Myths and Misconceptions about Exchange Traded Options

There are a variety of long-standing myths about options that need to be dispelled. The most widely held are: 1) options are too risky; 2) they're too complicated or you're not smart enough to use them; 3) you cannot use options inside of an IRA account; and 4) options on General Electric, for example, are no different than the exotic, highly esoteric derivatives that caused the current financial crisis.

And of course, many financial advisors have done nothing to dispel these myths. In fact, to a large degree, they have willingly helped to perpetuate them.

Misconception: Options are risky.

Risk is just the probability of an unfavorable outcome. Everyone has a threshold at which that probability becomes unacceptable. This is known as "risk tolerance." Old thinking says buying and selling options is a high risk strategy. That reputation has always frustrated me - mainly because it is completely false. Granted, with more risk comes greater reward, but it is possible to manage the tradeoff between the two.

By their nature, options are not risky. Buying and selling an options contract is mathematically a zero sum game. There is one winner and one loser on each side of any one option contract. When the buyer wins a dollar, the seller loses a dollar and vice versa. So, by definition, options are not inherently risky. They are a tool - a means to an end. Nothing more.

Think about the hammer in your toolbox. It is not dangerous in and of itself. But, if used carelessly, it could do real harm. Ask anyone who has smashed the dickens out of his thumb. But you don't hear public service announcements warning you away from using hammers because they might hurt your thumb.

So, back to options. If risk is not inherent in options, why all the bad press? The problem lies in the way people are taught to use them. Options can be risky when used to place a bet on the future direction of stock price. You might just as well pile your money up in the front yard, pour gasoline all over it and strike a match. Because you are placing a bet - a highly leveraged bet, no less - on a totally random event. Would you take your life savings to a Las Vegas roulette wheel and plunk it all down on black? What do you think will happen?

It is a travesty that so many sensible investors have been suckered into crap seminars that teach you how to use options ... to lose your money. It's just wrong - and that is why the myth, that options are risky, still persists. But it is absurd to say options are risky. It is using them incorrectly - like grabbing a knife by the sharp end - that makes them risky.

Lesson One: Options are not inherently risky or safe, any more than credit cards are inherently evil. It is how you use them that makes them one or the other.

The preceding is an excerpt from my newest special report: "A Surprising Solution for Creating Sustainable Retirement Income." You can download the full report for all five of the widely-held myths about options. Please share it with anyone you think would benefit from the information.

If reading isn't your thing, but you really want to learn more about how to solve your biggest investment worries -- whether you're in the Dallas Fort Worth area or not -- I encourage you to attend one of my upcoming Investor Briefings in January. (They are FREE! And offered both live and online.) I will discuss current trends standing between you and financial freedom and offer up solutions to your specific challenges. Register now.

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All investments involve risk including possible loss of principal. Please see our Owner's Manual for a complete discussion. More information can be found on our website or by calling 1-866-9SNIDER.

We don't have enough time to buy and hold

Market commentator and analyst Barry Ritholtz has recently posted on his blog about the big divide between the pundits and the public over the state of our economy. Or, as he puts it, “the disconnect between reality and the Pervasive Pollyannas of Prosperity.” Most of the analysts you see on CNBC, he says, are touting the strength of the economy, or at least its potential to turn around soon. The public, he says, sees the situation very differently – they’re expecting more rough seas ahead.

Barry says the pundits have just gotten ridiculous:

How absurd has the Panglossian cheerleading become? On my pal Larry Kudlow's show last night, several of Candide's descendants talked about how great stocks are if you hold them for 30 years. That's right, the holding period for equities according to this crowd is three decades. Of course, this means every pullback is a buying opportunity. Words such as these can only be spoken by someone who has never worked on a trading desk or managed assets professionally -- or if they did, they lost most of their clients' money.

Barry illustrates very clearly here the problem with the strategy of buy-and-hold. It’s true that the U.S. stock market has returned on average 10-12% annually over long periods of time. To take advantage of the long-term growth, you’d need to buy when the market is down. To a buy-and-hold investor, the current market downturn is a perfect buying opportunity.

But investing isn't just about knowing when to buy. The problem with buy-and-hold isn’t the “buy” part. It’s the “hold.” To get the long-term 10-12% return, you potentially have to hold for a really, really long time.

The Wall Street Journal is calling this “The Lost Decade.” From Dec. 31, 1999 to December 31, 2007, the return of the U.S. stock market was practically zero (1469.25 in 1999; 1468.36 in 2007). Here we are in the middle of 2008, and the S&P is below 1300. For us to get back to the 10-12% average, we would have to experience a very long period of above-average returns. The question is, how long? Nobody knows. It could take 10, 20 years or longer. History tells us there have been 20-year periods in the past where the average return of the stock market was less than 2%.

If you’re in your 50s, your retirement time horizon may be 40 years (10 years pre-retirement; 30 years in retirement). 20 years is a long time to wait for the market to even itself out.

That’s why buy and hold doesn’t work for most of us. We don’t have time for it!

This is precisely why I am a cash-flow investor. My goal is to exchange the long-term 10-12% annual returns of the stock market for something more tangible in the short-term. If I focus on generating cash in the short run, the ups and downs of the market over time don't tend to bother me as much.

I admit, investing in the stock market this way is a bit of a paradigm shift. You have to think of your stocks not as an appreciating asset, but as a means to an end. Once you view your stocks this way, it’s a little easier to endure the market slowdowns. 

SOURCES:

1. Ritholtz, Barry. "Persuasive Pollyannas of Prosperity," The Big Picture, 02 July 2008. http://bigpicture.typepad.com/comments/2008/07/more-on-the-pub.html

2. Browning, E.S. "Stocks Tarnished By 'Lost Decade'," The Wall Street Journal. (accessed 02 July 2008)

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Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, 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 and how to stop enriching your investment advisors at your expense, 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. Click here for performance statistics of the Snider Investment Method and a discussion of yield vs. total return.

Can You Have Too Much Home Equity?

The conventional wisdom used to be: Pay off your mortgage as soon as you can. Retire with a paid for home. Some personal finance writers still believe that. I used to believe it too, but not any more.

 

No debt is as bad as too much debt. I used to be a zero-debt advocate, but now I think zero debt can create a diversification and liquidity problem. If I have too much of my net worth tied up in home equity, I am very sensitive to falling real estate prices, and I am going to find it very difficult to tap my equity if I need it.

 

The problem with home equity is that the more I need it, the harder it is to get to. What lender, for instance, is going to give me a home equity loan when I have just lost my job? What kind of bargaining power do I have in the sale of my home if a loved one is sick and needs hugely expensive out-of-pocket medical treatment?

 

In response to my previous posts on this topic, some have suggested that taking out a home equity line of credit (HELOC) and letting it sit there unused is the answer to freeing up the equity in your home in case you ever need it. Sunday's New York Times shows us why that is not necessarily the solution.

 

Apparently, lenders across the country are freezing HELOCs across the country, even if you have a perfect credit score. In the last month, lenders have sent hundreds of thousands of letters to consumers telling them those home equity lines of credit they paid money to secure, can no longer be tapped.

 

Most of us think of diversification in terms of asset classes. You also have to think in terms of diversifying liquidity. On the liquidity continuum, cash is obviously most liquid. Businesses and limited partnerships are probably least liquid. In between you have a broad range.

 

Having an emergency fund is key. I believe in at least a six month supply of cash on hand. Next comes cash flow. Interest, dividends, option premium, rent, and royalty payments are all forms of short term liquidity. After that are items that can be readily bought and sold in efficient markets. This would include stocks, bonds, options and futures. From there, liquidity becomes murkier.

 

Some investments have lock-up periods in which you cannot sell them or you will pay a big penalty to sell them. Others, like real estate, can be easy to sell at times, but almost impossible to sell at others. The more complex the asset, likely the less liquid it will be.

 

It is helpful to consider that most companies don't go bankrupt because they lose money, they go bankrupt because they don't have sufficient liquidity to meet their daily obligations. Think of Bear Sterns.

 

The same is true of individuals. Most individuals who file for bankruptcy have jobs and assets. It is just that their cash inflows don't properly match up to their cash outflows. When this happens, you have a liquidity problem.

 

Your job, as family CFO, is to structure your assets so that no matter what happens, your cash inflows match up to your cash outflows. In on other words, liquidity has to be a primary consideration.

 

As a general rule, I like to think of liquidity as being inverse to assets. The less resources you have, the more liquid you need to be. As your assets increase, you can afford to put more and more of them in less liquid assets.

 

If you haven't already, sit down and list out your assets. Stack rank them from most liquid to least liquid. Then ask my favorite question … "What if?" Ask yourself, what if I had no income coming in for two months? Where would the money come from? What about six months? A year? Two years? What if I was permanently disabled? What if I was sued or someone in my family became ill?

 

Asking these questions forces you to examine your resources in terms of liquidity. If you don't like the answers you come up with, it might be time to restructure your assets or get going on augmenting your savings.

 

SOURCES:

 

1. Morgenson, Gretchen, “You Thought You Had an Equity Line.” New York Times, April 13, 2008 http://www.nytimes.com/2008/04/13/business/13gret.html?_r=1&oref=slogin (accessed April 15, 2008,).

 

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Kim Snider is the President and Founder of Snider Advisors, a SEC Registered Investment Advisor, 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 and how to stop enriching your investment advisors at your expense, 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 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, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

 

Know Your Greatest Risk

What is your most valuable asset? Your business? Your house? Your investment portfolio? The pile of gold buried in your backyard? What would you guess?

 

If you guessed anything tangible, you guessed wrong. Your most valuable asset is what economists call your human capital. This is the sum total of the skills knowledge and wisdom you possess which you then trade with your employer or your customers for money.

 

When you are young, human capital represents the lion share of your total wealth. As you age and begin to accumulate other assets, human capital becomes a smaller proportion but still is your largest asset.

 

If that is so, and economists tell us it is, then your biggest risk is not being sued if someone slips and falls in your driveway, a protracted bear market or the cost of long-term healthcare. Your biggest risk is disability or obsolescence. Both have the potential to seriously disrupt your income.

 

Think of it. As long as my income stream keeps flowing, I can get through almost everything else. Suppose someone does slip and fall in my driveway. They sue me and the court awards them millions of dollars. I may file for bankruptcy but the court will allow me to keep enough of my income to keep a roof over my head and feed and clothe my family.

 

Imagine we experience a depression which takes thirty years for stock prices to recover from. As long as I don’t lose my job and I can still work, I can still eat. Imagine I work in a family business that continues to pay me long after I have become old and feeble. Long term healthcare is not a problem.

 

I am not saying life would be champagne and caviar. I am just saying it would be better than the alternative. A steady income solves many problems. Loss of one can wreak havoc.

 

Disability

 

We have two choices when it comes to risk. We can either hedge it or insure it. Insuring a risk is almost always more costly than hedging it because the intermediaries, namely insurance companies, have to make a profit over and above the cost of the hedge.

 

We can insure the risk of disability by purchasing disability insurance. Some employers offer disability insurance as an employee benefit. Disability policies can be either short term or long term.

 

Short term disability policies pay you a percentage of your salary if you are temporarily unable to work because of injury or illness. A typical policy will you anywhere from 50% to 65% of your pay for anywhere from two weeks to two years, depending on the policy you purchase. A period of 13 to 26 weeks is more common and then long-term disability kicks in if you have it.

 

Long-term disability replaces income for a much longer period of time. Policies usually limit benefits to five years or age 65, whichever comes first.

 

Of course, being the optimists that we are, no one likes to think about what happens if disaster strikes. But the question asked by a Family CFO most often has to be, “What if?”

 

Data from the American Council of Life Insurers tells us one in seven will experience a disability lasting more than five years. The odds increase to one in five for those of us between the ages of 35 and 65.28 It turns out the leading cause of disabilities is not freak accidents, as many people think, but instead is caused by devastating illnesses such as cancer or heart disease. The long-term loss of income is so disruptive that 46% of home foreclosures are due to medical disability.

 

Obsolescence

 

You cannot insure against obsolescence but you can hedge against the risk. How? By making constant upgrades to the software between your ears. The best hedge against being replaced by a 23 year old whiz kid is lifelong learning.

 

	Those who do not read are no better off than those who cannot.€ ~Proverb

 

Lifelong learning need not be formal to be effective. I had the pleasure of interviewing Dr. Benoit Mandlebrot for my radio show several years ago. Dr. Mandlebrot is a mathematician who is best known as the father of fractal geometry. Fractal geometry is what makes the stunning reality of modern day computer animation possible.

 

Dr. Mandlebrot'€™s accomplishments are unique in that he has been awarded major prizes not just in mathematics but also in physics, medicine, science and technology. His concepts have also been applied to economics, earth sciences and linguistics.

 

Dr. Mandlebrot credits his ability to think outside the traditional confines of a single branch of science to his unconventional education. He said in one interview, "€œTo tell the truth, and not to sound pretentious, but circumstances prevented me from acquiring a real college or university education in the traditional sense, so I am primarily self taught."

 

Passive income

 

Disability and obsolescence can both be hedged by building a portfolio which produces enough passive income to pay all the bills, as described in chapter 14. When passive income equals or exceeds day-to-day living expenses, work is no longer a necessity, it is a choice.

 

For my husband Jim and I, we use a combination of passive income and disability insurance to hedge our risk. Because I am the public face of our company, if I were to become disabled, our business would be seriously impacted. But we still have employees and bills to pay.

 

We have a disability policy on me which specifically covers the overhead of the business in the event I am disabled. We rely on the passive income from our investments to replace our income from the business.

 

Longevity

 

Americans' increasing longevity can be an economic blessing or a curse. Provided we remain healthy, increased longevity increases our human capital. If our mental and physical health declines as we age, our human capital is diminished.

 

Thus, there is one other thing you can do to increase your odds of financial success and it has nothing to do with saving or investing. Take care of your body and your mind. Quit smoking, eat right and exercise. These are as much a part of achieving lasting financial success as a sound investment strategy.

 

The preceding is an excerpt from Kim Snider's yet-to-be published - but getting closer book, "The Family CFO's Guide to Financial Success." This book should be available in bookstores everywhere (don't you agree?), but isn't - until Kim stops procrastinating on the second draft!

 

Kim Snider, Kim Snider Financial Communications 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.

Options Find a Place in Retirement Accounts

The traditional view of options can best be summed up in one word - risky. That has always frustrated me, mainly because it is such a persistent myth. Options can be risky, particularly when they are used to place a bet on the future direction of price. If that's what you want to do, why don't you just go to Las Vegas?

 

Increasingly though, options are being used in the way I believe they ought to be used, which is to manage risk and create portfolio income. Even more specifically, they are being used to generate portfolio income for retirement portfolios.

 

Charles Schwab did a survey of some of its options customers and were pleasantly surprised to find most of them were using options in this very conservative way. The Wall Street Journal reports:

 

The survey showed that 61% of them consider themselves to be risk takers, but only 40% think there are more gains to be made with options than with stocks and bonds, and only 31% agree that they like trying to outsmart the market with their option trades.

 

Instead, a far higher number -- 69% -- consider option trading "a great way to generate income" and perhaps most interestingly 56% say option trading is part of their retirement investment strategy.

 

That last figure is particularly interesting to Randy Frederick, director of derivatives at Charles Schwab. It wasn't long ago that option trading wasn't considered appropriate for retirement, he notes.

 

I have also noticed a trend toward much more widespread understanding and acceptance of options. In my talks I always ask how many people in the room are familiar with options. Back in 2001, I'd say only about 10% - 20% raised their hands. Today it is well over half. And they don't express nearly the amount of fear and trepidation about using them they once did. Most people now realize they are pretty mainstream and want to learn more.

 

"I can't teach you how to get rich quickly trading options," he hammers home to customers, Mr. Frederick said, but, "I can teach you how to protect what you have and get rich slowly."

 

That is really the key. Professionals know options are just a tool for achieving certain objectives. Getting rich quick isn't one of them. Highly leveraged, speculative bets using options almost never work out. But using options to manage risk and create portfolio income almost always does.

 

I'd like to thank Professor Frank Anderson, from UT-Dallas, for sending me the heads up on this article and I'd like you to weigh in with your thoughts. As always, you can leave your comments below.

 

SOURCE:

 

1. Mohammed Hadi, "Options Find Favor With Investors Seeking Strategies for Retirement." Wall Street Journal 3 Jan 2007; C2. (registration required)

http://online.wsj.com/article/SB116778575233765465-search.html

 

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.

 

Hedging Your Biggest Risks

Our paycheck protects us against all sorts of risks. You are in a much better position to absorb unexpected bills, divorce, a lawsuit, or a 20 year bear market when you are employed and have a steady and dependable source of income. A paycheck also hedges you against inflation. Typically, your W-2 income will rise over time to account for increases in the cost of living.

 

Our biggest financial risk is not losing assets or market value. It is losing our source of income.

 

According to a paper published by the Center for Retirement Research, more than three-quarters of adults age 51 to 61 experience financial shocks over a 10-year period. They include widowhood, divorce, job layoffs, health problems, or the onset of frailty among parents or in- laws. Health problems and layoffs dominate at this age. They also find the incidence of financially disruptive events increases with age.

 

If our biggest risk is losing our paycheck and the safety net it provides, how do we hedge or insure against that risk? We build an investment portfolio that generates a steady and consistent source of cash flow. The goal has to be to generate enough inflation-indexed income to replace our W-2 income at a moments notice.

 

Investing solely for growth is not adequate to insure against these risks. Paper gains are fleeting. Assets that must be sold are too risky. And contrary to conventional wisdom, stocks are not a good hedge against inflation.

 

When do we lose our job? When the market and the economy are booming? No. The more likely scenario is we lose our job when the economy is slow, profits are being squeezed and stock prices are down.

 

I believe the job of our portfolio is 1) to protect us against financial risk; and 2) to create wealth. These two things are not mutually exclusive. If you accept my definition of wealth, which is the ability to maintain a certain standard of living indefinitely over time, then wealth is not measured by the number at the top of your statement. It is instead, measured by the inflation-indexed income your portfolio can generate.

 

It is my deeply-held belief that your focus should not be on how to grow your portfolio, although that is certainly a by-product of income re-invested. Rather, "How do I create MORE sustainable, inflation protected income?"

 

What do you think? What is your definition of wealth? Has it changed as you approach retirement? Does the ability to maintain an agreeable standard of living indefinitely without worry make sense to you as a definition of wealth? Leave your thoughts and comments below.

 

SOURCE:

 

1. Richard W. Johnson, Gordon B.T. Mermin, and Cori E. Uccello. "When the Nest Egg Cracks: Financial Consequences of Health Problems, Marital Status Changes, and Job Layoffs at Older Ages" Working Paper Center for Retirement Research at Boston College, Number 18; Released December, 2005.

http://www.bc.edu/centers/crr/papers/wp_2005-18.html

 

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 is well with the world right?

The Dow and S&P 500 continue their push into loftier heights. Your portfolio is going up in value. So, all must be right with the world, right?

 

Well, not so fast.

 

Investors are notorious for focusing on the narrowest of time frames -- today, this week, this month, even this year. But you simply cannot look at it like that. To make decisions based on a slice in time is what causes the performance of individual investors to be so lousy, as is well-documented.

 

In keeping with our recent dead money theme, let's look at the bigger picture. The Dow may be making new highs, but I’ll bet you dollars to doughnuts your portfolio isn't. Take out your contributions since 2001 and add back your distributions. See where you are? Chances are it isn't an all-time new high.

 

You have been sitting on dead money all this time. You haven't earned a single penny in over five years. And you think the new highs in the Dow and S&P are cause for celebration? I think they are an opportunity to cash out of something that hasn't worked for you and get in to something that makes more sense, like cash flow investing.

 

It is clear market timing, stock picking and even buy and hold have some fundamental flaws in a world where we often need to tap our investments because we lost our job, became disabled, or want to quit working and must fund 30 years of retirement. Cash flow investing gives you the best of both worlds -- income to act as a safety net and long-term participation in stock market gains.

 

The key to making money is buying when everyone else is selling and sell when everyone else is buying. Right now, everyone else is buying. What are you going to do?

 

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.

 

What is dead money?

Dead money is money that is earning its owner nothing. Examples of dead money include:

 

1. Money buried in your backyard or stuffed under your mattress

2. Equity in your home

3. Money invested in an asset that is under water and produces no cash flow

 

The opposite of dead money is money that is actively working. Examples include:

 

1. Interest bearing investments - CDs, money market funds, bonds

2. Cash flow investments - rental properties, dividend stocks, REITs, royalty trusts, etc.

3. Money invested in an asset worth more than you paid for it and still rising

 

I believe a fundamental rule of managing money is to avoid dead money like the plague. Your money is a tool. It has to work for you every single day. In this day and age, it has to work harder than ever because you face more risks than ever before.

 

Look at the first list up above. The old way of thinking about money encourages dead money.

 

The old way of thinking says to buy a house and put as much money down as possible. Make extra mortgage payments if you can. Get your mortgage paid off before you retire.

 

Today's reality is you cannot afford to have hundreds of thousands of dollars tied up in a mortgage. You are very likely going to need that money at some point along the way. Mortgages, home equity lines of credit and reverse mortgages have to be used as a strategic tool for financial planning today.

 

The old way of thinking says buy and hold. Stock prices go up over the long run.

 

But what about the short run? The new highs in the Dow notwithstanding, money invested in stock has been dead as a doorknob since 2001. It may still be dead. Dollars to doughnuts says if you remove any contributions you have made in the interim and add back any distributions, your portfolio value is less than it was.

 

Sorry to burst your bubble, but it's true.

 

The new way of thinking says losses in market value are unavoidable. Markets are cyclical and can't be timed. Cash flow is king. The only way to make money work consistently in the short run is for it to generate cash flow.

 

As long as I have sufficient cash flow, I can afford to hold for the long run because in the short run I have the income to deal with the unexpected without selling assets while they are down.

 

Many smart people believe these market highs are very temporary. They predict a recession is approaching. A lot of other really smart people say this is just the beginning of a new period of prosperity. I am just smart enough to know none of them know for sure. Flip a coin. It could go either way.

 

I always ask "what if?" I think a family CFO must plan for the unexpected. The way you do that is by asking "what if?"

 

What if I became ill and couldn't work. What if I lost my job or my business went under? What if housing prices fall - a lot? What if I can't flip this real estate investment I bought? What if 2007 is the start of another recession? What if the market loses 35% of its value over the next few years and takes another five to get back to current levels?

 

What if? And then -- what next?

 

The time to buy is when everyone else is selling and the time to sell is when everyone else is buying, not the other way around. These new highs are an opportunity to cash out and move to investments that will work for you even if "what if" happens. The key is to always plan so that no matter what happens, you'll still be OK.

 

Agree? Disagree? Leave your comments below.

 

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.

11-1-2006 - Items of Interest to Family CFOs

Saving and Budgeting

 

Money Magazine gives us 25 Rules To Grow Rich By. These cover the gamut -- from what remodeling will give you the biggest return when you sell your house, to how much company stock you should hold, to extended warranties. Each has its own calculator or resource box to go with it. While I don't agree with every one of them, they are good food for thought. (CNNMoney)

 

The Economy

 

The AP reports the median new home price fell 9.7 percent in September -- the largest amount in 35 years. That doesn't mean they fell everywhere, of course. The median is the midpoint. Half sell for more and half sell for less. Some areas, particularly those that have been hot in recent years, are harder hit than others. (Yahoo Finance)

 

Here is some more information, courtesy of Barry Barnitz, about falling home prices. "For two years running the S&P/Case-Shiller Home Price Composite Index has steadily shown tapering annual returns from its peak in July 2004. Not only do we continue to see shrinking gains but actual declines in most cities." (Financial Page)

 

The Wall Street Journal suggests the Goldilocks Economic scenario being suggested by many just got eaten. Eight days ago, the markets were pricing in a pretty rosy scenario. A slew of reports has (including the two above) changed all that. "It's prodded [the market] further into saying a slowdown of some magnitude is coming," says Mr. Ader. "People are thinking about a harder landing than they thought about two weeks ago." (The Big Picture)

 

Investing And Retirement

 

The vast majority of homeowners with adjustable-rate mortgages are worried their interest rates will rise, according to a Wells Fargo & Co. survey. But more than half think they'll be able to avoid a painful rise in their monthly payments by refinancing before things get too bad. 72 percent of homeowners said their home equity was their most important investment. That makes falling home prices and rising interest rates a bigger concern than ever before. (AP in Yahoo! Finance)

 

New numbers from S&P confirm what academics preach all the time: indexing continues to beat stock picking and market timing. Over the five years through the end of the third quarter only 29.1 percent of large-cap funds beat the S.& P. 500. 16.4 percent of mid-cap funds beat the S.& P. 400 index of mid-cap stocks, and 19.5 percent of small-cap funds beat their benchmark, the S.& P. 600 index of small-company shares. (New York Times, The Big Picture and Barry Barnitz)

 

John Markese, president of The American Association of Individual Investors, was interviewed by MarketWatch about creating portfolio income for retirement. He discusses maximum sustainable rates of withdrawal, a major shortcoming in my opinion, of the traditional asset allocation model. (MarketWatch)

 

Thoughts on any of these? Feel free to leave your comments below.

 

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.