This book is not what I expected; it’s still very good. Let me explain, and it will give you a better flavor of the book.
The author, Jason Zweig, is one of the top columnists writing about the markets for The Wall Street Journal. ?He is very knowledgeable, properly cautious, and wise. ?The title of the book Ambrose Bierce’s book that is commonly called The Devil’s Dictionary.
There are three differences in style between Zweig and Bierce:
Bierce is more cynical and satiric.
Bierce is usually shorter in his definitions, but occasionally threw in whole poems.
Zweig spends more time explaining the history of concepts and practices, and how words evolved to mean what they do today in financial matters.
If you read this book, will you learn a lot about the markets? ?Yes. ?Will it be fun? ?Also yes. ?Is it enough to read this and be well-educated? ?No, and truly, you need some knowledge of the markets to appreciate the book. ?It’s not a book for novices, but someone of intermediate or higher levels of knowledge will get some chuckles out of it, and will nod as he agrees along with the author that the markets are a treacherous place disguised as an easy place to make money.
As one person once said, “Whoever called them securities had a wicked sense of humor.” ?Enjoy the book; it doesn’t take long to read, and it can be put down and picked up with no loss of continuity.
Quibbles
None
Summary / Who Would Benefit from this Book
If you have some knowledge of the markets, and you want to have a good time seeing the?wholesome image of the markets?skewered, you will enjoy this book. ?if you want to buy it, you can buy it here: The Devil’s Financial Dictionary.
Full disclosure:?The author sent a free copy?to me via his publisher.
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What I am going to write here is half of my summary of how Asset Allocation is done. ?Most of this will be done in the context of personal finance, because it is the most complex case, though this paradigm is sufficiently general that it can be applied to any entity.
Good asset allocation, and financial planning generally, focuses on two main questions:
When will the cash be needed for expenses?
What are the likely returns being offered by asset classes over the planning horizon at every period in which cash will be needed? ?Also, how likely are those returns?
Tonight I am writing about the first question. ?For institutions, there are typically two solutions — there is a spending rule for endowments, whereas for defined benefit pension plans and other types of employee benefit plans, the actuaries will sit down and estimate future cash needs, and when the needs will take place. ?(The same applies to financial institutions, though for institutions with short-term funding?profiles, you won’t typically use actuaries, not that you couldn’t.)
For individuals and families, the issues come down to needs, wants, dreams, and risks. ?As for risks, you can look at the earliest series at my blog, [summary here] which was on personal finance. ?(I never intended to write much on personal finance, and so that was a summary set to get my main ideas out.)
Then comes the hierarchy of expense: needs, wants, and dreams. ?Aim to satisfy each one successively. ?Some people can only afford needs, others can get to wants, and a few others can get to dreams. ?Now, that’s an oversimplification, because many people will reshape their wants and dreams to fit their cost structure. ?Happiness is frequently a choice, rather than an abundance of goods and experiences.
Regardless, once you have a spending goal, and your main risks are covered, then you have something to shoot for, and asset allocation can begin. ?In the process you might come up with a return target to shoot for, which I call?Your Personal Required Investment Earnings Rate. ?The basic idea is this:
Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.? Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.
To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.? Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.? Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].
For more, you can read the article, which has a decent amount on whether return needs are reasonable or not. ?More on this topic when I try to describe setting asset earnings assumptions, which is decidedly more complex. ?Till then.
In general, people don’t do well with amounts of money significantly larger than they are used to handling. ?The most obvious example of that is people who win lotteries. ?The money typically gets wasted — bad purchases, bad investments.
Thus I would encourage you to be very careful with any large distributions of money that you might receive. ?Examples include:
Life insurance settlements
Disability insurance settlements
Structured settlements arising from winning a court case over a tort against you.
Lotteries
Pension lump sums
Inheritances
Big paydays, if you are one of the rare ones in a high-paying short career like entertainment or sports
There are three problems with lump sums — receiving them, investing them, and rate of their use for consumption. ?Let me take these topics in the order that they should occur.
Receiving a Lump Sum
Let’s start with the cases where you have?a stream of payments coming where a third party comes to you and says that you can get all of the money now. ?I am speaking of structured settlements and inheritances where trusts have been structured to dole out the money slowly. ?There is one simple bit of advice here: don’t do it. ?Take the payments over time. ?None of the third parties offering to give you cash now are giving you a good deal, so avoid them.
Then there are the cases where an insurance company is making the payments from a disability claim, a structured settlement, a lottery, a pension buyout, or an annuity that someone bought for you on your life. ?The insurance company will be more fair than any third party, because they aren’t usually looking to make an obscene gain, just a big one, because it reduces their risk, and cleans up their balance sheet, so they can do more business. ?One simple bit of advice here: still don’t do it. ?You can do better by taking payments, and building up money for larger purchases. ?Be patient.
People do best when they receive money little by little. ?When they get money materially faster than the speed at which they have previously earned money, they tend to waste it. ?It is almost always better not to take a lump sum if you have the option to do otherwise.
The last set of situations is when the party that owes the set of payments?offers you a lump sum. ?It could be a life insurance company, a defined-benefit pension plan, a lottery, or some option uncommonly granted by another payor. ?I would still tell you not to do it, but the issue of getting cheated is reduced here for a variety of reasons.
The defined benefit plan has rates set by law at which it can cash you out, so they can’t hurt you badly. ?That said, you will likely not earn enough off of your investments with safety to equal the stream you are giving up. ?The lottery is often similarly constrained, but do your homework, and see what you are giving up.
One place to take the lump sum is with life insurance companies off of a death benefit. ?The rates at which they offer to pay an annuity to you are frequently not competitive, so take the lump sum and invest it wisely.
Economically, the key question to ask on a lump sum versus a stream of payments is what you would have to earn to replicate the stream of payments. ?Most of the time, the stream is worth more than the lump sum, so don’t take the lump sum.
The second question is more important. ?Can you be disciplined and not waste the lump sum? ?Ask those close to you what your money habits are like, if you don’t know for sure. ?Ask them to be brutally honest.
Investing the Lump Sum
Again, one nice thing about taking payments, is that you don’t have to invest the lump sum. ?If you do take the lump sum:
First, pay off high interest rate debts.
Second, avoid buying big things and calling them investments. ?Don’t buy a big house when you don’t need a big one.
Third, don’t invest in any of your relatives’ or friends’ business ventures. ?Tell them you try to keep personal affection and money separate. ?It avoids hurt feelings.
Fourth, look at the time horizon of your real needs. ?Plan for retirement, college, etc. ?Invest accordingly — get a trustworthy adviser who will help you. ?Trustworthiness is the most important factor here, with competence a close second.
Fifth, don’t so it yourself, unless you have developed the skill to do it previously. ?If you want to do it yourself, you will have to gauge whether the various markets are rich or cheap in order to decide where to invest. ?For some general, non-tailored advice, you can look at articles in my asset allocation category. ?As an aside, don’t invest in anything unusual unless you are an expert.
Receiving Spending?Money from Your Investment Fund
The first thing is to decide on a spending rule: many use a rule that says you can take 4% of the assets from the fund. ?My rule is a little more complex, but will keep you safer, and adapt to changing conditions: as a percentage of assets, take 1% more than the yield on the 10-year Treasury Note, or 7% if less. ?At present, that percentage would be 2.21% + 1% = 3.21%.
Whatever rule you use, be disciplined about your spending. ?Don’t bend your spending rule for any trivial reasons. ?Size your budget to reflect your income from your investment fund and all of your other income sources.
Conclusion
Remember that most people who get a lump sum end up wasting a lot of it. ?The only thing that can keep you from a similar fate would be discipline. ?If you don’t have discipline, don’t take a lump sum. ?Take the payments over time. ?That will give you the maximum benefit from what is a very valuable asset.
There was one comment on the article that I would like to highlight. ?Here it is:
The other thing to watch for with retirement spending is not spending enough of your investments, especially in early retirement. Many studies have shown that actual spending in retirement decreases by around 50% from age 55 to age 80. One study in Germany showed that people?s wealth actually started increasing again in their 70?s as their pension incomes exceeded their lifestyle costs, with the resultant increase in savings.
People need to think about this in how they structure their retirement spending. It may make complete sense for someone with a $1 million portfolio and a standard government pension to spend $800,000 of that $1 million by age 80, leaving a $200,000 cushion for the lower cost part of their lives as most of their day-to-day living expenses will be covered by their pension.
People need to spend their money when they are active and mobile and able to enjoy it. I think the financial press needs to talk about this more, so people are not scared into not spending their money until it is too late.
“There is a fine line between over-saving and under-living.”
That particular story dealt with a couple that had been especially frugal, and after not earning all that much, at retirement had $6 million. ?They had a traditional marriage, and the husband handled the money entirely. ?He worked until 72, retired due to incapacity, and on the day of his retirement, he handed his wife a check for $3 million.
She thought it was a joke, so for fun she tried to cash the check. ?To her surprise, the check cleared. ?Then came the bigger surprise — her amazement gave way to anger! ?All the years of self-denial, and they were this well-off! ?There were so many things she denied herself along the way, and now both of them were too old to truly enjoy their riches.
There’s more to the story… the point the author goes for is mostly abut how husbands and wives should learn to cooperate on the shared tasks of household economic management, so that both are on the same page, and they can be agreed on goals and methods.
I agree with that, and would add that the best approach on spending versus saving is what I would call a conservative version of the “middle way.” ?Make sure that you are provident, but balance that with contentment and a happy enjoyment of what you have. ?Life is meant to be lived.
Yes, it is good to be prudent and frugal, but not to the point where you amass a lot of assets and never enjoy them.
[Now for those not crazy about Christianity, you can skip to the end.]
In Ecclesiastes 5:13-20, Solomon says [NKJV]:
There is a severe evil which I have seen under the sun: riches kept for their owner to his hurt. ?But those riches perish through misfortune; when he begets a son, there is nothing in his hand. ?As he came from his mother’s womb, naked shall he return, to go as he came; And he shall take nothing from his labor which he may carry away in his hand. ?And this also is a severe evil? just exactly as he came, so shall he go. And what profit has he who has labored for the wind? ?All his days he also eats in darkness, And he has much sorrow and sickness and anger.
Here is what I have seen: It is good and fitting for one to eat and drink, and to enjoy the good of all his labor in which he toils under the sun all the days of his life which God gives him; for it is his heritage. ?As for every man to whom God has given riches and wealth, and given him power to eat of it, to receive his heritage and rejoice in his labor?this is the gift of God. ??For he will not dwell unduly on the days of his life, because God keeps him busy with the joy of his heart.
Ecclesiastes 4:8 and 6:1-3 say similar things, and are cited by the Larger Catechism in question 142, where it says:
What are the sins forbidden in the eighth commandment?
The sins forbidden in the eighth commandment, besides the neglect of the duties required, are, theft, robbery, man-stealing, and receiving any thing that is stolen; fraudulent dealing; false weights and measures; removing landmarks; injustice and unfaithfulness in contracts between man and man, or in matters of trust; oppression; extortion; usury; bribery; vexatious lawsuits; unjust inclosures and depopulations; engrossing commodities to enhance the price, unlawful callings, and all other unjust or sinful ways of taking or withholding from our neighbor what belongs to him, or of enriching ourselves; covetousness; inordinate prizing and affecting worldly goods; distrustful and distracting cares and studies in getting, keeping, and using them; envying at the prosperity of others; as likewise idleness, prodigality, wasteful gaming; and all others ways whereby we do unduly prejudice our own outward estate, and defrauding ourselves of the due use and comfort of that estate which God hath given us. [Emphasis mine]
Along with questions 140 and 141, they summarize most of what the Bible teaches on ethics in economics. ?My emphasis is the last phrase “defrauding ourselves of the due use and comfort of that estate which God hath given us.”
This may be a surprise to some, but (among other things) God wants us to enjoy life. ?That is not the highest goal, but God commends it through the voice of Solomon in Ecclesiastes multiple times.
Now, not everyone in Christianity thinks this way. ?John Wesley famously said, “Earn all you can. ?Save all you can. ?Give all you can.” ?This is admirable as far as it goes, and Wesley’s life reflected it. ?He was very industrious, frugal, provident and generous. ?But in the middle of his life, he did not purchase?and enjoy some blessings, in an effort to give more to the poor.
Why? ?Black tea was relatively expensive back then, and the lower classes were spending too much of their money on the relative luxury of tea. ?Wesley liked tea a lot, but gave it up for two reasons: to set a good example to the poor, and have more money to give to aid the poor. ?(He also abstained from alcohol, fasted several days a week, and ate cheaply when he did eat.) ?That said, occasionally bothered him that some of the money he gave to the poor got spent by them on tea. ?Oh well. ?With something that is not in itself a sin, it was probably better to let people spend their money as they saw fir, and not discourage them by arguing that tea was a wasteful luxury.
I would amend Wesley and?say it this way, “Earn a?competent amount. ?Save a good portion of it. ?Give to poorer brothers who are ailing, despite doing their best. ?After that, enjoy the blessings God has given you.”
There is a reason why God is portrayed in the Parable of the Lost Son as a generous man who throws a party when his younger son repents of riotous living, while the older son (representing the Pharisees) is portrayed as a miser. ?God is generous, while many religious people get proud of what they have achieved, seemingly apart from God, and resent those who get gifts, while they themselves work. ?This is parallel to salvation, which cannot be purchased no matter how hard we work, but must be received as a gift from Jesus, who did all the work for those who would receive the gift of salvation. ?Echoing that, C. S. Lewis in The Screwtape Letters portrays God as jolly when “the patient” gets a girlfriend, while the demon Screwtape boasts of the grand austerity of Hell.
Closing this section, I would simply say take care of all your other obligations to God, but if God has given you something legitimate to enjoy, then enjoy it, and don’t feel guilty. ?Rather, take the opportunity to thank and praise God for the blessings he brings.
Conclusion
Assets and money are tools. ?They are valuable, but they are a means to an end. ?Use them to enjoy life, while being prudent as you do so.
Investing is difficult. That said, it can be harder still. Let people with little to no training to try to do it for themselves. Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell. They get there late, and then their emotions trick them into action. A rational investor would say, ?Okay, I missed that move. Where are opportunities now, if there are any at all??
Investing can be made even more difficult. ?Investing reaches its most challenging level when one relies on his investing to meet an anticipated and repeated need for cash outflows.
Institutional investors will say that portfolio decisions are almost always easier when there is more cash flowing in than flowing out. ?It means that there is one dominant mode of thought: where to invest?new money? ?Some attention will be given to managing existing assets ? pruning away assets with less potential, but the need won?t be as pressing.
1) The retiree doesn?t know how long he, his spouse, and anyone else relying on him will live. ?Averages can be calculated, but particularly with two people, the odds are that at least one will outlive an average life expectancy. ?Can they be conservative enough in their withdrawals that they won?t outlive their assets?
It?s tempting to overspend, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs. ?It is incredibly difficult to?avoid paying for an immediate pressing need, when the soft cost?is harming your future. ?There is every incentive to say, ?We?ll figure it out later.? ?The odds on that being true will be low.
2) One conservative estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%. ?That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero near the end of a bull market.
That said, most?people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets. ?At present, if interest rates don?t go lower still, that will likely (60-80% likelihood) work. ?But if income needs are greater than that, the odds of obtaining those yields over the long haul go down dramatically.
3) How does a retiree deal with bear markets, particularly ones that occur early in retirement? ?Can?he and?will he reduce his expenses to reflect the losses? ?On the other side, during bull markets, will he build up a buffer, and not get incautious during seemingly good times?
This is an easy prediction to make, but after the next bear market, look for a scad of ?Our retirement is ruined articles.? ?Look for there to be hearings in Congress that don?t amount to much ? and if they?do amount to much, watch them make things worse by?creating R Bonds, or some similarly bad idea.
Academic risk models typically used by financial planners typically don?t do path-dependent analyses.? The odds of a ruinous situation is far higher than most models estimate because of the need for withdrawals and the autocorrelated nature of returns ? good returns begets good, and bad returns beget bad in the intermediate term.? The odds of at least one large bad streak of returns on risky assets during retirement is high, and few retirees will build up a buffer of slack assets to prepare for that.
4)?Retirees should avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield ? it?is the oldest scam in the books. ?This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc. ?They have no guaranteed return of principal. ?On the plus side, they may give capital gains if bought at the right time, when they are out of favor, and reducing exposure when everyone is buying them.? Negatively, all junior debt tends to return worse on average than senior debts.? It is the same for equity-like investments used for income investing.
Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because many people are buying them as if they are magic. ?The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.
5) Leaving retirement behind for a moment, consider the asset accumulation process.? Compounding is trickier than it may seem. ?Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years). ?Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.
Thus, in one sense, there is no benefit much from a general rise in values from the stock or bond markets. ?The value of a portfolio may have risen, but at the cost of lower future opportunities. ?This is more ironclad in the bond market, where the cash flow streams are fixed. ?With stocks and other risky investments, there may be some ways to do better.
Retirees should be aware that the actions taken by one member of a large cohort of retirees will be taken by many of them.? This makes risk control more difficult, because many of the assets and services that one would like to buy get bid up because they are scarce.? Often it may be that those that act earliest will do best, and those arriving last will do worst, but that is common to investing in many circumstances.? As Buffett has said, ?What a?wise man?does in the beginning a?fool?does in the?end.?
6) Retirement investors should avoid taking too much?or too little risk. It?s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree. ?If a person can do that successfully, he is rare.
What is achievable by many is to maintain a constant risk posture. ?Don?t panic; don?t get greedy ? stick to a moderate asset allocation through the cycles of the markets.
7) With asset allocation, retirees should overweight out-of-favor asset classes that offer above average cashflow yields. ?Estimates on these can be found at GMO or?Research Affiliates. ?They should rebalance into new asset classes when they become cheap.
Another way retirees can succeed would be investing in growth at a reasonable price ? stocks that offer capital growth opportunities at an inexpensive price and a margin of safety. ?These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into. ?This is harder to do than it looks. ?More companies look promising and do not perform well than those that do perform well.
Yet another way to enhance returns is value investing: find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that. ?After the companies do well, reinvest in new possibilities that have better appreciation potential.
8 ) Many say that the first rule of markets is to avoid losses. ?Here are some methods to remember:
Always seek a margin of safety. ?Look for valuable assets well in excess of debts, governed by the rule of law, and purchased at a bargain price.
For assets that have fallen in price, don?t try to time the bottom ? buy the asset when it rises above its 200-day moving average. This can limit risk, potentially buying when the worst is truly past.
Conservative investors avoid the areas where the hot money is buying and own assets being acquired by patient investors.
9) As assets shrink, what should be liquidated? ?Asset allocation is more difficult than it is described in the textbooks, or in the syllabuses for the CFA Institute or for CFPs.? It is a blend of two things ? when does the investor need the money, and what asset classes offer decent risk adjusted returns looking forward?? The best strategy is forward-looking, and liquidates what has the lowest risk-adjusted future return. ?What is easy is selling assets off from everything proportionally, taking account of tax issues where needed.
Here?s another strategy that?s gotten a little attention lately: stocks are longer assets than bonds, so use bonds to pay for your spending in the early years of your retirement, and initially don?t sell the stocks.? Once the bonds run out, then start selling stocks if the dividend income isn?t enough to live on.
This idea is weak.? If a person followed this in 1997 with a 10-year horizon, their stocks would be worth less in 2008-9, even if they rocket back out to 2014.
Remember again:
You don?t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities.
That goes double in the distribution phase. The objective is to convert assets into a stream of income. ?If interest rates are low, as they are now, safe income will be low. ?The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.
Don?t look at current income. ?Look instead at the underlying economics of the business, and how it grows value. ?It is far better to have a growing income stream than a high income stream with low growth potential.
Deciding what to sell is an exercise in asset-liability management.? Keep the assets that offer the best return over the period that they are there to fund future expenses.
10) Will Social Security take a hit out around 2026? ?One interpretation of the law says that once the trust fund gets down to one year?s worth of?payments, future payments may get reduced to the level?sustainable by expected future contributions, which is 73% of expected levels. ?Expect a political firestorm if this becomes a live issue, say for the 2024 Presidential election. ?There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.
Even if benefits last at projected levels longer than 2026, the risk remains that there will be some compromise in the future that might reduce benefits because taxes will not be raised.? This is not as secure as a government bond.
11) Be wary of inflation, but don?t overdo it. ?The retirement of so many people may be deflationary ? after all, look at Japan and Europe so far. ?Economies also work better when there is net growth in the number of workers. ?It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.
Also consider other risks, and how assets may fare. ?Retirees should analyze what exposure they have to:
Deflation and a credit crisis
Expropriation
Regulatory change
Trade wars
Changes in taxes
Asset illiquidity
Reductions in reimbursement from government programs like Medicare, Medicaid, etc.
And more?
12) Retirees need a defender of two against slick guys who will try to cheat them when they are older. ?Those who have assets are a prime target for scams. ?Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make assets stretch further. ?But there are other scams as well ? retirees should run everything significant past a smart younger person who is skeptical, and knows how to say no when it is necessary.
Conclusion
Some will think this is unduly dour, but this?is realistic. ?There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.
Even with skilled advisers helping, retirees need to be ready for the hard choices that will come up. They should think through them earlier rather than later, and take some actions that will lower future risks.
The basic idea of retirement investing is how to convert present excess income into a robust income stream in retirement. ?Managing a pile of assets for income to live off of is a challenge, and one that most people?are not geared up for, because poor planning and emotional decisions lead to subpar results.
Retirees should?aim for the best future investment opportunities with a margin of safety, and let the retirement income take care of itself. ?After all, they can?t rely on the markets or the policymakers to make income opportunities easy.
Before I start on this tonight, let me say that I never begrudge any salesman a fair commission. ?When I was a bond manager, I made a point of never letting my brokers “cross bonds” to me, i.e., at no commission. ?I would raise my purchase price a little to compensate them. ?Had my client known that I did that, he might have objected, but it was in his best interests that I did it. ?As a result of that and other things that I did, my brokers were very loyal to me, and worked to give my client excellent executions whether buying or selling. ?They were also more frank with me about bonds they thought I should sell. ?Fairness begets fairness under most conditions, and suspicion and tightness also have their way of breeding as well. ?Consider that in all of your dealings.
My main reason for writing tonight is to remind investors to think about how the parties you transact with are compensated.
If they are compensated on?transactions, expect to see a lot of buying and selling.
If they are compensated on asset-based fees, expect them to try to get business, and then retain it.
If they are compensated on profits, they will try to get profits. ?Be wary of how much control they might have over the accounting, they will be incented to be liberal if they have any control. ?They will also be incented toward volatility, because volatile assets offer the best possibility of a big score, even if the probability is moderate at best.
The greater the potential compensation, the greater the tendency to act along the incentives offered. ?As a result, if a life insurance salesman has a product offering a high commission, and one offering a low commission, he may act in the following way:
Figure out if you are price-sensitive or not.
Figure out if you are willing to accept a product that has a long surrender charge. ?Long surrender charges lock in business, and allow for high commissions to be paid.
Also analyze how much complexity you are willing to accept — more complex permanent policies and especially ancillary riders are far more profitable because even external actuaries would have a tough time analyzing them.
If you are price-sensitive, bring out the low commission policy that is more competitive.
If you are price-insensitive, bring out the high?commission policy that is less?competitive.
(Note: there are state laws in every state that constrain this behavior for life insurance agents, but it can never be eliminated in entire.)
Now, many agents will act in your interests in spite of their own interests, but some won’t, so be aware. ?Always ask a question like, “This seems expensive. ?Don’t you have another policy that is less expensive that accomplishes only the main goal that I am shooting for?”
You could always ask them what commission is that they will earn. ?Most won’t answer that. ?First, it’s kind of offensive, and second, they will argue that it is not material to your decision.
But it is material to your decision. ?Here’s why:
The size of the commission directly affects the size of the premium that you pay.
It also directly affects?the length and size of the surrender charge that you would pay if you terminate the policy early.
After all, the actuaries or other mathematical businessmen are trying to avoid the risk of paying a commission that they can’t recover under ALL circumstances. ?They will get their fees from you to recoup the commission cost. ?They will either get it from you coming or going, but they WILL?get it from you, at least on average.
If the?salesmen?disagree with you after mentioning this (or showing them this), you can say to them that every actuary knows this is true, don’t argue with the actuaries, they know the math. ?(And its why we tend to buy term and other simple policies. ?Shhh.)
I’ve seen more than my share of ugly products in my time. ?I’m happy I never designed any. ?I did kill a few of them. ?That said, one of the most unpleasant duties I ever had as a life actuary was about 18 years ago when I inherited a department to clean up, and I got the responsibility of talking to the clients that were the most irate, demanding to talk to the man in charge. ?I never created those products, but I was nominally in charge of the division as I cleaned up the pricing, reinsurance, reserving, accounting, and asset-liability management.
I’ll tell you, it is no fun talking to people who conclude that they have been had. ?It is even less fun to be the one who has been had. ?Thus I would tell you to view all salesmen of financial with skepticism. ?It is hard to assure a good result with intangible products that are hard to compare. ?Thus aim for simplicity and lower surrender charge and commission products.
Now, I used life insurance as my example here because I know it best, and it excels in complexity. ?But this applies to all financial products, especially illiquid ones. ?Be wary of:
Brokers who make money off of commissions
Those who sell private REITs and structured notes
Any product where you have a limited ability to liquidate or sell it.
Any product that you can’t understand how the company and salesman are making money off it.
Any product where you can’t understand what the legal form of the investment is (Stock, bond, mutual fund, partnership, derivative, insurance, etc.)
Here are some final bits of advice:
Look for advisers who are fiduciaries, and are responsible to look out for your interests (but still be wary)
Look at the fee structures, and look for lower cost alternatives.
Remember, regardless of what laws exist, you are your own best defender when it comes to your own economic interests. ?Be aware of the economic incentives of those who seek your business with financial products, and be reasonably skeptical.
This financial book is different from the 250+ other financial books that I have reviewed, and the hundreds of others I have read. ?It tells real life stories that the author has personally experienced, and the financial ramifications that happened as a result. ?Each?of the 60+ stories illustrates a significant topic in financial planning for individuals and families. ?Some end happy, some end sad. ?There are examples from each of the possible outcomes?that can result from people interacting with financial advice (in my rough large to small probability order):
Followed bad advice, or ignored good advice, and lost.
Followed good advice, and won.
A mixed outcome from mixed behavior
Followed bad advice, or ignored good advice, and won anyway.
Followed good advice, and lost anyway.
The thing is, there is a “luck” component to finance. ?People don’t know the future behavior of markets, and may accidentally get it right or wrong. ?With good advice, the odds can be tipped in their favor, at least to the point where they aren’t as badly hurt when markets get volatile.
The stories in the book mostly stem from the author’s experience as a financial advisor/planner in Maryland. ?The stories are 3-6 pages long, and can be read one at a time with little loss of flow. ?The stories don’t depend on each other. ?It is a book you can pick up and put down, and the value will be the same as for the person who reads it straight through.
In general, I thought the author advocated good advice for his clients, family and friends. ?Most people could benefit from reading this book. ?It’s pretty basic, and maybe, _maybe_, one of your friends who isn’t so good with financial matters could benefit from it as a gift if you don’t need it yourself. ?The reason I say this is that some people will learn reading about the failures of others rather than being advised by well-meaning family, friends, and professionals. ?They may admit to themselves that they?have been wrong when they be unwilling to do it with others.
I recommend this book for readers who need motivation and knowledge to guide themselves in their financial dealings, including how to find a good advisor, and how to avoid bad advisors.
Quibbles
The book lacks generality because of its?focus on telling stories. ?It would have been a much better book if it had one final chapter or appendix where the author would take all of the lessons, and weave them into a coherent whole. ?If nothing else, such a chapter would be an excellent review of the lessons of the book, and could even footnote back to the stories in the book for where people could read more on a given point.
I know this is a bias of mine regarding books with a lot of unrelated stories, but I think it is incumbent on the one telling the stories to flesh out the common themes, because many will miss those themes otherwise. ?In all writing, specifics support generalities, and generalities support specifics. ?They are always stronger together.
An Aside
I benefited from the book in one unusual way: it gave me a lot of article ideas, which you will be reading about at Aleph Blog in the near term. ?I’ve never gotten so many from a single book — that is a strength of reading the ideas in story form. ?It can catch your imagination.
Summary / Who Would Benefit from this Book
You don’t need this book if you are an expert or professional in finance. ?You could benefit from this book?if you want to improve what you do financially, improve your dealings with your financial advisor, or get a good financial advisor. ?if you want to buy it, you can buy it here: Financial Tales.
Full disclosure:?The author sent a free copy?to me directly. ?Though we must live somewhat near to one another, and we both hold CFA charters, I do not know him.
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.
I have my list of concerns for the economy and the markets:
Unexpected Global Macroeconomic Surprises, including more from China
Student Loans, Agricultural Loans, Auto Loans — too much
Exchange Traded Products — the tail is wagging the dog in some places, and ETPs are very liquid, but at a cost of reducing liquidity to the rest of the market
Low risk margins — valuations for equity and debt are high-ish
Demographics — mostly negative as populations across the globe age
Wages in the “developed world” are getting pushed to the levels of the “developing world,” largely due to the influence of information technology. ?Also, technology is temporarily displacing people from current careers.
This is worth watching. ?It seems like there isn’t that much advantage to corporate borrowing now — the arbitrage of borrowing to buy back stock seems thin, as does borrowing to buy up competitors. ?That doesn’t mean it is not being done –?people imitate the recent past as a useful shortcut to avoid thinking. ?Momentum carries markets beyond equilibrium as a result.
If the Federal Reserve stimulates by duping getting economic actors to accelerate current growth by taking on more debt, it has worked here. ?Now where is leverage low? ?Across the board, debt levels aren’t far from where they were in 2008:
As such, I’m not sure where we go from here, but I would suggest the following:
Start lightening up on bonds and stocks that would concern you if it were difficult to get financing. ?How well would they do if they had to self-finance for three years?
Fiscal policy will remain riven by disagreements, and hamstrung by rising entitlement spending.
Long Treasuries don’t look bad with inflation so low.
Leave a little liquidity on the side in case of a negative surprise. ?When everyone else has high debt levels, it is time to reduce leverage.
Better safe than sorry. ?This isn’t saying that the equity markets can’t go higher from here, that corporate issuance can’t grow, or that corporate spreads can’t tighten. ?This is saying that in 2004-2006, a lot of the troubles that were going to come were already baked into the cake. ?Consider your current positions carefully, and develop your plan for your future portfolio defense.
Unlike many commentators, I tend to think credit scores are a good thing. In a big world, it is difficult for large financial institutions to figure out the most import “C” of the four Cs of Credit — Character. ?Credit scores offer an imperfect but generally useful shortcut in what is often an anonymous world.
In my last article on the topic, I noted that in addition to lending, credit scores are used in renting, insurance, employment, and a wide number of other areas. ?One new place where credit scores could prove useful is analyzing a prospective spouse. ?An academic paper suggests the following:
Birds of a feather flock together — in general, people tend to enter into long-term relationships?those?with similar credit scores.
Relationships?with higher credit scores tend to last longer.
Those with larger gaps in the credit scores have a higher probability of the relationship ending sooner.
Though the paper is more broad than marriage, I am going to shift over to marriage for the rest of this article. ?Why? ?Every now and then, I get called in to do marriage counseling, typically along with my pastor and fellow elders. ?I’m not perfect, so my marriage isn’t perfect, but it is very good.
Marriages tend to fail because the husband and wife disagree on goals or methods for the partnership that they have entered into. ?Common disagreements and problems involve:
Money
Sex
Children — number, methods of raising
Lack of companionship — shared goals, responsibilities, etc.
Bad communication patterns
Sins that need to be repented of — anger & abuse, adultery & related, laziness, substance abuse,?disdain, lying, etc.
And more — there are more ways to get it wrong than to get it right, just as there are more wrong answers on tests than right answers.
I’m only going to handle the money issue here, though laziness, lying, bad communication, and lack of clearly specifying and agreeing to goals play a large role in money problems. ?Going back to my earlier article on credit scores, you might recall that I said that credit scores were a moderately accurate measure of moral tendency on average. ?Quoting:
Honoring agreements that you have entered into is an important indicator of your personality.? Those who do not repay are on average less moral than those that repay.? Those that are net creditors on average made efforts that net debtors did not.
Credit scores are important.? In a specific way, they measure your willingness to keep your word.? Anytime you enter into a debt contract, you make a promise to repay.? If you fulfill your promise to repay, you impress others as one of good moral character.? If you don?t repay, it is vice-versa, you appear to be of low moral character.? (Note: I am excluding those that got hoodwinked by lenders that defrauded borrowers in a variety of ways.? That said, if you can be hoodwinked, that says something else about you, and that may have an impact on your creditworthiness as well.)
Now, before I continue, these concepts work on average, and not always in particular.? I have helped some at the edge of society with gifts and loans.? In some cases there is a cascade of bad events that the most intelligent would have a hard time facing.? Being wise helps, but there are some situations that would tax the soul of anyone, and be difficult to claim that they were blameworthy; it?s just the way things happened.
The “keeping your word” part is important for marriage. ?After all, marriage begins with a simple public promise of mutual fidelity between a man and a woman. ?If you can’t keep your word in one area, i.e., paying off a debt, your ability to keep your word in another area, marital fidelity, may be less likely as well. ?As such, it shouldn’t be too surprising that those with higher credit scores tend to have longer lasting relationships on average. ?They keep their word better, and will tend to have fewer money problems, because they manage their finances well.
As for the couples that have dramatically different credit scores between the two of them, there is the possibility that the more responsible one will get fed up with the lack of discipline on the part of his/her spouse. ?Or, the one with less self-controlled spouse will grow to disdain the one trying to bring order. ?If not handled properly, it can lead to a breakup — no one wants to feel their resources are being wasted, and no one likes constant criticism.
No Determinism Here
For those that do have difficulties here, I can tell you that you can change. ?It is not a question of ability, but of willingness to do so. ?The same is true in saving any marriage. ?Ask, “Is this the way I wanted things to end up? ?Didn’t I have better goals than this?” ?and then get to: “Am I willing to give up my bad habits, my purely personal interests, my pride, for the good of my spouse? ?Am I willing to work in the best interests of the both of us, even if I don’t get everything I want?”
Tough stuff. ?It’s a wonder that any marriages hang together. ?But change is possible, and it usually begins with a shared commitment to agree on goals, execute those goals faithfully, leaving behind laziness, overspending and over-committing (taking on too much debt). ?Dave Ramsey and many others are good counselors in this area.
If you have never budgeted before, it will be time to do so. ?Again, there are many good guides on the Internet, and at bookstores. ?Find one that fits your personality and go with it. ?(I have never kept a budget in my life, so I would have a hard time advising there. ?I don’t spend much on myself, and neither does my wife.)
Telling you that you can raise your credit score is superfluous. ?That’s a symptom, not the disease. ?If you manage household finances well, and keep your word on paying debts on time, that will take care of itself. ?The harder thing is changing the bad habits of spending incautiously.
Now, in the short run, for couples where the two parties are different with willingness to manage money well, there is another solution if both parties are willing to do it. ?The one that is less disciplined with money should cede management of finances to the one that is more disciplined. ?The one that is more?disciplined then gives the one that is less disciplined a regular allowance (mutually agreed upon). ?To husbands I would add that if the wife is the one who is better the money, cede that to her, and don’t let your pride get in the way. ?Be grateful that you have a bright and responsible wife, and take delight in it. ?Far better to have an orderly and well-run household than to have a household that is failing.
This is up to?both parties to the marriage to make it work. ?It is easy to be selfish, and hard to accept the fact that we are flawed in the way that we handle relationships. ?Once humility comes (something that I need too), and communication improves, then real progress can be made in repairing household finances, and hopefully bigger things as well — life isn’t all about money. ?But when money is badly handled, it is an engine of relationship destruction.
Thus, if you have money problems in marriage, choose wisely, be humble and unselfish, and do what is best for the one that you pledged to love till death do you part.
Both articles are exercises in understanding the time horizon over which you invest. ?If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets.
Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell. ?Some people don’t have much choice in the matter. ?They have retired, and they have a lump sum of money that they are managing for long-term income. ?No more money is going in, money is only going out. ?What can you do?
You have to plan before volatility strikes. ?My equity only clients had 14% cash before the recent volatility hit. ?Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened. ?That flexibility was built into my management. ?(If the market recovers enough, I will rebuild the buffer. ?Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.)
If an older investor would be?hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term. ?With a higher level of bonds in the portfolio, he could more than?proportionately draw down on bonds during a crisis, which would rebalance his portfolio. ?If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then. ?That also would rebalance the portfolio.
Again, plans like that need to be made in advance. ?If you have no plans for defense, you will lose most wars.
One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time. ?When the time for converting assets to cash is far distant, using a single point may be a decent approximation. ?When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi)?Monte Carlo simulations, and sensitivity analyses are done must reflect that.
Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement. ?The same would apply to an early spike in inflation rates followed by deflation.
The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation?analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes. ?If it doesn’t include the Great Depression, it is not realistic enough. ?Run them forwards, backwards, upside-down forwards, and upside-down backwards. ?(For the upside-down scenarios normalize the return levels to the right side up levels.) ?The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions. ?History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner.
You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time. ?Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there.
One more note: and I know how to model this, but most won’t — in the Great Depression, the returns after 1931 weren’t bad. ?Trouble is, few were able to take advantage of them because they had already drawn down on their investments. ?The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns. ?They had to be lower, because many people could not hold their investments for the eventual recovery. ?Part of that was margin loans, part of it was liquidating assets to help tide over unemployment.
It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low. ?That’s not all that much different than some had to do in the recent financial crisis. ?Now, who is willing to throw *that* into financial planning models?
The simple answer is to be more conservative. ?Expect less from your investments, and maybe you will get positive surprises. ?Better that than being negatively surprised when older, when flexibility is limited.
