Wealth...Uncomplicated

Quick and Dirty Real Estate Investment Analysis Spreadsheet - calculates present value of annual and cumulative cash flows, present value of equity, and annual growth rates ignoring taxes

Below is a quick and dirty real estate investment analysis spreadsheet that I put together for a reader at FiveCentNickel.  While the spreadsheet is somewhat limited in scope compared to more sophisticated, professional level analysis tools, it does give some ballpark figures for present value and future value cash flows and equity as well as the annual rate of return while ignoring taxes and a few other data.  Using a spreadsheet like this is important for real estate investors because with so many moving parts, the real value of a property and it's annual rate of return can become clouded.

Anyone who has heard a fair amount of investment stories will typically be able to recall someone who 'doubled' their money on a property.  While doubling your money is a good thing, if it takes 30 years to do it, well...who cares?  What this spreadsheet is designed to do is put things into perspective of annual returns as well as present values of each component of the property's return components - equity and cash flows.

Of course, this is entitled 'Quick and Dirty' with good reason.  It ignores taxes including deduction, depreciation, depreciation recapture, and capital gains.  It also ignores the rate of return on free cash flows (assumes it matches inflation) so the returns characterized are understated overall.  Lucky for you, it's in Excel so you can customize it to your heart's desire.

Here it is:  Download Quick and Dirty Real Estate Investment Analysis

By the way, whether you're analyzing a particular investment or your retirement, it's important to put things into present value terms so that apples to apples comparisons can be made.  Beyond that, it makes it easier to understand.

Mutual Funds or ETFs - four screens to make a good decision

With the explosion in ETFs over the last decade and the continued reduction in trading costs over that time, it's important to know whether you should own mutual funds or ETFs.  To help you decide between them, there are four key criteria to examine.

#1:  Are You an Active Trader?

For active traders, ETFs are 100% the way to go.  Of course, you should take a harder look at your investment strategy as active traders typically lag well behind the markets and they get to pay higher transaction costs.  NOTE:  93% of millionaires surveyed in the book, The Millionaire Next Door, were long-term investors.

#2:  Do You Contribute?

If you are continuing to make regular contributions to your portfolio, mutual funds have inherent advantages over ETFs.  Generally speaking, mutual funds are better for investors who are continuing to add to their portfolios up to certain dollar amounts.  NOTE:  This largely depends on how much and how frequently you are contributing to your portfolio.  The lesser the frequency and/or the higher the dollar figure of the addition, the more ETFs will make sense.

#3:  How Much Will You Invest?

The smaller the amount of your investment portfolio, the more mutual funds will be favored over ETFs.  Even with ETF trading commissions coming down to around $4/trade, it's hard to justify a $50 trade that costs $4 or 8%.  You could do better even if you had to pay a load on a mutual fund.  To know what's better, use this formula:

        Total Commissions  /  Total Value of Trades  =  Percent Cost

By knowing the percent cost, you can compare the cost of ETFs directly with mutual funds.  If the percent cost of buying an ETF is greater than a mutual fund over your projected holding period, go with the mutual fund.

#4:  Are You Style Conscious?

For those that care about investment style (typically those that are on the outer areas of the risk spectrum - low or high), you will need to go with a mutual fund that has a philosophy that matches your needs.  While ETFs and mutual funds have value and growth index offerings, this doesn't always match up with each investor's needs.  If you really care about investment style, mutual funds are the only way to go.

To learn more about ETFs, click here.

From WSJ: Where to Hide if Bonds Fall

In this article from The Wall Street Journal on October 14th, Larry Light does a very good job of explaining where to take cover in the event that bond prices fall as a result of inflation.  The problem with inflation is that when it starts to get higher than the Fed likes, they will typically raise interest rates as high and as fast as they deem appropriate to choke off inflation.  With the money supply still incredibly loose and government spending on the greatest bender in half a century, this is a timely article.

Interest Rates Up, Bond Prices Down

There is a great illustration that has been used countless times to drive this fundamental relationship home to investors and professionals alike.  It is the old see-saw picture of interest rates, bond prices, and maturities and I've grabbed a copy for your enjoyment below:

 

As the picture so adequately demonstrates, when interest rates rise, there is an opposite effect on bond prices - they drop.  The amount that they drop is largely dependent upon the amount of time until the bond matures.  The further away from the center of the see-saw, the more sensitive a bond is to changes in interest rates.  Conversely, the closer to the center, the less sensitive a bond is to rates.

Historical Context

Now that we've mastered the fundamental relationship between bond prices, maturities, and rates, let's take a quick look at where we are with respect to interest rates.  This is a nice graph showing interest rates on 10 year Treasury notes:

 

As the graph very clearly points out, we are near the bottom of where interest rates have been historically, and my wicked good intuition tells me that rates will eventually move up.  When that will happen, I haven't a clue, but they will sometime sooner than later.

What to Do Now

At present, there is no evidence that would suggest that rates would increase significantly in the next three months.  This means that you can feel relatively safe holding intermediate to long maturity bonds without fear of getting crushed with an interest rate hike.  Until the economy shows that it is solidly out of recession (and this will happen even as unemployment increases), it is unlikely the Fed will be in a position to raise rates.

Side Note:  The Fed must first make sure the recovery will last before raising rates because if they raise rates too soon, too fast, or too much, we will have a double dip recession which is an untenable situation.  Think Japan's Lost Decade.

What to Do When Rates Rise

When rates rise, and this is the point of The Wall Street Journal article, there are three places to go that will shorten your maturities and thereby reduce your risk of getting crushed in your bond portfolio.  These are (1) short-term bond funds, (2) certificates of deposit, and (3) stable value/money market funds.  Any of these three will do, but it's usually a good idea to be around a three year average maturity or less.

Three More Places to Look

Beyond this, I'd also like to add three other places to go when interest rates flare up from inflation concerns.  The first are I Savings Bonds which currently yield 0%, but are tied to inflation rates.  If inflation does start to pick up, I Savings Bonds will pay the then current inflation rate plus a certain fixed percentage based on when the bond was issued.  I Savings Bonds purchased today will pay inflation plus 0.10% (the next rate posting is due next month).

The next place to go is into TIPS or Treasury Inflation Protected Securities.  These are very similar to I Savings Bonds, but instead of posting interest earned, TIPS price will increase based on the inflation readings.  These are typically the best place to go to find a true hedge against inflation as they are pegged to inflation anyway.

Finally, if inflation does spark higher interest rates, you can go to some of the newer commodities basket ETFs and mutual funds.  While accredited investors (really rich folks) can get access to more of these kinds of funds, owning some commodities isn't a bad idea to hedge against inflation.  After all, inflation is an increase in the cost of goods and commodities either are or are a part of the production of these goods.

Out of the six possible places to go, there isn't a one size fits all answer.  Usually a good mix of all of these will work to your advantage when rates are increasing.

By the way, one of the very interesting stats in the WSJ article is that for every 1% that the 10 year Treasury increases in yield, there is a corresponding loss of 8.5% in the price of the bond.

Inflation on the Horizon, Stagnant Market through 2015+

If you take a step back and look at the long-view big picture, you find some pretty interesting events that will ultimately lead to a stagnant market through 2015 or later.  First, we entered a stagnant market back in 1999/2000 and since then we've seen a couple of deep troughs that put us where we are today.  In an effort to stimulate the economy, monetary policy (the money supply controlled by the Fed largely through interest rates) is incredibly loose and fiscal policy is on one hell of a spending binge.

Add to this the fact that we are likely in a long U shaped recession if not an L shaped depression and you get a market that won't be able to move significantly higher for several years yet.  There is a kind of zig zag pattern that emerges when we have a serious recession and it's something that is both easy to predict and incredibly difficult to time properly.

To walk you through this, let's consider the history of how we got here today.  The market growth of this decade was largely fueled by the housing and financial sectors along with mergers and acquisitions activity that reached a fever pitch in 2007.  Of course, since then the financial sector has for all intents and purposes failed.  Housing collapsed and mergers and acquisitions have slowed considerably.

Putting this together, we find ourselves in the worst recession since the Great Depression and the cure for what ails us--consumer spending--has basically disappeared.  In a typical knee jerk reaction, personal savings rates jumped from negative numbers not so long ago to what will likely be 7% by the time this recession is over.  If the consumer isn't spending, the Fed will usually drop interest rates to try to stimulate spending, but this time around, interest rates are as low as they can be and consumers still aren't spending.

This leads us to fiscal policy (government spending) as the sole mechanism of spending to stimulate the economy.  While Obama's administration is pumping a couple of trillion dollars into the economy through various means, it still takes time before fiscal policy can really make the economy move.  That is where we are today.  The economy is stabilizing, but not yet into growth figures.

The problem with monetary and fiscal stimulus on the level that we're seeing today is that when we do turn the corner and the economy starts to grow again, we have a very high risk of seeing rampant inflation.  Once inflation gets into the high single digits or even low double digits, there will be a response from the Fed.  That response will be to raise interest rates.

The effect of raising interest rates will be to increase unemployment so consumers and businesses will slow down their spending.  This will then lead to another recession of some sort and we'll not be back to a controlled economic environment for a few years.

In addition, with the government having spent an incredible amount of money, taxes will also be increased, further choking off spending.  Again, this won't happen until the economy gets back to growth, but it is likely to happen in the future.

So let's recap for a moment.  First, we're in this deep recession.  Eventually (Q4 2009/Q1 2010) we get back to a small amount of growth.  Next, consumers start spending again and the economy heats up (around 2011/2012) as interest rates remain low and money supply is loose.  In response to the increased economic growth, government can finally raise taxes and interest rates (2013/2014).  Finally we have inflation that is rising at an alarming rate.  To combat this, the Fed raises rates to control inflation and also puts us back into a recession (2015/2016).  Finally, we can see some sustainable growth which will wind up being as early as 2015 or as late as 2017.

While this is just one possible scenario, it would appear that we're on our way there assuming we avert going Japan.  Regardless, if you believe in this potential future, here is what you would prefer with your investments:

• Short-term bonds are favored over long-term bonds
• Inflation protected securities such as I Bonds or TIPS are favored over traditional bonds
• Stock allocation will need to be monitored and rebalanced in response to market swings
• Emergency funds/cash reserves will remain valuable as we work through a choppy time economically
• Real estate should be financed with fixed rate mortgages only
• Commodities prices will vary based on the economy and as soon as things turn around, expect higher prices

Diversification is Dead

Wow, that title is just funny to me.  I've seen an increasing number of articles declaring that diversification is dead--an argument that is both ridiculous and myopic.  In the latest article on this topic, I couldn't help but laugh at the analysis that was used to declare the death of diversification. The author uses a poor diversification model to make his point, and perhaps this is where the morticians of diversification are going wrong.

In his words:

"From the 2007 highs to the March 2009 lows, the S&P 500 lost 55.19%. How did a diversified portfolio fare over the same period of time? A portfolio with equal exposure to the Vanguard Total Stock Market ETF (NYSEArca: VTI - News), iShares Barclays Aggregate Bond ETF (NYSEArca: AGG - News), iShares Dow Jones US Real Estate ETF (NYSEArca: IYR - News), iShares MSCI EAFE (NYSEArca: EFA - News), iShares MSCI Emerging Markets ETF (NYSEArca: EEM - News), and iShares S&P GSCI Commodity ETF (NYSEArca: GSG - News) would have lost 48.12%.

Admittedly, 48.12% is better than 55.19% but either way investors lost about half of their money. That is simply not acceptable."

Let's take a closer look at this so-called diversified portfolio.  First off, the Total Stock Market ETF, Dow Jones US Real Estate ETF, MSCI EAFE ETF, and MSCI Emerging Markets ETF all fit under the broader asset class of equities or stocks.  To put this more simply, four out of the six investments or two-thirds are of the same asset class.

The other two fit into other asset classes that serve to give real diversification to the portfolio, but I don't know of many investors that use commodities as an asset class.  In fact, I'd say that this should be thrown out of the portfolio altogether on the grounds that commodities are inherently speculative in nature and are outside of the big three asset classes--stocks, bonds, and cash.

Now, let's use the author's equal weighting and apply it more appropriately over the same time period.  Assuming we started with a portfolio at the peak in 2007 that had one-third each in stocks, bonds, and cash, we find that there is a significantly different result.  Here are the numbers:

• Stocks (VTI) - Loss of 56.65%
• Bonds (AGG) - Gain of 0.57% excluding yield
• Cash (Avg. Bank Rates) - Gain of 2.25%

In total, the portfolio would have lost a total of just 17.94% which is a far cry from the 48.12% loss the author posits.  The fundamental difference is that stocks, bonds, and cash is a better diversified portfolio than stocks, bonds, stocks, stocks, stocks, and commodities.  See the difference?

The problem isn't that diversification is dead, rather the problem lies in the lack of diversification among meaningfully different asset classes.  Stocks are still stocks and it doesn't matter all that much if they're small, medium, large, domestic, or foreign.  It matters a little bit, but not nearly as much as the differences between stocks, bonds, and cash.

Bottom Line:  Diversification is alive and well.

Takeaways

• Diversification starts with allocations in stocks, bonds, and cash
• Secondary diversification within asset classes is necessary, but won't be nearly as effective as allocations among the three major asset classes

Investing 099 - Investment, defined

An investment is anything that you put money into and expect to receive something more in return over a period of time.  There are all kinds of different investments and each has a different expected return along with an associated level of risk.  When we make decisions with regard to investments there will always be a risk/return trade off that you'll need to assess in terms of your personal financial situation and the broader financial landscape.

This assessment of risk/return, little picture/big picture is where many go wrong with their investments and is the leading cause of poor investment returns over time.  To walk through an example, let's look at the average investor in the late 1990s.  Many were new to the stock market, but with new highs coming with regularity, it was almost impossible not to get caught up in the hype.  

When a new investor began combing through stocks and stock mutual funds, they initially looked for the highest return.  Unfortunately, what they didn't realize is that the shares were seriously overpriced and carried a much greater amount of risk than the same stocks or mutual funds did a decade earlier.  With the allure of high returns many investors got hammered in 2000 through 2002 when the internet bubble burst.  

The mistake here was a poor assessment of the risk/return, little picture/big picture.  With respect to risk, growth stocks were trading at price-to-earnings ratios that were considerably higher than at other points in history.  In other words, for each dollar of earnings in a company, investors had to pay considerably more (twice as much as the average or more in many cases).  The long-term average p/e of the S&P 500 is closer to 15 whereas many growth stock funds had p/e ratios in the 30s.

As for return, new investors believed that stock prices could continue to go higher and that a New World of investing was coming to life before their very eyes.  Wrong.  Companies still have to make profits and most of the internet companies simply hadn't profited a dime.  Without earnings in the underlying companies that the stocks represented, there could be no long-term investment returns.

The little picture analysis for many in the latter part of the 1990s was to determine how much cash they could scrape together to throw it into the stock market that was returning 20% or more.  Many ignored keeping a healthy emergency fund, some borrowed on margin (like getting a mortgage on your stock portfolio), and of course, there were those that took out home equity loans to get into the market.  This left their personal finances exposed to an inordinate amount of risk.

What's interesting to note is that by any big picture analysis at the time, it was apparent that the market was trading well above its historic average and even above its historic range as measured by p/e ratios.  Of course, investors were in love with the market and blinded by the double digit returns offered annually.  Making matters worse were the pundits on CNBC that were declaring that earnings no longer mattered and revenues were what stock values should be based on.  Umm...no.  Anyone who runs a business knows that if you don't make a profit, it doesn't matter how much you sell because you're losing money.  Again if your underlying investment is losing money, you will lose money too.

Does this sound anything like what happened in real estate?  Great returns attract money; risk is perceived to be much lower than reality; individuals put themselves at greater risk to 'get in the game'; the big picture reveals that the market is way out of whack and prices cannot be sustained; investors get crushed.  Yep, that's about right.

Takeaways

• Investments have an inherent risk/return trade off
• Creating and managing your investment portfolio must include a risk/return, little picture/big picture analysis or you will have a poor investment experience

Our Vaca Fund at Zecco - updated thru 5/22

Another week of ups and downs, but all for naught.  The market was basically flat this week and so too was our vacation fund.  At this point, we're still in the black and waiting for a short-term market decline in the coming weeks.  It would appear that the market rally has stalled for now, but we're still betting on a short-term decline prior to the market moving up for good.  Below is a chart for BGZ for the week.  A lot of action, no real change.

To view our investment strategy, click here.

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Dynamic Asset Allocation - a follow on to Rob Bennett's guest post

After reading yesterday's guest post from Rob Bennett, you might have some questions about what a dynamic asset allocation model might look like, who should use it, and what to expect from this type of strategy.  To address these points, let's take a quick walk through what the strategy looks like in terms of how your portfolio would be positioned using a basic outline.

Establish a Baseline Asset Allocation

This will be different for everyone, but let's say that you're 40 years old and expect to retire in twenty years.  You have a moderate risk tolerance--meaning you don't freak out when the market tanks and you don't get overly greedy when the market is on fire.  You might determine that your baseline asset allocation will look something like this:

• 70% Stocks
• 25% Bonds
• 5% Cash

Determine Min/Max Allocations

Since the market is sometimes underpriced and other times overpriced during various periods of the cycle, we need to set up some rules for how much money you're willing to put into or take out of any of these asset classes based on prevailing market conditions as measured by price-to-earnings ratios (P/E).  For this example, let's use:

• Stocks - Minimum Allocation of 50%, Maximum Allocation of 90%
• Bonds - Minimum Allocation of 10%, Maximum Allocation of 50%
• Cash - Minimum Allocation of 0%, Maximum Allocation of 10%

Changing Allocations Based on P/E

The historical average P/E of the S&P 500 is a little north of 15, and as such, we'll make this our 'market neutral' measuring stick.  When the average P/E of the S&P 500 is less than 15, we'll hold more stocks, and when it is greater than 15, we'll hold more bonds and cash.  This is where we'll make a determination of when to change allocations.  To continue our example, it might look something like this:

• On a proportionate basis, stock allocations will increase up to maximum levels when the average P/E of the S&P 500 hits 8 times earnings.
• On a proportionate basis, bond and cash allocations will increase up to maximum levels when the average P/E of the S&P 500 hits 23 times earnings.

As an example, let's assume that the P/E of the market goes up to 19.  On a very basic level, this means that the market is more expensive than historical averages.  In response to the relatively high price of the market, this is what the new allocations would look like:

• Stocks - 60%
• Bonds - 32%
• Cash - 8%

This is determined based on the current P/E of 19 which is 50% of the way to the maximum P/E (23 - 15 = 8, 19 - 15 = 4, 4 / 8 = 50%).  As a result, we subtract 10% to the baseline allocation of 70% in stocks leaving us with 60% of the portfolio in equities.  The reason for this is that if stocks are more expensive than historical averages, we expect that they will correct at some point back to historical norms.  As a result, less stock exposure will reduce the risk of price declines.

On the flip side, if the current P/E was 11 (we're pretty close to that now), then we would have an allocation that looked to have more exposure to relatively inexpensive stocks as follows:

• Stocks - 80%
• Bonds - 17%
• Cash - 3%

This is determined in the same manner, but instead of reducing exposure to stocks, we are increasing it in the hopes of taking advantage of relatively cheap stock prices.

What to Expect from Dynamic Asset Allocation

A well implemented dynamic asset allocation strategy will reduce the volatility in a portfolio to varying degrees based on market conditions.  Major declines like those seen from October of 2007 through March of 2009 are an instance where dynamic asset allocation portfolios would have performed well relative to the market since they would have shifted assets out of stocks and into bonds and cash before the crash.  Sounds great, right?

This is the other side of the coin.  When the market heats up and moves higher by leaps and bounds (remember the 1990s?), dynamic asset allocation portfolios will significantly underperform the market because assets will be shifted away from a fast growing stock market.

In short, dynamic asset allocation will do the following:

• Increase gains when the market is coming out of a bottom
• Reduce gains when the market is at the tail end of a boom
• Generally reduce volatility within a portfolio

What About Performance?

This strategy does not necessarily produce higher or lower returns than a buy and hold traditional asset allocation model.  The reason for this is that while you cut out major losses, you also cut out major gains.  The fact remains that much of the total return of the stock market is achieved when P/E ratios are high and rising.  Missing this upside while cutting back on downside adds up to no net superiority of investment returns.

Why Bother?

If the return characteristics are similar to a simple buy and hold strategy, you might wonder why anyone would pursue this strategy.  One word--risk.  For those that need and want market participation to keep pace with inflation, this strategy offers an avenue to participate while still paying attention to risk.  It is the risk aspect that makes this strategy worth pursuing for the right people.

Who Should Use This Strategy?

It is for anyone that is (1) more concerned with risk than return, (2) willing to put the time and effort into tracking the market and making allocation changes as needed, and (3) could be considered a 'savvy' investor.  In other words, this strategy is for more active investors that have a decent amount of knowledge and the discipline to execute.

Broadly speaking, retirees and those looking at retirement within 15 or 20 years will be more likely to adopt this strategy than younger investors with longer time horizons and less concern with risk.

Summary

Dynamic asset allocation is a sound investment strategy for those that are concerned more with managing risk than returns.  It will please when the market comes down off of a peak or up from a bottom and will frustrate when the market roars to new highs.  The strategy requires time, attention, and a certain level of skill, but for those that desire to manage risk, it's a strategy worth exploring further.

A Better Approach to Investing from Rob Bennett of A Rich Life

I'd like to introduce you to a very solid approach to investing from Rob Bennett, author of A Rich Life.  His investment approach has been given many names (the one I use for it is dynamic asset allocation).  The principles are sound and over the long run, it will serve to reduce overall risk in your portfolio while providing more than adequate returns when compared to static or strategic asset allocation methods.  To learn more, read on...

The conventional investment advice is to go with as high a stock allocation as you believe you can handle emotionally (because stocks offer the best returns in the long run for those who buy and hold) and then stick with that allocation no matter what. I don’t buy it for three reasons.

Reason #1:  Stocks Don’t Always Offer the Best Long-term Return

I have a calculator (“The Stock-Return Predictor”) at my web site that employs a regression analysis to reveal the most likely 10-year annualized return on a purchase of a broad U.S. stock index. It shows that stocks do indeed generally offer the best long-term return. But it also shows that when stock prices are where they were from 1995 through most of 2008, equities can offer less than impressive returns. At those price levels, it’s easy to beat stocks with far safer asset classes. Why take on all that extra risk when you are not likely to see any reward for doing so?

Reason #2:  Risk Tolerance Isn't Just About Feelings

It’s true that different personalities are better able to accept the risks associated with investing in a volatile asset class. But the historical stock-return data shows that a far more important consideration is stock prices. When stocks are selling at high prices, they are a whole big bunch more risky than they are when selling at moderate or low prices. There have been four times in history when stocks were selling at the prices that applied before the big crash. The average price drop on those four occasions has been 68 percent. That sort of loss is hard to take regardless of your level of personal risk tolerance. I don’t think it makes sense to ignore the differences in the riskiness of stocks at different price levels.

Reason #3:  Static Asset Allocation Doesn't Make Sense Emotionally

I take price into consideration when buying houses and cars and comic books and bananas.  
Why not when buying stocks? For me to be able to stick with a strategy for the long run, I need to have confidence in it. I could never have confidence in a strategy that required me to ignore price changes because the idea just defies common sense. If I don’t have confidence in the conventional approach to buy and hold, it’s not going to work for me.

So what do I do? Am I one of those investors who jumps in and out of stocks in a futile effort to time the market effectively?

By no means.

Short-term Timing versus Long-term Timing

I am persuaded by claims that short-term timing (changing your stock allocation with the hope of seeing a payoff for doing so within a year or two) does not work. This discredited approach to taking prices into consideration isn’t the only way to do so, however. How about the approach to timing that does work; the approach that the historical data shows is likely to be successful rather than unsuccessful?

That’s long-term timing (changing your stock allocation in response to big price swings with the expectation that you will see a payoff for doing so within five years or at most ten years). Long-term timing couldn’t be more different than short-term timing. All of the studies that show that timing doesn’t work actually show that short--term timing doesn’t work. The studies that look at long-term timing show that long-term timing does work. It’s not just common sense that says that you should be changing your stock allocation in response to major price swings. The historical record says so too.

Why does long-term timing work when short-term timing doesn’t? Because stock prices are set by investor emotion in the short-term, and emotions are unpredictable. In the long-term prices are set by the economic realities that are to a large extent predictable and are far from emotional. In circumstances in which stock prices are predictable, timing makes sense.

Those who engage in long-term timing were going with low stock allocations in the years prior to the price crashes in 2000 and 2008. They have far more in the way of assets today as a result. They will be earning compounding returns on the differential for many years to come. The data shows that those who practice long-term timing for 30 years should be able to retire up to five years sooner than those who do not.

I view long-term timing as an asset allocation strategy better in numerous ways than the conventional buy-and-hold approach.

Kudos to Rob for making a strong case for dynamic asset allocation.  This is a sound investment strategy and one that you should seriously consider in planning your own investments.  By the way, if you don't get this in the text version, checkout this chart from dshort.com.  Do you see how out of whack P/E ratios and stock prices get just before a massive crash?  That's what Rob's talking about.  When using stock prices alone, it's difficult to predict a crash without digging a little deeper.  After seeing the P/E ratios relative to historic ranges, it becomes much, much clearer.

Rob Bennett writes the “A Rich Life” blog. His “The Investment Strategy Tester” shows investors how they can recover all of their recent stock losses by converting from a passive investing strategy to a valuation-informed strategy.  You can find his blog here and The Investment Strategy Tester here.

Our Vaca Fund at Zecco - updated thru 5/15

The market was down this week, meaning we made some money on BGZ, the Russell 1000 3x Bear ETF from Direxion.  While we didn't make a killing, it was nice to see the bear market rally finally stall.  There are a great many problems with the economy and I'm not of the opinion that we're out of the woods.  For a quick list of problems still out there, you can take your pick from:

• Residential and commercial real estate price declines
• Increasing defaults on mortgages, loans, and credit cards
• Increasing unemployment
• Bankruptcy of two of the Big Three and pending trickle down
• Ailing banks and insurance companies
• Et cetera, et cetera, et cetera

You name it, we still have problems, but we must keep in mind that the stock market is a leading indicator and is usually six to nine months ahead of actual economic events.  Should this rally be sustained, it would indicate the economy would return to growth sometime in the September, October, or November timeframe.  I'm not that optimistic, as I think we can all agree that we're in the midst of a formidable recession second only to the Great Depression.

As a result, we're looking to take advantage of the bear market rally by shorting from what I believe to be a temporary peak.  We'll follow the market down and likely cash in once we have a 25% profit on the position.  Below is a quick chart for BGZ this week from Yahoo! Finance.

To view our investment strategy with this account, click here.

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Our Vaca Fund at Zecco - updated thru 5/8

Well, we took the plunge and bought BGZ, the 3x Large Cap Bear, betting on a market hiccup.  Since then, we're down on the position and on the account as a whole.  Bad timing to be sure, but we're under the assumption that the market will retest lows before ultimately moving higher in the second half of the year.  When you buy something at what appears to be the wrong time (and the glowing news from Wall Street would indicate as much), you need to go back to your assumptions.

For us, we have been operating on the belief that the market will move higher in the second half of the year with the economy moving out of recession around the first quarter of 2010.  With the recent gains on Wall Street, it would indicate that the recession would be over sometime in the 4th quarter of this year and they might be right.  Either way, we're going to hold BGZ for a bit and sell once the market hiccups in the coming weeks.

Also, I can no longer use Mint.com for tracking purposes, as once we sold TNA and bought BGZ, Mint's performance tracking engine blew a gasket.  As a result, we're simply going to use a screenshot from Zecco's trading center until either Mint fixes the problem or another free performance monitoring service pops up.

You'll notice that we already have a limit order to sell BGZ.  We've done this in the event we're sleeping through a market decline.  Otherwise, we generally favor market orders.

To view our investment strategy with this account, click here.

To setup an account with Zecco, use the banner below.

Our Vaca Fund at Zecco - updated thru 4/17

Another week of positive gains put our account up 66% since our initial investment on March 16th, ahead of the S&P 500 by 54% over the same period.  This market rally should lose some steam sometime soon which has us contemplating a short term 3x bear trade.  We also requested the addition of another $104.50 to keep up with our dollar cost averaging strategy.

The question of the day is:  Should we maintain our long-term strategy knowing that the market is still considerably lower than it will be by the end of our time horizon -OR- should we trade into a 3x bear ETF to take advantage of the short-term decline we are anticipating?  It'll be a game-time decision.  Either way, here's what our account looks like today:

To view our investment strategy with this account, click here.

To join the Zecco trading community, use the banner below.

Our Vaca Fund at Zecco - updated thru 4/10

The market rally continued this week and our vacation fund also benefited.  Since 3/16 of this year when we made our opening investment, the account is up 58% and is ahead of the S&P 500 by 41% over that span.  While this is great news, I must admit that I'm hoping for a nice hiccup in the market sometime soon so we can continue our investment program at lower market levels.  Here's a look at our performance from Mint.com:

To learn more about our investment strategy, click here.

To join the Zecco trading community, use the banner below.

Real Return - the most important number in investing

When it comes to measuring investment performance, we often only hear about the total return of an investment on an annualized basis.  However, an investment's real return is the most important number you need to know in the world of investing.  Measuring real return is simple enough, take the total return after taxes and subtract inflation.

If your investment returns 8% and inflation is 4%, your real return is 4%.  Easy enough, right?

The reason real return is so important is because if you know it, you will be able to more easily determine how much you'll need to fund any income goal you have from the return on your assets.  This can be anything from retirement to starting a foundation, and it's incredibly simple.

Calculating Asset Requirements

Take any annual income goal that you have and divide it by your real rate of return.  This would look something like this:

     $1,000 income goal  /  4% real rate of return  =  $25,000 in assets

In other words, for every $1,000 of income that you need, you'll need $25,000 of investments returning 4% annually after inflation.  Not many of us can sustain a retirement on just $1,000 annually, so let's look at a $30,000 annual income.

     $30,000 income goal  /  4% real rate of return  =  $750,000 in assets

Whoa, whoa, whoa!  That's more money than only the wealthiest people have, so how can anyone afford to retire?  Well, no one said it was easy, but if you remember, $481 is all you need to save monthly to become a millionaire.  Plus, Social Security will kick in some money...how much is yet to be determined.  However, let's say you get $10,000 from Social Security:

     $30,000 income goal  -  $10,000 from Social Security  =  $20,000 income goal from assets

     $20,000 income goal  /  4% real rate of return  =  $500,000 in assets

Conservatives Beware

What if you're a super conservative investor that puts money into 'safe' places like long term treasuries or other lower return investments?  Well, you're road to financial security is a heckuvalot tougher.  Try this on for size.

     4.5% total return from 'safe' investments  -  3.5% inflation rate  =  1.0% real return

     $30,000 income goal  /  1% real rate of return  =  $3,000,000 in assets

This is the fundamental reason that it is so important for our markets to work and provide returns well above inflation.  If they didn't provide the 4% real return, making it to retirement would become a virtual impossibility for all but a tiny fraction of the population.  See, the stock market isn't just for the rich, it's the most efficient way for everyday people to realize financial security--when it's working properly anyway.

Where are You Now?

If you're trying to figure out what you could afford in retirement today, here is the calculation for you:

     $150,000 in assets  x  4% real return  =  $6,000 annual income

The reason I used $150,000 is because this is the average pot of money that baby boomers have at retirement.  This doesn't equate to a very good income stream during retirement, but then again, 67% of boomers are unprepared for retirement according to Hewitt Associates, a major employee benefits provider.  Also, this calculation is for those that want only to live off of the investment returns and never eat away at the principal.  

Those that are unprepared for retirement will eventually run out of money if they live long enough.  To cover the shortfall, look forward to higher taxes to fund Social Security, Medicare, and Medicaid.

A Note on Deflation

What if we happen to go down the not so pleasant road known as deflation?  Well, the equation doesn't change, and earning a 4% real rate of return is still possible.  If you were in Japan over the last several years, you experienced deflation.  In 2003, the inflation rate was -0.90%.  At the same time, U.S. government bonds were yielding in excess of 4%.  The real rate of return in this deflationary environment was:

     4% total return from U.S. bonds  -  -0.90% inflation rate  =  4.90% real return

This ignores exchange rates, but you get the idea.  Even in times of deflation, solid real returns are available to investors that know where to find them.  Sometimes you have to look abroad, but that's part of building a well diversified portfolio.

Takeaways

• Real Return  =  After-tax Total Return  -  Inflation
• Assets Required  =  Income Goal  /  Real Return
• Annual Income Afforded  =  Assets  x  Real Return
• Social Security and pensions reduce annual income needs
• Deflation can still offer opportunities for strong real returns

Knowing your real rate of return helps you plan your retirement and more effectively manage your investments.  By having this information, you can better understand what is needed to fund a comfortable retirement and more effectively manage your investment portfolio.  This is just one piece of information that you need to know, but it is a critical one to be sure.

Our Vaca Fund at Zecco - updated thru 4/3

Another week of positive returns as the market continued its little rally and another week of standout returns for our vacation fund at Zecco.  The account is now up 41% overall and is trashing the S&P 500 as seen below.

 

While the uptick has been nice, we fully expect to see a significant pullback sooner than later that could wipe away any gains we've made to this point.  

If you want more information on our investment strategy for this account, click here.  

If you would like to join the Zecco trading community, use the banner below.

Still Sitting in Cash? - here's the plan

If you are one of those really smart...errr...lucky market timers that got out of the market before the implosion, it's time to start thinking about your re-entry plan.  Early this year, I put my prognostications out there and I still stand by them today.  The market will recover and it's just a matter of time.

So what should you be doing right now?  The first thing is to start setting some estimates as to where you think the bottom will be.  As of today, I'd say we have better than 90% of the information needed to make a guesstimate.  We're still not sure if the trillions allocated to save the financial system will work, but we do know that the administration is ready to print as much money as it takes--long term consequences be damned.

This tells me that we're going to come out of this recession a little slower than had the government not intervened in such a massive way, but we can also be thankful that the market crash wasn't as bad as it could have been otherwise.  With that said, I think a dollar cost averaging plan based on where you think the bottom may be is the order of the day.

If you think the bottom is Dow 5,500, then you might want to start investing around the 7,000 mark and funnel money in for every 500 point drop thereafter until you hit your 'bottom'.  As for how much, this is dependent upon your situation, but whatever your long-term stock allocation looks like, you would divide it up so that at least 2/3rds of your money would be invested at 'bottom'.

Just remember that timing the market is an idiotic proposition and calling the final bottom is only slightly easier than the superfecta at the track.  What's important to remember is that you need not be perfect, pretty good is fine.  Say the market hits bottom at Dow 6,000, but you started investing at Dow 7,000.  The thousand points isn't really going to matter when the market eventually climbs to 12,000.  You'll still be happy you got out when you did and you'll be happy you got back in while the gettin' was good.

The biggest problem with market timing and why I never advised clients to participate in it is the simple fact that it's easy to pull money out of the market, but very few are able to get back in the market before it's too late.  If you buy the market at even a point below where you sold, you're money ahead in my book.

At any rate, here's what a dollar cost averaging plan tied to market performance would look like:

• My projected market bottom is _____________ on the Dow/S&P/Russell
• I will invest ______% at Dow/S&P/Russell ____________
• I will invest ______% at Dow/S&P/Russell ____________
• I will invest ______% at Dow/S&P/Russell ____________
• I will invest ______% at Dow/S&P/Russell ____________
• By the time the market reaches my projected bottom, I will have invested at least ______% of the stock/equities portion of my portfolio.
• This will leave me ______% in my stock/equities portfolio to invest in the event that my forecast is wrong.
• If my forecast is wrong, I will continue to invest should the market decline by ______%
• This will be in stages that I will outline as conditions demand.

There is no way of knowing what the future holds, but I'm an optimist and a big-time believer in capital markets.  As a result, I never so much as question if we'll recover, it's always a matter of when we recover in my mind.  However, the entire framework of capitalism could come unglued and if you sat in cash the rest of your life, it might just work out for you.  It's all a gamble to some extent, but I like the odds of the market right now.

By the way, what if the market never gets to your bottom?  That's why you start investing before you get to the bottom so you at least have some market participation.  The important thing to remember is that you got lucky in getting out of the market, don't let it go to your head.  Pretty good is great when it comes to market timing.  After all, chasing perfection is so Captain Ahab.

Our Vaca Fund at Zecco - updated thru 3/27

Since opening our vaca funding account at Zecco, our returns have been very good (+28% since 3/16) as illustrated below.  Keep in mind that we're at the front end of our funding strategy so we expect to see some losses along the way, but as of right now, the market has been very kind and TNA is performing well.

We're using Mint.com to track our investment performance, and while they have Zecco spelled as 'Aecco', it's just fine with us.  Green is good!

To see our investment strategy, click here.

If you want to join the Zecco trading community, please use the link below.

Build a Better Portfolio - eliminate bum industries

There was a headline on Yahoo! Finance on Tuesday that read, "Airlines group predicts big industry losses".  As we gasp collectively at this shocking statement, let's consider this headline that could have been this year, last year, the year before that, the year before that, and well, just about every miserable year that airlines have been in business since deregulation.

The airline industry is one of a few bum industries that I really try to avoid whenever possible.  The companies that represent the industry are notorious for tallying huge losses and providing next to zero long term value for shareholders.  It's not entirely their fault, but understanding some of the industry dynamics will help you to see why I shy away from the entire industry--good management or not.

Here are some of the top systemic problems with the industry:

1. Enormous capital requirements for aircraft
2. Aircraft are depreciating assets that will eventually be worthless
3. Fuel costs are as variable as the wind and will trend upwards over time
4. Price competition is the only thing that travelers care about - unless you're flying Virgin at $18k a seat for first class
5. Unions make reducing labor costs on the fly more difficult
6. Stricter environmental regulations will come about sometime in the future, increasing costs to the airlines
7. Poor management has consistently sought expansion rather than a cleaner balance sheet during boom times--lining up companies for failure later

After you see these issues, some might say, "Why not just invest in Southwest?  They seem to do a better job with these things."  If you want to invest in an industry leader in profitability like Southwest, that's fine, but I still wouldn't expect rates of return equal to the S&P 500 over the long haul.  There are too many other places to invest that don't have the inherent problems that airlines do.  By the way, have you seen Southwest's performance in the last five years?

Bottom Line:  If you could eliminate the bum industries from your portfolio or even the S&P 500 over the next 30 years, wouldn't that put you ahead of the game over the long term?  Get rid of the bums in your portfolio.

Why $481 is Magic

What if I told you that $481 is all that separates you from being a millionaire and being financially destitute when you retire?  Would you believe me?  Of course you would--I'm an honest guy.

I was doing some research for another project on determinants of income, wealth distribution, and the like when I came across this magic figure of four hundred eighty-one dollars.  This represents the monthly amount you would need to invest over 30 years to reach one million dollars with a 10% rate of return.  $481 seems so small compared to $1,000,000 and that's why it's magic.

After I discovered this number, I wanted to see what this would mean to the Average Joe in terms of the number of hours worked each week.  Taking our $481 and breaking it down weekly, one needs only to save $111 per week to become a millionaire.  In terms of work hours, I found that the Bureau of Labor Statistics reported the average wage for American workers was $18.41 as of last month.  This means that to obtain extraordinary wealth earning an average wage, you would need to work just six hours more per week.

Ask yourself this question:  Is it worth giving up six hours of each week to become a millionaire?

Obvious answer, right?

Now you know why $481 is magic, and I'll leave you to your own devices to figure out how to make the magic happen.  Just remember that the difference between wealth and poverty is typically a series of small efforts strung together over a long period of time.

Read This Now - Jim O'Shaughnessey's Generational Opportunity

In the October 22nd issue of CiN Weekly, I wrote about getting greedy like Buffett because the market was looking very attractive.  Almost five months later, Jim O'Shaughnessey makes the same argument, but with far more historical data than I could present in print.  If you read nothing else this year, please take the time to read this article.  It is as solid an argument as I've seen for buying stocks and while we're not completely out of the woods yet, the market is at a generational opportunity level as O'Shaughnessey so adequately points out.

Our Vacation Fund at Zecco

I opened our Zecco account last week for the purpose of funding a $10,000 vacation in 2015.  Our investments will be speculative and I've drawn up an outline of our investment strategy.  We plan to invest a total of $1,000 net of commissions over the next nine months and accumulate shares in the Direxion 3x Russell 2000 ETF (symbol:TNA).

Investment Thesis

The assumptions that I'm using in putting this investment strategy together are as follows:

1. Market Bottom is Coming Sooner than Later - while I don't know where the bottom of the market is going to be, I am betting on a recovery to begin sometime in the next nine months.  This also means that I am betting on the economy to begin its recovery within 15 to 18 months which should be plenty of time for things to start looking up again.
2. Small Caps Lead Recoveries - whenever the market creeps out of the depths of a recessionary bear, small companies typically lead the way.  The reasons for this are relatively simple.  Small companies are by their very nature quicker to change and before large companies can produce their products or services, they call on small companies to produce.
3. Big Bears Rearrange Landscapes - as we watch some of the largest companies crumble, it illustrates something that happens with every big bear market--small companies can snap up market share and get bigger.  The big, slow, safe corporations are typically still cutting back their workforce when a recovery begins.  Smaller companies have less fat to trim and often can seize on these opportunities.
4. Dollar Cost Averaging - since I don't have a reliable crystal ball but believe a recovery will happen in the next nine months, buying into the market systematically will help to reduce overall risk in the portfolio and calling the exact day of the bottom is unimportant--as long as it happens in the next nine months.
5. Maintain Leverage Until Dow 11,400 - since the market is so far in the tank and we are in a long-term stagnant market that began in 1999, the portfolio will remain leveraged at the 3x level until the Dow recovers to near its peak level a decade ago.

Using leveraged ETFs presents a level of risk that borders on insane, so I don't recommend just anyone to do it.  I've been investing for well over a decade, have a professional background in investing, and this portfolio represents a very small percentage of our investable assets.  In other words, I know the risks, am prepared for the bumps, and can handle a complete failure of this portion of the portfolio.

While this little experiment in speculative investing unfolds, I'll keep you updated with the good, the bad, and the ugly.  One guarantee is that whenever you're speculating, you can expect to get creamed at some point.

Tax Myth: Keep Your Mortgage, Invest the Tax Savings

There are a lot of really bad ideas out there and for whatever reason, this one chaps my backside more than most.  Perhaps it's because I've had many an accountant feed my clients this load of bull or maybe it's because the math is just so flawed, but either way, I'm going to make the argument using professional grade tools you've probably never seen applied to this myth.

The Myth

Accountants love tax deductions--particularly low level accountants that think in a very narrow and constricted box.  They reason that taking a tax deduction and investing the savings into the stock market will result in a higher ending net worth than simply paying off a home that has a slower growth rate and no tax deduction.  This makes complete sense and they'll even run a spreadsheet that proves it...allegedly.

Pardon Me While I Laugh

Sorry, I just started laughing quietly to myself because this argument fails in so many respects.  To make this argument work, there exists a truckload of conditions that must be just right and in real life, it simply doesn't happen.  Sorry, I'm still laughing.

Human Behavior

The greatest flaw in this argument is the underlying assumption that the taxpayer/investor will be disciplined enough to put the money saved from the tax deduction into an investment account on a regular basis.  Considering that 70% of the country lives paycheck to paycheck, I don't see that happening.  While human behavior won't show up on a spreadsheet, we all know too well that this kind of discipline is a very rare commodity.

Investment Discipline

Assuming that the individual pursuing the perfection of the myth is able to manage to put the tax savings into an investment vehicle, we must then believe that he or she will invest it wisely.  The most likely place to put this money is in a 401k or other employer sponsored retirement plan that offers pre-tax contributions.  If you examine 401k holdings over the last decade, you will find that the top three holdings are (1) cash, (2) company stock, and (3) fixed income.  In other words, the average investor isn't very good at investing.

To add to this, if you look at the annual DALBAR studies that examine average investor returns versus the S&P 500 over 15 year periods, you will see that the average investor trails the index by anywhere from 5% to 11% over those stretches.  Another damning piece of evidence that this myth is riddled with basic human problems.  When investors see declines, they flee the markets when it's too late and return after the bulk of the rally has passed.

Continuity of Savings

By now, you should realize the myth is really preposterous, but let's keep going because I'm in full fledged pulpit mode.  The argument for maintaining a mortgage also assumes that the individual continues these investments of tax savings the entire time the mortgage is in place.  Of course, financial emergencies happen and when they arise savings and investing almost always suffer.  There's job loss, sickness, disability, and a host of other things that can disrupt even the most well intended saving and investing plan.  

On average, one can expect a major financial emergency to strike about once every decade and when big emergencies happen, both cash flow and assets can take some hits.  Having an emergency while still paying a mortgage serves to compound the problem, as more cash flow is required through a job loss, sinking asset balances and sapping valuable cash flow.  Think about our current market.  I think we'd all agree that for the many 50 or 60 something workers that have been let go and still have a mortgage on top of decimated retirement account balances, they are experiencing the greatest financial emergency of their lives.

Market Cooperation

What if one is lucky enough that they haven't been thrown off track to this point?  This is where the completely uncontrollable forces of the market come into play.  In a post yesterday that got me fired up to write this, a commenter suggested that 10 years was a long enough time horizon to carry out this strategy of keeping a mortgage and investing the tax savings.  The market is negative in the last 10 years and I haven't seen a bank that's paying borrowers to take out a mortgage so it's obvious that when the market is bad, the myth becomes a nightmare.

In my post last month, I pointed out the fact that markets go through these kinds of periods and its completely normal.  The problem is that most of us don't remember the last bad market because we weren't market conscious yet.  To really make an assumption about market returns, a 25 year period or longer is required.  The variance in returns over that period are much narrower and are positive 100% of the time.  Even with an expanded time horizon, you'll still need market returns above the net interest rate on the mortgage.

Disappearing Deductions

If you think that paying mortgage interest guarantees that you will be able to deduct it on your tax return, you're wrong.  On the two extremes of the income scale, we find that low income and high income households lose out on the full value of itemized deductions that include mortgage interest.  On the low end, we have the standard deduction that can eat up part of the deduction and on the high end, we have something known as phaseouts of deduction values.

First, the low end.  If you pay mortgage interest and have a small amount or no other itemized deductions, your mortgage interest would need to exceed the standard deduction that breaks out as follows for 2008:

• Married filing jointly:  $10,900
• Single or married filing separately:  $5,450
• Head of household:  $8,000

For those of you lucky enough to live in a state without an income tax, you have much greater odds of losing part of your mortgage interest deduction to the standard deduction.

Now for our high income earners.  This group is defined as married joint filers earning more than $159,950 and single or married separate filers earning more than $79,975.  Once you exceed these numbers, your itemized deductions are more than likely going to be reduced.  

This can happen from the simple phaseouts for very high income earners or because of the alternative minimum tax (AMT).  I've worked with the AMT a great deal and suffice it to say that it's a nasty tax that can strip out all of your itemized deductions if your income is high enough and we'll leave it at that.  see Form 6251 and page A-10 of the 1040 instructions for more on phaseouts and the AMT

Monte Carlo Analysis

This is something that is relatively new to consumers but has been used by professionals for a good while.  I used Money Tree Software to take a look at what mortgage payments do to the sustainability of one's nest egg based on the variability of returns and consumer behavior over a 20 year retirement.  The results should end the debate on this topic because Monte Carlo Analysis takes into account variations that are dictated by standard deviation assumptions.  Put simply, it takes into account the ups and downs of spending and investing.

Here is the report for someone without a mortgage payment, focus on the last page - Download 2009 0311 Without a Mortgage

Here is the report for someone with a mortgage payment, focus on the last page - Download 2009 0311 With a Mortgage

If you don't want to download the report, here are the outcomes:

• With a Mortgage:  26% chance of retirement nest egg lasting 20 years
• Without a Mortgage:  41% chance of retirement nest egg lasting 20 years

The assumptions not listed in the reports are a $150,000 mortgage at 6%.  I reduced the starting nest egg for the 'without a mortgage' report by $150,000 to be fair while also reducing the after tax spending requirement to compensate for the lack of a mortgage payment.  This report is from the latest in financial planning tools that accounts for variable investment, inflation, and spending patterns over the course of the twenty year retirement modeled and covers 10,000 possible scenarios in the aforementioned variables.

The reports are clear.  41% is better than 26% and it's really that simple.  Payoff your mortgage and you will have a better shot at stretching your nest egg through retirement.

Myth Debunked

After taking into consideration all of the information I've presented in this case, I believe we can all agree that this myth has been successfully debunked.  Now you can get out their and payoff your mortgage early knowing that it's the right thing to do...tax deduction be damned!

Two Positives Amid Gloom - resources for a turnaround are in place

If you don't read The Good News Economist, you probably haven't seen any good news about our present economic condition.  There were two positives I saw recently that Liz Ann Sonders from Chuck Schwab discussed.  The first was that the U.S. personal savings rate went from being below zero a couple of years ago to over 5% today.  The second was that for the first time in memory, Americans paid down their personal debt in consecutive quarters.  

What this means is that a good deal of purchasing power to push the economy forward is available, but being directed towards cleaning up personal balance sheets.  This is a good thing for all of those households that are carrying far too much debt because they will eventually pay off their debts and have free cash flow to put back into the economy on a continuous basis.  Depending on how long this trend continues, it could make for a strong recovery if spending habits return and savings rates decline or a slower but more steady recovery should savings rates remain at their current levels.

Either way, we know that there is a great deal of cash on the sidelines and in precious metals, households are putting their incomes towards savings and debt, and this means that the resources exist for the market and the economy to turnaround.  The key piece of this puzzle is a return of confidence to the consumer to shift assets into the markets and incomes into the economy.  When this will happen, I don't know, but it will be sooner than later...likely when it's least expected.

Want Cheap Stock Trades? Try Zecco

With the market in the tank, stocks haven't looked so attractive in my lifetime.  That's why I started looking for a cheap trading platform to start buying some broad market exchange traded funds (ETFs).  An ETF is very similar to a mutual fund except instead of being priced once daily, it is priced continuously throughout the day and trades just like a stock.  With my search, I considered Scottrade at $7, but decided on opening an account for my own entertainment at Zecco.

The name Zecco was originally derived from the company's pioneering concept of offering zero cost commissions for stock trades.  They've had to back off of this a little bit, but still offer 10 free trades per month for account holders with $25,000 or more.  The reason they keep it cheap is because they don't have a network of advisors, offices, and other expenses that their competitors have.  Plus, they add the online community feel that is the classic element of Web 2.0 technologies.

For me, the goal is to turn $1,000 into $10,000 by 2015 so that the wife and I can take a pretty swank vacation to destination unknown.  While this will require a pretty crazy annual rate of return, there are a number of ETFs that can help me on my way.  With the introduction of leveraged long and short ETFs, my path to vacation will be easier, but involve a great deal of risk.

With that in mind, if you're looking to get into the stock market using ETFs or stocks, you can open an account with Zecco and pay $4.50 per trade or get 10 free monthly with $25,000 or 25 trades per month.  I do not recommend trading 25 times per month, but even if you only pay $4.50 per trade, that's still an awfully good deal.

Note:  Zecco charges $10 per mutual fund trade, so if you want traditional mutual funds, find another provider.

To setup an account with Zecco, click the banner below.

Financials, Buying Opportunity or Fool's Gold?

I am a value investor at heart and that usually means that when a stock is battered, bruised, and even near death, I'm interested.  With that in mind, the idea of buying big name financials now is a supremely high risk proposition.  There is the opportunity to make substantial profits or to lose your entire investment through bankruptcy.  As a result, buyers of financials must be very aware of not only the survivability of a the financial company involved, but also how a total loss will impact their individual situation.

Stock Analysis

If you're looking at some of the highest risk stocks in the sector such as Citigroup, Bank of America, Fannie Mae, or Freddie Mac, be aware that while the shares are cheap, they are cheap for a reason.  The reason for this is the much talked about 'toxic assets' that these banks possess.  Some argue that they are undervalued because of mark to market rules that require them to record these 'toxic assets' at current market prices.  Since the market has discounted these assets, their shares are trading at below realistic prices.

On the other side of the argument is the fact that these assets have an unquantifiable risk.  Because of the complicated nature of securitizing mortgages through what are known as collateralized debt obligations (CDO), there is no way to know what kind of default risk is involved.  

Core Problems

To better understand this, let's review the process by which a CDO is created.  First, individuals go to a bank or mortgage loan company to acquire a mortgage.  After the bank or mortgage company has loaned out a certain amount of money through mortgages, they will then package them up and sell them to another--typically larger--bank or mortgage company based on criteria such as average credit score, loan-to-value ratios, and other factors.  This is where the securitization process takes place and also where the acquirers of the CDOs will lose any readily ascertainable risk assessment.  Once the mortgages that originated at the individual level are securitized, they can be traded in the secondary market (the bond market) many times causing the splintering of the original CDO.  Meanwhile, the individual that is paying the mortgage could be experiencing a job loss, disability, death in the family, devaluing of their home, or any number of other issues--all of which the subsequent debt owner will have no idea about.

The result is two-fold for our uses:  (1) there is no way of knowing the risk and (2) unknown risk makes for fewer buyers.  You combine these factors and you have the significant decline in value of these debt obligations.  The effect to the bank holding them is they own investments that were worth X and are now worth considerably less than X.  This means they become thinly capitalized--meaning they can't lend as much money and need to find cash to cover the missing value.  Under normal circumstances, they could get a loan against the value of the stock, but with share prices down the toilet and nearing the treatment plant, this is near impossible.  Thus the financial crisis.

My Answer

Getting back to the question at hand, only time will tell whether or not an investment in this sector will be profitable or a hard lesson in high risk investing.  Some will no doubt weather the storm and one day thrive again, but as last year showed us, even seemingly strong institutions can collapse.

This brings me to the most important part of the discussion.  If you have an adequate emergency fund, are maxing out your retirement savings opportunities, and have a high tolerance for risk, there's no reason you can't take a flier on some of these companies.  However, if you're not in a financially strong position, you may want to work on the other areas of your finances first.

For me, the risk/reward trade-off on the high risk end of the sector isn't favorable.  With the entire market on sale right now, I'd much rather take my chances with strong companies with strong balance sheets where I don't have to evaluate their chances of remaining solvent.

Bottom line:  One of my core investment rules is when everything is cheap, buy the market.  When everything is expensive, search for values.  Heck, with this market, you can be an ape throwing darts at the stock pages and you'll look smart ten years from now...as long as you throw enough darts.

Please Remain Calm, This is Normal

October 9, 2007 - The Dow Jones Industrial Average reaches a new all time high closing at 14,164.53

February 20, 2009 - The Dow Jones Industrial Average hits its lowest level in eleven years closing at 7,365.67

16 months and 11 days isn't a very long time by anyone's standards, but during that span of time, we went from feeling pretty good about ourselves to believing the sky may actually fall.  What changed?  Everything...and nothing.

Since the most recent market peak, we've discovered that the real estate bubble has considerably more fallout than originally expected.  The breadth and depth of the problems related to real estate has rippled through our economy, and we still do not know the full extent of the damage.  Over a trillion dollars has been expended by our government to try to minimize the fallout, but even this will likely fall short.

Illustrating Normal

The fact is that we are facing an unprecedented problem that is bigger than anyone could have predicted.  As a result, the stock market has lost nearly half of its value and will likely fall further in the coming months.  However, this is normal.

To illustrate this, take a good look at the chart below and you will see what I mean.

The truth is that our markets and our economy go through long term cycles that are far larger than the short-term bull or bear, expansion or recession.  In fact, our markets have 12 to 25 year cycles that either stagnate or demonstrate exponential growth.  The problem we face today is that we're in the midst of a normal stagnant cycle, but most investors are reacting as if this is the first time a massive market decline has happened.  In fact, it truly is the first time for most of us.

Story Time

Consider the case of a 22 year old college graduate today.  She might know that the economy is bad because finding a job is difficult.  However, she's used to being poor and finding a low paying job wouldn't cause a great deal of discomfort since she has no dependents and is accustomed to a meager lifestyle.  Also, she has read the headlines that the stock market has plummeted, but since she has no investments, she really doesn't care a whole heckuvalot.  As a result, this experience will largely be lost to her in later years.

Fifteen years later, at the age of 37, she's working at a good paying job, is married, and has two children to support.  The market and economy are doing well after coming out of the slump of the early part of the century.  Things are going well, and she and her family are quite comfortable.  She saves regularly for retirement and college, and her investments are worth about $50,000.

Fifteen years later, at the age of 52, she's still working to payoff the student loans for her kids, is earning more than ever before, and the economy has been doing well for the last decade and a half.  'Suddenly', the market collapses and the economy goes into a deep recession.  Her home value drops by 20% and her retirement nest egg that was worth $500,000 before the decline is now cut in half.  Unemployment rises and with her high salary and long tenure with the company, she is asked to take an early retirement package.  She struggles to find a new job, and begins to take money out of her retirement--compounding her financial problems.

Changing Perspectives Over Time

What changed?  Everything...and nothing.  At age 22, she was young, hopeful, responsibility free, and oblivious to investing.  At age 37, she had responsibilities, started learning the market, was doing well and feeling confident.  At age 52, her investments were worth more than her income, retirement was within sight, but the market and economy dealt a surprising and stunning blow.  Everything changed in her life, but the long-term market cycles didn't change a bit.

Sounds familiar, doesn't it?  You could rewind this story to 1968 or 1929 and find a similar picture unfold.  Unfortunately, we don't have a chart that goes back to the 1800s, but you would see these long-term cycles play out again and again.

Welcome to Capitalism

While the politicians, economists, marketeers, pundits, and other talking heads disect this messy economy, at least you now know that capitalism can dole out some pretty nasty punches, but at the end of the fight, those that can position their income and assets properly in light of the long-term realities of capitalism, will be standing victorious in the end.

Preventing the Pain

So how does this translate to action?  Follow these basic rules and you will fare rather well compared to your peers:

1. Live on 70% of what you make after taxes
2. Avoid all debt except an 80% or lower loan-to-value fixed rate mortgage
3. Insure all of your risks including your health, property, life, etc.
4. Maintain an emergency fund that starts at two months' worth of expenses at the beginning of your career and expands to two years' worth of income by the end of it
5. Maximize savings into tax preferred accounts such as 401k/403b plans, IRAs, etc.
6. Maintain a balanced mix of investments and reduce risk over time starting with all stocks at 25 years or more until retirement and moving to 25% to 50% stocks by the time you retire
7. Never, never, never think you are impervious to the ups and downs of capitalism
8. Never, never, never lose hope in a better tomorrow

Number 8 is perhaps the most important part of this equation.  Hope is what drives capitalism and is why our breed of capitalism has been so successful over the years.  It is hope that feeds ideas that make our lives better and it is hope that allows us to persevere when faced with hard realities.

Why Value Got Crushed in 2008

Traditionally, the value style of investing has been less volatile during bear markets and investors have become accustomed to these stocks, many of which pay healthy dividends, providing some buffer against downturns.  Unfortunately, 2008 saw value get hammered to an even greater degree than their growth counterparts.  The reason for this seemingly strange activity can be traced back to the fact that when market behavior enters extremes, all investment managers can become susceptible to greed.

The kind of greed in this situation may seem almost counterintuitive, but when financial stocks began their descent, value managers greedily snapped up these seemingly good companies that were falling at alarming rates.  This is the value manager's greediest moment.  When shares fall on bad news that they believe to be of a short-term, recoverable variety, value managers salivate.

Just as tech fund managers in the 1990s loaded up on growth stocks that were soaring to new heights, value managers in 2008 loaded their portfolios with financials that were sinking to new lows and most were paying highly attractive dividends.  These dividends were often in the 5% range and many value managers believed that companies paying this amount of cash dividends would offer less risk than those stocks not paying dividends.  The thinking here is, "If all stocks decline by 20%, I'll still have that 5% dividend to reduce the losses."

The problem, of course, is that financial stocks were hit with a barrage of bad news and events.  Last year we saw such venerable institutions as AIG, Lehman Brothers, Bear Stearns, Countrywide, Washington Mutual, Wachovia, and Merrill Lynch collapse under the weight of an unraveling financial system.  The problems with these companies were irrecoverable and value managers that had overweighted their portfolios to financials early in the year were left holding a truckload of worthless stocks be the end of the year.

The net result is that most value funds got crushed in 2008.  The lesson here is that no matter which style of investing you choose, there are situations, albeit rare, when each style will expose you to levels of risk you wouldn't expect.  What this means to you is to stay balanced, have growth and value in your portfolio and to overweight, but not completely exclude one style or the other.

Designer Jeans or Wranglers? Why Investment Style Matters

Believe it or not, there are different styles involved in stock investing. I’m not talking about the difference between a pair of designer jeans and Wranglers. Actually, that’s exactly what I’m talking about. There are two basic investment styles with one being considerably sexier than the other.

Designer Jeans

The growth style of investing will demand investment in stocks of companies that are growing their revenues faster than their competitors (usually because of a new product, technology, etc.). These are sexy stocks because they are companies that are fast growing and often will become ‘Wall Street Darlings’ that investment commentators will tout as the next great company. To get back to our fashion analogy, these stocks are the ones walking the catwalk at the high fashion shows for everyone to see.

Wranglers

On the other side is the value style of investing. This discipline is like a pair of Wrangler jeans. They’re cheap, sturdy, and get the job done though they may not have the flair of their growth counterparts. In essence, after a stock has been beaten down, value investors will scoop up shares of good companies that for whatever reason are experiencing a decline in share price. These dogs would never be allowed to walk the catwalk or even be admitted to the show.

Fashion Frustrations

Depending on how the market is doing, you might become frustrated with either of these styles if you don’t understand them properly. For example, if you were holding value stocks in the late 1990s, you were flat out angry that you’re portfolio was underperforming when it seemed like a monkey could get rich picking stocks. On the other hand, when the tech bubble burst, you were content to see your value stocks holding up nicely.

Why Style Matters

The reason you need to know these things is that one of the top reasons that investors experience terrible returns compared to the market is they jump ship too frequently and at the wrong time. One minute they’re in growth stocks riding high, and then next they’re dumping growth for the perceived safety of value…but only after their portfolio gets spanked. By understanding these investment styles, you can do a better job of being patient with your portfolio.

Pick Your Style

Over the long term, these styles actually produce similar returns so there isn’t an inherent advantage to using one over the other for the sake of higher returns. However, there is a significant difference in risk. Historically, value stocks have demonstrated a little less risk over the long term, but during many short term declines, value stocks show a significant reduction in risk.

As a result, if you’re looking for a more stable ride to the same destination, value stocks are for you. If you like a roller coaster ride with all the excitement, growth stocks will be a better fit.  There is one caveat.  When a broad based decline in stocks occurs like the one we're experiencing right now, all stocks are hammered indiscriminately.

By the way, see this 10 year chart (provided by Yahoo! Finance my first stop for financial news) below of Vanguard Value Index versus Vanguard Growth Index.  This is what I'm talking about.  Growth is great in 1999 then turns to crap.  Value is great after that, but then the financial meltdown crushes both of them.  Pick your style it's the same destination.

A Consumer Staple - Netflix

When the economy tanks, there are a number of 'defensive' industries where stock investors seek refuge.  Among them are consumer products, food, and now, movie rentals.  Netflix reported a profit increase of 45% on revenue growth of 18% year over year.  This strong performance amid a recession shows that movie rental companies are officially a consumer staple; when times are tough and wallets tighten, movies at home become an inexpensive entertainment substitute.

To illustrate this, take a look at the following chart:

As you can see, Netflix was up about 30% in the last two years while the Dow Jones Industrial Average lost almost 35%.  While this is just one company in the right industry and doing the right things, examining the consumer staples sector versus the same index, we see a similar picture:

While the industry as a whole lost money, it didn't lose nearly as much as the broader market.  In fact, the Fidelity Advisor Consumer Staples Fund A lost about half that of the Dow.

What can be learned from this news story is that stocks in the consumer staples market aren't sexy, but they are comparatively sturdy.  In building a conservative, all-weather portfolio, consumer staples funds will help you during times of trouble.  Don't worry about scrambling to add this to your portfolio, as many mutual fund managers will overweight to this sector anyway, but if you want to buy some old line, boring companies, that don't lose as much during downturns, consumer staples is a good place to start.

For Future Reference:  Overweight Consumer Staples during declines and underweight them during ascents.

Target Date Retirement Funds

I love target date retirement funds for a very simple reason - they're simple.  When it comes to investing, one of the biggest problems that investors have is staying invested through thick and thin.  Often, investors move in and out of various funds and lack a consistent or meaningful investment plan.  The result is that investors typically capture only one-third of market returns according to surveys published by DALBAR.

Definition

A target date retirement fund is a mutual fund that holds a variety of other mutual funds (also known as a fund of funds) that will usually include all major asset classes.  Based on the target date, there will be varying allocation percentages to stocks, bonds, and cash.  In addition, there will be additional segments of the financial markets covered including large, mid, and small company stocks, domestic and international stocks and bonds, etc.  As time moves forward, these funds will dial back the risk by cutting stock exposure and increasing cash and bond allocations.

Why Use Them

In thinking through the investment management process, you would probably agree with the following statements:

• I would like to have my money managed professionally
• I want my portfolio to be well diversified
• When I'm young, I'd like my portfolio to grow aggressively
• When I'm older, I want my portfolio to be less risky

In essence, a target date retirement fund accomplishes all of these things.  The fund is managed by a multitude of professionals including the primary fund manager, the fund managers of the other funds in the portfolio, and an asset allocation specialist that determines how and when to dial back risk over time.  This type of fund is well diversified and will be aggressive early on and eventually become very conservative.  It's the no-brainer method of investing and part of why Congress mandated these fund choices for employer based retirement plans such as 401k or 403b plans.

Drawbacks

While this type of fund is great for anyone that wants a fully hands off approach, there are a few drawbacks.  The chief knock on these funds is that they are impersonal.  They have no customization beyond your target retirement date and may not match your exact needs at any given time.  Another problem is that most of these funds contain only one mutual fund company's funds.  For example, the American Funds Target Date Retirement Funds only contain American Funds mutual funds.

While American Funds is a terrific fund complex with great managers, they don't have a corner on all of the great investment ideas and they aren't great at everything.  Small company stock fund management comes to mind...but I digress.  This seems to be somewhat of a temporary problem, as more money is going into these types of funds, the more likely a multi-manager approach will be used meaning that the best funds in each category may be employed to increase total returns.

Final Analysis

In the end, if you don't have a desire to manage the details of your portfolio and don't have any special financial circumstances, target date retirement funds will be a sound solution for you.  However, if you want to manage your portfolio more actively or have circumstances out of the ordinary, you should consider constructing and managing your own portfolio.

Top Providers

In the area of target date retirement funds, there are only a handful of mutual fund companies that do a good job in this area.  They include:

• Fidelity - the leader in target date retirement funds
• Vanguard - the leader in low-cost index funds
• T. Rowe Price - world class management and low expenses
• American Funds - the top provider through an advisor

CiN Weekly Column: What to do after baby

Checkout my CiN Weekly column on the racks or find it online here.

100 Battle Tested Funds from Smart Money

It's not often that I see a top 100 mutual fund list that I actually like, but Smart Money seems to have gotten it right this month.  In their list of 100 battle tested mutual funds, they provide an excellent core group of mutual funds that have demonstrated sound returns over the last 21 years.  If you use this list as a starting point for putting together your portfolio, you'll likely fair better than your average bear.

Experience Counts

Anytime you're putting together a portfolio of mutual funds, there are a few important steps to remember.  First, experience is critical.  The average mutual fund manager has been at the helm of his or her mutual fund for less than four years.  In other words, most managers barely make it through their junior year before getting canned or moving on.  If you choose managers that have at least five years of experience and preferably ten years, you'll be well served.

Relative Performance

Second, you should look for mutual funds that have a track record of beating their peers and their index over the long term.  This should be measured over a five and ten year period instead of one or three years.  The reason is simple, the average market cycle from bottom to top to bottom again is around five to seven years.  If you measure performance in myopic one or three year timeframes, you're highly likely to lose out by becoming guilty of chasing returns.

Consistency of Returns

Finally, if you have a mutual fund with good returns and an experienced manager, the last screen is consistency in returns.  This means that you should try to use mutual funds that haven't achieved their high returns as a result of a one year home run.  To see this, go to Morningstar to look at the relative returns versus the fund's category and relevant index.  If you see one year with a huge differential and the rest not as much, you're looking at a one hit wonder.

Tools to Use

If you go to Morningstar or use your investment provider's fund screen, you can set the screens for the first two criteria, but you'll have to manually review the last screen yourself.  If you don't have the time or inclination to do this yourself, hire an investment advisor to provide you with a list of funds screened in the manner described above.

Prognostications for 2009

In order to prepare you for the upcoming year, here is a list of my prognostications in seven key areas of personal finance for you to use in planning your money:

• Economy - the economy will begin its recovery in the latter part of 2009 with this recession coming to an end before March 31, 2010.
• Interest Rates - the Federal Reserve will hold rates steady for the first part of the year, and as the economy shows signs of stabilizing, will begin to raise rates near the end of the year.
• Inflation - with the global recession in full swing, inflation will remain tame for the entire year with only mild spikes in commodities prices.
• Deflation - a month or two of declining prices may occur, and these numbers are more likely to produce sensationalized headlines in the media than cause real duress for the economy.
• Stock Market - equities will lead the major asset classes with positive returns in excess of 10% for the year.
• Fixed Income Market - corporate bonds will lead the way as bondholders realize many of these bonds have been unfairly beaten down in the marketplace and double digit returns are not out of the question.
• Cash Equivalents - I bonds will continue to be the best place for cash equivalents with high yield FDIC insured bank accounts in second.

What this translates into is that the economy is going to recover meaning that job opportunities will begin to spring up toward the end of the year.  I always advocate improving job skills on a continuous basis through formal and informal education and training.  

In addition, if you've survived with your job intact during this recession, you may want to consder where you want to be when the next recession comes.  Do you want a change in career, a higher position in your company, start a new company, etc.?  Once you answer that, make a plan for your career over the next five years or more.

Interest rates are critical because they affect lending rates.  Since interest rates are at all time lows and should remain near these levels for the year, you should use fixed rate mortgages ONLY and try to eliminate as much variable rate debt as possible.  If you're living with variable rate debt, when interest rates increase in the coming years, you have the risk of being buried under interest charges.

Inflation that was a major concern prior to the financial meltdown last year will be relatively tame.  This means that there should be no hurry to make major purchases this year, even though companies will be pushing product at significant discounts throughout 2009.

Deflation is a somewhat rare occurrence in the United States, but if you take a look across the Pacific to Japan, you can see that it is a problem that has yet to be solved.  In Japan, they've had years of deflation and if you pull up a long-term chart of the Nikkei, you will be appalled at the sight of it.  We may have a small patch, but I have faith in the American consumer to get back to the old habit of spending.

The stock market should return 10% or more this year, but what's more important to understand is that we are near the bottom established in 2008.  This means that you should be contributing to retirement plans and other accounts and buying the market while it's still incredibly cheap.  In my estimation, staying on the sidelines is far riskier than buying the market at current levels.

Last year, many companies filed bankruptcy, leaving bondholders with virtually worthless junk bonds.  At the same time, good companies' bonds were unfairly beaten down and are priced very attractively.  As a result, once the economy shows signs of firming, these higher quality bonds will produce returns from their stated interest rates and through an increase in principal value.

I bonds remain very attractive through May 1st when the next interest rate change is scheduled, and under normal circumstances, they would likely lose out to high yield bank accounts.  However, since the Federal Reserve has reduced rates to near zero, I bonds should slightly outperform high yield bank products on balance for the year.

While these are only projections, I can tell you that it is far easier to see the bottom than it is to see the top.  When times are tough, fear seems to eventually dissipate into apathy, but when times are good, greed seems to have no limits.