(Written 11 October 2008)
A correspondent with whom I disagree pretty thoroughly on financial matters e-mails:
An interesting poll of IFP's (Independent Financial Planners) reported today on Kuldow's MSNBC programme that 85% don't believe investors over 55 should be in equities at all. AT ALL, because the 10 year recovery horizon is dubious. I agree.
Here are some thoughts of mine on matters monetary. Call it chutzpah if you will, but I think my thoughts are as good as, if not better than, those of most financial planners. My thoughts derive from reading good books, independent reflection, and experience. And I don't charge for them! Be aware that I have no credentials in this area. (Be also aware that credentials are only a rough and defeasible guide to a person's competence.) You absolutely must think for yourself, and since its inception in 2004, this site and its ancestors has been devoted to promoting independent thinking. That is part of what the 'maverick' appellation is supposed to convey.
That was a mistake because once on the sidelines it is very difficult to know when to get back into the game. Long story short, I missed out on a lot of the '90s gains. Here are some of the conclusions I came to, quickly stated, and no doubt in need of refinement, revision and amplification.
Some Principles of a Financial Conservative
1. One must decide on an asset allocation that fits one's psychology and is appropriate to one's age. By my count there are five main asset classes: stocks, bonds, cash and cash equivalents, real estate, and precious metals. There are fancier instruments, but never invest in what you don't understand. If you invest in four or five of the main asset classes you should do well in the long run. If you are conservative like me, you will want to limit your exposure to stocks to say, no more than 30% of your net worth. But of course it depends on how risk-averse you are and your age.
2. Should a person over 55 be in equities at all? Well, how long can you reasonably expect to live? 90 is not an unreasonable expectation for people nowadays. So if you are 60, then you might have 30 years left. Given that fact, I would say it would be foolish not to have some of your money in equities. But as you get older you should shift your asset allocation away from stocks (equities).
Suppose you are 80 and single. Then perhaps you should not be in stocks at all or only to the the tune of 10% of net worth. But suppose you are married to a woman who is 65 and dependent on you for support. Since she might live another 30 years, you might be well advised to be 20-30% in stocks. Or you might have children to whom you want to leave a legacy.
3. Stocks are a long term investment. If you don't think and plan long term, stay away from them. Money that you will need within the next five years should never be put into the stock market, not even when it is in a bull phase. Everyone should have a cash reserve and that money should never be invested in the stock market. Park it in passbook accounts, certificates of deposit (CDs), and money market accounts. Bear in mind that money market accounts are not FDIC insured, and that the standard $1 share value is not guaranteed. But a Treasury money market fund will be very safe for obvious reasons.
4. Of course, no investing for the long term until you (a) have a cash reserve sufficient to get you through two years (not six months as the financial planners often recommend!) of unemployment, and (b) have eliminated all credit card and other non-mortgage debt. If you run credit card debt you will never get anywhere financially speaking. Use credit cards like I do: for the float, the substantial rebates, the record-keeping, and the convenience, but NEVER pay even one cent of interest. I never pay interest, I never pay for the use of the cards, but the CC companies pay me $300-400 per annum in rebates. Not a bad deal. Never buy what you can't afford to pay cash for right now. There is only one good exception to this rule and that is real estate, in particular the house you live in. Cars are not a good exception except perhaps when you are starting out.
To get anywhere financially you must consistently, month by month, year by year, live below your means. Not at your means, below them. Consistently. Very few people do this, but then most people make messes of their lives financially and otherwise.
5. Every form of saving and investing involves risk. You are being one-sided if you point to the risks of the stock market while ignoring the risks of other vehicles. Stuff greenbacks under your mattress and they might get stolen or consumed in a fire. Money in passbook accounts and CDs won't generate enough return to offset inflation. Banks and S & Ls have been known to fail. (And if enough fail at once, that much-vaunted FDIC and FSLIC insurance won't save your bacon!) No doubt it is the return of your money that is more important than the return on it, but if the return does not offset inflation, then, although the money returned to you may be nominally equal to or greater than the money invested, it will really be less: it will be less in terms of buying power, which is all that matters, since money is for spending. And of course the taxes you pay on passbook, money market and CD returns is also a factor to consider.
You think bonds are safe? A bond is a debt instrument. In essence, you loan money to some entity which promises to repay the money at a certain future date with a certain interest. If the entity goes out of business you lose. Since no vehicle of saving or investment is perfectly safe you must:
6. Diversify! Diversification will dilute your return over the long haul but it will reduce overall risk. You should consider diversifying across every economic parameter. Remember the Enron fools? They put their money into one stock, the stock of the company they worked for. So when Enron went down, they were doubly screwed: they lost their 401k accumulations and their income. Everyone knows that one must never put all one's eggs in one basket. So why did these people do something so abysmally stupid? They let their greed suborn their intellects. It was at bottom a moral failure. This is a recurrent theme of mine: the subornation of the intellect by the vices. That is the fundamental reason why we are in the mess we are in right now. There has been a wholesale collapse of morality and common sense both in the population at large and in the elites: the legislators, the academicians, and the business types.
Stock diversification is easily achieved by investing in mutual funds. Choose no-load (no front end or back end sales charge) mutual funds that also feature a low expense ratio. Since the actively managed funds will cost you more and may not deliver more, consider investing in index funds. There are even balanced index funds that provide instant diversification across the entire U.S. stock and bond markets.
7. The stock market is now in free fall, and no one knows where the bottom is. Many will panic, cash out, and lock in their losses. I plan to stay the course. That is, I plan to stay invested and continue buying at the rate I decided was appropriate. I plan to follow the course that I arrived at after due deliberation, and not second-guess myself or let the emotions of the moment throw me off a course judged right in calmer moments. And above all, I will not allow myself to be unduly influenced by what other people are doing or saying. Tune out the noise, trust your judgment (assuming it has proven to be sound in the past), and stay the course.
[Addendum 25 October 2009: My decision has so far proven itself to be correct: my investments have rebounded nicely.]
What are my reasons for staying the course? First, my asset allocation is very conservative and reasonable, fits my psychology (I have no trouble sleeping at night), and my time-horizon allows for recovery. Second, this is an outstanding buying opportunity. Everyone knows that you are supposed to buy low and sell high. But this maxim is very hard to implement because of greed, fear, and conformism. So people almost always do the opposite: they buy high in bullish markets and sell low when the bears come out. They follow the crowd, becoming irrationally exuberant when the markets are rising (no matter what the market, stocks, real estate, precious metals) and irrationally depressed when the markets are in decline. By staying the course and continuing to invest, I buy low.
"But why not cash out, wait for the bottom, and then get back in? That way, you get the benefits of buying low but without losing the value of what you have already accumulated. Why ride it down to the bottom?"
This reasoning is superficially plausible but it presupposes something that is false, namely, that one can know when the bottom has been reached. One cannot predict where the market is going or how it will move. The market cannot be timed or predicted. And it can turn around very quickly. If the DOW can drop 700 points in a day it can also gain 700 points in a day, and you cannot make money in a market unless you are in the market. You must be in the market on the days when it moves up. If you miss those days you will lose out. This from Barron's:
Consider that $1 invested in stocks from February 1966 through May 2007 would have grown to $16.58 in that period. That's a 7% annual return. By contrast, investors who were out of the market in the five best days each year during that span were left with only 11 cents. That's a pretty good case for the buy and hold philosophy, or, if you're out of the market, for getting back in soon.
A third reason for staying the course is that if I bail now, I lock in losses. But holding as I am for the long term, my losses are paper losses as opposed to real losses.
"But a paper loss is a real loss because your net worth is less than what it was before the decline."
This objection ignores the fact that stocks are a long term investment. Since the wise investor never puts money that will be needed in the near term into a long term investment (whether stocks or real estate), he is not fixated upon his actual net worth at any given time. Such an investor accepts fluctuations in net worth as long as there is a reasonable expectation of long term gain. (And if the asset allocation is very conservative, the fluctuation may affect only the rate of growth of a steadily growing net worth.) So, although it is true that the value of one's stock holdings if liquidated during a sharp decline or 'crash' as we are now experiencing will be much less than if liquidated before the decline, this does not bother the long term investor since he has no need and no intention of liquidating his shares. This, I take it, is what is meant by 'It's only a paper loss.'
You can live in a house but not in a stock mutual fund. That being understood, there is an analogy worth drawing. It doesn't matter whether the market value of my house increases or decreases in the near term since I like where I live and I have no intention of selling.
The crucial point, again, is that stocks are a long term investment. If you don't think long term, or if you think the long run won't be your run, or if you think we are on the eve of economic destruction, then stay away from the stock market.