrinsic value. They are like wampum: they are only worth what two people in a transaction agree they are worth. Humans do not have a great record at determining monetary worth when something has no intrinsic value. This is not a 21st century problem, as evidenced by the tulip bulb craze in the early 17th century. Even when something has intrinsic value (gold, silver, real estate), we humans often go hog wild—or conversely can’t see the value in the dirt below our feet.

To summarize, bitcoins have no intrinsic value and are programmed to inflate. That does not sound like a winner to me. But wait, there’s more! In addition to the inherent risks of buying with no intrinsic value, bitcoins contain exogenous risks as well.

Unfortunately, I have very little clue—and, if they are honest, no one else does either—what the exact characteristics of those risks are.

For example, what prevents those “in charge” of the open source coding from deciding to increase the number of available bitcoins past the current 21 million limit, continuing to inflate the currency? I’m sure those in charge insist it can’t happen. But it is certainly a real risk, and I can’t quantify it.

How secure is the system from hackers? I have a firm belief that if humans made it, other humans can break it. This theory applies to more than just the system that creates new bitcoins according to a predetermined schedule. How safe is your bitcoin account? If someone raids your bank your loss is covered (up to certain limits) by the bank or their insurance. Will the same hold true for your digital bitcoin wallet? Who pays those insurance costs? How secure is the insurer? I have no clue.

If the value of bitcoins stabilizes so that its conversion to traditional currencies is primarily determined by inflation in the traditional currency, it would make bitcoins a perfect inflation hedge. That would have utility. However, with a maximum of 21 million of the little critters—and at a recent price of $628—total currency in circulation will max out at a bit over $13 billion. The world’s annual output of goods and services is something north of $70 trillion. US Debt—the world’s “safe” place for parking money—is over $17 trillion.

So there we have it: an entity with no intrinsic value, a currency guaranteed to inflate 70%, with lots of potential risks for which there are no guarantees. Investing in bitcoins sounds to me like making a bet based on the greater fool theory.

Does that mean we should ignore bitcoins all together?

No. They might soon have transactional value. Right now if someone in the U.S. buys one of my novels or my bridge book and uses a credit card, I pay the transaction costs. Using my Square credit card reader, the fees are 2.75% if I swipe a credit card and 3.5% if I enter the transaction manually. Square doesn’t work for foreign transactions.

If someone comes up with a methodology that reduces my transaction fees and allows for instant conversion of bitcoins back to U.S. dollars so I don’t have a currency risk, I’ll adopt in a flash. And since bitcoins are not individual country centric, I could use them abroad without the foreign transaction fees charged by most credit cards.

Bitcoins may be the opening salvo over banks’ and credit card companies’ bows. Technology continues to attack the value of intermediaries—those people and corporations that stand between buyer and seller. If entrepreneurs find a way to reduce the necessity of intermediaries and their attendant transaction costs, it will have major ramifications.

When people first used the internet to exchange messages, most had no clue how dramatically the internet would change the way we do business. The same may be true with bitcoins, and venture capitalists are already making their bets. It is too early to tell how this will all turn out, but it’s too important to ignore.

While I’m waiting to see how that turns out, I won’t be holding bitcoins. Too much risk.

~ Jim

Friday, December 27, 2013

Understanding Financial Leverage

Recently, friends mentioned that their periodic meeting with their investment advisor happened to coincide with their decision to purchase a new car. The investment advisor recommended that they take the dealer’s 0.9% financing because “our portfolio is doing a lot better than that.”

Which ignores the point that taking out the loan will leverage their portfolio. If levering up portfolio returns was such a good thing, why had they not discussed that as a strategy before? Investments exist that can provide leverage without the portfolio itself borrowing money.

So, back to my friends’ situation.

Looking only at long-term averages, borrowing at 0.9% to invest in the markets is a winner. After all, any reasonable mix of stocks and bonds has done much better than that over the last few years, and is expected to earn more than 0.9% for any given future year. Unfortunately every year is unique; averages are only the place from which standard deviations start, not the actual results.

For discussion purposes only, and not to reflect my friends’ actual finances (of which I have no knowledge), let’s assume a balanced portfolio of 60% stocks and 40% bonds, and that the price of the car is equal to 5% of the portfolio value. Here are two alternatives:
  1. Sell off 5% of the portfolio and buy the car in cash.
  2. Borrow 5% of the portfolio from the dealer at 0.9% and each month sell enough of the portfolio to make the car payment.
The actual car loan in this case was for three years. For simplicity, let’s look instead at a 1-year loan with a lump sum payment due at the end of 2014. This changes the actual facts, but does not affect an understanding of how this leveraging will work. The actual return of the portfolio in 2014 as a percentage of assets can be designated as R.

The value of the portfolio at the end of 2014 using the pay-in cash-approach will be  P1 = [.95 *P0 * (1+R)]

And taking the 0.9% car loan the value of the portfolio at the end of 2014 will be:    P1 = P0 * (1+R) - .05 * P0 * (1.009) = .95 * P0 * (1+R) + .05 * P0 * (1+R - 1.009)  = [.95 * P0 * (1+R)] + .05 * P0 * (R - .009)

Comparing these two scenarios, we see mathematically what we logically knew all along: as long as the actual return (R) beats the 0.9% financing cost of the loan, we’re ahead. Mathematically, this shows as difference between the two formulae: .05 * P0 * (R - .009)

Paying cash and eschewing the car loan, my friends were going to have a portfolio that went up or down solely based on their asset mix. By taking the loan, my friends now changed their results. If the portfolio earned more than 0.9% for the year, they would end up with more money at the end of the year. Conversely, if the portfolio did not earn the 0.9% threshold, they would have a lower portfolio value than would have been the case without the loan.

This is what leveraging does. Given the loan is equal to 5% of the portfolio, by taking the loan rather than paying in cash, we have (1.00/.95) = 1.0526 times the earning power before we have to pay off the loan.

What are the chances that 2014 won’t provide an investment return of at least 0.9%? I’ll tell you for sure on December 31, 2014. In the meantime we can look at past results as an indication of what 2014 may bring. According to [] there is a 35% chance of a balanced portfolio losing value in any given year. The maximum one-year loss on a balanced portfolio (so far) has been 35%. That would feel terrible, but after taking the loan we’ll actually lose closer to 37%.

Of course the best year in the past produced a gain of 89%, which with the leverage would increase to almost 93.6%.

In most years, the investment return will range between plus or minus 10%, which with leverage translate to a range of -10.6% to +10.5%. The loan/no loan difference is hardly earth shattering. Due to the law of diminishing returns, the extra gain caused by increased leverage won’t make us feel much better. If the markets went up 89%, we would only feel marginally better earning 94%. However, if we lose more money than we otherwise would have—especially those of us who are retired and don’t have the ability to replace lost investments through earnings, that can hurt. It hurts a bit monetarily, but even more psychologically. We tend to beat ourselves up about bad decisions much more than we give ourselves credit for good decisions.

Everyone can make their own choice about leverage. As a retiree with a sufficient portfolio to live in a manner that is acceptable to me, my risk concerns revolve around bad things happening to my portfolio, not whether someone else made more money than I did in the market.

It won’t surprise you that I paid cash for my car.

~ Jim

Tuesday, December 17, 2013

Delaying Social Security Benefits Revisited

Roughly a year and a half ago, I wrote about my decision to delay the start of my Social Security benefits. In that article I argued that for those of us fortunate enough not to have to live off Social Security payments, we should  concentrate more on our risk of outliving our money rather than on the risk of dying too early and not spending all we could have. In the intervening months between the first article and this one a lot has happened politically and in the financial markets that make some question whether my decision to delay payments is still valid.

I think it is.

Politically, we are another eighteen months closer to running out of money in the Social Security Trust Fund with no hope of Congress acting in a manner to avert the problem. Many Republicans are back to ballyhooing their flawed idea of individual retirement accounts replacing traditional Social Security benefits (after all, the stock markets are hitting new highs) and Democrats are on this issue the “party of no”—as in they want no change, regardless of expert testimony that the current approach is unsustainable.

As each day passes, more Baby Boomers hit retirement age, making it harder to change their benefits. As a large demographic that votes, they can throw their weight around with targeted lobbying by organizations such as AARP. Given the demographics, it will take significant political will to make changes in Social Security. The 113th Congress has shown no political will or wisdom, and there is no reason to think the 114th will be better.

Congressional inaction continues to increase the risk of the Social Security Trust Fund running out of money. So with all that, why shouldn’t you do the Boomer thing of take the money and run.

Without Congressional action, the Social Security actuaries project the retirement Trust Fund will be empty around 2033. That does not mean Social Security benefits must stop. However, it does mean the benefits will become strictly pay-as-you-go: total payments (the benefit checks) can’t be more than the total income (the retirement portion of FICA taxes).

As I illustrated in the earlier blog, by deferring the start of Social Security payments until normal retirement age (66 for me, 67 for those born after 1959 and something in between for those born in 1955-1959) you maximize the portion of your assets indexed to inflation. Let’s say your Social Security normal retirement benefit starting at age 66 is $1,000 a month. If you begin payments at age 62, you will receive only $750 a month. Assume inflation runs at 3% every year (that won’t happen, but it could average out to about that). Here’s what you would get at various ages:

With Age 62 Retirement
With Age 66 Retirement

With Age 62 Retirement
With Age 66 Retirement






During the first four years you are unambiguously better off if you start your Social Security benefits at age 62. Over those four years you will receive around $37,500 in benefits. Assuming a risk-free return equal to the inflation rate, those payments would have an accumulated value of approximately $39,000. You’ll need that money to reimburse yourself for the greater normal retirement benefits you could have been receiving had you delayed your Social Security retirement. Your accumulated pot of money (continuing to grow with interest but shrinking with the make-up payouts) runs out around age 77. From then on you are less well-off compared to deferring Social Security retirement.

Because the Trust Fund will not run out of money until 2033, anyone born before 1956 who delays payments will have already reached their break-even point and thus be ahead of the game before the Trust Fund hits zero. Once the Trust Fund runs dry, and if there is no other change in Social Security, benefits must be cut by roughly 25% to balance benefit payments with FICA taxes. Note that if you delayed the start of benefits, you will continue to receive considerably more from Social Security each month compared to what you would get if you started benefits as early as possible because the cuts are proportional. Using Age 85 from the table above, if you took your benefits early a 25% cut reduces your monthly benefit from $1,480 to $1,110. The benefit those who deferred receive declines from $1,941 to $1,456.

Does that mean you can best hedge all political risk by deferring the start of Social Security retirement? Not necessarily. The scenario above assumes an across-the-board 25% haircut. While that’s what people are currently discussing, it is possible that the cuts could come from the top down by imposing a cap on the monthly benefit. Even in this take-from-the-rich-and-give-to-the-poor scenario, those my age are still better off delaying the start of retirement because the cut occurs after we have reached our break-even point. Younger folks will need to evaluate when it’s time for them to make the take early/defer decision. Also, Congress could enact this type of benefit cut earlier. It’s not likely, but it is possible, and if they did, it could delay the breakeven date, making it less attractive.

From my perspective at the end of 2013, the politics of the last year and a half have not changed my decision to continue to delay the start of my Social Security retirement benefits.

Recently someone smirked that if I had only taken early Social Security and invested those payments (after-tax) in the stock market, I would be monetarily far ahead. Investment gains would defer the break-even point—maybe even to eternity.

There are two problems with this argument. First, it uses an ex post facto analysis. When I made the decision to defer I did not know what the stock market would do. This looking at what actually happened and saying what I should have done is similar to saying that in December 2002, I should have sold my house, borrowed to the hilt, and invested it all in Apple at $14 bucks a share. Then, in perfect market timing, I should have sold the stock on December 17, 2012 at $700. [And even sold it short that day if I were so prescient.]

Social Security provides an almost risk-free investment. (It used to be risk-free until some Tea Party advocates decided having the US government default on its debt was acceptable.) Since my reason for delaying Social Security benefits is to insure against running out of money if I live too long, I should not then foul the comparison of a risk-free return and one investing early payments in a risky proposition such as equities. Doing so defeats the strategy of taking out longevity insurance. This faulty thinking is the same that caused many defined pension benefit plans to invest heavily in equities to “hedge” against morality risk. While stock markets rose, it looked brilliant, but in the recent past it proved disastrous for companies and governments alike. Some plan sponsors have frozen future benefits, and eliminated non-guaranteed benefits—not an option for an individual.

So unless I learn that I am suffering from a disease that significantly decreases my life expectancy, I plan to stick with my decision and defer the start of my Social Security benefits until I turn 70.

~ Jim

Saturday, March 31, 2012

Is the Multi-year Bond Rally Over?

Back a month ago, I needed to rebalance my portfolio by selling some equities. I’ve dithered around reinvesting those proceeds in the fixed income portion of my portfolio, but when a CD matured this month, I simply had too much money sitting in a money market fund earning a walloping .03% a year. (That’s $30 per $100,000.)

Thinking about fixed income forced me to ask this question: is the multi-year bond rally over? My conclusion is that it is, but I have no clue how long rates will continue to stay at their current low levels. As I am writing this, 1-year treasuries have a yield of about .18%; 10-year treasuries yield 2.21%. For TIPs the real rates of return are -.11% for 10-year bonds and only .89% for 30-year TIPs.

Think about that for a second. If you buy 10-year TIPs you pretty much guarantee that after ten years you can buy less with the results of your investment than you can buy right now, and that’s before you pay taxes on your “gains.” Such a deal!

The Federal Reserve has committed to keeping short-term rates close to zero through 2014 in order to stimulate economic growth. They have also worked to flatten out the yield curve, which is part of the reason 30-year TIPs have real rates of return under 1%. (And 30-year mortgages are again under 4.00%)

Another reason for the current low interest rates is that with the instability of global economics, the US economy still looks like a good bet to those worried about their money. Despite the massive budget deficits the US runs, whenever there is a spike in economic uncertainty, money continues to plow into US treasuries.

Short-term we can have more uncertainty. The Fed can institute QE3 (quantitative easing round 3) and interest rates will again decline. Or Congress can do something stupid (alright, even more stupid than what they have been doing) and cause confidence in the dollar to drop. If I could prognosticate short-term bond moves, I’d be raking in 8 figures a year—and I’m not.

But looking at the long-term I think we must be very near to the end of the multi-year bond rally.

1. Very short-term rates cannot go much lower on a long-term basis than the virtual zero currently in effect. Yes, if there is a scare people may be willing to accept negative short-term nominal rates, but not for long.

2. Although we know bond buyers are willing to buy “safety” at the price of real value retention (witness the 10-year real TIP yield of -.11%), even as the Fed tries to flatten the yield curve, how much more real return are investors willing to give up for safety? And for how long a period—surely not for  30 years? This phenomenon cannot last forever.

3. US Inflation is running around 3% in an environment of 8% unemployment and the Fed holding down interest rates. If the Fed is successful at stimulating the economy, at some point wages will again start to rise and inflationary pressures will increase. Not only will bond yields will have to increase in order to maintain the same real rate of return, but the Fed may switch from worrying about unemployment to worrying about inflation and start to actively increase interest rates itself.

4. Money continues to move away from bonds, seeking higher returns. Corporate bonds have had a very strong run, with high-yield corporate bonds doing even better. As even these riskier investments are priced higher and higher, people will turn away from fixed-income securities and chase commodities (even more than they have.) Eventually the housing stock will rebalance and housing prices will start to rise, attracting new money.

5. Once the Fed either (a) no longer pumps money into the system because they think the employment market is healed or (b) starts to worry about inflation, their massive support of low interest rates will wane. At that point, there will be a very rapid rise in interest rates with the consequential large capital loss—largest in high-duration fixed income instruments.

I don’t know when this will happen, but I do think it will. And when it does, unless one can quickly liquidate one’s position, the capital losses will be massive. Unlike other fixed income bear markets where coupons offset much of the capital decline, now we have almost no coupon interest and so there is no cushion.

My personal conclusion is to keep in money markets only that amount I will need for expenses in the next year. Because of the Fed’s low rates, banks have little current need for investor funds so CD rates are pitiful. However, even those pitifully low rates are better than the equivalent duration treasuries, so CDs are preferable given that their principal is guaranteed (with limits) by the FDIC.

However, to even match inflation, I’ll need to put the rest of my bond allocation in short-term corporates. Doing so, I am taking on more risk, but I do not see corporate debt quality declining much in the next 24-months (and I’ll stay away from junk.) I’ll ladder a few securities, giving a bit of diversification in both company and duration. As bonds mature, I can decide how to redeploy those funds.

If I am wrong, I’ve given up a bit of yield to long-term bonds I could have purchased instead. If I’m right, I’ll save a lot in capital losses I have avoided. That sounds like a good trade-off to me.

~ Jim

Friday, February 17, 2012

Time to Rebalance?

Just a quick post to let everyone know I rebalanced my portfolio today. I was rushed, so technically, I only partially rebalanced—I sold equities. Since the beginning of the year, domestic and international equities have risen. At the same time interest rates have risen, meaning bond prices have fallen.

The net result for me was enough of an imbalance compared to my target allocation that I needed to rebalance. Over the weekend, I’ll address the bond side of my rebalancing and increase my bond holdings to get them back in line.

Your securities may have responded differently than mine, but perhaps it is time to take a gander at your allocation and see if you too should rebalance.

~ Jim

Thursday, December 29, 2011

Positive Returns in Volatile Markets

Last year I wrote a long post concerning the whys, wherefores and how tos surrounding rebalancing your portfolio. Calendar year 2011 isn’t yet over and anything could happen in the last two days of the year. However, unless the last two days are really bad, my net worth will increase in 2011.

As a reminder, I’m retired and have no income except from my investments. That means I was able to live off my investments and still have more at the end of the year. For this retiree, that is a successful investing year.

So in another twelve-months that most pundits are chalking up as one more “lost year,” after already “losing” the first decade of the 21st century, how did that happen?

I have two answers: diversification and rebalancing.


In another post I set forth my then asset allocation policy:

Bonds (44.0%)
    Short-term                     Balancing Item
    Medium-term                       4.0%
    Long-term                            0.0%
    Inflation-protected               15.5%
    Pension                               Actual%

Equities (50.0%)
    US Large-cap                       23.0%
    US Small-cap                       10.5%
    Europe                                  7.5%
    Pacific                                  3.5%
    Emerging Markets                  5.5%

Other Real Estate                      3.0%
Commodities                             3.0%

Total (100% )

The only changes I made to my asset allocation policy during the year were to reduce the medium-term bonds to 2.0% and decrease the Inflation-protected bonds allocation to 14% —both reflecting the lowering real rates of return. I kept the overall bond/stock/other allocations the same, temporarily moving the additional funds into money market accounts (where they are earning next to nothing).

Bonds increased in value through the year as the Federal Reserve continued downward pressure on interest rates, helped in large part by the instability in the rest of the world that made US treasuries look relatively rock-solid. The US stock market was mostly sideways or down for the year. Foreign securities were down a bunch, especially valued in US dollars. Commodities were up, down and now sideways. Real Estate Investment Trusts (REITs) added value during 2011.

Since I have more money in stocks than bonds and a higher proportion of international stocks than most, with a buy and hold strategy without rebalancing I would have generated a decrease in total asset value worse than the average bear.

Yet even after living expenses, I ended up with an increased net worth. Is this some new application of Wall Street math? No, it’s not. In 9 ¾ years of retirement and following my strategy of diversification and rebalancing, my net worth has increased about 45%. Diversification has helped even out my returns, as has periodic rebalancing.


The markets did not go uniformly up or down; they rollercoastered throughout the year. I rebalanced four times during 2011. I should have done it more often, but was distracted by other things. This is particularly true of my commodities position, where rebalancing would have earned me a better return. Live and learn.

Rebalancing is particularly useful in volatile markets. In some sense it forces you to sell when an asset is high and buy when it is lower. Looking at my actual purchases and sales of the Vanguard Index 500 Fund in 2011 shows how this worked to my advantage.

In January I sold shares at 117.59. In February the index increased and I needed to sell more shares to rebalance, which I did at 120.54. By September the index had declined to 111.37 and I needed to buy shares to rebalance. By December, I had to rebalance again, primarily because of the declines in international equities and sold most of the shares I bought in September at 116.48.

The gains are not huge, but they did earn about 5% on those funds that I would not have earned had I not rebalanced. Don’t confuse this with market timing where one attempts to pick the bottom to buy and the top to sell. Had I been prescient, I would have sold all my stock at the beginning of the year and put it into long-term bonds. Only my need to rebalance dictated the timing of the purchases and sales.

This strategy is about hitting lots of singles, about picking yourself from the dirt when the markets throw a bean ball and being prepared for the next pitch whatever it may be. If I were to fault myself for this year’s performance it is that I should have rebalanced a bit more often to reflect the increased volatility.

~ Jim

Thursday, May 26, 2011

Anchoring and Personal Finance

We all belong to the species homo sapiens, which has variously been defined as “thinking man” or “wise man” or “knowing man” or sometimes “rational man.” Of these proposals, only thinking man fits the bill—and that only if we include irrational, absurd and incorrect thinking as part of our nature.

In psychology the term “anchoring” refers to the human tendency to rely too heavily on a single piece of information to make a decision. We anchor our choices around this datum. The process itself makes some sense. If asked to answer the question: how many leaves are on an average mature sugar maple tree on June 24th, most of us would have no clue where to start, so we invent our own anchor.

We might think of the pile of leaves we had to rake from beneath a maple tree and use its remembered volume as a start—an anchor from which we then will try to guess how many leaves made up ten cubic meters of leaves. Or we might start with the height of a tree, decide branches Y every two feet, each twig holds twenty leaves and make our guess.

The point is we start with something—and it turns out that when faced with estimating something we have no clue about we will anchor off random numbers. For example, assume you split all the people you know into two random groups. Ask Group 1 whether the tree has more or less than 50,000 leaves. Ask Group 2 whether the tree has more or less than 500,000 leaves. People will make their guesses and don’t tell them if they are right or wrong.

Then ask each person to give you their best guess what the actual number of leaves is. Those in Group 1 will guess a much lower number than those in Group 2. Your first question anchored their response. The final guesses were influenced by the number in your first question.

What does anchoring have to do with personal finance? PLENTY!

Which would you rather buy, something marked 50% off or 30% off or something you need to pay a premium to acquire? We all like a bargain, but here are the actual circumstances:

     Store 1: List price is $100, marked 50% off. Final price $50.
     Store 2: List price is $70, marked 30% off. Final price $49.
     Silent Auction: Donated value $35 (wholesale). Winning bid $45.

When I put it that way, we would all rather buy the item at the silent auction, pay less and at the same time benefit some charity or church. Yet we consistently ignore the bottom line and rely on false anchors to influence our decisions or, more insidiously, how we feel about our decisions.

Let’s say at the beginning of an imaginary year half of us invest $100,000 in Stock A and the other half in Stock B. The Bernie Madoff endorsement from the broker guarantees we will make money. There is a caveat: we can’t sell the stock until the end of the year.

The half who buy Stock A for $100,000 watch as each month it increases $1,000 so at the end of the year the position is worth $112,000. Pretty good investment, right? It earned 12% during the year. They cash out and have $112,000 in the bank.

At the same time the other half buys Stock B for $100,000. In the first four months it increases $25,000 per month. At the end of four months it doubled to $200,000. In the next eight months it loses $11,000 per month. At the end of the year this position is worth $112,000. Pretty good investment, right? It earned 12% during the year. They cash out and have $112,000 in the bank.

How would you feel with each of these investments? You should feel the same, but you probably won’t. Stock A went up and up and up and up. It provided good news twelve months in a row. It is a Snoopy Dance stock.

Stock B doubled in four months and then, while there was nothing to do but watch, month after month after month it gave away your money, until you only had $112,000 at the end of the year. If you are like most of us, you will anchor on the $200,000 you could have had if you sold Stock B at the end of April. You feel miserable as you watch your money shrink.

Oh, but that doesn’t make sense, the rational reader will say. Who said anything about feelings and decision-making being rational?

I know all about anchoring, yet I fall into the trap all the time. I can tell you, for example, that my net worth reached its zenith in October 2007. Three and a half years later it has climbed back to within $10,000 of the all-time high. (Of course that was before this month’s market declines, but I only do my balance sheet at the end of the month.) When I think this way, I feel a bit diminished.

But wait! During those three and a half years I’ve been retired. I’ve removed three and a half years of living expenses from my assets. I’m actually ahead of the game—as long as I set the right anchor to view my finances. In fact, if I compare my current net assets now to those when I retired, I’m up 50%. At the time I retired I figured I had enough to live on, and now I’m way ahead of that with nine fewer years to live. (CPI has only increased 26% in the 9+ years of my retirement.) I should be, and am, delighted with my finances because I choose to compare my actual situation to my original plan and ignore the intervening highs (and lows.)

An acquaintance recently listed his second home for sale at a price that was appropriate when he bought the house at the market peak, but is no longer close to what buyers will pay. His rationale is that he’s in no hurry, but wants to get his investment back. I’ve seen people do this with stocks they hold as well. I’ll sell, they say, when I can make a profit.

The real question in both cases is not what you paid for something, but what its current market value is, and given its current value, whether or not you can apply the proceeds to a better investment? What you paid for something is only interesting when you are looking at the tax ramifications of a sale (which is important to do, but is the tail, not the dog.) If the current stock holding has the best potential, you should hold whether or not it shows a loss or big gain relative to book value. Conversely, if something has better prospects, take your loss and move forward.

We need not beat ourselves up because we are innately irrational. What we need to do is recognize when we are inappropriately anchoring. To do that requires us to remember our goals and objectives and reflect reality.

~ Jim

Monday, January 3, 2011

How to Get Rich in Less than One Hour a Day

Happy New Year, Readers.

My skepticism was roused by the headline in a full-page ad in Smart Money magazine: Make Up To $500 In The First 59-Minutes of Every Trading Day.

Heck, anyone can make up to $500 in the first hour of trading. (Conversely, you can lose up to all your money if you did everything wrong.) What I found intriguing about this ad was the sophisticated use of psychological triggers to hook the buyer. There is no over-promise: up to $500 doesn’t sound unreasonable, does it? And the use of the first 59-minutes of the day rather than an hour. That specificity tends to lead credibility to the claim.

It gets better as you read the ad. Turns out the promoter – Manny Backus by name – is a smart dude with an IQ of 157. And he plays chess – only brilliant people play chess, right? The ad features a picture of a clean-cut male dressed in a suit and tie about to move the black queen on a chessboard.

Oh, and act quickly because there are a limited number of seats available in his exclusive club – 575 to be exact. When I went to the website listed, the specific number of slots available (23 when I showed up – a nice prime number, implying 552 people have gotten there before you and the pressure is on – don’t let 23 people get this great deal while you dither about pulling the trigger.)

Finally, there’s a thirty-day free trial. What can it hurt, eh?

Now I don’t know Manny Backus from a hole-in-the-wall, but here’s how I figure the system works for him and how it would work for you if you were to follow it after the free month. He chooses one or two stocks each morning that because of perceived order imbalances will be overbid or oversold at the stock market’s opening or soon thereafter and therefore are likely to either slip back or bounce up from the opening price. He sells short (borrows the stock and sells it) the overbid stocks and buys the oversold stocks. He uses limit orders for protection. He has a target price to close out the position (buy back sold stock, sell bought stock). The idea is to avoid being too greedy, just make a little on each trade.) If he has erred in his judgment he has a predetermined price at which to close out the position.

You and up to 574 other members of the exclusive club are in a chat room where Manny gives you the information and tells you when and what he has bought or sold. There is no proof that he is making these trades, but I suspect he is in order to avoid legal entanglements. Let’s say he trades a round lot (100 shares) for $1 trading cost each way. Four trades a day (two stocks round trip buy and sell) that will cost him roughly $1,000 a year—as we’ll see that’s chump change.

Once your trial period is over, membership costs $297. (Not a round $300 – we humans feel we’re getting a bargain anytime a price ends in seven.) If he has a full book of 575 active members that earns him $170,775 per month. That’s over $2 million a year. Even if he can only keep 100 members active at any given time that’s still $350,000 a year.

Manny has a really nice business going based on the memberships alone.

Now let’s assume Manny takes more than a nominal position in the trades he presents. He asks people to have at least $25,000 in their trading account. Let’s just assume Manny trades with that much himself to show he’s doing exactly what he suggests others do. Because he makes his trades and tells everyone else, he gets to front-ride his members. While some of his stock picks are highly liquid, I’d guess others have a thin market, which means Manny’s followers will move the market by their trades. Let’s see how this could work.

Let’s say Manny proposes to short the YTREWQ stock. (My intention is to make up that stock symbol.) He says he hopes to do it at say $25.00. He’s hoping for at least a 1% gain and so his initial target buyback would be about $24.75. The stock doesn’t quite reach $25.00 and Manny ends up shorting at $24.90 and tells his followers that’s what he did. They all hit their trading keys to sell shares and with a bunch of people selling at the same time, those folks buying don’t need to pay as high a price. The stock price quickly drops as his followers make their sales and levels out at (say) $24.55 where Manny buys the stock back.

Manny’s made a bit less than his target 1% on this transaction but can proclaim it as a successful trade since he made a bunch of bucks in a few minutes time. For a 1,000 share trade using his entire $25,000 trading account, he would have made a quick $200 less commissions.

Now what about the followers? Those in their free-trial month who are shadow-trading (i.e. making the trades on paper and not with real funds to see if the system works) will buy and sell at the same time and price as Manny does and credit their paper account with $200. If Manny wins, they will win and more often than not Manny will win. What about those who are trading in real accounts?

Those most nimble may have been able to sell their shares close to $24.75, but in a thinly traded stock the price will decline quickly and many will only be able to sell at (say) $24.60 or lower. Once Manny’s troops are done selling, the artificial sales pressure to keep the stock price down disappears. Manny puts in his repurchase order and announces the action. Now Manny’s followers begin to buy and the share price springs up. Again the most nimble will be able to get out at a price close to Manny’s. Others will be lucky to get out at the same $24.60 for a wash. The slowest will have a loss on the deal.

Manny’s results will be much better than his followers because they are following his trades and by following, helping assure Manny’s trades (and those who are shadow-trading) work. Because his followers reinforce his choices in the market, they act like a little insurance policy that his picks will work out.

Over the long run, I anticipate that many if not most of Manny’s paying followers will be disappointed to find that not only are they not earning 1% a day (which he does not promise, but suggests by having a calculator on his website which he has you use to determine how much money you can make a year if you earn 1% a day), they are losing money—particularly when the $297 monthly fee is included in costs. Newbies who are shadow trading are making money—and enough of them will fill the ranks of the paying who drop out to assure Manny his stable monthly income.

From time-to-time Manny will hit a big winner. When that happens he’ll have a cadre of loyal proponents until he makes a really bad trade and washes a bunch of people out. Psychologists know the strongest behavior modification technique involves random positive reinforcement. That is exactly what Manny’s product will do since there will be periodic winners and losers with an occasional big gain. The ones who early on experience a big gain are the people who will write true accounts of their success under Manny’s tutelage that Manny will use on his website as testimonials.

In short, assuming Manny is doing everything legally, he’s invented a great way to make consistent money off human rabbits.

Rabbits get fleeced. Don’t be one of them.

~ Jim

Wednesday, December 29, 2010

Four Steps to Rebalance Your Portfolio

If you implemented the ideas behind the last six posts, you have a fair idea about how to put together your personal portfolio policy. In previous posts we’ve talked about rebalancing, but never really addressed the question of how often and how best to accomplish it.

I suggest you look at your portfolio at least once a quarter to see if it is still aligned with your portfolio policy. If you enjoy getting down and dirty with numbers, then a monthly review will work even better. If you really, really hate this, but know you need to do it, then push the odious task out to six-month intervals—but recognize you are probably giving away a bit of your long-term performance.

Rebalancing is a four-step process:

Step 1: Determine the market value of all your investments. These days the market value of most of your investments should be available online. (And I know you can get online because you’re reading this.) Add up all the investments in each bucket of your portfolio policy.

Step 2: Compare the current allocation of your investments with your policy targets. I do this as dollar amounts; some people prefer to use percentages above or below their target. For example if large-cap domestic stocks are supposed to be 25% of your portfolio and that should be $100,000, and they actually are $110,000, then under my approach I would show the large-cap stocks as $10,000 too high. The percentage folks would show it as 110% of target (or 10% over target.)

Step 3: Identify any investments that are significantly higher or lower than your target. Rarely will you be exactly on target, and it takes time (and sometimes money) to rebalance your portfolio. Therefore you need to pick a threshold to rebalance. I choose a dollar threshold, so if the deviation is above that amount, I need to do something; below the limit means I can delay rebalancing that particular asset because the class is not significantly skewed.

Percentage devotees will pick some bracket and say that if the asset stays between (for example) 90% to 110% of target, there is no need to rebalance. Outside of the range, they need to do some buying and selling.

If you are in the investing stage of your life, you can often address your imbalances by deciding where to put new money. Sometimes you are constrained because much of your new investment is going into your employer’s 401(k) plan and you can change your contribution allocation a limited number of times a year.

In any event, the time to decide your rebalancing criteria is when you first set up your portfolio policy. If you wait until later, inertia will cause you to let the rebalancing slip (oh, it’s not too far off the procrastinator says) or fervor will cause you to rebalance more than you need (gosh, large-caps changed 1% today, I’d better fix that imbalance right now!)

Step 4: Decide the most effective way to rebalance. To the extent possible, I try to rebalance in my tax-deferred accounts because those sales do not generate taxes. If you’re a faithful reader of my blog, you know I use mutual funds for equities rather than individual securities [see Risk in Buying Individual Stocks 5/26/2010]. I mostly use index funds with no sales or purchase fees. (The rare exception is an emerging market fund with a low redemption fee.) With bonds, I use an online broker. The idea is to keep the transaction costs as low as possible. As a general rule, the higher the transaction costs, the less frequently you should rebalance because transaction costs diminish the benefits of rebalancing.

I maintain both a Rollover IRA and a Roth IRA. I hold some mutual funds in both accounts because many of them have frequent trading restrictions, meaning I can’t buy sold shares back in the same fund for two months. But if I sell (say) the S&P 500 Index in the Roth IRA and a month later I need to buy some back because of a big price swing, I can do so in my Rollover IRA if I have duplicate funds set up.

If you do want to frequently rebalance, and the repurchase restrictions are a problem, split your assets between two mutual fund companies. As long as you keep sufficient funds in each to qualify for the lowest fees the fund company offers, you can circumvent the repurchase restrictions. For example, you can sell Vanguard S&P 500 shares in December and purchase Fidelity S&P 500 shares in January if necessary.

If you only rebalance quarterly, this whole repurchasing issue won’t be a problem for you.

If you have to rebalance using taxable accounts, keep in mind the tax effects of any sales. Try to sell funds with capital losses or small capital gains; but if you can’t do that, it is better to pay some taxes (particularly at a maximum 15% rate) than to allow your portfolio to become significantly unbalanced.

If you use mutual funds with loads or sales costs, I suggest you consider no-load funds and make any new purchases in them. Over the long-term loads are a shackle on your flexibility and net returns—but that’s a different post.

Whatever route to rebalancing you choose, keep it simple so you can implement and stick with your plan. Better to rebalance only twice a year than commit to doing it monthly and then become sufficiently annoyed at the time and hassle that in frustration you stop rebalancing all together.

Following this approach you will usually end up selling winners and buying losers. For individual stocks that may not be a great plan, but when dealing with widely diversified mutual funds, I think of it as shopping in the bargain aisle and funding my shopping spree by selling off things that are becoming more and more expensive (as the price increases.) Unless you have the will of a mountain, you too will be tempted to hold on to a mutual fund “because it’s still going up.” Keep this in mind: if everyone believed those stocks must go up, they would have already increased in price.

Similarly, sometimes it feels like you are throwing good money after bad as some category falls into disfavor. Do it anyway. If you really feel squeamish, spread your purchase out over a few months rather than making it in one lump.

Financial professors have written a number of papers that show the most important determinant of long-term investment performance is the asset mix. I’d like to add that once you’ve made that all-important decision, the next best thing is rebalancing.

A couple years ago I had a financial advisor compare my personal investment returns to an approach using the same mutual funds utilizing rebalancing only once a year. He reported that in each of the five years my rebalancing policy had beaten the benchmarks. Will that always be the case? Undoubtedly not. A year will come when one asset class only goes up, another only drops—and I kept selling the former to fund the latter. In that kind of year I will not do as well as a strategy that does not rebalance, but none of us knows in advance when that is going to happen. Those who followed the tech stock boom up discovered it cratered much more quickly than it climbed. That’s usually the case for bubbles. If you haven’t been selling on the rise up, it will be too late when the crash comes.

An old Wall Street adage goes something like this: Bulls can make money; Bears can make money; Hogs get slaughtered! (Jim’s caveat is that if you can become the CEO the last statement no longer seems to hold.)

The calendar year is about to end. Isn’t this the traditional time for resolutions? How about reviewing (or creating) your investment portfolio allocation policy and rebalancing if things are out of whack.

~ Jim

Monday, December 27, 2010

Developing an Asset Allocation Model (Part VI)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy, the four main asset classes we’ll consider, two posts on various asset subclasses and the previous post, which revealed my personal asset allocation policy. This final post in the series will discuss the rationale for my current thinking and what changes might cause me to modify the policy in the future.

As a reminder, here’s the policy I have in place as of 24 December 2010:

Bonds: 44.0%
Short-term Balancing Item
Medium-term 0.0%
Long-term 0.0%
Inflation-protected 15.5%
Pension Actual%

Equities 50.0%
US Large-cap 23.0%
US Small-cap 10.5%
Europe 7.5%
Pacific 3.5%
Emerging Markets 5.5%

Real Estate 3.0%
Commodities 3.0%

Total 100%

I based the overall allocation between stocks and bonds on my risk profile. As we discussed in the first part of this series [link1], each of us has different risk parameters. In my case I (hopefully) have a large number of years still in retirement. While I have hopes of income from my writing, realistic expectations indicate I should discount those hopes and assume I am relying on my current assets to fund my retirement.

Consequently, I need sufficient cash flow to fund each year’s expenses and a mix of securities to provide a real rate of return over and above inflation. The biggest risks to my financial security are (1) longevity, (2) significant declines in asset values and (3) inflation. Given those, I started with a 50/50 allocation between bonds and equities. I then added the two additional classes of Real Estate (REITs in my case) and Commodities (precious metal coins and ETFs.)

I chose to carve the Other category out of the Bond allocation because current rates of returns on bonds are significantly below my long-term expectations. If real rates of returns on bonds were higher than my long-term expectation, I might well be fully invested in the bonds and carve the Other category out of the Equities, or be someplace in between.

Turning to the Bonds: I determine the present value of my defined benefit pension plan annuity. (If you don’t have the wherewithal to do that yourself, send me a note and I’ll send you an excel file with instructions.) I convert the present value into a percentage of my total assets.

Other than the pension, my main bond category is the Inflation-protected bonds. These bonds do a good job of addressing all three of my major risks. I have two different assets included within this subclass: Series I Savings Bonds and TIPs (Treasury Inflation-protection bonds). The target percentage I use varies based on the real rate of return on TIPs. The higher the real rate, the higher the target percentage. For example, at a 2.5% real rate of return, the target percentage is 28%. The minimum and maximum of the target range are 14% and 42%. (If I reach the higher end of the range, I would be cutting into my equity allocation, but I would be happy to do that with an inflation-protected real rate of return of 3.25% or higher.)

When I first started investing in this category, my preferred approach was to utilize Series I savings bonds [link to description of Series I bonds]. Their real rates of return were in excess of 3% at the time and I bought as much as the government allowed. With their current real rate of return at 0%, they are very unattractive. I cherish the Series I bonds I have and probably won’t cash them in until they mature. Consequently, all my purchases and sales now involve TIPs. Real rates have been creeping up recently and I will probably soon increase my target percentage.

With the Federal Reserve actively pushing down interest rates, I do not want to invest in standard medium or long-term bonds. I believe the low interest rates are much too low to compensate for the risk of increasing rates because (1) the Fed stops buying bonds, (2) inflation starts to kick up again or (3) foreign creditors stop purchasing the United States’ ballooning debt. Because of the Fed’s actions, the remainder of my bond allocation is sitting in short-term securities. This consists of money market funds paying almost no interest and short-term CDs and corporate bonds with maturities of less than three years. These will fund much of my spending over the next two-three years.

If real rates of return increase, I may gradually lengthen the duration of my bond purchases and increase TIP holdings, otherwise I’m concerned bonds are the next minor bubble with losses ahead of them. See for example Vanguard’s warning to its investors.

Let’s turn now to Equities. Within the equity allocation I found two issues to address. The first question revolves around US equities: how much to allocate between large-cap and small-cap stocks. The actual market percentage varies depending on the flavor-of-the-year. Sometimes the masses like big stocks; sometimes they go gaga over the little stuff. (The tech boom is an example of this.) I’ve settled on roughly 2/3rds of my US allocation going to large-cap stocks and the remainder to small-cap.

The other question is what percentage of equities should be allocated to US, Europe, Pacific and Emerging Markets? Search the internet and you can come up with widely different views of the market capitalization of the various markets. Vanguard, for example uses: North America 44.0%, Europe 26.7%, Pacific 13.5% and Emerging Markets 15.8%. That would imply that of the non-North American markets, 48% belongs to Europe, 24% to Pacific and 28% to Emerging Markets.

If one were a world denizen, an allocation such as Vanguard’s might make sense, but I mostly spend dollars in the United States, so it makes sense to me to overweight my home country for two reasons. Large-cap US corporations have considerable international operations, but because they are US based, they tend to think in dollar terms and hedge some of their currency risk. Thus large-cap US corporations give me access to foreign markets on a hedged basis. Pure plays in the foreign markets subject me to currency risk. I like some currency risk because it tends to provide diversification and so stabilize asset values. However, at the end of the day I am spending dollars not euros or yen.

So I’ve taken the position that US corporations will account for roughly 2/3rds of my equity allocation. Of the remainder allocated to foreign markets, I have again taken a position that 1/3rd will go to emerging markets with the remaining split between Europe and Pacific more or less based on their relative world allocations.

To summarize, I am overweighting the US by increasing its allocation by about 50% and underweighting the rest of the world by 40%. Within the foreign allocation I overweight emerging markets by almost 20% while underweighting Europe by about 5% and Pacific by about 10%.

I’ve tweaked these percentages over the last decade or so. It is interesting to me that for the longest time most of the investment advice I received or read suggested I should have lower allocations for foreign securities than I had. Recently I have seen a number of articles suggesting larger foreign allocations than I hold—which might be the reason we’ve been seeing net outflows from US domestic stock funds and into foreign stock funds. I have to admit it makes me a little nervous when the world starts agreeing with me.

Any Other subclass that I choose to track needs to be sufficiently substantial to have a measurable effect on diversification and risk/return. I’ve set that minimum as 2% of total assets. Originally I had two subclasses: Real Estate and Precious Metals. This year gold skyrocketed past the point where I thought holding the bullion made sense, so I sold out that position and moved into a couple of commodity indexes as an inflation hedge. We’ll see how that works out. I could argue for higher percentages for each of these two subclasses and in fact moved the precious metals from 2% up to 3% over time—mostly through inertia of price increases and a reluctance to sell, until I did.

If something in this analysis struck you as not making sense or it made you feel a bit uncomfortable as you read it, I suggest you try to understand the basis of your feeling. Perhaps I’ve introduced a different way of looking at something that you might want to consider; or perhaps my approach isn’t right for you and that explains your discomfort. The whole point is to make good decisions for yourself. After all, I have to live with my choices; you get to live with yours.

In the next post I plan to talk about the when and hows of reallocating your portfolio.

~ Jim