Jim'sMoneyBlog

Financial Opinion and Insights

Archive for February 2011

Inflation’s Coming! Buy Gold, Right? Maybe Not.

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

We’ve heard it a hundred times.  It’s in all those TV commercials:  Gold is an inflation hedge!  If you’re worried about hyper-inflation, you should buy gold now!

True?  Is gold really linked to inflation?

History simply doesn’t bear that out.

Look at the last ten years:  Almost zero inflation.  If gold were linked to inflation, gold prices would have been flat.  But, gold prices moved higher, as did the stock market.  Few would say gold is linked to the stock market.

Maybe, with interest rates low and unemployment high, gold was linked to something else:  Fear.

Maybe gold is linked to the dollar!  After all, the dollar has been getting weaker for years; maybe that’s why gold prices have been going up.

That doesn’t appear to make sense, either.  If that were true, the price would have been declining against the other currencies that have been getting stronger; but, that hasn’t been the case.  Gold has been appreciating against all currencies, even those that have been getting stronger.

Many investors have short memories; it’s called a `recentcy bias’, attaching more importance to a recent event than one that happened long ago.  Few remember when gold prices went through 25 years of year-to-year negative returns.  The `that-was-then-this-is-now’ mentality is exactly why people buy into investment environments only after they’ve seen a run-up and are then convinced it will continue.

Does it make sense to own gold?  Probably.   Gold, like most investment vehicles, can be used as a risk diversification tool due to its correlation characteristics.   Most IFG clients are urged to maintain a 5% allocation to commodities, which include precious metals including gold.

If you’re not using gold as a part of your allocation, you may want to talk to your financial advisor.

Jim

—-

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com.

Predicting Market Returns May Be A Waste of Time

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

Last week I wrote about the futility of chasing past performance.   Despite the fact people are continually told not to use past performance as an indicator of future success, an entire industry has been built on trying to get people to do just that.

I thought you might enjoy taking a look at this chart from Morningstar.   It shows the S&P index returns from 1926 through 2010 .  Careful inspection just might lead you to believe – correctly – that investment success is more about process and discipline than predictions.

Enjoy!

Inflation is Sneaky – The Hazards Are Huge

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

Inflation is like glaucoma.  You can’t see it on a day-to-day basis, but the erosion of purchasing power is still there.  Do you remember when $50,000 a year was a lot of money and $5,000 would buy a luxury car? 

My dad retired in 1974 and lived 32 years in retirement!  Suppose he had $800,000 on the day he retired and someone had sold him a guaranteed 5% investment that would pay him $40,000 annually for the rest of his life.  It would have looked good to many people in 1974; but after 20 years of inflation, that $3,333 per month—BEFORE taxes—wouldn’t have looked so good… and he would live more than another decade!

Consider a 54-year-old widow who puts $2,500,000 into a guaranteed fixed-income investment yielding 4%.   A $100,000 a year income sounds pretty good and the money is considered safe!  But, let’s examine the situation in the real world.

The Impact of Inflation

Widow, age 54, 30-year life expectancy

4% Interest Rate

3% Inflation Rate

$2,500,000 invested

                     (A)                                   (B)                    (C) = A x B

Capital      Interest                   Real

Year          Purchasing Power     Rate               Yield

Now          $2,500,000                        4%                   $100,000

10             $1.860,235                        4%                   $  74,409

11             $1,384,189                        4%                    $ 55,368

12             $1,029,967                        4%                   $  41,199

Source: Asset Allocation, Roger C. Gibson, McGraw Hill, 4th Edition.

 

Notice the chart above which shows what really happened.  Her `safe’ money  was worth less and less  – and the same thing happened to the purchasing power of her income from interest.  At twenty years, with still a decade ahead of her, her income was worth just over half what it used to purchase and the same was true for her principal.   And, we didn’t even factor-in taxes.  That would be too scary.

Was this income certain?  Yes.  Was the outcome certain?  Yes, that too.  And, buy the way, what if inflation and taxes didn’t stay the same?    I’m getting beyond the scope of this piece, but you get the idea.

When it comes to stocks, investors seem to be hurt more by their behavior than their investments.  DALBAR, Inc., a Boston-based firm that provides research to the financial industry published an often-cited study entitled, “Quantitative Analysis of Investor Behavior”, comparing the track-record of the average investor in equity mutual funds to that of the S&P Index of U.S. large company stocks for the 20-year period between 1986 and 2005.  Based on the timing of contributions to and withdrawals from equity mutual funds, the average equity mutual fund investor earned just 3.9% while the S&P Index had an average annual return for the same period of 11.9%.  The major reason:  Investors chasing performance, which by definition is always past.

So, how does the average investor protect against inflation and taxes while still not exposing her portfolio to an unacceptable level of volatility?  The answer lies in the asset allocation that results from a properly researched and constructed plan.   You can request my paper on The Asset Allocation Process by using the `Request Info’ button on the IFG website.

Jim

—-

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.  The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.

How To Measure Success The Right Way

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

Quite often you’ll hear people talk about their stock portfolios and tell you about the returns they’re achieving; but seldom will you hear any discussion of risk management.  The closest thing you hear on television is usually when some pundit tells you that diversification means investing in two different unrelated industries.

Impressed?

You shouldn’t be.  There are more risks than that you should take into account when it comes to forming a portfolio strategy for your serious, long-term assets  – and let’s face it; if you’re over 50, all your money is your serious money.  What’s worth noting is that you can not avoid risk.  You can only manage it.

Here are some risks you might find familiar:

  • Market risk
  • Business risk
  • Inflation risk
  • Political/legislative risk
  • Liquidity risk
  • Interest rate/reinvestment risk
  • Currency risk
  • Market timing risk
  • Credit risk
  • Economic risk

Believe it or not, some of these risks cannot be diversified away!   If you purchased every single stock in an index, you wouldn’t diversify away market risk; you’d only replicate it!  So, some risk is can’t be diversified away.  However, ‘business risk’ can be reduced through diversification.

Most people are familiar with all these risks; but few have their portfolios constructed to optimize performance against these risks; and that’s where the rubber meets the road.

The Risk No One Talks About

Ask anyone how they compare their results to what they think they should be doing and they’ll almost always compare their portfolio’s performance to the ‘Dow’ or the S&P 500 index.

That’s their frame of reference.

For investors in the U.S., their reference is the U.S. market; and, it’s reinforced every time they turn on the television or read a newspaper.  It’s also reinforced every time they talk to their friends.  The broadly diversified, multiple-asset-class investor, however, would be in the minority in this conversation.  His portfolio will not behave the same way as the portfolio of his golfing buddies who don’t follow a portfolio strategy with the same breadth and degree of real diversification.

Do investors in Japan use the same frame of reference?  How about those in Great Britain, France, Brazil, or India?

Sound like a silly question?  Consider this:  During the ten-year period 2000-2009, the US market finished in the top 10 developed stock markets only three times and never finished higher than 3rd!  Only New Zealand finished 1st more than once!   Australia, New Zealand, Canada, Austria, and Switzerland finished in the top two more than once – Norway did it three times!   The U.S. made it to #3 only once.  It’s next highest finish was 8th![1]

Do you think the people in these countries compare their success to the U.S. market?  Should U.S. investors even compare themselves to the U.S. market? 

This is called `frame of reference’ risk.  People getting trapped into believing success is beating the market they’re most familiar with.

If the U.S. markets shouldn’t be your benchmark for comparison, what benchmark should you use?

The answer:  Your plan.

Your business plan – the one you create for your financial future – should be your frame of reference.  You’re either on-track or you’re not.   Your plan outlines where you are, where you want to go, how you plan to get there, and takes into account all the risks outlined on the slide.

And, not having one – a good one – can very likely prove to be the most expensive money you ever saved.

Jim

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.  The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.


[1] Source: Morningstar

Chasing Past Performance

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

Morningstar data reveals that mutual funds with four or five stars captured about 75% of the roughly $2 trillion of net inflows into all “star-rated” mutual funds over the 10-year period ending December 31, 2009. If that doesn’t reveal that investors are prone to chase past positive performance, nothing will.

Cambridge Associates, a consultant for institutional investors, studied the impact of chasing past performance and the outcome of firing “underperforming funds”  –  these are funds with below-benchmark returns but not in the bottom quartile – and replacing them with “top-performing funds.”   The fired funds often began to outperform, while the newly hired funds began to underperform!   By chasing past performance, investors were mostly selling at the bottom and buying at the top— sound familiar?   In fact, more than two-thirds of the mutual fund changes were harmful to performance.

Consider, for example, the Internet bubble of the late 1990s. Imagine how chasing double- and triple-digit returns worked out for investors after the market peaked!   Remember Lucent Technologies?

It isn’t surprising.  There isn’t a day that goes by I don’t hear someone telling me they purchased a stock or fund because someone they knew had it and it `did really well’ last year.

When you hear that a manager consistently performed in the top quartile for the past five years, does it really mean anything?

Suppose you assembled a group of 1,000 money managers – or they could be beauticians or plumbers – and required each of them to make security decisions on the basis of a random process, like rolling dice.  At the end of the first year, you rank these 1,000 managers based on their returns.  By definition, 500 will be above the median and 500 will be below.  After eliminating those below the median, the top 500 continue rolling dice.  After year two, you rank them again, this time eliminating the 250 that fell below median performance.  You continue in the same way for five years.  At the end of year five, you’ve identified the top 31 managers of 1,000 who have been among the top performers for five consecutive years.

Since we know they used a random process, we know not to attribute their success to superior skill; but, in the real world the same performance information can often lead an investor to be too quick to assume that superior skill is what made the difference.   And, in our media-driven culture, many investors continue to compare their performance against results achieved by the latest investment guru, continually reallocating money from one manager or vehicle to another as the search continues for the one who will produce the superior performance – and almost always jumping off something that’s going down to grab onto something that already has gone up.

Just as Einstein’s work on relativity didn’t invalidate Newton’s laws of physics – it merely limited the context within which Newton’s laws are true – traditional investment management with its emphasis on individual security selection has been eclipsed by modern portfolio theory(MPT), which considers each asset class not as an end in itself but rather as it stands in relationship to the others.  Realizing that all investments realize market gyrations, the concept of reducing movement correlation between classes means that MPT has redefined the limits within which traditional management approaches can add value.

Few investors approach the subject of MPT or portfolio strategy.  `Performance’ is more interesting.   But, as Morningstar data suggests, short-term thinking can derail long-term financial plans.  But, then, if there’s no plan, who knows the difference?

Jim

—-

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.  The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.