Personal Finance – Page 4

Book Review: Wiped Out

Posted on 19 August 2016 by David Merkel

Before I start this evening, thanks to Dividend Growth Investor for telling me about this book.

This is an obscure little book published in 1966. ?The title is direct, simple, and descriptive. ?A more flowery title could have been, “Losing Money in the Stock Market as an Art Form.” ?Why? ?Because he made every mistake possible in an era that favored stock investment, and managed to lose a nice-sized lump sum that could have been a real support to his family. ?Instead, he tried to recoup it by anonymously publishing ?this short book which goes from tragedy to tragedy with just enough successes to keep him hooked.

Whom God Would Destroy

There is a saying, “”Whom the gods would destroy, they first make mad.” ?My modification of it is, “Whom God would destroy, he first makes proud.” ?In this book, the author knows little about investing, but wishing to make more money in the midst of a boom, he entrusts a sizable nest egg for a young middle-class family to a broker, and lo and behold, the broker makes money in a rising market with a series of short-term investments, with very few losses.

Rather than be grateful, the author got greedy. ?Spurred by success, he became somewhat compulsive, and began reading everything he could on investing. ?To brokers, he became “the impossible client,” (my words, not those of the book) because now he could never be satisfied. ?Instead of being happy with a long-run impossible goal of 15%/year (double your money every five years), he wanted to double his money every 2-3 years. (26-41%/year)

As such, he moved his money from the broker that later he admitted he should have been satisfied with, and sought out brokers that would try to hit home runs. ?The baseball analogy is useful here, because home run hitters tend to strike out a lot. ?The analogy breaks down?here: a home run hitter can be useful to a team even if he has a .250 average and strikes out three times for every home run. ?Baseball is mostly a game of team compounding, where usually a number of batters have to do well in order to score. ?Investment is a game of individual compounding, where strikeouts matter a great deal, because losses of capital are very difficult to make up. ?Three 25% losses followed by a 100% gain is a 15% loss.

In the process of trying to win big, he ended up losing more and more. ?He concentrated his holdings. ?He bought speculative stocks, and not “blue chips.” ?He borrowed money to buy more stock (used margin). ?He bought “story stocks” that did not possess a margin of safety, which would maybe deliver high gains ?if the story unfolded as illustrated. ?He did not do homework, but listened to “hot tips” and invested off them. ?He let his judgment be clouded by his slight relationships with corporate insiders at the end. ?HE TRIED TO MAKE BIG MONEY QUICKLY, AND CUT EVERY CORNER TO DO SO. ?His expectations were desperately unrealistic, and as a result, he lost it all.

As he lost more and more, he fell into the psychological trap of wanting to get back what he lost, and being willing to lose it all in order to do so. ?I.e., if he lost so much already, it was worth losing what was left if there was a chance to prove he wasn’t a fool from his “investing.” ?As such, he lost it all… but there are three good things to say about the author:

He had the humility to write the book, baring it all, and he writes well.
He didn’t leave himself in debt at the end, but that was good providence for him, because if he had waited one more day, the margin clerk would have sold him out at a decided loss, and he would have owed the brokerage money.
In the end, he knew why he had gone wrong, and he tells his readers that they need to: a) invest in quality companies, b) diversify, and c) limit speculation to no more than 20% of the portfolio.

His advice could have been better, but at least he got the aforementioned ideas?right. ?Margin of safety is the key. ?Doing significant due diligence if you are going to buy individual stocks is required.

Quibbles

This book will not teach you what to do; it teaches what not to do. ?It is best as a type of macabre financial entertainment.

Also, though you can still buy used copies of the book, if enough of you try to buy the used books out there, the price will rise pretty quickly. ?If you can, borrow it from interlibrary loan. ?It is an interesting historical curiosity of a book, and a cautionary tale for those who are tempted to greed. ?As the author closes the book:

“Cupidity is seldom circumspect.”

And thus, much as the greedy need to hear this advice, it is unlikely they will listen. ?Greed is compulsive.

Summary / Who Would Benefit from this Book

A good book, subject to the above limitations. ?It is best for entertainment, because it will teach you what not to do, rather than what to do.

Borrow it through interlibrary loan. ?If you feel you have to buy it, you can buy it here:?WIPED OUT. How I Lost a Fortune in the Stock Market While the Averages Were Making New Highs.

Full disclosure:?I bought it with my own money for three bucks.

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.

Simple Stuff: What is Risk?

Posted on 15 May 2016 by David Merkel

Photo Credit: GotCredit

This is another piece in the irregular Simple Stuff series, which is an attempt to make complex topics simple. ?Today’s topic is:

What is risk?

Here is my simple definition of risk:

Risk is the probability that an entity will not meet its goals, and the degree of pain it will go through depending on?how much?it?missed the goals.

There are several good things about this definition:

Note that the word “money” is not mentioned. ?As such, it can cover a wide number of situations.
It is individual. ?The same size of a miss of a goal for one person may cause him to go broke, while another just has to miss a vacation. ?The same event may happen for two people — it may be a miss for one, and not for the other one.
It catches both aspects of risk — likelihood of a bad event, and degree of harm from?how badly the goal was missed.
It takes into account the possibility that there are many goals that must be met.
It covers both composite entities like corporations, families, nations and cultures, as well as individuals.
It doesn’t make life easy for academic economists who want to have a uniform definition of risk so that they can publish economics and finance papers that are bogus. ?Erudite, but bogus.
It doesn’t specify that there has to be a single time horizon, or any time horizon.
It doesn’t specify a method for analysis. ?That should vary by the situation being analyzed.

But this is a blog on finance and investing risk, so now I will focus on that large class of situations.

What is Financial Risk?

Here are some things that financial risk can be:

You don’t get to retire when you want to, or, your retirement is not as nice as you might like
One or more of your children can’t go to college, or, can’t go to the college that the would like to attend
You can’t buy the home/auto/etc. of your choice.
A financial security plan, like a defined benefit plan, or Social Security has to cut back benefit payments.
The firm you work for goes broke, or gets competed into an also-ran.
You lose your job, can’t find another job?as good, and you default on important regular bills as a result. ?The same applies to people who run their own business.
Levered financial businesses, like banks and shadow banks, make too many loans to marginal borrowers, and find at some point that their borrowers can’t pay them back, and at the same time, no one wants to lend to them. ?This can be harmful not just to the?banks and shadow banks, but to the economy as a whole.

Let’s use retirement as an example of how to analyze financial risk. ?I have a series of articles that I have written on the topic based on the idea of the?personal required investment earnings rate [PRIER]. ?PRIER is not a unique concept of mine, but is attempt to apply the ideas of professionals trying to manage the assets and liabilities of an endowment, defined benefit plan, or life insurance company to the needs of an individual or a family.

The main idea is to try to calculate the rate of return you will need over time to meet your eventual goals. ?From my prior “PRIER” article, which was written back in January 2008, prior to the financial crisis:

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].

I?m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.? There?s a reason for this, and I?ll get to that later.? Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.? (Today that would be higher than 9%.)? That means you are not likely to make your goals.?? You can either:

Save more, or,

Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don?t make those choices because they never sit down and run the numbers.? Now, I left out a common choice that is more commonly chosen: invest more aggressively.? This is more commonly done because it is ?free.?? In order to get more return, one must take more risk, so take more risk and you will get more return, right?? Right?!

Sadly, no.? Go back to Defined Benefit programs for a moment.? Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.? What have they earned?? On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion?s share coming from the less risky investment grade bonds.? The overshoot of the ?90s has been replaced by the undershoot of the 2000s.? Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

The article goes on, and there are several others that flesh out the ideas further:

Simple Summary

Though there are complexities in trying to manage financial risk, the main ideas for dealing with financial risk are?these:

Spend time estimating your future needs and what resources you can put toward them.
Be conservative in what you think you assets can earn.
Be flexible in your goals if you find that you cannot reasonably achieve your dreams.
Consider what can go wrong, get proper insurance where needed, and be judicious on taking on large fixed commitments to spend money in the future.

PS — Two final notes:

On the topic of “what can go wrong in personal finance, I did a series on that here.

Investment risk is sometimes confused with volatility. ?Here’s a discussion of when that makes sense, and when it doesn”t.

Risk vs Return — The Dirty Secret

Posted on 11 May 2016 by David Merkel

I’m thinking of starting a limited series called “dirty secrets” of finance and investing. ?If anyone wants to toss me some ideas you can contact me here. ?I know that since starting this blog, I have used the phrase “dirty secret” at least ten times.

Tonight’s dirty secret is a simple one, and it derives mostly from investor behavior. ?You don’t always get more return on average if you take more risk. ?The amount of added return declines with each unit of additional risk, and eventually turns negative at high levels of risk. ?The graph above is a vague approximate representation of how this process works.

Why is this so? ?Two related reasons:

People are not very good at estimating the probability of success for ventures, and it gets worse as the probability of success gets lower. ?People overpay for chancy lottery ticket-like investments, because they would like to strike it rich. ?This malady affect men more than women, on average.
People get to investment ideas late. ?They buy closer to tops than bottoms, and they sell closer to bottoms than tops. ?As a result, the more volatile the investment, the more money they lose in their buying and selling. ?This malady also affects men more than women, on average.

Put another way, this is choosing your investments based on your circle of competence, such that your probability of choosing a good investment goes up, and second, having the fortitude to hold a good investment through good and bad times. ?From my series on dollar-weighted returns you know that the more volatile the investment is, the more average people lose in their buying and selling of the investment, versus being a buy-and-hold investor.

Since stocks are a long duration investment, don’t buy them unless you are going to hold them long enough for your thesis to work out. ?Things don’t always go right in the short run, even with good ideas. ?(And occasionally, things go right in the short run with bad ideas.)

For more on this topic, you can look at my creative piece,?Volatility Analogy. ?It explains the intuition behind how volatility affects the results that investors receive as they get greedy, panic, and hold on for dear life.

In closing, the dirty secret is this: size your risk level to what you can live with without getting greedy or panicking. ?You will do better than other investors who get tempted to make rash moves, and act on that temptation. ?On average, the world belongs to moderate risk-takers.

You Can Get Too Pessimistic

Posted on 7 May 20169 May 2016 by David Merkel

Photo Credit: Kathryn || Truly, I sympathize. ?I try to be strong for others when internally I am broken.

Entire societies and nations have been wiped out in the past. ?Sometimes this has been in spite of the best efforts of leading citizens to avoid it, and sometimes it has been because of their efforts. ?In human terms, this is as bad as it gets on Earth. ?In virtually all of these cases, the optimal strategy was to run, and hope that wherever you ended up would be kind to foreigners. ?Also, most common methods of preserving value don’t work in the worst situations… flight capital stashed early in the place of refuge?and?gold might work, if you can get there.

There. ?That’s the worst survivable scenario I can think of. ?What does it take to get there?

Total government and?market breakdown, or
A lost war on your home soil, with the victors considerably less kind than the USA and its allies

The odds of these are very low in most of the developed world. ?In the developing world, most of the wealthy have “flight capital” stashed away in the USA or someplace equally reliable.

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Most nations, societies and economies are more durable than most people would expect. ?There is a cynical reason for this: the wealthy and the powerful have a distinct interest in not letting things break. ?As Solomon observed a little less than 3000 years ago:

If you see the oppression of the poor, and the violent perversion of justice and righteousness in a province, do not marvel at the matter; for high official watches over high official, and higher officials are over them. Moreover the profit of the land is for all; even the king is served from the field. — Ecclesiastes 5:8-9 [NKJV]

In general, I think there is?no value in preparing for the “total disaster” scenario if you live in the developed world. ?No one wants to poison their own prosperity, and so the?rich and powerful?hold back from being too rapacious.

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If you don’t have a copy, it would?be a good idea to get a copy of?Triumph of the Optimists. ?[TOTO] ?As I commented in my review of TOTO:

TOTO points out a number of things that should bias investors toward risk-bearing in the equity markets:

Over the period 1900-2000, equities beat bonds, which beat cash in returns. (Note: time weighted returns. If the study had been done with dollar-weighted returns, the order would be the same, but the differences would not be so big.)
This was true regardless of what presently developed nation you looked at. (Note: survivor bias? what of all the developing markets that looked bigger in 1900, like Russia and India, that amounted to little?)
Relative importance of industries shifts, but the aggregate market tended to do well regardless. (Note: some industries are manias when they are new)
Returns were higher globally in the last quarter of the 20th century.
Downdrafts can be severe. Consider the US 1929-1932, UK 1973-74, Germany 1945-48, or Japan 1944-47. Amazing what losing a war on your home soil can do, or, even a severe recession.
Real cash returns tend to be positive but small.
Long bonds returned more than short bonds, but with a lot more risk. High grade corporate bonds returned more on average, but again, with some severe downdrafts.
Purchasing power parity seems to work for currencies in the long run. (Note: estimates of forward interest rates work in the short run, but they are noisy.)
International diversification may give risk reduction. During times of global stress, such as wartime, it may not diversify much. Global markets are more correlated now than before, reducing diversification benefits.
Small caps may or may not outperform large caps on average.
Value tends to beat growth over the long run.
Higher dividends tend to beat lower dividends.
Forward-looking equity risk premia are lower than most estimates stemming from historical results. (Note: I agree, and the low returns of the 2000s so far in the US are a partial demonstration of that. My estimates are a little lower, even?)
Stocks will beat bonds over the long run, but in the short run, having some bonds makes sense.
Returns in the latter part of the 20th century were artificially high.

Capitalist republics/democracies tend to be very resilient. ?This should make us willing to be long term bullish.

Now, many people look at their societies and shake their heads, wondering if things won’t keep getting worse. ?This typically falls into three?non-exclusive buckets:

The rich are getting richer, and the middle class is getting destroyed ?(toss in comments about robotics, immigrants, unfair trade, education problems with children, etc. ?Most such comments are bogus.)
The dependency class is getting larger and larger versus the productive elements of society. ?(Add in comments related to demographics… those comments are not bogus, but there is a deal that could be driven here. ?A painful deal…)
Looking at moral decay, and wondering at it.

You can add to the list. ?I don’t discount that there are challenges/troubles. ?Even modestly healthy society can deal with these without falling apart.

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If you give into fears like these, you can become prey to a variety of investment “experts” who counsel radical strategies that will only succeed with very low probability. ?Examples:

Strategies that neglect investing in risk assets at all, or pursue shorting them. ?(Even with hedge funds you have to be careful, we passed the limits to arbitrage back in the late ’90s, and since then aggregate returns have been poor. ?A few niche hedge funds make sense, but they limit their size.)
Gold, odd commodities — trend following CTAs can sometimes make sense as a diversifier, but finding one with skill is tough.
Anything that smacks of being part of a “secret club.” ?There are no secrets in investing. ?THERE ARE NO SECRETS IN INVESTING!!! ?If you think that con men in investing is not a problem, read?On Avoiding Con Men. ?I spend lots of time trying to take apart investment pitches that are bogus, and yet I feel that I am barely scraping the surface.

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Things are rarely as bad as they seem. ?Be willing to be a modest bull most of the time. ?I’m not saying don’t be cautious — of course be cautious! ?Just don’t let that keep you from taking some risk. ?Size your risks to your time horizon for needing cash back, and your ability to sleep at night. ?The biggest risk may not be taking no risk, but that might be the most common risk economically for those who have some assets.

To close, here is a personal comment that might help: I am natively a pessimist, and would easily give into disaster scenarios. ?I had to train myself to realize that even in the worst situations there was some reason for optimism. ?That served me well as I invested spare assets at the bottoms in 2002-3 and 2008-9. ?The sun will rise tomorrow, Lord helping us… so?diversify and take moderate risks most of time.

If All Investments Were Private

Posted on 2 April 20163 April 2016 by David Merkel

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.

If Someone Tries to Sell You, Don’t Buy It

Posted on 19 March 201620 March 2016 by David Merkel

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.

Picturing Pensions

Posted on 11 March 2016 by David Merkel

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:

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.

They Can’t Help You

Posted on 4 March 2016 by David Merkel

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?

Sell a Fraction of Your Home?

Posted on 22 December 201522 December 2015 by David Merkel

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.

The Limits of Risky Asset Diversification

Posted on 11 December 2015 by David Merkel

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…