What is the Federal Funds Rate?

The federal funds rate is the rate banks pay each other for borrowing reserves. The Federal Reserve, the nation's central bank, requires banks to hold reserves against deposits. The Federal Reserve controls the federal funds rate. In effect, it is the price of money that they control.

Understanding the record in controlling this important price is key to understanding the housing crisis and the legacy of former Federal Reserve chairman Greenspan and the role of current chairman Bernanke.

Source: Baltimore Sun

As shown in the graph, the Federal Reserve lowered the rate to the unprecedented level of 1% in mid-2003 and kept it there for a year. Why? The party line was that the Fed was worried about economic weakness. This was after the dot-com meltdown in the stock market and the 9/11 attacks. Inflation had ratcheted down and  deflation was a worry. Looking over their shoulders, Fed governors saw Japan mired in a long-term economic slowdown because they didn't act aggressively  with macro economic policy.

But how weak was housing? The graph shows that single-family housing sales were on the upswing in 2003 as the Fed was aggressively cutting rates! Compare where housing sales were then to today, and think about the Fed and many others wondering why unemployment persists at such a high level.

Of course, all of this is history.  The Fed held the rate at 1% for a year starting in mid-2003 as the housing market went ever skyward!. Exotic mortgages were created. Mortgages were made with no down payment, no income requirements, and even the ability to have the principal increase over time as a payment option. Chairman Greenspan actually encouraged home buyers to use adjustable rate mortgages and take advantage of low teaser rates.

Gasoline was poured on a roaring fire. Bankers packaged and sliced and diced and manipulated ratings to push mortgage-backed structured product around the world. 

Then the Fed pulled the rug out from under the housing market. As shown in the first graph, they pushed the fed funds rate from 1% to above 5%. Again, the rest is history. Housing prices faltered, foreclosures rose, and the securities started to fall in price.

Today the federal funds rate is close to zero and has lost its capability to enable a pick-up in the economy. After all, it can't be pushed into negative territory.  Instead the Fed has come up with a new policy approach - "quantitative easing."  Quantitative easing is essentially an attempt to control the price of longer term money.

Part of the reason for the Chairman's recently instituted press conferences is to convince the American public he knows what he is doing.

Based on the record, I, for one, am not convinced.

What is the Difference Between the Federal Reserve and the U.S. Treasury?

Chairman Bernanke heads up the Federal Reserve and Treasury Secretary Geithner heads up the Treasury Department. Bernanke walks around spouting about his "dual mandate" and the Treasury Secretary says over and over that "...a strong dollar is in the interest in the U.S."  But what is the difference between the Fed and Treasury?

Each semester I tell my class that I wish we could hold a class at the local mall asking people as they walk in if they know the difference. In fact, I tell my class that I believe that the public not knowing the difference is part of the huge debt crisis problem facing the country. Sadly, I have to say that I believe we would be lucky if one person in ten could give a coherent explanation of the difference. One important take-away from my class is understanding this difference.

I begin my explanation by drawing a big circle on the board to represent the macro economy.  Inside the circle I put the main players:  Households (maximize utility), Businesses (maximize profits), Government (federal, state, & local), U.S. Treasury.

The U.S. Treasury is the bank of the federal government. Our federal government borrows more than it brings in in taxes, and it does this by issuing Treasury issues bills, notes, and bonds. Much of what goes on in the circle is off setting. Notice that it's simple - there is no international sector.

Outside the circle is the Federal Reserve. It, among other functions, manages the nation's money supply. To put more money in the circle, it buys Treasury securities from the entities in the circle. In this way, it creates money out of thin air. In fact, it could buy anything - used cars or pigs, for example. In fact, in recent times in response to the financial crisis, it has expanded the financial instruments it buys.
 
Once the Treasuries are bought and paid for with a check drawn on the Federal Reserve, the banking system can lend out a portion of the increased deposits because it is a fractional reserve system. If there is a demand for loans, and/or banks are willing to lend, a multiple expansion of money takes place with (again) money being created out of thin air.

If we go back and think of the Treasury borrowing by issuing bills, notes and bonds and realize that these can be bought by the Federal Reserve, we arrive at the concept of "monetizing the debt." This is the modern-day version of printing money. This debases the currency over time, lessens the value of saving, and leads to the problems that are slowly coming to a head today.

How Much Economics Do I Need to Know to Manage Investments?

Economists believe that you need to know economics to understand how the world works. More bluntly, they believe that  lawyers, MBAs, and many in the investment world just don't understand how the world works if they don't have a solid grounding in economics. In fact, the self-taught late economist Jude Wanniski wrote a book humbly titled The Way the World Works in 1998.

So what do economists understand that most people don't? What should you get out of a good intro to economics course? What is the take-away for the financial literacy crowd?

A good place to start is with the book, Economics In One Lesson by Henry Hazlitt. Hazlitt does an excellent job of explaining many of the principles first expounded by Bastiat. The one that has gained the most notoriety has been the "Broken Window Fallacy." This fallacy points out the importance of considering what isn't seen. In a nutshell, a thug breaks a window and a group of people reaches the conclusion that it isn't such a bad thing because it creates work for the glazier in repairing the window. What isn't seen is the suit of clothes the shop owner would have bought with the money spent on repairing the window.

Hazlitt provides numerous examples of where the broken window fallacy arises in every day economics and its consequences. In the process, he brings out the importance of understanding long-run and short-run consequences of policy actions.

Economics also teaches important points for investors to know about prices. For example, in a competitive market, where the product can be produced (example: housing), rising prices put in motion forces that will bring prices down. Understanding this fundamental principle, taught in every intro to micro course, could have saved the nation considerable resource waste over the last several years.

This is not intuitive to many investors. Let me cast it in terms of another example that looks at the flip side. If a tree falls and punctures our roof, we might be inclined to wring our hands and moan that the house will be flooded in the next rain storm. This, of course, isn't likely for the simple reason that we will look into getting it fixed. Similarly when the economy goes into a crash-and-burn state, our intuition tells us to bail. But again, this is exactly the wrong thing to do. Behind the scenes, actions take place to turn markets around. This is what was happening in early 2009. Powerful fiscal and monetary policy programs were  implemented.

A second point to understand about prices is the concept of asymmetric information, whereby typically a seller knows more than the buyer about the product being sold. The important work in this field was done by Akerlof in 1970 in a piece titled "The Market for Lemons: Quality Uncertainty and the Market Mechanism."  In this article, Akerlof examined the used car market and why buyers are more likely to get a "lemon."  Sellers will tend to hold on to well-maintained, etc. used cars and sell cars with problems into the used car market. The average used car then will be of poorer quality than is true of the entire population. This fundamental principle explains why buyers took toxic structured product debt and considerably exacerbated the 2008 financial crisis.

Incentives is another area that economics focuses on. For example, economists readily understand that there is typically more information indicated by an insider buy than by an insider sell. Insiders sell for many reasons -  to buy a second home, to pay little Joey's tuition - because options have granted more shares. They buy typically for one reason:  they like the company stock prospects.

These are all, of course, micro type considerations. On the macro level, a solid intro to economics course will provide the foundation for understanding the ongoing debate about macro economic policies as well as international considerations such as why the dollar is imploding. For those seeking a very solid intro to macro text, I would recommend a used edition of Mankiw's Principles of Economics paperback.

How to Find the Most Actively Traded Bonds

One of the most comprehensive online free data sources available to DIY investors is at the Wall Street Journal site. For those who invest in individual bonds, it can be an excellent source to follow that market.

Click the drop down arrow at the "Markets" tab.

Source: WSJ

Source:Wall Street Journal

Click "Market Data Center" and you come to a number of tabs containing data on various market sectors.  I recommend puttering around on the "Calendars & Economy"  and "Earnings" sections when you have the time.

Next click the "Bonds, Rates, & Credit Markets" tab.

Source: Wall Street Journal

 CLICK TO ENLARGE Again, notice the data at your finger tips!

Click as indicated and we get the list of most actively traded corporate bonds. You'll notice a "print button" at the top of the page making it very convenient to print weekly or so to follow the bond market over time. The table can be used to get a good idea of yields on particular maturity and ratings for bonds. CLICK TO ENLARGE

Source: FINRA TRACE data. Reference information from Reuters DataScope Data. Credit ratings from Moody's®, Standard & Poor's, and Fitch Ratings. 

What is the Cost of Investment Management?

I teach people how to manage their assets. Why? Because I feel people overpay for investment services and generally get poor service. You have to understand this going in. I'm biased on what I'm about to present.

For some people all of this investment stuff doesn't matter. They say they are happy with their investment advisor. Then they turn around and rant about how they don't have enough to retire. This is worth thinking about as you view the following.

A third point to keep in mind  is that financial planning and investment management are two different endeavors. You could get a sophisticated financial plan done by a financial planner and then have the assets turned over to Warren Buffett to manage. Again, they are separate functions. There is considerable confusion on this topic in the blogosphere. Let me be clear: for many people, a well done financial plan is worth paying for and, in fact, I've seen costly financial plans pay for themselves as the planner spots an attractive tax savings etc.

What we are going to look at is solely investment management. Specifically we'll think about how much could be saved managing your own assets. What we'll find is that the savings are huge - this isn't the old "change your own oil" tactic from graduate school days. This is meaningful savings. It is the difference between being able able to retire comfortably and not.

Regular readers of this blog know I  like periodic tables of investment returns and especially the Table put out by BlackRock for the 20 year period ended 2009 shown here:

Source: BlackRock

CLICK TO ENLARGE Granted there are many paths we could have gone down but this is one path we did travel. It seems that every time I look at this chart I learn something new. It shows the value of diversifying, why not to chase hot sectors, and the biggest ups and downs of the past 20 years. It also gives us what we need to calculate the cost of investment management. But first, let's backup and visualize what we are considering.

Google "wealth mangers" along with your zip code and you'll find at least 10 wealth managers within 25 miles, say, of where you live unless you're in the Amazon jungle or the North Pole. Call the 10 wealth managers and tell them you have $1.0 million in assets and you need help managing it.

To make a long story short they will gladly manage it for you at a fee of between 1% and 2% of the market value of assets. Thus, the first year fee on your $1.0 million will be approximately $10,000.

The question we are interested in is the cost of professional management  if we had gone back 20 years ago to 1990. What would have been the impact on the portfolio of professional management at 1% versus managing it ourselves? Keep in mind that assets typically need to be managed over much longer periods so we are actually looking at a short time frame - maybe someone in their mid 40s with a couple of rollover IRAs and 20 years to retirement.

This is not the place to point out that professionals, after fees, underperform markets over the long term. If you need evidence of this please do not hesitate to contact me. We are going to assume that the investment manager achieves the returns of the diversified portfolio in the BlackRock table.

We'll also assume that the investment manager gets paid at the end of the year. In the real world investment managers are paid at least quarterly.

Using the returns provided by BlackRock produces the following results for our little experiment:

YEAR

PORTFOLIO

RETURN

YEAR END

FEE

VALUE 2009

Financial Advice For 75-Year-Old Widow

 SmartMoney offers monthly portfolio advice for people in different stages of life. Much of the advice is worth considering for people as they contemplate their personal finances.  As with online advice in a lot of areas, however,  it sometimes is desperately in need of  further elaboration.  Consider this month's SmartMoney advice, "Perfect Portfolios: Finding the Right Fit,"  to the 75-year-old widow.

SmartMoney suggests "...you may consider putting about half of your savings into a guaranteed investment such as a fixed annuity."  Yikes!

I love 75-year-old widows.  In fact, I truly believe they are among the nicest people in the world.  Even the crotchety ones, if you can catch them in a rare good mood. Still...........

I don't have a problem with annuities per se.  The difficulty facing elderly widows (or any other annuity buyer for that matter) is knowing what they are buying.

From my experience, if you get one hundred 75-year-old widows in a room, 80 of them at least will have no knowledge of annuities, types of annuities, or how annuity sales people are compensated.  This makes them easy pickings for annuity salesmen and salesladies.  Suppose they accept the advice above and tell the sales person they would like to consider putting half their savings in annuities. Yikes!  What happens next?

This part isn't difficult to imagine.  The highest commissioned products will be pushed.  The widow will be hard sold on equity-linked products.  "Look, you can get stock market returns and be guaranteed that you won't lose your original investment."  "Look at this chart showing the S&P 500 since March 2009."   She will be sold on deferred product.  She will be hard sold on variable annuities . And, at least, 80 out of one hundred 75-year-old widows will have no idea what questions to ask.  If she buys the types of annuities that will be pushed on her, she'll have no idea what she bought.

How do I know?  They ask me later about how  the annuities they own work. What are the fees, etc.?  Were they good purchases?

The fact is that the right kind of annuity can be a great product for a 75-year-old widow.  Winning the lottery can also be great and, sad to say, the odds better than getting the right kind of annuity in many instances.

I would suggest that, just as you take an attorney to a real estate settlement, take an hourly compensated financial advisor when you sit down with the annuity sales person.  It is the easiest way to understand the fees, the guarantee, the likely performance of the annuities presented and, most importantly, whether the product is appropriate.

Can You Beat the S&P 500?

The S&P 500 stands as the challenge to many in the investment world. My readers know that DIY Investor is a proponent of indexed investing and recommends capturing as close to the market return as possible by using low-cost index funds. Still, DIY sees the fun of accepting the challenge of outperforming the popular index and, in the process, outwitting the pros at their game. When it comes to retirement money, DIY believes most investors should engage no more than 20% of their investable assets in this activity.

One way to seek outperformance of the index is by sector allocation.

Keep in mind the S&P 500 is part of the large cap portion of your assets.

Source: www,standardandpoors.com/indices

S&P 500 Sector Breakdown

CLICK TO ENLARGE As shown by the graphic, the index is comprised of 10 sectors: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecom Services, and Utilities.

To outperform the Index, the sector weightings are key. In fact, thinking through how the various sectors perform in different environments is useful mental activity. Market followers know how the energy sector has performed and what happened to the financial sector in 2008. They know, as well, the important difference between consumer discretionary and consumer staples in different environments.

CLICK TO ENLARGE This graphic shows price performance by sector.  Notice that year-to-date Energy is up over 15% and Financials are up by less than 1%. So, to beat the index, all that had to be done was to overweight the energy sector and underweight financials. Duh! How easy is this?  But how can we implement this strategy? What stocks are in those sectors? Do we  have to pick stocks?

At this point, most of you know where this is headed.
 
If you think you can analyze sectors of the macroeconomy and predict which will do better, then it is very easy to position a portfolio accordingly by using sector indexed ETFs. Please note that I am not recommending this - it is more difficult than it looks.

Using ETFs to Over and Under weight S&P 500 Sectors

Over and underweighting of sectors of the S&P 500 is easily accomplished using SPDR select sector ETFs.  They index the S&P 500 with the 9  sectors shown, and each ETF has an expense ratio of 0.20%.

Source: http://www.sectorspdr.com/aboutspdrs/

CLICK TO ENLARGE If you like to follow markets and feel you have a talent to predict sectors, then play around with sector prediction on paper. Simply rank the sectors by expected performance over the next month; and after a few months, you'll have some insight into how talented you are. More ambitious would be to actually put weightings on the sectors corresponding to the strength of your beliefs. Performance can be found at Select Sectors SPDRs performance.

Disclosure: This information is intended for educational purposes only. No recommendations are made. Individuals should do their own research or consult with an advisor before making investments.

Number 1 Principle Of Successful Investing

HOPPY EASTER

DON'T PUT ALL YOUR EGGS IN ONE BASKET! Although a bit late for former Enron employees, hopefully this helps a gold bug or two :)

Financial Literacy - Some Thoughts

Most interested observers agree the nation has a financial literacy problem.  In honor of Financial Literacy month, Digerati Life presents her thoughts and argues in favor of mandatory high school classes in money management skills. Most agree that financial illiteracy played an important  role in the 2008 housing crisis and is the fundamental factor in the ongoing struggle families have with credit card and other types of debt.

The departure point in the debate is how to solve the problem. Many people are quick to jump on the bandwagon calling for classes in high school and elsewhere, mandatory testing, and the usual type of solutions. Many are willing to throw a lot of money at the problem. Some, in fact, would have a lot of money thrown their way if their solutions were adopted.

A different view is expressed by Lauren Willis. A professor at Loyola Law School of Los Angeles, she has written "Against Financial literacy Education."  Ms. Willis does something  not typically done in this debate. She brings to bear evidence, and she thinks in terms of costs and benefits. She finds that the costs far outweigh the benefits.

One of the difficulties, I believe, is that financial literacy is such a wide-ranging subject area and  means different things to different people. Ms. Willis mentions the futility of turning people into "...financial experts."  This, to me and I suspect many others, is a bit of a strawman argument. Few proponents of financial literacy would even put themselves forward as "financial experts."  Most, themselves, use experts on complicated financial questions. They will have attorneys look over contracts and mortgages. They'll turn to financial advisors for investment advice and financial planners to do financial planning.

But, at the other end of the spectrum, there is the basic thinking about wants and needs. There is the basic understanding of compound interest and the value of saving and investing at a young age. There is the understanding of the basics of investing.

Extending these concepts to study how to think about buying a car or the analysis that goes into thinking about renting an apartment or even the whole subject of student loans is fairly straightforward. In fact, from the teacher's perspective, all of these subjects readily lend themselves to highly interactive classroom projects that students are interested in.

Even closer to home is the fact that there are really good blogs that speak to young people and cover these subjects in an entertaining way. I frequently recommend, for example, Ramit Sethi's blog to young people. Reading his blog for a year will ramp up people's financial literacy - both young and old.

The part that is not so easy is teaching when people need to get advice, when they need an objective analysis of whether they can afford the mortgage or whether they should take the adjustable rate loan or fixed rate loan.

It's Not Just the Rate of Drawdown

One of the stickiest problems in personal finance is determining a safe rate of nest egg draw-down in retirement. Original studies by William Bengen  showed that 4% of the starting portfolio value, adjusted for inflation, worked in many market scenarios for a given asset allocation. This rule-of-thumb has been bandied about and debated ever since. The thing is that, because of the nature of market,s we can never be sure. By definition, we are dealing with averages and probabilities and talking about what worked in the past. The future of course is unknown. What if we (gasp!) run into a 20-year period of down markets?

This subject is presented at "Free Money Finance" and centers on a recent piece in the New York Times. The Times notes that, if you retire near a market peak, then, when the market drops, your probability of success declines as well if you continue to withdraw the same dollar amount.

As a counter, the Times suggests flexibility by allowing the withdrawal rate to vary between 2.5% and 5% depending on market experience. This, of course, borders on the ridiculous as "Free Money Finance" points out. If you can vary your income between $20,000 and $40,000, say, then you're home free. "Free Money Finance" points out more viable solutions.

My quibble with all of this is that the studies tend to be simplistic. They assume stock funds are systematically reduced in down markets as retirees get their income by selling stock and bond funds. But the subject has progressed. Most people today, especially the researchers, know that retirees need a plan in withdrawing assets. Some people say put the assets in buckets with the first 5 years in short-term funds. My approach is to put about 1 year short-term and structure the portfolio to throw off dividends and interest of at least 60% of income needs (2.4% yield) to replenish short-term fund.

Whatever the approach, enhancing the sophistication of the withdrawal strategy greatly enhances the probability of success, i.e. the probability of not outliving your money. In fact, it worked well in actual practice over the nasty downturns of the last decade. The studies need to take this into account.

It's time that studies explicitly incorporate this into their analysis.

How to Screen for Stocks

When I was in graduate school pursuing a doctorate in Economics (actually achieved ABD - "all but done" or "all but dissertation" status), I had no question about what I would take as an elective. I took the highest level investment course offered in the business school. This put me as the only economist among a room full of budding MBAs - a bit intimidating, at least for the first 5 minutes, until my fellow students opened their mouths and started to talk.

The professor gave a quiz at the beginning of every class, typically comprised of 2 very basic questions. Apparently aspiring MBAs need a motivation to do the assigned reading.

At one class, the question was "What is a screen?" The class clown answered that it is a device that is used in the summer to keep flies out - amusing to everybody except for the professor. This was the exact same guy who announced before class one day that he had finished the semester paper that accounted for 50% of the grade. This was a week after it was assigned and 6 weeks before it was due. Do I have to tell you that he got a "D"?

Hopefully none of you got him as a broker. And, if by chance he is reading this, it is his opportunity to finally to learn what a screen is.

For our purpose, we'll use the New York Times screen. To me, screens are basically a way to test theories. You have an idea on how to find undervalued stocks (which you hope the market will recognize as undervalued in due time!) on the basis of some criteria. Maybe you haven't heard, but there was a guy one time who claimed he was great at picking undervalued stocks. The problem, he said, was that the market never recognized that they were undervalued!

Anyways.......start with the categories as follows.

Source: New York Times

For this basic example, first select "Fundamentals."  The criteria ranges from "Market Capitalization" to "Number of Employees."  Pick market cap. There the range is from""micro cap" to "large ca." Pick "small cap."  At the bottom of the column, you see that there are 1,968 small cap companies in the data base. Click "add criteria."

Next, go back to the criteria and click "Financial ratios."  Now you see 5 criteria. Select the ever-popular price/earnings (TTM). TTM stands for trailing 12 months and refers here to earnings. Range selections go from "lowest" to "highest."  Pick "low."

At this point, we've gone through the data base and picked out small cap, low P/E stocks. The screen has found 245 names that fit these criteria, as you can see if you click "view 245 results."  Here is the partial list:

Source: New York Times

CLICK TO ENLARGE As you can see, the list is alphabetical, with industry listed (valuable for diversification purposes) along with screening criteria.

Obviously, this can get pretty sophisticated because you have at your finger tips a lot of data and combinations you can sift through. Most financial sites offer a screen app so that you can easily pick the one you like once you get the hang of it.

If screening isn't your thing, then buy some index funds, patch the screen on the front porch, open a cool one and kick back.

Calculate Your Comeback

People like to compare financial magnitudes with their peaks. I caution against this because it generally serves no purpose except to make one feel badly. You'll know what I mean when you hit your 50s...anyways.

Once I met with a distraught potential client  and she  ( a psychologist no less), explained to me, in early 2009,  as tears practically welled up in her eyes, that her portfolio had been $1.2 million and now it was down to $850,000. I responded, in a commiserating way, that it must be difficult to have put in a million dollars and see it drop like that.  She straightened out and responded that she had not put in a million dollars. She let me know that she kept close track of how much she put in and that it was $600,000 ish (she knew the exact number - I'm rounding here because the exact number escapes me).

Whenever I see someone talking about how much their portfolio was worth at its peak I think of this lady.
Anyway, I came across a neat calculator for figuring out how to calculate how long it will take to get back to the peak value given certain assumptions at "Calculate Your Financial Comeback".

Source: New York Times

CLICK TO ENLARGE Just put in your numbers, slide the slider to your expected return and hit the "calculate" button. The result will be the number of years and a graph showing the growth of your portfolio.

The portfolio simplistically assumes that the assumed rate of return is achieved each year (AND WE KNOW THAT WON'T HAPPEN!) so the results have to be taken with a grain of salt. As we know whenever you are putting money in (building up the nest egg) or taking it out (drawing down the nest egg) the sequence of returns is important .

As it happens many people who kept on course and contributed regularly to take advantage of dollar cost averaging have exceeded or are close to their peak value.

Now if can just stop comparing the value of our house to what it was worth in 2006!

Demise of QE2 - What Does it Mean ?

Little Johnny falls off the chair and scrapes his knee. What do you do? Do you run over, scoop him up, and scold the chair? Do you assess the damage out of the side of your eye? Do you ignore his crying and let him gather himself  - hoping that he is learning a lesson from this?

It is very likely you won't always be there to scoop little Johnny up. There comes a time he will have to take care of his own scrapes. There is a point where he will dry his eyes, look around  and realize nobody's coming to his rescue. He's going to have to pick himself up.

The financial markets have a "little johnny  problem' of their own right now, albeit probably temporarily. On June 30 the program known as "Quantitative Easing 2 " (QE2) is scheduled to end. This program supports markets by buying large amounts of Treasury securities. It was initiated in March 2009 and is generally credited for the 90% increase in stock indices since then as well as sharp rises in commodity prices and the weakness in the dollar. Most importantly, it is credited with scooping up a damaged economy, brushing off its shorts, and putting it on an upward course.

Some have used the apt "taking off the training wheels" metaphor. Inevitably when economies are artificially stimulated, there comes that time where the stimulation has to be ratcheted down and eventually ended. Wait too long and we end up like China, where it is pushing interest rates higher and increasing bank reserve requirements to fight off inflation as the world watches nervously.

A subtle problem can arise if it actually works smoothly- the training wheels come off and we go pedaling down the road with a recovering economy and financial markets behaving. Bernanke and cohorts will likely have an ongoing high-fiving party and then, when we hit the next bump, be fast on the draw to pull out the QE tool again. This is what leads to longer-term problems. This is what makes Johnny an adult who needs help blowing his nose. A recent example of this was the so-called "Greenspan put" whereby the former Fed Chairman lowered rates at every sign of an economic slowdown--gaining the title of "The Maestro" in the process. Eventually lower rates became impotent, and they had to be pushed to 1%--resulting in the housing crisis and its aftermath.

An even longer-term manifestation of this was the embracing of deficit financing even when the economy wasn't severely weak. We will be digging out of that one for a while.

Walking For NAMI

Source: NAMI/Howard County

Mostly this blog is for getting ideas from others and presenting resources and ideas others may find useful in the investing world. This post is different. It is to ask for support for an outstanding cause - helping families and individuals in the community suffering from mental illness. Today, with state and local governments cutting back funding, your support is more important than ever.

A walk is being held in  Silver Spring, MD at Veteran's Plaza on May, 15 2011. 

I would like to ask you to come and walk with me or to donate to support my
participation in this great event. Visit my personal walker page to sign up:
http://www.nami.org/namiwalks11/MAR/rwazzy. It features a link to my team's page
where you can see who else is walking with me. There is also a link so you can
donate directly to me online. Donating online is fast and secure, and I'll get
immediate notification via e-mail of your donation. 

NAMI, the National Alliance on Mental Illness, is the largest education, support and
advocacy organization that serves the needs of all whose lives are touched by these
illnesses.  This includes persons with mental illness, their families, friends,
employers, the law enforcement community, and policy makers.  The NAMI organization
is composed of approximately 1100 local affiliates, 50 state offices, and a national
office.

The goals of the NAMIWalks program are: to fight the stigma that surrounds mental
illness, to build awareness of the fact that the mental health system in this
country needs to be improved, and to raise funds for NAMI so that they can continue
their mission.

NAMI is a 501(c)3 charity, and any donation you make to support my participation in
this event is tax deductible.  NAMI has been rated by Worth magazine as among the
top 100 charities "most likely to save the world" and has been given an "A" rating
by The American Institute of Philanthropy for efficient and effective use of
charitable dollars.

Thank you in advance for your support.

DIY Investor   

Is This the Key to Success?

Can You Resist?

In this short TED Talks video, Joachim de Posada describes the famous Marshmallow Experiment conducted in 1972 by Walter Mischel at Stanford University and presents his reproduction of the experiment with Hispanic children. If the video doesn't get you to laugh out loud, then (seriously), at your next physical, when the doctor asks if there any problems, tell him or her you've lost your sense of humor.



How important is the ability to delay gratification? DIY Investor would argue that its importance has increased over time with the advent and widespread use of credit cards along with the increased bombardment of ever clever advertising. I can't say that I've seen it, but I'm sure someone has worked up the number of advertisements we see within the first 15 minutes of logging on in the morning. Delaying gratification isn't easy; and, as Mr. Posada says at the very end, it is undoubtedly an important factor in the debt crisis the U.S. is now experiencing.

Follow Up Questions

This experiment has always fascinated me and suggested follow-up questions. I wonder if you do this with 100 kids who have older brothers and sisters, if it makes a difference compared to those who are an only child. After all, with older brothers and sisters you have to learn to wait for the things you want.

I wonder about the influence of parenting styles. To me, there are two types of parents. Johnny climbs up on the chair, falls off, and gives out a banshee scream and one type of parent runs over, scoops him up, scolds the chair, etc. The other expects little Johnny to pick himself up and take care of himself, reasoning that he got himself into the predicament. An aside:  guess which family votes Democrat and which is Republican?

I also often wonder why a presenter, like Mr. Posada,  in a presentation like this doesn't mention the person who originated the experiment.

Dividend Stocks and Dividend ETFs

Searching for yield but don't know where to turn? The blogosphere has plenty of recommendations. One of the prominent recommendations has been dividend stocks. There are a number of excellent sites that analyze and recommend dividend stocks - in other words, bloggers who do a lot of the work for the do-it-yourself investor. Some that I read on a regular basis include:

• Dividend Growth Investor
• theDividendpig
• The Dividend Guy
• The Passive Income Earner       

 The newbie investor does have to understand, however, that dividend stock investing isn't just a matter of picking the highest dividend stocks. A real key is sustainability. The long-term record of dividend payments and whether they have been increased on a regular basis is important. Whether companies will maintain and possibly increase dividends in the future depends on their financial health and prospects.


For those interested in going the exchange traded fund (ETF) route, an excellent article "Avoiding the Dividend ETF Trap" by Michael Rawson CFA, discusses how to pick ETFs that concentrate on dividend stocks. His article provides a useful table for comparison purposes that presents performance and states the approach used by ETFs in their dividend stock selection process.


I highly recommend the Rawson article to those seeking dividend ETFs. Another useful resource is the "Seeking Alpha" income investing page.

Are Mutual Funds a Scam?

Mark Hebner, CEO of Index Fund Advisors (IFA), gives his no-punches-pulled views on actively managed mutual funds to Henry Blodgett of Yahoo! Finance. He is of course "talking his book" since he heads up a $1.5 billion index fund management company. My perspective is this:  the evidence overwhelmingly shows that, after fees, it is very likely that you will under perform the market with an active fund over the long run. So, why risk your retirement assets in this endeavor?  Instead, if you buy into the long-term viability of the U.S. and global economy, then take advantage of the low-cost ways to participate.

The IFA website is worth a visit. Contains many useful resources.
Source:  Yahoo! Finance
Disclosure:  Information is presented for educational purposes and not intended as a recommendation.

How to Calculate Expected Inflation

Inflation expectations affect markets. Analysts scramble to find stocks with pricing power, investors sell fixed rate bonds, and consumers borrow to the hilt when expectations change.  Commentators make all kinds of predictions and debate the impact of Federal Reserve policies. When inflation worries start to rise, investors sense it; but how can expectations be measured more precisely?

Source:Bloomberg

Actually it is quite easy. Go to Bloomberg and the drop down list at "Market Data."  Click "Rates & Bonds". You'll see the rate on the 10-year U.S. Treasury note. Today it was 3.52%. CLICK TO ENLARGE.

Source: Bloomberg

Next scroll down on the Bloomberg page to the 10-year Treasury TIP (Treasury Inflation Protected Treasury note).  You'll see the yield is 0.87%. CLICK TO ENLARGE

To calculate the expected rate of inflation, just subtract the TIP rate from the 10-year Treasury note rate:  3.52 - 0.87 = 2.65%.

Why does this work? If the rate of inflation exceeds 2.65%, then investors will do better in the TIP note rather than the regular issue. This is because the principal amount of the TIP is adjusted by the rate of inflation.

By doing this calculation once/week or so, the DIY investor will get a feel for how inflation expectations are changing.

What 's My Job?

Client: Where's gold headed?
Financial Advisor: I have no idea.
Client: But that's your job.

Alternative scenario: Stocks have dropped 10%. Client is bummed out (70s expression)

Client: Why didn't we sell? Couldn't you tell that stocks were going to drop?
Financial Advisor: I don't have a crystal ball. I can't forecast stock prices. Forecasting stock prices is not my job.

Every advisor is familiar with this scenario. 

I don't speak for all advisors here. Some, in fact, see themselves as gurus. They see themselves as prophets. Hey, if it works for you, then go for it (referring to clients here). I belong to the "there is more than one way to skin a cat" club.  DIY Investor would, however,  like to offer the following quote from Benjamin Graham:

If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

Graham is one of the legends of Wall Street and Buffet's mentor, no less. Again, if you believe your advisor, your newsletter writer, or a talking head on CNBC over Benjamin Graham, then go for it. It's a free country, as they say.

So, if my advisory practice isn't about predicting markets, what is it about? What do I do to earn my fee? I go over this very carefully with potential clients but some don't really hear, although they nod throughout the explanation. So it's worth going over again.

I set up clients with a well-diversified portfolio that will capture close to the market return over the long term. I explain that the portfolio will at times experience choppy waters where markets will get scary, but that it will be able to withstand the down periods and will be positioned to participate in ensuing recoveries. I explain the desirability of down markets for those building up their nest egg and how the process of dollar-cost averaging works. For those in retirement and drawing down their nest egg, I explain the need for a plan - some type of "bucket" approach where a sufficient reserve is kept to ensure that they don't need to liquidate stock holdings at extremely adverse prices.

So when your friend introduces me as his/her advisor, don't be surprised at my response when you ask "so where's the market headed?" It's not my job!

Who is Bill Gross and What is He Telling Investors?

When I was a kid in North Carolina, the pool lifeguard would end our "sharks in the water" game with a big "everybody out of the pool " proclamation. It was mainly to give the life guards a chance to catch their breath and the adults a little stress-free swim time. It turns out it was also advance training for navigating investment markets.

Bill Gross, manager of world's biggest bond fund at PIMCO, has cut government linked debt to a negative percentage of his Total Return Fund's $236 billion portfolio and is publicly renouncing Treasuries as an investment choice. This is his "everybody out of the pool" statement. Cash equivalents now comprise 31% of portfolio assets, up from 23%, the highest percentage in 4 years.

Gross is concerned about the impact of the Federal Reserve ending its QE 2 Treasury buying program. He asked, “The question remains, when the Fed stops buying Treasuries, does the private sector take the baton and run the last leg of the relay race?”

This is an important week in this unfolding drama due to some important inflation data being reported as well as Treasury auctions taking place. On the inflation front, the market will get CPI , PPI , and import price reports. The core rate of the CPI (ex food & energy) is expected at 0.2% (roughly 2.4% annual rate). Above that and it could spook the market.

The key auctions will take place on Wednesday and Thursday. On Wednesday, the Treasury auctions 10-year notes and on Thursday the 30-year bond. How these auctions go depends a lot on investor's inflation outlook.

This is all playing out with the ongoing budget talks and looming debt ceiling issues adding a bit of spice. It's not hard imagining a perfect storm brewing.

Financial Contagion - An Interactive Graphic

Source: Washington Post

What could be more fun than wrapping up a rainy, blustery weekend than by playing around with an interactive graphic from The Washington Post that nicely illustrates potential financial contagion? This, of course, is much in the news these days as countries wonder, for example, about the impact of Europe's debt problems as well as the U.S. grappling with its debt problems.

The graphic is Europe's financial contagion by  Neil Irwin. CLICK TO ENLARGE . By clicking on the link, you'll see the so-called PIIGS on the left. Running your cursor over the various countries, you can see loan exposures as well as trade flows as a percentage of GDP. For example, Ireland's loans to Greece amount to 4.6% of GDP. Next, by running your cursor over Ireland, you find that Portugal is its biggest creditor with loans /GDP in excess of 8%. In this way, you can trace a contagion effect of one country's problems affecting others.

Note that the extent of the impacts is illustrated by the thickness of the arrows. DIY Investor is admittedly impressed by people's creativity in presenting data in the internet age.

DIY Investor believes that financial contagion gained prominence in 1997 when Thailand experienced currency problems. Most analysts saw it as a non-event - after all, Thailand is a small country on the global stage. Thailand's problems however quickly spread and eventually affected South America.

Start at Community College or 4 Year School?

Ron Lieber of the New York Times has written an excellent column on this question: "Bargains on the First 4 Semesters."

Given the dollar amounts involved, the financial planning considerations are important. The parent's retirement plans can be affected by the choice of college along with the student's loan burden.

The article contains excellent recommendations along the lines of checking out the community college, talking to advisors, not taking courses that are too specific at the community college, finding out how many transfer students actually graduate from a 4-year college, etc. To me, anyone who would follow these recommendations is a serious student and would have no problem going the community college route. The worry for many people is the academic environment. I have taught at both the community college level and a 4-year major college. The academic environments are different.

The community college I teach at is nationally recognized as an excellent institution. It has outstanding honors programs from which the transfer rate is exceptionally high and for which the 4-year graduation rate is high. To me what is  lacking, compared to a 4-year university, is the opportunity to join a hard-partying fraternity or sorority and big-time college sports. The education in the honors programs at the community college can be, I believe, superior to the university for the first 2 years, when individualized attention is considered.

Away from the honors courses, community college is a bit different; and the student who desires to successfully transfer to a 4-year school needs to be highly motivated. The non-honors courses are populated by students who decided at the last minute to attend community college (maybe because they couldn't get a job), didn't take a college level track in high school, have no idea of a career path, and very likely are taking remedial math and English courses.

At the university, it is different. Students have prepared for college in high school, have gone through a rigorous process to get accepted, and many have the necessary math and English skills.A higher percentage of the students know why they are there.

One advantage I believe that the community college offers is that the instructors tend to have real-world experience. Many of the instructors are adjuncts who are practicing law, accounting, economics, or nursing in the real world and can provide excellent advice on career paths.

I, for one, felt I was better prepared entering the university 3-credit-hours-short of junior status with an AA degree from community college.

The Lost Decade?

Frequently a phrase arises that captures a certain sentiment, and it proliferates to the point where it is repeated without thought. "The lost decade," describing the 10 years ended 12/31/2009 is, IMHO, such a phrase.  Everyone knows that investors got beat up over this 10-year period and their investments lost ground. Did they really? Which investors lost ground? How did the market indices do?

A financial columnist for Financial Planning magazine, Bob Veres, has written an insightful article discussing the difference between investing and gambling in which he provides some performance numbers for the so-called lost decade.

He states that, over the 10-year period ended 12/31/2009, the Wilshire 5000 had a negative average annualized return of -0.2% but the mid-cap index was up 4.6%/year and the small cap index rose 4.3% on average per year. International stocks lost -1.1% on average per year.

He goes on to say that with "...a reasonable percentage of bonds..." and rebalancing at least every year and "...at best opportunistically..." aggregate returns would have ended up a bit higher than 3%. As he points out, this isn't a performance that gets you "...shrieking in triumph"... but it did beat the rate of inflation.

All of this is used to argue that the odds in investing, even over a period of horrible luck relative to historical performance, are considerably better than you'll find in Vegas and other realms of the gambling world. My take-away is that, although the decade was a rough patch, it wasn't really a "lost decade" especially for those who followed the principles of diversifying among asset classes and rebalancing. This, of course, hasn't even touched on those who took advantage of dollar-cost averaging.

AAII Less Bullish

Individual investors are duly noted whenever they are on the wrong side of the market. In fact, their posture at any point in time is a widely used contra indicator. When they are positioned bullishly (i.e. for a rise in stock prices), many market timers take it as a negative sign, and vice-versa. And, that has happened over the past decades and has frequently been a major story. What doesn't get reported is when they get it right. And they got it right last year.

According to the Bullish Sentiment indicator of the American Association of Individual Investors (AAII), 45.3% of respondents were bullish 12 months ago. That compares to an historical average of 39%. The S&P 500 rose a bit more than 14% over the past 12 months.

Today AAII's Bullish Sentiment indicator stands at 36.0%, below the historical average but about 6% above the percent of respondents who are bearish. That leaves approximately 34% in the neutral camp.

What are you at this juncture - bullish or bearish?

A Tool for DIY Investors - Schwab ETF Select List

There are now thousands of ETFs, and they are proliferating almost faster than stink bugs. The challenge today is how to select among all the ETFs available.

One approach is to use, or at least start with, the Schwab ETF Select List. This list highlights the best ETF for each category, according to Schwab, based on wide ranging criteria, including "...assets under management, length of track record, trading volume, bid-ask spread, tracking error of the ETF to its underlying index....." The investor considering this resource should read the one-page write up of the selection process. DIY Investor and the working guy carrying all the tools, likes the fact that the list "...excludes leveraged ETFs, inverse ETFs, ETNs, actively managed
ETFs, muni bond ETFs with underlying holdings subject to AMT, and unmanaged baskets of securities."

Source: Schwab

How would a DIY investor use  this list?  Suppose, for example,  after the recent events in Japan, you were interested in seeking a Japan ETF. One way to proceed would be to pull up the 2-page Select List and look at the "International Equity ETFs" shown on the left.  CLICK TO ENLARGE.  Immediately, you find a Japan ETF, EWJ, and see its expense ratio and whether it has a trading commission.

Test question:  How fast can you find Schwab's recommended ETF for the telecommunications sector?

Disclosure:  I am not affiliated with Charles Schwab. The information in this post is for educational purposes only.

A Tool for DIY Investors - Morningstar X-Ray

DIY Investor's client portfolios are like people - they come in all shapes and sizes. One of the first steps DIY Investor undertakes for a new client is to work up an asset allocation for all of the client's assets. Then the actual asset allocation is compared to the desired allocation, which produces a road map for our destination. After all, as we all know, asset allocation - the percent invested in stocks, bonds, commodities, real estate etc.- is the primary determinant of investment performance.

But what do we do about mutual funds? After all, mutual funds don't invest solely in what you think they invest in. How can the DIY investor find out the asset allocation of a mutual fund?

Let's illustrate with an example.

A recent client had stocks, bonds, ETFs and mutual funds. Everything asset-allocation-wise was straightforward except for the mutual funds. The client held $31,700 market value of BlackRock Global Allocation Fund (ticker symbol MALOX), $20,800 First Eagle Global Fund (SGENX), and $31,700 T. Towe Price Emerging Markets Fund (PREMX).

Source: Morningstar

 To work up the asset allocation, go to Morningstar's x-ray tool. Simply put in the values as shown.






Scroll down and click "Show Instant X-Ray.:  The upper left hand portion of the page gives you the asset allocation as shown:

Source: Morningstar

CLICK TO ENLARGE

As you'll see, there is a lot more information on the page. Notice the "Fees and Expenses" section on the left hand side as you scroll down at the site.

Why Build a Nest Egg?

Source: Hammacher

Adrian at 7Million7Years has an interesting post on "The Fisherman's Fallacy."  It raises questions of what retirement is, why we save for retirement, and how our views change. I know young people who really don't see the point of struggling to build a nest egg. They're happy with a few good video games and the time to play them.

In the  fisherman's fallacy, the Wall Street banker approaches the man who fishes a few hours and spends the rest of of his time playing cards with friends and family. The banker explains to the man that, with a few years of  hard work, he could build a nice business that would enable him to retire and fish and spend the rest of the day with his friends - in other words doing what he's doing now.

Why would he even consider working hard to get to do what he is already doing? Read Adrian's post to find out.

Biz Expo

Yesterday DIY Investor participated in a Biz Expo, where local small businesses gathered at the community college and people in the community passed through, checking out the businesses.  Next to DIY Investor was a weight loss business and, on the other side, a food supplement business that takes away wrinkles. Hard to beat - DIY Investor could lose both pounds and years. My challenge was to explain to people, presumably after they were skinnier and more youthful-looking, how they could make money.

DIY Investor finds the world of small business invigorating. It is hard to find a more passionate group - start reading the literature on their table and they silently bite at the bit waiting to explain it all to you. Ask them how their business is going and their demeanor changes slightly, but only for a moment; it is imperceptible if you aren't looking closely. Starting a business is tough and, in this economic environment, it is even a bit tougher. Still, most entrepreneurs are hard nosed and  obviously feel their product or service is something the world needs but just doesn't know it yet.

For DIY Investor, promoting his services at this type of event is a challenge.  Simply, people are not prepared for retirement and, in a minute or so in a crowded aisle, DIY Investor has to try to persuade people to think about their retirement. I should keep a tally on how many people tell me they should be saving for retirement but aren't. Reminds me of  talking to smokers years ago.

 I should also write down the number of people who walked through and told me they didn't know if their company had a 401k or similar retirement plan or the people who told me they didn't know anything about it - their husband or wife handles it.

It even is hard to get across to those who have a more basic understanding and actually have an advisor that they are likely paying their advisor between 1 and 2% and, if their advisor is putting them in mutual funds, the funds themselves are charging, on average about 1.4%.  Most of those using broker/dealers have no inkling that their advisor is getting paid on what they are selling them. Some agree, as if they knew this, but claim their advisor still has done a good job. I ask them about their performance and they look at me blankly. To them, performance is absolute dollars. If their $1.0 million portfolio increased $80,000 last year, they believe their advisor did a good job. They don't really know that they seriously underperformed the market.

For those who want to chat a bit, I explain low-cost indexed investing. I encourage them to spend a weekend reading one of the books on my table (Bernstein, Malkiel and Ellis, Solin).  I tell them that I am not the only one offering low-cost investment management services ( although I thought I was when I first started). I also tell them I can do something I believe no one else will do for them. If they are so inclined, I will manage their assets for a period of time during which I will show them how to do it themselves .The bottom line is that they could, with a little effort, retire a couple of years earlier. What is that worth?