The Investment Policy Statement - a Resource

As an investment manager of institutional funds, I came to appreciate the value of an investment policy statement(IPS). The IPS typically specifies investment philosophy, permitted investments, rebalancing parameters, meeting dates, etc. In other words, it keeps everything in the investment process on track. It also provides a readily available history on how the fund was managed and is especially useful for transition purposes. The first thing a professional asks for when taking over a fund is typically the IPS.

DIY investors can profitably use this tool as well and can thereby change an ad-hoc investment approach into one that has some structure. The Bogleheads' Guide to Retirement Planning by Taylor Larimore et.al. has two examples starting on page 137 of their book. Both examples are less than a page in length.

Both examples have a "How Much to Invest" section. For "Captain Susan Saver" (I'm not sure how they come up with these names) she states,

I am currently investing $500 a month, which is about 10 percent of my pay. I will maintain the same percentage every year as I get a pay increase and invest half my raise when I receive a longevity increase or get promoted.

Putting the process in writing in this manner in itself creates a discipline to the investment process. Do you use individual stocks? What percent of total assets will be in bonds? What is the percent deviation you will allow asset classes before you rebalance? What is the maximum amount you will invest in individual names? All of these should be addressed in the IPS.

The IPS is also a good place to put down goals, etc. in terms of desired retirement, funding education needs, and so forth. The bottom line is that another person could pick it up and carry out your investment approach.

Developing or reviewing the IPS is a good way for the DIY Investor to start the new year.

Bernanke Interview

Here's the Bernanke 60 Minutes interview. He says he is not printing money. What does he think it is when you take a blank check book and you start buying Treasuries? Let me help him. The seller of those Treasuries takes the check and deposits it into the bank. It then is a deposit. M1 by definition is the sum of currency, demand deposits, other checkable deposits, and Travelers checks. Here's a graph of m1 -- you decide if the Fed is printing money.

Our Fed Chairman doesn't seem to know how this works. He doesn't seem to know that the graph of both currency and m1 are both on a moonshot. He says he is not printing money. What then explains the sharp push up in the money supply - we know it's not bank lending.

He says the Fed didn't understand what was happening with insurance companies (and Lehman Brothers, for that matter) because insurance companies fell outside the regulatory scope. The fact is that the garbage they were insuring (especially AIG) was held by the banking system off balance sheet. This huge build-up was never mentioned in FOMC meetings! The fact is that the Fed meets with the primary dealers daily, and Bernanke expects the American people to believe that they were unaware of the credit default swaps taking place? He is saying basically that the Fed, who is responsible for overseeing the health of the banking system, was unaware of the actions that came close to undermining the whole system.

The Federal Open Market Committee was perhaps more interested at the time in the heady process of fixing prices a la maestro Greenspan.

The American people need to impeach Bernanke. He is clueless, and now he is being disingenuous with the American people.

Don't Burn the House Down

Whether you are talking about an electrician or an investment advisor, professional services cost. And man's instinct is to avoid costs where possible. Woman's instinct is to raise her eyebrows. Eyebrows were raised as I set about to wire my family room. My thinking was that with a few weekends, a couple of six-packs, and the Reader's Digest Homeowners Guide I could save some bucks. I figured I would read a bit until I understood where the black wire goes, the white wire goes, and how to do the ground; and I would be on my way.

In the beginning, it was pretty easy. I got one of those drill bits that makes nice holes and drilled the holes to run the cable thru the 2x4s exactly as illustrated in the book. Going by the book - no problems. Hammered in the outlet boxes and put in the receptacles. Read up on how to strip the wire and, making sure the central power was off, started hooking stuff up, thinking all the time how I was beating the game.

Then my wife pointed out you could only turn the lamps off from one switch. She wanted to turn them off from two switches - entering and exiting the room. This was the next chapter - three way switches. No problem. This is where the chapter in statistics on permutations became real. I hooked up the switches according to the diagram on the 3-way switch package. ,Worked at one end, not the other.

Changed some of the wiring around after going to the Reader's Digest Book. Now it worked at the other end, etc. This is what you come to understand - with 3 wires and 3 places, they can be hooked up and two switches there are 17,653 different combinations. The permutations formula in statistics books is wrong.

Anyways, to make a long story short, a friend of a friend came over, looked at the situation, asked for my screw driver, changed a couple of wires and presto! - fixed the wiring inside of a minute. He didn't even look at the diagram. He could have at least pretended to look at the diagram.

All of this was no big deal - cost a couple of beers and some frustration. I learned that I could do simple wiring but the complex stuff should be left to the professional. At least that's apparently what part of my brain learned.

Time went by, my wiring experience receded to the reptilian part of my brain, and the Reader's Digest book went back on the shelf. Then the day came when the dryer needed to be moved. The amygdala stirred.

This is my advice - not appreciated at the time - don't try to wire a dryer. It is serious business. I changed wires around so much I ended up convinced that the dryer had to be broken. We must have broken it when we moved it. My wife pointed out it worked fine yesterday. , I appreciated that.

This time I called in a professional electrician and he looked at it and laughed. I provided his laugh of the day (that made me feel like I had accomplished something!). He looked at me with tears in his eyes and asked who had done the wiring. I guess he could tell by my expression it was me. As he walked out the door he muttered, loud enough for my wife to hear, "Lucky he didn't burn the house down."

That ended my career in wiring. The days came when the kids were upset that I wouldn't help them hook up the batteries for their science fair projects. They just didn't know.

For the DIY investors out there, think about bringing in a professional from time-to-time to discuss your investment program. You don't want to burn the house down.

Number 1 Top Tip for Financially Safe Retirement

In "Top Ten Tips for a Financially Safe Retirement," Tim Begany lists "An Immediate Fixed Annuity" as number 1.

This is interesting because it is how you convert today's 401(k)s/IRAs etc. into your father's pension plan. In other words, there is no need to sit around whining that we no longer have pension plans like in the past.

It is interesting also in that most people who use a financial planner will never have had the option presented to them - even by fee-only RIAs who puff themselves up proclaiming their fiduciary status. Why is that? It is simple - if you put the money into an immediate pay fixed annuity, the RIA won't have the funds to invest for you; and investing your money is where they make their money.

Imagine people who retired in 2007, when yields were higher, and before the sharp downturn in the market. Instead of going through that traumatic experience with their retirement on the line, they could have locked in a lifetime income stream of payments greater than that available today. Shouldn't their financial planner have suggested this for at least a portion of their retirement assets?

The Free Market is Dead

Sometimes we need to go back to square 1. The first day in Econ 101, after the administrative stuff is taken care of and before students start dozing off, a definition of economics is written on the board. It has to do with the allocation of scarce resources. Subsequent classes discuss different ways this is done (capitalism, socialism, control and command economies, etc.) and emphasis is put on the marvels of the free market system.

Keynes eventually comes into the picture, and the class is introduced to the conflict between his policies - at least the way they have been interpreted and applied - and the free market ideology.

I rehash all of this because of its relevance with today's conflicted macro economic policy making. I recently read an interview in which Treasury Secretary Geithner was asked what surprised him when comparing what he learned in graduate school to the real world. He said it was the practical application of Keynesian policy to the economic problems the country is now facing. In other words, he wasn't enamored with Keynesian policies in graduate school. Today he is. That the U.S. , and the world for that matter, is 100% Keynesian despite protests from the peanut gallery is beyond dispute.

This scares me because the policy makers are learning on the job - on my dime and your dime so to speak. They learned one thing and are applying another. To show how that is scary, let's take a look at a chart I found on NPR's Money Planet:

CLICK TO ENLARGE
From late 2001 to the middle of 2003, the Federal Reserve saw its mission as pushing down the federal funds rate to stave off possible deflation. It pushed rates to historically low levels. At the same time, the administration was promoting the theme of home ownership as the American dream. Mortgage brokers went wild producing esoteric mortgages and playing fast and loose with long-standing standards in order to qualify anybody and anything that was breathing.

All of this today is common knowledge, although there is still a general confusion, in the minds of many, of who exactly screwed up and who exactly is to blame.

Now let's look at the chart and think back to the definition of economics. During the 2001 to 2003 period, resources were allocated artificially - not by the market. In effect, central planners (Greenspan and Bernanke at the controls of monetary policy in conjunction with the administration) directed resources to the housing sector. Jobs were plentiful to build houses, sell houses, broker mortgages, etc. Resources were allocated to these sectors by Fed policies, not the free market. But then, in mid-2004, the central planners found they had been too aggressive and reversed course - they pushed interest rates up sharply.

After carrying out a policy that got people to buy houses they couldn't afford and then use their houses as ATMs, the Fed turned on a dime and wiped out the equity in people's houses.

Today people are scratching their heads. Why won't companies hire? Again, look at the chart. Notice that today construction is struggling. Fed policies put millions of people into housing and related industries and caused a severe over-building. The over-building was so severe that today, when money is practically free, real estate is still struggling. But this is Econ 101 stuff. Maybe 8 years ago, some of the people who saw the modern day gold-rush in mortgage banking brought about by Bernanke and his cohorts would have gone into health care or where a free market would have led them.

Here's my question: Have we learned anything from this? If you ask Greenspan, Bernanke, Geithner and much of Congress, they will respond by pointing fingers at players on the fringe. They'll point to rating agencies, securitization practices, mortgage bankers, etc. And they will continue in their central planning ways.

May the free market RIP.

I Love Capitalism

Once again, Grouch has posted an awesome video that I just had to pass on.



I was once at a flea market where an elderly lady kept holding algebra videos in her hands and clearly was on the fence about whether she should buy them. As sometimes happens, I couldn't help commenting, "Thinking of brushing up on your Algebra?" "No, no"," she said, "I'm thinking of these for my grandson." She told me how her grandson was struggling with math and how possibly the videos might help. I agreed and then suggested that, maybe the next time he asked to go to a movie or to be taken to the mall, she could say that she would take him if he completed a lesson on the videos.

That was not the right thing to suggest. She let me know that would be bribery and that she would never bribe her grandson.

At this point, you're probably wondering what all this has to do with the video from Grouch's site. Actually, capitalism is a type of bribery economic system. It bribes you to get out of bed every morning (even in the cold and with a hangover) to go out and do something positive for society. The bribe is, of course, a piece of the pie that the society produces. Economists prefer the word "incentive."

Think about the role of capitalism - private ownership of the means of production - as you view the world 's wealth increasing in the video.

Anyways, enjoy the video. I've often wondered how that grandson turned out and maybe if today he wished his grandmother had bribed him.

Michael Jordan's House

OK. So Michael Jordan bought a house and, all in, it's going to come to around $20 million. This has gotten a lot of commenters' knickers all in a snit. And the economics of it all is coming out. How could someone who played a game afford that kind of house when average Americans who worked "real" jobs all their lives blah! blah! blah!... The same arguments that come out over and over and that are dealt with in econ 101 - at least they should have been dealt with.

First off, I will admit that I find it hard to understand how someone wants a house with 11 bedrooms, a two story guard house etc. My house has 4 bedrooms and I'm trying to figure out how to downsize. But all of this is besides the point. If he wanted a $20 million purple dog house - hey, it's his money.

Secondly, just for the record, I've never heard of any of the commenters. The world has heard of Michael Jordan. He has entertained millions. That has something, obviously, a bit to do with the economics. When you have a skill that will fill an arena with people willing to pay top dollar, it is rare. Michael Jordans or Lady Gagas don't come along every day. And this gets us into the economics.

Economists worried about this fairness issue early on. They framed it in terms of what they called the diamond-water paradox. How could something like water, which is necessary for life, have a price of zero when a luxury item - total unnecessary- such as a diamond carries a high price. Through this paradox, they came to understand that value in use is not necessarily the same as value in exchange. School teachers, fire fighters, police officers, the military, hospital workers - the most valuable members of society - don't command as much in the work place as entertainers, money managers, etc. Value in exchange is determined by what economists call marginal utility and marginal cost (works out to demand and supply). A flawless diamond is very rare and is very difficult for mother nature to produce and, hence, carries great value in exchange. A glass of water has zero marginal utility (unless you are in the desert) because you've already had a lot of water.

This is important because many people, like the commenters, go a step further and proclaim that the free market system is unfair, etc. They haven't thought it through, but the implication is that they have a better way to set prices - they know what is "fair."

Let's hope it never gets to that point. Better: I would suggest the commenters work on taking off from the foul line and dunking the basketball. Then I'll pay the big bucks to see them. I have to admit, I don't understand the Lady Gaga thing - I just threw that in for effect.