Sep. 5, 2006 - Market Update 8/31/2006

We started the year wondering how 2006 might treat investors after a pretty good 2005.  In fact, I featured two writers who looked at the same data and trends, yet arrived at different conclusions for the upcoming year.

So where are we now?

As Charles Dickens might say, "It was the best of times, it was the worst of times."

The year started out with a boom through about the end of April.  It felt like 1999 again.  Then the bottom fell out during May and June.  It felt like 2000 through 2002 again.

We've suffered through bouts of angst over inflation, a slowing economy, record energy prices, a talkative Fed chairman, terrorist plots here and abroad, hurricanes in the Gulf of Mexico, nuclear nutcases on the Strait of Hormuz, the war in Iraq/Afgahnistan, and the upcoming Congressional elections.  There is always plenty to worry about in this world.

After all of that, the market has managed to eek out some pretty decent gains year-to-date as reported in today's Wall Street Journal (subscription only).  Here is a summary:

•   7.90%  Dow Jones Industrial Average
•   5.80%  Large-Cap Stocks (S&P 500)
•   2.43%  Mid-Cap Stocks
•   7.79%  Small-Cap Stocks
• 12.22%  International Stocks (MSCI EAFE) excluding currency effects

Not bad considering where we've been this year.

Based on these numbers, a well-diversified stock portfolio ought to have performed right around 7% according to a quick back-of-the-envelope calculation.  How are your investments doing?

Who knows where we'll end up for 2006 but I'm sure there will be plenty of excitement in the months to come.  Let's hope the current trend continues.

Apr. 4, 2006 - Nigerian Soccer and Investing

Check out this interesting headline:

"Take Bribes but Be Fair, Soccer Refs Told"

You are not hallucinating. 

That is the headline from a Reuters story on March 31 about referees in the Nigerian Football League being allowed to accept bribes from teams.  To maintain the integrity of the game, however, officials are instructed to "only pretend to fall for the bait, but make sure the result doesn't favor those offering the bribe."

They must be joking.  As a sports fan, such a practice astounds me but it appears to be true.

So what does this have to do with investing?

Believe it or not, a similar game is played at many investment firms in the United States.  It's called "revenue sharing."  Revenue sharing is when a mutual fund company pays an investment firm to promote its mutual funds over those of its competitors.  This is perfectly legal.

To understand how this crazy system works, let's stick with the soccer analogy.

• The referees are the investment firms you trust to help you make wise investment choices.
• The soccer teams are the mutual fund companies competing to attract your investment dollars.
• Your money is the prize that goes to the victor.

You put your trust in the investment firm to call a fair game between the available mutual fund companies and to help you achieve your investing goals. 

Unlike Nigerian soccer, however, in this game the investment firm actually tells you that the revenue sharing payments will likely impact the advice you receive and that it will be biased toward the mutual fund companies paying the most money.  That is, the outcome of the "game" is for sale to the highest bidders.  

And it's a big sale.

For example, Edward Jones reports that it received $172 million in revenue sharing payments in 2005, comprising 52% of the firm's total profit of $330 million!

Go read what Edward Jones has to say about its revenue sharing practices to get a flavor for what's at stake.

This game is played all over Wall Street at notable firms such as Morgan Stanley, Merrill Lynch, UBS, Ameriprise, Smith Barney, A.G. Edwards, etc.  It's not always described as "revenue sharing" but the result is the same -- you will be offered a smaller list of mutual fund choices.

The problem for you is that the recommended mutual funds may not be the best performing or least expensive investments on the market.  In the end, you foot the bill for revenue sharing.

It makes Nigerian soccer refs look tame.

[PS - Welcome readers from AllFinancialMatters.  Thanks for the link JLP.]

Related Tags: mutual funds, personal finances, investing, revenue sharing, Edward Jones, Morgan Stanley, Merrill Lynch, UBS, Ameriprise, Smith Barney, A.G. Edwards

Feb. 6, 2006 - Inflation, Taxes, & Investment Expenses

I read an interesting study published by Thornburg Investment Management that should be required reading for every investor. It is also an invaluable tool for parents wishing to teach fundamental financial principles and skills to their children.

The title of this 4-page gem is "A Study of Real Real Returns" and is available to download in pdf.

"What," you may be wondering, "are real real returns and why should I care about them?"

Inflation, Taxes, & Investment Expenses -- Oh My!

In short, real real returns measure the impact of the three most destructive financial forces on earth -- inflation, taxes, and investment expenses. The point of the study is to understand exactly how much gain an investor is left with after factoring in this terrible trio.

The fantasy world of advertising inundates us with data about investment returns from money market interest rates to stock and mutual fund gains. The financial media and others tout the glories of the latest investing fads such as gold, real estate, or oil. Then we hear from family, friends, or co-workers about their latest investment schemes and tips. Everyone has a success story to tell. On and on it goes, yada yada yada.

Forget the fantasy world. At the end of the day, the only statistic that matters is how much money you put in your pocket. All you care about is the real result to you. That's what real real returns measure.

You Will Be Shocked

Let's consider the 20-year period through the end of 2004. During this time, inflation averaged 3.00% per year. Doesn't sound like much but it adds up. According to the study, here are the real real returns of different investment categories after subtracting the impact of inflation, taxes, and investment expenses.

• S&P 500 Index (stocks) = 7.20%
• Municipal "A" Long Bonds = 3.11%
• U.S Treasury T-Bill = -0.02%
• U.S. Treasury 5-Year Notes = 0.87%
• U.S. Treasury Long Bonds = 1.31%
• Single Family Homes = 1.15% 

At 7.20% the returns for the S&P 500 look pretty good and are the clear winner. Other than municipal bonds at 3.11% everything else is anemic. Consider, however, that we witnessed the greatest bull market over the last 20 years which somewhat skews this result. The long-term (1926-2004) real real return for the S&P 500 is 4.96%. The good news is that it's possible to gain ground. The bad news is that it's not quite as much gain as "advertised." 

What About Investment Risk?

The above results should give you something to think about when it comes to measuring investment risk and selecting your investments.

Do you think stocks are risky? They are in the sense that their prices are volatile and you can lose your entire investment. (Note - diversification can mitigate much of that risk.) On the other hand, stocks are also the only investment that has gained significant ground over time as noted above. Stocks are king when it comes to building wealth for your future. You're not going to get very far by taking the "safe" route.

Do you think U.S. bonds or your home are safe investments? They are in the sense that they are not volatile in price like stocks, especially on a day-to-day basis. On the other hand, you will just barely make any money on either one as an investment. For example, that nice little house your folks purchased in 1975 for $75,000 must sell today for $273,000 just to keep pace with inflation, never mind the commission for selling it or the maintenance costs and taxes paid over the last 30 years. 

It takes risk to overcome inflation, taxes, and investment expenses. But I ask you which is riskier, the possibility that you might lose some money in stocks or the certainty that you will just barely keep pace with inflation, or maybe lose ground, with "safe" investments? Your greatest risk is taking the safe route when saving for the long-term.

What About "Hot" Investments?

This study got me thinking about several "hot" investments being touted these days, particularly gold. So I checked to see how gold has fared over the last 21 years.

Gold closed at $436/ounce at the end of 1984 and currently trades at $572/ounce. That's an increase of $136 or 31%. Sounds good until you look at the real real return. To keep pace with inflation only, the price of gold should be $819/ounce today. That's a 30% loss in buying power at today's price!

Just be thankful you didn't buy gold at its peak of $850/ounce in 1980. The inflation-adjusted price today is $2,015. That means an unfortunate investor at that time would have lost 72% buying power over the last 25 years!

A similar story could be told about oil and other commodities. Thus, despite all the hype about gold, oil, and other commodities, they remain poor-performing investments over time.

Conclusion

When investing consider all the risks, but especially the impact of inflation, taxes, and investment expenses on your investment results. They make or break you in the real world.

Ignore them at your peril.

Jan. 9, 2006 - Whither the Market in 2006?

It happens at every social gathering I attend.  At some point, someone asks me what I think the stock market is going to do.  This scenario was replayed several times during the recent Christmas season.

As usual, my inquiring acquaintances were disappointed to learn that I -- contrary to popular opinion -- do not own a crystal ball.  I'm glad they asked the question, however, because it provided a teaching moment that may save them some time and money someday.

Pay attention!  It may save you too.

It is natural for us to want to know the future, especially when it comes to our money.  Wouldn't you like to know what the stock market is going to do so that you could profit from it?  If only we could discern the "secret" to unlock vast treasures of wealth for our benefit.  Any little tidbit or insight will suffice -- something to give us an edge over other investors.

Such a "secret" does not exist anymore than pots of gold at the end of rainbows.

Yet people will scour reams of data, concoct elaborate theories, and invoke some of the goofiest superstitions imaginable -- and bet their financial futures on the outcome -- all in the name of discovering the "holy grail" of investing.

What you will quickly find when discerning the market tea leaves, however, is that two people can look at the same data or situation and draw opposite conclusions.  For example, below are 2 articles from January 1st which look ahead to the market's direction for the coming month and year.  Check out the headlines:

• "Stars May Be Aligned for Jan. Stock Rally" by Michael Martinez, AP

• "Are Bears Roaming Broad & Wall?" by Emily Chasan, Reuters

Both writers draw from similar historical information and discuss the same upcoming events, but paint very different pictures for 2006.  Who is right?

It depends on whom you want to believe.

Optimists subscribe to the rosy scenario and pessimists gravitate to the bleak scenario.  Both present rational cases for their views.  So which one are you?

It doesn't really matter.  The market will do what it's going to do whether or not you're an optimist or pessimist.

Rather than worry about the market direction or enter into endless debates between optimists and pessimists, I have found the following to be reliable guidelines for investing:

1.  Select investments appropriate for your goals and time horizon.

2.  Don't make changes based on a whim.

3.  Stay within your tolerance for risk.

4.  Diversify, diversify, diversify.

5.  Rebalance your portfolio periodically.

Not everyone agrees with such an approach.  There are those who insist the "holy grail" of investing is out there.  Some even claim to have found it.  But those claims are a little dubious since these same folks appear to make more money from selling us their ideas rather than from simply investing based on their ideas.  

To paraphrase one of Wall Street's most respected figures, Burton Malkiel, picking the next hot stock is like finding a needle in a haystack -- so just buy the haystack.

That goes not only for picking the next hot stock, but also for discerning the next investment fad, playing a "secret" formula or method, or trying to "time" the market.  They're all needles in the haystack.

What counts is how you build the haystack, not finding the needle.

No matter what you do, best wishes to you and your investments in 2006!

Dec. 16, 2005 - Mirage in the Desert

Several years ago, I received a call from an elderly couple I had been working with for only about 6 months.  An insurance salesperson had been over to visit them and was touting a new-fangled insurance product that appeared to be fool-proof -- equity-indexed annuities (EIAs).  The couple wondered if I thought an EIA might be a good idea for them.

I'm glad they called me before signing any papers because they were about to walk blindly into an investment that would have been disastrous for them but lucrative for the insurance salesperson.

How equity-indexed annuities work.

EIAs allow a person to invest in a stock market index (like the S&P 500) but without any downside risk (supposedly).  That is, the EIA guarantees an investor will at least break even or receive a modest return on the principal investment.  In exchange, the investor accepts a cap on the gains of the stock market index (and hence on the investment principal) and usually forgoes any dividends from the index.  So, in a bad year there are no losses, but in a really good year the returns are artificially restricted to a maximum percentage (say 8% or so).

In short, EIAs promise no losses while providing some upside potential.

This is a powerful and appealing investment alternative to seniors who are cautious of losing any money.  That was certainly the case with my client who called.  Before signing on with me, they had suffered horrendous losses during the bear market of 2000 to 2002 (mostly due to a lack of diversification and inappropriate investment choices, but that's another story altogether).  Who could blame them for being skittish?

Insurance companies understand older investors are skittish and play up those fears.  That's why EIA investments have grown so much in the last 5 years.  (Of course, it helps that the insurance salesperson earns a 9% to 10% commission.  That might also explain why EIAs are suddenly so popular).  But I digress.

It's a mirage in the desert.

While tantalizing on the surface, EIAs are really just piles of sand in the desert -- dry and bitter tasting.  In the specific case of my client, I was able to show this couple how much further behind they would have been over the last 5, 10, 15, 20, and 25 years by using the particular EIA presented to them versus just simply investing in an S&P 500 Index mutual fund directly.  The investment returns of the EIA were paltry by comparison.  They happily followed my counsel and avoided this bad investment.

Other studies now confirm how bad EIAs really are.

I was reminded of this episode with my elderly client when I saw a column in the Wall Street Journal last Wednesday (12-14-2005).  This column tackled the realities of equity-indexed annuities by highlighting recent research on this subject.

One study cited in the article was done by MassMutual Financial Group, a large insurance provider that does not sell equity-indexed annuities.  The MassMutual study came up with the following annualized returns over the 30 years ending in December 2003:

• S&P 500 Index with dividends reinvested:  12.2%
• S&P 500 equity-indexed annuity:  5.8%

By comparison, the columnist notes, an investment in perfectly safe, plain vanilla U.S. Treasury bills yielded 6.4% per year over that same time period.  That doesn't say much for the equity-indexed annuity.

Another study by MCP Premium Software showed how an investment of $100,000 would have grown from 1964 to 2003 in 8 different equity-indexed annuities.  The results are staggering:

• S&P 500 Index with dividends reinvested:  $4,847,000
• Best of the 8 equity-indexed annuities studied:  $1,312,000
• Worst of the 8 equity-indexed annuities studied:  $366,000

The numbers speak for themselves.

Don't let yourself be lured by the mirage in the desert called equity-indexed annuities.  More importantly, don't let your elderly parents, grandparents, friends, or neighbors be conned into this inappropriate investment -- unless, of course, they like to drink dry, bitter sand instead of real water.

Final note.  There are individuals and specific situations where EIAs make sense.  And, there are a few good EIA products available out of thousands on the market.  The point I am making is that there are many poor EIA products being sold to individuals in situations that are not appropriate.  You've got to be very careful.

Dec. 5, 2005 - Investments - Location, Location, Location

We've all heard that "location, location, location" is the key to successful real estate investing.  Did you also know that the same rule applies to successful investing in stocks, bonds, and mutual funds?

Here's how it works.

Diversification is one of the key principles of successful investing.  For example, betting all of your money on a single stock is a very risky strategy.  If the company doesn't do well, then you can lose everything.  Just ask anyone who owned Enron.  On the other hand if the company does well, then you can make a fortune (anyone out there own Google?).  Either way, you are taking a great risk.  Diversification is a means of spreading out that risk across multiple investments.

The principle of diversification has many applications, but I want to draw your attention to geography.  That's right, your retirement accounts or other investments can benefit from geographic diversification.

The United States may be a global economic powerhouse, but that doesn't necessarily translate to your portfolio.

Here are the 2005 year-to-date returns for some common U.S. investing benchmarks:

• Dow Jones Industrial Average +0.88%
• Nasdaq Composite Index +4.50%
• S&P 500 Index +4.39%

That's not much to write home about for 11 months of work, but certainly better than losing money (remember how ugly it was in 2000, 2001, and 2002?).

Now consider how various regions of the world have fared year-to-date:

• Americas (N. America & S. America) +7.50%
• Europe +22.20%
• Asia-Pacific +15.10%

There's some serious money being made out there -- especially overseas!  Are you benefiting from these gains?  Not if your money is all tied up in the U.S. markets!

Now don't go off and invest your life savings in Russia (up 90.5%) or South Korea (up 46.2%) just because they are hot.  You will eventually get burned like those investing in Venezuela (down 32.8%) or China (down 20.6%) right now.  My point is that you need to diversify your risks across many geographic regions.

It is not enough to stick all your eggs in the U.S. basket!

Experts vary in recommending what percentage of your investments should be non-U.S.  I have my opinion too, but it depends on a person's investing goals, portfolio objectives, risk tolerance, stage of life, age, etc.  There is no single answer that applies to everyone.  Just remember that a well-rounded, diversified investment portfolio must take "location, location, location" into consideration.

That's the kind of work that a good financial adviser does to ensure that you are minimizing risks while making the most of your investment opportunities.

Aug. 10, 2005 - Not All That Glitters Is Gold

The advertisement in the current issue of World Magazine has all the classic ingredients to suck you right in -- enticing question, amazing statistics, and assertive predictions. 

How can you go wrong?  You can't, according to the ad, because the value of this investment has never been zero.  What are they talking about?

Gold!  Pure gold!

Here's is what the ad says.

• Enticing Question
  • "How do your investments stack up?"
• Amazing Statistics
  • "Throughout history, its value has never been zero."
  • "The last time interest rates were this low and started to rise, gold prices skyrocketed over 300%."
• Assertive Predictions
  • "In a recent Barron's article, gold was predicted to again reach its historical high of $850/oz. due to a weak dollar and soaring budget deficits."
  • "The Gold/Oil Price Ratio says gold should now be trading at $770/ounce."
  • "1.2 billion Chinese citizens can now legally own gold.  This new demand alone is expected to drive gold prices above $800 an ounce...nearly double what it is today."

WOW!!!  Sounds fantastic!!!  Where do I buy???

Slow down, wipe the saliva off your chin, and let's consider this more carefully.

I'm not against gold and it does have a place in a well-diversified portfolio.  But before we're tempted to go overboard here, let's look at things logically instead of emotionally.

I want to use this ad to demonstrate how to read any investment pitch with a critical eye and a logical mind.  This is an invaluable skill that may save you money and untold heartache someday.  Pay attention!

Consider each of the above statements from the ad and their relevance to the investment decision you are subtly asked to make through the "enticing question."

1.  "Throughout history, its value has never been zero."  True.  Neither has the value of Microsoft stock since it went public.  Nor General Motors for that matter.  Or a host of other companies or commodities.  What does this statement have to do with evaluating the worthiness of making an investment in gold now?  Nothing.  Disregard it.  The intent is to appeal to our fears.  Investing based on fear is not a good strategy.

2.  "The last time interest rates were this low and started to rise, gold prices skyrocketed over 300%."  I wonder about the accuracy of this statement since they don't provide a time frame.  Gold prices only rose dramatically in the mid- to late-1970s but interest rates at that time were hardly "this low."  In fact, during the early-1970s interest rates were about 3% higher than today's levels and then they went up considerably from there.  But interest rates aren't really the key.  It was the rapidly increasing rate of inflation in the 1970s that drove the price of everything higher.  While interest rates are going up right now, there are no signs of rampant inflation -- even with soaring energy costs.  This is an appeal to greed.

3.  "In a recent Barron's article, gold was predicted to again reach its historical high of $850/oz. due to a weak dollar and soaring budget deficits."  Is that so?  And is Barron's the owner of a crystal ball that we should automatically assume their pronouncements as truth?  Hardly.  Financial publications make predictions all the time.  Some come true but many others don't.  This is just another appeal to greed by using a respected publication's good name to give credibility to the ad.

4.  "The Gold/Oil Price Ratio says gold should now be trading at $770/ounce."  Oh really?  Then why is gold trading at $435/ounce?  I guess all of us stupid humans just haven't figured out how brilliant the gold/oil price ratio really is.  An enterprising individual can concoct a set of statistics to support any argument.  What gold should be is a matter of opinion and is irrelevant.  Another appeal to greed.

5.  "1.2 billion Chinese citizens can now legally own gold.  This new demand alone is expected to drive gold prices above $800 an ounce...nearly double what it is today."  Interesting information but not necessarily a great predictor.  The Chinese have been allowed to legally own gold since October 2002 -- nearly 3 years.  When will this boom occur?  Maybe it already has or maybe it never will.  This is yet a final appeal to greed.

Here's the bottom line. 

The company running this ad makes its money selling gold it owns to the public.  Are they a credible source of information?  I don't know.  But if they really believe anything they've written in their own ad, then why are they so anxious to sell gold to me at $435/ounce?  Why not hang onto it and double, triple, or quadruple their money?

The truth is that they have no clue which way gold prices will go either.  But the more gold they trade, the more money they make (on commissions) -- no matter what the price does.

Gold may go up or it may go down.  If you own gold, I hope you make a fortune.  That's not the point.

The point is that you must evaluate every financial pitch before taking action.  Appeals that play on your fears or greed generally do not have much substance to them.  Be careful!

It also pays to do a little homework.

It seems very impressive that gold has risen from its recent lows of $252/ounce in 1999 to a peak of $454 in 2004.  That's an 80% increase in just 5 years!  But in the longer term, it has only risen 7% since its 1990 peak of $424/ounce and has actually fallen 47% since its all-time peak of $850/ounce in 1980.  And that doesn't even account for inflation.

As the old saying goes, not all that glitters is gold.  Sometimes, not even real gold!