Monday, Monday – Can’t Trust That Day
In the 1960s, John Phillips wrote a number of hit songs for his group, The Mamas and The Papas, as well as for other performers. The song that provides the title of this article was one of his biggest hits. It laments the fact that Monday can’t be trusted: a Monday that begins with love intact might end much differently, with love gone.
I think of this song sometimes when I’m talking with clients about retirement. Quite often I am able to confirm that the financial aspects of their retirement will work out satisfactorily. However, despite confidence about their financial security, some people find themselves uncomfortable with the idea that Monday will come and they will have nothing to do.
During the past sixteen years, I’ve had many people ask me for advice regarding the early retirement options being offered by their companies. I always answer their question with this question: “If you retire, what will you do on that first Monday morning?” When I see their response, I know how to advise them. If they have a plan – volunteer at the hospital, play more golf, return to college and take art classes – I know they’ll be fine. But sometimes, I’m greeted with the “deer in the headlights” look or worse, a cringe of terror. When I see one of those responses, I know that they’ll need to remain in their jobs at least a little longer while we work on the “what will they do” question.
In past generations, when it was common for men to be the breadwinners and women to remain home with the children, those men’s post-retirement life expectancies were relatively short. They worked literally all of their productive lives, then relaxed for a few years – often, a very few years – and waited for the end. Compared to those generations, many of the baby boomers who are now approaching retirement have maintained better balance in their lives. Often they have enjoyed various hobbies or outside interests during their working lives and thus have something they really want to do on that first Monday morning of retirement.
When The Mamas and The Papas broke-up around 1968, John Phillips “retired”, from regular performing. In his case, retirement included continued song-writing and even the re-establishment of his group when his daughter, Mackenzie, was old enough to participate. His experience exemplifies a baby boom generation trend: that people will continue to work during retirement but at something different. Sometimes, retirees are able to carve out the most enjoyable aspect of their current job or perhaps turn a hobby into a part-time business. Although I plan to work several more years, I can see that allowing Jalene to take over more of the day-to-day responsibilities of managing our practice has become appropriate. It has allowed me the luxury of concentrating on the things I enjoy most: spending time with clients, working on their investments and writing my articles. Hopefully, when I transition into retirement, I’ll remain able to contribute by focusing on two, or eventually even one, of those activities.
Helping our clients consider how they will spend their time goes beyond the scope of the typical financial planning engagement. However, at Warren Ward Associates, we believe that assisting clients in that way is an important element of the planning services we provide.
That Hall of Fame Economist, Yogi Berra
Several people have asked about the problems in the “sub-prime” mortgage market and what the recent upheavals might mean to regular investors. As with all investment questions, there are at least two issues to consider. First, the underlying realities to which markets respond: interest rates, liquidity, and economic strength. Second, how people interpret and react to those realities. I feel fortunate to be able to turn to a well-known voice which has offered thoughtful (even thought-provoking) insights in the past. Yogi is popularly credited with having said “Ninety percent of this game is half mental”. Although he was referring to baseball, I think his statement probably holds true for markets as well.
The founders of our country provided a framework which included certain inalienable rights but owning a home was not among them. Home ownership became an important element of the post-World War Two “American Dream” and most people since then have aspired to it. Regardless of how much we might wish things to be different, not everyone is a good candidate for home ownership. However, captialism has a way of trying to meet people’s needs. Over time, a sophisticated mortgage market developed. It allowed lenders to extend credit to less-qualified borrowers, typically at higher interest rates. An unfortunate perfect storm brought together Wall Street demand for higher-yielding securities, developers who needed to sell homes and brokers who received fees for “originating” these mortgages. What had once been a valuable service became a machine finely tuned to provide more and more loans to less and less qualified buyers. Before too long, disaster struck in the form of late payments and, eventually, forclosures.
Adding to the severity of the storm were hedge funds. I have written about these generally unregulated investment strategies before. Their original mission was to offer a true hedge against broader actions in the markets. However, as investors swarmed to them, they have tended to become more similar than different and have become key contributors to market swings. This past spring, Amaranth Advisors liquidated after having lost over $3 billion of investor assets through betting incorrectly on natural gas prices. As hedge funds lent to and became investors in mortgage companies, an unstable situation was allowed to persist until it came crashing down under its own weight a few weeks ago.
The fundamentals of our stock and bond markets are good. Interest rates are reasonably low, business is good (although not great, which has a tendency to bring an interest rate increase from the Federal Reserve) and employment is high. The “fact” portion of the equation seems to be in pretty good shape. However, the “reaction” (or as Yogi said, the “mental”) portion must still be addressed.
Markets have a tendency to make wider swings than the underlying facts might suggest are appropriate. People often buy based on their hopes (some would say their greed) which tends to drive prices up, then sell based on their fears, tending to drive prices down. The word “crash” has a way of grabbing headlines but we prefer the word “correction”. Our investment strategy at Warren Ward Associates has always been to keep a balance of asset classess covering multiple sectors of the US and global economies. The underlying reason for diversification just reared its head again. As we have commented in the past, whether it is tulip bulbs, tech stocks or sub-prime loans, markets have a way of being self-correcting. Or, to cite another of Yogi’s famous quotes: “It’s like déjà vu all over again”.
Lessons in Poker and Life
During the tech stock bubble of the late 1990’s, one of the questions I sometimes heard was: "How can I buy some of those ‘hot’ new stock offerings?" People were asking because they had seen share prices of some of the new stocks double or triple during their first day of trading and they wanted to get some of that easy money.
Brokerage firms have always offered such Initial Public Offering (IPO) shares but not every firm is able to be a part of every deal. Especially in the case of deals likely to be "hot", most shares are allocated before retail investors are given a chance to participate. Once in a while, we do hear about IPO shares being offered to individual investors but that, in and of itself, gives me pause. My old mentor in the brokerage business always said: "If there’s not enough demand for the shares on Wall Street, then they offer ‘em in Indiana. If they didn’t want ‘em on Wall Street, we don’t want ‘em either."
The tech stock boom-and-bust cycle has been completed but there always seems to be something else that makes people feel they are possible for smaller investors to participate in the wild and woolly world of hedge funds and the venture capital firm Kohlberg Kravis Roberts & Co is now in the process of opening itself up to retail investors. Hedge fund investing has historically been limited to the wealthiest of investors, those thought capable of understanding and assuming the large risks which are inherent in such strategies. KKR has stated that the reason they are planning on "going public" is to take advantage of more favorable rates of taxation. My guess is that most of the KKR partners are actually glad to pay tax on their gains – after all, they paid to become partners in hopes of receiving those gains.
I have never been a poker player but one bit of advice I have heard from several different sources is that, if after playing for fifteen minutes you haven’t identified the patsy at the table, it’s probably you. I have friends who tell me that they make money playing poker but my general advice to all gamblers is not to bet more than they can afford to lose.
As Wall Street deals start making it to Main Street, it might be a good time to ask why. Is a particular investment available because the large firms have decided it’s time to spread the wealth around? Or, perhaps, is it because there was not enough demand from large investors and the present owners still need someone to buy them out?
In my experience, our capitalist world has a tendency to rest in a reasonable balance between risk and reward. The late 90’s assertion that tech stocks would never lose value did not pan out for most investors. The market’s recent attempt to make home ownership available even to those traditionally unqualified introduced many small investors to what were thought to be high quality bonds backed by low quality mortgages. What are the chances that the next "hot deal" will prove to be any different? We have no answer but to reiterate that owning a diversified selection of investments has been the path to success in the past and we don’t see any reason to change that strategy now.
There’s More Than One Way to Manage Risk
My recent article about the flooding in Columbus led me to think some more about flood and other types of insurance. Many people who lived in areas where flooding might not have been expected did not carry insurance since it wasn’t required by their mortgage holder. I think the reason is pretty simple: people don’t want to pay for something they don’t think they’ll ever need.
My father was an attorney who practiced in Indianapolis. He gave me advice whenever I asked and I put much of it to good use. However, he and I made very different decisions about insurance for ourselves and our families. He never carried any insurance beyond what was required by law – i.e. he had no coverage on his health or life nor on my mother’s. As he explained it, during his working years he felt as if he was just trading dollars, that if his health costs never exceeded what he would have paid in premiums, he would have broken even. As far as protecting his children, he was a member of a fraternal society known as The Loyal Order of Moose. One of the benefits of that membership was Mooseheart, a residential facility for the orphaned children of members. His version of life insurance was knowing that my sister and I would be cared for if he became unable to raise us. I double-checked before writing this article and Mooseheart Child City and School is still operating in west suburban Chicago.
There are other examples of non insurance-based "insurance" in our modern world. Did you know that there have been fire departments which operated on a subscription basis? In 1948, a gentleman named Lou Weitzman watched his neighbor’s home burn down and decided to start a fire department in his unincorporated Arizona community. Not being able to fund it with tax revenues, he asked neighbors to subscribe instead, a concept which caught on quickly. Three years later, his small company signed a contract to provide fire protection to the nearby city of Scottsdale. The company he founded, Rural/Metro, no longer offers services on a subscription basis but does provide fire and/or EMS services to about 400 communities in twenty-two states.
In case you were wondering, no one was required to subscribe in order to have a fire put out by Lou’s first fire department. All fires were fought with the same level of skill and urgency but non-members were billed for the service, perhaps $7500 or more, depending on how many firefighters were at work and how long trucks were at the scene. Like those Columbus residents who were flooded, individual homeowners were allowed to pay in advance for protection or take the chance that there would never be a need for it and pay only in the event of a problem.
Health coverage is also available on a non-insurance basis. There are several nonprofit Christian organizations that offer people a chance to pay each other’s medical bills. Apparently, most of those who do have the option of regular insurance don’t pay much more or less for coverage through such groups. However, they do have the pleasure of helping someone else every month, knowing that others will do the same for them if the need arises. Individuals with limited traditional insurance options, perhaps the self-employed or those who have chosen early retirement, may find such an organization a useful alternative. Each requires proof of reasonable health as well as limiting enrollment to those who neither smoke or drink and are church members. Of course, collecting premiums and arranging for the payment of medical bills sounds very much like what insurance companies do, so several of these programs have been challenged by state insurance regulators. Different cases have gone different ways but I find it interesting that non-insurance can be utilized to cover heath care costs, at least in some cases.
If you’d like contact information for Moose or the Christian health care co-operatives, please let us know. At Warren Ward Associates, we do not believe that our clients necessarily need insurance to cover every eventuality but we do believe that risks should be evaluated periodically. That way, sound decisions regarding the need for coverage can be made.
Pogo-nomics: We Have Met the Enemy and He Is Us
I know, I’m dating myself by admitting that I remember the "Pogo" comic strip which ran in the Sunday funnies when I was a child. I’m not sure in what context Pogo made the statement I’ve quoted above but I was reminded of it while writing about sub-prime mortgage problems and their negative effect on our markets. I mentioned Wall Street’s fascination with high-yielding securities, laying blame at the feet of institutions instead of individuals. In fact, those large Wall Street brokerage firms would not have been establishing investment pools made up of such mortgages absent demand for them from individual investors and their brokers. Mine has been one of many voices regularly warning people about deals that appear "too good to be true". Yet, almost every year, we are offered another example of wishing outweighing thinking.
Investments can be complicated, so comparing something new with something we already understand can be a useful way to put things into perspective. For example, a Certificate of Deposit is a time-limited savings account with a bank. Banks have government-regulated financial strength requirements and their deposits, including CDs, are backed by an ultimate federal government guarantee. Since we know the level of quality represented by CDs, I often use them as a benchmark against which other interest-paying investments can be compared. Over the years, many of my clients have heard me say "If a CD is paying 5%, what risk do we have to assume to receive 10%?" I am not opposed to taking additional risk, especially if we believe we understand something that the broader market may have missed, but I want to understand the risks before making an investment on behalf of a client. My first concern is always how their principal will be returned. Once that is clear, I’m free to think about how much they might earn on their investment.
In the case of sub-prime mortgages, the rating agencies became convinced that the large number of different borrowers in each pool would provide security for investors. The agencies regarded it as unlikely that all the borrowers would get into financial difficulties at the same time. They apparently did not consider that, with a group of people who were not qualified for home ownership under the usual rules, all of them could easily face problems simultaneously when a planned but generally overlooked rate increase went into effect. Unfortunately for the borrowers, rates rose as scheduled and many borrowers have defaulted. Unfortunately for the investors in those pools, rating agencies are paid (by the issuers) to provide their ratings but do not guarantee them, so those investors lost money too. Unfortunately for the rest of us, the lack of confidence brought on by the potential for significant defaults shocked the remaining markets. No one was left unscathed.
What can we learn from this cascade of problems? Most likely, those individuals who are in the process of losing their homes will be more careful about reading the fine print in the next contract they are asked to sign. And perhaps next time, previously trusting investors will look beyond the hype and try to understand the details of the investment they are planning.
To me, the clearest lesson of Pogo-nomics is that risk and reward are inextricably entwined and neither one can be ignored in search of the other. However, it’s easy to forget that lesson when faced with the lure of the next "hot" investment idea. That is precisely why Warren Ward Associates advises clients to invest in a diversified portfolio of stocks, bonds and real estate; we know of no other way to protect investors from unexpected corrections in the capital markets.
A Ton of Feathers
Which weighs more, the grade school joke goes, a ton of lead or a ton of feathers? With gasoline prices hovering around $4 per gallon, a more appropriate question might be which costs more, a gallon of gas or a gallon of water? When I was in the manufacturing world, I followed the general rule that water needed for our dyeing/finishing processes cost a penny per gallon. Depending on the type of water you are interested in or what it’s mixed with, today’s answer might be a bit different. Here are some recent (approximate) costs per gallon for water and other water-based liquids:
|
1 gallon of tap water |
$0.04 |
|
1 gallon of diet soda (warm 12 packs in a grocery) |
$3.75 |
|
1 gallon of unleaded regular gasoline |
$3.99 |
|
1 gallon of diet soda (cold cans from a vending machine) |
$9.00 |
|
1 gallon of Starbucks coffee (grande cups) |
$14.80 |
|
1 gallon of Evian water (9 oz bottles) |
$21.00 |
|
1 gallon of Scope mouthwash |
$85.00 |
You probably noticed that I slipped a non-water entry onto the list. I didn’t compile this list to embarrass bottled water drinkers or provide an alibi for the gasoline companies. I just wanted a simple way to put the prices of several commonly purchased liquids into perspective.
Among followers of the automotive industry, Toyota has rarely been caught making a misstep. However, its decision to enter the large SUV market several years ago has hurt the company recently. As higher gas prices have sent truck sales plunging for Toyota, right along with Ford, GM & Chrysler. Honda, which might have appeared off track in its decision not to join the truck-based SUV fray now looks prescient as it adds capacity to build its economical Civic sedans in southeastern Indiana. It typically takes more than three years to bring an automobile plant on line. Three years is also the minimum time required to re-tool and update the design of a car. These long lead times require considerable forethought on the part of auto makers who must do their best to anticipate consumer wishes, and thus required production capacity, far into the future.
As complex a decision matrix as those manufacturers face, gasoline producers have even longer lead times and an even more convoluted market for which to plan. While drilling a new well in an area where current wells are producing might be completed in as little as a year, drilling in an area where oil is thought to be takes much longer. In addition, most of the "easy" oil fields have already been tapped so any new domestic well is likely to be located in deep water or a very cold climate. A new refinery takes at least ten years to bring on stream and not every refinery can produce every type of gasoline necessary for the US market, let alone the whole world.
For example, the city of Chicago is large enough to enforce its own pollution standards. Even though Michigan City, Indiana, lives very much in the Windy City’s orbit, extra gasoline available there cannot be diverted legally to meet a shortfall in Chicago due to those differing regulations. With at least fifteen different formulations required around our country, deciding when to switch refinery production from one blend to another is a difficult task with a significant financial penalty for making a mistake. An oil refinery or automobile factory could easily require an investment of a hundred million dollars or more. That’s an amount not to be spent lightly, no matter how large the company. The more predictability our economy offers, the easier the planning process is going to be for these critical suppliers.
I have never been one to insist on my own way if some sort of compromise seems possible. I was, of course, distressed by the oil spill from the Exxon Valdez but I also believe that importing the majority of the oil required to fuel our cars is not in the best interests of our country. In this campaign season, may I humbly suggest that "single issue" voting and the staking-out of extreme positions is not the best way to provide the most good for the most US citizens? With the two contenders seeming (in mid-July, anyway) to be moving towards the "center", perhaps we can look forward to a highly productive first term for our new President.
News Flash: Retirement Planning Can Be Complicated . . .
Perhaps because of its roots as a tax update letter, Kiplinger’s Personal Finance is one of the few consumer-oriented financial publications I read with any regularity. There was an article in the August 2007 issue on a topic I happen to have some experience with: the use of software as a retirement planning tool. The story opens with Bill, a 42 year old who wonders when he will have saved enough to retire. In an attempt to answer that question, he visited half a dozen different websites and used the calculators provided. Each asked for different pieces of information and all arrived at different conclusions. In order to followup, Kiplinger’s imagined a couple in their 30’s and ran their situation through five such calculators. Perhaps not surprisingly, each of those websites came up with a different answer for that situation, too.
Some of the article’s observations:
- Small changes in assumptions about potential rates of return and inflation can have a significant impact over 30 or more years of calculations.
- The range of estimated spending during retirement years varied widely.
- On-line vendors have been accused of using the calculators as "marketing gimmicks" intended to draw people into doing business with them.
Clearly, assumptions must be made when doing a projection like this. At Warren Ward Associates, ours change as our sense of the economy changes. We generally use 3% for inflation and have recently used around 8% as a rate of return for stock investments and 4% for bond investments. I would not suggest that anyone consider these percentages to be facts but they might provide a reasonable place to begin.
Of course, there is no guarantee that anyone will have enough money to last for their entire retirement lives but spending during those years can sometimes be adjusted. In making projections, we currently use 4% to 5% as a withdrawal rate from retirement accounts. However, once retirement has begun for our clients, we try to make adjustments for better and worse market years with the aim of making their nest eggs last.
A few years ago, my physician suggested that I begin a program of regular exercise, suggesting that "any" would be better than "none". In the case of financial fitness, that might not necessarily be the case. If a website’s answer is overly optimistic, you might assume everything will be fine and quit thinking about retirement planning. If it is too pessimistic, you might feel the urge to take extraordinary risks with your investments, trying to remedy the potential shortfall or perhaps give up altogether.
Retirement strategy reviews are a necessary part of planning. Both Bill, the original subject of the article, and the authors eventually decided that visiting a professional might be a better choice than depending on a website. The article rightly notes that a live planner will probably use software too, although hopefully, it will be only one of the tools employed, guided by the planner’s training and experience.
Just as the Weather Channel has turned us into a nation of amateur meteorologists, so the availability of numerous popular magazines and websites has turned us into potential financial gurus. As useful as software has become at Warren Ward Associates, we think the most satisfying results are likely to be obtained while working one-on-one with someone who is able to offer suggestions about appropriate assumptions and also help with interpretation.
. . . and all the children are above average
I have written before about what a mixed blessing averages can be. In trying to figure out how well a group of individual elements is performing, determining their average is a common place to begin. In my earlier comments about mutual funds, I stated that simply through calculating an average, one-half of the funds included must fall below it.
That’s not true, of course, in the case of Garrison Keillor’s mythical Lake Woebegon, where all of the children are above average. Actually, thinking of oneself as above average is a pretty common bias. According to the invaluable Wikipedia, back in 1981, Swedish researcher Ola Svenson found that 80% of respondents rated themselves in the top 30% of all drivers. I understand that this situation has now become known as "The Lake Woebegon Effect".
Thinking only about averages, it might be easy to assume that insurance on your home is a poor idea. It’s not likely that any of you reading this article are deliberately without property insurance but, if you relied only on the averages in making your decision, such coverage might not make sense. You have a less than 1% chance of having your home burn in any ten year period and most people don’t know anyone whose home has burned. Yet, the potential devastation is so great that most of us, quite appropriately, have looked beyond the averages in making our insurance decision.
Investment returns are often expressed as averages. For example, the average rate of return for the Standard and Poors 500 over the past 75 years has been greater than 11%. Does that mean that all S&P 500 investors have done that well? Unfortunately, it does not. That famous index is as much at the mercy of "the market" as any other investment. One of the problems with average rates of investment return is that how well you do depends to a great extent on when and for how long your money was invested. If you remained on the sidelines then invested at the top of the tech stock "bubble" in 1999, your account only recently returned to profitability.
Mutual fund investing raises further issues. From their advertising, you might think that all of them were above average. Their rates of return are usually expressed as a percentage from one date to another but most people don’t earn even the published return, as they make their investments in a much more random way. At the request of the Securities and Exchange Commission, the mutual fund industry has begun to address this issue, trying to establish a more appropriate way to express their performance.
At Warren Ward Associates, we are aware of average rates of return, but our investment process places much more emphasis on such specifics as manager tenure and a fund’s ability to stick to their investment strategy than it does on returns. Understanding what has happened in the past does not guarantee investment success but it is a key component of our strategy of reducing risk while trying to provide "average" returns.
