Posts Tagged ‘economy’

In Part XII: Bonds, reader Chronicrants commented:  “I’d love to see more on deflation. I’ve always been confused about it and about it’s consequences. It seems like it would be a good thing, and yet….”  Great point, and what better topic, I thought, for unlucky number 13 in this series!

lucky 13

Unfortunately, I forgot that was my plan and Withdrawal Rates got spot #13.  Sigh.  It’s tough getting old.

When deflation has come up in my previous posts it has been the ugly escort bringing Depressions to the Ball.  Indeed here in the USA we have had four depressions since our founding in 1776:  1818-21, 1837-43, 1873-96 (the duration record holder) and the one we think of most often:  The world-wide depression of 1930-33.  In each case deflation was there, walking side-by-side holding depression’s hand.

So what the heck is deflation anyway?  Simply put, it is the lowering of prices and the increasing of the value of money.

Hmmm….  As Chronicrants says, “It seems like it would be a good thing…”  In many cases, it is.  Let’s take a closer look.

Good Deflation.

One of the dynamic benefits of our economic system is the steady lowering of prices thru technological innovation and increased productivity.  Perhaps the clearest example of this in recent decades is the rapid fall in prices and improvement of products in the electronic/tech world.  The laptop or TV that was $2000 a few years back can be had now for $500.  People never tire of pointing out that we carry more computing power in our phones than that on the Apollo moon missions.

Apollo

Apollo Launch

Not Apollo, but here’s also a great sound track/video of a Space Shuttle launch.

As a percent of average earnings, the cost of food, housing and transport are all lower today than 50 years ago.  Yet thru innovation and productivity gains, the companies that provide these things are doing better as well.  Our money buys more of all these things and is thereby worth more than it was.  This is deflation, and it is a good thing.

Ugly Deflation.

Deflation turns ugly when prices drop for reasons other than increasing innovation and productivity.  This occurs during economic downturns.  At first, this too can be a good thing, but the danger is slipping into a Deflationary Spiral. It looks something like this:

Unemployment rises — Demand for goods slows — Prices come down — Profits drop — Companies cut production — Unemployment rises faster — Demand for goods slows further — Prices fall — Profits drop — Companies cut production — and on.  A few cycles of this and companies start folding and bread lines start growing.  The cycle can start with any of these points along the line.  It becomes a vicious circle that’s very tough to break.

Bowery-Bread-Line

Bowery Bread Line

Photo from:  Old Photo.com

The collapse of our housing bubble a few years back brought us to the edge of this abyss.  The antidote is a nice healthy dose of inflation and that’s exactly what the Federal Reserve has been trying to reignite.  It does this by lowering interest rates (now effectively zero) and pumping cash into the system.  The idea is this will break the cycle and get companies ramping up and people spending again.  It is an attempt to reverse the psychology.

The Psychology of Deflation.

Franklin Delano Roosevelt, the 32nd President of the United States (1933–1945), famously said, “The only thing we have to fear, is fear itself.”  He was talking about the psychology that threatened to mire the country in its deflationary depression.  Our housing crisis gives us an excellent tour of this in action.

Let’s suppose you were in the market to buy a house in 2005.  Prices had been rising for years and the pace was accelerating.  Every where you turned those who had bought were bragging about their gains.  If you waited, a year from now you might be paying 10-20-30% or more for that same house.  That not only raises your cost, it represents lost profit in your mind.  You are filled with an urgency to ink a deal.

Of course, you are not alone in this thinking.  Every time a house goes up for sale, scores of other people, driven by the same psychology, are competing with you for the privilege of buying it.  Meanwhile sellers, also realizing that their house is increasingly more valuable, become more reluctant and scarcer.  Up the prices go.  Endlessly, or so it seemed.

What we had was an Inflationary Spiral.  Just like with tulip bulbs in 1637, this bubble expanded till it burst.  Then, on a dime, the psychology reversed.

At a certain point, people just couldn’t afford to buy houses at the price levels they’d reached.  In fact, in this case with all the easy money that had been lent, many new owners couldn’t afford to own them in the first place.  Suddenly, houses went up for sale and no buyers showed up.  Prices softened.  Owners started to see their values drop.  They became more willing to sell, hoping to get out before prices dropped further.  Fewer houses sold, even as more came on the market.  Supply quickly outpaced demand.  Prices dropped again.

Potential buyers, of course, also saw this happening.  It didn’t take long to realize that now waiting to buy paid off. The house you looked at today would still be for sale tomorrow and for less.  Fewer people were able to buy and those that were, effectively got paid to wait.  If you’ve been wondering why real estate brokers are so eager to declare home prices are rising again, it is this.  Until buyers start to believe prices will be higher next year they’ll hesitate to buy now. Until then, housing is locked in this Deflationary Spiral.

The danger is, of course, that housing is a huge part of the economy.  When housing sales slow it spills into the sales of lumber, appliances, furniture, windows, HVAC, flooring, garden equipment and a raft of other stuff, along with the jobs related to them.  As those drop, other segments of the economy dependent on them and the folks that work for them get pulled down.  If enough get caught in their own whirlpools, the entire economy enters the deflationary spiral.  Next thing you know….

introductions

…Mr. Deflation is introducing you to Ms. Depression.

Deflation winners and losers.

As we’ve already seen, we all win thru the deflation of prices thru technological innovation and increased productivity.  And it’s not hard to see the losers in a deflationary spiral:  Companies fold, people get thrown out of work, investments collapse.  But even these ugly deflations have winners.

Remember, deflation is the lowering of prices and the increasing of the value of money.  Deflationary spirals simply accelerate this process.  You win if:

  • You hold cash.  This is why your depression era grandparents (or great grandparents) hoarded cash.  Deflation means cash buys more, it increases in value.
  • You hold bonds.  As you know from Part XII: Bonds, when you buy bonds you are lending your money. Deflation means that your money buys more when you get paid back at a later date.  Providing, of course, the bond issuer survives the depression and has the money to pay.  Default risk.
  • You are on a guaranteed fixed income.  Those on Social Security and fixed pensions would benefit as their income buys more goods and services.  Interestingly, Social Security has provisions to raise benefits in response to inflation, but none to lower them in times of deflation.  Same is true of most pensions.

Now before you go out and sell everything and stuff the money in your mattress, it is worth noting the Federal Reserve is working overtime to reignite inflation.  There is an old saying on Wall Street:  “Don’t fight the Fed.”  It is good advice.

“I wonder if it would actually be possible for every single person to retire a millionaire?”

That very provocative question was posed in the comments by reader mmrempen a few posts back.

 

It’s been rattling around in my brain ever since.

The short answer is a qualified “Yes!”  It is possible for every middle class wage earner to retire a millionaire.  But it’s never going to happen.  And that’s not because the numbers don’t work.

The numbers tell us that, compounded over time, it actually takes very little money invested to grow to $1,000,000. For instance, just $15,000 invested in the Dow stocks in 1975 would be worth over a cool million today.

Pretty amazing considering the financial turmoil of these past 37 years.  But compounding takes time. So it helps to start young.  Here’s a fun tool to play with:  http://www.globalrph.com/invcomp.cgi

Of course, a million dollars is a very arbitrary goal.  Perhaps the better question is:  Can everybody achieve financial independence?

Living Small

There are countless stories of people of modest income who by way of fugal living and dedicated savings get there in remarkably short time.  You can find some here.  If you can live on $7000 per year, $175,000 gets it done figuring an annual withdrawal rate of 4%.

Then too, I remember having lunch with a friend of mine a few years back just before Christmas. He’d just gotten his annual bonus: $800,000. He spent the lunch complaining that it just wasn’t possible to make ends meet on what he made. Listening to his expenses, he was right.  He’s burning thru more than 175k every three months.  Financial independence is a distant dream for him.

Money is a very relative thing.  Right now I have roughly $100 in my wallet.  For some people out there $100,000 has less relative value to their net worth.  For others, $1,000,000.  For still others it might be more than they’ll see in an entire year.

Being independently wealthy is every bit as much about limiting needs as it is about how much money you have.  It has less to do with how much you earn — high income earners go broke while low income earners get there — than what you value. Money can buy many things, none of which are more important than your financial independence. Here’s the simple formula:

Spend less than you earn – invest the surplus – avoid debt

Do simply this and you’ll wind up rich.  Not just in money.

If your lifestyle matches or, god forbid exceeds, your income you are no more than a gilded slave.

Let’s consider an example.  Suppose you make $25,000 per year and you decide you want to be financially independent.  Following some of the examples here you organize your life in such a fashion as to live on $12,500. Two important things immediately happen.  You’ve reduced your needs and you’ve created a source of cash with which to invest.

Assuming you’ll be FI (financially independent) when you can live on 4% of your net worth each year, you’ll need $312,500.  Investing your $12,500 each year in VTSAX and assuming an 8% annual return (far more modest than the actual 12% of the last 37 years) you are there in less than 15 years.  Use 12% and it takes about 12.

Now say you begin to live on the 4%/$12,500 your $312,500 nest egg can now provide.  But you decide you like working and want to continue for a few more years.  Since you’re living on your investments you can save your entire $25,000 earned income each year. Adding it to your pot and earning 8%, 11 years later you are at $1,091,000.

Or, suppose you say, “OK I’m done with saving and I’m going double my lifestyle and spend my full earned $25,000 from now on. But I’ll leave my nest egg alone.”  In 11 short years it will have grown to $675,000 without you having to add a single dime.  That yields $27,000 @ 4%.  You can now quit working and give yourself a raise.

For simplicity sake, yes, I’ve ignored taxes.  But we’ve also assumed you’ll never see an increase in income.  We are just doing a bit of “what if” analysis to help see that your money can buy you something far more valuable than trinkets and trash.

But few will ever even see this as an option.  There are pervasive and powerful marketing forces at working to obscure the idea that such a choice exists.  There’s a lot of money to be made persuading folks they really simply must have the latest in trinkets and the most fashionable of trash.

There is a huge marketing effort designed to keep people spending and in debt slavery. We are relentlessly bombarded with messages telling us that we need this, we must have that and if you don’t have the money, no problem.  That’s what credit cards and payday loans are for.  This is not an evil conspiracy at work.  It is simply business.  But it is deadly to your wealth.

buy our gin and you’ll find more than olives in your martini glass

The science behind the art of this persuasion is truly impressive and the financial stakes are huge.  The lines between need and want are continually and intentionally blurred.  Years ago a pal of mine had bought a new video camera.  It was the best of the best and he was filming every moment of his young son’s life.  In a burst of enthusiasm he said:  “You know, Jim, you just can’t raise a child properly without one of these!”

Ah, no.  Actually you can.  In fact, billions of children have been raised over the course of human history without ever having been video taped.  And, horrific as it may sound, many are still today.  Including my own.

You don’t have to go far to meet someone who will tell you about all the things they can’t live without.  You likely have your share.  But if you want to be wealthy, both by controlling your needs and expanding your assets, it pays to reexamine and question those beliefs.

One of my key objectives with this blog is to present another way.  If you’re still not so sure about the cost control part of the equation you might check out:

http://lackingambition.com/?p=911

and/or

http://www.mrmoneymustache.com/2012/05/14/first-retire-then-get-rich/

Our pal mmrempen followed up with another question:

“I wonder how much of our economic strength is based on reckless spending, and what would happen to it if EVERYONE started acting more responsibly with their money. I might well be out of the job!   After all, who needs to spend so much on movies?  (He is a film maker and you can check out his work here.)

“It’s no knock on your financial advice, now. Just a thought experiment.”

Still from a mmrempen film

No worries, MMR……my advice should be expected to stand up to a few knocks. :)

In fact, the whole wealth building point is to have plenty of money to do with your life as you choose. Some you’ll invest, some you’ll spend and both help drive the economy.

Your concern is based on a widely held view that consumption is the primary driver of economic success. Counterintuitive though it may be, it is only one part of a far more complex mosaic.

The concern that everyone might suddenly become responsible is a classic “non-problem.” “Non” because:

  1. It is unlikely to happen.
  2. If it does it will be at a very gradual rate allowing for easy adjustments.
  3. If it does it would be a very good thing.  Less consumption would make for a far more sustainable world. No small consideration with 6.5 billion of us running around.  Certainly such a change would cause a round of “creative destruction” as companies making and peddling trinkets and trash faced major adjustments.
  4. In a society with frugal, debt free, financially independent people the necessary and highly beneficial process of “creative destruction” vital to a dynamic economy is far less traumatic.

And my bet is they’ll still be going to movies.

That’s OK.  It’s about to start.

Today we’re gonna look at the fun stuff.  What, exactly, can we use to build and keep our wealth.

I’m going to give you three portfolios each using the tools (funds) we discussed last time.  First will be exactly what I tell my 20-year-old to do.  She could care less about investing.  With this simple approach she doesn’t have too.  All she needs to do is to keep adding to the pot and let it ride.  Years from now she’ll wake up rich.  Along the way she’ll out-perform roughly 80% of the more actively engaged investors out there.  We’ll call this The Wealth Building Portfolio.

Next I’ll share with you what Mr. and Mrs. jlcollinsnh do as the semi-retired couple we are.  We’ll call that one The Wealth Preservation and Building Portfolio.

Your personal situation is likely different from ours.  But using these two as parameters, and after reviewing your personal “considerations” as we discussed last time, you should be able to fashion the four tools into something that works for you.  If you have questions just post them in the comments and we’ll work thru them together.

Finally, I’ll share with you an idea I’ve been playing with of late.  Let’s call it The Wealth Building with Cash Insurance Portfolio.  I know I’ve got some pretty sharp investors reading this blog and I hope they’ll weigh in with some opinions on it.

The Wealth Building Portfolio.

Here’s the thing.  If you want to survive and prosper as an investor you have two choices.  You can follow Dr. Lo’s advice and seek out broad diversification with asset allocation.  Your hope is that this will smooth out the ride even as it reduces your long-term returns.

Screw that!  You’re young, aggressive and here to build wealth.  You’re out build your pot of F-you Money ASAP.  You want what’s behind door #2.  You’re going to focus on the best performing asset class in history:  Stocks.  You’re going to “get your mind right,” toughen up and learn to ride out the storms.

You’ve heard the expression, “Don’t keep all your eggs in one basket.”

You’ve likely also heard the variation, “Keep all your eggs in one basket and watch that basket very closely.”

Forget it.  Here’s what your old uncle jlcollinsnh says:

Put all your eggs in one basket and forget about it.  

The great irony of investing is the more you watch and fiddle with your holdings the less well you are likely to do.  Fill your basket, add as you go along and ignore it the rest of the time.  You’ll likely wake up rich.

Here’s the basket: VTSAX.  No surprise here if you’ve been reading along in this series so far.  Stock Index Fund.  Low cost so almost all our money is working for us.

Owning 100% stocks like this is considered “very aggressive.”  It is and you should be.  You have decades ahead.  Market ups and downs don’t matter ‘cause you avoid panic and stay the course.  If anything, you recognize them as the “stocks on sale” buying opportunities they are.  Perhaps 40 years from now you might want to add a Bond Index Fund to smooth out the ups and downs.  Worry about that 40 years from now.

At this point I can see the financial gurus of the world gathering feathers and heating up the tar.  So let me explain.

Previously, we explored the idea that financial crisis are just part of the landscape and the best results come from simply riding them out.  You can’t predict them.  You can’t time them.  Over your investing career you’ll experience many of them.  But if you are mentally tough enough you can ignore them.

So now if we agree that we can “get our minds right” what shall we choose for riding out the storm?  Clearly we want the best performing asset class we can find.  Just as clearly, that’s stocks.  If you look at all asset classes from bonds to real estate to gold to farmland to art to racehorses to whatever, stocks provide the best performance over time.  Nothing else comes close.

Not even close

Let’s take a moment to review why this is true.  Stocks are not just little slips of traded paper.  When you own stock you own a piece of a business.  When you own VTSAX you own a piece of every publicly traded business in the USA.  Many have extensive international operations so you get to participate in the world markets too.

These are companies filled with people working relentlessly to expand and serve their customer base.  They are competing in an unforgiving environment that rewards those who can make it happen and discards those who can’t.  It is this intense dynamic that makes stocks and the companies they represent the most powerful and successful investment class in history.

Because VTSAX is an index fund we don’t even have to worry about which will success and which will fail.  It is ‘self cleansing.’  The failures fall away and the winners can grow endlessly.

A portfolio of 100% stocks, which is what VTSAX gives you, in study after study provides the greatest return over time.  The only downside, and I mean only, is that the ride will be very rough at times.  Admittedly, it’s a big one.  If you are not tough enough to stay the course, if you get scared and bail when the storms are raging you are going to drown.  But that’s a failure in you, not a downside of this asset class.

As an aside, there are a few studies that indicate that a 80%/20%, stock/bond mix will actually outperform, very slightly, 100% stocks.  It is also slightly less volatile.  If you want to go that route and take on the slightly more complicated process, you’ll get no argument from me.

Could it really be this easy?  Yep.  I started investing in 1974.  At the time VTSAX had yet to be created (Bless you Jack Bogle!), but just $15,000 invested in the Dow stocks, and left to ride, by the end of 2011 would be $1,000,000. This despite all the panic and collapses and recessions and disasters that we’ve endured during these last 38 years.  Imagine what you’d have if you’d kept adding to the pot along the way.

Unfortunately, I wasn’t smart enough at the time to do it.  But this is the “Simple Path to Wealth” I created for my then 19-year-old daughter:  Put all your eggs into one basket, add more whenever you can and forget about it.  The more you add the faster you’ll get there.  Job done.

The Wealth Preservation and Building Portfolio.

But wait you say, I’m at or nearing retirement.  I’ve built my wealth.  Now I want to hang on to it.  I want a smoother ride.  What then?

Yeah, me too.  A few years ago as I was nearing my own retirement I made some additions to VTSAX.  Hold on now, this is going to get really complicated.  You’re going to have to add two more index funds.  Oh my!

We now enter the world of Asset Allocation and this will require slightly more of our time.  In addition to adding the additional funds we’ll want to decide how much to allocate to each.  Then once a year or so we’ll want to rebalance to keep the allocations where we want them.  This is also what you’ll be doing if you use the 80% stock/20% bond mix option above.  It’s going to take a couple of hours once a year.  You can handle it.

100% stocks, even in the broadly diversified VTSAX is considered very aggressive.  High short-term risk (read: gut wrenching drops) rewarded with top long-term results.  Perfect for those who can handle the ride and have the time.

But it’s not for everybody.  Maybe you don’t want to deal with this level of risk.  Maybe a bit more peace of mind is required.  As you get older you might want to smooth the ride a bit, even at the cost of lower overall returns.   You have to sleep at night.

Now that I’m kinda, sorta retired and we have F-you Money, me too.  My wife and I hold some other stuff in our portfolio.  But not much.   Here it is:

50% Stocks.  VTSAX (Vanguard Total Stock Market Index Fund)  Still our core holding for all the reasons we’ve discussed.

25%  Real Estate.  VGSLX  (Vanguard REIT Index Fund) and the equity in your home if you own one.  REITs (Real Estate Investment Trusts) invest in real estate.  They provide an inflation hedge and dividend income.  But during periods of deflation real estate prices plummet.

REITS are the Ying to our Bonds’ Yang.

20%  Bonds.  VBTLX (Vanguard Total Bond Market Index Fund) Bonds provide income, tend to smooth out the rough ride of stocks and are a deflation hedge.  But during times of inflation and/or rising interest rates they get hammered.

5%  Cash.   Cash is always good to have in hand. Cash is also king during times of deflation.  The more prices drop, the more your cash can buy.  But idle cash doesn’t have much earning potential and when prices rise (inflation) its value steadily erodes.

We mostly keep ours here:  VMMXX.   Money Market Funds used to offer higher yields than banks.  When rates rise they will again.  These days, with interest rates near zero, not so much.  Now we also keep some in our local bank.  If you prefer, an on-line bank like ING works fine too.

So that’s it.  Four simple tools.  Three Index Mutual Funds and a money market and/or bank account.  A wealth builder, an inflation hedge, a deflation hedge and cash for daily needs and emergencies.  Low cost, effective, diversified and simple.

You can fine tune these investments to your own personal considerations.  Want a smoother ride?  Willing to accept a lower long-term return and slower wealth accumulation?  Just increase the percent in VBTLX. Comfortable with volatility?  Want more growth?  Add more to VTSAX.  Expecting higher inflation?  Add more VGSLX .

The Wealth Building with Cash Insurance Portfolio.

Confession time.  I hate bonds and I’m not all that keen on REITs either.

The more I own of them the less I own of stocks and, as we’ve discussed, stocks are far and away the best performing asset class.  So, each dollar not in stocks is a dollar working below par.

Dollars in cash are completely lazing away in the sun drinking Pina-coladas.

Since I consider these dollars are my slaves I want them working full time all the time.

Problem is sometimes (to beat this analogy to death) financial panics and market collapses come along and kill off a bunch of my slaves working away in the stock market fields.  It’s nice then to have others less stressed to pull from the bond and REIT fields to take their place.  But still, even these tend to get wounded in a collapse.

The cash slaves on the beach their feet up in the lounge chairs, slathered sun tan oil and sipping cool drinks get fat and steadily worth less.  But when collapses come they are away from the bullets.  They are the most rested of all when I put them back to work.  Their laziness drives me crazy but when the crunch times come I always wish I had more of them.

Let’s look again at the The Wealth Preservation and Building Portfolio above, figuring we have a million in it:

  • 50% of our dollars in the stock fields working full tilt in the hot sun.  500k
  • 25% with easy duty in the REIT fields.  250k
  • 20% with really easy duty in the bond fields. 200k
  • 5% napping in the sun on the cash beach. 50k

You could easily pull about 4%/40k from it each year for your living expenses and ride out most financial storms.  But you are giving up a big slug of wealth building potential.  Since most financial storms last less than three years, maybe there’s a better way.  What if we did this:

  • 88% of our dollars working full tilt in the hot sun.  880k
  • 12% napping in the sun on the cash beach. 120k

Since most of the time the market goes up, this portfolio will have a far stronger ability to build wealth.  We can draw our 40k from the dividends and capital gains our stocks in VTSAX throw off.

When times get tough and stocks slide, we leave VTSAX alone and let it heal.  With a 120k/three year cushion in cash we can pull those dollars off the beach to spend in the meantime.

When times improve we go back to tapping VTSAX and we rebuild our cash position for the next cycle.

Mmmm.  I haven’t convinced myself just yet.  What do you think?

Disclaimer:  Like everything on this blog, this is only sharing ideas.  You are solely responsible for your own choices.

Simple is good.  Simple is easier. Simple is more profitable.

What I’m going to share with you in these next couple of articles is the soul of simplicity.  With it you’ll learn all you need to know to produce better investment results than 80% of the professionals and active amateurs out there.  It will take almost none of your time and you can focus on all the other things that make your life rich and beautiful.

How can this be?  Isn’t investing complicated?  Don’t I need professionals to guide me?

No and no.

Since the days of Babylon people have been coming up with investments, mostly to sell to other people.  There is a strong financial incentive to make these investments complex and mysterious.

Babylon

But the simple truth is the more complex an investment the less likely it is to be profitable.  Index Funds out perform Actively Managed Funds in large part simply because Actively Managed Funds require expense active managers.  Not only are they prone to making investing mistakes, their fees are a continual performance drag on the portfolio.

But they are very profitable for the companies that run them and as such are heavily promoted.  Of course, those profits come from your pocket.  So do the  promotion costs.

Not only do you not need complex investments for success, they actually work against you.  At best they are costly.  At worst, they are a cesspool of swindlers.  Not worth your time.  We can do better.

Here’s all we are going to need:  Three considerations and four tools.

The Three Considerations.

You’ll want to consider:

  1. In what stage of your investing life are you:   The Wealth Building Stage or the Wealth Preservation Stage?  Or, mostly likely, a blend of the two.
  2. What level of risk do you find acceptable?
  3. Is your investment horizon long-term or short-term?

As you’ve surely noticed, these three are closely linked.  Your level of risk will vary with your investment horizon.  Both will tilt the direction of your investing stage.  All three will be linked to your current employment and future plans.  Only you can make these decisions, but let me offer a couple of guiding thoughts.

Safety is a bit of an illusion. 

There is no risk free investment.  Don’t let anyone tell you differently.  If you bury your cash in the back yard and dig it up 20 years from now, you’ll still have the same amount of money.  But even modest inflation levels will have drastically reduced its spending power.

If you invest to protect yourself from inflation, deflation might rob you.  Or the other way around.

Your stage is not necessarily linked to your age.

You might be planning to retire early.  You might be worried about your job.  You might be taking a sabbatical.  You might be returning to the workforce after several years of retirement.  Your life stages may well shift several times over the course of your life.  Your investments can easily shift with them.

F-you money is critical.

If you don’t yet have yours, start building it now.  Be relentless.  Life is uncertain.  The job you have and love today can disappear tomorrow.  Nothing money can buy is more important than your fiscal freedom.  In this modern world of ours no tool is more important.

Don’t be too quick to think short-term.

Most of us are, or should be, long-term investors.  The typical investment advisor’s rule of thumb is:  subtract your age from 100 (or 120).  The result is the percent of your portfolio that should be in bonds.  A 60-year-old should, by this calculation, have 40% in conservative, wealth preserving bonds.  Nonsense.

Here’s the problem.  Even modest inflation destroys the value of bonds over time and bonds can’t offer the compensating growth potential of stocks.

If you are just starting out at age 20 you are looking at perhaps 80 years of investing.  Maybe even a century if life expectancies continue to expand.  Even at 60 and in good health you could easily be looking at another 30 years.  That’s long-term in my book.

Or maybe you have a younger spouse.  Or maybe you want to leave some money to your kids, grand kids or even to a charity.  All will have their own long-term horizons.

The Four Tools.

Once you’ve sorted thru your three considerations you are ready to build your portfolio and you’ll need only these four tools to do it.  See, I promised this would be simple.

1. Stocks.  VTSAX (Vanguard Total Stock Market Index Fund)  You’ve already met this fund in earlier posts of this series.  It is an index fund that invests in stocks.  Stocks, over time, provide the best returns and with VTSAX, the lowest effort and cost.  This is our core wealth building tool.  But, as we’ve discussed, stocks are a wild ride along the way and you gotta be tough.

2.  Bonds.  VBTLX (Vanguard Total Bond Market Index Fund) Bonds provide income, tend to smooth out the rough ride of stocks and are a deflation hedge.  Deflation is what the Fed is currently fighting so hard and it is what pulled the US into the Great Depression.  Very scary.   The downside for bonds is that during times of inflation and/or rising interest rates they get hammered.

3.  Real Estate.  VGSLX  (Vanguard REIT Index Fund)  REITs (Real Estate Investment Trusts) invest in real estate.  They provide an inflation hedge and, typically, dividend income.  REITs allow us the benefits of ownership without the headaches of actively buying and managing properties.  But during periods of deflation real estate prices plummet.  That’s exactly what’s been happening to home prices these past few years.

REITS are in a sense the Ying to our Bonds’ Yang.

4.  Cash.   Cash is always good to have in hand.  You never want to have to sell your investments to meet emergencies.  Cash is also king during times of deflation.  The more prices drop, the more your cash can buy.  But idle cash doesn’t have much earning potential and when prices rise (inflation) its value steadily erodes.

We tend to keep ours here:  VMMXX   This is a Money Market Fund and time was they offered higher yields than banks.  These days, with interest rates near zero, not so much.  Now we also keep some in our local bank.  If you prefer, an on-line bank like ING works fine too.

So that’s it.  Four simple tools.  Three Index Mutual Funds and a money market and/or bank account.  A wealth builder, an inflation hedge, a deflation hedge and cash for daily needs and emergencies.  Low cost, effective, diversified and simple.

You can fine tune the investments in each to meet the needs of your own personal considerations.  Want a smoother ride?  Willing to accept a lower long term return and slower wealth accumulation?  Just increase the percent in VBTLX.

Next time we’ll talk about a couple of specific strategies and portfolios to get you started.

Meanwhile, a brief note on….

You will have noticed Vanguard is the company that operates all of these funds.  It is the only investment company I recommend, and the only one you need (or should) deal with.  Vanguard’s unique structure means that its interests and yours are the same.  Vanguard the company is owned by the Vanguard funds.  In other words, by us, the fund shareholders. This is unique among investment companies.

Awhile back a commentator on Reddit, referring to one of my posts, said:  “This really just looks like a commercial for Vanguard.”  I can see his point, although I wish he’d made it directly on here.

I am a huge Vanguard fan, but I am not on their payroll and I have no financial interest in the company other than owning the funds I describe.

You might find an index fund in another investment company that is a bit cheaper.  They create some as “loss leaders.” But you can’t trust these other companies long-term.  Their interests are not your interests.  Their interests lie in making money for their owners.

If you play with snakes, to quote Dave Ramsey, you’ll eventually get bitten.

Don’t bother.  Stick with Vanguard.

Disclaimer:  Like everything on this blog, this is only sharing ideas.  You are solely responsible for your own choices.

Deflationary Depressions and Hyperinflation

So far we’ve seen that the stock market is a wonderful wealth building tool that goes relentlessly up.  Vanguard’s Total Stock Market Index Fund (VTSAX) is the only tool we need to access it.

But it is extremely volatile, crashes routinely and most people lose money due to their psychological tendencies.  Still, if we toughen up, ride out the turbulence and show a little humility regarding our investing acumen this is the surest path to riches.

Except……

Stock Market 1900 – 2012

There, in 1929, is the Big Ugly Event.  The Mother of all Stock Market Crashes and the beginning of the Great Depression.  Over a two year period stocks plunged from 391 to 41, losing 90% of their value along the way.  Should you have been unlucky enough to have invested at the peak, your portfolio wouldn’t have fully recovered until the mid-1950s.  26 years.  Yikes.  That’s enough to try the toughest investor.

Of course, if you had been buying stocks on margin (that is with borrowed money) you would have been completely wiped out.  Many speculators were.  Fortunes were lost overnight.

Lesson #1:  Never buy stocks on margin.

Lesson #2:  If a time comes when you are reading and hearing about people routinely making fortunes in an aggressively rising market using margin, something very, very bad is around the corner.  (Joseph Kennedy is said to have known it was time to exit the market in early 1929 when he started getting stock tips from shoe-shine boys.)

Lesson #3:  If you see Lesson #2 forming it is a good time to take your chips off the table.  Very tough to do when everybody is making “easy” money.

Lesson #4:  Once the crash comes, it is too late.

So what to do?

Does the possibility of another Big Ugly Event blow a big enough hole in this idea of “toughen up and ride out the storms” to make it useless?  The answer to that has everything to do with your tolerance for risk and your desire to build wealth.  There are ways to mitigate the risk and we’ll talk about them next time.

For now, let’s step back and consider a few things regarding The Big Ugly:

1.  It would have taken an investor of exceptionally bad luck to have borne the full weight of the the crash.  You would have had to buy precisely at the 1929 peak.

Suppose instead you had invested in 1926-27.  Looking at our chart this is about halfway up on the climb to the peak.  Many, many people were entering the market in these years.  Certainly they were destined to lose all their gains, and yet 10 years later, had they held on, they’d be back in positive territory.  Although another rough stretch was coming.

Suppose you’d bought at the earlier peak in 1920.  You would have taken an immediate hit and recovered five years later.  From the collapse in ’29 you’d be back even by 1936.  Seven years.

The point is that any given start would have likely been different and yielded an outcome not as severe as the widely quoted 90% loss, peak to bottom.

2.  Suppose you were just out of school and beginning your career in 1929.  Assuming you were in the fortunate 75% that kept their jobs, you would have had decades of opportunities to buy stocks a bargain prices.  Ironically, a crash at the beginning of your investing life is a gift.

3.  Suppose you were retired with a million dollars in today’s money.  By 1932 your stash is down 90%, to 100k.  Terrible for sure.  But remember the Depression was deflationary.  That means prices fell dramatically.  And that means your $100,000, while no longer a million, now has far more buying power than 100k did pre-crash.  Plus, it is poised to grow rather sharply from this low.

4. The Big Ugly Event has happened only once in the last 112 years.  Longer actually, but that’s how far back our DJIA data goes.  We haven’t had another in 83 years.  These are really rare.

5.  Many changes in economic policy were made post-1929 that, so far, have worked.  In 2008 we came right to the edge of the abyss.  Closer I think than most folks fully appreciate.  But we didn’t tumble over.  This I find encouraging.

Looking for Balance

What is not so encouraging is that a Deflationary Depression like that of ’29 is only one of the two possible economic disasters that can destroy wealth on a major scale.

The other is Hyperinflation.

Here in the USA we haven’t had to deal with this monster since the Revolutionary War way back in 1776.  But it destroyed Zimbabwe’s economy as recently as 2008.  Hungary had the worse case of it in history and many credit the German hyperinflation of the 1920s with ushering the Nazis to power in the 1930s.

Hyperinflation is very bad news, every bit as destructive as deflation, and it is exactly what it sounds like:  Inflation running out of control.

Zimbabwe money changer

A little inflation can be a very healthy thing for an economy.  It keeps the wheels greased and running smoothly.  It is the antidote to looming deflationary depressions.  This is why our Federal Reserve has been working overtime pumping money into the system these past few years.  We very much need to get some inflation going.  But, not too much.  It is a tricky balance and once in motion it can be hard to change direction.

In a deflationary environment delayed buying decisions are rewarded.  If you were considering a new house of late you would have noticed that prices are dropping, along with mortgage interest rates.  So you wait.  You can get both for less later. If enough potential buyers join you, prices and rates drop further.  Delay is further rewarded and action is punished.  Too much of this and the market slips into a deadly spiral of crashing prices.

But when inflation is high and growing, anything you want to buy will cost more tomorrow than today.  Buy that house (or car, or appliance or anything else) today and beat the price increase.  Delay is punished with higher prices later and action is rewarded.  Buyers become ever more motivated.  Sellers become ever more reluctant.  Too much of this and the market slips into a deadly spiral of increasingly worthless currency people are desperate to exchange for goods.

“Hyperinflation is often associated with wars or their aftermath, political or social upheavals, or other crises that make it difficult for the government to tax the population.”  Mmmm.  The quote is from Wikipedia and sounds a lot like our current situation to me.

Governments love a little inflation.  They can add money to the system, keep the economy humming and not have to raise taxes or cut spending to do it.  In fact, it is sometimes called “the hidden tax” because it erodes the buying power of our currency.  It also allows debtors, like the government, to pay back their creditors with “cheaper dollars.”

Given all this, it is hard not to see increasing inflation on our horizon.  In fact, it is far more likely today than any deflationary depression.

The good news for our VTSAX wealth building strategy is that stocks are a pretty good inflation hedge, as long as it is moderate and builds slowly.  After all, as we’ve discussed, in owning stocks we own businesses.  These businesses have assets and create products.  The value of those rises with inflation.

Still, if inflation rises too far too fast we’ll want to have something that reacts more quickly. So too for deflation.

The decision every investor must make is how much risk to accept in the wealth building process.  Looking at the past 100+ years, you have to ask yourself whether it makes sense to focus on the Big Ugly or to invest for the relentless rise that dominates.

None of this is to say that Big Ugly Events are not very scary and destructive things.

But they are rare and in the context of our overriding approach —Spend less than you earn – invest the surplus – avoid debt — they are survivable.

This is the first post of the blog:

https://jlcollinsnh.wordpress.com/2011/06/02/the-monk-and-the-minister/

The more able you are to live like the Monk, the more likely you are to live like the Minister.

Next time we’ll look at specific investments to build and protect our wealth.  As I promised in Part I, you won’t believe how simple it is.

Disclaimer:  Like everything else on this blog, this is only sharing ideas.  You are solely responsible for your own choices.

 Avoiding panic when it is raining stock brokers ain’t easy

On what was later to be called Black Monday, in 1987, at the end of a very busy day I called my broker.  Remember now, this was when we had brokers and before cell phones, personal computers, the internet and on-line trading.

“Hi Bob,” I said cheerfully.  “How’s it going.”

There was a long silent pause.  “You’re kidding,” he said.  “Right?”  He sounded dreadful.

“Kidding about what?”

“Jim, we’ve just had the biggest meltdown in history.  Customers have been screaming in panic at me all day. The market is down over 500 points.  Over 25%.”

That was the point at which I joined the rest of the planet in being absolutely stunned.  It is hard to describe just what this was like.  Not even the Great Depression had seen a day like this one.  Nor have we since.  Truly, it looked like the end of the financial world.

Time Magazine, 1987

Wrong

As any educated investor does, I knew that the market was volatile.  I knew that on it’s relentless march upwards there could and would be sharp drops and bear markets.  I knew that the best course was to hold firm and not panic.  But this.  This was a whole ‘nother frame of reference.

I held tight for three or four months.  Stocks continued to drift ever lower.  Finally, I lost my nerve and sold.

I just wasn’t tough enough.  That day, if not the absolute bottom, was close enough to it as not to matter.  Then, of course and as always, the market began again its relentless climb.  The market always goes up.

It took a year or so for me to regain my nerve and get back in.  By then it had passed its pre-Black Monday high.  I had managed to lock in my losses and pay a premium for a seat back at the table.  It was expensive.  It was stupid.  It was an embarrassing failure of nerve.  I just wasn’t tough enough.

But I am now.  My mistake of ’87 taught me exactly how to weather all the future storms that came rolling in, including the Class 5 financial hurricane of 2008.  It taught me to be tough and ultimately it made me far more money than the education cost.

Here’s the thing you need to understand:

The market always goes up.

Always.  Bet no one’s told you that before.  But it’s true.  Understand this is not to say it is a smooth ride.  It’s not.  It is most often a wild and rocky road. It’s not easy.  Reader JTH in the comments for Part I says:

“We’ve stayed the course, with a side-dish of panic.”

Great line there JTH, and staying the course is always served with a side dish of panic.  That’s why ya gotta be tough.

Because the market always, and I mean always, goes up.  Not each year.  Not each month.  Not each week and certainly not each day. But relentlessly up.  Take a moment and look at this:

The Dow Jones Industrial Average 1900 – 2012

Can you find my ’87 blip?  It’s there and easy to spot, but not quite so scary in context.  Take a moment and let this sink in.  You should notice three things:

1.  Trend is relentlessly, thru disaster after disaster, up.

2.  It’s a wild ride along the way.

2.  There is a Big, Ugly Event.

Let’s talk about the good news first.  We’ll tackle points 2 & 3 next time.

To understand why the market always goes up we need to look a bit more closely at what the Market actually is.

The chart above represents the DJIA (Dow Jones Industrial Average).  We are looking at the DJIA because it is the only group of stocks created as a proxy for the entire stock market going back this far.  Way back in 1896 a guy named Charles Dow selected 12 stocks from leading American industries to create his Index.  Today the DJIA is comprised of 30 large American companies.

But now let’s shift away from the DJIA Index, which I only introduced for its long historical perspective, to a more useful and comprehensive Index:   MSCI US Broad Market

If you click on that link it will take you to a article announcing that Vanguard is using this Index in crafting the Vanguard Total Stock Market Fund (VTSAX).  The Index and VTSAX are exactly what they sound like:  Groupings of every publicly traded US based company. By design they are almost precisely the same.  Since we can invest in VTSAX, going forward I’ll be using it as our proxy for the Stock Market overall.

In 1976, when John Bogle invented the Index Fund he gave the world a wonderful way to invest in the entire US Stock Market.  This is the single best tool we have for taking advantage of the market’s relentless climb up.  VTSAX is the market and as such does the exactly the same.

OK, so now we know what the stock market actually is and we can see from the chart that it always goes up.  Let’s take a moment to consider, how can this be?  Two basic reasons:

1.  The Market is self cleansing.  

Take a look at the 30 DJIA stocks.  Care to guess how many of the original 12 are still in it?  Just one.  General Electric.  In fact, most of these companies didn’t exist when Mr. Dow crafted his list.  Most of the originals have come and gone or morphed into something new. This is a key point:  The market is not stagnant.  Companies routinely fade away and are replaced with new blood.

The same is true of VTSAX.  It holds every stock in the US market. About 5,000.   Now, picture all 5000 of these companies along a classic bell curve graph.

Generic Bell Curve Graph

Those few at the left will be the worst performing.  Those few to the right, the best.  All those between at various points of performance.

Ok, looking to the left what is the worst possible performance a bad stock can deliver?  It can lose 100% of its value.  Then, of course, it disappears never to be heard from again.  As new companies grow, prosper and go public they replace the dead and dying.  The Market (and VTSAX as proxy) is self cleansing.

Now let’s look at our top performers on the right.  What is the best performance they can deliver?  100%?  Certainly that’s possible.  But so is 200, 300, 1000, 10000% or more.  There is no upside limit.  As some stars fade, new ones are on the rise.

The net result is a powerful upward bias.

But note, this only works with index funds.  Once “professional management” starts trying to beat the system, all bets are off.  They can, and most often do, make things much worse and they always charge more fees to do it.  We’ll talk a bit more about this in a later post.

2.  Owning stocks is owning a part of living, breathing, dynamic companies, each striving to succeed. 

To appreciate why the Stock Market relentlessly rises requires an understanding of what we actually own with VTSAX.  We own, quite literally, a piece of every publicly traded company in the USA.

Stocks are not just little slips of traded paper.  When you own stock you own a piece of a business.  These are companies filled with people working relentlessly to expand and serve their customer base.  They are competing in an unforgiving environment that rewards those who can make it happen and discards those who can’t.  It is this intense dynamic that make stocks and the companies they represent the most powerful and successful investment class in history.

So, now we have this wonderful wealth building tool that relentlessly marches upward but, — and this is a major but that causes many if not most people to actually lose money in the market — boy howdy it’s a wild and unsettling ride.  Plus, there’s that Big, Ugly Event.  We’ll talk about those next.

Disclaimer:  Like everything on this blog, this is only sharing ideas.  You are solely responsible for your own choices.

Previously:  Part IV:  I Become a Landlord

Part V: Sold! and the taxman cometh.

One of the few good things to come from all this was the bond and friendship we owners developed.

My pal, whose name I have somehow shamefully managed to forget, was now the Condo Association president and he kept an eye on my place for me as it sat empty.  He knew I was desperately interested in selling.  One happy day a woman approached him to ask if he knew of any units available for sale in the building.

“Well,” he said “this is a very desirable building and units rarely come on the market.  But, as luck would have it, I do know one owner who might be persuaded to part with his.”  And he gave her my number.  Bless you and your subtlety, my friend.  I should have remembered your name.

It took a lot to get this place sold

When she called my heart, as my old Medicine Man pal would have said, soared with the eagles.  I wasted no time in arranging a business trip to Chicago.

We met.  I showed her the apartment.  She loved it.  (It was, despite the bitter tale surrounding it, quite a nice place.)  Turns out her boyfriend lived in the building and they wanted to be closer together.  Guess what?  His unit and mine shared an adjoining wall.  They could, if they so choose, break this wall and create a single grand space.

Not only was this the building she wanted, my apartment was for her the most perfect one.  If only she’d been stupid my stars would have been fully aligned.  She was not.  She was, curse it all, a lawyer.

“How much do you,” she said cooly, “want for the place?”

“Well,” I said as nonchalantly as I could manage, “I hear condo prices have been flat these past few years.  I paid 45k for it back in ’79.  I could let it go for that.”  And then celebrate uncontrollably till my eyes fell out.

“I’ll give you 35k,” she said, not blinking.  This is a beautiful moment; when in the course of negotiations you get to a price that works for you and the rest is just how much icing will be on this cake.  The weight of years was finally lifting.

A bit of back and forth and we settled on 40k, not coincidentally what I owed the bank.

The deal went thru without a hitch.  It was the middle of 1985.  After six long years I was free and it only cost me $26,960.  $5000 loss on the sale and the $21,960 total of the monthly losses.

Of course, I’d had some tax breaks along the way that softened this a bit, but who’s counting?

The IRS, as it turns out, was counting.

According to them, I had a $15,000 profit and I now owed a $3000 (20% at the time) capital gains tax on it.  Surprised?  Well maybe not if you’re one of the real estate pros who read this blog, but I was stunned.

For the rest of us, here’s how.

As I mentioned, with all that cash bleeding away each month, I was desperate for some relief.  Turns out when you own investment real estate the acceptable business model allows you to assume the building will wear out over time.  This is called “depriciation” and it is considered an operating expense.  As such, it is deductable in the eyes of the IRS.  Further, back when I was doing this there was an option called “accelerated depriciation” and this is exactly what it sounds like.  You can choose to state that your building is wearing out at a faster rate and thereby take a larger deduction.  Of course, I grabbed this with both hands like the drowning man I was.

Now here’s the thing.  The IRS is nobody’s fool.  When you sell they are going to want their cut on your capital gain.  Your captital gain (or loss) is not the differnce between what you paid and what you sell it for. It is the difference between your “cost basis” and what you sell it for.

“But wait,” I hear you say, “you sold at a loss, Jim.  You sold for 40k and you paid 45k.  There is no gain to tax.”  You are half right.  There is no gain, but there is a 15k “profit” to tax. “Cost basis,” you see, is an entirely different thing that what you paid for the place.

The problem is the depricition I’d been taking must now be accounted for.  It amounted to 20k over the years.  This 20k reduced my cost basis from the 45k purchase price to an adjusted cost basis of 25k.  Since I sold for 40k, voila!  A 15k taxable gain.

The taxman givith and the taxman taketh away.

Here, finally, my sad tale ends.  This is the final tally:

$21,960 in operating losses

$5,000 capital loss on the sale

$3000 capital gains tax

$29,960 down the tubes.  That, my friends, in the early 1980s was serious cash.  When I really want to depress myself I calculate that invested in a fund like VTSAX it would be worth around a quarter million dollars by now.

I shoulda bought a Porsche.