Thursday, December 29, 2011

Positive Returns in Volatile Markets

Last year I wrote a long post concerning the whys, wherefores and how tos surrounding rebalancing your portfolio. Calendar year 2011 isn’t yet over and anything could happen in the last two days of the year. However, unless the last two days are really bad, my net worth will increase in 2011.

As a reminder, I’m retired and have no income except from my investments. That means I was able to live off my investments and still have more at the end of the year. For this retiree, that is a successful investing year.

So in another twelve-months that most pundits are chalking up as one more “lost year,” after already “losing” the first decade of the 21st century, how did that happen?

I have two answers: diversification and rebalancing.


In another post I set forth my then asset allocation policy:

Bonds (44.0%)
    Short-term                     Balancing Item
    Medium-term                       4.0%
    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%

Other Real Estate                      3.0%
Commodities                             3.0%

Total (100% )

The only changes I made to my asset allocation policy during the year were to reduce the medium-term bonds to 2.0% and decrease the Inflation-protected bonds allocation to 14% —both reflecting the lowering real rates of return. I kept the overall bond/stock/other allocations the same, temporarily moving the additional funds into money market accounts (where they are earning next to nothing).

Bonds increased in value through the year as the Federal Reserve continued downward pressure on interest rates, helped in large part by the instability in the rest of the world that made US treasuries look relatively rock-solid. The US stock market was mostly sideways or down for the year. Foreign securities were down a bunch, especially valued in US dollars. Commodities were up, down and now sideways. Real Estate Investment Trusts (REITs) added value during 2011.

Since I have more money in stocks than bonds and a higher proportion of international stocks than most, with a buy and hold strategy without rebalancing I would have generated a decrease in total asset value worse than the average bear.

Yet even after living expenses, I ended up with an increased net worth. Is this some new application of Wall Street math? No, it’s not. In 9 ¾ years of retirement and following my strategy of diversification and rebalancing, my net worth has increased about 45%. Diversification has helped even out my returns, as has periodic rebalancing.


The markets did not go uniformly up or down; they rollercoastered throughout the year. I rebalanced four times during 2011. I should have done it more often, but was distracted by other things. This is particularly true of my commodities position, where rebalancing would have earned me a better return. Live and learn.

Rebalancing is particularly useful in volatile markets. In some sense it forces you to sell when an asset is high and buy when it is lower. Looking at my actual purchases and sales of the Vanguard Index 500 Fund in 2011 shows how this worked to my advantage.

In January I sold shares at 117.59. In February the index increased and I needed to sell more shares to rebalance, which I did at 120.54. By September the index had declined to 111.37 and I needed to buy shares to rebalance. By December, I had to rebalance again, primarily because of the declines in international equities and sold most of the shares I bought in September at 116.48.

The gains are not huge, but they did earn about 5% on those funds that I would not have earned had I not rebalanced. Don’t confuse this with market timing where one attempts to pick the bottom to buy and the top to sell. Had I been prescient, I would have sold all my stock at the beginning of the year and put it into long-term bonds. Only my need to rebalance dictated the timing of the purchases and sales.

This strategy is about hitting lots of singles, about picking yourself from the dirt when the markets throw a bean ball and being prepared for the next pitch whatever it may be. If I were to fault myself for this year’s performance it is that I should have rebalanced a bit more often to reflect the increased volatility.

~ Jim

Friday, December 23, 2011

The Payroll Tax Hoo-hah – Part II

Well I had it mostly right. Senate Democrats did cave and give up on having “millionaires” pay for continuing the 2% payroll tax holiday through higher income taxes. What I did not imagine is the length House Republicans would go to snatch defeat from the jaws of victory.

Boehner was unable to convince enough fellow Republicans that they had won yet again and leave well enough alone. Instead, using the line that went something like the “American people are tired of kicking the can down the road,” they tried to grab another concession from the Democrats and force the Administration into making an early decision on building a gas pipeline.

The American people are not that stupid. They know neither side wanted blame for taking away their goodies. If that means Congress extends the payroll tax holiday in two-month increments, it’s no matter to them as long as it’s extended. The public may agree that a year-long deal is preferable, but if the choice is between putting up with partisan debate once again to get the benefit for the next two months or not getting the benefit at all, no one—except apparently some delusional Republicans—thought trying to cram something else down the Democrats’ throat was going to work.

Once the Senate voted 89-10 for the two-month extension (which included continued extension of unemployment benefits) the House should have gone through one round of speeches bemoaning the lack of vision in the Senate, passed the bill and gone home for the holidays.

Should politicians wonder why their approval rating is now under 10%, they need look no further than this latest round of nonsense.

Here’s the problem facing voters. Whenever we give power to either party (usually because the other party badly overreached), those voted in (usually by the slimmest of margins) think they have a mandate for their most partisan platform points. Mixed government used to be a solution because the two parties had to work together to accomplish anything and those discussion encouraged compromise. However, if the 535 children in today’s Congress were still in kindergarten the teacher would assign them repeated time-outs for their behavior.

We’ve lost the middle; how will we get it back? The “Third Way” tries to affect discussion by reasoned analysis that does not follow right- or left- wing philosophy. Nice try, but with the rise of Fox News and the yelling commentator, how can quiet, thoughtful ideas get any airtime? Ultimately when enough people disagree with the leadership of one party or another they form a third party. Historically, it has been the extremes who have broken off to form the third party.

Are today’s moderates yet mad enough to become tomorrow’s extremes and form a third party? Unfortunately, I don’t think so. Disgust doesn’t seem to lead to change, only to fanaticism. But hey, a new year is coming and hope springs eternal.

~ Jim

Thursday, December 15, 2011

The Payroll Tax Hoo-hah

If you work for your living and have started to wonder if Congress will continue the 2% reduction in payroll taxes you’ve been receiving, I think you should relax on that point and worry about something else—like how badly the euro mess will drag down the US economic recovery.

Republications appear unwilling to vote for anything that anyone could possibly consider as a tax increase—and both they and the folks across the aisle agree not continuing the payroll tax reduction would be a “tax increase on the middle class.” Therefore, they need to find a way to continue the partial tax holiday.

Democrats (despite what they claim) understand that the state of the economy will be a major determinant in the 2012 elections. For the economy to grow, people (or governments) need to increase purchasing. Businesses expand when people buy more stuff and contract when they buy less stuff. No politician (as opposed to economists) will claim out loud that governments should be spending more in the near future (even if it is to buy stuff that will help us). Even Democrats are wearing hair shirts and lamenting the imbalance between Federal government income and expenditures. So increased government spending isn’t going to improve economic conditions. That leaves the consumer.

The payroll tax decrease is a highly inefficient method of increasing consumer spending because the beneficiaries don’t spend it all. Instead they look at their own financial situation and save some or all of the “largess” (or reduce outstanding debt, which is the same thing from their perspective). Nonetheless, if that money is yanked away from consumers, spending will decrease and since the government can’t make up the difference, total spending will decrease.

Decreased spending means lower demand for products, which means businesses will slow or stop their hiring and the double dip recession will be upon us. For Democrats that will be an election disaster. Even if voters “throw all the bums out” the Democrats are the bums who control the White House and Senate and could easily lose both. Even if the Republican bums in the House were replaced with Democrats, the net result would be a massive loss in Democratic power and increase in Republican power. No, the Democrats need to try to avoid that scenario.

Democrats have suggested “paying” for the continued payroll tax reduction by increasing the income tax on those earning over $1 million a year. Republicans, ignoring polling data that shows widespread public approval of higher taxes for the “rich,” have drawn a line in the sand. Democrats think a sirocco of public dissent will cause the Republicans to retreat on this issue. Some Democrats are chortling that they finally have the Republicans over a barrel.

Perhaps they are right; we’ll soon see, but my perspective is that the Democrats have the weaker bargaining position. Regardless of who is blamed for the “tax increase” should a stalemate mean the 2% payroll tax holiday comes to a screeching halt when the New Years’ ball in Times Square drops, the economy will quickly suffer and diminish Democratic chances for the 2012 elections—something, I think they’ll decide they can’t afford. Therefore, I expect the Democrats to cave first in order to reach a deal.

~ Jim