Monday, March 16, 2009

Unsolicited Investment Advice

Throughout all of last year, though especially with gathering force towards the end of the year, people inexpert in managing the vagaries of our financial markets were eagerly looking for insight from someone involved in them professionally. Certainly, we should admit that it was the first time where it was okay (and maybe even kinda perversely and rubber-neckingly interesting) to pontificate at parties about the merits of the gold standard and the excesses of the "shadow banking system". Beyond the intellectual curiosity of those wondering what all the sound and fury was about was, of course, a real concern with their own jobs and assets, particularly from people of my parent's generation (the baby boomers broadly speaking).

Apropos of this, and of the work I have been doing over the last year on the "endowment model" of investing (there's also an interview with Dave Swensen that lays out the basics in a recent Yale alumni magazine), I felt like I should write something about how I believe the investor should invest their savings. Investing is really really hard. Most baby boomers don't believe this, probably because they only started to have money to invest beginning in the early eighties, coincidentally the exact moment that last and greatest bull market for financial assets got under way. The rising tide lifted all boats, more and more people saw the strong results that came of pouring money into the stock market or the housing market, and folks began to fundamentally confuse saving with investing. Saving is easy. All you have to do is make more than you spend. Put the difference in an interest bearing bank account and it will be there to spend later. Saving is easy and prudent.

Investing, however, is hard and risky. What you are trying to do in investing is actually increase the purchasing power of your savings over the long term. Think about that for a second. Think about what it means in almost protestant ethic type terms -- realize that you are asking for a handout. You are looking for a free lunch. You want to work one day and take two days off, rather than being content to work today so that you don't have to tomorrow. This is what most people don't understand about investing. It's hard. It should be hard. There should be no free lunch. And despite what it seemed like up till 2008, there really isn't any.

A lot of people didn't understand this, and judging from the continued popularity of the non-sensical talking heads brought nightly to the comfort of your living room, a lot of people still don't. Partly I think this is a failure of our educational system. I remember being taught how to mop and spell in fourth grade, but somehow double-entry bookkeeping didn't make it into the cirriculum; u can imagin wich of thees has provd more usefel. But beyond this failure of our educational system, the average educated person's fairly appalling ignorance of the basics of economics and finance has a more sinister cause as well. That's how us pros make money. The profits of the financial system are analogous to the frictional losses of a mechanical system. Finance is all heat and no light. Yeah, yeah, sure, we're matching what you should be saving to where you might be investing, and some value is created there. Banks and financial professionals that transform saving into investment in this manner are providing a public service in a highly competitive market. So we try to make it look like they are doing something more, something arcane and complicated and special and worthy of flying around in private jets. We make it way more complex that it needs to be and even than it can sustainably be. And then we charge you for that. None of us really have any incentive to let you figure it out. In this age of specialization and intellectual fort-building there's certainly a lot of professions like this; I'm not sure it's any different than with doctors and lawyers in this respect, though I continue to believe that our lobbying campaign is tops.

That, then, would be where my advice to folks like my parents or friends begins (not that any of them read this blog). Probably the single soundest piece of financial advice I have for the non-professional is to ignore most of the financial advice you hear. Investing is hard. A lot of really smart, highly incentivized people go to work everyday and deploy an immense quantity of resources in an attempt to lap each other around the same hamster wheel. Some of us will win and some will lose (by definition we can't all beat the market) but you can be certain that the fuel that powers the whole infernal apparatus is the money we take from you in the form of fees and transaction costs. And the more we obfuscate how the whole thing works, the more you think those fees and transaction costs must somehow be justified, till it gets to the point where you don't even realize that you're paying them because we've made the whole thing so damn complicated that we don't even have to officially charge you for it anymore. If anybody is going to get ahead with this scheme, it is us, not you. So I know I sound like a Cretan liar, but take my most basic piece of advice -- ignore my advice.

Having said that, I now have some hot stock tips.

Understanding that, as a part-time individual investor, the deck is stacked against you as far as investing goes is an important first step, but it doesn't tell you much about what you should do. So let's start boiling it down to some more concrete advice. First, some general suggestions for the management of your financial assets:
  1. Lower your expectations. Mostly you will spend tomorrow what you didn't spend today. You're free lunch, if any, will be very small. If it weren't, the demand for it would be much higher, and would push the price up. In a second, I'll go over the various types of financial assets, the returns you can expect from each on an inflation adjusted basis, and how much of each you should own, but to summarize quickly, most people should expect the purchasing power of their savings (ie. savings adjusted for inflation) to grow at a compounding annual rate of a bit more than 3% after all fees
  2. Lower your fees. Once you adjust your expectations to reality, you'll see that investing is so hard, and people are fighting so ferociously over such a tiny pie, that saving even a little money by avoiding getting involved in the rat race in the first place turns out to be pretty significant in the end. Mutual funds charge huge hidden fees that can top 2% a year once you tally everything up. Your broker and your bank and everybody else and his dog want to tack some fee on somewhere, because that is how they make their living. Those fees can eat through your 3% pretty quickly. The little graphic on the Vanguard site sums it up (Vanguard, by the way, are the pioneers of low cost investing, and run a decent, ethical outfit. They are always the first place to stop and compare costs, and the products are generally designed around exactly the philosophy I am giving you here).
  3. Lower your risk as you get older. There is a great rule of thumb that says you should allocate your age to bonds. If you are 55 years old, 55% of your savings should be in bonds and 45% in stocks (the rule is not counting your house, which is the other main asset people have). It's a pretty good rule. With people living longer these days, it might arguably shift to your age minus 10 years. People have forgotten over the last 30 years that stocks are risky assets. They remembered this quite suddenly last fall, and the forgotten lesson is all the more painful for those who were retired or closing in on it. The closer you come to retirement, the more you may want to spend your savings over a shorter time horizon. Bonds are less volatile, and pay a fixed amount of interest every year. It's even safer to have some of that money just in the bank. The money you keep in stocks should be money you will not need to spend for 10 years. Stock markets go though long cycles. On average you do better in stocks than bonds, and over a long time period, the difference can be significant, but the key here is on average and over time.
Fortunately, once you've seen the light with respect to the low expectations, low fees and low risk philosophy, investing turns out to be very simple, because you can basically ignore most everything. Investing is hard and you are overwhelmingly likely to lose trying to bet against the house, so don't try. Know thyself -- admit to your own ignorance and plan accordingly.

How does this all work in practice?

The typical middle class American has four basic assets. They own a home. They own some stocks. They own some bonds. They have a bank account. Let's go through what to expect from each of these investments one by one.

Safe as Houses

Contrary to popular wisdom, houses are not actually investments. Owning a house is a fine idea, and can be a good way to force yourself to save money, but over time, houses do not make an economy more productive and they do not tend to appreciate in value in real terms. In other words, houses are consumer goods.

I've discovered that most folks, even now, have an extremely difficult time understanding this. They were told that a house is a great investment, that it was always better to buy than to rent, and that they could always expect their home to appreciate in value. Unfortunately, they were misinformed. Houses, as you can imagine, have been around for a long time and have been built in many places. Accordingly, if you look at the data from these times and places, you will find that, on average, the long-term inflation adjusted price appreciation of a home is about 0%. The only times housing appreciates rapidly and consistently is during a bubble. In fact, history has shown that rapid and consistent increases in the price of housing is almost inevitably the sign of a bubble. In addition to being a solid and empirical fact, this conclusion also kinda stands to reason, if you think about it for a moment. After all, unlike building a factory, building a house doesn't allow you produce more stuff, which is the basic hallmark of a true investment. And there's only one part of a house that has any value that might be expected to appreciate over time -- namely the land -- and while this may be fixed in quantity and hence scarce, there really is a lot of it, as even a quick glance at suburban sprawl will show.

Given that for many middle class folks their home is their largest asset, this alone makes it difficult to have high expectations for their returns. Mostly, a house is a consumer item that everyone needs, the cost of which is reflected in your mortgage payment, and a means of ensuring that you save the down-payments instead of blowing it on high-living and fast cars.

So don't expect much real return from your house.

Bank On It

The other thing most people have that won't appreciate in value is a bank account. A bank account is a fine way to save money, and if properly managed can serve to maintain its purchasing power -- the interest the bank pays you will offset the loss due to inflation. Unlike with houses, people seem intuitively to understand that a bank account is just a way to store savings in a manner slightly safer than your sock. The point of having these savings is to manage to daily expenses of life and to have something for those unexpected expenses that everyone expects to appear periodically. As with houses, you should expect a real return of 0% here, so there's really no reason to leave any more money in the bank that what you expect to spend in the next several years, plus some rainy day money just in case. Obviously, as you retire you tend to have less money coming in from a salary or pension, and more money going out in expenses, suggesting that the amount you need to have ready in the bank to meet immediate needs should increase.

Buy Some Bonds

Finally, we get to the first true investment that the average Joe is going to make. I think most folks know more or less what bond is. You loan someone your money for a specified length of time, typically at a specified interest rate (known as the coupon), and at the end they give it back to you (the principal). The hope is that they pay you an interest rate sufficient not only to compensate you for the inflation that reduces the purchasing power of the principal, but something more for the risk that they don't pay your money back.

Taking this risk the the borrower will not be creditworthy, which you are not taking by having your money in a bank, means that you might hope to make a few percent annually in real terms. The exact amount of course depends on how much risk you want to take. The bond market is both very large (much larger than the stock market) and very complex -- all different levels of risk are available in all sorts of exotic flavors. Luckily, this is where the aforementioned philosophy of ignorance comes in handy. If you don't know what risk to take with your bonds, don't take any at all.

People consider US government obligations to be "risk-free". This is clearly an exaggeration. The US government has already defaulted once (in the Great Depression they devalued the dollar relative to gold, at the same time as they made it illegal to privately hold gold) and is perfectly capable of doing it again. Given that we no longer have a gold standard and the state now prints up, at essentially zero cost, the little green pieces of paper that count as satisfying its obligations, in practice the US would default on its debt by creating inflation. This risk exists not just for US government bonds, but for every bond; inflation corrodes the purchasing power of a bond, because both the coupon and principal are paid in fixed nominal dollars which lose value every year in an inflationary world.

Hence the simplest and therefore best bond would be a US government bond indexed for inflation. Fortunately, such a bond exists. It is called a Treasury Inflation Protected Security (TIPS). These bonds see their principal and coupon increase at a rate equal to the annual change in the consumer price index. Thus, they provide a guaranteed real return over the life of the bond -- typically of around 2%. This is the most basic investment you can make, and it is the benchmark rate for risking any of your money. Again, in my opinion, for the non-professional, there is no reasons to bother investigating any other type of bond. Other bonds will often produce higher returns, but they are also inevitably more risky. Many intelligent people compete to evaluate those risks and find those returns. The average investor is unlikely to beat them at this game by playing in his spare time. So if some bond appears to be paying more, there is likely to be a reason for it. This is not to say that the bond market is perfectly efficient and rational like they tell you in textbooks and neocon talk shows -- this is just to say that I'm likely to find out where it's inefficient long before you do.

So if you reign in your expectations and admit your ignorance it turns out to be really easy to invest in bonds. In practice you can either buy these bonds directly from the Treasury for very low fees, directly from your broker, through a mutual fund, or through what is called an ETF (Exchange Traded Funds are very similar to mutual funds but typically have lower and more transparent fees and trade continuously on the stock exchange like any stock). These last two options allow you to purchase an entire portfolio of bonds that mature at different dates in one go. This may be appealing if you are not inclined to plan out when you want the money back from the bonds in order to spend it. In this case, I would recommend the ETF, which trades under the ticker TIP.

On a final note, a lot of people have lately asked me about whether they should buy gold or other currencies. This is a reasonable question given that they hear a lot about the possibility of inflation and the debasement of the dollar. My advice for the average person is to forget it. Gold produces no interest and is inherently speculative; under no terms should it be considered an investment. Equally, the average person should simply not worry about trying to predict the global macroeconomic trends that govern the movements of other currencies. I have yet to see even experts correctly predict these with any consistency. My advice might be different for someone from some small country like Argentina, or if the US had some specific problem no other nation suffered from, but as it stands I do not believe that the individual investor has any clear option to protect themselves from true global financial meltdown, short of a vegetable patch and a shotgun.

In this regard you should hold to your ignorance like a faith. The government can nationalize companies and wipe out your stock portfolio. They can create inflation. They can fail to adequately insure your bank deposits, and in the final instance, they can even confiscate your house. There is not much you can do about any of these things as an individual investor. You should only lose sleep over these possibilities in your role as a citizen.

Stakes In Stocks

The final asset that most people will own at some point is stocks. Stocks represent a partial ownership interest in a company. Though everyone has heard this definition, most people have not come to grips with its most fundamental implication, namely that the lower stocks go, the more attractive they are from a long-term perspective, and vice versa. After all, if someone was going to sell you their entire business, you would feel much better about buying it at a lower multiple of the profits it was making, and much more uncertain if they asked for a higher multiple, all else being equal.

The same is true of stocks. Over long periods of time, returns in the stock market are governed primarily by the price you pay when you buy in. This is because the return you make investing in a business is composed of two essential ingredients. The growth in the profits of the business, and the amount of those profits that the business can pay out to you relative to the price you paid for this privilege. What makes stocks superior to bonds over the long-term is usually the growth in the profits (though in some periods stocks can be bought more cheaply -- at higher yields -- than bonds) that is directly attributable to the productivity gains in an economy.

Historically, the average real returns from stocks has amounted to around 6%. While this may not sound like much at first, the extra 4% one can make above and beyond bonds can be enormous if it compounds over long periods. Unfortunately, the key thing to remember here is the part about loooong periods. When investing in stocks, you should have a time horizon of close to ten years. This is not only because stocks are riskier, in the sense of suffering from volatile swings related to economic cycles, but also because the stock market experiences long periods of under and over-valuation. In the US, for example, productivity and profit growth has been quite strong over the past ten years, but because stocks began the millennium at such exorbitant valuations, the market has been essentially flat over this time period.

All these considerations of valuation and timing, however, lead us away from our philosophy of ignorance. Suffice it to say that stocks are the highest yielding investment one can make, but also the most risky, and accordingly should represent a decreasing percentage of your financial assets as you get older (remember the age-in-bonds rule).

The final question to confront in buying stocks is exactly which to buy. Here again, ignorance is bliss. If you don't know which stocks to buy, you should simply buy them all. Financial innovation has made this a remarkably easy task. For the first time in history, an individual investor can buy a basket of stock that more or less represents an ownership stake in all the world's enterprises. If you admit that you have no idea whether it would be better to own a piece of Microsoft than McDonalds, or whether the Indian economy might present more opportunity than the Dutch, you can simply opt out. This crown jewel of investor ignorance trades as an ETF under the ticker VT -- the Vanguard Total World Index is a low cost, one stop shop for investing in a diversified collection of all the worlds equities. It's fair to say that it may be the last stock you ever need to own.

So Finally

Where does all this leave us? In the end, the program is remarkably simple and low cost.

Own a home of your choosing, but do not expect it to appreciate dramatically in value.

Leave some money in a bank account or a rainy day. How much depends on how much money you are earning every year.

Of the remainder, allocate your age % to TIP.

Put whatever is left after that into VT.

I am sure many people will be offended by the almost stupid simplicity of that advice. It is a modest portfolio designed to minimize the uncertainty and costs of investing, yet still add something to your savings over time. My only defense is that if someone told me I had to invest all my money tomorrow and couldn't change my mind for another twenty years ... my money would be exactly where my mouth is.

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