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>Is 10% Realistic…Part II – The Economists

>In a previous blog I mentioned that I didn’t feel that the historical return we have enjoyed on stocks would continue in the future, however I also noted that I have no idea if I will be right – only time will tell. I mentioned that over the past 200 years “real” returns (return after inflation) averaged about 6.5%, this translates to about a 10% return including inflation. Recently the Wall Street Journal ran an article on Social Security and asked several prominent economists to weigh in on what they believe real returns will be over the next 44 years. What follows is the response:

Name Organization Stocks Gov. Bonds Corp. Bonds

William Dudley Goldman Sachs 5.00% 2.00% 2.50%
Jeremy Siegal Wharton 6.00% 1.80% 2.30%
David Rosenberg Merrill Lynch 4.00% 3.00% 4.00%
Ethan Harris Lehman Bros. 4.00% 3.50% 2.50%
Robert Shiller Yale 4.60% 2.20% 2.70%
Joseph LaVornga Deutsche Bank 6.50% 4.00% 5.00%
Paul Jain Nomura 4.50% 3.50% 4.00%
John Lonski Moody’s 4.00% 2.00% 3.00%
David Malpass Bear Stearns 5.50% 3.50% 4.25%
Jim Glassman JP Morgan 4.00% 2.50% 3.00%

There you have it, the experts forecasts of returns for the next 44 years. Keep in mind that economists are known for having the best jobs in the world, they are wrong most of the time, yet continue to recieve a paycheck. I do think though that the above economists, while not being fortune tellers are not far off. The most bullish estimate is that we will continue to have 6.5% real returns on stocks, while the lowest estimate is 4.00%. The lesson here is not that we should take everything economist say to be fact, but that it is unreasonable to think that future returns will resemble the past.

In this world of lower returns there are only a few things individuals can do to ensure that they earn all the return that they can. The first is to find superior stock pickers – unfortunately that is unrealistic (see my earlier blog on luck/skill). The four things an investor must do to ensure they earn as much of the future returns as possible are:

1.) Diversify across large, small, growth, value, & international stocks
2.) Keep mutual fund & advisory expenses low
3.) Don’t attempt to time the markets – stay invested through thick and thin
4.) Stay away from Active Management

If you do these four things you will greatly increase your odds of earnings all the future returns possible. In all likelihood you will outearn your neighbor who is chasing money managers, jumping in and out of stocks, and paying enormous fees to advisors who have no clue what they are doing.

To conclude this segment – expecations are everything…going forward there is a great likelihood that returns will be lower and you need to do everything possible to plan for this scenario.

Till next time…..



>Social Security Reform Shouldn’t Be Partisan

>I usually don’t like to discuss politics in my writing because I am bound to offend somebody, however I do feel compelled to say a few things about Social Security reform and the current debate.

First, this isn’t a partisan issue, this is an American issue and it is a problem. There is absolutley no way you can look at Social Security with any honesty and say there isn’t a problem with it. What irks me is that the press lately seems to think that if you are a republican than you are for reform, if you are a democrat you must be against it (if only because republicans are for it). I believe that if everybody had the straight facts that they would be in favor of making changes to the system to ensure it’s existence for the long term and ensure that it doesn’t become an anchor that drags on the economy.

Most people don’t realize that Social Security was never meant to be a retirement plan. It was designed as a safety net and as a way to get workers to retire (so that younger workers could get jobs during the depression). The first payments were lump-sum payments. The program evolved and became a monthly paycheck type system (an annuity) but the people who retired into the system at 65 usually only lived for a few years, life expectancy was 65 (meaning half of the people died before that age, thus half the people never collected a dime). The system was designed as a “pay-as-you-go” system where current workers pay for the benefits of the current retirees. This system works fine when you have lots of workers and few retirees who don’t live very long. However, America has experienced the perfect storm in terms of Social Security – a baby boom leading to lots of future retirees, followed by a baby bust leading to much fewer workers supporting the future retirees. In addition, those retirees are retiring earlier and living a lot longer (a good thing for us, a bad thing for Social Security). When you combine those facts you end up with a system that will eventually collapse on itself.

The system isn’t going to collapse today, or tomorrow, or even next year. But the system is not stable long term. There are many ways to fix it, including raising taxes, cutting benefits, creating private accounts, and a whole host of more complicated ideas. In the past we have raised taxes and it hasn’t made the system stronger, in the future if we solely rely on increasing taxes the payroll tax will have to rise from the current 12.4% to nearly 20%. This will choke America. I recently read that more younger workers believe in UFO’s than they do that they will recieve social security benefits. Younger workers have already mentally prepared themselves that benefits either won’t be there or will be much smaller.

The bottomline is that Social Security is not viable long term and instead of waiting for it to become unviable, we should act now and make the changes needed to keep it strong and keep it from becoming a drag on the economy. If we wait, the choices we have will be fewer and much harder to swallow. Let’s not let our politics get in the way of what is the right thing to do. Republican or Democrat, Conservative or Liberal…..put it aside and lets all work together to make social security stronger for everyone.

Till Next Time……



>The Problem With Mutual Fund Manager Skill……Luck or Skill?

>I am not a big fan of using money managers to manage my clients money. It’s not that these people aren’t smart, quite the contrary, its simply the fact that they rarely outperform the benchmarks they should be compared to. Of course a few always do outperform each year, sometimes a few outperform for many, many years. Bill Miller of the Legg Mason Value fund has “outperformed” the S & P 500 now for 14 years in a row. A recent headline read “Bill Miller’s Streak Preserved,” the story had the following comments:

“It came down to the wire, but Bill Miller has done it again. The storied Legg Mason Value Trust fund manager pushed his winning streak over the S&P 500 to 14 years as of today’s close, an unparalleled run.”

“You can’t help but cheer Miller on and hope that his streak says alive,” says Morningstar analyst Kunal Kapoor. “After all, he embodies what a good active manager should be: an independent thinker who invests with the long haul in mind.”

Surely Mr. Miller has skill, right? No other manager has beaten the index every single year for 14 years in a row, right? Perhaps Mr. Miller does have skill, though it is difficult to know as we would expect statistically for at least one money manager to beat the S & P 500 14 years in a row. Now, I am not a statistician, but let me give you an example of what I mean.

Pretend you were in a basketball arena full of people, 14,000 people to be exact. You asked each one of them to pull out a quarter and stand up. Next you ask everybody to flip the coin and if they get tails to sit down. Since the chance of flipping a tail is 50-50 we would expect half to sit down, leaving 7,000 people, what follows is what would happen if we kept this experiement going:

Start out with 14,0000

Flip 1 7,000

Flip 2 3,500

Flip 3 1,750

Flip 4 875

Flip 5 438

Flip 6 219

Flip 7 110

Flip 8 55

Flip 9 28

Flip 10 14

Flip 11 7

Flip 12 3.5

Flip 13 2

Flip 14 1

What does this mean? Well, after 14 coin flips we still have one person standing. This one individual has flipped heads 14 times in a row. Is this individual skilled or lucky? Does he know something about flipping coins that allows him to flip heads everytime, or is it simply luck? As you can see from above, statistically we would expect one person to still be standing, having flipped heads 14 times in a row, it wasn’t any skill on this individuals part, just pure luck. If we asked him to continue flipping an infinite number of times he would eventually revert back to half his flips being heads, the other half tails. He isn’t a gifted coin flipper, just a random person who out of a crowd of 14,000 individuals happened to be the one that flipped heads 14 times in a row.

This little story has two implications for your portfolio. The first, it is very difficult to tell whether your money manager (read: mutual fund manager(s)) have any skill or are just lucky. In fact, assuming there were 14,000 mutual funds in existence 14 years (probably wasn’t that many) we would expect at least one of them to do what Bill Miller has done – beat his index 14 years in a row. Is Bill skilled, or lucky? We can’t know, in fact it would take decades more of him managing money for us to know with certainty if he is skilled, by then it is too late.

The second implication is that we had no idea who the guy was that was going to flip heads 14 times in a row, in advance. In other words, if you were standing in the middle of the stadium and asked to identify which person would flip heads 14 times in a row would you have a very good chance of identifying him/her in advance? No, it would be nearly impossible. The same goes for mutual fund selection. Even though we know that statistically somebody each year will outperform, and we know that over periods of time somebody will outperform we don’t know who it will be in advance and we have no way of predicting – thus spending our time attempting to do so is a waste. We are spinning our wheels.

Next time you flip a coin think of the implications it has for your portfolio, are you basing your retirement on chance and luck? Active management and attempting to pick winning money managers is akin to spinning your wheels, it gets you know where.

Until next time……


PS – I ended up watching the half time show of the super bowl (what an improvement over last year)and the rest of the game, it was a good game, but since I really didn’t care who won I was mainly watching for the commercials. The guy with the spaghetti sauce, knife, and white cat cracked me up, but the Anheiser Busch commercial is the one that choked me up. If you didn’t see it was a thank you to the men and women who are putting their lives on the line to protect our freedoms (and that of others). My three year old (who now has memorized and says the pledge of allegiance everyday) was watching the game with me and I pointed to the TV and started to say “these are the men and women who are giving their lives for us,” but I couldn’t get the words out, I started to choke up and my son looked at me in bewilderment. The commercial was simple, a bunch of troops walking through an airport after getting home from being deployed…..everybody in the airport (including the janitors, cooks, & security) stood up and started clapping for them. I tear up just thinking about it. My son may not understand the depth of the commercial (especially in its simplicity), but somehow I think he knew by my reaction that these people where worth knowing about and paying tribute.

Nothing I can do is enough to thank our wonderful men and women (and families) who give up themselves everyday, but perhaps I can instill in my children the honor that they bring to our country and what they represent…….Freedom. If you are interested, Michael W. Smith has a great song that he wrote after 9/11 entitled “There She Stands” it is truly a classic and what inspired me to teach my son the Pledge….now if I could only get him to say the ABC’s outloud (he knows them…..).



>Is 10% Realistic? Part I

>This will be a short post, basically a precursor to others that will follow on the topic of future returns from the stock market. I want to make one thing perfectly clear before discussing this topic, I have no idea what returns in the future will be, nor does anybody else. The stock market might return 15% annually for the next 25 years, I highly doubt it, but can’t rule it out. Conversely, we may be entering into a time period where our stock market returns less than conventional fixed income products like bonds, fixed annuities, and Certificates of deposits. What I do know is that historically the markets have return about 6.5% after inflation over the past 200 years. The problem is that the 6.5% real return is not guaranteed and doesn’t happen in every time period we live in.

I believe that we are in for a period of lower “real,” (after inflation) returns than we have enjoyed historically. I don’t know this for a fact, but over the coming weeks and months I will give you my reasoning of why I believe that to be so. In the meantime, I invite you to look at one of my favorite websites (and my favorite financial author) William Bernstein authors the site and has written several wonderful books that I encourage everyone to read. “The Four Pillars of Investing” is perhaps the best book ever written on the topic of investing, you won’t be disappointed.

That’s it for now, stay tuned for more to come and have a great weekend.

Until next time………….



>Are Your Returns "Real"?

>When investors, wall street, and the media talk about the returns of different investments they are usually talking about “Nominal” returns. The term nominal refers to the actual return of an investment including the return generated solely by inflation (which really isn’t a return at all). What does this mean in plain english? The nominal return is the return you see, but not the return you get to spend. Most investors have no idea that they should be focusing not on “nominal” but on “real” returns. A “real” return is simply the rate of return you earn on an investment after subtracting inflation. Let me give you an example.

Let’s say you that on January 1, 2005 you put $1,000 into an investment with the intent of selling that investment in one year (January 1st, 2006). Your intent is to purchase an item that on January 1st, 2005 cost $1,000. During the year you earn a total return (nominal) of 6% and end up with $1,060 (ignore taxes for now). If the item you planned on purchasing with this money will now cost you $1,070 have you actually earned anything with your money? The answer is no. Even though your money earned 6% during the year, the prices of the items you want (and presumably need) to purchase rose by 7% during that same time period. Your investment return didn’t keep up with inflation. Even though 6% seems like a good rate of return, in reality your “real” rate of return (Return after inflation) was -1%. You actually lost purchasing power, your actual return, the return you can spend was negative.

As an investor your pursuits should focus not on the returns that you can see, but the returns that you can spend. Over the long run you want to invest with the goal of earning a “real” return. You want your money to grow faster than that of inflation so that your money can buy at least the same or more than when you started to invest it.

You often hear in the press that stocks have historically earned about 10%, however that shouldn’t mean anything to you. What you should really be asking is what did stocks (or bonds) return after inflation is taken out, what is my “real” return. Long term the “real” return of stocks has been about 6.5%. The next question that must be posed is whether or not going forward we can expect to continue to earn 6.5% above inflation from holding stocks. My instinct is that it is a possibility, but unlikely. My next column will focus on what return we should expect in the years ahead from different asset classes.

Until next time……….



>Residential Real Estate – Is It a Bubble?

>Yesterday a client of mine called and told me her son was purchasing a home in Arizona. 4 bedrooms, 2000 sq. ft with a front and backyard, basically brand new. The price of the home…….$200,0000 (up from the $170’s just last year). The same type of home where I live, sunny Southern California (Orange County) would go for at least $600,000 and have nearly $10,000 in real estate taxes annually to boot. That is a pretty big difference. With no money down you are looking at a payment with taxes of $4,334 per month in Orange County (assuming 30 year fixed), but only $1,218 in Arizona. Orange County is 3.6 times higher priced on a monthly basis. The question becomes “is living in Orange County (or many other expensive areas) 3.6 times better than in Arizona?” The answer is that I don’t know. Perhaps Orange County isn’t overpriced, Arizona is just underpriced.

What I do know is that from an investment standpoint the Orange County home doesn’t look like a very good deal. If you were to put 20% down (mortgage of $480,000) your payment with real estate taxes would be about $3,558 monthly, yet you would be lucky to get $2,400 in rent per month (I currently pay about $1,900 for such a home in rent). Even on an after-tax standpoint you aren’t breaking even cash flow wise, once you add in the cost of housing maintenance and vacancies (another $200 monthly minimum) you don’t have an investment, you have a speculation. You are speculating that either the price of housing will continue to rise, or that rents will rise quickly enough to make your cash flow work. Now, the Arizona property probably won’t cash flow either, but the difference is much less and long term the risk is much less – you don’t require that prices go up considerably to make money.

In my opinion residential real estate prices are too high in many, but not all areas. There are many factors involved in this that would take too long to explain here (see my links below). My advice is to be very aware of the risks that you are taking when purchasing a home in these expensive areas, don’t fall into the mindset of “Real estate can’t go down” or that “this time its different.” I am not saying don’t buy real estate, I am saying be sure it makes sense for you and that you understand all the risks going in.

What follows are some links to recent articles in Money magazine that I think you will find interesting.

The Schiller Interview

Irrational Exuberance – Again

Bang for the Real Esate Buck

Until next time………..



>2004 was a great 3 months…..

>2004 has come to an end and it turns out that it was a banner year for a diversified portfolio. Even the S & P 500 managed to rise above the 10% mark, not bad considering all the pessimism that pervaded the markets during 2004. Interestingly enough, the vast majority of the returns earned in 2004 came after the election.

Through September of 2004 the S & P 500 was up a meager 1.41%, however a globally diversified portfolio of stock mutual funds was up between 5 – 7.5%. Once the election was over the markets took off, let by small, international, & value stocks. A globally diversified all stock portfolio ended up with a return between 19 -22% where a more balanced portfolio holding 60% globally diversified stock and 40% fixed income returned in the 11-14% range. It is interesting to note that a globally diversified 60/40 portfolio beat the S & P 500 index for the year with less fluctuation. While this is great, don’t expect it to happen every year. The same portfolio vastly underperformed the S & P 500 during the go-go years of 95-99 and on a total return basis since 1995. Diversification is the smart way to go, but the price you will pay is that sometimes you won’t perfectly track the market – THIS IS OK.

I’ll be chiming in with more observations about 2005 soon, keep checking back!