Wednesday, May 14, 2014

Investing for the Long Run

Have you ever tried to start a campfire? You start with some really small, preferably dry sticks. Then you build a little teepee of slightly larger sticks over the original pile. Then you light (or try to light) the little pile in the middle. If you are lucky you will get it right on the first try. If not, you try again. Eventually, if you persist, you will get a flame. You watch the flame carefully, blowing on it every now and again, adding more and larger sticks as the flame grows. Finally, you can add some pretty good sized logs. Now you know your fire will continue to burn without a lot of attention. You can turn your mind to other tasks, like roasting hotdogs or even just watching the flames and enjoying the warmth you have created for yourself and your friends.

I don’t know what the future holds in store for American investors. Neither does anyone else. However some opinions are more respected than others. Jeremy Siegel has demonstrated that the American stock market has delivered a remarkably consistent 7% return in real terms between 1802 and 2001. While some decades greatly exceed 7%, some decades produce negative results. However, over any sufficiently long period of time 7% is a pretty good guess. It isn’t a natural law, but the academic community has accepted his research, naming this number Siegel’s Constant.

Rule Number 1: Never lose money.
Rule Number 2: Never forget rule Number 1.
Warren Buffett

There is a problem with just investing in American stocks, expecting to receive Siegel’s Constant, Buffett’s famous rules. What does this mean? Even the Oracle of Omaha, the most successful investor in the world, has lost money on investments. The answer is found in what is termed Modern Portfolio Theory. It turns out that mitigating risk is more important than reaching for return. That is why we diversify, buying bonds, foreign stocks, large cap stocks, small cap stocks, technology, gold, coal, oil, and other tangible resources. When something is going down, there is a pretty good chance something else is going up.

The simplest portfolio consists of low cost stock index funds with an age appropriate amount held in low cost bond index funds. Unfortunately Jeremy Siegel has also demonstrated you can only expect to get 3% to 3.5% from your bonds over the dreaded sufficiently long period of time.

American investors are quite delusional. I have recently read that the average American investor believes that he needs a 10% return to retire. Since inflation has run at an average of 4.0% per year over the last 50 years, they are going to need a whopping 14% return to meet their goals. Then they put their money in insured Certificates of Deposit that currently pay 0.2% or less because they are afraid of the future. Major pension funds, especially those of the 50 states, are commonly predicting returns of 8% and higher. Over the past 15 years the pension fund managers have not generated anything close to 8%. Some state pension funds are already in danger of bankruptcy. Some city and county retirement funds are already bankrupt. Expect to see more of this in the future.

Personally, I think Siegel is an optimist. This country as well as most of the developed world is currently suffering through what some economists term a Kondratieff Winter. There is just too much bad debt that needs to be squeezed out of the world financial system. This is going to take some time. Various heavyweights like Robert Shiller, John C. Bogle founder of the Vanguard Funds (one of my heroes), and the erudite John Hussman are worried about the future returns that might not be generated by the American stock market.

So what can an American investor do? Have you ever tried to start a campfire? You start with some really small, preferably dry sticks…. Perhaps you start by snagging the matching money offered by your company’s 401 (k). If your employer doesn’t offer a 401 (k) use the money from your tax refund to open a Roth IRA, a pretty cool idea especially for the young adult.

Assume a young couple earning a combined gross annual income of $60,000 a year never gets a single raise in their entire 40 year working life. If they save 15% of their pretax income in a retirement account that returns 5.5% they will retire with $1,297,123 that can provide them with an annual income of $51,884 INDEXED TO INFLATION for the rest of their lives. They are safe with or without Social Security. Since our couple paid off their 30 year mortgage they can add $200,000 in home equity to their net worth. Their net worth is pushing $1.5 million even if they have very little in taxable accounts.

Start small. Keep blowing on that little flame. Add more and larger sticks over time. Someday you will enjoy roasting some hotdogs over your fire, or now that you are in the autumn of your life, just enjoy the warmth you have created for yourself, your friends, and your families.

Psalm 121

1 I will lift up mine eyes unto the hills, from whence cometh my help.
2 My help cometh from the LORD, which made heaven and earth.
3 He will not suffer thy foot to be moved: he that keepeth thee will not slumber.
4 Behold, he that keepeth Israel shall neither slumber nor sleep.
5 The LORD is thy keeper: the LORD is thy shade upon thy right hand.
6 The sun shall not smite thee by day, nor the moon by night.
7 The LORD shall preserve thee from all evil: he shall preserve thy soul.
8 The LORD shall preserve thy going out and thy coming in from this time forth, and even for evermore.

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