Search Results for “"Personal Finance, Part"” – Page 2

Personal Finance, Part 5.1 ? Inflation and Deflation 2

Posted on 7 December 2007 by David Merkel

I wish that I had more time to respond to readers both in the comments and e-mail.? Unfortunately, I am having to spend more time working as I am in transition as far as my work goes.? I’ll try to catch up over the next week or so, but I am behind by about 50 messages, and I hate to compromise message quality just to clear things out.

That said, my inflation/deflation piece yesterday attracted two comments worthy of response.? The first was from James Dailey, who I would recommend that you read whenever he comments here.? We may not always agree, but what he writes is well thought out.? He thinks I attribute too much power to the Fed.? He has a point.? From past writings, I have suggested that the Fed is not all-powerful.? What I would point out here is that the Fed controls more than just the monetary base.? They control (in principle) the terms of lending that the banks employ.? With a little coordination with the other regulators, the Fed could restrict non-bank lenders by raising the capital requirements that banks (and other regulated institutions) must maintain in lending to non-bank lenders.? So, if credit is outpacing the growth in the monetary base, it is at least partially because the Fed chooses to allow it.? Volcker reined in the credit card companies in the early 80s, which was not a normal policy for the Fed; it had a drastic impact on the economy, but inflation slowed considerably.? (Causation?? I’m not sure.? Fed funds were really high then also.)

The other comment came from Bill Rempel.? He objected more to my terminology than my content, though he disliked my comment that “Inflation is predominantly a monetary phenomenon.”? I think we are largely on the same page, though.? I know the more common phraseology here, “Inflation is purely a monetary phenomenon,” and I agree with it, but with the following provisos:

If we are talking about goods, services, and assets as a group, or,
If the period of time is sufficiently long, like a century or so, or,
If we are talking about monetary inflation.? (Who disagrees with tautologies? 🙂 Not me.)

Part of my difficulty here, is that when we talk about money, we are talking about something that lies on the spectrum? between currency and credit.? By currency I am talking about whatever physical medium can be commonly deployed to effectuate transactions.? By credit, anything where the eventual exchange of currency is significantly delayed, and perhaps with some doubt of collection.? Because of the existence of credit, over shorter periods, the link between monetary inflation and good price inflation is more tenuous, which leads people to doubt the concept that “Inflation is purely a monetary phenomenon.”? My post, rather than weakening that concept, strengthens it, because it broadens the concept of inflation, so that the pernicious effects of monetary inflation can be more clearly seen.? I wrote what I wrote to distinguish between monetary, goods and asset inflation.? I think it is useful to make these distinctions, because most people when they hear the word “inflation” think only of goods price inflation, and not of monetary or asset inflation.

Now, onto today’s topic: how to protect ourselves from inflation and deflation.? With goods price deflation (should we ever see that under the Fed), the answers are simple: avoid debt, lend to stable debtors, and make sure you are economically necessary to the part of the economy that you serve.? You want to make sure that you have enough net cash flow when net cash flow is scarce.? You can use that cash flow to buy distressed assets on the cheap.? Economically necessary and low debt applies to the stocks you own as well.

On goods price inflation, take a step back and ask what is truly in short supply, and buy/supply some of that.? It could be commodities, agricultural products, or gold. ? As a last resort you could buy some TIPS, or just stay in a money market fund.? You won’t get rich that way, but you might preserve purchasing power.? In stocks, look for those that can pass through price inflation to their customers.? In bonds, stay short, unless they are inflation-protected.

This is not obscure advice, but there is an art to applying it.? There comes a point in every theme where prices of the most desirable assets discount or even over-discount the scenario.? Safe assets get overbought in a deflation toward the end of that phase of the cycle.? Same thing for inflation-sensitive assets during an inflation.? As for me at present, you can see my portfolio over at Stockpickr; at present, I split the difference, though my results over the last five months have been less than stellar.? I have companies with relatively strong balance sheets, and companies with a decent amount of economic sensitivity, whether to price inflation or price inflation-adjusted economic activity.

I don’t see the global economy heading into recession; I do see price inflation ticking up globally, and also asset inflation in some countries (China being a leading example). ? But we have a debt overhang in much of the developed world, so we have to be careful about balance sheets.

I may have it wrong at this point.? My equity performance over the last seven-plus years has been good, but the last five months have given me reason for pause.? Well, things were far worse for me 6/2002-9/2002; I saw that one through.? I should survive this one too, DV.

Personal Finance, Part 5 ? Inflation and Deflation

Posted on 6 December 2007 by David Merkel

This is another in the irregular series on personal finance.? This article though, has implications beyond individuals.? I’m going to describe this in US-centric terms for simplicity sake.? For the 20-25% of my readers that are not US-based, these same principles will apply to your own country and currency as well.

Let’s start with inflation.? Inflation is predominantly a monetary phenomenon.? Whenever the Fed puts more currency into circulation on net, there is monetary inflation.? Some of the value of existing dollars gets eroded, even if the prices of assets or goods don’t change.? In a growing economy with a stable money supply, there would be no monetary inflation, but there would likely be goods price deflation.? Same number of dollars chasing more goods.

Let’s move on to price inflation.? There are two types of price inflation, one for assets, and the other for goods (and services, but both are current consumption, so I lump them together).? When monetary inflation takes place, each dollar can buy less goods or assets than in the absence of the inflation.? Prices would not rise, if productivity has risen as much or more than the amount of monetary inflation.

Now, the incremental dollars from monetary inflation can go to one of two places: goods or assets.? Assets can be thought of? as something that produces a bundle of goods in the future.? Asset inflation is an increase in the prices of assets (or a subgroup of assets) without equivalent improvement in the ability to create more goods in the future.? How newly printed incremental dollars get directed can make a huge difference in where inflation shows up. Let me run through a few examples:

?In the 1970s in the US, the rate of household formation was relatively rapid, and there was a lot of demand for consumer products, but not savings.? Money supply growth was rapid.? The stock and bond markets languished, and goods prices roared ahead.? Commodities and housing also rose rapidly.
In? the mid-1980s the G7 induced Japan to inflate its money supply.? With an older demographic, most of the excess money went into savings that were invested in stocks that roared higher, creating a bubble, but not creating any great amount of incremental new goods (productivity) for the future.
In 1998-1999, the Fed goosed the money supply to compensate for LTCM and the related crises, and Y2K.? The excess money made its way to tech and internet stocks, creating a bubble.? On net, more money was invested than was created in terms of future goods and services.? Thus, after the inflation, there came a deflation, as the assets could not produce anything near what the speculators bid them up to.
In 2001-2003 the Fed cut rates aggressively in a weakening economy.? The incremental dollars predominantly went to housing, producing a bubble.? More houses were built than were needed in an attempt to respond to the demand from speculators.? Now we are on the deflation side of the cycle, where prices adjust down, until enough people can afford the homes using normal financing.

I can give you more examples.? The main point is that inflation does not have to occur in goods in order to be damaging to the economy.? It can occur in assets when people and institutions become maniacal, and push the price of an asset class well beyond where its future stream of cash flow would warrant.

Now, it’s possible to have goods deflation and asset inflation at the same time; it is possible to save too much as a culture.? The boom/bust cycles in the late 1800s had some instances of that.? It’s also possible to have goods inflation and asset deflation at the same time; its definitely possible to not save enough as a culture, or to have resources diverted by the government to fight a war.

The problem is this, then.? It’s difficult to make hard-and-fast statements about the effect of an increasing money supply.? It will likely create inflation, but the question is where?? Many emerging economies have rapidly growing money supplies, and they are building up their productive capacity.? The question is, will there be a market for that capacity?? At what price level?? Many of them have booming stockmarkets.? Do the prices fairly reflect the future flow of goods and services?? Emerging markets presently trade at a P/E premium to the developed markets.? If capitalism sticks, the premium deriving from faster growth may be warranted.? But maybe not everywhere, China for example.

The challenge for the individual investor, and any institutional asset allocator is to look at the world and estimate where the assets generating future inflation-adjusted cash flows (or goods and services) are trading relatively cheaply.? That’s a tall order.? Jeremy Grantham of GMO has done well with that analysis in the past, and I’m not aware that he finds anything that cheap today.

We live in a world of relatively low interest rates; part of that comes from the Baby Boomers aging and pension plans investing for their retirement.? P/E multiples aren’t that high, but profit margins are also quite high.? We also face central banks that are loosening monetary policy to reduce bad debt problems.? That incremental money will aid institutions not badly impaired, and might eventually inflate the value of houses, if they get aggressive enough.? (Haven’t seen that yet.)? In any case, the question is how will the incremental dollars (and other currencies) get spent?? In the US, we have another demographic wave of household formations coming, so maybe goods inflation will tick up.

We’ll see.? More on this tomorrow; I’ll get more practical and less theoretical.

Personal Finance, Part 4 — Health and Disability Insurance

Posted on 7 November 2007 by David Merkel

With health insurance, the main idea is that you should be covered in the event of a catastrophe.? First dollar coverage is nice if your employer is a sugar daddy (be sure and thank him, but not too effusively, lest he realize how much he is paying…), but insurance is not really effective at claims management; it is far more effective at risk-bearing.

To that end, high deductible plans can be effective for those that have to buy insurance privately.? Just make sure that you fund the deductible. Health Savings Accounts are triple tax free, and can be a particularly sweet deal.

Though this also applies to health insurance, with disability insurance, consider the claims-paying record of the insurer.? This is not a coverage where lowest premium payment wins.? Good companies do their underwriting on the front end, and pay legitimate claims.? Bad companies don’t do their underwriting on the front end, and deny legitimate claims.? This usually shows up in the complaint statistics at you state insurance department, so review those before buying disability insurance.

Also, with disability insurance, note the distinctions between “own occupation” and “any occupation” coverage.? With “own occ,” a surgeon who loses his steady hand could make a claim, but could not under “any occ.”? He could go flip burgers.? Also, note total and partial disability terms.? Under what conditions will they pay, and how much?

If you do become disabled, the insurance company may attempt to buy out your claim with a lump sum.? Don’t take the lump sum; they typically lowball the offers; claimants would receive a lot more over time if they were patient and took the payments gradually.

Now, not everyone needs disability insurance.? If you’re in a low-risk occupation, like me, odds are that you won’t be disabled to where you can’t earn money.? Analyze your own willingness to take risk in this area if you decide not to buy disability insurance.? Some risks are best self-insured.

Personal Finance, Part 3 — Buy The Life Insurance You Need

Posted on 6 November 2007 by David Merkel

Sorry that my posts have become more terse and less frequent.? A large part of that was recent computer troubles, which have largely been rectified.? I highly recommend the program and advice on this webpage if your computer is running slow.? Beyond that, I have had internet outages (thank you Verizon), and my efforts at obtaining long-term investors for my strategies have eaten up a lot of time.

Tonight’s post deals with life insurance.? My main advice: buy what you need, not what someone wants to sell you.? What most people need is protection for their loved ones from untimely death, which can be satisfied by term insurance.? Now, some wealthy people with complex estate planning needs can benefit more from other forms of life insurance, but that’s not common.? Also, people who aren’t so healthy can benefit from permanent insurance through an agent, because that may be the only way that they can obtain coverage on a reasonable basis.

Why do I favor term insurance?? It’s cheap.? It’s cheap because it is easy to compare the features of various policies against each other to find the best price.? But what if some company that is lower quality offers the best price?? The state guaranty funds stand behind the insurance companies, and no one has failed to receive a death benefit on a timely basis as a result.? (Note: agents are not allowed to tell you this, because the states don’t want lower quality companies to gain a marketing advantage by mentioning the guaranty funds.)

Term insurance offers another advantage: re-underwriting.? If after ten years, you are still in good shape, and you still need insurance, apply for a new policy at a lower rate over the same remaining term as your old one.? If you can get one, buy it and cancel the old policy.? If your health is not so good, keep paying premiums on the old policy.

Where do you buy the insurance, then?? Google the phrase “term insurance,” and a variety of comparison services will pop up.? Try a few of them, and buy from the cheapest.? The younger you are, the longer the term you should buy for, because the far-out years are cheaper.? The older you are, stick to ten years at most.

A few final points: don’t buy policy riders; they are an expensive way to obtain insurance.? Also, don’t buy convenience insurance policies that offer token amounts of insurance; they are expensive also.? Last, don’t scrimp on the amount of coverage.? Few people are overinsured when it comes to life insurance; 5-10x your salary is pretty standard, but analyze how much your loved ones will need in your absence, and buy that much coverage.

Personal Finance, Part 2 — Risks

Posted on 3 November 20076 November 2007 by David Merkel

I view personal finance through the prism of risk management. What can go wrong? Here are many of the threats that the average person faces:

Die too soon
Bad health
Disability
Inflation/Deflation
Unemployment
Property & Liability losses
Live too long
Not earn enough on investments

This list is not exhaustive; perhaps you can think of more. Each one reflects an aspect of life that we don’t fully control. ? Some of them can be fully or partially hedged through insurance (1, 2, 3, 6, 7), some can be fully or partially hedged through investment policy (4, 8 ), and some can’t be hedged at all (5).? My next few articles in the series will deal with the hedgeable risks, and what reasonable strategies can be for dealing with each one.

Personal Finance, Part 1

Posted on 2 November 2007 by David Merkel

This is the first in an irregular series of articles on personal finance issues.? I have only worked in two industries in my life — life insurance and asset management.? I have distinct opinions here, and ones that may prove to be controversial, because they will step on the toes of those who disproportionately benefit from how the system works at present.? All of that said, don’t take my word as gospel on these issues for your own personal situation.? Get personal, tailored advice from someone who knows your intimate financial details.

Tonight’s topic is on work.? Who drives your financial plan?? Either you can drive it, or, you can hire someone to drive it, or, you can let multiple parties take a “piece of the action” and end up with a crazy quilt.? The first option means that you have to work and learn.? The second option means that you have to learn enough to choose a good advisor.? The last option means that there is no organizing principle, but you end up with whoever successfully convinces you to part with money for a part of a financial plan on any given day.

I encourage the first two options.? They are cheaper, integrated, and you get better results.? When friends come to me for advice, my first question is “how much work do you want to do?”? It’s good to learn about financial topics.? Aside from the personal benefits, there are positive spillover effects into the rest of life.? It makes you more productive to those you serve, if you understand the basic economics behind the tasks that you do.

I understand enough about automobiles to be able to know whether my mechanic is likely lying to me.? The same is needed to be an intelligent user of financial professionals.? To not learn the modest amount needed to evaluate financial professionals is to invite financial salesmen to come and sell you on their product of the day, which may not be the best thing for you.

Twenty years ago, I? began spending an hour a day on average improving my knowledge of financial matters.? You don’t need to do that much, but you do need to learn about personal finance issues.? Future articles in this series will give my view of personal finance topics; I hope you can benefit from them.

Neither a Borrower nor a Lender be

Posted on 12 November 201912 November 2019 by David Merkel

Photo Credit: Ben Schumin || Looks like a place where you may get a fast deal, but not the best deal.

Remember 125% LTV loans on houses prior to the financial crisis? Well, auto loans now are their twin separated at birth. The Wall Street Journal wrote an article recently about those who lend more than 100% on automobiles.

Now, in the old days, auto loans were short. They were shorter than five years, and never more than 80% of the value of the car. This meant that the balance of auto loan would always be less than the depreciated value of the car under ordinary circumstances.

But as has been common in American history, we always test the limits in lending. Maturities have been lengthened and loan-to-value ratios expanded. If you need a car, and your current loan is more than the value of the car you want to trade in, some lender will be willing to roll the loss into the value of the loan to purchase the next car, with a higher interest rate to compensate for the added risk.

Why is the risk higher? Auto loans are collateralized by the car. If you don’t pay, the repo man comes and takes the car. If the car is worth less than the loan, the borrower is liable for the difference. When the difference is big, the lender will pursue the borrower for payment, and either get the payment, or send the borrower into bankruptcy. The costs of bankruptcy to the borrower means losing the car and not being able to borrow for seven years or so.

But there will be costs to the lender as well. In a financial crisis, most of them will go bankrupt themselves. They aren’t thickly capitalized, and can’t afford a lot of losses. That’s part of the price of making low quality loans.

What to do

The first step in doing well here is to buy a cheap car that is of reasonable quality, even if it isn’t fashionable. I have only once paid more than $11,000 for a car, and that was for a 15-seat Ford XLT Van that last 14 years for me. Typically these days, I buy refurbished cars that have been through a wreck, and carry a salvage title. I would say, “You don’t need to look good,” but I look just fine. I pay very little for cars, and they last well.

Part of the challenge is finding honest auto dealers who charge a reasonable markup over their costs. Ask your smart friends for advice. (If you don’t have smart friends, get some.) Part of the price of the method that I use is that few lenders will lend on “salvage title” vehicles, so I have to pay cash. It is better to borrow unsecured at a high rate and buy a cheap but quality salvage title car than to buy an expensive vehicle from a regular dealer.

There is a hidden cost to buying salvage title cars though. If there is an accident and it is totaled, the insurer will pay you far less than for a similar non-salvage title vehicle.

Don’t Borrow to Buy a Car

This is the simplest advice. When I was 27, my parents came to visit me in California. My Father looked at the two used cars that my wife and I owned, and praised me — “You haven’t bought a lot of fancy rolling stock.”

I have never taken out an auto loan. I never will. Borrowing should only be for things that don’t depreciate, like a house.

People need to get over the idea that their car has to be powerful or pretty, and focus on buying cars that are reliable. Paying less for a car is one of the easiest ways to save money, so long as you get a quality car.

Avoid Owning Shares in Auto Lenders

I don’t know who you have to avoid here. I can’t think of a pure play. If you know of one, please mention it in the comments. I simply know that those who lend without adequate security eventually get hosed.

You would think we would have learned from the Financial Crisis, but the more I look at current conditions, the more I think we are short-sighted.

We are not facing a banking crisis now, but maybe we might around 2030. The banks are mostly in good shape now, but perhaps we might see the failure of some non-bank lenders in the next recession who have lent too much on autos.

In summary, try to avoid borrowing on a car, and don’t own companies who lend more than 100% on a car.

PS — three articles that I have written on buying cars:

Simple Stuff: What is Risk?

Posted on 15 May 2016 by David Merkel

Photo Credit: GotCredit

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

What is risk?

Here is my simple definition of risk:

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

There are several good things about this definition:

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

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

What is Financial Risk?

Here are some things that financial risk can be:

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

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

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

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.? Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.? Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

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

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

Save more, or,

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

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

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

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

Simple Summary

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

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

PS — Two final notes:

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

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

Matching Assets and Liabilities Personally

Posted on 15 January 201315 January 2013 by David Merkel

An email from a reader:

I saw some of your articles on Seeking Alpha, then read through a bit of Aleph Blog.? Thanks for writing the articles, they are quite interesting.? I have seen the advice “Match Assets and Liabilities” more times than I care to count.? And your insurance example is a very clear one.? However, I have never seen a clearly worked example for an individual.? When I look at it for my own case I never quite see a clear optimality from matching assets with liabilities.? Perhaps part of the difficulty is that most individual liabilities (or at least for me) are flexible in some way (vacation – luxury or basic?).? Another issue is that my major “asset” is my salary – which produces vastly more income than my assets.? So I’d love to see you (or anyone) work out a clear example of how matching works for an individual, particularly one with more salary income than investment income.

If you care for some numbers, here is my rough case:

0) I have a significant buffer.? Green light here.

In addition to the buffer, enough cash to prefund all of the following:

1) 5,000 liability in 2 months

2) 20-30,000 liability in 6-12 months (I have some, but not total, flexibility in timing and amount)

3) 40-60,000 liability in 2-4 years (again flexibility, and hope that investment return could help increase the number)

After that are two larger expenses which I don’t have sufficient cash for.? The amounts would be significantly modified based on investment returns:

4) 100-200,000 purchase to upgrade house? in 5 to 10 years

5) In 30 years retire based solely on savings.

Let me start by mentioning two old articles:

Personal Finance, Part 11 ? Your Personal Required Investment Earnings Rate [PRIER]

Personal Finance, Part 12 ? Longevity Risk

Both concepts play a large role in what I will write here, but I am not going to repeat them here.? I’ll try to keep this simple.

Intuitively, people know that they need to match assets and liabilities, but they sometimes forget that when greed or fear emerge.? If I am planning on buying a house next year, and I have just enough for the down payment and closing costs, why do I not invest the money in stocks?? Because I might not be able to follow through on my goal if the market drops.

If I am planning on retiring in 30 years, but I am risk-averse, why shouldn’t I invest all my money in a short-term bond fund?? Because higher long-run average returns result from bearing moderate risk.? On average, maximum returns result from bearing moderate risk over long periods of time.

So, how does this calculation work?? You create two columns of numbers.? The first column is what I need to fund.? Now when I say that I am not talking about regular living expenses. I am talking about the big ticket items that are required, and that you know about now.? Plot out those cash flows, year-by year.?? For the really long cash flows, like retirement, you might want to add in an adjustment for inflation.

The second column is how much you will save each year after regular living expenses, including the excess assets that you have now.? The difference between those two columns is your net cash flow profile, and by using the IRR or XIRR function in Excel, you can figure out your PRIER.

Don’t expect to earn much more than what long Baa/BBB bonds yield now (presently 4.7%).? If the PRIER is so high that you know that you can’t earn that, then it is time to make hard choices:

Save more
Reduce goals
Work longer
Etc.

Now, as to the investment of funds to achieve those goals, it’s not that complex.? Inside five years, buy short/intermediate term bonds. 5-10 years half intermediate bonds, half risk assets, like stocks. 10-20 years should be 75% risk assets, 25% long bonds.? Beyond 20 years, 100% risk assets, or, extremely long bonds if attractive.

When I say this, I do not mean to ignore market conditions.? There are times when risk premiums are low, like now, 2000, 2007, and it does not look like risk will be rewarded on average over the next ten years — that is a time to preserve capital.? Then there are times when the market has washed out — 2002, 2009, those are times to take more risk.? Stocks are harder to measure, so if you need better guidance, look at the yields on junk bonds.

Asset allocation is a compromise between matching assets and liabilities, and examining relative advantage in the asset markets.? Sometimes stocks are better than bonds, or vice-versa.? Gold works well during times of financial repression.

In Closing

There are a number of key variables we don’t know here:

Future inflation
Likely savings
Asset returns in nominal or real terms

A good plan will attempt to leave some slack in case asset returns are lower than expected.? I would not assume that I could earn more than 5%/year over the long run, or maybe 2.5% after inflation.

Given what I know, this is the best answer I can give.? With more data, I could sharpen it.? But the really hard part is estimating expenses when retirement is a long way off.

The Best of the Aleph Blog, Part 4

Posted on 3 February 2011 by David Merkel

The period from November 2007 through January 2008 was challenging, but I did say a lot of good things.? Here’s a sample of the best:

Contemplating Life Without the Guarantors

Markets always beat governments, unless governments get so determined as to subvert markets.? Guarantors provide “thought insurance” so you don’t have to analyze the bond that they guarantee.? But what if the solvency of the guarantor is questioned?

The US Dollar and the Five Stages of Grieving

An important article that explains why currency interventions almost never work.? Required reading for Treasury Departments and Central Banks.

Why Did I Name This Site ?The Aleph Blog??

Cogent explanation for the odd name.? But I have gotten the question a few times as to whether I named my site after Jorge Luis Borges short story, “The Aleph.”? The answer is no, but after reading “The Aleph,” I would say that it folds into reason number four for why this is called The Aleph Blog.? Aleph is big.? Very, very big.

On the Value of Secondary and Primary Markets

They are valuable for different reasons, but they are related.

In Defense of the Ratings Agencies

The original piece, pointing out how the regulators have abandoned their responsibility, having outsourced it to the rating agencies.

Personal Finance, Part 6 ? The First Question

How much are you willing to learn, and how much work do you want to do? For people who ask my advice, that is usually the first question that I ask.

Booyah for Brainy Buybacks! (But not Brain-dead Buybacks.)

There is no simple answer to whether a buyback is the right strategy or not.? It depends on the price of the stock versus its value.

Options as an Asset Class

You can own/short options, but you can’t own/short volatility per se, at least not back in 2007.

Municipal Tensions

We are experiencing the front end of the woes now.? This won’t be over for 20 years.

How to Read the Whole Bible, and Survive the Experience

A simple way to read the whole of the Bible, and avoid getting bored, as so many do who try to read it straight through, and give up when 10-50% done.

In Defense of the Rating Agencies ? II

Anyone can criticize, but who can offer a system that is better than the present one on a comprehensive basis?

The Beauty of Broken Moats

Berky had an opportunity with almost all of the financial guarantors kicked to the curb.? It never worked out because Berky would not take modest risks.? In foresight today, those modest risks don’t seem so modest, so salute Mr. Buffett, who has forgotten more than most of us will ever know.

What Did Buffett Know about the Gen Re Finite Reinsurance Deal with AIG?

Odds are, Buffett knew a lot more than he confessed to know.? Buffett is a maven on insurance issues.

On Benchmarking

Benchmarking enforces conformity on managers, and the shorter-term the horizon, the more it makes them closet indexers.

Pandora and the Fair Value Accounting Rules

There are really tough issues here.? Everyone wants to be accurate, but over what time horizon, and how to adjust over time?? Bright investors will build in provisions for adverse deviation, and be conservative.

Unstable Value Funds?

This didn’t prove to be an issue, in this credit cycle, though form what I heard from insiders, it got close.? If the Fed hadn’t done 0% and QE, my dire predictions might have come true.? They still might in the future.? Be wary.

Meet Some of my Friends

Though the videos have disappeared, the story of how President George W. Bush, Jr. came to visit the factory of a friend of mine (of which I own 1.4%) is an interesting tale.? I was proud of my friend, who is a humble, but a great guy.

A Bonus from MoneySense Magazine

A free version of what Canadian magazine buyers had to pay for. How to earn more while taking less risk.

Personal Finance, Part 11 ? Your Personal Required Investment Earnings Rate

The intuitive explanation of what you need to earn in order to achieve all of your life goals.? It’s probably higher than you think.

With 401(k)s and Other Defined Contribution Plans, Watch Your Wallet

An important article — from the article:

If you are paying more than 1% of assets per year, then something is wrong, unless the asset classes are esoteric, which should not be the case for DC plans.? Remember, you have to be your own guardian with defined contribution plans.? No one will do it for you.? And, if a few of your colleagues complain at the same time, you will be amazed at how quickly it will be taken seriously, because the administrative staff of the plan sponsor usually doesn?t get that much feedback.

In general, high costs are closely correlated with low performance.? Keep a close hand on your wallet, and leave those who are charging you more than 1%, unless they are doing something special for you.

=-==-=-=-=-=-==-=-=-=-=-

I think I gave good advice in that era.? As the bubble deflated, investors needed to be more careful, and I highlighted that.? Not that I will always get it right…