Investment Guy

Many people are drawing parallels between this current market selloff and the credit crisis that nearly ended in depression a few years ago.  I don’t see any.

The downgrade of the US AAA rating is nothing like the collapse of Lehman Brothers, Bear Sterns, or any of the other firms that went under.

The credit crisis of 2008 was systemic.  It was the culmination of the housing bubble and the realization that that every bank had been lending gobs of money to absolute idiots in order to fund the purchase of houses they couldn’t afford.  And this had been going on for years.

The entire world suddenly woke up and found that there were bonds rated AAA but comprised of junk quality mortgages.  Nobody knew which investment was quality and what was toxic, and nobody wanted to own anything-  At all.

The market crashed.  Business, and the economy, nearly came to a complete halt .

Corporations laid off 3,000,000 people in 2008-09.      Then came Tarp, QE1, QE2…the economy was on life support.

Flash forward to today: 

If you want to buy a house in 2011 you need to have sparkling credit, 10 years of income history, 20% down, and the ability to lend the bank more money than you are trying to borrow.

Corporate America cut every wasteful expense, reduced inventories, curtailed spending, and today’s companies are lean operating machines.  That is why earnings beat expectations in the first 2 quarters of 2011.

Today we are adding 150,000 jobs per month. True, it will take a long long time to gain 3 million jobs back at that rate, but we are going in the right direction.

Additionally, interest rates are still low and inflation is still relatively tame.

This market selloff/crash is all about fear.  There is no more stimulus- zero – and that is scary.  But zero stimulus is a good thing; now we get to see the economy stand on its own.  Couple the removal of stimulus with several other potential bogey monsters that loom on the horizon (Greece, inflation, rising interest rates) and fear is understandable.

But these monsters are not new. Things are not substantially different than they were 2 weeks ago.  Fear and greed are what make the markets move, and right now fear is winning.  In 6 months this market swoon will be a distant memory.

As investors, we have a variety of opportunities to determine where to place our money and ‘bet’ on the markets. For an aggressive investor, the stock market has been the venue of choice. For conservative investors, bonds have had the upper hand.

The famous cowboy/philosopher Will Rogers always said “I’d rather have a return of my money than a return on my money”  Hopefully this quick guide to bond risks will help you invest in bonds and receive not only a return on your investment, but more importantly, a return of your investment.

Over time, the markets have expanded their offerings from traditional holdings of stocks and bonds to more creative opportunities and higher risk assets. Still, bonds have not changed their stripes over the years. These have traditionally been stable, secure investments that have offered a predictable stream of supplemental income.  This is because a bond is issued with a fixed payment rate of return over a specified period of time- typically until the bond matures.

 However, there are still risks to consider. Let me name a few:

• Inflation Risk: Because of their relative safety, bonds tend not to offer extraordinarily high returns. That makes them particularly vulnerable when inflation rises.
• Interest rate risk: Bond prices have an inverse relationship to interest rates. When one rises, the other falls.
• Default Risk: A bond is nothing more than a promise to repay the debt holder. And promises are made to be broken. Corporations go bankrupt. Cities and states default on muni bonds. Things happen…and default is the worst thing that can happen to a bondholder.
• Downgrade Risk: Sometimes you buy a bond with a high rating, only to find that Wall Street later sours on the issue. That’s downgrade risk.If a credit rating agency such as Standard & Poor’s and Moody’s lowers their ratings on a bond, the price of those bonds may fall.
• Liquidity risk: The market for bonds is considerably thinner than for stock. The simple truth is that when a bond is sold on the secondary market, there’s not always a buyer. Liquidity risk describes the danger that when you need to sell a bond, you won’t be able to.
• Reinvestment Risk: Many corporate bonds are callable. What that means is that the bond issuer reserves the right to “call” the bond before maturity and pay off the debt. That can lead to reinvestment risk.

If you want some more information about how individual bonds are priced in your account, check out Bonds and Your Brokerage Statement.

The first Ask the Investment Guy submission- and it’s from a real person!

Investment Guy, I know that starting a 401K or 403B or IRA is beneficial, but I currently live paycheck to paycheck. I’m 34- how can I make this happen? – Kevin

Hi Kevin- Thanks for asking! That’s a great question. Living paycheck to paycheck certainly makes this goal seem intimidating, but it’s attainable with a little bit of effort. Recognizing the need to save for retirement is an awesome first step. In order to save for retirement while your cash flow is tight requires commitment and sacrifice; once you are committed, read on.

Where is your money is currently going?

If you haven’t already created a budget, do so.  It’s an interesting exercise that will show you exactly where your dollars are going each month, and maybe you can find some wasted expenses to redirect towards saving. I’m not going to suggest you cut your diet down to ramen noodles, but maybe brown bagging your lunch every day is an opportunity to save a few bucks. It’s little things that go a long way. (here are 2 budget templates: one is for families , another if you are single)

How much to contribute:

Anything is much more than nothing- and it doesn’t have to be a lot. Can you afford $20/week?  Contributing $20/week with market growth of 5% over the next 30 years will total more than $66,000! Additionally, at the end of the year you will see an account statement with a bottom line number representing your progress. If you want to really improve your odds at a successful retirement, each year you should try to increase your contributions by a few dollars.

Make automatic contributions

Set up contributions to occur automatically straight from your paycheck or checking account. This keeps the money out of your hands and instills the discipline of consistency.

Behold of the power of tax deduction…

If you contribute $20 to a 401k, this money goes into your account before taxes are taken out.  Therefore, assuming a 20% tax bracket, your take home pay only goes down $16 and you saved $20 in your 401k for an additional $4 to you each week.

… and tax deferral

Inside of your retirement account the IRS allows you a free pass from paying taxes on gains that are owed in non-retirement accounts. In exchange for these tax benefits, you are waiving access to these dollars until you are 59 ½ at the earliest. These may seem small, but over time are powerful. It’s also one of the very few ways to legally avoid paying taxes.

Finally, if it’s simply not possible to find the extra money in your current budget, maybe you can try these 2 harder approaches: ask your employer for a raise of $20/week (ya never know) or find a second job for a couple of hours a week. If you ask me, it’s better to bust your hump while you’re in your 30’s instead of working into your 80’s.

Good luck Kevin!

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Here’s a neat little trick.  It’s a simple way to calculate the amount of time and/or the interest rate necessary to double an investment, and it’s called The Rule of 72.

Let’s say you know one of the variables: time.

If you want to calculate what interest rate is necessary in order to double your money double in 10 years, simply Take 72 and divide it by 10.

At 7.2% your money will double in 10 years.  It’s that simple.

8 years?  72 divided by 8 = 9%

It works!

It also works with interest rate as the variable:

You have an opportunity to earn 6% on an investment.  Now you know that it will double in 12 years.

4% doubles in 18 years.

These calculations are very close approximations (7.177% doubles in 10 years), assume compounding interest, and become less accurate as the interest rate rises.

I’ve said it before and I’ll say it again- Asset Allocation.  It’s the best way to invest.

I often feel like a broken record, but I believe in AA more and more every day.  I’ve been utilizing AA since 2003.  Before international and emerging markets were in vogue.  And when nobody wanted to own large cap us stocks.  And before metals were the flavor of the day.   It’s not going to be a silver bullet, because you will also own the worst performing asset class.  But it reduces risk, and that is my goal.

Asset allocation is not dead, as some people contend.   I am not going to look into a crystal ball and tell you what the future has in store.  I will be the first to admit that I don’t know what the best investment idea is for today’s current economic environment.  Earthquakes and tsunamis and nuclear reactors are certainly going to have some impact on the market.  So will the credit crisis of 2008-09.  And the dot com bubble.  These things are inevitable.  If you want to time the market or try to strategically overweight some of these styles, go for it.  But stay true to AA.  Keep the majority of your funds in an asset allocation, and dedicate a small percentage to overweight.

There is always going to be a sweet spot.  Whether its bonds or blue chips or gold or real estate (and the list goes on), there will always be a sweet spot.  And if you own different asset classes- the key is to own all of the asset classes- you will always be participating in that sweet spot.  By owning all of these you will always be positioned to participate.

 The “Oracle of Omaha”, Warren Buffet, CEO and the largest shareholder in Berkshire Hathaway said in his 2010 annual letter:

Fund consultants like to require style boxes such as “long-short,” “macro,” “international equities.” At Berkshire our only style box is “smart.”

My goal as an investment adviser is to reduce your risk while maintaining competitive returns.  The key to asset allocation is that it reduces risk.  Don’t get caught up in the investment of the day. 

Asset Allocate.  It’s smart.

On a Sunday night two months ago, Meredith Whitney went on 60 minutes and scared the hell out of muni bond investors with her talks of doomsday defaults across the country’s state and local governments.

Now congress is requesting Whitney’s testimony and an explanation of her research.

Whitney declined.

This morning, in the Philadelphia Inquirer I saw yet another article about her call.  I get a ton of questions from clients about what to do.  Here are a few responses that I found interesting, from various sources:

• My b/d, Commonwealth responds:  Day of Reckoning or Business as Usual
• Philadelphia inquirer: Analyst Says Now is the Time
• Vanguard: California is not Greece
• New York Times A seer on banks raises a furor on bonds
• MarketWatch: The Great Muni Panic
• Business Insider: 12 Reasons Meredith Whitney is Wrong
• and here is PIMCO’s commentary on the current muni market

Just in case you missed the original interview, here is the segment.  From the 60 minutes interview with Meredith Whitney on December 19, 2010:

Investments that have zero downside are known as risk free, and exist only in theory.

The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time.  There’s no such thing.

CD’s and money-markets?  Not risk free: Just ask anyone who banked at Washington Mutual or 1 of the hundreds of other banks that failed in the past few years.  (FDIC will insure your deposits up to certain levels, but it may take a while for you to collect!)

Government Bonds?  Throughout history, many governments have defaulted…the ratings agencies are watching.

Even hiding your money under your mattress is at risk of burglary and inflation.

In reality, there is no Risk Free.  There is LOWER RISK, however.

This concept of LOWER RISK investing is not new- ask any conservative investor.  The problem with Lower Risk is that the yield just never seems to be enough. For instance, in 2011 you’d you have to go out more than a year to get 1% in a CD or Treasury Bill.

Today’s interest rates are low- that’s no secret.

Many of my clients harken back to a time in the early eighties when bank CD’s were yielding 16%.   They say it as if they would be content investing in 16% CD’s for the rest of their life, getting rich at 16% a year!

It’s just not reality.   You can’t beat the system; in a 16% CD environment, bonds could easily be yielding 20% or more.  CD’s would be paying 16% for a reason.  For instance, according to the encyclopedia brittanica, in 1980 mortgage rates were 18.5% and inflation was 12.5%.

Remember: The Lower Risk  rate is a price of safety, and if you think you are going to get rich investing in CD’s once interest rates go up, think about it harder. Low risk = Low Return.  This will be forever true.  Whether a CD is paying 16% or 0%- this is the cost of safety.

The bottom line is that the Lower Risk rate will never be enough; a CD is always a CD.

Other notable events from 1980 according www.history.com :

March 21  - U.S. President Jimmy Carter announces that the United States will boycott the 1980 Summer Olympics in Moscow.

April 7 – The United States severs diplomatic relations with Iran and imposes economic sanctions

May 22 – Pac-Man (the best-selling arcade game of all time) is released.

October 1 – Associated Newspapers announces that The Evening News will close and merge with the Evening Standard.

October 21 – World Series: The Philadelphia Phillies beat the Kansas City Royals 4–2 in game 6.

December 8 – John Lennon, an English musician and peace activist, is murdered in New York City.

Certificates of deposits (CDs) typically offer a fixed rate of return if held to maturity, are generally insured by the FDIC or other government agency, and may impose a penalty for early withdrawal.

An investment’s principal and earnings are not insured or guaranteed and will fluctuate with market conditions

On Jan 3 2011  Byron R. Wien, Vice Chairman, Blackstone Advisory Partners, issued his list of The Ten Surprises for 2011. This is the 26th year Byron has given his predictions of a number of economic, financial market and political Surprises for the coming year. Byron defines a “Surprise” as an event which the average investor would only assign a one out of three chance of taking place but which Byron believes is “probable,” having a better than 50% likelihood of happening.

Byron started the tradition in 1986 when he was the Chief U.S. Investment Strategist at Morgan Stanley. Byron joined The Blackstone Group in September 2009 as a senior advisor to both the Firm and its clients in analyzing economic, political, market and social trends.

Click here for the list:  Byron Wien’s Ten Surprises for 2011

Are you still trying to come up with some New Years Resolutions?  Here’s a few ideas…

1. CONSOLIDATE Your IRA’s!

Consolidate your various IRA’s and 401k accounts into one IRA Rollover account.  I was just talking to a client today about the numerous accounts that he and his wife have (approx 8!), and suggested he collect all of the 12/31/09 statements.  Unfortunately, they have moved 2 times and have not updated the addresses at each institution.  Believe it or not, over time it is possible to lose these accounts!

2. Review your Beneficiaries

Ever hear the story about the guy who made his wife the beneficiary of his 401k plan?  A few years later they divorced, but he never changed the bene.  A few years later he remarried, and still, he never changed the bene.  Many years later… when he died his wife and kids were left out of the proceeds because everything was left to his ex.  Review your beneficiaries for every 401k, IRA, Annuity, Life Insurance Policy, etc.!

3. Make 1 extra mortgage payment this year

Making 1 extra mortgage payment each year reduces a 30 year mortgage to 24 years, saving a lot of interest.  To spread the payment out over the year, you can try paying your mortgage bi-weekly instead of monthly.  If you pay your $2000 mortgage in 2 increments of $1000 every-other-week you will pay your 30 year down in 24 years.  (You will be making 26 payments, not 24)

4. Save 10% more than last year

Start with your tax-deductible and deferred accounts…Resolve to increase your contribution to your employer sponsored retirement plan or IRA by 10% over your 2010 contribution.  If you’re already maxing out your limits, start a monthly investment plan of 10% more than last years savings.