Personal Finance – Page 8

From Stream to Shining Stream

Posted on 11 April 201512 April 2015 by David Merkel

There’s one thing that is a misunderstanding about retirement investing. It’s not something that is out-and-out wrong. It’s just not totally right.

Many think the objective is to acquire a huge pile of assets.

Really, that’s half of the battle.

The true battle is this: taking a stream of savings, derived from a stream of income, and turning it into a robust stream of income in retirement.

That takes three elements to achieve: saving, compounding, and distribution.

What’s that, you say? ?That’s no great insight?

Okay, let me go a little deeper then.

Saving is the first skirmish. ?Few people develop a habit of saving when they are relatively young. ?Try to make it as automatic as possible. ?Aim for at least 10% of income, and more if you are doing well, particularly if your income is not stable.

Don’t forget to fund a “buffer fund” of 3-6 months of expenses to be used for only the following:

Emergencies
Gaining discounts for advance payment (if you know you have future income to replenish it)

The savings and the “buffer fund” provide the ability to enter into the second phase, compounding. ?The buffer fund allows the savings to not be invaded for current use so they can be invested and compound their value into a greater amount.

Now, 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, 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. ?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.

1) With asset allocation, overweight out-of-favor asset classes that offer above average cashflow yields. ?Estimates on these can be found at GMO or Research Affiliates. ?Rebalance into new asset classes when they become cheap.

2) Growth at a reasonable price investing: invest in stocks that offer capital growth opportunities at a 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.

3) 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. ?As your companies do well, reinvest in new possibilities that have better appreciation potential.

4) Distressed investing: in some ways, this can be?market timing, but be willing to take risk when things are at their worst. ?That can mean investing during a credit crisis, or investing in countries where conditions are somewhat ugly at present. ?This applies to risky debt as well as stocks and hybrid instruments. ?The best returns come out of investing near the bottom of a?panic. ?Do your homework carefully here.

5) Avoid losses. ?Remember:

Margin of safety. ?Valuable asset well in excess of debts, rule of law, and a bargain price.
In dealing with distress, don’t try to time the bottom — maybe use a 200-day moving average rule to limit risk and invest when the worst is truly past.
Avoid the areas where the hot money is buying and own assets being acquired by patient investors.

Adjust your portfolio infrequently to harvest things that have achieved their potential and reinvest in promising new?opportunities.

That brings me to the final skirmish, distribution.

Remember when I said:

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.

Also consider the risks you may face, and how your assets may fare. ?How are you exposed to risk?from:

Inflation
Deflation and a credit crisis
Expropriation
Regulatory change
Trade wars
Etc.

And, as you need, liquidate some of the assets that offer the least future potential for your use. ?In retirement, your buffer might need to be bigger because the lack of wage income takes away a hedge against unexpected expenses.

Conclusion

There are other issues, like taxes, illiquidity, and so forth to consider, but this is the basic idea on 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.

Be wise and?aim for the best future opportunities with a margin of safety, and let the retirement income take care of itself. ?After all, you can’t rely on the markets or the policymakers to make income opportunities easy. ?Choose wisely.

Like a Cardinal, The Price Action Will Be Red

Posted on 21 January 201521 January 2015 by David Merkel

Okay, let’s roll the promoted stocks scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 1/20/15	Decline	Annualized	Dead?
GTXO	5/27/2008	2.45	0.011	-99.6%	-55.6%
BONZ	10/22/2009	0.35	0.000	-99.9%	-72.5%
BONU	10/22/2009	0.89	0.000	-100.0%	-82.3%
UTOG	3/30/2011	1.55	0.000	-100.0%	-92.0%	Dead
OBJE	4/29/2011	116.00	0.069	-99.9%	-86.3%	Dead
LSTG	10/5/2011	1.12	0.004	-99.7%	-82.5%
AERN	10/5/2011	0.0770	0.0000	-100.0%	-93.4%	Dead
IRYS	3/15/2012	0.261	0.000	-100.0%	-100.0%	Dead
RCGP	3/22/2012	1.47	0.003	-99.8%	-89.5%
STVF	3/28/2012	3.24	0.360	-88.9%	-54.2%
CRCL	5/1/2012	2.22	0.004	-99.8%	-90.2%
ORYN	5/30/2012	0.93	0.013	-98.6%	-80.1%
BRFH	5/30/2012	1.16	0.466	-59.8%	-29.2%
LUXR	6/12/2012	1.59	0.002	-99.9%	-92.3%
IMSC	7/9/2012	1.5	0.910	-39.3%	-17.9%
DIDG	7/18/2012	0.65	0.003	-99.6%	-89.1%
GRPH	11/30/2012	0.8715	0.021	-97.6%	-82.5%
IMNG	12/4/2012	0.76	0.010	-98.7%	-86.9%
ECAU	1/24/2013	1.42	0.000	-100.0%	-98.4%
DPHS	6/3/2013	0.59	0.003	-99.5%	-96.0%
POLR	6/10/2013	5.75	0.001	-100.0%	-99.5%
NORX	6/11/2013	0.91	0.008	-99.1%	-94.7%
ARTH	7/11/2013	1.24	0.200	-83.9%	-69.7%
NAMG	7/25/2013	0.85	0.013	-98.5%	-94.1%
MDDD	12/9/2013	0.79	0.022	-97.2%	-95.9%
TGRO	12/30/2013	1.2	0.056	-95.3%	-94.5%
VEND	2/4/2014	4.34	0.655	-84.9%	-86.1%
HTPG	3/18/2014	0.72	0.008	-98.9%	-99.5%
WSTI	6/27/2014	1.35	0.150	-88.9%	-97.9%
APPG	8/1/2014	1.52	0.035	-97.7%	-100.0%

	1/20/2015		Median	-99.3%	-89.8%

It is truly amazing how predictable the losses are from promoted stocks, and that is why you should never buy them. Today’s loser-in-waiting is Cardinal Resources [CDNL]. ?The promoters purport that this company will provide cheap clean fresh water to the world, and will make a fortune off of that. ?Now let’s look at some facts:

What commends this stock to you? ?Is it:

That it has never earned any money?
That the firm has had a negative net worth for the last four years?
That their auditors doubted on the last 10-K that this company would be a “going concern?”
That the company 12 months ago was known as JH Designs, which was in?the “home staging and interior design services business?”
That the writers of the promotion got paid $30,000 to write the speculative fiction of the promotion?
That affiliated shareholders of CDNL paid another $670,000 to publish speculative fiction about the company to unwitting people in an effort to raise the stock price, so that they can sell their shares?

Here, have a look at part of the disclaimer written in five-point type on the glossy ad they sent me in the mail:

Resources Kingdom Limited was paid by non-affiliate shareholders who fully intend to sell their shares without notice into this Advertisement/market awareness campaign, including selling into increased volume and share price that may result from this Advertisement/market awareness campaign. The non-affiliate shareholders may also purchase shares without notice at any time before, during or after this Advertisement/market awareness campaign. Non-affiliate shareholders acted as advisors to Resources Kingdom Limited in this Advertisement and market awareness campaign, including providing outside research, materials, and information to outside writers to compile written materials as part of this market awareness campaign.

Thus, we know who is sponsoring and profiting from this scam. ?It is existing shareholders who want to sell. ?I can tell you with certainty that you should not buy this, and that if you own it, you should sell it. ?There is one significant party that implicitly agrees with that assessment — the company itself, which issued shares at a price of ten cents per share in 2014, according to the recent 10-Q, if you look at the balance sheet and cash flow statements.

Avoid this company, and avoid all situations where stocks are promoted. ?They are bad news for all investors. ?Good investments never need promotion.

Living in the Land of Worries, Part 1

Posted on 3 January 20154 January 2015 by David Merkel

There is always a reason to worry, and always enough time to panic.

Look over there, behind that bush: interest rates are rising. In Europe and China, deflation is threatening. The geopolitical situation is in many ways tense over Russia and Middle East issues. Japan is a mess. Emerging markets will get hit when the Fed starts to tighten.

I could go on, and talk about the longer term demographic problems that we face, and other aspects of lousy government policy, but it would get too long. The point is, there are things that you can worry about. But what should you do?

For many people, worry paralyzes. If there are significant potential problems, they won’t invest, or they will keep their investments very simple and safe. They may fall prey to those who scam by offering “safety” though gold, guns, food storage, life insurance products, etc. Is there a better way to avoid worry?

The first way to avoid worry is to realize that more things can go wrong than do go wrong. Many of the things you might worry about will not happen. Second, even when things do go wrong, the market prices often reflect those possibilities, so the markets may not react badly. Third, the markets have endured many crises in the past and have come back from those crises. Fourth, in the worst crises you can imagine, it will not matter what you do if those take place — you will lose a lot, but so will everyone else. If no strategy can work in the worst problems, you should spend your time praying rather than worrying.

Some might say to me, “But I don’t want to lose a lot of money! I’m relying on it for my retirement (or whatever).” If that is your problem, the answer is simple — invest less in risk assets. Give up some potential return so that you can sleep at night. That has been my advice to a bunch of pastors who generally don’t understand the markets at all. We offer them blended portfolios of risky and safe assets ranging from low volatility to the volatility level of the stock market. I tell them to look at what the blended portfolios have lost in 2008, and size the risk of their holdings to what they can live with in terms of risk if they had to liquidate at a bad time. If they are still squeamish, I tell them to take the risk level down another notch.

There is a risk to not taking enough risk, and that will be the point of part 2, but it is better for the squeamish to implement a sub-optimal plan than no plan. It is also better for the squeamish to implement a sub-optimal plan than a plan that they can’t maintain, because they get too scared.

Solutions have to be real-world to meet people where they are. After that, maybe we can try to teach people not to worry, but human nature is difficult to change.

PS — for any that might say that they are worried that they aren’t going to earn enough to be able to retire or stay comfortably retired, part 2 will have something to say there as well.

Learning from the Past, Part 2

Posted on 2 January 201516 February 2015 by David Merkel

Happy New Year to all of my readers. May 2015 be an enriching year for you in all ways, not just money.

This is a series on learning about investing, using my past mistakes as grist for the mill. ?I have had my share of mistakes, as you will see. ?The real question is whether you learn from your mistakes, and I can say that I mostly learn from them, but never perfectly.

In the early 90s, I fell in with some newsletter writers that were fairly pessimistic. ?As such, I did not do the one thing that from my past experience that I found I was good at: picking stocks. ?Long before I had money to invest, I thought it was a lot of fun to curl up with Value Line and look for promising companies. ?Usually, I did it well.

But I didn’t do that in that era. ?Instead, I populated my portfolio with international stock and bond funds, commodity trading funds, etc., and almost nothing that was based in?the USA. ?I played around with closed-end funds trying to see if I could eke alpha out of the discounts to NAV. ?(Answer: No.) ?I also tried shorting badly run companies to make a profit. ?(I succeeded minimally, but that was the era, not skill.)

I’ve been using my tax returns from that era to prompt?my memory of what I did, and the kindest thing I can say is that I?didn’t have a consistent strategy, and so my results were poor-to-moderate. ?I made money, just not much money. ?I even manged to buy the Japanese equity market on the day that it peaked, and after many months got out with a less-than-deserved 3% loss in dollar terms because of offsetting currency movements.

One thing I did benefit from was learning about a wide number of investing techniques and instruments, which benefited me professionally, because it taught me about the broader context of investing. ?That said, it cost time, and some of what I learned was marginal.

But not having a good overall strategy largely means you are wasting your time in investing. ?You may succeed for a while with what some call luck, but luck by its nature is not consistent.

Thus, I would encourage all of my readers to adopt an approach that fits their:

Knowledge
Personality
Available time

You have to do something that you truly understand, even if it is hiring an advisor, wealth manager, etc. ?You must be able to understand the outer edges of what they do, or how will you evaluate whether they are serving you well or not? ?Honesty, integrity, and reputation can go a long way here, but it really helps to know the basics.

Picking fund managers is challenging enough. ?How much of their good performance was due to:

their style being in favor
new cash flows in pushing up the prices of the assets that they like to buy
a few good ideas that won’t be repeated
a clever aide that is about to leave to set up his/her own shop
temporary alignment with the macroeconomic environment
or skill?

Personality is another matter — some people don’t learn patience, which cuts off a number of strategies that require time to work out. ?Few things also work right off the bat, so even a good strategy might get discarded by someone expecting immediate results.

Time is another factor which I will take up at a later point in this series. ?The best investment methods out there are no good for you unless you can make them fit into the rest of your life which often contains the far more important things of family, recreation, faith, learning, etc. ?It’s no good to be a wealthy old miser who never learned to appreciate life or the goodness of God’s providence in life.

And so to that end, I say choose wisely. ?My eventual choice was value investing, which isn’t that hard to learn, but requires patience, but can scale to the time that you have. ?For those that work in a business, it has the side-benefit that it is the most businesslike of all investment methods, and can make you more valuable to the firm that you work for, because you can learn to marry business sense with your technical expertise, potentially leading to greater profit.

For me, I can say that it broadened my abilities to think qualitatively, complementing my skills as a mathematician. ?The firms I worked for definitely benefited. ?Maybe it can do the same for you.

Till next time, where I tell you how value investing is *not* supposed to be done. 😉

PS — one more note: it is *very* difficult to make money off of macro insights in equities. ?Maybe there are some guys that can do that well, but I am not one of them. ?Limiting the effect of my insights there has been an aid to doing better in investing, because it forces me to be modest in an area where I know my likely success is less probable.

Learning from the Past, Part 1

Posted on 23 December 2014 by David Merkel

This is another Aleph Blog series of indeterminate length. ?I won’t bleed as much as my friend James Altucher, but I will reveal the?worst investments of my life. ?There have been a lot of them. ?Good investments have more than paid for the losses, but the losses were significant in two ways:

The losses were large enough to hurt.
Each loss taught me something; usually I did not make the same mistake twice.

After I finish this series, I hope that it can serve as a guide on what to avoid in investing for younger folks, so they don’t repeat my errors. ?Okay, older folks can benefit as well… and maybe along the way, I’ll throw in a few colorful stories of investments that weren’t losses, but still taught me something.

Here we go!

=-=-=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-

In the late 1980s, I fell prey to a boiler room scam. ?I was relatively new to investing for myself, though I had paper-traded stocks for years, and was seemingly able to pick good stocks. ?So why did I give in to the slick sales pitch? ?Inexperience, for one, and slack capital for two — in my late 20s?I really did not have a plan for what I wanted to do with my slack capital. ?I had done some investing in the stock market, but made money too quickly, and I feared that the market was once again too high (isn’t it always?).

Regardless, it was pretty dopey, and ended up being a 98% loss. ?A class action suit was created, which after 8 years ended up with nothing for any of the plaintiffs, and as far as I can tell, the lawyers lost money as well, since they were seeking a share of the recovery. ?Somewhat bitter at the end, the law firm closed its last letter saying something to the effect of, “At least we have the satisfaction that all of those that we have sued have lost all of the money that we can find.” ?Cold satisfaction, that.

I can tell you that the experience made me unwilling to transact any personal business over the phone that I did not initiate. ?For long-time readers, this helped lead to my saying,

Don’t buy what someone wants to sell you. ?Instead, research what you need, and buy that.

That’s a good lesson to begin with. ?Till next time.

Out and About with The Aleph Blog

Posted on 20 December 201421 December 2014 by David Merkel

1. Recently I appeared on RT Boom/Bust again. ?The interview lasts 6+ minutes. ?Erin Ade and I discussed:

Who benefits from lower energy prices.
The No-Lose Line for owning bonds,
Whether you are compensated for inflation risks in long bonds
How much an average person should invest in stocks with any assets that they have after buying their own house.
The value of economics, or lack thereof, to investors today.

2. Also, I did an “expert interview” for Mint.com. ?I answered the following questions:

What is your most basic advice on investing?
What can you tell young people to help them stay financially secure in their futures?
How can a potential investor go about finding the best investment professional to work with for his or her individual needs?
Please explain how being a good investor and a good businessman go hand in hand.
What is your favorite part of your job?
You clearly do a lot of reading, as seen from your book reviews. What other genres of books do you enjoy?

3. Finally, Aleph Blog was featured in a list of the Top 100 Insurance Blogs at number 29. ?I find it interesting because my blog has maybe 18% of?posts on insurance topics. ?That said, I have a distinctive voice on insurance, because I will talk about consumer issues, and what are companies that might be worth owning.

Enjoy the overly long infographic.

An infographic by the team at Rebates zone

On Financial Risk Statements, Part 1

Posted on 13 December 2014 by David Merkel

Most formal statements on financial risk are useless to their users. Why?

They are written in a language that average people and many regulators don’t speak.
They often don’t define what they are trying to avoid in any significant way.
They don’t give the time horizon(s) associated with their assessments.
They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
They don’t consider whether history might be a poor guide for their estimates.
They don’t consider the conflicting interests and incentives of the parties that?direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
Occasionally, approximations are used where better calculations could be used. ?It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
Where complex math is used, there is no simple language to explain the economic sense of it.
They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story. ?I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did. ?The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into. ?It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them. ?The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual. ?You can’t believe how many people came to us saying, “I get it.” ?Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known. ?Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not. ?It combined the best of both rules and principles, going well beyond the minimum of what was required. ?Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

Investment prospectuses and reports, and all investment and insurance marketing literature
Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
The reports that sell-side analysts write
The analyses that those that provide asset allocation advice put out
Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned?for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Have Your Cake, Eat It Too, And End Up With Only Crumbs

Posted on 11 December 201411 December 2014 by David Merkel

Beware when the geniuses show up in finance. “I can make your money work harder!” some may say, and the simple-minded say, “Make the money sweat, man! ?We have retirements to fund, and precious little time to do it!”

Those that have read me for a while will know that I am an advocate for simplicity, and against debt. ?Why? ?The two are related because some of us tend toward overconfidence. ?We often overestimate the good the complexity will bring, while underestimating the illiquidity that it will impose on finances. ?We overestimate the value of the goods or assets that we buy, particularly if funded by debt that has no obligation to make any payments in the short run, but a vague possibility of immediate repayment.

The topic of the evening is margin loans, and is prompted by Josh Brown’s article here. ?Margin loans are a means of borrowing against securities in a brokerage account. ?Margin debt can either be for the purpose of buying more securities, or “non-purpose lending,” where the proceeds of the loan are used to buy assets outside of brokerage accounts, or goods,?or?services. ?Josh’s article was about non-purpose lending; this article is applicable to all margin borrowing.

Margin loans seem less burdensome than other types of borrowing because:

Interest rates are sometimes low.
They are easy to get, if you have liquid securities.
They are a quick way of?getting cash.
There is almost never any scheduled principal repayment or maturity date for the loan.
Interest either quietly accrues, or is paid periodically.
You don’t have to liquidate securities to get the cash you think you need.
There is no taxable event, at least not immediately.
Better than second-lien or unsecured debt in most ways.

But, what does a margin loan say about the borrower?

He?needs money now
He?doesn’t want to liquidate assets
He wants lending terms that are easy in the short run
He doesn’t have a lot of liquidity at present.

So what’s the risk??If the ratio of the value of assets in the portfolio versus accrued loan value falls enough, the broker will ask the borrower to either:

Pay back some of the loan, or
Liquidate some of the assets in the portfolio.

And, if the borrower can’t do that, the broker will liquidate portfolio assets for them to restore the safety of the account for the broker who made the loan.

Now, it’s one thing when there isn’t much margin debt, because the margin debt won’t influence the likelihood or severity of a crisis. ?But when there is a lot of margin debt, that’s a problem. ?As I like to say, markets abhor free riders. ?When there is a lot of liquid/short-dated liabilities financing long-dated assets, it is an unstable situation, inviting, nay, daring the crisis to come. ?And come it will, like a?heat seeking missile.

Before the margin desks must act, some account holders will manage their own risk, bite the bullet, and sell into a falling market, exacerbating the action. ?But when the margin desks act, because asset values have fallen enough, they will mercilessly sell out positions, and force the prices of the assets that they sell lower, lower, lower.

A surfeit of margin debt can turn a low severity crisis into a high severity crisis, both individually and corporately, the same way too much debt applied to housing created the crisis in the housing markets.

I would again encourage you to read Josh’s excellent piece, which includes gems like:

Skeptics from the independent side of the wealth management industry would ask, rhetorically, whether or not most of these loans would be made with such frequency if the advisors themselves were not sharing in the fees. The answer is that, no, of course they wouldn’t.

He is correct that the incentives are perverse for the advisors who receive compensation for encouraging their clients to borrow and take huge risks in the process. ?It’s another reason not to take out those loans.

Remember, Wall Street wants easy profits from margin lending. ?They don’t care if they encourage you to take too much risk, just as they didn’t care if you borrowed too much to buy housing.

The Free Advice that Embraces Humility

Just say no to margin debt. ?Live smaller; enjoy the security of the unlevered life, and be ready for the day when the mass liquidation of margin accounts will offer up the bargains of a lifetime.

If you have margin loans out now, start planning to reduce them (before you have to). ?You’ve had a nice bull market, don’t spoil it by staying levered until the bear market comes to make you return your?assets to their rightful owners.

Wisdom is almost always on the side of humility, so simplify your life and finances while conditions favor doing so. ?If you must borrow, do it in a way where you won’t run much risk of losing control of your finances.

And after all that… enjoy your sleep, even amid crises.

Risk Tolerance — The Ability to Deal with Loss

Posted on 25 October 201426 October 2014 by David Merkel

No one knows their financial “risk tolerance” outside of the context of losing money. ?Part of the trouble is that risk and return are often described in the same breath as if they are inseparable, when they are more weakly related than most think, and certainly not linear.

Surveys, no matter how well-intentioned or -designed do not typically grasp the asymmetry of gain and loss. ?People feel losses much more acutely than gains, and are far more likely to change their behavior after losses. ?Can’t tell you how many times I have had people say to me, “I’m never buying stock again,” after 2000-2 and 2008-9.

Nothing can prepare you for the event of loss except prior losses. ?Those who have made it through losing money have coping strategies ranging from diversification to rebalancing to benign neglect, etc. ?The best look at it as a cost of doing business, and try to view it together with all other investment decisions made — there will always be losses, but were there gains as well, and more of them over the long haul?

Risk is best faced in prospect, and not retrospect: ask?yourself if?the current assets that you hold offer fair compensation for the risks that they have. ?Are they building value even if the market is not reflecting it yet?

I’m going to be starting a new irregular series at Aleph Blog, where I go through my past tax returns and pull out all of the blunders over the past 25 years. ?I hope it will be instructive to my readers in many ways, but perhaps the most important of those ways is that you have to get up and fight again if you have been knocked down. ?Don’t give up! ?If you leave the game, it is typically at the time prior to gains. ?Rather, ask whether what you are doing now is the right thing to do on a looking forward basis. ?The past is gone, and the only time to affect the future is now.

So look for the new series, and appreciate my packrat tendencies that I still have the records for these matters. ?Hopefully it will be fun, and particularly instructive for younger readers because I was young once too, and I started in this game as an amateur. ?I made a lot of mistakes, but I did not compound my mistakes by leaving the game.

Managing Money for Retirement

Posted on 9 October 20149 October 2014 by David Merkel

Photo Credit: eric731 -- People can budget, but can they manage risk? — Photo Credit: eric731 — People can budget, but can they manage risk?

Investing is difficult. ?That said, we can make it harder still. ?We can encourage 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. ?We get there late, and then our emotions trick us into action, when the rational investor says, “Okay, I missed that move. ?Where are there opportunities now, if there are any at all?”

But investing can be made even more difficult. ?Investing reaches its most challenging level when you are relying on your investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will tell you, 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. ?(Note: at really high rates of cash?inflow, investing gets really tough as well, but that’s another story, and one that I successfully lived though 1998-2003…)

What’s tough is trying to meet a?cash withdrawal?rate that is materially higher than what can safely be achieved over time, and earning enough?consistently to do so. ?Doing so as an amateur managing your own retirement portfolio will be a particularly hard version of this problem. ?Let me point out some of the areas where it will be hard:

1) You don’t know how long you, your spouse, and anyone else relying on you will live. ?Averages can be calculated, but particularly with two people, the odds are that one will outlive an average life expectancy. ?Can you be conservative enough in your withdrawals that you won’t outlive your money?

2) My 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 when you are near the end of a bull market.

Now, 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 your income needs are greater than that, your odds of yields over the long haul go down dramatically.

3) Will you be able to maintain an iron discipline, and not overspend your assets? ?It’s tempting to do so, 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.

4) How will you deal with bear markets, particularly ones that occur early in retirement? ?Can?you and?will you reduce your expenses to reflect the losses? ?On the other side, during bull markets, will you 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 garbage like that.

5)?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 you capital gains if you use them right, buying them when they are out of favor, and reducing exposure when everyone is buying them.

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 a decent number of 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.

6) 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 you can do that successfully, you are rare. ?What is achievable by many is to maintain a constant risk posture. ?Don’t panic; don’t get greedy — just stick to your investment plan through the cycles of the markets.

7) As assets shrink, what will?you liquidate? ?The best thing would be?being forward-looking, and liquidating what has the lowest risk-adjusted future return. ?What is achievable is selling assets off from everything proportionally, taking account of tax issues where needed.

8 ) Are you ready for Social Security to take a hit out around 2026? ?Once the trust fund gets down to one year’s worth of?payments, future payments get reduced to the level?sustainable by expected future contributions. ?Expect a political firestorm when 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.

9) 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.

10) You need a defender of two against slick guys who will try to cheat you when you are older. ?If you have assets, you are a prime target for scams. ?Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make your money stretch further. ?But there are other scams as well — run everything significant past a smart younger person who is skeptical, and knows how to say no when needed.

Conclusion

If this all seems unduly dour (and I haven’t even talked about defined benefit plan issues), let me tell you that 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 you, you need to be ready for the hard choices that will come up. ?Better you should think through them earlier rather than later. ?Who knows? ?You might take some actions that will lower your future risks. ?More on that in a future post, as well as the other retirement risk issues.