More Profitable Health Care Is the Solution (2009-08-31)

by David John Marotta

Americans enjoy the best medical care in the world. When judged by nothing other than the ability to provide quality care, no country does better than we do. Every ranking that puts the United States less than first includes some other measurement.

We don't give it to everyone, however. And what we do provide is expensive. As a result, the quality of care is proportional to a patient's ability to pay. Every state doesn't provide insurance as a right of residence either. Americans also don't have the healthiest lifestyles. Too many people are overweight or drink too much.

Sexual promiscuity, lack of exercise and smoking are also increasing the costs of health care. For all of these choices, we bear personal responsibility. The inevitable result of using public funds to pay for health care will be all of us battling to restrict freedom of choice and forcing our idea of morality on each other.

Because of the expense and hassles associated with our current insurance coverage, Americans are not satisfied with the system as a whole. But we need to define which problem we're trying to solve before we can evaluate any prospective change. Some of the economic forces in place provide us with top-of-the-line care. Irreversible damage could be done by snake oil medicines.

First, we must acknowledge the limits of what is possible. No elixir of life, no amount of hopeful change can alter the fact that we are mortal. The cost of keeping us alive is asymptotically infinite. And every citizen's concern for the well-being of his or her loved ones translates to an unlimited incentive to override a dispassionate rationing of medical resources. No system can work fighting love, economics and the survival instinct.

The high cost of medical care is part of the reason why we offer the best. So many innovative techniques have developed here because patients are willing to pay enormous sums for them. But if you fix the price and ration who gets it, you only cause shortages. Unchecked by cost, rampant demand will overwhelm supply.

Some liberals advocate rationing. They argue it's what we have now because care is only given to the rich. They claim that in a rational system, care would be apportioned specifically where it would do the most good. For example, it would be spent on preventive medicine or on young people. Economically, this is foolishness.

We should not equate economic demand with rationing. Rationing is controlling the distribution by some method other than price and supply and demand. But when economic demand is used, it increases the supply. Patients who are willing to pay motivate more people to provide services at those prices.

In contrast, no doctor wants to treat patients on Medicaid. Reimbursement is both difficult to get and inadequate. The failure of the program represents all that is wrong with a government-run option.

According to its champions, when we all get together under a single-payer system, the government will have the leverage to negotiate lower costs for pharmaceuticals and medical services. They argue that this scenario will contain health-care costs without any negative side effects. This quackery ignores the proven effects of supply and demand.

Healthy competition requires both supply and demand. Think of a single-payer system as a government monopoly of demand with no competition. You may want health care and be willing to pay, but you are not allowed to pay. As a result, demand dries up.

Imagine the government was the only customer. They could tighten the screws on companies and fix the prices. Workers could either accept a pay cut or take a hike. Quality would certainly suffer. Worse yet, fewer of the best and brightest would attend medical schools if the outcome was working for reduced wages as government employees.

Other suggestions, such as information technology, are proposed to reduce medical costs. Whatever the merit of these ideas, the ability to implement them lies completely in the hands of the health-care industry. Government incentives to speed up automation will have unintended consequences. We should remember that if proposed systems are cost effective, they will stand on their own merits and be implemented like any other innovation in the free marketplace.

Attempting to circumvent economics is always a losing proposition. And trying to make the industry less profitable only defeats the industry's quality. It may sound strange to people not versed in economics, but the best way to reduce the cost of something is to find ways of making it more profitable. If you can do that, doctors won't have to charge as much to make the same profit and more people will pursue careers in the field.

The irony is that government could make medical care more profitable. For example, every doctor starts the year $250,000 in debt because of malpractice insurance premiums. That expense has made the cost of health care more expensive than it needs to be.

Anyone who claims that U.S. health care is expensive should compare malpractice insurance in the United States with other countries. Not only is the insurance added directly to the costs of health care, but to avoid lawsuits, doctors practice not necessarily the best medicine but certainly the most defensible. Tort reform is the solution to expensive malpractice insurance.

Another huge cost savings could be gained if it was easier for physicians to get paid. About half the cost of running a medical practice is paying support staff to handle insurance collections. Making it easy for a doctor to get paid would slash health-care costs.

If it were legal, patients who paid up front in cash could get their health care at half price. But because the government is the largest consumer of health services, by law preferential treatment can't be given to those who don't have government insurance. It doesn't matter that it costs more to try to collect from the government. They write the laws, so they get preferential treatment.

And when a doctor does submit an insurance claim for services rendered, keep in mind the great financial incentive to deny the claim. It doesn't matter why. Delaying payments is almost as lucrative as denying them entirely. Insufficient coding does the trick. If anyone complains, just say you are eliminating insurance fraud and protecting public funds. All the while, those willing to pay in cash subsidize those whose public insurance bloats a doctor's office with medical coding specialists trying to maximize minuscule government payments.

You may frown at this comparison because your employer-sponsored medical insurance acts the same way. Exactly! Employer-sponsored insurance looks and acts more like a government program than the free market. And private payers are forced to use a system shaped largely by government purchasing.

Great inefficiencies occur when the one who benefits from the services, the one who pays for the services and the one who evaluates the services are different. Half of the expense is wasted fighting competing interests. That's why health-care payments and decisions should remain in the hands of consumers.

Only consumers can balance their own competing values and make those tough decisions regarding what to purchase. And once they have made a choice, only they will be willing to pay for the services they receive without reams of bureaucratic red tape.

Reduce a doctor's malpractice insurance and collections staff, and you will get less expensive health care. In both of these cases, the laws on the books have costly consequences. Reducing these roadblocks for health-care providers could reduce costs in some doctors' offices by half.

Pushing doctors toward cheaper health care is too expensive. Only if we can make health care more profitable will competition naturally reduce the cost. Next week I examine the desire for universal coverage and the economics associated with that worthy goal.



from http://www.emarotta.com/article.php?ID=352

Avoiding a Civil War over Health Care (2009-08-24)

by David John Marotta

Advocates of small government are justifiably angry. And their anger is creating a new and genuine political activism. These citizens are deeply frustrated, and they don't know where to channel their dissatisfaction.

Liberals aren't very understanding or empathetic. They brand all conservatives as mean or stupid. They discount the sincerity. They say conservatives don't represent the real America.

So our American family is more polarized than ever. But we are still a family. Siblings can drive us crazy. They tap repeatedly on the annoy button. Their rhetoric runs hyperbolic. But for many people, it has gotten to the point that everything is maddening.

Our only civil war was inevitable, as Shelby Foote said in <a href="http://www.amazon.com/gp/product/B000BITUE8?ie=UTF8&tag=davidjohnmarotta&linkCode=as2&camp=1789&creative=390957&creativeASIN=B000BITUE8" target=_blank>Ken Burns's classic film</a><img src="http://www.assoc-amazon.com/e/ir?t=davidjohnmarotta&l=as2&o=1&a=B000BITUE8" width="1" height="1" border="0" alt="" style="border:none !important; margin:0px !important;" />, because we failed to do what we Americans do best: compromise. "We like to think of ourselves as uncompromising people," he said, "but our genius is for compromise, and when that broke down, we started killing each other."

Let's be grateful that we are still just yelling at each other. Or perhaps yelling past each other. The two very different views take the opposite sides of nearly everything debatable. If you are quick to assume the other side is ignorant or selfish, you will never understand enough to make peace. You are part of the problem.

Power breeds condescension and arrogance. Whether it is justified because "Elections have consequences" or a simple "We won," there has been a rush to ignore the 47% who didn't support the liberal view. Both parties tend to whine about bipartisanship when they aren't in power and then completely ignore it when they are. With one party holding a super majority, every pretense of being bipartisan has been dropped. But we can't afford four years of writing blank checks.

Compromise is not capitulation. It need not be more costly than either alternative. Every act of the free market is a compromise. Public policy ought to wait for a consensus. We must understand the two views well enough to safeguard the fundamentals of both.

Cognitive psychologist <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2Fgp%2Fentity%2FSteven-Pinker%2FB000AQ3GGO%3Fie%3DUTF8%26ref%255F%3Dep%255Fsprkl%255Fat%255FB000AQ3GGO&tag=davidjohnmarotta&linkCode=ur2&camp=1789&creative=390957" target=_blank>Steven Pinker</a><img src="https://www.assoc-amazon.com/e/ir?t=davidjohnmarotta&l=ur2&o=1" width="1" height="1" border="0" alt="" style="border:none !important; margin:0px !important;" /> labels the conservative view the "Tragic Vision" and the liberal view the "Utopian Vision." In his book "<a href="http://www.amazon.com/gp/product/0142003344?ie=UTF8&tag=davidjohnmarotta&linkCode=as2&camp=1789&creative=9325&creativeASIN=0142003344" target=_blank>The Blank Slate</a><img src="http://www.assoc-amazon.com/e/ir?t=davidjohnmarotta&l=as2&o=1&a=0142003344" width="1" height="1" border="0" alt="" style="border:none !important; margin:0px !important;" />," he describes these two perspectives in a very balanced and evenhanded way.

Pinker comments that the "sciences of human nature really do vindicate some version of the Tragic Vision and undermine the Utopian outlook." Studies also suggest that those who share the Tragic Vision understand the Utopians better than the reverse. Liberal ignorance, especially of economics, is a leading cause of political unrest.

Although I acknowledge the dangers of political simplification and my own lack of neutrality, I believe the current anger stems from an overreaching on the part of Utopian liberals. Those who are irate can't believe the speed with which liberals have run roughshod over the family and the family's finances.

Most disturbing is the use of economic spoils to win democratic majorities.

Half the people in America don't pay any taxes. All the compassionate empathy and good intentions count for nothing when you are being generous with other people's money. Any good that government does is the result of the rich who actually pay, not the liberals who vote for it. It is like telling Dad you will mow the lawn and then threatening to beat up your brother unless he does the job. Later, as if to add insult to injury, you boast to Dad that you got the job done and your brother didn't want to help.

Liberals often quote Oliver Wendell Holmes Jr., who said, "Taxes are the price we pay for civilization." If that is true, they demonize the very people who make civilization possible. The other half are political Vikings who pay their taxes by raiding and pillaging the productive.

Even though 50% of Americans pay some taxes, the top 2.5% who make more than $250,000 pay half the total tax revenues. This hardworking minority are mostly small business owners to whom we are indebted for nearly all of America's economic and job growth. Rather than receiving our recognition and gratitude, however, this group has been vilified as though their productivity is somehow shameful. Entrepreneurs are saddled with the highest marginal rate of taxes, and every new program pushes their rates higher.

You can understand the top marginal tax rate by this simple metaphor: Government spending burns and pillages half of every new field that an entrepreneur plants. People are weary of planting fruits that others eat and building villages that others raid. They are angry because every citizen's first responsibility is to take care of himself or herself and not burden the rest of society. Although they are charitable, they know it isn't charity when strangers claim an entitlement, seize it by force and then resent it.

My grandmother Florence and her brother Frank used to get a nickel for candy for the week. She would spend a penny and save the rest for later. Frank would spend his entire nickel the first day. At the end of the week when Florence still had some money, her mother would make her share her candy with her brother. Florence didn't see why she was obligated to share with her brother just because he was broke as a result of his own actions. My sympathies are with my grandmother.

Similarly, every policy this year rewards irresponsibility and punishes prudence. We have allowed government, which should be the referee who keeps the game fair, to influence the game or even compete on the field. And at the same time, Congress is writing rules that specifically favor the economic success of the government and its allies. So what should be orderly markets degenerates into a train wreck.

The Community Reinvestment Act forces banks to make risky loans while Fannie Mae and Freddy Mac collect 80% of all the country's loans because of their favored status as a pseudo-governmental agency. The government takes over irresponsible financial institutions and then floods them with liquidity so they can maintain their market dominance. The government seizes all the equity in GM and then provides cash incentives to boost their business. It's no wonder that people are worried about the government underwriting health insurance.

The Utopian Vision has left a trail of disappointment and broken promises. Failed government programs with bloated wasteful budgets litter the political landscape. Despite enjoying every political advantage, they still fail miserably. Given the cost of Social Security, every senior should retire as a millionaire. Medicare/Medicaid and the Veterans Administration are among the poorest run of the country's health-care options.

Conservatives are just as empathic and compassionate as liberals. In fact, although liberal families earn 6% more, conservative-headed households give 30% more to charity. Conservatives have many of the same ideals, but they have a different view of human nature. As Pinker puts it, they believe "humans are inherently limited in knowledge, wisdom, and virtue, and all social arrangements must acknowledge those limits." Only when those limitations are respected can programs go beyond mere good intentions and actually produce beneficial results.

Liberals need to heed the Tragic Vision if they actually want to implement fiscally responsible and economically viable ways to improve people's lives. I've tried to refrain from adding to the rhetoric without softening the critique. In your replies, respect these grievances the way you would a family member.

It may seem counterintuitive, but the government that governs best, governs least. The most fiscally responsible periods in recent history occurred when the two political parties split the executive and legislative branches. Ronald Reagan with a Democratic Congress broke the back of inflation and reduced the top marginal tax rate from 70% to 28% in seven years. This limited government produced the economic boom of the 1980s.

Part of the cost was congressional deficit spending that raised the national debt from $700 billion to $3 trillion. But even after adjusting for inflation or viewed as a percentage of gross domestic product, this amount is paltry compared with our current deficit spending.

The second period of fiscal responsibility was Bill Clinton's presidency with a Republican Congress. This combination held back on spending increases and actually began to run a surplus and pay down the deficit. America's system of checks and balances was based on the Tragic Vision of human nature. The rush to get it done, unfortunately, is a Utopian failing.

Next week to continue the spirit of compromise, I will lay out a plan for what type of health-care reform might actually satisfy the core values of the two competing visions.

 

from http://www.emarotta.com/article.php?ID=351

Cash for Clunkers: A Bad Idea (2009-08-17)

by David John Marotta

Ten days ago President Obama signed an additional $2 billion into law, tripling the original expense of the "cash for clunkers" program. The president describes the program as a "proven success" because it is stimulating the economy and will reduce carbon emissions. You should examine such economic claims carefully regardless of your politics.

Most of our public officials evidently are willing to opt for the expedient solution, slapping a Band-Aid over a fracture and calling it healed. Unfortunately for the American people, these same politicians do not understand they are responsible not only to their present constituents but to future generations.

Henry Hazlitt's classic book "Economics in One Lesson" should be required reading. Politicians, especially those too busy to read the legislation they are voting on, could take Hazlitt's thesis to heart. He writes, "The whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence. The art of economics consists in looking not merely at the immediate but the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups."

To evaluate the long-term effects of the cash for clunkers program, consider the real-world example of Jerry and Janny. They have two children and are expecting a third. The couple owns a Ford Expedition with 144,000 miles that gets 14 miles to the gallon (mpg). They've been interested in getting a replacement and are taking advantage of the cash for clunkers program to subsidize it.

Thus the government handout is merely accelerating Jerry and Janny's plans to purchase a new car. But this small acceleration in new car spending won't last. Compare it to the energy levels of a college student who drinks caffeinated beverages all night cramming for an exam. The immediate stimulus is followed by the inevitable slump.

Neither is the cash for clunkers initiative truly green. The Ford Expedition still has value as a used vehicle. It may not be shiny new, but it could continue to serve Jerry and Janny or another family for several more years. Instead, the regulations require it to be completely stripped and destroyed within 180 days. To measure the true carbon offset from this program, you would need to compare the increased gas efficiency of a new vehicle against the energy it takes to scrap old cars and build new ones.

Jerry and Janny's car is usually full of kids. So the small hybrid vehicles that Obama touts when praising this program are too small for them. They are deciding between the GMC Acadia and the Saturn Outlook, which both average 19 mpg. They could probably help the environment more by just inflating their tires.

As a result of this misguided program, the price for used cars will increase both unnecessarily and artificially. Many cars worth less than the offered bailout will be traded in to be scrapped. Charities will receive fewer automobiles as donations. And people who are struggling financially won't be able to find a clunker that costs less than $4,500. The program seems to encourage new car ownership at the expense of the used car market. The rationale behind it is neither economically nor environmentally sound.

When considering the entire carbon footprint of this program, you will find that continuing to drive your current used car for as long as possible is one of the most green-friendly things you can do.

On one hand, the price of scrap metal may go down, and the price of used parts may go up. On the other, scrap yards may ignore the rules and salvage usable parts anyway. The more useless and wasteful the government rules, the more people learn to break them. Maybe that's why the Soviet Union developed such a large black market and the country today has such thuggery and disregard for the rule of law. A loophole exists when the government hasn't tied you down enough to remove your free will completely. A black market is simply the result when the government tries to remove all the loopholes.

A country can't prosper destroying perfectly good used cars. At the end of the day we still have increased taxpayer spending to pay for destroying a perfectly good car. Hazlitt describes the fallacy behind thinking that when a hoodlum breaks a baker's window it will stimulate the economy. The glazier may make a simple argument in favor of broken windows, but he overlooks the secondary consequences.

Bad economics is easier to present in a sound bite, but that doesn't mean we should heed the glazier. We must be willing to think holistically or else the hoodlums and glaziers will win and the breaking glass will continue. Only in this case, the government is the hoodlum and the automobile unions are the glaziers.

Consider who gains from the cash for clunkers program. Follow the money. General Motors (GM) makes both of Jerry and Janny's prospective cars. The three largest stakeholders in GM are the U.S. Treasury (61%), the United Auto Workers Union (18%) and the Canadian government (12%).

Any earnings that cash for clunkers generates for GM will not create additional profit and growth for the American people. It will be recycled back into government and union coffers. But like all government programs, it is an inefficient method of graft. Foreign automakers will benefit from many of the stimulated new car sales. Essentially, our taxpayers are also subsidizing the economies of Japan and South Korea.

The government chose the auto industry as deserving of such a redistribution of resources because it essentially belongs to them now, and it is failing. The cash for clunkers program surreptitiously serves to benefit their supporters to the detriment of others.

So should Jerry and Janny not purchase the car they want for a $4,500 discount? Of course not. If their children will have to pay the interest on the money we are borrowing from China and Japan to pay for this program, they can at least receive some of the inefficient benefit.

The great illusion of success in the cash for clunkers program comes from its visibility. You will inevitably know someone who appears to have benefited from the program, and it our elected officials will cite it as a reason for their reelection. Vote the bums out! Good economics requires us to consider what this $3 billion could have accomplished if we had never removed it from the wallets of American citizens or mortgaged against our children's future. Some people could have started a business or hired more employees. Some might have been able to buy a clunker for $3,400 and then been able to travel to a better job across town. Some might have paid off their mortgage or just paid down some of their debts. However they would have spent it, it would have been better spent.

 

from http://www.emarotta.com/article.php?ID=350

Investment Strategies Part 5: In Defense of Diversification (2009-08-10)

by David John Marotta

Diversifying your asset allocation among investments with a low correlation can and should reduce your portfolio's volatility and boost your returns. But critics are claiming this strategy is no longer valid. That's because they don't understand the nature of what happened in 2008.

Fickle followers of asset allocation point to the market drop in the fourth quarter of 2008 as evidence that diversification has been discredited. Every investment philosophy and asset class moved downward at the same time. They point out that asset classes are more highly correlated when stocks move down than when they move up. In other words, they complain that just when diversification was supposed to help, it failed.

So does modern portfolio theory need to go back to the drawing board? In many cases critics are not suggesting alternatives, but they are sure something else is needed. They see the trees but are missing the forest.

Correlation is measured mathematically and does not necessarily reflect a causal explanation. It is a fact that every investment class moved down at the same time. But you must understand why in order to evaluate ways to defend against it in the future.

Everything went down in sync because it is all denominated in dollars. The markets moved not because the markets changed but because the value of the dollar changed.

When all the financial institutions either had to deleverage or go bankrupt, they needed dollars for their very existence. The demand for dollars naturally went up. When the credit markets froze and financial institutions would not lend to each other because they suspected their collateral was toxic, the velocity of money went to zero. As a result the demand for dollars went up.

When the value of the dollar doubles, everything else denominated in dollars drops in half. Deflation sinks all ships equally. Everything consequently moves in sync, and correlations approach 1.0.

For example, take investments A and B. Imagine that A would have gone up 2% while B would have gone down 2%. These two investments would have had a correlation of −1.0. They would have been perfectly negatively correlated and provided diversification. But when the demand for dollars skyrockets and both investments are denominated in dollars, the result is very different.

In that case, investment A goes down 48% and investment B goes down 52%. The movement of the dollar swamps the relative movement of the underlying asset, and all correlations approach 1.0.

In my December 2008 article, "When Will the Markets Stop Dropping?" I wrote, "It is as though your next-door neighbor got into credit card debt and is now trying to pay it off. On his front lawn he is having a yard sale. His couch is going for $10, his good china for $20 and his plasma TV for $25. And you think to yourself, "That's the exact same couch I just paid $200 for, and my neighbor is selling it for $10!" In fact, you are amazed that the entire contents of your house have dropped in value.

"Diversification among household contents did not help because the financial institutions that are deleveraging also owned a nice diversified portfolio. Nothing is fundamentally wrong with couches, china and plasma TVs. The problem is that when a nation is deleveraging, everyone wants cash to pay off their debts."

No one wanted shares of stock because they needed cash to deleverage and survive. Financial companies wanted barrels of oil even less as oil dropped from $140 to $32 a barrel. The downward slide in oil and other commodities provides further evidence that the movement was a movement in the value of the dollar.

In other words, if you measure the market's return in dollars, it dropped roughly in half. But if you measure the market's return in barrels of oil, it doubled in value.

You can see additional evidence as the federal government began pouring trillions of dollars of bailout money first into the financial institutions and then salted liberally through government largess. The primary purpose was to devalue the dollar and therefore revalue stock prices. They wanted to stop deflation and reinflate stock market values.

So, assuming my analysis is correct, how could investor portfolios that are valued in dollars have been protected against a sudden and sharp demand for dollars? Well, the short answer is that with a few exceptions, they couldn't. It wasn't just a failure of diversification. Most other strategies failed worse. So-called balanced funds or target funds have seen a decade of losses. Because they have fewer equities, they didn't have enough growth in the decade before 2008 to remain positive. Only the diversification into small value, foreign, emerging markets and hard assets gave well-diversified portfolios a positive 10-year return. And ironically, the categories with the best 10-year returns are the same ones that dropped the most at the end of 2008.

We could liken searching for a viable strategy when the dollar suddenly doubles in value to looking for a safe location when the sun goes supernova. But in our case, what would have been trying to be safe in 2008 would only be extremely foolish in 2009. What is safe when the dollar suddenly doubles in value is extremely foolish when the government is relentlessly pouring out dollars to devalue it.

A recent Wall Street Journal article quoted Ibbotson Associates chief economist Michele Gambera about what he deemed safe in the event of such a nova. Gambera concluded that only a few asset classes other than cash proved helpful. They were gold, intermediate-term government bonds and Treasury Inflation-Protected Securities (TIPS). Well, there are few surprises in that list. Cash and cash equivalents are always a good investment when the demand for cash suddenly increases.

But sometimes cash and fixed-income investments are as equally risky as they were prudent this past fall. Now that the dollar is being devalued, cash is a risky investment. We recommend that at least half of your portfolio be protected against the risk of a falling dollar. You can do so with investments in foreign bonds, foreign stocks and hard asset stocks. One of the best ways to protect your portfolio, hard asset stocks as a class have also provided one of the best returns since 2002.

Gold is a strange category for Gambera to include in his recommendations. Investments in gold did not fare well in the last half of 2008. Gold prices topped $1,000 an ounce in the summer of 2008 and dropped to a low of about $700 at the bottom of the markets in November. It is true that during times of market turmoil many investors flee to gold and push the demand for gold higher. In the recent situation, however, crisis gold did not correct as much as the markets and has still not rebounded well. Although on average, gold doesn't appreciate more than inflation, it is still normally a safe store of value. Just not in the fall of 2008.

So how much of your investments should you allocate to cash, treasuries and other stable investments? Always keep five to seven years of spending in relatively stable investments. That will help you sleep well during a dollar crisis--at least for the next five to seven years! The remainder of your portfolio should be able to weather the duration of even this tsunami.

So is asset allocation dead? By no means. No better way exists to protect your investments. But all these events remind us that monetary policy, deficit spending and the actions of the Federal Reserve do impact currency stability.

The markets are inherently volatile, including the financial markets that trade loans. It was government intervention in the credit markets that helped put all our eggs in one basket. The Community Reinvestment Act (CRA) and government-run Fannie Mae and Freddie Mac contributed to the lending crisis. Their policies encouraged or even required financial institutions to make loans to those with little ability to repay. The unintended consequence was the shock of the imminent failure of our financial system and the sudden dive in the value of the dollar.

Recently, monetary policy is moving in the other direction. The markets are going up partly because massive government deficit spending is devaluating the dollar. Now is not the time to protect your assets against deflation. That tsunami has passed. The current danger is a backwash flowing in the opposite direction. Now is the time to protect your assets against inflation, and cash again may be the most dangerous asset category.



from http://www.emarotta.com/article.php?ID=349

The False Lure of Multi-Level Marketing (2009-08-03)

by David John Marotta

Multi-level marketing (MLM), or network marketing, is a nonsustainable business model because it does not provide a valuable service but simply a product that has been marked up in price.

MLM is based on the faulty premise that as you network with people, all you have to do is find a few individuals who are excited about the idea and want to join the pyramid. You will get paid not only for your own sales but also for sales in your downline, those under you in the pyramid, all the way to the seventh level.

So theoretically, even if you only recruit two people and they only recruit two people, by the time you reach the seventh level, you will have 255 people in your downline supplying you with commissions. Sadly, nothing could be further from the truth.

First of all, only a limited number of people will be attracted to MLM. Think of fishing for recruits to join your downline like offending all of your friends, neighbors and relatives and seeing who can tolerate it. Most people can't take the constant rejection. The few who can stand being rebuffed can only handle it from someone who is not a close friend or family. Building a relational business model with acquaintances and strangers is not possible.

The few who do respond will be more motivated by the money-making opportunity than the product. And when the hose doesn't flow with cash, the average recruit opts out of the scheme after three months.

With half of your people dropping every quarter, you can't build a business. No matter how hard you work, you'll spend all your energy looking for new people and training them. Burnout is pervasive. Although some MLM participants try to automate the process through audio and video pitches, this strategy simply removes the personal touch required to persuade newcomers. Million who have tried are shamefully quiet about their lack of success. It is like trying to fill a bucket with no bottom.

Even if you could draft sufficient numbers of people, you still would not be actually running a business. True businesses add value to people's lives. If you leave the pyramid, it is irrelevant. Everyone still gets the product. Your presence in the pyramid doesn't add any value, either to the company or to those buying from it.

You don't actually take orders, which typically are transacted online. And you don't actually sell a product or services. People are lured into MLM schemes because supposedly they won't be required to sell. They're told they can simply cash the check, which sounds like a very attractive option. Unfortunately, many people inexperienced in business believe that's what business owners do.

Nothing could be further from the truth, however. Real businesses sustain themselves by making a genuine contribution to society. The more real value they can offer, the more people are willing to pay for it. Every successful business owner knows that to stay competitive, you have to be thinking all the time about how to add more value.

Most MLM participants gross very little. In many cases, the money they earn doesn't even cover their own use of the product. It certainly is not enough to compensate them for their time and expenses even at the minimum wage. Many lose substantial amounts by purchasing additional tools that promise to boost sales and numbers of recruits.

Because it requires more of your time and effort, MLM is even less sustainable than buying lottery tickets. The few successes are simply those positioned at the top of the pyramid who collect from the endless recruiting hopefuls churning at the bottom.

True entrepreneurship, in contrast, is decidedly worthwhile. Many people with a high net worth made their money by starting and running a business. Along with the satisfaction of hard work well done, successful business owners enjoy a plethora of financial and tax-planning opportunities as well as the satisfaction of seeing their vision made real.

Hundreds of legitimate business opportunities are available for entrepreneurs who want to build companies that provide real value. But entrepreneurship is for those who feel empowered by hard work, not those trying to escape it. There are ways to find the right business adventure to sustain a lifetime of hard work, but MLM will always be a distraction from a genuine vocational calling.



from http://www.emarotta.com/article.php?ID=348

by David John Marotta and Matthew Illian

According to a Dalbar Financial Services study that tracks investor returns, from 1989 to 2008 the S&P 500 yielded 8.35% annually. But the average investor only earned 1.87% over the same period. This fact deserves restatement. The average investor received less than a quarter of the general market return and did not even keep pace with inflation.

The study suggests that average investors would enjoy better outcomes if they simply invested in bank certificates of deposit (CDs) rather than trying their hand at more aggressive investing. We certainly do not endorse abandoning the equity markets. Seeing so many people forgo their retirement dreams, however, is very discouraging.

We call the difference between the market return and typical investor returns the "termite gap." Termites eat away at the very foundation of your retirement plans. They hide in layers of financial intermediaries that all take a bite out of your portfolio. And the most dangerous termites lie within your emotions.

Fees are the strongest predictor of a fund's performance. John Bogle, founder of Vanguard Funds, commonly shares a simple and compelling mathematical equation that highlights the importance of managing fees. If the performance of all of the market participants make up the average return (A), then after fees (B), investors underperform the market by the amount of those fees (A - B = C). Thus the higher the fees, the higher the underperformance. And when you find out you have termite damage, the first thing you need to do is call the exterminator.

The obvious solution for average investors is to find proven investments with the lowest administrative fees. However, they are left in a very difficult situation. Most do not have the time or expertise to uncover these hidden costs. In a market with so many 401(k) options, we would expect highly competitive pricing. Instead, investors and plan sponsors of small to medium market cap companies display very little price sensitivity when making 401(k) investment decisions. The Government Accountability Office (GAO) found that 80% of 401(k) participants are unaware they are paying any fees.

Many mutual funds with annual operating fees more than 1% will likely underperform and should be avoided. Request a copy of each fund's prospectus and use a magnifying glass to uncover these first three hidden termites. Look for subjects like "wrap fees," "subtransfer agency fees" and "mortality and expense fees" (M&E). M&E fees are an extra insurance charge in annuity contracts. You may have heard that combining your investments with your insurance is a bad idea. Inside a retirement plan, it is a terrible idea.

The fourth hidden termite is 12(b)1 fees. These fees actually pay for a fund's advertising, which is strange. Consider the consumer outcry if grocery stores started charging an extra line-item fee to cover their advertising.

In addition to the standard investment management expenses, mutual fund companies have agreed to pay retirement plan providers so they can be included on a short list of available funds within a 401(k).

If we were describing the mafia, we would call these arrangements "kickbacks." Retirement plan providers have convinced the public they are merely "revenue-sharing" agreements. However, this is not the sharing you learned about in kindergarten. Mutual fund companies create a new "class" of shares, often called "retirement shares" in standard plans or "insurance class" inside of annuities. These new shares are created with higher fees than the standard fund to pay for these types of fee arrangements: the fifth termite.

Unless you are lucky enough to participate in a large corporate 401(k) plan, you typically will not find more than a small handful of no-load Vanguard funds or index funds in these accounts. You will find a large list of funds that try to justify their high expenses by raising their risk levels through active management. The cost of portfolio turnover is the sixth termite affecting expenses. Higher portfolio turnover increases the transaction costs of buying and selling the individual securities in a mutual fund or other investment account. These transaction costs are not separately identified but are netted with the investment return.

Management fees in the 401(k) industry run about 1.6% for the average equity fund. Add in portfolio turnover costs and the impact of sales charges, and another 1.4% of cost has been added. That brings the 1.6% management fee or expense ratio up to 3% a year for a typical 401(k) plan.

High fees do not need to be put on a 401(k) plan. We've designed dream 401(k) choices for our small business owners with less than half those amounts. Incentives always exist for the industry to hide these fees. So being an informed investor is critical.

The seventh and final termite is found within. Common sense tells us to buy low and sell high. The evidence of mutual fund flows suggests that many investors pull their money out of the markets when it is falling and reinvest it back as it is rising. Behavioral finance identifies and addresses these self-destructive actions. But solutions are lacking. Target date funds and managed accounts have helped guide 401(k) participants away from the folly of focusing too closely on individual fund returns. Unfortunately, the termite damage remains.

Imagine a world without financial termites. A person who makes $60,000 a year and invests in the company's 3% matching retirement plan would have $434,947 in 30 years at market returns (8.35%). If this same investor, subject to the termite gap, receives only average investor returns (1.87%), the portfolio would be worth $143,108, nearly $300,000 less than expected.

Average employees cannot make changes to their 401(k) provider. So here are a few words of advice. We usually recommend that people invest up to their match and no higher. Maximize other low-cost investment opportunities, including a Roth IRA, before saving unmatched money in a typical 401(k) plan. If you have left a job or are retired, roll your money over to an IRA that offers low-cost investment options unencumbered by excess fees. If you are currently employed, diversify your investments among index funds and, if necessary, actively managed funds with lower expense ratios.

If you are a business owner or HR director, seek a revenue-neutral investment advisor. In other words, find someone who does not accept revenue-sharing payments or commissions from mutual fund companies. When any mutual fund rebates these revenue-sharing payments, a revenue-neutral advisor will pass these payments back to the plan to offset fees. These investment advisors are more likely to choose low-cost index funds rather than high-cost actively traded funds. The best advisors are fiduciaries. Registered Investment Advisor fiduciaries must disclose fees in writing, invoice the plan sponsor or plan for those stated fees and credit any revenue-sharing fees back to the 401(k) retirement trust. The goal for all employees and plan sponsors should be to capture as much of the market gains as possible.

 

from http://www.emarotta.com/article.php?ID=347

by David John Marotta

For years I've been annoying local realtors by claiming that real estate values were headed lower. Over the past few years, I've been <a href="http://www.emarotta.com/article.php?ID=269" target=_blank>advising young clients to rent and wait for better deals. And I've been suggesting that those who are holding real estate waiting for it to go back up will probably see their property decrease in value before it goes up</a>.

Early in 2005 I coauthored the column <a href="http://www.emarotta.com/article.php?ID=109" target=_blank>"We Could Be in a Real Estate Bubble"</a> with my father George Marotta. We wrote, "Home values may be peaking and ready to correct." We explained that "Delinquency among the less creditworthy 'sub-prime' market that accounts for 10% of mortgages has jumped to 8.07% from 4.5% in 1999. Delinquencies on FHA loans that make up about 15% of mortgages are at a 30-year high of 11.8%.

"As a result, Americans' equity in their homes, net of debt, has dwindled to 57%, compared with 85% a half-century ago. But those are averages. Thirty-nine percent of homes are owned free and clear, but the remaining homeowners have average debt burdens exceeding 80% of the value of their homes. Mortgages over 80% of the value of the home offer little margin of safety should home prices level off or should they fall as much as 20%."

We ended the column with this prediction: "What can be suggested is that the housing prices boom shows signs of weakness, and that they may correct or at least underperform for the next few years. Higher interest rates will slow housing growth in 2005, but the bubble, if it is a bubble, could pop as late as 2006 or 2007."

Our prediction was accurate. Real estate continued to rise through 2005. But it was relatively flat in 2006, underperforming the markets that appreciated over 15% that year.

Two years later, in <a href="http://www.emarotta.com/article.php?ID=226" target=_blank>"Breaking Spaghetti: A Seven-Year Financial History,"</a> I wrote, "Many homeowners with adjustable rate mortgages have seen their monthly payments increase 50%, due to the higher rates. With the sudden jump in monthly mortgage payments, many are finding they can no longer afford to stay in their homes. The rate of late payments and foreclosures has continued to rise leaving many lenders on the brink of bankruptcy themselves. "

Again, the prediction was accurate. In 2007 the Cohen & Steers Realty Majors Index turned negative, losing 18.03%. Residential real estate did even worse. Apartments suffered one of the largest declines, down 25.4%.

Since then, real estate has continued to decline. The Charlottesville Area Association of REALTORS reported that real estate prices declined 8.5% during the first two quarters of 2009 compared with the first half of 2008. The median home price fell to $247,000, a drop of $22,900 over the first half of last year. Midyear sales were down 28% compared to the same period last year.

Although inventories have started to contract slightly, the average days on the market stands at 125, well above a healthy market average of 90 days. Homes priced above $1 million are spending nearly 226 days on the market.

Nathan Rothschild offered the contrarian advice to "Buy when there's blood in the streets and sell to the sound of trumpets." It is time to consider buying residential real estate. The bottom is forming, although it may continue to do so through early 2011.

So this is the time when you should be looking for deals, which must begin with sound planning. I'm going to give you four pieces of important advice.

First, don't be afraid to make a radically low offer. Even 50% of the asking price is OK if that's what you think it is worth. Foreclosures are going for 20% or 30% of the assessed value in some regions of the country. In this market, if your first offer is accepted, you probably bid too high. When we purchased our house in Charlottesville in 1990, it took seven offers and counteroffers before we reached agreement with the owners.

Second, be patient. Some remarkable deals will be available over the next two years but only for those who are patient, amenable to making a ridiculous offer and willing to walk away. With 3,600 active listings, you can afford to wait for a deal.

Third, know how to structure your purchase to maximize your tax savings. First-time home buyers are eligible for an $8,000 refundable tax credit if the purchase is made before December 1, 2009. As long as you have not owned a house during the past three years, you are eligible for first-time home buyer status. The credit is refundable, meaning the IRS will write you a check even if you don't pay taxes. Phaseouts start at $150,000 for married couples and $75,000 for other taxpayers.

To receive some of that government money, it doesn't matter who pays the mortgage. You may want to consider helping your children or grandchildren buy their first home so they can receive the tax credit. The laws are complex enough that you should talk to a comprehensive financial planner to structure the best intergenerational financial plan and maximize everyone's tax rates and itemized deductions.

Finally, be sure not to miss out on the low mortgage interest rates. But don't buy down any points. Most families do not keep their homes long enough to justify the cost of buying down the interest rate on their mortgage.

My parents' mortgage when I was growing up was at 4.00%. I never thought rates would get anywhere near that low again. When my wife and I bought our first home, we were able to assume a 12.5% mortgage when rates for new loans were at 18%. Today you can get a 30-year fixed mortgage with no points for as low as 5.0%. Rates are at historical lows, so the next few years are the time to take advantage of them.

There's blood in the street, so don't miss this opportunity to look for a great real estate deal.

 

from http://www.emarotta.com/article.php?ID=346

by David John Marotta

In my first job teaching computer science, someone stole my wallet off my desk during my office hours. Although I canceled all my credit cards, the thief used them around town, buying everything from clothes to tobacco. In those days cards were run manually on paper, and there was usually no instant electronic verification.

Identity theft is becoming distressingly common as personal information becomes easier to swipe. Internet sites all ask the same security verification questions. One site could easily collect your information and then try using it on others. For example, a student filled out a credit card application outside a university football game with the promised bonus of a free T-shirt. The perpetrators used all his information on a real credit card application but changed the mailing address. By the time the student realized his identity had been stolen, creditors were hounding him for hundreds of dollars of charges.

Having your identity stolen costs an average of $40 and 10 hours defending your name and cleaning up the mess. It happens to about 0.8% of the U.S. population each year. Even if your time is worth $100 an hour, the average loss to you is only about $8 annually. So clearly it's not the monetary cost that bothers people. What's really worrisome is the potential vulnerability and personal violation they feel. Fortunately, there is a simple and easy way to acquire a full credit lockdown so no one can initiate changes to your credit without your permission.

Your credit information is stored at three main credit bureaus: Experian, Trans Union and Equifax. At the end of 2003, Congress passed legislation that requires these bureaus to allow you to put a fraud alert on their credit reports. The alert only lasts 90 days, but during that time lenders have to verify your identity before they can issue a credit card in your name.

Since then, several companies have used this law to offer a renewal of the fraud alert every 90 days on your behalf. <a href="http://www.lifelock.com/" target=_blank>LifeLock</a> is the best known among these services. The company went so far as publishing its CEO's Social Security number and daring people to try and steal his identity.

LifeLock's one-stop service initiates a fraud alert with all three bureaus and renews and monitors your credit status for $10 a month. As a result, you receive less junk mail and sleep better at night. They will pay up to $1 million in losses due to stolen credit.

This service angered the credit bureaus. They make most of their money by selling credit information about you to lenders. If the lenders actually have to verify the information, it becomes too expensive for them to act on. The data for LifeLock customers wasn't worth the cost required to verify it, damaging the bottom line for the credit bureaus.

In retaliation, the credit bureaus accused LifeLock of deceptive marketing practices. Experian sued in California court claiming that the 2003 law only permits individuals to put an alert on their credit. They claimed that LifeLock posed as individuals and put alerts on an account even when no suspicion of identity theft existed, costing Experian millions of dollars to process the requests.

In a decision last month, a California judge found LifeLock's practice illegal. Only family members, guardians or an attorney can make the request on behalf of an individual. Fraud alerts ought to be standard and permanent for everyone.

The decision is surprising, and the case seems disingenuous for the credit bureaus. They have turned free credit report legislation into a multimillion-dollar industry through their own deception and fear mongering.

Although LifeLock's service was convenient, you can still duplicate their services by placing a credit security freeze on your own credit record. A credit freeze does everything a fraud alert does and more. First, it is permanent, not just for 90 days. Second, it prevents lenders from seeing your credit report unless you specifically grant them access. This strategy prevents identity thieves from getting new credit in your name even if they have every bit of your personal information.

If you do apply for additional credit, you will have to remove the freeze temporarily or give the specific party who wants to access your information your personal identification number (PIN).

If you plan on applying for additional credit cards or getting a new cell phone provider or cable package, a credit freeze may not be advisable. And those promotions linked to new credit card applications will no longer flood your mailbox. But these deals are never a way to build real wealth. Get the few credit cards you need, and don't let any promotional offers suck you in.

For Virginia residents to initiate a security freeze, each credit bureau charges a onetime $10 fee. If you have already been the victim of identity theft, the charge is waived. However, some states do not permit credit agencies to charge its customers for placing a security freeze. We recommend a credit freeze for anyone who has already established the credit they need. A freeze both reduces the frenzied marketing of additional credit opportunities and the potential harm of compromised personal information.

After a few minutes of effort and $30 in payments, your credit should be locked for life. Here is how to accomplish securing your credit at each bureau:

-At Experian (888-397-3742), go to <a href="http://www.experian.com/consumer/security_freeze.html" target=_blank>http://www.experian.com/consumer/security_freeze.html</a>.

-At Trans Union (888-909-8872), go to <a href="https://annualcreditreport.transunion.com/fa/securityFreeze/landing" target=_blank>https://annualcreditreport.transunion.com/fa/securityFreeze/landing</a> to start the process.

-At Equifax (1-888-766-0008), you can put a lock on your credit by visiting <a href="https://www.freeze.equifax.com" target=_blank>https://www.freeze.equifax.com</a>.

The process is not standardized across the three credit bureaus. Each uses a different methodology. But with a little effort, your credit will be safe and secure.

Each bureau will give you a PIN. They are likely to be all different. Don't lose these. Trying to get a security freeze lifted when you have forgotten the PIN necessary to change your credit security is a catch-22 you don't want to experience.

 

from http://www.emarotta.com/article.php?ID=345

Last-Minute Tax Savings for College Expenses (2009-07-06)

by David John Marotta and Matthew Illian

My youngest will be a first-year student at the University of Virginia this fall. My coauthor Matthew's oldest child is almost two years old. So he is just beginning to think about college funding and I'm about to start withdrawing from my final 529 plan.

With a well-designed 529 college savings plan, you can fund a college education at a deep discount. But even if you haven't saved much for college beforehand, simply passing college expenses through a 529 plan can save you $200 to $2,000.

A 529 college savings plan offers three types of tax savings. Virginia residents receive a state tax deduction in 2009 on contributions up to $4,000 per account. Students are permitted to attend a college out of state. If you don't live in Virginia, you can research your own state’s tax benefits. In every state you receive both federal and state tax-deferred growth and tax-free distribution when you are ready to use the money. These latter two tax benefits are the most significant. But you must invest early.

The Virginia state tax deduction, in contrast, is available merely for putting money into a 529 plan. You are allowed to make a withdrawal immediately to pay for college expenses. This worthwhile tax deduction can help trim expenses. Consider it Virginia's way of promoting higher education.

Make sure you understand what counts as an educational expense before you begin this process. The withdrawal must be for tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution. In a recent change, a personal computer now also qualifies.

If you are paying tuition and fees, have a check sent directly from your 529 account to the college. This direct deposit will simplify bookkeeping and make filing your taxes easy. If your fees are spent elsewhere, keep receipts of all the qualifying expenses.

Consider Paul and Ali Hewson, whose oldest child Jordan will begin college in the fall. The Hewsons haven't saved much, but Paul's career is really taking off. So they now have the money to pay for Jordan's college expenses. As Virginia residents, they are entitled to a $4,000 state tax deduction if they put at least this amount into one of the state's approved 529 plans. At the 5.75% state tax rate, they will net a $230 savings for 2009 after they file taxes in 2010.

Jordan has decided to bypass Virginia's fine in-state institutions and attend a more expensive private college. Consequently, the Paul and Ali now have $40,000 of upcoming qualified educational expenses they can pass through a 529 plan to build a decade worth of carry-forward state deductions. Virginia 529 plans allow for an unlimited carry-forward deduction until the amount of contributions has been deducted. Assuming the tax laws and rates remain the same, the Hewsons will take a $4,000 deduction each year for the next decade. They will accrue a total savings of $2,300 savings over this 10-year period.

Paul and Ali can use any of the three different 529 plans in Virginia to accomplish this savings. We estimate it should take no more than an hour to set up the accounts and an hour to make the disbursements.

The <a href="https://www.americanfunds.com/college/college-america/" target=_blank>CollegeAmerica</a> program, the state-sponsored plan run by American Funds, must be accessed through a financial advisor. Unless you have a relationship with a fee-only advisor, you will pay a hefty commission to use this plan. If you can access the American Funds without paying a commission, invest your pass-through money in the Money Market Fund, the most liquid and stable investment in the plan. This fund requires a $1,000 minimum deposit for the initial setup. With the American Funds, expect to pay a $10 account setup fee and a $10 annual maintenance fee that kicks in if you hold the account through the end of the year.

Investors can access the state-run Virginia Education Savings Trust (VEST) program directly at <a href="www.va529.com" target=_blank>www.va529.com</a> to begin online enrollment. The plan charges a $25 annual fee in November and no other setup costs. It also has a money market fund available as part of its nonevolving portfolio investment options. Both the VEST and CollegeAmerica programs have received the highest scores from a recent Wall Street Journal report and other rating groups.

Virginia also has a program administered by the Union Bank & Trust called <a href="http://www.virginia529.com/SavOptCollegeWealth.asp" target=_blank>CollegeWealth</a>. You can open a money market account at a Union Bank branch to receive the state tax deduction. If you are comfortable completing this task online, you may find working with a local bank difficult only because you must go there to complete all your paperwork.

Better than waiting until the last moment to start funding a 529 plan, consider investing now. With a depressed stock market, your funds can expect a healthy return for the next several years until your child is ready for college. If you have grandchildren you can get the same tax deductions by opening accounts for them. If you do not have a lump sum available to invest, start a monthly contribution from your paycheck directly into a college savings account. Although you may have to wait until your children bless you with grandchildren, they will ultimately thank you for it.

 

from http://www.emarotta.com/article.php?ID=344

Safeguard 8: Avoid an Advisor with a Lavish Lifestyle (2009-06-29)

by David John Marotta

There will always be swindlers masquerading as investment advisors. You can learn to recognize such people by their over-the-top lifestyle. Avoid them at all costs.

The differences between the manager of a Ponzi scheme and a model citizen are almost imperceptible, which is not surprising. Those who would perpetrate a Ponzi scheme are usually not the demons everyone makes them out to be. And they are obsessed with appearing successful.

This fixation on appearances, however, is the red flag. If you are the millionaire next door, you know that frugality is one of the marks of an effective financial advisor.

But you may have to train your eye to recognize an immoderate lifestyle. If someone in business is worth $300 an hour, some apparent extravagances may in reality be productivity gains.

For example, if you hire a chauffeur to drive you to and from work each day so you can be productive, society gains. If you hire a gardener so you can continue contributing in your area of expertise, society gains. And if you hire a butler or a chef, so long as you employ someone else for less than $300 an hour, society gains.

Productivity gains are not synonymous with a lavish lifestyle, and with some careful observation you can learn to discern the difference. Productivity gains are all about function, and if you discover them you will find out accidentally. In contrast, the whole purpose of an extravagant lifestyle is to be noticed.

Consider Bernie Madoff. He and his wife lived in a $7M penthouse apartment in New York City and a house worth $3 million in the Hamptons. They also owned a $9.3 million Palm Beach mansion. Plus they maintained a $1M million chalet and two boats on the French Riviera.

They spent an average of $100,000 monthly on the corporate credit card on chartered jets, limousines, top hotels, fine wines, world travel and shopping. When they drove themselves, they rode in style in a BMW and or one of two Mercedes. Madoff bought a vintage Aston-Martin for his brother as a company car. The couple owned a Steinway concert grand piano worth $39,000. Madoff purchased tickets at the Mets Citi Field at $40,000 a season.

Madoff was also a prominent philanthropist, but his interests were anything but altruistic. He started the Madoff Family Foundation and gave to charities, which in turn invited him to serve on their boards. Madoff then invited them to invest their endowments.

He and his wife also gave more than $200,000 to the Democratic Party. He gained high-level connections to those in Congress who write the laws and are supposed to provide regulatory oversight. Madoff was one of the first to exploit kickbacks for brokerage order flows. He argued they should remain legal and not alter the price that customers received. His connections prevailed.

The Madoffs themselves owned $62 million in securities and $45 million in municipal bonds. They loaned their sons $22 million and $9 million, respectively. Oddly enough, having siphoned billions, the couple only has a net worth of about $823 million.

Wealth is what you save, not what you spend. That's why an ostentatious and excessive lifestyle is a red flag for an investment advisor. The middle class buys liabilities like boats and cars. The rich buy investments. If Bernie Madoff had bought businesses and investments, he would be able to make restitution of those initial investments. He might even be able to pay a fraction of the gains he claimed to have.

We all wonder what happened to the $65 billion. Much of it was phantom gains, and a lot of it was simply spent a million here and a million there. Excessive spending is a warning sign that your advisor doesn't understand wealth building personally.

In April this year, the Securities and Exchange Commission (SEC) charged Shawn Merriman of Aurora, Colorado, of collecting $20 million in a Ponzi scheme "to support his lavish lifestyle." He lied to investors, reporting "impressive and consistent annual returns" as high as 20%.

Merriman was known for showcasing his high-end art collection. U.S. marshals seized hundreds of works of art including some by Rembrandt and Picasso from his sprawling three-story home. Also seized were a silver Aston Martin, 1932 and 1936 Auburns and a 1932 Ford Highboy.

This spring the SEC also filed charges against Pennsylvania advisor Tony Young for allegedly stealing $23 million from investors to "support a lavish lifestyle for his family, including payments for expenses related to horse ownership and racing, construction, boats, limousines, chartered aircraft and other luxuries." That lifestyle included an opulent vacation home in Palm Beach, Florida, near the Madoffs' vacation home. Young also lied to accountants who prepared statements and claimed his losses in 2008 were only 5.8%.

Ponzi schemes are often discovered after market downturns when investors make the mistake of fleeing to safety. They want to take their stellar returns and put the money someplace safe while the storm blows over, only to find that no money is really there.

Additionally, the news cycle runs in themes. After the Madoff scandal, every Ponzi scheme became national news. The theme, played over and over, is that all financial services, from Fannie Mae to AIG, are rife with corruption and mismanagement and need more government regulation.

But more control won't protect you from dishonesty. More law can't protect you from an unethical person. Fannie Mae and Freddie Mac had direct congressional oversight. Madoff was good friends with the regulators. Regulation is more likely to be used politically than responsibly.

Your best defense is to engage an advisor whose daily practices reflect ways to safeguard the money under his or her fiduciary care. As part of identifying such an advisor, make sure there is a mutual understanding that an ostentatious lifestyle is not a valid financial goal.



from http://www.emarotta.com/article.php?ID=343

Safeguard 7: Avoid Investment Advisors Who Sugarcoat Reality (2009-06-22)

by David John Marotta

We've already discussed the many ways you can safeguard your money. But these methods cannot protect you from an unscrupulous advisor. My brother, who is a lawyer, has a saying we must all take to heart: "You can't do a good deal with a bad person."

Morality can be described as a continuum from pure altruism to unadulterated self-centeredness. All advisors have their shortcomings, of course. But excellent advisors work hard to cultivate certain traits, and among them honesty is paramount. This quality in an advisor includes communicating clearly and straightforwardly exactly how bad the markets have been and can be.

Advisors naturally want to look good, and you must overcome your own desire to have a good-looking advisor. You need the truth. You can handle the truth, and without it, you certainly can't make realistic financial plans.

The markets are profitable. The markets are volatile. You can't pick just one. Even in our recent financial meltdown, I believe the wisdom of rebalancing back into fallen markets will be vindicated. But you still need to know the facts.

There are certain red flags to watch for with advisors, ways they may try to circumvent the tough honesty you need. I include both what conscientious advisors should do for their clients, as well as how financial salespeople hide their mistakes.

Ask your advisor to provide a return for your entire portfolio, not just the underlying investments. Reporting how each investment did doesn't show how you did. Your advisor can buy an investment at the very end of the quarter and then report it did well during the entire quarter. Or your advisor can sell investments that are not doing well toward the end of the quarter. These changes do nothing for you, but they help an advisor who doesn't report a return on your entire portfolio look successful.

Also, advisors should give you an accounting of your return net of all fees and expenses. Any fund expenses, fees, commissions or trading costs diminish the bottom line of the return. Only by receiving information at the portfolio level can you measure the net effect of every expense you were charged.

Always insist on a time-weighted return (TWR). Returns can also be dollar weighted, sometimes called an internal rate of return (IRR). Often the IRR looks better. It is possible for the TWR to be negative and the IRR to be positive.

A TWR removes the effects of cash flows, which allows you to judge how your advisor's underlying investment strategy performed. If your advisor reports both, that's fine. But he or she should include the TWR as well, which is considered the industry standard and allows you to compare apples with apples between two different strategies.

Returns should be reported consistently over standard and preestablished time periods. In addition to the quarter that just ended, our firm reports year-to-date, the past 18 months, and the returns gained since we began to track the portfolio. We chose 18 months because it is the shortest time period that is still long enough to discern significant market trends.

One year isn't long enough to eliminate market noise. We've considered adding three- and five-year returns, but whenever an advisor changes the time periods reported, it is cause for concern.

The bottom of the last market occurred in October 2002, so three-year returns started looking good in the fall of 2005 and five-year returns in the fall of 2007. The recent market downturn provides an opportunity to report these longer time periods without arousing suspicion that these intervals are being changed simply for window dressing.

Getting an accurate accounting of your portfolio's return shouldn't be optional. If your advisor can't supply it, perhaps it means they don't know themselves or don't consider it important to their recommendations. Unfortunately, many so-called advisors in the financial services world would prefer to focus instead on how their own fees and schedule of commissions are doing.

Even if you safeguarded your money in the many ways we have suggested, you should also insist on only entrusting your money to an advisor who regularly reports what total TWR, net of all fees and expenses, your investments have made for the quarter and for longer periods of time.

 

from http://www.emarotta.com/article.php?ID=342

Investment Strategies Part 4: Don't Rebalance at the Sector Level (2009-06-15)

by David John Marotta

Rebalancing between asset classes boosts returns and decreases volatility. But setting your asset classes based on sectors of the economy is not an effective strategy.

You can rebalance your investment allocation at three levels: stocks and bonds, between asset classes and among subclasses. At the highest level, rebalancing between stocks and bonds reduces risk. Selling some of your stocks after the market has appreciated limits your portfolio’s volatility and locks in some of your gains.

Correlation between investment categories helps define asset classes and sort out which are merely subclasses. The lower the correlation, the greater the bonus you can gain by rebalancing regularly. Rebalancing between U.S. stocks, foreign stocks and natural resource stocks offers a significant bonus because these asset classes have the lowest correlation.

Smaller bonuses are available within each asset class for categories with a higher correlation. But the law of diminishing returns comes into play as the number of categories continues to double and the correlation between divided subcategories approaches 1 (one).

Some investors try to allocate and rebalance between sectors of the economy. For example, Dow Jones divides the economy into these 10 sectors: Financials, Consumer Services, Telecom, Industrials, Basic Materials, Consumer Goods, Utilities, Oil and Gas, Technology and Health Care.

I don't recommend rebalancing at this level. You cannot know what percentage to allocate to each category. Putting 10% in each sector doesn't make sense because the division is arbitrary. Dow Jones puts Oil and Gas together in one sector. If they had divided it into two sectors, it would not have justified twice the investments. Dow Jones divides the index one way, and the S&P 500 indexes another.

Additionally, some of these sectors represent a greater percentage of the economy. If you set your target percentages now, the economy will change and your targets will be out of date. Technology has grown significantly as a percentage of our economy. Investors who continually moved out of technology missed much of the best returns during the 1990s.

Ten sectors taken two at a time produces 47 different pairings, each with its own correlation and rebalancing bonus or penalty. I computed those statistics using annual returns from 1992 through 2008. Some pairings have a bonus, and some have a penalty. I don't recommend rebalancing at the sector level, but an analysis of which sectors offer a bonus and which cost a penalty can suggest some investment strategies.

Some have a high correlation and have little or no bonus, such as Consumer Goods and Financials. Consumer Services, Telecom and Technology are also all highly correlated.

Basic Materials and Oil and Gas are subcategories of the natural resources asset class and therefore highly correlated. Oddly enough, they have one of the largest rebalancing bonuses partly because they represent different natural resources that are subclasses of the natural resources asset class. This is also true because Oil has had its bubbles.

Categories with a higher average bonus for rebalancing include Financials, Telecom, Technology and Oil and Gas. These are all sectors that have expanded and then corrected sharply.

Rebalancing out of bubbles is always warranted and valuable. But of course recognizing them is challenging. The bonus for rebalancing out of technology is the smallest of these because the growth in technology was mostly a shift in the economy and only a bubble at the very end of that trend. Shifting out of technology early would have killed returns. Timing the shift perfectly would have been difficult.

Rebalancing in this case is a poorer version of tilting toward value. A better bonus would be gained simply by emphasizing those stocks with a low price-to-earnings (P/E) ratio. When stocks in a sector bubble, they often experience high P/E ratios because they represent a greater percentage of the S&P 500.

The markets are smarter than the experts. It is by definition that they know what market cap a given industry deserves. It may bubble in its growth getting there, but you only know the bubble is over after it bubbles.

Four sectors offer a large rebalancing penalty with each other. They are Industrials, Basic Materials, Consumer Goods and Services.

Sectors of the economy wax and wane with the business cycle. As a result, when stocks in one sector of the economy are performing poorly, they may continue that way for some time. This form of rebalancing will result in lower returns than if you just let the market cycle adjust your portfolio.

Business cycles vary in length. As a result, annual rebalancing will incur a large penalty when you move out of a sector that did well last year into a sector that will do poorly next year. The penalty appears to be the worst for sectors that peak and valley at similar times during the business cycle, such as Industrials and Basic Materials or Consumer Goods and Services.

In this case, intelligent rebalancing, which takes the business cycle into account and rotates which sectors you are emphasizing, would at least try to capture the bonus and avoid the penalty. Knowing where you are on the business cycle, however, is just as demanding as predicting which industry will have the highest return.

Utilities are the least highly correlated to other sectors. They are a defensive sector and often do better than other sectors when the market is dropping. A sector rotation strategy suggests overemphasizing utilities and underemphasizing stocks when P/E ratios are high.

Sectors of the economy grow or dwindle based on global macroeconomic trends. Over time, companies responding to market conditions increase the capitalization of those goods and services that society demands and decrease those that are phasing out of the economy.

In the beginning we were an agrarian society. Then the industrial revolution began in America and Great Britain. Now we have more of a service-based economy. Perhaps genetics will bring about a health-care boom in the near future.

The lifetime of my grandparents spanned the Wright Brothers to landing on the moon. Your grandchildren may choose a college major that hasn't even been invented yet.

Setting percentages of your portfolio at a level of the sector of the economy doesn't make sense. If you set those percentages today, based on current levels in the S&P 500, our economy may never again match those percentages. There is no reversion to the mean for sectors of the economy.

Setting investment percentages also doesn't allow you to make strategic investments in sectors that you expect to grow and outperform over the next three to five years.

Rebalancing at the capitalization level (large cap and small cap) makes sense because large- and small-cap companies will always exist. Small companies have a higher expected rate of return because it is easier to double the size of a small company than a large company.

Similarly, it makes sense to rebalance using investment style (value and growth) criteria because these are universal descriptions of stock types and not specific to industry. A company can move between value and growth based on its price. Overweighting value companies outperforms growth stocks because of the risk of a growth company faltering in its expansion and causing a serious price correction. Limiting your investment in such stocks slightly smooths and boosts your returns.

Although the markets as a whole often revert to profitability and growth, this isn't true of individual stocks or industries. Most of the dot-com stocks that bubbled at the beginning of 2000 will never regain their former glory. Buggy whip manufacturers are no longer ubiquitous.

A better strategy is to look for three- to five-year trends in the economy and simply overweight those that have the best chance of continuing to grow in importance. Such trends last long enough for investors to take advantage, assuming they are looking forward to what may do well and not backward to what has been recently bubbling. Two such industries I would expect to do well going forward are health care and technology.

The most critical expertise that an investment manager can provide is a good investment philosophy. Investment analytics give you the best chance of matching your specific financial goals with the diversified investment mix that is optimum to meet those goals.



from http://www.emarotta.com/article.php?ID=341

Investment Strategies Part 3: Rebalance Regularly Between Asset Classes and Subcategories (2009-06-08)

by David John Marotta

The investment metric correlation helps you continually take your gains off the table for safe spending. And it helps you determine what constitutes an asset class and which subcategories to consider for further diversification. Once these categories are defined, correlation can also reveal how much of a bonus to expect from your returns when you rebalance between two categories.

In his 1996 article "<a href="http://www.efficientfrontier.com/ef/996/rebal.htm" target=_blank>The Rebalancing Bonus</a>," William J. Bernstein presented a brilliant formula to approximate the extra return you can expect by rebalancing your portfolio regularly. We rarely focus on a formula in this column. But there is deep wisdom here, both for portfolio construction and for determining which categories are worth regular rebalancing. Here is the formula:

B_1,2 = P₁P₂{σ₁σ₂(1 - c) + (σ₁ - σ₂)² / 2}

Where B is the bonus, P is the percentage allocation, sigma (σ) is the standard deviation (SD) and c is the correlation between the two assets.

The implications of the formula are useful, even for average investors. We can learn six valuable lessons from Bernstein's model.

First, notice the approximate size of the rebalancing bonus. A 50-50 allocation between two investments with a 0.5 correlation where each investment has an SD of 20% might be typical for equity investments. Such a mix has a rebalancing bonus of 0.5%. We will use the formula to demonstrate ways to boost this bonus. Even a half percentage point is noteworthy.

Investment professionals divide an extra 1% into hundredths of a percent, called "basis points." Earning an extra 50 basis points is huge. Investment advisors bend over backward for an extra 10. So rebalancing pays.

Second, the rebalancing bonus is the sum of all possible rebalancing bonuses. Our example of a 50-50 allocation has a 0.5% bonus because there is only one potential allocation mix to rebalance. With three categories allocated 33-33-33, the bonus rises to 0.67%. Each of the three rebalancing opportunities contributes 0.22%. Four categories split 25-25-25-25 provide a 0.75% bonus by giving six smaller rebalancing opportunities. Five categories of 20% each give 10 separate pairs of rebalancing for a 0.80% bonus.

Investors are taught to minimize the number of investments and investment categories. Although there is a gradual law of diminishing returns, diversification provides investment gains any time the investment itself is worthwhile and the correlations are low. With computer support for the analysis and rebalancing, investors can handle a large number of categories and holdings.

Third, note that the rebalancing bonus is proportional to the product of the percentage allocated to each holding. With a 50-50 allocation, the product is at its maximum at 0.25. A 60-40 allocation is nearly as high at 0.24. With a 70-30 allocation, the product drops to 0.21. And 80-20 drops all the way to 0.16.

The bonus is at its maximum when roughly equal allocations are made to each asset category. The smallest allocation should be at least half the size of the larger allocations. Our example, with four equal holdings of 25-25-25-25, resulted in a 0.75% bonus. An allocation of 30-20-30-20 is still high with a 0.74% bonus. But a 40-10-40-10 allocation drops the bonus to 0.66%. And an allocation of 85-05-05-05 drops the bonus way down to 0.27%.

Thus when an option is investment worthy, it merits a significant allocation. A good rule of thumb is to only skew an investment choice as much as two thirds to one third. Always invest at least a third into the smaller allocation.

The remaining lessons come from the terms inside the curly brackets of the formula. The allocation product is multiplied by the sum of these two terms. Maximizing their sum augments the bonus gained from rebalancing. Either of these two terms might be zero under certain circumstances. Each term has lessons to teach the savvy investor.

The first term depends on the correlation between the two investments. That is, the lower the correlation, the higher the bonus. A correlation of 1 has no bonus. Our example had a correlation of 0.5 and a bonus of 0.5%. If the correlation drops to zero, the bonus doubles from 0.5% to a full percentage point. At negative 0.5, the bonus becomes a full percentage point and a half.

So lesson 4 teaches us that the lower the correlation between two investments, the greater the importance of rebalancing. Rebalancing at the asset class where correlation is the lowest is more consequential than rebalancing between suballocations with a higher correlation.

Fifth, we learn that the higher the volatility of the investments, the greater the bonus in actually rebalancing. In our original example, both investments had a SD of 20%. The higher each SD, the higher the rebalancing bonus. By raising the SD of both investments from 20% to 30%, the rebalancing bonus increases from 0.5% to 1.13%. At 40%, the bonus is 2%. At 50%, the bonus is 3.13%.

Emerging market investments are extremely volatile. When they appreciate, an excellent strategy is to trim the position and take some profits off the table. When it drops precipitously, it is equally critical to reallocate and invest some more. Volatility equals opportunity if you rebalance regularly.

The last term is the difference between the SDs. It was zero in our example because the SDs were both 20%. To consider the contribution to this term, take the case where one of our investments has a 20% SD. But the other investment is as secure as possible and has a SD of zero. The first term becomes zero, but the second term makes up the difference.

With half invested in stable investments, the rebalancing bonus when the other half has a SD of 20% again is 0.5%. As the equity investment becomes more volatile, the bonus increases. At 30% SD, the bonus is again 1.13%. At 40%, the bonus is 2%. And at 50%, it is 3.13%.

Thus the greater the difference between the SD of two investments, the greater the bonus from rebalancing. Moving money from bonds back into stocks after a market correction yields substantial gains. A recent study from Fidelity shows exactly that: "Millionaires who used past recessions as buying opportunities now boast an average of $1 million more in investable asset than millionaires who shifted into more conservative investments."

Finally, we must learn to recognize when rebalancing provides a good chance of boosting returns and when it is unimportant. Rebalancing between two categories of U.S. stocks with a 0.85 correlation only gains a 0.15% bonus. In contrast, rebalancing between fixed income and emerging markets gains nearly 1.5%.

I asked formula creator William Bernstein how he might caution investors. He answered, "Rebalancing works best with high-volatility, low-correlation assets with similar long-term returns. Although this usually boosts the return of the equity part of the portfolio, if the returns are different enough, as occurred with Japanese equity over the past two decades, it can actually reduce return. This is not a free lunch."

The markets are inherently volatile. Rebalancing works best for categories that qualify as asset classes or subclasses. Next week we explore which investment categories do not warrant rebalancing because you are more likely to reduce returns than boost them.

Rebalancing is always a contrarian move, selling what has done well and buying what has done poorly. Many investors don't have the discipline to take that step when it is appropriate. But regularly rebalancing your portfolio offers expected returns about a percentage point better than buy and hold. Rebalance your portfolio regularly, and take advantage of this bonus.



from http://www.emarotta.com/article.php?ID=340

Investment Strategies Part 2: Use Correlation to Define Asset Classes (2009-06-01)

by David John Marotta

To boost returns and protect your investments, you can use the investment metric called correlation. It will rebalance your portfolio at three levels of investment allocation: stocks and bonds, asset classes and sectors of the economy. The dominant categories of stability and appreciation are the most basic way to view your portfolio. By continually trimming your stocks while the market appreciates, you can replenish the money that we hope you are setting aside regularly for safe spending.

Over a long enough time, an allocation to lower performing investments such as bonds generally results in a lower expected return. Thus asset allocation at this level helps control risk. It also provides enough allocation to stable investments to cover a period of safe withdrawal rates of five to seven years, so the appreciating assets have time to recover after a market correction.

Below the broadest categories of lower risk bonds and higher returning stocks are candidates for asset classes. Asset classes are used to set the percentage of your investments that you will put in each category. Each investment advisors may define their asset classes differently. But studies have shown that diversifying among categories with the lowest correlation produces the most return for the least risk. Therefore these categories represent the optimum candidates. As the correlation rises, assets are more apt to be classified as merely sectors or subsectors of the investment world, rather than asset classes.

Six-month correlations fluctuate over time. Many of the correlations between investments were near their lows in mid-2007. Throughout this article I cite correlations at these lows usually against the S&P 500. Recently, six-month correlations have been relatively high. A demand for dollars has caused all categories to move down in sync with one another.

The Natural Resources Index at 0.38 has one of the lowest correlations to the S&P 500. This index does not represent commodities but rather the companies that produce or provide them. For example, the index tracks oil and mining companies, not the price of oil or minerals.

Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver), and base metals such as copper and nickel. It also covers other resources like diamonds, coal, lumber and even water. Real estate is also included because land serves as the underlying hard asset. Having such a low correlation clearly shows these companies deserve their own asset class.

Many advisors don't have an asset class for natural resource stocks. Instead they select one portion of the category, typically real estate, and make that the asset class. This can also be a good idea. Real estate indexes have correlations as low as 0.49 against the S&P 500. We use real estate as a subclass within the natural resources category because at times it has a low correlation with energy and other commodity movements.

Not only do natural resource stocks have a low correlation to other U.S. stocks. They have an even lower correlation to U.S. bonds. Natural resources (commodities) often exhibit a negative correlation to fixed-income investments due to their inverse relationship to inflation. So their optimum allocation depends on both the amount you designate to stocks and the amount you designate to bonds.

The second best candidate for an asset class is foreign stocks. The correlation of the EAFE Foreign Index is 0.57. It hasn't always been that low. The correlation between U.S. stocks and foreign stocks fluctuates over time between 0.4 and 0.9. When the correlation is high, many advisors argue that no benefit will accrue from investing in foreign stocks. When the correlation is low, it is often because foreign stocks are doing better.

At the end of April 2009, for example, the EAFE index hadn't lost anything over the past 10 years. Compare that with the S&P 500's negative 2.48% annual return resulting in a 22.2% loss for a decade's worth of investing. At times little diversification may be realized by investing in foreign equities. But the benefits happen consistently enough for our firm to consider foreign stocks its own asset class.

Some people try to diversify internationally by investing in U.S. companies that gain a significant portion of their revenue from sales abroad. But studies have found that these multinational companies still track fairly closely with other domestic companies. And they don't offer the same benefits as investing in foreign stocks.

We use country selection and emerging markets as our subclass allocation. At 0.50, the Emerging Markets Index correlation to the S&P 500 is even lower than the EAFE. It has also has had some of the best returns, recently averaging 8.24% and totaling 120.7% over the past 10 years.

And these stellar returns include having lost 42.90% over the last year! Sometimes you have to make a large profit to still have decent returns after a market correction.

Because correlations fluctuate, defining what constitutes an asset class and what constitutes a subclass is subjective. It is always open to review and reevaluation. Generally, a correlation that can drop below 0.6 with other asset classes is a good candidate to become its own asset class. The correlation of around 0.85 between emerging markets and other foreign stocks suggests it should simply be a subclass of foreign stocks.

Within the asset class of U.S. stocks are also several subclasses that provide opportunities for diversification. The Russell 2000 small-cap index, for example, has a correlation of 0.75 against the S&P 500.

Using correlation to define our top-level asset categories, therefore, we use three asset classes for stability (short money, U.S. bonds and foreign bonds) and three for appreciation (U.S. stocks, foreign stocks and natural resource stocks). Then within each asset class, we suballocate for additional diversification.

Most investors and even many advisors use investment categories entirely contained within U.S. stocks and bonds. A low correlation investment strategy, in contrast, would suggest broadening your horizons to obtain the lower volatility offered with a broader definition of asset classes.



from http://www.emarotta.com/article.php?ID=339

Investment Strategies Part 1: Rebalance into Stable Investments in an Appreciating Market (2009-05-25)

by David John Marotta

Diversifying your portfolio means finding assets that have value on their own merits but do not move exactly alike. A critical investment metric called "correlation" is used to construct a portfolio most likely to meet your personal financial goals.

Correlation measures how much two different investments move together, measured on a scale of positive one (+1) to negative one (-1). A perfect correlation (1.00) would mean that both investments always move in the same direction with the same magnitude. A perfect inverse correlation (-1.00) would mean that two assets always move in opposite directions.

Correlation comes into play at three levels of investment allocation: stocks and bonds, asset classes and sectors of the economy. At each level it can provide you with a better chance of boosting your returns and protecting your investments. But the way correlation is used is different at each level. In this column we will cover its use at the highest level.

The most basic allocation in your portfolio is between investments that offer a greater chance of appreciation (stocks) and those that provide greater portfolio stability (bonds). These two categories have the largest negative correlation. Thus decisions made at this level are the most important in determining how well behaved your portfolio returns will be.

Not only do these two categories have the largest negative correlation, but they also have very different expected average returns. Stable investments like bonds have an average return of about 3% over inflation. Appreciating assets like stocks have an average return of approximately 6.5% over inflation.

If your portfolio is 100% in stocks, it will have the greatest long-term appreciation, but it will also be the most volatile. Consequently, it may not give you the best chance of meeting your goals. For example, a long-term average return around 10% from U.S. stocks certainly sounds appealing. But they also have a 19% standard deviation. So about six or seven times a century, you will experience a decade of flat or negative returns.

These awful returns happen even more frequently than a Gaussian function (or bell curve) would predict because stock market returns are not well-behaved Gaussian statistics. They behave more like fractal power laws, which in lay terms means the curve has lumpy tails far from the average.

We all know, at least experientially, what a lumpy tail looks and feels like because we just lived through one in 2008. According to Gaussian statistics, you should not experience such terrible years in the U.S. stock market as frequently as you do. Sometimes such events are called "black swans," or outliers. Sometimes we just say that the markets are inherently volatile.

This wild volatility may threaten the fulfillment of your financial goals. Aiming for a 10% return with wild volatility doesn't make sense if you only need a 7% return to guarantee meeting your financial goals. So sometimes slightly lowering your expected return can vastly lower your expected volatility. As a result, you increase the odds of exceeding the modest return you need to meet your goals.

Because of the difference in returns between stocks and bonds, they won't rebalance themselves over time. Left to itself, the allocation to stocks will grow larger and larger until it represents close to 100% of your investments. As this happens your portfolio will also grow more and more volatile and your goals more susceptible to market corrections.

Due to the difference in expected returns and the need to handle withdrawals during retirement, we consider the categories of stability and appreciation to be larger than asset classes. Correlation at this level will not boost returns because stocks normally outperform bonds. But it will definitely protect your investment. Consistent rebalancing by selling stocks and buying bonds helps protect your net worth and consequently your lifestyle. The reverse, selling bonds and buying stocks, is not as necessary and only appropriate for younger investors who are still adding to their portfolio.

Older investors should have at least five to seven years of their safe spending rate allocated to stability. For them, replenishing the allocation to stability during times when stocks are appreciating helps secure future years of spending.

Only younger investors who are still a number of years away from retirement or who have more stability than they need to support their lifestyle can afford to rebalance from stability back into stocks after a market correction. Doing this can help boost returns somewhat, but it has risks if the markets continue to decline. Therefore never shift more than you can put at risk back into uncertain appreciating assets.

All investors should set a limit to their losses and allocate that limit to stability. That limit generally should be five to seven years of safe spending, but it could be eight to 10 years for very conservative investors. If an investor is frugal enough, he or she can afford to be 10 years in stability. Forgoing the chance of appreciating won't endanger a sufficiently frugal lifestyle.

Using the negative correlation between stocks and bonds properly means trimming stock market gains regularly to keep portfolio risk and volatility under control. This discipline gives you the best chance of supporting your safe withdrawal rates during retirement.



from http://www.emarotta.com/article.php?ID=338