Federal reserve makes markets dive

Nothing gets stock markets so excited as the Federal Reserve.  Here is a chart of the S&P 500 yesterday.  Quick, when do you think the Fed announced that it was going to raise interest rates?  Everything was going fine—it was a pretty smooth day and then at about 3pm the Fed made its decision and the bottom fell out of the stock market.  Why is the Fed so important?  What is it doing that can make a calm market move to much so quickly?

Basically (and this is very basic, as there is a boatload of nuisance in this) the Federal Reserve, and for that matter the central banks of any country, control the core interest rate.  That single, yet enormously powerful tool, allows the fed to influence the economy in a major way.

The guiding mission of the Fed is first and foremost to maintain a healthy level of inflation.  In the US that is around 2-3%.  Being too low has some problems that reasonable people can debate, but pretty much everyone believes that when inflation gets too high, that’s when really bad things happen.  So more than anything, the Fed is tasked with keeping inflation low.  Then a secondary goal is to promote a healthy and growing economy that keeps unemployment low.  So basically the Fed has two jobs, keep inflation low and keep the economy strong.

 

How does the Fed impact the economy?

Let’s imagine a really simple economy.  There are ten companies named A and B and C all the way down to J.  Just like in real-life, not all companies are created equal, with some being much more profitable than others.  Here A is the most profitable (maybe like Apple) while J is the least profitable (maybe like JC Penney).

Interest rates will play a big part in the profitability of these firms.  As interest rates go up, the amount they spend on interest for all their debt goes up as well.  Because A is so profitable, it would only start to lose money if interest rates went really high, up over 10%; however J is much more vulnerable and will become unprofitable if interest rates go over 1%.  All the other companies have a similar situation as shown in the graph.

So this is where the Fed comes in.  Let’s say the Fed sets the interest rate at 6%.  Firms A, B, C, D, and E are all profitable even when the interest rates are that high; but firms F, G, H, I, and J are not.  Because of that things won’t look good for firms F-J.  Maybe it’ll be so bad that they’ll go bankrupt or maybe they’ll lay off people or put a hiring freeze on.

At 6% interest, you have five firms that are doing well (A-E)—growing, hiring more people, expanding, etc.—and five that aren’t (F-J).  And at 6% the economy is performing at a certain level.  But what would happen if the Fed lowered the interest rate from 6% down to 5%?  One more firm (F) would be profitable, and in general it would benefit all the firms.  The profitable ones would be doing even better, and the unprofitable ones wouldn’t be quite so bad off.  And that would lead to a strong economy: more “stuff” would be produced and more people would be employed.

So there is very clear relationship that lower interest rates led to a stronger economy.  Having a strong economy is one of the Fed’s goals, so that begs the question, “Why doesn’t the Fed push rates all the way down to 0%?”

This is where it starts to get interesting.  It’s my favorite topic: Inflation.  Remember that the Fed’s first job is to control inflation.  Let’s look at the Fed’s decision to move interest rates from 6% to 5%, but now look at it with an eye towards inflation.

In our pretend world, let’s assume at 6% interest rates the economy is doing well.  Things are growing and unemployment is fairly low.  When interest rates go to 5%, firm F will become profitable so they’ll want to hire some people—makes sense.  But remember that unemployment is low, so F is going to need to tempt people who are already working for A or B or C or who ever to come work at F.  How does F do that?  They pay them more.

F starts to pay people more, but A doesn’t take this lying down, so A starts paying more.  This wage increase trickles through the economy.  But A and B and even F need to make money, so the increase in compensation they’re paying to their employees gets passed along to consumers in the form of higher prices.  When prices start rising, that’s INFLATION.  And controlling inflation is the Fed’s #1 goal.  So that creates the difficult balance for the Fed—they want the economy to do well but not so well that it triggers inflation.

So there you go.  You just completed a course in “Introductory Macroeconomics”.

 

What’s going on today?

Now that you have that little lesson under your belt, how does that relate to what’s going on with the Fed right now?  For the past couple years, the Fed has interest rates at historic lows, at about 0%.  Then about two years ago they started slowly raising interest rates to more normal levels, although even now the interest rates are still low by historical standards.  Obviously that’s super low, so shouldn’t the Fed be worried about inflation?

Remember the circumstances of how interest rates got that low.  At the beginning of 2008 the economy was going strong and the Fed interest rate was at over 5%.  But then the financial crisis hit, blowing up the banking industry, and sending the world economy into a very sharp recession.  A ton of people lost their jobs (unemployment went up) so prices stayed flat or even started to fall a little bit.

With all this going on, the Fed threw a life raft to the economy in the form of near 0% interest rates.  In the intervening years, the economy has rebounded and unemployment has fallen, but inflation has remained pleasantly low.  This is kind of the best of both worlds for the Fed—the economy is strong and there’s no inflation.  The two things they have to balance are both in happyland, so they have kept interest rates low.

 

What does it really mean when the Fed changes interest rates?

With all of this, are we just a bunch of idiots?  Should we really be so happy if the Fed is keeping rates low, and should we be so bummed if the Fed raises rates?

As the parent of two boys who one day may start sponging off Foxy Lady and me, I think the parent-child relationship is a good analogy.

Imagine you have parents (the Fed) who have a grown child (the US economy).  Times are tough for the child (the economy is doing poorly) so the parents help out (the Fed lowers interest rates).  The good scenario is that the child starts doing better to the point where he doesn’t need his parents’ help (the economy strengthens so it can withstand higher interest rates).  The bad scenario is the child becomes dependent on his parents’ help and is never able to make it on his own.

In this analogy the parents reducing the amount of help they give (the Fed raising rates) is a good thing, isn’t it?  It means that the kid is getting things on track and is standing on his two feet.  For this reason, I actually think it’s a good thing if the Fed raises interest rates because it means that the economy is strong enough that it doesn’t need insanely low interest rates any more.  Yet the markets react in the exact opposite direction.

I get it.  Just as the kid would be bummed if the parents said, “hey pal, since you’re starting to make some money now, we won’t be sending those monthly checks”, the companies are bummed that they can’t borrow money so cheaply.  But that isn’t sustainable.

I chalk this up to yet another of a million examples of how the stock market acts in a goofy manner in the short term.  And another reason why I NEVER try to time the market.  I just keep my head down and invest for the long term, regardless of what is going on with interest rates.  But watching everyone hang on Janet Yellen’s every last word does make for perverse entertainment.

 

As the current debate unfolds, what do you think?  Is the economy strong enough for the Fed to continue to take away the credit card?

BREXIT—when experts were idiots

On June 23, 2016, the UK voted to leave the EU—Brexit.  The outcome of the vote was unexpected and EVERYONE freaked out.

As it turns out, nearly all those dire predictions were totally overstated.  A more objective view shows that the UK and the broader world are doing JUST FINE, probably even better than fine.  This is a good lesson that just because experts say something, especially in this world of 24-hour news cycles where crazy proclamations get the headlines, doesn’t mean they’re going to happen.

Brexit is a really good example were most experts, at least the loudest experts, got it totally wrong.

 

Let’s everyone totally freak out

The general consensus among mainstream media was this was an unmitigated disaster.  The imagery of UK self-inflicting a fatal wound was pervasive.

CNN described the impending “Brexit hangover” as though the British were a bunch of youngsters who did something immature and thoughtless like vote to leave the EU (or go out on a drinking binge).  In the light of day they would realize their error and suffer economically for their folly (hangover).

CNN also had the headline “Brexit + Deep Uncertainty = Market Chaos”.  The first line claims, “One of the foundations of the political world was thrown in disarray.”  The world in disarray????  Maybe a bit melodramatic on that one.

Magazines and newspapers had provocative headlines and covers.  The Economist called the vote “tragic”; the New York Daily News called it “foolish”; the New Yorker equated it to a suicidal leap off a cliff.  Let’s be serious for a second.

Even President Obama lent his voice to the echo-chamber chorus, warning Britians before the vote that Brexit would put them at “the back of the queue” when doing trade deals.  Clearly this was meant to scare British as a threat to their economy and livelihoods.

Making it more local, my Facebook feed was filled to the brim with dire Brexit predictions.  Nearly all these posts are from graduates of the University of Chicago’s business school.  These are people who have studied economics MUCH MORE than your average Joe.  Look at some of those comments.  Equating Brexit to World War II???   Really???

The point is Brexit was fairly universally acknowledged as a total disaster in the making by the loudest (but not necessarily the smartest) voices.  It’s easy, just based on the volume and frequency, to imagine there was something to that.  It’s been almost two years, so let’s look at what has actually happened to the UK since its citizens voted for Brexit.

 

Just the facts

For all the talk that Brexit was going to tilt the ENTIRE WORLD into financial disaster, let’s be real.  First, the UK isn’t that important.  It’s 21st in terms of population (a country with 0.9% of the world’s population), and it’s 6th in terms of GDP (3.4% of world’s GDP).  Let’s not overestimate the impact, ambiguous at best, that such a political move might have on the world.

In case your curious, the world’s GDP grew about 2.5% last year.  Equity markets are up about 25-30% since the vote happened.  That seems pretty darn good to me.

Looking at the UK in particular, it seems like things are going okay too.  There’s no totally objective way to assess the “strength of an economy”, especially among people whose political views predispose them to think one way or another.  That said there are some widely accepted metrics to look at.

 

UNEMPLOYMENT—UK unemployment since the vote has fallen pretty much in lockstep with the rest of the EU.  In June 2016 it was at 4.9%, and now it’s at about 4.3%.  That’s very slightly above Germany (widely regarded as the strongest economy in the EU), and much lower than the other major EU countries who have embraced EU-ism: France (9.2%), Italy (10.8%), and Spain (16.4).  VERDICT: not total disaster.

 

GDP GROWTH—UK GDP growth has been at about 0.4% quarterly since the vote.  That’s fairly middle of the road.  As usual, Germany’s metric is a bit better (0.6% growth), while France’s and Italy’s are in line (0.4-0.5%), Spain’s is higher (0.7%).

GDP growth is a very fickle metric in that it looks at changes, not absolute values.  Were Spain’s higher numbers because it is doing well now or that it was doing so poorly a few years back, and today’s number just look favorable compared to crappy numbers.  You can see the challenge.  Either way, it’s pretty clear that the UK isn’t performing at substantially worse level than the other major EU players.  VERDICT: not total disaster.

 

STOCK MARKET—The UK stock index (FTSE) is up about 20% since the vote.  That’s a bit less than the US (33%) and Europe (26%).  Maybe that’s evidence that the stock market thinks the UK made a mistake.  First, being up 20% definitely defies the idea that the UK is a disaster.

Second, just like GDP growth, there are a lot of factors that make it a bit challenging on how exactly to interpret it.  Right after the vote, the UK’s stock market well outperformed the others, and then it decelerated.  I chalk it up to general market gyrations.  VERDICT: not total disaster.

 

EXCHANGE RATEAfter the Brexit vote, the exchange rate for the British Pound to the Euro fell from about 1.25 down to its current rate of 1.12.  Definitely you can see a clear move down.  Often times a depreciation in your exchange rate reflects negative circumstances for the country’s economy (see Venezuela).  Yet, that’s way too simplistic a view.  In the past year, the US dollar is down about 15% compared to the Euro, and I don’t think anyone seriously thinks the US economy is in a state of disaster compared to the European economy.

Also, if you look at the Pound/Euro exchange rate over a longer time period, the 1.15 range is actually where it has spent most of its time.  It was there in the early 2010s (when the UK was part of the EU), then it rose dramatically in 2015 when Greece’s drama unfolded as it nearly toppled the EU’s common currency (hmmmm . . . maybe that’s a reason why the British voted for Brexit).  Now it has fallen back to those previous levels.  VERDICT: not total disaster.

 

The point of all this is that it’s definitely not CLEAR that the UK’s Brexit vote was a total disaster.  Despite the incredibly smart people with a firm grasp of macroeconomics at CNN and the New Yorker among many, many others (I’m totally being sarcastic here—I think they’re idiots), just because they say something doesn’t mean it’s true.  They have the loudest voices in media today, but that doesn’t mean they have the smartest.  Remember, I am smarter than a Nobel Prize winner, and I do think Robert Schiller is really smart.

If you were Rip Van Winkle and slept through the last two years, and then upon waking were asked which Top 20 economy voted on an economic policy that was tantamount to “Tragically foolish suicide that pulled the world into chaos”, I’m not sure you’d zero in on the UK.  Actually, you’d think things look pretty good there, not nearly as horrible as that description would lead you to believe.

There’s a bit of a lesson here.  Keep this in mind when everyone in the media and on your Facebook feed starts talking about how obviously good or obviously bad something is.  Quick things that come to mind are: economic impact of Trump’s tariffs, inevitability of China overtaking the US in GDP, the impact/harm of the Trump tax cut.  These things are highly complex and very nuanced; rarely are they unambiguously good or bad in the manner that grabs headlines in our oversaturated media landscape today.  Don’t be a sucker.

Championship—Asset allocation v. Tax optimization

Basketball hoop

This is what we’ve all been waiting for.  After two weeks of amazing investing tournament challenge action (just indulge me, will you?), in this post we will crown the champion of investing strategies.  Here we have Asset allocation taking on Tax optimization.  In the Final Four, Asset allocation pounded Index mutual funds with higher returns early on and limiting risk as you approach retirement.  Tax optimization made it two thrillers in a row, beating Savings rate on the strength of major tax savings with a little bit of work and education, but not a lot of monetary sacrifice.  As always, see the disclaimer.

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Obviously both these strategies have tremendous upside, otherwise they wouldn’t be here.  So how do you pick between them?  It’s no easy task, but for you, my loyal readers, I’m ready to take it on.  Let’s see who cuts down the nets.

 

Reasons for picking Asset allocation:

In some ways Asset allocation seems really easy, since all you’re doing is figuring out what percentage of your portfolio goes into stocks, bonds, and cash.  90% Stocks, 10% bonds, and 0% cash; there, I’m done.  That didn’t seem so hard.  Obviously it’s more complicated than that.  We already know that Asset allocation is critically important throughout your investing time horizon.  When you’re younger you probably want to be mostly in stocks (even now the Fox family is 99% in stocks).  As you approach and ultimately enter retirement you want to be more in bonds, but stocks still probably need to be a significant part of your portfolio.

About 10 or so years ago, the mutual fund companies came out with a really cool innovation called target-date funds.  The basic idea is that these handle your Asset allocation for you.  Imagine today you’re 35 and you want to retire when you’re 60, in 2040.  You could invest in a fund like Vanguard’s Target Retirement 2040, and it will automatically shift your Asset allocation from mostly stocks today (currently it’s about 90% stocks, 10% bonds) to gradually less stocks and more bonds as you get closer to retirement.  It’s been a wonderful innovation that has proven extremely popular among investors.

So there you go.  Problem solved, right?  Well, not so fast.  I actually don’t think these really solve the Asset allocation problem because they figure everyone retiring in 2040 is in the same situation, but that’s definitely not the case.  Let’s say you and your twin retire in 2040, but you will get $1000 from Social Security while she’ll get $3000.  What if she had her house paid off completely while you have always rented?  What if you worked for a company with a 401k and she worked for a company with a pension?

All those scenarios are very real for investors, and require more individualization than knowing you want to retire in 2040 can give.  For all those, conventional wisdom would say that your twin should take on more risk (French for “invest in more stocks”) than you because she has other “assets” that are generating more cash.  Reasonable people can debate that last point, but clearly the idea is that Asset allocation is much more complex than just picking a year and being done with it.

So where does that leave us?  I am a firm believer in investing DIY, and Asset allocation is no different.  But I think this is one of the areas where the degree of difficulty is much higher just because you’re balancing a couple opposing forces and there’s never a clearly “right answer”.  You want to be in stocks but not too much in stocks, and then that changes over time.  Oh yeah, and the stakes are super-high.  Getting it “right” whatever that means could give you an extra few percentage points in return and it could also save your nestegg from catastrophic failure if another 2008 rolls around.  When I work on the Fox’s nestegg, this is probably where I spend the most time.

 

Reasons for picking Tax optimization:

As we’ve said ad nauseam, Tax optimization is important and can lead to enormous savings.  What makes taxes so difficult is that the tax code is constantly changing and the stakes are super-duper high (the stakes for Asset allocation were only “super high”).

Every year there are hundreds of changes to the tax code which keeps accountants employed and programs like Turbo Tax (the Fox family uses Turbo Tax) flying off the shelves.  With the new tax reform bill that just passed, there were major changes to your taxes like the deductibility of mortgage interest and local taxes.  Those changes have massive implications on choices of where to live–both at the level of which state to live in but also whether to buy or rent.  These were huge and made the news.  What about the others that do hit the media’s radar and you never hear about?

There’s always talk about more changes, perhaps profound ones like a wealth tax.  You have to keep up.  Also, it can get really confusing.  I think I’m fairly knowledgeable on these matters but I am still befuddled by the Alternative Minimum Tax, and I know I screw up the foreign interest paid on my international mutual funds.  This stuff definitely isn’t easy.

Also, look at the stakes.  If you screw up on your taxes, theoretically you could go to prison.  If it’s an honest mistake I don’t think the Internal Revenue Service will push it that far, but horizontal stripes are definitely in play as Wesley Snipes can attest.  What is more likely is the IRS will hit you with a fine composed of a penalty plus interest.  Oh, by the way, that interest rate is about 6%; that’s not “Pay-day Loan” high, but it’s still pretty freaking high these days.  That certainly can make someone cautious about how far to push Tax optimization, even when they’re clearly in the right.

However, there is a silver lining.  If you want professional help, there are thousands of Certified Public Accountants who are there to help you out.  For under a few hundred dollars most people can probably have their taxes done by a CPA who can make sure that you stay on the IRS’s good side.  Unfortunately, when it comes to developing creative Tax optimization strategies, my experience says there’s a huge range in quality that you’ll get from CPAs.  Several years back I had a horrible experience with H&R Block and thought they were border-line incompetent.  No way would I trust them to advise me on the finer points of maximizing the tax advantages of investing.  But there are amazing CPAs out there right now (like David Silkman who did our small business’s taxes when we lived in California) who I do think can really help.  But this is a real caveat emptor situation.  Maybe Angie’s List might help.

 

Who wins it all?

It all comes down to this.  In the end, I have Asset allocation pulling it out 76-70.  Obviously both investing strategies are amazingly important and getting them right can have an exponential impact on your portfolio.  For me I gave the nod to Asset allocation over Tax optimization for a couple of reasons:

First, if I met a total train wreck of an investor (he was just stuffing cash in his mattress) and I could only give him one piece of advice, I think it would be to get that money invested in some combination of stocks and bonds.  Tax optimization strategies like an IRA or 401k are nice, but first things first.

Second, I think the big rocks for Tax optimization seem to me better understood and more accessible than for Asset allocation.  Most investors probably know that investing in your 401k or an IRA is a good idea, and probably most could tell you why (at least be able to say “it helps with taxes”).  I think that’s different for Asset allocation where you have a lot of investors who are totally off on what is probably appropriate for their situation (age, income, other assets, etc.).

Third, there’s no real “right” answer for Asset allocation.  I could have a lively debate with my dear friends/loyal readers who work in the financial industry like Jessamyn and Mike, where we argued whether the Fox family should be more in stocks or more in bonds.  But there’s no right answer (other than if stocks go up a year from now, then you know you should have been more in stocks).  It depends on so many variables as well as risk tolerance which are super-hard to quantify.  With Tax optimization you can get closer to a right answer—either the tax code allows you to do that or not.  Of course, you typically sacrifice ease of access to your money for tax benefits, so that does add a complication.

Finally, I think it’s easier and cheaper to get expert advice on Tax optimization.  As I mentioned, a good CPA can probably really help guide you on Tax optimization.  Sure, the quality of CPAs is pretty wide, but good ones are out there, and probably they’ll charge you something with in the three-digit range.  With Asset allocation if you want professional help you typically need a financial adviser.  Unfortunately, and this is just my opinion, it’s a little more Wild West for financial advisers than CPAs.  A really good financial adviser is probably worth her weight in gold (140 pound of gold is worth about $2.6 million, so maybe they aren’t worth quite that much), but the range of quality is staggering; there are some real shysters out there.  Also, they’ll probably charge you in the four- or five-digits range.

So there you go.  Put that all together and I think Asset allocation comes out on top 78-71, finishing the sentence, “if you only do one thing in investing make sure you get Asset allocation right.”

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I hope you have enjoyed reading all these posts on investing as much as I have enjoyed writing them.  While Asset allocation “won” remember that all eight of these are important and should be definitely be considered as you think about bulking up your portfolio.

First Round: Asset allocation versus Diversification

I’ve got my tickets to the Regionals in Charlotte, thanks to my neighbors Mr and Mrs Nittany Lion.  In honor of that I am kicking off the investing strategy tournament to determine which is the single best investing strategy if you could only pick one (which fortunately isn’t the case–you can pick all these).  As always, I am not an expert.  So without further ado, we’ll start with the contest between Asset allocation and Diversification.

bracket-begin

Reasons for picking Asset allocation:

Asset allocation is picking the right mix of stocks, bonds, and cash which maximize your investment returns while also limiting that chances that you hit a bad patch of time which cripples your portfolio beyond recovery.  The basis of the concept of asset allocation is the fact that as your expected investment returns increase, so does its volatility.

So for example, cash (or money market accounts) are the least volatile investments around where the chances of you losing money are nearly zero, but they also offer the smallest return at about 1-2%.  On the other end of the spectrum are stocks which historically have averaged about an 8% return, but where about one-third of the years you lost money.  Bonds are between those two, both in terms of returns and risk of losing money.

In my experience screwing up Asset allocation, especially among young investors, is one of the most common missteps.  The conventional wisdom is that you want to take more investing risk when you’re younger because you have more time to “recover” from any market downturns (as was the case with me in 2001 when I was just starting out).  That means that typically (and of course, each individual is different) younger people should allocate more to stocks than bonds or cash.  However, so often I talk to younger investors who have a significant chunk of their 401k in bonds or worse yet, cash.

Why is this so bad?  Well, over a period of decades, the investment horizon when you’re in your twenties or thirties, you end up leaving a lot of money on the table.  Using historic averages, if the 25-year-old you invested your 401k in stocks and your twin invested in bonds, when it comes time to hang up the spurs, it’s no contest—you’re so far ahead of your twin.  Remember that historically, stocks have returned about 8% while bonds have returned 5% and money markets (cash) have returned about 2%.  Just doing some really simple math, the historic difference between stocks and bonds has been about 3%–that adds up to huge differences over an investing career (remember from “The power of a single percentage” how big a difference 3% can make?).  Who knows if it will be like that in the future, but based on history that could lead to hundreds of thousands or even millions of dollars over time.

Of course, you probably read A Random Walk Down Wall Street, so maybe you’re saying, “but when you invest in stocks you’re only getting a higher return because you’re talking on more risk.”  There’s no such thing as a free lunch, and right you are.  That argument is exactly why Asset allocation is so important.  If you were 60 years old and getting ready for retirement, it probably wouldn’t be a good idea to risk losing a big chunk of your portfolio by investing the majority of your money in stocks.  But if you’re 20 or 30 years old, then you can invest in stocks to get the higher return knowing you’re at less risk of a catastrophic loss because you have three or so decades to ride out any storms.

 

Reasons for picking Diversification:

Diversification is the strategy of picking multiple investments so that you can reduce the volatility of your portfolio.  When some of your investments are down, others will be up.  This is really Investment 101 stuff, and I don’t think you’ll find many legitimate investors who would not say it’s a good thing.  But if you think about it, how much is Diversification really doing to help you achieve your financial goals?

The fact of the matter is that Diversification does not increase your investment returns, on average (“on average” is a critical phrase here).  If that’s true, then why does everyone make such a big deal about Diversification?  Because by diversifying with several stocks you even out the highs and lows that would occur with a single stock.  As an example let’s look at investing in an S&P 500 index mutual fund which is considered highly diversified, and compare that to investing in a single stock.  Here I picked Catepillar because from 1980 to today, it and the S&P 500 had largely the same performance (they were both up about 2300% over those 38 years).

Over that time both investments had their ups and downs, but the difference was that Caterpillar’s ups were much higher and its downs much lower.  Since 1980 (38 years), the S&P 500 index had eight negative years with its worst year being 2008 when it was down 39%.  It also had 13 years where it had a return of 20% or better with its best year being 1995 when it was up 39%.

Now compare that to Caterpillar over the same time, remembering that over the entire 38 years they both had total returns fairly similar to each other.  Caterpillar had 17 years with negative returns, the worst being 2008 when it fell 55%.  On the other side, it had seven years where returns were over 55% (16% better than the best year of the S&P 500 index), with the best year being in 2010 when it increased 90%!!!

So think about that.  If you decided not to diversify and put all your money in Caterpillar back in 1980, you would have ended up in pretty much the same place as your twin who diversified with the S&P 500 index, but you would have had a much crazier ride.  2008 would have sucked for both of you, but much more so for you than your twin.  Also, almost half of your years would have been negative (15 out of 34 years) where it was only about 7 out of 34 years for your twin.  Of course, that would have been offset by some real “bumper crop” years (I had to get a farming analogy in) like 2010 when your portfolio would have almost doubled.  No one is complaining about a year like that, but it that a good thing?

Even recently, with Caterpillar you would have had 2014 and 2015 which were down over 10%, but that was made up in 2016 and 2017 which were both up over 60%.  Meanwhile, the S&P 500 was trudging along at double digit gains.  Holy Cow!!!

How do you plan for something like that?  Pre-2010 you were probably figuring you’d have a moderate retirement, and then 2010 rolled around and life all the sudden got a lot sweeter.  Exact same story after 2015.  Just look at the graph—far and away the most common annual return for the S&P 500 index was the 0-20% bucket; for Caterpillar the returns were all over the board and the most common was -20% to 0%–a loss!!!

And of course, I picked Caterpillar because over the 38 years it was pretty close to the S&P 500.  Remember that if you picked a single stock randomly from a broad index like the S&P 500, you would expect the stock to do just as well as the index, because the index is just an average of a bunch of those stocks.  And it’s true that on average a single stock will do as well as an index, but what if I randomly picked United Airlines which went bankrupt just like many, many other companies do every year (there’s no real chance that the value of the S&P 500 would go down to zero in a similar way)?  Or if I picked Medtronic (one of the greatest companies ever) which outperformed the S&P 500 some 8x?

My personal preference with investing is that I want as much predictability as possible, and that is even tough to come by when you’re highly diversified; when you aren’t diversified, there’s no chance.  Maybe if you like those types of thrills that putting everything into a single stock brings, you may want to think about BASE jumping or free diving.

But assessing it honestly, Diversification does not lead to higher returns on average.  It just reduces the crazy swings up and down.

 

Who wins?

Asset allocation wins this one pretty easily, 86-59 (I just made that up to look like a basketball game score, but it seems about right).  Diversification definitely helps smooth things out, but Asset allocation can undeniably increase your returns which translates to real money.

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So Asset allocation moves on to the Final Four.  Make sure you come back tomorrow to see Free money take on Index mutual funds.

Going all in with stocks

buried-money

With the recent craziness in the stock market, I’ve chatted with friends about how much of their portfolio should be in stocks.  Actually the conversation goes more like:

THEM:  I am about 50% stocks, 50% bonds.  How does that sound?

ME:  50% stocks and you’re 41 years old, and you have a good job?!?!?!?  Are you crazy?  That’s way too conservative.

THEM:  But I don’t want to be too risky.

ME:  You have a lot of safe investments that you probably don’t even know about.  The investments you can invest in stocks you should so you can get the higher return over the long term.

THEM:  ??????

 

So here is what I am talking about–the hidden cash in your portfolio.

We know that you need to balance risk and return in our investments.  This is most clearly done when we choose our mix of stocks (more risky, higher average returns) and bonds (less risky, lower average returns).  As an investor gets older they want to shift their asset allocation towards less risky investments because their time horizon is shortening.  We all agree with this.  So where is this hidden pot of gold I’m talking about?

 

Let’s look at the example of Mr and Mrs Grizzly.  They are both 65 years old and entering retirement.  They worked hard over the years and socked away $1 million that will see them through their golden years.  They do some internet research and learn that a sensible asset allocation in retirement is 40% stocks and 60% bonds, so they invest $400k in stocks and $600k in bonds.  Knowing the long term average returns are 8% for stocks and 4% for bonds, they expect their $1 million nest egg to generate about $56,000 per year ($400k * 8% + $600k *4%) , knowing that some years it will be more and some years it will be less.   So far so good, right?

1 m

THEY ARE LEAVING MAYBE $20,000 PER YEAR ON THE TABLE.  That’s a ton of money.  How can this be?  They seem to be doing everything right.  The answer is they are being way too conservative with their asset allocation.  They shouldn’t be investing $600k in bonds and $400 in stocks; stocks should be a much higher percentage.

Waaaaiiiiiiiittttttttt!!!  But didn’t we agree that about 60% of their portfolio should be in less risky investments?  Yes, we did.  Are you confused yet?

 

Hidden cash

Here’s what I didn’t tell you.  Mr and Mrs Grizzly have other investments that act a lot like bonds that aren’t included in that $1 million.  Both Mr Grizzly and Mrs Grizzly are eligible for Social Security with their monthly payments being $2000 each.  If Mr Grizzly (age 65) went to a company like Fidelity and bought an annuity that paid him $2000 each month until he died (doesn’t that sound a lot like Social Security), that would cost about $450k.  So in a way, Mr Grizzly’s Social Security payments are acting like a $450k government bond (theoretically it would be worth more than $450k since the US government has a better credit rating than Fidelity).  And remember that Mrs Grizzly is getting similar payments, so as a couple they have about $900k worth of “bond-ish” investments.

Also, Mr and Mrs Grizzly own their home that they could probably sell for $300k.  They don’t plan on selling but if they ever needed to they could tap the equity in their home either by selling it or doing a reverse mortgage.  So in a way, their house is another savings account for $300k.

If you add that up, all the sudden the picture looks really different.  They have about $950k of Social Security benefits that have the safety of a government bond.  Plus they have that $300k equity in their house.  That’s $1.25 million right there.

 

Investing your portfolio

So now let’s bring this bad boy full circle.  Remember their $1 million nest egg they were looking to invest?  Look at that in the context of their Social Security and house.  Now their total “assets” are about $2.25 million.  If you believe that the Social Security and house kind of feel like a bond, just those by themselves account for 55% of their portfolio.  If on top of that if you invest 60% of their $1 million nest egg in bonds, they have over 80% of their money in bonds, and that seems way too high.

2 25 m a

On the other hand, let’s say they only put $100k of their nest egg into bonds and the rest into stocks, after you include their social security and home, they’d be at about 60% bonds and 40% stocks.  Isn’t that what they were aiming for the whole time?

2 25 m b

Wow.  It took a long time to get there, Stocky.  The punchline better be worth it.  Remember that with $600k in bonds and $400k in stocks, they had an expected return of about $56,000 per year.  However, if they have $100k in bonds and $900k in stocks, because stocks are more volatile but have a higher expected return, they can expect about $76,000 ($900k * 8% + $100k *4%).  THAT’S $20,000!!! 

But aren’t they taking on a lot more risk to get that extra $20k?  Remember, there’s no such thing as a free lunch.  For sure, but if you look at it in the context of their Social Security benefits and their home, they have a fair amount of cushion from “safe investments” to see them through any rough patches in the stock market.

 

I wrote this post to show that people really need to take account all the financial resources they have.  In the Grizzly’s case, it was their Social Security benefits and their home.  Others of you may be getting a pension (Medtronic is generous enough to offer the Fox family one) or a second home or a dozen other things like that.

When you take those cash flows into account, all the sudden it seems a lot more reasonable to invest the rest of your money a little more heavily in stocks which you know over the long haul will give you a better return.

Market dips are awesome?!?!

Holy crap!!!  The last week of the market has been insane.  We’ve seen the largest point drops in the history of the Dow—1175 drop on Monday and 1033 drop on Thursday, although neither ranked within the worst 50 drops in percentage terms.  This is crazy, yet why would I possibly think that this is a good thing?  Over the past 6 trading days, the market is down about 7%.  Yowza!!!

I am, and most of you are, long term investors.  The money I am investing in the stock market is meant to be spent years, or more likely decades, from now.  Sure, what happened right now sucks and maybe is scary (although I think it’s actually the opposite).  That should be comforting because, although we’ve taken a huge body blow, the good news is that we have a really long time to recover.

 

Dollar cost averaging

OK, that might explain why it’s not so bad, but how could it possibly be good?  If you can take a Pepto and keep your head, this is actually a great time to be investing, be it regular contributions to your 401k and IRA or just regular stock purchases.  If you were excited to buy stocks two weeks ago when the market was frothing, you should be even more so now that stocks are “on sale” at 7% off.

Sure, that might make sense philosophically, but how does that work in real life.  Let’s look at my nephews Risky Fox and Safey Fox.  Risky Fox invests $10 every day no matter what happens.  His twin Safey Fox cut a deal with the investing gods where every day the stock market goes up an equal amount.  Both twins started investing on January 1, 2000, and each has invested $10 every day for those 18 years.  They both start when the S&P 500 was at 1455 at the start of the millennium and they both end last Friday when the market was at 2,620.

Those 18 years have had crazy bull markets and crazy crashes—the dot-com bubble and it’s popping in 2001, the Great Recession of 2008, and the Trump run of 2017.  Those are the big ones but there have been mini-crashes and corrections too like August 2011 and January 2016.

Through all of that Risky invested $10 through thick and thin, no matter where the market was, high or low.  In her bizzaro alternative universe, Safey invested $10 every day , knowing each day the market went up a small but consistent amount (0.0129% each day if you’re curious).

Who ends up ahead?  It would be a pretty stupid column if it was Safey . . . of course it was Risky Fox.  Each invested $45,560 over those 18 years.  Safey ends up with $62,011 which isn’t bad.  But Risky ends up with $89,773, about 45% more.

How does such a thing happen?  In 2001 the dot-com bubble popped and stocks fell 45% over three years.  Throughout all that Risky kept plugging away, investing his $10 each day, but now he was getting stocks at a huge discount.  Stocks recovered after a few years and that looked like a great buying opportunity in hindsight.  Then in 2008 the Great Recession his and stocks fell about 55% in a little over one year.  Again, Stocky keeps investing and when stocks bounce back, he looks like a genius for having kept faith and picking up stocks at a substantial discount the whole time.

And just to prove it isn’t a unique thing, if you did the same Risky/Safey experiment for the 1970s, 1980s, and 1990s, you get similar results.  The 1960s and 1950s have Safey coming out ahead, but by a much smaller amount.

 

Risky

Safey

Difference

2000 to 2018

$89,733

$62,011

45%

1990s

$69,324

$56,044

24%

1980s

$51,181

$48,492

6%

1970s

$28,650

$27,538

4%

1960s

$29,951

$31,100

-4%

1950s

$48,480

$50,926

-5%

 

And never lose sight of the fact that what Safey is doing is impossible.  The market doesn’t work like this.  This just shows that what Risky is doing, something we all “have” to do, really isn’t all that bad.

It’s similar to asking if you can get from point A to point B faster by walking with your feet or flying with your wings.  You can get there with your feet most of the time more quickly, but even if that wasn’t so, none of us have wings.  The whole point is that buying through market down turns (or walking with your feet) does pretty well, even when compared to some fantasy construct.

 

Faith

Ultimately, this is a lesson of faith.  When we were in the depths of the Great Recession, Warren Buffet famously professed his faith in the US economy.  He turned out to be right and made tens billions (billions with a “B”) along the way.

There’s no proof that markets will always go up (predicting the future of human behavior is always impossible), and at the end of the day it’s a matter of faith.  If you believe in capitalism then you believe that stocks will always go up.  I do believe in capitalism so I do believe that stocks will always go up.

That’s what makes the little experiment with Risky and Safey work.  Even when things look horrible, like it did in the dot-com bust and the Great Recession, if you have faith in capitalism you’ll look at the downturn as a temporary turn that will ultimately return to rising prices.  You can see this by looking at a long term stock chart of US stocks: they have an unrelenting upward march through all sorts of markets over 100 years.  Or you can look at the data that shows that historically consistently investing in stocks has never lost money over a 20-year horizon.

S&P 500 since 1950

That brings us full circle.  We’ve been bashed in the face the past 6 trading days.  Stuff like this happens.  I have total faith in capitalism which means I have total faith that things will recover.

When people have asked me what I think will happen/what I think they should do, I tell them to keep on keeping on.  Keep investing in your 401k, keep putting away money in the 529 and your IRA.  It’s probably a lousy time to withdraw a ton of money for a beach house or some other massive expenditure, but beyond that, what’s going on in the stock market really shouldn’t be impacting you at all.

Jan 2018 has been sizzling . . .

. . . and it shows you can’t outsmart the market.

It’s been a mere three weeks into the new year, and stocks are way, way up: US stocks are up over 5%, and international stocks are up nearly 6%.  IN THREE WEEKS!!!  That’s crazy . . . crazy awesome.

As you sit back and count all the money you’re making in the market, let’s put January 2018 into perspective.

 

How special is this?

5% in a month (and we aren’t done yet) is good, but not too special.  Since the S&P 500 began in 1950, there have been 90 months at least as good as this January has been.  That’s about 11% of the time, so a little more than once per year on average.  So that’s not too special . . .

. . . But this one is coming off the heels of some really strong performance.  In the past, most months at had at least a 5% return were rebounding from the previous month which wasn’t that good.  So for example, in September of 2015 that month had a 6.6% return but the month before the market was down.  Same thing in October 2015, October 2011, December 2010, September 2010, and July 2010 (those are the most recent 6 instances).

It might make sense for a really good month if it was sling-shotting off a really bad month, like those most recent examples.  Yet, that’s definitely not what we’ve seen.

January is actually the 10th month in a row that the S&P 500 has been up.  Since 1950 there have been two other streaks like that, in 1954 and 1958 (both of which were 11-month streaks).  So we’re in one of the longest, sustained market runs of all time, and we just busted out a 5.1% month.  That’s a bit like running a marathon and in the 22nd mile kicking out a 4:00 minute-pace.

No matter how you cut this, the market for the past year has been really special.  We’ll be telling our grandchildren about this.

 

You can’t outsmart things

The market is a benevolent teacher.  Actually, maybe not benevolent (some of the market’s lessons can be quite harsh), but certainly a teacher.  There’s a valuable lesson here.

Go back in time three weeks ago.  We were all enjoying football games on New Year’s Day, making resolutions we probably won’t keep, and taking stock (pun intended) of how our investments went in 2017 and what we can expect in 2018.

There was every reason to think 2018 might be a bad year for stocks.  Stocks had just been on an incredible run, so it wasn’t unreasonable to predict a bit of a correction.

Of course, there are a million ways you could go, but there are a ton of really reasonable arguments you could make for why the market might not do so well in 2018.  Yet, so far in January it has busted out a huge month, and if you are fully invested you have made a ton of money.

On the other hand, if you tried to outsmart things and time a market decline, you missed out on a really great month, and that has costed you hundreds or thousands or hundreds of thousands of dollars.

The point of all this is, and I certainly eat my own cooking on this, that you can’t predict the market.  You can spend countless hours trying to figure it out, but it’s unfigured-outable.  The best thing you can do it invest your money and keep it in the market until you need it.

 

That said, I hope you have been fully invested and those numbers on your spreadsheet have been going up and up.

 

Keeping up with the Jones . . . financially that is

 

Quick story

Los Angeles is a pretty bizzaro place in general, and this is especially true when it comes to personal finances.  Houses are so expensive, that it’s hard to understand how people do it.  Also, there’s a culture of conspicuous consumption that pervades everything; everyone looks like they’re spending a ton of money (and often they are).  A friend once very wisely said “In LA the BMW 3-series is what Honda Civic is to the rest of the country.”

Foxey and I both had good jobs, were saving a lot, and thought we were “making it”.  Yet, in a lot of ways we looked like the “poor” people on the street.  Our house was fairly average looking, we mowed our own lawn, we both drove old cars (a 1998 Toyota 4-Runner and a 2001 Honda Civic), and in general we had a humble existence.  There seemed a disconnect, and it took an emotional toll.  We were working so hard to save but it didn’t seem like it was making an impact.  Everyone else “looked” richer than we.  What gives?!?!

One day we were at a party, talking to a neighbor who was a mortgage broker.  The neighbor had a few glasses of wine in her and mentioned that she did the mortgages for several people on the street.  She didn’t violate anyone’s confidentiality, but she made a general statement that “you would be shocked at the shit-show that is most of our neighbor’s finances.”  She left it at that.

We’ll come back to this in a second.

 

Looking at the data

According to the US census, the median net worth for an American is . . . $80,000—and that includes home equity; if you strip out home equity it falls to $25,000.  Since this is an investing blog, and also since you know I don’t think you should rush to pay off your mortgage, let’s just look at net worth excluding home equity.

If your first reaction toggled between “that can’t be right” and “that’s really low” and “Holy Crap!!!” then you’re in good company—that was my reaction. My other reaction was “a really large percentage of their net worth is in their home, and that’s no good.”  But that’s a topic for another post.

The Census Bureau breaks it down every which way.  I think the most interesting is by age:

Age Net worth—with house Net worth—without house
Less than 35 years $6,900 $4,138
35 to 44 years $45,740 $18,197
45 to 54 years $100,404 $38,626
55 to 64 years $164,498 $66,547
.65 to 69 years $193,833 $66,168
.70 to 74 years $225,390 $68,716
.75 and over $197,758 $46,936

 

There’s an obvious trend that you would expect.  As you get older your net worth grows, peaks in your older years, and then towards the end starts to fall as you spend your nest egg.

 

People don’t like showing their rear-ends

How do you reconcile all this?  The obvious answer is that, sadly, many people live way beyond their means, showing off a glitzy façade while the financial foundation is completely rotted.  Back in LA, I am certain that we had a net worth higher than nearly all our neighbors.  We certainly had cars crappier than all our neighbors.  We were certainly one of the very few (only?) that mowed our own lawn.

No one wants to “seem” poor, especially when they aren’t.  As I said, it took a bit of a toll.  Fortunately, Foxey and I have good, midwestern roots and were raised to save a big part of our income.  But that’s no fun.  I’m a bit of a freak so I actually derive a lot of pleasure from buying index mutual funds and watching numbers on a spreadsheet get larger.  Foxey is much more normal, and enjoys buying actual things rather than just socking the money away.

Our neighbors, on the other hand, were not saving as much as we were.  If you believe the mortgage brokers comments, many were spending much more than they were making, and weren’t saving at all.  Looking at the national data, they had that in common with much of America.

I don’t want to seem as though I don’t think $100,000 is a lot of money.  It definitely is, but it doesn’t seem like a lot over a lifetime of savings.  Yet, that $100,000 is significantly more than most Americans have saved.  I’m guessing it is probably more than many had on our street, despite all outward appearances seeming to indicate otherwise.  It just seems weird and sad.

 

The point of all of this is that it’s good to know how much you have saved.  Hopefully, one of the things you get from this blog is how to take stock of where you are and what your plan is to achieve your financial goal.

It’s also good to put your savings into perspective.  Saving money is HARD work, especially emotionally given that we live in a world of conspicuous consumption where we are inundated, in the words of Tyler Durden: “Advertising has us chasing cars and clothes, working jobs we hate so we can buy shit we don’t need.”

It may not always be apparent, but I think it’s always worthwhile.  Amazingly, and very sadly too, just doing a little bit of savings over a long time will put you well ahead of the average American.  Take a look at those median values again—it’s sobering.

Maybe all of us savers need a special handshake or something so we can know that we aren’t alone.  I hope this post makes you as a saver feel that you aren’t alone and that it is worth while.

Dear 2017, You were pretty awesome

As the door closes on 2017, let’s take a few minutes to reminisce about what an incredible year 2017 was for investors.  For the Fox family it’s awesomeness was especially welcome given that our careers have shifted quite a bit, moving away from working for the man to working for ourselves (though, one of us happens to be a man).

Let’s look at the numbers, and figure out what it all means.

 

A tale of the tape

Like most investors, we had a really good 2017.  Here is how our portfolio broke down:

Investment

Portfolio weight

2017 return

US stocks (VTSAX)

52%

19%

International stocks (VTIAX)

37%

24%

Real Estate Investment Trusts (VGSLX)

7%

1%

Commodities (DJP)

2%

1%

Lending Club

2%

2%

TOTAL

100%

19%

 

Cha-ching

No matter how you look at it, 2017 was a GREAT year for stocks.  The US stock market did really well, growing 19%.  This can become really political really quickly when assigning credit/blame for such things to politicians.  However, I think it’s fair to say the Trump administration has been fairly pro-business.  That, along with the massive tax cut, definitely gave a boost to stocks.

Also, we saw economic growth really pick up while unemployment went to historic lows.  And all that was happening while inflation remained very low (more on this in a second).  If you put all that together, that’s a perfect recipe for awesome stock performances, and that’s exactly what we had.

Not to be outdone, international markets really kicked it into high gear.  Coming into 2017, US stocks had outperformed international stocks (pretty dramatically, actually) for four years in a row, every year since 2012.  That ended this year.  International stocks were up an astounding 24% compared to the paltry 19% that US stocks were able to muster.

I think that’s a good reminder that you can never really outsmart the market.  At the beginning of 2017 there was every reason to believe that US stocks would do better.  There was a ton of momentum in the US coming off of Trump’s election.  Plus, Europe seemed embroiled in political quagmires—Brexit, French elections with extreme candidates polling well, Greece being Greece.  Asia similarly seemed poised for another yawn of a year—Japan remain in a deflationary stagnation, Noth Korea being a total wild card, and it looked like China’s economy would slow down.

Our interpretations were dead wrong and those markets kicked butt, and international markets outpaced the US markets by 5%.  5%!!!  That’s a lot actually.

 

Inflation remains dormant

While all this was happening, inflation remained remarkably tame.  You know I spend a ton of time and energy talking about inflation because it has such a big impact on the purchasing power of your savings.

Huge returns like we had in 2017 are great, but what’s the point if those gains are all eaten away by higher prices?  The final reading for December will come out in mid-January, but preliminary readings indicate that inflation for the year will come in at about 2.1%.  2.1%!!!  As high as those 20-ish% returns were, that’s how low 2% inflation is.

As an investor, it really doesn’t get much better than that—high returns and low inflation.

 

Regrets, I’ve had a few

As you know, I always use New Years as a natural time to take stock (no pun intended) of things.  Now is a really good time to look at how we did, thinking about the things we did well with our investments and what we could have done better.

The high points of our investments were the US and International stocks.  We invested in all index mutual funds so we really didn’t do anything here.  Just “set it, and forget it”.  I suppose that speaks to how useless I am as an investor—the best part of our portfolio is the one that I did the least for.

Certainly, we did have some not-so-great investments.  I hate to be picky in a year where our portfolio grew 19%, but 2017 really exposed some stupid decisions that I had made.  Look at our returns, and the two “basic” investments that everyone should have (I even wrote a whole post on this very subject).  Those did the best.

The investments that did the worst were those “other” investments that aren’t one of the three basic ingredients.  I’m stupid, and that stupidity probably cost us $50,000 this year.  Ouch.

I’ve chatted about our commodities investment and our Lending Club investment, both of which have been incredible duds.  Currently, we’re in the process of eliminating those from our portfolio, so hopefully in 2018 we won’t have to deal with that crap.  Of course, because the investing gods like to humble stupid people, I am sure those two will perform spectacularly this year.

As for the REIT, over the longer-term it’s done fairly well (not as good as US stocks but better than International stocks).  This was just a down year, so that happens sometimes.  Still, it begs the question why we got into this instead of just sticking to the three ingredients, and I have some lame excuses, but nothing worth mentioning.  Hmmmm.

 

So there you have it.  2017 was an incredible year for being an investor.  Despite the couple misses we had, our two biggest investments really did well, so we’re happy.

How about you?  How did your portfolio do in 2017?

Lending Club—No Bueno

About two years ago we broadened our investment portfolio with this new-fangled things called peer-to-peer lending with Lending Club.  This has turned out to be a pretty major disappointment for us, and we are in the process of exiting the investment (which isn’t a quick process—more on this in a second).

Basically, the idea of peer-to-peer lending is like match.com for lenders and borrowers.  People who want to invest/lend money meet people who want to borrow money.  Borrows can get money they need at much lower rates and much less hassle than if they got a loan from a bank.  Lenders can earn interest at a much higher rate than they would get from a bank.  Banks are cut out of the process and everyone wins, right?

 

How it works

There are people looking to borrow money for debt consolidation/payoff credit cards (that’s about 80% of the loans), help their small business, pay for home renovations, etc.  Let’s say a given loan is for $10,000.  A bunch of lenders like us each kick in $50 or so, so you’ll be in this loan with hundreds of other people.  The person gets the money and then pays off the loan over 3-5 years.

Lending Club vets each loan and each applicant, and assigns a credit score.  That credit score determines the interest rate which can range from 5-20%.

As a lender you can go through all the thousands of loan application and pick which ones you want to lend to.  That’s fun at first, but quickly becomes a hassle, so you can just put it on auto-pilot and Lending Club will pick the loans for you.  That’s what we did.

 

What happened to us

In mid-2015 we opened our account, starting with $3000.  Of course, I watched the process like a hawk, from the loans I picked to when they started paying back.  At first it went great (isn’t that line in pretty much every movie, before everything goes to hell?).  We were getting paid back by all our loans, and our return was over 12%, which of course is amazing.  That’s free money.

We put more money in over the next couple months, and then when we sold our California house we put a big chunk ($60,000) in.  By that time, our account was worth about $100,000.  Through mid-2016 things were going well.  Our returns had inched down to about 10% (still spectacular), and I was congratulating myself on being a financial genius.

Towards the end of 2016 I started to see some of my loans default.  Of course, this is to be expected.  Some of the loans will go bad but those should be offset by the higher interest rate, and everything works out.  Still, it was a disturbing trend.

After a few months, the bad loans kept coming and my return steadily dropped, until it settled at 2.5% which is where it’s at today.  That’s crazy!!!  Obviously, there’s a huge difference between a 10% investment and a 2.5% one.

In early 2017 I decided to pull the plug, and stopped reinvesting my money.  Now, as the small loans (we have about 3000 out there) pay off, we take that money and put it back in our Vanguard account.  Unfortunately, this isn’t a fast process so it will take us about 5 years to unwind everything.  Oh well.

 

Why it works (or doesn’t)

On paper it sounds like one of those awesome ideas where the power of the internet changes an old business model for the better, and I think there’s a lot of truth in that.  It brings borrowers and lenders together and cuts out the middlemen, and lowers the borrowing costs substantially.

The problem lies in their ability to ensure payments are made.  Fundamentally, what is stopping borrowers from getting the money and then just going away and not paying?  It may not happen a lot, but it doesn’t take a lot of these to really kill your return.

I have a bit of insight here because I was a large enough account that I would get a call about once per quarter from them “seeing how I was doing”.  You can imagine the tone of these calls changed as my return dropped.

These loans are unsecured, so the only thing that makes borrows pay back is morality (I never want to count on that when it comes to money), the threat of negative marks on their credit rating, and the general badgering from Lending Club as it tries to collect.  With traditional bank loans that are collateralized, the threat of repossessing something seems a lot stronger.

Not difficult to predict, there was a large portion of the borrowers who would take the money and then not pay it back.  Some might be thieves who borrowed the money in a scam and never intended on paying back.  Others certainly intended on doing it but things didn’t work out.  Given the economy has been super strong the past couple years, this is especially troubling because it should be as good as it gets right now.

When someone stops paying Lending Club goes after them with phone calls, but those don’t seem really effective.  Seriously, what are they going to do?  Some delinquent borrows do starting paying back but most either never answer the phone, or they do and say/demand that Lending Club quit bothering them (there are actually notes lenders can see on all this activity).

I personally think that in our litigious environment today, lenders don’t have that much leverage.  Also, to avoid claims of bias or discrimination, it’s probably not easy to turn down borrower applications.  That leads to a perfect storm of crap that I think I got caught up in.

 

What is the lesson?

Investing is an interesting psychological experiment.  The simple approach of buy-and-hold broad index mutual funds is almost certainly the best, yet it’s the most boring.  When you’re doing that and things are going well, there’s that itch to see “what else you can do” and “what you can do better”.

That’s what happened to me, and most of the time that’s death.  That’s what happened with us and our commodities investment, which has been a major loser.  That was also the case with Lending Club, and we’ve had disappointing results (especially since stocks are up about 15% annually in the time we’ve invested in it).

So the lesson here is that it’s probably always better to stick with the boring but tried-and-true approach.  History is on your side here.  We have over 100 years of data on how stocks behave, in good times and bad.  Peer-to-peer lending is fairly new so you don’t really know how it will play out.  Maybe you’ll miss out on something that’s new but amazing (see: Bitcoin), but that leads to an interesting second point.

Many leaders—NFL head coaches, CEOs, politicians—say that success finding all the great things, but more avoiding the bad things.  Stocks are similar.  It’s a game rigged in your favor, but there are pitfalls along the way that are so tempting.  That’s where I think I tripped up.  Lending Club and commodities were sexy investments at the time, and it scratched that itch for me to be “doing something.”  And it hurt me.

Of course, that doesn’t mean we never innovate.  Peer-to-peer lending may turn into something big; digital currencies might turn into something big.  They might be important parts of a financial portfolio, but I think now is way too early a time to be putting my money down on that bet.  I know I’ll miss some big wins, but hopefully I’ll also avoid big losses and come out ahead.