Kimmunications

Time to Tackle Some Widespread Myths

I was going through my magazines the other day, and one little graphic jumped out at me. It showed the results of a survey of working 56-65 year-olds who were asked about their retirement plans. What it told me was that there are still a lot of misconceptions out there on how to plan, save and invest for the future.

The mainstream press doesn't do much to shatter these myths. So I'm going to go point-by-point through the survey results, and I hope I'll be able to set many people straight.

Finding: 43% of those surveyed believe they'll be able to withdraw 10% or more of retirement savings each year without exhausting their capital.

Reality: The widely accepted "safe" withdrawal rate is more like 4%-5% per year from a well-diversified portfolio of stocks and bonds, according to several studies. As with most of investing, the term "safe withdrawal rate" comes with a disclaimer: 4%-5% is merely a figure based on historical data that provides a high probability you won't outlive your money.

How can that number be so low if the stock market, on average, returns 10.4% a year? It's because the 4%-5% figure takes into account the fluctuations of the stock market as well as inflation -- an often overlooked piece of the retirement income puzzle.  First, the "safe" withdrawal rate assumes you aren't 100% invested in stocks; you have at least some assets in bonds and cash, which carry lower returns. Second, the average market return is an oversimplification of how the market really works. If the S&P 500 is up 10% one year and down 10% the next, the "average" return is 0, but you would end up with less money. Third, you have to take into account inflation. If you assume that the historical rate of inflation is 3.5% per year, your portfolio's returns have to grow that much just to keep up, and your withdrawals have to increase at the same rate so you don't lose purchasing power.

This is why I say that you have to target double-digit returns with your investments.* To be able to withdraw 4% a year, keep up with inflation (3.5%) and pay your taxes (assuming a 25% bracket), you'll need to aim for at least 10% a year -- more if you want to withdraw more, if inflation is higher than 3.5%, or you're in a higher tax bracket. I wrote an article on bonds a while back that explained the math behind this statement.

Remember, this is a target of at least 10% so you can potentially withdraw 4% a year. Most retirement portfolios aren't set up to target double-digit returns, which means withdrawing 10% is well beyond a pipe dream for most people.

Finding: 49% of those surveyed believe their income needs will drop by half after they retire.

Reality: I meet with retired clients all the time to go over their financial situations. Rarely do I see cases where their spending has declined in retirement. In fact, the opposite is true more often than not -- they typically spend more!

That's just from personal experience, but academics are finding similar results. Researchers at the University of Michigan found that in the aggregate, pre-retirement spending and post-retirement spending are about the same. Other studies suggest that spending initially goes up in retirement and doesn't begin to decline below pre-retirement levels until the retiree gets much older.

Although your job-related expenses may decrease and you may have paid off your mortgage, you have to take into account other expenses such as travel and healthcare. The cost of healthcare, and the cost of healthcare insurance, is rising at twice the rate of inflation.

Finding: 38% of those surveyed believe that long-term care is covered either by health insurance, Medicare or disability insurance.

Reality: Medicare covers few long-term care services, and people must meet strict income and asset requirements to qualify for Medicaid. Health insurance and disability insurance generally doesn't cover the cost of long-term care. And those costs can be huge.

A private room in a nursing home today costs about $70,000 a year.  Since 1990, the price has been increasing at an average of 5.8% a year. If you have enough millions in the bank to cover these kinds of costs, you probably don't need long-term care insurance. For everyone else, it's a different story.

Finding: 60% of those surveyed believe that at age 65 they will have a 25% chance or less of living beyond age 85.

Reality: The odds are more like 50%, and the expected joint life expectancy of a healthy 65-year-old couple is 30 years. That means there's a good chance that one member of the couple will live to age 95. Which brings us to the next point…

Finding: 56% of those surveyed say the greatest financial risk for retirees is longevity risk.

Reality: I'm glad to see they got this one right. But it tells me that a large number of people aren't connecting the dots: They think they can withdraw 10% or more per year and have much lower expenses, but they're still worried about outliving their money. They don't seem to realize how one affects the other.

But you aren't like that now, are you? You now know that to successfully make it through your golden years, you need to save prodigiously and invest wisely. And you need to plan. If you feel you're already on the right path, then congratulations! If not, it may not be too late. Email me or give me a call at 214-245-5236, and perhaps we can work together to get you back on track.

SOURCES:
1. "Taking a pass on financial reality," Investment News, 30 June, 2008.
2. Bengen, William P. "Determining Withdrawal Rates Using Historical Data," FPA Journal, [accessed 21 July 2008].
3.  Cooley, Philip L., Carl M. Hubbard and Daniel T. Walz. "Retirement Savings: Choosing a Withdrawal Rate That is Sustainable," AAII Journal, February 1998, Volume XX, No. 2, [accessed 21 July 2008].
4. Easterling, Ed. "Waiting For Average," Crestmont Research, [accessed 21 July 2008]
5. Hurd, Michael D. and Susann Rohwedder. "Changes in Consumption and Activities at Retirement," Michigan Retirement Research Center Research Brief, July 2005, [accessed 22 July 2008].
6. "Facts on Health Care Costs" (National Coalition on Health Care, 2007) [accessed 22 July 2008]
7. "The Importance of Personal Financial Protection" (American Society of Pension Professionals & Actuaries, 2006),[accessed 22 July 2008]

*Double-digit returns is an objective, not a guarantee

---

Kim Snider is the President and Founder of Snider Advisors, an investment adviser registered with the SEC, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Why Bonds Won't Cut It

Some of you know I went to the University of Colorado (go Buffs!), also known as CU, also known as "Ski-U". Freshman year, my ski days were in the triple digits, if that gives you any indication - and no, I wasn't on the ski team.

 

Back then, we could buy books of coupons good for discounts on food, lodging and lift passes at ski areas all over the state. At the time, I could ski the top notch areas, like Aspen or Vail, for less than $20 a day.

 

I started thinking about that last week while Jim and I were in Las Vegas. While we were there, I read an article that said one-day lift passes, at many of the big ski areas, are now approaching $100 - a day! This is why I believe inflation, not market losses, is the biggest threat to your wealth.

 

Since I was in college, back in the early 80's, the price of a lift ticket has gone up an average of about 6.5% per year. That is faster than the rate of inflation overall, which averages between 3.5% and 4% per year.

 

Now, imagine I was a college student living on a fixed income of $100 a month. Back in 1985, I was living large on $100 - I could ski anywhere, for an entire weekend, on less than that - gas, food and lodging included. (Granted, I wasn't staying at the Four Seasons, but still!)

 

Today, assuming my income wasn't being adjusted by at least the rate of inflation, I can barely afford a one-day lift pass. My income is unchanged, but my purchasing power is sharply diminished.

 

A friend of mine asked me why would anyone invest in stocks? She had all of her money in bonds paying 5%. There was almost no risk, and the income produced was enough to pay all of her bills … today! She thought, as long as she only took out the 5% each year, she could live indefinitely on that money. What she wasn't accounting for was … you guessed it, inflation.

 

So, let's see how much you really need to stay ahead of the inflation boogey monster. Suppose you spend 4% of the value of your portfolio each year, after tax. Assume a 25% marginal tax bracket and a 3.5% average annual rate of inflation. You would need a gross average annualized return of 10% ((4 + 3.5) / (1-.25)).

 

Over the last ten years, the U.S. bond market total return has been approximately 5.5%. Clearly a bond portfolio falls woefully short. Unless you are Warren Buffett - in other words, a billionaire with a reasonably modest standard of living - you are going to have generate something significantly higher than bond market returns in order to sustain a reasonable standard of living.

 

So, while we would all like to stop worrying about the markets ups and downs and retreat to the so-called "safe havens" offered by lower return investments, our reality requires us to do two things: 1) Move UP the risk-reward continuum toward higher risk - higher return investments sufficient to support a reasonable standard of living; and 2) Avoid the mistakes that cause investor return to be lower than investment return.

 

Not sure how to do that? Then I would invite you to one of our Snider Investment Method™ information sessions. 'Nuff said!

 

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

All We Can Know About the Stock Market

Way back in the day, when I used to trade for a living, I probably placed nine bets that a stock or index would go down in the near future for every time I placed a short-term bet on up. It is just my natural bias.

 

Some people look at a chart or a news story and their brain reaches for why this should go up. Mine goes instantly to why it will go down.

 

But as an investor, and someone who teaches others to invest, I believe you CANNOT make money betting AGAINST the U.S. stock market.

 

The data is overwhelmingly convincing on this point. Since 1926, the U.S. Stock Market has averaged 10.4% per year (Ibbotson). Bonds, in general, have averaged 5.4% over the same time period, while U.S Treasuries have barely outpaced inflation at 3.7%. Inflation is running at 3% a year. Again, these are all averages.

 

No one would argue that stocks do not carry risk in the short term. That is why, as a trader, with a four hour time horizon, I used to bet on stocks going down all the time - and win (sometimes).

 

Even over longer time horizons, stocks will go down. Looking back over time, it is reasonable to expect a losing year every couple years. More frustrating, even when markets in general are going up, individual stocks of perfectly good companies will go down, often for no apparent reason.

 

Take yesterday for example. The market went up 117 points. 2,110 stocks on the New York Stock Exchange went up and 1,188 went down. 164 stocks made new 52 week highs. An even greater number, 203, made new 52 week lows.

 

But that is the short run. Let's look at the long-run.

 

Over any given five-year period, stocks have lost money just 10% of the time. Stocks have beaten the return of bonds and cash equivalents in about 80% of all rolling five-year periods. And stocks have beaten bonds and cash in all rolling 20-year periods since 1926.

 

To borrow from Nick Murray:

 

"There are really only a few things we can know about the market. Fortunately, they're the only things we ever need to know. (1) It will continue to reflect the growth of the leading companies in the world's most innovative, most flexible, most transparent economy. (2) Because of its inherently higher volatility, it will always provide significantly higher returns than do less volatile asset classes like bonds. (3) No matter what the market is doing today, nor what you fear it may be doing tomorrow, ten years from today you will wish you had invested in it every dollar you could have laid your hands on."

 

SOURCE:

 

1. Nick Murray. "It Goes To Show You Never Can Tell," Financial Advisor, November 2007; p45, 46, 175 <No on-line version available>

 

 

Kim Snider Financial Communications makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Diversification does not protect against market losses in a declining market. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk, including possible loss of principal.

It's All In How You Look At It

Look at the ballerina below. Is she turning clock-wise or counter-clockwise?

I see her turning clockwise, which is supposed to mean I am more right brain. Most people will see her turning counter-clockwise, which means you are more left-brain. But the cool thing is you can change which way she turns.

 

Focus on her turning the other way. Sometimes I have to look off the screen to get her to change. Sometimes it is really hard. Can you do it?

 

It just goes to show it is all in how you look at it. I had a caller on my radio show on Saturday who said he had pulled all of his money out of the stock market because he was afraid of terrorism. In other words, he was afraid of the risk. I, on the other hand, always have all of my money IN the stock market (by way of the Snider Investment Method™) because I too am afraid. Only I am afraid of running out of money.

 

Some people focus on short term risks that cause temporary market declines and opt for cash or bonds to manage risk. I focus on longer term risks like inflation and longevity and opt for generating cash flow from stocks to manage risk. Both of us see the same set of facts but interpret them differently.

 

Who is right? I guess it depends on how you look at it.

Kim Snider Financial Communications makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Diversification does not ensure a profit or protect against loss of in a declining market. All investments are subject to risk, including possible loss of principal. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing.

Loss of principal may be the wrong dragon

A man is lying in his hospital bed, surrounded by friends and family, reflecting on his recent near death experience. "I always thought it'd be the ulcer that killed me. I did everything the doctors told me. I drank the cream, ate the butter, drank the milk. And now I have a heart attack!" This was a scene from a new original series on AMC, called "Mad Men", set on Madison Avenue in 1960.

 

It is also a scene playing itself out in the portfolios of millions of Americans. Like Don Draper's boss in Mad Men, many of us are fighting the wrong dragon - and killing ourselves in the process.

 

At each speaking engagement I do, I ask my audience, "When thinking about your investments, what worries you most?" One of the first answers offered is always losing money. Capital preservation is our ulcer. Inflation is our heart attack.

 

Think about the average Baby Boomer - someone born around 1952. For many of you, that won't be too tough. You are the average Baby Boomer. Assuming your parents were 25 when you were born, your parents would have been born right around 1927. How do you think that shaped the messages you got about money, and in particular about investing? How do those messages affect you today?

 

The dominant financial experience in the lives of most of our parents, and certainly our parents' parents, was the Stock Market Crash and ensuing Great Depression. As a result, Baby Boomers were imprinted with certain ideas about money, almost from birth: Don't put your money at risk, pay off your home, stock market losses are ruinous.

 

It is not just investors who are indoctrinated with this belief system. The ranks of financial advisors, financial journalists and government regulators are populated by this same demographic cohort, with the same belief system, stemming from the same seminal event.

 

As a result, as we accumulate assets, we become focused - obsessed in some cases - on avoiding capital losses. So, as we age, we put more and more of our money into fixed income securities like bonds. If capital preservation is the ulcer, fixed income portfolios paying 5% or 6% are the cream.

 

"How so", you ask? The first thing you have to understand is the fact from which all your investment decisions must emanate, assuming your objective is to someday be able to live off the proceeds of your portfolio, is your life expectancy.

 

The average retirement age for all Americans retiring in the year 2007 is 62. So let's consider the case of the average couple retiring this year. They are both 62 years old and non-smokers. I want you to take a guess as to the age at which the second death will occur. In other words, both are 62 years old today. According to the actuarial mortality tables, how old will the latter to die be, when he or she passes away?

 

Jot the number down or just fix it in your mind. Got it?

 

If you would like to dig for the answer, or verify the answer I am about to give, go to your insurance agent and ask to see the mortality tables for the joint life expectancy of a 62 year old man and a 62 year old woman who don't smoke. They will confirm for you the answer is 92 years old. Their joint life expectancy is 30 years.

 

This is the good news bad news joke. We are living longer, but that longevity is also one of our greatest risks.

 

Now I want you to consider this. In 1988, I was fresh out of college and I made $18,000 a year. I was single. I had my own one bedroom apartment in a reasonably nice apartment complex. I had a new Ford Probe Turbo, on which I made monthly payments. I paid my insurance and gas. I could afford to eat out, go out at night with friends and take a couple of vacations a year. I could do all that on $18,000 a year. Granted, I didn't save anything, but my lifestyle was pretty comfortable.

 

So imagine one of my grade school teachers who retired, in 1977, with a pension of $20,000 a year. They were probably able to live pretty comfortably too - for awhile. After all, the median income in 1977 was $13,572. In 1977, a gallon of regular gas cost $0.62. You could buy a Porsche 924 for $9395! The median price for a new home was $54,200.

 

But fast forward thirty years to 2007. How well do you think my grade school teacher is doing on that $20,000 a year pension now? Even with a Social Security check and a paid for house, I can promise you, her monthly income doesn't go far enough.

 

So here is where our inherited belief system clashes with our reality. The cost of living rises, in the United States, an average of 3.5% per year. That does not take into account health care, which is rising at least twice that rate. If you hold a portfolio which returns 6% a year, for example, your real rate of return, or the return left after inflation, is only 2.5%. This is not enough to sustain any reasonable standard of living over a period which will likely span 30 years of retirement.

 

The only way to sustain a reasonable standard of living over that long of a time period is to earn a real rate of return significantly higher than that paid by bonds. In short, your long-term standard of living is directly correlated to the percentage of your assets you place in what has traditionally been thought of as the riskier asset classes, like stocks.

 

And therein lies the conundrum. In order to live comfortably, you must do the thing that you fear, which is put your capital at risk - because profit is the reward for risk. Without risk, there is no risk premium. And you must earn the risk premium in order to be able to live when you no longer have a paycheck.

 

That is the bad news. Here is the good news. In spite of what you may think, in spite of what your gut might tell you, and in spite of the belief system passed on to you by your parents, there is, effectively, zero risk in the stock market for the long term investor holding a diversified portfolio. Market risk only exists in the short term.

 

To that end, we have to stop thinking of our investment time horizon as our retirement date. Our investment time horizon is as long as we will live. For almost everyone reading this, we are talking a minimum of twenty years. For most of you, much longer.

 

I am 44. For planning purposes, I assume my investment time horizon, for example, stretches to the age of 102. In other words, my investment time horizon is 58 years. If I plan to hold an equity based portfolio for that long, what risk do I have? Not much.

 

Will I experience temporary declines in my portfolio value? Of course. Markets are cyclical. They go up and down. But at the end of 58 years, how likely is it that my investment will not have grown at a rate that exceeds the total return on bonds? As my grandmother used to say, "Nothing's impossible, just highly improbable."

 

Therefore, your choices are really quite simple. In order that you not run out of money, or at least purchasing power, you must commit a substantial portion of your assets to equities and keep them there for the long term - through the ups and downs - all of the panic buying and selling. The only way to make the required return is to always be in the stock market. Not market timing. Not stock picking. Holding a portfolio of America's greatest companies over long periods of time.

 

For most of you, that is not easy. It will never be easy. It goes against programming imparted to you almost at birth. But you have to do it anyway. To do otherwise is to guarantee a heart attack by treating the ulcer.

 

Kim Snider Financial Communications makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Diversification does not ensure a profit or protect against loss of in a declining market. All investments are subject to risk, including possible loss of principal. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing.

Illusory Correlations

An article by Mark T. Finn and Johnathan Finn, published in John Mauldin's Outside the Box E-Letter points out one of the more difficult aspects of economic decision-making - that is that we are constantly fooled by randomness:

 

Consider a classic experiment done in 1948 by B.F. Skinner. Paul Slovic describes the experiment as follows:

 

Skinner found that hungry birds, given food at brief random intervals, developed very idiosyncratic, repetitive actions. The precise form of this behavior varied from bird to bird, and Skinner referred to these actions as superstitions. What happened to these birds can be described in terms of the concept of positive reinforcement. The delivery of food increased the likelihood of whatever form of behavior happened to precede it. Food was then presented again. Because the reinforced behavior was occurring at an increased rate, it was more likely to be reinforced again. The second reinforcement caused a further increase in the rate of this particular behavior which improved its chances of being reinforced again, and so on. After a short while the birds were found to be turning rapidly counter clockwise about the cage, hopping from side to side, making odd head movements, etc. Because such behaviors are reinforced less than 100 percent of the time during learning, they persist even when reinforcement stops altogether. Animals trained in this way have been known to make many as 10,000 attempts to obtain a reward that was no longer forthcoming.

 

(Psychological Study of Human Judgment: Implications for Investment Decision Making, Paul Slovic, The Journal of Finance, Vol. 27, No. 4, Sep., 1972)

 

With only partial tongue in cheek we would point out a strong similarity between Skinner's experiment and investing in the stock market. There is the fertile ground of overwhelming data from which illusory correlations can be drawn. The outcome is expected to be positive (an increase in wealth). That expected positive outcome is associated with positive reinforcement (good performance) that is at least intermittent if not random. There are few statistically valid analyses provided as systematic feedback that would refute an illusory correlation.

 

I see this time and time again among investors. Imagine I bought 10 different stocks and all the stocks whose company name begin with A go up in price while the others all go down. The heuristics, or logical shortcuts in our brain's operating system cause us to leap to an illusory correlation between the company name and rising stock prices. Consequently, I start buying more stocks that begin with A. A random distribution of returns in a rising market would suggest, incorrectly, that stocks beginning with A go up more often than not. With an ever-increasing percentage of stocks in my portfolio beginning with A, I cannot see that stocks that begin with other letters go up in equal percentages.

 

You may say that is ridiculous. Admittedly, I made the example extreme to illustrate the idea. But make it somewhat plausible and people do it all the time without realizing.

 

Let's take technical analysis as an example. If I buy several stocks when they rise above their 20 day moving average and I make money on them, I will create an illusory correlation between the two. As long as I can spot the pattern sometimes and make money on it, which reinforces the correlation in my mind, I will continue to look for it and bet on it. It doesn't matter that the pattern often fails to hold true. I will continue to believe in the correlation.

 

The problem is that to make the correlation in our minds is very easy. It only requires a tenuous association between an event and a reward. But to disprove the correlation is hard. Few people are going to sit down and calculate the correlation coefficient between price and the 20 day moving average!

 

One other thing I find interesting is the link between these behaviors and addictions. What makes something really addicting is when we receive intermittent variable reinforcement.

 

"The interesting thing that Skinner discovered about intermittent reinforcement and maybe one of Skinner's most important discoveries was that behavior that is reinforced intermittently is much more difficult to extinguish than behavior that is reinforced continuously."

 

A slot machine is a perfect example. We put money in and occasionally money comes out - not always and the amount varies. This is intermittent variable reinforcement. It is this characteristic that makes something really addictive.

 

Email is another example. Do you know anyone who constantly checks email? Why do they do it? Intermittent variable reinforcement. You are not sure what you will get each time, or if you will get anything at all, so you keep checking.

 

Of course, the leap from gambling to investing is not a big one. Like gambling, investors get random, or intermittent reinforcement (profits) that vary in size and frequency. Do you think it is a coincidence that most investors don't buy bonds (not variable or intermittent) even though portfolio theory says you should have a substantial percentage of your portfolio in bonds?

 

I think one of the most beneficial things an investor can do is to study these sorts of behavioral issues in finance. In fact, I think it is time far better spent than studying stock charts and trading strategies. Only if we can understand our behavior and that it is far more complex than we probably realize can we hope to overcome our shortcomings as investors. For many of us, it isn't our lack of knowledge of investing that screws us up. It is our lack of knowledge about how our own brain functions.

 

What do you think? Leave your thoughts and comments below.

 

PROPS:

 

Thanks to Snider Method, alumni Dr. Andrew Lipscomb, for giving me the heads up on this article.

 

If you would like to subscribe to John Mauldin's newsletters (free and highly recommended) you can find them here.

 

SOURCE:

 

Mark T. Finn and Jonathan Finn, CFA; "A Look in the Mirror"; Mauldin's Outside the Box E-Letter; 15 Jan 2007.

http://www.investorsinsight.com/otb_va.aspx?EditionID=453

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Cash Flow the Best Measure of Wealth

I would like to share with you an excerpt from the November 2, 2006 edition of John Mauldin's Thoughts From the Frontline newsletter. As I have said elsewhere, if you don't already subscribe, you should. It is one of the most cogent letters out there. Which is why it goes out to over two million readers each and every week I am sure.

 

In this week's issue, titled "The Return of the Muddle Through Economy", John includes a summary from Rob Arnott in the Financial Analysts Journal on wealth:

 

What Is Wealth?   "How we define wealth," says good friend Rob Arnott, "or investment success, drives our approach to investing. Benjamin Graham was fond of saying that the essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept."   Writing in this month's Financial Analysts Journal, Rob gives us a different way to look at wealth. (Rob, besides successfully running billions of dollars at various funds, is the editor of the FAJ and has given me permission to use this material.) Quoting:   "Can we measure our wealth as the value of our portfolio? Hardly. Today, $1 million buys much less than it did 25 years ago. "Is wealth defined by the real value of our portfolio? Only if we plan to spend it all right away. "Is wealth the long-term spending that our portfolio can sustain--the annuity that our assets could procure? This definition is closer to the truth, but like the first, it ignores purchasing power. "Is wealth, then, the inflation-indexed real income that our assets could sustain over time? For most investors, this is probably the most useful definition of wealth."   But what assets should we invest in to get the best inflation-indexed returns? Stocks? Bonds? Commodities? And what about the risks of these various asset classes? In a very interesting study, Rob redefines risk not as volatility of the asset class in terms of price but in terms of real sustainable spending. And he defines returns as not just a simple return, but as the growth in the real spending stream that the portfolio can sustain.   It's all about cash flow, or about the cash flow an asset or business can maintain. Real estate can produce a stream of income. Stocks can produce dividends or can be sold and invested in an annuity. Bonds pay an income. Entrepreneurs strive to build a business income model that does not solely depend on their continual involvement. (If you can't walk away and the business still produce an income, or if you can't sell the business to someone for cash to invest, you have a job, not a sustainable business.)   As investors, what we are ultimately concerned with should be future streams of income or cash flow. We work to get our portfolios to grow faster than inflation, and to enough size to support our desired lifestyle. But Rob is suggesting that it is not the size of the portfolio, but the ability to produce a sustainable long-term lifestyle.   Normally we think of T-bills as being the most risk-free investment. When viewed in terms of sustainable spending, however, T-bills become riskier than TIPS (inflation-adjusted bonds) and/or a regular bond portfolio. Look at the chart below. It represents the sustainable spending risk-adjusted returns of various asset classes. The red line is drawn between T-bills and stock market returns (as represented by the S&P 500). This is the classic capital market line between the "risk-free" asset and risky stocks.   Surprise. What you find out is that almost all asset classes produce a return or alpha higher than does the classic capital market when your define risk in terms of sustainable spending.

 

This is the point I have tried to make so many times and in so many ways. When your ultimate objective is income, traditional investments are not ideal - far from it. That idea is a throw-back to the days when all investments by the individual were essentially risk capital.

 

That is no longer the case. It hasn't been the case for almost twenty years. Unfortunately, we have been slow to recognize that fact and it isn't until we see the outcome for the retiring Baby Boomers that this reality will hit home. By then, in my opinion, it will be regarded as obvious but too late for tens of millions of Baby Boomers who were erroneously taught to focus on accumulation and capital appreciation instead of cash flow.

The way to measure performance is not the growth in the account value but the growth rate of the cash flow produced by a portfolio. If that cash flow is sufficient to sustain a decent standard of living, and is growing faster than inflation, then and only then do you have the ability to enjoy a sustainable standard of living indefinitely into the future.

 

My thanks to Snider Investment Method™ alumni, Shel Travis, for giving me the heads up on the John Mauldin newsletter.

 

If anything in this post inspires you to agree, disagree or ask questions, please feel free. You can leave your comments below.

 

SOURCES:

 

1. John Mauldin, "The Return of the Muddle Through Economy," Thoughts From The Frontline Weekly Newsletter; 2 November 2006. (subscribe here)

http://www.frontlinethoughts.com/pdf/mwo110406.pdf

 

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Annuities: Fixed or Variable, Immediate or Deferred?

I began questioning how many people understand the difference between different types of annuities after I received an email this week from one of my Snider Investment Method™ Workshop graduates. Annuities come in a thousand different flavors and colors. No two are exactly alike.

 

I think most people lump them together without understanding the difference. Or maybe they just think I automatically think all annuities are bad. That is not true. I think MOST annuities are bad and the rest have very limited application.

 

Annuities are basically either fixed or variable and either immediate or deferred. Beyond that, the permutations become endless. That is one of their drawbacks. They are very complicated, almost impossible to compare apples to apples, and very few people understand what they are buying when they buy them. Nowhere in the investment world is buyer's remorse more prevalent, in my experience, than with buyers of annuities.

 

A fixed annuity is an insurance contract that promises you, or you and your spouse, a predetermined income for as long as you live--no matter how long that might be. For example, you pay the insurance company a lump sum of $100,000, say, and they promise you $3,000 to $6,000 a year for the rest of your life.

 

The advantage of a fixed annuity is that it provides you with a guaranteed cash flow indefinitely - provided, of course, the insurance company remains solvent. If you live a long time after buying the annuity, you may even receive more in payments than you put in. The second advantage is its consistency. You know exactly how much you are going to get. The amount does not fluctuate with market conditions or interest rates.

 

The downside is, when you die, the remainder of your initial payment belongs to the insurance company. Your heirs get nothing. Another disadvantage is that most fixed annuities are just that - fixed. The amount you receive each year remains constant so the purchasing power is eaten away, over time, by inflation. Finally, it is highly likely that even a conservative investor can get far better returns than the annuity.

 

When is a fixed annuity appropriate? The only time a fixed annuity makes sense to me is for an extremely risk-averse investor. An example would be someone who has almost no retirement savings, no other sources of income, and for whom the loss of even a single dollar would be catastrophic. Even then, the problem I have is you can do so much better with just a smidgeon of extra risk using CDs and bonds.

 

A variable annuity, on the other hand, is very different. The initial investment is invested in a range of investment options, usually mutual funds, called subaccounts. The amount of money you receive is, as the name implies, variable, and is based on the performance of the investments.

 

Variable annuities are generally reviled by all but those who sell them. The problems are legion and I won't go into them here. If you are interested, you can check out my previous posts on the subject, my interview with Gary Schatsky, chairman emeritus of the National Association of Financial Planners on the subject, or get a quick run down of the problem from two good articles here and here.

 

I never, ever, ever recommend a variable annuity. Bring on the angry email from the insurance salesmen. I don’t care. You can’t convince me otherwise.

 

The other characteristic of annuities is immediate versus deferred. An immediate annuity begins paying out immediately.

 

A deferred annuity has an accumulation phase and a payout phase. During the accumulation phase, you contribute to the annuity and hopefully give the principal time to grow. When you reach retirement age, you can elect to annuitize the principal, in which case you would begin receiving regular periodic payments, like a fixed annuity, or you can request a lump sum distribution.

 

While I admit there may be specific scenarios in which an annuity makes some sense, my general advice is, be they fixed or variable, immediate or deferred, annuities are an investment you can probably do without.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Mass Affluent Moving Into Cash

Rising yields and market volatility have caused many to re-consider holding larger positions in cash and cash equivalents. The mass affluent, those with investable assets of between $100,000 and $1 million, are increasingly moving to cash, according to a new HSBC Bank survey.

 

These numbers are somewhat surprising to me. The survey found more than a third of the mass affluent have greater than 20% of their portfolio cash. The average across all investors is only 12% cash. Both are much larger than I would have expected.

 

The reason this is surprising is I find there is a widespread belief among investors that cash is bad. When most people see cash laying around, they want to do one of two things with it: spend it or invest it in something that has the possibility of high returns and consequently, a bunch of risk.

 

I think the opposite is true. I really like cash and we hold a lot of it. We use it to reduce risk in our Snider Investment Method™ portfolios. We also hold back plenty of cash in case of emergencies and for normal household operating expenses. Finally, any money that we have been saving for a specific purpose and know we will need to spend in the next two years, we hold in short term, risk free vehicles like CDs and T-Bills.

 

But suddenly deciding to "move into cash" smacks of chasing the market, which is something I never do. I don't move money between asset classes because one now looks more attractive in relation to another. That is the herd mentatilty at work and accounts for the generally lousy investor performance documented by studies. This is a sure-fire way to end up buying high and selling low.

 

Instead, Jim and I decide on what outcome we are trying to achieve - for example, have the cash saved up to be able to buy a farm in South Carolina - then we decide how best to achieve it and then we execute on that plan. We don't change horses in mid-stream, ever. That would constitue reacting emotionally to external events which is a no-no in our investment philosophy.

 

We hold cash because we determined that we needed to - to control for one or more risks - not because of the return it can or cannot provide at the time.

 

I am curious how much cash you hold, why and how often you change your allocation? Take the short survey. Also, feel free to leave any additional comments below. They are welcome, as always.

 

 

SOURCE:

 

1. "Mass Affluent Moving Into Cash"; Financial Advisor; August 2006 p30

http://fa-mag.com/issues.php?id_content=2&idIssue=112&show=fronline

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

The Power of a Portfolio Paycheck

Suppose I buy a diversified portfolio of stocks hoping that over time they will increase in value so I can sell them. Until that happens, and I have consummated the sale, I have not made one thin dime. So, until that happens, I sit and I sweat. I worry about interest rates, the dollar, the economy, the possibility of terrorism. Everything is a potential boogie man lurking under the bed. No wonder investors are manic depressive!

 

Suppose instead I buy a portfolio that generates enough passive income, year after year, to pay all my bills and then some. Suddenly, interest rates, the dollar and geo-political events become much less scary because my standard of living is not at risk.

 

Now suppose we experience a ten year bear market. Both portfolios lose 80% of their value. The stock portfolio just sits there - dead - for ten years, doing nothing. It is not contributing to your well-being in any way. In fact, the opposite is true. You stress over it every day.

 

The income portfolio, on the other hand, is also down 80% in value but it continues to generate enough cash flow each year to pay all your bills, and then some. Which do you feel better about? Which causes the most anxiety? Which sounds like the better alternative for you and your family?

 

That is the power of a portfolio paycheck. It is the power to make your portfolio a source of comfort rather than a source of anxiety. It is the power to make work a choice rather than a necessity.

 

If an understanding of any two words has the power to change your financial situation, I believe it is income, or cash flow, versus capital appreciation. Let's recap:

 

Capital appreciation is when you buy something for a dollar and hope it goes up to two dollars so you can sell it to someone else. The difference between what you bought it for and what you sold it for is known as capital appreciation. An example of capital appreciation investing is buying a piece of land in hopes that its value increases and you can sell it to someone else for more.

 

Income, or cash flow investing, is when you buy something for its ability to generate passive cash flow. Income investing is the farmer who buys the land, never intending to sell it, but buys it instead for its ability to grow crop that can then be sold for cash, over and over again.

 

In the past, we have thought of income investing primarily in terms of real estate (rental properties), bonds (coupon payments) and dividend paying stocks. Today, there are many more ways to safely generate portfolio income with much higher yields than what were available in the past.

 

I believe one of the reasons most of us are so stressed out by our investments is we have been taught to focus on capital appreciation investments instead of cash flow investments. Capital appreciation focuses on a number to gauge success - either account value, return percentage, or both. Income investing is focused on outcomes - can I live comfortably without fear of running out of money?

 

One of the biggest disservices done to investors was brain-washing them to believe that income investing is only appropriate as you approach retirement. Income investing is not only appropriate at all ages, I believe it is essential. Here's why:

 

The biggest risk we face is not market risk. Our most valuable asset is what economists call our human capital. It is the skills and abilities we possess, which we trade in the form of employment, for money. Our biggest risk, therefore, is disability, losing our job or obsolescence.

 

There is no law that says you have to spend portfolio income. When you don't need the income, because you have a W-2 paycheck coming in, you re-invest the income to create growth. But what a portfolio paycheck does for you that capital appreciation portfolios can't, is it limits conversion risk.

 

Suppose you lose your job in your company's most recent lay-off. Imagine that you are approaching retirement age and so you are finding it difficult to get a new job because no one wants to invest in training you only to have you retire a few years from now.

 

The good news is that you have saved a lot of money over the years and have invested it in stocks. The bad news is the market recently declined 50%. In order to live off that money, you have to sell those stocks at a depressed price. Once you convert the assets, the lost value can never be regained. That is what I refer to as conversion risk.

 

Now imagine, instead, that you had a portfolio of income producing investments that generated enough income to pay all your bills. While you were working, you just re-invested the income to get growth. Again, you are laid off and again the value of your portfolio is down 50%. But now, there is no need to convert assets and lock in the losses. You simply divert the income to your checking account and use it to pay the bills, leaving the assets intact. This allows you to participate in the long term growth of the stock market, which we all know doesn't go up in a straight line, while at the same time protecting your standard of living.

 

Maybe, at that point, you decide to just hang it up and retire. You hadn't planned on it, but the point is, you can - because a portfolio paycheck makes work a choice, not a necessity. When you decide to finally move on to the next phase of your life, there is no stressful reorganization of your assets. You already have the means in place to harvest the wealth you created. Whether the S&P is at 1000 or 1500 is no longer a consideration when you are deciding when to retire.

 

Modern Portfolio Theory, the most widely accepted investment theory, was developed in the 1950s. These are not the 1950s. Our parents and grandparents lived in a very different world. They went to work for a company and stayed there until they retired and got the gold watch. Today's worker has changed jobs nine times by the age of 32! Pension? Social Security? Do you want to count on that? Not me!

 

Capital appreciation investing may have been appropriate when we our sources of income - both before retirement and after - were guaranteed. But today, if there is one thing I know to be true, there are no guarantees. That means it is up to you to create your source of permanent income that you can count on, both now, and in the future.

 

 

SOURCE:

 

1. Elaine Chou. "Working Together to Build the 21st Century Workforce" Speeches by Secretary Elaine Chou, Department of Labor website; 15 Nov 2002.

http://www.dol.gov/_sec/media/speeches/20021115_GHWB_Library.htm

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Wealth in America 2006

Americans are becoming more focused on preserving wealth. This seems to be particularly true for Americans who already have wealth to preserve - those we refer to as affluent or high net worth.

 

A study done for Northern Trust, titled "Wealth in America 2006," indicates 20% of investors with $1 million or more in investable assets are planning to increase the portion of their portfolio being held in cash. Those investors had an average of 13% of their assets in cash - much higher than traditional asset allocation models recommend. Another 15% was being held in bonds.

 

Interestingly, younger millionaires appear to be even more conservative. They were holding 19% of their portfolio in cash.

 

More than two-thirds of respondents said their focus was on preserving capital rather than growing it further this year. The federal budget deficit, energy prices, terrorism, rising inflation and deteriorating U.S. foreign relations were all factors cited in pessimistic outlook. Participants' expectations for market returns this year were 6%. It should be noted this study was completed in November 2005, well before the recent market declines.

 

Other interesting findings: 68% think real estate is overvalued and 21% manage their own investments. Investors over the age of 75 are far more likely to be assisted by an advisor than their younger counter-parts and men are far more likely to manage their own portfolios than women.

 

Only 30% of high net worth baby boomers are already retired. 40% plan to retire in the next ten years and 27% say it will be more than ten years for them.

 

SOURCES:

 

Nothern Trust. "Wealth in America 2006,"

http://www-ac.northerntrust.com/content/media/attachment/data/white_paper/0602/document/wealth_america2006.pdf

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Does the Snider Investment Method Buy and Hope?

I discussed what I call the Buy and Hope strategy in a post dated June 28, 2006. A number of people, including some practitioners of the Snider Investment Method™ left comments asking if the Snider Method didn't also rely on buy and hope. I started to post my reply as a comment but it got so long I decided I'd just put it up as its own post. So here goes …The Snider Method doesn't rely on hope - not in my mind - although some people may do it anyway.

 

I don't have to hope because I don't care what the stock price does. The reason I don't care what the stock price does is I am an income investor. I would be willing to hold any of my Snider Investment Method positions forever because I created them for the express purpose of generating a consistent income over very long periods of time regardless of what the stock price of the underlying asset does.

 

Many people can never let go of the concept of account value. That's fine. It's their money so they are entitled to think about it in any way they want.

 

For me, my account value is an irrelevant concept. I never look at it and I never worry about it. I only care about the standard of living my portfolio can sustain. You don't measure standard of living using account value - you measure it by income generated.

 

Every dollar of income that can be generated indefinitely out into the future is the equivalent of a dollar of income I would otherwise have to make by working. My goal is to make sure I always have enough passive income that I never have to work. So long as I am meeting that goal, the only person who cares about my account value is my heirs and I am thinking my heirs care a lot more about my dignity when I am living (and not having to take care of me) than they do about the amount I leave them when I die.

 

Steve mentioned winters in his post. Winter, in the Snider Method, is a month in which a Snider Method position does not generate any income. I know most people view winters as bad. I don't. Winters were designed into the system and are included in our historical return numbers.

 

The problem with winters, of course, is as soon as you enter one you are convinced that spring will never come. That feeling is compounded if you get multiple positions in winter at the same time - which happens. My grandmother used to say, "Nothing is impossible, just highly improbable." Our experience over the years is no matter how bad they feel, positions generally come out of winter within a few months - though not always.

 

Sure, we could have designed the Snider Method so we didn't have winters. That would mean there would be no risk. No risk means low return. There are already no-risk investments - CD's and Treasuries, for example. That wasn't our objective. We are willing to take an acceptable amount of risk for an acceptable amount of return. That is, for us, a standard deviation of 6% for a yield of 13% annually. Others may or may not find this risk reward trade off appealing.

 

You have to remember the Snider Investment Method is not a short term trading strategy. It is a long term investment strategy. It is absolutely self-destructive to look at the returns of any investment from month to month. The question you must ask is, "Is this investment meeting my needs and objectives over my given time horizon?" If your time horizon is a month, six months, or even a year - you are in the wrong vehicle.

 

The Snider Method is nothing more than a substitute for bonds in your portfolio. The Snider Method creates a portfolio of synthetic bonds, which in the aggregate, have about the same level of risk as investment grade corporates and act similarly.

 

My own personal philosophy, as I have stated many times, is that I will not put my own money at risk in stocks. I think they are too risky given that each of us must now create a portfolio capable of sustaining an acceptable standard of living for 30+ years. I have also said, as a result of that philosophy, that my own money is only invested in CD's, money markets, and bonds. I, of course, include the Snider Method in the bond category as it is a terrific alternative to traditional bonds because the yield is so much higher for the same level of risk and shorter duration.

 

Accordingly, my family and I have the vast majority of our investable assets in the Snider Investment Method. Where else would we put it given that approach to investing? That doesn't mean you will, or even should. That is a decision you have to make given your tolerance for risk versus return and your temperament.

 

The best way to understand the liquidity issue, I think, is to think of a Snider Method portfolio as what it is - a portfolio of laddered, synthetic, investment grade corporate bonds. By laddered, I mean the bonds in your portfolio are of varying durations. Some of them "mature" after only a month. Many will go as long as two years. The infamous Checkfree position we dissect in the workshop took four years and one month to close. The average duration of a Snider Method position over time has been about six months - but that is just an average.

 

The Snider method is definitely not highly liquid - any more or less than a traditional bond portfolio is. We tell everyone not to put any money in the Snider Method that you aren't willing to leave the principal invested for at least two years. The income you can scrape off monthly but there is a liquidity risk, which we discuss in great detail in both the workshop and our free information sessions.

 

So to Steve's second post: We agree totally. You should always have an emergency fund of cash set aside for emergencies. Everyone should have six months' to a year's worth of bills set aside in liquid cash equivalents before you invest in anything - your 401(k), stocks, bonds or the Snider Method. Otherwise, you are robbing Peter to pay Paul. To invest before you have your basic needs covered is crazy.

 

So we assume you do have cash reserves. Given that, my personal philosophy is that your nest egg is sacrosanct - no matter what happens, you never, ever, rob your retirement funds to cover short term cash flow problems.

 

If circumstances are such that you have run through your emergency funds then it is my belief you have to do whatever you would do if you had saved nothing for your retirement. In my mind, it is as if the principal in your retirement doesn't exist.

 

I do have one caveat: If your retirement funds are producing income, like the Snider Method does, I think it is not only OK to use the income if you have to, but it is in fact one of the reasons I advocate becoming an income investor early in life. But robbing principal? Never.

 

That is the easy way out and years from now you will wish you hadn't. You can never recover the gift of time in the market. No matter how you rationalize it, you'll never catch back up. You are robbing money from a period in your life when you will have no earning power during a period in which you do - even if that means flipping hamburgers at McDonalds or picking up cans by the side of the road.

 

So, as far as I am concerned it is as if that money doesn't exist. From that mindset, which is the way I look at it, the liquidity issue becomes a non-issue because no matter what, I am never going to cash out a Snider Method position for any reason. Any money Jim and I know we will need later, we plan for and systematically remove from our Snider Method portfolio well in advance of needing it.

 

I think the main point is this - no investment is perfect. All have pros and cons, including the Snider Method. Every investor, and every investor's situation is different. It is up to you to develop a coherent philosophy that makes sense to you. Mine may or may not work for you - it does work well for me but that's because I am me. Your job is to be as rational and realistic about the future as possible, plan accordingly and then employ the tools that make the most sense to you in order to actualize your plan.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.