Archives for February 2009

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Cash Flow = Wealth

Here in the U.S. we tend to express wealth in terms of net worth: “Bill Gates owns $X Billion.” I’ve read, however, that in other parts of the world, people express wealth in terms of income: “Bill gates is worth X [local currency units] per year.” (Can any non-US readers confirm that this actually does happen, by the way?)

This cash-flow-centric way of looking at wealth makes a lot of sense to me. After all, isn’t the whole goal of personal finance to ensure that our cash flow will exceed our expenses throughout our lives? Isn’t that precisely what we’re trying to achieve when we take money and sock it away during our cash-flow-positive years and save it for those years that we expect to be cash-flow-negative?

Benefits of Looking at Cash Flow

It keeps your focus in the right place: When we focus entirely on net worth, we develop an unhealthy tendency to monitor the value of our investments far more frequently than necessary. And I suspect that the more a person obsesses over her current account value, the more likely she is to panic and sell after a market decline.

In contrast, if that same investor were to focus instead on her cash flow, she might see that:

  • She’s earning more than she spends,
  • She’s protecting her income (by owning life insurance & disability insurance), and
  • She’s putting away money for the period in her life when she expects not to naturally be cash-flow-positive.

Maybe things don’t look so bad after all. Maybe there’s no need to panic. 🙂

It makes it easy to see whether or not you’re saving enough: Many investors don’t even know where to start in terms of figuring out how much they need to invest each month in order to meet their goals. Of course, this is no surprise, given that many investors are similarly clueless about how much money they’ll need in order to retire (if that is, in fact, their goal).

Once we put the focus where it belongs–cash flow–we can start figuring out how much money a person will need in order to retire. That is, once you know that you’re going to need $x per year in order to pay your bills, it’s relatively easy to figure out how much you’ll need to have accumulated in investments in order to generate that level of income.

What do you think?

How do you most frequently think of (financial) wealth? Why?

Don’t Retire.

I just read what is without a doubt the most thought-provoking thing I’ve encountered in a good while: Chapter 4 to Stephen Pollan’s Die Broke. The chapter is titled “Don’t Retire.”

Now, I’ve read that piece of advice several times before. Many people make the case that if you’re doing work you love, there’s no need to plan on retiring. And that makes sense to me.

But that’s not what Pollan is saying.

He’s saying to give up the traditional idea of retirement because it’s a lost cause. Literally. He believes that the Baby Boom generation and those after it have roughly zero chance of retiring in the way that our society has come to imagine (that is, retire at age 65 then play golf in some nice sunny community in Florida until the day you die).

The history of retirement

Pollan explains that the concept of retirement didn’t even arise until the Great Depression. As part of the New Deal, Social Security was created. The goal: Pay the older workers to leave the workforce in order to make room for younger workers. Of course, back when the age for Social Security benefits was set at 65 years, the average life expectancy was only 62 years. In other words, the first generation to receive Social Security enjoyed, on average, very short retirements.

It was the second generation to retire (the Baby Boomers’ parents) that actually created the spend-the-rest-of-your-life-traveling-and-playing-golf image of retirement. However, Pollan argues that their ability to retire was simply the result of a freak coincidence of economic forces:

  • They had absolutely no doubt as to the solvency of the Social Security system.
  • Many had been able to accumulate wealth through their entire working years due to never having had giant student loans to pay off. (The GI bill had covered college for them.)
  • More than half of them had pensions.
  • As they were retiring and selling their homes to move southward, they were able to make out like bandits due to the spike in demand created by the Baby Boom generation becoming the right age to start buying houses.

Is retirement impossible?

Pollan argues that none of those things will be the case for future generations. To make matters worse (in terms of being able to retire), every generation is likely to have a longer life expectancy than the generation before it.

Combine those facts with the reality that most investors:

  • Invest far too little,
  • Invest far too conservatively, and
  • Ruin their returns by bailing out of the market after declines…

…and you get a bleak picture indeed.

But look at the bright side!

Fortunately, giving up the idea of retirement as the ultimate financial goal can be surprisingly liberating.

A few thoughts:

  • When retirement was created as a goal, older workers were less productive than younger workers. (A huge portion of the work being done was still manual labor at that point.) This simply isn’t the case today.
  • It frees you from the necessity of having saved X dollars by age Y. You’re no longer in a race against the clock. What a nice feeling! (Of course, that doesn’t mean we wouldn’t need to save & invest at all. It’s very likely that even if a person doesn’t retire completely, his/her income would still drop significantly starting around age 60, so having investments to provide income is still necessary.)
  • If you’re planning on working forever (or close to it), disability insurance becomes extremely important.
  • Doing work that you truly enjoy becomes that much more essential.

What do you think?

Is retirement (in the traditional sense) an attainable goal for most people? Should we even be striving for it in the first place?

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How’s Your Financial Fitness?

William Bernstein recently wrote an article for Money magazine where he proposes the idea that your emotional fitness is a huge factor in determining your investment results. Here’s how he explains it:

[Investors] are handing over their stocks, at cheaper prices, to the disciplined investors who began the race in good financial condition. By financial condition, I don’t mean the state of the buyers’ bank account or even their market expertise but rather their emotional fitness to handle market volatility. And most of us aren’t born with that. You have to train.

This is exactly what I said a while back when I wrote that people could increase their tolerance for volatility. Bernstein suggests that it can be done by implementing a system of annual portfolio rebalancing, thereby training yourself to sell high and buy low. I think that’s a great idea.

I would add, however, that I think it can be also be done simply by learning more about market history and its cyclical nature. (Note: I’m not saying to do this instead of portfolio rebalancing, I’m saying to do it in addition to portfolio rebalancing.)

The good news is that unlike an elite athlete, an emotionally fit investor doesn’t have to wake up at 6 a.m. every morning to work out (or tune in to CNBC). In fact, it’s better not to think about investing most of the time. I know no greater investment pro than Vanguard founder John Bogle; he tells me that he peeks at his holdings only once a year. In this race, the edge goes to the disciplined couch potato.

Whether you call it Oblivious Investing, or being a “discliplined couch potato,” it’s a neat concept: Stop worrying about your investments, and they’ll start performing better (because you won’t be ruining their returns).

Fundamental Factors in Determining Investment Return

As you know, the whole point of this blog is to encourage people to focus on the basics of investing while ignoring everything else. So for today we have the two fundamental factors in determining investment return.

  1. How much money is the investment expected to pay?
  2. How predictable is the payout?

It really is quite simple, but a little explanation probably wouldn’t hurt.

How much will the investment pay?

We’re not talking about a rate of return here. We’re talking about an amount of money. For example, a bond might be expected to pay $500 every 6 months for the next 10 years.

Of course, with many investments, this is clearly an estimate. For example, we can see that a given stock is paying X dollars in dividends each quarter, but we then have to make guesses as to whether that amount will increase, stay the same, or decrease.

How predictable is the payout?

All else being equal, investors will pay more for an investment that will reliably pay $500 per year than they will for an investment that will perhaps-pay-somewhere-around $500 per year. And that makes perfect sense.

As a result, the investment with the reliable payout will have a lower rate of return. (Paying more for a given payout by definition means a lower rate of return.)

All the factors that might make the payout on an investment less predictable are what are known collectively as “risk” (according to the traditional technical definition).

How to take advantage of this knowledge

Here’s the most important part: When investors consider the predictability of an investment’s payout, they look almost exclusively at short-term predictability.

As a result, stocks (unpredictable over the short-run) end up being priced such that they have a greater rate of return than bonds (fairly predictable over the short-run) and a much greater rate of return than CDs (very predictable over the short-run).

What’s so great for long-term investors, though, is that long-term stock payouts (for big enough groups of stocks, anyway) are actually relatively predictable. And this “high return plus predictable payout” is precisely what makes stocks so great for long-term investors.

Hopefully, if we can keep in mind the fact that there are fundamental reasons why stocks will earn more than other investments over extended periods, we can do a better job of keeping our heads during down markets. 🙂

Volatility is harmless…sometimes

While recently reading Against the Gods, I came across one of the best explanations I’ve ever heard for a topic that I spend a lot of time talking about: Volatility. The author (Peter Bernstein) quotes a fellow named Robert Jeffrey as saying that:

Volatility per se, be it related to weather, portfolio returns, or the timing of one’s newspaper delivery, is simply a benign statistical probability factor that tells us nothing about risk until coupled with a consequence.

I love that he compares the volatility of portfolio returns to the volatility of the timing of your morning newspaper delivery. That’s fantastic. 🙂

What he’s saying is that neither one has any inherent significance. However, depending upon your particular situation, either one of them might happen to be very important.

So just to spell it out, let’s run briefly through the effects of volatility on your investment success.

Still buying? If so, volatility is good.

As we’ve discussed before, if you’re still in the accumulation stage (i.e., you’re still buying investments), then volatility is actually a good thing. It amplifies the effect of dollar cost averaging, thereby allowing you to buy more shares for less money.

Only potential exception: You know yourself well enough to know that you’re in that category of people who tend to feel a strong desire to sell an investment immediately after a sharp decline in its market value. (And if you are in that group, my advice would be to learn about why that’s a terrible idea, rather than to invest primarily in non-volatile investments.)

Selling soon? If so, volatility can be ugly.

Logically enough, for investors who are regularly selling their investments (i.e., dollar cost averaging out of them), volatility has precisely the opposite effect. That is, it leads to your selling more shares for less money. And yes, that’s as bad as it sounds.

Of course, it’s still important for retired investors to maintain significant portions of their portfolio in equities in order to combat inflation.

In short:

Volatility itself is neither inherently good nor inherently bad. (I find it simultaneously fascinating and frustrating that people often state that it’s a bad thing.) Whether or not you should seek to avoid volatility depends entirely upon your current situation.

Is the Behavior Gap Real?

In case you haven’t run into it yet, let me introduce you to one of my new favorite blogs: Behavior Gap. The primary idea behind the site is that investors, on the whole, tend to actually underperform the investments they own.

Why? In short, because they buy and sell them at the wrong times. In other words, people chase performance—buying after a fund has just done well, and selling after it’s just done poorly.

Potential issues with the Behavior Gap concept

Yesterday’s post at Behavior Gap quoted a study by Dalbar which calculates the behavior gap as a roughly 7% annual difference in investor returns as compared to investment returns over the last 20 years.

A few readers asked some very intelligent questions in the comments: How is that possible? Isn’t it a given that investors (as a group) earn precisely the same return that their investments (as a group) earned over a period?

The answer to that question is of course “yes, before expenses.” A significant part of the 7% gap in the Dalbar study is the result of the fact that the study includes sales charges and expense ratios.

Issues with the study

However, there are a couple legitimate issues that can be raised as to the study’s methodology. First, it uses the S&P 500 as the measurement for “the market.” As a result, if large-cap stocks outperform small- and mid-cap stocks over the period, the gap will look larger than it really is.

Second, when calculating “investor return” the study only uses returns earned by investors in mutual funds. As such, any holdings in the form of individual equities–whether by individual investors or by large institutions like pension funds–are not considered.

Using another study

Conveniently enough, the Dalbar study isn’t the only one to have attempted to tackle this concept. A few months back, I linked to a study done by Ilia Dichev (an Accounting professor at the University of Michigan).

Dichev’s study attempts to calculate the behavior gap (or lack thereof) by comparing a time-weighted return for the entire market to a dollar-weighted return for the entire market. What he finds is a much more modest gap: 1.4% annually. However, as we’ve seen, even a 1% difference per year can crush your total wealth accumulation.

Still, the question arises as to where this difference comes from. After all, if all transactions in the market are zero-sum (that is, if somebody is selling a share of stock, somebody must clearly be buying it), then wouldn’t the time-weighted return and dollar-weighted returns be the same?

Well, yes, they would. But here’s the catch: Not all transactions are zero-sum. When companies issue new shares of stock or repurchase shares of their own stock, money is literally added or subtracted from the market.

And guess what? Companies tend to issue shares of stock when the market is high and buy shares of their own stock when the market is low. Hence, a very real (though perhaps significantly smaller) Behavior Gap.

A more important question

Granted, there still may be issues with Dichev’s study. I haven’t found any, but I could be missing something.

However, what I know for a fact is this: Even if the Behavior Gap turns out not to exist in total, it most certainly exists for a great many investors. And that alone is enough to make it worthwhile to discuss.

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