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THE BLUE MONEY REPORT.
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The Blue Money Report
"It is better to be vaguely right than precisely wrong. "
~ Wildon Carr
Welcome to the Blue Money Report
Today's Commentary: 10.24.02 I want to thank Larry Swedroe for contributing this article. Larry has done work for this column before and his material is always well done. Keep in mind that he does make some valid points but that he is also an advisor himself. This column will appear in two parts, the second part concluding on Saturday 10.26.02
How Good Advisors Add Value Tennis players know that a pro can teach them the skills needed to make the variety of shots required for a well-rounded game. A teaching pro can also provide the winning strategy and the discipline to stick with that strategy. That is why even the top players in the world continue to have a coach. Investors can benefit from coaching in the same way a tennis player does. Just like the tennis pro, a good financial advisor will provide: We will begin our examination of the many ways in which a good advisor can add value at the most logical point‹the starting line of the investment journey. No rational person would begin a journey to a place they have never been without a road map and directions. Neither should an intelligent person begin a business without a business plan. Using the same logic, individuals should not begin their investment journey without an investment plan, or what is known as an Investment Policy Statement (IPS). The IPS is a road map, including directions, identifying the investment objectives and risk tolerance of the investor. The outcome of the IPS includes both the asset allocation and the accompanying rebalancing table. The IPS should be the result of a long and thoughtful process during which the investor¹s ability, willingness, and perhaps most importantly, need to take risk are carefully identified. Arriving at the correct asset allocation is an extremely important part of the process as it determines virtually all of the risk and rewards of the investment portfolio. Thus it is extremely important to get the allocation correct. And since there is no correct asset allocation, just one that is correct for each individual, the process used is extremely important. Let's see how a good advisor can add value during the process by helping the client to best judge their ability, willingness and need to take risk. Ability to Take Risk Equity investors must be aware that the longer the investment horizon, the more likely it is that the expected will occur (i.e., stocks will outperform both money market funds and bonds). Conversely, the shorter the horizon, the more likely it is that the expected will not occur (i.e., stocks will generate negative returns). Therefore, investors with long investment horizons have a greater ability to take risk and can thus allocate a greater percentage of their portfolios to equities than can investors with shorter investment horizons. It is also important to consider that an individual or family may have several different investment horizons, each of which should be independently considered. For example, there may be a twenty-year horizon to retirement and a forty-year life expectancy, but a five- to ten-year horizon for expenses related to the costs of college education. Specific major expenses, like a down payment on a home, for which there are anticipated horizons, should be considered independently of the rest of the portfolio. Thus it may be even be appropriate to set up several investment accounts, and have a separate related IPS. The second limb of the ability to take risk is the stability of one's income, be it earned, or unearned (like social security or alimony). For example, a tenured professor or a civil servant is likely to have a high stability of income. Thus they have a greater ability to accept the economic cycle risks related to stocks than might a construction or automobile worker. They also have a greater ability to accept the risks of value and small-cap stocks that have more economic cycle risk than do large and growth stocks. The key issue that needs to be addressed is how highly correlated is non-investment income to the economic cycle risk of equities. The reason is that if an investor's income becomes at risk or is lost, then the investor might be forced to sell stocks to meet daily living expenses. Being forced to sell equities during a bear market can have devastating consequences to a portfolio, consequences it may be difficult, if not impossible, from which to recover. A good advisor can help an investor identify and analyze not only these type risks but also the best way to address the risks. Willingness to Take Risk It is important to identify the point at which the investor's ability to sleep well begins to be impacted, which should be occurring well before the "panic and sell" level of distress has been reached. The reason is that life is just too short not to enjoy it, and there are far more important things in life than just achieving the highest rate of return. It is extremely important to find the appropriate sleep well level. The reason is that understanding the "threshold for pain" is important to successful investing. This is because the emotion of fear often leads to panic, and well-thought-out investment plans are tossed into the trash heap. It is always easy to stay the course in bull markets, but it is far more important to stay the course in bear markets in order to avoid the far-too-human propensity to sell at market bottoms. Thus the role that emotion plays in the success of an investment strategy cannot be overemphasized. A good advisor makes every effort to make sure the right level is found. This effort involves: Educating the client on financial history, pointing out that bear markets occur with great frequency, far more often than many investors realize - on average about once every three or four years. Educating the client on how painful bear markets can be, going over the history of the worst periods such as the 197374 bear market, as well as pointing out that just because it was the worst one experienced in the post-World War II era, does not mean we could not experience an even worse one in the future. The bear market that began with the bursting of the technology bubble in March of 2000 is a good example of why it is extremely important to address this issue. A good advisor would also help a client understand how this current bear market relates to prior ones in terms of losses experienced. Making sure the client does not treat even the highly unlikely as impossible - such as a bear market like the one experienced in Japan since 1989 or one like the world experienced during the Great Depression. Making as sure as possible that the client does not make the mistake of being overconfident of their abilities to deal with the emotions caused by severe bear markets.
The Need to Take Risk Considering only the first two issues‹the ability and willingness to take risk - while ignoring the need to take risk - is a very serious mistake made by many investors and advisors alike. The greater the rate of return needed to achieve one's financial objective, the more equity (and/or small and value) risk one needs to take. However, in considering the financial objective it is important to very carefully consider what economists call the marginal utility of wealth - how much is any potential incremental wealth worth relative to the risk that must be accepted in order to achieve the greater expected return. While more money is always better than less, at some point most people achieve a lifestyle with which they are very comfortable. At that point, the taking on of incremental risk required to achieve a higher net worth is no longer acceptable to most people. The reason is that the potential damage of an unexpected negative outcome far exceeds the benefit that would be gained from incremental wealth.
Part Two continues here.
Larry Swedroe is the author of "What Wall Street Doesn¹t Want You to Know," "The Only Guide To A Winning Investment Strategy You Will Ever Need," and "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," was published in June by St. Martins Press. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.
Today's Commentary: 10.21.02 I try so desperately to find some sort of common ground on some things, that when there are none, I feel slighted. Somehow, recent items appearing in the news have caught my attention.
First on the list is the sly yank of the budget strings. The administration offered for those careful enough to find the low key information, a passing adjustment concerning the Security and Exchange Commission's budget. Now these dollars were allocated back when we were all hyped over corporate governance. This is necessary big government enforcement that was sorely underfunded for far too long.
But the budget increase was short lived even though the increase was supposedly signed into law. Sen. Paul Sarbanes, D-Md., chairman of the Senate Banking Committee and co-author of the bill was as equally shocked as those who found the President signing it were. Much fanfare was made about this administrations ties to some questionable corporations and their accounting practices. This money would have allowed the SEC to at least provide a proverbial cop on the beat.
"We proposed the largest increase in the SEC's budget of modern times, and that was part of a fiscally responsible budget that has been submitted to the Congress,"
~ Ari Fleischer This agency has been literally handcuffed since the Reagan era and looks to be no better off now. Sure it is only a couple hundred million and the administration is quick to point out that this is a lot more than the agency has had in the past. All kidding aside, it is like giving a kid a toothbrush on Halloween. It's good for them but not even close to what they want. In this instance, not even close to what they need. (Partial transcript of the White House Daily Briefing below.)
When the Senate and the House return from their little campaigning vacation, they will have to find some way to get the money back into the bill. Unless the Republicans come back with control of Congress.
Secondly, there is the ever looming pension problem which many investors are turning a blind eye to in some sort of attempt to make it go away. It won't and neither will the returns they have projected for some of these funds. Where are these companies coming off suggesting that they are capable of returns north of 9%. This is a screaming alarm that there are some seriously underfunded pensions out there and it isn't the employee I am worried about. 70% of company sponsored pension plans have found themselves underfunded and this is not something that can be isolated as a problem that belongs to the business sector. The federal and state governments will be faced with serious bailout obligations based on the accounting of these funds.
If you are unclear how this would effect you, the shareholder, and you, the pension recipient, it works like this. Companies invest their current obligations and their future needs based on a discount rate that in turn is based on the interest rate of high quality corporate bonds. These discount rates are based on the present value of those obligations. So when interest rates decline, the discount rate does also. When that happens, the future obligation increases. That was okay when many of these funds were overfunded from those go-go years past. But even these titans of industry miscalculated the length of the current downturn. These liabilities, what the company owes it's funds have increased 70%.
Now companies have dutifully decreased their estimates, in some cases from the lofty expectation of 10% this year (IBM) to 8 to 8.5% in 2003. These missed numbers mean two things. Charges taken against shareholder equity and accounting regulations on how these accounts are booked. Neither one bodes well for the current corporate outlook if the bears stay in town for too much longer.
Thirdly, what still gets me laughing is the notion, popular among die hard optimists, that bull markets are surrounded by bear markets of short duration. I have no idea where this thinking came about. Even after today's move upward, folks are still denying that the bear market is tenacious enough to hold on for much longer. Earnings, even those that have been dramatically adjusted, are nothing short of dull.
James T. Kahn offered his view recently about whether this is going to be a prolonged bear market or simply a blip on the economic cycle. He trotted out info dating all the way back to 1792 suggesting that bulls average length of stay runs about 10 1/2 years. But the bears tend to hang around for much longer periods averaging 14 1/2 years. His contention is that bull markets are the result of human nature, a force that is both chartable but highly unwavering its predictability.
If that is the case, recent rallies are merely, that, rallies. There is, according to him, far too much historic data suggesting that this current market will continue at least, emphasis on least, through next year. Never has the market rallied itself out of its slump during a mid-election year. If anything, it will get worse.
Most of us live in a three market cycle, this money manager from ParkSouth Securities suggests. There is the most recent one, one from our youth, and then the bear nestled in the middle, or as he refers to as the non-conforming market.
Fourth on my list of potential newsworthy itmes draws my amusement. It is the recent cries for more companies, especially S&P 500 companies, to issue dividends. Microsoft, one of the most capable of spreading the wealth is probably the least likely to participate. This is company who could have owned the world if they had shared the source code for their operating system. Not only would they have saved millions in R & D, but their products would have developed unbelievably profitable lives of their own. And they would have worked. On a side note, it is still a surprise to me that the box makers such as Dell and Gateway would allow someone else to build the most important component of their product and not insist on better quality.
And lastly, on Wednesday, the Federal Reserve releases it beige book, which for those who don't know what that contains is the survey of regional economic conditions. This is the info that the central bank uses at its next interest rate meeting, early next month. I am thinking that Alan Greenspan could take a page from the car makers and jump-start this economy with some fancy interest rate offers. I realize that it is impossible, but wouldn't it be neat if their was a two tier interest rate for businesses. For every dollar they borrow to increase their business profile, a matching interest free dollar would be provided to purchase technology. Borrow a billion at the current rate and while the paper work is still on the desk, qualify for another interest free billion to outfit yourself with new tech toys. Sort of a zero down, zero interest for a year program that has presold the auto industry into next year. Companies would spend on technology which would spur the growth which would drive the customer... and so on.
Thursday brings reports on weekly jobless claims and mortgage rates. We are mostly comfortable with the jobless recovery scenario and growth of 3%. This means that this news is non news and the markets shouldn't even bat an eye in the direction of either of these numbers.
As promised, Exerpts from White House Daily Briefing
Q: Ari, if I could just change topics a little bit. Could you explain
why the White House feels it's necessary, going back to Friday, to cut
the SEC's budget, or to not increase it as much as had been previously
agreed to and supported by the White House?
MR. FLEISCHER: Well, we've proposed the largest increase in the SEC's
budget in modern times --
Q: -- increased it more, and now you want to increase it less than
that, even though it's still an increase. And I know that there's some
back and forth about increases and cuts, but it's still less than what
you had supported before.
MR. FLEISCHER: Can I answer your question?
Q: Yes.
MR. FLEISCHER: Thank you. We proposed the largest increase in the
SEC's budget of modern times, and that was part of a fiscally
responsible budget that has been submitted to the Congress. Congress
has not finished its work. It continues to work on the budget not only
for the SEC, but for every agency in the government outside the
defense and military construction.
When Congress returns we're going to continue to work with them on the
SEC's budget, and we want to pass a large increase for the SEC and
make sure we do so in a fiscally responsible way.
Q: So you're willing to put it back up, is that what you're saying?
MR. FLEISCHER: We're continuing to work with the Congress on what the
exact budget will be. And I do want to draw your attention to the fact
that the budget that is proposed is the budget that the SEC asked for.
The SEC in July notified the President and the Congress, and publicly
in a letter, that their needs were -- they recommended that their
initial budget request be increased by an additional $100 million,
bringing it to $567 million. That is the level of funding that the
President has proposed to the Congress, which is almost a 30 percent
increase in the SEC's budget, and it is the amount that the SEC said
it needed.
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