Monday, March 28, 2005

Start Life In Debt and Why It Makes Sense..SS Part II

The best thing we can do for our children right now is to put them in debt from the day they are born.

About two years ago I came up with a method for saving social security & medicare long term; actually abolishing both while still providing economic security and providing for a higher standard of living than current retirees have. I mentioned the idea to a few people, my wife included and they thought it was a great idea. The problem though was that the idea was too great, not to mention extremely costly in the short term. I shrugged the idea off as yet another great idea that would never be implemented by government.

Two years later and the nation is starting to focus again on the problems of social security and a lot of proposals are being floated around Washington. One of the proposals caught my attention because it sounded very similar to my own.

Paul O’Neil, the former Treasury Secretary for President Bush (and former CEO of Alcoa) was being interviewed by a newscaster and low and behold, Mr. O’Neil was talking about a plan very similar to what I had come up with a few years back. A story by the Washington Bureau captured the genesis of his idea:

“To move away from Social Security's chronic funding problems, O'Neill suggests that the government put $2,000 in a special investment account for every newborn American. The government would invest $2,000 more each year until the child reaches 18.
The money would be invested in a conservative index of stocks and bonds and couldn't be touched until retirement. The investment would grow at a compounded rate, meaning that as the value of assets in the account grows, profit would be reinvested so the account would grow even more. Without adding a single cent beyond compounding after the child turns 18, he or she would retire at age 65 with $1,013,326 in the account, O'Neill reckons.

"If you do the arithmetic, the $1 million would provide an annuity of $82,000 a year for 20 years," O'Neill said in an interview.”

My idea was slightly different. I would have the government loan each child born a much higher amount, giving them a lump-sum instead of payments for 18 years. This gives the money more time to compound and grow. The stock market tends to go up more than it goes down, thus a lump-sum of a similar amount, say $36,000 would grow to about $5,000,000 by the time the child retired at 65.

This would provide an inflation adjusted income of about $31,000 in today’s dollars, with the ability to leave money to heirs. The other thing that is different about my plan is that the government is not “giving” the child anything except a government subsidized loan. The child would be required to pay it back once they begin working. Instead of paying into social security, which would amount to 12.4% of their potential income, they would be paying off the loan instead. Even a person at minimum wage could end up paying off the loan during their life very easily and not pay nearly the rate of 12.4%, plus they would have the benefit of an account with a huge growing balance. Imagine having the opportunity to retire with more money than you made during your working years. This plan would benefit low-income workers without subjecting them to welfare.

Are there some flaws with my plan? Sure. It would require a ton of borrowing, the details would be a little more complex, and we would need to figure out a way to take care of the disabled, widowed, and survivors. But these are problems that would be easily overcome. The best thing we can do for our children right now is to put them in debt from the day they are born. The public in America has a love affair with debt, as does the federal government, isn’t it about time that we started using debt in a much more powerful way? Of course an idea like this would never work on capitol hill; it’s too good of an idea and the government usually rejects those. I applaud Paul O’Neil and his idea and hope the congress will see that meaningful reform in the long term will lessen welfare, increase economic security, and grow the economy while empowering people.

Until Next Time......


Friday, March 25, 2005

The Rise of Interest Rates

For nearly two years I have predicted interest rates will rise. Of course I was not alone in my prediction, pretty much everybody thought the same. We were all wrong for nearly two years, which just goes to prove you can be right about something, just not right about when it will happen. For example, I could predict that American will have another terrorist attack, but if I can't tell you when, am I really making a prediction?

Short term interest rates have actually been rising for the past year, at the end of March last year the 90 day treasury bill was yielding .96%, which meant money market accounts were yielding about half that, some of them yielding nothing. However, as of yesterday the 90 day treasury bill was yielding 2.70% and you can get a money market account paying 3.25% at In other words, short term rates have nearly tripled in the last year. This marks one of the fastest rises of short term interest rates in history.

Long term interest rates on the other hand stayed pretty much the same throughout the year. The ten-year for a short period jumped up to the 4.80% range, but then quickly fell back down to the 4% level and didn't budge.......that is until February. Since February the ten-year treasury has risen to 4.63% (as of 3/22/05), not a huge rise, but one worth noting as it will add nearly 3/4 pt to a mortgage loan.

The real question is whether or not the trend will continue. It appears that if Greenspan has his way it will. What most people don't know is that Greenspan mostly has control over short term rates, long term rates are determined more by the market than what Greenspan wants. Thus there is the possibility that short term rates could continue to rise, while long term rates stay in the mid 4 - 5% range. This would actually hold the best of both worlds scenarios, good returns on short term bonds, and good rates on mortgages. My first mortgage was 7.75% and I thought I was getting an incredible deal, of course my loan was only $163,000. If rates rise I think new home buyers will still be able to squeeze into a home, but they will start having a harder and harder time.

What does this mean for your portfolio? Well, your bonds and bond funds will take short term hits to their principal, but will start earning higher interest rates as interest and maturing bonds are reinvested into new bonds paying higher rates - in the long run rising rates are good for bonds and bond funds especially (despite what most illiterate financial advisors will tell you).

There it is, my treatise on interest rates for the end of the 1st quarter, nothing fancy, but things are starting to look up......rates that is!

Till next time,


Monday, March 07, 2005

Does Diversification Always Work? Why Most People Would Have Fired Me......

I build diversified portfolio's for my clients. This means that I have my clients buy all sorts of different types of investments. A typical portfolio will have large stocks, small stocks, value stocks, growth stocks, & international stocks along with bonds. Diversification is the bedrock of investing and serves to give you a similar (hopefully better) return than the market with less fluctuation. But does it always work?

No. Diversification doesn't always work. There will be time periods, sometimes long time periods where the benefits of diversification do not seem readily apparent. Between 1995 and 1999 a diversified portfolio drastically underperformed the market. The market, as represented by the Russell 3000 returned an annualized 26.95% between 1995 - 1999, an incredible run. A well diversified portfolio that held international stocks returned about 16% annually, a great return, but over 10% less than the overall market. How enthused with a diversified portfolio would you have been after five years of drastic underperformance? Had you invested $100,000 on January 1, 1995 you would have had nearly $330,000 if you bought the market, but only about $212,000 with a diversified portfolio - a difference of over $100,000 - would you have been happy with this differential? It is entirely likely that you would have already fired me and moved on to an advisor who was willing to put you in what was hot at the time, large cap growth stocks. Let's consider what happened over the next five years.

Between 2000 and 2004 the market as represented by the Russell 3000 returned a negative 1.17% (that is -1.17%) annualized. A diversified portfolio during the same five year stretch annualized a 10.41% return, an outperformance of about 11%. People who invested $100,000 in a diversified portfolio on January 1, 2000 and held till the end of 2004 would have ended up with about $164,000 vs $94,000 with the market strategy. At the end of this five year period a diversified portfolio strategy would have look ingenius.

For the entire ten year stretch the market returned an annualized 12%, with a diversified portfolio a little over 13%. The diversified portfolio had a higher return, but more importantly a more consistent return. The diversified portfolio had only one down year versus three for the market. The market based portfolio fluctuated nearly 30% more than the diversified portfolio. The diversified portfolio had less fluctuation and a higher, more consistent return. In hindsight it is easy to see which would have been better, but while you are in the moment people tend to make decisions based on emotion.

What will the next five years bring us? I wish I knew, unfortunately I haven't located the crystal ball that will tell me. What I do know is that a diversified portfolio should provide much more consistent returns with less fluctuation than the overall market, and with a higher return to boot. We may be in for a time period where the market outperforms diversified portfolios, I urge you to not follow the crowd and do what is easy. Stick with a diversified portfolio and in the long run you will be the real winner. I can't promise we will beat the market in the short term, but in the long term I believe that a well diversified strategy combined with low costs will give you the best chance of success.

Until next time....


Tuesday, March 01, 2005

Is 10% Realistic...Part III - Vanguard's View

What follows is an article from Vanguard's website which I thought you might find interesting about returns.

The Story

February 22, 2005
'Normal' stock returns are, actually, quite abnormal

It's often noted that the historical average yearly return of stocks is 10%. Paradoxically, this quite-accurate figure isn't the return that most investors are likely to receive in a year.

The 10%-a-year figure is an average calculated over very long time periods, such as the 78 years from 1926 through 2003.* Averages are useful, of course, but you should also be aware of their limitations. Take the extreme example of a desert with freezing cold nights and fiery hot days. An average of the temperatures might show that this desert is quite comfortable.

Stock market returns aren't as extreme as those temperatures, but returns can vary greatly. That's why annual stock market returns matched the 10% average, plus or minus 2 percentage points, in only 6 of the past 78 years, as the accompanying chart shows. And negative returns occurred more often than many investors may be aware: Investors lost money in 24 of the years, or 30% of the time.

Accumulators: Stay focused

By keeping in mind that stock returns can veer widely from historical averages—sometimes for years at a stretch—investors who are accumulating funds for long-term goals may be able to fight the temptation to jettison their investment plan during difficult market periods.

What that 10% figure does mean is that, over the decades, the years of good returns have more than compensated for the years of bad returns. Moreover, for the period 1926–2003, stocks' average annualized return outperformed that of money market investments by about 6.5 percentage points and that of bonds by about 5 percentage points. This difference in returns compounds significantly over time. It's certainly true that past performance is no guarantee of future results. But the historical record does underscore the need to focus on the long term (while also making sure that your asset mix doesn't focus on chasing returns but, instead, matches your risk tolerance, goals, and time horizon).

Awareness that the 10% average is a product of more extreme ups and downs can also help you resist the temptation to overload your portfolio with stocks when the market is way above average—and create a portfolio that may be riskier than you originally intended.

Retirees: Withdraw funds gingerly

For retirees, the challenge is to acknowledge that variable stock market returns, not the steady long-term averages, are the normal state of affairs, and to make their portfolio withdrawal decisions accordingly.

Particularly important is the sequence of yearly returns. A series of good stock market years at the start of retirement can add significantly to a nest egg and make any future bad years easier to bear. But a series of bad years at the start can make it difficult to recoup losses later and can result in a faster depletion of assets.

No one knows what future markets will be like, so retirees should plan to withdraw funds conservatively during the good years and be prepared to modify their spending plans in the bad years. To help put this strategy into practice, Vanguard has developed two portfolio withdrawal techniques aimed at increasing the odds that assets won't be depleted early. They're described in Select Your Withdrawal Method in the PlainTalk® on Managing Your Retirement area.

* The exact average for that time period is 10.4%, based on the Standard & Poor's 500 Index from 1926 through 1970 and the Dow Jones Wilshire 5000 Composite Index from 1971 through 2003. Note that the returns and the principles cited here apply to broadly diversified groups of stocks and bonds and don't take taxes into account. Earnings results for individual stocks or nondiversified portfolios are likely to vary significantly from those shown here.

Scott's Comments:

I think Vanguard is on the right track and providing great education with this piece. I would love to hear your comments.

Till Next Time......


Is 10% Realistic...Part II - The Economists

In a previous blog I mentioned that I didn't feel that the historical return we have enjoyed on stocks would continue in the future, however I also noted that I have no idea if I will be right - only time will tell. I mentioned that over the past 200 years "real" returns (return after inflation) averaged about 6.5%, this translates to about a 10% return including inflation. Recently the Wall Street Journal ran an article on Social Security and asked several prominent economists to weigh in on what they believe real returns will be over the next 44 years. What follows is the response:

Name Organization Stocks Gov. Bonds Corp. Bonds

William Dudley Goldman Sachs 5.00% 2.00% 2.50%
Jeremy Siegal Wharton 6.00% 1.80% 2.30%
David Rosenberg Merrill Lynch 4.00% 3.00% 4.00%
Ethan Harris Lehman Bros. 4.00% 3.50% 2.50%
Robert Shiller Yale 4.60% 2.20% 2.70%
Joseph LaVornga Deutsche Bank 6.50% 4.00% 5.00%
Paul Jain Nomura 4.50% 3.50% 4.00%
John Lonski Moody's 4.00% 2.00% 3.00%
David Malpass Bear Stearns 5.50% 3.50% 4.25%
Jim Glassman JP Morgan 4.00% 2.50% 3.00%

There you have it, the experts forecasts of returns for the next 44 years. Keep in mind that economists are known for having the best jobs in the world, they are wrong most of the time, yet continue to recieve a paycheck. I do think though that the above economists, while not being fortune tellers are not far off. The most bullish estimate is that we will continue to have 6.5% real returns on stocks, while the lowest estimate is 4.00%. The lesson here is not that we should take everything economist say to be fact, but that it is unreasonable to think that future returns will resemble the past.

In this world of lower returns there are only a few things individuals can do to ensure that they earn all the return that they can. The first is to find superior stock pickers - unfortunately that is unrealistic (see my earlier blog on luck/skill). The four things an investor must do to ensure they earn as much of the future returns as possible are:

1.) Diversify across large, small, growth, value, & international stocks
2.) Keep mutual fund & advisory expenses low
3.) Don't attempt to time the markets - stay invested through thick and thin
4.) Stay away from Active Management

If you do these four things you will greatly increase your odds of earnings all the future returns possible. In all likelihood you will outearn your neighbor who is chasing money managers, jumping in and out of stocks, and paying enormous fees to advisors who have no clue what they are doing.

To conclude this segment - expecations are everything...going forward there is a great likelihood that returns will be lower and you need to do everything possible to plan for this scenario.

Till next time.....