Greath Wealth -Investment Information & Services

What if the U.S. Government Goes Broke?

A few days ago a client called who had been rattled by a doomsday friend of his. From what I remember, his friend’s primary concern was that the U.S. government is going broke and that the market will go to zero as a result, or something very near that.

No, I’m not a blind optimist and I do agree that it may not be good for the U.S. government to go broke, as it is ~20 percent of the U.S. economy. And no, I don’t want to trivialize the possibility.

However, we just need to look around at the states to see what would happen if the U.S. government “goes broke”. In California (CA), is Apple Computer going broke along with the CA government? No, quite the opposite. Apple is turning in record profits.

What about in Pennsylvania (PA), where 77,000 state workers have been over a month without a pay check because the politicians are at loggerheads because they can’t agree on a budget? Well, Pam and the girls are in PA now, and when I asked Pam how Friday night was at a regional family owned amusement park Pam replied: “It was more packed than I’ve ever seen it…” I know that’s pretty unscientific, but it’s a valid anecdote that the people of central PA are definitely not starving. To the contrary, everyone but the government workers are probably relieved that one element of the state government finally stood up and said: “No New Taxes!”

Even more in support of the marginal impact of the U.S. government is an article in today’s Wall Street Journal by Zachary Karabell. Mr. Karabell argued that because the world economy is so intertwined that fewer and fewer American companies need a strong domestic economy for their earnings to grow. Yes, that’s bad for the U.S. citizens looking for a job and it’s bad for the out-of-control tax hungry U.S. government, but it’s great news for the global investor.

Yes, the U.S. government may get desperate and may print too many dollars and drive U.S. inflation through the roof. However, as we witnessed in the 1980s, at some point the currency will come under control and the market will regain its losses, either through U.S. business or through business from abroad. Yes, the American citizen will feel the pain from the situation, but the global investor will survive, and ultimately, thrive.

We don’t sail around the world in wood ships any more, and with or without the U.S. government, the world economy will march forward.

Thanks,

Rod

PS: Pam is on vacation for two weeks, ending this Wednesday, and she’ll be commenting on everyone’s site again regularly after she returns.

PS 2: Let me know if anyone is interested in our web guy’s services. He’s a good kid (30 something), easy to work with, knows his SEO stuff and as you can see, does good work.

The Strength of Markets

This post is NOT about politics, but rather about an example of how people think and the strength of markets.

Last week, on the drive to Pine Cove Family Camp, Pam and I began talking about the possible socialization of the American health care industry.  My stance was simply:  The government can do what it wants, but there will always be some who are wealthier than the masses and you can bet that they’ll find good health care, and the best of the physicians and other professionals will migrate to serving the wealthier crowd.

To this, Pam replied:  “What if the government makes it illegal to practice medicine privately, as it is in Canada?”  We thought a minute, and then Pam said:  “Do you remember the mercy ships we’ve heard about that provide health care for undeveloped countries by pulling a health care laden ship into their ports and serve the ultra-poor by bringing them on board the ship?  Some enterprising individual can do that, pull a boat for the wealthy into a U.S. port, take it out 12 nautical miles into international waters, provide the necessary medical procedures, and then pull back into port that evening or the next day.  There’s nothing the U.S. government can do about what happens in international waters.  Ships do it for gambling.  They can do it for health care.”

A few days later we were having breakfast with a couple of physicians and the health care situation came up.  With a solution similar to Pam’s medical ship idea, one of the physicians said:  ”Yes, if they socialize the industry and make it illegal for private practice, you can bet physicians will be setting up shop in Mexico and offering package deals that include the flight, accommodations, meals, the medical procedure and the return trip home.”  He’s absolutely right.  We’ll see the best and brightest physicians, along with the world’s best medical centers, move to Mexico and the professionals will live like kings without worrying about defensive medicine, being sued, and all the other headaches that come along with our highly regulated industry, which is about to be regulated even more.

Even more interesting is that this physician went on to say the average new physician is entering the market with $250,000 – $400,000 in debt associated with medical school and training.  Wow!  That’s staggering.  Who, in the right state of mind, would go through ~12 years of school and training, take on $250,000 – $400,000 in debt and then settle for a government paid job?  That’s definitely no way to attract the best and brightest.

So what’s the bottom line in all of this?  Markets move, and they move with more power and smarts that any government has ever dreamed of having.  Hence, when you’re thinking of “outsmarting” the market, you may want to think again.  There’s millions of people out there, and when it comes to publicly traded companies, you can bet that others are thinking the same thing.

Once again, markets are efficient.

Thanks,

Rod

Thoughts on Investing TODAY

Everyone,

As always, thank you for your kind words.  In posting today I decided to post my response to a client’s questions about where to put some money from bonds that just matured.  The clients are within ~5 years of retirement.  I have to keep the amount confidential, but it was approximately 1.5 percent of their total portfolio.  Although it’s not a huge amount, it’s still significant.  They pay me to watch every penny, which is what I do my best to fulfill.

Susan:

Thank you for getting back to me.  I have two thoughts on the $X that matured with the GRDA.  Each has its own risks and rewards issues.

The first option is to put it back into the municipal bond market.  If we were to go this route I’d highly recommend a municipal bond fund instead of single municipal bonds.  Why?  we’re not going to get significantly better returns going the single municipal bond route.  Yes, we can go with something that triple A and insured, but in today’s environment that doesn’t always mean a lot.

Have I lost faith in municipalities?  No, but I’d much rather spread the risk over hundreds or thousands of bonds, such as the DFA short term municipal bond fund or something similar, instead of putting it into one issue.  Why?  Some of the states are in financial trouble, which could trickle down to the municipalities. Can’t we go with safe states like OK and/or TX?  Yes, we could, but the federal government, with its “stimulus” plan, is threatening the states to take on huge fiscal liabilities.  As it now stands, the Feds take on the expense the first two or so years, but then dump it on the states.  That’s not good, as we don’t know which states are going to get whacked the hardest.  Hence, I’d much rather spread the risk across the entire country instead of buying a single issue that sounds good today but gets hammered with something unforeseen in a couple of years as the government fiscal landscape is changing.

How much are triple A municipal bonds getting right now?  Triple A, maturing in 5 years, as of a week or so ago, were getting 2.5 – 2.8 percent tax free.  One can get toward 3 percent if you go out 8 years, but I recommend sticking with 5 years and under.  Why?  Did you see the jump in interest rates last week? Mortgage rates climbed ~0.4 percent in two or three days.  Rates then fell back some on Friday, but still, to climb 0.4 percent in two days is outrageous.  As interest rates go up, bond values go down.  Hence, the shorter your time to maturity, the less you get hurt.  Should we invest at all in bonds with rising interest rates?  It’s not a good financial move, but its less volatile than stocks or real estate.  This is a move I don’t like to make; i.e., looking for the route of least potential pain.

What else is there?  I realize that John and you are highly skeptical of investing in stocks, but now may be a good time to get into some large “blue chip” stocks.  This would bring your portfolio back toward the long term stock and bond balance we’re seeking, as we designed a few years ago when I brought you on board with the Schulz Financial/TDAmeritrade/DFA team.

I’ll be the first to admit that I’m not clairvoyant, but the market isn’t in the free-fall that it was in from last Sep/Oct through Feb/Mar.  Also, as far as weathering out changes, I have more faith in a broad section of “blue chip” companies than a broad section of government bonds.  I don’t know if you noticed, but a couple of weeks ago one of the rating agencies (I believe it was Standard and Poors) warned the UK that it was thinking about downgrading their bond rating. And you don’t have to look far on our side of the pond to see similar things happening.

For example, I believe California’s bonds are now rated as either “junk” bonds or one step above junk bonds.  Oregon is contemplating (a) shutting down some courts; (b) letting convicted felons out of prison early; and (c) trimming its public school year from 9 months to 8 months, or some combination of (a) – (c) to save money because it’s in such dire financial straits.  NY, NJ and MI aren’t far behind.  And in the private university world, Ivy League Dartmouth College recently had its credit rating revised downward.  Yes, people are starting to realize that the U.S. government may have its bond rating reduced.  In reality, the bond has already been hit by the time the agencies take something down a notch.  Markets are efficient.

What about CDs?  Everyone who’s within ten years of retirement should have some money in CDs but we need to realize that their long term return, after taxes and inflation, has historically been negative.  Yes, CDs have increased their yield in the last couple of weeks due to the rise in interest rates, but we also need to keep in mind that inflation has gone from ~0 to ~2 percent.

In summary, we’re not out of the woods.  However, it may be a good time to take some or all of the $X that matured with the GRDA and roll it into a broad cross section of large cap “blue chip” stocks.  Another option is a municipal bond fund, and still another option is splitting it 50/50 between the two. CDs may feel safe, but, long term, too much in CDs won’t get us where we need to be financially.

What do you think?  Please drop me a note or give me a call.

Thanks,

Rod

Your Personal Investment Strategy Wrap Up Summary

Everyone,

Thank you for staying tuned and please excuse me for taking a few days off.  I tried to write yesterday, but I couldn’t get an adequate lake-side wireless connection through my 3G wireless card, so I’m writing from the inside of a Starbucks in Tyler, TX today.

Today I’ll be brief, as I just want to provide a summary of the topics we discussed in April and May.

1. The Three Factor Model.  Keep in mind that three things explain approximately 90 percent of your portfolio’s performance.  These three things are:  (a) the return of the general stock market minus the risk free return; i.e., stocks vs bonds;  (b) large stocks vs small stocks; and (c) value stocks vs growth stocks.  Keep in mind that NONE of the touted commercial sales factors, like portfolio manager, mutual fund company, market timing, etc. come anywhere close to the above three factors when it comes to explaining what impacts your portfolio’s performance.  Code word:  Focus on the three factors above.
2. The Global Economy Marches On.  Economic cycles are as old as commerce itself.  However, in general, and it’s a strong general, you drive the economy forward by going to work every day and making a living.  No one in the free world, and much of the third world, works for absolutely nothing.  Countries and societies rise and fall, but we don’t sail around the world in wood ships any longer.  Code word:  It’s a pretty safe bet that the global economy will continue with its forward march.  It’s wired into our souls.
3. Own the Casino Instead of Just Being a Player at the Casino.  No one is clairvoyant, and when it comes to investing, statistics is a factor.  Code word:  Use the things we’ve discussed to play the game as the owner of the casino instead of a player at the casino.
4. Risk:  We Can Measure It and Design for It.  Do you remember the bell curves?  If we define risk as uncertainty, we can measure it.  Moreover, we can evaluate your personal risk tolerance and time horizon, and then tailor a portfolio for what fits your personal situation.  Hence, rather than rely on non-existent clairvoyance and increase your risk by jumping in and out of the market, you’ll be ahead to get into a portfolio tailored for your situation and ride out the inevitable ups and downs of the markets.  Code word:  Don’t shoot from the hip when you can measure and design for something critical.
5. The Past Doesn’t Predict the Future.  Do you remember the comparison of 1970 – 80 mutual fund superstars to their performance in 1980 – 90?  While past performance may be an indication of future performance in many of life’s arenas, it means next to nothing when it comes to managed investment portfolios.  Code word:  Don’t let any mutual fund company convince that their ABC fund will do good the next ten years because it drummed the market in the last ten years.
6. The Market is Efficient.  As Fama hypothesized in 1965, the market processes and adjusts for all publicly available information almost instantaneously, and its movements follow a random walk pattern.  One measure of the validity of his hypothesis is the performance of index funds versus managed funds.  Code word:  Index funds have a better return, lower risk and lower cost than managed funds.  Those are things we like.
7. Design Your Portfolio.  While we didn’t give this issue the time it truly deserves, you can build a portfolio like a master chef measures and mixes his/her ingredients.  Why leave something as important as your life savings to random chance?  Get into a portfolio that’s optimally designed and built for your risk tolerance, time horizon and investment options.  Code word:  It’s possible to get more return with equal or less risk.  That’s good.
8. Investment pecking order.  We can get one step more scientific than index funds with DFA.  Past performance doesn’t predict future performance, but we do know that DFA funds are more scientifically built than index funds and that their historical performance does more than pay for the additional overhead.  However, if DFA isn’t available or if you don’t want to go that route, a portfolio of index funds is the next best option.  Bringing up the rear of the field is managed funds, but they’re often what someone has to live with because they’re ~90 percent of the market.  But even with managed funds we can apply the three factor model, dial in the risk and design a portfolio that uses efficient frontier optimization.  Code word:  Do the best you can with what you have available.

Although I’m at family camp this week, I’ll continue to blog.  Further, I plan to get back to doing it on a daily basis when we return to Houston next week.  Stay tuned, as more good stuff will follow.

Thanks,

Rod

An Example of Scientific Diversification

Again, many thanks for following along.  Tonight I’ll be brief, very brief, as I’m sure you’re tired and would like a break.  With that said, I’ll provide you with an actual example of numbers I ran with data from DFA.

Consider two indexes, the S&P 500 and the MSCI Japan index (I believe MSCI stands for Morgan Stanley Composite Index, but don’t hold me to it).  From January 1, 1970 through June 30, 2005 (I did the project in August of 2005) the S&P 500 had a geometric average annual return of 11.1 percent.  Similarly, the MSCI Japan index had a geometric average annual return of 10.6 percent for the same period.

That’s return.  What about risk?  For the subject time period, the S&P 500 had 44 negative quarters, compared to 55 negative quarters for the MSCI Japan index.

What happens if you combine these two investments, with 60 percent going toward the S&P 500 and 40 percent going toward the MSCI Japan index?  Logically, you’d expect a geometric average annual return of something between 10.6 percent and 11.1 percent, right?  I mean, that’s only logical.

And as for risk, if you do the 60/40 combination you’d expect something between 44 and 55 negative quarters, right?  Again, that’s only logical.

However, if you combine the two assets and run the numbers, you get a combined geometric average annual return of 11.6 percent, which is above either investment by itself (see bar chart below).  Wow!  That’s great!  The combination is greater than the sum of its parts.

And what about risk?  The combined portfolio has only 40 negative quarters, which is less than either portfolio on its own.  LESS RISK, MORE RETURN!  That’s what we want.

No,, this isn’t voodoo math.  Rather, it’s a combination of statistical covariance and linear programming – for the investors’ benefit!

Stay tuned, as more good stuff is yet to come.  We want to raise your return, reduce your risk and cut your costs.

Thanks,

Rod

Benefits of Portfolio Diversification

The Science of Diversification

Many thanks to everyone for your kind words about my summary.  Although we could spend a week or two on the above topic, I plan to cover it in just two days and then have a wrap up summary for all my posts to date.

Diversification.  Investors often think it’s merely a matter of not putting all your eggs in one basket.  While we don’t want to put all our eggs in one basket, we’d miss half the story if we stopped at that.  So how do we get at a highly sophisticated, quantitative topic in a short, fun and easy few minutes?  As usual, I’ll explain it with an analogy.

So where is the analogy from today?  Christian may like this, as it from the kitchen, where I know barely enough to be dangerous, which you’ll see in the next few paragraphs.

Diversifying One’s Diet

Although we all enjoy a well cooked meal, we’re going to start with the basics and move up.

Option 1:  No Diversification.  Imagine having a kitchen with nothing in it but flour and water.  It may sound terrible, but if you’re hungry enough, that flour and water, before it turns to glue, may taste pretty good.  Yes, if that’s all you get you’re likely to suffer from malnutrition after a while.  But for a period of time that flour and water will keep you from starving.  It may not be real tasty, but it’s better than nothing.

The comparison of this to investing is having a portfolio with one ingredient.  Surprisingly, it’s not that uncommon.  Maybe the single ingredient is a money market account, or stock in the company you work for.  Another possibility is having it all in real estate, or gold, or whatever may feel good at the moment.  You’re not going to starve, you may not go broke, but you’re far beyond the optimal investment mix.  It’s like trying to live on flour alone.

Option 2:  Several Kinds of the Same Thing.  This is the structure of many portfolios.  How?  They may contain five mutual funds or ten stocks, but they’re all different colors of the same thing.  For example, maybe one has five different mutual funds, but they’re all large cap value stock mutual funds.  Or, maybe one has ten stocks in their portfolio, but they’re all high-tech stocks.  Do you remember the .com bust in ~2002?

Investing this way, which is common, is like living on five different kinds of flour.  Maybe you have wheat flour, white flour, chinese flour and a couple of other types of flour, but it’s really all the same.  it may blend to a slightly different color and taste a bit different, but it’s still a case that will ultimately lead to malnutrition.

Option 3:  Random Ingredients.  With this option, imagine having a well stocked kitchen, but getting your meal prepared through a random selection of ingredients that are then cooked for a random amount of time.

For example, imagine tossing a tomato and peanut butter into a bowl and mixing it well.  Then you add some fresh chopped garlic and a dash of soy sauce.  After spooning this into an oven safe pan, we throw a piece of salmon into the blender, let it run for five minutes, pour it over the oven safe pan, set the oven for 467.3 degrees F and let the mix bake for 11.23 minutes.

This has to be good, right?  After all, we have good ingredients:  peanut butter, a tomato, a clove of fresh garlic, some soy sauce and fresh salmon to top it all off, literally.

The taste may be absolutely terrible.  However, you’re going to get a diet that’s at least somewhat balanced.  And if you’re hungry enough, it may even taste acceptably.  Who knows, maybe you’ll get lucky and it’ll end up being a random masterpiece.  But probably not…

This is similar to the most common type of portfolio I see, before I go to work with Nobel Prize winning tools.  The investor has random amounts of the available ingredients (investment options) that are thrown together.  The end result may be far from optimal, but it’ll likely keep them from starving.

Option 4:  Enter the Master Chef.  This time we put a well-trained, experienced chef in the well stocked kitchen and let him go to work.  By adding the right amounts of the right ingredients and cooking them for the right amount of time, he ends up with the optimal meal.  It’s not only nutritious; it also fits your particular taste and situation.

This is what someone can achieve with the right blend of science, software, experience and training.  What is the science and software piece of this?  It all started way back in the 1950s, when a future Nobel Prize winner (1992), Harry Markowitz, was working on his PhD thesis under another future Nobel Prize winner (1976), Milton Friedman.  And where were they doing their work?  You guessed it:  The University of Chicago…

Portfolio Optimization – Briefly

I won’t bore you by going into the quantitative part of this.  It gets complex, quick.  But let me say the young Harry Markowitz found that when you apply two mathematical tools called statistical covariance and linear programming he discovered the whole of a portfolio could be greater than the simple sum of its parts.

Again, I won’t get into the details, but if you look at stocks A and B on the risk/return graph below, you’d think that if you combined the two you’d get portfolio performance characteristics that lie on a straight line connecting the dots.  However, the world is not all straight lines, and if you combine the “right A” and the “right B” you can get a result that lies up and to the left of the straight line that connects stocks A and B.

Why is being up and to the left of the straight line something that justified, in part, Dr. Markowitz winning a Nobel Prize?  It’s really quite simple.  If you go straight up from the straight line connecting A and B without moving to the right (more risk), you get MORE return for the SAME amount of risk.  That’s COOL, it’s what every investor desires:  More return without increasing the risk.  YES!

What’s this called?  Mean Variance Optimization, or MVO for short.

Does it have a limit?  Yes.  The optimal mix lies on an optimal line that’s up and to the left, a line called the efficient frontier.  You can see an example of this line in comparison to common investment benchmarks on the second chart.

Limitations of MVO

Keep in mind that MVO is not a panacea.  And more specifically, we’re applying a mathematical tool to an economic/investment analysis problem.  Yes, it does have its limitations, which we’ll discuss briefly tomorrow, along with an actual example of how this stuff works.

But for now, we need to keep in mind that there is a scientific way to build an optimal portfolio to raise your return, reduce your risk and cut your costs.  That’s what we want.  And yes, it applies to the real world, which we’ll see an example of tomorrow.

Stay tuned, as we’ll have more fun before wrapping things up on Wednesday.

Thanks,

Rod

PS:  Now you know why Pam, who’s of Italian descent, does all the cooking in our house, while I’m left to do the investing.  We’re a good couple.

MVO and The Efficient Frontier

Risk-Return of Various Benchmarks