Search Results for “build the buffer” – Page 2

Pay Down Debt, or Invest?

Posted on 3 July 20214 July 2021 by David Merkel

Photo Credit: Mike Cohen || Certainty versus volatility

One question that many ask is “Should I invest or pay down debt?” Let me quote from a prior article Retirement — A Luxury Good.

What is a safe withdrawal rate?

A safe withdrawal rate is the lesser of the yield on the 10 year treasury +1%, or 7%. The long-term increase in value of assets is roughly proportional to something a little higher than where the US government can borrow for 10 years. That�s the reason for the formula. Capping it at 7% is there because if rates get really high, people feel uncomfortable taking so much from their assets when their present value is diminished.

How should you handle a significant financial windfall?

If you have debt, and that debt is at interest rates higher than the 10 year treasury yield +2%, you should use the windfall to reduce your debt. If the windfall is still greater than that, treat it as an endowment fund, invest it wisely, and only take money out via the safe withdrawal rate formula.

I have been debt-free for eighteen years. Being debt-free enables me to take more risk with my assets if I think it is warranted. At present, I think that if someone has debts with interest rates higher than 3.4%/year, it makes sense to pay down debt rather than invest more. Now there may be tax reasons why one would not liquidate assets to pay down debt, but if you have free cash not needed for a buffer fund, then use the excess cash to pay down debt. Don’t use the Dave Ramsey method, which is stupid. Pay down the highest interest rate debt first.

I can say this with greater confidence at present, because most stock portfolios and private equity portfolios will lose money in nominal terms over the next ten years much like the 2000-2010 decade. Valuations are comparable to that of the dot-com bubble, and unless you are invested in stocks with low valuations and low debt, you will get whacked when the next crisis hits, as growth stocks will decline by more than 50% unless the Fed intervenes, which it might NOT do if inflation is hot.

All other things equal, a debt-free lifestyle is pleasant — there is less worry. Anytime you lower the amount of money that must go out each month, life gets easier.

What’s that, you say? When would I be willing to invest rather than decrease debt? If I had an investment that I thought would return more than 7% over the interest rate of my highest yielding debt, I would invest, assuming that the investment has a sustainable competitive advantage.

I’ve given two rules here, and there is a considerable possibility that neither rule may apply. In that case, do half. Take half of the excess cash and pay down debt, and invest the other half. The “Do Half” rule exists to make good decisions easier when situations are uncertain. It’s not perfect but it will give you the second-best solution. And if you always do second-best, you are beating most of the world.

My bias is to pay down debt. It’s a happier lifestyle, and most people don’t do well acting like mini-hedge funds — borrowing to invest. In a bull market, it looks like genius, but when the bear cycle hits it is traumatic, and many don’t survive it well, particularly if they get laid off.

With that, in the present environment, I encourage you to reduce debt. Unless you invest in unpopular stocks, as I do, future returns will be poor. Reducing debt gives you a relatively high return, and with certainty. Take the opportunity to reduce debt when it makes sense.

Review Your Credit Profile

Posted on 29 December 2020 by David Merkel

Picture Credit: Daniil Vin || As a condtion of using the picture, his firm is CreditDebit Pro. This is NOT an endorsement of his services; it is a “thank you” for use of the image.

Before I start this evening, I want to mention three old articles that I have written on personal credit issues. Now some of my articles on having enough cash on hand would also apply, but the following three articles meet the topic the best:

On Credit Scores
The Asymptote of Joy and Woe (Okay, this is a cash management article, but it could have been written through the lens of credit scores as well.
Long-term Relationships and Credit Scores

The last article is a little “out there” but the range of things that credit scoring can affect is huge. For a humorous over the top take on such a system that has gone out of control, consider the Webtoon LUFF, which just recently completed.

As I said earlier regarding the many ways credit scores get used:

The same is true for many other uses of credit data. Different parties want different aspects of the underlying data. Whether it is employers, lessors, lenders, insurers, etc., in an impersonal world, where there are fewer shared ethical values than in the past, economic actors rely on semi-public data to get comfortable about who they are dealing with.
On Credit Scores

All manner of decisions are based off of your credit score and related scores. They can affect:

Loan decisions
Insurance coverages (Auto, Home, Umbrella, Small Business coverages, and maybe even Life)
Rental and Leasing
Employment
And, at the outer edge, relationships.

Credit scoring is a subset of algorithmic scoring that is going on with greater frequency in our anonymous world today. To escape some of that, you can try setting up a relationship with a local community bank, smaller insurance companies, etc. They will treat you as more of a person, and less of a number. That said, it will likely cost more on average. Your mileage may vary.

What to do?

I decided to write this because I went through my own credit profile at one of the credit bureaus, and decided to try to correct some information that looked wrong. Now my credit score is fine, but what I was doing was in the nature of locking a door to your house where that door is never used.

I called up credit card companies to close credit cards that had not been used in years, a few of which I thought had been closed, but the credit report did not reflect that. Also one where it said there had been a dispute over the account. Oddly, that one was the easiest to deal with. They have now closed the account.

Now there are many sources of getting credit data on yourself. This is a non-exhaustive list:

Credit monitoring from data breaches. I usually get enough of these that I rarely don’t have this credit data.
Through third parties doing you a service as a part of a broader offering to ad some value. My example here is AAA, where they have thrown in credit monitoring as a service.
From credit card companies themselves. My longest-dated credit card is from JPMorgan Chase, and they give me credit monitoring as well, and free access to my credit score. (Note: it is just one credit score. There are many of them and they are not identical, but typically they are highly similar.)
Finally, available to EVERYONE — AnnualCreditReport.com.

Complete data, totally free, excluding credit scores, is available at AnnualCreditReport.com. You can get all three credit bureaus at once, or, you could do a different one every four months in order to keep a closer eye on your credit profile. They all have roughly the same data anyway — I have never seen a significant difference on my profile between the three. But then, I have no loans and few credit cards outstanding. I have deliberately kept things simple over my lifetime.

Look at your credit data for things that are wrong. Talk to the lenders to correct things, and if that doesn’t work, file statements with the credit bureaus to tell your side of the story. Close unused accounts, with the exception of your longest-standing account, which plays a role in your credit score. Credit scores give you more points for the length of your longest open credit account.

Practically, I keep two personal credit cards. One is the card offering the best deals to me in terms of money back, and the other is the backup card, which is the one that I have had the longest. I keep two cards because of the possibility of fraud on one of the cards. When fraud happens, a card gets cancelled and reissued. During that time where you wait for the reissue, a backup card is a big help; the convenience of using a card for deferred payment is considerable if you pay off the bill in full each month.

I review credit card charges once a month to check for fraud. I have a monthly “finances day” for my home and business, where I check my finances, and manage future cash flow. I review the overall credit profile two or three times a year. Most of the time it yields nothing, but it only takes five minutes unless something needs to be corrected.

As I often say here: you are your own best defender. But if you feel that you are in over your head, find a smart friend who is local to you and ask him for help.

Finally, keep enough liquid assets around to deal with moderate disasters. Build a buffer against common troubles. If you do these things, and have insurance against most common risks, you will survive better than most, and absolutely survive 99% of the time.

The Asymptote of Joy and Woe

Posted on 9 October 2019 by David Merkel

Picture Credit: David Merkel / Aleph Blog || I call the middle of the graph “the slope of hope,” but really, it depends what side of the graph you are on…

This is one of my basic pieces on personal finance. The shape of the graph is illustrative, and the units don’t mean anything. It’s meant to motivate a simple concept that everyone should maintain at least a minimum savings buffer.

It is as Solomon said in Ecclesiastes 9:11:

I returned?and saw under the sun that?
The race?is?not to the swift,
Nor the battle to the strong,
Nor bread to the wise,
Nor riches to men of understanding,
Nor favor to men of skill;
But time and?chance happen to them all.
https://www.biblegateway.com/passage/?search=Ecclesiastes+9%3A11&version=NKJV

Accidents happen, both bad and good. We also will grow old, and get weaker. We may meet untimely deaths. Alternatively, we may live a comparatively long period of time, and find we didn’t lay enough aside for our old age.

Even the best of us may not plan well enough for the contingencies of life. That said, there is adequate preparation for most emergencies. First comes a buffer fund of 3-6 months expenses. Second comes basic insurance coverage: health, property and liability. Third comes insurance coverages for others that need your support: life and perhaps disability insurance. Fourth and last is planning for long term goals like retirement and perhaps some help for kids going to college.

This article is meant to deal with the first of those preparations — the buffer fund. It is meant to show how difficult life can be when you don’t have it, and how not having it likely means you may never have it. On the other hand, if you have the minimum buffer fund you may find that bit-by-bit, you get better off.

There are two reasons for this: first, both saving and not saving are usually habitual. This correlates partly with income, but more with your degree of future orientation. I’ve known managing directors on Wall Street that were living paycheck to paycheck. I’ve also known immigrants that earn little, but save half of it. Are you willing to sacrifice some of the present to gain a better future? Are you willing to consume the future through borrowing for expenses in order to have a temporarily better time in the present?

This is one reason why people with the buffer fund tend to keep going upward — they keep saving and investing. And, many without a buffer fund always find themselves in debt. Stuck in debt.

Then there is the second reason: accidents. Those with the buffer fund can handle most bad accidents, and can take advantage of most good accidents. We can call the good accidents “opportunities.”

When the person with the buffer fund faces a bad accident, it is typically a “speed bump.” Nothing notable happens to family life. If no bad accidents happen, he may find that he possess valuable options for the use of excess cash:

1) Pay your insurance premiums in annual installments?
2) Buy your next car without financing it?
3) Pay off your credit card bills in full each month?
4) Ask for a discount for cash when buying big ticket items?? (You?d be surprised.? I drove quite a deal with my orthodontist for my wife and eight kids. I?m the only one that hasn?t had braces.)
5) End the escrow account on your mortgage?
6) Pay tuition bills in full, rather than a payment plan?
7) Take advantage of financial crises, and extend credit at tough times?? (I am still receiving 13% from a business associate that I lent money to in March of 2009, with warrants.)
8 ) Retain cash in your corporation to reduce financing costs?
9) Not worry about the minor disaster that recently hit?
10) Raise your deductibles on your Auto, Home and Health insurance premiums to save money?
11) Receive discounts on services that you want to receive, by getting a discount for buying years ahead?
12) Fund your 401(k), IRA, HSA, whatever, to the fullest?
13 And more?
http://alephblog.com/2011/09/01/build-the-buffer/

When others are offering great deals in the rare times where they need fast cash, the man with the buffer fund (and more) can take advantage of the situation and become even better off.

He can also take advantage of the flexibility that has has to start a business, or, work for a startup that he thinks is particularly promising.

For those without a buffer, at best it can be treading water. But an accident can force someone underwater. Most of the avenues for borrowing with those not having assets who are borrowing to meet expenses are expensive in terms of the rate paid, and onerous in terms of the terms demanded.

Once enslaved to onerous debts, it becomes very difficult to get out of the slimy pit. Note also that credit scores affect all manner of economic affairs, and can affect insurance pricing (wealthier people are better risks on average), job applications, rental opportunities, and much, much more… consider this a minor third reason why my graph above applies. Penalties from banks and credit card companies are stiff, and further entrench debts.

And to those that are really bad off, driving uninsured, not keeping up with payments to the motor vehicles department of your state, not paying on auto debts can find their car repossessed, with the possible loss of employment if he can’t get there. At worst the person can lose the ability to rent and be out on the street. These thing don’t happen overnight, but I have seen them happen piece by piece. It is desperately difficult to reboot a life once you no longer have a place to live. Predators hire people like that, and find ways to cheat them. Those with no assets and many debts have no means of defense. In some cases friends and family may help, but even they cut their losses when things seem hopeless.

This is pretty glum stuff. Aleph Blog is first realistic, and second optimistic. Bad things like these happen, and the people who hit the bottom are typically not only poor money-wise, they are poor relationally as well. Typically they have offended most family members and friends on the way down, and are simply surviving in shelters and tent cities, maybe working, maybe begging, maybe stealing. It’s tough, and for those that work with them, it is exceedingly tough to rebuild the habits and conditions that modestly successful people have.

Closing

So is this just “The rich get richer, and the poor get poorer?” No, it is only partly that. For those that are starting out, make it you goal to be a saver and have a buffer fund of at least three months expenses. For those that are in debt and trouble, fight as if your back is against the wall, and pay off the debts. As you succeed, maybe some friends and family will see the change in your life and help you. For those that are working, but hopelessly behind on debt, declare bankruptcy with the firm determination that you will find a way to make it different in the next phase of your life.

Those at the very bottom need personal help to reboot their lives. Government programs won’t do it. Some churches and focused charities succeed slightly at it. It all depends on whether habits will change or not, and that is the toughest nut of all, humanly speaking. I have seen it happen. I have seen it fail. It comes down to the willingness to sacrifice to create a better life later, which is where this article began. Will you give up some of the present to get a better future? That is where the rubber meets the road.

PS — David X. Martin’s book Risk and the Smart Investor is an engaging way to deal with this topic for those that are better off.

What if I Need Something More Important Later?

Posted on 28 September 201929 September 2019 by David Merkel

Photo Credit: Nicholas Erwin

Some people find it difficult to save. This not only applies to people, but corporations, endowments, governments, etc. There is some amount of cash available to be spent. Why not spend it? There is some amount of borrowing that could be done that could allow you spend more. Why not do it?

Often the spending and borrowing that is done in the short-run lacks comprehensive thought about priorities. One way to try to get this across to some people is to say, “What if your car breaks down next week? How will you handle it?” or some other large outlay that is unexpected now.

Now some people never change on this. They go from cash flow crunch to cash flow crunch, from debt to more debt, from default notices to the repo man showing up when they are not there.

In a more sophisticated way, it can apply to some nonprofits with giving and drawing on their endowment. “Today’s priorities are the most important for our mission; we need the maximum from our resources. Tomorrow is too late.” Smart endowments keep slack assets around, because they can never tell when disaster or opportunity might strike.

Same for corporations that max out their borrowing profile to buy back stock. I realize you don’t want to leave a ton of cash around or you could be a takeover target, but eliminating all of your inexpensive flexibility presumes too much on business plans doing well. Good management teams keep a prudent amount of slack assets.

And governments… the tyranny of spending now can compromise your solvency, even if defaults produce extreme inflation or deflation, if it gets bad enough. These things only happen to Zimbabwe, Argentina, Venezuela, and Turkey, right? With a little help, the PIIGS are fine now, right?

Sigh. The repo man for governments is sometimes a civil war, which might erase bad prior spending commitments, or substitute them for a new set of spending commitments.

Back to home, where things are simpler… Jesus said, “Take heed and beware of covetousness, for one’s life does not consist in the abundance of the things he possesses.” [Luke 12:15, NKJV] We first have to understand that more spending, more goods, will not make us happier.

With some friends, wait for a teachable moment, and say, “Don’t you wish you didn’t have all the problems from this debt?” “Has all this spending really helped you?” And perhaps they might have the openness to change, but habits are stubborn things; breaking habits requires a desire greater than that of the habit, and that can be tough when some have a hard time saying “No.”

This is America. Freedom is prized. The pitch could be: do you want to be free — free from the headaches of all this debt? The positive goal could motivate change. There are lots of ways to budget and reduce debt; effective ways of motivating the need to change are scarce.

I’ve talked about the “stoplight rule” on spending:

* Less than 3 months expenses in the savings fund? Red light. Defer all discretionary expenditures.
* 3-6 months expenses in the savings fund? Yellow light. Some discretionary expenditures allowed, so long as you don?t dip back into the red light zone.
* More than 6 months expenses in the savings fund? Green light. Discretionary expenditures allowed, so long as you don?t dip back into the red light zone.
http://alephblog.com/2011/09/01/build-the-buffer/

But here’s another way to think about spending slack cash: think about a major goal you want to achieve, and ask whether the current expense ranks above that goal. Introducing the concept of opportunity cost in a friendly way could be useful.

And in that way, we can manage finances better, which means managing the priorities and opportunities of life better. After all, when opportunity or disaster knocks, do you want to find yourself short on resources?

The Best of the Aleph Blog, Part 35

Posted on 31 May 2018 by David Merkel

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In my view, these were my best posts written between August 2015 and October 2015:

Learning from the Past, Part 6 [Hopefully Final, But It Won?t Be?]

The currently final episode on my investing errors, covering the last eight years.? Note that Valero has made me five times on my initial investment, though, and I still own it now.? This piece has more of the bright side of what I learned.

Musings on the Wealth Effect

“None of the ways I mentioned for getting more money for spending out of investments is likely to produce a lot of additional spending in aggregate across the economy. ?As a result, I think that the Executive Branch, the Congress, and the Federal Reserve should be cautious of trying to make asset values rise, or encourage more borrowing against assets. ?It will likely not have any significant effect to grow the economy over the intermediate -to-long term.”

The Surprise Dividend

A hypothetical piece for a company that wants to pay its shareholders more, but wants to do it in a more tax-efficient way.

Thinking About Pensions, Part 1

Thinking About Pensions, Part 2

This is a very realistic look at the issues surrounding retirement, and how to fund it.? it is very frank, and accurate in terms of what is possible.

Quarterly Financial Reporting is Needed, Productive, and Good

Why Companies SHOULD Offer Earnings Guidance

Quarterly earnings reporting is necessary for proper oversight.? If we did not have earnings guidance, a cottage industry would grow up to give it because investors want to know whether companies are performing adequately or not.

The Importance of Your Time Horizon

This is one of the most important concepts in financial planning.? When will you need the assets to provide spending money?

Buying The Next Hot Idea

This is an idea that rarely works.? Why do people fool themselves and chase fads?

When to Deploy Capital

A full answer to the question, “When do I invest cash balances?”? Hint: a middling solution is usually best.? Don’t be too bold or too timid.

When to Double Down

This is a tough question, but I give a clear answer:

Now, since I set up the eight rules, I have doubled down maybe 5-6 times over the last 15 years. ?In other words, I haven?t done it often. ?I?turn a single-weight stock into a double-weight stock if I know:

The position is utterly safe, it can?t go broke

The valuation is stupid cheap

I have a distinct edge in understanding the company, and after significant review I conclude that I can?t lose

Plan and Act, Don?t React

In general, the best investing anticipates likely changes.? By the time a change is revealed, it is too late to make investment decisions.

Too Many Vultures, Too Little Carrion, Redux

I suggested at the time that there were too many investors buying distressed energy assets, many of which went broke.

The Incredible Chain of Lending

Why to be careful when the financial sector grows too large.

A Bigger Brick in the Wall of Worries

I suggest that nonfinancial corporates may be the next financial crisis.? This is looking more likely now.

Volume Is Usually Low At Turning Points

This is a less-known truth: you can’t catch the bottom or the top, particularly if you have a large portfolio to manage.

Modeling Financial Liquidity and Solvency

Why most bank cash flow testing stinks, and how to improve it.

Don?t Worry About Public Bond Market Illiquidity

Bonds are illiquid, aside from the cash that they regularly throw off.? That’s normal; get used to it.

How Much is that Asset in the Window?

How Much is that Asset in the Window? (II)

A theoretical discussion about what assets are worth, settling on the unhappy idea that it is utterly relative, and that changing macroeconomic situations can affect things markedly.

At Least Build A Small Buffer

Having a small cash hoard is better than no cash hoard

Commissions Matter

I disembowel the idea that it doesn’t matter how large the salesman’s commission is.

Long-term Relationships and Credit Scores

An interesting piece on marriage, and how to make things work out, even when there are economic disagreements.

One Dozen Thoughts on Dealing with Risk in Investing for Retirement

“The basic idea of retirement investing is how to convert present excess income into a robust income stream in retirement. ?Managing a pile of assets for income to live off of is a challenge, and one that most people?are not geared up for, because poor planning and emotional decisions lead to subpar results.”

Who Needs Liquidity Most?

Posted on 27 December 201627 December 2016 by David Merkel

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Here’s the quick summary of what I will say: People and companies need liquidity. ?Anything where payments need to be made needs liquidity. ?Secondary markets will develop their own liquidity if it is needed.

Recently, I was at an annual meeting of a private company that I own shares in. ?Toward the end of the meeting, one fellow who was kind of new to the firm asked?what liquidity the shares had and how people valued them. ?The board and management of the company wisely said little. ?I gave a brief extemporaneous talk that said that most people who owned these shares know they are illiquid, and as such, they hold onto them, and enjoy the distributions. ?I digressed a little and explained how one *might* put a value on the shares, but trading values really depended on who was more motivated — the buyer or the seller.

Now, there’s no need for that company to have a liquid market in its stock. ?In general, if someone wants to sell, someone will buy — trades are very infrequent, say a handful per year. ?But the holders know that, and most plan not to sell the shares, looking to other sources if they need money to spend — liquidity.

And in one sense, the shares generate their own flow of liquidity. ?The distributions come quite regularly. ?Which would you rather have? ?A bucket of golden eggs, or the goose that lays them one at a time?

Now the company itself doesn’t need liquidity. ?It generates its liquidity internally through profitable operations that don’t require much in the way of reinvestment in order to maintain its productive capacity.

Now, Buffett used to?purchase only companies that were like this, because he wanted to reallocate the excess liquidity that the companies threw off to new investments. ?But as time has gone along, he has purchased capital-intensive businesses like BNSF that require continued capital investment. ?Quoting from a good post at Alpha Architect?referencing Buffett’s recent annual meeting:

Question: ?In your 1987 Letter to Shareholders, you commented on the kind of companies Berkshire would like to buy: those that required only small amounts of capital. You said, quote, ?Because so little capital is required to run these businesses, they can grow while concurrently making all their earnings available for deployment in new opportunities.? Today the company has changed its strategy. It now invests in companies that need tons of capital expenditures, are over-regulated, and earn lower returns on equity capital. Why did this happen?

Warren Buffett?It?s one of the problems of prosperity. The ideal business is one that takes no capital, but yet grows, and there are a few businesses like that. And we own some?We?d love to find one that we can buy for $10 or $20 or $30 billion that was not capital intensive, and we may, but it?s harder. And that does hurt us, in terms of compounding earnings growth. Because obviously if you have a business that grows, and gives you a lot of money every year?[that] isn?t required in its growth, you get a double-barreled effect from the earnings growth that occurs internally without the use of capital and then you get the capital it produces to go and buy other businesses?[our] increasing capital [base] acts as an anchor on returns in many ways. And one of the ways is that it drives us into, just in terms of availability?into businesses that are much more capital intensive.

Emphasis that of Alpha Architect

Liquidity is meant to support the spending of corporations and people who need services and products to further their existence. ?As such, intelligent entities plan for liquidity needs in advance. ?A pension plan in decline allocates more to bonds so that the cash flow from the bonds will fund expected net payouts. ?Well-run insurance companies and banks match expected cash flows at least for a few years.

Buffer funds are typically low-yielding assets of high quality and short duration — short maturity bonds, CDs, savings and bank deposits, etc. ?Ordinary people and corporations need them to manage the economic bumps of life. ?Expenses are up, and current income doesn’t exceed them. ?Got cash? ?It certainly helps to be able to draw on excess assets in a pinch. ?Those who run a balance on their credit cards pay handsomely for the convenience.

In a crisis, who needs liquidity most? ?Usually, it’s whoever is at the center of the crisis, but usually, those entities are too far gone to be helped. ?More often, the helpable needy are the lenders to those at the center of the crisis, and woe betide us if no one will privately lend to them. ?In that case, the financial system itself is in crisis, and then people end up lending to whoever is the lender of last resort. ?In the last crisis, Treasury bonds rallied as a safe haven.

In that sense, liquidity is a ‘fraidy cat. ?Marginal borrowers can’t get it when they need it most. ?Liquidity typically flows to quality in a crisis. ?Buffett bailed out only the highest quality companies in the last crisis. Not knowing how bad it would be, he was happy to hit singles, rather than risk it on home runs.

Who needs liquidity most now? ?Hard to say. ?At present in the US, liquidity is plentiful, and almost any?person or firm can get a loan or equity finance if they want it. ?Companies happily extend their balance sheets, buying back stock, paying dividends, and occasionally investing. ?Often when liquidity is flush, the marginal bidder is a speculative entity. ?As an example, perhaps some emerging market countries, companies and people would like additional offers of liquidity.

That’s a major difference between bull and bear markets — the quality of those that can easily get unsecured loans. ?To me that is the leading reason why we are in the seventh or eighth inning of a bull market now, because almost any entity can get the loans they want at attractive levels. ?Why isn’t it the ninth inning? ?We’re not at “nuts” levels yet. ?We may never get there though, which is why baseball analogies are sometimes lame. ?Some event can disrupt the market when it is so high, and suddenly people and firms are no longer so willing to extend credit.

Ending the article here — be aware. ?The time to take inventory of your assets and their financing needs is before the markets have an event. ?I’ve just completed my review of my portfolio. ?I sold two of the 35 companies that I hold and replaced them with more solid entities that still have good prospects. ?I will sell two more in the new year for tax reasons. ?My bond portfolio is high quality. ?My clients and I are ready if liquidity gets worse.

Are you ready?

One Dozen Thoughts on Dealing with Risk in Investing for Retirement

Posted on 31 October 2015 by David Merkel

Photo Credit: Ian Sane || Many ways to supplement retirement income... — Photo Credit: Ian Sane || One of many ways to supplement retirement income…

Investing is difficult. That said, it can be harder still. Let people with little to no training to try to do it for themselves. Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell. They get there late, and then their emotions trick them into action. A rational investor would say, ?Okay, I missed that move. Where are opportunities now, if there are any at all??

Investing can be made even more difficult. ?Investing reaches its most challenging level when one relies on his investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will say that portfolio decisions are almost always easier when there is more cash flowing in than flowing out. ?It means that there is one dominant mode of thought: where to invest?new money? ?Some attention will be given to managing existing assets ? pruning away assets with less potential, but the need won?t be as pressing.

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 a retirement portfolio is a particularly hard version of this problem. ?Let me point out some of the areas where it will be hard:

1) The retiree doesn?t know how long he, his spouse, and anyone else relying on him will live. ?Averages can be calculated, but particularly with two people, the odds are that at least one will outlive an average life expectancy. ?Can they be conservative enough in their withdrawals that they won?t outlive their assets?

It?s tempting to overspend, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs. ?It is incredibly difficult to?avoid paying for an immediate pressing need, when the soft cost?is harming your future. ?There is every incentive to say, ?We?ll figure it out later.? ?The odds on that being true will be low.

2) One conservative estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%. ?That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero near the end of a bull market.

That said, most?people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets. ?At present, if interest rates don?t go lower still, that will likely (60-80% likelihood) work. ?But if income needs are greater than that, the odds of obtaining those yields over the long haul go down dramatically.

3) How does a retiree deal with bear markets, particularly ones that occur early in retirement? ?Can?he and?will he reduce his expenses to reflect the losses? ?On the other side, during bull markets, will he build up a buffer, and not get incautious during seemingly good times?

This is an easy prediction to make, but after the next bear market, look for a scad of ?Our retirement is ruined articles.? ?Look for there to be hearings in Congress that don?t amount to much ? and if they?do amount to much, watch them make things worse by?creating R Bonds, or some similarly bad idea.

Academic risk models typically used by financial planners typically don?t do path-dependent analyses.? The odds of a ruinous situation is far higher than most models estimate because of the need for withdrawals and the autocorrelated nature of returns ? good returns begets good, and bad returns beget bad in the intermediate term.? The odds of at least one large bad streak of returns on risky assets during retirement is high, and few retirees will build up a buffer of slack assets to prepare for that.

4)?Retirees should avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield ? it?is the oldest scam in the books. ?This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc. ?They have no guaranteed return of principal. ?On the plus side, they may give capital gains if bought at the right time, when they are out of favor, and reducing exposure when everyone is buying them.? Negatively, all junior debt tends to return worse on average than senior debts.? It is the same for equity-like investments used for income investing.

Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because many people are buying them as if they are magic. ?The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.

5) Leaving retirement behind for a moment, consider the asset accumulation process.? Compounding is trickier than it may seem. ?Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years). ?Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, there is no benefit much from a general rise in values from the stock or bond markets. ?The value of a portfolio may have risen, but at the cost of lower future opportunities. ?This is more ironclad in the bond market, where the cash flow streams are fixed. ?With stocks and other risky investments, there may be some ways to do better.

Retirees should be aware that the actions taken by one member of a large cohort of retirees will be taken by many of them.? This makes risk control more difficult, because many of the assets and services that one would like to buy get bid up because they are scarce.? Often it may be that those that act earliest will do best, and those arriving last will do worst, but that is common to investing in many circumstances.? As Buffett has said, ?What a?wise man?does in the beginning a?fool?does in the?end.?

6) Retirement investors should avoid taking too much?or too little risk. It?s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree. ?If a person can do that successfully, he is rare.

What is achievable by many is to maintain a constant risk posture. ?Don?t panic; don?t get greedy ? stick to a moderate asset allocation through the cycles of the markets.

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

Another way retirees can succeed would be investing in growth at a reasonable price ? stocks that offer capital growth opportunities at an inexpensive price and a margin of safety. ?These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into. ?This is harder to do than it looks. ?More companies look promising and do not perform well than those that do perform well.

Yet another way to enhance returns is value investing: find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that. ?After the companies do well, reinvest in new possibilities that have better appreciation potential.

8 ) Many say that the first rule of markets is to avoid losses. ?Here are some methods to remember:

Always seek a margin of safety. ?Look for valuable assets well in excess of debts, governed by the rule of law, and purchased at a bargain price.
For assets that have fallen in price, don?t try to time the bottom ? buy the asset when it rises above its 200-day moving average. This can limit risk, potentially buying when the worst is truly past.
Conservative investors avoid the areas where the hot money is buying and own assets being acquired by patient investors.

9) As assets shrink, what should be liquidated? ?Asset allocation is more difficult than it is described in the textbooks, or in the syllabuses for the CFA Institute or for CFPs.? It is a blend of two things ? when does the investor need the money, and what asset classes offer decent risk adjusted returns looking forward?? The best strategy is forward-looking, and liquidates what has the lowest risk-adjusted future return. ?What is easy is selling assets off from everything proportionally, taking account of tax issues where needed.

Here?s another strategy that?s gotten a little attention lately: stocks are longer assets than bonds, so use bonds to pay for your spending in the early years of your retirement, and initially don?t sell the stocks.? Once the bonds run out, then start selling stocks if the dividend income isn?t enough to live on.

This idea is weak.? If a person followed this in 1997 with a 10-year horizon, their stocks would be worth less in 2008-9, even if they rocket back out to 2014.

Remember again:

You don?t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income. ?If interest rates are low, as they are now, safe income will be low. ?The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don?t look at current income. ?Look instead at the underlying economics of the business, and how it grows value. ?It is far better to have a growing income stream than a high income stream with low growth potential.

Deciding what to sell is an exercise in asset-liability management.? Keep the assets that offer the best return over the period that they are there to fund future expenses.

10) Will Social Security take a hit out around 2026? ?One interpretation of the law says that once the trust fund gets down to one year?s worth of?payments, future payments may get reduced to the level?sustainable by expected future contributions, which is 73% of expected levels. ?Expect a political firestorm if this becomes a live issue, say for the 2024 Presidential election. ?There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.

Even if benefits last at projected levels longer than 2026, the risk remains that there will be some compromise in the future that might reduce benefits because taxes will not be raised.? This is not as secure as a government bond.

11) Be wary of inflation, but don?t overdo it. ?The retirement of so many people may be deflationary ? after all, look at Japan and Europe so far. ?Economies also work better when there is net growth in the number of workers. ?It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.

Also consider other risks, and how assets may fare. ?Retirees should analyze what exposure they have to:

Deflation and a credit crisis
Expropriation
Regulatory change
Trade wars
Changes in taxes
Asset illiquidity
Reductions in reimbursement from government programs like Medicare, Medicaid, etc.
And more?

12) Retirees need a defender of two against slick guys who will try to cheat them when they are older. ?Those who have assets are a prime target for scams. ?Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make assets stretch further. ?But there are other scams as well ? retirees should run everything significant past a smart younger person who is skeptical, and knows how to say no when it is necessary.

Conclusion

Some will think this is unduly dour, but this?is realistic. ?There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.

Even with skilled advisers helping, retirees need to be ready for the hard choices that will come up. They should think through them earlier rather than later, and take some actions that will lower future risks.

The basic idea of retirement investing is how to convert present excess income into a robust income stream in retirement. ?Managing a pile of assets for income to live off of is a challenge, and one that most people?are not geared up for, because poor planning and emotional decisions lead to subpar results.

Retirees should?aim for the best future investment opportunities with a margin of safety, and let the retirement income take care of itself. ?After all, they can?t rely on the markets or the policymakers to make income opportunities easy.

Lagging Long Yields

Posted on 22 November 201423 November 2014 by David Merkel

I’m a very intellectually curious person — I could spend most of my time researching investing questions if I had the resources to do that and that alone. ?This post at the blog will be a little more wonky than most. ?If you don’t like reading about bonds, Fed Policy, etc., you can skip down to the conclusion and read that.

This post stems from an investigation of mine, and two recent articles that made me say, “Okay, time to publish the investigation.” ?The investigation in question was over whether yield curves move in parallel shifts or not, thus justifying traditional duration [bond price interest-rate?sensitivity] statistics or not. ?That answer is complicated, and will be explained below. ?Before I go there, here are the two articles that made me decide to publish:

The first article goes over the very basic idea that using ordinary tools like the Fed funds rate, you can’t affect the long end of the yield curve much. ?Here’s a quote from Alan Greenspan:

?We wanted to control the federal funds rate, but ran into trouble because long-term rates did not, as they always had previously, respond to the rise in short-term rates,? Greenspan said in an interview last week. He called this a ?conundrum? during congressional testimony in 2005.

This is partially true, and belies the type intelligence that a sorcerer’s apprentice has. ?The full truth is that long rates have a forecast of short rates baked into them, and reductions in short term interest rates usually cause long-term interest rates to fall, but far less than short rates. ?There are practical limits on the shape of?the yield curve:

1) Interest rates can’t be negative, at least not very negative, and if they are negative, only with the shortest highest quality debts.

2) It is very difficult to get Treasury yield curves to have a positive slope of more than 4% (30Yr – 1Yr) or 2.5% (10Yr – 2Yr).

3) It is very difficult to get Treasury yield curves to have a negative slope of more than -1.5% (30Yr – 1Yr) or -1% (10Yr – 2Yr) in absolute terms (i.e., it’s hard to get more negative than that).

On points 2 and 3, when the yield curve is at extremes, the real economy and fixed income speculators react, putting pressure on the curve to normalize.

Aside from that, on average how much do longer Treasury yields move when the One-year Treasury yield moves?

Maturity	Sensitivity
3-year T	94.64%
5-year T	89.31%
7-year T	85.17%
10-year T	81.14%
20-year T	75.41%
30-year T	72.89%

The answer is that the effect gets weaker the longer the bond is, bottoming out at 73% on 30-year Treasuries. But give Greenspan a little credit — in 2005 the 30-year Treasury yield was barely budging as short rates rose 4%. ?Then take some of the credit away — markets hate being manipulated, so as the Fed uses the Fed funds rate over a long period of time, it gets less powerful. ?In that sense, the Fed and the bond market integrated, as the market began looking past the tightening to the long-term future of US borrowing rates, what happened to short interest rates became less powerful on long yields. ?This is particularly true in an era where China was aggressively buying in US debt, and interest rate derivatives allowed some financial institutions to escape the interest rate boundaries to which they were previously subject.

Also note my graph above. ?I took the Treasury yield curves since 1953, and used an optimization model to estimate 10 representative curves for monthly changes in the yield curve, and the probability of each one occurring. ?If yield curves moving in a parallel direction means the monthly changes at different points in the curve never vary by more than 0.15%, it means that monthly changes in yield curves are parallel roughly 70% of the time.

When do the non-parallel shifts occur? ?When monetary policy moves aggressively, long rates lag, leading the yield curve to flatten or invert on tightening, and get very steep with loosening.

Later, the article hems and haws over whether rising long rates would be a good or a bad thing, ending with the idea that the Fed could sell its long Treasury bonds to raise long yields if needed. ?That brings me to the second article, which says that long interest rates are at record lows, as measured by average Treasury yields on bonds with 10 years or more to mature.

The graph in the second article shows that it takes a long time for inflation to come back after the economy has been in a strongly deflationary mode, where bad debts have to be eliminated one way or another. ?Given the way that monetary policy encouraged the buildup of the bad debts from 1984-2007, it should be little surprise that long rates are still low.

Conclusion

So what should the Fed do? ?If they weren’t willing to try a more radical solution, I would tell them to experiment with selling long Treasuries outright, and not telling the market that it was doing so. ?The reason for this is that it would allow the Fed to separate out the actual effect of more Treasury supply on yields, versus how much the market might panic when it learns?that the long Treasuries might be available for sale. ?The second effect would be like Ben Bernanke mentioning the word “taper” without thinking what the effect would be on the forward curve of interest rates. ?It would be an expensive experiment, but I think it would show that selling the bonds in small amounts would have little impact, while the fear of a flood would have a big but temporary impact.

If the Fed doesn’t want to raise long rates, it could try moving Fed funds up more quickly. ?Historically, long rates would lag more than with a slow rise. (Note: 2004-2007 experience does not validate that idea.)

What do I think the Fed will do? ?I think that eventually they will let all long Treasuries and MBS mature on their own, and?replace them with short Treasuries, should they decide not to shrink the balance sheet of the financial sector as a whole. ?That’s similar to what they did after the 1951 Accord, which restored the Fed’s independence after monetizing some of the debt incurred in WWII. ?Maybe this is the way they eliminate the debt monetization now, if they ever do it.

I think the present Fed will delay taking any significant actions until they feel forced to do so. ?They have no incentive to take any risk of derailing any?recovery, and will live with more inflation should it arrive.

PS –?that?long rates move more slowly than short rates may mean that duration calculations for longer bonds are overstated relative to shorter bonds. ?It might mean that 30-year notes would be 2-3 years shorter relative to one year notes than a parallel shift would indicate.

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.

Classic: Ways to Cut Risk

Posted on 23 March 201423 March 2014 by David Merkel

This was published in late 2007 at RealMoney. ?I don’t know exactly when.

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I came into the investment business through the back door as an actuary and a risk manager. For more than a decade, I worked inside several large life insurance companies creating investment products. My team?s dirty secret? We just wanted to clip a smallish profit on the assets, without taking much risk ourselves. If we could do that, and produce a reliable investment result for our clients, we were happy.

That was my job then; in a different sense, it is my job now.? My goal as a writer, commentator, and independent money manager is to take much of the risk out of personal investing while retaining most of the profit potential.

Nobody can avoid every up and down in the market. What you can do, however, is to ensure that you don?t get crushed when the market rolls over. My own portfolio is a case in point. Over the last seven years, starting in September of 2000, my investment process has yielded an annualized return of 20% a year.? I manage to a long horizon, so I don?t try to cut losses in the short run.? I am willing to take pain if I feel that the underlying fundamentals are intact.? I had only one losing year in that time, but it was a doozy. During four months in 2002, my portfolio lost 32% of its value.? I was shaken, but I scraped together my spare cash and invested. Over the next 16 months, my portfolio rallied 86%, which I found about as astounding as the 32% loss.?

The experience taught me that risk control works. Oddly enough, though, risk control doesn?t get a lot of attention. The most popular books and websites on investing spend nearly all their time focusing on the prospect of big returns; they rush over the matter of how to avoid big losses or how to deal with these losses when they happen. The result? Many people sour on investing because they take risks they don?t intend and lose a lot of money. They conclude that the investment game is rigged against them and they leave investing.

It doesn?t have to be that way. Let me suggest five simple ways you can control your worst tendencies, reduce your risk and become a happier investor.

Spread your bets around. The most basic rule of risk control is to diversify your investments. It is also the most neglected rule.

Perhaps the neglect is because most people don?t understand what diversification means. For starters, it means building a buffer against all the stuff you would prefer not to think about?unemployment, sickness, a horrible bear market, etc. Before you start investing, you need three to six months of living expenses set aside in bank deposits, money market funds and short-term bond funds. Having this cushion protects you from having to sell investments in an emergency, which in turn allows you to take risk with your remaining assets.

On top of your emergency funds, your portfolio should include a dollop of high quality bonds that mature in anywhere from two to 10 years. For older people, bonds cushion the downside of the total portfolio and ensure that you can?t be devastated by a stock market downturn. For younger people, bonds provide an additional benefit?you can sell them to buy stocks or other investments if the market plunges and you spot tempting bargains. So how much of your portfolio should you devote to bonds? As little as 20% of your portfolio if you?re in your twenties and a risk taker; 50% or more if you?re above 65 or naturally cautious.

Once you?ve got your emergency funds and your bonds stowed away, it?s time for stocks?and, once again, diversification should be your starting point. You don?t want to bet your entire future on a handful of stocks or on one industry or even on a single country. The easiest way to ensure that you?re widely diversified among many different stocks is to invest in a mutual fund or exchange-traded fund that holds scores of individual stocks, representing a multitude of different industries.

If, like me, you prefer to buy individual stocks, you have to balance your desire to be widely diversified against how much money you have to invest and?just as important?how much time you have to spend researching companies. My minimum for reasonable diversification is 15 stocks. When I started investing as a serious amateur back in 1992, I started with 15 stocks in my portfolio, and I bought $2,000 of each of them. Since then I?ve made maybe a dozen serious investing mistakes, but because I had my money diversified among many companies, none of my mistakes ever cost me more than 2% of my total capital.

These days I?m even more diversified: I run with 35 stocks, which is close to the maximum an individual can hope to track and research. Generally I devote an equal amount of money to each of my stocks?an equal weight, in investment jargon?because usually I can?t tell what my best ideas are. When a position gets more than 20% away from its target weight, I consider whether I should bring it back to equal weight or sell the whole thing.? Occasionally I deviate from equal weighting, but only when I have a very safe stock that is grossly undervalued. I never go above a double weight, which means that a single stock rarely accounts for even 6% of my overall portfolio.

The final way I diversify my portfolio is intellectually. I try to listen to as many viewpoints from as many different people as I can. I do this because the ideas of all but the most careful investors are internally correlated. They reflect some idea of what the economy is likely to do in the future, and they lean toward companies that fit that view. Some investors love companies with high P/E multiples and incredible growth stories. Other investors?and I?m one of them?love companies in distressed industries that are going for a song. You should listen to both camps. Doing so insures that you learn to think about investments from a wide number of perspectives. It makes investing more businesslike.

Here?s one trick you might find handy. As I gather my ideas from a wide number of sources, I print them out, and place them in a pile next to my computer.? I try to forget who gave me the idea, which forces me to look at the idea fresh, without the biases that come from trusting an authority figure.

Follow the cash. Most investors pay a lot of attention to how much a company earns; few investors realize how easily management can manipulate those earnings with fancy accounting. To reduce risk in the stocks you buy, keep an eye on a company?s cash flow as well as its earnings.

Your first step should be to look with a questioning eye at the non-cash, or accrual items, on the company?s financial statements. These include entries for such things as depreciation, inventory adjustments, or bad debt allowances. Cash is certain, but non-cash items such as these are anything but. Earnings can be thrown up or down by how quickly management decides to write down the value of a new factory or by how much it estimates its inventory of rotary-dial phones is really worth. The accounting industry tries to set guidelines for accruals, but management still has a lot of leeway.

For non-accountants, the easiest way to sniff out possible trouble is to compare the earnings statement with the cash flow statement?specifically the top segment of the cash flow statement, which shows ?cash flow from operations.? This is the amount of cold hard cash the company?s operations are generating, before making any payouts to lenders or shareholders, or investing in new equipment. In most cases, if a company?s earnings are growing, its cash flow from operations should also be going up, since higher earnings just about always mean more cash going through the business. So what if a company says its earnings are growing, but its cash flow isn?t?? You should be very, very wary. The financial statements aren?t necessarily bogus, but you have to puzzle out how a company?s earnings can be rising without throwing off more cash.

Sometimes there is no good answer to this puzzle. Remember Sunbeam, the small-appliance maker that hired ?Chainsaw Al? Dunlap to goose its business? I owned the stock in 1996 when Dunlap came on the scene. But after two earnings reports I became suspicious. ?All of these restructuring efforts are improving earnings, but they?re not producing cash from operations,? I thought. ?What gives?? I concluded something fishy was going on, so I sold for a nice gain. Over the next six months, the stock rose by 60%?then plunged 90% as it became clear that most of Sunbeam?s increase in earnings was the result of accounting shenanigans, not real business gains.

Love the unloved. Most people avoid industries that are under stress.? Who can blame them?? The industry outlook is horrible; there can?t be anything good here.?

I take a different view. I believe that some of the safest plays you can make consist of buying financially strong names in weak sectors. These companies are usually cheap in comparison to their earnings and to their book values. You can find out more about how to spot undervalued companies by visiting the website of Tweedy Browne, the famous value-investing firm, and reading their excellent paper on What Has Worked In Investing (http://www.tweedy.com/library_docs/papers/what_has_worked_all.pdf).

In addition to the standard measures, I look for companies with good bond ratings.? The ratings agencies are out of favor now, because of the current furor over securitization, but they produce the best single measure of a company?s creditworthiness. The raters award the best ratings to companies that can generate cash well in excess of what is needed to pay all their creditors and that possess a low ratio of debt to assets.

Once I?ve bought a stock, I try to be patient, because the payoff is usually not instantaneous. In 2001, when steel stocks looked horrible, I bought Nucor, the soundest company in the industry. Steel companies dropped like flies in 2002 and the stock did nothing?until the end of the year, when enough steel-making capacity had been closed down that steel prices began to rise. Nucor flew, and I made a nice profit.

The key to making this contrarian strategy work is to not overdo it. Some industries?newspapers, say, or fixed-line telecom companies?truly do have questionable futures. You have to analyze each situation on its own merits.? At present, my favorite industries are insurance, energy, agriculture/food processing, cement, and chemicals.

My value-hunting approach means that most of the stuff I buy is not popular. I veer away from firms that are pioneering new technologies or markets. Such companies are easy to get enthusiastic about, but difficult to value because there are so many unknowns.

When I talk about the companies I own, the response is often, ?You invest in obscure stuff.? What do you think about Google?? I don?t have an opinion on Google.? I can?t tell you whether it will produce enough profits over the years to justify its current price or not.? So much depends on future tastes and competition. I?d rather own cement companies; they are very difficult to make obsolete.

Take emotion out of it You should look over your portfolio two to four times a year. In my own case, I follow a very structured process. I take all of the investment ideas that I have gathered up since my last portfolio pruning, and rate them on valuation, momentum, and accounting quality to arrive at a composite measure of their overall desirability. I compare these ideas to the companies that are already in my portfolio.

This sounds complicated and so it is. But exactly how you do your ranking is less important than having a system for comparing the stocks in your existing portfolio to the alternatives that the market is offering you. Your goal should to take some of the emotion out of investing. You don?t want to fall in love with the companies that you already own. To avoid this, I try to pinpoint what companies in my ideas list are better than the median idea in my portfolio.? These become purchase candidates and I do further research on them.

I also look at the companies in my portfolio that are below the median in desirability, and I ask why I?m keeping them. In many cases, the companies are less desirable because they?ve gone up in price and are no longer as cheap as the once were. In other cases, they?re less desirable for the opposite reason? the company?s business has deteriorated and shows no signs of turning around. Every three to four months, I typically sell two or three companies from my 35-stock list and replace them with more promising companies from the ideas list. I typically hold a stock for three years.? Many of my ideas go against me at first, but often turn and make money for me later.

Smart money is slow money. If a stockbroker or financial planner tells you that you?ll miss a huge opportunity if you don?t buy right now, ignore them. A smart investor moves at his or her own pace.

To make sure that you don?t get pressured into buying something, it?s nearly always a good rule to avoid salespeople. Stockbrokers, financial planners, mutual fund salespeople and even the experts on the television all have financial incentives that can pull them in directions opposite to what?s in your best interest. Before buying any stock or any financial product, you should do a bit of background reading so that you understand what you?re buying and how much rival products cost. In many cases?insurance is a good example?you?ll find that the simplest product is your best buy. Complexity in insurance, and many other investments, is usually a cover for increased fees.

Especially when it comes to buying stocks, patience is your best friend. If an idea seems like a sure thing, sit on it for a month.? If the idea is still a good one, you will usually still have time to act on it.? If the idea is a bad one, the extra time will help you do further research and may make its problems evident.

One of the best ways to make money is to avoid losing it. When I approach new ideas, I try to ask how likely it is that I will lose money, and how much I could lose if I am wrong. I lose about 20% of the time. Six times in the last 15 years, I have lost half my money on an investment. Those are actually pretty good numbers. I can?t avoid all losses, but if I wait, take my time and do my research, I can limit my losses, and make money on the rest of my ideas.