Photo Credit: Falcon® Photography

Photo Credit: Falcon® Photography  || In this story, TSB stands for “The Storage Bank”

This piece is another one of my experiments, please bear with me.

“Measure Twice, Cut Once” — A very intelligent woman (I suspect) whose name never got recorded the first time it was uttered

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” — Warren Buffett

Imagine for a moment:

  • The public secondary markets didn’t exist
  • Investment pooling vehicles were all private, and no one published NAV estimates
  • Stocks and bonds existed, but they were only formally offered through the companies themselves, and all private secondary trading was subject to a right of first refusal on the part of the issuing corporation.  This includes short-term debts like commercial paper.
  • Banks and life insurance companies still offer products to retail savers/investors, but nonforfeiture laws didn’t exist, and CD penalty clauses were very ugly.  In other words, because of no public secondary markets, the price of liquidity was very high, with a strong incentive to hold financial instruments to their maturity date.
  • Accounting rules are only partially standardized.
  • Deposit insurance still exists.
  • So does limited liability.

In this thankfully fictitious world, what would investing be like?

The main factor would be that liquidity would be dear.  Because the “out” doors for liquidity are thin or closed for a long time, money would go into any investment only after great study.  The 4 Cs of credit would be present with a vengeance — character, capacity, capital and conditions — and character would be chief among them as J. P. Morgan famously said.

This would be true even if one were investing in the stock of a firm, rather than the debt.  Investing in such a world, even with limited liability, is tantamount to an economic marriage back in a time where divorce was mostly for cause, and not easy to get.

You’d have to be very certain of what you were doing.  Perhaps you would diversify, but one would quickly realize how difficult it can be to keep up with a bunch of private firms — we take for granted how information flows today, but with private firms, you are subject to the board and management.  What do they choose to share with outside passive minority investors?

Excursus: It is said that it is easy to teach a child to say “please,” because it is the equivalent of “gimme.”  It is harder to teach them “thank you,” until they realize that it means, “I’d like an option on the next deal.”

Why would private firms choose to be open with outside private minority investors?  They want a continuing flow of capital, and with no secondary markets, that can be difficult.  Granted, there are always hucksters that say with P. T. Barnum, who is alleged to have said, “There’s a sucker born every minute.”  Those characters exist regardless of market structure, but in a healthy culture, they are a small minority in the markets.

The same would apply to the debt markets.  The fourth C, Conditions, would also impact matters.  If you can’t get out easily/cheaply, then you will limit the term of the borrowing at which you are willing to lend, unless there are features allowing for participation in the upside, such as stock conversion rights.

You might also find that insolvency becomes a very personal matter, as prior capital providers who know the business better than others, are invited to “prepackaged reorganizations” when the business is illiquid or insolvent.  The bankruptcy code might still exist, but gaining enough data on a firm in trouble would probably prove difficult. The board and management, unless legally compelled, might not find it in their interests to be open.  Control is a valuable option, one that is only surrendered when the situation is virtually hopeless.

That said, a man very good at estimating character and business value could make some amazing profits, because “in the land of the blind, a one-eyed man is king.”  And, the opposite would be true for many, as they get taken advantage of by less scrupulous management teams.

Back to the Present

“…[R]isk control is best done on the front end.  On the back end, solutions are expensive, if they are available at all.”  — Me, in this article, and a bunch of others.

The purpose of what I just wrote is to get you to think about an illiquid world as a limiting concept.  All of the problems of our world are there, usually in a form that is less severe than we experience because of the benefit of liquid secondary markets and vehicles for diversification.

If valuable for no other reason, market panics make liquidity disappear, and it is useful to think about what you will do in an absence of liquidity before the time of trouble happens.  The same is true of corporations needing liquidity.  Buffett said something to the effect of, “Get financing before you need it; it may not be available later.”

It’s also useful to consider more carefully the financial commitments that you make, so that you don’t make so many blunders.  (True for me, too.)  The ability to trade out of investments is useful but limited, because we don’t always recognize when we are wrong, and mechanical trading rules can lead us to the “death by one thousand cuts.”

Beyond that, realize that character does matter.  A lot.  The government tries as hard as it can, but it is far better at punishing fraud after the fact than it is catching fraud before the fact.  It will always be that way because the law is tilted in favor of the one in control; it has to be, or property rights are meaningless.  But consider those that try to warn about financial disasters — they do not get listened to until it is too late.  Madoff, Enron, housing bubble, various short sellers alleging improprieties, etc., etc.  Very few listen to them, because seeming success talks far louder than an outsider.

My counsel is the same as always, just look at the risk control quote above.  But to make it stark, ask yourself this, a la Buffett, “Would you still buy this if you couldn’t sell it for ten years?”  Then measure twice, thrice, ten times if needed, and cut once.

Picture Credit: Arturo de Albornoz || "Do unto others, as you would have others do unto you." -- Y'Shua Ha'Mushiach

Picture Credit: Arturo de Albornoz || “Do unto others, as you would have others do unto you.” — Y’shua Ha’Mushiach

This is an extension of a recent piece Decline Free Food.  Things have gotten worse with the mail situation at the Merkel house as I get older.  It’s not enough that AARP keeps sending us offers join.  (I keep a pile of AARP cards next to my work area to snip up if I am feeling blue. 😉 )  Now that I have turned 55, I am getting a flood of invitations from bloodsuckers financial services marketers asking me to come to their free information session.

The three recent ones were:

  • A conference asking “DO YOU HAVE THE COURAGE TO RETIRE RICH?”  The answer is real estate speculation.  Ah, if it were only that easy.  Yes, I know that a tiny amount of flipping has been profitable of late.  The only thing more profitable than flipping and speculating is getting others to pay for your advice and services so that they can go out and lose money speculating and flipping.  As I said to the guy pitching at a “Rich Dad” seminar, “If there’s that much money lying around in mispriced properties, why not go start a REIT and vacuum up all that money yourself?”  His answer, “What’s a REIT?”   I said, “If you don’t know that, you don’t know real estate.”
  • The pitch: “In a moment of decision the best thing you can do is the right thing.  The worst thing you can do is nothing. — Theodore Roosevelt”  A little more classy, but wrong.  Often the right thing to do is nothing, particularly if you don’t know the right answer… better to wait, study and learn.  Don’t be biased toward action, particularly in investing.  Only a salesman wants you biased toward action, and that is for his good, not yours.  In this case, the course offered doesn’t look so bad, and the price is cheap — but they don’t care about the cost of the course aside from the fact that it psychologically commits you to the course, and that you will more likely come, and be more likely to purchase further services from them.  The biggest thing you would learn from the course is that you don’t know much… so buy their services.
  • The next one advertises a dinner.  This one tries to scare you into coming — there’s a crisis around the corner. Boo!  But we can keep your retirement safe.  Inflation is coming.  Boo!  But we will get you an income that keeps up with inflation.  Then, to aid credibility, it mentions that their firm has been mentioned in a variety of local newspapers that no one pays for that cumulatively have less reach than this blog.

When I recently went and spoke to the Baltimore chapter of the American Association of Individual Investors, I told them, “I’m not going to market anything to you,” and I didn’t.  I response to a question, I did show them a page from my blog.  Yes, the one that lists all my worst mistakes.  And, I took a fairly extensive Q&A where if I didn’t know an answer, or there wasn’t a good answer, I said so.

My credibility is worth more to me than a little business.  Beyond that, I never want a client to think that I goaded him into working with me, or, that I went overboard to retain him if he wants to leave.  After all, I say to them, “It’s Their Money.”

As I often say:

“Don’t buy what someone else wants to sell you.  Buy what you have researched that you want to buy.”

I would say if someone sends you a slick ad on financial services, ignore them.  Always.  Do your own research.  The best firms don’t advertise, because they don’t have to.  Talk to intelligent friends, and see what they do.  Ask investment managers if they died and their firm went out of business, who would they want their spouse to use?

Don’t respond to retirement, investment management and financial planning ads.  Develop your own proposal, and put it out for bid.  Let multiple providers tell you what they will do for you.  Have smart friends help you review the submissions. Then choose the best one.

Keep the hucksters and charlatans at bay.  Ignore them.

Photo Credit: Tori Barratt Crane || "When is the next pension check coming, dear?"

Photo Credit: Tori Barratt Crane || “When is the next pension check coming, dear?”

I’ve seen a small group of pension articles in the recent past, none happy:

  1. Europe Faces Pension Predicament
  2. More Companies Freezing Corporate Pension Plans
  3. The Tragedy Of California’s Public Pensions
  4. Retirement Is Looking Even Worse for Americans

A defined benefit pension is a stream of payments that continues until the beneficiaries die, mainly.  It is funded from the assets set aside by the sponsor, and the earnings that flow from them, as well as additional contributions, should the assets not be enough.  With municipal pensions that means taxes.

Pension benefits are like debt, and sometimes more so.  What I mean is this — pension benefits earned can’t be reduced, except in bankruptcy.  Many states give municipal pension payments preferential treatment, so troubled municipalities can’t compromise pension payments easily, even in bankruptcy, if allowed.  (The main point of the third article is that underfunded pension plans in California will lead to taxes rising further, or, some sort of compromise, with a huge political fight either way.)

In principle, if defined benefit pensions had been funded properly, there wouldn’t be a lot of furor over them.  From inception, funding rules were not conservative enough, particularly in what plans could assume they would earn off investments.

Thus the second article is no surprise.  From my start in investment writing over 20 years ago, I predicted that more corporate pensions would get frozen, terminated, and replaced with defined contribution plans.  Plans assumed too much in the way of investment earnings. Sponsors contributed too little, encouraged by the IRS, that wanted more tax revenue, and thus limited the amount sponsors could contribute.

Things could always be worse, though… many nations in Europe will undergo a lot of strain trying to pay all of the benefits that were promised.  Here’s a quotation from the first article:

“Western European governments are close to bankruptcy because of the pension time bomb,” said Roy Stockell, head of asset management at Ernst & Young. “We have so many baby boomers moving into retirement [with] the expectation that the government will provide.”

Even the U.S., with a Social Security trust fund of $2.8 trillion, faces criticism for promising more than it can afford. That is because the fund—which is mostly in the form of IOUs from the Treasury—is projected to fall short of the sums needed to cover all benefits in a dozen years or so, and run out in 2035. Europe’s situation is much worse.

When taxes are already high, and because of demographics, the ratio of workers to pensioners is falling, it gets difficult to figure out what many European governments will do.  It will be a political fight.  Think Greece — but more widespread.

And from the article, one thing that all should expect is that older people will work to supplement their economic needs — the homey example was the lady raising berries to sell, and rabbits for her personal consumption.

The fourth article had a lot of pension factoids:

  • New York is the worst state to retire in, by one survey.  (But no state is that well off.)  Wyoming, South Dakota, Colorado, Utah, and Virginia are supposedly the five best states for retirement.
  • The odds for a woman of being in poverty after age 65 are high.  Part of that is that women live longer.  Also, the private pensions of most women are smaller.  Another part is that joint pensions for the often higher-earning husband drop in amount paid after he dies.  Two *do* live more cheaply than one, so that *is* a loss.
  • Most people think they won’t have as comfortable a retirement as their parents. (Probably true.)

Altogether, many are worried about retirement.  That is a rational fear.  I have older friends who have thought ahead, and retrained for lower-impact occupations.  If you don’t have assets, you will probably end up working.  Best to think about that sooner, rather than later.  After all, many Americans get to age 65 with less than $100,000 saved.  In this low interest rate environment, getting less than $4,000/year from your savings won’t do much to pad old age, but maybe working in a nice place could.

This isn’t the advice that many want to hear, but for 75% of Americans reaching 65, it is realistic.  Be grateful if you get to retire.  Be more grateful if you don’t get bored.

Before I start this evening, I want to add one follow-up to last night’s piece on Berkshire Hathaway.  My summary was that it wasn’t a great year, and the profit margins are likely to shrink in insurance, because BRK is being conservative there.  So why do I still own it for my clients and me?

BRK is trading maybe 8% over the level at which it would begin buying back stock.  Even in a pessimistic year, I expect BRK’s book value to rise to the level that triggers the buyback.  Thus, I think the floor for the stock is pretty close below me, and there is a decent possibility that Buffett could do some things with the cash that are even better than buybacks, especially if the market falls into bear territory.

It is positioned well for most market environments, even one where insurance gets hit hard.  BRK is “the last man standing” in any insurance crisis — they have the ability to prosper when other companies will have their capital impaired, and can’t write as much business as they want.

That’s why I own it.

Long BRK/B for my clients and me

=-=-=-=-=-=-=-=-=-=-=-=-=-=-

Onto tonight’s topic.  This is partially spurred by an article at Bloomberg.com entitled Angry Americans: How the 2008 Crash Fueled a Political Rebellion.  There was one graph that crystallized the article.  Here it is:

Incomes have not improved for the bottom 80% of Americans over the last decade.  Before I go on, recognize that the income distribution is not static.  The same people are not in each decile today, as were in 2006.  Examples:

  • Highly skilled students in a field that is in demand graduate and get jobs that pay well.
  • Highly skilled immigrants in a field that is in demand come to the US and get jobs that pay well.
  • Less skilled people who relied on the private debt culture to keep getting larger no longer have jobs that pay well in finance, construction, real estate, etc.
  • Workers and businessman who expected the commodities and crude oil boom to go on forever have seen their prospects diminish.
  • Some people have retired and their income has fallen as a result.
  • Layoffs have come in some industries because many people did not realize that they were lower skilled workers, and as such the work that they did could be automated or transferred to other countries.
  • Manufacturing continues to get more efficient, and we need fewer jobs in manufacturing to produce the same output (or more).  This is true globally; manufacturing jobs are being reduced globally.
  • Technology firms that apply the advantages of the internet gain value, while legacy firms lose value.  Whole classes of goods go away because they are replaced, and in other cases, some firms find that they can’t price their products to make a decent profit, while other firms can.
  • Some effects are demographic, like mothers ceasing work to raise children, or industries with a lot of older workers becoming uncompetitive because their pension plans are too expensive to fund.
  • Divorce usually ruins the prospects of the wife, if not the husband.
  • Throw in death, disability, substance abuse, and serious diseases.
  • And more…

Thus there is a lot of reason to look at the graph and not say, “The rich are getting richer,” but, “Those who are getting rich today are doing so faster than those who were getting rich back in 2006.”

My life is even an example of that… I make less than 30% of what I was making in 2006.  On an income basis, I’ve gone from the top of the graph to the middle.  I’m not upset, because I’m debt free, and manage my finances well.  I’m grateful to have my own little firm, and every client that I have.

Resentment

That said, many feel that the comfortable life that was theirs has been denied to them by forces beyond their control. They think that shadowy elites want to turn previously well-off people into modern serfs.

It’s a tempting thought, because most of us don’t like to blame ourselves.  Myself included, we all make mistakes.  Here is a sampling:

  • Did we make a bad decision in the industry in which we chose to work?  The particular firm?
  • Did we choose a bad field of study in college?  Rack up too much student loan debt?
  • Did we borrow too much money at the wrong time?  (Remember, debt is always a risk.  If you don’t know that, you shouldn’t borrow money.)
  • Did you make bad decisions regarding your assets, and get too greedy or fearful at the wrong times?
  • Did you spend too much during your good years, and not save enough for the future?
  • Did you not buy the insurance that would have protected you from the disaster that hit you?
  • Throw in relationship errors, etc.

The truth is, changes in technology, and to a lesser extent demography, affect the entities that we work in, and affect our personal economics as a result.  There are some politicians blaming immigrants for our problems, and that’s not a major source of our difficulties.  Most people don’t want to do the work that unskilled immigrants do, and skilled immigrants get hired when there aren’t enough people seeking those positions.

There is a need for retraining, but even that has its difficulties, as technology is changing rapidly enough that more areas may face job reductions.  Again, this is a global thing.  Those that think that making trade less free will help matters are wrong.  It’s not trade; it’s technology.

Some think that matters can be fixed by changing government taxes and spending.  That would only help limitedly, if at all.  Businesses and people can move to other countries.  In an era of the internet, many more things can move than ever did previously.

Now, if the developed  countries collaborated to unify tax policies, some of that would end.  But cheating under such a regime is too tempting, just as Indiana and Wisconsin try to attract businesses to move out of Illinois.  The relatively healthy governmental entities have advantages that allow them to prosper at the expense of the sick ones.

You’re Going to be Disappointed

Politicians live to promise.  I can tell you right now that not one of the surviving candidates for President has a realistic proposal that could be voted up by the next Congress or the buyers in the US Treasury market.  It’s all airy-fairy… just as most politicians have been since we stopped running balanced budgets.

I would encourage you therefore to look at your own situation and resources soberly, and assume that the next government will do nothing better for you than the current one.  All of the main drivers of what could improve matters for the middle class are outside the power of any individual government, so plan your own situation accordingly and adjust your economic expectations down.  After all, there is no place in the world that can promise its people prosperity.  Why should the USA be any different in this matter?

Photo Credit: andrew wertz || Half a house is better than none...

Photo Credit: andrew wertz || Half a house is better than none…

I am usually not into financial complexity, but I ran into a service today called Point that could be useful for some people if they need credit and:

 

  • you have a well maintained property in a neighborhood that has appreciation potential
  • you have a strong credit history
  • you have household income that covers your debt obligations (and some)
  • you have built up some equity in your home. After Point funding, you should still own at least 20% of the equity in your home
  • you live in one of the areas where Point is currently available
  • we reach agreement with you on a fair value for your property
  • you will sell the home within the term of your Point Homeowner Agreement or you will be in a position to repay Point at the end of the term

This is taken from Point’s website

The basic idea is that you sell a fraction of the equity/ownership of your home to Point.  You will still have to maintain it and service all of the debt on the home, but beyond that, you can live in your home rent-free.  When you sell the property, Point gets its share of the sales price.  According to the Bloomberg article:

With Point, credit scores can be less than 620, but homeowners must have at least 25 percent to 30 percent equity in their houses. Point adjusts the cost of its investment based on the owner and the property, taking a larger percentage of price appreciation from riskier customers. Should the homeowner not pay Point, the firm has the right to sell the home to recoup its investment and take its portion of the gains.

Those who decide not to sell their homes have to pay the company back at the end of the 10-year period, similar to a loan, with an annual effective interest rate that’s capped at about 15 percent, comparable to rates on some credit cards or unsecured consumer debt. Annual percentage rates at LendingClub range from 5.32 percent to almost 30 percent on three-year personal loans.

Point is investing in properties it expects to appreciate in value, initially focusing on California, with plans to fund homeowners in other states next year, according to a company marketing document.

Repayment with appreciation occurs at the earlier of the end of a 10-year term, sale of the property, or the will of the owner to buy out Point’s stake at the appraised value.

So, what could go wrong?

Personally, I like the idea of selling an equity interest because it delevers the owner.  The owner does not have to make any additional payments.  He forfeits some appreciation of the property, and faces either a need for liquidity or a sale of the property 10 years out.  (The 10-year limit is probably due to a need to repay Point’s own property investors.)

Possible issues: you might not like the price to buy out Point should you ever get the resources to do so.  You may not want to sell the property 10 years out if you realize that you can’t raise the liquidity to buy out Point.  If you do sell your home, you will incur costs, and may have a hard time buying a similar home in the market that you are in with the proceeds.

But on the whole, I like the idea, and think that it could become an alternative to reverse mortgages in some markets where properties are appreciating.  An alternative to that odious product would be welcome.

Full disclosure: I don’t have any financial dealings with Point.  I just think it is an interesting idea.

 

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best.  First, I don’t like infographics or video.  I want to learn things quickly.  Give me well-written text to read.  A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem.  Do you want to reduce the volatility of your asset portfolio?  I have the solution for you.  Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard.  Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?”  In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments.  Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

  • Growth stocks
  • Midcap stocks (value & growth)
  • Small cap stocks (value & growth)
  • REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
  • Developed International stocks (of all kinds)
  • Emerging Market stocks
  • Frontier Market stocks
  • And more…

And initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Not much.  The diversification from investor behavior is largely gone (the liability side of correlation).  Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets?  Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

  • Timberland
  • Real Estate
  • Private Equity
  • Collateralized debt obligations of many flavors
  • Junk bonds
  • Distressed Debt
  • Merger Arbitrage
  • Convertible Arbitrage
  • Other types of arbitrage
  • Commodities
  • Off-the-beaten track bonds and derivatives, both long and short
  • And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what?  Much the same thing happened here as happened with non-“blue chip” stocks.  Initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Some, but less.  Not everyone was willing to do all of these.  The diversification from investor behavior was reduced (the liability side of correlation).  These don’t move in perfect lockstep, so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are some that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short.  Many of those blew up last time.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again?  Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point.  Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder.  Think of cash, which doesn’t earn much or lose much.  Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time.  Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%).  This isn’t a call to go nuts and sell all of your risky asset positions.  That requires more knowledge than I will ever have.  But it does mean having some dry powder.  The amount is up to you as you evaluate your time horizon and your opportunities.  Choose wisely.  As for me, about 20-30% of my total assets are safe, but I have been a risk-taker most of my life.  Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification.  You will have to wait for those ideas to be forgotten.  Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

71WwKT7VGsL

This book is not what I expected; it’s still very good. Let me explain, and it will give you a better flavor of the book.

The author, Jason Zweig, is one of the top columnists writing about the markets for The Wall Street Journal.  He is very knowledgeable, properly cautious, and wise.  The title of the book Ambrose Bierce’s book that is commonly called The Devil’s Dictionary.

There are three differences in style between Zweig and Bierce:

  • Bierce is more cynical and satiric.
  • Bierce is usually shorter in his definitions, but occasionally threw in whole poems.
  • Zweig spends more time explaining the history of concepts and practices, and how words evolved to mean what they do today in financial matters.

If you read this book, will you learn a lot about the markets?  Yes.  Will it be fun?  Also yes.  Is it enough to read this and be well-educated?  No, and truly, you need some knowledge of the markets to appreciate the book.  It’s not a book for novices, but someone of intermediate or higher levels of knowledge will get some chuckles out of it, and will nod as he agrees along with the author that the markets are a treacherous place disguised as an easy place to make money.

As one person once said, “Whoever called them securities had a wicked sense of humor.”  Enjoy the book; it doesn’t take long to read, and it can be put down and picked up with no loss of continuity.

Quibbles

None

Summary / Who Would Benefit from this Book

If you have some knowledge of the markets, and you want to have a good time seeing the wholesome image of the markets skewered, you will enjoy this book.  if you want to buy it, you can buy it here: The Devil’s Financial Dictionary.

Full disclosure: The author sent a free copy to me via his publisher.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Photo Credit: Teresa Robinson || Your plans, your needs, your dreams, your risks...

Photo Credit: Teresa Robinson || Your plans, your needs, your dreams, your risks…

What I am going to write here is half of my summary of how Asset Allocation is done.  Most of this will be done in the context of personal finance, because it is the most complex case, though this paradigm is sufficiently general that it can be applied to any entity.

Good asset allocation, and financial planning generally, focuses on two main questions:

  • When will the cash be needed for expenses?
  • What are the likely returns being offered by asset classes over the planning horizon at every period in which cash will be needed?  Also, how likely are those returns?

Tonight I am writing about the first question.  For institutions, there are typically two solutions — there is a spending rule for endowments, whereas for defined benefit pension plans and other types of employee benefit plans, the actuaries will sit down and estimate future cash needs, and when the needs will take place.  (The same applies to financial institutions, though for institutions with short-term funding profiles, you won’t typically use actuaries, not that you couldn’t.)

For individuals and families, the issues come down to needs, wants, dreams, and risks.  As for risks, you can look at the earliest series at my blog, [summary here] which was on personal finance.  (I never intended to write much on personal finance, and so that was a summary set to get my main ideas out.)

Then comes the hierarchy of expense: needs, wants, and dreams.  Aim to satisfy each one successively.  Some people can only afford needs, others can get to wants, and a few others can get to dreams.  Now, that’s an oversimplification, because many people will reshape their wants and dreams to fit their cost structure.  Happiness is frequently a choice, rather than an abundance of goods and experiences.

Regardless, once you have a spending goal, and your main risks are covered, then you have something to shoot for, and asset allocation can begin.  In the process you might come up with a return target to shoot for, which I call Your Personal Required Investment Earnings Rate.  The basic idea is this:

Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.  Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.  Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.  Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

For more, you can read the article, which has a decent amount on whether return needs are reasonable or not.  More on this topic when I try to describe setting asset earnings assumptions, which is decidedly more complex.  Till then.

In general, people don’t do well with amounts of money significantly larger than they are used to handling.  The most obvious example of that is people who win lotteries.  The money typically gets wasted — bad purchases, bad investments.

Thus I would encourage you to be very careful with any large distributions of money that you might receive.  Examples include:

  • Life insurance settlements
  • Disability insurance settlements
  • Structured settlements arising from winning a court case over a tort against you.
  • Lotteries
  • Pension lump sums
  • Inheritances
  • Big paydays, if you are one of the rare ones in a high-paying short career like entertainment or sports

There are three problems with lump sums — receiving them, investing them, and rate of their use for consumption.  Let me take these topics in the order that they should occur.

Receiving a Lump Sum

Let’s start with the cases where you have a stream of payments coming where a third party comes to you and says that you can get all of the money now.  I am speaking of structured settlements and inheritances where trusts have been structured to dole out the money slowly.  There is one simple bit of advice here: don’t do it.  Take the payments over time.  None of the third parties offering to give you cash now are giving you a good deal, so avoid them.

Then there are the cases where an insurance company is making the payments from a disability claim, a structured settlement, a lottery, a pension buyout, or an annuity that someone bought for you on your life.  The insurance company will be more fair than any third party, because they aren’t usually looking to make an obscene gain, just a big one, because it reduces their risk, and cleans up their balance sheet, so they can do more business.  One simple bit of advice here: still don’t do it.  You can do better by taking payments, and building up money for larger purchases.  Be patient.

People do best when they receive money little by little.  When they get money materially faster than the speed at which they have previously earned money, they tend to waste it.  It is almost always better not to take a lump sum if you have the option to do otherwise.

The last set of situations is when the party that owes the set of payments offers you a lump sum.  It could be a life insurance company, a defined-benefit pension plan, a lottery, or some option uncommonly granted by another payor.  I would still tell you not to do it, but the issue of getting cheated is reduced here for a variety of reasons.

The defined benefit plan has rates set by law at which it can cash you out, so they can’t hurt you badly.  That said, you will likely not earn enough off of your investments with safety to equal the stream you are giving up.  The lottery is often similarly constrained, but do your homework, and see what you are giving up.

One place to take the lump sum is with life insurance companies off of a death benefit.  The rates at which they offer to pay an annuity to you are frequently not competitive, so take the lump sum and invest it wisely.

Economically, the key question to ask on a lump sum versus a stream of payments is what you would have to earn to replicate the stream of payments.  Most of the time, the stream is worth more than the lump sum, so don’t take the lump sum.

The second question is more important.  Can you be disciplined and not waste the lump sum?  Ask those close to you what your money habits are like, if you don’t know for sure.  Ask them to be brutally honest.

Investing the Lump Sum

Again, one nice thing about taking payments, is that you don’t have to invest the lump sum.  If you do take the lump sum:

  • First, pay off high interest rate debts.
  • Second, avoid buying big things and calling them investments.  Don’t buy a big house when you don’t need a big one.
  • Third, don’t invest in any of your relatives’ or friends’ business ventures.  Tell them you try to keep personal affection and money separate.  It avoids hurt feelings.
  • Fourth, look at the time horizon of your real needs.  Plan for retirement, college, etc.  Invest accordingly — get a trustworthy adviser who will help you.  Trustworthiness is the most important factor here, with competence a close second.
  • Fifth, don’t so it yourself, unless you have developed the skill to do it previously.  If you want to do it yourself, you will have to gauge whether the various markets are rich or cheap in order to decide where to invest.  For some general, non-tailored advice, you can look at articles in my asset allocation category.  As an aside, don’t invest in anything unusual unless you are an expert.

Receiving Spending Money from Your Investment Fund

The first thing is to decide on a spending rule: many use a rule that says you can take 4% of the assets from the fund.  My rule is a little more complex, but will keep you safer, and adapt to changing conditions: as a percentage of assets, take 1% more than the yield on the 10-year Treasury Note, or 7% if less.  At present, that percentage would be 2.21% + 1% = 3.21%.

Whatever rule you use, be disciplined about your spending.  Don’t bend your spending rule for any trivial reasons.  Size your budget to reflect your income from your investment fund and all of your other income sources.

Conclusion

Remember that most people who get a lump sum end up wasting a lot of it.  The only thing that can keep you from a similar fate would be discipline.  If you don’t have discipline, don’t take a lump sum.  Take the payments over time.  That will give you the maximum benefit from what is a very valuable asset.

My last article, One Dozen Thoughts on Dealing with Risk in Investing for Retirement, was a mashup of two of my older articles Managing Money for Retirement and From Stream to Shining Stream.  I wrote as a submission to a Society of Actuaries request for essays on the topic of Post Retirement Needs And Risk Committee Managing Retirement In Light Of Diverse Risks.  I added more material, chopped out some of the weaker stuff, and tried to rewrite it to have a consistent tone, etc.  As Susan Weiner, our go-to person on investment writing says, “The best writing is rewriting.”  Given some of the responses I got, the article was well received.  Hopefully the folks at the SOA will like it as well, but it will probably be the least technical essay they receive.  It also still has some typos.  Oops.  So it goes.

There was one comment on the article that I would like to highlight.  Here it is:

The other thing to watch for with retirement spending is not spending enough of your investments, especially in early retirement. Many studies have shown that actual spending in retirement decreases by around 50% from age 55 to age 80. One study in Germany showed that people’s wealth actually started increasing again in their 70’s as their pension incomes exceeded their lifestyle costs, with the resultant increase in savings.

People need to think about this in how they structure their retirement spending. It may make complete sense for someone with a $1 million portfolio and a standard government pension to spend $800,000 of that $1 million by age 80, leaving a $200,000 cushion for the lower cost part of their lives as most of their day-to-day living expenses will be covered by their pension.

People need to spend their money when they are active and mobile and able to enjoy it. I think the financial press needs to talk about this more, so people are not scared into not spending their money until it is too late.

The author of the book that I most recently reviewed, Carlos Sera, gave one of his sayings on page 97 of his book:

“There is a fine line between over-saving and under-living.”

That particular story dealt with a couple that had been especially frugal, and after not earning all that much, at retirement had $6 million.  They had a traditional marriage, and the husband handled the money entirely.  He worked until 72, retired due to incapacity, and on the day of his retirement, he handed his wife a check for $3 million.

She thought it was a joke, so for fun she tried to cash the check.  To her surprise, the check cleared.  Then came the bigger surprise — her amazement gave way to anger!  All the years of self-denial, and they were this well-off!  There were so many things she denied herself along the way, and now both of them were too old to truly enjoy their riches.

There’s more to the story… the point the author goes for is mostly abut how husbands and wives should learn to cooperate on the shared tasks of household economic management, so that both are on the same page, and they can be agreed on goals and methods.

I agree with that, and would add that the best approach on spending versus saving is what I would call a conservative version of the “middle way.”  Make sure that you are provident, but balance that with contentment and a happy enjoyment of what you have.  Life is meant to be lived.

Yes, it is good to be prudent and frugal, but not to the point where you amass a lot of assets and never enjoy them.

[Now for those not crazy about Christianity, you can skip to the end.]

In Ecclesiastes 5:13-20, Solomon says [NKJV]:

There is a severe evil which I have seen under the sun: riches kept for their owner to his hurt.  But those riches perish through misfortune; when he begets a son, there is nothing in his hand.  As he came from his mother’s womb, naked shall he return, to go as he came; And he shall take nothing from his labor which he may carry away in his hand.  And this also is a severe evil— just exactly as he came, so shall he go. And what profit has he who has labored for the wind?  All his days he also eats in darkness, And he has much sorrow and sickness and anger.

Here is what I have seen: It is good and fitting for one to eat and drink, and to enjoy the good of all his labor in which he toils under the sun all the days of his life which God gives him; for it is his heritage.  As for every man to whom God has given riches and wealth, and given him power to eat of it, to receive his heritage and rejoice in his labor—this is the gift of God.   For he will not dwell unduly on the days of his life, because God keeps him busy with the joy of his heart.

Ecclesiastes 4:8 and 6:1-3 say similar things, and are cited by the Larger Catechism in question 142, where it says:

What are the sins forbidden in the eighth commandment?

The sins forbidden in the eighth commandment, besides the neglect of the duties required, are, theft, robbery, man-stealing, and receiving any thing that is stolen; fraudulent dealing; false weights and measures; removing landmarks; injustice and unfaithfulness in contracts between man and man, or in matters of trust; oppression; extortion; usury; bribery; vexatious lawsuits; unjust inclosures and depopulations; engrossing commodities to enhance the price, unlawful callings, and all other unjust or sinful ways of taking or withholding from our neighbor what belongs to him, or of enriching ourselves; covetousness; inordinate prizing and affecting worldly goods; distrustful and distracting cares and studies in getting, keeping, and using them; envying at the prosperity of others; as likewise idleness, prodigality, wasteful gaming; and all others ways whereby we do unduly prejudice our own outward estate, and defrauding ourselves of the due use and comfort of that estate which God hath given us. [Emphasis mine]

Along with questions 140 and 141, they summarize most of what the Bible teaches on ethics in economics.  My emphasis is the last phrase “defrauding ourselves of the due use and comfort of that estate which God hath given us.”

This may be a surprise to some, but (among other things) God wants us to enjoy life.  That is not the highest goal, but God commends it through the voice of Solomon in Ecclesiastes multiple times.

Now, not everyone in Christianity thinks this way.  John Wesley famously said, “Earn all you can.  Save all you can.  Give all you can.”  This is admirable as far as it goes, and Wesley’s life reflected it.  He was very industrious, frugal, provident and generous.  But in the middle of his life, he did not purchase and enjoy some blessings, in an effort to give more to the poor.

Why?  Black tea was relatively expensive back then, and the lower classes were spending too much of their money on the relative luxury of tea.  Wesley liked tea a lot, but gave it up for two reasons: to set a good example to the poor, and have more money to give to aid the poor.  (He also abstained from alcohol, fasted several days a week, and ate cheaply when he did eat.)  That said, occasionally bothered him that some of the money he gave to the poor got spent by them on tea.  Oh well.  With something that is not in itself a sin, it was probably better to let people spend their money as they saw fir, and not discourage them by arguing that tea was a wasteful luxury.

I would amend Wesley and say it this way, “Earn a competent amount.  Save a good portion of it.  Give to poorer brothers who are ailing, despite doing their best.  After that, enjoy the blessings God has given you.”

There is a reason why God is portrayed in the Parable of the Lost Son as a generous man who throws a party when his younger son repents of riotous living, while the older son (representing the Pharisees) is portrayed as a miser.  God is generous, while many religious people get proud of what they have achieved, seemingly apart from God, and resent those who get gifts, while they themselves work.  This is parallel to salvation, which cannot be purchased no matter how hard we work, but must be received as a gift from Jesus, who did all the work for those who would receive the gift of salvation.  Echoing that, C. S. Lewis in The Screwtape Letters portrays God as jolly when “the patient” gets a girlfriend, while the demon Screwtape boasts of the grand austerity of Hell.

Closing this section, I would simply say take care of all your other obligations to God, but if God has given you something legitimate to enjoy, then enjoy it, and don’t feel guilty.  Rather, take the opportunity to thank and praise God for the blessings he brings.

Conclusion

Assets and money are tools.  They are valuable, but they are a means to an end.  Use them to enjoy life, while being prudent as you do so.