The role of luck in a financially secure retirement

A new type of mutual fund was introduced in late 2007 by the fund industry called managed-payout funds. The goal of these funds is to give retirees a steady stream of income. At the time, they were touted as being an easy way for investors to get regular income payouts, professional money management and relatively low fees. Early players in the managed-payout fund arena were Fidelity, Vanguard, John Hancock, and Charles Schwab.
 
These funds demonstrate something known as the “sequencing of return problem” for retirees. If a retiree experiences losses early in their retirement, principal is quickly depleted and the amount of time until the retirement portfolio runs out of money is reduced.
 
Like the new retiree, these funds are being decimated by the stock market plunge. Right out of the gate, these funds are unable to meet their obligations to retirees and are basically returning principal.
 
"The plight of managed payout funds dramatizes boldly, what can happen to investors if they experience a serious market downturn early on, when they are starting to draw down their payments in retirement," said Dan Culloton, a fund analyst at Morningstar.
 
The Sequencing of Return Problem
 
When you are in growth mode, sequence of returns doesn't matter. Regardless of whether a portfolio experiences weak or strong returns early on, the ending market value will be the same.
 
Let's look at an example:
 
Assume we have two portfolios, X and Y. Each starts with $500,000. Neither is taking withdrawals. Portfolio X experiences early losses. Portfolio Y experiences early gains. As you can see from the chart below, there is no difference in the ending value.

This is not the case once you begin taking distributions. As you can see from the chart below, Portfolio X experiences losses early on and runs out of money in less than 20 years. Portfolio Y has strong early returns and is still going strong at age 100.

Even though both averaged 6.5% return, the difference in the two outcomes is massive!

This demonstrates the tragic flaw in a traditional capital appreciation portfolio when your investment objective is income replacement. There is just too much dependence on luck. You are basically betting on a random sequence of numbers over 30 years and the consequences if your bet doesn’t pay off, are catastrophic.
 
How cash flow solves the sequencing of return problem
 
Capital appreciation is when you buy something in hopes it will go up in price. When it does, you sell it for more than you paid for it, and the profit is called capital appreciation.
 
Cash flow is money that comes to you while you still own the asset. Examples of cash flow would be rent, royalties, interest, dividends, and option premiums. The key characteristic of cash flow is that you do not have to sell the asset in order to make money.
 
Another important characteristic of cash flow investments is cash flow is typically tied to the amount invested rather than the market value. Take a bond, for example. The yield is a percentage of the face value. A $1000 bond paying 6% will pay $60 in cash flow whether the bond is worth $900 or $1100.
 
Cash flow is the blindingly obvious solution to the sequencing of returns problem, among others. Imagine your monthly expenses are $9000 a month and your portfolio generates $12,000 a month in cash flow. So long as the $12,000 is not connected to the market value of the portfolio, the sequencing of return problem goes away. Your portfolio withdrawals would be unaffected by the sequence of return.
 
Why does Wall Street continue to try to shove the same old square pegs in increasingly round holes, as evidenced by the dismal failure of the managed payout funds? As Robert Frey, an adviser in Bozeman Montana, says, "These funds are dogs." It's time for the capital appreciation model to be put out of its misery.
 
SOURCE:
 
    1. Funds Featuring Managed Payouts Off To Rocky Start. (2009, February 11). InvestmentNews. Retrieved from http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20090201/REG/302019983/1030/MUTUALFUNDS.

No statement in this article should be construed as a recommendation to buy or sell a security or to provide investment advice unless specifically stated as such.  All investments involve risk including possible loss of principal.  Complete information can be found on our website or by calling 1-888-6SNIDER. Some information for this article has been gathered from external sources.  We believe they are reliable, but Kim Snider and Snider Advisors assume no responsibility for the accuracy of this information.

The mother of all reverse compounding problems

The only proven way to achieve a passive double-digit yield to replace your income is to own businesses – either directly or indirectly through common stock ownership. But this creates a challenge.

The chart [at left] shows each of the bear market declines since the end of World War One. We are in the tenth decade and there have been twenty bear market drops of 20% or more –about one every five years. If you want to get even more specific, it is about sixteen months out of every sixty that we spend in bear markets. Of the twenty bear markets since WWI, eight of them have had a drop of more than 40% in the S&P.

It is absolutely true stocks go up over the long run. But your time horizon isn’t the long run when your objective is income replacement. You have bills to pay each and every month. When you are living off your portfolio, in order to pay those bills each month, you must sell some of the stocks and bonds in the portfolio. Based on historical market data, those sales will be at a loss a large percentage of the time. These regular losses create the mother of all reverse compounding problems.

You know about the power of compounding right? Which would you rather have? A million dollars or a penny doubled every day for thirty days?

Miraculously, a penny doubled thirty times is $5,368,709.12. But the bad news is it works the opposite in reverse. If you sell assets at a loss, you get reverse compounding. If you have a $100K stock portfolio and it loses 50% of its value, how much does it have to go up to get back to $100K? 100%! It has to double. That is reverse compounding.

The challenge is approximately one out every five years in the stock market is a down year. You have to sell off assets every year in order to eat. So, in order to live off the portfolio, you are going to have to sell stuff at a loss on a fairly regular basis. If those losses occur in the wrong order, it dramatically increases the chances of what academics call retirement ruin – a nice euphemism for running out of money before you run out of breath. This is known as the “sequencing of returns problem.”

Take, for example, the 17 year period from 1987 to 2003. The average return was 13.47%. Assume a portfolio of 100,000 taking $10,000 a year adjusted for inflation by 4% over those 17 years. Depending on the sequence of returns which produce the 13.5% average, the ending portfolio balance could be as high as $76K or as low as negative $187K! That is a big swing and obviously meaningful to your situation late in life.

Lesson Four: To avoid the sequencing of returns problem and negative compounding, an investor must avoid permanent losses of capital at all costs. Permanent losses of capital occur when assets are sold at a loss.

The preceding is an excerpt from my newest special report: How to not just survive, but thrive, in turbulent financial markets. Feel free to download the report and share it with anyone you think would benefit from the information.

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Disclaimer: 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. This article is not a complete discussion of the benefits and risks of the Snider Investment Method®. For a complete discussion, read the Snider Investment Method® Owner's Manual, available by calling 866-9-SNIDER (866-976-4337). Please read and consider carefully before investing. All investments are subject to risk, including possible loss of principal.

Great Historical Perspective on Recent Market Action

Here is a really useful histogram of the annual return of the S&P 500 going back to 1825. I found it on the web in a number of places. All attribute the chart to Value Square Asset Management but I am afraid I have been unable to find the original source document. (Click on the chart to get the full size version).

This is our fifth bear market in twenty years. Contrary to public opinion, business cycles have existed since businesses have existed and they will continue to cycle between boom and bust in spite of government's best efforts to control or eliminate them. If that is true, then ipso facto, capital appreciation investing cannot work.

Just follow through the logic with me. I need double digit returns to pay myself, pay Uncle Sam and keep up with inflation in retirement. Owning businesses, either directly or indirectly through the stock market is the only proven way to get double digit returns over long periods of time. But about every five years, the business cycle takes the market down with it. If I have to sell in order to create income to live and with capital appreciation, I have to sell in order to realize profits, which means in order to pay my bills I have to sell at a loss, capital appreciation cannot work. Let me repeat. It cannot work.

And yet, that is what we continue to be sold. It is as absolutely as simple as that and it doesn’t take a rocket scientist, Harvard MBA or Ph.D. in finance to see that is true. The problem is quite simply that our world has changed dramatically in the very short time since the 1980’s and our investments haven’t. It is time to change our paradigm. I don’t know how to put it any more simply than that.
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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. This article is not a complete discussion of the benefits and risks of the Snider Investment Method®. For a complete discussion, read the Snider Investment Method® Owner's Manual, available by calling 888-6SNIDER. Please read and consider carefully before investing. All investments, including the Snider Investment Method® are subject to risk, including possible loss of principal. Income is objective and not a guarantee. Dollar cost averaging does not guarantee you will not experience capital losses.

Cutting through the confusion

There are a lot of financial talk shows on the radio every weekend. My show is one of nine on KRLD each Saturday and Sunday, and if you consider all the other stations in the area, you can get an idea of the variety of voices and opinions that confront the average investor each week.

If I were someone who tuned in every week, intently listening to hopefully learn the best way to manage my finances, I think I would be incredibly frustrated. That's because there's so much conflicting advice out there. One host may tell you that variable annuities are the greatest thing that ever hit the market. I, of course, will tell you the opposite -- to stay away from them at all costs. One host might say that the stock market is too risky and that you should invest in real estate instead. Another will say that real estate is no good; life settlements are the way to go. (By the way, they're not!)

If you opened your brokerage statements over the last couple of weeks and said to yourself, "I've got to try something different," your head is probably spinning with all the choices out there. Who's saying the right thing? Who is trustworthy? You know that doing nothing isn't really an option, but you don't know where to turn.

I won't tell you that I'm the only trustworthy one out there and that you should just come to me. That would be too blatantly self-serving. Not everyone has the same investment objectives and temperament. Although I know I can help many, many people out there, I recognize that what we do isn't for everyone. And I would be dishonest to tell you otherwise.

I've noticed in my years helping people with their investments that there seems to be two kinds of financial advisors. The first kind is the one who will say or do anything to make a buck off of you. Sadly, that seems to be the majority of advisors out there. They're more interested in selling you whatever product will earn them the highest commission, regardless of whether it actually fits your needs.

The other kind of advisor is the one who really does care about your needs. But even those advisors can and will disagree on the best course of action for you. More on that in a second.

So how do you distinguish between the advisor who just wants to make a buck off of you and the one who really cares? My best advice is don't take anything at face value. Do your research. Meet with the potential advisor and go over your objectives. Treat this as a job interview, because your advisor is really an employee. Read my articles on financial advisor red flags (here and here) to help you weed out the bad ones. Screen out the ones who try to hide the facts from you or try to hype up any particular investment.

After you've narrowed down the list, it's time to pick the advisor who best matches your values and objectives. And this can be the most difficult -- and most important -- task.
Very smart, thoughtful and caring advisors can have very different opinions on what makes a good investment. Let's use the variable annuity as an example. I've written extensively on the problems I see with variable annuities. Every time I write one of those articles, I get several emails from financial advisors who I'm sure are very earnest and have a lot of integrity, but they disagree vehemently with my position. And they'll put forth a very well-thought-out argument stating their case.

I've often wondered, how can we both have our clients' interests at heart and yet come to opposite conclusions? After running into this situation time and time again, it occurs to me that it must come down to what you value and what you place a priority on.

Investing is really just the management of a series of trade-offs. All of investing is about balancing risk and reward, and risk and reward both come in many different forms. An advisor who puts safety and security first and focuses on trying never to lose a dime for his clients will probably recommend low-yielding but very safe investments like CDs and bonds. An advisor like me, on the other hand, who puts a priority on generating a maximum amount of income for you to live on will recommend something different. A CPA who is mostly concerned with minimizing this year's taxes may tell you that converting a traditional IRA to a Roth is a very bad idea, while I may think it's a very good idea. We're both sincere and attuned to your needs; we just happen to think that different things should take priority.

So what's an investor to do? Before you seek out an advisor, whether it's an educator or a money manager, think long and hard about your objectives and your values. Find out where your priorities lie. Then ask lots of questions as you interview to find the advisor who best matches up with your needs. When it's a good fit, chances are you'll know fairly quickly.

Any financial advisor worth his or her salt will welcome the chance to go over your needs and objectives, and they'll recognize when their philosophy isn't a match with yours. When I meet with clients, I can tell when someone is a good fit. If they're not a good fit, I'll politely tell them so and try to direct them to another advisor who may be a better match.

I guess finding the right financial advisor is a lot like dating. You'll meet several scumbags and genuinely nice people who don't quite fit along the way, but when you find the right match, you know. And the right match makes all the difference. 

Interested in learning whether our approach makes sense to you? Give me a call at 214-245-5236 or toll-free 1-888-6SNIDER. I'll be happy to talk things over with you and even schedule a one-on-one meeting.

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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.

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.

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.

Are you unhappy with your job?

According to the Hudson Employment Index, 28% of workers in the Dallas Fort Worth area, where I live, are unhappy with their job - more than one in four. And yet, what is our antidote for insufficient retirement savings? I'll just work longer.

 

The Retirement Confidence Survey done by EBRI in 2006 finds 67 of workers expect to work past age 65. Really? Even though one in four hate their job now and only 27 percent of people over 65 work today? Sounds like a classic case of putting off until tomorrow what I don't want to do today - save.

 

A comfortable retirement, at whatever age, requires you to do only three things:

 

1. Plan and budget carefully so you can save for tomorrow

2. Manage your retirement funds very wisely - don't be greedy, fearful or dumb

3. Turn those funds into a source of low-risk, reliable income

 

If you ask some people their financial objective, they'll say growth, or income. Some will say to be able to retire at 62. Others will say to have a million dollars by age 65.

 

My personal financial objective, for a very long time now, has been financial freedom. I define that as having enough portfolio income to sustain my lifestyle indefinitely out into the future. I want work to be a choice, not a necessity.

 

I don't express that goal in terms of a number. I express it in terms of an income. If it takes $10,000 a month for me to live the way I want to, then I need an after-tax portfolio income of at least $10,000 a month. I also need that $10,000 a month to grow by at least 3% a year to keep up with inflation. Whether my portfolio is worth $500,000 or $3 million is irrelevant. It is the portfolio it can generate that I care about.

 

I think the entire notion of a growth investor is outdated. The primary investment goal for almost every American under the age of 65 has become income replacement, whether they think of it in those terms or now. Given the Hudson Survey, I'd say it is full income replacement as soon as possible. Failure to meet that goal is a life sentence of work.

 

If you go to one of these retirement calculators on the web, they will tell you how much you need in order to retire. What is the magic number? But to say I need a portfolio of $X to retire, which is our old way of thinking about income replacement, is bassackwards. I don't intend to spend my entire portfolio on the day I retire. I intend to live off of it for 30 years.

 

If that is true, the goal of an investor has to be to maximize income, not to maximize the portfolio value. What do you think? Agree? Disagree? Leave your thoughts and comments below.

 

SOURCES:

 

1. "National Employment Index," Hudson, Dec 2006

http://www.hudson-index.com/node.asp?SID=4394

 

2. "2006 Retirement Confidence Survey," Employee Research Benefits Institute, Apr 2006

http://www.ebri.org/publications/ib/index.cfm?fa=ibDisp&content_id=3630>

 

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.

 

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.