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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part two of our series takes a look at the positives and negatives of real estate investing.
After deciding against purchasing the liquor store, my next move was onto real estate. I have several friends that thrive in the area of real estate investing and have learned that hiring a management team can provide relief from having to do the maintenance and the management yourself, so I began the search.
I focused primarily on residential properties as well as multi-family units.
I had determined that I wanted to get at least a 10% return with this investment. Looking at the real estate industry, I figured I could get a minimum of a 7% return and in some cases, as great as 17%.
Recognizing the Three Components of Return
All investments have three components of return: earnings or cash generated each year, growth of earnings, and (hopefully) increase in valuation. Earnings are the cash flow that is generated and paid to you. The growth of earnings is the increase in those expected earnings over a period of time. Last, the increase in valuation is the upturn in price per unit from the time you buy to the time you sell.
In terms of stocks, earnings are dividends that are paid to you. If a particular stock is paying a 10% dividend yield, you as the investor can expect 10% from dividends. The increase in earnings is the rise of dividends each year paid out to you. If the stock was purchased for $10 and the dividend was originally $1 per share, but increased to $1.30 over the course of five years, then the increase in earnings was 30% total, or 6% per year.
Last, you might have purchased the stock for 10 times a dollar of earnings and sold for 15 times a dollar of earnings. This represents a 50% increase in the valuation over five years, or 10% per year. As a result, you would have a total annual return of 26% per year: 10% for dividends, 6% from growth in earnings, and 10% for appreciation.
Wouldn’t a return like that be nice to get now a days? Unfortunately, the stock market has only averaged about 4.5% a year for the past 15 years.
Looking into the real estate market, I found homes that I could rent and expect to receive a 7% return from the rental income. I estimated I could increase the rent by 2% per year, and expect to see a 1% increase in the valuation.
I looked at buying a home for $150,000 and charging an annual rent of $10,750 or 7%. I could expect the rental income to increase from $10,750 in the first year to $13,450 at the end of a five-year period; roughly a 1% increase per year. At the end of five years, I could anticipate selling the property for $165,000, which in total would earn me a return of 10%. This would be good!
The Reality of Real Estate Investing
However, weighing into this grand plan would be the cost of annual maintenance, the expense of personally managing the home or hiring a property manager, and the toll of having a potentially unruly renter.
In the end, I decided that although I might be able to earn a great return on a real estate investment, I would still have to put up with the risk and hassle of managing the rental to some extent, in which the costs may outweigh the benefits of such a return.
My next FLOW post specifies how and what I decided to invest in.
In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part one of our series focuses on the pros and cons of commercial investments.
With the recent decline in the stock market, I’ve began to wonder what it really means to invest. This question takes me back a couple of years ago to when I attended the Berkshire Hathaway Annual Meeting. The meeting in itself was a spectacle for investors, as Warren Buffett and Charlie Munger drew in over 19,000 attendees to Omaha, Nebraska.
What really struck me was that both Buffett and Munger urged the attendees to think of each and every investment as though they were going to purchase the entire company for themselves.
I knew it was important, so I logged it away in my “Mind Palace”, what Sherlock Holmes calls his memory vault.
After so many years of high valuations and low interest rates in the stock market, I found myself growing antsy, in search of my own reasonable investment. Without one to be had, I even thought about buying a liquor store.
A good friend had purchased one and I was slowly recognizing the benefits of owning such an establishment. I was following the financials closely and had become aware of the store’s ability to generate cash flow. In addition, I realized people tend to purchase more alcohol during slow economic times, therefore offsetting investments that decreased in value during economic slowdowns.
Assuming a Sizable Workload for a 10% Return
Owning a liquor store would produce about a 10% return on my capital, meaning that for the money I put down, I could expect (as the owner) to generate a 10% return each year. Some years would fare better than others, while some years I would not make my 10% return.
My wife and I met with the business broker. We toured the store covertly as customers and visited nearby liquor stores as well.
Owning the liquor store was possible and I was hopeful for the generated 10% returns; however, as the owner I would still have to run the store. This meant buying the liquor at reasonable prices, interviewing and hiring staff, maintaining a weekly shift schedule and enduring the drama that employees can often create.
In the end, we decided not to invest in the liquor store. The 10% returns were attractive, but the additional work necessary to run the business made the potential return a less desirable deal than I was willing to take on.
Stay tuned for the next FLOW post, where I discuss the second investment I contemplated making in the market.
When it comes to preparing clients for a fruitful retirement, Professor Dr. Hans Becker, CEO of Humanitas Foundation in the Netherlands has a unique outlook.
“Apartments for Life” is a Dutch senior housing community that was developed and driven by Dr. Becker and the Humanitas Foundation in the mid-90s. The initial concept behind the community was generated in response to an overabundance of elderly individuals demanding an alternative to old-style nursing homes and hostels. Many of these individuals wanted to continue living independently and remain in their own communities for as long as they could, even if their health was failing and their mobility was limited.
For Dr. Becker, the wellbeing of the residents, or “clients” as he calls them is broken down into several basic values:
- Exercise a “yes culture”
- Use it or lose it
- Be the boss of your own life
At Capstone, we demonstrate a similar model when it comes to handling your finances and helping you reach your goals. Our idea of restylement incorporates these same values to help you get a handle on your financial wellbeing and gives you the tools necessary to live the life you want.
Creating a “Yes Culture” for your Clients
To best understand the “yes culture” of our clients, we first must understand the most important elements of theirs lives. At “Apartments for Life”, when it comes to reasonable resident requests, Humanitas provides. This is Becker’s “yes culture” — a recurring term that implies individuals should focus on what is still working, rather than what isn’t, and to make the best use of it. At Capstone, we encourage our clients to evaluate what is financially working in their lives and how small tweaks can provide a more beneficial outcome.
Utilizing Your Resources Constructively
The second value Dr. Becker’s organization focuses on is “use it or lose it,” a philosophy that reflects on personal strength and the belief that overprovision in terms of elderly care is more damaging than the effects of under provision. As a result, residents are challenged to exercise their independence and do as much as they possibly can for themselves. Giving them the power to make the decisions that will firmly impact their lifestyle leads to individualized experiences and higher customer satisfaction.
Designating Yourself as the Driver
According to Dr. Becker, individual freedom can be achieved by rejecting the idea of conventional home care. “People there are patronized,” he states. Instead of focusing on illness and degeneration that often leads to people feeling robbed of their independence, he believes his clients should instead focus on obtaining a sense of empowerment. The core message behind “Apartments for Life” is to listen to what people want and focus all efforts on making it happen.
As individuals are continuously changing their personal and financial lifestyles, it is important to understand both why and how one wants to live in order to organize a strategy to make it a reality.
This article was originally posted on October 2013 on AUM in a Box. This blog entry has been updated with new data through the end of December 2015.
Last week the Consumer Price Index (CPI) was released by the Bureau of Labor Statistics, stating that “over the last 12 months, the all-items index increased 0.7% percent before seasonal adjustments.”
As an update, the Economist Big Mac price in the U.S. came in at $4.93, up $0.14 from $4.79 in January 2015. This represents a 12-month change of 2.9% and is a representation of typical inflation; however, this is certainly greater than the Bureau of Labor Statistics’ measure of inflation.
The rise in the price of a Big Mac is occurring faster than the official rise in consumer prices and has been this way since the late 90s. In 1998, the average price of a Big Mac was about $2.50. As of January 9, 2016, The Economist reports that the average Big Mac now equals $4.93. If we were using the Consumer Price Index (CPI), the price of a Big Mac today would be about $3.80 (see the graph below). The price hikes represented by this popular burger will impact individuals more than the saturated fat content the Big Mac bears.
The rise in the price of the Big Mac foreshadows how the printing of money is eroding the financial system’s arterial walls. The impact is broad-based:
- Each dollar we own is buying less
- For individuals relying on Social Security, the compensation for inflation is not keeping up with the prices people actually pay
- The price of bonds would be much lower if interest rates fully accounted for the rise of inflation based on the Big Mac
- The official economic growth rate would be lower today if prices were based on the Big Mac Index
Using the Big Mac Index to Measure Inflation
The Economist Newspaper created the Big Mac Index in 1986. It was designed to compare the price of currencies between different countries. The index is based on a theory called purchasing-power parity. This theory looks at the same basket of goods in each country and then adjusts for the interest rate one would pay for a loan or receive with a savings account. This adjustment for interest rates makes the price of a Big Mac comparable in each country. The Big Mac Index has just one item; however, because it contains beef, dairy (cheese), wheat (bun), cost of labor, and the cost of real estate, we believe it is a good representation of prices in the United States and abroad.
Rather than use the Big Mac Index for comparing the value of currencies between countries, we wanted to take the price of the Big Mac each year within the U.S. to see how it changes over time. You could also use this approach to look at the trend of prices for other countries as well.
By graphing the trend of the Big Mac Index each year since 1986, we are shown that prices have accelerated much faster than the official reported Consumer Price Index (CPI) from the Bureau of Labor Statistics. On the BLS’s website, CPI is defined as “a measure of the average change over time in the prices paid by consumers for a market basket of consumer goods and services. The basket includes food & beverages, housing, apparel, transportation, medical care, recreation, education & communication, and other goods & services.” However, there are two broad concerns with the CPI. First, CPI accounts for the substitution effect whereby if the price of beef increases, it is assumed that fewer people will buy beef and will instead buy chicken. Second, there is a “chained” effect, meaning the basket of goods isn’t consistent from one time period to the next. The reason for this is that it is believed people change their spending habits as prices change, which is why the Bureau of Labor Statistics instituted this policy.
Since 1986, the price of a Big Mac has increased by 208% from $1.60 to its current price of $4.93. During this same time period, the Consumer Price Index has increased at a much lower rate of 116%. More disconcerting is the effect of aggressive adjustment of monetary policy by the Federal Reserve, which began in 1999. This policy shift started with the Asian crisis and Long-Term Capital Management, followed by the Internet bubble, housing bubble, Great Recession, and now the “New Normal” of zero federal funds rates and quantitative easing. In the context of these federal policies, the rate of price increases for the Big Mac is almost three times greater than the official Consumer Price Index.
In 1986, $1 would have purchased over half of a Big Mac. Today, you would have to cut the Big Mac into three pieces and only eat one of these bites to get your dollars’ worth. Consequently, each dollar we have is buying a lot less.
Hidden Cuts to Benefits
Individuals on Social Security are provided a cost of living index. This index is based on the Consumer Price Index. If an individual received $1,000 per month in 1999, they are receiving $2,164 today. In contrast, if the Big Mac Index were used, beneficiaries would receive $3,081. By using the Consumer Price Index, the government is paying out $917 less than they would otherwise pay based on the rise in price of a Big Mac. Throughout history, it has always been much easier for governments to quietly inflate away their excess liabilities rather than attempt outright cuts and painful austerity. The streets of Europe are a present-day example of the social difficulty of outright cuts. By understating inflation, the federal government is effectively reducing the amount owed to retirees and thereby cutting the long-term deficit.
Bond Prices and Inflation
The price of bonds should reflect the rate of inflation. Ed Easterling, founder of Crestmont Research, links inflation to the estimate of interest rates. By printing money to buy bonds, the government has pushed the interest rate of a 10-year government bond down to about 2.0%. However, Easterling points out that the 10-year government bond rate should be about 1% above inflation. The current rate of inflation reported by CPI is 0.7%. Adding 1% for the increased risk of holding a bond for 10 years gives you a rate of 1.7% using official inflation estimates. The current interest rate of a government bond is 2.0%, but if we were to account for inflation based on Big Mac prices, the 10-year government bond rate would increase from 1.7% to 3.9%, and bond indices would decline by about 16%. In other words, in the long run, 10-year government bonds are overvalued by about 16% primarily due to persistent intervention (manipulation) by the Federal Reserve.
Propping Up GDP Numbers by Underestimating Inflation
Lastly, Gross Domestic Product (GDP) is the measure used for the growth rate of the overall economy. GDP is adjusted for inflation. An understatement of assumed inflation makes the reported GDP headline number look better. Conversely, an overstatement makes the calculated growth rate look worse. Over the last few years, using a higher CPI has benefited GDP reports. Using the Big Mac Index instead of the official CPI would reduce GDP growth rates. With little or no growth from the price of the Big Mac or the CPI, we find that inflation overall has impacted GDP very little in the last year. Further, GDP has had an insignificant impact from other components as the Bureau of Economic Analysis (BEA) reported that for the first quarter of 2015, the economy was growing at a 2.0% annualized rate.
In the last 13 years, three bubbles have emerged; each funded by the government artificially lowering interest rates and printing money. Each subsequent contraction has been worse than the last. Why should this latest bout of artificial growth — which is even steeper than the previous three — end differently?
Implications for Investors
There are two main implications to point out. First, individuals need more income to sustain the same level of consumption they have had in the past. Second, Easterling believes that the value of the stock market is predicated on the level of inflation. However, if inflation is higher — or lower — than what is reported, does that make valuations of the stock market more unstable than they already are?
Recently, Easterling wrote in “Nightmare on Wall Street: This Secular Bear Has Only Just Begun”:
“Now, finally, the stock market is fairly-valued for conditions of low inflation and low interest rates (assuming average long-term economic growth in the future). But what about the future? If inflation remains low and stable indefinitely, then this secular bear will remain in hibernation until the inflation rate runs away in either direction.” (Updated February 4, 2015)
What if inflation is already above the level to support heightened valuations for the stock market? Does that mean that the stock market could lose its lofty stance even quicker?
Certainly this is a possibility and further justifies ongoing tracking of the Big Mac as the inflation measure of choice for financial advisors to use with your clients.
Thanksgiving has come and gone and many of us likely found ourselves partaking in the elaborate spending process of Black Friday and Cyber Monday to prepare for the holidays. Grandiose sales and deals can be enticing, but in order to plan for a life a restylement, one must understand the importance of tracking your expenses and developing a budget to adequately prepare for life after work. In part two of our series on restylement, we integrate the idea of intentional saving to understand what is financially needed in your post-working years so that you can sustain a similar, if not better quality of life.
Once you know how much you have to provide for the future, you can begin investing into your restyled life. If your needs are not in the near future, you can invest these savings more aggressively.
The landscape of retirement has changed, which is the result of two factors. First, people are not wishing to just retire; they are wanting to continue a stimulation of their mind and body. Second, the recent shift away from pensions has hindered the majority of people’s financial ability to simply select when and how they will retire.
Saving for something as abstract as retirement is challenging. The difficulty behind this process is knowing when we will need it and how much we will truly need. For most of us, this action requires a saving method that eliminates our power of control. Participating in a company-sponsored plan like a 401(k) is a successful, safe way to achieve a retirement goal. Another method is to set up automatic withdrawals from a specific account.
There are company-sponsored plans including 401(k) and 403(b) plans. There are also individual retirement accounts (IRA) and Roth IRA options, as well as individual and joint brokerage options. The best way to utilize the various account type options will depend heavily on your specific situation.
Maximizing a company-sponsored plan is the easiest option for retirement saving, as the funds are deducted before you receive your paycheck and are difficult to access until you reach the age of retirement – the definition of intentional saving. For others, the flexibility of a broader range of investment options available in non-company sponsored plans is more favorable.
Saving For Restylement
With so many people changing how they are saving for their later years, it is more important than ever to understand why and how you want to live.
One of the most common questions we are asked is: “How much do I need for retirement?” The answer to that depends on your individual situation. Think about your personal finances. How much do you spend? How much income will you have available in retirement, including Social Security, pensions, and real estate income?
Regardless of where you are in terms of approaching a time of restylement in your life, the best methods you can practice in order to prepare is to save every available dollar and invest them accordingly.
To review, in our two-part series, we have covered emergency funds, saving for major goals and top priorities, and how to properly fund for your restylement. What is left is funding a legacy – leaving money to children or funding a charitable organization.
Once you have covered funding for all your other priorities, you can then begin directing excess savings to your restylement goal and invest according to the conditions of the goal.
Preparing for your restyled life is an abstract concept. We work hard, pay our bills, buy what we need or want, and rinse and repeat this cycle on a routine basis. But if we want to live intentionally, we need to restyle our lives, and save and invest intentionally.
When you spend 40 hours a week or more at your job, it can be hard to envision a life outside of the grind. Or perhaps it is easy to envision, but hard to accomplish.
This post focuses on the many ways you can prepare to restyle your life in order to accomplish the goals you set forth.
While the methods are plentiful, most people simply do not want to think about this process.
So let’s review what our process at Capstone is all about.
Understanding Your “Why”
Simon Sinek has created a fascinating book and a fun presentation on realizing your WHY — or as he titles his Ted talk, Start with WHY. The idea behind his presentation is that we as individuals will be happier, more invigorated and excited about what we are doing when we determine what it is that truly drives us.
At Capstone, we want to know your why. Once we know what it is that motivates you, we can then set the road map of how to get there. Our strategy begins with organizing a list of goals. From there, we backtrack our steps to figure out the funding mechanisms needed to achieve each individual goal.
For some individuals, the primary thought process is to think about what areas we can pull from in order to fund the desired goals. Tracking your expenses and saving intentionally helps make funding these goals possible.
All too often, it is easy to let the day-to-day life take over our true intentions. Determining your top priorities in your job, family, community and business allow you to live more intentionally. Of course, the difficulty is to then be disciplined enough to live by these priorities without letting the noise get in the way.
There are financial considerations to make when it comes to funding your priorities. The first is an emergency fund – this is an amount of money that exists solely for one purpose – to cover unintended expenses. If your air conditioning breaks, the roof leaks or your hot water heater gives out, you need the funds to cover this.
Having an emergency fund prevents you from either going into debt, or being forced to take funds out of investment accounts at inopportune times.
The funds in an emergency account should be in a safe, accessible place such as a savings account or money market fund. Despite the low interest rates we are seeing now, do not expect your money to grow and avoid putting it into an account that may be inaccessible when you need it.
Once your emergency fund has been established, you can direct your focus on the next funding priority level, which is major expenses: buying a home, purchasing furniture or paying for home renovations.
Before we know what we can spend, we need to determine if we have any money to save.
For most people, talking about expenses equates to creating a budget, and organizing a budget is simply no fun.
If you don’t want to set up a budget, the easiest way of understanding your expenses and savings opportunities is to look at the value of your checking account at the end of each month. If you have money left over, you have money to save.
Of course, this simple method does not allow you to know what you are spending your money on. Paying $269 for your monthly cell phone bill, or spending $186 on housekeeping and paying for a landline when everyone in your house owns a cell phone may not be top priorities; however, you must know what you are spending your money on in order to be intentional about what you are saving for.
Begin by simply tracking your expenses. Don’t dive into setting budgets and limits just yet. Instead, find a method that works for you that you are capable of performing on an ongoing basis to track what you spend. There are several ways to do this. You may find that it’s easiest to write them down in a log, or you may opt to use a spreadsheet, a software system such as Quicken, or an online service like Mint.com.
Whatever method you use, build it into your routine and keep up with it daily or weekly – lapses mean you have to catch up and catching up can make the process a much more daunting task.
Through this exercise, you will see patterns in your expenses. This will help you make better decisions on items that you do or do not need. You will subconsciously begin to spend less on discretionary items and will gain a clear picture of what you have available after each paycheck.
Starting this process is essential. Whether retirement is still years away or right around the corner, you cannot plan for the withdrawal phase without defining your expenses.
Stay tuned for part 2 on how to properly save for the restylement process!
Money can be an influential tool at times.
I learned the power and the utility of money in college, about as far away from the university and campus as you can imagine. We were on a road trip in the Rocky Mountains and our car had broken down. Adding to the pressure, we were expected to meet friends that evening for a weekend away.
What I learned was that having money gave us options. The option to get the car fixed, the option to obtain transportation to our expected location while the car was being worked on. Just having money gave us options — more options than if we did not have the money to begin with.
Money; however, did not determine our contentment with being stranded. Money did not affect how we perceived our predicament.
Money enables us to have options in life, but no amount of money will tell us how we enjoy ourselves.
It is this realization that 20-some years later, I reflect on the conversations I have had with clients and realize that as advisors, our focus is on taking the dollars out of money and putting wealth to work for what is significant in the client’s eyes.
Let me tell you, the money that you need to enjoy your retirement is significantly less than what you may expect.
More Money Does Not Purchase Happiness
Money can help you do some powerful things in your lifetime, but no amount in any account will create peace of mind.
Assurance that everything is all right comes from discovering what it is that you truly enjoy. When we reflect on the meaning we want our life to hold – what our accomplishments are, who we want to become, the mark we wish to share with others – we tend to find greater significance in the “$” we hold in an account.
And yet the $ amount tends to become the barometer of one’s success or significance.
True wealth lies not in the value of an investment account. This value can be used as a tool, and it can be put to great use in helping your accomplishment, but it is merely just a tool.
Money can only take us so far. If it is peace of mind you seek, then dig deep and think about what truly makes you smile, what enables you to laugh, and what inspires you.
Time Is Invaluable
Money has never had the power to address the core problem. It may have helped me fix a car and get on my way years ago, but it did not determine how successful that weekend was or how much fun I had with friends.
According to www.drugdigest.org, 25% of North American adults are battling depression. With that percentage in mind, acquiring a sense of fulfillment can seem burdensome. No matter how much or how little you have, money unfortunately cannot solve these issues.
As Mitch Anthony, author of The New Retire-Mentality states, “figure out what other things bring you pleasure and spend time on them in lieu of working.”
Instead of focusing on monetary spending, concern yourself with how to spend your time; using the freedom that wealth affords you. This could mean spending time with relatives, doing volunteer work or merely pursuing that challenge of running a triathlon or crafting something from wood. Learn to enjoy the most mundane of tasks.
When we think about what makes us smile, laugh and enjoy each day, it is seldom the dollar value in a bank account.
Financial risk is associated with the permanent loss of money. In order to measure the amount of risk a client is dealing with, advisors use maximum drawdown to measure the largest single drop from peak to bottom in the value of a portfolio. It also helps to offer financial advisors a worst-case scenario so they can prepare portfolios based on potential risks that are assessed.
To adequately prepare for maximum drawdowns and elevated risk, financial advisors spend a great deal of time educating clients on loss aversion and how it can affect client behavior. Loss aversion, first demonstrated by Amos Tversky and Daniel Kahneman, refers to a client’s tendency to strongly prefer avoiding losses versus their desire to acquire gains.
Most studies suggest that losses are twice as psychologically powerful as gains. There are four primary benefits of understanding loss aversion when helping clients cope with risk:
- Investments and stock shares can be sold quickly in times of decline
- Documenting past losses can help prepare individuals for future risks
- Remedies, including diversification, focusing on the big picture, paying less attention to accounts and the stock market can be applied to help save high-risk investments
Applying Mental Accounting to Regulate Investments
To avoid losses from occurring due to an investor panicking and selling at an inopportune time, certain strategies should be practiced by the advisor and client alike. Mental accounting helps individuals to organize, evaluate, and keep track of financial activities, including the source of the money and purpose for each account.
Because clients often value various amounts of money in different ways, mental accounting can help assign different functions to each asset group, which affects consumption decisions and other behaviors pertaining to investment strategies.
Unfortunately, bad things do happen to good people. When it comes to managing risk, we see many of these instances occur as a result of poor research and a constant desire to believe only half of the facts. Quite often, clients choose to ignore the base rate, also known as the base rate fallacy. This occurs when individuals are uncertain of the probability that something detrimental may occur and therefore follow historical probabilities from the past year in order to keep a low insurance deductible. Advisors will frequently encourage clients to ignore the basic, nonexclusive data and only focus on specific information that pertains to a certain investment decision unique to their particular portfolio.
Another way that clients often find themselves actually welcoming risk into their investments is through heavily practicing confirmation bias, which is the act of seeking out things that support your viewpoint, while ignoring data that disputes their belief. This bias may result in unforeseen risks and loss of principal.
Overconfidence in the investment process can also lead to serious declines and an elevated level of risk as it gives clients the assumption that their investments will be protected, despite the actual unpredictability of the stock market. This prompts frequent decisions being made without sound research and potential losses being overlooked.
You Win Some, You Lose Some – Why Risk is Needed
While playing it safe can seem like a good idea in the investment world, taking too little risk can actually cause problems to your portfolio. Taking a minimal approach to risk can result in investment loss when inflation is low, much like it is now, as no money can be made when it is sitting idle in a bank account. As an investor, keeping up with inflation is crucial, as the value of the dollar continues to drop. For example, 20 years ago, a Big Mac sandwich from McDonalds could be purchased for $1. Fast forward to today, where the same sandwich now is averaging $4.64. By applying an appropriate amount of risk to your investments, each dollar is able to stretch further as you continue to keep pace with the rate of inflation.
Regardless of the amount of risk you are willing to take, it’s important to diversify your investments. Rather than concentrating all of your risk in one particular investment, seek to hold multiple investments that all pose a different risk profile. By owning a series of investments, you can reduce the overall risk found in each individual investment. One may zig while the other zags, working together to reduce your risk.
For more information on risk management and how to accurately balance your portfolio, contact us today.
by Ted Schwartz
As we near new “all-time highs” for the Dow Jones average, the financial services community seems about to throw a party. I say leave the champagne on ice! I don’t want to be a curmudgeon, but…..
The very lowest bar for any investor is the rate of inflation. If your investments don’t at least keep up with the rate of inflation, you have lost money in terms of real buying power. There is no reason to save if you do not at least keep your current buying power.
So, the Dow all time high was reached in October of 2007. The website Inflationdata.com has a calculator that computes the inflation from then through January of 2013 at over 10%. So, if we hit a “new high” it will mean that market losses over the past five plus years are all the way down to 10% in real terms! The clock will continue ticking on inflation, so who knows when you will finally really break even in this market. Hardly seems like a reason to celebrate to me.
By Ted Schwartz
I am a long term believer that good investing is a balancing act of evaluating how much you expect to make from an investment and how much risk is involved in trying to make that return. I believe this is a dynamic and changing calculation. When investments are expensive, your risk will increase and your expected return will drop. Not a good idea!
So, I was shocked to see the money flows for 2012 in mutual funds. About a hundred billion dollars went out of Equity Funds and into Intermediate Term Bond Funds. The expected returns for these bond funds are near an all-time low at this point. Their coupons (the amount paid to you in interest) are often about the same as the expected rate of inflation. So, in real terms you get nothing from that component. The only way you could make any money on the valuation side would be for interest rates to decline even further. This is not impossible, but there is not much room for further rate decline. History says rates will rise, the only question is when. That means the potential returns on these investments are very, very small indeed.
The risks? Due to rates being so low, relatively small increases in rates would likely cause relatively large declines in bond prices. A one percent increase in interest rates (still leaving us well below normal) would likely cause a loss of 5% or more in bond values. A two percent change would likely elevate this to double digits.
Why take the risk of these losses to potentially have such a small return on your investment? That is the question for which I cannot find a good answer. Anyone?