>The Rise of Interest Rates

>For nearly two years I have predicted interest rates will rise. Of course I was not alone in my prediction, pretty much everybody thought the same. We were all wrong for nearly two years, which just goes to prove you can be right about something, just not right about when it will happen. For example, I could predict that American will have another terrorist attack, but if I can’t tell you when, am I really making a prediction?

Short term interest rates have actually been rising for the past year, at the end of March last year the 90 day treasury bill was yielding .96%, which meant money market accounts were yielding about half that, some of them yielding nothing. However, as of yesterday the 90 day treasury bill was yielding 2.70% and you can get a money market account paying 3.25% at www.emigrant-direct.com. In other words, short term rates have nearly tripled in the last year. This marks one of the fastest rises of short term interest rates in history.

Long term interest rates on the other hand stayed pretty much the same throughout the year. The ten-year for a short period jumped up to the 4.80% range, but then quickly fell back down to the 4% level and didn’t budge…….that is until February. Since February the ten-year treasury has risen to 4.63% (as of 3/22/05), not a huge rise, but one worth noting as it will add nearly 3/4 pt to a mortgage loan.

The real question is whether or not the trend will continue. It appears that if Greenspan has his way it will. What most people don’t know is that Greenspan mostly has control over short term rates, long term rates are determined more by the market than what Greenspan wants. Thus there is the possibility that short term rates could continue to rise, while long term rates stay in the mid 4 – 5% range. This would actually hold the best of both worlds scenarios, good returns on short term bonds, and good rates on mortgages. My first mortgage was 7.75% and I thought I was getting an incredible deal, of course my loan was only $163,000. If rates rise I think new home buyers will still be able to squeeze into a home, but they will start having a harder and harder time.

What does this mean for your portfolio? Well, your bonds and bond funds will take short term hits to their principal, but will start earning higher interest rates as interest and maturing bonds are reinvested into new bonds paying higher rates – in the long run rising rates are good for bonds and bond funds especially (despite what most illiterate financial advisors will tell you).

There it is, my treatise on interest rates for the end of the 1st quarter, nothing fancy, but things are starting to look up……rates that is!

Till next time,



>Does Diversification Always Work? Why Most People Would Have Fired Me……

>I build diversified portfolio’s for my clients. This means that I have my clients buy all sorts of different types of investments. A typical portfolio will have large stocks, small stocks, value stocks, growth stocks, & international stocks along with bonds. Diversification is the bedrock of investing and serves to give you a similar (hopefully better) return than the market with less fluctuation. But does it always work?

No. Diversification doesn’t always work. There will be time periods, sometimes long time periods where the benefits of diversification do not seem readily apparent. Between 1995 and 1999 a diversified portfolio drastically underperformed the market. The market, as represented by the Russell 3000 returned an annualized 26.95% between 1995 – 1999, an incredible run. A well diversified portfolio that held international stocks returned about 16% annually, a great return, but over 10% less than the overall market. How enthused with a diversified portfolio would you have been after five years of drastic underperformance? Had you invested $100,000 on January 1, 1995 you would have had nearly $330,000 if you bought the market, but only about $212,000 with a diversified portfolio – a difference of over $100,000 – would you have been happy with this differential? It is entirely likely that you would have already fired me and moved on to an advisor who was willing to put you in what was hot at the time, large cap growth stocks. Let’s consider what happened over the next five years.

Between 2000 and 2004 the market as represented by the Russell 3000 returned a negative 1.17% (that is -1.17%) annualized. A diversified portfolio during the same five year stretch annualized a 10.41% return, an outperformance of about 11%. People who invested $100,000 in a diversified portfolio on January 1, 2000 and held till the end of 2004 would have ended up with about $164,000 vs $94,000 with the market strategy. At the end of this five year period a diversified portfolio strategy would have look ingenius.

For the entire ten year stretch the market returned an annualized 12%, with a diversified portfolio a little over 13%. The diversified portfolio had a higher return, but more importantly a more consistent return. The diversified portfolio had only one down year versus three for the market. The market based portfolio fluctuated nearly 30% more than the diversified portfolio. The diversified portfolio had less fluctuation and a higher, more consistent return. In hindsight it is easy to see which would have been better, but while you are in the moment people tend to make decisions based on emotion.

What will the next five years bring us? I wish I knew, unfortunately I haven’t located the crystal ball that will tell me. What I do know is that a diversified portfolio should provide much more consistent returns with less fluctuation than the overall market, and with a higher return to boot. We may be in for a time period where the market outperforms diversified portfolios, I urge you to not follow the crowd and do what is easy. Stick with a diversified portfolio and in the long run you will be the real winner. I can’t promise we will beat the market in the short term, but in the long term I believe that a well diversified strategy combined with low costs will give you the best chance of success.

Until next time….



>Is 10% Realistic…Part III – Vanguard’s View

>What follows is an article from Vanguard’s website which I thought you might find interesting about returns.

The Story

February 22, 2005
‘Normal’ stock returns are, actually, quite abnormal

It’s often noted that the historical average yearly return of stocks is 10%. Paradoxically, this quite-accurate figure isn’t the return that most investors are likely to receive in a year.

The 10%-a-year figure is an average calculated over very long time periods, such as the 78 years from 1926 through 2003.* Averages are useful, of course, but you should also be aware of their limitations. Take the extreme example of a desert with freezing cold nights and fiery hot days. An average of the temperatures might show that this desert is quite comfortable.

Stock market returns aren’t as extreme as those temperatures, but returns can vary greatly. That’s why annual stock market returns matched the 10% average, plus or minus 2 percentage points, in only 6 of the past 78 years, as the accompanying chart shows. And negative returns occurred more often than many investors may be aware: Investors lost money in 24 of the years, or 30% of the time.

Accumulators: Stay focused

By keeping in mind that stock returns can veer widely from historical averages—sometimes for years at a stretch—investors who are accumulating funds for long-term goals may be able to fight the temptation to jettison their investment plan during difficult market periods.

What that 10% figure does mean is that, over the decades, the years of good returns have more than compensated for the years of bad returns. Moreover, for the period 1926–2003, stocks’ average annualized return outperformed that of money market investments by about 6.5 percentage points and that of bonds by about 5 percentage points. This difference in returns compounds significantly over time. It’s certainly true that past performance is no guarantee of future results. But the historical record does underscore the need to focus on the long term (while also making sure that your asset mix doesn’t focus on chasing returns but, instead, matches your risk tolerance, goals, and time horizon).

Awareness that the 10% average is a product of more extreme ups and downs can also help you resist the temptation to overload your portfolio with stocks when the market is way above average—and create a portfolio that may be riskier than you originally intended.

Retirees: Withdraw funds gingerly

For retirees, the challenge is to acknowledge that variable stock market returns, not the steady long-term averages, are the normal state of affairs, and to make their portfolio withdrawal decisions accordingly.

Particularly important is the sequence of yearly returns. A series of good stock market years at the start of retirement can add significantly to a nest egg and make any future bad years easier to bear. But a series of bad years at the start can make it difficult to recoup losses later and can result in a faster depletion of assets.

No one knows what future markets will be like, so retirees should plan to withdraw funds conservatively during the good years and be prepared to modify their spending plans in the bad years. To help put this strategy into practice, Vanguard has developed two portfolio withdrawal techniques aimed at increasing the odds that assets won’t be depleted early. They’re described in Select Your Withdrawal Method in the PlainTalk® on Managing Your Retirement area.

* The exact average for that time period is 10.4%, based on the Standard & Poor’s 500 Index from 1926 through 1970 and the Dow Jones Wilshire 5000 Composite Index from 1971 through 2003. Note that the returns and the principles cited here apply to broadly diversified groups of stocks and bonds and don’t take taxes into account. Earnings results for individual stocks or nondiversified portfolios are likely to vary significantly from those shown here.

Scott’s Comments:

I think Vanguard is on the right track and providing great education with this piece. I would love to hear your comments.

Till Next Time……



>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) www.efficientfrontier.com. 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………….



An Independent Fiduciary

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