The Money Professor

An answer to a discussion on LinkedIn about my "Bonds and Stocks" article

noreply@blogger.com (The Money Prof) — Mon, 18 Feb 2008 20:48:00 +0000

I posted a question about "mixing bonds and stocks" on LinkedIn with a link to my article on TheStreet.com.

I didn’t plan to “answer the answers” but given that some of the answers are quite sharp and say, “you are a bad, bad advisor”, let me reply and explain why they are mistaken in both their understanding of what I was talking about, and in that they don’t know what I really do with my clients and jump to conclusions (and bad ones at that).

Fundamentally, the mistake many financial advisers make is using short-term decision making for the long-term. Exactly what their clients do, unfortunately.

The answers below can be divided to three groups. The first completely agree. The second does acknowledge the importance of the time horizon discussed and how one defines risk, and then falls into the trap of discussing volatility. The third group provides volatility-based arguments, with or without citations of studies and publications, some of which are indeed by noble laureates.

I clarify: The time horizon discussed in the article is 20-30 years with 25 being mentioned as the basis for discussion. I define risk at the end of the article as “Not having what you need or want when you need or want it.” If you examine this definition carefully, you’d find that ALL risks falls under it. Those include loss of principal, liquidity risk, inflation risk, but most importantly, the client (or you) not having what you need/want when you need/want it.

What is volatility?

It is a factor that affects your risk. It is not risk by itself. Additionally, there seems to be some confusion between variance and volatility. Variance is, of course, a measure of the distribution around the mean. Volatility is the up and down movement. The research quoted is talking about low or negative co-variance between different parts of the portfolio, and not volatility. However, low co-variance is NOT important in this case because you are freezing the money for 25 years.

By the way, it’s not variance that kills you. It’s the losses. You can have a return of 8.1%, for example, if you don’t have losses, but you’d need 10.5% if you do have losses even though you have a similar variance.

Volatility can have two effects in particular:
1. Loss of principal – this only happens due to losses, not volatility per se, and of course, not due to variance.
2. Losses at the beginning of the distribution phase that coupled with withdrawals move the portfolio to below the threshold to support the desired distributions for the term projected. In plain English – you lose too much at the beginning and if you draw a fixed amount, that fixed amount represents too much in terms of percentage, and more than your return, thereby decreasing the principal until it is gone (too quickly).

The second part is not relevant because I didn’t talk about distributions at all! I only asked about the accumulation phase.

The first risk, the loss of principal, is mitigated by using a well diverse basket (index of sort) of stocks. If ALL the stocks in the S&P 500 have lost all the value, why, do you think ANY bond would not default? Or that you’d get ANY return on any fixed instrument?

The point is that over periods of 25 years, well-diversified stock portfolios (essentially indexes) have good returns (10.4% for the S&P500 for example) with relatively low variance. You don’t care about volatility along the way! Because you don’t keep trading in and out you don’t need bonds to counter that variance in the opposite way. After all, the “countering” is only illusionary because you HOLD YOUR BONDS TO MATURITY, and therefore they have NO VARIANCE!

It’s dangerous to give mathematical models to two groups:
1. Those who don't understand them.
2. Those who are too enamored with the mathematics of it to forget the real purpose.

The second group is more dangerous because its members tends to convince the first group they know what they are doing by dazzling them with mathematics.

Example: say you split your money, of 100K to two piles and put them in two safes. One is the 80 in S&P500’s safe (80%) and the other is 20K in bonds’ safe. You open the safes after 25 years and look at the piles. Your 80K grew by 10.4% average annual compounded rate (AACR for the technicians amongst you). Your 20K grew by 5% AACR. Would you have been better off by moving the 20K to the S&P500 safe?

You bet ya.

What do I do with my clients?

I cut the loss-of-principal risk by using an Equity indexed universal life insurance policies that are MAXIMALLY funded (not over funded). As a result my clients enjoy the following benefits:

1. No losses because the minimum they can get is usually 2%
2. S&P 500 like returns as the cash value gets, basically, the S&P500 returns (between the min cap of 2% and the max cap of commonly 13%-17%).
3. Tax free growth!
4. Tax free access! This means an ability to draw MUCH MORE than if the money grew in a regular tax deferred account.
5. Shielding from the danger of losses at the beginning of the distribution phase.
6. Liquidity.
7. Total cost of insurance (and all fees) that amounts to 1% - 1.5%
8. Higher returns to the beneficiaries in case they die (because of the death benefits that are higher than the cash value).
9. Tax free Transfer to the beneficiaries (when coupled with the appropriate Trust configuration to avoid sending the proceeds to the Estate, which could trigger taxes at the estate level).

If that doesn’t satisfy you – what will? ☺

Why mixing Bonds and CDs with stocks actually increases your risk

noreply@blogger.com (The Money Prof) — Mon, 18 Feb 2008 20:41:00 +0000

This article was published on TheStreet.com and therefore I can only post here some bits, and you'll have to go to the article to read it.

Warning: If you are a financial adviser, financial planner or another type of "consulted one," the following article might pose a risk to your health. By reading further, you agree that the author is not liable for any symptoms or problems you may have due to your response to this article, and you bear full responsibility to all such.

...Why supposedly? Don't bonds and CDs have a different (lower) risk profile than stocks? After all, bonds and CDs offer a guaranteed return and as such, are not "risky," right?

The answer is yes and no. Yes, bonds (only if held to maturation ) and CDs do offer a guaranteed return. No, they don't lower a portfolio's risk.

Bonds and CDs Don't Do What?!

Enjoy the full article here and if you like it, do press "I recommend it" :-)

Personal Finance meets Stimulous Plan

noreply@blogger.com (The Money Prof) — Wed, 06 Feb 2008 14:30:00 +0000

In the face of growing fears of recession or stagflation (recession with inflation) President Bush, Mr. Bernanke the Federal Reserve Chairman, and most of the presidential candidates called for tax cuts, and naturally the House immediately pushed a bill to that effect.

The reasoning is the Keynesian economic view, as discussed by the Wall Street Journal’s editor in the January 18 edition, that prescribes that the government give money to low and moderate income people who will spend it, thereby creating demand for goods and services, and “stimulating” the economy. Mr. Bernanke emphasizes the “low to moderate” because higher income people would not spend the money but save it.

Four main questions should be asked: Are the tax cuts going to stave off recession or stagflation and help in the short term? Are tax cuts good for the long term? Are tax cuts the “right” thing to do? Where will the money come from?

I provide my clients with advice on how to create and grow wealth, and simply put, it is not by “spending your income away.” In fact, when I show my clients how to reduce their expenses by optimizing their assets and reallocating their expenses, often paying lower taxes as a result (I guess I should be given rebates by the government for my work?), I do not tell them “oh, please go ahead and spend it.” I tell them the money is going to savings and investments. The simple reason is that this money is to fund their retirement. I say so regardless of what level of income and wealth the client is.

The President, Congress, the Fed’s chairman, and the presidential candidates are telling everyone exactly the opposite. They are telling us, “spend money, don’t save it.” This is in the face of several known problems with the US economy and its future.

Firstly, the savings rate in the past decade has been dismal and even reached negative levels. Most Americans do not have enough saved for retirement and are not likely to have enough to maintain a moderate life style, let alone their one at retirement. This is when they are budgeting for 10-15 years of retirement under the “average age” assumption, when they should be budgeting for 25-30 years, assuming a retirement age of 65-67.

Even worse, Social Security is bankrupt in the sense that all projections are showing it will not have enough money at some point in Baby Boomer’s retirement future.

Therefore, spending those tax cuts is the wrong thing to do for exactly the people who are supposed to get it, the low to moderate income ones.

Of course, if the people who are to benefit from the proposed tax cuts would save the money, as they should, instead of spending it, it would defeat the purpose. The economy would not receive the money, and would not be “simulated.”

Thus, the tax cuts are not “the right” thing to do because they encourage spending when the problem is that people should be saving more.

Where would the money come from?

The answer is simple. Given that the government runs a deficit, it has to come from future income, either in the form of lower healthcare, education, social security, or other governmental expenditure on future benefits, because it definitely will not come from special interests expenses during an election year.

The silly argument proposed is that the tax cuts will stimulate the economy, thereby produce more taxable income, and therefore tax revenues, thus paying for themselves. Unfortunately, this sounds like a bad joke I sometimes tell that starts with two people walking down the street and seeing a pile of horse excrement (change the word accordingly), ending with the pile gone and the two being happy for having had a high monetary trade volume.

Then if this is clear, and given that there are 76 million baby boomers who tend to vote in higher percentages, are the presidential candidates willing to tell them: “look, I need to make you feel good now so you elect me, so I offer this tax cut, and the result will be that you’d face even harder times at retirement.”

Will the tax cuts solve the short-term issues of recession or stagflation?

Firstly, more money means higher inflation, and therefore a higher chance of stagflation. Secondly, the looming recession, which has multiple factors, is definitely not a result of low consumer demand. Therefore, increasing consumer demand, temporarily, is like covering an inflamed wound with a bandage without applying antibiotics to cure the underlying infection. The only thing it does is make the inflammation even worse.

Fundamentally, tax cuts do not solve the long-term problems the US economy has. It doesn’t solve the trade deficit, which means basically the US is buying more than it is selling, which in personal finance terms means the country’s income is less than what it spends. It also doesn’t help the budget deficit, which means in personal finance terms that the country is borrowing on its credit card, leaving the bill to future generations to pay. In fact, the tax cuts are only going to make it even worse. If in providing my clients with financial advice, I would tell them to borrow more on their credit cards so they can spend more today on things they can’t afford to begin with, my clients would walk out of the door without a second thought. However, for some strange reason, we buy it when President Bush, Mr. Bernanke, Congress, and the presidential candidates provide us with such advice.

Borrow on your credit cards, everyone. “The government” (you and your kids) is paying the bill.

Should you refinance now? Why Mortgages are an insurance against falling Real-Estate prices

noreply@blogger.com (The Money Prof) — Mon, 21 Jan 2008 18:47:00 +0000

Everyone is saying now: refinance your mortgage because rates are falling down and you want to lock that low rate for the next 30 years.

Are they wrong?

Not really, but they miss the real points of taking a mortgage or refinancing: lower risk and higher return. Oh, and tax benefits as well.

Firstly, let’s quickly examine the argument behind “refinance when rates are going down.” It is really a simple one: pay some money now in closing costs of the new mortgage to create long-term savings due to the lower rate. If the net present value (the value of the savings in today’s dollars) is higher than the closing costs, it’s a good deal. If not, it’s not.

Two assumptions are being made when this argument is put forth. The first is that rates are NOT going to go down further. History, however, suggests that when rates start going down (or up) they continue to do so for a while. The reason is that macro-economic factors play over longer terms than the effects of the overnight rates of borrowing (that’s the rate the Fed controls) that really affect short-term borrowing. Additionally, the Fed tends to be conservative and rarely make really big rate cuts, but rather tend to make gradual cuts over a period of time. Combine the two, and the expectations for a recession, and it means you probably should not jump to refinance quite yet.

The second assumption is that all you do is replace one loan with another. What if, and you have to bear with me here before you jump up shouting, you took MORE money out, or low and behold, you mortgage your house to the hilt?

Wait, I know what you are going to say about the mortgage crisis, and foreclosures, and all that. As I said, bear with me a while.

Douglas Andrew, the author of the NY Times best sellers, Missed Fortune 101, and Last Chance Millionaire, is champion of the Equity Management movement, and the biggest proponent of pulling out equity in order to invest it in safe investments. Mr. Andrew argues as follows, “The criteria by which we should evaluate our investments, as well as liabilities and assets, are Liquidity, Safety, and Rate of Return.” “Then,” Mr. Andrew says, “if you get tax benefits, this is the cherry on top. It is not the reason to make decisions, but it is certainly a nice feature to have.”

Why does Mr. Andrew argue for Liquidity, Safety, and Rate of Return as criteria? To understand this argument, we should think about what is risk.

Usually, the financial world considers volatility to be “risk.” Indeed, volatility can pose risk; at least the downside of volatility might do so. However, volatility is not risk, only a driver of possible risk.

The following definition is critical to understand risk, and how to evaluate it, something which even notable economists have a problem with.

Risk is: “Not having what you need or want when you need or want it.”

It is a very simple definition but very powerful. When I defined it as such, it illuminated for me many paradoxes in human behavior, as well as economic and financial problems. Recently, Howard Kunreuther, one of my former mentors and the director of the Risk Management and Decision Processes center at Wharton, together with Dave Krantz, from the Psychology department at Columbia University, wrote an article for the Judgment and Decision Making Journal in which they suggest that we make decisions based on goals, and not as economist been claiming we do, namely by evaluating options’ utility (economic speak for benefits or costs) regardless of our objectives. This new, goals based approach is indeed more in line with the above definition of risk. Indeed, Professor Kunreuther and I are discussing future research and articles about it.

The problem with mortgages is that the whole financial industry, except for Douglas Andrew, and not surprising, many mortgage brokers and bankers themselves, focuses on foreclosures consequences and does not examine what are the sources of risk in real-estate and mortgages. The common assumption is also that they money we borrow is spent and not invested in a safe side-fund.

We will assume that we put the equity we pull out into a good safe side fund that cannot lose money. It is an important assumption to remember in order to understand the rest of this article. As for the side fund, there are such risk-free investments that provide very good (long-term) returns at low cost, but those options are not the focus here.

Sources of Risks

The first source of risk in mortgages is the inability to make payments on the loan, resulting in foreclosure. This means that you might not have the house you want or need. However, when do we face such risk? Most of the time, if we had NOT gambled on short-term increases in real-estate prices using introductory rates knowing we cannot afford the full payment on the loan, this risk comes from losing a job, health problem, and similar unexpected events. In this event, if you DID NOT pull the money out of the house and put it in a (safe) side fund, you are indeed in a bind. The banks, as Citibank, in an ironic twist, found out recently when it needed to borrow money to cover mortgage defaults losses, will not loan you the money. As they say, “it is better to have the money and not need it, then to need it and not have it.”

If, however, you did pull equity out and put it in a side fund, you can use the side fund to cover payments until you recover. In the worst case, you can forgo the house, which might be emotionally difficult and painful, but you would still have your money in that side fund, and you would be able to start anew.

In fact, unless you don’t have any mortgage, the LOWER your mortgage balance, the MORE you are at risk of foreclosure!

The reason is simple, and even more critical to understand now when real-estate prices are falling. Banks don’t want to foreclose on properties because it costs them on average $50,000 per foreclosure, and that’s only direct costs of legal fees and such. It costs them more due to higher borrowing rates they face – much like us, banks are rated on “credit worthiness” and the higher a bank’s foreclosure rate, the more it get charged. Therefore, they foreclose on properties they can make money on and try to avoid foreclosing on properties they would have to sell at a loss. Therefore, the lower your mortgage balance, the more likely the bank can get rid of it in the foreclosure auction, or at worse, take it back and sell it as a Real Estate Owned. With falling real-estate prices, banks are even more concerned about foreclosing on a property with a high mortgage balance because by the time they get the house and are able to sell it, prices would be even lower.

What is the lesson?

Pulling your equity out and putting it in a SAFE side fund reduces your risk of foreclosure!

The second source of risk, and other minor issues such as your return on investments and taxes will be discussed in the next blog.