I posted a question about "mixing bonds and stocks" on LinkedIn with a link to my article on TheStreet.com.
I didn’t plan to “answer the answers” but given that some of the answers are quite sharp and say, “you are a bad, bad advisor”, let me reply and explain why they are mistaken in both their understanding of what I was talking about, and in that they don’t know what I really do with my clients and jump to conclusions (and bad ones at that).
Fundamentally, the mistake many financial advisers make is using short-term decision making for the long-term. Exactly what their clients do, unfortunately.
The answers below can be divided to three groups. The first completely agree. The second does acknowledge the importance of the time horizon discussed and how one defines risk, and then falls into the trap of discussing volatility. The third group provides volatility-based arguments, with or without citations of studies and publications, some of which are indeed by noble laureates.
I clarify: The time horizon discussed in the article is 20-30 years with 25 being mentioned as the basis for discussion. I define risk at the end of the article as “Not having what you need or want when you need or want it.” If you examine this definition carefully, you’d find that ALL risks falls under it. Those include loss of principal, liquidity risk, inflation risk, but most importantly, the client (or you) not having what you need/want when you need/want it.
What is volatility?
It is a factor that affects your risk. It is not risk by itself. Additionally, there seems to be some confusion between variance and volatility. Variance is, of course, a measure of the distribution around the mean. Volatility is the up and down movement. The research quoted is talking about low or negative co-variance between different parts of the portfolio, and not volatility. However, low co-variance is NOT important in this case because you are freezing the money for 25 years.
By the way, it’s not variance that kills you. It’s the losses. You can have a return of 8.1%, for example, if you don’t have losses, but you’d need 10.5% if you do have losses even though you have a similar variance.
Volatility can have two effects in particular:
1. Loss of principal – this only happens due to losses, not volatility per se, and of course, not due to variance.
2. Losses at the beginning of the distribution phase that coupled with withdrawals move the portfolio to below the threshold to support the desired distributions for the term projected. In plain English – you lose too much at the beginning and if you draw a fixed amount, that fixed amount represents too much in terms of percentage, and more than your return, thereby decreasing the principal until it is gone (too quickly).
The second part is not relevant because I didn’t talk about distributions at all! I only asked about the accumulation phase.
The first risk, the loss of principal, is mitigated by using a well diverse basket (index of sort) of stocks. If ALL the stocks in the S&P 500 have lost all the value, why, do you think ANY bond would not default? Or that you’d get ANY return on any fixed instrument?
The point is that over periods of 25 years, well-diversified stock portfolios (essentially indexes) have good returns (10.4% for the S&P500 for example) with relatively low variance. You don’t care about volatility along the way! Because you don’t keep trading in and out you don’t need bonds to counter that variance in the opposite way. After all, the “countering” is only illusionary because you HOLD YOUR BONDS TO MATURITY, and therefore they have NO VARIANCE!
It’s dangerous to give mathematical models to two groups:
1. Those who don't understand them.
2. Those who are too enamored with the mathematics of it to forget the real purpose.
The second group is more dangerous because its members tends to convince the first group they know what they are doing by dazzling them with mathematics.
Example: say you split your money, of 100K to two piles and put them in two safes. One is the 80 in S&P500’s safe (80%) and the other is 20K in bonds’ safe. You open the safes after 25 years and look at the piles. Your 80K grew by 10.4% average annual compounded rate (AACR for the technicians amongst you). Your 20K grew by 5% AACR. Would you have been better off by moving the 20K to the S&P500 safe?
You bet ya.
What do I do with my clients?
I cut the loss-of-principal risk by using an Equity indexed universal life insurance policies that are MAXIMALLY funded (not over funded). As a result my clients enjoy the following benefits:
1. No losses because the minimum they can get is usually 2%
2. S&P 500 like returns as the cash value gets, basically, the S&P500 returns (between the min cap of 2% and the max cap of commonly 13%-17%).
3. Tax free growth!
4. Tax free access! This means an ability to draw MUCH MORE than if the money grew in a regular tax deferred account.
5. Shielding from the danger of losses at the beginning of the distribution phase.
6. Liquidity.
7. Total cost of insurance (and all fees) that amounts to 1% - 1.5%
8. Higher returns to the beneficiaries in case they die (because of the death benefits that are higher than the cash value).
9. Tax free Transfer to the beneficiaries (when coupled with the appropriate Trust configuration to avoid sending the proceeds to the Estate, which could trigger taxes at the estate level).
If that doesn’t satisfy you – what will? ☺
Monday, February 18, 2008
Why mixing Bonds and CDs with stocks actually increases your risk
This article was published on TheStreet.com and therefore I can only post here some bits, and you'll have to go to the article to read it.
Warning: If you are a financial adviser, financial planner or another type of "consulted one," the following article might pose a risk to your health. By reading further, you agree that the author is not liable for any symptoms or problems you may have due to your response to this article, and you bear full responsibility to all such.
...Why supposedly? Don't bonds and CDs have a different (lower) risk profile than stocks? After all, bonds and CDs offer a guaranteed return and as such, are not "risky," right?
The answer is yes and no. Yes, bonds (only if held to maturation 
) and CDs do offer a guaranteed return. No, they don't lower a portfolio's risk.
Bonds and CDs Don't Do What?!
Enjoy the full article here and if you like it, do press "I recommend it" :-)
Wednesday, February 6, 2008
Personal Finance meets Stimulous Plan
In the face of growing fears of recession or stagflation (recession with inflation) President Bush, Mr. Bernanke the Federal Reserve Chairman, and most of the presidential candidates called for tax cuts, and naturally the House immediately pushed a bill to that effect.
The reasoning is the Keynesian economic view, as discussed by the Wall Street Journal’s editor in the January 18 edition, that prescribes that the government give money to low and moderate income people who will spend it, thereby creating demand for goods and services, and “stimulating” the economy. Mr. Bernanke emphasizes the “low to moderate” because higher income people would not spend the money but save it.
Four main questions should be asked: Are the tax cuts going to stave off recession or stagflation and help in the short term? Are tax cuts good for the long term? Are tax cuts the “right” thing to do? Where will the money come from?
I provide my clients with advice on how to create and grow wealth, and simply put, it is not by “spending your income away.” In fact, when I show my clients how to reduce their expenses by optimizing their assets and reallocating their expenses, often paying lower taxes as a result (I guess I should be given rebates by the government for my work?), I do not tell them “oh, please go ahead and spend it.” I tell them the money is going to savings and investments. The simple reason is that this money is to fund their retirement. I say so regardless of what level of income and wealth the client is.
The President, Congress, the Fed’s chairman, and the presidential candidates are telling everyone exactly the opposite. They are telling us, “spend money, don’t save it.” This is in the face of several known problems with the US economy and its future.
Firstly, the savings rate in the past decade has been dismal and even reached negative levels. Most Americans do not have enough saved for retirement and are not likely to have enough to maintain a moderate life style, let alone their one at retirement. This is when they are budgeting for 10-15 years of retirement under the “average age” assumption, when they should be budgeting for 25-30 years, assuming a retirement age of 65-67.
Even worse, Social Security is bankrupt in the sense that all projections are showing it will not have enough money at some point in Baby Boomer’s retirement future.
Therefore, spending those tax cuts is the wrong thing to do for exactly the people who are supposed to get it, the low to moderate income ones.
Of course, if the people who are to benefit from the proposed tax cuts would save the money, as they should, instead of spending it, it would defeat the purpose. The economy would not receive the money, and would not be “simulated.”
Thus, the tax cuts are not “the right” thing to do because they encourage spending when the problem is that people should be saving more.
Where would the money come from?
The answer is simple. Given that the government runs a deficit, it has to come from future income, either in the form of lower healthcare, education, social security, or other governmental expenditure on future benefits, because it definitely will not come from special interests expenses during an election year.
The silly argument proposed is that the tax cuts will stimulate the economy, thereby produce more taxable income, and therefore tax revenues, thus paying for themselves. Unfortunately, this sounds like a bad joke I sometimes tell that starts with two people walking down the street and seeing a pile of horse excrement (change the word accordingly), ending with the pile gone and the two being happy for having had a high monetary trade volume.
Then if this is clear, and given that there are 76 million baby boomers who tend to vote in higher percentages, are the presidential candidates willing to tell them: “look, I need to make you feel good now so you elect me, so I offer this tax cut, and the result will be that you’d face even harder times at retirement.”
Will the tax cuts solve the short-term issues of recession or stagflation?
Firstly, more money means higher inflation, and therefore a higher chance of stagflation. Secondly, the looming recession, which has multiple factors, is definitely not a result of low consumer demand. Therefore, increasing consumer demand, temporarily, is like covering an inflamed wound with a bandage without applying antibiotics to cure the underlying infection. The only thing it does is make the inflammation even worse.
Fundamentally, tax cuts do not solve the long-term problems the US economy has. It doesn’t solve the trade deficit, which means basically the US is buying more than it is selling, which in personal finance terms means the country’s income is less than what it spends. It also doesn’t help the budget deficit, which means in personal finance terms that the country is borrowing on its credit card, leaving the bill to future generations to pay. In fact, the tax cuts are only going to make it even worse. If in providing my clients with financial advice, I would tell them to borrow more on their credit cards so they can spend more today on things they can’t afford to begin with, my clients would walk out of the door without a second thought. However, for some strange reason, we buy it when President Bush, Mr. Bernanke, Congress, and the presidential candidates provide us with such advice.
Borrow on your credit cards, everyone. “The government” (you and your kids) is paying the bill.
The reasoning is the Keynesian economic view, as discussed by the Wall Street Journal’s editor in the January 18 edition, that prescribes that the government give money to low and moderate income people who will spend it, thereby creating demand for goods and services, and “stimulating” the economy. Mr. Bernanke emphasizes the “low to moderate” because higher income people would not spend the money but save it.
Four main questions should be asked: Are the tax cuts going to stave off recession or stagflation and help in the short term? Are tax cuts good for the long term? Are tax cuts the “right” thing to do? Where will the money come from?
I provide my clients with advice on how to create and grow wealth, and simply put, it is not by “spending your income away.” In fact, when I show my clients how to reduce their expenses by optimizing their assets and reallocating their expenses, often paying lower taxes as a result (I guess I should be given rebates by the government for my work?), I do not tell them “oh, please go ahead and spend it.” I tell them the money is going to savings and investments. The simple reason is that this money is to fund their retirement. I say so regardless of what level of income and wealth the client is.
The President, Congress, the Fed’s chairman, and the presidential candidates are telling everyone exactly the opposite. They are telling us, “spend money, don’t save it.” This is in the face of several known problems with the US economy and its future.
Firstly, the savings rate in the past decade has been dismal and even reached negative levels. Most Americans do not have enough saved for retirement and are not likely to have enough to maintain a moderate life style, let alone their one at retirement. This is when they are budgeting for 10-15 years of retirement under the “average age” assumption, when they should be budgeting for 25-30 years, assuming a retirement age of 65-67.
Even worse, Social Security is bankrupt in the sense that all projections are showing it will not have enough money at some point in Baby Boomer’s retirement future.
Therefore, spending those tax cuts is the wrong thing to do for exactly the people who are supposed to get it, the low to moderate income ones.
Of course, if the people who are to benefit from the proposed tax cuts would save the money, as they should, instead of spending it, it would defeat the purpose. The economy would not receive the money, and would not be “simulated.”
Thus, the tax cuts are not “the right” thing to do because they encourage spending when the problem is that people should be saving more.
Where would the money come from?
The answer is simple. Given that the government runs a deficit, it has to come from future income, either in the form of lower healthcare, education, social security, or other governmental expenditure on future benefits, because it definitely will not come from special interests expenses during an election year.
The silly argument proposed is that the tax cuts will stimulate the economy, thereby produce more taxable income, and therefore tax revenues, thus paying for themselves. Unfortunately, this sounds like a bad joke I sometimes tell that starts with two people walking down the street and seeing a pile of horse excrement (change the word accordingly), ending with the pile gone and the two being happy for having had a high monetary trade volume.
Then if this is clear, and given that there are 76 million baby boomers who tend to vote in higher percentages, are the presidential candidates willing to tell them: “look, I need to make you feel good now so you elect me, so I offer this tax cut, and the result will be that you’d face even harder times at retirement.”
Will the tax cuts solve the short-term issues of recession or stagflation?
Firstly, more money means higher inflation, and therefore a higher chance of stagflation. Secondly, the looming recession, which has multiple factors, is definitely not a result of low consumer demand. Therefore, increasing consumer demand, temporarily, is like covering an inflamed wound with a bandage without applying antibiotics to cure the underlying infection. The only thing it does is make the inflammation even worse.
Fundamentally, tax cuts do not solve the long-term problems the US economy has. It doesn’t solve the trade deficit, which means basically the US is buying more than it is selling, which in personal finance terms means the country’s income is less than what it spends. It also doesn’t help the budget deficit, which means in personal finance terms that the country is borrowing on its credit card, leaving the bill to future generations to pay. In fact, the tax cuts are only going to make it even worse. If in providing my clients with financial advice, I would tell them to borrow more on their credit cards so they can spend more today on things they can’t afford to begin with, my clients would walk out of the door without a second thought. However, for some strange reason, we buy it when President Bush, Mr. Bernanke, Congress, and the presidential candidates provide us with such advice.
Borrow on your credit cards, everyone. “The government” (you and your kids) is paying the bill.
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