My optimism overfloweth

“The report of my death was an exaggeration.”  –Mark Twain

A couple weeks ago Robert Schiller published an article warning investors that the next couple decades are going to be tough ones for the stock market, and they should prepare themselves accordingly.  I read this and I have to say that I disagreed with him.  Professor Schiller won the Nobel prize in economics last year and is a world renowned professor at Yale; I was one of 100 students to graduate with honors from the University of Chicago’s MBA program in 2006.  It should be pretty obvious which of the two of us is just a little more credible.

The premise of Professor Schiller’s argument is that stocks are at all-time high valuations, and they have to come down.  Intellectually I agree with this, but I think he’s missing the mark in two major ways:

Robert_Shiller_-_World_Economic_Forum_Annual_Meeting_2012_(cropped)
Nobel laureate, Robert Schiller

 

Predicting major moves in the stock market is really, really hard

As we learned from A Random Walk Down Wall Street (I’m sure you all went out and read it after reading my incredible review, right?), it’s nearly impossible to predict when things will happen with the stock market.  In 2015 Professor Schiller is predicting we’re going to have a major correction/sustained period of flat stock prices.  Sure, he’s probably right that that will happen, but is it going to be in 2015, or in 2020 when stocks are 50% higher than they are today, or in 2030 when they are double what they are today?

I think this is where history is a good guide.  The 1980s were an awesome decade for the stock market* with returns averaging an astounding 14% per year.  As you can imagine, there were a ton of pundits saying the stock market rose too fast, valuations were too high, things just weren’t making sense–you had to get out of the stock market.  What happened?  The 1990s came along and outperformed the 1980; stocks returned 18% per year.  People didn’t realize that the computer revolution of the 80s was leading to the internet revolution of the 90s, and if you missed the 1990s investing boat because the 1980s had been so good, you were hating life.

Even look at the internet boom and the bubble that eventually burst in 2000.  In the 1990s year after year, the stock market was putting up tremendous gains.  I remember in about 1997 or 1998 the chorus of naysayers was deafening; they were predicting that valuations didn’t make sense, a bubble was building, and stocks were going to plummet.  It turned out they were right, but the plummet happened 4-5 years later.  In the meantime, the DJIA went from 6800 in 1997 to a peak of 11,200 in 2000.  Of course, the bubble burst, but the stock market only went down to 7600 (Sep 2002).  Sure the pundits were right .  . . sort of.  The bubble burst, but if you took their advice when they gave it, you would have missed out on a market that rose from 6800 to 7600 with a crazy ride in the middle.

The history of the stock market is littered with these examples; literally everyday you have some market expert saying the end is near, yet the market consistently proves them wrong.  Professor Schiller is much smarter than I am, and there probably will be a time they the stock market crashes or goes sideways for a long time.  But no one knows when that is (and I would think Professor Schiller would agree that he doesn’t know that either), and you might miss out on a great run in the meantime.

 

Innovation is always happening

Innovation is one of the main drivers of the stock market.  Companies innovate, figuring out new ways to do it better, faster, cheaper.  This leads to higher profits which lead to higher stock prices.  It was the electronics innovations of the 1950s that led to 160% increase in stocks in that decade, computing innovations of the 1980s; and internet innovations of the 1990s.  Sure you have off decades like the 1970s and 2000s, but those happen less often; even then innovation is still happening, but it’s just not translating to stock gains until later.  Is there any reason to believe that in the next 20 years we won’t have unimaginable innovations that will change our lives the way computers and the internet did?  I think those will happen and I think those will drive stocks higher.

google car

Eventually cars will drive themselves.  My neighbor just bought a Tesla and the thing can start itself, open the garage, pull out, and have the car all nice and toasty, so all Mr Grizzly has to do is get in and go.  There is no doubt in my mind that in a few years they’ll be driving themselves.  Can you imagine once that happens?  Auto accidents and drunk drivers will all but be eliminated.  Old people, blind people, pre-16 kids will have incredible mobility.  Traffic jams will fade away.  Commuters will have hundreds of hours of their life back each year.  And all this innovation will make some companies tremendous profits and their stocks will skyrocket.

Every year solar panels become more efficient and less expensive.  Soon they are going to be as common on roofs as DirecTV dishes.  Electricity bills will go down, carbon emissions will drop (also thanks to automated, electric cars from above).  The world will benefit and some companies are going to make a killing.  Amazing medical advances are happening every day; really smart people at Amazon.com are figuring out how drones are going to change the world; light bulbs are going to last 100 times longer and use 100 times less power; new methods are going to find more oil less expensively.

I’m going to be wrong on nearly all the details I listed above, but I truly believe that I am going to be right on the general message that the innovations we have in store for us are going to dazzle our minds.  And they’re going to make tons of money for the companies that do them, and tons of money for the investors who own those stocks.

 

So I respectfully think Professor Schiller is wrong.  Investing in stocks is a great investment now and will be a great investment for years to come.  In fact, I’m putting my money where my mouth is and have 95% of the Fox’s portfolio in stocks.  I would welcome Professor Schiller to respond—he’s always welcome to write a guest post 🙂 .  Of course if he does, I will become giddy as a school girl and ask that he pose with me for a picture and then autograph it.

 

*  I’ll be using the Dow Jones Industrial Average in these examples

How to invest a windfall

raining-money

We got this letter from a reader:

Stocky,

Sadly my father passed away, but he had a $200,000 life insurance policy.  My mom spent $60,000 as a down payment on a house and $40,000 for my sister’s medical school.  That leaves $100,000 left; I was thinking about going into business with a couple shady guys to start a liquor store, but my wife talked some sense into me.  So we decided to invest the money in an S&P500 index fund (VFINX). 

My question to you is, should we invest the $100,000 all at once or spread it out in smaller investments over a couple months?

Walter Y from Chicago, IL

 

I admit I may have made this letter up as a framing device, but Walter’s problem is a pretty common one.  Maybe it’s an insurance payout, a tax refund in April, a bonus check, or a bunch of cash you’ve accumulated in your checking account.  In fact, every July the Fox family faces this exact scenario when I get my bonus check.  Let me tell you my thoughts on the matter (which of course is not an expert opinion, and which looks at historical price movements but makes no prediction on future stock movements).

When I get my bonus, and what I would have suggested to Walter, is to take the big chunk of money and invest it in equal pieces over a couple months.  Vanguard and most places will let you set up an automatic investment, so in the words of Ron Popeil “you can set it and forget it.”  So let’s imagine for Walter he would invest $10,000 per week into his mutual fund for the next 10 weeks.   Why do I do it this way?  Because I’m a spaz.

If I invested all the money at once, I would be totally freaked out that I would buy at the wrong time—either I would buy the day after stocks went up 1% or I would buy the day before stocks dropped 1%.  Using Walter’s scenario of $100,000 to invest, that would mean I could “lose” $1000 by investing at the wrong time.  That would totally tie me up in knots and I would be looking at the stock market trying to find the exact right time to jump in, like a kid on the playground playing jump-rope.  Of course we know from A Random Walk Down Wall Street, that all that stuff is random so there’s no point trying to time it, but I’m not totally rational when dealing with that much money.

For the blog, I did a little analysis and found that 12% of the time stocks* lose at least 1% in a single day; if I bought the day before that happened, I’m out at least $1000.  On the other side, about 13% of the time stocks rise 1% or more in a day; if I bought the day after that I’d similarly be out $1000.

My fragile nerves just can’t take that so I want to “diversify” the timing of my purchases to even out those big ups and big downs.  This is a strategy called “dollar cost averaging”.  So as I said, initially I would have recommended to Walter that he take the cautious path, take his $100,000 and split it into $10,000 chunks, and invest those each week for the next 10 weeks.

 

windfall analysis 2

But then using the magic of spreadsheets and the internet, I decided to see what the actual data said.  I looked at every week for the market since 1950 and did a comparison of the two scenarios:

  1. Invest your entire chunk of money all at once
  2. Spread your investment evenly over 10 weeks (dollar cost averaging)

Wouldn’t you know that on average it’s better to invest your entire chunk at once?  I’ve been doing it wrong this whole time, so thank you Stocky Fox.  In fact it’s not even close—historically it has been better to do option #1 about 61% of the time.

The thinking is that historically, stocks have always gone up.  Sure there have been some rough patches, some of which can last a really long time, but the general trend is definitely upwards.  So if you wait to invest your money over a longer time period, you’re missing out on some of that upward trend.  I looked at every week since 1950 (if you were curious, there are about 3400 weeks) and on average you gain about 0.7% by going with option #1 instead of option #2.  0.7%!!!  Holy cow.  Remember that post on The power of a single percentage?  We just found a 1% coupon right there.

So Walter, my advice is to pick a day this week and invest it all in one fell swoop.  You might get hit with bad luck, but the odds are better that you’ll get hit with good luck to the tune of about 0.7% (which in your case is about $700).  On the day you do it, don’t even look at the stock market and have several tablets of Alka Seltzer on hand.

*For this analysis I am using the S&P 500 data going back to 1950.

Movie review–A Raisin in the Sun (1961)

In honor of black history month, I am posting a review of A Raisin in the Sun.  It was originally a play written by Lorraine Hansberry in 1959 which experienced significant success on Broadway, after which it was adapted into a movie in 1961.  Over the years it has appeared in playhouses around the country in many incarnations as well as being made into three films.  Walter Younger, the main character, was originally played by the incomparable Sidney Poitier and later by Joe Morton, Danny Glover, Puff Daddy, and most recently Denzel Washington.

 

Poitier in RitS-2
Walter (Sidney Poitier) trying to convince his mother (Claudia McNeil) to use the insurance money to start a liquor store

The drama centers on the Younger family: Walter, his wife Ruth, and their son Travis; Walter’s sister Benny; and Walter’s mother Lena.  The entire family is living in a two-bedroom slum apartment on the south side of Chicago (near where I went to graduate school).  Walter is constantly dreaming of making it big with some get-rich-quick scheme, while Ruth and Lena have accepted their humble lives, and Benny is soaking up all life has to offer while studying to become a doctor.

As a stroke of bitter-sweet fortune, Walter’s father who had recently died, had a life insurance policy that paid $10,000 to Lena (which today would be the equivalent of between $80,000 and $200,000 depending on how you calculate it).  Walter wants to put it towards opening up a liquor store while Lena wants to use it to buy a home and help pay for Benny’s education.

Eventually Lena puts $3500 down on a new home in an all white neighborhood for the family, but gives the rest to Walter.  She instructs him to put $3000 in a savings account for Benny and then do with the rest as he thinks best because he is the “man of the house now”.  Walter uses the whole $6500 (including Benny’s $3000) to pool with some friends to open their liquor store but is swindled when one of his partners bolts with the money.

A bitterly dejected Walter, having squandered his family’s windfall, tries to redeem himself by offering to resell the house his mother bought to their soon-to-be neighbors who are willing to buy the Youngers out (and at a profit for the Youngers) so they don’t have to have a black family among them.  At his darkest moment, Walter’s family rallies around him and Walter rejects their neighbors’ offer and the family moves into their new home.

 

There are two analogies which come to mind when thinking about this movie: first mole sauce and second a time capsule.

Mole sauce, because it’s made of something like 1000 different ingredients, and it seemed like Hansberry deliciously layered about 1000 different social issues into her intriguing play.  Race was the dominant issue of the drama—white racism against blacks most overtly, but also black racism against whites as well as black racism against fellow blacks.  You also had questions of what it meant to be a black person living in white America as well as the relationship black Americans should have to Africa.  The play also looks at gender roles, the evolving role of religion, poverty issues and the potential for upward mobility, and if all that wasn’t enough it even throws in abortion and child abuse.  All of those were relevant then and they remain relevant today.

Time capsule, because as I was watching the movie in 2015 I was asking myself “Is that really what life was like in 1960?”  Whether it’s the race issues, how women are viewed both by Walter and the women themselves, a defeatist attitude about upward mobility, or their insane views on how to use the money (more on this in a second); it just seemed like this was another world, not 50 years ago.  I don’t know if I’m naïve when I think it couldn’t really have been that bad then, or if I’m proud of our society for having come so far in the five decades.  On the surface the movie is so anachronistic but at its core it features the issues and struggles that we have today just as we did in 1960.  Very thought provoking.

Benny is the most interesting character (but also the character I get most frustrated with) because it seems all these issues use her as a foil.  She wants to be a doctor to help society and break out of poverty, but her family only sees her as the future wife of some man, preferably a rich man.  She ends up dating two men—one is a wealthy, educated black man who has completely assimilated to “white America” while the other is a Nigerian who asks her to embrace her African roots and ultimately return to her ancestor’s continent.  She wants to experiment with all life has to offer (photography, horseback riding, music) while her impoverished family can’t really afford such fickle luxuries.

And of course, any review of this movie is incomplete without a comment on Poitier’s performance.  Obviously, it’s sublime.  He creates an amazingly complex character who is at the same time oppressively pessimistic but also unswervingly optimistic; defeated by life yet playful; prideful and stubborn yet able to lead the family when it needs him most.  Many people have written many pages on the greatness of Poitier (as I have just done) and deservedly so.  Additionally, I would be remiss if I didn’t also compliment Puff Daddy for an unexpectedly wonderful performance as Walter in the most recent movie from 2008.  Who knew?

 

Combs in RitS
Puffy Daddy and Phylicia Rashad from the 2008 movie

You’ve been patient with me so far, and maybe you’re wondering, “yeah, that’s all great, but what does this have to do with personal finance?”  The movie revolves around a family that receives a huge financial windfall, and they need to figure out what to do with it.  This is actually a very common scenario in real life, and actually one I’ll dedicate next Monday’s post to.

And just like in real life, the family has all sorts of ideas on how to spend the money, ranging from quite sensible to insanely frivolous.  Lena uses a chunk of it as the down payment for a house and intends another big chunk to go towards her child’s education, both fairly sensible.  Walter wants the money to start a business which is high-risk/high-reward; of course one of the major risks there is you expose yourself to malfeasance which ultimately bites him.  Other ideas are thrown about like Lena should use the money to take a luxurious vacation (sounds like fun, but not very responsible), donate it (noble but doesn’t solve the Younger family’s problems), or even just hang the check up on the wall and look at it.

It pains me that they never consider the idea of investing it in the stock market.  Of course in hindsight maybe they were wise to avoid the 1960s (a decent decade for stocks) and 1970s (a terrible decade for stocks).  But I suspect it speaks to the lack of financial literacy and knowledge of investing in the broader population from the 1960s, and particularly for the impoverished.  This is actually a place where I think we’ve made a tremendous amount of progress as a society (more on this in a future post).  Had the book been set in 1950, 1980, 1990, or 2010, not considering the stock market would have been a costly oversight.

 

So there you have it.  I think it’s a great movie, especially appropriate as we reflect on black history month and look at its intersection with personal finance.  I love Poitier and the social issues are incredibly thought provoking.  But I feel the other characters don’t match Poitier’s excellence (tough to do).  Also, you can obviously tell the movie is an adaption of a play; the action is stilted and the scenes overly dramatic the way live performances so often are (sometimes you feel you’re watching a camcorder recording of a play, instead of a movie).  I definitely recommend it, and give it three out of four stocky foxes.

3 foxes

Week in review (27-Feb-2015)

The biggest stories this week were:  Fed speaks to congress (Tuesday, Wednesday), American cars get high rank (Tuesday), TJ Maxx raises wages (Wednesday), and Net neutrality regulations passed by the FCC (Thursday) .  Of course, there were the daily Greek gyrations, but I figured I covered that adequately on Wednesday.  It was a pretty tame week for the markets virtually flat across the board.

graphic

 

Fed comments:

Janet Yellen spent Tuesday and Wednesday testifying before Congress, and the markets were hanging  on her every word, of course waiting for any indication as to when  the Fed will raise interest rates.  As par for the course, about half the market watchers thought her comments dovish, indicating that the currently low rates would remain low for longer, while others thought her comments hawkish, indicating that a rate increase would happen sooner.

Of course, when the Fed does increase rates, it will most likely mean they think the economy is healthy enough to not to have to be propped up by the super-low interest rates  that have been present for the past 5+ years.  The markets will freak out when that happens in the short term, but it will be a good thing for the long term.

 

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The Buick Regal was named best sports sedan

American cars do well:

Consumer Reports announced its annual winners for each car category, and American brands sat atop three of the ten categories, including Tesla being named best overall car.  This is important for a couple reasons: First, it shows that the domestic car industry is alive and well, creating really strong offerings.  This will of course lead to greater sales which will lead to higher profits and ultimately rising stock prices.  So that seems particularly good for the US automotive industry that was so bad for so long.

Second, the report really highlights the amazing technological advances that are going into all these cars.  These cars (and trucks) are becoming computers integrated into our lives in amazing ways.  They’re making driving safer and more convenient.  Over the next 10 or so years, I think we’re going to see a major transformation in the auto industry, especially as self-driving features become mainstream, which is going to be amazing for society but also tremendously profitable for the companies who can put it together.  Also, it doesn’t hurt that tremendous innovators like Google and Apple are entering the fray.

 

TJ Maxx chart
TJ Maxx announced the pay increase on Wednesday along with its earnings, which led to a sharp increase in the stock price

TJ Maxx raises wages:

On the heels of Wal-mart’s announcement last week, TJ Maxx announced that it was following suit in raising the wages of their lower-paid workers to $9 per hour.  In contrast Wal-mart’s experience, TJ Maxx’s stock rose sharply on the news; of course, that was the same day they announced really strong quarterly earnings.  So it’s hard to tell if the market thought that TJ Maxx’s wage decision was a good one, or if they thought it a bad one which was masked by the otherwise good earnings news.

Either way, it’s undeniable that now this movement has a little momentum.  Wal-mart and TJ Maxx are just two of thousands of companies that have low-wage workers, but now there are two more companies who are voluntarily raising their wages than there were before two weeks ago.  If this movement continues to grow, it will certainly have important implications for the stock market but also, more importantly, society as a whole.  It will pressure the profits of those companies (a bad thing for stocks), but it will also put more money in the pockets of a segment of the population that is mostly likely to shop at those stores (a good thing for stocks).

Also, probably the largest implications for this are appealing to my libertarian roots.  Wal-mart and TJ Maxx have voluntarily made these moves.  No government intervention was required (although perhaps it was the threat of government intervention, but I doubt that given our divided government).  Will this show that when left to their own devices, companies will find win/wins for themselves and their employees?  I hope so.

 

Net neutrality:

This is one that definitely will be a big deal; the only thing now is no one really knows if it will be a big deal in the positive or negative direction.  This legislation just passed by the FCC imposes rules on internet carriers similar to those placed on phone carriers.  It has a lot to do with how internet carriers now cannot provide preferential access to certain websites, etc. (although I must admit that I find the legislation confusing).

The reason I think this is so important is that this is one of the first steps in governing the largely “unregulated” internet, and that poses the question: “Is that a good thing?”  On the one had you could say that the internet has grown up and is now such an integral part of our lives and our economy that it has to be regulated to ensure fairness, safety, quality, etc.  On the other hand, you could say that the internet has grown to be so valuable because it has been given a free hand to grow as the open market dictates, and government meddling will just mess all that up.

I am a strong believer in free markets, and I side with the idea that less government regulation tends to be better.  These changes make me a little apprehensive.  The regulations the FCC is imposing are similar to the ones imposed on long-distance phone carriers 80 years ago, so reasonable people may wonder how appropriate that is.  Also, this is happening in a thriving part of the economy that has provided amazing technological advances that have given huge benefits to society, so the stakes are pretty high.  I just hope we don’t look back on this and say this is one of the things that hobbled the internet.

 

So there you have it.  Greece and the Fed took center stage and spent a lot of time saying stuff that didn’t have a lot of substance to push the market one way or the other.  But you also had some pretty interesting stories pushing stocks both higher and lower.  At the end, we ended up pretty much where we started, and isn’t that just the way with these things so often.

The skinny on the Grexit

Cracked euro and Greek flag

 

“I’m sorry but this relationship just isn’t working.  It’s not me, it’s you.”

The Greek financial crisis continues to dominate the financial press.  Last Friday, when the European finance ministers reached a last-second agreement, the Dow Jones Industrial Average rose over 100 points.  Monday there started to appear fissures among Greek legislators with some thinking Alexis Tspiras gave too much, causing markets to drop.  Then on Tuesday the lenders approved Greece’s plan, and the markets surged.  So what is an investor to make out of all of this?  In this post, I’m going to break down what I think will happen and how that will affect us as investors (as always, this is just my opinion and I am not guaranteeing the future).

As I said in my Feb 13 weekly review, there are broadly three options on how this situation can play out:

  1. Greece uses the loans as a bridge to reforming its economy so it can reestablish itself as a self-sustaining country which can support itself without foreign intervention.
  2. Germany and the European community continues to subsidize the Greeks in spite of their failure to drive the sufficient reforms necessary to become fiscally solvent.
  3. Germany and Greece don’t agree, Greece defaults on its debt package, and they will ultimately leave the Eurozone–Grexit.

 

The first option—Greece stands on its own—is the one everyone has been hoping for, and really the reason for all the effort in the first place.  Yet, it also seems incredibly unlikely.  Greece spends too much money and it takes in too little in taxes.  Their pension system is incredibly generous and expensive; some estimate that last year 40% of the people who started collecting pensions were below the official retirement age.  Their public sector is enormous and inefficient, and their tax system is corrupt and totally ineffective with so many loopholes it reminds you of Swiss cheese (thank you, I’ll be here all week).  But most damning is they just aren’t very productive.  Quick, name a product that is made in Greece that you’d want to buy.  Not easy to do.

Put all that together and it’s a total recipe for disaster that has led us to where we are.  That’s not to say a country can’t dig itself out of this hole with the proper motivation and a willingness to sacrifice–Ireland comes to mind as a country in a similar place that has started down the slow, long, painful path to recovery–but the Greeks seem to have neither.  Just a month ago they elected a prime minister who ran on the platform that he would repeal all the austerity and reform measures that were imposed on Greece to get them back to self-sufficiency.

If Greece were able to pull this off, then it would be a huge boost to all the stock markets, especially the European markets, and most especially the Greek markets.  But I just don’t think the Greeks have it in them.  I hope they prove me wrong.

 

The second option—Greece continues to get loans without meaningfully improving—seems to be where we have been for a while now.  If you accept the reality that Greece will never be able to right itself, then this seems like the best option except for ONE MAJOR PROBLEM—eventually the Germans and the rest of Europe will get tired of subsidizing Greece’s reckless spending problems.  And by the looks of it, “eventually” might be soon.  Just like the parents of their 26-year-old, unemployed son living in the basement are one day going to say “enough is enough” so that will happen with the Germans and the Greeks.

So long as the loans keep coming, Greece has shown very little motivation to make the hard choices to get better.  Remember in 2012 when Tspiras and his Syzria party first started making waves, he basically was calling Germany’s bluff, saying that the loans would continue even if Greece rolled back the reforms because no one was willing to kick Greece out of the Eurozone.  Incidentally, isn’t that just a massive “screw you” he gave to the Germans?

This whole drama started 7 years ago and has Greece been able to fix its problems in that time . . . no.  Germany and others continue to lend money which creates a drag on their economies and lowers their stock markets, while Greece takes the money and fritters it away.  Believe me, I would love to be partying all the time while someone else pays the tab, but life isn’t like that.  If we continue down this path, I would expect returns from European markets to continue to be lower than those in the US, as has been the case for the last five years.

 

The third option—Greece leaves the Eurozone—seems to be eventually where we end up once Germany cuts up Greece’s credit card–Grexit.  Since no country has ever left the Eurozone, no one really knows what will happen.  People with a vested interested in keeping the status quo use scaremonger tactics to paint a picture of economic catastrophe if this happens.  But what would really happen if Greece left the Eurozone?  Here’s my take:

Undeniably, it would be bad for Greece and anyone investing in Greek stocks, really bad.  They’d have to introduce their own currency which would start trading against the Euro, and because of the shambles of the Greek economy it would depreciate rapidly.  Greece would experience huge inflation and imports would become much more expensive which would have a huge negative effect on the quality of life for the Greek people.  Also, when they went to borrow money internationally, their past track record would make it so they would only be able to do so at interest rates much, MUCH higher than they are getting now from the subsidized loans from Europe.  Greece would tumble into a huge recession that would make the past five years look like a day at Mykonos (again, I’ll be here all week).  After many, many years, things would start to normalize but Greece would be firmly entrenched in the ranks of a 3rd world economy rather than a peer among Europeans.  That would really suck if you were Greek.

The major unknown is what would happen to the other European countries in the Eurozone.  Probably for a little bit it would be rough sailing just because the maneuver of a country exiting the common currency has never been done before, but what would really change over the long-term?  Would Seimen’s x-ray machines (Germany) be any less accurate; would Heinekens (Netherlands) taste any less good; would Michelin tires (France) be any less durable; would Ferraris (Italy) be any less of a status symbol?  No, they’d all maintain their competitive positions, continue to sell, and maintain the value of their stocks.  After the brief hiccup when Greece leaves and things get settled, the European economies would probably be even stronger because they wouldn’t be dragging Greece along with them.  Sure, their imports to Greece would be hurt, but remember the Eurozone is about the size of the US economy while Greece’s economy is about the size of Connecticut’s; not a huge deal in the grand scheme of things.  I would predict that within two years (and probably even less), the European stock markets would be higher than they would on the day of Grexit.

As far as the rest of us go, the whole Greek saga really has no bearing.  As I mentioned before Greece is tiny in terms of its economy.  If/when Greece exits the Eurozone and its economy implodes it will go unnoticed except by our news organizations which are going to have to find something else to talk about, but that’s really it.  In fact, because Grexit will be good for Europe, it will benefit the other global economies just because we will have a healthier and stronger Europe to work with.

 

So there you have it.  That’s my take.  The sooner we face reality, the sooner we accept that Greece just isn’t capable/willing to support itself, the sooner we’ll be able to move forward.  And that moving forward will help all our economies and be positive for the stock market.

The power of a single percentage

2014-02-18 (1 percent)

“How can something so small be so impressive?” –Belinda Heggen

1% doesn’t seem like a lot.  It’s the extra sales tax my city adds, hoping I don’t notice it.  It’s the maximum amount of gross stuff food companies can put in packaged food without having to tell us (I don’t know it that’s true or not).  But in investing 1%, while so easy to overlook, can make a huge difference.  Here we’re going to find out how we can get that 1% to help us.

Let’s go back to my neighbors, Mr and Mrs Grizzly.  Each year they will save $10,000, investing it in a stock index mutual fund with an expected annual return of 6%.  After 30 years, they expect to have $790,581 saved (good time for the disclaimer that I am not predicting future stock performance, just giving an example), a tidy little sum to help see them through their golden years.

However, Mrs Grizzly starts playing with her spreadsheet and changes the annual return from 6% to 7% just to see what happens.  She’s astounded to see that the $790,581 that she gets with a 6% return balloons to $944,608 if she assumes a 7% return; that increase in the annual return of 1% led to an increase in her nest egg of 19%.  Tempting fate she sees what happens with an 8% return: $1,132,832.  She’s a millionaire now.  Cranking the return up to 9% made her nest egg $1,363,075; just increasing her return 3% nearly doubles how much she and Mr Grizzly will have to retire on.  Ladies and gentlemen, welcome to the power of compound interest!!!

Percentage graphic

The point here is that a seemingly small 1% change in your investment return can make a huge difference over time.  By tailoring your investment strategies to collect as many “1% coupons” as possible, you can substantially increase, even double, the value of your nest egg.

So how do we get those higher returns?  Most people will default to higher stock returns: “It’s a no-brainer.  Instead of investing in the stocks and mutual funds that return 6%, let’s invest in the ones that return 7%.”  Unfortunately, after reading A Random Walk Down Wall Street we know this isn’t so easy.  For any given level of risk, our investment return is probably going to be what it will be.

Now that changing the actual investment return is out, what are our options?  Fortunately there are a lot of other things that affect our total return beyond just what our investments give us.  We’ll dive into each one of these with its own blog post, but a few to think about at a high level are:

  1. Mutual fund management fees: Each year mutual funds charge between 0.05% all the way up to 1.50% or more for management fees.  Going from high-cost mutual funds to low-cost funds can easily get us a 1% coupon.
  2. Financial planner fees: There are a lot of people out there who are more than willing to tell you how to invest your money for a small fee.  Except that fee doesn’t tend to be all that small: about 1-2% of your total assets.  Do-it-yourself investing can absolutely give you that 1% coupon, and the results you produce will probably be similar to those your investment adviser would.
  3. Being smart with taxes: You know Uncle Sam is going to take his cut.  However, you can delay when he takes his share with IRAs, 401k’s, etc.  This allows you to keep the money longer, and it allows to you be taxed on the money later in your life when you will probably be in a lower tax bracket.  Being smart with your taxes can easily get you a 1% coupon.
  4. Take the “free money” offered to you: Many of us work for companies that match 401k contributions.  Except they only give you the extra money if you invest in your 401k.  So at least putting in up the minimum amount of get the match can absolutely give you one or two 1% coupons.
  5. Proper asset allocation: We all know that some of your investments should be in higher return, riskier investments like stocks and some should be in lower return, less risky investments like bonds.  Properly assessing your portfolio to know how much you already have in less risky investments (especially things like pensions, Social Security, your home equity, etc.), can allow you to safely put more money in investments like stocks.  Over the long term, this could easily increase your return each year and get you a 1% coupon.
  6. Fully investing: So many people I talk to have $10,000 or $20,000 or $50,000 in their checking account that they’re “just waiting to figure out what to do with it.”  These are certainly Champagne problems, but they are also fertile ground to find 1% coupons.  Just taking that money and putting it in a bond fund instead of a checking or money market account could easily give that extra 1% or more; investing in a stock fund will provide even greater returns over the long run.

Those are just a few examples of how you can squeeze an extra 1% or more from your investment returns.  You’ll notice that none of those strategies include “outsmart Wall Street and pick the stocks that are going to do the best.”  I’m not that smart; I wish I was because then the Fox family would own its own island in the Caribbean next to Johnny Depp’s island.  These are all really simple strategies that anyone can do, and each of which takes less than a couple hours to set up, and can lead to hundreds of thousands of dollars over your investing lifetime.  The Fox family has benefited by these little strategies probably to the tune of 4-5% extra return each year over what seems typical among your average American investor, and that has equated to hundreds of thousands of dollars.

So here’s the bottom line:  As you read this blog, we’ll constantly be finding “extra 1% coupons” that you can redeem to increase your overall investment returns.  As Mrs Grizzly showed, even one of those can add $150k to your nest egg.  If you can gather two or three or even more, you can double your nest egg.

Book review: A Random Walk Down Wall Street

2015-02-21 (RWDWS book image)

“One ring to rule them all.”  –JRR Tolkien, Lord of the Rings

A Random Walk Down Wall Street by Burton Malkiel literally changed my life.  Back when I was an undergrad at the University of Pittsburgh, and I was showing a budding interest in finance, a professor recommended this book to me.  I ripped through it in about two days.  The concepts were so simple yet so complex.  It made so much sense to me, and a light bulb totally went off in my head, completely shaping the way I have looked at investing for the past 20 years.  If you’re going to read just one book on investing, this is the one you should read.

The book basically talks about two fundamental concepts of investing: what will happen in the future, and why some stocks (or asset classes) have higher returns than others.  Combine these two and you pretty much have an airtight understanding of why the stock market does was it does.

 

Efficient Market Theory

The entire book is based on the concept that stocks follow a random walk which basically means that you can’t predict their movements, especially over the short term.  Some days the market will go up, others down, and that pattern is totally random; in the same day some stocks will go up while others go down, and that is totally random.  Because of the randomness, it’s impossible to predict when the stock market will move up or which individual stocks will perform best, so you might as well invest in an index fund with a buy and hold strategy (much more on this in a future post).

Headline (full)
An article on Yahoo!Finance from Wednesday that perfectly illustrates the book’s central point

 

The theory rests on two core ideas:

  • New information drives stock movements and that new information affects the prices nearly instantly. So if Tesla develops a new battery technology, once that news becomes public, Tesla’s stock will rise to reflect the new value of the information.  A week, a day, an hour, or even a minute later, the market has already digested the information–the news has become old news.
  • People only buy or sell stocks for what they think they’re worth. If Apple was trading at $120, but everyone knew it was really worth $140, no one would want to sell it for $120 but instead would only sell it for $140.  If there were people stupid enough to do it, their shares would be bought instantly by people who knew the stock was worth more.  This means that whatever price stocks are trading at is the “right” price.

The efficient market theory makes investing both much simpler and more comfortable.  Simpler because you don’t have to waste countless hours trying to figure out if now is the right time to buy into the market or which stock will do best.  The stock markets are completely unpredictable in the short term so now is as good a time as any.

Comfortable because any price you pay is the right price.  You could buy a stock in a company you’ve never heard of in an industry you know nothing about, and market forces have done you the favor of ensuring it’s the right price.  If the price was too high sellers would have dumped shares and brought it down, while if the price was too low buyers would have snatched up shares and brought it up.  There’s a real load off—Thank you efficient market theory!!!

 

Risk-reward

Everything isn’t totally out of your control, and the book spends a lot of time discussing the one thing that investors can do to impact their returns—take on risk.  If you like “eating well” and want bigger returns, you should purchase stocks that are fundamentally riskier; if you like “sleeping well” and want steadier returns, you should purchase stocks that are fundamentally less risky.

Use the example of Tesla and Wal-mart.  Tesla is a fundamentally riskier stock: its technology is still novel and unproven, it’s entering a market with established competitors, and the legal system works against it (auto dealerships in New Jersey and Texas).  Maybe they “win” and become a dominant auto maker, but maybe they’ll “lose” and go bankrupt.   The downside is very real, so the upside has to be especially sweet to investors to compensate them for taking the risk.  Contrast that with Wal-mart: it’s already the dominant player with enormous economies of scale and a proven strategy that has been consistently successful.  If it “loses” it might be lower sales, but most people don’t expect it to go out of business.  Since the Wal-mart’s downside isn’t nearly as grim as Tesla’s, the upside doesn’t have to be nearly as big.  So over the long-term if you invested in a diversified portfolio of risky companies like Tesla, you would get a higher return than a diversified portfolio of less risky companies like Wal-mart (as always, I’m never predicting future stock movements).

 

Malkiel does an amazing job explaining these concepts (much better than I can in a thousand-word blog) and many others, and then shows how history has proven their accuracy with myriad examples.  My copy is an earlier edition (I bought it used because I’m cheap) published in 1980s, and those concepts apply to today’s stock market just like they did 30 years ago.  Subsequent editions have been updated to include the internet boom and bust of the late 1990s and early 2000s as well as the banking crisis of the late 2000s.  There’s a part of me that almost wishes he wouldn’t come out with new editions (but I get it, republishing is a real cash cow for him) just so he can say, “Look, the things I wrote 40 years ago are exactly apply to what is happening now.”

So as you step into the pool of personal investing, this is an essential guide.  It will undeniably change the way you look at investing (for the better), and it might even change the way you look at life (geez, you’d think I had a man-crush on Burton or something, but the book is that darn good).  I unreservedly give it the maximum four stocky foxes.

4 stocky foxes (for movies)

Week in review (20-Feb-2015)

Weekly review 2015-02-20

The biggest stories this week were: Greek debt restructure (every day), oil train explodes in West Virginia (Monday), US Federal reserve takes dovish tone on interest rates (Wednesday), and Wal-Mart raising wages for workers (Thursday).  US stocks were up just under 1% while international markets were all up about 2%.

Greek flag

Greek drama, continued:

I’m no longer calling this a Greek drama—it’s more like a Greek saga or Greek epic.  Monday everyone was playing nicely, Tuesday the Greek finance minister didn’t wear a tie and that insulted the sensibilities of everyone else, by Wednesday they seemed to be making progress again, on Thursday Germany rejected Greece’s bailout request, and today at the eleventh hour they agreed on a four-month extension which powered the US markets up about 1%.

Next week I’m writing an entire blog post on how this story is totally overblown and that it really doesn’t impact ordinary investors that much.  Suffice it to say, similar to the weather, this story is going to change constantly (that weather analogy does not apply to Southern California where it’s pretty constantly sunny and warm—sorry all you people buried in two feet of snow).  Greece bought itself some time, but you get the feeling they’re just kicking the can down the road.  The media is going to continue to pound this story because it makes good copy, and the markets seems to be bouncing with it between optimism and pessimism.  No way in the world the Greek economy is important enough to have this type of impact on the world’s stock markets.

 

oil fireball

 Oil tank train crash

I actually think this one has the potential to be a big deal.  As the North American oil boom unfolds, the logistics of how to get the crude from North Dakota and Alberta to market are becoming increasingly important.  Oil tankers on trains have carried most of the burden, and so long as projects like the Keystone Pipeline languish on the president’s desk, those trains are going to continue to need to do so.

The concern I have is that the oil tanker cars that exploded in West Virginia over the weekend were supposed to be top-of-the-line with enhanced safety features.  Fortunately this time no one was seriously hurt, but there have been several of these accidents, some of which have caused loss of life, all of which have caused significant damage.  Extracting oil from those shale fields has been one of the great economic success stories in the past few years (remember when gas was $4+ per gallon?).  However, there aren’t enough people driving cars in North Dakota to use all that oil; it has to get to market somehow.  If trains can’t efficiently, cost-effectively, and safely do it (do you see the picture of the fireball?) and regulators won’t approve pipelines, I have a concern that a real albatross might hang over the domestic oil industry.  Transporting the oil is going to be much more regulated and a lot more expensive.

Accidents like this are just going to continue to highlight the dangers, and even if the accidents are happening less than 1% of the time, can you blame people for getting concerned?  I mean, it blew up the side of a town.

 

Fed decision:

The US Federal Reserve released its minutes and seemed to indicate that it was leaning towards raising interest rates later rather than sooner.  The equity markets increased a little bit, but bond prices shot up like a rocket.

Everyone agrees that interest rates will have to go up (which tends to lower stock and bond prices).  What is up in the air is when those rates will go up, and today’s news said we’ll still have the lower rates a little while longer, confirming what it seemed most were expecting.

 

Wal-mart chart
Wal-Mart stock reacts negatively to new of higher employee wages on Thursday

Wal-mart raises pay:

Surprise move from Wal-Mart, one of the most reviled companies in terms of worker compensation.  The major debate is asking if they did this because:

  1. The economy is strengthening and they need to pay workers more to attract and retain the best people. If that’s the case this is pretty unambiguously great news for the economy, although it could be a sign that inflation pressures might be returning.
  2. Political and social pressures finally compelled Wal-mart to pay its people more. If this is the case, it’s either good news or bad news depending on where you sit on the political spectrum.
  3. Wal-Mart’s culture in its lower ranks is so soul-crushing that they needed to do something to shore up people’s spirits just do they don’t actively try to sabotage the company while at work. If this is the case, that’s really, REALLY bad for Wal-mart.

Either way, the market didn’t think this was good news for Wal-Mart.  The stock was down over 3% on a day when the market was pretty much flat.  My take is of the three reasons above, it’s closer to #2 than #1, probably about 1.8, with just a smidge of #3 sprinkled in.  Wal-Mart just increased its cost structure about $1 billion without a corresponding increase in revenue, making it a loss of about $1 billion.  If this is a populist pay increase (reason #2) which spreads through the economy, I think it will hurt other stocks the way it hurt Wal-Mart’s Thursday.  So it will be interesting to see how other companies who employ a lot of low-skill, low-cost workers like McDonald’s who have been in the “minimum wage” crosshairs react.

 

Have a great weekend.  I’ll be posting my book review of my absolutely favorite book on investing tomorrow so be sure to check it out.

Impact on investments of terrorist tragedies

“He saw the horrors and screamed, and that scream was heard for miles”

The world has been battered by a spate of deplorable militant Islamic attacks—17 French killed in the Charlie Hebdo attacks, over 2000 recently killed by Boko Haram in Nigeria plus nearly 300 girls  kidnapped and still at large, ISIS beheading and even burning alive hostages, and the Danish attacks just this weekend.  It’s beyond tragic, and it’s enough to make some doubt the future of humanity.  Translated to investments, events like these increase the VIX, commonly called the “fear index” in investing parlance.  As I write this, in no way do I want to diminish or trivialize the horror of these events.  What has happened to the victims of these barbarians sickens me, and my heart truly aches for them and their families.

Yet, how should we think of these events in the context of investors?  The answer is “not much.”  History, both ancient and sadly recent, is littered with these types of tragedies and other events that violently shook the faith of investors.  Yet, in each case, while the short-term may have been rocky, investors who stuck it out over the long term were rewarded by attractive returns.

I picked a few significant events, and looked at how an investor would have fared had he invested $1000 per month in the Dow Jones Industrial Average starting in the month of the event and every month thereafter for 1-year, 3-year, 5-year, 10-year, 20-year, and 30-year periods.

Nazis--Sep 1939
Returns on DJIA after Germany starts WWII (September 1939)

Nazis start WWII:  In September 1939 Hitler and the Nazis invaded Poland and started World War II.  Had someone started investing $1000 that month he would have a loss of $855 after one year and $4763 after three years which is understandable because the world was overtaken by war.  But after five years there would be a profit of $9663, a profit of $25,564 after 10 years, a profit of $540,843 after 20 years, and a profit of $754,004 after 30 years.  Entering the darkest period of the 20th century, when more soldiers were fighting than ever before, when more people were killed than ever before, when the holocaust was perpetrated and atomic bombs dropped—despite all those tragedies, it was a good time to invest.

Atomic bomb--Aug 1945
Returns on DJIA after atomic bomb dropped (August 1945)

Entering nuclear age:  In August 1945 Americans dropped two atomic bombs on Hiroshima and Nagasaki, killing 200,000 Japanese civilians.  After the Soviet Union developed its own nuclear capabilities in 1949, the threat of nuclear apocalypse and human extinction became a very real possibilities.  However, the following years were good years to be an investor; steady investing led to profits for the 5-year, 10-year, 20-year, and 30-year periods.

MLK--Apr 1968
Returns on DJIA after Martin Luther King’s assassination (April 1968)

Assassination of Martin Luther King, Jr:  In April 1968 a racist assassin struck down the civil rights leader, plunging the nation into deadly race riots.  Race relations precipitously deteriorated, and many could argue remain tragically strained.  While investments would have shown a loss after 10 years, they showed a profit after 20 years and an astounding $2+ million profit after 30 years.

Stagflation--Jan 1982
Returns on DJIA at “capitulation point” for US economy (January 1982)

Interest rates peak:  In January 1982 the US was in its worst economic situation since the Great Depression.  Inflation was 12% and interest rates were at 20%, both near the highest levels in the nation’s history; to put those in perspective, today both inflation and interest rates are less than 2%.  Back then the economy had never looked so bad, the stock market had been flat for nearly 20 years, and people were openly questioning whether capitalism was a viable economic system.  For those brave souls who were buying stocks (and probably chased stock purchases with a swig of Pepto), it turned out to be a great time to be an investor.  Every time period—1-year, 3-year, 5-year, 10-year, 20-year, and 30-year—were profitable.

 

The common theme is obvious: in all of those eras, investors who continued to buy stocks, no matter how scary the world looked at the moment, profited in the long run (of course past stock performance has no bearing on the future).  Putting the recent Islamic terrorist events in context with some of the events we just looked at (and again, in no way trivializing or diminishing the horror of these recent attacks), it seems reasonable to assume that as investors there isn’t a lot to fear.

While the recent attacks are atrocious, they seem quite small when compared to WWII, both in terms of human costs and overall destruction.  ISIS and Boko Haram have embraced barbaric practices, yet those have a destructive scope orders of magnitude smaller than the horrors of nuclear war.  Sadly for citizens in Nigeria, Syria, and Iraq, the threat of these extremists is palpable, yet those countries have tiny GDPs (about 1% of the world’s GDP for those three countries combined) and proportionally small investing relevance; it just doesn’t hit close to home in the big-GDP countries the way the US riots and racial discord did in the 1960s and do today.

As a human, those attacks are deplorable and I want civilized society to do everything in its power to end them and bring the perpetrators to justice.  As an investor, they are minimally important to the point of irrelevance.

#bringbackourgirls

The tax man cometh

2015-02-13 image (grim reaper)

“In this world nothing can be said to be certain, except death and taxes” –Benjamin Franklin

I love this woodcut from the 1600s.  I imagine the artist drew it so the skeleton’s hand is asking for the guy’s life, but it kind of looks like he has his hand out asking for money like he’s collecting taxes.  Either way, if you’re death or the tax man, you probably aren’t too popular.

Obviously taxes are important when you’re thinking about investments and your retirement.  Uncle Sam (for all you foreign readers, what is the name of the personified tax collector in your country?) is definitely going to take his share of your earnings and investments.  Given the progressive nature of most countries’ tax codes, as your nest-egg gets larger and larger, they take a bigger percentage, so that raises the stakes.

The government has built the tax code to offer huge tax breaks to people saving for retirement, particularly allowing people to defer taxes from their earning years to their retirement years. That’s really all that accounts like 401k’s and IRAs are doing, taking money you earn when your income is high and allowing you to pay taxes on it when your income is low.  It may not seem like a big deal at first but suffice it to say, optimally managing your tax situation can be the difference of hundreds of thousands of dollars.  As always, it’s important to remember that I’m not a tax expert; also I’ll be making assumptions on future stock returns which in no way guarantee that is what will actually happen in real life.

 

Working tax rate versus retirement tax rate

US tax rates go up pretty quickly the more money you make.  So when you’re in your prime earning years, that is when your tax rate is going to be the highest.  Take my neighbors Mr and Mrs Grizzly as an example.  They both work and have a combined income of $150,000.  Throw in a couple assumptions like they have two cubs, a mortgage, and live in the great state of California, and they are paying a total of about $41,000 in taxes, about 27% (there’s a great website that I used for these estimates).  Look a little deeper and their marginal tax rate is 43%; that means if they earned one more dollar they would pay $0.43 in taxes, and conversely if they lowered their income by one dollar they would save $0.43 in taxes.  Wow!!!  That’s a lot in taxes.

Now let’s fast forward and think of Mr and Mrs Grizzly in retirement.  Their house is paid off and they don’t have to save for their cubs’ educations, so what they need to support their retirement lifestyle is $80,000 (believe me, I will have many future posts dedicated to estimating how much someone needs per year in retirement, but for now let’s just take the $80k on faith).  Each year they tap into their savings and the $80,000 breaks down into three buckets: $20,000 is interest and dividends; $30,000 is long-term capital gains on the profits from their investments over the years; and $30,000 is the basis, the original money they invested which doesn’t get taxed.  Run your tax calculator again and they’re paying a measly $1,200 in taxes!!!  Read that again; it’s not a misprint.  That’s only 2% compared to the 27% they were paying while they were working.  And their marginal tax rate is 4% in retirement instead of 43% while they were working.

That, my friends, is some powerful stuff!!!  Now, how do Mr and Mrs Grizzly translate that into cash money?

 

The value of deferring taxes

During their working years, Mr and Mrs Grizzly set up their budget to save $1000 per month.  Because they are avid readers of the Stocky Fox, they know they should save that through their 401k’s (in this unfortunate example, let’s assume their cheapskate company doesn’t offer any matching).  In a year they will have saved $12,000 but since 401k’s are tax deferred they don’t pay taxes on that money, saving themselves $5160 in taxes (remember, their marginal tax rate is 43%).  Nearly $5200!!!  That’s some serious honey comb.  They do that each year and after 30 years (let’s assume a 2% dividend and a 5% stock increase), and they have a nice little honey pot of $1.12 million for retirement.  They’ll withdraw their $80,000 per year and pay the lower tax rate on it, and life is good.

The Grizzleys are sitting pretty, but what would happen if didn’t use their 401k to defer taxes and instead invested their money in a normal brokerage account?  Each year, they’d pay the $5200 in taxes but then they would also have to pay taxes on the dividends of their investments at about a 33% marginal tax rate (special thanks to my ChicagoBooth classmate, Rich, for correcting me on this).  If you assume the same investments as we did above, 2% dividends and 5% stock increase, after 30 years they would have $815k.  That’s nothing to sneeze at, but that’s about $300k less than what they had with their 401k.  Those numbers seem crazy, but that’s the power of tax deferral.

2015-02-16 deferred taxes graphic (qd)

So the lesson is that using tax deferred accounts offers a really powerful way to accelerate the growth of your nest-egg by cutting out the tax man (in a totally legal way, of course).