Wednesday, December 29, 2010

Four Steps to Rebalance Your Portfolio

If you implemented the ideas behind the last six posts, you have a fair idea about how to put together your personal portfolio policy. In previous posts we’ve talked about rebalancing, but never really addressed the question of how often and how best to accomplish it.

I suggest you look at your portfolio at least once a quarter to see if it is still aligned with your portfolio policy. If you enjoy getting down and dirty with numbers, then a monthly review will work even better. If you really, really hate this, but know you need to do it, then push the odious task out to six-month intervals—but recognize you are probably giving away a bit of your long-term performance.

Rebalancing is a four-step process:

Step 1: Determine the market value of all your investments. These days the market value of most of your investments should be available online. (And I know you can get online because you’re reading this.) Add up all the investments in each bucket of your portfolio policy.

Step 2: Compare the current allocation of your investments with your policy targets. I do this as dollar amounts; some people prefer to use percentages above or below their target. For example if large-cap domestic stocks are supposed to be 25% of your portfolio and that should be $100,000, and they actually are $110,000, then under my approach I would show the large-cap stocks as $10,000 too high. The percentage folks would show it as 110% of target (or 10% over target.)

Step 3: Identify any investments that are significantly higher or lower than your target. Rarely will you be exactly on target, and it takes time (and sometimes money) to rebalance your portfolio. Therefore you need to pick a threshold to rebalance. I choose a dollar threshold, so if the deviation is above that amount, I need to do something; below the limit means I can delay rebalancing that particular asset because the class is not significantly skewed.

Percentage devotees will pick some bracket and say that if the asset stays between (for example) 90% to 110% of target, there is no need to rebalance. Outside of the range, they need to do some buying and selling.

If you are in the investing stage of your life, you can often address your imbalances by deciding where to put new money. Sometimes you are constrained because much of your new investment is going into your employer’s 401(k) plan and you can change your contribution allocation a limited number of times a year.

In any event, the time to decide your rebalancing criteria is when you first set up your portfolio policy. If you wait until later, inertia will cause you to let the rebalancing slip (oh, it’s not too far off the procrastinator says) or fervor will cause you to rebalance more than you need (gosh, large-caps changed 1% today, I’d better fix that imbalance right now!)

Step 4: Decide the most effective way to rebalance. To the extent possible, I try to rebalance in my tax-deferred accounts because those sales do not generate taxes. If you’re a faithful reader of my blog, you know I use mutual funds for equities rather than individual securities [see Risk in Buying Individual Stocks 5/26/2010]. I mostly use index funds with no sales or purchase fees. (The rare exception is an emerging market fund with a low redemption fee.) With bonds, I use an online broker. The idea is to keep the transaction costs as low as possible. As a general rule, the higher the transaction costs, the less frequently you should rebalance because transaction costs diminish the benefits of rebalancing.

I maintain both a Rollover IRA and a Roth IRA. I hold some mutual funds in both accounts because many of them have frequent trading restrictions, meaning I can’t buy sold shares back in the same fund for two months. But if I sell (say) the S&P 500 Index in the Roth IRA and a month later I need to buy some back because of a big price swing, I can do so in my Rollover IRA if I have duplicate funds set up.

If you do want to frequently rebalance, and the repurchase restrictions are a problem, split your assets between two mutual fund companies. As long as you keep sufficient funds in each to qualify for the lowest fees the fund company offers, you can circumvent the repurchase restrictions. For example, you can sell Vanguard S&P 500 shares in December and purchase Fidelity S&P 500 shares in January if necessary.

If you only rebalance quarterly, this whole repurchasing issue won’t be a problem for you.

If you have to rebalance using taxable accounts, keep in mind the tax effects of any sales. Try to sell funds with capital losses or small capital gains; but if you can’t do that, it is better to pay some taxes (particularly at a maximum 15% rate) than to allow your portfolio to become significantly unbalanced.

If you use mutual funds with loads or sales costs, I suggest you consider no-load funds and make any new purchases in them. Over the long-term loads are a shackle on your flexibility and net returns—but that’s a different post.

Whatever route to rebalancing you choose, keep it simple so you can implement and stick with your plan. Better to rebalance only twice a year than commit to doing it monthly and then become sufficiently annoyed at the time and hassle that in frustration you stop rebalancing all together.

Following this approach you will usually end up selling winners and buying losers. For individual stocks that may not be a great plan, but when dealing with widely diversified mutual funds, I think of it as shopping in the bargain aisle and funding my shopping spree by selling off things that are becoming more and more expensive (as the price increases.) Unless you have the will of a mountain, you too will be tempted to hold on to a mutual fund “because it’s still going up.” Keep this in mind: if everyone believed those stocks must go up, they would have already increased in price.

Similarly, sometimes it feels like you are throwing good money after bad as some category falls into disfavor. Do it anyway. If you really feel squeamish, spread your purchase out over a few months rather than making it in one lump.

Financial professors have written a number of papers that show the most important determinant of long-term investment performance is the asset mix. I’d like to add that once you’ve made that all-important decision, the next best thing is rebalancing.

A couple years ago I had a financial advisor compare my personal investment returns to an approach using the same mutual funds utilizing rebalancing only once a year. He reported that in each of the five years my rebalancing policy had beaten the benchmarks. Will that always be the case? Undoubtedly not. A year will come when one asset class only goes up, another only drops—and I kept selling the former to fund the latter. In that kind of year I will not do as well as a strategy that does not rebalance, but none of us knows in advance when that is going to happen. Those who followed the tech stock boom up discovered it cratered much more quickly than it climbed. That’s usually the case for bubbles. If you haven’t been selling on the rise up, it will be too late when the crash comes.

An old Wall Street adage goes something like this: Bulls can make money; Bears can make money; Hogs get slaughtered! (Jim’s caveat is that if you can become the CEO the last statement no longer seems to hold.)

The calendar year is about to end. Isn’t this the traditional time for resolutions? How about reviewing (or creating) your investment portfolio allocation policy and rebalancing if things are out of whack.

~ Jim

Monday, December 27, 2010

Developing an Asset Allocation Model (Part VI)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy, the four main asset classes we’ll consider, two posts on various asset subclasses and the previous post, which revealed my personal asset allocation policy. This final post in the series will discuss the rationale for my current thinking and what changes might cause me to modify the policy in the future.

As a reminder, here’s the policy I have in place as of 24 December 2010:

Bonds: 44.0%
Short-term Balancing Item
Medium-term 0.0%
Long-term 0.0%
Inflation-protected 15.5%
Pension Actual%

Equities 50.0%
US Large-cap 23.0%
US Small-cap 10.5%
Europe 7.5%
Pacific 3.5%
Emerging Markets 5.5%

Real Estate 3.0%
Commodities 3.0%

Total 100%

I based the overall allocation between stocks and bonds on my risk profile. As we discussed in the first part of this series [link1], each of us has different risk parameters. In my case I (hopefully) have a large number of years still in retirement. While I have hopes of income from my writing, realistic expectations indicate I should discount those hopes and assume I am relying on my current assets to fund my retirement.

Consequently, I need sufficient cash flow to fund each year’s expenses and a mix of securities to provide a real rate of return over and above inflation. The biggest risks to my financial security are (1) longevity, (2) significant declines in asset values and (3) inflation. Given those, I started with a 50/50 allocation between bonds and equities. I then added the two additional classes of Real Estate (REITs in my case) and Commodities (precious metal coins and ETFs.)

I chose to carve the Other category out of the Bond allocation because current rates of returns on bonds are significantly below my long-term expectations. If real rates of returns on bonds were higher than my long-term expectation, I might well be fully invested in the bonds and carve the Other category out of the Equities, or be someplace in between.

Turning to the Bonds: I determine the present value of my defined benefit pension plan annuity. (If you don’t have the wherewithal to do that yourself, send me a note and I’ll send you an excel file with instructions.) I convert the present value into a percentage of my total assets.

Other than the pension, my main bond category is the Inflation-protected bonds. These bonds do a good job of addressing all three of my major risks. I have two different assets included within this subclass: Series I Savings Bonds and TIPs (Treasury Inflation-protection bonds). The target percentage I use varies based on the real rate of return on TIPs. The higher the real rate, the higher the target percentage. For example, at a 2.5% real rate of return, the target percentage is 28%. The minimum and maximum of the target range are 14% and 42%. (If I reach the higher end of the range, I would be cutting into my equity allocation, but I would be happy to do that with an inflation-protected real rate of return of 3.25% or higher.)

When I first started investing in this category, my preferred approach was to utilize Series I savings bonds [link to description of Series I bonds]. Their real rates of return were in excess of 3% at the time and I bought as much as the government allowed. With their current real rate of return at 0%, they are very unattractive. I cherish the Series I bonds I have and probably won’t cash them in until they mature. Consequently, all my purchases and sales now involve TIPs. Real rates have been creeping up recently and I will probably soon increase my target percentage.

With the Federal Reserve actively pushing down interest rates, I do not want to invest in standard medium or long-term bonds. I believe the low interest rates are much too low to compensate for the risk of increasing rates because (1) the Fed stops buying bonds, (2) inflation starts to kick up again or (3) foreign creditors stop purchasing the United States’ ballooning debt. Because of the Fed’s actions, the remainder of my bond allocation is sitting in short-term securities. This consists of money market funds paying almost no interest and short-term CDs and corporate bonds with maturities of less than three years. These will fund much of my spending over the next two-three years.

If real rates of return increase, I may gradually lengthen the duration of my bond purchases and increase TIP holdings, otherwise I’m concerned bonds are the next minor bubble with losses ahead of them. See for example Vanguard’s warning to its investors.

Let’s turn now to Equities. Within the equity allocation I found two issues to address. The first question revolves around US equities: how much to allocate between large-cap and small-cap stocks. The actual market percentage varies depending on the flavor-of-the-year. Sometimes the masses like big stocks; sometimes they go gaga over the little stuff. (The tech boom is an example of this.) I’ve settled on roughly 2/3rds of my US allocation going to large-cap stocks and the remainder to small-cap.

The other question is what percentage of equities should be allocated to US, Europe, Pacific and Emerging Markets? Search the internet and you can come up with widely different views of the market capitalization of the various markets. Vanguard, for example uses: North America 44.0%, Europe 26.7%, Pacific 13.5% and Emerging Markets 15.8%. That would imply that of the non-North American markets, 48% belongs to Europe, 24% to Pacific and 28% to Emerging Markets.

If one were a world denizen, an allocation such as Vanguard’s might make sense, but I mostly spend dollars in the United States, so it makes sense to me to overweight my home country for two reasons. Large-cap US corporations have considerable international operations, but because they are US based, they tend to think in dollar terms and hedge some of their currency risk. Thus large-cap US corporations give me access to foreign markets on a hedged basis. Pure plays in the foreign markets subject me to currency risk. I like some currency risk because it tends to provide diversification and so stabilize asset values. However, at the end of the day I am spending dollars not euros or yen.

So I’ve taken the position that US corporations will account for roughly 2/3rds of my equity allocation. Of the remainder allocated to foreign markets, I have again taken a position that 1/3rd will go to emerging markets with the remaining split between Europe and Pacific more or less based on their relative world allocations.

To summarize, I am overweighting the US by increasing its allocation by about 50% and underweighting the rest of the world by 40%. Within the foreign allocation I overweight emerging markets by almost 20% while underweighting Europe by about 5% and Pacific by about 10%.

I’ve tweaked these percentages over the last decade or so. It is interesting to me that for the longest time most of the investment advice I received or read suggested I should have lower allocations for foreign securities than I had. Recently I have seen a number of articles suggesting larger foreign allocations than I hold—which might be the reason we’ve been seeing net outflows from US domestic stock funds and into foreign stock funds. I have to admit it makes me a little nervous when the world starts agreeing with me.

Any Other subclass that I choose to track needs to be sufficiently substantial to have a measurable effect on diversification and risk/return. I’ve set that minimum as 2% of total assets. Originally I had two subclasses: Real Estate and Precious Metals. This year gold skyrocketed past the point where I thought holding the bullion made sense, so I sold out that position and moved into a couple of commodity indexes as an inflation hedge. We’ll see how that works out. I could argue for higher percentages for each of these two subclasses and in fact moved the precious metals from 2% up to 3% over time—mostly through inertia of price increases and a reluctance to sell, until I did.

If something in this analysis struck you as not making sense or it made you feel a bit uncomfortable as you read it, I suggest you try to understand the basis of your feeling. Perhaps I’ve introduced a different way of looking at something that you might want to consider; or perhaps my approach isn’t right for you and that explains your discomfort. The whole point is to make good decisions for yourself. After all, I have to live with my choices; you get to live with yours.

In the next post I plan to talk about the when and hows of reallocating your portfolio.

~ Jim

Friday, December 24, 2010

Developing an Asset Allocation Model (Part V)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy, the four main asset classes we’ll consider and two posts on various asset subclasses.This post puts it all together in a personal Asset Allocation Policy. This post and the final post will present my rationale for the allocation I’ve chosen.

Before we do that, however, we need to deal with two assets: Personal Real Estate and Social Security.

Personal Real Estate

My philosophy has always been that my house is my home. If I happen to make money on its appreciation, great, but my main reason for buying a house is to live in it. I am fortunate enough to have two houses, one north and one south. When I become sufficiently decrepit, I will sell the northern house and live full-time in the south. More decrepit and I’ll end up selling the southern house and living in an assisted care facility or nursing home (ugh).

I have not bought and do not plan to buy long-term care insurance. I treat my housing as that insurance. When it comes to my personal balance sheet, I show my two homes as “Other Assets.” When it comes to my Asset Allocation Policy, I do not include them at all. That’s just my way of doing it; you may choose otherwise.

Social Security

I noted earlier that I treat the defined benefit pension I receive from a former employer as a bond. By parallel reasoning, I should treat Social Security as an indexed bond because the monthly payments are linked to CPI. But I don’t.

I do not have post-retirement medical insurance from my employment. I am purchasing catastrophic coverage until I reach Medicare eligibility, at which point I will have whatever Medicare coverage is then available. (It has to change, but that’s a topic for another post.) I’m sure I will need to purchase a supplementl policy to cover what Medicare does not.

I really have no clue where healthcare in the United States is going, and so for now I have olayed the entire issue by keeping the value of my future Social Security Payments off balance sheet. My implicit assumption is that the red cape of my Social Security payments will cover the charging bull of my post-65 medical costs. It’s inaccurate, mismatches timing somewhat, but it works for me—which is why you won’t see Social Security in my Asset Allocation Policy.

If you (very reasonably) take a different approach toward your Social Security Benefits, I recommend you treat it as an inflation-protected bond.

Jim’s Asset Allocation Policy

So here we are after four and a half posts at the moment to cue the drummer and press the red button that activates the stage curtain. It retracts and reveals:

Jim’s Asset Allocation Policy as of 24 December 2010:

Bonds: 44.0%
  Short-term Balancing Item
  Medium-term 0.0%
  Long-term 0.0%
  Inflation-protected 15.5%
  Pension Actual%

Equities 50.0%
  US Large-cap 23.0%
  US Small-cap 10.5%
  Europe 7.5%
  Pacific 3.5%
  Emerging Markets 5.5%

  Real Estate 3.0%
  Commodities 3.0%

Total 100%

In the final post of this series, I’ll discuss the rationale for my current thinking and what changes might cause me to modify the policy in the future.

~ Jim

Wednesday, December 22, 2010

Developing an Asset Allocation Model (Part IV)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy and the four main asset classes we’ll consider. In the previous post and this one, we are looking at asset subclasses and how to handle them.

Recall that we broke assets into four general categories of assets: Cash equivalents, Bonds, Stocks and Other.

Stocks (Equities)

There are almost as many ways to classify equities as there are people willing to classify them—which are mostly mutual funds and brokerage firms marketing the latest and greatest fund for your immediate purchase.

Some choose to look at dividend paying vs. those stocks that pay no dividend. Others look at the historical or projected future growth in earnings and split equities between “growth stocks” and “value stocks.” Pundits don’t always agree on which is which and occasionally you will find the same stock on both lists. Further, a growth stock can stop growing (a bad thing) and a so-called value stock can become a faster grower (a good thing).

I prefer to consider stocks based on their size (market capitalization) and geographical location (Domestic, Foreign “mature” market, Emerging Market).

With regard to market capitalization, I use the admittedly arbitrary split of the S&P 500 as large and all others as small. (Many argue there is a mid-cap that covers the larger portion of the market—and if you want to make that distinction, I have no objection.)

Regarding geography, there are four main markets: North America (dominated by the US), Europe (mature), Pacific (mature) and Emerging Markets (which cuts across all continents.)

When people talk about geography, they are really referring to the geography of corporate headquarters. Yet McDonald’s (US Corporation) earns the vast majority of its income outside the US, as do many other US corporations. Japanese car companies sell a lot of cars in the US. There is no easy pigeonhole where you can put international corporations. Many larger corporations across the world have significant exposure to the Emerging Markets.

Is it necessary to look at each stock within a mutual fund you own and allocate it between the various geographical areas—and if so, based on what? Revenue, profits or investment? I don’t have the time or energy, nor do I think it a worthwhile proposition.

Those companies headquartered in the Emerging Markets deserve their own subclass. They are generally smaller companies, their financial markets are less transparent, currency fluctuations can be significant and they can be subject to bubbles (of optimism or despair) because it takes much less money to flood or starve these smaller markets. It is a risky subclass. It is also a subclass that does not tend to move lockstep with other equity markets, another good reason for keeping it separate.

Rather than try to keep track of foreign large-cap versus foreign small-cap, I use separate subclasses for Europe and Pacific. Although there is much in common between these two areas (as there is between each of them and North America) there are also significant differences. I have found that rebalancing between Europe and Pacific a useful technique.

Only within the US do I keep separate subclasses for large-cap and small-cap.

To summarize, I keep track of five equity subclasses:

US Large Capitalization
US Small Capitalization
Emerging Markets


Here’s my personal approach to the “Other” subclasses. If it does not reflect at least 2% of your portfolio, then lump it with something else. With that stipulation, I currently have only two subclasses: Real Estate and Commodities.

Real Estate for me includes REITs. It does not include my personal residences. (I’ll talk about the reasons why in the next post where I give you the reasons for my current asset allocation policy.) If I had rental property, I would keep that as a separate subclass. Farm land or timber partnerships might also deserve their own subcategories within real estate if they meet the 2% threshold. Similarly, if my commodity position were sufficiently large and diverse, I might split out bullion holdings from other commodities because they react differently to economic and psychological forces.

I don’t have that large a portion of my assets in the "Other" category, so for me Real Estate and Commodities covers the gamut of my needs.

Next up: Putting it all together in an Asset Allocation Policy.

~ Jim

Monday, December 20, 2010

Developing an Asset Allocation Model (Part III)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy and the four main assets classes we’ll consider. In this post and the next, we’ll look at asset subclasses and how to handle them.

In the last post we broke assets into four general categories of assets: Cash equivalents, Bonds, Stocks and Other.

Cash Equivalents

Cash equivalents should not need any subclasses since the whole purpose of this category is to be ready cash. Whether you are holding $100 bills, have a checking or savings account, short-term CDs or money market accounts is of no matter.


I think of bond subclasses as having three dimensions.

One dimension is the time until maturity. I use three categories: short, medium and long.

Short: Up to 3 years.
Medium: 3-10 years
Long: Anything 10 or longer.

A second dimension is who is responsible for paying the bond.

US Government
Agencies of the US Government (for example Fannie Mae)
State or Local Government
US Corporations
- Investment Grade
- Junk Bond
Foreign Governments
- Mature Markets
- Emerging Markets
Foreign Corporations
- Investment Grade
- Junk

The third dimension is a catch-all that includes the other characteristics of the bonds:

Discount (zero-interest)

Good heavens, we could have fifty or more subclasses of bonds! Yes, but you don’t need that many. It is important to avoid purchasing any security you do not fully understand. (How many people understood CMO’s—Collateralized Mortgage Obligations—for example. If they had, the banking system may have avoided its recent near collapse. But I digress…) So when you purchase an individual bond or a bond fund, you’ll want to understand all of its characteristics, but our main discussion point is your personal asset allocation policy, and for that we can combine categories.

I use six subclasses only:


I use the first three categories to loosely categorize my interest rate risk for those bonds where interest rate risk is the primary determinant of my overall return.

Properly speaking, the financial tool for understanding interest rate risk is a bond’s duration rather than its maturity. The idea behind duration is to reflect when you expect to receive payments for the bond. A zero-income bond with ten-year maturity, for example, pays nothing until the end of ten years. It is subject to higher interest-rate volatility than another bond with ten-year maturity that pays semi-annual interest and pays back one-tenth of its principal each year. The second bond has much less money at risk in future years. Consequently, the effect of interest rate changes is smaller on this bond than on the zero-coupon bond.

Unless I am dealing with a zero-coupon bond or mortgage-backed security (which pays principal back as the mortgagees make their monthly payments), I rely on maturity to classify it. For callable bonds (one the issuer can choose to “call in” – i.e. pay back – before maturity, which they are likely to do when the bond’s interest rate is higher than current rates) I use the call date if I think the bond might be called and otherwise I use the maturity date to classify whether it is a short, medium or long-term bond.

Inflation-protection bonds are a different cat with their own sets of risks and rewards. While I have loosely stated my main financial objective is to not run out of money before I die, what I really mean is I want to maintain at least a certain minimum standard of purchasing power until my demise. Because Treasury Inflation Protection Bonds (TIPs) directly reflect CPI-measured inflation in their investment returns, they are an important class for me—and I monitor them separately.

Corporations are the primary issuers of junk bonds, although some municipal bonds also have sufficiently low ratings to qualify them as junk. In recent years I have avoided junk bonds. Junk bonds have higher expected returns than bonds from quality issuers because the risk of default is much higher. In addition to the effect of interest rate movements, how the company is doing financially significantly influences the financial performance of the bond. [If the company starts doing better, the risk of default declines and the bond price increases; if the company’s performance worsens, the risk of default increases and the bond price declines.] Because of the significant effect company performance has on the bond price, when I do own them I keep them as a separate category.

Foreign bonds, whether corporate or government, have one additional risk that causes me to segregate them as a separate subclass: they are subject to currency fluctuations. If the dollar strengthens relative to a particular foreign currency, all other things equal, the bonds of that country lose value in terms of the US dollar. I buy things with US dollars—that’s the purchasing power I want to preserve.

Some funds holding foreign bonds hedge the currency risk. If the fund hedges most of the currency risk (say at least 2/3rds), I wouldn’t bother with a separate subcategory. Any less hedging, then I want to add a category to recognize the additional risk I have taken by allowing currency fluctuations to affect the value of my holdings.


I am lucky enough to have a corporate pension from one of my former jobs. I consider it a bond because its value to me closely resembles that of a bond paying monthly interest with no maturity date. My monthly payments are fixed and will continue as long as I do. Like a bond, this stream of payments loses value if inflation kicks in because I can buy less with my monthly payments. Should we experience deflation, the value of my monthly payments rises because I can buy more with them.

Since my pension came as the result of a qualified corporate pension plan (and is relatively modest), the Pension Benefit Guarantee Corporation guarantees all of my benefit payments (unless Congress retroactively changes the law.) Given these characteristics, my pension looks a lot like an insured bond and that is how I value it.

Social Security is also bond-like, but unlike my corporate pension, future payments (more or less) reflect inflation subsequent to the start of payments.

Later in this series of articles, I’ll discuss the specifics of how I recognize the value of my corporate pension and Social Security in my personal asset allocation policy and balance sheet.

Next up: Asset Subclasses in Your Portfolio (Stocks and Other Investments)

~ Jim

Friday, December 17, 2010

Developing an Asset Allocation Model (Part II)

In the first part of the series we discussed the need to understand your risk tolerance before developing an asset allocation strategy. In this post we’ll talk a bit about assets classes you might consider.

I think of the world as made up of four general categories of assets: Cash equivalents, Bonds, Stocks and Other.

Cash Equivalents

For our purposes, cash equivalents consist of assets that you can readily turn into cash without suffering asset price volatility or a significant cost for the conversion. Stuffing your mattress with currency is one way to hold your cash. Most people choose to use checking accounts, savings accounts and money market funds that pay a modicum of interest. Treat Certificates of Deposit (CDs) as a cash equivalent if there is no penalty for cashing them in early. If the penalty is as much as one month’s interest, I would still consider it as a cash equivalent. But if you can’t cash it in before maturity and are required to sell it to a third party or if there is a sizeable penalty for cashing in the CD, then I would consider it a bond.


We’ll consider any loan not counted as a cash equivalent as a bond. The loanee can be a corporation (corporate bond), a state or local government (municipal bond), the US Government (Treasury bills and bonds), foreign corporations or governments, or a loan to Junior that you really do expect him to repay.

Some bonds come with periodic interest payments; others are sold at a discount from the maturity value and you collect earnings when the bond matures.

Some bonds are secured by assets. (For example, when you take out a car loan, the loan—a bond from the bank’s perspective using our definition—is backed by your car. If you don’t make the payment, the bank takes your car.) Some bonds are backed by plant and equipment, others by tolls paid on a highway. Other bonds are backed only by the full faith and credit of the organization.

For reasons I’ll explore in a later piece, I include pensions due me as bonds. I am lucky enough to have a corporate pension from one of my former jobs. Most of us have Social Security. Both have characteristics that make them bond-like.


I would substitute the word equities for stocks because that’s how I think of the category. An equity position means you are eligible to share in the profits of the company while it is an ongoing concern and share in its liquidation value if it stops doing business. (The liquidation value is often zero because bond holders have to be paid off before the equity holders.) Partnership shares in a business would fit here.


Real Estate is included under “other” as are precious metals, commodities, art, the baseball card collection your mother didn’t throw away and anything else that has value.

I can see the purists out there pulling out their micrometers to measure the fit of some asset or another with its assigned bucket. “What about convertible bonds?” (bonds issued by corporations that can be converted to common stock under certain conditions), they say. If most of a convertible bond’s value is attributable to its coupon payments and principal return, call it a bond. If most of its value relates to the fact you can convert it into an equity position in the company, treat it as a stock. When in doubt choose those characteristics that most determine its price.

Could you have more classes? Of course. In the next two posts we’ll consider subclasses and discuss which ones are worth separate recognition.

Next up: Asset Subclasses in Your Portfolio

~ Jim

Wednesday, December 15, 2010

Developing an Asset Allocation Model (Part I)

In my May 24, 2010 post I discussed rebalancing portfolios and how that assists in buying low and selling high. This week I rebalanced because stocks have been going up and bonds declined in value, so my portfolio was off kilter.

In addition to rebalancing this week, I also changed the target percentages for various asset classes. The percentage allocation to asset classes should be at the core of any investment program. One size does not fit all. I knew someone who got an A on an MBA finance exam when she answered a question about asset allocation by indicating she was completely risk averse. Preservation of principal was her only objective and therefore she would keep all of her money in cash, short-term treasuries and government insured bank accounts and money markets.

As long as the US government does not default, this investor will meet her objective of capital preservation. Since I don’t have sufficient assets to live off the current paltry interest return treasury bills, money market funds and the like pay, I need to take more risk in order to (hopefully) get greater return. My risk tolerance and yours may not be the same. We may have different objectives (mine is to not run out of money before I die) for our investments. If you are not sure of your objectives and risk tolerance, you can use any of a number of online tools to help define them. Use several since they have different implicit assumptions and their average advice may be more accurate than any one model.

I’ve periodically tweaked my asset allocation as I moved from employed to retired. Contrary to many popular wives tales, asset allocation need not change on account of age per se. The critical components are (1) whether you are accumulating, spending or in transition between the two, and (2) when you need to spend the money. Bull markets are never a problem; what happens to your assets in the inevitable down market cycles and how that affects your plans is the key issue.

When you are accumulating wealth, bear markets can be good things. You are a buyer regardless of market conditions. If you have $1,000 to invest, you will get twice as many shares if XYZ sells for $10 a share than you do when XYZ sells for $20 a share. If you have many years of accumulating to go, your future investments likely far outweigh the value of your current portfolio, and so market ups and downs are of little concern.

In the spending phase, you no longer have “excess” income to invest. Your portfolio accumulation is finished and you no longer benefit from buying at depressed levels after a market “correction.” Judicious rebalancing will help, but, for the most part, the only way to adjust to decreased investments is to decrease spending or dying earlier. Neither are pleasant alternatives. While a portfolio of Treasury bills will solve the problem of investment losses, they provide little real return, which leads us back to the problem of insufficient funds to live solely on Treasury bill income. Most of us must take some risk in our portfolio.

I define the transition phase as the period before retirement in which the size of accumulated investments has become large enough that future annual additions can no longer make up for large market declines. The earlier you start to save, the quicker the transition period comes.

Next up: Asset Classes to Consider in Your Portfolio

~ Jim

Saturday, November 27, 2010

A Basic Financial Education

When I went to college I chose a liberal arts education instead of one more technically oriented because I had a sense that a broad survey of information rather than a super-concentration in a major would serve me well over my lifetime. Looking back almost forty years from my college graduation, I’m happy with my decision. I was a math guy and so I took some rather intricate mathematics courses, of which I now remember precious little. What those math courses did provide me was an opportunity to think logically and gain a deep understanding about how worldviews are based on assumptions. Math isn’t the only route to that understanding, I’m sure. I suspect had I majored in philosophy or religion I could have developed a similar set of skills. In my case I was more comfortable with mathematical symbols than word symbols, so mathematics it was—but I digress.

In a liberal education you should get a smattering of other stuff that, if taught well, will tweak interests for a lifetime. For example, Job figures in literature continue to fascinate me because one English class I took focused on the subject.

So what, I wondered as I was helping a friend work on her required math course for a BA degree, should be the elements of a math course if someone was going to take one and only one math course? I concluded that all the important math concepts can and should be taught with the objective of developing sufficient knowledge for healthy personal financial management. In short a person should be able to:

  • Balance a checkbook
  • Understand discounts and mark-ups
  • Deal with interest both from the standpoint of earning it on savings accounts and paying it on credit cards and loans
  • Understand the effects of late fees on the interest rate
  • Comprehend the basics of insurance (life, auto, car, consumer warranties) and realize what insurance is good for, what it is not, who makes money on it and how
  • Recognize what kinds of professions earn commissions and how the way someone gets paid can affect the advice you receive
  • Negotiate at the 101 level
  • Recognize when something falls into my catch-all category: “What’s missing from this analysis?” Develop a critical understanding of how numbers don’t lie, but marketers (of product or ideas) cherry pick data to support whatever they are selling.

Think what it would mean if everyone who graduated college had these basic understandings. [Yes, it should be a high school requirement, but in today’s environment of teaching for the test, that has no hope of implementation.]

Now be honest, wouldn’t what I’m suggesting be more useful than learning how to deal with logarithmic functions—whatever the heck they are?

~ Jim

Wednesday, November 17, 2010

“The Will of the People”

Shortly after the election results were in, we began to hear blathering about the “will of the people.” The winners claim that voters have clearly repudiated their opponents’ agenda and strongly support the one proposed by the winner. “The voters have spoken.”

Of course they have, but what is the collective message? For example, in the recent Florida senate race, republican Rubio won going away over independent Crist and democrat Meek. The margin of victory being 19.2%. Pretty convincing right?

Well, let’s consider this from another aspect. Rubio won 48.9% of the vote. Crist and Meek won a combined 49.1% of the vote. [I have no clue who or what got the remaining 1%—Mickey Mouse usually gets a few write-ins.] From this standpoint, the will of the people (by a slim margin) was to NOT elect Rubio. That’s the real shape of the republican landslide win in Florida.

In Alaska, Joe Miller’s challenge of Lisa Murkowski write-in votes with minor misspellings or somewhat illegible spelling is another example of how politicians subvert the “will of the people.” With my handwriting, had I been an Alaskan who wanted to cast a write-in vote for Lisa, I would never be able to get the Joe Millers of the world to agree I wrote Murkowski on a piece of paper. My cursive leaves even me wondering what I wrote and, at its best, my printing leaves vowels open to interpretation. Miller is spending considerable time and energy trying to convince a court that his strict interpretation of Alaska election law should strip the voters of their intent.

Our election system is a winner-take-all approach and, as much as I dislike many things about the way government runs in the United States, I prefer the results of our (generally) two-party approach over the gridlock in those nations with a party for every possible voting bloc. I would ask, however, that our politicians recognize that with few exceptions the best they can honestly claim is that a majority of those voting decided at the time they cast their votes that the winners were the lesser of two evils.

If politicians entered their governmental service with that humble recognition, they might indeed find a way to serve “the will of the people.”

~ Jim

Sunday, October 31, 2010

Why the Democrats Will Lose

With Election Day right around the corner, the attack ads are pounding the airwaves. I suspect most people do as we do, mute the TV when they come on. All the pundits agree the Democrats will lose big-time in this mid-term election, but I would like to suggest a different reason for the size of their loss from those most often proposed.

The reason the Democrats are going to get pounded this election is because they are not being honest with the voters about what they have accomplished in the last two years. Democrats came to office on the back of “making change,” and they have indeed made a large number of changes. If they had spent a good bit of their campaign energy helping the voters understand those changes, this year’s election would be about the Republican and Democratic visions of governing America. (Or maybe about the Republican, Democratic and Tea Party visions of governing America.) Instead, the Democrats have ceded the conversation with the American people to those who shout the loudest in protest.

Democrats spent much time and energy passing health care legislation and financial reform legislation. They should have trumpeted the reasons for these bills and what the actual provisions are. Voters can then decide whether they are better off or worse off with those bills. Allowing nonsense like “death panels” to misinform does everyone a disservice. These “catch-phrases” do stick in the mind, but with patient conversation about facts, most people will come to understand what the real provisions are. That does not mean they will necessarily like them, but at least they will understand them.

Almost all economists, regardless of party preference, agree the country needed the stimulus and that it helped prevent a further deterioration in the economy. Where they differ is largely on whether it was too little, not too much, and specifics on how to spend the money. Yet Democrats have allowed themselves to be negatively tagged with the stimulus and bailouts (most of which actually occurred during the Bush administration.) They should be proudly proclaiming that their actions prevented more unemployment. Admittedly, “it could have been worse,” is a weak response to criticism. What is necessary was to paint a vivid picture of what would have happened without the bailout – some reminders about the Great Depression would have been useful.

Democrats should also be telling voters how regulations have changed from the Bush to the Obama administrations. The differences are significant. Again, letting voters understand the true significance of the differences allows them to realize the two parties are not the same. We have short memories and we forget the cause of today’s troubles. The purpose of these discussions is not to convince everyone the Democratic way is better; the purpose is to inform the electorate of the differences. An educated electorate will make good decisions.

Democrats should be conversing not only with those on the “far left” but with those in the middle half of American political leanings. Instead, they have allowed the political conversation in the country to be dictated by those on the far right.

In short, Democrats are going to be creamed this election not because they are career politicians who happen to be in power. (That would have caused the normal midterm election losses.) They are going to be creamed because they have been inept politicians who have not told the people what they have accomplished and will accomplish. They have not provided a vision.

~ Jim

Tuesday, October 12, 2010

More Thoughts on the Mortgage Crisis

The politicians are all hot and lathered about the latest bone-headed moves by banks that submitted faulty documents as part of their foreclosure process. I watched the debate between the Democratic and Republican candidates for Michigan governor Sunday night. The Democrat beat his breast about how we needed a moratorium on all foreclosures because of the banks’ misdeeds. The Republican suggested that since the rules the banks and their employees should follow do work, we should punish the rule-breakers, not suspend the process.

In the election hot air, many politicians are willing to ignore any and all economists in order to play to the crowd—even when the solution they propose (in this case a holiday from all foreclosures) will only worsen our overall economic situation.

With an exception here and there to prove the rule, the right houses are being foreclosed by the right banks because homeowners are not meeting their mortgage obligations. Do I condone the sloppiness of those who try to circumvent the legal process? No – see my comments on the subject. Those banks should stop their foreclosure processes until they have their paperwork in order. However, anything that artificially slows down the adjustment process hurts everyone. If politicians impose a moratorium, people will not ultimately keep houses they otherwise would lose. They will still lose them; it only delays the day of reckoning.

Furthermore, until the massive supply of foreclosures is cleared out of the system, we cannot regain market equilibrium. With the huge volume of overhanging foreclosures, who can say for sure what the market price of a home is? Certainly those people being foreclosed are not willing sellers, and banks who have already written off their losses tend to sell properties at a lower price than the rest of us. Why would housing prices increase (or even stabilize) until this overburden of foreclosed houses becomes a de minimus part of the overall market? It’s like asking people to pay full price when the store is proclaiming in big letters: CLEARANCE SALE COMING SOON. Only when we return to willing buyers and willing sellers can a fair market value be determined.

Many of those who will be foreclosed have lost their jobs. As long as they “own” a house—particularly one that costs them little to maintain because they have stopped making mortgage payments and investing in upkeep—they are less likely to move to another area to take a new job. This too inhibits the recovery process because the job market has an added inefficiency.

Whenever governments artificially prop up a market it involves a transfer of wealth to the benefactors from everyone else. Sometimes the cost is worth the benefit. Not this time. The best thing we can do for the housing market is to have it function with minimal governmental interference. We humans are very adaptable, but resistant to change. Putting off the inevitable delays healing. As sick as I feel for those who are losing their homes, they aren’t going to start to heal until they move on; nor will the market heal until it transcends the foreclosure tsunami.

~ Jim

Wednesday, October 6, 2010

Where’s the Jail Time?

Almost as soon as the most recent recession hit, I began to read stories about the illegal activities in the real estate market. The one story I haven’t read since then is about arrests of the hundreds, or perhaps thousands, of mortgage brokers who broke the law by fabricating data on mortgage applications to allow them to sail through the approval process. They collected their fees or commissions; the rest of us are paying the price.

In bringing up children one of the more important lessons parents can instill is that actions bring consequences. Yet when it comes to illegal activity in the business world, that rarely seems to be the case. Oh yes, I know companies are fined – big deal. I’m talking here about individuals paying the consequences. There have been notable exceptions: Ivan Boesky, Michael Milken and Martha Stewart come to mind. Yet where are the little guys that made this mortgage mess possible – the ones who knowingly allowed borrowers to fabricate income for example?

Since nothing much has happened to mortgage brokers in the last two years, I suppose I will be disappointed. However, with the newest revelations about individuals knowingly signing false affidavits as part of the foreclosure process, I am once again forced to ask the question: where is the arrest warrant?

Take for example, Jeffrey Stephen of GMAC Mortgage LLC. Assuming the allegations are correct (see for example STOPA Law Blog) I think Mr. Stephen should be arrested for false statements to the court. (I’m not a lawyer, so I don’t know the correct terms – the point is lying to courts is clearly illegal—that’s why they have to sign affidavits.) To the extent Mr. Stephen’s direct supervisor knew he was signing affidavits without proper verification, he too should be subject to legal repercussions and termination at the least. If at some level within the GMAC hierarchy someone really didn’t know what was going on, that person should also be fired for incompetence – they should have known.

Will this happen? I’m not holding my breath.

~ Jim

Thursday, September 30, 2010

Annuity or Lump Sum Payment? (Part IV)

In the first post I asked you to consider the risk you should be trying to mitigate as you choose between a lump sum and an annuity. In the second post I discussed considerations if you choose the annuity. In the third post we discussed alternatives for investing a lump sum. In this post we’ll consider how much money you can safely withdraw each year.

Deciding how much you can withdraw leads right back to this question: how long are you going to live? The shorter your life span, the more you can “pay yourself” each year. With one year, all the money is yours to do as you wish. If you want to keep the inflation adjusted principal to give to your favorite charity (which may be your kids) you can only spend the real return each year. With long TIP real returns less than 1.75%, you need a huge pile of money to live off the income. For example, to pay yourself $50,000 a year that will increase with inflation, a 1.75% real rate of return means you need to have $2,857,000. Those are the extremes; what about the rest of us?

Okay, so no one has given you a look into their crystal ball to determine your date of death. You are going to have to guess. If you guess too many years, you didn’t use your money wisely—some will be left over. If you guess too few years, you are penniless when you live past the date you guessed.

Let’s say you have a nest egg of $1,000,000. With a real rate of return of 1.75%, if you only expected to live ten years, the first year you can take out $108,000. Planning to live twenty years? You can withdraw only $59,000. Thirty years? Only $42,000. Forty years? Then $34,000 for you in year one. The next year you get an increase to cover inflation during the year.

Taking on more risk (add equities, corporate bonds, etc. to your portfolio) in order to increase your expected real rate of return works well if you start when markets are low; poorly if markets are at their top. How do you know which is which? You don’t, except in retrospect. We all know trying to time the markets doesn’t work well for most of us.

Wait, you say, I Googled it and depending on my age websites tell me I’m safe to take out 4%, 5%, 6% a year. Do they guarantee you won’t run out of money? No, they don’t. The more sophisticated models give you a percentage chance that you’ll be okay. Which is great if your life is a Monte Carlo simulation where there are hundreds of thousands of you who live to various ages and get various results on their investments. But you are only one person.

Yeah, you say, but I like that 95% probability from the simulation.

And I say the only way you are going to do that is if a very large part of your portfolio is made up of annuities where you have no mortality risk and you’ve minimized the inflation risk as much as you can (see post 2).

I’m glad we have that settled!

~ Jim

Tuesday, September 28, 2010

Annuity or Lump Sum Payment? (Part III)

In the first post I asked you to consider the risk you should be trying to mitigate as you choose between a lump sum and an annuity. In the second post I discussed considerations if you choose the annuity. In this post we’ll consider how to mitigate your risks when you choose a lump sum.

Many investment advisors recommend taking a lump sum instead of an annuity because of the annuity’s lack of inflation protection. That concern is legitimate (and discussed in the second post), but advisors commonly fail to mention the issue of your longevity. So what are their recommendations?

Variable annuities: The idea here is that the increase in the underlying value of the assets will fund ever increasing annuity payments. There is, of course, no direct link between inflation and equity prices. In the long run, equities have outpaced inflation, but in the long run we are also dead. The issue if you are retiring is all about the relatively short run of the next 30, 40 or 50 years.

Buying a variable annuity right before the most recent stock declines would put you in a very large hole that your annuity might not recover from. Fortunately, inflation is currently low, but it might not stay low. If you purchase a variable annuity, the payments will decline if the underlying assets decline, meaning you may end up with less than that fuddy-duddy annuity you cashed out of.

Also of note are the fees attached to many variable annuities. Those fees (going to your broker who suggested you take the lump sum—he gets nothing if you choose to stay with the company’s annuity) and the profit the insurance company thinks they should get for providing you the product and maintaining it over the decades, also mean there is less going into your pocket. Remember: the more for them, the less for you.

You can purchase variable annuities with certain levels of guaranteed benefits, which lessen the risk of a decline in the nominal benefit. Those annuities limit your upside potential in order to pay for covering the downside.

Alternatively, you might purchase a traditional annuity, without the equity element – but wait a minute, that’s what we had to start with. Years ago interest rates used by some pension plans to determine lump sums were lower than those used by insurance companies to determine annuities, so even with the commissions, fees, insurance company profits and the like you could make out on that kind of deal. Today, except under unusual circumstances (when interest rates have rapidly increased), no such a deal will be worthwhile.

How about TIPs? Treasury Inflation Protection bonds provide a floor in the case of deflation and match the CPI for inflation. The current real rate of return for long-term TIPs is less than 2%. Not going to get rich that way, but it at least provides protection.

Your advisor could suggest some mix of stocks, bonds and cash – and we know there are no guarantees with any mix, other than cash and its equivalents and those leave us subject to inflation.

But let’s say you’ve made your choice. Some combination of equities, TIPs, REITs, some foreign securities—a nice balanced portfolio. You know it can go up and down and you’re prepared for that. Now, how much are you going to take out each year?

We’ll discuss that question in Part IV.

~ Jim

Friday, September 24, 2010

Annuity or Lump Sum Payment? (Part II)

In the previous post I asked you to think about the risk you should be trying to mitigate as you consider the lump sum vs. annuity issue.

Most people’s greatest risk is outliving their money and relying on Social Security. Annuities can mitigate that risk, but not eliminate it. Life annuities will continue for as long as you live, but most pensions do not adjust benefits for increases in cost-of-living. You've lessened, but not eliminated your risk of outliving your money when you choose an annuity over a lump sum. This risk of outliving assets applies not only to the person receiving the annuity or lump sum, but also to a spouse or partner.

If you are married, you can take your annuity as a joint and survivor form to allow continuation of some or all of your pension after your death. The payments will continue as long as your spouse lives. Your benefit is reduced to pay for this insurance. All other things equal (although they rarely are), I suggest the joint and 75% or 66-2/3% options because one person cannot live well on half the income two had. For example, if you own a house or rent an apartment, you’ll need more than half the space if you decide to move and if you don’t move, your rent or real estate taxes stay the same.

If you have an unmarried partner, you have the same considerations, except many corporate pension plans will not allow joint and survivor benefits. Then you need to look carefully at what happens when you die, and how much income needs to be continued. Perhaps a life annuity will be fine because the partner has sufficient retirement assets to take care of himself. If not, then either you can take the lump sum (see the third blog in the series for problems with lump sums) or some portion of the monthly benefits will need to be set aside to take care of the partner.

Let’s say the partner needs to have the equivalent of a 50% of the pension annuity income continued after the annuitant dies. To use an example, let’s say the annuity is $2,000/month and if you were allowed to take a joint and 50% survivor benefit, your benefit would be reduced to $1,800 to cover the cost of the survivorship benefits. Actual reductions depend on the age differences between the partners and pension plan specifics. If that option isn’t available, you can look at how much life insurance you can purchase on your life for $200 a month. (To simplify I am ignoring taxes here.)

Purchasing guaranteed renewable term insurance might be a good way to fill in the gap, essentially buying the survivor benefits from an insurance company instead of from the pension plan. It’s not as efficient, but it can work.

I should mention that if the need for post-mortem income is limited to a fixed period of time, plans often allow optional benefit forms of 5-, 10- or 15-years certain. Under those annuity forms, if you die before the end of the certain period, the benefits will continue for the remainder of the guaranteed 5, 10 or 15 years, as elected. Note: these forms of benefit are only useful if there is some need of finite years (for example a child’s education) that you are trying to protect. Do not use a years-certain option in lieu of joint and survivor options for a life-income need.

How can you handle the issue that most annuities do not have inflation protection? It takes discipline, but here’s one approach: Determine (you can do this online or have your friendly insurance agent or financial advisor get the information for you) how much your annuity would need to be reduced to get inflation protection. It’s rare for an insurance company to provide full protection, so you may need to settle for a proxy to determine an estimated cost – such as using an annuity that automatically increases benefits 3% or 4% a year.

Let’s just say your original $2,000 per month annuity must be decreased to $1,333 per month in order to provide full COLA protection. In year one, you will need to invest the $667 monthly difference between your standard annuity and what it would be with future COLA adjustments. In year two, the annuity will continue to pay you $2000, but let’s say there was some inflation and the $1,333 would have grown to $1,375. In year two, that’s the amount of your pension you can spend and the rest ($625/mo.) you will invest. (Again, I’m ignoring taxes.)

At some point the $1,333 increased by cumulative COLA differences will exceed the $2,000; let’s say it is $2,025. Then you are taking the entire annuity and making up the $25 difference by dipping into your savings.

Will it work perfectly? Not at all. On average, for a very large number of people it might work out well, but some people will die before they exhaust the savings made up of “scrimping” in the early years. For some, inflation will be less than expected and they too could have spent more in their earlier years. For others the opposite will be the case. Perhaps inflation runs higher than expected – or you live much longer than average. In both cases you should have spent even more in the very early retirement years, and now you will have to cut back in your later years.

Not a perfect solution by any extent, but at least with the life annuity, the nominal payment is guaranteed for as long as you live. For lump sums, the issue is even worse.

Next up in Part III, what happens when you take the lump sum instead of an annuity.

~ Jim

Wednesday, September 22, 2010

Annuity or Lump Sum Payment? (Part I)

For me, the choice was easy. My defined benefit pension plan didn’t allow for lump sum payments, so the only question I needed to answer was the form of the annuity. My defined contribution pension plan didn’t allow an annuity, so lump sum it was. In this discussion I will use generalities regarding taking a lump sum from a defined benefit pension plan.

Lump sums are determined based on the defined benefit otherwise payable, interest rates and mortality assumptions. The law defines minimum and maximum lump sums; the pension plan itself contains the rules for determining your specific lump sum. I could regale you with atrocities plan sponsors and financial advisors perpetrated on plan participants in the bad old days; but the law was changed and those abuses are no more.

If you are going to die the day after you receive the distribution, taking a lump sum is a great idea for your estate. Clearly, if your expected mortality is significantly worse than assumed in determining the lump sum you are better off taking the cash now.

If you don’t expect to get personally acquainted with the grim reaper in the near future, then a lump sum is not a clear winner—even with historically low interest rates. Before the next post, I want you to think about what risk you should be trying to mitigate. (Here’s a hint: it’s not about dying too soon.)

The next blog will explore the risk that should be paramount in your decision-making and what that means.

~ Jim

Monday, September 6, 2010

Social Security May Plug the Payback Loophole

I’m sure this provision in Social Security started life as someone’s altruistic idea to help out folks who made a poor decision. Essentially, the payback works like this: you can restart your Social Security benefits to eliminate any early retirement reductions and take advantage of delayed retirement credits with one small hitch—you need to pay back any benefits you received with interest.

What’s wrong with that? If someone made a bad choice, why not give them a do-over? Because the only people who can take advantage of this payback option are those with enough money on hand to pay back all their previous Social Security benefits. That does not include most people.

Let’s take a simplified example that ignores the effect of cost-of-living adjustments and interest charges. Mr. Former Wage-Earner started benefits in 2005 at age 62 at the rate of say $10,000 per year. His full retirement age was 66 (in 2009). If Mr. Wage-Earner had waited until 2013 to start benefits they would have been (again ignoring COLA adjustments and Wage Base Increases) roughly $17,500.

Under the payback rules, he could stop benefits, pay back $80,000 (8 years at $10,000/yr.) and for the rest of their life get $7,500 more per year in benefits. Still ignoring interest, as long as he lives to age 81, he’s ahead of the game.

Since most retirees should be much more worried about longevity risk than the date they break even, this is an excellent deal for those in decent health since it provides 75% more benefits for folks who live to ripe old ages, mitigating the risk of living longer than money lasts. Further, if you compare this deal from Social Security to the cost of purchasing a life annuity with full CLOA from an insurance company at age 70, you’ll discover this is a also an excellent monetary deal from that standpoint.

Because people are using the payback for other than “oops” situations, the Social Security Administration wants to change the rule so it only applies for the first year after Social Security benefits start, which covers the purported original intent of the provision.

If you want to take advantage of this loophole (1) get top-notch investment advice about whether this makes sense and all of the ramifications, and (2) hurry—the loophole may not last long.

~ Jim

Monday, August 30, 2010

On Building Mosques and other Religious Intolerance

Here is a simple test to determine whether or not objections to building a mosque are based on religious intolerance. Would the objections be exactly the same if a Baptist church, Catholic Cathedral, Jewish Synagogue, Mormon Temple or Quaker Meeting House were planned for the exact same spot?

If everyone agrees that (for whatever reason) no religious establishment is appropriate for a particular location, forbidding the building of a mosque in that spot is not Islamophobia – although it maybe antireligious—but that is a different issue.

Those who oppose building the proposed mosque within two blocks of the former World Trade Center do not pass the test. Nor do those in the towns and cities across the country where they criticize building mosques in areas zoned for religious institutions.

To liken the protests, as recently did to those by the National Parks Conservation Association (“NPCA”) against building a Wal-Mart on parts of the Wilderness Civil War battlefield not incorporated into the National Park is specious. They claim both protests are based on the same principle: “It is simply the wrong building in the wrong place regardless of developers’ legal rights.” The difference is NPCA opposed building any big box store on the civil war battlefield directly opposite the visitor’s center. Wal-Mart happens to be their current target.

Opponents of the mosque, however, do not oppose any building for the site. Their claim is that a mosque, in particular, is inappropriate. Why? Because the World Trade Center terrorists were Muslims and building a mosque would be “insensitive” to the victims of that tragedy. So go further and note that Saudi Arabia doesn’t allow Christian churches, so “fair is fair.”

Malarkey. One of the things that has made the United States great is the First Amendment of the Constitution. We are not Saudi Arabia with a state religion. For those who love the constitution, but forget to actually read the document, here is the First Amendment in its entirety:

Amendment 1
Freedom of religion, speech, and the press; rights of assembly and petition

Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.

One of the best ways to show terrorists that their 2001 attack on the United States failed miserably is to adhere to our principles. Let the mosque be built so terrorists from around the world can see that, unlike in their countries, we will NOT prohibit the free exercise of religion—even when it is of a small minority of residents. That we value the right for all peoples to peaceably assemble—regardless of their secular or religious message.

We win by remembering who and what we in these Unites States stand for. We lose if we become as intolerant as our enemies.

~ Jim

Monday, August 23, 2010

Another Damper on Housing Prices

In case there weren’t enough reasons for housing prices to stay low for many years, I recently read about one more. On August 2, 2010, I discussed the law of supply and demand concerning housing. One area of supply I did not include is this:

In many areas of the country, the percentage of home sales to absentee buyers has increased dramatically. For example, the LA Times reports that in the Inland Empire area of California the rate has increased from 19% at the end of 2008 to 30%.

In that area, almost one-third of all home sales are to investors who are planning to flip the houses. The good news regarding the influx of professional investors into buying property at auction is that they are bidding prices higher, building a bit of a floor under current prices. The bad news is that these houses will be back on the market in the next year and a half or so. Thus July’s reported 10+ month inventory (which will go higher this month for sure) is understated in the sense that all of these flipping houses (if you’ll pardon the term) are deferred inventory.

As we look out over the next several years, flippers will continue to add inventory as they finish rehabbing foreclosed properties they acquired. More supply means lower prices—all things equal.

~ Jim

Monday, August 16, 2010

Prediction: No Social Security CPI increase for 2011

Unless something unexpected happens, we will have positive inflation for 2010, but I do not expect Social Security benefits to increase for 2011. That seems unfair—until we look at the larger picture.

Social Security benefit increases for a calendar year are based on the ratio of the average CPI-W (CPI for Urban Wage Earners and Clerical Earners published by the Bureau of Labor Statistics) factors for the previous July, August and September as compared to the highest average CPI-W for any previous July, August, September period. If inflation monotonically increases (that is there are no decreases) the comparison is from one year’s third quarter average to the previous year’s third quarter average. That’s what happened with the CPI-W index for all years through and including 2008, resulting in annual Social Security benefit increases.

In 2008 the average was 215.495, a whopping 5.8% higher than 2007’s 203.598—and for 2009 Social Security beneficiaries received this 5.8% increase. [You may recall oil prices were skyrocketing during that period, driving up the CPI.]

Oil prices declined, the world went into recession and prices declined. In 2009 the CPI-W third quarter average was only 211.001, a 2.2% decrease from the previous year. Fortunately for Social Security recipients, benefits may not be decreased because of decreases in CPI-W, and so for 2010 they remained unchanged. While it didn’t feel like it to retirees, from a math geek’s perspective, they were getting a bonus during 2010 because their benefits did not decline—relative to the index they were getting a raise.

July 2010’s CPI-W was 213.898—higher than last year, but still not as high as 2008. Unless inflation increases significantly in August and September (it would need to increase at an annual rate of roughly 9%), the average for 2010 will be less than 2008’s average. Consequently, no increase in benefit levels for 2011.

The outlook for a 2012 increase is reasonable. The CPI-W is only about 1.1% below its all-time high in July 2008 and for the last twelve months the CPI-W increased about 1.6%, although the rate of increase has declined recently.

For those not receiving Social Security benefits, the lack of a cost-of-living adjustment will also mean the contribution and benefit base for 2011 will remain unchanged from 2010 (and 2009) even though average wages have continued to increase. Once the average third quarter CPI-W does exceed 2008’s level, the wage base will increase based on the National Average Wage Index.

~ Jim

Thursday, August 12, 2010

Alternative to Gun Control

For reasons I don’t understand or agree with, the courts appear to be interpreting the second amendment to the U. S. constitution to give individuals (rather than state militias) the right to own guns with limited restrictions. Everyone agrees it is bad for criminals to have guns; however, those who despise all gun control consider it the lesser of two evils. For now they have won.

Here are my suggestions on controlling gun use, recognizing that forbidding people from owning them is not going to work.

1. Require background checks for all gun purchases, including those at gun shows (currently a huge loophole.)

2. Register the guns with their owners. This includes new purchases and all guns already owned. There should be no cost to gun owners for this registration. Anyone possessing an unregistered gun is committing a felony.

3. Each owned gun must have a ballistics test performed. The FBI will maintain a nationwide database as they do with fingerprints. This does not preclude states and local governments from keeping similar data bases if they choose. Because this will take time, require all gun sales (new or used) to include a ballistics test. Older guns can be included over time—starting with those types of weapons police deem most likely to be involved in crimes.

4. The owner has the responsibility for proper storage and use of the gun. If an unauthorized person gets hold of a gun and causes no harm, the owner has committed a misdemeanor. If a crime is committed with their gun (other than carrying a firearm not belonging to the person), the owner is guilty of a felony. If the gun is stolen and it was impossible for the owner to know, then they are off the hook—but the burden of proof is on the owner. I forgot to lock my gun cabinet doesn’t cut it.

5. Run periodic nationwide “turn-in-your-gun” events that allow people to turn in guns to the local police, who, after verifying ownership, will destroy the guns. I suspect anti-gun proponents can raise sufficient funds from their supporters to pay for this program.

With these simple law changes, the gun owner clearly bears the consequences of a gun’s misuse. This changes the battle lines from gun-owning rights to gun-owning obligations, which given where we currently are in this over-armed United States—might be a good change.

~ Jim

Monday, August 9, 2010

The Need for Parallel Universes

The political primary season is upon us with much hue and cry from politicians on the far right that the Federal Government response under Bush and Obama to the financial crises was wrongheaded. Government should not have interfered with “necessary market adjustments.” If firms (investment banks, commercial banks, auto firms) went bankrupt, them’s the breaks. Our biggest problem, they claim, is the ballooning Federal deficit.

Here’s where a parallel universe would be useful. In this alternate universe, we could see the effects of the advocated nonaction during the financial crises. Alan Blinder (Professor of Economics at Princeton) and Mark Zani (Chief Economist at Moody’s) published a paper on July 27, 2010 in which they estimate without the massive government intervention, GDP would be 11.5% lower and 8.5 million MORE jobs would have been lost.

I do not claim that each and every dollar was well spent. I’ve already discussed in a previous post how worthless the $8,000 home purchase credit for new buyers was. However, when I look at my own spending, in retrospect I wasted quite a bit of money on goods or services that didn’t meet my expectations. If I can’t get it perfect on a micro-level of one person, why would I expect the Federal Government not to waste some money here and there? The main thing is they provided liquidity and stability when the global economy needed it.

Without parallel universes to provide the “true” answer to what if questions, those not in power point to the current problems and wail how bad it is—and no one can prove them wrong.

I want to express now my personal thanks for those who took risks during those dark days and saved us from worse. Thank you.

~ Jim

Friday, August 6, 2010

The Mythical Man-Month

Recently, I watched the third episode of The Pillars of the Earth. The book is by Ken Follett and is one of my all-time favorites. His love of cathedrals shines. What caught my eye in the made-for-TV series shown on Starz was a scene in which all of the nearby townspeople come out (in the nick of time) to work one day on the cathedral (for which they are paid and given a free dispensation from the church). The progress is so vast that the project moves from almost dead to sufficiently amazing as to impress King Stephen.

What’s wrong with this picture? It suffers the same problem as outlined by Fred Brooks in his 1975 book The Mythical Man-Month even though Brooks was writing about software design and Tom Builder is designing a cathedral.

When a project is running unacceptably late, a first reaction (okay, probably a second reaction; the first is to lay blame) is to add more people. Brooks postulates that adding more personnel tends to further delay the project because (1) all the new people have to get up to speed, and (2) communication issues increase exponentially. These same issues must have applied to 12th century England, even in the made-up town of Knightsbridge.

Yes, the skills the villagers applied were menial—but still, would one master builder be able to keep all the carts hauling earth, carved stone and the like straight? Might not someone have bumped a support pole here or there? Well, it was in a movie, so I’ll cut them some slack.

Back in the real world, however, we keep applying the same mistake. We see a surge works in Iraq and add more men in Afghanistan—ignoring the communication and infrastructure needed to support the surge. We pour massive resources of people and money at improving our security networks, tell everyone to “play nice” in the sandbox and are amazed when terrorists slip through the cracks.

You can add your examples in the comments below. One point to remember is if the proposed solution is to add staff to catch up, it’s probably going to make it worse.


Wednesday, August 4, 2010

And the Band Played On…

In the last post, I talked about the future of the housing market. Today I want to look at the banking industry. To date the Federal Deposit Insurance Corporation (FDIC) has closed more than 100 banks. When the FDIC closes a bank, it finds another bank in strong(er) financial condition to take over the assets and liabilities. Since the closed bank was undercapitalized, usually the FDIC guarantees any losses over a certain threshold as part of the deal.

This process makes the entire banking system stronger and, in theory, should help promote future loans as more assets are available to strong(er) institutions.

Unfortunately, we’ve only seen the tip of the bank closing iceberg. The FDIC keeps an official list of distressed banks. Banks are included on the list based on a variety of characteristics including underperforming business loans, commercial mortgages and home mortgages. The official FDIC list of “problem” banks has increased from 416 in Q2 2009 to 775 in Q1 2010. (Note closed banks are removed from the list, so the number of banks in trouble has more than doubled when we consider the hundred plus already closed this year.)

There will be more. Banks must reflect the underwater nature of mortgages they hold; but if housing prices drop even a few percent more, it will drive an even larger percentage of mortgages under water. An estimated 14 million home mortgages are already underwater (roughly 30% of mortgages). Four million of those are underwater by over 50%. Surely these must either be restructured or foreclosed.

The total face value of all mortgages underwater exceeds $2 trillion. If the average of these mortgages is 25% underwater, that’s a half a trillion bucks. Every 1% decrease in prices leads to at least $20 billion of additional losses (and that doesn’t consider mortgages currently above water that will slip below the surface at various price declines).

In order for the economy to grow, we need investment. In order to have investment, banks must make loans. In order to make loans, banks must minimally feel a teeny bit confident in order to stop hoarding cash.

It’s clear to me this confidence is not going to come from looking at their mortgage portfolios.


Monday, August 2, 2010

The Housing Bubble Continues

I suspect many areas of the country have not seen the lows in housing prices. As with other goods and services, in the long term housing prices are subject to the laws of supply and demand. Right now there is lots of supply and not much demand, which implies a future decrease in prices.

Available housing is still overabundant, with a 10+ month supply, and it will continue to worsen. In a few cities, like Detroit, there is an oversupply that will not be matched by demand because of migration from the area. In most places, the oversupply can eventually clear, either through price declines or increases in demand.

Let’s look at both sides of the supply/demand curve starting with the demand for housing:

Interest rates are at generational lows, which means mortgage costs are relatively low. That’s already priced into the current market, so unless interest rates decline further, this will not increase demand.

The US population continues to grow and form additional family units. Eventually this will require additional housing. However, many families have substantial elasticity on when a new household is formed. Children return to parental homes after college; roommates rent together for longer periods before taking separate residences. Parents go and live with their children. Over the long term, this will boost demand for housing, but the long term can, and I think will be, several years out.

The ill-conceived $8,000 tax credit for new homebuyers frontloaded demand. Any first-time home buyer who was close to being ready to buy a house had an $8,000 incentive to close the deal before the end of June. People who might have bought houses later in the year, or even in the first few months of next year, accelerated their plans to make an earlier purchase. The credit was ill-conceived because it did not change demand a whit; it only moved it forward and rewarded one lucky class of home buyers at the expense of future taxpayers (not at the expense of current taxpayers since no taxes were raised to pay for the largess).

Job growth is paltry, and wage growth for those employed is also low.

Turning now to the supply for housing:

Foreclosures continue and are starting to include those who negotiated revised terms with their banks.

The percentage of homeownership for the 75+ age cohort has increased since the housing bust. This suggests deferred listings. This group may be unwilling (at least for now) to sell their homes at prices they perceive as “too low.” Eventually, death, morbidity or decreased financial circumstances will force these sales. When that happens, more inventory will dump onto the market.

Not all current inventory is being counted in the supply figures, particularly in the condo market. This takes two forms. Rentals are replacing sales as developers hope to generate sufficient cash flow to hold off creditors until the market turns around, when they can again sell at a profit. I recently read reports indicating entire developments in some cities stand empty and unlisted. Furthermore, houses in the midst of repossession may be abandoned but have not yet reached formal listing.

While Congress recently extended unemployment benefits, that extension did not increase the time jobless benefits are paid. With the dismal job creation, more families are running out of those benefits as their unemployment has extended past the limit for payments. Many of these families will be forced to move.

Lastly, builders continue to construct new units. They are sitting on expensive land with mortgages that must be paid or they too will be foreclosed. Many of these builders are in survival mode and will build smaller houses with less expensive accoutrements in order to meet lower price points (and appear to be decreasing prices.) While they may hope to earn modest returns on these houses, their real economic drive is to reduce debt burdens by selling parcels. I suspect those with deep pockets can find some very attractive deals on raw land currently—which undercuts the market price much the same way distressed sales depress the prices for all completed homes.

As housing prices continue to tumble, Congress may consider a second round of support. I don’t think anything will pass, but the possibility will keep first-time buyers on the sidelines. Why buy now when prices continue to decline and it’s possible the government may throw money at you later?

A grim picture, indeed. This too shall pass. Eventually the continued weakness in the housing market will flush the remaining weak owners and builders from the system. Once that is done, housing prices will stabilize and start to rise. Just don’t hold your breath.


Friday, July 30, 2010

Plusses and Minuses of I Savings Bonds, Part II

So far in this group of posts on savings bonds we have covered the now defunct Series E bonds, the basics of Series EE Bonds, the basics of Series I Bonds, how to buy and sell savings bonds, two posts comparing Series EE savings bonds with Certificates of Deposit (CDs) and Treasury bills and notes and the first half of an analysis comparing Series I bonds to TIPs.[Link here]

Here’s the remainder of that discussion:

Rates of return: TIPs that mature in about five years currently yield 0.5%., a slightly higher return than the current 0.4% real interest rate on Series I savings bonds. If we increase the maturity to 10 years, the yield on TIPs rises to 1.2%—significantly higher than you get with the current Series I bond. At 20 years (actually closer to 18.5 years given the outstanding TIP issues) the TIP yield is up to almost 1.9%. That rate remains essentially flat for bonds up to the longest outstanding TIP (not quite 30 years).

Taxes: Taxation: How savings bonds interest is taxed has been discussed in previous posts.

Both the interest and increased principal from TIPs are taxed in the year earned. Every six months you will receive the interest payments but not the increase in principal. Consequently, you must pay taxes on the increased principal from other funds. Taxation of the earned, but not yet received, principal increase is one reason most people choose to own TIPs in their IRAs rather than in taxable accounts.

In the previous post I discussed the general advantages of deferring taxes, but in summary, although tax-deferral is an advantage of savings bonds, at today’s interest rates, and assuming constant tax rates, the effective rate of return on Treasuries is greater than Series I bonds and overwhelms the Series I tax-deferral advantage.

Conclusion: Again, there is no simple one-size-fits-all answer. Compared to TIPs, Series I bonds have three significant advantages: they are simpler to buy and redeem; you can buy them with as little as $25; in case of deflation, they provide more value than TIPs.

If you really think deflation is going to be the norm during the period you expect to hold your bond, then you should buy neither TIPs nor Series I bonds. Hie thee to the treasury market and buy a Treasury Strip of your desired duration.

Unless you are not planning to hold your purchase for a few years, the extra yield on TIPs seems to me to be worth the added aggravation (which isn’t much with TreasuryDirect®) of buying TIPs online provided (1) you can take accept the swings in market value TIPs endure, (2) you don’t plan on selling before maturity (or have the financial resources to handle a capital loss, and (3) you are purchasing at least $1,000 worth of securities.