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March 9, 2015

Ask an Ex-Banker About The Big MO: What Are Returns?

A version of this appeared in the San Antonio Express News

Dear Michael,
I own a little of MO, purchased some time back with an average cost of $27.37. As you know it pays $2.08 dividend, and when I tell my friend my return is 8%, he says my return is what the stock presently pays, 3.8% or so.

I figure my return on my cost, not present price. Who is correct?

George, in Boerne, TX

Marlboro_man — The Marlboro Man, before dying a horrible death

Dear George,
Thanks for your question, which hinges on what we mean by ‘returns’ when we talk about an investment. And I can tell you who is right.
I will also use your question to discuss the unending debate between returns on stocks and returns on bonds.

Dividend Yield
Your friend’s definition of return at 3.8% posits a very particular number known as ‘dividend yield.’ We figure dividend yield mathematically by dividing the annual dividend of a stock by the current price of that stock.

Since the stock MO (slightly more commonly known as Altria, more likely known as Phillip Morris, and best known as a massive purveyor of cigarettes such as the iconic Marlboro brand) pays $2.08 per share per year in dividends and currently trades around $55 per share, the dividend yield is roughly 3.8% – which is $2.08 divided by $55.
I know precisely zero people (like your friend) who would call 3.8% the ‘return’ on owning MO stock.
So he’s wrong.

Instead, the return of MO stock ownership is the calm satisfaction you get from funding a delicious and refreshing tobacco-smoking experience for millions of satisfied customers.

Haha just kidding, lolz, smoking is disgusting.

Annual vs. Overall Returns
What I actually mean is the real return of MO stock ownership is calculated, as you already indicated, by figuring out your average purchase price, the current market price, and any dividends you may have received in the interim. Since your MO shares have doubled in price since you bought them, your overall return is something north of 100%, so far.

And so far, so good, for you.

However, we frequently talk about ‘annual return’ on an investment rather than ‘overall return’. If you made this purchase nine or ten years ago, your annual return might be something like the 8% you stated.
But I don’t know. It depends partly on when you bought, and also how you did or did not reinvest dividends.

If you know your way around an Excel spreadsheet, I could use the ‘IRR’ function to input your various annual purchases, plus any interim dividend cashflows, and then the proceeds you would collect when you sell, in order to calculate your annual return.

Then you can tell your friend to put that number in his pipe and smoke it, so to speak.
It’s well above 3.8%.

Knowable vs. Unknowable returns
But since you haven’t sold MO, you don’t actually know yet what your total, or annual, returns will be on the stock. You have to sell the shares to know your return on any stock investment.

And that leads me to a thought on the psychological problem of investing in stocks, especially when compared to bonds.
Since you have to sell to know your return, and since the correct holding period for stocks is roughly ‘forever,’ stock returns are less knowable than bond returns.
Stock returns, unlike the returns on bonds, are unknowable ahead of time. You basically have to leap into the unknown with stocks, which you don’t have to do with bonds.
Unlike stocks, traditional bonds simply ‘mature’ after a set number of years and ‘return’ your money back to you in the fullest sense of the word. Because your money ‘returns’ to you with a bond at a set date, calculating bond returns is knowable.

Donald_rumsfeld — As goofy as he sounded, Rumsfeld was right. About investing, at least

Bond yields are, however, a bit mathematically complicated.
For simplicity’s sake, traditional bonds have a known ‘Coupon Yield’ which tracks the income an investor can reasonably expect just by holding the bond. This would be analogous to your ‘Dividend Yield’ that I described for stocks above.
The Coupon Yield is the ratio of the annual bond payments to the bond price, so a bond issued with a 3% annual coupon starts off with a Coupon Yield of 3%.
Sophisticated bond investors do not consider ‘Coupon Yield’ an accurate enough measure of bond returns, however.

Calculating bond yields
After a bond has been issued, the ‘annual return’ or ‘yield’ you get holding a bond depends on whether you paid more or less than face value for the bond. If you paid less you will make a higher return than the coupon, and if you paid more, you will earn a lower return than the coupon. A precise yield or return calculation would require applying a special ‘discounted cash flow’ math formula to all remaining bond payments.
Confused yet? That’s the way we finance people want to keep it!

Haha just kidding, lolz. Finance is disgusting.

Ok, no, it’s not disgusting, but I’d have to direct you to some math to learn more about calculating bond yields and ‘returns.’ Don’t worry though, because a main point is this: The final ‘returns’ of a traditional bond held to maturity are knowable, making bonds psychologically comfortable for some folks.

Final ‘returns’ on a stock depends on an average purchase price and average sale price. So until you sell the stock, you have unknown returns. This partly explains why stocks are psychologically uncomfortable for some folks.

Stocks v. bonds
So which one should you own in your investment portfolio?
Well, let’s see, that’s a complicated question with many answers.
Let me tap out the tobacco in my pipe, my young friend, clear my throat heartily, and tell you in a deep voice that it depends on your time horizon, your risk appetite, your savings rate, plus a sophisticated calculation regarding the number of years until your retirement.

Haha just kidding, lolz.

You should own stocks.

Please see related posts:

Stocks vs. Bonds

Discounted Cash-Flow formula

Another discounted cash flow example

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October 27, 2014October 27, 2014

Rebalancing, Explained

Editor’s Note: A version of this post appeared today in the San Antonio Express News:

A former student at Trinity sent me a Facebook message recently. He linked to an advertisement message for an investment advisory company that emphasized the importance of ‘rebalancing’ one’s investment portfolio every quarter or every year.

I realized I had not taught that principal at Trinity in our personal finance course last Spring. When the link came in on Facebook with the simple query from my student: “What is rebalancing?” I thought “Uh-oh, I missed that one.”

To make it up to that student, as well as to anyone else who might have the same question, here’s the quick explanation of rebalancing.

Rebalancing is one of those investment things you should do regularly, like brushing your teeth (only less frequently) or going to your college reunion (only more frequently). Once a year rebalancing is fine.
The point of rebalancing is to avoid two big No-Nos of investing:
1. Overexposure to one particular type of risk; and
2. The “Buy-high, Sell-low” investment behavior that everybody unwittingly does.
I’ll illustrate the simplest form of rebalancing with an example, assuming you have just two types of investments in your portfolio: a stock mutual fund and a bond mutual fund.
Let’s say you and your investment advisor agreed that you needed the 60/40 allocation to stocks and bonds that 98.75 percent of all investment advisors inevitably urge on their clients.
[Quick aside: I totally disagree with this allocation, and I’m not an investment advisor, so for both reasons please don’t think I’m recommending this for you. In fact I wouldn’t recommend it for the vast majority of people, but that’s a whole other column – or series of columns to come – in the future.]

Ok, back to my example, which will happen to match up – by pure coincidence! – with how 98.75 percent of your investment advisors have set up your portfolio.]

After one bad year in the stock market in our example here, let’s say stocks have dropped by 12 percent and bonds have returned a positive 5 percent, and now your portfolio allocation has shifted due to the market.
The new portfolio at the end of Year 1 now has a 56 percent stocks to 44 percent bonds allocation.

Here’s where the rebalancing part comes in.
When rebalancing at the end of the year you would sell some of your bonds – in my example 9.6% of your bond allocation so that it only makes up 40 percent of your portfolio again. With the proceeds of the bond sale you would purchase stocks, also returning stocks to just 60 percent of your portfolio. You would now begin Year 2 with your previously agreed-upon 60/40 asset allocation.
Next year, let’s say the stock market rebounds, returning a positive 18 percent, while bonds return just 1 percent overall.
Using numbers from my example, you end up with a 0.66% larger portfolio at the end of Year 2 through rebalancing. That may not seem like much, but those little amounts add up over time. If you have a $100,000 portfolio you would be $660 richer after just one rebalancing.

Let’s extend the example one more year. At the end of Year 2, before rebalancing, you have a 63.6% stocks and 36.4% bond mix. We’ll have to sell about 5.6 percent of our stocks to return to our preferred 60/40 mix.
In Year 3, let’s say stocks return a positive 8 percent and bonds return positive 3 percent. You will now have a portfolio 2.1% higher than if you had never rebalanced, or $2,100 on your original $100,000 portfolio. The math works in your favor this way with any asset allocation in which assets have different returns in different years. It also works just as well with more than two types of assets.

calculating_rebalancing — A screenshot of the spreadsheet I used for calculations

I’d like to list a few more important points about rebalancing, why it works, and also some caveats.

First, the act of regular rebalancing forces you to “Buy-low, Sell-high,” at least on a relative basis. Whichever asset class has outperformed the others will be the one you sell (high) and whichever asset class has underperformed will be the one you buy (low).

Second, while regular rebalancing makes sense, I doubt it makes sense to do this more than once a year. If you have a taxable account (a non-retirement account) then the tax costs of selling winners may outweigh the benefits. Also, frequent trading is always a mistake, so rebalance with moderation.

Third, because of point number two, if it’s possible for you, the best way to rebalance is not through selling existing investments, but rather through new investments. If you regularly contribute to an investment account, you can ‘rebalance’ your portfolio without tax consequences by simply purchasing more of whatever has become underweighted in your portfolio. This has the happy effect of allowing you to buy (relatively) low with your new investments, rather than to do what everybody else does, which is chase whatever hot sector has recently outperformed.
This may seem super-duper obvious and it is indeed super-duper easy to do.

But!
Most people don’t do it. After Year 1 of losing 12 percent in the stock market, for example, few people have the guts, rebalancing discipline, or a nudgy-enough financial advisor to remind them that their allocation is out of whack. Simple rebalancing will help correct that whack.
We get scared to buy something down 12 percent. After Year 2, we also have a hard time selling something that just soared 18 percent in a year. “Ride that winner!” we tell ourselves, to our later regret.

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September 8, 2014September 8, 2014

The Giffen Good Concept Applied To Investments

Editor’s Note: A version of this post appeared in the San Antonio Express News “So…Money” column.

The only “C” I got in college was in Intermediate Macroeconomics, but I remember one economics term that I really loved — the “Giffen Good.”

With ordinary, rational, economic behavior, we expect that when prices go up, people buy less, and when prices go down, people buy more. We buy more things, for example, at Wal-Mart and Costco because of their low prices. We buy fewer things at Nordstrom because of their higher prices. Makes sense, right?

A Giffen Good — named for a 19th Century Scottish economist named Sir Robert Giffen — is an odd thing. It’s something that people buy more of as the price goes up. With a Giffen Good, people act in exactly the opposite way we would normally expect them to in response to the price of things.

When you look up Giffen Good in Wikipedia — as I just did to refresh my memory — you read that little evidence exists for Giffen Goods in the real world, and people do not generally purchase more of something when the price goes up.

When it comes to our investments, however, I totally disagree with Wikipedia.

Ever since learning about Giffen Goods, I see them everywhere, as well as what’s known by analogy as “Giffen Behavior.”
Outside of the investing world, I remember reading with much interest the story of a guy trying to get rid of his mattress. He posted a “Free Mattress, Used” notice on Craig’s List, and got no responses. When he posted “Mattress, used, just $10,” he had to turn away interested buyers who lined up with their trucks to try to take advantage of a great bargain. That’s a Giffen Good.
Here’s an example of a Giffen Good from the art world: Imagine if I landed on Earth knowing nothing about art and somebody offered me the Edvard Munch painting “The Scream” for $1,000 to hang in my living room.

The_Scream_giffen_good — I’d offer you $75 for this, because I love a bargain.

I don’t know about you, but I might just think, “Whoa, that’s kind of a lot of money, and although there’s something neat about the painting, it’s still a bit creepy.”
And then I might think, “How about I give you $75 for it?” Because I love a bargain.

Of course, knowing that somebody else paid $120 million for it last year changes its attractiveness to me. Would I sell every single one of my worldly possessions right now to own “The Scream?”

Duh. I’m a finance guy. Of course I would. That painting is the ultimate Giffen Good.

Shifting from the absurd to the irrelevant, a concept like Bitcoin suddenly became everybody’s most desired tulip bulb last year when the price starting shooting upward, making it the Giffen Good of 2013.

And now lets return to the core of ordinary investment behavior: Discretionarily-managed equity mutual funds typically charge 0.75 to 1.5 percent management fees, while equity index mutual funds typically charge one-third of that amount in management fees, despite offering the same long-term results, according to every academic study that’s ever been done. Like, ever.

Most investors figure — wrongly — that if the fees on the discretionarily managed equity funds are higher, they must be a better product. The lower-priced index mutual funds just seem less attractive. That’s a Giffen Good.

In fact, much of the time, the entire stock market is an example of a Giffen Good. We really don’t want to own stocks when they fall in price. On the other hand, we really, really, really get interested in stocks after they’ve jumped 10 to 15 percent a year for a couple years in a row. This is madness, of course, but it’s also exactly what drives much investing activity.

active_vs_index — Most of the time, indexing wins

Beware of your own Giffen Behavior.

Final note: Real, live economists reading this may object to my imprecise adaptation of an economic term for the popular illustration of a personal finance concept. In anticipation of their objection, I can only show them my previously mentioned “C” on my college transcript. Also, lighten up, dismal scientists.

Please see related post: Guest Post by Lars Kroijer – Agnosticism over Edge

A book review of Investing Demystified by Lars Kroijer

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July 24, 2014December 22, 2014

Book Review: The Automatic Millionaire by David Bach

A few weeks back I sent out a proposal to a few prospective agents, expecting at least one would recognize the genius – and their own self-interested business opportunity – in my personal finance book proposal.

One prospective agent asked a reasonable question in reply: “What’s the one thing you would like to get across to readers of your book?”

At the time I got his email I was in the process of sitting down to watch a summer blockbuster movie in the theater[1], so I fired off what came into the top of my head, to which he replied:

“Not good enough. You need to give readers something more concrete and memorable, like ‘Bach’s Latte Effect.”

I puzzled over that one throughout the movie, as I did not recall anything about delicious lactose-based caffeinated beverages in my limited knowledge of the Brandenburg Concertos.

Fortunately, when the movie let out I had recourse to The Google.

I learned that one of the most popular personal finance book of the last decade – The Automatic Millionaire: A Powerful One-Step Plan To Live And Finish Rich, by David Bach – makes use of Bach’s Latte Effect as a central, simple concept for getting rich.

David Bach, not Johannes Sebastian, composed the ‘Latte Effect.’

The next day I ordered the book, fully hoping to hate it, all the better to discard the agent’s comment in an ego-protective way.

I’m sorry to say: This book is quite good.

I mean, mine’s better, obviously, but David Bach has the distinct advantage over me of actually having written and published his book. And, it’s got a couple of extraordinarily simple, memorable, easy steps that could help most people get wealthy by the end of their lifetime.

Bach has two, and only two, major points to make, both of which are absolutely correct.

Bach’s first point – The Latte Effect

You do have money to invest.

Nobody thinks they do. Most days I don’t think I do. I mean, the money always runs out first, right? How would I even scrape together an extra $100 a month? It’s just not happening, right? Wrong.

samuel_jackson_motherfucker — Yes, my barista actually made this Samuel Jackson latte and gave it to me. That’s how good a coffee customer I am. Which is scary.

The Latte Effect, coined by Bach, refers to the correct idea that all of us – ALL OF US[2] – are paying for things on a daily and weekly basis that we don’t have to. Each one of us – were we to track every little, literal, expenditure – buys small things that we do not have to buy.

Me, as an embarrassing example of the Latte Effect

Personally I have gotten in the habit of feeding my Starbucks addiction to an embarrassing level. Let’s say I spend $2.50 on a Grande per day,[3] for a total of $17.50 per week. And let’s say three times a week I grab a ‘classic sandwich’ for breakfast from that smug little green mermaid because I’m in a rush to drop off the girls at school or camp or whatever for a total of $12 more dollars per week. So I spend $29.50 per week at Starbucks.

So, sue me, what’s the big deal?

The big deal is that this tiny little forgettable expenditure, after 52 weeks, comes to $1,534 per year.

And the next big deal is what I’m not building in long-term wealth by spending that $1,534 annually.

How big is the Latte Effect?

Let’s say I saved and invested an additional $1,534 per year in the stock market, and let’s further say I did that for the next thirty years, until I turned 72. How much richer would I be?

Plug this into your compound interest calculators everybody:

At a plausible 6% return from the markets I’d be more than $128 thousand richer by age 72.

At a backward-looking, historically-realized 10% return I’d be more than $277 thousand richer.

What if instead of getting wise at age 42, I had cut out my destructive Starbucks habit and began my caffeine-free living at age 22? Now this gets really interesting.

At the plausible rate of 6% return from the market, I would end up at the age of 72 $472 thousand richer. And if markets returned as much as 10% every year I would be over $1.9 million richer.

So what is my Latte Effect?

Over my working lifetime (age 22 to 72) somewhere between $472 thousand and $1.9 million. Actually I am certain the range of the effect is much higher, as I’ve underestimated both my weekly Starbucks consumption and other unnecessary consumption items, but you get the idea. I should be, and could be, much wealthier.

And so could you. So what’s your Latte Effect?

Your Latte Effect

Now, you may be feeling quite smug because you’re Mormon and you never touch the Starbucks poison. Good for you. You still have a Latte Effect. I guarantee it.

You buy lottery tickets. Or gum. Or tic-tacs. Or Spotify/Pandora. Or Netflix/Hulu/AppleTV. Or internet porn. Or extra leveling-up manna on the Freemium games for the iPhone. I know you have a weakness, you’re just not telling me.

Which is fine. But you should be honest with yourself about your own Latte Effect, if you aren’t coming up with money at the end of the month to invest for your long-term financial security.

automate_your_investments — Automate Investments For The People

Bach’s second point: Automate the Investing

Not only do we not think we have any money at the end of any month, but very few of us – even if we had the money at the end of the month – have the willpower to turn it over to our long-term investment accounts.

The only surefire way to invest – and here I have to give Bach credit for totally nailing it, although also of course I independently urged people to do this last year[4] – is to set up automatic deductions from your checking account (or better yet, directly from your paycheck) into your investment accounts.

[Why does this work? I don’t know. It has something to do with the idea that money that either doesn’t stay in our checking account – or doesn’t even hit it – is money that we will not be tempted to spend. Humans are weird psychological puzzles when it comes to money. Incidentally, here’s a good book I reviewed that explores all the different irrational things we do with money. Ok, back to our regularly scheduled program.]

The following statement – a paraphrase of Bach’s book – deserves the bold, italic, underlined all-caps designation I’m giving it.

THE MOST IMPORTANT STEP YOU CAN TAKE TO BECOMING RICH IN THE LONG RUN IS TO AUTOMATE YOUR MONTHLY INVESTMENT CONTRIBUTIONS

I’ll stop shouting now, and offer a few additional calm thoughts.

The first best place to automate investment contributions is to your 401K and IRA, both of which are tax-advantaged, awesome investment vehicles.
If you already contribute to your company’s 401K (or 403b for non-profit folks), then check to make sure you are maximizing your annual contributions.
Your friendly bank or brokerage company will happily set up a monthly or bimonthly automatic transfer from your checking account into the investment account you open there.
If you’re just starting out and don’t think you qualify for the investment to open an account, you can sometimes convince them to waive the minimums, if you set up an automatic investment program.
If you’ve never invested before, try dedicating just 1% of your income to your investment accounts through automatic investing. Over time, once you’ve automated contributions, you will see that moving to 5%, and then 10%, of your income is no big deal.

Automatic investing this way is not simply a way to invest, or one way to invest. No. I say with confidence it’s the ONLY way to invest. If you haven’t tried this, but have always wondered how other people actually invest money over time, you may be amazed to learn that the vast majority of people did it, one way or another, based on automatic investing.

So, the TL;DR on David Bach’s book:

You could have money left over at the end of the month if you stop drinking lattes (or whatever), and you could become wealthy if you automatically made contributions to your investment accounts, starting with your tax advantaged retirement accounts.

Caveats

I have only two caveats about The Automatic Millionaire, and these caveats apply to every single personal finance book I’ve ever read so far.

Who buys this?

First, the type of person who picks up a personal finance book is already different from your average person who needs help with their finances. A personal finance book buyer has self-selected as someone oriented toward financial self-improvement, and asking for outside ideas. Will buyers and readers of The Automatic Millionaire follow Bach’s advice? I hope so. Will the people who need the book the most actually end up buying it, in order to take their first few simple steps toward financial security? I don’t know.

Compound interest

My second caveat is just my personal pet peeve. Bach makes good use of the concept of compound interest, urging his readers to invest early in their lives to get rich later. Multiple charts and tables in the book show how a few thousand dollars invested, for X years, earning Y% return, will result in Z riches. This is great.

BUT!

Bach, like every other personal finance author who has ever been published, declines to show exactly how the math is done. He decided, the same way every other publisher has previously decided, that book readers cannot be trusted to learn a simple algebraic formula.

With a little attention and a simple spreadsheet, readers should be taught compound interest. Am I the only person who thinks that personal financial advice starts with people understanding compound interest well enough to do the calculations themselves, rather than refer to somebody else’s table in a book?

Apparently, yes.

If I ever spoke with that agent again, I’d like to tell him that the one thing people should understand is the compound interest formula. That is my most firmly held belief.[5]

But I’m afraid it’s not something the publishing world is comfortable with. They don’t trust readers enough to walk them through the junior-high level math. So we get tables and charts instead.

Please see related post All Bankers Anonymous reviews in one place!

Please also see related posts on:

Compound Interest and Wealth

Compound Interest and Debt

The Humble IRA

Become a Money Saving Jedi

[1] 22 Jump Street, if you must know. What? Whaaaat? My wife tells me Channing Tatum is quite a good actor. But I still haven’t convinced her to start calling me “Magic Mike.” I don’t know why she refuses me this simple courtesy.

[2] Ok, obviously not all of us. Because there is real poverty everywhere. And I know there is food insecurity within a few blocks even of my own house, so I should not exaggerate. But many, many, many, more of us – pretty much anybody who is gainfully employed right now and not on complete federal assistance – has their own Latte Effect were they to examine their daily habits scrupulously.

[3] I happen to know my Starbucks habit is much, much worse than this, but I’m not about to confess this to just anyone on the Interwebs. I mean, I have some pride. Also, there are some crazies on the Interwebs, have you noticed? Sheesh.

[4] I’m just bragging here so that any book agents reading this know that I’m totally all over this topic.

[5] That, and also the firmly held belief that Rihanna would totally prefer me over both Drake and Chris Brown, if she was ever given the opportunity. Sorry, RiRi, I am happily married.

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April 18, 2014April 21, 2014

The New MyRA – From the Department of Bad Retirement Ideas

The federal government – following an idea proposed during Obama’s January 2014 State of the Union address – will role out a new simplified IRA plan later this year, designed as a starter retirement account, known by the catchy name MyRA.

Geared to lower- and middle-income earners, the accounts will have the following features:

1. Automatic deduction of contributions from payroll (that’s a good thing).

2. Same income limits, contribution limits and tax treatment as the Roth IRA – post-tax contribution, $5,500 total per year, $129,000 income per individual (that’s fine).

3. A maximum size of $15,000 total before investors need to roll it over to a private IRA (that seems arbitrary).

4. A single investment option, in a variable-rate “G Fund,” that matches the Thrift Savings Plan Government Securities Investment Fund. (that’s a terrible idea).

Why that’s a terrible idea

I understand the federal government designed the MyRA to solve a set of identified problems, explained in this White House Press Office blog post.

First, one half of all Americans have zero retirement savings.

Second, half of all full-time workers have no access to an employer-sponsored retirement plan (like a 401K or 403b), and that number climbs to 75% for part-time workers.

Third, lots of people who had retirement accounts invested in public markets lost money in the last financial crisis.

These are all admirable problems to tackle, although the existing IRA accounts are already available to anyone not covered by an employer’s plan.

Will the MyRA actually force small business owners to enroll employees?

The most interesting innovation appears to be the automatic enrollment by employers and automatic deduction of employee paychecks feature of MyRAs, although I can already hear the cries of “Nanny State” and “Government Don’t Tell Me How To Run My Small Business Or How To Save Money.”

I cannot tell from the White House memo how coercive the MyRA enrollment will be. Does every small business have to enroll their employees if they don’t offer a retirement account? I just can’t believe the current Congress would pass anything that resembles coercion against small businesses. So my guess is that this MyRA becomes an optional program, and this most innovative part of the MyRA program disappears.

What remains after Congress eliminates automatic enrollment, however, is a disservice to lower- and middle- income employees.

Without automatic enrollment, the MyRA seems to address the first two problems – zero savings and zero employer-sponsored retirement plans – by creating an account with tremendously similar features as the existing Roth IRA plans, but with one terrible feature.

The terrible feature

Your only option is to invest in US government debt.

The interest rate will vary over time according to prevailing interest rates, but, by design, this will be most secure dollar-denominated investment available, and therefore the lowest yielding.

The current 1 year rate offered by the “G Fund” is 1.89%. After inflation, the return on your money in a MyRA is close to zero.

Although the G Fund rate – and therefore your expected return – will go up or down with changing interest rates over time, the way the income yield on US government debt works is that it will only ever barely exceed the rate of inflation over time, almost by definition, as a result of market forces.

The fact that your income will be available upon retirement ‘tax-free’ like a Roth IRA is close to meaningless, since there will be hardly any income to enjoy, tax-free.

This is unacceptable as a product for retirement savings, and unacceptable to market as a vehicle for lower- and middle-income employees, who badly need the benefit of higher compound returns, even more than other retirees.

The memo describing the MyRA boasts that MyRA investors may rest assured that they cannot lose their principal. They can be confident that their retirement savings will not be subject to the kind of volatility that we’ve seen in recent years.

What the memo does not spell out, but that make the MyRA troubling, are the following key ideas about retirement investing:

1. Over longer time horizons – say between 5 years (70% of the time) to 15 years (95% of the time) to 20 years (99.5% of the time) – stocks win. The volatility of the stock market ceases to be a risk when compared to investing in bonds. This is because despite the volatility of stocks in the short run, stocks always offer a superior return in the long run. Retirement savings – the most long-run investing that individuals do – must skew toward higher-risk, higher-return products like stocks, and away from bonds [For more on this idea, see this post on “100% equities for the long run.”]

2. The long-run risk of investing in bonds in a retirement account is the terrible loss of purchasing power due to inflation, as well as the missed opportunity of long-term wealth accumulation from higher-risk, higher return investments.

In sum, if the MyRA only lets investors earn the “G Fund” rate of return, it’s totally unsuited for anybody’s retirement account.

An even more cynical view

Now let’s apply a paranoid Wall Street skeptic’s eye for a moment.

I do not believe the Obama administration has an evil master plan here.

They are not proposing to automatically deduct a portion of salaries from poorly paid, unsophisticated folks with no other retirement money and thereby extract the limited savings of the country’s underclass to fund the nation’s debt, at a good-for-the-government-but-bad-for-the-poor long-term interest rate. I don’t believe that comes from a Dr. Evil plot deep inside the Treasury Department.

On the other hand, that would be the actual result of this MyRA plan.

One man’s investment is another man’s debt

What is obvious to Wall Street folks but less obvious to Main Street folks is that the bonds we buy for investment are the borrowing mechanism of the companies and governments who issue bonds. My bond investment = the (company/government) bond issuer’s borrowing.

When I earn a 3% return on a Coca Cola bond over ten years, that just means Coca Cola borrowed money from me at a 3% interest rate for ten years. When you buy a municipal water company bond at 4%, that just means the municipal water company took out a loan at 4% from lenders.

When the US Government offers a 1.89% “G Fund” return to lower-income workers in a MyRA, that also means the US Government borrows money from its lower-income workers at 1.89%. Which, while not intended as such, creates an evil result.

Dr_Evil_one_Million_dollars — I will offer you 1.89% on your One. Million. Dollars.

While it’s not an evil plot, it is a terrible plan.

To encourage lower-income (and presumably less-sophisticated) workers to earn a paltry 1.89% return on their longest-term investment is unconscionable retirement planning for the nation’s poorest, that just happens to, simultaneously, fund US government debt at a cheap interest rate.

Please see related posts on the IRA account investing:

The Humble IRA

IRAs don’t matter to high income people

A rebuttal: The curious case of Mitt Romney

The magical Roth IRA and inter-generational wealth transfer

The 2012 IRA Contribution Infographic

The DIY Movement and the IRA

Angel Investing and the IRA

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February 15, 2014February 17, 2014

Interview: Author Lars Kroijer (Part I) – on Global Diversification

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In the first section of this interview with author Lars Kroijer we talk about his idea, from the book Investing Demystified, that we should all seek portfolio exposure to the broadest segment of global equities – essentially all 95 stock markets in the world. In the second part of this interview we talk about the opposite – namely the dangers of concentrating all of your investment portfolio within, say, your home country.

Michael: I’m talking to Lars Kroijer, [/Kroy’-er/] the author of Investing Demystified which I’ve reviewed on the Bankers Anonymous site. First things first, I read your book and I agree with a ton of it, the theory. And then I thought about my own portfolio, and I thought I’m two-thirds the way towards what you’re saying. By that I mean I invest in index-only Russell 2000 index funds. Talking about my retirement portfolio. I halfway embraced what I think is – in shorthand – an efficient market hypothesis. But I’m not entirely there, so tell me about why I’m doing it wrong.

Lars: It’s an interesting place to start because you are doing it less wrong than most people in the world would be. You being an American investing in a very broad US index, you are already invested in a very large portion of the world-equity portfolio. What I would normally tell people is you need to invest cheaply and extremely broadly in equity indices for your equity exposure.

Now what does that mean? That means all equities traded in the world. I think there are 95 public equity markets in the world today, and you should be invested in all those in proportion to their values. You’re only invested in one, the US one, but that’s the biggest one by a very large margin. So failing to invest abroad is less of a sin than it is for someone who is based in Denmark, where I’m from, that represents only 1 or 2% of the world-equity markets. Where I’d tell you you’re going wrong is you should diversify beyond the US, and you’re not doing that.

danish_flag — Only ~1 % of global equities in Danish stock market

Michael: So I’m a complete hypocrite on this front. I worked in emerging markets so I professionally, on Wall Street, worked in non-US markets. Whenever I speak to friends, I say, “If you’re completely exposed to the US, you’re doing it wrong.” And nobody who grew up in any other country but the US would probably ever dare to be so bold as to only invest in their own country. It’s an irony.

Lars: It’s interesting you say that, if I could just interrupt you there; you look at institutional investors in the UK or in Denmark, really any country in the world, and a lot of them will have exposure to just their own domestic stock markets, for lots of terrible reasons.

I’m saying that is generally a mistake, but in your case, it’s less of a mistake than if you lived in Denmark. If you lived in Denmark you would only have exposure to 1% of the world equities, where in the US it’s more like 35-40%. When I tell people to go buy the world-equity portfolio, you already have 35-40% as opposed to in Denmark you’d have 1-2% of that, so that is a big difference.

Michael: Getting extremely practical, how many different positions in either ETFs or mutual funds do I actually need to buy if I’m going to get some kind of efficient frontier of global equity exposure?

Lars: You can do just one.

Michael: There’s a single ETF?

Lars: The reason I’ve refrained from endorsing just one specific security is because I’m hoping that world-equity markets is a race to the bottom in terms of fees product. Right now, that might be called MSCI All Country World. Personally I don’t care what the index is called because what we’re after is the broadest, cheapest exposure. If someone comes up with a cheaper, better index, that’s even better. If an index-tracking product is cheaper and better, that’s even better. But you can buy the MSCI All Country World in one ETF, iShares will do that, DB Trackers will do that, Lyxor will do that. Vanguard does a version of it.

Michael: I was going to ask: I use Vanguard because of their brand name, and low cost, passive mutual fund investing.

Lars: They’re very good.

Michael: They have this global, total world-equity exposure. Are there another half-dozen US fund companies who also –

Lars: Yeah all the large ETF providers will have it.

This idea that you have your house, your education, your pension, all your assets come together and really are correlated to the same thing, which is typically your local economy. So one example I have in my book is imagine you’re a London-based real estate agent and you have your own flat. And you have a pension with the real estate agents, and then on top of that you own a couple of real estate related stocks in the UK.

Now, you are really long in London real estate market and that’s crazy to do that in your investment portfolio when you’re already so long in the rest of your investment life. This is yet another reason you’ve really got to stay diversified in your investment portfolio. Even sometimes your future inheritance is going to be in the same stuff: your parents’ house, your spouse’s job, dependent on the same local economy, your future job prospects dependent on the same local economy. Don’t have your investments in that same area.

This argument actually works better outside the UK because you can apply it to ‑‑ instead of London real estate I say Denmark. So very easily don’t have your equity investments in Denmark because you’re already long in Denmark. I think that’s a hugely important part of why these kind of diversified products really make a lot of sense for a lot of people. And why I think it’s a great shame that people tend to have their equity investments and investments generally so close to where their other assets are. They really all can go badly wrong at once, and that’s exactly what you should avoid.

Michael: We know from the 2008 crisis that all risk assets correlate almost to one. In extreme downturn – everything that is a risk asset goes down all at the same time. That was a very scary reminder of that. There is nothing that is at all risky that doesn’t drop in value in a crisis.

Lars: You’ve got to diversify. Then you could also look at if you’re a Greek investor, your real estate, your future pensions, your house, your job, all that would go belly up at the same time. Meanwhile, the rest of the world was fine. Imagine you had Greek government bonds as your low-risk asset. If you’d also had the Greek equity market as your equity exposure, you really would’ve been toast. Don’t do that. You’re not getting additional expected returns to reward you for that.

I think that’s an area that’s very important that people don’t talk enough about. That frustrates me. Again, people don’t want to listen to it because there’s little money in telling someone to buy the world-equity index. No one is interested in that.

Michael: As an emerging-markets guy, it’s clear to me that anybody with any kind of net worth in any of these countries which has experienced typically a currency devaluation or nationalization or national political crisis, anybody generationally who grew up in that who has any net worth, always has a significant portion of their assets in Europe or the US or hard currencies. But in the US we don’t have an experience of having our credit – of course it’s been downgraded in the US but it’s not been junk status.

Our currency has never devalued wildly or unexpectedly. People are quite complacent about the idea of our exceptionalism. I’ve often said ‑‑ you said you wrote this book in a sense for your mom. I’ve often had conversations with my mom along these lines of do you know that most US investors have never considered that their house, job, currency exposure, government credit exposure is all US based? With almost no diversification. And we’ve gotten away with it up to this point, but it doesn’t mean we will in the future. It’s imprudent but as you say, people continue to do it because it’s either complicated, seems hard, boring, or not enough people are telling them to look elsewhere.

Lars: No one is really incentivized for you to do that. No one makes money. The CFAs or financial planners don’t make money from this. What we’re talking about is not a good thing for the financial-planning industry either.

Michael: It’s a much lower fee situation.

Lars: Much lower fees, and paid by the hour kind of stuff.

Michael: For the typical ‑‑ my orientation is the US investor ‑‑ the typical US investor, it will sound like madness when you say exposure to every equity market such that two-thirds of your money will be exposed to non-US will sound very aggressive to the US market. It doesn’t sound aggressive to me. It sounds like an obvious, logical outcome of the efficient-market hypothesis, just get the broadest exposure. But it will sound aggressive. You mean you’re going to put 65% of your net worth in non-US?

Lars: You’re going to own Indonesian stocks? Where’s Indonesia?

Michael: It sounds very aggressive. It sounds less aggressive to anybody who doesn’t live in the US, because they’re used to that.

Lars: That’s right, I couldn’t agree more. This book actually shouldn’t but it’s going to be an easier pitch outside the US because you’re already likely to have exposure to non-domestic securities or at least you’re going to be accepting of the possibility that you should.

Michael: In currencies and government exposure, and all of that.

Lars: That’s why all the best FX (foreign exchange) traders are all Argentine. They grew up ‑‑ my college and business school roommate is from Bolivia. He said the one time in his life his mom ever hit him was when he was a kid and he’d gotten some US dollars. He had to run down to the bank and exchange them. Or he had some bolivar or whatever it’s called. He ran down and exchanged the US dollars. He came across a [soccer] pitch and a bunch of guys were playing football, so he played football for two hours and then he went to exchange it. The amount of money that had cost in the currency…

Michael: Poor kid.

Lars: You learn about inflation real quick.

Michael: Tough lessons about inflation.

Please see related post, a book review of Investing Demystified, by Lars Kroijer.