Investing
The Dollar is Crashing!!
Feb 23rd
What was this stuff I kept hearing last year about the dollar crashing? In December 2009 this talk reached a fevered pitch. Here’s the dollar index over the last year and you can see how much it’s recovered since the dark days of December 2009:
You can track the US Dollar index at this link.
Since this time the Euro has taken a pounding due to the issues with Greece possibly going into sovereign default. This drove the Euro down and the Dollar was the beneficiary. I’m not a dollar bull necessarily, but I post this just to show (yet again) that reacting to news that everyone else already knows is rarely a good way to invest. The markets are random and things we think must happen may not happen for a very long time (if at all).
Best to ignore all of the financial news and just stick to a simple diversified portfolio that can take care of you whether the dollar is sinking or flying.
Complicated costs. Simple saves.
Feb 12th
I was going through some old investing books today getting ready to dispose of them to make room on my shelves. When paging through the candidates for removal, I saw so many complicated investing strategies. Some of the portfolio recommendations held 10 or more different mutual funds as part of their allocations! I bought these books early in my investment career and during that time they convinced me that only a complicated investment strategy could deliver diversification and performance.
Boy, was I wrong.
After looking back over the many years when I first bought these books it showed me this: Despite the complexity of these various strategies, not a single one of them added anything significant to investor diversification over this time. Owning a bunch of stock funds does not make you diversified. If anything, these approaches were tremendously risky for what you got out of them. Yet, the approaches hid those risks by making you think you had diversification because you owned so many different stock assets.
Well, stocks share the same market risks by and large because of the deep interconnections that exist between them all. Just because an investor owns some small company stocks, large company stocks, foreign stocks, etc. is no guarantee that a bad bear market can’t come up and bite them all at once. I didn’t go back and run the performance numbers, but my quick look predicts that over the period I owned the books they wouldn’t have done any better than a simpler portfolio. With the additional trading and management costs involved, there is a chance they did worse than a simpler approach.
This just reminded me how important it is to keep investing simple. Complicated investment schemes can hide many risks and expenses. The simpler you keep investing, the less chance you have of making a mistake. Investors don’t need to follow complicated investment plans to get good results. Indeed, I’ve found the simpler you keep investing the more likely you are to turn a good profit and not face any wicked surprises.
Why I own stocks…
Feb 11th
After 2008 many people swore off stocks. “Too Risky!” they say and then tell you about their hot new investment in a multi-level marketing scheme or their Uncle’s new franchise opportunity. Isn’t it funny how whatever assets you don’t own you always think are “too risky” when someone else owns them? I’m as guilty as the next guy on this. For instance, I don’t touch junk bonds and emerging market debt. It’s too risky. 
But I think I can make a better case for this position than people who don’t own any stocks for the same reason.
I own stocks and I admit it. I feel comfortable with stocks in my portfolio because they represent an ownership stake in the productive capacity of my country. Every time someone buys a Coca Cola, a computer or any other product they hand me money through the profits. When I’m awake they are handing me money. When I’m asleep they are handing me money. They are handing me this money 24 hours a day and seven days a week across the planet as they make their purchases.
Stocks have risks. Sometimes these risks show up in big price declines. But sometimes these risks cause the prices to climb far higher and faster than any other asset you can own. Over time, stock dividends reinvested can grow capital by large amounts through compounding. This makes it different than assets like gold which cannot grow on its own as it pays no dividends.
While market risks can impact a company’s stock over a period of time, I also realize that most companies are resilient and can adapt to changing economic conditions and survive. Not all of them can do this, but most do. This is why I own a broadly based stock index fund. Such a fund may own over 5,000 individual company stocks. This means any one of company going bankrupt has an insignificant impact on the entire portfolio. Not only this, but stock index funds are cheap. Every penny an investor saves in management fees is another penny in their pocket each year to compound and grow.
I know the markets have proven to be efficient over time. This means it’s almost impossible to outperform the market averages as everyone else on the planet receives the same information you do almost instantly. I recognize that sometimes the markets are not 100% efficient all the time. But I also recognize that it’s close enough that debating the point is academic because rebalancing between assets eliminates these risks.
I admit that all the brokerage houses receive news of major events within seconds and have computers and people that will trade positions just as fast in reaction to it. Therefore, I don’t try to compete with these people by out trading them because someone like me is always the last to know. Instead, I just hold on to my boring index fund that owns everything and profit from the thrashing the professional and amateur traders are doing underneath. Over time, my index fund will beat in excess of 95% of all of them.
The markets are random. The price movements are not predictable day-to-day or even each year so I balance my stock ownership with assets like bonds, gold and cash. I don’t own just stocks because owning 100% in stocks is extremely risky and not guaranteed to bring any more success than a diversified portfolio. I know there have been protracted decade-plus stretches where stocks have performed poorly in real terms (such as the 1970s and 2000s). Therefore, I reject the idea that stocks are the only asset any investor needs. Instead, I diversify just in case the next decade of under-performance happens to be during a period of time when it could hurt me.
I understand that portfolios which do not have any stock exposure face the risk that they will not be able to grow faster than inflation over time. So I accept that stocks have risks of loss in order to ensure I have the chance to take advantage of gains when they present themselves to grow my money. Although assets like gold and bonds by themselves are useful to diversify against certain market risks, I know they may not be enough to beat inflation and grow the portfolio alone. That’s why I own stocks.
Why I own gold…
Feb 10th
Why do people freak out so much when you tell them you own some gold in your portfolio? It’s as if you had just told them you killed a dozen people before lunch. The hyper-ventilation you hear from some when you even mention this topic is just nutty. It usually starts with some juvenile comment involving tinfoil hats. Then they pull out some quote from an economist (usually one that loves inflation to solve all problems) about how useless gold is. They may even hit you with the ol’ “gold is not a form of wealth but just a shiny metal” lecture (ignoring the bulk of human history, and all major central banks, that disagree with them). Then they tell you how “risky” gold is when their own portfolio may be loaded to the hilt with junk bonds, emerging market debt or other complicated investment products. They must think the Nigerian stocks they hold in their Frontier Market fund are a sure thing (assuming they even know what’s in the funds they own).
Well, I own gold and I admit it. I feel comfortable owning gold in my portfolio. I sleep well at night knowing I own gold even though it could drop in value. I understand that in a balanced portfolio gold is a useful tool. I trust gold to protect me in high inflation more than indexed linked bonds (TIPS) ever will.
Gold has no interest or dividends. I admit these things and acknowledge that this is one area that makes gold different than stocks and bonds. However, this does not make gold useless for diversification.
Gold maintains real purchasing power over time and it’s really good at doing this. No other asset on this planet has such a long history. I don’t worry about politicians printing trillions of dollars of gold. This is because politicians can’t print gold. Gold can also be owned directly without any obligations attached to it. These are unique attributes for an asset class when used properly in a portfolio (and properly does not mean 100% gold).
While gold does not have the interest or dividends of stocks and bonds, it has other benefits that can work at certain times to protect a portfolio that does hold stocks and bonds. Gold for instance does very well under high inflation when stocks and bonds do not.
Gold has risks just as stocks and bonds have risks. I understand what these risks are and how they fit in a diversified portfolio. Yet, I do not rely only on gold in a portfolio. I also own stocks and bonds to drive returns when gold is performing poorly. In diversification there is safety which is why I own all these assets and don’t get religious about it. I accept gold’s quirks because I know when it comes time for it to perform it will do so better than all its contemporaries.
The empirical evidence says that owning some gold in a portfolio is not the death sentence academic literature would suggest. In fact, at certain times having gold can be a tremendous help. So, either reality is wrong or the academic theories are. Given a choice between the two, I’ll take reality. That reality is that all portfolios should hold some gold for diversification against stocks and bonds despite what critics state. That’s why I own gold.
Book Review – Books on Risk (and two podcasts)
Jan 28th
A theme you’ll hear on this blog about investing is the idea that the markets are not predictable. You may believe that I’m referring to the idea that you can’t predict returns on investments ahead of time and that’s partially true. The other part though relates to extreme risks that sweep through the markets in unpredictable ways with unpredictable results.
Aside from standard market risks, when you look at your investments it’s also important to always ask yourself: “What if I’m wrong?” Because, odds are, you will be wrong eventually. It’s just a question of degrees on how wrong it will be: A little or a lot.
The Permanent Portfolio has protection against unpredictable market risks and being wrong. If you’re wrong, you’re not going to be wrong so much that you take a crushing blow to your portfolio (because your asset allocation is widely diversified in relatively small chunks). We should also understand though that all investments have risk. Without risk, you will not get rewards. So risk must be taken to grow a portfolio, but it must be done with specific goals in mind. We need profits, but we also need defenses against an unknown future.
In this light, I’d like to share with you some books and podcasts that I think really hit at this problem of risk, uncertain futures and protecting yourself against being wrong. They may help you understand why diversifying and eliminating unnecessary risks in your portfolio is so important and why being wrong does not have to be fatal if you handle it correctly.
First there is John Allen Paulos and his book A Mathematician Plays The Stock Market. This 2003 title is one of a series of excellent books written about his worldly observations as a mathematician. In this case, the book details his own personal story of losing money in the stock market and how uncertainty rules. It’s an interesting look at many concepts you see in the investing world with respect to stocks vs. bonds, efficient market hypothesis, chaos theory, etc. And, best of all, it’s a very easy and fun read with almost no math but high level explanations of many concepts with real-world examples. He has a number of books written in his “A Mathematician” series exploring everything from innumeracy in society to his experiences investing (and losing) lots of money in Worldcom as he discusses in this book. The bottom line is that risk is real, markets are random, and trying to beat it can be very costly. His dedication reads:
To my father, who never played the market and knew little about probability, yet understood one of the prime lessons of both. “Uncertainty,” he would say, “is the only certainty there is, and knowing how to live with insecurity is the only security.”
John Allen Paulos – A Mathematician Plays the Stock Market Dedication
Now that’s a dedication I can get behind! That is the core philosophy of how the Permanent Portfolio is designed to operate.
Next, there is Nassim Nicholas Taleb and his series of books on chance. First there was Fooled By Randomness followed by The Black Swan. Both of these books explore the idea of unpredictability in the world. While his advice is largely being linked to finance today (he was a former trader), his observations come into play in many areas of life. His book, The Black Swan, pre-dated the 2008 crash involving Fannie Mae but said this in one of his footnotes:…the government-sponsored institution Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events “unlikely.”
Nassim Taleb – The Black Swan Pg. 225
I’d say he certainly called that one correctly.
I also think you’ll enjoy these two podcasts from Nassim Taleb. One recorded in 2007 talks about his book The Black Swan. The second was recorded in 2009 after the market meltdown as an after-action report on what he had written and said before:
Taleb on Black Swans – April 30, 2007
Taleb on the Financial Crisis – March 23, 2009
One thing about Taleb is while he has disdain for most fields of economics (and especially the very silly Keynesians), he does have an affinity for the Austrian Economic School and their dislike of the over-application of mathematics in economics for what is, essentially, a human behavioral problem (aka. scientism). Why does this matter? For one, you cannot model risks accurately with standard statistical methods because human behavior is not predictable. Secondly, Harry Browne was a firm believer in Austrian Economics and the Permanent Portfolio design, at its absolute core, is based on the Austrian School’s theory on monetary cycles (a lengthy topic for another day) and embracing unpredictability in the world. In fact, I think that one of the reasons the Permanent Portfolio is good at dealing with market risk is because the Austrian Economics school is right about a great many things. This outlook helps to drive the portfolio down the right path over time avoiding serious pitfalls and dangerous assumptions about the future.
With these three books and two podcasts you will understand more about market risk than most professional investors and economists. Seriously. Combine that with Harry Browne’s podcasts, and his own previous books, and you’ll be well versed in the dangers of the unpredictable in the investing world and how to position yourself to deal with them.
Strategize, analyze, optimize and lose money all with one tool!
Jan 25th
I just saw an ad on TV talking about TDAmeritrade’s new options trading tool. They had some hipster guy walking in with a bag full of groceries in his hand. He was very serious and lecturing about the need for strategy in trading. They then cut away to some other beautiful people talking about keeping up with the market first thing in the morning and watching some blinky lights on the computer monitor giving them information.
One lady looked intensely at a “heat map” that showed where the money was going that day. I thought she was playing Tetris but the commercial says this is part of the trading strategy. It looked more like a video slot machine, which I suppose it actually is in some respects, but it certainly wasn’t investing.
Well, it was just too much to bear so I took a quick look at what other pretty charts their software can make from their website above.
The “Heat Map” feature. Here you can see where the hot money for the day is going in the market so you can be the chump jumping in after everyone else and be left holding the bag:
TDAmeritrade's "Heat Map"
This chart is a representation of your money being sucked down a black hole by doing options trading:
Options Black Hole
The website says: “See a clearer picture of the potential profit or loss of your options trades.” Is this chart clear to you:
Options Huh?
Here’s a chart they left out:
Bad Option
That’s my projected returns on $100 for most options traders.
If the information in TDAmeritrade’s “heat map” and other technical indicators was worth anything, why would they be telling it to you? Why wouldn’t they use their secret insight into the markets and make a killing themselves? They’ll just have to be happy with their per-trade commissions while their options trading customers are pulling down the big bucks. I guess they’re just being nice guys.
I know people who lost their life savings trading options. Stay far away from this stuff.
FerFal Responds About Gold and Real Estate
Jan 21st
The previous book review of The Modern Survival Manual: Surviving the Economic Collapse covered the insider’s view of the Argentina financial crisis of 2001 and what happens when a society sees their currency lose more than 2/3rds of its value in a short period. It was an interesting read with unique insights into economics and sociology that you just won’t find in a standard textbook on the subject.
Now, I’m impartial to investment assets and don’t believe in extremes. I had some questions along the lines of going to extremes in investments and wrote to FerFal (Fernando – author of the book above) about his views having lived in a time when extremes did happen in his country. He gives his thoughts below.
On extremes in investing in gold (100% gold vs. not owning any gold) and real estate:
Extremes are bad, and I know what you mean. There’s people that believe anything other than gold is worthless and others that state “When the world ends I’ll trade an egg for a bar of gold!” You can only roll your eyes and think ok buddy, you sit there waiting for doomsday while I live in the real world.
I’ve noticed that both my father and grandmother have one thing in common. Grandma was a farmer in Spain, when she came to Argentina she started a successful bakery shop, lost their savings several times for many reasons, inflation, change of currencies, takeovers, etc.
My father is an accountant, he worked in banks most of his life, was on the board of directors of bank Boston in Boston, Massachusetts, practically lost the money he had to put into his retirement fund in Argentina.
The thing they both have in common? After a number of economic changes, inflation and corralitos of various kinds, the only thing both of them have left were their real estate investments. Those survived better than money in the bank, and unlike the almost useless retirement plans, the rent will be what really allows them to retire and live well.
Thought it was worth mentioning. I consider real estate an important part of one’s portfolio as well.
FerFal brings up a point that I hope to explore more in the future. I believe strongly that investors should have what a poster at the Bogleheads forum “chicagobear” aptly called a “have money” and a “make money” side of their portfolio.
Inside the Permanent Portfolio you have four assets: Stocks, Bonds, Cash and Gold. Stocks and bonds are your “make money” portfolio as they pay interest, dividends and have capital appreciation. Cash and gold are more of your “have money” portfolio because they pay little in interest (such as cash) or have no interest or dividends like gold (but may have capital appreciation). However these “have money” assets have tremendous ability to ride out very bad markets when your “make money” assets are doing poorly. The “make money” and “have money” halves of the portfolio work together to lower volatility and provide good returns.
But FerFal brings up another interesting asset: Real estate. It combines the aspects of “make money” by giving you an income stream from rent but also is a “have money” as it is an asset that can’t be inflated away easily.
For the Permanent Portfolio, Harry Browne cautioned against using real estate as an investment as he considered it speculative in nature. In many respects this is true. However if you own rental property you do have potential to make money if you choose a good location, have good renters, can manage maintenance costs, have a good management company, etc. This is the speculative risk part. It could work out, but there is risk that one or more things could happen to make it not profitable.
What about Real Estate Investment Trusts (REITs)? You get the high income streams from owning real estate, but don’t get the calls at 3AM in the morning about a leaking roof. REIT index funds own a wide variety of companies that have exposure to malls, office buildings, public storage companies, etc. So you get geographic and industry diversification as well. However, by owning stock you don’t own the actual property itself which may defeat the purpose of real estate entirely as a hard asset like gold. Yet, for investors that want to have some real estate exposure, but don’t want the hassle, it may be an acceptable trade off.
As it is, in terms of “make money” and “have money” side of things, real estate seems to straddle the fence. It combines elements of stocks and gold investing (along with both of their risks). It is a hybrid asset. If owned directly it can provide inflation insurance that stocks and bonds may not. Yet it can also provide an income stream that gold and cash cannot. With REITs you give up the direct ownership, but they do provide a nice income stream which is hard to ignore.
Are there risks? Of course. There are risks involved just as you’d suspect and they need to be managed effectively. For instance, property management seems like one of the biggest headaches for real estate investors (but not for REIT owners). In Argentina FerFal handles it this way:
About managing real estate, I’ve found that in most cases its better to spend a couple bucks each month and let a real estate agency collect the rent and argue with the people you rent to.
In few cases, you find the right person and things run smoothly, most often it doesn’t and a middle man like the real estate agency collecting rent and making the calls if they get behind saves you time and lots of headaches. Besides, they [the renters] pay better ( pay when they are supposed to) when they dont have the actual owner in front of them to cry to.
Never heard of owning real estate through stocks [REITs]. Here, most people manage their own property, with a real estate office always taking care of the contract ( very important to have a good contract) and some have real estate managers like the ones I mentioned.
Here its important to be good at haggling like I say in the book. I’ve had very serious, suit wearing real estate agents cut down their managing asking fees down to 10% of what they where originally asking for. It’s important to know the market, know what a realistic asking fee is.I’m a nice guy and dont like pushing people ( people that come up with excuses for not paying rent) but like everything else, you learn little by little, know when someone really just needs a couple more days, or when he’s playing with you. Again, best thing is to have someone else take care of it, specially if you’re not planning on having much time to chase people around to get paid.
Here in the states many rental property owners do use management companies and this does seem to lessen the stress. They manage the renters, the maintenance, etc. There are some potential pitfalls to navigate though (such as the management company overcharging you for services and maintenance, carrying insurance, etc.). So rental property ownership is far from a sure thing and will take some work on your part to choose wisely.
However if you think you have the stomach for it, rental properties may be a consideration if you’re looking to have exposure to hard assets but also want that asset to deliver an income stream. BTW. I don’t think time shares fall into this category. I think time shares are the kind of investment made to be sold, not bought. Also, when we’re talking about owning real estate I feel we’re talking about property where you own the note yourself and not taking out loans to buy properties and risk you can’t make the payments. Taking out large loans to buy property other than your own home is a violation of Rule #7 of the 16 Golden Rules of Financial Safety.
If you don’t want to deal with any of these risks, or don’t have funds to buy additional real estate outside of your home, it may make more sense to look into a REIT fund like Vanguard’s REIT index (Ticker: VGSIX) or the iShares Realty Majors Index (Ticker: ICF). If you are eligible, the TIAA-CREF Real Estate Fund has an excellent reputation as well. These options provide inexpensive exposure to real estate with the trade off being you don’t own the property itself. If you are comfortable with that, the REIT funds above provide an easy way to get real estate exposure. They also have the other advantage that they are very liquid. Meaning that you can sell them in 60 seconds to get your funds instead of waiting days, weeks, months or even years to unload a physical property plus realtor commissions.
In terms of asset allocation, real estate is in the variable portfolio side of the house. Basically, only do it with money you can afford to lose. Also realize that if you own a broadly based stock index fund like the Total Stock Market you already own REITs. You just don’t own a lot of them in proportion to everything else.
Also remember that real estate does have risk just as all investments do. It’s just a question of diversifying these risks against all your other assets to reduce losses if they should show up. REIT funds dropped over 65% from their 2007 highs to their lows in 2008 as a recent example. And despite what realtors always claim about physical property prices, many areas experienced significant price drops in real estate that could take years, or decades, to recover. Yet, with the real estate bubble clearly popped in the US this asset could be a reasonable buy for someone looking to diversify a little of their play money and have some protection against unexpected events as well.
Thank you Fernando for answering my questions. Please be sure to visit his blog where he provides information on many topics.