Sunday, February 26, 2012

The Compass and the Map

“The individual investor should act consistently as an investor and not as a speculator. This means.. that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase.” -Benjamin Graham

Yesterday afternoon I spent a fair amount of time remembering when I first started learning about investments how badly I wanted a road map that told me how to get from where I was to where I wanted to be. This morning I read a post in Seth Godin’s wonderful blog entitled “The Map Has Been Replaced by the Compass.” Sometimes things just come together. There isn’t any road map. Imagine if your GPS needed to be updated every second. The markets change too fast. With the advent of high speed computerized trading, information can literally become obsolete in milliseconds.

Seth observes, “The compass, on the other hand, is more important than ever. If you don't know which direction you're going, how will you know when you're off course?” Fortunately there are some compasses available. Solomon, for example, is a proponent of diversification and systematic investment. The Intelligent Investor by Benjamin Graham is a timeless classic. Although just about all the companies he discusses in a book first published in 1949 are bankrupt or a part of some other company, the principles he expounds are as valid in the 21st century as they were two years before I was born.

Once I purchased Technical Analysis for Dummies by Barbara Rockefeller, a respected expert in her field. Although I decided I was not cut out to be a trader, this book provided me with a compass, the basic principles and discipline used by successful traders. More importantly, if I was so inclined, her book provided an excellent bibliography of the finest available texts on the subject.

Seth ends his post with the observation, “If you don't know which direction you're going, how will you know when you're off course? And yet...And yet we spend most of our time learning (or teaching) the map, yesterday's map, while we're anxious and afraid to spend any time at all calibrating our compass.”

Ecclesiastes Chapter 11

[1] Cast thy bread upon the waters: for thou shalt find it after many days.
[2] Give a portion to seven, and also to eight; for thou knowest not what evil shall be upon the earth.
[3] If the clouds be full of rain, they empty themselves upon the earth: and if the tree fall toward the south, or toward the north, in the place where the tree falleth, there it shall be.
[4] He that observeth the wind shall not sow; and he that regardeth the clouds shall not reap.
[5] As thou knowest not what is the way of the spirit, nor how the bones do grow in the womb of her that is with child: even so thou knowest not the works of God who maketh all.
[6] In the morning sow thy seed, and in the evening withhold not thine hand: for thou knowest not whether shall prosper, either this or that, or whether they both shall be alike good.

Saturday, February 25, 2012

The Only Guide Series

“Confirmation bias (also called confirmatory bias, myside bias or verification bias) is a tendency of people to favor information that confirms their beliefs or hypotheses.” Wikipedia

We all suffer from it. That is why it is important to read different points of view from serious authors, as we go about investing our money. “The Only Guides” series by Larry Swedroe give a well reasoned approach to investing that is somewhat different from the authors I usually favor, but not really all that different. He presents sound statistical data to support his positions, which according to both his critics and his proponents are more focused on not losing money than they are on making money. After all, why take unnecessary risks with your hard earned dollars?

This review covers two of his books, The Only Guide You’ll Ever Need for the Right Financial Plan and The Only Guide You’ll Ever Need to Alternative Investments, The Good, The Bad, The Flawed, and the Ugly. I intend to buy a copy of the Right Financial Plan. Alternative Investments, while well worth reading, spends too much time discussing investments that are so obviously bad that I don’t want to know enough about them to justify the cost of a hardback book. Sadly, these alternative programs are sold to the naïve, the greedy, and the fearful. The author recommends, If you don’t understand it don’t buy it. If you are excited by greed or fear, run away until you are capable of making a rational decision. Emotion is the enemy of intelligent decisions.

Like all the good authors, Swedroe repeatedly observes there are no “right” answers. Every investor has different goals, different resources, and a different tolerance for risk. Swedroe demands is too weak a word that before beginning an investment program, that you develop a written plan stating your goals, your investment philosophy, limits on investment types (for example: 50% in stocks means that if your holdings in common stock grows past 50%, you sell even if your portfolio is going up). Consider this Investment Policy Statement a contract with yourself. To change any underlying element of your behavior requires a change to a written document. He also councils consulting with a CPA or a fee only investment advisor who will never receive any commission from any product he recommends.

Swedroe is a proponent of diversification, carefully selected to minimize total portfolio risk. Hence, a small amount of money invested in a very risky class of stocks may well lower the risk of the entire portfolio if that asset tends to move in a different direction than your other holdings. The discussion of what to buy and why is too complex to cover in detail in this review, but he is a proponent of a mix of large and small cap stocks and a variety of different bond types that serve to mitigate different kinds of risk. Unlike most authors he is not all that concerned with sector diversification.

The most controversial material in these texts addresses the argument between those who believe they can pick individual stocks and those who believe the market is efficient, that is everyone has access to the same information, therefore the best one can do is buy low cost index funds that mimic the action of the entire market. Statistical studies do indicate that picking stocks contains a greater amount of luck than a sport like football. However, Swedroe’s position is rather extreme. He believes that buying anything other than low cost index funds is a waste of time. He does admit that at moments in time the market may not be efficient. Think Enron. This company was for all intents and purposes bankrupt for months prior to that fact becoming public. During that period the “opaque” market in those shares destroyed thousands of investors. He also allows that very smart people can take advantage of special situations, but only for a very short time with limited amounts of money. Bond arbitrage* with a few million dollars is a lot easier than the manipulation of billions. The author provides an example of how scale bankrupted a major hedge fund run by the best economists and statisticians money could buy, including two Nobel Prize winners.

What did I learn about myself while reading these books? First, I do buy individual stocks when I believe I know enough to make an intelligent decision. Fortunately I have been right more often than I have been wrong. I tend to buy stock in well managed companies that pay a sustainable dividend. This policy is not bulletproof, remember British Petroleum was one of the most profitable well run companies in the world until one of their deep water platform caught fire. Then BP lost half its value in a few weeks.

Most of my holdings are in funds of the sort recommended by the author. I buy funds when I have no choice, as in the case of my holdings in the Government version of a 401K, I do not believe I am capable of making an intelligent selection of individual issues, as in my tax free municipal bond fund, or owning individual securities outside of a fund is just too inconvenient.

Swedroe points to a major weakness in my portfolio, holdings in developing markets such as Brazil, Russia, India, and China. I keep putting off that decision because I have been thinking in terms of individual stocks or individual countries which I perceive as very risky. I believe, following the author’s recommendation, I will purchase some shares in a Vanguard fund that invests both in large and small companies located in all these countries. I have about 15% of my holdings in foreign shares, an amount frequently suggested for moderately conservative investors. Swedroe makes a compelling case that this number should be 30% or more. Again this money is to be carefully diversified between large and small cap stocks in developed and developing markets. About half the world’s wealth is still in America but about half is now located in the rest of the world and that number is growing. He is probably right about foreign investments.

I have been operating under the assumption it is more important to make money than to worry about paying taxes. Yes, I am conscious enough to keep my tax free bonds in a taxable account. Not worrying about taxes has been OK because I rarely sell stocks so there are not often any tax consequences to worry about. However, that is about to change. When I retire, how I use my savings and when and how I choose to liquate certain assets could have major tax implications. Swedroe is constantly concerned with the tax implications of every investment decision. Fortunately I have a CPA to hold my hand when the time comes.

In conclusion, these books are well worth the time it takes to study them. They are not written for the novice investor. The author assumes that his reader has at least an intermediate understanding of finance, statistics, and other relevant subjects. However, a degree in Finance is not necessary to comprehend his arguments.

*Arbitrage: “The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.”--Investopedia

Friday, February 24, 2012

The Holy City

We just returned from an all too brief vacation. Charleston, SC just offers too much to see and appreciate in six nights. We first discovered Charleston in the 1970s before the rest of the world made it a tourist destination. After the creation of the Spoleto Festival it was no longer the bargain that appealed to our then small household budgets, so we haven’t vacationed there since sometime in the early 1980s.

Since then Charleston has experienced a renaissance. I heard the tale as told by a very conservative local businessman. He claims that the rebirth of Charleston began with Hurricane Hugo in September 1989. After this deadly and destructive storm, Federal dollars poured into the area. The businessman observed that unlike other cities, the Government of Charleston and Charleston County used the rebuilding funds to rebuild the city rather than on fraudulent schemes and outright corruption. He praised Mayor Joseph Riley, a Democrat first elected in 1975 and still mayor to this day, as a man who understands the needs of business. He pointed to the recent hiring of more policemen at a time when most cities are cutting their police forces as an example of his common sense. Charleston, particularly North Charleston, has a pretty high crime rate. The mayor understands tourists and businesses looking for a new location don’t choose dangerous cities. High praise indeed, coming from a conservative Republican.

Whatever the reason, new business is pouring into the area. Boeing is going to be building Dream Liners in South Carolina. Google is locating a large new facility in Charleston. In fact, I was informed so many Silicon Valley companies are opening new operations in the Charleston area some are calling the city Silicon Harbor. Although the Navy Yard is gone, the harbor still remains one of the busiest in our nation and the Naval Weapons Station is still a major employer. A quick look at real estate in the area gave me the impression that expensive properties, particularly quaint beautiful old homes near Battery Park, are doing just fine. Also, lower cost housing does not seem to be that impacted by the crash of 2006. However, it looks like middle priced properties have been squeezed by as much as 25%. Due to the presence of the Medical School, Law School, and a couple of Universities, apartment rents are way too high relative to house prices, particularly in the downtown area. Eavesdropping on a conversation overheard at a restaurant, two well dressed businessmen perhaps attorneys, were lamenting that new construction combined with the number of foreclosures and short sales were crippling the demand for existing properties. I saw a lot of new construction, commercial construction, out near the airport, but not the new residential construction that distressed the two businessmen enjoying a late lunch at a stylish bistro.

The old city of Charleston is more European than American in appearance. The lower part of the city is filled with gorgeous, beautifully preserved, old homes dating back to the 1700s. As you wander around these neighborhoods, you can peer into their amazing private gardens behind wrought iron gates that are themselves real works of art. The many venerable old churches give Charleston its nickname, the Holy City. From the harbor, their steeples dominate the city skyline. All this architectural beauty survived long enough for me to appreciate it, in part because General Sherman did not visit Charleston during the Civil War. He considered burning Columbia a higher priority. Next time I visit Charleston, I would like to take one of the horse and carriage tours that provide a detailed lecture on the history of these homes and churches.

If you love food, you will love Charleston. It seems every third restaurant has won more than one noteworthy award. The culinary offerings have extended beyond the traditional seafood and barbecue restaurants than we enjoyed in the 1970s. My wife enjoyed shrimp and grits, a local delicacy, at Poogan’s Porch, an upscale downtown restaurant in an artfully decorated Victorian home. This kind of cuisine, while not cheap, really isn’t that expensive compared to other urban areas. Even little hole in the wall restaurants off the beaten track, like the Sunflower Café, offer sophisticated recipes at reasonable prices. For those of us, like me, who prefer food to cuisine, places like Jim and Nick’s still offer very good traditional Southern barbecue and fixins.

If you visit Charleston, don’t forget to visit Sullivan’s Island and the Isle of Palms. These are two upscale beach resorts that are not particularly inviting to new development or outsiders (unless they have a lot of money). In Southern novels, dysfunctional families go to their beach homes on these islands to have parties where they say nasty things about each other and anyone who has owned property on the island for less than three generations. If you want something a little more laid back, try Folly Beach on the other side of the harbor. This is a more normal family beach resort, but it still has managed to avoid the trap of over development. The locals on Folly Beach view themselves as a poor man’s Key West. By the way, if you visit Folly Beach check out the Lost Dog Café. It offers an imaginative breakfast and lunch menu in a dog friendly environment. You can choose to eat lunch with your pet in their garden or on their porch. They provide water dishes and treats for their four footed patrons, as well as good meals for their owners.

I have already written too much and not yet touched on Civil War history, the Gullah culture, or famous restored plantations found on the outskirts of the city and how they are all intertwined.

One word of warning, parking in Charleston is a problem. The narrow European like streets while quaint and charming, don’t offer much in the way of parking. The city provides parking garages, but there are not enough of them, they are poorly marked, difficult to find, and expensive enough to be annoying but not prohibitive as in New York City. Parking is also a problem at the beach resorts. It is either not encouraged by the upscale resorts or there just isn’t enough to go around out on Folly Beach.

Saturday, February 11, 2012

A Thought Experiment

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”--Warren Buffett

In today’s world it is likely that you are your own financial risk manager. There is no free lunch. Risk and reward both come with associated costs. Learning how to evaluate these costs and making wise decisions are an essential part of building net worth and reaching particular financial goals in the different seasons of your life. On the one end are futures contracts and options. On the other end are fixed annuities sold by insurance companies. What is right for you? When listening to salesmen and financial teachers how can we evaluate their competing claims?

As regular readers know, I find it disturbing that in Dave Ramsey’s teaching he insists on projecting a 12% return on retail mutual funds and recommending 100% all in stocks at all times, rather than the more usual recommendation of a mixture of bonds, stocks, cash, gold, and foreign currency based on age, income, and tolerance for risk.

Consider the following thought experiment.

I will give you a check for $5,000 if you guarantee to give me $17,426.78 ten years from the date of agreement. That is 12% compounded quarterly (dividends are normally distributed on a quarterly basis) according to Bankrate’s simple savings calculator. If Dave Ramsey is correct, you could go out and put it into any 4 mutual funds that meet his criteria with a near certainty of making money.

Dave Ramsey states that there is a 97% probability that if you accept this bet you will make a profit or at least break even. That is as close to a sure thing as you can get in this unhappy world. Just imagine that you are blindfolded. You place you hand in a vase that contains 97 blue marbles that tell you how much money you win and only 3 black marbles that tell you that you have lost money.

But no reasonable person would take the bet I have offered because he or she would believe the risk of losing money exceeds the potential of making money. However, there is some point at which this becomes a fair bet. A fair bet is defined as a proposed bet in which a reasonable man would be just as likely to choose one side of the bet as the other side of the bet.

For example, I might take either side of that bet maybe somewhere between 3% and 5% return. I would have to think about it. Above 5% I think I would always take the guaranteed return. Below 3% I think I might make the offer to you, though on a limited basis.

In financial terms, what I have proposed is a Dave Ramsey Bond, guaranteed by his good name and personal fortune. You will notice there are not very many bonds that offer a 12% rate of return. Those that do offer a return of 12% or more have a name, junk bonds.

This post is inspired by a retirement article from Kiplinger published by Yahoo and my reading of The Plight of the Fortune Tellers by R. Rebonato, a difficult but stimulating read.

Sunday, February 5, 2012

Get Rich Quick

If you suffer from insomnia, you’ve seen them. The late night air waves are filled with hucksters, scam artists, and worse promoting opportunities to get rich quick with no effort, prior knowledge, or skills. They are selling everything from $20.00 books to courses or software packages that cost many thousands of dollars. These scams and their predecessors offering free lunches at “informational” meetings that are in fact nothing more than opportunities to be subjected to a high pressure sales pitch have been around for a long, long time but somehow it seems worse during periods of high unemployment.

If it sounds too good to be true, it probably is too good to be true.

Let’s start with one that particularly annoys me, perhaps because my primary investment strategy involves stocks. Stock trading is a discipline that requires a great deal of study as well as a temperament found in skilled poker players. For a few thousand dollars “they” will sell you magic software that will tell you when to buy and sell shares in any company that interests you. Since major investment banking houses have devoted hundreds of million dollars over decades into highly proprietary trading software, do you really think that your little package on the PC can compete with the big boys? From The Tricks behind Infomercial Get Rich Pitches (Yahoo Finance): “In 2008, Utah residents Linda Woolf and David Gengler were charged in connection to the "Teach Me to Trade" stock-picking system. Customers paid between $3,000 to $40,000 to learn the system, even though the duo were, in the words of the Securities and Exchange Commission, "unsuccessful traders." Combined, they earned more than $6 million selling the product.”

Most of these scams pitch some variant of the no money down, property flipping, real estate scheme. Experts can buy distressed properties or foreclosures at steeply discounted prices, but they have enough equity positions to have a line of credit with one or more banks. Frequently these houses need considerable work before they are a marketable commodity. A person in this line of business needs to know the actual value of the property in its initial condition, what needs to be done to fix it, who can fix it, what that effort should cost, and the selling price of the final product. Boxes of CDs and books by late night TV conmen are not going to buy you houses with no money down even with bad credit.

A more recent variant on real estate get rich quick quackery is Russell Dalbey’s Winning in the Cash Flow Business, brokering seller-financed mortgage promissory notes. The initial program was sold for $40 to $160. Then the victims were encouraged to spend thousands more for additional products and coaching. The Federal Trade Commission and the Colorado Attorney General’s office are prosecuting the people involved in this scam for false and misleading claims by supposed customer endorsements. The Denver Better Business Bureau has been after these people since 2003.

By the way, the self help industry has discovered this ploy. I recently bought a interesting self improvement book in an airport shop, to help pass away the hours spent in terminals and airplanes between here and there. The material was OK, but as I read the book, it became obvious its primary purpose was as a sales tool promoting access to a website and personal coaches.

Let me end this post with a mention of the king of late night get rich quick scams, Kevin Trudeau. The following information comes from Wikipedia. Kevin Trudeau started his career posing as a doctor while depositing $80,000 in bad checks. Also in his early days, he stole credit card numbers and made $122,735.68 in fraudulent charges. After his release from prison, he was charged with running a nutrition multi-level marketing firm that was in fact a pyramid scheme. He settled with the state of Illinois and seven other states for $185,000.

Next he promoted dietary supplements, baldness cures, memory improvement courses, and real estate investment schemes on infomercials. This led to regulatory action by the Federal Trade Commission claiming, “That his broadcasts contained unsubstantiated claims and misrepresentations. In 1998, he was fined. In 2004, he settled a contempt-of-court action arising out of the same cases by agreeing to a settlement that included both payment of a $2 million fine and a ban on further use of infomercials to promote any product other than publications protected by U.S. Constitution's First Amendment," that would be the books he sells today including:

Natural Cures "They" Don't Want You to Know About
The Weight Loss Cure 'They' Don't Want You to Know About
Free Money "They" Don't Want You to Know About

He continues to be in and out of trouble with the law. His latest exploits include, a Federal Trade Commission warning concerning the drugs promoted in his weight loss book. Most recently, “On Nov. 29, 2011, Trudeau lost his 2010 appeal in the Seventh Circuit Court of Appeals. The court found that the $37.6 million fine for violating his 2004 settlement with the Federal Trade Commission was appropriate as Trudeau had aired 32,000 infomercials and described the figure as "conservative." The court considered sales only from the 800 number used to place orders and excluded internet and store sales. Additionally, the court found that requiring Trudeau to make a $2 million performance bond prior to participating in an infomercial was constitutional.”

Kevin Trudeau has also been recently charged with billing customers for materials they did not order including newsletters and other items.

Friday, February 3, 2012

Long Term Care Insurance

Traditional wisdom dictates that the prudent consumer purchase a long term care policy sometime in their 50s or certainly when they turn 60.

Long term care insurance LTCI, according to my wife who was a hospital case worker, is a tertiary product that kicks in after private health insurance and Medicare are exhausted. If an individual is going to need assistance with Activities of Daily Living (ADL) such as dressing, bathing, eating, toileting, getting in or out of a chair, or walking for an extended period of time, LTCI will pay for this kind of care. Depending on the policy, this care may be limited to a nursing home or may allow the patient to receive care in an assisted living facility or even their own home.

LTCI policies generally are defined by their waiting period, maximum daily rate, their total cap, and inflation protection. Obviously, the longer the waiting period and the lower the inflation protection number (5% compound inflation protection is recommended) the lower the premium. Flexibility costs. The more options covered nursing homes, assisted living facilities, home care, or even home care by relatives, the greater the cost. The amount of coverage required is highly dependent on location. A nursing home in a desirable urban area, say San Francisco is going to cost much more than a similar facility in Travelers Rest, South Carolina.

If you actually need LTCI, due to a diagnosis of an illness or conditions such as AIDS or Alzheimer’s, be assured it is too late you will not qualify. In the United States, if you are considered financially destitute according to current law, Medicaid will provide medically necessary services to patients who need nursing home care. However, Medicaid does not generally provide coverage in a home or assisted living facility. If you find yourself or a loved one in such a situation, work with the hospital social worker or case manager to develop plan that makes sense. Government regulations are so complex and arcane that a new cottage industry providing private case manager services is developing. If you can afford this kind of consultant, it might be worth the investment.

Since I turned 60 last year, I spent a considerable about of time researching long term care insurance. What I found was not encouraging. Prices for long term care insurance have undergone a drastic increase over recent years. More importantly, policies that had no cap can no longer be purchased. One of the students in the Financial Peace University class I coordinated had an elderly relative in a nursing home. Unfortunately, she has been in that nursing home for many years. Fortunately, she has a long term care insurance policy that will continue to pay until she dies. You can no longer purchase that kind of coverage. Long term care insurance is sold in increments of $100,000. From what I have read $300,000 is the recommended sweet spot. I can self insure at $100,000. To purchase $300,000 policies for both my wife and myself would be a deal breaker. I simply could not afford to retire and pay for that kind of coverage.

My solution was starting a separate joint account with Vanguard. I plan to invest an amount roughly equal to the annual premium for a single policy in a pair of hybrid bond/stock mutual funds that will give me a 50/50 split between investment grade bonds and conservative dividend paying stocks. If we do not need to tap this fund until our mid-eighties, we will be OK. If we need it tomorrow, with or without $300,000 in long term care insurance, we would be financially ruined.