Modern Marvels of Finance

Much rhetoric today is focused against “Wall Street”, bankers, hedge funds, and speculators.  People are upset about the effects of the Great Recession, but are often misguided about the causes.  I submit the idea that the foremost cause of the Great Recession was the business cycle (or economic cycle).    If we are to blame the people and institutions behind the business cycle for the Great Recession we must also applaud them for the periods of growth between recessions.  To one degree or another we are all participants in the business cycle.

Of course, there have been behaviors ranging from ethical violations to fraud, particularly in the arena of mortgages and mortgage-backed securities, and (MBS) credit default swaps.

While there are flaws and imperfections in the US financial system, the accomplishments of the system deserve some attention.  The United States represents an economic marvel of the 20th century and 21st century financial achievements of the American financial system.  Like Rome, the United States incorporates the best of other systems.  The stock exchange did not originate in the United States, but the US and Europe improved upon it.  To the best of my knowledge, the index fund and the ETF both originated in the US.

Right now, today, US investors have access to:

  1. Low cost online brokerage accounts.   It is easy to find brokerage accounts that charge less than $8 per trade and have a list of commission-free ETF trades.  With effort, it is possible to find accounts with trades costing less than $5, or even lower.
  2. Free stock and ETF market data. (For example Yahoo! Finance and Google Finance).
  3. Superb ETF offerings. (SPY, VTI, SCHB, BND, VEA, VEU…)
  4. Excellent order fulfillment and pricing (with most brokers).

Just imagine a world without stock exchanges.  Could you imagine placing a classified ad or holding a garage sale to trade stock certificates?  Ludicrous, right?

The current US financial system is indeed a modern marvel.   English, Canadian, and  European exchanges have been similarly efficient and successful.  Other exchanges around the world are playing catch up, and doing so quickly.

The global world of finance is constantly evolving, but as of today the options available to US investors are quite spectacular.  We are wise to take advantage.

Thinking about Asset Allocation

In my blog post Financial Toolkit: Indexing the World I discussed 5 ETF building blocks for diversified investment portfolio construction.  In this financial blog post I’m going discuss a hypothetical investing situation:

Deborah is a 40-year-old woman with a $100,000 401K who just changed jobs.  She transferred her 401K to an IRA, and has $100,000 now sitting in cash.  Deborah’s new job pays $60K/year and she plans to contribute $10K/year to her new 401K.  How might she invest her IRA funds?

As a proponent of diversified index investing, I suggest the following category questions… What percent  1) Domestic vs. foreign?  2) Stock versus bond?

I put forward the suggestion that Deborah’s choices in regard to these two questions will predict 80-90% of the performance of her chosen portfolio.  (Don’t believe it, then read this asset allocation paper sometime when you are afflicted with insomnia.)

Let’s say Deborah decides that a 80/20 domestic versus foreign allocation, and 60/40 stock versus bond allocation are right for her.  Working out the math that’s $80,000 for US investments and $20,000 for foreign investments.  Applying the second stock vs bond ratio to each yields the following: $64,000 for US equities, $16,000 for US bonds, $12,000 for foreign equities, and $8,000 for foreign bonds.

The US part is pretty easy to achieve.  Plunk $64,000 in a low-cost, broad-market ETF (or mutual fund) like SCHB, and $16,000 into a total (aka aggregate) bond ETF like BND.  The foreign stock component is easy too; but $12,000 into VXUS.  Only the foreign bonds require two ETFs because there are no foreign total bond ETFs (to my knowledge); thus I suggest $4000 in a foreign government-bond ETF like IGOV and $4000 in a foreign corporate-bond ETF like IBND.

There you have it.  A simple example of asset allocation.

My personal opinion is that an initial asset allocation process can be very simple and effective.  Notice that I was able to avoid several secondary asset allocation measures such:

  • Value vs Growth (stocks)
  • Large-cap vs Small-cap (stocks)
  • Sector allocation (stocks)
  • Developed vs Emerging markets (stocks and bonds)
  • Short-term vs Long-term (bonds)
  • Average Maturity or Duration (bonds)
  • Government vs Corporate (bonds)
  • Investment-grade vs non-investment grade (bonds)
  • Average credit rating (bonds)

All of these “secondary asset allocation factors” can be side-stepped by purchasing “total” stock and bond funds as outlined above.  Such total (or aggregate) ETFs seek to own a slice of the total, investable, market-cap-weighted investing universe.  Essentially, a total US stock fund seeks to own a piece of the whole US stock market.  Similarly with a total US bond fund, etc.

In summary, if you have a diversified, low-cost investment portfolio, the two biggest ratios to know are domestic/foreign and stock/bond.    [If you don’t have a diversified, low-cost investment portfolio you might want to think about changing your strategy and your financial adviser!]

Negotiating Financial Setbacks

We all face occasional financial setbacks.  One way to increase feeling of financial loss is to check your portfolio daily.  Since I have a private fund that I manage, I feel obliged to stay on top of it daily.  I’ve noticed that when the fund is up I feel modestly happy, but when it is down I feel doubly disappointed.

Sometimes various financial stresses come together at the same time.  Recently minor financial setbacks have converged for me:  modest potential issues with my rental business, and a few percentage points drop in my fund, and long hours at my day job.  Navigating these financial stresses involves 1) avoiding impulsive decisions, and 2) carefully considering available options.  For example part of me wants to sell the rental property in the next year or so, namely to avoid the occasional headaches of being a landlord and property manager.  Another thought is to contract with a property management company, who charges a fee, but helps manage some of the day-to-day property management duties.  Finally, I impulsively want to deleverage some of my investments.

I am approaching my latest bought of financial stress as I always do.  With contemplation and composure.  At least outwardly I am composed and seemingly unflappable.  Internally, I am stressed and a bit anxious.  This comes with the territory of managing a wide range of investments.   This occasional stress is one of the few things I dislike about finance and wealth management. Of course it too shall pass.

I simply wanted to share the fact that, at times, maintaining a financial course can be emotionally challenging.  I spend a lot of time talking about how successful investing can be easy… and in many ways it can be.  Creating a financial plan can be fairly simple, but sticking to it at times can be stressful and nerve wracking.  Financial discipline is worth it, and financial impulsiveness should be kept to a minimum.  That is what I intend to do; even when it is not so easy.

Choose your Fear: Motivating Financial Choices

I freely admit fear is a motivating factor behind my financial decisions.  High on my list of fears (worries, concerns) is inflation.  For a variety of valid economic reasons, long-term bond returns are generally worse than equity returns in an inflationary environment.  In other words, an uptick in inflation hurts bonds more than it hurts stocks.

Fear of market volatility steers me away from stocks, fear of inflation steers me away from (long-term) bonds.   In the current interest rate environment, real rates of return on short-term Treasury debt are negative.  High-quality corporate bonds are only paying a pittance.  And as I have recently blogged, TIPS based on the CPI-U, are not looking so good either.

What options are left to the anxious investor?  Some remaining choices are:  foreign-debt ETFs (as a hedge against US and US dollar inflation), foreign-equity ETFs, and junk bonds.  Perhaps, value stocks as well.  Unfortunately each of these options comes with their own particular set of risks and worries.

The moral of this stories is there are few low-anxiety options for the investor who fears volatility, uncertainty, and inflation.  Retirees looking to reinvest expiring bonds and CDs are finding few good investment options.

There remains on strategy to fall back on to help ease financial anxiety: diversification. Diversifying between equities, bonds, and cash.  Diversifying between US and foreign equity. – Diversifying between large-cap and small-cap. Diversifying between long-term and short-term debt.  Diversifying between high-quality and high-yield (junk) debt.  And, yes, even diversifying between value and growth.

Still, I choose my fears.  Inflation is number 1.  Volatility is number 2.  Fear of missing gains is number 3.  Inflation concerns and dismal interest rates are motivating me to hold more equities (via low-cost equity ETFs) than I otherwise would.

Smart People, Dumb Investments

When I started this financial blog a couple years ago, I wondered if I would run out of ideas to blog about.  Luckily, so far anyhow, I have had a different problem — How to choose amongst all of the ideas that pop into my head.

Thing train of thought takes me to consider what explains the relative success and failure — the investing fates if you will — of various investors.  It would be foolish (and wrong) of me to make the blanket statement that smart people make poor investors.  On the contrary I believe that successful investors are very smart people — John Bogle, Warren Buffett, Carlos Slim, Peter Lynch, Bill Gross.

What is interesting and occasionally baffling to me are the poor choices that I see smart people making.  For whatever reason, people tend to share two things with me:  personal information and personal investing information.  If I had to guess why, it is for two reasons.  1) I am actually interested, fascinated in fact. 2) I am very discrete.  Still this doesn’t quite explain why relative strangers tell me these things.

One thing is for sure.  I listen. And on thing I have learned is that people love to tell of their investing success and are hesitant to share their investing misses.  I feel privileged to hear both types of stories.

For the record there is, perhaps, no such thing as a bad (or good) investment in the present.  The “goodness” or “badness” of a given investment is only truly realized when the position is closed and the gains and/or losses are counted.   There are, however, in my opinion, poor portfolio decisions.

Here is my overall impression of the types of under-performing (aka bad) portfolio decisions that smart people make.  Most notably rationalizations for extreme non-diversification.

1) I work in field X.  I understand field X.  I believe the outlook for field X is tremendous, therefore I’m going to pick my favorite stocks that participate in X.  [I heard this all the time during the tech/dot-com pre-bubble and bubble].  I’m going to focus my portfolio in X…. meaning I’m going to severely underweight all other sectors.

2) I’ve followed fund manager, fund company, or my investment manager Y, and I trust and believe in them.  I’m going to put most/all of my money in their hands.

3) I understand the economy, the markets, and what’s going on.  I’m going to make my own decisions, and cut my losses when appropriate.  I’m going to manage my own money, and I’m not going to sheepishly follow conventional wisdom (things such as time-horizon-based asset allocation and CAPM models).  I’m going to bet big and win big on what I believe in.

Over the years I’ve seen that hubris and pride are subject to positive self-reinforcement.  When bets pay off, bettors place bigger bets.  In most cases though, luck eventually runs out and large losses are realized.  This is soul searching time.  Some respond by becoming hyper-conservative for a while (I will only save money in the bank and in T-Bills), some by becoming moderate for a while (I will own some stocks, but mostly bonds), and some by doubling down.

I understand these impulses.  In fact I see that impulse control is a key factor in rational investing.  I understand that smart people are accustomed to being correct.  It is instinctual to believe that this extends to investment decisions.  I’m saying, “If you believe you are orders of magnitude smarter than ‘the market’, think twice.” Or put another way, it is better to be wise than smart when it comes to investing.

To summarized, I know first hand that smart people sometimes make very dumb portfolio decisions.  They believe that their personal academic and career success will translate directly to investment success.  I also know that many such very smart people have been burned, to the tune of $100,000+ (if not millions) of losses directly attributable to non-diversification.

And finally, as to my personal investments, I happily say that I have been relatively steadfast in my Boglehead-like investing style.  So far it has paid dividends.

IMF Chief’s Arrest

In brief, I say about Dominique Strauss-Kahn’s arrest, innocent until proven guilty. The markets are under no such obligation of assumption. Speculation and rumor are as viable as fact in bond markets, stock markets, commodities markets, options markets… you name it.

The impact of Kahn’s situation has short-term ramifications on the European debt crisis as most loudly exemplified by the Greek debt crisis. Strauss-Kahn’s personal crisis could slow or alter IMF/World Bank actions.

I am not surprised, but I am disturbed by the general media reaction to the allegations against Kahn.  “Innocent until proven guilty” should trump “presumed guilty upon allegation”.  Recent examples of the Duke Lacrosse Team and Kobe Bryant loom large as examples of premature media reaction.  I hope that cooler heads will prevail; that the facts will come out… either way (possibly somewhere in between)…  in the slow, laborious, and languid way that the law dictates.  Until then I assume innocence.

US Debt Ceiling… Sky’s the Limit?

The current debt ceiling is set at $14.294 trillion, and according to CNN Money we are days away from reaching it.  Treasury Secretary Tim Geithner estimates he and his team can keep the US out of default until early August.

I appreciate the increased attention on the US nation debt.  My concern is the the US is beginning to flirt with danger:  increasing risk of a debt crisis.   US debt is a fair ways removed from the debt crises of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain).  However, the current trend of debt as a percentage of GDP is ominous.

A US debt crisis would look a bit different from that of the PIIGS because the US is not bound to a multi-country currency like the Euro.  Devaluation of the USD is likely to be a component of (or reaction to) a US debt crisis.  So are austerity and tax increases.

The danger is that buyers of US debt will demand higher and higher interests rates to compensate them for taking on three key risks,  inflation, devaluation, and default.   As debt increases so do these risks.  As the US refinances debt for expiring Treasurys it does do at greater and greater costs.  As the government raises taxes to combat debt (and pay higher borrowing costs) the US economy is increasingly depressed and tax raises do not result in nearly as much federal revenue as hoped.  Eventually only austerity and devaluation (via the printing press and increases in money supply).

The way I see it, playing brinksmanship now with the debt ceiling in an effort to but the brakes on the US deficit is a reasonable risk.  The current trajectory of the US debt is unsustainable and reckless.  With US debt 90% of GDP and closing in fast on 100%, we are in jeopardy.  This number puts the US next to the troubled Ireland and not far from Italy as shown in this table.

It is time for Congress to get its fiscal act together.  Time is rather short.  I hope we can start making some sort of progress.

Are Options, Futures, and Derivatives Useful?

Some of my friends and family like to give me a hard time about the evils of Wall Street, banks, and the financial industry.  They like to argue they produce nothing physical and simply keep coming up with gimmicks and schemes.

When I point out that the stock market allows the raising of capital to launch and expand real business.  Banks serve a similar purpose, especially in supporting small business.  Usually after this they concede these points, but argue that derivatives are pointless, useless, and wasteful.  That they are primarily tools for spectators.

The classic comeback is what about farmers, airlines, and insurance?  Farmers benefit from futures contracts (and crop insurance).  Airlines use futures and options to avoid getting pinched by rapidly rising fuel prices.

The classic retort is “Okay, maybe, but only consumers and producers should be able to participate; speculators should be excluded.”

My thought is who would take the other side of the trades?  Who would take the other side of corn or oil futures contracts?  Sure there would be a bit of action from oil producers and oil consumers, a bit of action from corn consumers (e.g. Kellogg’s).  But the action would be thin, the spreads wide, and the trades few.  Can you spell “illiquid”?

At which point my generic conversation partner tends to say something like “Don’t give me none of the financial gibber-jabber!”

But is it?  I think not.  I believe that commodities futures and options are potentially useful to producers (like farmers) and consumers (like Nestlé) and that “speculators” provide liquidity.  I put “speculators” in quotes, to include not only speculators, but hedgers, investors, arbitrageurs, and market makers.

I’ve only begun to delve into this topic.  To be continued…

Intangibles

Intangibles, short for intangible assets, are what economists and accountants call things that are not easily measured, valued, or counted. In life, it is the intangibles that matter.

Summer-like weather has me thinking about the reasons I work hard, save hard, and invest. My home has tangible value, and has appreciated in spite of the rough housing market.  The intangible aspects also have value to me.  Planting trees and watching them grow, year after year.  Maintaining my yard, and enjoying the first emerald green grass of the year.  Watching the flowers and flowering bushes come out in their sequence.  And of course, enjoying summer parties in the backyard.

I enjoy my modest home and the myriad home improvements I have made over the last decade.  Not only has been a reasonably good investment, my home has made me feel a greater connection to my community.

When I bought my house, I was approved for a much larger mortgage.  But I insisted on buying a cheaper house.  My first real estate agent kept showing me homes 10 of thousands of dollars above my price range.  After a couple months of that, I fired him, and selected another agent.  My next real estate agent actually respected my price range… only going over by a few thousand dollars, under the idea that we could make a lower offer conforming to my price range.

It worked.  After another several months of near misses, I found a house I really liked and offered $2500 below the asking price… valid for 24 hours.  After about eight tense hours at a friends house, my realtor called and said that the sellers had accepted.

For the last couple years I’ve been thinking that I’d like a larger house, with amenities like a 3-car garage.  We’ve even thought about buying land and building a custom home and looked at a few lots.  But so far I’ve resisted, partially because real-estate commissions and seller-side closing costs could eat easily up $15,000 of net worth.  In-town moving expenses would probably add another 3,000 dollars, and buyer-side closing costs (assuming we buy rather than build) another 7,000 dollars.  Something like $25,000 down the drain  to step into a new, upgraded dream home.

So the plan is to stick it out in the current home or another 5 or so years.  In order to enjoy it more we continue to make upgrades large and small.  About half of the upgrade work is DIY, the rest we contract out.  The return on investment for DIY work is probably 200%, the work contracted out will only pay back 50-60 cents on the dollar.

There is something nice about working on the home.  A sense of progress and accomplishment that is enjoyable.

I keep telling myself the cons of buying a dream home for twice the cost the current home.  Property taxes will double, utilities will go up, real-estate commissions and other costs will eat up a big chuck of equity, moving will be a hassle, etc.  And of course, do I want to live here for the next 10, 20 years?  Hard to say.  Until I make the next big move on the housing front, I plan to delay and enjoy my current home and neighborhood.  Take some walks, host some parties, and do some gardening.  Enjoying the intangibles of home ownership and try not be to hasty in my desire to keep up with the Joneses.

Only Half… of our Income?

I was having lunch and one of my friends said that something was troubling him.  He said that he worked out the numbers and, by his calculations, he needed to save 25% of his gross income for retirement.  And taxes took another 25%.  So, that meant he only got to use half of his income.  Only half!  Only half?   Were his calculations wrong?

My first reaction, was no, his computations sound about right.  But, I said, “Please tell me more. Maybe I’m missing something too?”

He explained that his projections were 8% return while he is saving, and then 5% while in retirement mode.  He explained that he had talked with his parents and other retired folks to estimate what their expenses are.

I asked him about how inflation factored into his calculations.  He said that he was estimating about 3-4% for inflation.

So, yes, his estimates made sense.  Knowing his age, and assets, etc, made me think that he had it about right.

So he confided, yeah, but I also have a mortgage and property taxes and insurance?  That takes, more, maybe another 30%.  So that leaves me with, like, 20%.  How am I supposed to do anything with that?!   My income is whittled down to almost nothing!

I could only sympathize.  Yes, I said.  You’ve sussed it out.  I hope that nonetheless you are enjoying your life.   Living responsibly for your future is not easy.  You and your family will, hopefully, thank you later.  The twin tyrannies, taxes and inflation, are the saver’s ever-present adversaries.  Facing them taxes the soul.  The intelligent saver faces them nonetheless, perseveres, and is better for it.

That was the best advice I could offer. It is the advice I give myself. It is unsatisfying, it is adult, it is realist. Are taxes and inflation such tyrants, such a drain? Historic facts say yes. It is the harsh truth. The wise face that truth, and succeed in spite of it. Best wishes, and hang in there. You can do it.