The markets have been selling off lately. Since these portfolios are a mix of US and non-US companies there aren’t “simple” indexes that I can use to compare them. But in general, the US markets which by various measures had been up in the 10-20% range are mostly back down to where they were in the beginning of the year and European and Asian markets are about the same or mostly worse.

These portfolios are meant to be long equity-only vehicles for young individuals with a very long time horizon in front of them (50+ years). They are “part” of a total portfolio and meant for a specific purpose; no one should just put all their wealth into a long-only stock fund.

Thus based on these elements I am loathe to do specific buys and sells based on total market conditions, because you are often selling off one stock for another stock with similar characteristics. Our markets today have very high “correlation”, meaning that almost all of the stocks tend to go up or down on a single day, especially when big market events occur. Correlation has been increasing over the years, meaning that even if you have a diversified fund (a rule of thumb is that you have 10 or more instruments that aren’t similar to one another) that doesn’t necessarily “save” you if they all move together.

The nature of the stock markets have been changing in the eleven years since I started this effort with Portfolio One, right around 9/11. There are many trends, but here are the key ones in my opinion:

• Rise in international markets – international markets have always been important, even to US-centric investors, but today they are even more critical.  A stock market is fundamentally about “growth”, and most of the real growth is occurring off US shores.  Thus to not invest internationally, even with all their structural differences from the US market and other risks, is to miss out on the future
• Reduction in IPO’s – the number of companies listed on exchanges has fallen as the number of IPO’s hasn’t kept pace with companies being acquired either by other companies or “going private”.  Also the IPO’s are later (see FB) meaning that a lot of the “upside” is gone when they launch, or there often is no upside at all if they are being sold out of a private equity fund (they already captured that)
• Focus on Dividends – some of the dividend focus is due to favorable tax treatment (the limits on double taxation of dividends) and their 15% rate rather than as ordinary income and some is due to the gradual dawning on more investors that a substantial part of the total return is due to dividends and not just share price appreciation (unrealized)
• Increased government intervention – in order to understand markets today you need to anticipate government moves to a greater degree than in the past.  Our large banks might never have survived the 2008 crisis without government intervention, and today they exist.  Will the government let them survive the next crisis, or will equity holders be wiped out like their were for Fannie Mae and Freddie Mac or Lehman?  Now you need to anticipate government reaction
• Increasing Currency gyrations – for many years we had currency stability but we may be entering an era of less stability, especially in the key currencies the dollar, Euro, pound, yuan, etc…  This has many effects on competitiveness and immediate valuations
• Low interest rates – a low interest rate policy has many effects on the market.  It depresses interest earnings (which impacts some equities) but also makes equities more attractive relative to debt instruments, especially when the chance of default rises.
• The rise of Chinese stocks – while the US market went (mostly) moribund a whole host of Chinese companies came onto US exchanges or were accessible to US investors.  A lot of the “froth” and potential “boiler room” activities went into those stocks instead of US stocks

Here at Trust Funds for Kids we try to look at the long time horizon and make decisions accordingly.  This doesn’t mean that short term gyrations aren’t painful, as well.

Riverbed (RVBD) is a stock held by portfolio 5, one of the newer portfolios. In the news I noted that they slightly missed in their revenue guidance for 2012 and their stock value dropped by almost 30%.

This article at Motley Fool asks the question of how such a minor revenue drop drove such a major impact on the stock price.

Clearly the market doesn’t work in very precise ways, but honestly how does a $5M revenue cut in guidance lead to such a dramatic loss of market value? Maybe “fuzzy math” is at work.

Most investors probably saw that Riverbed Technology (RVBD) lost nearly 29% of its market value on Friday. The company reported basically in-line Q112 numbers. Not too bad at this point considering the major product transition going on. Then the wheels started falling off during the conference call. The CFO guided to revenue that at the high end would miss the $202M Q2 estimate by roughly $5M.

Yes, anybody doing the math is probably struggling to understand the stock plunge. It dropped 29% due to a 2% reduction in revenue. All while investors should’ve known that the company was going through a product transition that would muddy up the financials for the 1H of the year.

Since we don’t recommend specific stocks here and everyone should do their own homework I don’t make general recommendations. In the case of my portfolio stocks I watch them and try to assess whether this is a temporary event or a permanent loss of value. It has to be noted that any stock with a high multiple which means that their value is based on looking forward to years of earnings growth is subject to risk when they miss earnings by even a little bit because analysts then tend to “jump off the train”.

In this case after reviewing everything I am going to put the stock on “watch” to see if it comes back next quarter and if the analysts are right or if the stock just hit a minor transition.

Recently I wrote about ETF’s for international bond funds that are denominated in local (non US Dollar) currencies.  The NYT in their Sunday edition had a mutual fund report (they still segregate mutual funds from ETF’s, even though they are generally substitutes for one another) that discussed a similar tactic called “Emerging-Market Bonds Quench a Yield Thirst“.  This article is focused on emerging markets (like Brazil and China and the Asian countries) rather than the developed markets that those ETF’s target.

The article approaches foreign bonds as a way to achieve a higher yield (interest income) since US interest rates are minuscule.

With the measly yields now offered on presumably safer bonds, like United States Treasuries, savers are seeking more appealing sources of income.  And in the first quarter this year, the average emerging-bond fund tracked by Morningstar returned 7 percent, versus 0.3 percent for the Barclays Capital US Aggregate Bond Index.

The article gets more sophisticated but this is a “classic” case of confusing risk and return.  The return on emerging market debt SHOULD be substantially higher than for less-risky debt, assuming that US debt is actually less risky.

The relative risk of emerging markets compared with developed markets has changed… The average debt level of emerging market countries like Brazil and China is far lower than that of developed ones like the United States and Japan… emerging economies have continued to surge even as much of the developed world keeps struggling with the aftermath of the 2008 financial crisis.

That’s true.  If you ignore the complexities of legal systems and whether or not a country like Brazil or China would default if it was in their best interests to do so, by statistics alone they are superior to the developed world.  Having a modern legal system and being tied to the West didn’t save Greek debt holders from having to take a 75% loss on principal, after all.

The article goes on to describe two key differences – bonds issued in US dollars (“dollar bonds”) and those that invest in bonds denominated in local currencies.  In the previous article on foreign ETF’s I covered Germany, Canada and Australia – those countries would not offer bonds denominated in anything but their local currencies (Euro for now, Canadian dollar, and Australian dollar) but for emerging countries often the debt is denominated in some other currency which makes it more palatable to investors, particularly non-local investors.

If you denominate an emerging market bond in US dollars, then that has the same effect as “hedging” your bond portfolio against fluctuation in the local currency against the dollar, which is a frequent practice for many mutual funds because investors wanted purely the higher yield (and theoretical increase in risk of principal loss that come with this) and didn’t want to also add in the “currency risk” of fluctuations against the US dollar.

Whether the mutual funds invest in “dollar bonds” or bonds denominated in local currency will impact the potential returns of the fund as well as the riskiness of the assets in the fund (likelihood of default).  Per the article many of the funds operate a “mix” of these strategies, which may mitigate some risk (dollar bonds may be issued by more solvent issuers and also don’t have currency risk) but likely leaves some yield “on the table” from local issuers willing to pay a higher rate in local currency as well as the potential gain or loss on fluctuations from the local currency vs. the US dollar.

In the US, corporations mostly go to the public corporate bond market for funding, whereas in emerging countries companies often go to local banks (and Europe is somewhere in the middle).  Since so many companies in the US rely on markets for debt funding, the overall market is (relatively) liquid and large in size, and as a result there are many metrics to track and there is a long history of data to review.  In developing countries, the corporate markets aren’t very deep, and those that do issue debt rather than going to banks often issue it in “dollar” bonds instead of local currencies.  Per the article:

Local-currency corporates exist in Brazil, but the market isn’t very deep… in a less mature market, he might stick with dollar issues.

Compared to the total universe of mutual funds and ETF’s, the portion that is tied to

• emerging market debt
• has bonds denominated in local currencies and / or “dollar” bonds
• has a liquid enough market to make sense

Recently I have been evaluating my total portfolio in terms of US dollar exposure.  Traditional (primitive) metrics of portfolio evaluation picked concepts like

1. Splitting your portfolio between cash / bonds / stocks / real estate
2. Splitting your stock portion between US and foreign stocks
3. Breaking down your stock exposure into industry sectors like technology, finance, consumer products, etc…
4. Adding a category for commodities, generally broken down between the precious metals (particularly gold, which had a huge run up) and everything else (oil, grains, metals, etc….)
5. Reviewing your investments in terms of yield whether it is measured in interest return (bonds, REITS) or dividends (stocks)
6. Categorizing your investments by “tax efficiency”, which favors municipal bonds (which are exempt from Federal and often state taxes) and currently dividends (taxed at a 15% rate) but punishes normal interest which is taxed as ordinary income
7. Splitting your personal portfolio into “retirement” funds which generally are invested without paying taxes, grow (hopefully) over the years with reinvested dividends and interest, but are taxed when you retire and start taking withdrawals, from “non-retirement” funds which are subject to current taxation on dividends and interest but whose “basis” or original investment value have already been taxed.  A third category is Roth investment vehicles which are taxed now but the gain or loss above the current value is not taxed when you take out funds upon retirement

These concepts are all useful ways to review how your money is being allocated across all these sectors of investing.  There is no “one” right way to allocate your portfolio or to even assess how your portfolio is currently deployed.

On the topic of bonds, to me they traditionally represented 1) primarily a vehicle to earn interest, with the rate of interest dependent upon the riskiness of the bond 2) a (relatively) secure means of investing meaning that you expect to get your principal back (i.e. if you invest $50,000 at 2% which unfortunately would be a great rate now you pretty much are focusing on earning $1000 / year in interest and ultimately getting back your $50,000 when the bond matures).

However, the general perception that the bond world is “safe” doesn’t jibe with events that have occurred over the last decade or so.  These events include:

• The massive budget deficits being run by the major world democratic powers in the US and Europe both at the Federal and regional / local levels, which are unsustainable as we found out in Greece and are likely to find out in many other places to come
• The decline of over 30% in the US dollar against other currencies over the last few years, caused by many factors but primarily our low interest rates and a semi-deliberate policy of devaluation
• My personal local exposure to government entities in Illinois at the state and local level (Illinois has the worst state credit rating in the US, and Cook county and the city of Chicago are famously corrupt) which leads me to expect the worst from the municipal bond market

These factors caused me to begin researching foreign bond funds.  My goal was to find foreign bond funds that are

1. From countries with a reasonable prospect of being stable and paid back (i.e. not Greece or countries with no track record)
2. Denominated in a currency that is not US dollar based that is likely to be around in the future (i.e. Canadian or Australian dollar, the Asian currencies, etc…)
3. Put into a fund that doesn‘t HEDGE vs the US dollar – many overseas bond funds hedge against the US dollar so although you get foreign investment exposure in terms of returns and risks, you still are based on the US dollars gains and losses over time.  This is new because until recently most of the funds I can find tended to hedge currency exposure
4. Have a low cost of ownership; preferably as an ETF which doesn’t (generally) incur capital gains and losses on a given year; these changes are “baked” into the share price which fluctuates over time and then you can choose when and how to incur the gain or loss by selling shares rather than being forced to book the gains or losses each year depending on fund activity

I briefly considered buying individual foreign bonds but this required a lot more work and understanding than I was prepared to do.  This may be something I’d consider in the future but since I don’t want to be consumed in research and exposed to unknown IRS forms and risks (since we do our own taxes and direct our own investment) for now I was looking at something less complex.

While it may seem that a lot of individuals are thinking the same things as me (the above thoughts are pretty obvious) sometimes you have to “wait around” for the industry to come to the same conclusions.  I bought the first dividend-focused ETF (DVY) when it came out and was waiting for a while to find it (and I heard about an early cash-back credit card and was an early adopter of this, as well).

PIMCO recently seemed to have what I was looking for when they released three new ETF’s.  The ETF’s are for Australia, Canada and Germany.  Here is a link to the PIMCO web site describing these three investment opportunities.

 PIMCO recently introduced three country index exchange traded funds (ETFs) focused on enabling investors to capitalize on the investment opportunities in Australia, Canada and Germany. PIMCO believes these three countries have balance sheets and debt dynamics that are well positioned in the global economy, considering the potential for slower growth and ongoing deleveraging, and offer important diversification of currency exposures for U.S. investors.

This description from their web site has what I am looking for:

• Countries whose debt load appears sustainable or well managed
• Non US currency exposure THAT IS NOT HEDGED
• In ETF form to limit annual capital gains and losses but allow you as the investor to choose the time for “harvesting” your gains and losses
• A reasonable level of total expenses, which are incredibly important for interest bearing instruments at a time of low interest rates (they are 0.5% for the Australian bond fund, which is still on the high end for me)
• A reasonable level of asset size is desired so that the ETF doesn’t behave erratically or face the possibility of closure (sometimes ETF’s are closed and money is given back to investors).  It helps that PIMCO is huge and if they are likely to move into a sector like foreign bond ETF’s they wouldn’t seem likely to just shut down a fund if it grows more slowly than anticipated
• Australia in particular offers yield (investment return) much higher than US bonds; they currently are above 4% when you’d be lucky to get 2% in US equivalent Federal debt right now.  This of course is factored into the currency level vs. dollar (it is high now) so in some “grand equilibrium” scheme they may or may not be in balance; but in the short to medium term it is fair to say that Australian debt “yields” more than US equivalent debt

In my investing I generally try not to anticipate specific events but rather to have a broader and more diversified spread on investments.  From a currency side, you have the Australian dollar, the Canadian dollar, and the Euro.  The Australian and Canadian dollars have had a huge run-up against the US dollar, which would make someone “chasing return” salivate, and the Euro faces downward pressure for many reasons most notably the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and their expanding financial difficulties and deficits.  However, the game ahead is very long, and anyone that can reliably predict the trend of currencies against the US dollar wouldn’t be writing a blog like this or even commenting on it, they’d be in a giant private jet flying to their giant private island because that is an exceedingly difficult or possibly impossible thing to do.  And even if the Euro goes kaput, a German focused fund would convert into the new German currency, which would be predicted to be among the best currencies of the broken-up Europe.

I will look at these three funds in detail and likely buy ETF’s in them which will 1) be in the bond class 2) hold a reasonable prospect of continued repayment 3) provide non US dollar diversity.

Cross posted at LITGM

Portfolio Two is our second longest portfolio. It has been up and running for 7 1/2 years. You can see it here or on the link on the right side of the blog page.

Contributions from the beneficiary total $4000 and from the trustee it is $8000 for a total of $12,000.

The portfolio is now worth $14,142, for a gain of $4,142 or 18%, or about 3 1/2% / year over the life of the portfolio.

All of the portfolios have been helped by the recent run-up in the stock market. Right now a lot of the stocks are marked “green”, meaning that they are up over $200 (unrealized gains plus dividends), and none of the stocks currently held are “red” (meaning they are down over $200 in unrealized losses less dividends).

Wynn Resorts (WYNN), which owns a huge money making casino in Macau off China’s coast, has been in the news a lot because the CEO is feuding with his Japanese partner. It is difficult to tell how this sort of thing will turn off but we are holding on for now because gambling in China is a great place to be. Urban Outfitters (URBN) took a dive when they missed earnings and subsequently the CEO resigned but we held on because they had no debt and seemed to be a candidate for a turnaround… we are watching them for now and if nothing happens we will sell prior to the next buying round at the end of the summer. Our “net” position in Toyota (we bought them twice) is about break-even when dividends are taken into account; it was far down due to the brake scandal and other items but have come back lately at least to even.

For 2011 taxes, this portfolio doesn’t have to file based on “unearned income” (gains plus dividends plus interest income, although now interest income is so damn small it doesn’t matter anymore). There was a gain on Ralcorp that we sold of $295 and dividends of $241 (see “box”) that comes on the 1099 form from the brokerage but unearned gains have to be $950 in order to file in 2011 per the IRS publication 929 which summarizes tax rules for children.

The Wall Street Journal today had an article titled “Why Stocks are Riskier Than You Think“. The article discussed a strategy using iBonds & TIPS as a partial alternative to stocks along with the use of options to limit risks of a large downswing in your stock portfolio value.

While I am not here to recommend a particular investment strategy I do discuss iBonds and they have a little infographic called “Creating a Safety Net” with iBonds and TIPS and it describes the key features of each. Here is a link to the infographic. They talk about how the bonds move with inflation, interest, maturity, fees, taxes, and price fluctuations.

But on the key measure of “purchase limits”, which has fluctuated over the years from as high as $30,000 per SSN (with the option to also buy equivalent “paper” iBonds which are no longer offered) to as low as $5000, the article says that the limit is now:

Each Social Security number is entitled to a maximum of $5000 a year in electronic bonds.

However – this is incorrect. If you go to the site http://www.treasurydirect.gov, which is now the only place where you can purchase iBonds (you can no longer buy paper ones at banks) – here is what the US Government web site says:

Buying I Bonds through TreasuryDirect:

Sold at face value; you pay $50 for a $50 bond.
Purchased in amounts of $25 or more, to the penny.
$10,000 maximum purchase in one calendar year.
Issued electronically to your designated account.

This price limit changed a few months ago and whomever wrote this article didn’t bother to check this basic fact. That is unfortunate.

In looking at as many of the comments as I could (they are filled mostly with rants and one-sided arguments) no one there knew about this limit either. So Wall Street Journal – could you please fix your infographic? It supports your argument (by allowing for larger purchases) and that little infographic is pretty good other than this key error.

I go through all of the portfolios individually and track all the transactions in order to create the spreadsheets that you can see on the sidebar.  One of the items I noted a while back is that if you receive a dividend on an ADR from an overseas company, your broker will withhold taxes and you won’t receive your entire dividend in cash.

A little background – an ADR is an instrument that trades on a US stock exchange that moves along with the underlying stock on a foreign exchange.  These ADR’s allow you to get stock exposure to overseas markets on an individual stock basis without having to purchase them through an international exchange, which brings additional procedural and processing headaches.  Generally only very large and liquid overseas stocks have US based ADR’s.

For instance Portfolio One, our longest tenured portfolio at over ten years, has the following ADR’s:

- Statoil (STO) – Norway
- CNOOC (CEO) – China
- China Petroleum (SNP) – China
- Taiwan Semiconductor Manufacturing (TSM) – Taiwan
- Toyota (TM) – Japan
- Canon (CAJ) – Japan

The determination of whether or not there is tax with-holding depends on the country.  The rate also depends on the unique circumstances of the country.

This article has a list of countries that do not withhold taxes at all and the rates that they use for US citizens. Below are some of the rates of countries for which my portfolios either have stocks or may consider to have ADR’s in the future –

No Withholding:
Columbia – 0%
India – 0%
Singapore – 0%
South Africa – 0%
UK – 0%

Taxes Withheld for US Citizens:
Australia – 30%
Brazil – 15%
Canada – 15%
China – 10%
Finland – 28%
France – 25%
Germany – 26.4%
Israel – 20%
Italy – 27%
Japan – 10%
Mexico – 10%
Netherlands – 15%
Norway – 25%
South Korea – 27.5%
Spain – 19%
Sweden – 30%
Switzerland – 35%
Taiwan – 20%
Turkey – 15%

As an investor, you can deduct the tax that you pay to foreign countries on your US tax form. This is a tax “credit” so it reduces your tax liability dollar-for-dollar, the best type of deduction. There is a publication called 514 “Foreign tax Credit for individuals” that explains this in more detail. Like everything else related to taxes, ask a professional for advice or read the form yourself. Here is a layman’s summary:

- If you only have passive income (dividends or income) such as is found on a 1099-DIV or 1099-INT
- You claim less than $300 in foreign tax credits (or $600 if married filing jointly)

If the above 2 items occur, then you can just put the amount of foreign taxes paid on your return and you don’t have to file a form 1116 which also ultimately puts limits on the amount of foreign taxes that you can deduct on your US return and is more complicated, as a result.

Thus you may want to select ADR’s from countries with favorable tax treaties with the US and with low withholding of dividends. For instance, China at 10% (and UK at 0%) are better than Switzerland at 35%. This won’t generally matter at the level of dividend income that my portfolios create each year – for instance portfolio 1 had about $500 of dividends in 2011 – so if all of it was (worst case) withheld at 35%, this would be ($500 * .35%) = $175. You need to own a pretty large portfolio to cross $300 in foreign with-holdings… for instance if you had $50,000 in foreign stocks which returned 4% in dividends at 15% foreign withholding that would mean that $50,000 * 4% * 15% = $300.

Note that whether or not the foreign taxes were withheld, you still owe US taxes. Since the recipients of my portfolios aren’t working full-time they have low (or no) income levels and they have low tax rates, anyways. They also benefit (like all investors) from the dividends received rule which limits dividends to 15% tax rates, and their capital gains are also lower because they are in low income brackets.

I hope this is helpful. I always learn something when I take apart the detail of my brokerage statement and try to recalculate everything (now I can recalculate the withheld taxes on dividends!). I recommend that over time you try to do the same, as well. Financial literacy is your friend.

Like every tax rule, there are exceptions and complications, so do your own research.

Traditional stock picking focused on various fundamentals:

- the “value” of the stock taking into account the discounted cash flows of future profits
- what the assets of the company was worth after liabilities were removed
- how the technical characteristics of the market as a whole impacted the stock price

In addition “macro” items such as interest rates and inflation, too, impact the market as a whole.

While politics has always been part of the equation, today the market seems to be moving more than ever based on what the politicians are saying they’ll do. A recent WSJ article titled ‘CEO’s Message – Fix Europe, Or Else” had this great quote from an the CEO of Kingfisher, a UK company:

The outcome is very binary. It’s up to politicians

In order to invest in this sort of climate you need to be kind of like a “Kremlinologist”, or an analyst that used to attempt to decrypt what was going on inside the USSR’s communist party leadership, based on arcane clues and utterances.

Unfortunately guessing on what politicians will say or do is a new dimension of investing, and if it is moving markets, we all need to either get better at predicting their next reaction (since they rarely seem to plan ahead and mostly react when events are far gone) or stay out of the market.

All active investors are effectively “Kremlinologists” now.

This site has been a big fan of iBonds for several years now. Here is a link to a post I wrote in early 2010 that basically sums up the key elements of iBonds including:
- very low risk
- able to defer taxes indefinitely until redemption (up to 30 years). They are also exempt from state and local taxes
- very competitive interest rate of a “base” low amount plus inflation adjusted every six months
- able to buy $10,000 / year worth of bonds (that is the limit if you buy “jointly” between you and your spouse, but you can buy $10,000 in your name and $10,000 in your spouse’s name if you are not worried about will or trust issues)
- because they are very simple (deferring taxes) you don’t have to do much of anything as far as work to maintain these securities. You won’t get a 1099 form for interest if you select the “base” method which is deferring taxes until maturity or until you redeem them

The downsides are
- you can’t get at the money for 12 months (your latest purchase; if you have been buying iBonds annually for years it is only your most recent purchase that is held for 12 months)
- if you redeem within 5 years, you lose 3 months of accrued interest
- the interest rate, while WAY better than money markets or savings accounts, isn’t that great. The “base” interest rate offered by the US government now is 0.0%, so essentially you only receive the inflation component. Even with a “0.0%” base interest rate, inflation paid about 3.75% in 2011 which is a great rate considering the alternatives

Here is a link to the Treasury Direct site discussing iBonds. Starting 1/1/12 the US Government will no longer issue paper iBonds anymore. Thus you must buy them through the US government if you want them.

The Wall Street Journal recently had an article about iBonds. The article summarized their advantages and noted that beginning 1/1/12 they no longer were going to allow for “paper” issued iBonds which limits the number of bonds individuals can purchase. This article says that iBond limits were going to be $5000 per person; the treasury recently updated their rules and now you can buy up to $10,000 per person.

If you haven’t bought iBonds before now would be a good time to start. You can purchase bonds by year end 2011 (the next few days) and then buy some in early 2012. This starts the “clock” on the 12 months where you can access your money. After that the money is available for short-term cash needs (you do lose 3 months of interest in the next 5 years).

Stock market “co-variance” means in laymans’ terms that, when something happens, all the stocks in your portfolio move in the same direction. Regardless of an individual companies’ performance, financial position, or future prospects, every stock in the index moves up or down together. As you can see in the list above, the 20 or so stocks in this portfolio ALL went down today.

The types of events that used to move markets like this were due to wars, elections, or changes in policies such as interest rate meetings like the Fed. Now, however, it is often due to the inexorable series of financial crises that we have faced in the US and now in Europe with the Euro crisis. Today the German bond auction had difficulty, and this ricocheted across the ocean into our markets.

To be an investor today you need to keep one eye on the stocks that you select and another eye on the overall factors that are causing the market to rise or fall. Unfortunately, many of these items causing the market to rise or fall are caused by government policies and actions which are impossible to predict in the short run and impact the entire market.

It is frustrating…

A recent Wall Street Journal titled “The Young and the Riskless” details how “twentysomethings” are not investing in stocks, but instead are putting their savings into less risky investments.  The tag line on the article is:

Twentysomethings are seeking safety from market volatility at precisely the wrong moment in their investing lives.  Here’s how to get back on track.

From the outset I was struck by the author’s presumptuous and scolding tone. I also like their strategic use of the word “volatility” instead of the more appropriate term of “losses” when describing market events over the twentysomething’s financially sentient lifetime, which would be something like the last 10-15 years.

Per the charts in the article

The percentage of young investors who say they’re willing to take above-average or substantial risk has declined from 52% in 1998 to 31% in 2011. 52% of investors in their 20′s who say they will “never feel comfortable in the stock market”. 33% of 20-somethings’ non-401(k) portfolios held in cash, versus 27% for all investors.

It is important to understand how “faith” in the market is typically defined in the popular financial press. Faith usually means putting your money in an index fund (or ETF), with low fees, continuing to do so regardless of market conditions, and relying on the belief that “in the long run” it will all turn out alright and you will be able to retire rich. The “financial calculators” have an assumed rate of return that you receive on your money, similar to the same calculators that public pension funds use, and they are typically “set” between 6% and 10%. Due to the “miracle of compounding returns” you can amass large sums of money in the future.

The problem with this mantra is that NO ONE has been winning with this strategy for a LONG time. What you see, instead, is that money put into the market is often battered immediately by volatility and is worth a fraction of what you put in only months prior. If you change jobs regularly (once every 2-3 years, as younger people often do) and are an avid 401(k) saver (which is recommended), many times when you pull out your money it will be valued far less than what you put in, or about even when the company match is taken into effect (depending on vesting). This can be demoralizing. I know that when I left companies in the late nineties and after the dot-com collapse I started putting more of my money into cash-like investment selections (despite warnings from my employers’ 401(k) educational materials) just because I hated moving balances worth a fraction of what I held back out of my pay when I left to start with a new company.

Also, in order to win “in the long run”, you have to stay with it in the short run. This means that when stocks plummet, you need to stay in the market and keep investing. If you decide to cut your losses and run, or stop putting new money in during market troughs, you don’t get the same benefits when the stocks rise later. This post I wrote basically said that no matter what you did in 2007, it turned out to be a loser, but if you bought during the trough in 2008 (or held throughout) you saw big gains later as the market turned back around (to where it was before). BUT if you didn’t stick with the markets, you didn’t benefit from these gains and ended up as a net loser. It is VERY HARD mentally to keep investing when markets are going down, but if you don’t buy low there is no way you can even conceptually win in the “long run”. If you bail, for sure you are going to fail, assuming you are following the mantra (which is what the WSJ article’s author was lamenting).

Kids see their parents’ struggles. Their parents have been believers in the markets, since the bear markets of the 70′s were replaced by the bull markets of the 80′s and 90′s. If you retired in the 90′s, after years of investing in the doldrums, you not only benefited from high interest rates which appeared to “goose” the compounding effect, but you also essentially did some great “market timing”, buying low and selling high. But the parents of today’s twentysomethings didn’t retire in the early 90′s, they kept working, and watched their investments suffer along. Now the parents’ are in a bind.

Not only did the markets get hit, but there isn’t really an underlying foundation of belief in WHY the market should do so great “in the long term”. In the past you could look at the track record of the US and show how we weathered recessions, panics and depressions, wars whether declared or un-declared, and always came out ahead. But today everything seems to be static or declining; our unemployment rate is high, we have high “real” inflation from commodity price increases (oil, food), and the cost of services like a college education or health care (if you can get insurance at all) is very difficult to bear. In order for the market to rise, the country needs to be productive, well run, and growing – does this seem to be today’s perception of American performance? This lack of an underlying narrative in why markets should rise of the long term (other than it has happened in the past), combined with the miserable ACTUAL performance during the last decade and a half, is killing confidence in the “long run” hypothesis that markets go up.

Another element of caution is that not only did stocks crater (or stay flat), but everything else fell apart too, in defiance of what the typical financial media said would occur. Housing became a miserable investment, rather than the guaranteed path to wealth that was painted in the press. Can’t you remember people saying that renting was “throwing your money away”? I remember having many, many people look at me in a dumbfounded fashion when I told them that I rented for over a decade when I could have easily bought. This thinking has obviously changed radically, despite record low interest rates (high rates would have made the housing problems unimaginably worse, at least in the short and medium term).

If kids travel, they can see how the “US Peso” doesn’t go far overseas. The dollars is worth a fraction of what it used to buy vs. the Euro, the Canadian dollar, the Australian dollar, or the Japanese Yen. The devaluation of the US dollar is another signal of our relative decline, along with our equity markets and housing markets.

The popular press’ scolding is going to fall on deaf ears until young adults see something out of their own experience that would convince them that stock investing is a winning strategy. The lack of anything except (comparatively) ancient charts of a world before the cell phone and the internet won’t sway them.

It really comes down to faith vs. experience. And among the young, experience is winning.

Generation X Addendum

This wasn’t mentioned in the article but a parallel trend I personally have noticed is that people of my generation (Gen X) are taking charge of their finances in their own way. Those with means tend to personally select stocks and get involved directly in their investing rather than “passively” investing through indexes (although ETF’s are part of their portfolio). While I am in the finance industry, many of my friends and acquaintances are not, but they have grown tired of bad and counter-intuitive advice and are taking matters into their own hands, in a variety of ways. Their particular strategies aren’t important – what is important is that they don’t believe the common wisdom and are taking responsibility for their own investment outcomes. In my opinion this is another manifestation of what the twentysomethings are doing, except by people with more assets to invest in the first place.

Cross posted at Chicago Boyz

The portfolios that we run on this site coincide with a market that effectively is a “do nothing” market.  We are basically flat over the last 13 years, meaning that there hasn’t been growth in the indexes since 1998.

The money that an index investor would have earned (i.e. if you put $100,000 in the SPY ETF or a mutual fund such as Vanguard’s VFINX) would have come through dividends, which averaged about 2% / year during the period.  Thus every year you received $2,000 in dividends (taxable each year) which means over the 13 year period you made roughly $30,000 (adding in compounding of interest) before taxes or maybe $24,000 after taxes depending on your bracket (and whether or not the 15% dividend received deduction applied during the period).

This is reflected in our results; while valuations fluctuate about 1/2 the total return of portfolio one, our longest lasting portfolio at over 10 years, is due to dividends.  When we look to select stocks a strong (and sustainable) dividend yield is an important, although not the only factor we look for in the “list of six stocks” that we pick from each year.

In the October 24, 2011 issue of Barron’s there is an article titled “It’s Cheaper the Second Time Around” that discusses the fact that indexes have been flat for the last 13 years.

The fact that we are struggling daily to hold above a level first reached nearly 13 years ago is both sobering and, viewed in the proper light, profoundly encouraging for true long-term investors… we are finally returning to a time of ‘stocks for the long run’… anyone who believes in mean-reversion investing has to consider the current starting point for equities at least somewhat attractive…

Jim Paulsen of Wells Capital was kind enough to calculate the 10-year forward return from all points in historry when the market was flat or down over the priod 12 yars.  The result: a 7.2% annual gain, versus 4.7% for all other times, not including dividends.

It is good that this analysis disclaimed the impact of dividends and yet noted that they are important, although if the yield is relatively consistent over time (which isn’t true, since yields go down when stocks go up, and vice versa) the analysis should hold true.

This type of investing approach is also a version of “market timing” – you should buy when items are cheap, and sell when they are expensive.  The most obvious example of this is housing; if you bought in 2007-8 you probably are regretting it right now – that same house probably would cost you a lot less to buy in 2011 then it did back then, for the same exact house.  It isn’t obvious HOW to do market timing, but the effects are real for anyone struggling to pay on an underwater mortgage today.

Like every good investment analogy, there is a counterpoint – Japan.  Japan peaked long ago, in 1989, and still hasn’t recovered to the highs.  In order to be a long-run investor in Japan you apparently have to be very patient, indeed.  Of course at some point investors are entering the market and they don’t care about recovering 1989 highs anyways.

For our portfolios here at the site flat returns mean a few things:

1) we don’t feel so bad at our struggles to raise values since the market has been poised against us

2) we have been right to focus on dividends, since they have been the only reliable source of cash over the period (relative to stock values)

3) while the analysis is more complex many of the overseas indexes weren’t flat over the same time frame; we have been putting up almost 1/2 our picks from overseas companies (US based ADR’s to keep it simple) in that same time frame

4) there is some hope that our patience will be rewarded if values increase in the next decade