Saturday, June 20, 2009

Rainy day money, why not double-down?

For a young investor (say under 35).

You are starting out your investment career.

You are determining how much money you dream of having when you are an old fart.

You don't want to work very much or at all for spending money

You want to pass some money on to people (spouse, kids, and relatives) after you die.

You want to feel wealthy and independent (you want income to exceed expenses without busting your ass all the live-long day)

Wouldn't it be nice...

So what do you do?

Typically, you go to the people you've been banking with all your life (likely a service rep. at your local financial institution)

Or you can trust your parents to tell you what to do

Or you can trust someone who is older than you and followed a path to riches and is open and honest with you about money.

But you will typically know someone who works at a bank, and they will refer you to an investment advisor.

It's not entirely unlike asking someone if they know a good dentist- if they've ever been to a dentist, the odds are they know a relatively competent one.

Emphasis on relatively. With respect to dentists, relative means that from one certified dentist to the next, there may be a few perks like softer chairs or newer equipment, but the skill and dexterity of every dentist is extremely consistent across ages, areas, sexes, etc. for all dentists.

Relatively speaking, the 'average' competent investment advisor is competent relative to someone who throws darts at a board or bets on cock fights as a way of determining your investment strategy.

Relative to a skilled and honest investment advisor, the average advisor is no better at generating consistent returns than the average DIY investor.

What I'm speaking of relates directly to why I feel that young investors are told they are 'young enough' and 'therefore have a high enough risk tolerance' to invest heavily in the stock market. This line of reasoning introduces the theory that because the investor is so young, inflation, the rise in their wages, and taxation liabilities will require the need for immediate tax relief in the short- medium- and long-term.

Within this world-view of investment, bonds will never be profitable (even if they guarantee to return your money) because of historic returns of bonds vs. Stocks, inflation and taxation issues.

Sadly, this world-view does not correspond to reality. This world view makes sense only on the premise that stocks are capable of beating bonds by at least a factor of 2-1 and also relies on the notion that stocks will always be taxed at a rate that is almost 5-1 in favour of stocks (this changes completely once you retire and depending on rrsp and now tfsa context).

Tell someone to save up $500 000 (or better still save only $250 000 and borrow the rest at 5% interest), tell them they can get a 10% return, pay about 10% in tax because of the dividend tax credits you'll receive

Bingo, you are some old fart earning about $ 45 000 every year after tax. That should be enough to support a healthy and affluent lifestyle for a long time, still leaving a nice chunk of change to pay for your funeral, burial, headstone and give something to the kids, etc.

There are now millions of westerners who were sold this line of reasoning, told that they could sleep at night and are now facing the sad reality of impoverishment and never being able to retire.

This line of reasoning has earned thousands of investment advisors a steady income of anywhere from $ 75 000 - $125 000 every year. Every year that they were telling people not to worry, telling people that the bull market was on, telling people it was too late to sell, it goes on.

But there are always people who understand that excessive return means excessive risk. There are people who demand that they get their money back in less than 10 years, no matter what. There are people who understand some of the basics of macroeconomics and follow the news and history. These people are not afraid of inflation or taxes. These people instead focus on working hard, proving their worth in the world and getting compensated for a job well done. To these people, your best weapon against inflation and time is your own two hands. Your labour is what fights inflation because wages rise faster than stocks or interest rates in inflationary economies.

For these brave souls, these 'bondageers', there is but one simple rule: DO NOT GIVE AWAY YOUR SAVINGS!!!

If you intend to save something, it must never go down in value. That is why it is 'saved'- think evangelicals getting into heaven, they go only up.

High yields be damned, my capital is there for the future, for emergencies, it must never be allowed to fluctuate in value and must always be contractually guaranteed to be repaid in my name by whoever holds it as investment. Furthermore, never trust someone more than you can throw them. 20 years until you repay me? Forget it. 10 years? In this environment, it's a stretch.

The bondage freak is into power. "I give you my money. You better repay me. Pay me back my money and give me points for every day that you have it. Don't like it? Too bad, there are all kinds of players out there who are happy to hold money, and make enough of it on their own to gladly give me points."

It is these people who fear not the economy, its mood swings, the rise of china, inflation, Caesar, Huns, Visigoths, it matters not.

Seek to protect what you have saved from this cruel world. Seeking growth from that which is the product of labour is to seek derivative output from a non-productive entity. This is akin to gambling. Gambling is what you avoid by saving money. Gambling is not what you do with saved money.

This is not happy news for anyone who plans around the 10% fantasy. You are more likely to go back in time and have sex with Bo Derek while on the set of '10' then achieve your financial goal.

Monday, June 8, 2009

How does a bondage freak fare when interest rates plummet?

Bit of an unrelated article, but it's always interesting to see how George Soros is doing and what he's thinking.

George Soros, in case you were unaware, is a Hungarian born immigrant to the US of humble beginnings. Soros said that when he was young he wanted only to be a philosopher (a seeker and debater of truth and knowledge). In his twenties and without a family depending on him, Soros rationalized that if he was able to get a job on wall street, and frugally save up his salary over a ten year period, he should be able to save approximately $500 000 of which he could sustainably invest and draw upon as needed for the rest of his life. With that nest egg, Soros would then be free to write and comment on the world and hopefully earn extra income from becoming a published philosopher.

By the time the 10 year period was expired, Soros was a billionaire investor and worldwide guru. He was described as 'the man who beat the bank of England'- correctly predicting a sell-off of the British pound on the eve of major fiscal announcements.

So what lessons can we draw upon for the bond market investor?

Well, we are living in a time of historically low interest rates. This has frightened many retail investors away from bonds. They fear the boogie man of 'inflation down the road'.

Have you heard people in the media throwing this phrase around? It's not a legitimate fear. Economists understand that society actually needs a constant level of inflation in order for the entire economy to continue to expand. This is why all the intelligent analysts were more concerned with fighting deflation (which we are still experiencing). History has shown that preventing any form of inflation causes much more havoc than benefit.

So 'inflation down the road' is not only an expected thing, it's a good thing. This is counter-intuitive to what everyone in the media or the investment advising industry tells average retail investors.

But how can it be a good thing for a bond investor if interest rates, even long term, are declining and declining and declining? Surely this will expose an investor to the risk that inflation will rise more rapidly than it has in the past, while their bond investments are earning a very small yield- so small that it might be less than the inflation rate.

This is why you ladder your portfolio, and this requires you to change the way you think about earning money.

If interest rates plummet, and you have bonds coming due- you should follow the advice of what George Soros is talking about in the CNN article.

I'm not saying buy a mutual fund or etf for China (though you probably will make money with that investment), but you should find "the right assets rather than saying 'I'm not interested in investing'".

What this means for the bond investor is that you GO SLOWLY.

If interest rates for short term and long term bonds drop substantially, it may be in your best interest to take more short term bonds to provide flexibility in 1-3 years if inflation rises. It may be in your best interest to buy lower quality, but still investment grade BBB bonds that still pay interest that's around 6-7%. It may be in your best interest to move some of that returned money into the stock market (this spring was probably the greatest time to buy banks stocks in Canada ever).

Or you might buy any other asset that you feel is profitable.

When you keep over 90% of your money in guaranteed investment vehicles you can shift money around to 85% bonds 15% stocks, so long as you remain overall conservative, you can adjust to provide a steady cash amount of income every year.

But if you stick with bonds, and interest rates plummet and remain depressed, your overall portfolio will eventually start showing a lower total % yield, and this will eventually translate into smaller amounts of cash.

So what will this mean? So long as inflation and interest rates are at historic lows, the price for a great many of the goods and services we consume will remain at a steady and/or declining level. Your portfolio of diversified issuers and maturities will reflect the general growth and contraction of inflation and the economy. You will receive less total income, but your standard of living and ability to plan for your financial future will likely be completely unaffected.

Once the gradual rise in interest rates begins again, you will begin to buy new issues at higher rates, meaning you may be at the beginning of an economic cycle and earning less compared to new entrants into the market. However, the flexibility of a laddered portfolio will provide consistent opportunities to catch up and eventually rise above the average market returns.

Sunday, June 7, 2009

10 percent is a fantasy

People need to consider the difference between real and nominal.

Nominal is what you see, real is what it actually means

I've noticed that a lot of young investors, trying to plan for their retirement are using 10% as their expected annual return.

They expect that if they can earn a long-term average 10% annual return and reinvest everything, the power of compounding will eventually turn them into multi-millionaires.

Starting out with a house worth $ 400 000, a mortgage worth $300 000.

Savings from their job is about $ 150 000, imagine if they borrow an additional $100-150 000 to invest in the stock market.

Imagine they have to pay interest on all their loans at around 5%

Imagine someone tells them that they can get 10% return from their investments every year.

Seems like the investments might be able to pay off all the interest on your loans and then some.

After the loans are paid off, the investor is much wealthier than if they had not borrowed money to put in the stock market.

But how long does it take to pay off the principle? That makes a big difference in the time the investor ever actually sees any improvement in their standard of living (eg. Having a big wad of cash in your hands at all times).

But here is the most important thing: that 10% number is not guaranteed. In fact, in every document you ever read, it clearly states somewhere that there are explicitly no guarantees anywhere on anything in the financial industry.

So where does this 10% figure come from? From the article I linked last post, the argument is made that this figure is basically a fabrication of the investment advising industry. Why would an investment advising industry pick this figure and promote it as the way to make your retirement dreams come true?

Because it is double the average return of bonds, which averages around 5% annual return over the long run. I'll comment more in the future about this number, but it's also in my original post.

So what happens to people who sign over their money because an investment advisor is telling them it's a 'more efficient' way to make money?

They get convinced that they are 'young enough' and have a high-enough 'risk tolerance' to put most, if not all of their hard earned savings into mutual funds or the stock market. All products which do not promise to repay your capital.

Why do people buy into this? Greed is an obvious answer. So is the lack of good information on the real returns offered in the long-term for the various asset classes.

It's a simple rule: you can't make good decisions without good information. Investment advisors have promoted a long-term annual return from the stock market at 10%, 8%, 7%. It doesn't matter. The truth is, whatever the return has been it is characterized by extreme long-term volatility. You essentially have to hope (for your entire working life) to be lucky when you retire and begin to start drawing on your investments, ask anyone who is experiencing that now (old, tired, lost lots of money and can no longer afford to retire).

The bond market? It fluctuates along with economic cycles as well. But unless the issuer is bankrupt, your principal was protected the whole time.

Bonds have beaten stocks over the past 40 years. That is an entire working lifetime for the average middle class investor. What will the next 40 hold for us? Where should we really think about putting our money? And what should we really expect to earn for doing nothing?