What do you do when price goes down?

When you buy a new car and drive it off the lot, the price others would pay for it goes down that instant. In fact, on average, the market price of a new car declines 20% in the first year. How do you react to that?

Did you make a mistake in buying? Did you think about that price drop ahead of time? Would you feel better or worse if you had daily, monthly, quarterly or annual price quotes on  your purchase?

These questions are not idle chatter, because any investment you make will decline in market price at some point in time. If you respond rationally to that decline, you'll get very satisfactory results over time. If you don't, you'll be your own worst enemy.

Every investment rises and falls in price over time. Go ahead and accept that right now. Cash fluctuates with inflation and deflation; bonds fluctuate with interest rates; commodities fluctuate with supply and demand; stocks fluctuate with all the above and more. It's a fact of life.

If you expect fluctuations to occur, you can react prudently to market price--benefiting from volatility. If you hope your investments will only go up in price, you'll panic and sell at the wrong time. That will lead to lousy results.

Acknowledge it right now: whatever you buy will fall in price at some point in time. You should be prepared, specifically, to see any stock you buy both drop by half and double over time. How can you possibly sleep at night or react prudently to such an acknowledgement? By clearly understanding the difference between market price and underlying value.

As Warren Buffett put it, price is what you pay and value is what you get. Let me modify that statement a little: market price is the amount you'd pay or receive if you had to buy or sell RIGHT NOW! If you don't have to buy or sell right now, market price should not be your main focus.

Market price is the intersection of the price a seller is willing to sell and the price a buyer is willing to buy. If the seller is panicking, they are likely to take a lower price. If the seller is euphoric, they're likely to want a higher price. When sellers and buyers agree to make a transaction, that's market price.

But, what if particular buyers and sellers aren't knowledgeable or rational. What if they are panicking like they did in early 2009, or overly euphoric about technology stocks like they were in early 2000? In those cases, market price may not be a very good indication of underlying value.

Market price tends to depend on who is doing the selling and buying at any point in time. If the people you are selling to or buying from are sober-minded, intelligent, knowledgeable, then market price and value are likely very similar. If not, then not.

Underlying value is the value to someone sober-minded, intelligent, knowledgeable. Think about someone who has been in an industry for 30 years, who knows and understands suppliers and buyers, who grasps the full context of where the industry has been and is going, who knows growth rates, input prices, distributors, shipping costs, financing rates, the competition, etc.

When that expert looks at a business, they don't think about market price, they think about dividends, returns on investment, cash needs, industry dynamics, and they think about it over the long term. When an expert comes up with what a business is worth, that assessment is based all the relevant information available at the time, and will much more accurately reflect the long range value of the business. Unlike Wall Street analysts and most investors, an expert isn't thinking about market price in 6 months or 6 seconds, they are thinking about customers, buildings, factories, raw materials, long term contracts.

To successfully invest, you need to focus on underlying value instead of market price. Market price then becomes your servant instead of your master. If buyers and sellers are scared, you may want to buy from them. If they are euphoric, you may want to sell to them. At all other times, you look at their price quotes like a disinterested shopper. You aren't forced to buy or sell and aren't swayed by the crowd's frequent price quotes and dramatically shifting opinions.

This is the key to successful investing. If you need to buy and sell right away, market price is your guide, and you're likely get a poor deal. If you don't need to buy and sell, then you should feel free to focus on underlying value first and market price second.

In this way, you benefit from swings in the market. If you focus on what the expert does: long term cash flows, industry dynamics, underlying asset values, etc., you can easily take or leave market prices. Then you can buy assets cheap and sell them expensive, and you'll get very nice returns.

But, if you focus primarily on market prices, you'll panic when price drops and sell at the bottom, or become euphoric as prices climb and buy at the top. That's what most people do in the stock market, and that's why they get lousy results.

Next time the price of something you own drops, ask yourself if you are focused on market price or underlying value. If the truth is that you don't know anything about the underlying value of what you own, you shouldn't be investing your own money. If you are focused on underlying value, ask yourself if you would be panicking if you owned the whole business. It is, after all, a portion of the business that you own. 

Yes, the future may not look as good as the past. Yes, competitors or the economic cycle may be making things difficult, but did the value of your buildings, factories, inventory, cash and future cash flows really drop by 30% just because reported earnings missed Wall Street's forecast by 5%? 

If no, then it's probably time to buy more of the business. If yes, then take a week or month to think about and review all the relevant data, and wait until your emotions have simmered down. In the cold light of full analysis, you may decide the business isn't as bad off as others think. Or, you may decide it really is doomed and you should sell. Wait until you're sober-minded to do so.

Make market price your servant, not your master. Focus on underlying value. Your net worth will reflect this choice over time.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Breaking up the banks?

Sandy Weill, the big banker most associated with breaking down the government barrier between investment and commercial banking to form Citigroup, now says that big banks should be broken up to protect taxpayers.  

Richard Kovacevich, the former CEO of Wells Fargo (full disclosure: my clients and I own shares of Wells Fargo), says banks are safer as big banks.

Who's right?  Who should voters, legislators, regulators, the Federal Reserve, the executive branch, the press, etc. listen to?

Let's look at their respective records.

Citigroup was formed by the merger of Travelers group--run by Weill--with Citigroup in 1998.  Citigroup's split-adjusted stock price was over $300 per share in April 1998, the month its merger occurred. Weill was chairman of Citigroup until he retired as CEO in 2003 (Citigroup: $474 per share) and chairman in 2006 ($500 per share).  Weill hired as his successor Chuck Prince, who later became famous for excusing Citigroup's participation in the sub-prime meltdown by saying, "as long as the music is playing, you've got to get up and dance." Prince chose to enter early retirement in November 2007 after Citigroup blew up.  Citigroup gladly took $45 billion in assets from the government's Troubled Asset Relief Program (TARP) in 2008 and 2009 and has paid back only 44% ($20 billion). Citigroup also received $306 billion in asset guarantees as part of the TARP program. Citigroup's stock price crashed to $15 per share in 2009 (down 97% from May 2007), and is currently around $28 (down 91% since the Citigroup merger, and 94% since Weill retired as CEO and chairman).  

Wells Fargo was formed by the merger of Norwest Corp.--run by Kovacevich--with Wells Fargo in 1998.  Wells Fargo's split-adjusted stock price was $18 in November 1998, the month its merger occurred. Kovacevich stepped down as CEO in 2007 ($35) and chairman in 2009 ($27). Kovacevich's successor, John Stump, is still CEO and chairman of Wells Fargo.  Wells Fargo was forced (Kovacevich has been quite vocal in his criticisms of TARP and how he pounded the table--literally--trying not to be forced to take the funds) to take $25 billion in TARP funds and repaid them in full as soon as the government would allow it. Wells Fargo received no asset guarantees as part of TARP. Wells Fargo was strong enough during the financial crisis of 2008 to buy out distressed Wachovia (snatched from Citigroup's clutches because Citigroup required government loss guarantees to buy Wachovia). Wells Fargo's stock price fell to $12 per share in 2009 (down 67% from May 2007), and is currently $34 (up 89% since the Wells Fargo merger, and down 3% and up 26% since Kovacevich retired as CEO and chairman, respectively).

Basically, Weill created a Frankenstein's monster of a bank that, not surprisingly, blew up during the financial crisis of 2008. Weill was a deal-maker that used his political influence and bluster to build an unstable house of cards that collapsed with the first real puff of wind. His bank would have gone under without government guarantees that are outstanding to this day. Not only did his bank fail on almost every measure, it destroyed 90% of shareholder value. Why exactly would anyone want to listen to this "expert's" opinion?

Kovacevich, on the other hand, built Wells Fargo slowly and stably over time. His bank was sound enough to handle the worse financial crisis since the Great Depression, so much so that he could afford to bail out another large unstable bank without any government assistance. He did it because he understood banking instead of political influence. Under his stewardship and that of his successor's, Wells Fargo has succeeded on almost every measure and has created value for shareholders. Kovacevich is the type of expert that people should be listening to, and he's not calling to break up the banks.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Illusory Patterns

Some people's investment results would improve from targeted brain damage.

This rather shocking statement is based on an article Jason Zweig wrote in the Wall Street Journal, "Why We're Driven to Trade." Neuroscience research has shown that specific parts of the brain contribute to certain decision making. More narrowly, researchers have found that one part of the brain, the frontopolar cortex, contributes to predicting rewards.

To better understand such decision making, researchers set up an experiment with three groups: two groups without brain damage and one group with damage to their frontopolar cortex. Then, they let the three groups play a series of games where the rewards varied unpredictably. 

What they found was that the two groups without brain damage tended to base their decisions on very recent data--their last two games played--whereas the group with brain damage tended to base their decisions on cumulative data of all the games they'd played. The more effective approach is to use cumulative instead of recent data.

Basically, the frontopolar cortex is a part of the brain that's used to recognize patterns. It works great when there are useful patterns to be recognized, but when no patterns exist (as they don't with random data) it goes right on recognizing illusory patterns that aren't really there. 

The result is that when we run into rewards with unpredictable variability, our brains still tend to react as if it finding patterns (even though there are none). That's why people with a damaged frontopolar cortex have an advantage in dealing with such circumstances: they don't have a part of the brain that would recognize and act on illusory patterns.

This research holds lessons for investors, because investment returns--and you may have guessed this--vary unpredictably just like the game in the experiment. Like the two groups without brain damage, most people base their investing decisions on recent instead of cumulative results. This leads them to trade too frequently, selling something that has done poorly recently and buying something that has done well recently only to find what they bought does poorly and what they sold does well.

The good news is that you don't need to damage your brain to invest better. Investors who base their decisions on long term, cumulative results instead of recent data can do just as well as those with a damaged frontopolar cortex. 

First, don't buy just because a stock goes up or sell because a stock goes down. That's basing your decision on recent data. Second, use long term, cumulative data to make decisions instead of short term, recent data. Third, make sure you have three reasons, outside of stock price movements, for deciding to buy or sell. And, last, keep track of your results so you can generate a cumulative record of what does and doesn't work. This is best done by keeping track of what you sell as well as what you buy.

You don't need brain damage to do better, you just need to create a deliberate decision making process that does an end-run around the part of your brain that sees illusory patterns. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Optimism = poor returns

It's easiest to invest when you feel good about a company or the economy. That feeling reflects good recent results, and a herd of other people who share your good impression. Good feelings cause people to push prices far above underlying value. When the future turns out to be not as rosy as people's inflated expectations, prices move back to value and poor returns result.

Exhibit A is 1999, when almost everyone was so optimistic about technology stocks, right before they dropped 76%.

Exhibit B is 2006, when almost everyone was in love with the real estate market, right before it plunged over 30%.

It's hardest to invest when you feel terrible about a company or the economy. That bad feeling is due to poor recent results, and a herd of other people who agree that prospects are lousy. Bad feelings cause people to sell or not buy, pushing prices far below underlying value. When the future turns out to be not as bleak as most expect, prices move back up to value and better than average returns ensue.

Exhibit C is 2003, after the stock market dropped 48% and the second Gulf War started, right as the market started to climb 95% over the next 4 1/2 years.

Exhibit D is 2009, after the stock market dropped 56% and there were rumors the government was going to nationalize the banks, right as the market started to climb 106% over the following 3 years.

My point: optimism leads to poor returns, and pessimism precedes great returns.

The above is easier to grasp than it is to follow. Most people know they should buy low and sell high, but they mistakenly believe that they should wait "until the coast is clear" to invest, and run for cover "when the future looks scary." They know what they should do, but they succumb to optimism or pessimism and don't act.

Warren Buffett is the most successful investor alive because he is "greedy when others are fearful and fearful when others are greedy." Follow his lead:

• If the coast is clear and it looks like everything is coming up roses, that's not the time to double down--expect poor future returns
• If some people are optimistic and others pessimistic, then you can expect average returns
• If people are panicking and running for cover, that's the time to double down--expect high future returns

In other words, don't expect great results if everything looks safe, and don't expect poor results just because everything looks gloomy. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

A little perspective

If you ever want an experiment in what's important, try packing everything you value into two cars with danger at your heels.

I live in the foothills the Rocky Mountains, in Colorado Springs, Colorado. Because of the Waldo Canyon fire, we had to evacuate our home on Tuesday, June 26th.  The fire started on the 23rd, so we had over 3 days to prepare--plenty of time. And yet, it seemed like a somewhat theoretical effort until smoke covered our neighborhood, a bizarre yellow light shown on everything, and ashes were literally falling from the sky.

In hindsight, firefighters stopped the fire 1.8 miles from my home, and 0.6 miles from my in-laws' home. What seemed theoretical and just-in-case at first became starkly real on Tuesday evening when we went from voluntary to mandatory evacuation in about 20 minutes (not including the delay in receiving that information--yikes!).

First: bring what can't be replaced.  Wife, check; daughter, check; cat, check; fish, can't really transport on short notice. Also, bring photo's that aren't digitally backed-up (something to look into...), paperwork like marriage and birth certificates, passports, wills and life insurance documents, business paperwork, computers, other records, memorabilia, heirlooms, old daily planners, etc . If you're a nerd--I am--bring underlined books (the others can be replaced, but the underlining can't).  

Second: bring stuff you'll need to get by for a couple of days like clothes, food and water, sleeping bags and thermarests, so you can sleep anywhere. Be prepared to find out that all hotels are booked and you may need to find someplace else to stay (in a town of 500,000, there aren't 30,000+ hotel rooms, of course).

Third, other people can be amazingly helpful. My father-in-law owns a commercial building with a vacancy, so we had a place to crash that first night. We went to eat at Old Chicago's, and the manager gave us our meal and drinks for free after he found out we had been evacuated (talk about a brilliant loyalty program). Before we even asked, we had 4 offers of places to stay in Colorado Springs, and 3 in Denver. After one night in the commercial building, my mother-in-law's tennis friend, and her husband, gave us their home in Monument, CO while they went on a trip to Chicago to see family. We spent 3 nights there before returning to our home last Saturday (no damage whatsoever--thanks to the firefighters).

Fourth, everyone has a job to do, and I'm endlessly fascinated by the professionalism of people who do good work. From the beginning of the fire through today, I've been watching the intelligence, tireless efforts, and efficacy of firefighters, emergency-responders, police, utility operators, etc. This has been truly inspiring.

I've watched firefighters from the forest and city brief us twice daily, and this has given me a new appreciation and vocabulary (point protection, anchor, dozer line) to describe wildfires and how to fight them. Rich Harvey is the man.

I've also watched aircrews (helicopters and fixed wing) and firefighters fight the fire day and night for the last week and a half. They've had amazing victories (the fire is 55% contained at present), and terrible defeats (346 homes destroyed, 2 lives lost). It could have been much worse if it weren't for the firefighters' dedication and efficacy, but the outcome is still awful nonetheless.

All told, I have a new appreciation for what I own, what's truly irreplaceable, the wonderful people I know, and for the people I don't know, but can truly respect and admire from afar.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Downturn ahead?

With economic data getting worse and markets looking shaky, the question on everyone's mind seems to be: our we heading into another economic and market downturn?

Specifically, economic and market data in the U.S. are rolling over, Europe seems to be in full-out recession, and China is growing more slowly with its manufacturing sector even pulling back. This makes everyone wish they knew whether recent trends will continue down, or if a rebound (or central bank support) is on the way.

The reason people care is that it makes a BIG difference on short term returns. If the economy and markets roll over, then you want to be in long bonds, which do great under that scenario. If recent numbers are just a head-fake, and we're going to see growth resume, you want to own stocks and commodities because they're dirt cheap assuming growth resumes.

But, the above thinking assumes that it's possible to know whether the economy and markets will turn down or resume growth. Such an assumption is, however, suspect.

Can experts accurately predict either economic or market downturns? Their track record, contrary to popular belief (and the amount of money you pay for it), is terrible.  

Economists and market strategists, brilliant people who parse economic data on a full-time basis, are dreadful forecasters. As a group, they have never--not once--predicted a recession beforehand. 

Individually, most of them are wrong most of the time. Every once in a while, an economist or market strategist "correctly" predicts a recession or rebound, but no one--and I mean no one--gets it right more than a couple of times. 

Keep in mind that a broken clock is right twice a day--that doesn't mean it correctly tells time. A market strategist who calls for a downturn all the time will look right one third of the time, and an economist who always calls for growth will be right two thirds of the time. That doesn't make them accurate forecasters, and that won't help you get into and out of investments at the right time.

If the experts are consistently wrong, maybe the right place to look is the aggregate opinions of millions of market participants.  Do markets correctly predict market downturns or rebounds?  Not at all.  One famous quote is that "the stock market has predicted 9 of the last 5 recessions." Translation: markets predict recessions and rebounds much more frequently than they actually occur.  Once again, such guidance does investors more harm than good.

Well, if brilliant experts tracking all the data can't get it right, and the judgment of crowds can't do it, what's to be done?  

First off, accept the premise that, at present, no one has figured out how to consistently time markets over the short term. It's like forecasting the weather--it's such a complex and adaptive system that no one knows what's going to happen ahead of time (even though they can tell you precisely what happened in the past). 

If no one can successfully time the market, then don't try to do it--don't try switching in and out of stocks, bond and commodities in a failed attempt to get better returns. Channel Nancy Reagan and just say "no" to market timing.

Instead, do what has worked over the long run: buy cheap and sell dear. Instead of spending gobs of time, effort, and money trying to guess market direction, spend your time trying to figure out which companies to buy and then calculating what price to buy and sell them (relative to underlying fundamentals).

It doesn't work every time, and it won't necessarily work over the short term, but it does work over the long term with a high degree of confidence.

Avoid the rat-race of unsuccessfully wondering if a downturn is ahead, and focus instead on underlying value. Your results and your psychological well-being will be better for it.  

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Prior assumption: saving

As much as I love to blather on about investing in this blog, I must also make clear that all investing rests on a prior assumption: saving.

Put logically, saving precedes investing. Whether you can generate better or worse returns matters little if you don't save or don't save enough. A 100% return on $100 dollars will move your retirement meter an immaterial amount more than a 2% return on $100.  

Even prior to saving, you must manage your money. You must earn more than you spend or spend less than you earn to have savings. After that, you need to set aside that money for investment. Only savings can be invested.

My point may seem so blatantly obvious that it goes without saying. But, the truth is, people focus too much on investing (including yours truly) and not enough on saving.

There are two additional points with respect to saving that should be highlighted: 1) the more you save, the better; and 2) the earlier you save, the better.

To elaborate on #1, even if you generate moderate or weak returns, you can reach your goals if you save enough. For example, someone who saves $2,260 a year and generates 10% annual returns from the time they are 25 to 65 will have just as much money as someone who saves $8,278 a year and gets 5% returns from 25 to 65. 

Yes, the second person must save much more than the first, but savings can make up for poor returns. It's smarter to adjust your savings to the returns you get rather than vice versa.

Also, the impact of compounding is greatly enhanced by saving more over time.  Even if you don't get great returns, you can always work hard to save more money (earn more, spend less). The more you save, the better the outcome, all things equal.

The second point is probably even more important: the earlier you save, the better.

Early savings benefit more from compounding than later savings. For instance, if you assume two people get 10% returns, someone who saves $1,000 a year from age 25 to 35, but then doesn't save another dollar, will end up with $278,100 by age 65; whereas someone who saves $1,000 a year from 35 to 65 will end up with $164,500. Even though the first person saved only $10,000 and the second saved $30,000--three times as much--the fact that the first person started earlier means they end up with 70% more money and therefore a 70% higher standard of living.

Many people think such an argument is pointless if you aren't 25, but the math is the same with 40 to 50 and 50 to 80, or 55 to 65 and 65 to 95. The earlier you save, the better.

The prior assumption of saving before investment is frequently overlooked, but need not be.  

• Saving precedes investment
• Raise your savings to meet future goals
• Start investing earlier rather than later 

Getting great returns is only relevant once you've saved enough--so focus on saving first.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Patient capital

People are generally too impatient. Unfortunately, this doesn't serve them well.

Whether chasing crash diets, miracle cures, or playing the lottery, most people want quick fixes. They understand that longer term paths to success--eating less and exercising more--work, but they aren't willing to put in the time and effort to succeed. They want results NOW, so they end up with results alright--bad results!

One reason people do this is they get fooled by randomness (to use Nassim Taleb's phraseology). Short term solutions sometimes appear to work, and long term solutions sometimes appear not to work. Luck and timing plays a much bigger role in the short run, and this throws people off. If they were more patient, they'd figure out what works over the long run and stick with that instead of chasing quick fixes.

This phenomenon is readily on display with investing. Value investing--making investments with low price to fundamentals (sales, assets, earnings, book value, etc.)--consistently beats growth investing--high price to fundamentals--over the long run. But, randomness leads growth to sometimes out-perform value for a period, which leads impatient investors to chase what is "working" in the short run. They begin their chase only to find value out-performing growth yet again.

Why not just be a value investor through thick and thin? Because it requires a lot of patience.  

Just like people jump into fad diets, they won't stick to value investing because it isn't "working" right NOW. After all, it's hard to stick with something that isn't working, especially because this under-performance can go on for years (the last 7 being a good, but not historically unusual, example).  

But, just as night follows day, value investing will win over time, and patient investors will be the one's retiring on time while their impatient brethren are putting off retirement for a few more years.

Such is life.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Unsurprising drop

The stock market was down 2.5% on its first trading day of June. This follows a decline of 6.8% in May, leaving stocks down 10.2% since its high of April this year, and down 18.9% since the high of October 2007. This seems to have surprised, and even shocked, many investors.

When asked what the stock market would do, J.P. Morgan famously said, "It will fluctuate." Benjamin Graham told investors (in his book The Intelligent Investor) to resign themselves in advance "to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent of one-third or more from their high point at various periods."

In other words, the stock market is a roller coaster, and investors should anticipate and even expect frequent stomach-churning drops and thrilling climbs along the way. These drops are not a sign of something unusual and dreaded, but something expected and even eagerly anticipated. Why? Because drops lead to opportunity as merchandise that cost $100 a few days ago is now on sale for less (sometimes, much less).

As I pointed out in my posts, Better than zero and "Where's the market going next year?", the math underlying expected future returns should have warned investors to anticipate drops. And, as I expressed in my post, All eyes on China, news of slowing growth from China would likely lead markets lower, and it has.

I think investors were surprised because they don't think of the stock market as a roller coaster, or they try too hard to relish the climbs and forget the inevitable drops. Perhaps they also suffer from myopia, attending to recent company reports and economic news instead of thinking about longer term data. 

Nevertheless, drops will happen, and they should be exploited instead of feared. Lower prices mean higher future returns--clearly a good thing. Panicky investors that sell as the market drops benefit longer term investors that buy from them. I'm not saying the drops won't pull at your stomach--they will. What I'm saying is drops are to be expected and wise investors will have the courage to act as the market drops to exploit short-term oriented investors.

I'm not panicking as my portfolio drops, but lining up my buy list and making purchases as the market sinks. The more it sinks, the more I'll buy. Just like riding a roller coaster, I look forward to the plunges and climbs, because that's the nature of the beast.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Sound and Fury

JPMorgan Chase announced it had a $2.3 billion trading loss last Friday, and politicians and the press are having a field day.  

To put this loss in perspective, the company made almost $5.4 billion last quarter, and $18.8 billion over the last 12 months.  That $2.3 billion loss occurred relative to an asset base of $2.3 trillion (the loss was 0.1% of assets), with $190 billion of equity (the loss was 1.2% of equity), $256 billion of long term debt, and $78 billion of short term debt.  In other words, JPMorgan would have had to lose $1.1 trillion before even one depositor with the bank would have been at risk.

Businesses will have losses as well as profits, and in this case JPMorgan's loss doesn't and couldn't possibly impact the solvency of the bank much less impact depositors or tax-payers.  

Politicians and the press are generating a lot of sound and fury at present, but don't seem to know or care what kind of business JPMorgan is, or whether it has put tax-payers in any way at risk.  

The reality is that a $2.3 billion trading loss is egg on the face of JPMorgan and Jamie Dimon, but has little impact on the viability of the bank, depositors or tax-payers.

To assume--as politicians and the press do--that regulators would have prevented this from happening is to forget the last 200+ years of banking regulation, which always has and always will manage to close the barn door long after the animals are gone.  

Regulators are human beings, too, and just like the hard-working people at JPMorgan, can and will make mistakes.

The assumption that more controls and regulations would prevent such events is pure fantasy, and is more likely to create than solve any problems.  Chasing down minor events like this loss that will have minimal impact on equity investors that have knowingly and voluntarily put capital at risk is worse than a waste of time--it's counter-productive.

JPMorgan's loss is bad for JPMorgan shareholders, not bond-holders or depositors.  The press and politicians are eager to use this event to call for increased regulations and control, but a short evaluation of JPMorgan's capital position and the "success" of previous regulatory reforms should make people pause and think before listening to the press or politicians.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Quantity AND Quality

When I offer my daughter the option of ice cream or cake, she frequently replies she'd like ice cream AND cake. To her, I offer a false alternative when the "OR" can very clearly be an "AND." In this case, her reasoning is sound.  There is no need to give in to the tyranny of "or," instead we should--as Jim Collins recommended in Built to Last--embrace "and."

I see this every day while investing. Should you invest in Growth OR Value?  Properly understood, this is a false alternative, because growth is one of the most important inputs to value.  

The value of a company is based on it's future cash flows. If those cash flows are growing, the company is clearly worth more than if they are not (you get more cash flows over time, all things equal). Value is based on Growth, so Value AND Growth must be understood.

For example, if you want a 12.5% return over the long run, you should pay eight times earnings for a 0% growth company, and 15 times earnings for a 6% growth company (almost twice as much!).  Growth has a HUGE impact on Value.

Another mistake investors make is to focus on either Quantity OR Quantity. Once again, Quality is a key input to Quantity. For instance, a company with high barriers to entry and superior management is more likely to achieve quantitative measures of performance like sales per share, profit margins and growth rates than a company without these qualities.  

The degree of certainty that a quantitative result will occur is a qualitative factor, so the quantitative result is driven by the qualitative situation. Once again, Quality OR Quantity is a false alternative--you must pay attention to Quality to correctly grasp Quantity.

Just think about Coke. An inexpensive, frequently purchased product with addictive qualities (caffeine, taste, habit) is much easier to quantitatively predict than an expensive, infrequently purchased product with no addictive qualities (like washing machines). Quality heavily impacts Quantity.

Successful investing is about understanding the nature of each investment. To successfully do this, you must focus on Growth AND Value, Quality AND Quantity. Don't suffer from the tyranny of "or," do as my daughter does and embrace "and."

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Picking a money manager

It has been well documented (by organizations like Dalbar as well as tons of academic research) that investors get lousy results over time. 

One reason is that they try to do the investing themselves, but lack the knowledge, skill or temperament to invest successfully. Another reason is that they're lousy at picking money managers. I can't help with the first problem--it's up to each person to be honest with themselves about their own abilities and results--but I can help with the second: picking money managers.

There are basically two ways to pick a money manager:

1. Examine past results
2. Examine a manager's process to see if it is a good one

The benefit of examining past results is that it can be done quickly and seems objective. The problem is that separating random luck from real skill is extremely difficult. 

Every money manager's past record includes a component of randomness, or luck, and a component of skill. How do investors know whether they are seeing a record due to luck, or skill? They don't.

Investing results are much more random than most investor recognize, especially over the short term. Looking at a record of less than 3 years is likely meaningless. Records of more than 3 years are more meaningful, but even outstanding money managers can under-perform for 5, and sometimes even 10 years!  Correlatively, some managers have great records that don't last because they were lucky, not skillful. 

Most investors examine past records, but their ability to pick good managers by looking at investing results is terrible. Even professional consultants and investment committees filled with experts get this wrong much more often than right.

Examining past records has a dreadful track record of successfully picking managers.

The other option, examining a manager's investment process, is much more time consuming, but has a much better chance of being done successfully.

Specifically, there are two measures that seem to be both reliable (persistent) and valid (actually lead to the desired result).

The first is called active share, which is a measure of how different a money manager's portfolio looks from the general market. To beat the market, you have to be invested differently than the market. You want to find a manager whose portfolio looks different than the market, and therefore has high active share.

The second measure is called tracking error, which is a measure of how differently a manager's portfolio moves relative to the market. If a manager is all in cash, his portfolio will not move up and down with the market at all, and that leads to high tracking error. A manager who owns the same stocks in the same proportions as the market will move in lock-step with the market, and that leads to low tracking error. 

A manager with a good process tends to have moderate tracking error, which means his portfolio neither moves precisely with nor against the market. Such a manager doesn't try to time market segments (all technology or all energy), nor does he try to pick "winning" asset classes (all cash or bonds to get in and out at the right times). A good manager picks investments that don't mirror the market, but that do tend to move in the same general direction as the market over time.

Most investors use the wrong methodology to pick money managers and their results suffer. Instead of looking solely at past records and hoping they can guess whether that record reflects luck or skill, investors should look at a manager's process. 

If a manager picks investments different than the market (especially if those investments have been carefully analyzed), and doesn't try to time segments or asset class exposures, you're likely to have found a manager that will get good results in the future.

Examine a manager's process, not just their record.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Forever growth?

Growth stocks have been crushing value stocks over the last several years, by:

• 6.3% year-to-date
• 7.1% over the last year
• 3.8% annually over the last 3 years
• 5.5% per annum over the last 5 years

Such a strong run leads many investors to question if growth has formed a permanent advantage over value.  

Briefly, the answer is no.

Over the short to intermediate term, it's quite normal for growth or value to out-perform for a time. But, these periods always end. Just looking back over the last 10 years, value beat growth by 1.1% annualized (even including the last 5 years of dramatic out-performance of growth over value). Over the last 80 years, the data are even more compelling: value has out-performed by over 3% a year.

What gives? Basically, investors tend to herd. They run in one direction for a while, take that too far, and then reverse direction. Value, after under-performing for 5 years, goes on to crush growth for the next 5 years. And then, following that, growth goes on to crush value for the next 5 years. Rinse and repeat. (It's not always 5 years at a time--sometimes it's 1.5 years, sometime 3, 5, 7, or even 10.)

Just like night follows day, growth and value go in and out of favor only to see that reversed time and again. Smart investors look to benefit from this regression to the mean by examining 20 years of results instead of the last 3 or 5 years. You can't time the reversals, so don't try.  Instead, bet on the long-run winning hand, and over time you'll do very well.

You can well imagine that Apple's outstanding growth and performance has greatly contributed to the excellent run of growth stocks over the last decade. Apple now accounts for 4% of U.S. Gross Domestic Product (GDP) and 4.4% of the value of the S&P 500.  

Even if Apple starts producing oil, cars, food, and all the other things in the economy (highly unlikely), its growth will eventually regress to the 3% growth of the underlying economy. When that happens, and it's likely sooner than most think, Apple's growth stock tailwind will turn into a headwind, and value will come back into favor.

I have no idea when this will happen, but I do know growth's out-performance will end and value's out-performance will re-emerge. In the meantime, I've positioned myself to benefit from long-run, time-tested investing wisdom instead of trying to play the short-run, unreliable trends of the moment. Over time, that is the winning hand.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Investing: 3 part harmony

Investment returns seem mysterious to most. You buy one investment and it takes off; you buy another and it tanks; you buy a third and it goes nowhere. Why? It seems more random and unpredictable than the weather at times.  

The underlying reality is more simple than that, though.  Investment returns can be broken into three parts and analyzed individually. Understanding that three part harmony makes investing seems much less mysterious and more practical--and so it is.

Investment returns consist of:

1. dividends relative to price paid
2. underlying earnings growth
3. change in the multiple to underlying earnings

The dividend seems like the most straightforward part of investing returns, but many people seem to overlook the importance of it. What matters is the dividend relative to the price paid over the full period of investment. If that dividend is eliminated (like banks in 2009), shrinks (Real Estate Investment Trusts) or grows (Johnson and Johnson), that can have a big impact on your return. It's important to understand the dividend yield as well as the sustainability of that dividend (whether it will grow or shrink).

The second element, earnings growth, is (in my experience) the hardest to predict, and has  the second largest impact on returns. If earnings grow while you hold an investment, then you have a nice tailwind that can allow you to generate good results (Apple). If earnings shrink (Best Buy), or even tank (Citigroup), it probably won't matter what price you paid or dividend yield you start with, your investment results are likely to be unsatisfactory.  

Earnings consist of underlying sales and profit margins (or book value and return on equity in the case of banks, insurance companies, etc.). If sales grow and margins are stable (Wal-Mart), then earning will most likely grow. If margins grow and sales are stable (IBM), you'll likely experience earnings growth. If margins and sales tank because technology has become obsolete (Blackberry, anyone?), earnings shrinkage will be a big headwind to your results.

The third element, change in multiple to earnings, is the most difficult for people to grasp and is likely to have the biggest impact on return. The multiple people are willing to pay for earnings, which is frequently expressed as price to earnings ($10 per share stock price, $1 per share in earnings, 10x price to earnings multiple), is a reflection of how market participants think of a company and its future prospects. If people think very highly of a company (Amazon), they may be willing to pay 20x or more on earnings; if they think poorly of a company and its prospects (Xerox), they may be willing to pay only 5x earnings.

Market sentiment towards companies changes a lot over time. When people become despondent with a company, it can trade very low to fundamentals; when people become euphoric, a company can trade at very high multiples. Whereas one can analyze and predict dividends and earnings based on underlying evidence, multiples are more likely to be a result that must be judged and reacted to rather than predicted. Buying at a low multiple and selling at a high one gives a tremendous tailwind to investing results.

When you put together multiple change, earnings growth and dividend yield over the life of an investment, you have the three parts of investment return. By analyzing those three parts, you can understand why your investments do well or poorly, and then make adjustments to your investment process. The three part harmony of good returns requires a keen understanding and mastery of all three parts.  

Investment results can be clearly understood if you take the time to do so. Such an effort removes the mystery and reveals an understandable system that can be used to produce good results. This may not sound as exciting as shooting from the hip in hopes of a big win, but good results over time create great wealth, and that's as exciting as can be.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

How much money do I need to retire?

One of the most frequent questions I get is: how much money do I need to retire?

This is a much more complicated question to answer than most grasp. It depends on the returns you can get from now until the day you die, and that isn't a number you can look up on Wikipedia. It depends on how much savings you have, and how much you can and will save from now until you retire. It depends on inflation over the rest of your life, how much you withdraw each year in retirement, how long until you retire, how long you (and your spouse) will live after you retire, how much you need to live on each year, what tax rates will be over the rest of your life, what kind of accounts you have your money in (tax deferred: traditional IRA and 401k; pre-taxed: Roth IRA; taxable account, etc.), and so on.  

As you can see in the list above, there are so many unknowns and unknowables that you can't possibly come up with a precise figure. The best you can really do is calculate an estimate. Added to this, so many people make invalid assumptions (including many financial planners, I'm afraid) that they come up with misleading answers. Other people don't even try because they feel overwhelmed by the process or are just trying to get by from day to day.  

Unless you're in bad health and expect to die before you stop working, it's a very good bet you'll need money in retirement, so this is a number you really should think about. The ostrich technique won't work here any more than it does in any other part of life.

With this in mind, I believe there is a simple way to derive an estimate that will succeed. Like all simplifications and rules-of-thumb, it's not fool-proof, but having spent countless hours thinking about it, crunching the numbers, and applying it, I know it works.

My rule of thumb is to multiply the annual amount of money you want live on in retirement by 30. For instance, if you want to live on $100,000 a year in retirement, then you can retire when you've saved up $3,000,000. This estimate works at any age, too, whether 20 or 60 (although it's probably more than you'll need if you're over 70--and that's a high-class "problem" to have).  

A lot of people gasp when they hear my rule, because it's a lot higher than they expect. Most people don't have anywhere near that amount saved, and they feel daunted by a number so beyond where they are or believe they can get.

I'll admit, my "times 30" rule doesn't assume you have a pension, and it also assumes you won't get social security. This may seem like a gross simplification, but if you understand the adequacy of pension and social security funding, you may want to be prepared for that money to be reduced or cut altogether (especially if you're younger than 50). If you believe you'll get your pension/social security, just use my "times 30" rule for the amount you'll need beyond those retirement dollars (if you'll receive $30,000 from social security and need $100,000 a year in retirement, then use 30 times $70,000: $2,100,000).

My "times 30" rule assumes a 3% withdrawal rate. Most assume they can get much better returns and believe they can withdraw more than 3% a year. The empirical evidence is against them--people who withdraw more than 5% a year are likely to run out of money before both spouses die, and people who plan to get 20% returns are living in fantasy-land.  

Most long term tests show that a 4% withdrawal rate provides enough money to last until death. My problem with that plan: it doesn't provide a margin of safety. Just like I'd prefer to drive over bridges that are designed to handle much more than "expected" loads, I want my retirement plan to be able to handle the unexpected, too, and I believe my "times 30" does this. I use the "times 30" rule personally, so I'm eating my own cooking, here.

Another issue is that most people don't really adjust for the destructive impact of inflation.  We don't know what it will be, so we want to be prepared come what may. I think "times 30" does this (along with a retirement plan that protects investments from the ravages of inflation).

Keep in mind, too, your retirement dollar number isn't something you want to under-estimate. Many who retired around the year 2000 thought the stock market would keep going up and ended up having to go back to work after they retired. That's not a very good plan. You'll want more than enough to retire so you don't end up in that situation.

If "times 30" sounds too difficult to reach, here are some things to focus on that will allow you to get there. First, save as much as you can as early as you can. The impact of compounding makes high, early savings worth a lot more money over time. Einstein called called compounding the eighth wonder of the world, and he knew a thing or two about math.

Second, try to get good returns. Other than saving as much as you can as early as you can, your returns will have the next biggest impact on how soon you can retire. This doesn't mean take your retirement dollars to Las Vegas or play the lottery, it means investing intelligently. Either work hard to find someone with investing skill, become an expert investor yourself, or buy low cost index funds and stick with them. Don't try to time the market or switch into and out of funds to get better returns. Make an intelligent plan and stick to it!

Finally, monitor your path and make adjustments as necessary. I review my retirement plan with my wife at least once a year to make sure we're on track. The way to get on track isn't to switch investments every three years, but to increase your savings to make up for any short-falls. If you have more than you'll need, it's probably because the market is over-valued, so don't spend that portion thinking you're ahead. Plus, there's nothing wrong with reaching retirement early, or with more than you'll need.

If you save 30 times the amount you'll need on an annual basis, I believe you can retire right away--whether you're 20, 40, 60, whatever. This rule isn't a cure-all, but it's an excellent aim-point for those who want to reach retirement and then have enough money to enjoy it.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Stick to your knitting

There are many ways to invest, but, what's more important than any particular method you choose to is whether you stick to it.

One fundamental choice is passive or active. Passive investing is investing with the market. This method is agnostic about market value and broadly diversified. It's low cost and tends to beat most active managers, but can go through long periods of poor absolute returns, like we've seen over the last 12 years. If you don't want to search hard for superior investors and can't stand being out-of-step with other people, then passive is probably your best approach.

Be careful, though, not to waffle between passive and active. More important than your choice of passive or active is whether you can and will stick to your choice. Those who switch between passive and active do worse than those who stick to either passive or active.

Active is investing differently than the general market in an attempt to beat market returns. This is very difficult to do, but if you can find a superior money manager, it can make a huge difference in your long term wealth. Once again, you must stick with the approach for it to work, and this will be hard to do when your active manager is out-of-step with the market, under-performing the market, and charging you higher fees than passive investing. Once again, if you switch back and forth between passive and active, you will do worse than either approach.

Within active, there are several approaches, too. There's macro investing: trying to bet on economic trends in the attempt to have exposure to the best sectors or countries. There's market timing: trying to anticipate market sentiment and buy when things go up and sell before they go down. There's growth: trying to buy the fastest growing companies to beat overall market growth. There's value: trying to buy companies selling at the lowest price to underlying fundamentals. Value has the best long term performance, but even it goes long periods of under-performance between bouts of out-performance.  

I'm going to risk sound like a broken record, but it's too important not to emphasize again: it matters less whether you choose value, growth, marketing timing or macro, and more whether you stick to it. Value may out-perform over the long run, but it won't work if you try to do it when it's "working" and try to do the other methods when they're "working." The academic and anecdotal research on this is unequivocal, people who try to switch methods at just the right time grossly under-perform those who stick to one method consistently.

I'm a dyed-in-the-wool value investor, I'll readily admit, because it works better than the other options. To succeed, though, I have to stick to it in good times and bad, not just when it's "working."

If you want good investment results, pick your method and stick to it. Though some work better than others, nothing works as poorly as trying to switch between them.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

You choose: short term "reward" and long term risk, or short term "risk" and long term reward

 

Whether they want to or not, investors face a basic choice: some options will allow you to achieve your goals, and others won't. To reach your financial destination, you can either:

• get lower returns and save more money over time (thus having less to spend )
• get higher returns and save less money over time (thus having more to spend)

There's no option to save less and get low returns--that won't work.

The difficulty investors face is that they want to take little or no "risk"--avoiding anything unpopular or seemingly scary. But, what if the avoidance of supposed risk prevents you from reaching your goals?

A beautiful drive in the country can be pleasant, but if it doesn't your destination, then it's the wrong route. You can make valid choices among routes that will get you where you want to go, but you can't successfully ignore whether the route will get you there.

With investing, you need to clearly understand your options, you must flesh-out the pro's and con's of each, and then you must choose your path.

Right now, investors face a fundamental choice between risk and reward. On the one hand, you can choose options that will likely do well in the short run and terribly in the long run. On the other hand, you can choose options that will will likely look unrewarding in the short run, but ultimately be much more rewarding in the long run. The choice is between: 

• cash (including checking, savings, CDs, etc.)
• bonds
• commodities
• stocks
• real estate

Cash and bonds will likely do well in the short run and be an unmitigated disaster over the long run. Cash and bonds have done well over the last 30 years as inflation and interest rates have gone from mid-double-digits in the early 1980's to low-single-digits now. This process simply cannot repeat (going from 2% inflation to -11% inflation?). This means cash and bonds may look good in the short term, but will almost certainly provide terrible returns over the long run. To choose cash and bonds, you must either be able to perfectly time the point when inflation and interest rates change direction, or you will not reach your financial goals.

Commodities are likely to do well in the short to intermediate term, but then drop like a rock at some indeterminate point in the future. Commodities have done very well over the last 12 years and are likely to continue to do so over the next 5 to 10 years. In the not-too-distant future, though, they will fall off a cliff and provide investors with very poor long term returns. Any observation of long term (inflation adjusted) commodity prices will make this abundantly clear. Like with bonds, commodities will go from great to terrible very quickly, and unless you can time that switch perfectly, you will not reach your financial goals.

Another option is stocks. Stocks have done poorly over the last 12 years, and are likely to provide unexciting returns over the next 5 to 10 years. The outlook beyond that, though, is bright indeed, with 10%+ average returns. The problem is that very few investors are willing to look beyond the short term--or their wished-for ability to time the market--to reap the much better long term results from stocks.  

The last option is real estate. Real estate has had a dreadful 6 years, and is obviously an unpopular place to invest right now. The returns from real estate are likely to be much better than cash, bonds and commodities over the long term, but the short term looks unenticing. Real estate is another choice with little short term upside, but good long term reward.  

To me, the choices seem clear. Cash, bonds and commodities provide short term "reward" with significant long term risk, and stocks and real estate provide short term "risk" with real long term reward. If you want to reach your goals, and don't suffer from the delusion you can time the market, then stocks and real estate are clearly the best options.

If your financial plan permits lower returns, real estate is likely to be a less bumpy ride. If you require or desire higher returns--and the vast majority of people do--then stocks are the best option.  Choose wisely.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Investor, know thyself

 

From a psychological perspective, being a part of the herd feels comfortable.  Going against the herd, in contrast, feels almost unbearably miserable.  

Believe it or not, investment success is mostly about understanding this psychology, making a conscious choice to be in or out of step with the herd, and then acting accordingly over time.

Let me describe this in more detail.  If the market is hitting new highs and your portfolio is going nowhere, it feels almost unbearably painful.  If the market is hitting new highs and your portfolio is fully invested, it feels great to be "participating" in the run-up.

This is called herd psychology for good reason.  When running with the herd, animals are least likely to become a predator's meal.  When running against or away from the herd, you're quite likely to become lunch.  Our general psychology reflects this herd bias because it worked oh-so-well during human evolution.  Being away from the herd is painful.

This carries implications for investing.  If you prefer running with the herd, or know yourself well enough to acknowledge you'll feel miserable standing apart from the herd, then invest in an index fund.  The benefit is you won't feel the psychological pain of being out of step and thus make big investing mistakes at just the wrong time.  The downside is you'll generate mediocre results and thus have to save more money over time.  

They key is objectively understanding your temperament, and then making a choice that you can actually--not hypothetically--stick with.  You must know yourself, first.

If (and that's a BIG if) you have the temperament or will-power to run apart from the herd, the benefit is you can achieve above average results, and thus have a bigger retirement or reach your retirement goals with less required savings over the years.  But, you must be able to tolerate the psychological pain of being out of step.  This is no trivial matter.

Most people say they would prefer to do better than the herd, but very few actually have the stomach to do so.  They believe they can stick relatively close to the herd and generate better results, but they simply can't.  They say they can tolerate being out of step, but when their portfolio is going nowhere and the market is moving up, they get cold feet and decide to jump back into the herd.

This is why they do worse than both the herd follower and the out-of-stepper who can stay the course: flipping from out-of-stepper to herd follower and back again--at the time of maximum psychological pain--over and over again, generates terrible results (Dalbar publishes results each year supporting my position).

The important point isn't which method works best by itself, but which method you can stick to from a psychological standpoint.

Beating the herd is not impossible, but it requires a willingness and ability to go against the herd through the psychological pain of being out of step.  Fewer can do it than are willing to admit it to themselves, but that's also why it works.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Americans generally not prepared for retirement

The latest Employee Benefit Research Institute survey is out, and it's not pretty (and hasn't been since I started following it).

Only 14% of Americans are very confident they will have enough money to live comfortably in retirement.

Employment insecurity is the most pressing financial issue facing most Americans.

60% of workers have less than $25,000 in savings and investments (!) outside their home and defined-benefit plans (pensions).

Half of retirees said they left the workforce unexpectedly (due to health problems, disability, layoffs, or their employer closing)--meaning that most of those expecting to work longer won't really have that option.

I don't know if retirement just seems too far in the future, or if the virtue of thrift has gone by the wayside, but most Americans aren't doing what it takes to prepare for their future.  

They may heartily blame someone else, but "truth be told, if you are looking for the guilty, you need only look into a mirror." 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Know what you're getting yourself into

Suppose I gave you 3 investment options:

• Investment A charges 0.05% in fees per year
• Investment B charges 0.20% in fees per year
• Investment C charges 1.5% in fees per year

Which would you choose?  

A lot of investors, and their advisers, would blindly choose Investment A because they believe lowest fees always win. To which I would ask: lowest fees for what? The goal of investing is not to minimize fees, but to preserve and grow capital.

Suppose I gave you 3 new investment options:

• Investment A has 0% standard deviation over 5 years
• Investment B has 18%  standard deviation over 5 years
• Investment C has 68%  standard deviation over 5 years

Now, which one would you choose?

Most finance professors, investors and their advisers would chose Investment A because they believe lowest volatility wins. Risk equals volatility, they'd say, so reduce risk by investing with lowest volatility. To which I would ask: is the goal of investing to avoid volatility, or generate returns?

Suppose I gave you 3 new investment options:

• Investment A has returns of 5% a year for 5 years
• Investment B has returns of -8%, +20%, -8%, +32%, and +20% over 5 years
• Investment C has returns of -5% a year for 4 years, then jumps 146% in year 5

Now, which investment would you choose?

Most investors would choose A because B would be "too much of a roller coaster ride" and C would "go nowhere" for too long. To this situation, I'd ask: is the goal of investing the avoidance of "roller coasters" or "going nowhere," or to generate returns?  

Suppose I gave you 3 final investment options:

• Investment A generates a 5% annualized return over 5 years
• Investment B generates a 10% annualized return over 5 years
• Investment C generates a 15% annualized return over 5 years

Which would you choose this time?

Most investors and advisers would chose Investment C because it produces the best return.  On this one, I'd agree.

If you recognized that Investments A, B and C were consistent throughout my examples, then excellent observation on your part.  

Investment A is basically a saving account or Certificate of Deposit (not that you can find that kind of yield now). There is no daily market quote for the instrument so it appears not to fluctuate at all (which means the volatility appears to be zero), the fees are very low, the returns are steady, but the result is low compared to other alternatives.

Investment B is basically an index fund invested in the stock market. The fees are low, but not as low as at the bank, the returns are unpleasantly volatile--hence the roller coaster comment--but generate a very respectable return of 10% per year (assuming the market is at average value).

Investment C is basically a value-style investment. The fees are high, the standard deviation of returns is quite volatile, the investment goes nowhere for 4 years before taking off (meaning that it doesn't track with the overall stock market--which vexes professors, investors and advisers to no end!), but the returns are truly outstanding.

My attempt here is not to say that investment C is the right choice for everyone--it most certainly is not--but to illustrate the choices investors are faced with and some of the inherent trade-0ff's they must make.

If you believe that low fees are the most important criteria, then I'll quote Oscar Wilde: "The cynic knows the price of everything and the value of nothing." Price is what you pay, value is what you get. It's a mistake to look at price and not what you get for that price.

If you can't stand volatility of any kind, like watching your investment double one year and plunge 50% the next, then you should probably avoid the stock market. If 5% returns aren't enough to allow you to reach your financials goals, you have a true dilemma on your hands. If 5% returns will get you where you want or need to go, then why bother with more volatile options?

If you invest in stocks, don't expect 10% returns each and every year, but 10% returns over time assuming you invest when the market is at fair value. If you invest when the market is high, you won't get 10% returns; if you invest when the market is low, you'll do better than 10%.  In either case, don't expect a smooth ride. There is no such thing as a free lunch, so don't expect to invest in the stock market and get bond-like or savings-account-like returns.

If you want better returns than a saving account or the stock market offers, then don't expect steady returns or returns that track the market. To do better than the market, you may have to be willing to "go nowhere" for quite some time.  Better returns will very likely be more volatile, look very different than the market, and test your patience. Conversely, an investment that is steady or mirrors the market is extremely unlikely to generate above average returns.

Successful investing is less about fees and volatility and more about knowing what you're getting yourself into. If you buy C and expect A or B, you'll be disappointed and bail out before good results accrue. If you buy A and expect B or C, you'll be disappointed with low returns. If you buy B and expect A, you'll be scared out by volatility. If you buy B and expect C, you'll wonder why you're not tracking to the market.

Most financial plans fall apart not because things go awry, but because people don't know what they are getting themselves into and bail out at just the wrong time. Successful financial planning begins with a clear understanding of the options, the likely outcomes, and the probable path to the destination. People leave a restaurant when they expect steak and potatoes and get foie gras and escargot.  

My wife has a saying, "you knew it was a snake when you picked it up." Know what kind of snake you're picking up, and don't judge it by nonessential characteristics.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.