BRIC Countries: A Passage to Indian Freedom (2008-09-08)

by David John Marotta

The modern-day Indian republic was born in 1950. During the cold war between the United States and the Soviet Union, India was a prominent nonaligned country. It was highly socialistic with the government exercising control over every aspect of the economy. These restrictive policies caused extremely low growth rates, derisively dubbed the "Hindu rate of growth."

Not until the late 1980s, when facing deficits and a major balance-of-payment crisis, did Prime Minister Rajiv Gandhi attempt to remove price controls and reduce corporate taxes. Growth increased, but partial freedom just moves economic bottlenecks to the next malfunction of Fabian socialism.

Finally in 1991, Prime Minister Narasimha Rao, along with Finance Minister Manmohan Singh, began to privatize publicly owned industries and to relax government controls in earnest. Since then India has emerged as one of the wealthiest economies in the world. Its recent growth rate of 9.1% is second only to China among the large emerging markets.

India scores 54.2% free in the Heritage Foundation's Economic Freedom index, making it "mostly unfree." Although it currently ranks 115 out of 157 countries, it has been improving slowly and steadily since the index began in 1995, gaining 9.1% over those 14 years. But even slow progress counts as progress. According to the study, every percentage point of freedom correlates to a drop in unemployment and inflation and an increase in per capita gross domestic product.

The example of Indian economic liberalization makes a strong case for increasing economic freedom. It is no longer intellectually honest to claim that restricting economic freedom benefits the people. Economic authoritarianism inevitably breeds economic malfunction.

Despite its slow economic improvement, however, India still ranks as mostly unfree. And unfree economies are scandalously wasteful. Indian government enterprises are only about 10% as efficient as the average U.S. output, and private-sector Indian firms attain only 40% of the U.S. level.

Because of globalization, emerging markets today develop much more rapidly. Poor countries like India do not need to reinvent the industrial revolution. They can benefit from the world's knowledge and experience and double their economies much quicker than it took historically. If industries in India used these best practices in technology today, they could triple their output per worker. But because of its lack of freedom, the country uses only a small portion of the rich store of world knowledge.

Poor countries are poor partially because their companies are not free to choose the best technologies. In India, obtaining a business license requires endless trips to government offices and can take a year or more.

India's lowest scores in economic freedom correlate directly with its lack of financial freedom. The country has 28 state-owned banks that control three fourths of all loans and deposits. The government also owns nearly every rural and cooperative bank. Banks are forced to lend to those who are deemed priority borrowers. Foreign ownership of banks is severely restricted.

India even legislates a list of items banned from production in large-scale plants. And because such lists are updated regularly, the potential for bribery is rampant. Like other BRIC countries, centralized planning breeds corruption. India ranks 72nd, tied with Brazil and China, out of 179 countries in Transparency International's Corruption Perceptions Index.

India has a saying for such frustration: "The fence itself grazed through the field." A fence is intended to stop cattle from grazing on your land. But what if the fence is the culprit? For that problem, you need fewer fences, not more. The best check on greedy people certainly is not to create a whole caste system of government bureaucrats and then tempt them with an overabundance of laws to enforce subjectively.

The United States would do well to learn from this example. Far too often, people react to problems by saying, "There ought to be a law." Think of the Indian proverb and translate this sentiment to "There ought to be another fence grazing through my field."

India represents only about 5.6% of the Emerging Market Index. Investments in India have done very well. Although the MSCI India Index is down 12.63% over the past year, this has only pulled the annual average return over the past five years down to 27.25%. India has been volatile but very profitable.

The Indus India Index consists of the 50 Indian stocks selected from a universe of the largest companies listed on two major Indian exchanges. Although mostly energy (28%) and materials (15%), the third and fourth largest sectors are information technology (14%) and telecommunications (8%). These industries represent India's large knowledge outsourcing.

Many of our primary contacts with India occur when we call there, thinking we are reaching an American company's help line. At first, India was the butt of help-line jokes. But now the punch line is more likely to be that you knew your tech support person was in India because he spoke English too well and could solve your problem.

We should celebrate how rapidly India is pulling its people out of misery. Globalization enhances people's welfare to the extent that they participate in the global economy. And the process of globalization is positive even when it empowers abuses and creates sweatshop conditions.

Consider the 100,000 waste pickers in India living on less than a dollar a day who sift through the garbage from Delhi. They recycle about 60% of the city's plastic, paper, glass and metals and were doing it long before it became commonplace in the United States. The stench from the rotting garbage is overwhelming; there are more flies than you can imagine. Some 300 million Indians, more than the entire population of the United States, live off less than a dollar a day.

To these Indians, a sweatshop is a step up out of the grave. They can work indoors. They can eat. They can earn more money. They can sleep under a roof.

Americans point to abuses of power and supervisors who take advantage of young women. But these abuses are only possible because employment, albeit in a sweatshop, offers the possibility of a better life. Even these abuses show to what extremes workers are willing to go to gain the value created by putting factories in India.

Additionally, American companies have nothing to gain from these abuses. Supervisors who use their position to shake down employees take value from the company. Globalization has brought democratic norms of decency and protection that have raised the treatment of women and untouchables after a long history of victimization under India's caste system.

Oddly enough, sweatshops may be the only hope for the 100,000 Delhi waste pickers. The landfills they recycle for free produce methane gas. A new waste incinerator is scheduled to be built in Timarpur, a suburb of Delhi, to collect the carbon credits under the Kyoto Protocol. Money gained from carbon credits is the primary motivation, not the environment. Although the incinerator will reduce carbon emissions, it will emit cancer-causing dioxins, mercury, heavy metals and fly ash.

Under Kyoto's Clean Development Mechanism, carbon credits generated in a poor country can be sold to a rich country and count toward the latter's emissions reductions. Oddly enough, this policy encourages the dirtiest industries and makes them more profitable. Slight improvements there can generate large credits, which the cleanest industries subsequently buy because they have trouble improving their own carbon emissions. As much as it doesn't make economic sense, Kyoto makes the cleanest industries subsidize the dirtiest.

It is already evident that Kyoto is positioned to make billionaires out of eco-traders and marginal corporations that can make coal-fired power plants slightly more fuel efficient or capture waste heat from steel plants. With great power comes great exploitation. It is difficult to imagine that carbon traders are interested in improving human suffering when millions of dollars are at stake and the World Bank is handling deals and collecting a 13% commission on every trade.

Real trade benefits real people. The unanticipated outcome of Kyoto may simply be to eliminate employment for Delhi's extreme poor. If India continues its progress toward freedom, foreign investment could do well by doing good. We can only hope more sweatshops than fences are built in place of the landfills.

 

from http://www.emarotta.com/article.php?ID=300

BRIC Countries: Russia (2008-09-01)

by David John Marotta

Since the fall of the Soviet Union in 1991, Russia has been trying to remake itself and regain its former glory and respect. The country's fall from superpower to emerging market deeply wounded its people's pride. Although the Russian Federation represents over 70% of the economy of the former Soviet Union, a lack of glasnost ("tell the truth") and perestroika ("decentralize power") still plagues the country.

Gorbachev rose to power in 1985. Two years later, at the plenary session of the Communist Party Central Committee, he laid out his plans for economic restructuring, or perestroika. At that point the black market represented the only real activity in a sluggish economy.

Perestroika took baby steps toward economic freedom. For the first time since Lenin's new economic policy in 1921, private ownership of some of the commanding heights of industry would be allowed. For those of us who grew up with the Iron Curtain, the changes seemed radical. After 70 years of communist propaganda in the East and socialist sympathizers in the West, classical free-market liberal views apparently had won the debate.

But baby steps were not enough to save the Soviet economy. Initially, high taxes and employment restrictions discouraged private investment. And foreign investment fared no better because 51% of the venture must be Soviet owned, and the chairman and general manager have to be Soviet citizens. Centralized planning was eliminated in favor of decentralized planning, rather than allowing market supply and demand. Price controls remained, as did state support for unprofitable enterprises. Because the culture long accepted corruption, socialism deteriorated into a more local form of cronyism. Traditional shortages became critical shortages of basic necessities. In short, Russia tried to institute certain economic freedoms from the top down rather than simply allowing them to grow organically from the bottom up. But fish rots from the head.

In August 1991, the military staged an unsuccessful coup against Gorbachev aimed at preserving the party apparatchiks. Unable to contain the furor for freedom and independence, however, the attempt simply hastened the regime's collapse and dissolution.

One of my favorite souvenirs, a KGB (secret police) 70-year anniversary pin, reminds me that the lifespan of centralized planning efforts is limited. These attempts at universal control lack the negative feedback that would encourage them to self-correct. Ultimately, unintended consequences build up, and a revolutionary upheaval explodes and causes the system to reset. China's communism won't turn 70 until 2019.

Russia has the largest landmass in the world, and before 1991 it had the second biggest economy. But today, Russia has become just the second letter in BRIC, four promising emerging market countries: Brazil, Russia, India and China.

During the Yeltsin years, Russian industries were privatized. But the process was rife with political patronage. Russian billionaire oligarchs thrived, confirming the adage "We hang the thief who steals 3 kopecks and honor the one who steals 3 million."

A currency crisis in 1998 devalued the ruble. Russia's gross domestic product (GDP) dropped by 50%, and the stock market lost 93% of its value. Russia defaulted on its government bonds. In the United States, the bond default contributed to the infamous bankruptcy of the hedge fund Long Term Capital Management.

Since then, Russia has demonstrated impressive growth. It has progressed from its standing in 1999 as the 22nd largest economy in the world to about 9th today. Its GDP has increased an average of 6% in recent years, less than China (10%) and India (9%) but about twice that of Brazil (3%). Russia's export growth is nearly 50% a year.

Russia is second only to Saudi Arabia in oil exports; energy companies Lukoil, Gazprom and Rosneft dominate the economy. The Russian stock market index is 39% oil and gas. It has a low correlation with the S&P 500 of only 0.43.

Until recently, Russian stocks were averaging more than a 40% return annually. But during much of this time, they were just recovering from their precipitous drop in 1998. Currently the Russian stock market is down over 30% year to date and struggling again. And at 13% it has the highest inflation rate among the BRIC nations, which eats into the buying power of local returns.

Russia differs from the other BRIC countries demographically. Its population, like Europe's, is both shrinking and aging. To try and reverse this trend, the government offers 250,000 rubles (about $10,000), equivalent to an average yearly income, to women who have a second child.

After a brief encounter with chaos under Boris Yeltsin in the 1990s, Russia moved back to a more authoritarian "managed democracy" during the reign of Vladimir Putin (2000–2008), a former high-ranking KGB official.

This is where Russia's troubles lie. Although it never really tried free markets, Russia has fallen back into the familiar weaknesses of a controlled economy hindered by bureaucratic restrictions, inconsistencies and corruption. Rated at just below 50% free, Russia earned the Heritage Foundation's lowest economic freedom ranking, repressed and on a par with countries like Vietnam, Guyana, Laos and Haiti.

Russian laws do not protect private property. State involvement in the economy has been increasing as the country has retaken its "national champion" industries of energy, shipping, shipbuilding and aerospace. Some of these takeovers represent a renationalization of industries of strategic geopolitical importance under Kremlin control. Some of them are retaliation against those who acquired their wealth in the Yeltsin years by raiding. These are popularly justified as stealing from the thief. In the absence of law, evidently power is all that remains.

And power is wielded at every opportunity. Russia ranks 121 out of 163 countries in Transparency International's Corruption Perceptions Index. Corruption is both widespread and brazen in the number and size of bribes sought.

Enforcing contracts is difficult. The judicial system, corrupt or at best inconsistent, cannot handle complex cases. When money talks, the truth stays silent. As a result, intellectual property rights are routinely violated.

Even President Putin described the corruption and cronyism. He said, "One of the most acute questions is inactivity, red-tape and excessive control in the business life of many regions. Administrative intervention is out of proportion, local markets are monopolized, closed to any activity from the outside, the local authorities are often used as a tool of unfair competition and are vulnerable to corruption."

Until recently, investment in Russia was attracting interest, but positive past returns should never be the primary reason for investing. The invasion of Georgia makes it clear that the Russian ethos still depends more on political thugs than on freedom and the rule of law. Investments in Russia are owned only at the whim of current political opinion. Therefore, we suggest you limit any assets invested in Russia to a very small portion of your emerging market allocation.



from http://www.emarotta.com/article.php?ID=299

BRIC Countries: Brazil (2008-08-25)

by David John Marotta

In 2003, the Goldman Sachs Global Economics Department predicted the economic and geopolitical influence of Brazil, Russia, India and China (the BRIC countries) would become increasingly visible in the developed world and even dominate it by 2050. These countries have averaged a total return on investment in their stock markets of 38.28% over the past five years, up 5.02% over the past year.

It pays to look outside the United States for investment options. Every portfolio should be crafted to have the optimum amount of noncorrelated assets in order to lower volatility and increase returns. Understanding BRIC countries helps investors and their advisors determine what percentages best meet those goals.

According to the original investment thesis, these emerging market countries have the preconditions needed in an emerging market to encourage sustainable successful development. Their economic strengths should be able to overcome their economic or political weaknesses.

The term "BRIC" has become synonymous with "emerging markets" in investors' minds. But when the acronym was coined, the BRIC countries were perceived as distinct entities. They have never represented more than 30% of the Emerging Markets Index. The three largest countries, representing more than 40% of the index, are South Korea, Taiwan and South Africa.

Over the past five years, the BRIC subset has beaten the Emerging Markets Index annually by a whopping 11.07%. And the index is down 4.36% over the last year, whereas the BRIC index is up 5.02%.

Brazil, the biggest BRIC country, is credited for most of this performance. It has the fifth largest landmass and the fifth largest population in the world. Brazil also has the best five-year return. As of the end of July, the MSCI Brazil Index showed a five-year annualized return of 53.91%, and it is up 32.05% over the past year.

But these returns came with a price. An editorial last month criticized President Lula for "loving investment grade [securities rating] over the welfare of his people." The Brazilian central bank has set the interest rate at 13%, although inflation is only expected to run at about 5%. This has kept Brazil's currency strong. Contrast the Brazil's strong currency policy with the U.S. current interest rates of 2% while inflation is running an actual 5% to 10%. As a result of the difference in monetary policy, the Brazilian real (R$) has appreciated 222% (16% annualized) against the dollar since January 2003. Brazil's conservative monetary policy has helped it lower government debt to 41% of gross domestic product compared with the U.S. debt currently at 70%.

Brazil has potential, but a lack of economic freedom still holds the country back. Graft and corruption are rampant at every level of government. Injustice is commonplace. Who people know determines the amount of bureaucratic regulation they have to suffer. "For my friends, everything. For strangers, nothing. For my enemies, the law." This common Brazilian adage is a sobering reminder of the mindset there.

Starting a business in Brazil takes 152 days, more than three times the world average. Obtaining a business license is difficult. Just going bankrupt takes four years. Such an environment is difficult for most Americans to comprehend.

The resulting extreme inequity between the haves and the have-nots in Brazil motivates the latter group to seek relief politically. More than 30% of the population live below the poverty line and identify with the socialist and communist political parties.

But as political activists press for more laws, opportunities increasingly open up for unequal application by corrupt officials. This blocks the development of commerce. A professional class of intermediaries is required to facilitate introductions and grease governmental red tape. Substituting personal relationships for the rule of law also creates instability, so entrepreneurs hesitate to take risks. As a result, a well-intentioned socialism actually helps perpetuate the opportunity for abuse and inequality.

One area where Brazil has excelled is making headway toward energy independence. The 1973 oil crisis hit the economy particularly hard. During the recession that followed, Brazilians learned the hard way about the importance of energy. Today, Brazil's extensive system of rivers generates about 90% of its hydroelectric power. The country has also developed a large sugar industry to provide ethanol for domestic use and as an export. In the last few years, Brazil has begun drilling for offshore oil and natural gas. So it may become an oil-exporting country.

The United States imposes a $0.54 cents a gallon tariff on Brazilian ethanol made from sugarcane to protect the ethanol made from U.S. corn, currently at $2.90 a gallon. Ethanol made from Brazilian sugarcane at $1.40 a gallon would be less than half the price. But the tariff pushes Brazil to sell to other markets that do not impose a tariff.

Oddly enough, Brazil itself discourages imports through a wide range of nontariff barriers. As the world economy falters, somehow a majority of people in different countries believe they are the losers in free trade, one of the most simple and easy ways to enrich the world.

Today the winds of trade wars are blowing cold everywhere. Politicians need foreigners to blame for domestic economic troubles. Even our own mantra has become "fair trade, not free trade." But the word "fair" is left vague. This is a political advantage; after all, no one favors unfairness. The unintended harm of trade restrictions are difficult to connect to the cause and take years to unfold.

President Clinton should be praised for moving the United States toward free trade. In the fall of 1991 while running for president, he overruled his campaign's internal debate. "Clinton looked up over his spectacles and said, 'I want all of you to understand something: I'm not going to run as an isolationist, and I'm not going to run as a protectionist,'" recalls political theorist William Galston.

Today, Republican presidential nominee John McCain is the heir to the Clinton administration's economic principles. He says, "Every time the United States has become protectionist we've paid a very heavy price. Free trade has been the engine of our economy." His position won't help him any in the upcoming election.

During the Clinton years, a majority of Americans viewed free trade positively. But after the Democrats lost control of Congress in 1996, fear became a political tool. Job loss to foreign workers is an easy target. Specific anecdotal experiences trump clear economic studies. As a result, unions and environmentalists, opponents of free trade, heavily contributed to the Democrats winning a majority in Congress in 2006. Today, 68% of those surveyed in a Fortune magazine poll believe that America's trading partners benefit more than Americans from free trade.

In Brazil, political sentiments appear to be no different, except that we play the role of greedy foreigners. This occurs despite the fact that much of the country's historical growth has been export driven.

Emerging market countries are volatile. Brazil is no exception. A military dictatorship ruled the country from 1964 until 1985; the constitution was rewritten in 1988. A decade later, Brazil experienced a currency meltdown. Then in 2002, Brazil received a record International Monetary Fund bailout it repaid in 2005, earlier than required. Since that time, the real has appreciated tremendously against the U.S. dollar. It is responsible for 16% of the 53.91% annualized real return in the past five years.

Generally BRIC countries don't move in sync with the U.S. markets. The EAFE Foreign Index has a five-year correlation of 0.81 with the S&P 500. The emerging markets correlation is only 0.72, and Brazil's correlation is only 0.58.

We don't recommend that BRIC countries comprise a major portion of your portfolio, but they should be represented. Although any unstable investment can endanger the chances of meeting your financial goals, a small allocation to a volatile investment can enhance them, especially if that investment doesn't move in sync with your other investments.

 

from http://www.emarotta.com/article.php?ID=298

Behavioral Finance: Patience Is Its Own Reward (2008-08-18)

by David John Marotta

To process financial information, our minds often attempt unwise shortcuts. By understanding behavioral finance, we can limit the information we use and keep our decisions balanced and on track.

Financial information on the Internet is excessive and changes daily. This overload leads to excessive trading, which in turn results in lower returns. Studies suggest that analysts who depend on all this overwhelming advice make poorer decisions even though they feel more confident about them.

Another reaction to information overload is paralysis. When investors have one attractive option, they tend to invest. When they have two or more appealing choices, they may fail to act because they are afraid of making a wrong decision and looking stupid. This regret aversion motivates them to go with the status quo, which is often more costly than either of the promising alternatives.

Over the long term, the U.S. stock markets go up an average of 11% annually, beating inflation by about 6.5%. But to earn this great typical return, studies in behavioral finance indicate that we must be able to tolerate the year-to-year volatility.

In each of the last five years, the stock markets were up. The three years before that (2000 to 2002), the markets were down. Many people worry about the timing of getting into or out of the markets: Will 2008 be an up year? What about 2009?

I will give you the forecast for the next <i>ten</i> years in the U.S. markets: up, down, up, up, down, up, down, up, up, up. These predictions are not in chronological order. This year could be one of the "up" years or one of the "down" years. It is a gamble, but unlike most gambling, the odds are in your favor. About seven of every ten years are up years, and they are usually stronger than the down years.

If you are an investor, the odds are in your favor. But not everyone who buys and sells stocks is an investor. Some people play the markets looking for short-term gains and follow hot tips or quickly timed movements. These people are speculators, not investors.

Compare an investor with an orchard manager who goes to a nursery to buy some peach trees. He buys the trees because he understands about growing and selling fruit. He knows how to care for the trees, harvest the peaches, and deliver them to market. He understands what is involved across the whole spectrum of his business: from nurturing the natural juicy fruit to savoring it baked in a delicious peach cobbler.

Speculators buy some peach trees when they see the nursery's supplies are dwindling. Then they stand in the parking lot hoping to resell the trees at a profit. Speculators do not care what they are buying or selling so long as the price moves quickly. So they never really buy peach trees. Speculators purchase snow blowers when the blizzard is forecast or generators as the hurricane gathers strength, or whatever else they think might show a short-term spike in price.

If the blizzard misses or the hurricane fizzles, speculators lose money. The possibility of more demand raises prices appropriately. If the likelihood increases, prices go up even higher. If the likelihood decreases, so do prices.

As soon as it is feasible, speculators sell quickly because they believe the spike is short lived and temporary. This tendency led to the investment truism "Buy on rumor and sell on news."

In other words, even if speculators are right, their profits depend on being faster to buy and faster to sell. For the speculator, speed is everything. Not so for investors.

Investors, like farmers, substitute seasons of patient labor and care for speed and market timing. They make their money off the gradual growth in the value of their investments. In contrast, salespeople must keep their merchandise moving because their product isn't getting any more valuable. They make their money off commissions on the transaction itself. For them, what is important is the speed and number of transactions. Brokers and those who sell "loaded funds" are salespeople, not peach farmers. Their livelihood depends on the number and rate of trades in an account. These incentives for speed can lead to abuses.

Frequent trading in an account for the purpose of gaining commissions is called "churning," measured by the turnover rate in an investment portfolio. Turnover is the percentage of an investment account's asset that are bought or sold during a year. Churning can be defined as a turnover rate of over 300%, meaning the entire portfolio value is bought or sold every four months.

An important criteria we use for equity mutual fund selection is a turnover ratio of under 50%. We advise you to be patient and try to ignore the market's ups and downs.

Studies show that mutual funds with a lower turnover rate perform better. Short-term trading has a cost and usually reduces performance. To make money, speculators usually must guess the highs and lows in the stock market within six weeks.

This investment philosophy does not depend on what the markets did in the last four months or what they will do in the next four months. We can't imagine a peach tree that would look good to buy and hold for only four months. Investing is like planting a peach tree: You have to wait for the fruits of your labor.

So don't worry too much about the timing of getting in and out of the market. Focus instead on having a diversified enough portfolio to weather any market--up or down. Once you have a brilliant investment strategy, a successful investor's greatest virtue is patience. As scientist and mathematician Georges-Louis Leclerc said, "Patience is genius"--and it is often the best defense against short-term noise that can ruin your long-term results.

 

from http://www.emarotta.com/article.php?ID=297

Behavioral Finance: Herd Mentality (2008-08-11)

by David John Marotta

One of the early studies on herd mentality was the Solomon Asch experiments in the 1950s. The setup was a mock vision test. In reality, all but one of the participants were actors, who after a few correct answers started agreeing unanimously on a wrong choice.

In a control group, participants had no trouble answering correctly. But participants waffled when a group of three or more people who preceded them confidently selected a different answer. Three out of four responded incorrectly to at least one question. In the end, participants answered incorrectly about 37% of the time.

First we must acknowledge that the phenomenon of the herd mentality can be useful in many situations. For example, computer simulations show that even when only 5% of the animals in a herd know the location of the watering hole, the entire herd is able to find it. In nature, keeping the number of leaders low helps minimize those who are put at risk. People use these instincts every day as they leave theaters and navigate crowded streets.

Although the herd mentality may help you find greener pastures if you are a bison, it won't help you find untrampled pastures. In investments, every bison ahead of you has already run the price up, and the only buyers of your investment are behind you. Straggling along at the back of the herd doesn't stop you from reaching the watering hole, but being toward the end of a run-up in the markets can be as deadly as drinking from fouled water.

In the original Asch experiments, those who were persuaded to give wrong answers used two different sets of reasoning. One group believed that everyone was trying to give the right answer and they had somehow fallen victim to an optical illusion. The assumption that three presumably honest people are correct and you must be wrong could help you avoid some mistakes. The herd mentality can keep you from wandering off into the desert seeking to drink from a mirage.

The other group gave the wrong answer knowing it was wrong simply because it wasn't worth giving a different answer. Every time they broke the pattern of giving the same answer as everyone else, the cadence would stop and the entire group would look at them. They suspected that everyone else was wrong, but they saw no harm in going along and agreeing anyway. This is how the herd mentality can help your social life.

Even though a herd mentality can be useful in some situations, equity markets isn't one of them. In the markets, the herd effect benefits those at the front of the herd who can sell their place at the watering hole to those at the tail end before too many bison have fouled the water. Being at the tail end of the herd produces regret as the herd moves on, leaving you in a trampled field. But to avoid the pitfalls of this herd instinct in your investments, you need knowledge and conviction as well as an awareness of when you are susceptible to the influence of the herd.

In the original study, at least three actors were required to achieve this herd effect, and they had to be unified. If even one person gave the correct answer, it provided a role model for defiance and the herd effect was reduced. People seemed to need permission to disagree with the herd.

I give you permission to disagree with the herd.

Countering the herd effect is the essence of being a contrarian, that is, an investor who buys a category when most others are selling and sells when others are buying. A contrarian doesn't chase what is hot but often buys a category that has recently underperformed.

Major news sources move markets just by their tone of optimism or pessimism. The financial news often focuses on daily price movements, and like all sports trivia, it tends to emphasize winning or losing streaks.

Stock prices can move on very low volume if it is all in one direction. Even when the vast majority of those who hold stocks continue to hold them, if even a few investors are motivated to buy or sell, the price moves significantly.

In the long term, the markets are brilliant at setting appropriate stock prices. In the short term, though, they have the IQ of a gnat. The markets offer so much inherent opportunity that even conservative investors get swayed by the siren songs of greed or fear. The strait between Scylla and Charybdis is a narrow path safely navigated only if you have a nymph like Thetis to guide you.

In the financial world, your Thetis is a long-term investment strategy and the discipline to purposefully avoid moving in one direction. Not following the crowd describes a contrarian perfectly. And the cornerstone of that role is rebalancing your portfolio regularly.

Imagine you have a $100,000 portfolio consisting of two different categories, A and B. Your wise financial advisor suggests diversifying your portfolio by investing half in each category. At the end of the first year, A has earned 30% and B has just broken even. You now have $115,000: $65,000 in A and $50,000 in B.

You are happy with your investment in A, but you still aren't sure about B. All the financial news is about A's stellar returns, how the industry is booming, and why A's products are essential to life on this planet. The news also reports the slump in Category B. No one is buying their products. They are laying off employees, firing CEOs, and facing a wall of pending indictments and lawsuits.

To make matters worse, your neighbor to the right works in Category A, and his 30% investment returns is all he can talk about. Your brother-in-law is dumping all of his investments in B and adding to his investment in A. So you call your financial advisor and ask if you should make some adjustments in your asset allocation as well.

"Yes," answers your financial advisor, "sell $7,500 of A and invest that in B." You are stunned. You wonder if your investment advisor is so stubbornly enamored by B that she won't admit her mistake and insists on pouring more of your investment gains down the drain.

Although you are not convinced by this so-called strategy, you decide to give it another try. So you sell some of A and buy more B. Now you have $57,500 invested in each.

Fortunes change. The layoffs and new leadership in B return profitability and the industry begins to recover. Stock prices, beaten down because of losses, rebound from their lows, and B gains 30% the second year.

Meanwhile, A's growth falters. Stock prices had been driven up from new investments and were pricing the company for 30% annual growth. When the industry of A only experiences 15% growth, however, the stock prices falter and appreciation ceases. Despite 15% growth, current stock valuations are barely justified and drift sideways for a 0% gain for the year.

Your brother-in-law and your neighbor to the right are tight-lipped.

Your neighbor to the left, however, is ecstatic. He works for a company in B. Not only is his company doing better, his investment made a 30% return this past year!

You are satisfied but not ecstatic. You've never gotten a 30% return. You meet with your investment advisor and ask her, "If you knew B was going to do well, why didn't we put all the money in that category?"

"I didn't know B would do well," your advisor admits. "But when a good category falls out of favor with investors, rebalancing your portfolio is automatically a contrarian investment. Your portfolio returned 15% the first year and 15% the second year. Unlike your neighbors, the second year's gains compounded with the first year's gains produced a total gain of 32.5%."

You are amazed. The simple contrarian act of pulling money out of the investment that was the darling of the industry and investing it in the dogs of the industry boosted your two-year returns by 2.5%. Not only did your investments do better than your neighbors did, but you avoided the feast or famine volatility inherent in their approach.

As a financial advisor, I can often predict which category will perform the best over the next year just by observing the reluctance of new clients to invest in that category. A savvy Rothschild banker once gave this "contrary" advice: "Buy when there is blood on the street and sell on the sound of the trumpet."

It's tough being a contrarian, but investing in trampled on categories is too critical for your investment returns to let emotions or the herd mentality block your success.

 

from http://www.emarotta.com/article.php?ID=296

 

Behavioral Finance: Overconfidence (2008-08-04)

by David John Marotta

Think of confidence as a continuum: Lack of confidence is paralyzing, self-confidence is good, but overconfidence is deadly. Successful investors seek to find a balance between rashness and timidity. Understanding the psychology that causes us to act overconfidently will help you avoid it.

Before we really understand something, we may either lack confidence or express overconfidence. A common type of overconfidence stems from inexperience. For instance, more than 70% of naive investors wrongly assume they are enjoying above-average returns.

Part of the problem is certainly overconfidence. Research studies indicate that a majority of members of any group will rate themselves above average on a given task. But part of the difficulty may also be what people value in the task.

For example, 82% of students rate themselves in the top 30% of safe drivers. Some new drivers define the quality of their performance by how many accidents they've had. Others use speeding tickets as a measure. And sadly, some young adults consider themselves safe drivers because they can execute trick maneuvers drunk while doing 100 miles an hour. Inexperience often breeds overconfidence.

According to behavioral finance studies, overconfident investors trade more and earn less than those who opt for a buy-and-hold strategy. These brash investors time the market poorly, all the while assuming they're doing better than average. They maintain this delusion by selectively forgetting how they believed all the misleading and confusing indicators that falsely predicted certain outcomes were inevitable. If the outcome happens months later at half what they predicted, they still say, "I told you so." Without calculating an accurate time-weighted return each month, they assume their own brilliance.

We tell stories so we will remember experiences, not forget them. We say, "I don't want to talk about it" because that helps us forget. In investing, we recount our winners and prefer not to talk about our mistakes. This tendency is universal even if we are only reviewing our investment decisions in the confines of our own minds. Thus without a rigorous review methodology, how we remember trumps what actually happened.

Certainly a little overconfidence is better than a lack of confidence. Because the markets on average go up, an emotional bias that keeps us invested helps us earn better returns. Overconfidence that causes us to underperform the market by 2% annually still translates into reaping quite satisfying returns. Therefore overconfidence only becomes dangerous when we can't conceive of failing.

A demotivational poster available at <a href="http://www.despair.com/overconfidence.html" target=blank>despair.com</a>, entitled "Overconfidence," pictures two downhill skiers trying to outrun an avalanche. The caption reads, "Before you attempt to beat the odds, be sure you could survive the odds beating you." That's sage advice.

Deadly overconfidence causes us to break one or all of these five rules of investing humility:

<b>1. Don't borrow money to buy stocks.</b> The markets are inherently volatile, and your investment strategy must be able to survive a prolonged downturn. If you have purchased stocks by heavily margining your account, you will experience a margin call when your investments drop in value. Being forced to sell equities when the markets are down is a surefire way to lock in losses and lose your shirt. Many options and other investment derivatives also leverage your investments and increase the potential for disaster.

Here's a humbler approach: Err on the side of caution and keep a portion of your portfolio in cash or fixed income. "Keep some dry powder" is the maxim. Having cash to buy back into stocks after a market correction both boosts as well as smooths your investment returns. And thanks to the effect of compounding, smoother returns produce better returns.

<b>2. Diversify.</b> Even if you are right nine out of ten times, if you always bet the farm, then one mistake will lose everything. No matter how confident you are, plan on doing OK even if you are wrong. Diversification means you will always have something to complain about. But it also means you won't make more than half a mistake.

Many investors make their fortunes through a few lucky picks and mistakenly believe they can maintain their wealth the same way. Easy come, easy go. Especially if you got rich by being lucky, you need to wise up and realize you don't know it all. Find an asset allocation that will survive the next 30 years.

<b>3. Avoid correlated investments.</b> Correlated investments all move in sync with one another. Investors at the end of the 1990s believed they were diversified because they had five different large-cap growth mutual funds. They all moved in sync with one another and lost 69% of their value shortly thereafter.

When the correlation between two investments rises, the value of diversifying between them diminishes. Stay alert about events that always appear more unlikely based on historical statistics than they actually are. Past performance always underestimates the actual volatility. Because it is often these unknowns that pose the real risk, take precautions that help protect you no matter what the disaster may be.

<b>4. Keep short-term spending safe.</b> Maintain a cash emergency fund that can provide three months of spending. Keep another three months' worth in safe fixed-income investments. During retirement, keep the next five to seven years of spending in fixed income. This strategy allows you to put the remainder of your portfolio in the markets and survive the inherent volatility.

<b>5. Lean toward indexed investing.</b> Select funds with low expense ratios based on an index that follows the asset class you are investing in. Even using index funds, you may end up with a few dozen funds, but each should provide a low-cost way of investing in that asset class.

Low-expense passive index investing has been receiving a growing percentage of investment dollars. This suggests that investor overconfidence in beating the market is decreasing. Investors have learned that just achieving a good market return is sufficient to achieve their goals.

Self-diagnosing investment overconfidence is nearly impossible. It's safe to say that if you are invested as much as you should be, you are likely overconfident. You are probably losing a few percentage points to this overconfidence, but because you aren't keeping track of your time-weighted return, you remain blissfully unaware.

A quarterly review of your portfolio for the five rules of investment humility just described can help you avoid a world of hurt. Brokers and agents don't have a fiduciary duty to act in your best interest. Visit the National Association of Personal Financial Advisors (<a href="http://www.napfa.org" target=blank>www.napfa.org</a>) to find a fee-only advisor in your area.

 

from http://www.emarotta.com/article.php?ID=295

Behavioral Finance: Overconfidence (2008-08-04)

by David John Marotta

Think of confidence as a continuum: Lack of confidence is paralyzing, self-confidence is good, but overconfidence is deadly. Successful investors seek to find a balance between rashness and timidity. Understanding the psychology that causes us to act overconfidently will help you avoid it.

Before we really understand something, we may either lack confidence or express overconfidence. A common type of overconfidence stems from inexperience. For instance, more than 70% of naive investors wrongly assume they are enjoying above-average returns.

Part of the problem is certainly overconfidence. Research studies indicate that a majority of members of any group will rate themselves above average on a given task. But part of the difficulty may also be what people value in the task.

For example, 82% of students rate themselves in the top 30% of safe drivers. Some new drivers define the quality of their performance by how many accidents they've had. Others use speeding tickets as a measure. And sadly, some young adults consider themselves safe drivers because they can execute trick maneuvers drunk while doing 100 miles an hour. Inexperience often breeds overconfidence.

According to behavioral finance studies, overconfident investors trade more and earn less than those who opt for a buy-and-hold strategy. These brash investors time the market poorly, all the while assuming they're doing better than average. They maintain this delusion by selectively forgetting how they believed all the misleading and confusing indicators that falsely predicted certain outcomes were inevitable. If the outcome happens months later at half what they predicted, they still say, "I told you so." Without calculating an accurate time-weighted return each month, they assume their own brilliance.

We tell stories so we will remember experiences, not forget them. We say, "I don't want to talk about it" because that helps us forget. In investing, we recount our winners and prefer not to talk about our mistakes. This tendency is universal even if we are only reviewing our investment decisions in the confines of our own minds. Thus without a rigorous review methodology, how we remember trumps what actually happened.

Certainly a little overconfidence is better than a lack of confidence. Because the markets on average go up, an emotional bias that keeps us invested helps us earn better returns. Overconfidence that causes us to underperform the market by 2% annually still translates into reaping quite satisfying returns. Therefore overconfidence only becomes dangerous when we can't conceive of failing.

A demotivational poster available at <a href="http://www.despair.com/overconfidence.html" target=blank>despair.com</a>, entitled "Overconfidence," pictures two downhill skiers trying to outrun an avalanche. The caption reads, "Before you attempt to beat the odds, be sure you could survive the odds beating you." That's sage advice.

Deadly overconfidence causes us to break one or all of these five rules of investing humility:

<b>1. Don't borrow money to buy stocks.</b> The markets are inherently volatile, and your investment strategy must be able to survive a prolonged downturn. If you have purchased stocks by heavily margining your account, you will experience a margin call when your investments drop in value. Being forced to sell equities when the markets are down is a surefire way to lock in losses and lose your shirt. Many options and other investment derivatives also leverage your investments and increase the potential for disaster.

Here's a humbler approach: Err on the side of caution and keep a portion of your portfolio in cash or fixed income. "Keep some dry powder" is the maxim. Having cash to buy back into stocks after a market correction both boosts as well as smooths your investment returns. And thanks to the effect of compounding, smoother returns produce better returns.

<b>2. Diversify.</b> Even if you are right nine out of ten times, if you always bet the farm, then one mistake will lose everything. No matter how confident you are, plan on doing OK even if you are wrong. Diversification means you will always have something to complain about. But it also means you won't make more than half a mistake.

Many investors make their fortunes through a few lucky picks and mistakenly believe they can maintain their wealth the same way. Easy come, easy go. Especially if you got rich by being lucky, you need to wise up and realize you don't know it all. Find an asset allocation that will survive the next 30 years.

<b>3. Avoid correlated investments.</b> Correlated investments all move in sync with one another. Investors at the end of the 1990s believed they were diversified because they had five different large-cap growth mutual funds. They all moved in sync with one another and lost 69% of their value shortly thereafter.

When the correlation between two investments rises, the value of diversifying between them diminishes. Stay alert about events that always appear more unlikely based on historical statistics than they actually are. Past performance always underestimates the actual volatility. Because it is often these unknowns that pose the real risk, take precautions that help protect you no matter what the disaster may be.

<b>4. Keep short-term spending safe.</b> Maintain a cash emergency fund that can provide three months of spending. Keep another three months' worth in safe fixed-income investments. During retirement, keep the next five to seven years of spending in fixed income. This strategy allows you to put the remainder of your portfolio in the markets and survive the inherent volatility.

<b>5. Lean toward indexed investing.</b> Select funds with low expense ratios based on an index that follows the asset class you are investing in. Even using index funds, you may end up with a few dozen funds, but each should provide a low-cost way of investing in that asset class.

Low-expense passive index investing has been receiving a growing percentage of investment dollars. This suggests that investor overconfidence in beating the market is decreasing. Investors have learned that just achieving a good market return is sufficient to achieve their goals.

Self-diagnosing investment overconfidence is nearly impossible. It's safe to say that if you are invested as much as you should be, you are likely overconfident. You are probably losing a few percentage points to this overconfidence, but because you aren't keeping track of your time-weighted return, you remain blissfully unaware.

A quarterly review of your portfolio for the five rules of investment humility just described can help you avoid a world of hurt. Brokers and agents don't have a fiduciary duty to act in your best interest. Visit the National Association of Personal Financial Advisors (<a href="http://www.napfa.org" target=blank>www.napfa.org</a>) to find a fee-only advisor in your area.

 

from http://www.emarotta.com/article.php?ID=295

Behavioral Finance: Mental Accounting (2008-07-28)

by David John Marotta

The essence of successful financial planning is using your money to meet your life's goals. In the process, one dollar is as good as another, but curiously our minds do not perceive it that way. We tend to fall prey to the fallacy that behavioral finance calls mental accounting, commonly known as the "two-pocket" theory of money. We treat money differently depending on its source.

It is as though we put earned income in one mental pocket and money we did not expect in another. Studies show we are much more willing to spend money impulsively out of this second pocket.

Our supposedly rational mind objects to mixing the money from the two different pockets. But our minds are tricking us because dollars are completely interchangeable.

To clarify, we are not talking about budgeting. Earmarking dollars for vacation, big-ticket purchases, house payments, college savings and toward retirement is clearly positive and very much encouraged. This type of positive mental accounting aligns perfectly with meeting your financial goals.

But the type of mental accounting that gets us in trouble is what happens when the way we acquired a dollar causes us to ignore our careful planning and spend it differently.

Imagine a university graduate student who budgets enough for rent and food and hopes to save $500 every month, but her take-home pay is only $1,500. Then she sells her textbooks at the end of the semester and finds herself with an extra $250. Rather than putting the additional $250 toward savings, she indulges in luxury items until she's sure she has spent all the money.

Put yourself in this student's situation. In your mind, it is as though you have $1,500 in one pocket where you put serious earned money and stick to your budget. In the other pocket, you put the $250, which you now regard as play money, and rationalize that you should only use it to make frivolous purchases.

Most of us find this tendency so strong and irresistible, we would all do well to find ways to forestall the impulsive spending that slows progress toward achieving our financial goals. Allocating your money to meet your needs and desires is an important step in the financial planning process. But first you must gather all the money available in a single pool and allocate it according to your family's priorities. The source of the money shouldn't matter. When it does, we cause ourselves unneeded harm.

Studies show that gamblers rarely leave the casino as winners. The reason is not simply because the house has an edge on every game. Mental accounting is also the problem. Gamblers consider their winnings as house money and reason that they can keep on gambling for free. So most gamblers only stop playing when they are losing.

Research has also revealed that when people receive money unexpectedly, they make impulse purchases, typically quite soon afterward. If the amount is significant, perhaps more than $10,000, they may spend 40% to 50% of their windfall. If the amount is small, such as $1,000, they may actually spend two and a half times more than they received.

This propensity is the hope behind the recent stimulus checks Americans received from the government. The rebate was designed to be a relatively small amount, $1,800 for a family of four. Even when people say they plan to use the rebate to pay down debt, they are already engaging in mental accounting, thinking of the money differently simply because of the source.

In polls, Americans claim they will spend only 18% to 40% of the rebate. But if we tracked their actual spending, mental accounting would have badly misled them.

Perhaps they will pay off some of their debt or put money into their 401(k). But most Americans will jump at the chance that they have some extra money to justify a purchase they would not otherwise have made. And they will probably do it more than once.

In fact, studies suggest that average consumers will spend an astonishing additional $4,500 in relatively small purchases simply because they received a $1,800 check: extra money on eating out, electronic toys, and large appliances. Children may be given their $300 as though it somehow belongs to them, and husbands and wives may rationalize using the money as an excuse to make that purchase their partner considers unnecessary. Past research supports the prediction that consumers will spend 250% of their rebate check without even realizing it.

Even the most rational of us who receive money this way spend more as a result. The psychology behind this thinking is so strong, we can safely assume we are all influenced by it.

Thus found money, the green stuff we do not earn or save, is easily spent, wasted, and risked. Most lottery winners are broke or worse within five years of their win. Unfortunately, winning encourages the worst tendencies of those with the temperament to play the lottery in the first place.

Although mental accounting is described as the two-pocket theory of money, I propose adding a third pocket. Earned income is linked to planned purchases in one pocket. Some money is gained unexpectedly and too often provokes impulse spending in the second. But in the third pocket, we could put automatic income, that is, money gained from investment interest, dividends and appreciation. Mental accounting often leaves this third pocket in an investment account to compound and appreciate, helping us reach our long-term goals.

You can't spend apart from increasing your lifestyle. And when you increase your lifestyle, you increase by large multiples what you will need in retirement to support that lifestyle. Here's a sobering fact: Every time you increase your spending by $1, you need $23 more in your investments when you retire.

If you get and spend an extra $1,000, you will need $23,000 more in retirement to support your increased lifestyle. You can spend your way into financial troubles, but you can never make your troubles worse by saving.

Another error of mental accounting is to differentiate between income and appreciation. If one stock trades at $100 per share paying a $6 dividend, it's equivalent to another stock that pays no dividend whose share price rises from $100 to $106 per share. Some people mistakenly think the dividend-paying stock is better during retirement and the appreciating stock is better when you are younger.

Now there is a small distinction: The dividend-paying stock forces you to pay the capital gains rate on the dividend paid, whereas the appreciating stock allows you to defer the capital appreciation until later. But the difference in tax treatments doesn't matter once you are retired. And it's much less relevant now that qualified dividends are taxed the same as capital gains. In retirement you can simply sell appreciated stock and pay the capital gains to generate cash for withdrawals.

The real difference between dividend-paying stocks and appreciating stocks is in the type of company. A company with little growth potential, such as a utility, pays its profits out to shareholders in dividends. A different company, perhaps a restaurant with ambitions to open branches across the country, uses its profits to expand. As it does so, it generates more profits from more locations, which drives the share price up. Both types of companies provide portfolio returns that you can spend in retirement.

If you struggle with self-control, only taking the dividends allows you to limit your withdrawals. But it may also cause you to adjust your asset allocation to maximize dividends, putting all of your net worth in one type of investment.

The biggest mistake occurs when people believe they need interest and dividends to generate cash in retirement. As a result they put too great a percentage of their portfolio into fixed-income bonds and do not invest enough in stocks that will keep up with inflation and provide appreciation for the end of their retirement.

The source of your money, whether from interest, yield (dividends) or capital appreciation should not matter.

Part of the emotional push toward using a two-pocket theory of money may stem either from an effort to be disciplined or a failure to do so. In general, people both want to enjoy the money now and also plan for the future. This dilemma between a short-term and long-term focus requires a measure of discipline and willpower that most people don't have. So they fudge by feeling guilty about using hard-earned money frivolously but fall prey to using easily received money quite carelessly.

There is an upside, however. You can use mental accounting to your advantage by using that third pocket of money and automating as much of your savings as possible. People tend not to count money that is automatically deducted from their paycheck as money they can spend. Increasing the amount you have withdrawn in your 401(k) or 403(b) account is an easy way to use the third pocket to your advantage.

It is also just as painless to have money transferred regularly from your checking account into an investment account. This automatic savings puts money into a mental accounting third pocket from which it is very difficult to spend emotionally. Add to this account any money you receive unexpectedly, and you will be well on the way to securing a successful retirement.

 

from http://www.emarotta.com/article.php?ID=294

Behavioral Finance: Anchoring

(2008-07-21) by David John Marotta

Rational analysis is essential to making smart investment decisions. Unfortunately, our first reaction to a complicated situation, usually instinctive, often does not serve our best interests. The field of behavioral finance studies how and why we make economic decisions.

Researchers have identified dozens of mental shortcuts. One heuristic that the brain uses to solve complex evaluations is to make an initial guess and then adjust from that point as we receive additional information to find a better answer. This mental process is called "anchoring."

Anchoring is one of the root psychological flaws that pushes otherwise brilliant people to make financial mistakes. It's critical to admit this heuristic is hardwired in your brain or you will continue to succumb to it. To avoid making serious financial mistakes, you must become a vigilant contrarian.

In the mental process of anchoring, we begin with some tentative solution to our problem and then we seek a better or more accurate solution. For example, we walk onto a car lot and note the sticker price, and we use that number as our starting point for negotiations. We know we can buy the car for that amount, and we start the process of seeking to get a better price.

Studies have shown that the higher the first price we are given, the higher will be the final price we end up paying for the exact same item. Stores sometimes bump their prices 30% higher before a 30% off sale because they understand this principle. Sellers on eBay may set a "buy-it-now" price artificially high simply to induce higher competitive bids.

We use mental anchoring more when we are unfamiliar with what the right answer is supposed to be. Conversely, the antidote to anchoring is to have done your homework and be able to evaluate the anchors you are given. Doing your research online before setting foot on the car lot helps you step into the process with the ability to analyze the reasonableness of that sticker price.

To understand how paradoxically our minds can work, researchers have shown that even when we know the anchor is a completely random number, it still has a significant effect.

For example, ask a friend to use the last three digits of his Social Security number to form a date somewhere between A.D. 0 and 1000. Next, ask him if he thinks Attila the Hun died before or after that date. Finally, ask him what year he thinks Attila the Hun died. People with a higher last three digits of their Social Security number tend to guess a much higher date for Attila the Hun's death.

We are not rational creatures.

The antidote for this type of anchoring is doing the extra analysis to evaluate the answer more rationally. In other words, those who actually know the date of Attila the Hun's death do not succumb to the mental fallacy of anchoring on the last three digits of their Social Security number.

Anchoring is like finding ourselves sitting in a chair in a pitch-black room. When we stand up, we keep one hand on the chair and reach as far as we can in each direction to try to get a feel for our location. The anchor of the chair keeps us from straying too far from our original point. The answer, of course, is to turn on the lights.

Most investors feel like they are in the dark. Sometimes having too much information to evaluate equates with having no information at all. Consequently, we anchor on the latest market movements or the high-water mark of what something was worth.

Although nearly all of us seem to say we are long-term investors, our tendency is to be swayed emotionally by the most recent short-term movements in the markets. We want to invest more in sectors that have recently been doing well, and we want to avoid, eliminate or reduce sectors that have recently dropped in value.

One study found that because of moving in and out of mutual funds at exactly the wrong moments, investors in mutual funds experience returns that underperform the very funds they were invested in, by 2.2 percentage points annually.

Funds are more likely to take new deposits after performing well but less likely to perform that well going forward. Similarly, funds that have not performed as well take in much less in deposits or have net redemptions but usually do not continue to underperform quite as badly. Investors experience returns that underperform because they buy the fund high and sell it low.

This isn't to say you should stay in a poor mutual fund with high fees and expenses. But moving in and out of mutual funds to catch hot sectors of the economy produces returns that badly underperform a simple buy-and-rebalance strategy.

Even the investment news falls into the trap of describing past performance in the present tense. They say, "This stock is going up" or "This stock is plummeting" when what they really intend is simply to describe the most recent short-term past trend.

Given that 98% of daily stock market movements are noise, for long-term investors this is like saying, "We are bumping to the left" when driving on an old gravel road. Monthly stock movements are no better. They are 76% noise. Again, for a long-term investor, talking about monthly stock movements can be likened to saying, "We are curving right" when driving on a winding country road. Even annual returns have about 46% noise. Sometimes you need to drive south for an hour before you pick up the interstate. Only when you start looking over a 10-year time horizon can you safely describe your direction and say, "We are heading west."

Investors tend to fixate on relative past performance. If their portfolios have gone straight from 100,000 to 120,000 over the past year, they are happy. If their portfolios rose to 150,000 before dropping back to 120,000, however, they are upset and depressed. People anchor to the high-water mark of their portfolios and are only satisfied when they hit an all-time high.

Avoiding the mistakes that stem from anchoring requires adopting an investment philosophy that does not depend on historical prices and past performance. Adopt an investment philosophy that dampens rather than amplifies trends. If your philosophy is to panic and sell at corrections and then wait to get back into the markets after they are appreciating again, your emotions amplify any losses.

Learn to be a contrarian and rebalance your portfolio regularly. Set buy and sell targets. Monitor an objective stock evaluation. Pretend you don't already own it and you have to buy it at the current price. Make half a mistake, sell some and take some profit off the table.

One of the first principles of investing is humility. Knowing that your first instinct is probably wrong, doing nothing is often better than doing something quickly. Hence minimizing trading, being patient and investing in the markets going up is an excellent way to tune out the noise of short-term movements.

Second, if your instincts are often wrong, and the markets are inherently volatile, plan on some of your investments losing money. Therefore avoid leverage or options that could amplify a mistake to a loss that might jeopardize your financial goals.

Finally, practice setting an asset allocation that provides diversification. Regular rebalancing to a target allocation gives you the best chance of meeting your goals and an objective standard to practice contrarian investing by selling what has gone up and buying what has gone down.

from http://www.emarotta.com/article.php?ID=293

Foreign Freedom Investing 2008 (2008-07-14)

by David John Marotta

You can both diversify for safety and boost your returns by adding international investments to your portfolio. In the past year, international stocks performed 2.5% better than U.S. stocks. And developed countries with the most economic freedom returned an additional 4.4% more than the international index.

None of these returns, however, were positive. During the one-year period ending June 30, 2008, the S&P 500 index lost 13.12%. The MSCI EAFE Index of international developed markets lost 10.6% (in U.S. dollars). Significantly, 10 of the most economically free countries only lost 6.2%.

These premiums for investing oversees in countries with the most freedom are even more impressive for longer time periods. Over the past five years, the S&P 500 has averaged 7.6% and the EAFE Index 16.7%. In striking contrast, the countries with the most economic freedom averaged 21.5%.

Put some money into the "emerging markets" category, and you can gain even greater diversification and returns. Emerging markets, as measured by the MSCI Emerging Markets Index, actually gained, appreciating 4.6% (in U.S. dollars) in the past year. They have averaged a whopping 29.8% over the past five years. Of course, there is a caveat. Emerging markets are inherently more volatile than the markets of more developed nations.

If you have a very small account, investing in one good international fund is sufficient. For slightly larger amounts, a savvy asset allocation might be to invest two thirds in the MSCI EAFE Index and one third in the MSCI Emerging Markets Index. Using this technique, you would have only lost 5.5% in the past year and averaged 21.0% over the past five years.

For larger accounts, use a more complex asset allocation for further diversification. Take advantage of the fact that economic growth often flourishes in countries with the greatest economic freedom. We use the Heritage Foundation's measurement to select those places that combine the greatest economic freedom with large investable markets.

Since 1994, the Heritage Foundation Index of Economic Freedom has used a systematic empirical measurement of economic freedom in countries worldwide. Their conclusions clearly show that economic freedom and higher rates of long-term economic growth go together. Investors can use the study to select countries for their foreign stock allocation.

According to the Heritage Foundation, "Economic freedom is defined as the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."

The foundation bases a country's economic freedom score on 50 measurements. They fall under these 10 categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.

Although all 10 boost economic growth, some, such as investment freedom, are more significant to outside investors. Others, such as monetary freedom, are more critical to that country's own citizens.

Only 17 countries out of 157 scored high in investment freedom, which measures the ability of capital to flow freely in and out of the country. Free countries impose few or no restrictions on foreign investment. Thus they represent the greatest opportunities for investment. More than a third of the world imposes serious restrictions on the ability to run businesses, purchase real estate or transfer capital. These countries are best avoided.

A number of the countries ranked high in economic freedom have exchange-traded funds (ETFs), such as Hong Kong, Singapore, Australia, Canada, Switzerland, United Kingdom, the Netherlands, Germany, Sweden and Austria. These funds track each country's market index and offer a convenient and inexpensive way to invest there. ETFs combine the liquidity of individual stocks with the diversification of an index fund. They also typically carry lower expense ratios than most mutual funds.

For larger accounts, we recommend you invest half of your assets using the simple technique just described. A third is invested in the MSCI EAFE Index fund and a sixth in the MSCI Emerging Markets Index fund. The other half is divided among the 10 countries with the most freedom whose markets also accommodate a country-specific ETF.

Canada had the best returns over the past year, mostly because of its emphasis on energy stocks, earning 13.9%. In the same time period, 8 of the 10 countries cited earlier beat the broad MSCI EAFE Index. Only two (the United Kingdom and Sweden) fell short.

Japan, with the world's second largest economy, has demonstrated more financial freedom in recent years. But government spending is greater than a third of its gross domestic product. And a large number of legal restrictions on capital make investing in Japan quite problematic. It is ranked below average in government size and financial freedom and lower than we would recommend in the important investment freedom category. These restrictions push the country down to the 17th most free economy. We can attribute Japan's malaise after its own stock market bubble to its lack of economic freedom and the government's overly aggressive interventions. Former prime minister Junichiro Koizumi's changes made the country a more attractive place to do business. It remains to be seen if these changes are significant enough.

Diversifying your foreign investments is just one critical element of an optimal asset allocation. Building balanced portfolios that are more likely to meet your financial goals doesn't happen by accident or by working with someone whose interests are in conflict with yours. Visit the website of the National Association of Personal Financial Advisors at <a href="http://www.napfa.org" target=_blank>www.napfa.org</a> or call 1-800-366-2732 to find a fee-only advisor in your area.



from http://www.emarotta.com/article.php?ID=292

Rebalance Accounts Regularly (2008-07-07)

by David John Marotta

A year ago when the markets were all setting new highs, people were asking what they should do with their retirement portfolio. I answered, "Rebalance." Now that the market is setting new lows, I get the same question, and my response hasn't changed.

Rebalancing requires discipline. You set a target asset allocation for your investments and then periodically buy and sell different investments to stay focused on your objective. Without rebalancing, those categories that do well may continue to grow as a percentage of your portfolio until they significantly underperform the markets. The ones that do the best often bubble and finally burst. Rebalancing avoids this needless anguish.

Investing in an S&P 500 index fund does the opposite of rebalancing. The S&P is a capitalization-weighted index. A stock's capitalization is the total outstanding shares multiplied by the stock's current price. Therefore, those stocks whose price has appreciated comprise a greater share of the index. The S&P automatically increases its holding in stocks that have gone up and decreases its holdings in stocks that have gone down. This is the opposite of what you want.

Having the right asset allocation in the first place is an essential part of rebalancing. Rebalancing back to an S&P 500 allocation misses the emphasis on value stocks that will help your portfolio returns.

Stocks that have decreased in price have a lower price-to-earnings (P/E) ratio. They are called "value stocks." These stocks on average do better than growth stocks. But capitalization-weighted indexes such as the S&P 500 miss this method of boosting returns.

Several new investment products tout what is called "fundamental indexing." They set target allocations based more on earnings than price and therefore gain a value tilt. This is a good strategy, but the funds using it are currently charging higher fees and expenses than necessary. As expenses on these funds drop, they may prove to be a better investing strategy. In the meantime, you can develop a less expense asset allocation with the same value tilt simply by putting part of your asset allocation into a value fund. Adding a large-cap value fund to your S&P 500 fund will emphasize those stocks with a low P/E ratio. A value fund will sell stocks whose price has appreciated enough that they are no longer considered value. And it will buy stocks whose price has dropped enough for them now to be considered value.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining how well behaved your portfolio returns will be.

Even if you are creating a very aggressive portfolio, including some fixed-income investments actually increases returns. Stable investments provide some cash on the sidelines, and having cash to buy stocks after a market correction both boosts as well as evens out your investment returns. Thanks to the effect of compounding, smoother returns produce better returns.

Periodic rebalancing is the simplest and most common method. Waiting for an asset category to exceed some threshold and then bringing the allocation back within some tolerances seems to produce slightly better returns and lower volatility. Although different ways of rebalancing produce somewhat variable results, the method you use is not as important as committing to a regular rebalancing plan.

Crestmont Research studied the difference in returns between rebalancing every year versus every two years in varying types of markets. They found that in secular bull markets, rebalancing less frequently had a slight 0.3% annualized advantage, but in secular bear markets, rebalancing more frequently had a more significant 1.3% advantage. Another study of the same time period verified smaller advantages for even more frequent quarterly and monthly rebalancing. And a study of the Yale endowment attributed 1.6% of its portfolio returns to rebalancing.

Making an extra percentage point a year is significant. The Crestmont study concluded, "In choppy and volatile markets, a more frequent rebalancing approach can add significant additional return to an investor's portfolio. Based upon recent secular market history, the risk (cost) of more frequent rebalancing in secular bull markets is far less than the opportunity from more frequent rebalancing in secular bear markets."

Crestmont's observation is true because a secular bear market does not simply go down every year. Rather these markets often swing up and down wildly. The Crestmont study analyzed the secular bear markets from 1966 to 1981 and concluded that rebalancing more frequently made the difference between experiencing positive or negative returns.

Keep in mind what rebalancing in a secular bear market means: buying stocks after they have gone down and selling stocks after they have gone up. Probably the point at which more frequent rebalancing pulled ahead the most was 1973 and 1974 when the market dropped 17% and then 28%, and more frequent rebalancing meant putting more money back into the markets. Then in 1975 and 1976 when the market rebounded 38% and 18%, respectively, it provided better results.

Rebalancing is as daunting as putting more money into the markets now after our recent declines. But it is also as prudent as taking profits off the table a year ago when the market was setting new highs. Rebalancing, always a contrarian move, helps investors make those emotionally difficult but safer and more profitable decisions.

Portfolio design and rebalancing is both a science and an art. It may be helpful to understand the physics of why a spinning ball hooks and bends. But when you are playing golf or soccer, it is the execution and follow-through that produces the desired outcome. Knowing that rebalancing boosts returns is useless unless you as the investor have the time, discipline and nerve to follow through and actually strike the ball.

Untended portfolios can quickly become more volatile. Thus frequent watching of a portfolio is required even if frequent rebalancing is not the best methodology. Watching your portfolio every day and choosing strategic inaction allows you to seize the day when the portfolio is significantly far enough out of balance to warrant action.

How frequently you need to water your garden is totally contingent on current weather conditions. Similarly, when you should rebalance your portfolio depends more on what the markets are doing than the calendar.

Rebalancing need not trigger a taxable event. You can do it when you are adding to your portfolio or during retirement when you are making withdrawals. Another way of rebalancing without triggering capital gains is to make the changes in your traditional or Roth retirement accounts. You can also pay dividends and interest in cash rather than reinvesting them. Then use this cash to rebalance by purchasing more in the asset category, which has done the worst lately. But even if you have to trigger capital gains, the capital gains tax is at an all-time low and will probably be raised in the future. So go ahead and rebalance your portfolio and generate those capital gains.

If your portfolio had the right asset allocation to begin with, we would currently be advising you to add to U.S. stocks or withdraw from hard asset stocks or fixed income. However, most of the portfolios we see for the first time already have too much U.S. stock and little, if any, hard asset stocks. Again, getting the right asset allocation is always the first step to rebalancing.

Watching the asset allocation balance on a portfolio may not seem like a very active strategy. But because it can increase your returns by over a percentage point a year, it is worth the time and effort. At a minimum, you should have a target asset allocation and an easy way to rebalance it at least once a year.



from http://www.emarotta.com/article.php?ID=291

Inflation Part 3: Protecting Yourself Against Inflation (2008-06-30)

by David John Marotta

Officially, inflation today is calculated about 4%. Unofficially, it is over 7%. Since 1997 the government has stolen productivity gains from Social Security recipients and pushed middle-class taxpayers into alternative minimum tax rates. But you can learn how to hedge your assets against underreported inflation and protect your retirement goals.

First, don't count on Social Security for your retirement, especially if you are young. It may be unthinkable, but Social Security payments will probably be eliminated for the middle class and above. And even if you qualify, the government's official cost-of-living adjustments will continue to be calculated significantly below actual inflation. If you don't keep pace with inflation, by the end of your retirement you will have lost your lifestyle, your independence and ultimately your dignity.

An irresponsible government may underreport inflation and jeopardize the retirement of truly needy seniors. But responsible citizens will strive to take care of themselves in retirement without government assistance. Public funds thus will be available for those who can't take care of themselves. In other words, financial planning is simply planning not to be the truly needy.

Second, ask yourself, "What are safe investments that should more than keep up with inflation?" This is a challenging question.

Because of inflation, cash, normally a safe store of value, has been the riskiest investment since 2002 when the U.S. dollar began losing much of its purchasing power. Since then, the U.S. Dollar Index has dropped over 39%, from 120 to 72.95. It has also dropped more than 44% against the euro and over 67% against gold.

During inflationary times, U.S. bonds are not a safe store of value either. They pay a fixed rate of return in diminishing dollars. In a rising interest rate environment, intermediate- and long-term bonds drop in value too. When interest rates are rising, keep your money in a money market account where the rates adjust immediately.

Inflation-indexed bonds only do slightly better. Because actual inflation is underreported, these bonds have not kept up with the real inflation rate. The adjustments on them are tied to the official consumer price index, so they also are depreciated for any productivity adjustments. These investments may do better but only to the extent that inflation is reported accurately.

Foreign bonds provide the best protection against a falling dollar but only if they are unhedged. Many foreign bond funds hedge their investments against a rising dollar, providing returns tied to U.S. dollars. If your goal is to guard against a falling dollar, a fund that hedges against the dollar defeats this purpose.

Unhedged foreign bonds yielded about a 10.5% return in 2007 and about a 6% return so far in 2008. Determining if a foreign bond fund is unhedged can require some research. Also, foreign bonds of developed countries perform differently than those of emerging market countries. They represent two distinct baskets of currency. Emerging market bonds at times have a higher return, but they also have a higher risk and volatility. We recommend putting a small portion of your foreign bond allocation into emerging market bonds.

The danger with any unhedged foreign bonds is that the U.S. dollar may strengthen against foreign currencies. Also, unhedged foreign bonds cannot protect you against global currency inflation. So you don't want all of your fixed-income investments in unhedged foreign bonds, although this investment does protect you to some degree against U.S. dollar inflation.

Cash, U.S. bonds and foreign bonds are all investments for stability rather than appreciation. Stable fixed-income investments generally make about 3% over inflation. It's not a wide enough margin to stay ahead of inflation during times when interest rates are low or rising.

A significant allocation to appreciating equity investments is necessary to accomplish the long-term growth that ensures a comfortable retirement. Equity investments, on average, make about 6.5% over inflation. Although they are more volatile in the short term, they give you a better chance of achieving the appreciation necessary in today's longer retirements.

The third way to protect your portfolio against inflation is to refrain from being too aggressive or too conservative. Keep most of your investments in appreciating equities, but plan the next five to seven years of spending in stable fixed-income investments.

If you don't have the next five years of spending in stable investments, you may be forced to withdraw from your portfolio while stocks are down. Your portfolio will be depleted and unable to rebound. However, if you are too conservative, you may sleep well tonight but eat poorly a decade from now because your fixed-income investments haven't exceeded inflation.

The balance between risk and return should not depend solely on your emotional risk tolerance. Rather you should focus on what risk-return allocation mix affords the best chance of meeting your investment goals. Your allocation to stability should be fixed and your allocation to appreciation should appreciate. The goal of stability eliminates risky, or junk, bonds. The goal of appreciation also eliminates speculation, which adds needless noise rather than real return.

The fourth principle is that investing for appreciation means selecting only investments that on average go up, are publicly traded, and have low expenses and fees. Savvy investors buy shares of long-term businesses that produce worthwhile goods and services.

Speculation, in contrast, can include trading options or commodities. It can encompass limited partnerships or hedge funds that are illiquid and often subject to high fees and expenses. Diversification does not mean buying every kind of investment regardless of its suitability to help you meet your financial goals.

The fifth protection against inflation is to guard over half of your portfolio against the risk of a falling dollar. The asset classes of foreign bonds, foreign stocks and hard asset stocks offer the best protection. As a class, hard asset stocks have also yielded one of the best returns since 2002.

Hard asset investments include companies that own and produce an underlying natural resource, such as oil, natural gas, precious metals, base metals, and other resources such as diamonds, coal, lumber and water.

Keep in mind that investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment in raw commodities or their volatility. Buying a gold mining company is a hard asset stock investment.

The Goldman Sachs Natural Resources Index tracks hard assets investments. It is comprised of 85% energy and 13% materials. At the end of May 2008, this index was up 12.12% year-to-date. Its three-year annualized return is 30.47%. Its five-year annualized return is 29.56%.

Foreign stocks also protect you against a falling dollar. They are priced in foreign currencies and benefit when the dollar drops in value.

The MSCI EAFE foreign index is only down 3.03% year-to-date compared with the S&P 500, which is down 3.80%. Over the past five years of a dropping U.S. dollar, the MSCI EAFE index has on average done much better than the S&P 500.

Adding international investments to your portfolio is an excellent way to diversify for safety while boosting returns. International stocks have appreciated more than U.S. stocks. What's more, companies located in countries with the most economic freedom have appreciated more than the broader international average.

Since 1994, the Heritage Foundation Index of Economic Freedom has used an empirical system to measure economic freedom in countries worldwide.

One of the 10 categories it measures is monetary freedom. The worldwide average inflation rate per country from 2004 to 2006 was 10.6%. Having a monetary authority to maintain a sound currency clearly is critical to economic freedom. As the Heritage Foundation report states, "Monetary freedom is to market economics what free speech is to democracy. Free people need a steady and reliable currency as a medium of exchange and store of value. Without monetary freedom, it is difficult to create long-term value."

When investing overseas, emphasizing countries with the most economic freedom can help prevent trying to avoid U.S. inflation only to be caught in some other country's inflation.

Finally, tax management is critical. Underreported inflation pushes middle-income Americans into higher tax brackets. Many techniques to tax-manage your investments are worth exploring. Putting fixed-income investments into pretax accounts and foreign stocks into taxable accounts can mean a tax benefit of about 1% a year.

Normally a Roth conversion does not have any benefit unless you are in a higher tax bracket during retirement. With inflation underreported, you are being pushed into a higher tax bracket every year. And with the political winds portending higher taxes regardless of inflation, you will almost definitely be paying more in the future. Paying the taxes now and funding or converting to a Roth account while you have a relatively low rate could result in significant tax savings.

So despite inflation rates that are higher than reported, you can still protect your investments, achieve your financial goals and enjoy a comfortable retirement.

 

from http://www.emarotta.com/article.php?ID=290

Inflation Part 2: The Results of Underreporting Inflation (2008-06-23)

by David John Marotta

Officially, inflation today is about 4%. Unofficially, it is over 7%. Inflation at this rate causes serious harm to our nation's economy and its citizens.

Since 1997 the Consumer Price Index (CPI) has manipulated the raw data and significantly underreported inflation. This tactic has saved the government hundreds of billions of dollars. Entitlement program recipients find their benefits reduced every year. And middle-class taxpayers are pushed automatically into ever-higher tax brackets.

Instituted by the Clinton administration and willingly continued by the Bush administration, this hidden tax burden transcends the political ideology of conservative and liberal. It threatens the idea of limited government.

As economist Milton Friedman said, "Inflation is the one form of taxation that can be imposed without legislation." John Maynard Keynes agreed. He commented, "The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens." And none other than Vladimir Lenin wrote, "The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation."

Lenin may have intended to grind just the upper class. But in America, everyone ends up as grist for the mill. Average Social Security recipients, that is, retirees, are crushed the most. Technological advances are factored out of Social Security cost-of-living adjustments. Seniors are left to live Amish lives in a digital age.

Productivity and technological advances should result in dollars that are capable of buying more each year. If inflation was being reported accurately, simply putting dollars in the bank would result in a 3% boost in purchasing power. These technological advances are the fruits of capitalism and innovation as businesses develop better products and services. Why should the government deny people the advantages of business innovation by deficit spending and increasing the money supply?

In fact, the CPI is deceptively labeled. The name takes something that government has done to confiscate capital wealth and blames it on businesses: rising consumer prices. But businesses aren't at fault. If the CPI was accurately named, we would call it "Capital Piracy by Inflation."

Instead of seeing their money grow in value, people with dollars in the bank experience the equivalent of an extra 3% tax on their savings. People on fixed incomes such as Social Security experience the equivalent of a 3% reduction in their benefit payments. Like any compounded taxation, the cumulative effect over the past decade has taken its toll. The lifestyle of millions of the elderly has suffered as a consequence.

Middle-class workers aren't exempt either. The alternative minimum tax (AMT), established in 1970, is not even indexed to official inflation. So middle-class taxpayers are pushed higher and higher into a tax intended for the ultra rich. The AMT punishes taxpayers for having children or living in a state with high taxes. Thus being hit with the AMT turns many of the tried-and-true rules of thumb on taxes upside down. Ironically, many of the wealthiest taxpayers are now avoiding AMT penalties entirely. Those with large incomes pay enough tax to avoid the AMT while the middle class is penalized.

There's another concern too. Underreported inflation also masks the current recession. Official first-quarter real gross domestic product (GDP) growth was 0.9%. Current reports suggest that annual economic growth for 2008 will be 2.4%. But if official inflation is at 4% and actual inflation is over 7%, then real economic growth is 3% less than reported. That means growth for 2008 isn't 2.4% but rather -0.6%. If it feels like a recession, don't let official government statistics fool you.

During inflationary periods, finding capital is challenging. No one wants to loan expensive dollars today only to be reimbursed with dollars that are worth less in the future. This situation also makes it difficult for companies to capitalize their businesses. Why risk valuable dollars today to create and expand production when inflation devalues the rewards significantly? So of course businesses are not investing. First-quarter fixed investments were down 7.8%.

We risk a business environment similar to the 1970s. Inflation then caused declining price-to-earnings ratios and hindered small business capitalization. Small businesses are responsible for the majority of GDP and job growth. Inflation slows the economy and increases unemployment. Drastic steps by the Reagan administration were necessary to deal with the stagflation of the 1970s and put the economy back on a secure footing. Our current malaise may require some equally bitter measures.

Historically, people worldwide counted on the U.S. dollar holding its value. We sometimes forget that a stable currency is not a given in every country. In the past, people outside the United States were willing to trade their goods and services for nothing more than our currency's safe store of value. The result has been a trade deficit where our biggest export has been U.S. dollars. About 60% of all U.S. dollars today circulate outside the United States.

But global confidence in the dollar has been shaken recently. Now foreign markets are not committed to holding dollars. They would rather trade those dollars for some of our real goods and services. All those dollars coming home to roost may be good for our trade deficit. But it only exacerbates the problem of too many dollars in this country chasing too few goods and services.

When we have no reliable way to measure the purchasing power of the U.S. dollar, all statistics calculated in our currency become suspect. How can economists or accountants measure anything accurately when their ruler is made of rubber? And if statistics aren't measurable, then business forecasting is impossible.

All of these are serious public policy concerns. But they don't have to block your personal financial goals. Despite inflation rates that are higher than reported, you can still protect your investments from being ravaged. In the final part of this series, we will describe practical ways you can hedge against excessive and unreported inflation and secure and guard a comfortable retirement.

 

from http://www.emarotta.com/article.php?ID=289

Inflation Part 1: How the Government Lies About Inflation (2008-06-16)

by David John Marotta

Officially, inflation today is calculated about 4%. Unofficially, it is over 7%. Since 1997 the government Consumer Price Index (CPI) has manipulated the raw data and significantly underreported inflation.

Recently I watched the 1997 movie "Conspiracy Theory" starring Mel Gibson and Julia Roberts. Before the opening credits have finished rolling, we understand that Gibson's character is a crackpot cab driver who sees conspiracies everywhere. But our perception changes by the end of the film when we realize for ourselves that some of his theories are true.

For years I've hesitated writing about the CPI, computed by the Bureau of Labor Statistics, for fear of being compared with a paranoid character like the one in "Conspiracy Theory." The message that the government lies to us about inflation and, as a result, quietly confiscates hundreds of billions of dollars from its citizens isn't the easiest message to swallow. It only goes down when accompanied by a healthy draught of political cynicism.

What's changed over the past year, however, is that we are closer to the end of the movie. It is clearer now not only that inflation is running rampant but also that the government's numbers are still ridiculously low. More Americans have come to mistrust official inflation statistics, and therefore they are ready to understand how and why the government skews these numbers and to learn how they can protect their family's savings.

Take 2007 as an example. Bread price rose 7.4%, gasoline 8.2%, health insurance 10.1%, whole milk 13.1%, eggs 29.2%, but according to the CPI, somehow inflation was only calculated as 4.1%. This year to date we have seen an even shaper rise, which still has barely affected the official numbers.

In 1975 programs such as government pensions, Medicare and Social Security were indexed to inflation. With rising inflation in the early 1990s, public officials realized that entitlement programs made government deficits impossible to control. Politically it was just too difficult to cut spending to this program. It was much easier simply to lower their cost-of-living adjustments.

So a commission of five economists in 1996 studied the CPI and issued a report stating that the index overstated inflation by at least 1.1%. Lower CPI adjustments would not only save money in entitlement programs but also raise tax rates mostly among the middle class. Tax brackets, personal exemptions and the standard deduction are all indexed for inflation. Lowering these adjustments has the effect of increasing the tax paid, with the greatest impact on middle-class taxpayers.

The argument that the CPI was overreported went something like this: In 1970 a mid-priced car cost about $3,500. Today, in 2008, the same size car costs about $25,000. After adjusting for inflation using official CPI data, today's car costs $4,515 in 1970 dollars.

It certainly looks like inflation has been significantly underreported, even though the government argues the exact opposite. In their 1996 study, they suggested that although it looks like today's cars are more expensive even in inflation-adjusted dollars and that CPI has been underreported, in fact it is the opposite. They claimed that today's cars are simply better built.

According to their logic, what we called a car in 1970 doesn't even qualify to be called a car today. It wasn't fuel efficient. It had no airbags, no power windows, no power door locks, no heated seats, no tilted steering wheel and no CD player.

The government has decided that the enjoyment you get from all of these extra features is why a car costs more today. Thus you are buying a better model than you did in 1970 and therefore it should cost more. The extra pleasure you get from the car should be measured as your choice, not as inflation.

You can see the problems with these government assumptions. You still need a car today. Apparently, you can't buy what we used to call a car in 1970. A combination of government mandates and changes in market preference have added features. Rather than being able to take advantage of these improvements simply because you are living in the 21st century, these improvements have diminished the value of your currency.

The official term for this type of adjustment is a "hedonic deprecator." If the computers available this year are twice as fast, then the government counts that as 50% deflation. You are getting twice the hedonism for the same dollar, so only half the price is reported in the price indexes. It evidently doesn't matter that you paid the same price. And it doesn't matter that a computer at the old speed won't run any of the new software.

Hedonic adjustments are a way to discount any improvements in productivity. Under the old method, when a reserved Federal Reserve kept inflation in check, productivity improvements resulted in every dollar of your paycheck buying more. Now, an unreserved Federal Reserve deflates the value of every dollar. By counting the bonuses from increased productivity, the government does not need to report the real inflation it is causing.

Not everything is more expensive. Clothes cost less, thanks to continued globalization. And communications costs less too, along with many other electronic gadgets. However even these items are used against consumers. In a concept called "creative substitution," the government CPI numbers did not count electronics when they were expensive but now counts the drop in their price as anti-inflationary.

The government's argument is that very few people owned a calculator when it cost $100. But now that the same calculator can be purchased for $5 and everyone owns one, it should be counted as deflationary. According to this mindset, the fact that your calculator and cell phone each costs $100 less should more than make up for the fact you can't afford to buy basic foodstuffs or drive your car.

With food, the government adjustments are a little more imaginative. They assume if the price of beef goes up, you will eat less beef and more chicken. If chicken goes up, you will choose pork. And if pork goes up, you will eat more tofu. They assume that when the price of something goes up, some people creatively substitute something less expensive.

Lacking any standard for a U.S. dollar, we can make two observations: your currency has been devalued, and this devaluing is not reported as inflation. Standard of living improvements due to technological advancements have been withheld from those who are on fixed incomes and those who keep their wealth in dollar-denominated investments.

It was none other than former Federal Reserve chairman Alan Greenspan who in 1966 wrote, "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."

Unreported runaway inflation has made dollars unappealing to hold. This is good for our trade deficit because those outside the United States now want to trade dollars of diminishing value for real goods and services, but it could have detrimental effects on our country and its citizens. Next week we will describe those effects and how to protect yourself against them.

 

from http://www.emarotta.com/article.php?ID=288

Last week's column described how certain critical assumptions can affect retirement planning. Here we discuss how to determine maximum safe withdrawal rates that will not compromise a long retirement.

Imagine you knew you were going to die peacefully in your sleep at the end of your 100th year. Becoming a centenarian is more common these days, and it's a much safer assumption than using average longevity. Half the people live longer than average, and a significant percentage live much longer. So our best case scenario is not just a fantasy.

As you turn 100, you could plan to spend 100% of your portfolio. At the end of the year when you run out of money, you also run out of life, literally dying broke. It makes sense to keep all of your assets in cash or a money market account. Investing in stocks risks a market correction that could leave you short on funds and make your last days miserable.

Now back up a year. You are 99 and could spend about half of your portfolio's value, reserving the other half for your final year. You will keep money for your 99th year in cash. Money reserved for your 100th year could be put in a CD or a bond for more interest. You should be making a real return on your investments that is greater than inflation.

Imagine you planned on reaching your 99th birthday and several years ago bought bonds to mature at the beginning of each of your last two years. The bond for your 99th year has just matured and is waiting in cash for you to spend. The bond for your 100th year has one more year to mature and is earning about 3% over inflation. So after factoring out inflation, you can spend 50.70% of your portfolio this year, knowing the 49.30% of your portfolio left in the bond will grow by inflation plus 3% to cover a cost-of-living increase for your final year.

Back up yet another year. You can spend a little over a third of your portfolio for your 98th year, just over a fourth for your 97th year and just over a fifth for your 96th year. Gradually as you work backward, the amount of interest over inflation you are earning becomes more significant. Once you establish a laddered bond portfolio of five to seven years, putting those assets with a longer time horizon into the stock market is a good idea.

Investing in fixed income gives you peace of mind, knowing your lifestyle for the next few years will be relatively stable and not depend on the whims of an inherently volatile market. Investing in stocks is appropriate only when your time horizon is at least five years or longer. Therefore, we recommend keeping the next five to seven years of spending in fixed-income investments during retirement. You can keep five years of spending in fixed income if you are aggressive and seven years if you are conservative. Five to seven years is an appropriate range. If you keep whatever you feel like based on an emotional risk tolerance, you may jeopardize your retirement lifestyle.

In our examples we assume you have set aside six years of spending for stable investments in fixed income and allocated the remainder of your portfolio in appreciating equity investments. This money is invested in quality fixed-income investments. There is no reason to invest in "high-yield" junk bonds for the stability side of your portfolio. Junk bonds act like stocks and are liable to fail when you need them most. With your fixed-income investments in quality bonds, you can safely afford to put more of your portfolio in appreciating stocks.

Knowing your retirement spending is relatively secure for the next six years, we suggest putting the remainder of your portfolio into more volatile stock investments to achieve a better long-term rate of return. With this technique, not only do you have a maximum safe withdrawal, you also have a maximum allocation to fixed income: to balance the need for six years of stable spending with the need for appreciation to cover the seventh year and beyond.

For your stable investments, we have assumed a rate of return consistent with fixed income, about 3% above inflation. Assumptions for the equity portion of your allocation are more problematic. In the long run, stocks average about 6.5% over inflation, but in that long a run both your retirement and your life are over. Stocks are inherently volatile. Do not count on any reliable rate of return during your retirement. Past performance is no indication of future results. Just because a 30-year loss in the U.S. markets hasn't happened yet doesn't mean it couldn't happen during your retirement.

You can handle uncertainty in two different ways: throw lots of dice and see what happens or make conservative assumptions. What we learn from the first can help us with the second.

In the financial planning world, throwing lots of dice is called Monte Carlo analysis. It involves running a retirement projection against many randomly generated investment returns to see if that portfolio growth outlasts many random lengths of life. Sometimes returns are selected from history; sometimes they are generated mathematically. Hundreds of assumptions are built into Monte Carlo simulations. As a result, the method illustrates risk better than it actually predicts or protects against it.

We learn from Monte Carlo that every plan has some small chance of failure, and you must accept the possibility that you will need to adjust your lifestyle. We also discover that a string of early bad returns with a high withdrawal rate makes for a difficult recovery. Monte Carlo analysis has so many associated problems, we advise taking the lessons learned and simply making some conservative assumptions.

Assume your stock investments will only average bond-like returns, about 3% over inflation. Normally the markets do much better, but sometimes they do much worse. Working backward from 100, at age 90 with 11 year of spending remaining, you should be able to spend 10.42% of your portfolio.

Continuing to work backward from age 100, we can compute exactly what percentage of your portfolio you can spend if you are retired at any age. Here are those maximum safe withdrawal rates by age, along with the maximum percentage you can safely allocate to fixed income and still leave enough in appreciating equities to keep up with inflation:

Age	Withdrawal Rate	Maximum Fixed Income
50:	3.64%	18.4%
55:	3.82%	20.4%
60:	4.06%	22.4%
65:	4.36%	25.0%
70:	4.77%	32.2%
75:	5.35%	36.4%
80:	6.22%	42.4%
85:	7.66%	51.6%
90:	10.42%	67.8%

The safe withdrawal rate never drops lower than 3%. If your portfolio appreciates 3% over inflation and you take 3% out, your portfolio will have grown exactly by the rate of inflation. You can retire the day you are born if you can live off 3% of your trust fund. A 3% withdrawal rate can continue indefinitely as long as your portfolio appreciates annually by at least 3% over inflation.

Every year your portfolio earns greater than 3% over inflation, your standard of living can go up. If your portfolio loses money one year, you may be able to keep your spending constant and wait for above-average portfolio returns to get you back on track.

In this way you can adjust your standard of living dynamically and avoid a "plan once and blindly follow," on the one hand, and "let my standard of living bounce between feast and famine" on the other. This middle ground keeps lifestyle spending appreciating when the market returns are typical and keeps spending constant in terms of dollars during down markets.

Withdrawal rates lower than these maximum safe rates provide an even safer retirement plan and also allow more of your portfolio to remain invested and appreciate. In addition, withdrawal rates lower than the maximum permit greater flexibility in your asset allocation. With conservative enough withdrawals, you can afford to put more assets either in fluctuating equities or in less appreciating bonds.

Staying under these maximum withdrawal rates in conjunction with a diversified asset allocation gives you an excellent chance of having enough money during your retirement. And if your portfolio experiences average market returns (as opposed to the average bond returns used for planning), you will also leave a nice legacy for your heirs.

from http://www.emarotta.com/article.php?ID=287