I periodically read your blog and it seems like you have a strong grasp of the insurance industry.  As well, given your background as a life actuary I imagine you might have some valuable insights on whole-life products.  I am having a baby in the late spring and have been considering the right composition of my life insurance coverage (term vs. whole life), and have thus far had a lot of trouble making sense of the whole life math and why it is a compelling option for me.  I have received quite a lot of data from an insurance broker with the IRR’s, cash surrender values at different periods, etc., but unfortunately can only get this data in PDF form without really understanding the assumptions behind how the cash surrender value grows, or how the dividends get calculated.  In short, I have been unable to come to a more developed thesis than the idea that whole life is just a way to lock yourself in to a middling return while the insurance company benefits from your float and makes a spread off you, while taking insurance company credit risk for decades, with some benefit in the ability to pass down a decent amount of money tax free to one’s kids when they die.  

How do you view whole life, do you own any yourself?  If so, I’d love to understand your logic.  I recently re-read part of Buffett’s 94 letter in which he states how he buys whole life policies from people about to stop paying premiums for more than the cash surrender value and can only surmise that somehow at the point he is buying them there is probably a higher IRR than in the beginning of the policy (which makes sense given the math I have seen.)   

I am skeptical because I can’t figure out the answer, which makes me not inclined to lock myself in to a life-long financial commitment with an institution that might not be around in 70 years.

For most of my life, I have had term insurance.  It was cheap, and protected my wife against an untimely death of me when we were less-than-well-off.  At present, we are uninsured on my life because my wife has enough assets that if I die, she can fund the educations of the remaining kids, and live thereafter, with perhaps some work on her part.  She’s really bright, but who would be smart enough to hire her?

In general, I think it is smart for young people to buy 20 or 30-year term insurance.  It takes care of the period where your family is most vulnerable.  You get coverage when you are young and healthy, because you don’t know what tomorrow will bring.  Then save and invest to build up assets to meet the needs you may have when the term policy runs out.  If you still need insurance at that point, and are healthy, get underwritten again for a new policy.

There is one place where a whole life policy can make sense. Sometimes mutual insurers use a portfolio method for interest rate crediting. In an environment like this, where interest rates have fallen so much, that means they are crediting to new money the same rate that they are getting old money. That is quite a bonus, so if you can find that, it may prove to be cheaper than getting a long term insurance policy.

As for the second reason to buy life insurance, it is one of the most enduring ways to scam the taxman.  Death benefits are not taxed by the states or the federal government, and unless the person dying was the policy’s owner it is immune from estate tax.

This creates a wide number of vehicles that wealthy people use together with annuities and trusts to transfer wealth out of their estate, and into death benefit proceeds that will pass to their heirs outside their estate.

This is one reason why I believe the estate tax has to go. It does not accomplish its stated ends. The wealthy find all manner of clever ways to escape it. It would be far better to eliminate the ability to shelter income from taxation while they are living. Besides, the government needs the money now.

Closing Points

 First, don’t worry about the credit risk, within limits, the state guarantee funds stand behind the insurance companies. For most people that should be enough.

Second, as for Buffett buying life policies, this is done only when an investor buys a policy from someone who is expected to live less long than the actuarial tables would’ve predicted at the time of policy issuance. The policy is more valuable than the cash surrender value; the investor attempts to make money off the difference.

This is a controversial area, and I am generally against the practice. It should not be legal; it endangers the tax favored status of life insurance, because it allows people without an insurable interest to benefit from the proceeds of life policy. That said, the market would go away if insurers were willing to deal more favorably with those who have impaired lives, and want to cash out their insurance policy.

Third, I have run into really advanced methods for scamming the taxman that involve asset-backed securities, trusts, and what else? Life insurance. In general, I think the U.S. Treasury should use their anti-abuse rules in order to invalidate these transactions, because they lack true economic purpose. That is, even if they are structured in such a way as to give the appearance of economic purpose, there is no reason that a businessman in his right mind would structure the business in that way, except to avoid taxes.

Finally, remember that the agent has a different motive than you. He wants to earn a commission. Commissions are low, and prices are easily comparable on term policies. There are services that will even do the comparison for you. The only way that an insurance agent will earn high commission is by selling a policy that is complex, not comparable to other policies, and builds up assets. The insurance company pays a high commission on such policies because they can earn investment returns off of the excess premiums that you pay in relative to a term policy.

As an aside, the father recently died, and he was quite a guy, but humble.  If you ever get therapy in a hospital that requires a cyclotron or any delivery device that allows positrons or any anti-particle to be used in surgery, my father-in-law was the brains behind it.  He was an amazing man, and though my wife is astounding, one benefit of marrying her was getting to know her father, who was an amazing man.  (Did I tell you he was amazing? )

Anyway, the first time my wife gave me investment advice was when I worked for the St. Paul.  My boss invited me to his officein early 2000, and handed me an envelope.  He said, “This is your bonus, invest it wisely.”  At that point in time, St. Paul was in the tank, and no one liked it much at all.  I took the wad, and put it all on The Saint Paul.  (My wife was amazed at the size of the bonus, but the bonus was given for keeping the company safe, not for making a ton.)

Eventually, it leaked out that I had invested so much in the parent company.  Members of my investment team told me I was a dope, and that the St. Paul was a lousy company to invest in. One told me, “No that’s not value investing, value investing requires a catalyst, and there is no catalyst here.”  (Note: catalysts do not always appear, and they can be expensive.)

Me, a value investor thought that buying a company at 55% of liquidation value, and a single digit multiple of forward earnings would do fine.  After one month, several P&C insurance CEOs announced that they were seeing pricing power, and the stock of the St. Paul rose 30%.  I could not sell, because I was constructively an insider, though I had no insider information.

After another 3 months, the cycle was in full swing, and the St. Paul’s common stock was up 80% from where I bought it.  At that point, my wife came to me and said, “You’ve been talking a lot about the St. Paul over the last few weeks, how important is it to our family?”  I told her, “It is half of our net worth.”  She said, echoing things she had heard me say previously, “Shouldn’t you take something off the table?”  I told her that I would.  I liquidated the whole position at my first opportunity, given my restrictions.  My gain was 95%, over six months.

As it was, after I did this, that many people at the St. Paul came to me saying, “You sly dog, you are a genius, but now we are doing it too; we are in this with you.”  I told them, “Aack, no.  Don’t do this.  You are buying  the top.”  And, wrong again, the price rose for a few more months, only to fall dramatically.

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A few years later, my wife said to me, “You keep talking about Wright Manufacturing, and how well it is doing, but how much do we own of the company?  I said, “You see our house?”

She said, “Of course.”

I said “Well, our holdings are worth a little more than our house.”

Beyond her ordinary ability, she asked, “Okay, David, but would you invest in this company to the degree that you have if it were publicly traded?”

I told her “No.”

She then asked, “then why don’t you take something off the table?”

I was cut to the heart, and I told her I would do so.  I sold half of my shares to the second largest shareholder.He told me that he would meet me at my office at Hovde.  After he got there he was amazed at me and said, “Wait, you are a smart guy, what am I missing here?”  I told him that I needed the money for the college educations of my children, so I needed more liquidity.

That mollified him, and allowed me to sell before the price cratered in 2008-9, as the company nearly failed.

But that’s another story, one where I bought amid distress, but not enough….

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I love my wife.  We just celebrated our silver (25th) anniversary.  She is wonderful in so many ways that I cannot describe here, and her children (and mine), biological and adopted would agree.

Though a princess, she absorbed enough of my ideas to counsel me at two particularly important turning points for the good of our home.  With the St. Paul, I probably would have done the right thing but with Wright Manufacturing, probably not.

So I praise her here for absorbing my wisdom, and applying it to me, when I could not do so myself.

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To bright people in finance I would say pay attention to those near you who don’t have your acumen, if they have been around you long enough.  They may give you cues that you could not ordinarily get, and it might just save your hide.

For me, this gives me an opportunity to praise the second most important person in my life, my wife, who typically has no impact on financial decisions, but at a few critical points did very well for me and the family.  She learned from me.

As for the one most important, that would be Jesus Christ, who many imagine they are honoring at this time of year, even though he never asked that his nativity be celebrated.  Just saying.

Ask yourself this: where does investor put his money if he wants to stay safe?  Most people are savers not investors, so ideally they would want to put their money on deposit and earn a real return with the ability to access their money at any time.  Then there is the alternative asset, gold.  Gold is a hedge against inflation, but it throws off no interest.  But at some level of real return, savers begin to conclude that they aren’t earning all that much, so they may as well hold gold.  Vice versa when real rates rise.

One more thing: gold doesn’t benefit from productivity increases, as stocks do.  Rapidly increasing productivity makes gold less attractive than stocks.

Eddy’s model boils down to this (in my implementation):

Percentage change in gold price = Multiplier * Percentage change in (Deflator Index / Real return Index)

where the Real Return index compounds three month T-bill yields less inflation via the 12-month CPI-U in arrears.

Here is how well the mode works, since 1970:

The first model attempts to minimize absolute dollar price differences between actual and model.  The second attempts to minimize the ratio between actual and model prices.  Both have R-squareds over 90%.

The deflator return is constant in percentage terms.  For the two models it is around 2.3%/yr, which is not far from productivity gains.

As for the multiplier, it is near six.  The multiplier is like a duration figure with bonds.  What this means is that the percentage change in real interest rates, three-month T-bills less CPI-U inflation, is projected to persist for six years.  Six years is a reasonable figure, because monetary policy changes slowly, but not glacially.

Now, at present levels of real interest rates, with T-bill yields near zero, and the CPI above 3%, it implies a gold price rising at 3% per month.  If inflation stays where it is and the Fed holds good on its promises, that means a gold price in the $3000s in mid-2013.

Do I believe this?  Partially.  I own lots of oil stocks, but nothing in metals at all.

Eddy’s model helps to clarify the value of gold.  It is a store of value, as its price anticipates the degradation and strengthening of the dollar, because changes in real rates will persist on average for six years.

This is prompted by Barry Ritholtz tweeting to me a piece he wrote 3 months ago called, Take The Loss.  Good piece, worth a read.

What I suggest to you today is that there is a better way to manage portfolios.  Ignore the cost basis — the price at which you bought it.  Instead, focus on improving the economic value of your portfolio.

It is hard, really, really hard to choose the best assets.  I  can’t do it. It is easier to choose assets that are better than the ones you currently own.

This assumes that you have a reasonable way of estimating the value of assets.  When I was a corporate bond manager, it was easy, because I had a large number of rules to help me estimate the proper yield tradeoffs, perhaps more than most managers had at the time.

• Discount vs Par vs Premium bonds
• Differing maturities
• Special covenants
• Deal size
• Secured, senior unsecured, junior unsecured, trust preferred, preferred stock
• Implied credit betas of different industries (take more/less risk when you want to)
• Spread tradeoffs needed for capital requirements and likely default/capital losses
• Holding company vs operating subsidiary
• Public bond vs 144A vs private placement

There are probably more, but they aren’t coming to me now.  It is generally easier to estimate the tradeoffs with fixed cash flow streams with a maturity than unlimited life instruments where any cash flow back to you is uncertain.

Thus equities are squishier, where you have to compare valuation, industry trends, use of free cash flow, company quality, etc., to determine what is more valuable.  This is a much harder game, but one that can be played with discipline to good effects.

It is a lot easier to do swaps in equity portfolios than to to try to create the current optimal portfolio.  It is much easier to make comparative judgments (these are better) than absolute judgments (these are the best).

Other things equal, can you:

• Improve the cheapness of your portfolio?
• Improve the quality of your portfolio (unless you are in a period where leverage is expanding dramatically, and the opposite will pay off for a time)?  This applies both to balance sheet and accounting quality in earnings.
• Improve your industry allocations?
• Own management teams that use cash flow more effectively, and are more shareholder oriented?

Always trade for what is better, and ignore the price where you bought the assets.  It doesn’t matter what you paid; that is a historical artifact.  Trade for better securities regularly, subject to transaction costs and other limits.

Now for all of my prior penny stocks that I have been written about, all have done horribly.

• Bonanza Gold
• GTX Corp
• Bioneutral
• Uniontown Energy Inc.
• Obscene Jeans Corp

Now we have AER Energy Resources [AERN] which has done horribly, and does not file financial statements, having “gone dark.”  From a research note on the web, this is what they said:

Please be advised that VictoryStocks.com has been paid $1,300,000 by Sanaz Trading Inc. to perform promotional and advertising services for a one month profile of AER Energy Ressources Inc. which services include the issuance of this release and the other opinions that we release concerning AERN   VictoryStocks.com has not investigated the background of Sanaz Trading Inc. the hiring company. Anyone viewing this newsletter should assume the hiring party or , affiliates of the hiring party own shares of AERN of which they plan to liquidate, further understanding that the liquidation of those shares may or may not negatively impact the share price. VictoryStocks.com has received this amount as a production budget for advertising efforts and will retain amounts over and above the cost of production, copywriting services, mailing and other distribution expenses as a fee for our services. As such, our opinion is neither unbiased nor independent, and you should consider that when evaluating our statements regarding AERN. VictoryStocks.com is owned by: FreePennyAlerts, LLC, 40 East Main Street, Suite 572, Newark, Delaware 19711. Questions regarding this release may be sent to Editor @ VictoryStocks.com.

I only ran into that scam because I Googled Lone Star Gold [LSTG], and that popped up.  Lone Star Gold is a negative income negative net worth stock.  A promoter for Lone Star Gold snail mailed me, complete with handwriting and excess staples, but the horrid disclosure in teeny tiny type was this:

IMPORTANT NOTICE AND DISCLAIMER: This paid email advertisement by XXX (hereafter “XXX” does not purport to provide an analysis of any company’s financial position, operations, or prospects and this is not to be construed as a recommendation by XXX, or an offer to sell or solicitation to buy or sell any security. Lone Star Gold Corp. (hereafter “LSTG”), the company featured in this issue, appears as paid advertising. Mermaid Finance Ltd has paid $1,768,000 for the dissemination of this info to enhance public awareness for LSTG. Although the information contained in this advertisement is believed to be reliable, XXX makes no warranties as to the accuracy of any of the content herein and accepts no liability for how readers may choose to utilize it. The information contained herein is based exclusively on information generally available to the public and does not contain any material, non-public information. Readers should perform their own due-diligence before investing in any security including consulting with a qualified investment advisor or analyst. Readers should independently verify all statements made in this advertisement and perform extensive due-diligence on this or any other advertised company. YYY has received twenty thousand dollars for this and related marketing materials. YYY/XXX also expects to receive new subscriber revenue, the amount which is unknown at this time, as a result of this advertising effort. YYY and XXX nor any of their principals, officers, directors, partners, agents, or affiliates are not, nor do we represent ourselves to be, registered investment advisors, brokers, or dealers in securities. XXX is not offering securities for sale. An offer to buy or sell can be made only with accompanying disclosure documents and only in the states and provinces for which they are approved. Research and any due diligence was conducted by an outside researcher for this advertisement. More information can be received from LSTG’s website at www.lonestargold.com. Further, specific financial information, filings and disclosures as well as general investor information about publicly listed companies and other investor resources can be found at the Securities and Exchange Commission website at www.sec.gov and www.nasd.com. Any investment should be made only after consulting with a qualified investment advisor and only after reviewing the financial statements and other pertinent corporate information about the company. Many states have established rules requiring the approval of a security by a state security administrator. Check with www.nasaa.org or call your state security administrator to determine whether a particular security is licensed for sale in your state. This advertisement is not intended for readers in any jurisdiction where not permissible under local regulations and investors in those jurisdictions should disregard it. Investing in securities is highly speculative and carries a great deal of risk, which may result in investors losing all of their invested capital. Past performance does not guarantee future results. The information contained herein contains forward-looking statements and information within the meaning of Section 27A of the Securities Act of 1933 and Section 21 E of the Securities Exchange Act of 1934, including statements regarding expected continual growth of the featured company. Forward-looking statements are based upon expectations, estimates and projections at the time the statements are made and involve risks and uncertainties that could cause actual events to differ materially from those anticipated. Forward-looking statements may be identified through the use of words such as expects, will, anticipates, estimates, believes, or by statements indicating certain actions may, could, should, or might occur. Any statements that express or involve predictions, expectations, beliefs, plans, projections, objectives, goals or future events or performance may be forward-looking statements. In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the publisher notes that statements contained herein that look forward in time, which include other than historical information, involve risks and uncertainties that may affect the company’s actual results of operations. Factors that could cause actual results to differ include, but are not limited to, the size and growth of the market for the company’s products and services, regulatory approvals, the company’s ability to fund its capital requirements in the near term and the long term, pricing pressures and other risks detailed in the company’s reports filed with the Securities and Exchange Commission. XXX is a trademark of YYY. All other trademarks used in this publication are the property of their respective trademark holders. XXX is not affiliated, connected, or associated with, and are not sponsored, approved, or originated by, the trademark holders unless otherwise stated. No claim is made by XXX to any rights in any third-party trademarks.

Each promoter paid more than a million bucks.  Given the light level of trading in the stocks, and the low share price, the promoters were trying to do a significant pump-and-dump.  Personally, I think it would be really tough to squeeze over $1 million off of these tiny horrible companies, but maybe I don’t know the revenue model so well.

As I frequently say, “Don’t buy what someone want to sell to you.  Buy what you have researched, and what you think has value.”  Ignore penny stocks, with all of the ads that are on the web.  Short them if you dare.  These are horrible companies; any stock that has someone paid to promote it is a sell.  Sell, sell, sell!

This could not be simpler, so ignore the touts that promote penny stocks.  Short them if you dare, “the market can remain insane longer than you can remain solvent,” as Keynes said.

Penny stocks are for losers who dream of great gains.  They get the losses that they deserve.

I sometimes phrase it like this: use the stoplight rule.

• Less than 3 months expenses in the savings fund? Red light. Defer all discretionary expenditures.
• 3-6 months expenses in the savings fund? Yellow light. Some discretionary expenditures allowed, so long as you don’t dip back into the red light zone.
• More than 6 months expenses in the savings fund? Green light. Discretionary expenditures allowed, so long as you don’t dip back into the red light zone.

For what it is worth, the same rule works well with congregational and other nonprofit budgets, for nonprofits without a significant endowment.  It balances mission needs, and donor giving.

But let’s take another look at the buffer, and why you might like to have it bigger.  Consumer finance charges really eat into the incomes of many people.  What if your buffer was so big that you could:

1. Pay your insurance premiums in annual installments?
2. Buy your next car without financing it?
3. Pay off your credit card bills in full each month?
4. Ask for a discount for cash when buying big ticket items?  (You’d be surprised.  I drove quite a deal with my orthodontist for my wife and eight kids. I’m the only one that hasn’t had braces.)
5. End the escrow account on your mortgage?
6. Pay tuition bills in full, rather than a payment plan?
7. Take advantage of financial crises, and extend credit at tough times?  (I am still receiving 13% from a business associate that I lent money to in March of 2009, with warrants.)
8. Retain cash in your corporation to reduce financing costs?
9. Not worry about the minor disaster that recently hit?
10. Raise your deductibles on your Auto, Home and Health insurance premiums to save money?
11. Receive discounts on services that you want to receive, by getting a discount for buying years ahead?
12. Fund your 401(k), IRA, HSA, whatever, to the fullest?
13. And more…

Even when Fed policy is insane, the low rates do not apply to the masses, aside from GSE-supported lending.  In this environment, Fed policy starves liquidity in traditional lending to send it to the government, and related entities.

So, even though you can’t earn anything by saving, there is still the advantage of receiving a discount for full cash payment up front.  That doesn’t change, and because there are so many with bad finances, that discount is still valuable to businessmen who don’t want to deal with the costs of bad credit.

Now be wise.  When you use your liquidity to buy ahead, plan to replenish the buffer.  Don’t do everything at once; note the limitations of your liquidity, and act accordingly.

This is basic stuff, but I see many neglecting it.   Incidentally, the same rules apply to small businesses.  Being well-capitalized has advantages.  Take advantage of vendor finance discounts where you can.  Seek discounts for prompt cash payment wherever it makes sense.

I’m not saying be a miser and hoard cash.  I am saying there is a happy middle ground where you have enough cash to meet most contingencies and normal needs, and use the remainder to further long term goals and whatever you enjoy.

PS – I write this by the light of four candles as I continues to wait for power to be restored.  The candles illuminate my keyboard.  I will post this in the morning.

Many fundamental investors have been shaped by Peter Lynch.  Invest from the bottom up.  Analyze companies, not the economy. Time spent on analyzing the economy is wasted time.

This book takes the opposite approach.  If you understand the economy, and think you know how GDP growth and inflation will go, you have a better chance of choosing the right industries and outperforming.

Like my methods of investing, he looks to understand where we are in the business cycle.  After that, look for good companies that exploit the tailwind.

I became familiar with the main author in the mid-2000s, when he worked for ISI Group.  I appreciated his approach to the markets, which was similar to mine, as the bubble grew, and he and I warned about it.

Think of it this way.  If you had been reading the main author in mid-2006, and had listened to him, how much better off would you be now?  Considerably better off and I offer many warnings over at RealMoney.com before the crisis emerged.

The book will help you understand the sectors and factors in the market that affect returns, and what elements lead those returns.

Beyond that the book expresses skepticism over many of the current economic policies of the US and other governments amid the overindebtedness of much of the world.

At the end, rather than saying, “This is what you should do,” the book asks what your views are, and says if you believe in “such and so” as an economic future, this is what you ought to do.

I liked the book a lot.  I think it is of value to most fundamental investors.

Quibbles

None

Who would benefit from this book: Most fundamental investors could benefit from this book.  If you want to, you can buy it here: The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground.

Full disclosure: The publisher sent me a copy of the book for free.

If you enter Amazon through my site, and you buy anything, 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.

401(k) investors tend not to change their allocations often, except to panic when things are going bad, or arrive late in bull market, and buy near the top.  In general, if you don’t have a lot of investment knowledge, it is good to come to a place where you “set it, and forget it.”  Remember, those with no experience are far more prone to the errors of fear and greed than most experts are.  Those arrive late to a rise or a fall in the market, and say, “Look what I have missed out on,” or ‘Look at how much I have lost,” are going to make the wrong move again and again.

There are temptations as an investor to not diversify.

• “I’ll just hold all my assets in a money market fund.  I don’t want to lose anything.”  Money market funds preserve value at best.  They won’t help you build value.
• “I’ll just hold all my assets in gold.  I don’t want to lose anything.”  Gold preserves value at best.  It won’t help you build value.
• “This manager is the greatest.  I’m putting it all on him.”   Sadly, managers have hot and cold streaks.  Many people join in near the end of hot streaks.  The quote I heard this from was a professional in 1999, deciding to invest all his money with Bill Miller.  Bad timing.
• “Stocks win in the long run.  I am investing only in stocks.”  If you have a really long time horizon, and you are certain that your nation will not go through a revolution, or something close to it, that will work.  Otherwise, you are taking a risk.

There are more, but I think you get the point.  In most of life, those who do the best are the ones that take prudent risks.  Prudent risks are where the likely rewards outweighs the likely risks.

Think of it: in business, the guy who never takes risk does not do well.  The guy who takes huge risks blows up frequently, and does not do well on average.  The guy who takes moderate, prudent risks tends to do well.

The same is true of bond investing.  Those who invest in bonds of medium risk (BBB/Baa) tend to do best, those that play it safe or risk it all do less well.

The same is true of stock investing.  Stock investing is risky by nature, and in general, those who take less risk tend to earn better returns over time.  Ignore the canard: more risk, more return.  It ain’t so.

So what would I do if I were a 401(k) investor facing a limited menu of choices?

• Put 60-70% in conservative, value-oriented stock funds. (US and Foreign)
• And 25-35% in moderately risky bond funds. (US and Foreign)
• And 5% in cash.
• And rebalance yearly.  Do it after you complete your taxes, or something like that.

Avoid complexity.  Even if the plan offers a wide number of choices, winnow it down to a few funds, say five at most.  Over the long run, your investments should prosper, because you are doing things that few investors will do, and enjoy  returns from bearing risk successfully.

This is the first time I heard about them.  Doing a little digging, there is controversy around them.  But let’s talk about the benefits first:

• You receive a high and steady income.
• The stated value of your holdings remains stable, thus insulating investors from the chaos of the market.
• Professional management of commercial real estate is now available to small investors, with high returns.

But then there are the limits:

• Liquidation through the sponsor is limited.  (Dated, but gives you some idea…)
• You likely can’t cash out in full except through illiquid secondary markets where you take quite a haircut.
• If the underlying real estate does not do well, your income will shrink or disappear.
• You have little data on how the underlying real estate is doing.  Is the dividend they are paying coming from income or return of capital?

Long-dated, illiquid assets exist for two reasons:

1. To illustrate high yields to non-knowledgeable investors.
2. To pay large commissions to those that sell them.

It’s hard to tell which of those are more important, but this is another reason why I continue to talk about illiquid investments, and why most people should avoid them.  It is much easier to cheat people when there is no liquid market available to validate what is happening with the investment.  It is not that Non-Traded REITs protect investors from volatility, as much as they hide volatility from investors.

Large commissions on investments are only possible when there is a lock-in where surrender charges pay off the commission.  Where there are large commissions, misguided investing is more likely.

Look, I could set up 10-year stock trusts.  I will tell you what I will invest in, but since you have no withdrawal rights, you’ll have to wait 10 years for liquidity.  That does not sound like a better investment than going to Vanguard.  But many don’t go to Vanguard because they will not do their homework.  Should we begrudge those who sell to the fools that will not do their own homework?

I wish that we could.  Hey, the SEC is going after them.  Why not?  It is a reply of the limited partnership era of the ’80s.  Illustrate high returns — deliver capital losses.  I could not get why my first boss bought his limited partnerships, because of the losses taken in the era.

It follows the paradigm for illiquid investments — Offer high yields, suck in money, pay high yields, and if things go bad, deliver large capital losses.

With publicly traded REITs low yields have returned better then high yields.  The attempt to generate high yields requires a strategy where everything must go right.  That doesn’t work.  The low yield strategy does work, because there is more flexibility to manage, and raise payouts only after strategies have succeeded.

It is the same for Non-Traded REITs.  They offer high yields after paying high commissions.  Those high yields rely on capital gains on the properties.   Relying on capital gains is poison.

I will say it plainly: unless you are an expert who knows more than the seller, avoid buying illiquid investments.

Closing notes

There are many well-dressed people in this business.  But none discuss the scandal surrounding it.

This an example of those that prey upon small investors to get them to invest in non-traded REITs.

This is a growing area of investment, as people seek yield.

Pricing of Non-Traded REITs is controversial.

Here’s an example of a Non-Traded REIT that failed.

Look, my view is that that value of liquidity is usually underrated.  Liquid investments allow you to shift when opportunity favors such a move.  Whether you are ready for such a move is another matter, but whether you are ready to give up liquidity should require a similar degree of thinking.

I would not invest in Non-Traded REITs, the protections are lower than comparable investments.  Avoid illiquidity.

From reading your blog, it isn’t clear whether you are a value investor or a valuation based investor. When you wrote that you would sell something only if you had a better opportunity, it sounds different from a traditional value investor (buy at a discount to fair value and sell when it approaches fair value, all assuming you can determine a fair value that the market is not properly recognizing). That is, perhaps you have x% in equities, split among a variety of holdings, and you are generally keeping an eye out for new opportunities, so that when a stock become really attractive, you will sell your least attractive (from a future returns perspective) holding in order to fund the new purchase.

Elsewhere, though, you wrote about the benefits of holding cash.

Perhaps you could write a post clarifying how these might relate. If you have cash, you don’t need to sell something (potentially good, or you wouldn’t have been holding it in the first place) in order to buy when a good opportunity comes along. When do you deploy cash (change the % of equity vs cash or bonds) rather than swapping equities? Or raise it? Do you have a macro view that governs when to increase/decrease your equity exposure? Or would you consider selling stock to “buy” cash (ultra short duration fixed income) as a “better investment opportunity”?

Are moves like this more selling driven (i.e. time to lighten up on equity, or this stock has gone up to a level of very low future returns)? Or are they buying driven (i.e. ABC is a great opportunity at this price, how should I pay for it? Cash or swapping out a position?)? Or is it just a complicated circumstance based mix?

Thanks for considering these issues.

ps I really appreciate the honesty and integrity you appear to bring both to your investing and your writing about investing.

pps Do you index at all? Or only hold individual securities?

This reader asks some interesting questions, and I want to give him some answers.

First, I am a value investor — I try to buy equities that have a margin of safety, with some potential for positive surprises.  I don’t buy securities where the balance sheet is weak.  But I have a more expansive view of value, because I am willing to buy into industries that have good growth prospects relative to their valuations.  In 2002, my biggest sector was technology.  Today, with big company technology so cheap, it is my third largest sector.

I do vary my stock holdings versus cash, but I limit my cash to 20% of my stock portfolio at maximum because I have been generally good at picking stocks over the years.  Cash is useful, but I try to vary it in proportion to valuations.

Take a look at my eight rules, they will tell you a lot.  One of my main ideas is that people aren’t good at making decisions when they have a big menu in front of them, but they are good at binary comparisons.  They can say, “This is better than that” with reasonable accuracy.

So most of the time, I do swap trades, trading things I like better for things I like less, much like a bond trader would.  When I am more bullish on the market, I add in an extra buy, and when I am bearish, I add in an extra sell.  But I stick with the essential idea of swap trades, because it forces the idea of the binary tradeoff.

That’s how I do it.  Now I wish it were working better for me over the last year, but I’m not worried because my methods have worked well for a long time.

PS — I never index.