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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.
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 July 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 0.1 percent before seasonal adjustment.”
As an update, the Economist Big Mac price in the U.S. came in at $4.79, down $0.01 from $4.80 in July 2014. Clearly this indicates little or no inflation over the last year.
The adjustment in price of the Big Mac and the CPI are similarly unchanged over the last year. This runs counter to what has occurred over the past 25 years.
The hike in the price of a Big Mac is quicker than the official rise in consumer prices and has remained this way since the late 90’s. In 1998, the average price of a Big Mac was about $2.50. As of July 16, 2015, The Economist reports that the average Big Mac now totals $4.79. If we were using the Consumer Price Index (CPI), the price of a Big Mac today would be about $3.82 (see graph below). The price climb represented by this popular burger will impact individuals more than the saturated fat content that these sandwiches bear.
The acceleration in the price of the Big Mac foreshadows how the printing of money is eroding the financial system’s arterial walls. The impact is broadly based:
- Each dollar we own is buying us 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 should be much lower if interest rates are fully accounted for the rise of inflation based on the Big Mac
- The official economic growth rate would be lower now 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. The Big Mac Index was designed to compare the price of currencies between different countries. The index is based on a theory called purchasing-power parity (PPP). This theory looks at the same basket of goods in each country and then makes adjustments according to the interest rate one would pay for a loan or receive for a savings account. This adjustment for interest rates makes the price of a Big Mac comparable in each country. The Big Mac index just has one item; however, because it contains beef, dairy (cheese), wheat (bun), cost of labor, and the cost of real estate, I believe it is an accurate 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 Consumer Price Index (CPI) from the Bureau of Labor Statistics has reported. 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 when it comes to 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 purchase 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 199% from $1.60 to $4.79 today. 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, beginning in 1999. This policy shift started with the Asian crisis and Long Term Capital Management, followed by the Internet bubble, housing bubble, and Great Recession, and now the “New Normal” of zero federal fund 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 piece 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 roughly $1,410 today. In contrast, if the Big Mac index were used, beneficiaries would receive $1,970. By using the Consumer Price index, the government is paying out $560 less than they would otherwise pay based on the rise in the 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. 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 rate 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 1.9%. However, Easterling shows that the 10-year government bond rate should be about 1% above inflation. The current rate of inflation reported by CPI is 0.1%. Adding 1% for the increased risk of holding a bond for 10 years gives you a rate of 1.1%, and that’s using official inflation estimates. The current interest rate of a government bond is 2.4%, but if we were to account for inflation based on Big Mac prices, the 10-year government bond rate would decrease from 2.4% to 1.9% and bond indices would decline by about 24%. In other words, 10-year government bonds are undervalued by about 27% mainly 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, and conversely an overstatement makes the calculated growth rate look worse. Over the last few years, using a higher CPI has benefited GDP reports. Applying 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 little impact from the other components. The third estimate of the U.S. GDP for the first quarter of 2015, the Bureau of Economic Analysis (BEA) reported that the economy was contracting at a -0.17% 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 any differently?
Implications for Investors
There are two main implications to point out. First, individuals need a higher 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 based 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?
In an article, titled “Nightmare on Wall Street: This Secular Bear Has Only Just Begun”, Easterling wrote:
“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.” July 1, 2012 (Updated October 1, 2013)
What if inflation is already above the level that is needed to support heightened valuations for the stock market? Does that mean that the stock market could lose its lofty stance 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.
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?
By Ted Schwartz
This week I met with two very bright individuals who parroted the CEO cry that we “need certainty” before the economy will improve and companies will hire people. At the same time, I am reading Taleb’s, Antifragile. His whole point would be that things in life are not predictable and actual results often do not even approximate the outcomes we think are possible. Taleb would argue that certainty is a bad thing, making us more fragile to the problems that will inevitably crop up in the future.
For me, the whole notion of certainty being a necessity goes against the grain of everything I know. The rationale for why entrepreneurs can earn more than employees is that they are taking a risk. The reason equity investors make more than fixed income investors is referred to as the risk premium. You expect to earn more due to the increased risks you take. Now, the cry is that we have to be assured of future results and of what taxes we will owe on our profits. We now refer to things like “making the tax cuts permanent.” The chart below shows the changes in the maximum marginal rates since 1913. Does this look like we offered “certainty” and low taxes up until President Obama arrived on the scene?
Let’s not forget that we experienced a huge amount of growth during the period since 1913. During this time frame we also experienced almost 20 recessions. Yet, we did not have entrepreneurs constantly saying they would not hire or invest unless they were given certainty of results. It is the cry of the 21st century entitled, “the successful class must be assured results before taking any risks.” It really can’t work that way.
By Ted Schwartz
We begin the New Year with a market surge due to clearing the lowest hurdle imaginable. The “Cliff” agreement pleases almost nobody and solves almost nothing. Yet, the markets are right to rejoice this very small step. My belief is that the vote really tackled only one question, one not relating to wither revenue or expenses. This was an up or down vote on whether public officials were willing to compromise in order to do the people’s business. In the Senate, 90% of both Republicans and Democrats voted yes to this very simple and basic notion. In the House, we passed this on a much closer vote and almost refused to vote on it at all.
The question of whether we can move from this very simple vote to ones that actually address revenue and expenses in a meaningful way lies ahead. It is not very heartening that this first step was so difficult to get behind us.
As we look to the New Year, we are cautiously optimistic. Not being in the business of forecasting, we can none the less check the current conditions of the economy. Things are slowly improving on most fronts. Housing and other economic measures show slow improvement at this point. The stronger positive for the market is the relative rewards offered investors for owning stocks versus other investment opportunities. Stocks are somewhere around their long term average expected returns while safer investments continue to offer their lowest returns by historic measures. It is not a stretch to say that safe investments (CDs, Treasuries, etc.) offer a negative return when you factor in inflation. So, we believe investors have to accept the risks of owning equities in order to attempt to have positive growth from their investments.
In terms of our Tortoise (the well diversified portfolios that we endorse) and Hare (the equity market as represented by the S&P 500 Index) last year, the Hare won by a convincing margin. Despite a small loss for the fourth quarter, the S&P closed the year up over 15%. That far outpaced the returns for commodities and bonds for the year. The Dow Jones Moderate Portfolio Index (representing a well- diversified portfolio) was up just over 2/3 of the S&P for 2012. For two years, it is up a bit less than 2/3 as much as the S&P 500 Index. For three years, the diversified portfolio trails the S&P by about 20%.
So, isn’t it time to hitch our trailer to the S&P and take off? We think not!! The tortoise still wins by not losing as much. For five years, the Dow Jones Moderate Portfolio Index doubled the return of the S&P 500. For ten years, it has outperformed by almost 20% (and that excludes the bear market of 2000-20002). The Tortoise wins and…..you avoid a lot of ulcers on the voyage. If you truly believe we have finished a secular bear market that began in 2000, you might advocate increasing risk in order to capture more returns. We see no evidence that we have begun a bull market, so….we will continue to be a Tortoise in 2013 and the foreseeable future. The Tortoise has many more ways to succeed and win the race.
The name Capstone was chosen many years ago and was a very purposeful choice. The name was selected because we wanted to convey the idea that what we offered was quite necessary (“a crowning achievement”), but was not sufficient in and of itself. Money and its accumulation are very important to our clients, but they do not define their success nor are they equivalent to a successful life. A well-managed group of financial goals and a sturdy plan to implement them help a person be “anti-fragile” to borrow an idea from Nassim Nicholas Taleb. A super-diversified group of assets helps you avoid vulnerable economic outcomes as you age.
Since selecting this name many years ago, we have only seen more and more of society concentrating on money as the only issue of merit. Financial cliffs, political squabbling, education as only vocational training, etc. give us a short sighted view. As we look to the future, we must not lose sight of the more important things in life. Let’s relook a quote from Robert Kennedy in 1968:
“Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile. And it tells us everything about America except why we are proud that we are Americans.”
That is the essence of why we chose Capstone as our name. We help you add a crowning piece on your life plan, but we do not deal with the areas that truly define you and your value. We believe our service is of great utility, but we cannot replace those moments that make your life a joy. We wish you a very happy and prosperous New Year as you head a bit further down your path. We look to the New Year with considerable hope for the future. Things continue to improve slowly (with far too little help from our public servants).
By Ted Schwartz
Well, it turns out the world did not end on December 21. Shocking, isn’t it? So, we have to look ahead to what we might expect in 2013.
Dr. Doom here is actually mildly optimistic. We are not in the business of forecasting, but we think taking the patient’s vitals does give you an idea of what his condition is. So, we have many risks due to the inability to agree on public policy as I pen this. However, even the lowest expectations that I have for our public servants does not entertain the likelihood that they will plunge us into a recession on purpose as opposed to finding at least a half-baked solution to the fiscal cliff.
Once that is behind us, I see a slow positive momentum building. Things are getting better, though not quickly. Housing is showing signs of having bottomed and that should help along with generally improving conditions elsewhere. The biggest threat to the markets may come from over confidence and high expectations rather than actual problems. The backdrop that I see propelling markets is a beginning of money flowing towards rather than out of equities. They are fairly valued while bonds are way overvalued. We believe this will cause investors to realize the equity risk is more appealing at this point than the risks of bonds given their extremely low yields. Despite the fears around taxation of dividends recently, we believe that investors will find those dividends appealing versus the yields they can get in fixed income.
Unfortunately, we think we will not see serious solutions to our long term problems discussed or implemented in 2013. That means the next “Black Swan” will continue to lurk in our future and may even find some nourishment next year.
By Ted Schwartz
If you tune in to politics recently, you are encouraged to take sides in a false dichotomy. You are asked to choose between the people who believe in the free market and the people who believe in government (AKA “Socialism”). This is an absurd choice as both paths would lead to total destruction. Unfettered free markets are not in place to deal with long term societal issues. The government is not in place to deliver optional goods and services to people in an efficient manner. So, fortunately, we have a hybrid system that attempts to carve out a middle ground that allows us to muddle through. So, the real question for this and every election is, what is the optimal mix going forward of government and capitalism.
Free market capitalism seems to be the optimal system to provide goods and services to people. As its focus is primarily on profitability, a layer of regulation is necessary to protect the health and welfare of the public. Too much regulation can harm the market system and too little leads to toxic excesses (see 2008!).
The government’s main role is to look after society’s best interests now and in the future. That includes many complex and unprofitable tasks (how do we protect people from fire, workplace safety, what goods and services should we provide to poor children, how do we protect the earth for future generations, what infrastructure is needed to support the private sector). These big picture items are beyond the scope of the market economy. Some tasks offer no hope of profit ever and some offer no current profit so will be shirked by the market economy.
Both the government and the private sector have a tendency towards waste and excess if left to their own devices. We, the voters and taxpayers, are charged with closely monitoring these systems, serving as a check and balance to unfettered power, and ultimately choosing where we should set the mix of government and private enterprise to maximize outcomes. It is a very tough and very important decision that we face, but it is not the decision bandied about on television and in the media.
By Ted Schwartz and Kevin Starkey
Bill Gross has always been one of the few voices that we at Capstone believe is worth listening to. The world’s largest fixed income manager got that way through solid performance over decades. His thinking is usually lucid and his worldview often intriguing. As other financial industry talking heads are peddling something and Bill sells fixed income, could he be selling something new?
That said, he seemed to fall off of a turnip truck this week. He forecasted anemic real GDP growth of 1.5% per year for the US for the next decade. We are not forecasters, so will not take issue with this gloomy forecast. However, he went on to say that “if real GDP grows at 1.5%, then a diversified portfolio of stocks and bonds would probably grow at 1.5% as well.”
While GDP growth would certainly be correlated to expected stock returns, the 1:1 correlation that Mr. Gross throws in to the equation has been pulled from thin air. The long term growth rate of GDP is rather consistently around 3% per year. The long terms real return of stock is around 6.5% per year. In other words, stocks have historically grown at a rate far higher than GDP.
Why would this be true? Well, financial physics is about the basics of return on equity. As companies are already earning money every day as we enter Mr. Gross’ 1.5% decade, the companies have earning that are considerable to add to their bottom lines before we consider growth. Companies can 1) distribute money they earn through dividends; 2) they can use it for share buybacks that should increase stock prices; 3) they can use it for expansion, acquisitions, and debt reduction which should increase net earnings. All of these choices should yield shareholder returns well in excess of Mr. Gross prediction of GDP growth. So, even with his dire prediction, we may hope for returns that are rather paltry but well above Mr. Gross’ calculations. Stay tuned for the pitch!