Personal Finance – Page 23

On Con Men

Posted on 17 March 201117 March 2011 by David Merkel

Recently, I made a visit to the Cato Institute, and I bumped into a guy who indicated he was interested in investing with me.? We exchanged cards, and around 10 days later he called me, telling me about his scheme for investing the money of (my and other) IRA investors in wind farms that he had in upstate New York.

He talked for a while, and I said, “So are these limited partnership interests?”? He said no and rattled on about the opportunity.? I then asked, “Is this a private company, and you are offering shares?” He said no and rattled on about the opportunity.? I then asked, “Are these general partnership interests?? He said no and rattled on about the opportunity.? I then asked, “Is this some sort of structured note?”? He said no and rattled on about the opportunity.

I then said, “Stop.? If after five minutes, I can’t tell what it is that you are doing, it can’t be anything good.? I have worked in almost all areas of the securities markets, and if you can’t tell me the legal form of what you are doing, I have no interest, particularly not for my clients.” He rattled on about the opportunity, and I hung up on him.

Note: confidence is not a bad thing, but hyper-confidence is.? If someone is not willing to quickly trot out the risk factors on an investment, avoid them.? All investments have risk.? REPEAT: ALL INVESTMENTS HAVE RISK.? There, I feel better now.

I have said before, and I will say it again, “Don’t buy what someone is trying to sell you.? Buy what you have researched and want to buy on your own.”? Hey, I got cheated on penny stocks when I was young and inexperienced.? Many of us make mistakes when our knowledge is immature.

Also, even in institutional investing, I can tell you that complexity is the enemy of the one receives it.? I avoided most complex transactions when I was a corporate bond manager.? While working for the hedge fund, I happily set up a structured note that reflected my view of the world, after refusing one the broker created.? We won on that one.

So avoid complex investments.? Particularly avoid investments that you don’t understand.? At minimum, find a competent friend, or some neutral party that will look at the deal.? If you can’t find such a friend/party, don’t do the deal.? The friend is important, because he does not want you to come to harm, or lose you as a friend if things go bad.

I have a friend, the son of a dear deceased friend of mine, who seemed to attract Nigerian-style scams the way dryer traps collect lint.? I finally took him aside and said to him, “Ignore these.? If it is too good to be true, it most likely is too good to be true.”? Happily, he took the hint, and did not lose a dollar to the scammers. (I lost a couple hours proving the opportunities were bogus.)

Financially, this is a dangerous world, outside of the well-established channels for investment.? (I write this as one with significant private equity investments.)? Be careful in how you allocate your funds, and don’t give into a slick pitch that promises high returns (over 7%), or extreme safety (no way you can lose), without significant due diligence.

Update: One more note.? I often find it useful to ask the seller to send me all of the documents, and tell him that that I might pass them by my lawyer.? I don’t have a lawyer; for practical purposes, I am my own lawyer on securities matters.? I can read the documents myself as well as any lawyer.? But that usually cools the ardor of any con man; he knows that the deal will not get done, and he gives up.

Musings on Yield

Posted on 1 March 2011 by David Merkel

When I closed my piece on Warren Buffett’s Annual Letter, I ended with an important statement tat when I read it in the morning, I thought many would find it cryptic.? Here it is:

And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.? Yield is the decision of the company, but what you should? ask is what is the increase in value of the company.? Look for investments that increase your net worth the most.

And I would add “With an eye toward safety.”

When I say there is no such thing as yield, I am overstating a matter to make a point.

Will the debtor make the interest (or principal) payment?
Will the company pay the regular dividend?? Will they increase it?
Will you be able to hold the instrument so that you can realize the yield over the long haul?

During times of stress, yield has a nasty tendency to disappear, often with significant principal losses.? Thus I am skittish whenever I hear someone say that they need to get a certain yield.

Individuals and Institutions, for better, but usually for worse, often rely on getting a certain yield from fixed income investments.

If I don’t get this yield, I won’t be able to meet my monthly expenses.
If I don’t get this yield, my quarterly earnings will miss.
If I don’t get this yield, our ability to support our charitable endeavors will suffer.

Sigh.? Look, this could have been entitled “Education of a Corporate Bond Manager, Part 13,” but I didn’t because this is more broad and important.? It affects everyone.

Once there are no wages/nonfinancial profits, investors usually move into a yield-seeking mode.? I experienced this in spades for the insurance company that I helped to manage money for.

And yet, in the midst of the furor 2001-2003, we often acted against the insurer’s wishes in order to save their hide.? Particularly me; I could not bear doing the wrong thing, thinking that I would have the failure of an insurer on my conscience.

So in the midst of the nuttiness of 2002, I often did up-in-credit trades, reducing complexity trades, etc., when the market favored it.? Lose yield, gain safety, when the market is hot.? (Not when it is cold.)

I preserved the capital of the insurer, and it survived.? I even made extra money for them in the process, which they wasted on writing underpriced annuity business.

There was no level of yield that could have satisfied that client, even assuming that we could get it with safety.

But now as I start my asset management business, I deal with clients that are aiming for a certain yield.? To my surprise, even my Mom, the one who taught me the rudiments of investing is seeking for yield now.

You might or might not recall that the fourth real post at this blog was entitled Yield = Poison.? There are times to look for yield, and times not to.? The times not to are when yields and spreads are low.? At such a time, the best decision is not to reach for yield, but rather to forgo yield and preserve capital.? Buy TIPS, foreign bonds, and move up in quality and down in maturity in dollar terms.

I did this for an internal client 2004-2007, and made money for them, but it was utterly unconventional.? They could afford to deal with my idiosyncracies, because they didn’t need a current yield.

So, as I move to offer a fixed income strategy, I find myself butting heads with those that want a reliable income from bonds, and other fixed income instruments.? I’m sorry, but preserving principal is more important than getting yield.? Far better to eat into principal a little when spreads are tight, than to meet the spread target and get whacked in the bear phase of the credit cycle.

So, do I have a market for such investing in bonds, or is human nature so unchangeably mixed up that there will be few if any takers for my fixed income management?? Sadly, I think the answer is the latter.

Critical Analysis of Buffett’s Annual Letter

Posted on 27 February 201128 February 2011 by David Merkel

I’ve written a lot about Buffett over the years.? I think this is the eighth shareholder letter that I have written about.? I have the unique perspective of being both an actuary and a value investor.? I get what Buffett is doing, though by no means am I his equal.? This is a commentary on his 2010 shareholder letter.

Buffett begins with the transformational merger of Burlington Northern.? I spoke well of this merger that many dissed in my piece, The Forever Fund.? Face it — where could you find such a big business that is inflation-protected, and with such a large moat?? No one could replicate BN at the price that Berky paid.? This acquisition reshaped Berky, making it far more of an industrial firm, albeit one financed with insurance float.

Measuring Performance

From page 2:

In Berkshire?s case, we long ago told you that our job is to increase per-share intrinsic value at a rate greater than the increase (including dividends) of the S&P 500. In some years we succeed; in others we fail. But, if we are unable over time to reach that goal, we have done nothing for our investors, who by themselves could have realized an equal or better result by owning an index fund.

The challenge, of course, is the calculation of intrinsic value. Present that task to Charlie and me separately, and you will get two different answers. Precision just isn?t possible.

To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value ? book value ? when measuring our performance. To be sure, some of our businesses are worth far more than their carrying value on our books. (Later in this report, we?ll present a case study.) But since that premium seldom swings wildly from year to year, book value can serve as a reasonable device for tracking how we are doing.

This is a wise way to measure performance, and many value-oriented insurance companies do this.? But Berky isn’t just an insurance company, and book value isn’t a perfect metric.? But change in book value plus dividends is a much better metric than earnings, so using that is a reasonable metric to evaluate Berky.? On that score Berky has done very well over the years, and I would argue that Buffett has done even better in his later years because it is increasingly difficult to deploy a large amount of money and still beat the averages.? Look at what I call “dollar alpha.”? The amount of outperformance is limited, but Buffett is absorbing a large portion of the alpha in the market.? (Of course aggregate alpha is zero, but if a large player continues to do well, that has a disproportionate effect on the rest of the market.)

Capital Management

Our flexibility in respect to capital allocation has accounted for much of our progress to date. We have been able to take money we earn from, say, See?s Candies or Business Wire (two of our best-run businesses, but also two offering limited reinvestment opportunities) and use it as part of the stake we needed to buy BNSF.

Buffett understands the difference between businesses that have reinvestment opportunities, and those that don’t.

Culture

Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.

To start with, the directors who represent you think and act like owners. They receive token compensation: no options, no restricted stock and, for that matter, virtually no cash. We do not provide them directors and officers liability insurance, a given at almost every other large public company. If they mess up with your money, they will lose their money as well. Leaving my holdings aside, directors and their families own Berkshire shares worth more than $3 billion. Our directors, therefore, monitor Berkshire?s actions and results with keen interest and an owner?s eye. You and I are lucky to have them as stewards.

This same owner-orientation prevails among our managers. In many cases, these are people who have sought out Berkshire as an acquirer for a business that they and their families have long owned. They came to us with an owner?s mindset, and we provide an environment that encourages them to retain it. Having managers who love their businesses is no small advantage.

Cultures self-propagate. Winston Churchill once said, ?You shape your houses and then they shape you.? That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior. (As one wag put it, ?You know you?re no longer CEO when you get in the back seat of your car and it doesn?t move.?) At Berkshire?s ?World Headquarters? our annual rent is $270,212. Moreover, the home-office investment in furniture, art, Coke dispenser, lunch room, high-tech equipment ? you name it ? totals $301,363. As long as Charlie and I treat your money as if it were our own, Berkshire?s managers are likely to be careful with it as well.

Berky is one of the few companies where they have the interests of the outside passive minority shareholder at heart.? The company runs thin; excess expenses are small to nonexistent.

Insurance

He gives his usual praise of Ajit Jain who I have met.? A genuinely bright guy, and friendly as well.

With Gen Re, he emphasizes pricing discipline — the willingness to walk away, and not write business.? This is the core of good insurance management.? Never intentionally write business for an underwriting loss.

Manufacturing, Service and Retailing Operations

He talks abut the improvement at NetJets, which had been quite a dog for Berky.? David Sokol had quite an impact there.? But beyond that, Berky has a wide number of businesses that do very well.

He also discusses the black box that is Marmon, that Berky owns a majority of, and will own the whole thing by 2014 at latest.? It is also doing well.

Regulated, Capital-Intensive Businesses

BNSF and MidAmerican Energy fill out this segment.? Buffett is more than logical to put them together, because their enterprises are subject to their regulators, but enough distant from insurers that they get a different classification.? Why?

Like insurance, you don’t have perfect freedom to redirect earnings as you wish.? Some earnings must be reinvested into maintenance, and with discretion, into growth.

What Matters Least at Berky

The public investments, large as they are, are a small part of what makes Berky run.? People pore over the investments that Berky makes, but the guts of Berky are not investing, but managing a conglomerate of businesses funded by cash flow from insurance.

Todd Combs

While at a prior employer, I came to know Todd Combs, and we traded a bunch of ideas in the insurance space.? He was a bright guy.? I have little doubt that he will do well for Berky.? I remain available for any additional mandate that Berky might? require.? (I giggle as I write this, because though I have done well, why should Warren want a shmoe like me?)? That said, I am willing to manage any assets of Berky at my bottom rate of 0.1%/year.

Derivatives

Buffett describes how he has use derivatives to his advantage.? Amid the criticisms, he has made money there as the stock markets of the world have recovered.

Life and Debt

Buffett explains how avoidance of debt is wise. And after that:

We agree with investment writer Ray DeVoe?s observation, ?More money has been lost reaching for yield than at the point of a gun.?

True, utterly true.? And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.? Yield is the decision of the company, but what you should? ask is what is the increase in value of the company.? Look for investments that increase your net worth the most.

Problems with Constant Compound Interest (5)

Posted on 23 February 2011 by David Merkel

This is a continuation of an irregular series which you can find here.? Maybe if I were more scientific, I would have called it “All Exponential Growth Processes Run Into Constraints and Threats,” or if I were more poetic, “Nothing Lasts Forever — Nothing Grows to the Sky.”

Regardless, simple modeling is the bane of long-duration financial calculations.? I remember talking with some friends who served on a charitable board with me, about some investment grade long bonds (11-30 years) that I had purchased for a life insurance client that yielded 7-9% in late 1999.? They said to me that it was foolish to lock up money for so long in bonds, when you could earn so much more in stocks.? My three comments to them were:

Prohibitive for life insurers to hold equities
At current levels of the market, the yield of these bonds more than compensates for the possibility of capital growth in equities (valuations are stretched)
The risk in the bonds is a lot lower.

And, I said we ought to shift shift our charity’s asset allocation to more bonds, as we were invested past the maximum of our guidelines in equities.? They looked in the rearview mirror and said that we were doing fabulous.? Why change success?

I was outvoted; I was a one-man minority.? There are a lot of people who would have loved to make that change in hindsight, but done is done.? I ended up leaving the board a year later over a related issue.

Now, don’t think that I am advising the same in 2011.? We may be headed for significant inflation or deflation; it is difficult to tell which.? Bonds offer little competition to equities here.? Commodities and cash may be better, but I am reluctant to be too dogmatic.? If the economy turns down again, long Treasuries would be best.

Here’s the difficulty: most people have been trained to think at least one of a few things that are wrong:

That we can use simple models to forecast future outcomes.
That average people are capable of avoiding fear and greed when it comes to investing.
That financial markets are random in the sense that last period’s return has no effect on the returns of future periods.
Over long periods of time, average investors can beat long Treasuries by more than 2%/year.? (Corollary to the idea that the equity premium is 4-6% versus 0-2%/year over high quality bonds.)
That financial markets are expressions of what is going on in the real economy.
That the real economy tends toward stability
That government actions make the real economy more stable

I’m prompted to write this because of two articles that I ran across in the last day: Retiring Boomers Find 401(k) Plans Fall Short, and Stay Out of the ROOM (registration required).

I’ve written about this before in many places, including Ancient and Modern: The Retirement Tripod.? And yet, when I wrote about these issues 20 years ago, one of the things that I tried to point out was that as the demographic bulge retired, it would be difficult for homes and asset markets to throw off the returns necessary, because there would not be enough buyers for the assets/homes.? If a large portion of the population wants to convert assets into a stream of income — guess what?? They are forced sellers, and yields that they will get will be compressed as a result.

In a situation like that, those that are better off, and can delay turning all of their assets into an earnings stream should be disproportionately better off.? As with corporations, so with individuals/families: those with slack assets and flexibility are able to deal with volatility better than those for whom the environment must be stable/favorable for the plan to succeed.

Now, the Wall Street Journal article points at the problems of 401(k) plans.? What they say is true, but the same is true of other types of defined contribution and defined benefit plans.? When assets underperform, and/or investors make bad choices, guess what?? The pain has to be compensated for somehow:

401(k): They will work longer, maybe all of the rest of their lives, and cut back on expenses and dreams.
Non-contributory DC: maybe the employer will ask them to kick in voluntarily, or he might give more.? Also same as 401(k)…
Private sector DB plans: employers may contribute more, or they may terminate them.
Public sector DB plans: Taxes may rise, spending cuts enacted, forced contributions to retiree plans negotiated, plans terminated for a 457 plan, partial plan termination, job cuts, funny accounting practices (worse than the private sphere), brinksmanship over debts, etc.

Note that one of the answers is not “take more risk.”? First, risk and return are virtually uncorrelated in practice.? Only when enough people realize that might risk and return become positively correlated.? Second, there are times to increase and decrease risk exposure.? Typical people won’t want to do that, because of euphoria (the example of my friends above) and panic.? The time to add to high risk assets is when no one wants to touch a high yield bond.? More broadly, always look for asset classes that throw off the best cash flow yields, conservatively estimated, over the next ten-plus years.? Be sure and factor in the likelihood for economic regime changes and capital loss, inflation, deflation, etc.

Good asset allocation marries the time horizon of an investor to the forecasts for future returns, conservatively stated, and considers what could go wrong.? At present, investment opportunities are average-ish.? I would be wary of stretching for yield here, or raising my risk exposure in equities.? Stick with high quality.

And, for those that are retired, I would be wary of taking too much into income.? I have a simple formula for how much one could take from an endowment at maximum:

10 Year Treasury Yield
Plus a credit spread — 2% if spreads are sky-high, 1% if they are good, 0.5% if they are tight.
less losses and fees of 0.5% — higher if investment expenses are over 0.25%.

Not very scientific, but I think it is realistic.? At a 3.5% 10-yr T-note yield, that puts me at a 4% maximum withdrawal rate, given a 1% credit spread.? This attempts to marry withdrawals to alternative uses for capital in the market.? You may withdraw more when opportunities are high, and less when they are low.? (But who can be flexible enough to have a maximum spending policy that varies over time?)

Now some of the advanced models that calculate odds of retiring successfully are a step in the right direction, but they also need to reflect demographics, time-correlation of returns, regime-shifting returns/economics, etc.? Things don’t move randomly in markets; that doesn’t mean I know which way things are going, but it does mean I should be cautious unless the market is offering me a fat pitch to hit.

These statements apply to governments as well, and their financial security programs.? In aggregate, investments can’t outgrow growth in GDP by much, unless labor takes a progressively lower share of national income.? (And who knows, but that the pressure on union DB plans to earn high returns might lead to takeovers/layoffs in private firms…)? The real economy and the financial economy are one over the long haul, but can drift apart considerably in the intermediate-term.

In summary, any long promise/analysis/plan made must reflect the realities that I mention here.? We’ve spent years on the illusions generated by assuming high returns off of financial assets.? Now with the first Baby Boomers trying to retire, the reality has arrived — sorry, not everyone in a large birth cohort can retire comfortably.? Wish it could be otherwise, but the economy as a whole can’t generate enough to make that proposition work.

I don’t intend that this series have more parts, but if one strikes me, I will write again.

Book Review: Never Buy Another Stock Again

Posted on 2 February 2011 by David Merkel

With this book review, I put a knife to my throat.? Alas, I have been investing in individual stocks for over 23 years, and have done well the whole way.? Is it time to abandon my craft?

No, and I think the author would agree.? He is making a relative argument but the title phrases it in absolute terms.? On average, the advantage of investing in stocks is smaller than commonly believed, and for investors that can’t keep their wits about them when all is going wrong, the results are worse still.

This book attempts to infuse common sense (ordinarily sorely lacking in investments) into readers who are retail investors.

One nice feature of the book is that the author recapitulates everything in each chapter in a closing section entitled “Boiling It Down.”

Another nice feature of the book is that the author went and interviewed clever asset managers to flesh out his own understanding of the topic.? That helped produce a much richer book.

Quibbles

I don’t go in for using stop losses.? I analyze risk, and there will be a tiny number that really hurt, but the cost of using stop losses is missing the frequent snapback rallies, which on average in my experience more than pay for the losses.

Also, in this environment, where everything is so correlated, because of ETFs, he recognizes the difficulty of achieving real diversification.? But in his asset allocation advice, it is as if he forgot this.? If I were rewriting his asset allocation chapter, I would have introduced the concept of the credit cycle, and why good asset allocators vary their positions based on the opportunity offered, rather than a more static view of asset allocation.

I also would have given a little more credit to value investing.? If you are going to be anything but a trader, you may as well focus on value.

But on the whole, this was a very good book, and these are quibbles.? He writes very well, far better than me.

Who would benefit from this book:

Most inexperienced to moderate investors would benefit from this book.? It would help them to avoid common mistakes in investing, as well as make them aware of modern problems in investing that classic texts would not have been aware.

If you want to, you can buy it here: Never Buy Another Stock Again: The Investing Portfolio that Will Preserve Your Wealth and Your Sanity.

Full disclosure: This book was sent to me, because I asked for it, after the publishers offered me a copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

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

On Bonds in Retail Accounts

Posted on 25 January 2011 by David Merkel

One small added benefit that I offer clients is extra advice.? The following would be an example:

By the by, I wonder if I can ask you for some bond advice.? I currently use Fidelity for most of our investments, but have become quite dissatisfied with the breadth of their individual bond offerings.? Can you suggest an alternative that would have better bond breadth along with reasonable bid/ask spreads?? I’m not particularly interested in bond funds as I want to be in control of buy/sell timing for tax purposes.

Regarding bonds ? bonds are tough in a retail context.? I grew up spoiled as a bond manager, having never done bonds in a retail context, but reading horror stories from those who were ?getting their eyeballs ripped out? by their brokers.? Now, from what I heard, Fidelity was among the better in the retail bond area, but I know that most retail bond areas are the ?home for misfit bonds.?? Odd lots, tag ends, bonds that are cheap for a reason? and whatever is allocated to retail for those that can or want to ask for bonds that are newly issued, for which you have to be on your toes, in the right place at the right time.

So, I?m used to the relatively good liquidity available on the institutional side, where once you get up to trading $1 million at a time, the bid/ask spread is around 3 basis points in yield, and selection and other tools are considerable.? If I were forced to manage the bonds of a smaller portfolio (which I did for a prior employer? only had $7 million in bonds), I would do one of the following:

Outsource it to Vanguard, PIMCO, or Loomis Sayles.
Or, what I actually did… buy Treasuries directly, and use closed-end funds and ETFs to allocate the rest.? If I had less than $20 million of bonds under management, that?s what I as a manager would do? even with the added fees and limited palette of colors to paint with, it beats the costs and limitations of retail bonds.

Now, someday I?d like to bring out a bond fund/strategy, but I want to get this portfolio established first.? Now, I could try to crowdsource the opinions of others, and ask where others think they get a good deal in retail bonds by turning this into a blog post (leaving your name out of course).? Would you like me to do that?

=-=–=-==–==-=–=-=-=

So with that, I ask my readers, what would you do?? Are there better alternatives for retail investors in bonds?? Let us all know in the comments.

Dave, What Should I Do? (3)

Posted on 18 January 2011 by David Merkel

Some of my friends want to invest with me, but I am not a total solution to anyone’s financial needs, because the only stuff I am managing is the risk capital.? All of my clients have to go through a suitability check, where I tell some of them, “No.? That is too much money to place with me.? You would be placing more money at risk than would be good for you.”

I do that even more with close friends.? Why?? They want to support me.? They have a non-economic reason to invest with me, so I have to be all the more prudent and tell them in many cases, “Not so much invested with me.”? Eeee, my wife worries about investing the money of friends.? So do I, but I also know that I have done well for myself over the last 20 years, and my friends could do worse than investing with me.

So, I have four friends to talk about tonight.

1) 91-year old widow, mother/mother-in-law of some dear friends of mine.? Has all of her money in a money market fund in a bank, and earning what is a very good yield for a money market fund.? Bank isn’t in the greatest shape, but the amount is below the FDIC’s limits.? She doesn’t need the money because she has a pension that more than cares for her needs, and she lives with my friends.? Very conservative lady; does not want to take risk, but she asked for advice.? The excess money would go to her children at death, she already gives them some excess each year now.

I ended up saying that I thought I could earn more for her, but that it was by no means certain.? I thought it would be 1 in 3 over the next ten years that the strategy might lose versus her money market funds.? The FDIC should be good if the US government is good, and for her likely lifetime it probably is.? So she decided to stay where she was.? Easy, and, it keeps the dear old lady from worry.

2) A friend, 55, wants to retire 65-70.? Owns two houses free and clear near DC.? Wants to invest all of his IRA assets with me.? I tell him, “No more than 50% with me, and the rest in bonds.”? So, he says that he has an account at Vanguard.? What should he invest in?? I suggest:

23% Short-Term Investment Grade [VFSTX]
23% High Yield Corp [VWEHX]
23% Inflation Protected Securities [VIPSX]
23% Total Bond Market Index [VBMFX]
8% Long-Term Treasury [VUSTX]

Why did I suggest this?? Credit should do well over the next year, and this portfolio will hedge somewhat against inflation, and to a greater extent deflation.? The duration on this set of funds is below the market average, quality is above, and yield is above as well.? Also, convexity/optionality is above average, and will leave room to make changes.

3) Another friend, born 6 days after me (50), just changed jobs.? Wants advice on the new 401(k) plan, again Vanguard, but a different selection set.? They may want to invest some taxable money with me after that, but who can tell… one thing for sure, I never want to push anyone to invest with me.

I ended up suggesting:

15% V Wellington Trust TIPS Portfolio
15% V Short-Term Bond Index
10% V Target Retirement Income Trust (30% equities)
10% V Total Bond Market Index
10% V FTSE All-World Ex-US Index
10% Templeton Foreign Equity
10% V PRIMECAP
10% V Midcap Value
10% Longleaf Partners Small Capital

That would give reasonable diversification across a broad number of scenarios, and a tilt toward equities versus bonds — 53/47%.

4) The widow of the dear guy I call “The Collector” asked for more advice.? I call him “The Collector” because he bought new funds frequently with new money over many years, and he had a reasonably good eye for managers.? I can kind of guess when he bought them — many did quite well in their time.

But she wants income, so she wants to sell a couple of funds that she owns, and buy some Wells Fargo.? I have no objection to the sale of the funds, but she will not earn much income from Wells Fargo, and she already has too much single stock risk , including existing holdings of Wells Fargo.? What I need to tell her is to use the proceeds add to her holdings in Vanguard Wellington and Wellesley Income funds, both very well run.

I also need to explain to her that total return matters more than current income.? Income can be generated by liquidating small amounts of funds expected to underperform.? (I have given her a list tagging funds add, keep, reduce.)

So it goes.? It is a tough time to be investing, but as a new friend pointed out to me recently, quoting T. Rowe Price, “The hardest time to invest is today.”? Sage words.? The present is always a balance between bullishness and bearishness.

Book Review: What Investors Really Want

Posted on 18 December 2010 by David Merkel

Meir Statman wants to tell us about the human condition.? We make bad economic decisions regarding investments.? That comes mostly from having multiple desires regarding investing that are inconsistent.? What are our problems?

We look for free lunches.
We think he past is prologue.
We get hopeful.
We want to look like a winner for friends.
We follow the herd.
We are reckless with money not easily earned.
We save too little.
We want an option on riches, and a guarantee against poverty.
We are loss averse.
We are tax averse.
We want to be accepted into exclusive investments.
We want our investments to reflect our values.
We want fairness.
We want our progeny to thrive.
We don’t know what we are doing, can someone teach us?

The spirit of the book says to me that most people don’t have the vaguest idea on what to do with investments.? They invest for many reasons, many of which are not economic.

This is a reason why pension plans should strip the investment authority away from participants, and put it in the hands of trustees.? Face it, only 20% of people at most know how to invest.? Amateurs have a hard time? distinguishing between the long-run and the short-run.

My take is that one has to unemotional, Vulcan-like, in investing, in order to be successful.? Our feelings, whether of fear or greed, deceive us.? We must resist and suppress our feelings in order to be good investors.? And as for me, it took me 5-10 years to get there.? By the time I was done, I created a system that tied my hands when I would be tempted to make a rash decision.

Quibbles

Page 84 demonstrates how short-sighted people pay up for flexibility, paying credit card rates for extra cash. On pages 96-97, he managed to convince me by bad arguments that the old system of segregating capital and income is correct.? Truth, a market-base spend in rule would float with the 10-year Treasury yield, with adjustment for how optimistic we are about the stock market.? Unless the income taken from an endowment floats with the market, it is not possible to be fair across eras.

The book describes our problems in economic decision-making, but provides no cure.? The last chapter tries to make up for it, by suggesting that an intelligent mix of paternalism and libertarianism would be the best solution.

Yes, that would be the best solution, but the devil is in the details, and the author spells out few of them.

Who would benefit from this book:

Anyone wanting to understand why he makes bad economic decisions would benefit from this book.? That would include most of us, and me.? As you read it, think of how you would change your behavior for your good.? Personally, I have designed my buying and selling methods in the stock market to avoid these troubles, but it means I have to have no emotions in the market, and that is tough to do.

If you want to, you can buy it here: What Investors Really Want.

Full disclosure: This book was sent to me, because I asked for it.

Ethics and Investment Writing

Posted on 13 November 201014 November 2010 by David Merkel

There are three things that I am happy with when it comes to writing about investments:

I am glad that Jim Cramer invited me to write for RealMoney seven years ago.? Motown Josh Brown put together a great piece on the influence that TSCM has had on the financial media.? I heartily agree, and I don’t think we know the half of it.? I interacted with a lot of young TSCM staffers, and it amazed me what an education they got in the markets working for TSCM.? TSCM blended respect and skepticism for the markets, and though you couldn’t have done it without Cramer, the effect on the financial media exceeds him, and for that we can all be grateful, because the financial media is a lot sharper than it was 15 years ago.? (Okay, leave out much at CNBC.)? And who knows, maybe I will return to TSCM someday in some capacity; the door is open.
I’m glad I started my blog.? I still think that financial bloggers are the conscience of Wall Street.? There is a need for knowledgeable people to write about economic/investing/finance issues.? It does not replace journalists, but supplements them.? Intelligent commentary complements “neutral” reporting on a topic.? Journalists learn from area experts, playing them off against each other to get a fuller picture of the debate.? (As an aside, the motive to start the blog began on one of the comment boards at TSCM for Cramer.? Readers were fascinated that I would post there, and told me I needed to develop my voice.? A few called me the anti-Cramer, but I never took up that moniker.)
I am grateful that I am a CFA Charterholder.? Harry Markopolos recently spoke to the Baltimore CFA Society, mainly about his uncovering of the Madoff scandal, but he spent a decent amount of time explaining why the CFA Institute and our ethics code can make a huge difference in reforming Wall Street.? I was impressed; his beliefs in honesty and fair dealing drive his actions.? (I talked with him afterward, and we realized we must have met seven years before, at a regional meeting of the Northeastern CFA societies, when I was sent by the Baltimore CFA Board to represent us in a ticklish issue regarding the leadership of AIMR.? He had helped lead the effort to replace the existing leadership.)

But that’s not my major reason for writing tonight.? I want to comment on two pieces in the Wall Street Journal that comment on shady practices.

The first one is entitled Shining a Light On Murky 401(k) Fees.? The Department of Labor has the dubious distinction of being less effective than the SEC on investment regulation.? A lady I sat next to at the Denver conference regaled us with how her daughter’s 401(k) plan had expenses equal to 12%/year of assets.? I hope she made a math error, but she is a Ph. D; it’s not likely.

From my own experience at Provident Mutual in the nineties, it was easy to see how expenses could get layered.? We tried to be among the more ethical in that business, but the temptation to pay a lot in order get more business was dangled in front of us regularly, and we refused.? We had a rule that if comp was not disclosed, agents had to disclose that comp was not disclosed. And if they took nondisclosed comp, they could not have additional disclosed comp, because it would give the illusion of “That’s all I am paid.”

Do we need limits on 12b-1 fees?? I would prefer a full disclosure of fees — who and how much, poking through relationships to explain who ultimately is giving services to the 401(k) plan, and who is collecting rents as “gatekeepers” for the plan.

There is a lot to be done here.? Would that the DOL would invest a little money in buying skeptical experts, and really grasp the complexity of what is going on there.

The second one is entitled Structured Notes: Not as Safe as They Seem.? When I (along with others) was taking a demo of a custodian recently, the rep of the custodian went out of his way to show the area of the website that offered structured notes.? I commented, “Those are evil. They offer yield, but they make people short expensive options.”? After an embarrassed pause, the rep said, “Let me demonstrate an area of bonds that is not evil,” and he moved onto Agencies.? I didn’t have the heart to tweak him twice.

I wrote a piece a while ago called “Yield, the Oldest Scam in the Books.”? Structured notes offer above market yield, while that yield, or some of the capital, could be negatively affected if events perceived to be unlikely would occur.? The investment banks can hedge those risks more effectively than the Structured Noteholders can, and they pocket large profits.

The concept of “contingent protection” annoys me.? The odds of triggering such protection are much higher than the average person expects.

Do not buy structured notes.? The investment banks know far more than you.? Do not buy what others want to sell you.?? Use your good mind, and buy what you like.

There is no one on Wall Street looking to do you a favor, so view your broker with skepticism.

Book Review: That Thing Rich People Do

Posted on 13 November 2010 by David Merkel

If you know anything about investments, this is not the book for you.? This is the book for your relative or friend that doesn’t have the barest idea about how to manage money.

This was another book that I thought I would not like after the first few chapters.? Too cutesy.? Too certain.? As the book moved on, it broadened out and gave the sort of advice that I would give to neophytes, with a few exceptions.

The book’s title derives from the show “30 Rock,” where the character played by Tina Fey says, “I have to do that thing rich people do, where they turn money into more money.” (Sigh.? I am so glad I don’t own a television.? Hey, let me give you some unsolicited advice: get rid of your television.? You will become far more rational and productive, and then, you will have more opportunities “to do that thing rich people do, where they turn money into more money.”? Sorry, turning rant mode off.)

This book gives the basics:

Saving
Stocks
Bonds
Asset allocation
Warnings on insurance and annuities.
Diversification
Avoiding Fear and Greed
Avoiding Expenses
Avoiding Taxes
Passive Investing (best for neophytes)
Further Reading — if a neophyte needed a book list to expand his knowledge, the author gives a good list.

The book is clearly written, and sometimes engaging, sometimes humorous.? But it gets the job done for neophytes, and that is what counts.

Quibbles

It would have been a benefit to the average reader to point them to Vanguard, especially for bonds, when expenses eat up so much of the returns.

Who would benefit from this book:

Only neophytes will benefit from this book.? It’s not long at ~140 pages; the chapters are easy to read at an average of 6 pages.

If you want to, you can buy it here: That Thing Rich People Do: Required Reading for Investors.

Full disclosure: I asked the publisher for a copy, and they sent one to me.